DEPARTMENT OF PLANS AND PROGRAMS MACROECONOMIC POLICY DIVISIÓN
APPENDICES TO THE DOMINICAN REPUBLIC MACROECONOMIC ASSESSMENT PAPER, 1993
APPENDICES
Appendix I.
Flow of Funds Framework Account DĂŠficit.
for a Privately-led Current
Appendix II.
Real Wages and the Inflation Tax.
Appendix III
Decomposition of Nominal Interest Rates and Spreads in The Dominican Republic: A Simple Framework.
Appendix IV
Effects of High Interest Rates and of Structural Adjustment on the Solvency of the Banking Sector.
Appendix V.
Endogenous Growth: Dominican Republic.
Rationale
and
Sources
in
the
APPENDIX I The Flow of Funds Framework For a Privately Led Current Account Déficit. This Appendix describes the elementary arithmetíc of the financing of current account, discussed in Section II-B.3 of the report. In particular, it illustrates the difference between prívate -capital flows that finance a current account déficit and those that finance a change in the quantity of money. The framework is kept at the simplest possible level. It is considered that there are two Consolidated sectors: the "government", which includes both the central government and the central bank and the "private sector" that includes the banking system. It is also assumed that the central bank fixes the exchange rate and follows a strict "convertibility" policy (i.e., creating money only through the purchase of foreign exchange). In addition, the economy is assumed to be small, with all goods being internationally traded. Then, the nominal exchange rate becomes the international price level, the inflation rate is assumed at zero, and the distinction between nominal and real magnitudes becomes unnecessary. For added simplicity, it is assumed the case of a non-growing economy. At every period, the government budget constraint is [1]
g + rf - t = Af + Am
where g is government expenditures in goods and services, f the stock of net foreign liabilities held by government, r is the real world interest rate, t are taxes, and m the stock of real money. The symbol A , as usual, represents the change between the beginning and the end of the period. The budget constraint of the private sector, in turn, is [2]
e + ra - (y-t) = Aa - Ara
where a are private net foreign liabilities, y is income (product), and e are private expenditures. Notice that these two expressions tell a very similar story: In equation [1] the excess of public expenditure - including payments of interest on the debt - over income is financed by either an increase in the foreign public debt or else by the issuance of money. In equation [2], the excess of private expenditure - including payments of interest on the debt - over disposable income is financed by the accumulation of foreign private debt in excess of the increase in the demand for money. Notice also that the stock of foreign liabilities (f and a) would be negative in the case of assets. If these two expressions are merged together, they yield
[3]
Ai + Aa = g + e + rf+ ra - y
which is the economy's budget constraint or the balance of payments identity. Thus the balance of payments is equal to the sum of the prĂvate sector's and the public sector's budgets. Equilibrium in the market for commodities requires the total supply of commoditles (i.e., the sum of commodities produced, y, plus commodities imported) be equal to the total demand (i.e. , the sum of the domestic demand for commodities by the private sector, e, and by government, g, plus commodities exported). Since exports minus imports is equal to the balance of trade. T, then equilibrium requires 14]
**'.-*-,.••
so that the balance of payments can be written as [5]
Af + Aa - fr + ar - T
Where the right hand side of [5] is the current account balance (CA) CA = rf + ra - T
Expression [5] is useful to highlight the fact that, for a country. an excess of expenditures including interest payments on the debt, over income can be financed only by an increase in the foreign debt ( or else by a depletion of International reserves) of either the government or the private sector. Of course, all these relationships (except the condition for equilibrium in the market for commodities [4]) are identities, and say nothing about behavior. But they are still useful for characterizing several different possibilities . Consider the private sector constraint [2], and the relationship between: changes in foreign private liabilities, Aa; changes in the real money stock; Am, and change in the level of expenditures, e. In particular, suppose that for a certain period we observe borrowing from abroad,1 i. e., a term Aa > 0. For a given level of income and taxes , this could be generated by either (i) a transitory rise in private expenditures, e, or (ii) a desire to accumulate real cash balances, Am > 0. In the first case, the real money stock does not change, i. e., Am = O , and nothing changes in the government budget constraint. At the end of the period, the level of the debt, a, would be higher, and this will require that the private sector repay the debt through a permanent lower level of expenditures 2, but this may not necessarily involve _ 1
This could be in the form of autonomous " capital inflows" drawn by high interest rates or else the contracting of loans abroad by the private sector. 2
Unless the higher current expenditures are in productive investments and as a result a higher income and expenditures result.
government in any way. In case (ii), in whích the capital ínflow is used to accumulate real money, i.e., Aa = A/n, some terms in the government budget constraint are affected: the public transfers foreign exchange to the government in exchange for domestic money, and government's (more specifically, the central bank's) foreign assets increase. In terms of the overall balance of payments expression [4] , this is a simple "switch" from private to government foreign assets (i.e., from a to f). ' Three features that characterize the current macroeconomic framework of the DR are: (i) a surplus of 1.6% of GDP in the public sector's budget in 1992, (ii) a big jump in the current account déficit from 2.5% of GDP 1991 to 6% in 1992, (iii) an increase in the demand of money as evidenced by the decline in the velocity of broad money from 3.6 in 1991 to 3.1 ín 1992. The mechanics of the process leading up to the current account déficit can be shown in terms of the simple equations of this Appendix. The current account déficit originates in the private sector's budget (equation [2]) because the public sector's budget (equation [3]) is in surplus. The excess of private expenditure (e+ra) over private disposable income (y - t) is not financed by drawing down holdings of real domestic money because the demand of money is expanding. Rather external capital inflows to the private sector are financing both the excess expenditure and the built up of money balances. From equation [1] the combination of the public sector surplus and the increase in the demand for money (seignorage) result in a reduction in the external public debt (Af < O ) . In fact this reduction, by itself, works towards a current surplus, as can be checked in equation [3]. But since this effect is much smaller than the external borrowing by the private sector (Aa > Af) the final outcome is a huge current account déficit. The two issues regarding the privately led current account déficit are sustainabilty and vulnerability. As to sustainabilty the key questions are: (i) is the excess of expenditures in consumption or in investment?; (ii) if in investment, will the return be sufficient to repay the debt service?; and (iií) is the excess of expenditures the result of a one-time self correcting process or else does it require cool down policy action?. As to vulnerability, the key question is whether the excess expenditure will be quickly washed out if financing were suddenly withdrawn or alternatively whether the withdrawal will prompt a foreign exchange crisis. The data for the DR shows that the 3.5% of GDP deterioration of the current account from 1991 to 1992 is associated with a 2.6% of GDP increase in investment and a 0.9% increase in total consumption. This tells us that the process is safe on this account. (However, as noted in the report; the sectoral distribution of the ratios is worrisome because private consumption to GDP rose unlike public consumption to GDP which dropped; in other words, the brunt of the adjustment was borne by public savings). The problem is that a significant share of external financing of the current account déficit comes in the form of speculative short term capital inflows. These are attracted by the very high interest rates
(about 10% real annual) and then on-lent to borrowers at real annual rates of over 25%. The fact that the financing is short-term poses the question of vulnerability. In turn, the high lending rates suggest the possibility of borrowers' default risk and thus the process might not be sustainable.
APPENDIX II Real Wages and the Inflation Tax. During the months preceding the enactment of the current stabilization program, the DR experienced extremely high and accelerating levéis of inflation. As a result of the program, the inflation rate fell almost immediately. The parpóse of this Appendix is to show the effect of these inflation rates on real "disposable" wages, thus to underline why nominal wages deflated by the consumar price level is an inadequate measure of the purchasing power of real disposable wages. We provide a crude measurement of both the inflation tax and the welfare costs of inflation for the typical case of a wage earner who receives a nominal salary at the beginning of the month and spends it through the month. It is well known that inflation is a "tax" on cash balances, being the counterpart of the revenues captured by the monetary authority vía the creation of money. As any tax, there ís a transfer from the payer (money holders, in this case) to the collector (the government) . Also, as in the case of other taxes, there are net "welfare costs". i. e., a loss to somebody (the tax payer) which is not a gain to anybody.1 It is also known that the inflation tax is highly regressive. Those in the lower income brackets have far less possibilities of holding their wealth in other assets, and hold proportionally more cash balances than those in higher brackets. It should be emphasized that these costs are unrelated to. and independent from any deterioration of the real wage due to a lack of monthly adjustment to inflation. Table A2-1 shows the annual inflation rates from July 1990 to March 1991, both for the last 12 months (as it is usually computed) and for the last month (i.e., the annual rate at which prices have been rising during the last month). The highest level of the latter occurs in August 1990, at a 420% annual rate. Suppose the "demand for money" (i.e., the average of real cash balances held through a month), m, is an expression of the form [1]
ñ = (y/2)exp(-aji) ,
where y is real income, it is the monthly inflation rate and a is a parameter, which determines the "semilogarithmic" elasticity of the demand for money. What [1] shows is simply that, the higher the inflation rate (which is a cost of holding money), the lower the real money stock held by the public. The higher the coefficient a, the stronger the response of the real money stock to the inflation rate. For our purposes, [1] has been written assuming that for an inflation rate of zero the real money stock held will be equal to half the monthly real income (wage).2
1
This is called sometimes the "deadweight loss" of the tax. i
2
This implies that the wage is spent uniformly through the month.
Table A2-1 Annual Inflation Rates from July 1990 to March 1991 (Percent)
Jul
Aug
Sep
Oct
Nov
Dec
Jan
Feb
Mar
Last 12 Months
43
60
67
76
90
100
97
97
96
Last Month
81
420
187
285
264
180
.8
10
20
For a given inflation rate 7t, the inflation tax payment (and government revenue) is the product of real money (the "tax base") times the inflation rate (the "tax rate"), i.e., InflTaxPmt= (y/2) exp (-arc) u.
[2]
There is, in addition, a "welfare cost", which is raeasured as the área under the demand curve. This represents the costs of performing transactions with a smaller money stock.3 A crude measurement can be given by "linearizing" expression [1] and simply taking the difference between the stock and the stock that would prevail with zero inflation, times the inflation rate, divided by two, i.e., WelfCost = {[y/2] - [ (y/2) exp (-ajt) ]} JT / 2 .
[3]
Charts 1 and 2 show the results of some calculations to illustrate the importance of the inflation tax and welfare costs on the purchasing power of real disposable wages. The first is an illustration of the "tax costs", welfare costs and their sum, for the highest inflation rate of the period (420% per year in August 1990), for alternative valúes of the parameter a (from zero to 20). Notice that although higher valúes of a mean that less of the inflation tax is payed, but it also means that the welfare costs of using less money are higher. For the inflation rate of 420% per year, the máximum costs is for a zero coefficient a (7.5% of the real salary). Higher valúes of the parameter decrease the total costs to the wage earner, but never below 4% of the salary. Chart 2 calculates the same magnitudes (inflation tax payment, welfare cost and their sum) but taking a given level of the parameter, at a = 5, and plotting different annual inflation rates. Notice that the "tax payment" is also the revenue received from government, and (as in any
3
For example, the costs of storing consumption goods at home rather than performing more frequent purchases.
Chart 1
TOTAL COST OF INFLATON TAX
0.08
6 8 10 12 U SsmiülasHclty of Damand for Money
"Tax" Costs
• Welfare Costs
16
18
- Told Costs
Chart 2
TOTAL COST OF UFLATION TAX (Tax Poymenís and Welfare Casis)
0.12
0.1 0.08
o
3
0.06
~ 0.04
0.02
60
214
435
792
1355
2230
Annud Per C«nt Inflotion • Tax Pml and Reverme
• Welfare Cosí
• Total Cosí
3564
20
other tax) there is an inflation rate above which the tax payment (and government revenue) decreases. In our case, of a parameter a = 5, such a point is at an annual inflation rate of 792% (which is equivalent to 20% per month). The point highlighted by this exercise is that, during the period of highest inflation, the total costs to wage earners (as to any other money holders) have been important (probably between 7 and 5 per cent of their real salary). The fall in the inflation rate increased the level of real disposable wages by reducing the inflation tax and the welfare cost of inflation.
APPENDIX III Decomposition of Nominal Interest Rates and Spreads in the Dominican Republic: A Simple Framework. The high level of bank lending rates in the DR, rL, is made up of two components, a large international spread, s1, between the DR bank deposit rate (in DR$) , rB, and the US deposit rate (in US$), rus and a large spread, SH, between DR's lending and deposit rates.
[1]
[2]
The Domestic Spread. The high domestic spread can partly be accounted for by the 20% noninterest bearing reserve requirement against deposits. With riskless deposit and lending rates, free entry into the banking industry, and few intermediation costs, it would be the case that the competitive risk-free lending rate, r, is given by
[3]
Where rB is the requirement (non When a - 0.2, as would be 1.25 on
i-a
risk-free deposit rate and a is the (binding) reserve interest-bearing reserves as a fraction of deposits). in the DR, the ratio of lending rate to borrowing rate this count.
Lending rates of course are far from riskless, because of the possibility that the borrower might default on the loan. The actual competitive lending rate, r, is therefore the risk-free lending rate plus the borrowers' default risk premium, fi1.1 Thus,
In addition, the banking sector in the DR is far from competitive, so the
1
With risk-neutral banks, the risk premium is obtained from the following relationship: icL=iĂ(z)f(z) dz+iÂż~f(z) dz Here i1 is the rate of return obtained by the borrower, and f(z) is the density function of i1. i
actual lendlng rate rL is the sum of the competitiva lending rate and a monopoly premium, ¿i, which includes both excess profits due to monopoly and any x-inefficiency or organizational slack permitted by the absence of effective competition.2 [5]
r*=rL+i
Summarizing the relationship between the lending and the borrowing rate thus far, we have [6] X "~c
or [7]
i ¿j
Thus the spread between the lending rate and the risk-free borrowing (deposit) rate can be attributed to: the reserve requirement, the borrowers' default risk premium, and a monopoly premium. The International Spread. The DR$ borrowing (deposit) rate can differ from the risk-free US$ deposit rate for three reasons.3 Without complete de jure and de facto deposit insurance , deposits are risky. The second is expectations of changes in the exchange rate. Under uncovered interest parity (ensured by perfect International financial market integration, risk neutrality, and statistical independence of changes in the exchange rate and the rate of inflation) the Dominican deposit rate would equal the US deposit rate plus the expected proportional increase in the price of the US $. The third is any difference other than depreciation and default risk, reflecting market segmentation; that is , imperfect capital mobility. Let, é, be the expected proportional rate of depreciation of the Dominican peso, 5B the default risk premium on DR$ deposits, m the spread due to International market segmentation, and rus the US deposit interest rate. It follows that,
or
2
n also includes the influence of risk aversión, ignored in the note.
3
Dífferential taxation issues are ignored.
Thus the spread between the DR's borrowing (deposit) rate and the riskfree US$ deposit rate can be attributed to combination of three factors: exchange rate devaluations, international market segmentation, and a default risk premium.
3
APPENDIX IV Effects of High Interest Rates and Structural Adjustment on the Solvency of the Banking System. Introduction As mentioned in the Report, the DR, after the implementation of the stabilization and reform program, continúes to experience both high expost real interest rates and high spreads between borrowing and lending rates. This phenomenon is common to many economies undergoing structural reforms as well as an important reduction in the inflation rate. The purpose of thís Appendix is to provide a very simple framework that helps to explain the mechanism by which transitory shocks can have a lasting, persistent and sometimes permanent effect on both lending interest rates and the solvency of the banking system. The transitory shocks that can trigger this mechanism are, precisely, the kind of shocks to which the DR has been subjected, i.e., a rise in the real ex-post borrowing interest rate (due to abrupt disinflation and to the lack of certainty about the ultímate success of the stabilization effort) and a change in the structure of relative prices (due to the trade reforms). The mechanism has a very simple intuitive explanation: shocks that temporarily reduce the profitability of existing firms forcé firms to borrow beyond the current valué of their net worth. This generates the existence of liabilties to banks which exceed the firms's net worth, and a higher lending rate charged by banks. Depending on the severity and persistence of the shock, in some cases this leads to a temporary problem, which is resolved as the firms'profitability is restored, but in others it leads to a situation which is not sustainable in the long run, with lending rates and spreads growing without bound and a threat to the solvency of the banking system. In what follows, we first present a very simple framework that formalizes this mechanism. Then, we proceed to illustrate the different possible scenarios by means of simulations. It should be stressed that these simulations are for illustrative purposes only. although the qualitative conclusions are applicable to the case of the DR. A Simple Analytical Framework We consider the case of the typical firm, with accrued profits at time t being defined as [1]
U* * ptx - w-B^rf.!
where xpe are sales (output, x , multiplied by the "real", or relative price of the product, pt ), w are payments to labor and Bt_^,it-\ are, respectively, the firm's indebtedness and the real interest rate at the end of the previous period (i.e., the beginning of the current period). All variables are expressed in real terms. We assume that profits are i
distributed if and only if accrued profits defined as in [1] are positiva, and that [!' ]
Be - BM = -U? = w + BM r£j - pex
i. e. , that the firm engages in net borrowing, at every period, by the same amount of its accrued losses (negative accrued profits) . Thus the typical firm increases its indebtedness , when necessary, to pay for its wage bilí and the interest on its previous indebtedness. If the firm is in a long run equilibrium, its indebtedness is constant, net borrowing is zero and profits will be positive and constant. We also assume that in this long run equilibrium real indebtedness is equal to the market valué of the firm stock of capital, k, which we take to be constant. We define "non-performing debt", B1"' , as the difference between debt and the valué of the typical firm's capital stock, i. e.,
[2]
Bf = *,-*,
and assume that commercial banks establish a lending rate that depends on both the borrowing rate and the proportion of non-performing debt to total debt, according to the following expression: [3]
rS-rVB^/We'1'""'"
where IL , and IB are the lending and deposit (banks' borrowing) rates , and y is a positive coefficient. For simplicity, and in order to highlight the role of non-performing debt that we are analyzing, we assume that banks profits are zero, and that there are no costs associated with the operations of banks . l Expression [3], that has a simple intuitive explanation, consists of two parts. The first is the term rg (B/k) , which reflects the fact that if nonperforming bank assets cannot be recovered during the period, then the interest rate charged on loans needs to be sufficiently high so that interest on performing assets is sufficient to pay for all loans, i. e.,
[3'] or
[3"]
1
IL = IB (B/k)
For simplicity we are ignoring the effect on the spread between the borrowing and lending rate of reserve requirements, operating costs, and any xineffeciency. These are discussed in the previous appendix.
which is the first term of [3]. The second term, eT[BJn>M/A:1 , is intended to reflect aversión to risk by banks, which results in a rate still higher than the one indicated by the first part of the expression, for y > O . Expressions [2] and [3] are sufficient to determine the behavior of all the magnitudes involved (firms'profits, borrowing and indebtedness, nonperforming loans, the lending real interest rate and the "spread"), provided we know the behavior of the borrowing rate and the price of the product. These are precisely the variables that we will use to motívate various plausible scenarios. Both real deposit rates and relative product prices are magnitudes playing an important role in countries undergoing stabilization programa and structural reforms, in particular trade reforms, as is the case in the DR. Some 'stylized facts' derived from experience of many episodes can be summarized as follows. Concerning real deposit rates, there may be a long period in which those rates may be at high levéis, for various reasons most of which stem from uncertainty about the success and long-run permanence of the stabilization and reforms program. These reasons tend to acquire more and more importance if reforms to secure the government's long run solvency are not implemented with the passage of time. The typical behavior of real deposit rates ís, then, an initial rise. due to the unexpected fall in the inflation rate (of which a dramatic example is the end of 1991 and the beginning of 1992 in the Dominican Republic), a subsequent fall as inflationary expectations start to diminish, counterbalanced sometimes by a tendency to rise if the public does not perceive that lasting fiscal measures are being taken to insure long run government solvency. In order to reflect all these possibilities, in the simulations that follow we use the following expression to characterize the path of the monthly real deposits rate: [4]
r*(t) = Cié'"'6 + Cae'"lt + i'B
where Cl, C2, a1 and a2 are coefficients, and r*B is the long run real deposit rate. The appropriate choice of the coefficients allows to simúlate a large variety of possible paths of the real deposit rate. Consider now the role of a structural shock. The first and most important effect of a structural reform, foremostly a trade liberalization reform, is a change in relative prices. This, of course, implies losses for some established firms and gains for both existing firms and others that have not being yet established. Therefore, although the portfolio of the banking system consists of liabilities of all kinds of firms, there will be an initial dominance by established firms, that at least initially will suffer losses. Furthermore, we can think of the "typical firm" described before, as one that undertakes all kind of activities (import substitution and export activities). If this is the case, we can model the temporary effects of changes in relative prices as an initial fall in the relative
price of the typical firm, with a recovery that, although concludes with a higher relative price, such recovery takes time. In a manner formally similar to the case of the real borrowing rate, in the simulations that follow we use the following general expression to characterize the behavior of the relative price of output: [5]
p(t) = D^e-*** + D^-^ +p*
where D1,D2,al and a2 are coefficients, and p* is the long run relative price. As in the previous case, a suitable choice of the parameters generates plausible paths for the relative price. The Results of Some Simulations The "general flavor" of the mechanism Before we proceed to perform some illustrative simulations, it will be useful to comment on the intuitive interpretation of the mechanism at work. As explained before, the element or external shock that triggers the adjustment can be either changes in the real deposit interest rate or the relative price of output, or both. In either case, the nature of the adjustment is the same: a transitory fall in the firms'profitability, that eliminates normal profits and requires additional net borrowing for covering production costs (the wage bilí) and for paying interest on the existing debt. The accumulation of indebtedness beyond the firms'net worth (i.e., the presence of "non-performing" assets in the banks'portfolio) motivates banks to increase the real lending rate to firms (and therefore the spread). Since the external shock is transitory, if the magnitude and duration of this higher lending rate is minor then positive accrued profits reappear and are used to pay for the transitorily higher cost of credit, non-performing loans are gradually eliminated and the systems settles to a long run equilibrium. But if the magnitude and duration is intense enough this will not be possible, and after some time the system will embark in a non-stable course, that inevitably leads to a bank crisis and/or the need for government assistance. In all the simulations used in what follows for illustrating these various possibilities, the following valúes of the basic parameters are used: Monthly real output (x) = 100; monthly wage bilí (w) = 60; monthly long run profits (U(O') )= 10, real market valué of the firm's capital stock (k) — 9163.83; preexisting annual real borrowing and lending interest rate (r0* = ig-) - .04 (4 per cent), and preexisting relative price of output (Po-) - 1. Additional parameters differ indicated in each case.
for
the various
simulations, and are
The case of interest rate shocks We report here on the results of simulations in which the motivating element is a transitory increase in the real deposit rate, starting at time t = 0. The valué of the parameters used in the simulation are as follows: Dl = D2 = O , and p* = p0- = 1 , so that the relative price of output does not change; y = 0 ; C3 = O, at = -.06, C1 = .00316029, r*D = 0. 00327374 . First, we consider a case in which the shock is mild enough so that, over time, firms recover, and the banking system returns to a long run equilibrium. For this parpóse we specify r£. = 0.8 per month, i.e., initial "jump" of the real deposit rate from a preexisting level of .04 (4 percent per year) to .08 (8 percent per year). Charts 1 to 5 show the behavior of the most interesting magnitudes. Chart 1 depicts the annual borrowing and lending rates, which makes clear that after the initial shock at time t = O both rates converge back to their initial levéis. Chart 2 describes the path of firms'profits, both accrued and distributed. Accrued (and distributed) pre-shock profits are at a level of 10. As an initial result of the shock (Chart 1), accrued profits fall to approximately -20 (i.e., an operating loss of 20), Chart 2, so that distributed profits cease. As the lending rate, after the initial shock, falls quickly enough to more than compénsate for the interest on the accumulated additional debt, smaller and smaller losses take place, and after approximately 20 months accrued profits reappear. For some time, though, those accrued profits, rather than being distributed, are used to diminish firms'indebtedness. By about 51 months indebtedness has been brought back to the firms'net worth, non-performing loans have been eliminated and profits start to be distributed again. Charts 3 shows the flow of monthly net borrowing (positive or negative). Chart 4 graphs the spread between borrowing and lending annual rates, which increases rapidly following the shock but is eliminated equally rapidly. Finally Chart 5 shows the percentage of non-performing loans. Consider now the case of a more severe shock, case 2, to the real borrowing interest rate. Here, for the same valué of all other parameters, except C^ = 0.02516242 we assume that the initial shock to the annual real borrowing rate is a jump to r£ = 0.4 (40 percent per year). Al though this is an extremely high valué, it is entirely plausible for the kind of abrupt disinflation episodes of the magnitude that recently took place in the DR. Charts 6 through 10 describes the variables. In Chart 6, notice that although the real borrowing rate returns to its long run equilibrium valué, the real lending rate, which initially also falls, after a relatively long time starts increasing again. This is reflected in the spread depicted in Chart 9. Chart 7 helps to explain this behavior. After the initial fall to a negative level, accrued profits start to recover, but by approximately 60 months the situation is reversed, and from there
Case 1:
Small Interest Rate Shock
Figure 2
Figure 1 EX-POSI KAL NTBCST R*TES
Figure 3
Figure 4
FRMS NETBOWOWK5
HTEREST 8ATC SPREAD
I 11
O
14
M
41
10
72
*4.
II
104
120
14
M
101
120
Figure 5 PERCENTAGEOF NON-PERTORUMO LO/WS
O JIM
0404OJK» O
12
24
M
72
U
SI
Case 2:
Large Interest Rate Shock
Figure 7
Figure 6 EX-POSI REAL KIEBEST RAIES
FRMS PROFITS
-250-tmwimwWmr
IM
Figure 8
Figure 9
FRMS NET BCRMMNG
MTERESr RATE 5PREAO
Figure 10
PERCENTAGE OF NCN-PERTORMHG LOANS
7
(fe
on losses start increasing without limit. This is mirrored in Chart 8 which depicts the firms'net borrowing. What has happened in this case is that the intensity of the shock has made impossible for profits to eliminate, over time, indebtedness above the firms' net worth, i.e., to eliminate non-performing loans. What is remarkable in this case is that for a long time, after the initial effects of the shock. the problem would seem to be on its way to elimination: the real lending rate and the spread are falling, and so are firms'losses and net borrowing. After a while, nevertheless, the system shows to contain the seeds of instability -Chart 15- as the percentage of non performing loans increase without bound. The case of a structural shock Next, we consider the case where the shock originates in a transitory fall of the relative price of output, resulting, as explained before, from a structural reform that changes relative prices, as in the case of trade liberalization. We assume that the relative price, after the initial fall, settles at a level above the initial, pre-shock level. We dĂscuss the case when the intensity of the shock is sufficient to preclude an equilibrium with banking solvency. We assume no change in the real borrowing interest rate, which remains at its initial level rB = .04 (4 per cent per year) throughout. The rest of the fundamental parameters are as the same level as in the previous simulations, except that now we take the coefficient y = I, rather than zero. The parameters for the behavior of the relative price equation [4] are: D! = -0.6, D2 = 0.5, P! = 0.015,P2 = 0.05, and p* = 1.1. The parameters for the borrowing interest rate, equation [4] are: Cx = C2 = 0. The result of this shock is that although the relative price of output converges to an ultĂmate higher level of 1.1, its transitory fall is deep and prolonged: as shown in Chart 11, it reaches a minimum of approximately 0.57 after 7 months and from there on it recovers slowly. Charts 12, 13, and 14, present the behavior of firms' profits and net borrowing very similar to the severe shock in interest rates case, and a constantly rising level of the real lending interest rate. Notice, in Chart 14, that since there is no change in the borrowing rate, the behavior of the spread can be traced easily from the levĂŠis of the lending rate. Here again, crisis is inevitable, as witnessed by the secular rise in the percentage of non-performing loans (see Chart 15) despite the fact that for some time firms' losses and net borrowing seem to start diminishing.
Case 3:
Severe Structural Shock
Figure 12
Figure 11 WOUTPUT
m
yX *
•
X x*
x^ ^
•
11
14
M
41
M
n
Í4
V 14 ""TU
Si
i """"W
M
i\
'U"""i ii"""Tt
Figure 13
Figure 14
FFMS NET BQRROWttG
£X-fOST «AL NTEK5T RATES OjM
0.075
12
24
M
41
W
Figure 15 PCRCO4TAGE OF NCN-PfJtrORMNG LOAtó
M
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APPENDIX V Endogenous Growth: Rationale and Sources in the Dominican Republic. Structural reforms - supply side policies discussed in Section III of the report- that contribute to the reduction of macroeconomic imbalances and the improvement of resource allocation creates the foundations for a recovery of economic growth. Although conventional wisdom has held that economic policy and the investment rate are major determinants of growth, only recently, in the new endogenous growth theory literature, have models been developed that capture the links between policy, investment and long term growth. These new models not only stress the importance of trade, fiscal, and financial policy, but also highlight that promoting human capital by providing adequate nutritional levéis, basic education skills and investment in research and development can break an economy out of a poverty trap, as changes in the rate of human capital investment lead to changes in the long term rate of growth rather than simply to changes in the level of output.1 The allocation of expenditures between physical and human investments, incuding government expenditure therefore has critical ramifications for future economic growth. Thus, two important insights of the new endogenous growth theory are: (i) the recognition that for the purpose of understanding the sources of economic growth (and for accurate growth accounting) one should work with a concept of capital that is much broader than the conventional stock of physical, reproducible capital, and (ii) the conjecture (supported by some evidence) that a number of externalities (non-rival and non-excludable inputs) may play a key role in economic growth. The above can be illustrated by the following simple model. Using the convenient Cobb-Douglas specification, we can represent the valué added production function of the "representative Dominican enterprise" as in equation [1] 2. [1]
y-a^J^V
Where: a, fi, 7, 5 and e t 0; yít is the output of the ith firm; Y aggregate output; a¿ an Índex of firm efficiency; k^ the private physical capital stock (plant and equipment) of the ith firm; Kp the aggregate private physical capital stock; Kg the stock of social overhead capital (inf ras truc ture); and t^ the stock of human capital employed by the ith
The poverty trap is a situation where low income and low human capital (inadequate level of education and health) créate incentives for high population growth and low investment in human capital that perpetúate a state of poverty. 2
It is assumed that the valué added production function is separable from the inputs of imported intermedíate and raw materials, and thus ignoring, in the formal model, issues regarding the foreign trade regime.
firm. The human capital of the ith firm is the product of the labor forcé of the ith firm Iít and the quality of its labor forcé, q±
[2]
h !
Modern growth theory emphasizes that the ith firm's productive capacity is enhanced not only by its own capital stock, kp^ which yields services that are rival (my use precludes your use) and excludable (property rights can be enforced at negligible cost) , but also by the inf ras truc tur e, Kg (roads, railways, ports, airports, telecommunications, power distribution etc), and possibly by the capital stock of the industry in which it operates (or possibly by the whole private capital stock), Kp. Most infrastructure is likely to be congestible, so we enter the ratio of the social overhead capital stock to (an exponential function of) the aggregate level of economic activity, Kg/Ye, as an argument in [1] . There is congestión if e > 0. Aggregating [1] over all enterprises and assuming that there are constant returns to rival private inputs (a+6 = 1) . Denote a as the índex of average efficiency for given valúes of Kp, Kg and H. H is the aggregate stock of human capital, L is total employment and Q is the average quality of the labor forcé. Letting 9 denote the proportional growth rate of aggregate output (and similarly for the growth rates of all other inputs) we get:
[3]
The growth rate of the labor forcé in efficiency units is , in turn, the sum of the growth rate of the labor forcé and the growth rate of the average quality of the labor forcé:
Note -in equation [3]- how most of the sources of growth are endogenous . Obviously, the rate of growth of the private capital stock, £p, and the rate of growth of the nation's infrastructure, Kg, are respectively private and public choice variables. In addition, even if we take the rate of growth of the labor forcé as independent of the usual macroeconomic policy instrumenta (at least in the short and médium term) , the quality of the labor forcé is influenced directly by education and training. Other policies that influence the quality of management and more generally improve the quality and accessibility of the commercially useful stock of knowledge and know-how can influence á , the growth of total factor productivity.
The practical policy implications, of the above, are that there should be an increase in expenditure (both public and prívate) on: (i) infrastructure, Kg, and its composition should be directed at reducing congestión,e , (ii) on health and education and targeted anti-poverty programs to increase H, (iii) structural reforms in general to increase total factor productivity, a. Although not dírectly captured in the above simple model, recent empirical work, invoking modern growth theory, suggests that more open economies have higher rates of growth. By using their resources more efficiently they achieve a higher level of saving, investment and ultimately growth. Further countries that are open to trade produce with more up-to-date technology, and invest more in quality improvement and research and development. After controlling for factor accumulation, studies also suggest that financial deregulation, from initially distorted posítion, also has a positive effect on growth. Although in this case care has to be taken in the speed and the sequence of reform. The relation between fiscal policy and growth is a complex one, and country specific, however, it has a negative effect on growth particularly when funds are wasted on worthless projects, there are bloated bureaucracies, and when taxes and regulations dístort savings and investment decisions. Finally empirical evidence suggests that the lower the regulatory distortion and higher the expenditure on education and health the greater the rate of growth. In the DR, the growth record of the last decade has been disappointing. Real per capita GDP is essentially where it was fifteen years ago. Population is still growing very rapidly (around 2.3 per cent per annum), putting considerable strain on the nation's environmental, health, educational and housing resources. Human capital formation is not taking place in the quantity and quality necessary for a human resources driven improvement in the economic growth record. Fiscal expenditures on Education declined over the 1980's as a share of total government spending and of GNP. By the late 1980s the ratio of public expenditure on education to GDP represented less than half the average for Latin America. Prívate spending on education increased but not by enough to offset the decline in public resources, especially among the poorest groups. Higher education continúes to absorb a disproportionally large share of the scarce educational resources. Support from the Multilaterals for vocational training, including on-the-job-training, in collaboration and partnership with prívate firms, industrial or trade associations and with the government, might be a productive use of resources. The relatively high life expectancy at birth (69 years for women and 65 years for men) belie the fact that the health status of much of the population is poor and may well be deteriorating. Apart from the human suffering this entails, it also constitutes a direct drag on the nation's productive potential. Some of the major public health problems (such as water-borne and -related diseases) directly reflect the history of inadequate infrastructure investment in sanitation and potable water. Physical capital formation rates have declined, hovering around 15% of GDP
for gross prívate capital formation and varying for the public sector from over 11X of GDP in 1989 to just over 8% of GDP in 1992. The productivity (or ICOR) of part of past investment is certain to have been sunk in capital goods appropriate to the oíd, distorted relative price structure. It should no longer be expected to be viable now that prices are closer to the true opportunity costs. The recent reforms can be viewed, in terms of equation [3], as an attempt to raise á, the growth rate of total factor productivity. While they are likely to do so in the médium to long run, if they are credible and are actually adhered to. they are certain to cause dislocation and increased transitory unemployment in the short run, as factors of production are redirected towards their proper uses. Beyond the gains from reform, any sustained increase in the growth rate will require an increase in the rate of accumulation, broadly defined to include both prívate and public fixed domestic capital formation as well as human capital accumulation through improvements in public health, education and training. The vast worldwide stock of productive knowledge cannot be transplanted to the Dominican Republic and turned into local commercially useful knowledge and know-how without significant prívate and also public investment.
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