Competition and Scope of Activities in Financial Services

This article analyzes the costs and benefits of different degreesof competition and different configurations of permissible activitiesin the financial sector and discusses the related implicationsfor regulation and supervision. Theory and experience demonstratethe importance of competition for efficiency and confirm thata competitive environment requires a contestable system—meaningone that is open to competition—but not necessarily alarge number of institutions. A competitive banking system canimprove the distribution of consumer credit, enhance the corporatesector's access to financing, and mitigate the risks of financialcrises. In an open market, in which services and products areprovided in response to market signals, financial institutionsrespond by offering a wider scope of financial services. Theoptimal institutional design for supervisory functions is lessobvious.      

PRIVATIZATION: LESSONS FROM MARKET ECONOMIES

In the past decade governments all over the world have begunprivatizing state enterprises—indeed, it is becoming quitehard to find a country without a program of privatization underway or at least on the policy agenda. This striking reversalof the push to expand state ownership in the 1960s and 1970sresults from generally poor performance of state enterprisesand a disappointing record of past reform efforts that fellshort of ownership change. This article examines the objectives of privatization and thestrategies for achieving them, documenting recent trends andreviewing the experience with privatizing state-owned commercial,manufacturing, and service enterprises in both competitive andnoncompetitive markets. The authors analyze the various tacticsthat can be or have been employed, in relation to scope, pace,sequencing, and methods of implementation. The evidence showsthat privatization produces benefits of efficiency and innovation—ifdone right. The lessons of experience discussed in the articleoffer guidance on how to realize the promise of privatizationwhile minimizing the risks and costs.      

Economic Reform and Labor Unions: A General-Equilibrium Analysis Applied to Bangladesh and Indonesia

Noting the trend toward more independent trade unions in developingcountries, this article examines whether the presence of unionsstrengthens or weakens the benefits to be gained from economicpolicy reform. We show that the presence of "passive" unions—onesthat choose their wage-employment contract given the firm'scost-minimizing strategy—increases the welfare gains fromtrade liberalization, because trade reform lowers the wage premiumenjoyed by the unionized sector, reducing a distortion in thelabor market. These gains are amplified when the unions are"active", namely, when they negotiate a contract with the firmthat is off its labor demand curve. Such a contract resultsin featherbedding—paying workers more than their marginalproduct—and trade reform reduces the amount of featherbedding.The policy implication for Bangladesh—a country with strongtrade unions and a protected unionized sector—is thatthe benefits of further trade liberalization may be greaterthan otherwise predicted. In Indonesia, where both unionizationand import tariffs are low, allowing greater independence tounions may preserve flexibility and reward workers better thanthe current minimum-wage policy.     

Diversification of Macroeconomic Risk and International Integration of Capital Markets: The Case of Mexico

This article tests the arbitrage pricing theory in the contextof the unstable macroeconomic years in Mexico, 1977–87.Using information on returns on assets available to domesticinvestors—primarily stocks traded at the local stock exchange—anattempt is made to ascertain the extent to which these assetshave offered premia for a set of proposed sources of risk. Thepervasive factors that play an important role in asset pricingin Mexico are unexpected inflation, unexpected money growth,innovations in the Standard & Poor's 500 price series, andinnovations in the dollar oil price. A residual market factoris obtained, using the McElroy and Burmeister model. Given thatthese risks get premia over and above the riskless rate, expectedrates of return in Mexico have been higher during the yearsof erratic macroeconomic conditions. Mexico is not consideredto be well integrated with the international capital marketsbecause local sources of risk—such as inflation—arenot priced in the United States, whereas international sourcesof uncertainty—such as oil price shocks—are pricedlocally but not in the United States.     

Counting the World's Poor: Problems and Possible Solutions

As recent discussions have made clear, the apparent lack ofpoverty reduction in the face of historically high rates ofeconomic growth—both in the world as a whole and in specificcountries (most notably India)—provides fuel for the argumentthat economic growth does little to reduce poverty. How confidentcan we be that the data actually support these inferences? Atthe international level, the regular revision of purchasingpower parity exchange rates plays havoc with the poverty estimates,changing them in ways that have little or nothing to do withthe actual experience of the poor. At the domestic level, theproblems in measuring poverty are important not only for theworld count but also for tracking income poverty within individualcountries. Yet, in many countries, there are large and growingdiscrepancies between the survey data—the source of povertycounts—and the national accounts—the source of themeasure of economic growth. Thus economic growth, as measured,has at best a weak relationship with poverty, as measured.      

Insights on Development from the Economics of Happiness

The literature on the economics of happiness in developed economiesfinds discrepancies between reported measures of well-beingand income measures. One is the so-called Easterlin paradox:that average happiness levels do not increase as countries growwealthier. This article explores how that paradox—andsurvey research on reported well-being in general—canprovide insights into the gaps between standard measures ofeconomic development and individual assessments of welfare.Analysis of research on reported well-being in Latin Americaand Russia finds notable discrepancies between respondents’assessments of their own well-being and income- or expenditure-basedmeasures. Accepting a wide margin for error in both types ofmeasures, the article posits that taking such discrepanciesinto account may improve the understanding of development outcomesby providing a broader view on well-being than do income- orexpenditure-based measures alone. It suggests particular areaswhere research on reported well-being has the most potentialto contribute. Yet the article also notes that some interpretationsof happiness research—psychologists’ set point theory,in particular—may be quite limited in their applicationto development questions and cautions against the direct translationof results of happiness surveys into policy recommendations.      

Saving Transitions

This article takes a systematic cross-national approach to identifyingsaving transitions— defined as sustained increases inthe saving rate of 5 percentage points or more—to studytheir determinants and to reexamine the question of causalitybetween growth and saving. Countries that undergo saving transitionsdo not necessarily experience sustained increases in their growthrates. In fact, growth rates typically return to their levelsbefore the transition within a decade. By contrast, countriesthat undergo growth transitions—arising from improvedterms of trade, increased domestic investment, or other sources—doend up with permanently higher saving rates. Hence saving transitionsdo not appear to be causal with respect to superior economicperformance.     

HOW WELL CAN METHOD SUBSTITUTE FOR DATA? FIVE EXPERIMENTS IN POVERTY ANALYSIS

No one doubts that good data are essential to sound policymaking.Alas, data are invariably faulty. Methodological solutions todata inadequacies have often been proposed and implemented,but they have been tested only rarely. Yet the methods thatare used may well determine the direction of policy. For example,the particular survey method used—and the way nonsurveydata are interpreted—may be critical in assessing whethera country's strategy for reducing poverty is working. This articleshows how counterfactual experiments can help test the reliabilityof various methods of dealing with common data problems. Well–designedmethods—and they need not be very complicated—canhelp get around the problem, although it appears that substitutingmethod for data is a long way from being perfect.      

CASH FLOW OR INCOME?: The Choice of Base for Company Taxation

Cash flow and equity income (or income) are two alternativebases advocated for taxes on businesses throughout the world.Although in practice most tax systems are hybrids with elementsof both types of taxes, recent literature has stressed the meritsof the cash flow tax because it is simple in concept and itdoes not distort decisions about capital expenditures and financing.But international issues and administrative complexities—particularlytax evasion—present problems that must be sorted out beforea cash flow tax can be implemented.      

TECHNOLOGICAL CHANGE AND COMMERCIALIZATION IN AGRICULTURE: The Effect on the Poor

Do the economic gains brought by technological innovation andcommercialization in agriculture work their way through to thepoor? The prevailing optimistic view is that they do. But thisview is not universal: some hold that these forces for changecan interact with, or even induce, institutional and marketfailure, with adverse consequences for the poor. Adherents of the pessimistic view point to real-world instancesin which the poor have failed to reap the benefits, or evenhave lost, from the technological change or commercialization.Where these effects have occurred we find that they are mostlyattributable to inelastic demand or adverse institutional features;often, when technology or commercialization has been blamedfor the decline in income of the poor, other—not necessarilyconnected—policies have in fact been responsible for thedamage. This article contends that the optimistic view is, by and large,correct: normally, technology and commercialization stimulateagricultural growth, improve employment opportunities, and expandfood supply—all central to the alleviation of poverty.The evidence does not offer much encouragement to an extensionof this view—that through "social engineering" the benefitsfrom technology and commercialization can easily be targetedtoward the poor; the limited opportunities for such targetingshould of course be seized.      

Equilibrium Underdiversification and the Preference for Skewness

We develop a one-period model of investor asset holdings whereinvestors have heterogeneous preference for skewness. Introducingheterogeneous preference for skewness allows the model's investors,in equilibrium, to underdiversify. We find support for our model'sthree key implications using a dataset of 60,000 individualinvestor accounts. First, we document that the portfolio returnsof underdiversified investors are substantially more positivelyskewed than those of diversified investors. Second, we showthat the apparent mean-variance inefficiency of underdiversifiedinvestors can be largely explained by the fact that investorssacrifice mean-variance efficiency for higher skewness exposure.Furthermore, we show that idiosyncratic skewness, and not justcoskewness, can impact equilibrium prices. Third, the underdiversificationof investors does not appear to be coincidentally related toskewness. Stocks most often selected by underdiversified investorshave substantially higher average skewness—especiallyidiosyncratic skewness—than stocks most often selectedby diversified investors.     

Pricing and Hedging Discount Bond Options in the Presence of Model Risk

This paper focuses on pricing and hedging options on a zero-couponbond in a Heath—Jarrow—Morton (1992) framework whenthe value and/or functional form of forward interest rates volatilityis unknown, but is assumed to lie between two fixed values.Due to the link existing between the drift and the diffusioncoefficients of the forward rates in the Heath, Jarrow and Mortonframework, this is equivalent to hedging and pricing the optionwhen the underlying interest rate model is unknown. We showthat a continuous range of option prices consistent with noarbitrage exist. This range is bounded by the smallest upper-hedgingstrategy and the largest lower-hedging strategy prices, whichare characterized as the solutions of two non—linear partialdifferential equations. We also discuss several pricing andhedging illustrations.     

REFORMING FINANCE IN TRANSITIONAL SOCIALIST ECONOMIES

Financial reforms initiated in most transitional socialist economiesdo not yet adequately provide many of the financial servicesassociated with market-oriented financial systems. Such services—mobilizingresources, selecting firms and allocating capital, monitoringfirm managers, and facilitating the management of transactionsand risk—are a necessary condition for economic reformto improve living standards. This article envisages four central strategies to guide reformof the financial sector: • Building an infrastructure based on clear and enforceableproperty rights, modern accounting and auditing standards, reliablepayments systems, sound prudential and enforcement regulations,and professionals trained in finance • Ending the shell game of trying to hide the losses ofstate-owned enterprises, and separating government decisionsto finance "priority" firms from the allocation decisions ofindependent financial institutions • Privatizing some financial institutions early—althoughnot necessarily precipitously—in concert with the privatizationof firms and supervisory capabilities, meanwhile cleaning upbank loans to maximize the chances that firms and banks willsucceed as private entities • Improving the tax system and stressing a prudent interestrate policy to reduce uncertainty, distortions, and excessiverepression of the financial sector.      

Foreign Direct Investment in Mexico since the Approval of NAFTA

Cross-country panel data are used to assess the effect of free-tradeagreements on flows of foreign direct investment (FDI). Free-tradeagreements are found to have a significant positive effect onFDI flows, and free-trade agreements are found to matter morefor the smaller members of the agreement. For example, the NorthAmerican Free-Trade Agreement’s (NAFTA) effect on FDIflows into Mexico is much larger than its effect on flows intothe United States. These cross-country results are used to assessNAFTA’s effect on FDI flows into Mexico. After controllingfor a set of other factors—such as an increase in worldwideFDI flows—the trade agreement is found to generate FDIflows nearly 60 percent higher than they would have been withoutthe agreement.     

Technical Analysis and Liquidity Provision

The apparent conflict between the level of resources dedicatedto technical analysis by practitioners and academic theoriesof market efficiency is a long-standing puzzle. We explore apreviously unexamined feature of technical analysis —namely its relation to liquidity provision. We demonstrate thatsupport and resistance levels coincide with peaks in depth onthe limit order book and moving average forecasts reveal informationabout the relative position of depth on the book. Furthermore,we show that these relationships stem from technical rules locatingdepth already in place on the limit order book.     

WHEN DO HETERODOX STABILIZATION PROGRAMS WORK?: Lessons from Experience

What advantages and disadvantages does the heterodox strategyoffer to stabilization programs in countries with chronic highinflation? Heterodox stabilization programs, in our definition,are those that support orthodox policies— that is, tightfiscal policy and a fixed exchange rate—with the initial,temporary use of incomes policies— that is, price andwage controls. This evaluation, based on several heterodox programs,successful and unsuccessful, from the 1960s and 1980s in LatinAmerican countries and Israel, affords four principal lessons: * The rapid reduction in inflation at the beginning of heterodoxprograms (which usually comes about at small cost) is the easypart; the problem is to maintain price stability over time. * Incomes policies in heterodox stabilization programs are justifiedonly in countries with high chronic inflation, where persistentinflation is more pervasive and problematic. * There is a case for a bigger fiscal adjustment in heterodoxthan in orthodox programs because of the risk that a programwith price controls may be misperceived as a populist devicefor achieving price stability without adjusting. * The failure of a heterodox program is more likely to destabilizeinflation than is the failure of an orthodox program.      

TRADE POLICY AND PRODUCTIVITY GAINS IN DEVELOPING COUNTRIES: A Survey of the Literature

Despite the widely accepted view that liberal, outward-orientedtrade policies are superior to restrictive, inward-orientedpolicies, doubts about liberalization remain strong in manycircles. One reason for such doubt is the dearth of researchquantifying the large gains that liberal trade policies aresaid to generate. The survey of the literature undertaken forthis article was a review of the evidence on the link betweentrade policy and efficiency, or productivity, gains in developingcountries. Does the literature support the view that more opentrade policies bring greater efficiency? Several inferencesare drawn from the literature on sources of growth—particularlywith regard to increases in capacity utilization and economiesof scale. The article also examines evidence from the few studiesthat explicitly try to correlate efficiency gains directly withtrade policy. These studies fall into three categories: thosethat evaluate the effect of trade policy on market power ordegree of competition; those that measure total factor productivityor technical efficiency gains and correlate these with the degreeof protection; and those that estimate the aggregate effectsof changes in trade policy on welfare (mainly with computablegeneral equilibrium models, which measure dynamic efficiencygains from trade). In a final section, the article pulls togetherthe findings from the indirect and direct evidence as a basisfor suggesting a number of hypotheses on the link between efficiencyand trade policy. One conclusion is that country-specific analysisover time appears to be superior to cross-country comparisons.      

Trading Arrangements and Industrial Development

This article outlines a new approach for analyzing the roleof trade in promoting industrial development. It offers an explanationas to why firms are reluctant to move to countries with lowerlabor costs and shows how trade liberalization can change theincentives for firms to locate in developing countries. It modelseconomic development as the spread of concentrations of firmsfrom country to country. Different trading arrangements mayhave a major impact on this development process. By changingthe attractiveness of countries as a base for manufacturingproduction, they can potentially trigger—or postpone—industrialdevelopment. The analysis shows that unilaterally liberalizingimports of manufactures can promote industrialization but thatmembership in a preferential trading arrangement is likely tocreate larger gains. South-South preferential trading arrangementswill be sensitive to the market size of member states, whileNorth-South arrangements seem to offer better prospects forparticipating southern countries, if not for excluded countries.     

Service Sector Protection: Considerations for Developing Countries

The inclusion of services in the Uruguay Round of multilateraltrade negotiations has focused attention on the protection ofdomestic service suppliers against competition from foreignsuppliers. Issues arising from these negotiations, however,may obscure another and more important issue: the case for unilateralliberalization. This article first surveys methods of protectionin the service sector, and then examines the likely cost ofprotection. Particular attention is given to developing countries.What evidence there is suggests that the costs of protectionmay be high. The article also discusses economic principlesthat could guide a review of policy toward international transactionsin the service sector. Quantitative restrictions or bans onforeign service suppliers—whether they wish to supplythrough trade or establishment—cannot easily be defendedin economic terms, and provide an obvious first target.     

THE ECONOMICS OF NATURAL RESOURCE EXTRACTION: A PRIMER FOR DEVELOPMENT ECONOMISTS

As developing countries become major consumers of the globalsupply of commercial energy, it is essential to understand thedeterminants of future energy prices. At the same time, manydeveloping countries are relying on exports of their own naturalresources—tropical hardwoods, oil, tin, gold, and otherminerals—to generate badly needed foreign exchange. Governmentpolicies influence how much of a resource is extracted todayand how much is saved for the future. Flawed policies needlesslywaste precious national wealth.