Direction: Answer the questions. I will use this for my reporting….

Question Answered step-by-step Direction: Answer the questions. I will use this for my reporting…. Direction: Answer the questions. I will use this for my reporting. What is the key sentence/s in this paragraph?After finding the key points, explain each. Financial Liberalization, Real Interest Rates, Savings, and Investment                    The restriction of loans to a few large borrowers, together with the widespread existence of high inflation, growing budget deficits, and negative real interest rates, led to a serious “credit crunch” among developing countries during the 1980s. The global recessions of 1981-1982 and 1987 exposed the frailty of many development bank loans so that by the end of the decade, almost half of these banks were reporting 50% or more of their loans in arrears and another quarter had delinquency rates in excess of 25%. With real interest rates on savings deposits in the negative and expectations of continued inflation and exchange-rate devaluation contributing to substantial capital flight, it is not surprising that few individuals were willing to save.                   In addition, commercial banks and other financial intermediaries were subject to numerous lending restrictions and faced mandatory interest-rate ceilings on loanable funds at levels well below market-clearing rates. These artificial interest-rate ceilings were often set by governments seeking to finance their budget deficits through the sale of low-interest bonds to private commercial banks. These banks in turn had to resort to rationing the available credit beyond the normal credit rationing observed in developed economies as a response to adverse selection. The Effects of Interest-Rate Ceilings on Credit Allocation shows the impact of binding nominal interest-rate ceilings at below-market-clearing levels. With the interest- rate ceiling at , which is below the market-clearing equilibrium rate rE, the demand for loanable funds, L2, greatly exceeds the available supply, L1. This excess demand leads to a need to ration the limited supply—a phenomenon known as financial repression because investment is limited or “repressed” by a shortage of savings, which in turn results from administered real interest rates below what would occur in a market setting. In the absence of outright corruption in the allocation of L1 loanable funds, most commercial banks choose to allocate the available credit to a few large borrowers so as to minimize the administrative overhead costs as a proportion of the total costs of lending. Thus the net effect of government controls over lending rates is that even fewer loans will be allocated to small investors. Banks can cover the additional administrative costs and the added risks of smaller loans only by charging higher interest rates. Hence small farmers and urban entrepreneurs have no recourse but to seek finance from the unorganized money market, where, as we see from Figure 15.1, they are willing to pay above-market-clearing rates of rU.                     One suggested solution to the problem is to liberalize the financial sector by allowing nominal interest rates to rise to market-clearing levels. This would cause real interest rates to rise to positive levels and thus remove the explicit interest-rate subsidy accorded to preferred borrowers (rent seekers) who are powerful enough to gain access to the rationed credit. Higher real rates should also generate more domestic saving and investment and permit some borrowers to shift from the unorganized to the organized credit market.27 The World Bank cites evidence from countries such as Thailand, Turkey, and Kenya, where the liberalization of interest rates generated more saving and investment.28 However, evidence of the effects of financial reform in Chile during the 1970s revealed many shortcomings of the process. These included the acquisition of numerous banks by large conglomerates, or gropos, who used their new financial resources to buy recently privatized firms or to expand their own companies. When many of their firms faced financial losses, these grupos had to resort to additional funding to avoid bankruptcy. This made the Chilean financial system particularly vulnerable when the debt crisis struck in the 1980s.                       Reform and liberalization of the organized money sector is therefore no panacea for the financial systems of developing nations. The early success of South Korea and Taiwan (and before them, Japan) with financial systems that exhibited many of the attributes of repression demonstrates that judicious and selective government intervention can be a stimulus to industrial development. Although there is evidence that the elimination of substantial interest-rate distortions can promote greater saving and more rapid economic growth, financial reform must always be accompanied by other more direct measures to make sure that small farmers and investors have access to needed credit. Furthermore, as shown in the next section, careful supervision of the banking and financial sectors is needed to prevent undue concentration by local elites. As we have already pointed out in this text, “getting prices right” is only one step, albeit an important one, in making development serve the needs of the forgotten majority.  Arts & Humanities Writing ENG 126 Share QuestionEmailCopy link Comments (0)