Masters in

DEVELOPMENT FINANCE

ISSUES IN DEVELOPMENT FINANCE*

*Compiled by Dr Matthew Ocran, Nelson Mandela Metropolitan University

© 2012 Africagrowth Institute
 ISSUES IN DEVELOPMENT FINANCE

Contents

1 INTRODUCTION 2
1.1 The key concepts 2
1.2 Financial processes 8
1.3 The development finance system 10
1.4 Concluding remarks 13

2 FINANCIAL MARKETS AND TRANSACTION COSTS 14
2.1 Introduction 14
2.2 Transaction costs 14
2.3 Economics of contracts 15
2.4 The principal-agent problem 15
2.5 Asymmetric information 16
2.6 Moral hazard 18

3 CAPITAL MARKET THEORY 20

3.1 Introduction 20
3.2 Capital market theories: Selected concepts 20
3.3 Capital markets in developing countries 26
3.4 Equity market 27
3.5 The bond market 28

4 CREDIT MARKETS IN DEVELOPING COUNTRIES 32
4.1 Introduction 32
4.2 The formal credit market 33
4.3 Credit rationing 34
4.4 Informal credit market 35

5 EXTERNAL AID AND DEVELOPMENT 39
5.1 Introduction 39
5.2 Official development assistance 39
5.3 Foreign aid and economic growth: The debate 41
5.4 Aid effectiveness 42

6 COUNTRY RISK ANALYSIS 45
6.1 Introduction 45
6.2 Assessment of country risk 45

7 FINANCE AND SUSTAINABLE DEVELOPMENT 49

7.1 Introduction 49
7.2 Environmental issues, sustainable development, and finance 49
7.3 Response by governments 50
7.4 Response by business 50

LIST OF REFERENCES 52
 CHAPTER ONE

INTRODUCTION

Development finance is basically concerned with the financing of development in developing countries. The finance of development
may be considered at the household level, the firm level, or even at the governmental or national level. The development finance is-
sues covered in these lecture notes consider all three spheres of development finance.

In order to appreciate any finance-related course, it’s important that the student have a good grasp of the key principles. While the
principles are not exactly many, they do not lend themselves to straightforward definitions. Consequently, the first part of these
lecture notes will be devoted to the review of a certain number of basic concepts of finance, financial processes, and financial mecha-
nisms.

Like Kitchen (1985), we introduce the subject of development finance by considering a set of fundamental concepts of finance and
a number of concepts related to financial processes. However, unlike Kitchen (1985), we also consider an overview of the entire
architecture of development finance as part of the introductory material, prior to the discussion of issues related to development
finance. The objective of this approach is to afford the student the opportunity to put subsequent topics in this module in their proper
perspective. While the development finance system is quite broad, we have attempted to represent the architecture in a compact
manner. The discussion in this chapter draws on the earlier work of Kitchen (1985). Even though the work is dated, the concepts are
as applicable today as they were three decades ago.

1.1 The key concepts

Risk
The idea of risk in finance is not necessarily the same as that found in standard economics. The conventional definition of risk as
used in economics is attributed to the earlier work of Knight (1921). Knight suggested that, unlike the concept of ‘uncertainty’, in
the case of ‘risk’, one could attach probability estimates to the range of possible outcomes. For instance, it may be argued that the
probability of, say, rainfall in certain regions can be predicted using time-series data; therefore, with the help of models, the risk of
drought can be estimated. Again, in the insurance industry, actuarial tables are drawn up and based on historical data. With the aid
of these tables, various estimates are then made about the risks associated with given events.

Thus, in situations where historical data or some means can be used to make ex-ante measures of risk that can be used to make future
risk assessments, we have a measurable risk. Even in situations where one cannot make a definite pronouncement on the exact level
of risk, if the risk associated with a given number of outcomes can be ranked, that, in itself, is good enough. For instance, if firm A
is associated with a higher risk of failure as compared to firm B, because firm B is in, say, a more vibrant industry, then a financial
institution can rank the two firms in terms of their risk of default.

Financial institutions usually charge borrowers with a higher risk profile higher interest rates than they do borrowers with a lower

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risk profile. For example, if two firms, say British Airways (BA) and Air Gabon, go to the international capital market to raise the
same amount of funds, it is most likely that BA will come out with a lower interest rate as compared to Air Gabon. The same goes
for governments that have raised money on the international capital market by selling sovereign bonds. Another example is the
difference between the price of government bonds in Germany and the price of bonds in most other European countries. German
bonds are associated with lower interest rates compared to the bonds of most European countries, because of the perceived low risk
associated with the German economy. Currently, the difference between the interest rates of German bonds and those of other Eu-
ropean countries is a measure of relative risk. In January 2010, when the Greek economy deteriorated, the spread between its bonds
and that of Germany escalated sharply (i.e. it widened) by more than 4 percent. The same was the case with Ireland in the wake of
its financial crisis, which deepened by the last quarter of 2010. In each of these instances, the yield (interest rates) associated with the
bonds of the countries of perceived increased risk of default escalated quite significantly.

In the corporate bond market, the higher the risk associated with a company, the higher the spread between the interest rates on its
bonds and that of the benchmark-lending rate – the London Inter-Bank Offer Rate (LIBOR) in the UK, and the Johannesburg
Inter-Bank Offer Rate ( JIBOR) in South Africa. It’s important to mention that these measures of risk are ex-ante, and in some
cases they are actual outcomes. Ex-post risk is very much different, because this is an assessment of risk based on historical returns.

In finance, and for the purposes of this module, the most significant attempt in assessing the size of risk is provided by the capital
market theory, also known as the modern portfolio theory (MPT).

The modern portfolio theory is based on the seminal work of Harry Markowitz, with his paper “Portfolio Selection”, which was
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published in the Journal of Finance in 1952. Thirty-eight years later he was awarded the Nobel Prize for Economics with Merton
Miller and William Sharpe for what has become a broad theory for portfolio selection.

In the period before Markowitz’s paper, investors tended to assess the risks and rewards of individual securities in constructing their
portfolios. The conventional investment advice was to find those securities that offered the best opportunities for return with the least
risk and then construct a portfolio from them. Following this advice, an investor might conclude that technology stocks all offered
good risk-reward features and compile a portfolio entirely from them. Naturally, this would be thoughtless. Markowitz formalized
this intuition. This was done by providing a model for portfolio diversification: he suggested that investors focus on selecting port-
folios based on their overall risk-reward characteristics, instead of merely compiling portfolios from securities that each individually
have attractive risk-reward characteristics. In sum, inventors should select portfolios of securities, and not individual securities. The
whole idea of risk diversification is to pick a portfolio where overall risk is reduced, rather than a situation where one is faced with
just one risk. Risk diversification is used widely in a range of financial institutions, markets and instruments, as well as in develop-
ment finance.

In the context of portfolio theory, risk is defined as the variability of return on a given asset, using either standard deviation or beta
as a measure, both of which are measures of volatility.

1
Markowitz, H.M. (1952), “Portfolio selection”, Journal of Finance (December 1952).

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Portfolio theory suggests that some risk (unsystematic) may be reduced by holding a diversified group of assets, while others cannot
be eliminated because they are risks inherent in a particular market (systemic risk) and cannot be diversified away.

One other important observation is that there are several forms of risk that face actors and players in mainstream finance, as well
as development finance, to the extent that a supplier of development finance may face a variety of risks. It is important to note that
while some of the risk may easily be separated from the rest, some risks are such that they are difficult to distinguish from one an-
other. For instance, a portfolio investor who wants to put money into the capital market in, say, South Africa or Kenya may be faced
with business risk, country risk, and exchange rate risk, among others. These forms of risk are very much related. Having said that,
it is always helpful to attempt to make a distinction between the types of risk, in an effort to define ex-ante measures that can help
in predicting future risks.

Types of risk
A useful point of departure in describing the variety of risk forms is the work of Archer and D’Ambrosio (1972). The authors de-
scribe a number of risk forms that face suppliers of capital. These are business risk, financial risk, purchasing power risk/inflation
risk, interest rate risk, and market risk. However, capital market theory points out two main forms of risk, namely specific risk, on
the one hand, and market or systemic (systematic) risk, on the other hand. We also have project risk and country risk. The concept
of ‘moral hazard’ also has its own associated risk. Buyers of capital, or those on the demand side of capital, may also face interest rate
risk, exchange rate risk, and business risk. Note that a number of these forms of risk may be very much related.

Business risk
Business risks are largely associated with the business operations and the related decision-making processes of the business. The risk
associated with the operation of the firm or the running of a project may eventually be reduced to variability of return that accrues
to the firm or project as a result of the assets held. Business risk is therefore concerned with the profit potential of a business entity.
A firm may either be successful (by making a profit) or fail (by incurring losses). Business risk may therefore be viewed from either
the perspective of the supplier of capital or the buyer of capital, because each of these parties can be affected by the risk in one way
or another. Uncertainties that may affect the attainment of one or more business objectives are market size, revenues, and profits,
among other things.

Financial risk
Financial risk may be described as the probability of loss inherent in the means used in financing a firm that may damage the firm’s
ability to provide an adequate return. This type of risk is determined by the nature of financial assets that constitute the capital struc-
ture of a business venture. The empirical and theoretical literature on finance provides insight into the hierarchies of financial assets
and the related order of risk. A consideration of the types of risks that face a firm in operation, particularly risks associated with
failure, is worth noting. For operational firms, profits may be used in paying suppliers of capital in the order of priority: interest on
secured loans; interest on unsecured loans; dividends on preference shares; and dividends on equity. Consequently, as far as returns
are concerned, secured loans are less risky compared to dividends on preference shares.

2
Ryland, R. (2009), Investment: An A-Z Guide, 2nd edition, London: The Economist.

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In the event of firm failure, claimants to the firm’s assets are paid in a particular order, and this is related to the seniority of their
claims. Thus senior debt must be paid before subordinated debt may be paid. In general, the order of seniority may be given as fol-
lows:

• the receiver/liquidator
• certain preferred creditors (tax authorities, employees)
• secured creditors (secured long-term and trade credits, and debentures with fixed charge over certain assets)
• holders of floating charges over assets (secured loans/debentures)
• unsecured creditors (unsecured loans and loan creditors)
• holders of unsecured preference shares and loan stocks
• ordinary shareholders (equity)

This hierarchy is also in ascending order of risk. The capital structure of a business enterprise therefore determines its degree of fi-
nancial risk. For example, in the case of a firm that is heavily geared or leveraged, a small percentage change in the interest rates that
it pays on its debt may result in a substantial erosion of profits. That is why debt itself may be considered a form of risk.

Inflation risk
This refers to the likelihood of inflation eroding the purchasing power of the expected return, or the purchasing power of the assets.
Investors are usually concerned with the real returns on assets, as well as the real capital value of their assets. For example, in recent
times governments have resorted to issuing inflation-linked bonds that reflect the overall inflation compensation required to make
the holding of nominal bonds attractive. Inflation-linked bonds compensate for the expected level of inflation and charge a premium
to compensate for inflation risk. In South Africa we have the inflation-linked retail savings bonds, issued by the government. Ghana
started issuing inflation-linked bonds in 2001 (i.e. the 3-year GGILBS). Other countries that issue inflation-linked bonds (ILBs)
include Brazil, Mexico, Peru, Columbia, Chile and Argentina in Latin America. In Europe, countries such as Poland, Slovenia and
Kazakhstan also issue ILBs. Israel also issues inflation-linked bonds.

Interest rate risk

Interest rate risk is the risk to returns or capital due to changes in interest rates. This may be due to the difference in timing between
rate changes and cash flows. Interest rate risk is based on the possibility that movements in interest rates will change the value of an
investment or return. For example, if an investor purchases bonds and the interest rate subsequently rises, the returns to the investor
will decrease, and the market value of the bond will reduce. Consequently, if one purchases a car, or any other asset, for that matter,
through a bank lending facility at a variable interest rate, the risk of interest rate hikes is borne solely by the borrower.

Exchange rate risk

Holding a financial asset or liability in a currency other than one’s domestic currency leads to exposure to exchange rate risk. The
holder of the financial asset is faced with the probability of the security or the liability losing value due to the depreciation of the
currency in which the asset or liability is held. When one considers international financing efforts, then the question of exchange rate
risk is very important. The international financial market has instruments that may be used to deal with exchange rate risk. Forward
exchange markets may, for instance, be used to cover some of the exchange rate risk involved in a transaction. The risk of exchange
rate losses may also be avoided by ensuring that one lends only in the currency that one holds

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It is therefore not surprising that in countries with very weak currencies and high inflation some domestic banks even provide loans
denoted in foreign currencies.

Market risk
Market risk may be considered in two ways. The first view is the capital market theory perspective, which postulates that the market
or systematic risk of a security is given by the sensitivity of the security price to changes in the broad market index (beta coefficient).
The second view is rather more related to finance in developing countries, namely the marketability of a security. This comes up when
the market for a security is narrow with a large shareholding and has to be traded under imperfect conditions. In such instances,
securities cannot be readily converted into cash, i.e. they are illiquid. This situation is very common in capital markets in develop-
ing economies. For example, the small stock exchanges in Africa, such as those in Ghana, Namibia, and Botswana, etc. have very
low turnovers; they are therefore associated with high market risk, due to low marketability of securities. While it is uncommon for
the JSE to have daily turnovers in excess of US$1billion, most of the stock exchanges in Africa will be lucky to have turnovers of
$100,000 in a typical trading day. As a result of this situation, investors may struggle to liquidate their shareholding in certain firms.

Idiosyncratic/Specific risk
Specific risk is associated with the changes in a company’s share price due to firm-specific factors. Some of these factors may arise
as a result of product or raw material price changes, an industrial action, a takeover bid, a product or technology discovery of conse-
quence to the firm, etc. These factors may only impact on a given company, with no impact whatsoever on the entire market. Note
that there may be a certain degree of overlap regarding the factors that underlie business risk and specific risk.

Project risk
Possible events that may endanger the planned course or goals of a given project constitute project risk. This kind of risk ensues
when project finance is used to finance infrastructure projects, among other things. In cases where the debt can be financed only by
cash flow from the financed project, the issue of project risk assumes great importance. In cases where securities or guarantees are
provided, then the focus of the risk changes to the guarantor. Now, if government provides a guarantee for project finance, the lender
has to deal with country risk, instead of project risk. We can consider two examples here. First, Eskom Holdings Ltd, the South
African power utility company, is engaged in the raising of capital to finance power generation and distribution infrastructure in
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South Africa. The government has provided guarantees amounting to $350bn to enable Eskom source financing from overseas. The
guarantee also helps in reducing the cost of the loans. In 2010 the Ghanaian government also signed a deal with credit guarantees
for STX, a South Korean company, to provide 200,000 housing units in Ghana over a 4-year period at a cost of US$10bn.

Country risk
The question of country risk emerges when lenders provide funds to foreign countries. Usually we have a situation where an interna-
tional bank or private financial institution lends to a foreign country or to state-guaranteed companies, as described in the examples
above. In cases of foreign direct investment, the question of country risk becomes quite pertinent. The main risk faced here is the
probability of default or rescheduling.

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A government guarantee is an assurance to a lender by government or her agency that a financial obligation will be honoured
even if the borrower defaults.

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Usually the defaults merely reflect deeper problems. Examples of underlying conditions that may precipitate sovereign debt defaults
include a world economic recession, such as the recent one in 2008.

Greece and, lately Ireland, have had to take bailouts from the European Central Bank and elsewhere to prevent them from defaulting
on their sovereign debts (see the attached article from the magazine The Economist). Deterioration, in terms of trade, commodity
price collapse, balance of payment difficulties, capital flight, and the political risk of government expropriation, are some of the fac-
tors that can lead to default. In the case of Ireland, the risk was largely a result of the massive bailout the government offered to the
banking sector that was in distress.

In recent times, sophisticated models have been developed by lenders to measure country risk. There are also renowned rating agen-
cies that measure and publish country risks throughout the world. Fitch, Standard & Poor and Moody’s are some of the institutions
that are well known for their country risk assessment. These three rating agencies accounts for over 80 percent of the market for the
industry. The other important institutions engaged in country risk rating are:

• Dun and Bradstreet;

• Institutional Investor;
• Frost & Sullivan;
• Euromoney;
• Fraser Institute;
• Credit Risk International (Paris);
• International Country Risk Guide (NY/London);
• Coface & Ducroire; and
• the Heritage Foundation.

These assessments are based on a wide range of factors, such as political risks, debt service ratio, balance of payment position, and
budget deficit, among other things. The risk assessment provided by these institutions is a major factor in the determination of
whether international banks will lend to a country or not, and at what interest rate.

Returns
The expected return is the most important reason behind most financial transactions. The other reason is related to the desire to
protect one’s financial asset from losing its value as a result of inflation, exchange rate losses, and even taxation, among many other
things. By postponing present consumption to the future one can expect to be compensated for the deferred consumption through
the receipt of returns on a given financial asset. The returns are also payments for accepting the risk of forgoing consumption. Gen-
erally, the higher the risk associated with an asset, the higher the expected return. This basic principle is well discussed within the
context of the capital market theory. As part of the theory, a benchmark risk-free rate of return is defined. The risk-free return is
assumed to be the return on government securities, such as Treasury bills. While the return on government instruments is generally
assumed to be risk-free, these instruments are nonetheless exposed to inflation risk in many cases.

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Debt rescheduling is concerned with lengthening the repayment period or forgiving or dismissing part of the loan. In some in-
stances investors are pressured to take a haircut.

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Index-linked bonds may be purchased to deal with the problem of money or inflation risk (see above discussion on inflation-linked
bonds). However, even for non-index-linked bonds, the 90-day Treasury bill is deemed to be largely risk-free, because of its short
maturity period. In sum, government bonds may be regarded as largely risk-free in most stable economies.

Security
The purpose of security is to transfer a proportion of the risk inherent in a financial claim. For example, if a bank grants a firm a loan
amount that is secured against the fixed and/or financial assets of the firm, we may consider those secured assets as security. One
of the main factors that hinder SMEs in developing countries in their quest to access finance is their lack of security. Development
banks are supposed to help deal with these issues of security, in order to hasten the pace of economic development. An obsession
with the provision of security may work against firms that have the potential to contribute to growth but lack adequate security to
access capital.

1.2 Financial processes

In our discussion of financial processes we will consider five concepts. These are mobilization, intermediation, maturity transforma-
tion, risk transfer, and financial deepening and repression. This discussion will also serve as a background to the discussion of the
international development finance system.

Mobilization
Mobilization in finance is essentially concerned with moving surplus funds from savers to those who have a need for funds but do
not have them. In weak economies, where those with surplus funds are not given adequate incentives to place their surplus funds in
productive financial assets, savers may end up hoarding cash, or worse, continue to save their funds in hard currency. The aim of mo-
bilization efforts is to attract surplus funds from savers and put them into productive use, such as through lending for investment. In
poor economies, savings mobilization is largely done in the informal financial sector, since the majority of the population are outside
the reach of the banking system. Some of the informal savings mobilization schemes are the stokvel in South Africa and the susu in
Ghana (IFAD, 2000, Miracle et al., 1980). Most African countries have local names for these informal saving schemes. Notwith-
standing the formal financial sector, these informal saving schemes remain the main source of savings mobilization in developing
countries. Because the capital market in most sub-Saharan African countries is not very developed, most of the savings mobilization,
as well as lending, happens in the banking sector. Thus developing countries are faced with weak financial intermediation. In more
advanced economies, mobilization of savings happens in the formal financial sector, where the capital market is well developed and
highly liquid. However, in recent times efforts are being made in many countries in Africa to deepen the financial market. For in-
stance, a number of African countries have started stock exchanges. Governments are also increasingly selling bonds, all in an effort
to help with mobilization of funds in the economy.

Intermediation
The process of intermediation plays a pivotal role in the financial market. Through the intermediation process, an individual, institu-
tion or market sources funds and then issues a claim against itself; the claims end up as liabilities on the balance sheet. The claims
that the supplier of funds acquires from the user of the funds appear as assets on the intermediary’s balance sheet. Thus the inter-
mediary serves as the link between those with loanable funds (savers) and users who do not have funds of their own (borrowers) but
have investment opportunities.

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The theory of intermediation is based on the relationship between savers and borrowers. In the case where one is dealing with weak
intermediary institutions, it becomes extremely hard to ensure an effective flow of funds from savers to investors. In such a situation,
the ability to invest is constrained. Only savers are able to invest, and their level of investment is predicated on the level of savings
that they are able to amass. In such a situation, prospective investors who lack savings of their own are unable to invest. At the same
time there may be people with surplus funds, but who are not interested in investing. Therefore, the incentive to save is threatened,
as some savers might not be interested in investing. Thus we have an inefficient use of capital.

Maturity transformation
Maturity transformation helps firms, not just banks, to borrow short-term money to invest in projects of long-term duration. None-
theless, banks, by the nature of their business, are best placed to be efficient in maturity transformation, as they are able to raise
money through deposit mobilization. The liquidity backstop provided by the central bank in most cases helps to provide strength to
borrow “short” and lend “long”. The other factor that enables financial institutions to borrow short and lend long is the “law of large
numbers”. The very fact that a financial institution has a large number of lenders or depositors reduces the risk of an unexpected
upsurge in withdrawals. This is in stark contrast to an institution that has a relatively small number of depositors. These two features
explain to a large extent the success of building societies, which are able to mobilize short-term funds and then lend them for a long
term, particularly as mortgages payable in excess of 20 years.

Risk transfer
Investment efforts involving financial assets or physical assets entail a considerable amount of risk, as has been mentioned earlier. The
next logical question is “Which of the parties involved in the financial transaction bears the risk?” Consequently, a fair distribution
of the inherent risk and the returns associated with putting together financial packages are important factors that ensure that sav-
ings mobilization and investment happen in an efficient manner. Usually risk is apportioned using two approaches: first, by taking
one or other guarantee, and second, by choosing a financial instrument that has built-in capacity to handle risk. Given that the first
approach is pretty much straightforward, we will discuss the second approach, albeit briefly. What development banks do here is to
take an equity stake in a given project, in addition to the provision of a loan. In this way the lender manages to secure the loan and
a proportion of its total exposure to the project financing. Note that in the event of project failure, the loan is considered as a senior
debt in relation to the equity. By doing this the bank reduces its total risk exposure. The extent to which the bank apportions risk to
the shareholders or the project promoters depends on the proportion of its total financing that it offers in the form of a loan.

Financial deepening and financial repression

The literature on financial deepening and financial repression owes much to the initial work of Shaw (1973) and McKinnon (1973),
who laid down the basic macroeconomic concepts. However, there is now a large body of empirical work that examines the theo-
retical arguments posited by Shaw and McKinnon (e.g. Roubini and Salai-i-Martin, 1992). According to Shaw (1973), financial
deepening occurs when the rate at which financial assets are accumulated is faster than the rate at which non-financial assets are
accumulated. Shaw takes the view that the development finance markets and institutions are an important prerequisite for economic
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growth and that the shallow depth of financial markets in developing countries restricts growth. Financial repression ensues when
government controls the cost of borrowing.

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The empirical literature is not entirely unanimous regarding the direction of causality between financial development and eco-
nomic growth.

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In cases where interest rates are fixed by governments, savers tend to shy away from financial assets; they rather put their surplus
funds into non-financial assets such as gold and land. The case of financial repression tends to hinder the development of money
and capital markets.

Until recently, and for most of the 1980s and early 1990s, most African countries had financially repressive policies. However, there
has been a more deliberate effort to move away from interest rate controls, as countries have instituted sweeping financial reforms
that have involved the liberalization of the financial markets. This new policy direction has to some extent encouraged savings and
investments, as savings are now reasonably attractive.

1.3 The development finance system

This section of the notes considers the various aspects of financial mechanisms that help the functioning of the financial system,
particularly the development finance system. We discuss the types of financial institutions that constitute the development finance
system, with an emphasis on the new players in the financial system. The kinds of markets and instruments used to achieve the objec-
tives of development finance are also discussed.

Financial institutions
Development finance comprises six main types of institutions that serve as sources of funds. These are bilateral donors, multilateral
donors, global funds, and NGOs. The rest are private philanthropy and the private commercial sector. However, it is also important
to note that historically development finance has been associated with donor institutions that have provided development assistance
or aid. In recent times new players or actors have assumed a pre-eminent place in the development finance architecture, and in this
subsection we will try to throw more light on this new phenomenon. Following the Monterrey Consensus and the Johannesburg
Declaration in 2002, the private sector was encouraged to be active participants in the global development finance industry.

Figure 1 represents the diversity of suppliers of resources in the development finance industry. What is important though is the shift
in the composition of capital flows to developing countries that has been witnessed in the past three decades. For instance, the remit-
tances have grown at an average of 15 percent per year from a low of $76bn in 1999 to $240bn by 2007, thus constituting a quarter
of all financial flows to the developing world (Global Development Finance, 2008).

In addition to the shift from the traditional multilateral sources to private sources, it is important to note the increasing importance
of China as a major source of development finance, especially to Africa. To help African countries improve their infrastructure base,
the Chinese government has provided a number of preferential loans to help expand the commercial loans available to Africa. For
the period 2007–2009 China provided US$5bn of preferential loans and export credit to Africa. It has also earmarked another
US$10bn for Africa for 2010–2012. These loans are meant for the construction of big infrastructure projects currently underway, e.g.
the Bui hydropower station in Ghana, and an airport in Mauritius, among other things.

On the local or domestic level, especially in Africa, there are a number of informal financial institutions. These are the moneychang-
6
ers found in most countries in West and East Africa, and the savings and loans microenterprises, among others.

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Informal foreign bureaux

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 INTERNATIONAL DEVELOPMENT FINANCE SYSTEM

Notes: * China lent more money to other developing countries over the period 2008-2010 than the World Bank did. China Development
 

Bank and China Export-Import Bank signed loans of at least $110bn (£70bn) to other developing country governments and companies in
2009 and 2010, according to research conducted by the Financial Times. The World Bank made loan commitments of $100.3bn from mid-
2008 to mid-2010, itself a record amount of lending in response to the financial crisis.
Source: Financial Times, January 17, 2011.

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Figure 1: Net capital flows to developing countries, 1999-2007

 
Source: Based on data from the World Bank, GDF, 2008

Financial markets
Financial markets are the arrangements or provisions that allow individuals and institutions to buy and sell financial claims or instru-
ments. Financial markets operate at two distinct levels, namely primary markets, and secondary markets. A primary market refers to
any financial market where new securities, e.g. stocks, bonds, etc., are sold. For instance, a country may elect to sell sovereign bonds by
initially placing the bonds with a large institution. This transaction occurs in the primary market. The initial share offer of a company
also takes place in the primary market. By contrast, the secondary market is the arrangement that allows the sale and purchase of
previously issued instruments. In the case of the secondary market, the original issuer does not necessarily benefit, as the investors
who purchased from the primary market are now the beneficiaries of any new capital raised from the sale. The actors in the secondary
bond market may include brokers, investors, individual investors, and other institutional investors, such as banks, etc. The existence of
secondary markets for any given instrument is a great determinant of the willingness of investors to purchase the instrument in the
primary market. If the secondary market is small or non-existent, then activities in the primary market are very much constrained.

Money markets and capital markets

In addition to describing financial markets as either primary or secondary markets, they may also be classified as money markets or
capital markets, based on the maturity of the instruments traded in them. Financial instruments that have maturities of less than
one year are classified as short-term instruments. Instruments that have maturities of more than one year but less than 10 years are
described as intermediate-term instruments. Instruments that have maturities of 10 years and above are termed long-term securi-
ties or instruments. For example, 3-month Treasury bills are short-term instruments/securities, while a 5-year government bond is
intermediate-term security. A 10-year or 15-year bond is a long-term instrument. Traders and financial analysts define money mar-
kets as arrangements that allow the trading of short-term securities. The markets where intermediate-term and long-term securities
are traded are described as capital markets.

Money market instruments usually have large numbers of buyers and sellers. As a result, the market is relatively more liquid. Money
market instruments also tend to be associated with less risk, as compared to long-term instruments. For example, the probability
that a “bad thing” may happen in, say, three months’ time is far less than the probability that a “bad thing” may happen in, say, 20

12
years’ time. Consequently, a company that issues short-term instruments is more likely to find buyers than a company that issues a
20-year paper.

Capital markets are associated with longer maturity instruments, therefore the instruments traded in the capital market are normally
meant for funding capital investment projects. The stock exchanges and over-the-counter trading platforms are arrangements that
create spaces for trading in equity and bonds, as well as derivatives.

The capital markets in most developing countries, especially in Africa, are not well developed; they are highly fragmented and largely
illiquid. The JSE, which is the world’s 16th biggest exchange in terms of capitalization, accounts for 75% of all African trades in
equity, while the other 20 exchanges together represent a mere 25% of the stocks traded on the continent. Most of the exchanges on
the continent have limited listings. As a result, they are very weak when it comes to the raising of capital. The largely illiquid nature
of the capital markets makes it difficult for development banks to sell their equity in client companies to raise capital to support other
borrowers. This situation also constrains banks from being more active in funding companies in developing countries.

Because of the weak capital markets and low liquidity, governments in the developing world have resorted to raising capital on the
international capital markets through the issue of Eurobonds and Euronotes. Eurobonds are long-term securities issued in a cur-
rency other than the currency of the issuer. Euronotes, likewise, are securities issued in other currencies, but they have shorter maturi-
ties. The maturities of Euronotes are medium-term in nature. For example, Ghana raised US$750m from a Eurobond in September
of 2007 with a 10-year maturity at an interest rate of 8.67 percent. In December of the same year, Gabon, an upper-middle income
country, raised US$1bn from Eurobonds at a 7.85 percent interest rate with a duration of 10 years.

1.4 Concluding remarks

The above concepts, processes and mechanisms constitute the foundational principles underlying development finance. It is impor-
tant that one grasps these principles in order to appreciate the issues involved in the area of development finance.

Consequently, most of the themes will be discussed in further detail in the subsequent chapters. It is also important to note that,
while the form and emphasis of development finance change from time to time, the basic foundational building blocks remain un-
changed. The ideas represented in this chapter are equally applicable at the macro, meso and micro levels of development finance. The
principles are not only useful in developed country contexts, but are also important in the context of developing countries.

By and large, two themes emerge from the review of the finance principles of importance to development finance. These are capital
market theory associated with portfolio theory, and the concept of financial repression. While the former is more often linked with
financial markets in the developed world, the financial markets in developing countries are sometimes characterized by financial re-
pression. The market imperfections and the controls usually seen in financial markets in developing countries are features of financial
repression.

It is also important to note that the architecture of development finance is still evolving. For instance, some of the traditional domi-
nant players in the provision of development finance seem to be giving way to emerging development finance providers, such as
China. We also see additional efforts being made to bring entirely new development finance instruments to the fore.

Readings

De Gregario, J. and Guidotti, Pablo E. (1995), Financial Development and Economic Growth, World Development 23(3): 443-448.

Reisen, Helmut (2003), New Sources of Development Finance: An Annotated Conference Report, OECD Development Centre,
September 2003.

The Economist (2011), The Euro areas debt crisis: Bite the bullet. The Economist, January 13, 2011.

13
 CHAPTER TWO

FINANCIAL MARKETS AND TRANSACTION COSTS

2.1 Introduction

Financial markets work within a defined set of institutional frameworks. In order for the market to work optimally, the institutional
framework has to foster efficiency. However, while markets everywhere do not function in a perfect manner, the degree of weakness
in developing countries is very high. The challenges present in the financial markets hinder financial development, and thus impact
negatively on economic growth. In order to set the scene for a meaningful discussion of the shortcomings of the markets, a number
of principles that account for the high transaction costs associated with financial transactions have to be discussed. The principles
are associated with economic contracts, principal-agency theory, transaction costs, moral hazard, and asymmetric information. It is
important to note that each of these principles has a well-developed body of knowledge, both theoretically and empirically.

The concept of asymmetric information and how it informs the structure of financial institutions is very important for understanding
how these institutions operate. This chapter seeks to discuss how transaction costs influence financial structure, and how financial
intermediaries reduce transaction costs. In the discussion of the concepts of asymmetric information, adverse selection and moral
hazard, the emphasis is on how asymmetric information impacts on financial structure. In addition, a range of measures to help
reduce the problem of adverse selection will be discussed.

2.2 Transaction costs

Transaction costs may be defined as the costs incurred in undertaking an economic or financial exchange or transaction. When it
comes to dealing with transaction costs, the role of financial intermediaries becomes pertinent. The importance of financial interme-
diation is very well documented in the literature on finance. Four important roles played by financial intermediaries can be identified.
7
These are: (1) provision of adequate liquidity risk sharing , (2) reduction of inefficiencies arising from asymmetry information, (3)
ensuring that incentives are well aligned, to pre-empt the problems of moral hazard and adverse selection, among others, and (4)
facilitation of scale economies in the conduct of transactions and the provision of logistics (Hasman, Samartin and van Bommel,
2010). In essence, good financial intermediation contributes immensely to the reduction of transaction costs. Governments do have
a role to play in helping to stimulate the emergence of adequate financial intermediation. It is the responsibility of government to
provide a sound legal and institutional framework and an appropriate infrastructure, which together provide a favourable environ-
ment for financial intermediation. The issue of assignment of property rights, along with enforcement, is a key component of the
infrastructure that supports financial intermediation. The enforcement of property rights, for instance, is the sole responsibility of
the state concerned. Hernando de Soto, a Peruvian economist, provides a classic and stimulating argument about the huge benefits
that can accrue to developing countries if the question of property rights is adequately addressed. The immense role played by low
transaction costs in spurring on development in developing economies is well documented in the literature.

7
Diamond, D.W., Dybvig, P.H. (1983), Bank runs, deposit insurance and liquidity, Journal of Political Economy 91: 401-419; Broe-
cker, T. (1990), Creditworthiness tests and interbank competition, Econometrica 58: 429-452.

14
Rao (2003) argues that it is helpful to decompose transaction costs into their constituents as they apply in the market system or the
particular type of transaction concerned, in order to understand the critical role that they play. He suggests that the roles of search,
enforcement, measurement, and other components of transaction costs need to be examined separately in order to develop cost-
effective strategies to address the associated costs. It is assumed that some of the costs associated with governance can be reduced
considerably if user institutions themselves are engaged with government in their efforts to minimize governance costs.

In this regard, stock exchanges are one of the monitoring and supervision role players delegated by government to minimize transac-
tion costs associated with the securities trade. Regulatory institutions across various financial markets establish and enforce financial
norms and standards to reduce the informational challenges that push transaction costs up.

2.3 Economics of contracts

Contracts have a special place in the design and operation of institutions for financial and economic governance. A range of con-
tracts governs market participants, and the markets themselves. While there is no perfect contract anywhere, reasonably efficient and
workable contracts can be constructed to help reduce costs associated with the whole transaction experience that actors and players
in markets enter into. In general, contracts may be complete or incomplete.

A contract may be said to be complete if it spells out clearly and unambiguously measures that address every foreseeable contin-
gency or situation that may arise. Clearly, one cannot have a complete contract, in the strict sense of the word, anywhere. To the
extent that one cannot figure out every foreseeable contingency relating to contracts, we cannot have a complete contract, as such.
By contrast, a contract is deemed legally incomplete if parties to the contract accept to the terms of a given agreement subject to
available information or unverifiable information, as suggested by Rao (2003). It is also argued that generally the administrative and
legal infrastructure that a society possesses helps in ensuring the effectiveness, including cost-effectiveness, of contracts, in both their
design and enforcement.

In the case of financial contracts, the key elements are mostly related to the repayment of the principal and the interest within a
specified time schedule, collateral arrangements, as well as demands of contract enforcement.

Incomplete contracts have a negative impact on transaction costs. The cost of design and enforcement of contracts, if they are not
supported by adequate institutional and legal infrastructure, can be burdensome. Indeed, the characterization of modern and formal
economies, as compared to informal economies, is largely dependent on whether the design and enforcement of contracts is achieved
in a formal way, or otherwise. Another phenomenon of interest in the pursuance of efficient financial governance required in helping
reduce transaction costs, and thus stimulate financial development and economic growth, is the principal-agent problem.

2.4 The principal-agent problem

The principal-agent problem, which is sometimes referred to as the agency dilemma, is based on the seminal work of Ross (1973)
and Jensen and Meckling (1976). The theory addresses the difficulties or challenges that emerge from conditions of asymmetric
information when a principal employs an agent. The point here is that the principal and the agent may not have the same interests
and motivations; however, the principal apparently hires an agent to pursue the interests of the principal.

15
Usually various mechanisms or instruments may be adopted to help align the interests of the principal and those of the agent. These
may include things such as commissions, profit sharing, performance contracts, or the threat of dismissal, among others.

The agency cost that faces the principal in the case of financial firms is usually dependent on the degree of information asymmetry
and the monitoring of and cost of accessing relevant information. Again, the agency cost is very much related to the design and
enforcement of contracts in general in a given jurisdiction. Jensen and Meckling (1976, p. 308) provide a useful working definition
of agency cost, which is worth considering:

The agency cost comprises the sum of the monitoring costs by the principal, the cost of bonding the agent to perform tasks in conformity with
the performance objectives of the principal economic entity, and that of the residual losses that are attributable to the divergence of the optimal
decisions effected by the agent, in contrast to those that could have been taken by the principal if directly involved in the decisions.

The separation of corporate ownership and control comes with a certain amount of agency cost. This agency cost and other agency
costs, such as agency costs associated with external equity finance, and those associated with external debt finance, are particularly
important for development finance. It has been shown above that asymmetric information is critical in the design and enforcement
of contracts, in either principal-agent relationships, or in buying and selling financial products. Asymmetric information also has a
bearing on efforts to minimize transaction costs.

2.5 Asymmetric information

Akerlof (1970) makes a major contribution to the theory of asymmetric information, which has an important application in
development finance. Akerlof ’s seminal paper, “The market for lemons: Qualitative uncertainty and the market mechanism”, provides
the basic building blocks of the concept of asymmetric information. The problem of asymmetric information offers an interesting
theoretical basis for the inefficiency that occurs in the market in institutions that focus on development finance.

The essence of Akerlof ’s paper is that asymmetric information accounts for the existence of the adverse selection problem. The
argument is that if consumers for some reason are unable to determine the quality of a given product, they will be willing to pay
just an average price. Now, because they are willing to pay an average price, prospective sellers of quality products will not have an
incentive to offer their product for sale. Consequently, sellers of bad products (lemons) will rather choose to sell their bad products
at the price offered by consumers, hence the term “adverse selection”.

The lack of appropriate information about the products on offer leads to the offer of an unattractive price, which the producer of a
bad product finds adequate, but which is unattractive for the producer of the good product. Thus, more bad products (lemons) are
offered than good products. Given that consumers are rational, they will imagine this adverse selection and expect that at any given
price, if one randomly chooses a product, the product is more likely to be a lemon than a good product. The expectation of being sold
a bad product translates into a lower willingness to pay; therefore the proportion of good products that are offered for sale actually
decreases. This sets in motion a vicious cycle, such that the proportion of good products that are offered for sale reduces steadily, until
the market breaks down completely.

The lemons idea applies in the case of raising finance for development projects and programmes. In the case of funding development

16
projects, if investors cannot figure out the value of firms before they invest in them, they will be willing to pay an average price for the
equity in those firms. If the prices that investors are prepared to pay for equity in the firms that are promoting development projects
are average, then it stands to reason that only bad firms will actually be prepared to sell equity. This is because selling equity on the
market will not attract good firms. Under these circumstances, when investors are offered equity on the market, they will suspect that
the firms are bad ones; hence they will not be prepared to pay an average price for offered equity. The investors will hold the view that
the value of the firms offered for sale on the market is actually below the average.

Another example that illustrates the asymmetry of information concept is drawn from the literature on corporate finance. Myers and
Majiluf (1984) discuss the concept of asymmetric information, considering corporate financing and investment decision making when
firms have information that investors are not privy to. The authors demonstrate that in the presence of asymmetric information the
equity of highly profitable firms will be underpriced. If the level of underpricing is severe enough, these firms will avoid investments
in projects that have favourable net present values. The thrust of this paper is consistent with the concept of asymmetry information.
However, the problem associated with asymmetry information is in this case relevant to part of the firm’s cash flow. The conclusion
here is that under certain conditions the markets do not break down completely in the face of asymmetric information.

In order to throw more light on the main idea espoused by Myers and Majiluf (1984), assume that a business intends to raise money
to invest in a development project. If the firm decides to issue equity on the market, what the firm is doing is to invite investors
to become part owners of the firm, thus enabling outsiders to share in the profits that accrue to the owners, as well as to share the
ownership of assets owned by the business. Faced with this kind of offer, investors correctly suspect that the firm just wants them as
partners because the assets owned by the firm are not worth that much. The assertion here is that outsiders or prospective investors
who do not have access to adequate information about the business will not be willing to pay high prices for the equity they are
offered, because of the suspicion that the equity represents ownership of assets of low-grade value. If, on the other hand, investors are
of the opinion that a given firm has assets with underlying value, after all, the firm’s equity will be underpriced.

The lack of equal access to information between two parties engaged in a transaction constitutes informational asymmetry. The
concept may be generalized further, to the extent that there may exist unequal capacities between parties to a transaction to process
a given set of information adequately (Rao, 2003).

Participants (e.g. international banks, investors, etc.) in the development finance industry are constantly engaged in the allocation of
various types of risk. The design and sharing of risks associated with transactions in development finance is an important factor that
determines the efficiency of development finance, and economic systems in general. One of the many markets in finance where the
issue of asymmetric information is very relevant is the credit market.

8
For instance, the absence of responsive credit markets in developing countries has been found to be a great impediment to
sustained economic growth (USAID, 2004). This is because productive economic activities by entrepreneurs, SMEs and individuals
are severely hindered by the absence of effective credit markets. In contrast, in economies that have well-developed financial markets,
such is the case in developed markets, it is relatively easy to raise loans to finance economic activities. Firms can obtain finance to
support new ventures, and individuals can likewise obtain funds to acquire homes through mortgage finance.

8
This is a type of financial market designed for the exchange of debt securities or bonds.

17
Empirical research shows that credit to the private sector offers an impetus to economic growth (Levine et al., 2000; World Bank,
2004). To illustrate this point further, some statistics can be of help. The World Bank (2010) indicates that in most developed
9
economies and countries with well-developed financial sectors the domestic credit to the private sector is more than 100 percent of
the GDP of these countries. In contrast, in most countries in Africa the figure amounts to barely 20 percent of GDP. For example,
in Tanzania, Senegal and Zambia the figure is 16 percent, 24 percent, and 15 percent, respectively. However, the share of domestic
credit to the private sector in the US and the UK amounts to twice as much as the GDPs of these two countries (190 percent in the
case of the US, and 210 percent in the case of the UK). In Mauritius and South Africa, where the financial system is well developed,
domestic credit to the private sector is 88 percent and 145 percent, respectively.

The low volume of credit in developing countries is not entirely a problem of resource availability in the banking institutions, the
main source of finance. It is argued that banks in low-income countries lend only a small proportion of the total deposits that they
mobilize. In general, banks and other financial institutions have great difficulty in figuring out which borrowers are creditworthy,
largely due to the existence of a high degree of asymmetric information. In essence, prospective lenders have great difficulty in
knowing as much as the borrowers themselves, such as knowledge about any given borrower’s willingness/ability to repay, since the
institutions have limited or no access to information about their prospective borrowers.

The problem of asymmetric information partly accounts for market imperfections or inefficiencies that characterize financial mar-
kets, particularly in low-income countries. The problem of adverse selection can therefore be attributed to the existence of asym-
metric information.

2.6 Moral hazard

The problem of moral hazard is said to exist when a party which is responsible for the interest of the other party has incentive to put
her own interest ahead of the other party. An example of the phenomenon of moral hazard is a worker who neglects her responsi-
bility to do the job she is paid to do. In finance, one can think of many examples of moral hazard. For instance, if a financial advisor
sells a financial product to a customer whom she knows will not benefit from the product, we have an instance of moral hazard. Here
the advisor is probably only interested in her commission, and not the welfare of the buyer, because she knows the product will not
serve the interests of the buyer. Again, if a banker takes risks that she knows she can transfer completely to another party, we have
another instance of moral hazard.

Moral hazards are inherent in development finance, as well as the economy in general. Dealing with moral hazards, or bringing the
phenomenon down to a bearable limit, is a major question that the design of financial institutions and mechanisms should be con-
cerned with. It may be argued that the incidence of moral hazard has over time informed the nature of financial markets and the way
that they are organized, as well as the contracts that are written in development finance and the economy as a whole.

9
Domestic credit to the private sector includes financial resources provided for the private sector, such as through loans, purchas-
es of non-equity securities, and trade credits and other accounts receivable that indicate a claim for repayment. In some countries,
the data and the claims include credit to public enterprises.

18
One of the challenges in recent times regarding moral hazard is the socially excessive risk taking that has been perpetrated by some
in the finance industry. The recent global financial crisis has been attributed, in part, to unnecessary risk taking. A good example
is the story about mortgage financing. In the traditional sense, the bank that offers mortgage to, say, a borrower will usually hold
the mortgage to maturity. Therefore, banks have been careful in their risk assessment of lenders before loans were made, since the
banks bore the full risk of default. However, prior to the financial turmoil, financial institutions could originate a mortgage with the
intention of bundling it and selling it off to a third party. In this case, the risk of default is borne by the third party (the buyer of the
bundle of mortgage loans). This practice certainly led to a situation of huge moral hazard, as the banks that were selling mortgages
were not directly exposing themselves to the risk of default, and hence had no incentive to serious due diligence to avert imminent
losses. Hutchinson (2008) describes what happened in the US banking system in a very interesting way:

Even the doziest mortgage broker can originate subprime mortgages for even the least creditworthy borrowers. The fact that the borrowers are
incapable of making payments on the mortgage will magically be priced into the mortgage by the securitization process, which will bundle the
mortgage with other mortgages originated by a similarly lax process and sell the lot to an unsuspecting German Landesbank attracted by the
high initial yield. Everyone will make fees on the deal. Everyone will be happy.

Moral hazards may also arise or increase when, in a bid to stimulate the market for finance for development, loan guarantees are
offered to a lender or a borrower. Loan guarantees encourage reckless conduct by the guaranteed lender or borrower. Thus, when
offering such guarantees, it is important that there is an inbuilt mechanism that ensures that incentives are provided to each party
to act responsibly.

In sum, moral hazard is a feature in financial markets, and, indeed, in the economy as a whole, and measures need to be taken to
rein it in at all times. Failure to check moral hazards may lead to serious failure of the market, whether it is the development finance
market, or any other market, for that matter.

Concluding remarks

Transaction costs and asymmetric information are probably two of the major features of financial markets in developing countries
that account for the low level of financial intermediation. These phenomena also contribute, to a large extent, to credit market imper-
fection. Policy actions that can contribute to the enhancement of financial market efficiency will therefore have to include measures
aimed at reducing transaction costs and fostering increased transparency in financial institutions. The reduction of transaction costs
has to be considered from the perspective of both parties in a financial transaction. The importance of the concept of transaction costs
will again be seen when the issue of credit rationing is discussed later in these lecture notes.

Reading

Saito, K.A. and Vilanueva, D.P. (1981), Transaction costs of credit to the small-scale sector in the Philippines, Economic Develop-
ment and Cultural Change 29(3): 631-640.

19
 CHAPTER THREE

CAPITAL MARKET THEORY

3.1 Introduction

This section of the module looks at some of the important theories that underpin capital markets. We then consider a review of the
capital market in developing countries and attempt to identify some of the challenges that confront these markets. In all of the dis-
cussions, particularly regarding the trends in the capital market, we situate the state of capital markets in Africa in the bigger picture.

The relationship that exists between the expected return on financial assets and the risk associated with the investment in a given
asset is at the very core of capital market theory, or modern portfolio theory. The capital market theory does not only have impor-
tant implications for investment on the stock market, it also has a place in decision-making regarding capital investment. Capital
investment may be in either the private sector or at the level of government aimed at financing development. In order to follow the
arguments underlying capital market theory, it is important that certain key concepts are understood.

3.2 Capital market theories: Selected concepts

Measures of risk
The capital market theory is based on the assumption that investors have an idea of an “expected return”. The return, r, over a single
period is defined as

r = [D+T-1]/I

where D = dividends, T = terminal price of the asset at the end of the investment period, and I = initial purchase price of the asset
at the beginning of the period. The values of D and T here are assumed to be expected values. The expected value of T is defined as

When dealing with more than one period, r is considered as the internal rate of return, such that Ti is the ith possible outcome. There
are n possible outcomes, with each possible outcome having its own probability. While the average investor may not make explicit
calculations to obtain T, it is assumed that she has a good guess of what T ought to be.

Drawing on the above discussion, capital market theory considers the variation of the return of an asset around its expected return
as the investor’s estimate of the risk associated with a given asset. Usually the standard deviation, or variance (standard deviation
squared), is used to represent the level of risk. The dispersion, or variation of the returns, is normally distributed (this is an assumption
that precludes skewness). While other measures of risk have evolved, it is common practice to use standard deviation or variance as
a measure of risk in the financial market.

20
Variability
The values of securities, including shares, fluctuate and are generally inherently unstable. However, it is known that some securities
experience more fluctuations than others. The rise and fall in the value of securities is usually described as variability. Thus we have se-
curities that are characterized by high variability and low variability in prices. Securities associated with high variability tend to have
greater likelihood of greater gains and greater prospects of greater losses. By contrast, securities that have low variability in price do
have less likelihood of greater gains and, again, low likelihood of greater losses. We may measure variability as the difference between
the price of a security and its mean price over a given time period. Consequently, high variability means that we have a high value
for standard deviation, or variance, while low variability means that we have low standard deviation, or variance. The total variability
of a security or asset price may be divided into two components, namely market risk, and specific risk.

Total risk = market risk (systematic) + specific risk (idiosyncratic risk).

Market (systematic) risk and the market risk premium

Market risk is the kind of risk that is due to price changes of securities such as shares, bonds, foreign exchange, futures, etc. It is
generally assumed that prices of individual securities in a similar category (e.g. shares) on a given market tend to move together in
the same direction as the overall index that represents all the securities. So, for instance, if we consider MTN shares on the JSE, we
expect that the security will move in the same direction as the JSE’s All Share Index. We also know that various shares have varying
levels of sensitivity in terms of their movements relative to the All Share Index. That is, while a particular share may respond strongly
to the movement of the All Share Index, another share may be quite weak or slow in response. The degree of sensitivity of securities
to the movement of the index is characterized by the beta coefficient (β). For example, if a given share has a beta value of, say, 1.5, it
means that on average the share price moves 1.5% with every 1% change in the market index. On the other hand, a share with price
sensitivity of 0.4% will change at only 0.4% for every 1% change in the broader index. And a beta value of 1.0 suggests that a given
share moves in tandem with the broader market.

What we are describing here as market risk could also be an index for a group of securities on a given stock exchange, in the nar-
row sense. So, we may have, say, an index for all listed properties on the JSE when we are dealing with variability of, for instance, a
particular domestic property security, such as Stanlib’s Property Income Unit Trust. Market risk can also be considered as a reflection
of the risk of fluctuation in the entire economy, in a very broad sense.

Idiosyncratic risk
The performance of a firm, or even the performance of a development project represented by its share price, depends on a range of
factors that are specific to the enterprise. The performance of the security is also dependent on the performance of the entire econ-
omy. Now, if for a given security the beta value is unity(one), it is still possible to see a higher or lower sensitivity, or price variability,
within a certain shorter period. The argument here is that within the shorter time frame firm-specific factors, as well as market fac-
tors, may have driven the change. Examples of firm-specific factors may include, but are not limited to, instances of new technology
discoveries, the hiring of a new chief executive, loss of skilled labour, input cost escalations, and a sharp change in product demand.

21
Estimation of market risk and idiosyncratic risk
The size and level of market or specific risk can be estimated by using either a graphical or a regression approach. In practice, the
graphical method is somewhat clumsy and less useful in estimating specific risk. The regression approach is a little better, and is
discussed here. If specific risk is represented by the symbol α , and market risk by β , we can estimate both the specific risk and the
market risk at the same time for a share or portfolio of shares. We collect data on the returns of a particular security and the market
returns based on an all-share index, over a period of time. For argument’s sake, let us say we obtained weekly price changes for the
particular share, as well as the market index for the broad market, over a 52-week period. A regression of the weekly returns over the
market returns will give an indication of the market risk levels and the specific risk levels. Assuming we have

y =α + β x

where y is the weekly return on the selected security and x is the weekly return of the share or portfolio; the coefficient of x gives
us the sensitivity of the returns of the particular security to overall changes in the market. The constant in the model represents the
specific risk, once again demonstrating how independent specific risk is from market risk. This approach can be likened to fitting a
regression line to a scatter plot of weekly returns on the share against weekly returns on the market portfolio (such as an all-share
index).

We illustrate the regression approach by means of the following example. Let us assume we would like to estimate the specific risk
associated with INFRACO, a telecoms entity listed on the JSE. We first obtain monthly returns on the stock prices for a period of,
say, 36 months. Another series made up of the returns of the JSE All Share Index (ALSI) for a similar period is obtained. Regression
of the stock price return over the market return produces output in a form such as (figures are fictitious and are used for purposes
of illustration)

y = 0.5 + 0.7x.

In this example, α = 0.5, and β = 0.7.

Therefore the sensitivity of the INFRACO shares to the market portfolio is 0.7. This suggests that if the broad market returns
increase by 1 percent, INFRACO gains an increase of 1.2 percent, as illustrated below:

y = 0.5 + 0.7(1) = 1.2

The return on INFRACO, irrespective of movement in the market portfolio, is 0.5 percent at any point in time. However, if the
market index loses 1 percent, INFRACO shares increase by only 0.2 percent, as illustrated below:

y = 0.5 + 0.7(–1) = 0.2

Note that exercises such as these are nothing more than forecasts, and they tend to suffer the same fate as all forecasts, to the extent
that they are not exact or accurate, at the best of times.

22
The Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) was the first major asset-pricing model that was developed for estimating market value
of financial securities. The model can also be used in estimating the discount rate for physical projects. The pioneering work on
the CAPM was done by Sharpe (1964), Lintner (1965) and Mossin (1966). Over the years, however, the model has been heavily
criticized for its apparent weaknesses. The finance literature has new and sophisticated models intended for security valuation, and
while these models may have fewer flaws, there are other challenges that plague them. Some of the drawbacks are severe limitations
regarding their basic assumptions, questions about their predictive power, and problems associated with their parameterization.
These drawbacks notwithstanding, the CAPM continues to reign as the most widely used pricing model for decision making in
finance, for all practical purposes. Some of the more sophisticated models include the Arbitrage Pricing Model and the Option
Pricing Model for the valuation of derivatives.

The CAPM is essentially based on the assumption that financial markets are efficient. However, the key assumption of market
efficiency (which we discuss in more detail later) may be decomposed as follows:

1. The market for financial assets is a perfect one. It is characterized by many investors, and they are price takers; the
market for all securities clears(ie. Supply equal to demand).
2. All the investors face the same time-planning horizon.
3. All investors have equal access to all securities.
4. There is no transaction cost, to the extent that there are no taxes or commission in place.
5. Each investor is concerned with the expected returns and the variability of those returns.
6. All investors have the same understanding of the investment opportunities.
7. All investors borrow and lend at one risk-free rate of interest.
8. Investors are able to short (sell) any asset and are also able to hold a portion of any given asset.

Clearly, many of the assumptions underlying the CAPM are quite contentious, but the general intuition behind the whole model
is quite appealing. Two other concepts relating to the CAPM need to be mentioned. These are the security market line and the
portfolio market line.

Security market line

The efficient market hypothesis suggests that the optimal approach in investing is to apportion one’s portfolio between the market
portfolio and the risk-free investment. Investment in the market portfolio ensures the successful diversification of all idiosyncratic
risks, leaving alone the market risk, which, for all intents and purposes, cannot be diversified away. Consequently, the returns that
accrue to individual securities represent the compensation for taking on the market risk associated with the given security. Thus
security market risk is the only explanatory factor regarding the return on a particular share. Drawing on the above argument, it can
be demonstrated that the expected return on a given risky security is represented by a straight equation of the form

rk = rf + (rα – rf ) βk

23
rk = expected return on equity k;
rf = risk-free rate of interest;
r α = expected return on the market portfolio; and
β k = beta coefficient of equity k.

The return on the risk-free security, rf, is sure, therefore its beta value is naught. If the beta values of all the securities on a given
market are plotted against their respective returns, we obtain an upward sloping curve known as the security market line (SML).
Since the beta for the risk-free investment is naught, the SML cuts across the expected return axis at a point above the origin of the
curve. The vertical distance between the SML and the straight line – the horizontal line that represents the returns associated with
the risk-free investments – gives the expected risk premium.

The CAPM also has applications in corporate finance, particularly in determining the hurdle rates in project finance. First, one may
obtain the beta value from related stand-alone projects. The expected return or the hurdle rate may then be obtained.

The efficient market hypothesis

The efficient market hypothesis (EMH) is one of the key theoretical foundations of modern finance. The seminal work of Eugene
Fama in 1965, in which the term “efficient market” was first suggested, offers the basis for the EMH. The main thrust of the EMH
is the assumptions that suggest financial market features that are akin to perfectly competitive markets in general. However, the
emphasis here is on informational efficiency. The EMH may be defined as a financial market where all prices reflect all available
information. The assertion is that if and when financial asset prices deviate from their equilibrium or fair values, the deviations are
only temporary.

The definition of the EMH has over the years assumed a number of forms. Each of these variants depends on how we operationalize
the term “all available information”. The other important component of the definition is “they reflect all available information”.
Based on how we define the term “all available information”, we have one of three distinct characterizations of the efficient market
hypothesis. The three forms of the EMH are as follows:

1. Weak form (EMH) – The a priori assumption here is that prices of traded financial assets (i.e. bonds, equity, property,
derivatives, etc.) already reflect past prices.

2. Semi-strong form (EMH) – The hypothesis here is that prices of traded financial assets reflect all past prices, as well as all
currently available public information.

3. Strong form (EMH) – The null hypothesis related to the strong form of the EMH asserts that prices of traded financial
assets reflect all past prices, current publicly available information, as well as inside information.

The emphasis on “reflecting all available information” is to pre-empt arbitrage opportunities.

Example: If Apple Corporation, developers of the iPhone, iPad, and the Mac, had to announce the introduction of a new blockbuster

24
high-tech consumer electronic gadget, how would the share price of Apple reflect this? Probably three hypothetical outcomes can be
envisaged for the imminent price adjustment: (1) the price surges to a new but higher equilibrium level, (2) the price moves gradually
to the new equilibrium level, and (3) the price overshoots and then settles at a new equilibrium.

The assumptions considered under the EMH are many. For efficient market conditions to prevail in a financial market, the following
have to hold: (1) no transaction cost is incurred in the trading of financial assets or securities; (2) all information is readily and
freely available to (or accessible to) all market participants at the same time; (3) there is a large number of buyers and sellers for the
traded financial asset (a feature reminiscent of perfect competition); (4) all investors seek to minimize their risk while seeking to
maximize their returns; (5) all investors have the same view of the equilibrium price for a given security, and each investor forms her
expectations around this unique equilibrium price, and they also have the same expectation of the trade-off between risk and returns
(rational expectations); and (6) it is also assumed that the size of the asset market provides enough room for investors to sufficiently
diversify their portfolios, to attain the optimum portfolio balance.

Over the years the EMH has attracted a lot of criticism from the literature. In recent times, especially after the financial crisis that
started in 2007, behavioural economists have constituted the most ardent critics of this hypothesis. Undoubtedly, the EMH is
reckoned to be one of the most contested theories in finance, despite a massive volume of literature on the EMH, both theoretical
and empirical. In sum, economists are still divided on whether financial markets are actually efficient or not. [See The Economist
articles on the EMH – Readings.]

Most of the evidence in support of the EMH has been obtained by studying the performance of investment managers and unit trust
funds. The exercise has usually sought to find out whether share price movements were consistent with available public information,
10 11
random-walk behaviour associated with security prices, as well as the usefulness of the technical analysis . For the EMH to hold,
it means that investment analysts would beat the market all the time, but this is not the case. Again, empirical studies have provided
ample evidence in the past to suggest that unit trust funds do not beat the market. In other words, returns are random-walk in nature.
Jensen (1968) observed that when unit trust funds are grouped into those that were successful and those that were less successful in
terms of their ability to beat the market, those that were successful in the first time period were not the same as those that proved
successful in the second period.

The other dated literature that examines the evidence as to whether stock prices reflect publicly available information are the works
of Ball and Brown (1968) and, later on, Fama, Fisher, Jensen and Roll (1996). These works are supportive of the assertion. The
random-walk behaviour of share prices also renders technical analysis redundant (Karjalainen, 1999).

10
The term “random-walk” describes changes in a variable whose values are unpredictable (random), because a current value has
the same probability to move up or down. This means that, for all intents and purposes, the future value shares or security prices
should be unpredictable.
11
This is a method of share price or security price prediction with the aid of graphical analysis of past values, by trying to identify
patterns and trends, such as regular cycles etc. Eventually, the analysis purports to figure out rules for when to buy, hold, or sell.

25
The evidence against the EMH is enormous. For instance, studies have shown that small firms are able to outperform the market for
a considerable period of time (i.e. the small-firm effect). This is inconsistent with the EMH (Reinganum, 1983). Many reasons are
12
advanced in this regard, but we will not delve into that in this module. There is also the calendar effect . Many studies have provided
13
evidence in support of various calendar effects. For example, Hansen and Lunde (2003) found January and Monday calendar
effects in a number of stock price indices from stock exchanges in many countries in Europe, America, and Japan. The incidence of
market overreaction that results in excessive volatility, as seen in the wake of the recent global financial crisis, and the question of
mean reversion are all violations of the EMH. The slow pace regarding how new information feeds through the market, particularly
in developing country stock markets, has been used to dismiss the EMH. The incidence of smooth dividends but volatile stock prices
is another piece of evidence that is inconsistent with the EMH.

While the debate on the EMH is still raging, with no end in sight, the question that is relevant to those interested in the financing
of development is “How do financial markets in developing countries fit in in all this?” This is a question that we attempt to address
in the next section of this chapter.

3.3 Capital markets in developing countries

Stock markets are increasingly becoming important as capital markets in most developing countries. For instance, over the past two
decades a large number of African countries have started running stock markets. In 2010 there were 19 stock exchanges in Africa.
This compares favourably with the number of exchanges in 1981, namely seven. The three oldest exchanges are the Alexandria
Exchange in Egypt (1883), the Johannesburg Stock Exchange (1887), and the Zimbabwe Stock Exchange (1896).

Samuelson (1981) and Kitchen (1986) identify a number of factors that characterize inefficient capital markets. Most of these are,
incidentally, very much associated with the capital markets in developing countries, especially Africa. First, let us look at the factors,
and then attempt to review recent statistics on capital markets in developing countries. The factors are as follows:

(1) Inefficiency due to the small size of given financial markets, thus limiting the number of traders and trade. This situation also
reduces the scope of diversification of the investment portfolio.
(2) Inefficiencies that emerge from differences in the expectations of investors about the trade-offs between risk and returns.
(3) Inefficiencies attributed to weak governance and market infrastructure.
(4) Lastly, but most importantly, inefficiencies driven by high transaction costs, which, in turn, limit the participation of financial
market players.

12
Certain days, months, and/or times of the year have been associated with predictable above-average security price movement.
This phenomenon is referred to as “the calendar effect”. It is a clear violation of the random-walk effect.
13
Hansen, P.R. and Lunde, A. (2003), Testing the significance of calendar effects, Working Paper Series No. 143, Centre for Ana-
lytical Finance, University of Aarhus. Accessed on 10 February 2011.

26
In the developed world there appears to be unanimity in the literature regarding the fact that their stock exchanges are weak-form
informationally efficient. By contrast, capital markets in developing countries are largely inefficient, even though there are mixed
results in the literature. A careful consideration of the literature suggests a leaning against largely inefficient capital markets. For
example, while the Johannesburg, Mauritius and Alexandria stock exchanges are found to be weak-form informationally efficient in
most studies, the remaining exchanges in Africa are mostly inefficient.

The inefficiency in capital markets in developing countries is largely attributed to the following: (1) low liquidity, (2) thin trading, (3)
fragmentation – small-sized exchanges, (4) high transaction costs due to poor infrastructure, (5) limited listings, and (6) infrequent
and non-synchronous trading. To throw more light on the state of capital markets in developing countries, see Table 1.

3.4 Equity market

Over the past three decades or so, stock exchanges have played an important role in the financial markets of developing countries. The
phenomenal increase in the number of exchanges, and the surge in their capitalization, is ample evidence. For example, the number
of stock exchanges in Africa, which stood at seven in 1985, increased to 12 by 1993, and to 19 by 2010. While these exchanges
play an important role in the capital market, they do have certain weaknesses that prevent them from contributing optimally to the
mobilization of resources for development. Generally, the sizes of the stock exchanges in developing countries, particularly in Africa,
are quite small, when measured by capitalization and listed companies.

Indeed, of the 19 exchanges in Africa, only three have more than 100 listed companies. These are the stock exchanges in South Africa
(460), Egypt (306), and Nigeria (216). Four of the exchanges have 10 or fewer listed firms: Libya (10), Mozambique (9), Cape Verde
(4), and Cameroon (4). When it comes to the level of liquidity created on the markets, it is very low for the markets in developing
countries. Most of the markets in Africa are characterized by low turnover ratios. For instance, the majority of the 19 exchanges
(13 of the 19) have liquidities of less than 10 percent. Even in Brazil, a leading emerging market, and one of the more advanced
developing countries, the liquidity created on the Buenos Aires Stock Exchange in 2009 was just 6.5 percent. This compares poorly
with the London Stock Exchange, with a liquidity ratio of 121 percent, the New York Stock Exchange (150 percent), and the
Singapore Stock Exchange (2,460 percent), the highest in the world. However, the JSE (48%), the exchange in Egypt (50%) and the
Indonesian Stock Exchange (90%) are a few of the exchanges with an appreciable level of liquidity ratio. See Table 1.

The new capital raised on the equity markets, through IPOs and secondary public offers, is quite small in most developing countries,
except in a few countries. In Africa, only the JSE has been able to raise significant amounts of new capital over the past few years.
For instance, the JSE raised US$13bn in 2009, a figure that represented a 30-percent increase over the previous year’s inflows.
However, in other markets in Africa, such as Nigeria and Ghana, there was a sharp drop in inflows. Inflows into Nigeria dropped
sharply, from US$9.3bn to less than US$400m in 2009. Even the smaller markets also took a beating in terms of new investment
inflows; Ghana’s new inflows fell from US$2bn in 2008 to US$493m in 2009. While the inflows into developing countries are quite
modest as compared to the markets in developed countries, it is a sign that when the capital market is well nurtured, it can be an
important source of new capital (WFE, 2009). The fragmentation and low turnover ratios that characterize these exchanges prevent
the exchanges from effectively contributing to capital market development.

27
Table 1: Selected stock exchanges, 2009

Source: WFE (2009) and ASEA (2011)

Notes:*Turnover ratio (%) = value traded of listed securities/market capitalization

3.5 The bond market

The fixed income market, also known as the bond market, is one of the important markets for raising capital, but this segment of the
capital market is in its nascent state. Nonetheless, there are a few countries in the developing world with reasonably well-developed
bond markets. Notable among these are the markets in South Africa, Egypt and Malaysia.

28
For the most part, one cannot find any meaningful bond market in most countries. As shown in Table 1, there is even difficulty in
accessing up-to-date data on bond-trading activities. What is not in doubt is the vibrant short-term government paper that is traded
in most developing countries. That notwithstanding, it is important to note that new bond issuances, particularly sovereign bond
activities, are gathering pace, albeit slowly. For example, in recent times, a number of developing countries that have hitherto not
been able to raise capital on the international capital markets are beginning to access capital from these markets. Over the past five
years, countries from Vietnam in Asia, Nigeria, and Jamaica, among others, have floated their first sovereign and/or corporate bonds
in the international bond market (see table below), thus issuing international bonds for the first time.

Table 2: Selected exchanges with bond-trading activities, 2009

Source: WFE, 2009

29
Table 3: New bond issuers in selected developing countries, 2005 – 2007

Source: Global Development Finance, 2007

Conclusions

The thrust of the capital market theory is the assumption that financial markets can be reduced to a two-parameter model made up
of risk and return. This approach to financial modelling provides an important foundation for portfolio management and financial
asset valuation, and is, in general, an important rule of thumb for investment decision-making. However, instances of market
imperfections and high financial transaction costs are challenges to the efficacy of the capital market theory.

The efficient market hypothesis, as another important theoretical pillar of finance that guides financial market analysis, has been
quite contentious, particularly in the wake of the global financial crisis that started in 2007. Nonetheless, the theory still continues
to be relevant. The perceived differences between the efficient market hypothesis and what actually pertains in the financial market

30
has given rise to a renewed push for more attention to behavioural finance. The proponents of behavioural finance argue that there
exist a number of imperfections in investor behavior. Therefore, behavioural finance uses a number of psychology-based theories to
explain stock market anomalies that the efficient market theory fails to explain.

Readings

The Economist (2009a), The Grand Illusion: How efficient market theory has been proved both wrong and right. The Economist
Newspaper, March 5, 2009.

The Economist (2009b), Efficiency and beyond: The efficient market hypothesis has underpinned many financial industry’s models
for many years. After the crash what remains of it? The Economist Newspaper, July 16, 2009.

The Economist (2011), Why Newton was wrong: Theory says that the past performance of share prices is no guide to the future;
practice says otherwise. The Economist Newspaper, January 6, 2011.

Barbier, N. and Thaler, R.H (2002), A survey of behavioural finance, Social Science Research Network 1 (2) pp. 1053-1128.

31
 CHAPTER FOUR

CREDIT MARKETS IN DEVELOPING COUNTRIES

4.1 Introduction

There is a large body of literature that discusses the economic theories underlying credit markets. The literature suggests that the
weaknesses of the credit market, whenever they occur, are largely attributable to the phenomena of imperfect information and in-
complete markets.

In the developed countries, the credit market works well. For instance, households and firms, including SMEs, have unfettered access
to mortgages at reasonable cost and an array of consumer credit facilities from both banking and non-banking financial institutions.
There is also a wide range of sources of credit for SMEs. The formal credit market in developing countries has huge challenges. For
instance, the absence of important financial sector infrastructure such as public and/or private credit registries/bureaux tends to in-
crease the transaction costs of lenders. While these institutions are taken for granted in developed economies, in most cases they are
non-existent in developing countries. Even in the handful of countries that have these institutions, the level of coverage of the adult
population as a percentage of the total adult population is low (see Table 4). The absence of such important financial market infra-
structure contributes to a high level of information asymmetry, and the associated problems of moral hazard and adverse selection.
As a result, lenders are saddled with high transaction costs for lending. Consequently, formal lending institutions end up undertaking
credit rationing, which leads to a considerable size of unmet demand for credit in the formal credit market.

Table 4: Credit registry coverage, 2009

Source: World Bank, 2011

Many informal credit providers try to fill the gap between the demand and supply of credit in the developing countries. Among these
are microcredit suppliers – microfinance institutions.

32
4.2 The formal credit market

Access to credit from the private sector in developing countries, including households and firms, is very low. For instance, if one
considers the size of credit as a proportion of GDP in developing countries as compared to that of the more developed economies,
it is evident that developing countries lag behind.

The main source of credit for the formal sector in most developing countries is the banking sector. However, the proportion of the
population that has access to banking services is quite low (see Table 5). The low level of credit in the formal credit market has given
rise to other sources of credit, such as microfinance, and other informal credit service providers, such as moneylenders, to help finance
household and business activities. Even though the focus of this section is on the formal credit market, we begin the discussion by
first looking at a number of concepts of importance in the informal credit market.

Table 5: Domestic credit to the private sector as a percentage of GDP

Source: World Bank, 2010

33
4.3 Credit rationing

Credit is very important in the case of developing countries, where there is a massive deficit in infrastructure development and, of
course, capital for project implementation at the firm level. Credit is required for the financing of fixed capital, as well as working
capital. It is also required for smoothing the consumption spending of households. Indeed, the importance of capital in the whole
development effort cannot be overemphasized. It is therefore imperative that we explore a very important feature of credit markets
that is usually not seen in other markets, even the good or productive markets. This is the phenomenon of credit rationing. Credit is
said to be rationed when lenders elect not to supply enough credit, even when there is a demand at an expected interest rate of the
lender.

The question that needs to be answered is why credit gets rationed? One of the basic building blocks of economics is that market
equilibrium is attained when supply equals demand. Price movements, in this case the interest rate, address any imbalance in the
market place. The presence of credit rationing is an indication of a mismatch between the demand and supply of credit. Stiglitz and
Weiss (1981) prove that even in the event of equilibrium in the credit market, there may still be credit rationing. The authors suggest
that credit rationing occurs because of information asymmetry between the lender and the borrower, and not necessarily as a result
of financial repression policies such as credit/interest rate ceilings. The information asymmetry arises because borrowers may have
more information about their own risk of default, as compared to what the lenders have.

The basis of the theoretical argument is that the probability of default is positively related to the contractual interest rate, so that as
the interest rate on the loan goes up, the probability of default increases. The probability of default by some borrowers may actually
increase disproportionately in relation to the increase in the interest rate if the latter goes beyond a certain threshold level. The
suggestion here is that for a group of borrowers the expected return to the bank or lender may fall as the interest rate rises, because at
such a point the lender’s incentive to lend evaporates, hence the lender stops lending. The lender stops lending, even if the borrower
is prepared to live with the higher contractual interest rate. This situation leads to credit rationing. This is one of the poignant
conclusions that Stiglitz and Weiss (1981) draw in their very influential paper. In fact, Stiglitz went on to win a Nobel Prize in
Economics 30 years after that paper, and he was awarded this prize largely because of that seminal paper. For a formal proof of this
point, read the Stiglitz and Weiss paper.

The credit rationing theory due to Stiglitz and Weiss indicates that increases in the contractual interest rate by the lender set into
motion two possible outcomes First, there is an adverse selection effect, which is due to the fact that as the interest rate is increased,
the riskiness associated with the pool of potential borrowers increases, mainly because the less risky borrowers move out of the
market. Second, a moral hazard effect also ensues, because borrowers are pushed to go for projects that have higher expected returns
and, of course, are associated with higher risk of default. The result is that the lender is saddled with a situation where the higher
expected return is negatively affected by the higher risk of default. Note that the expected return to the lender for a given loan
amount is the product of the contractual interest rate and the probability of repayment. Due to adverse selection and moral hazard,
or adverse incentive, as Agenor (2004) calls it, an increase in the contractual interest rate results in a fall in the repayment probability,
or an increase in the probability of default to a level that exceeds the threshold level of the contractual interest rate. This analysis leads
to a new credit market equilibrium, namely the credit-rationing equilibrium. This new equilibrium is characterized by a situation
where there is an excess demand for loans, with the lender attaining the optimal contractual interest rate that provides her with the
maximum expected returns.

34
The Stiglitz-Weiss hypothesis regarding the credit-rationing equilibrium provides some insights into why bank credit is seriously
rationed in some developing countries. Thus we have a persistent situation where bank-lending rates are insensitive to excess demand
for credit. Stiglitz and Weiss (1981) also provide an additional motivation for the existence of credit rationing beyond the distortions
in the credit market due to a deliberate policy of financial repression.

The existence of vibrant informal credit markets in most developing countries is attributed in part to the serious problem of credit
rationing that exists in those countries, to the extent that in most countries in Africa, you have a thriving informal credit industry,
whose contractual interest rates are multiples of what is charged in the formal banking industry (Aryeetey and Urdry, 1995).

While the credit-rationing argument has a large following, there are also a number of dissenting views that point out certain
limitations associated with the theory. For instance, in response to the assumption that lenders are not able to figure out the riskiness
of potential borrowers, others argue that banks can invest in screening technologies to help provide information for borrower risk
assessment. There is also the issue of collateral. The introduction of collateral requirements can mitigate some of the risk of default,
and thus indemnify lenders in the event of default. It is said that where banks are unable to assess the risk of borrowers meaningfully,
collateral from the borrower can help reduce the moral hazard effect that faces the lender. Lastly, the role of collection and verification
activities is left out in the Stiglitz and Weiss model. If lenders undertake to incur some costs to verify project outcomes suggested by
borrowers, and also legally enforce the terms of the loan contract in the event of default, the conclusions by Stiglitz and Weiss may
be different (Agenor, 2004).

4.4 Informal credit market

Literature regarding the informal credit market identifies six characteristics that are associated with the market (see, for instance,
Raj, 1998). These are:

(1) Credit rationing – as previously discussed, we have credit rationing when lenders, usually banks, are unwilling to provide all the
loan requirements of borrowers at the going market rate. Even though borrowers are prepared to take loans at the prevailing interest
rates in the market, for some reason bankers are simply not willing to supply loanable funds.

(2) Limited information – There is a problem of asymmetric information, as the lender is not able to obtain full information about
the prospective borrower. In other words, the borrower tends to have more information about his or her risk of default than the
lender has (Nagarajan et al., 1995).

(3) Segmented market – There is a high degree of market segmentation due to the matching of borrowers and lenders via occupational
specializations, to help internalize transaction costs, and thereby enhance economic activity.

(4) Interlinkages between markets – there is a large measure of lending along occupation lines. Tenants borrowing from landlords
and traders and farmers and traders borrowing from each other are important characteristics of the informal credit market.

35
(5) High and varying interest rates – interest rates are very high, and this is largely due to the high transaction costs associated with
the informal credit market. For instance, in a survey on microfinance in 2005, The Economist reported that in the Philippines itiner-
ant lenders who travel from town to town plying their trade charge one peso for every five that they lend out. This translates to an
annual interest rate of 1,000 percent per month (The Economist, 2005a). In a separate study, by Schindler (2010), where the author
investigated borrowing behaviour of women in an African country, it was concluded that the high interest rates prevailing in the
informal credit market actually tended to trap the informal market traders in poverty.

(6) Exclusivity – lenders usually refuse to grant loans if borrowers are found to have outstanding loans with other creditors or lend-
ers. Thus there is a restriction on borrowing, as the borrower is constrained to stick with one lender. Thus we have a high degree of
local monopolies.

The informal credit market is made up of a large number of transactions representing lending and borrowing activities, by an equally
large range of actors. The participants of the informal credit market include, but are not limited to, trained and unqualified mon-
eylenders, private finance firms, indigenous bankers, rotating savings and credit associations, pawn shops, traders, landlords, and, to
some extent, households (Agenor and Montiel, 1999).

The extensive informal credit market transactions may be grouped into four categories. First we have lending by individuals and
institutions using their own loanable funds, or funds sourced from third parties. Examples of lenders in this category include pawn-
brokers, indigenous bankers, and finance companies. Then we have individual firms and institutions that sometimes provide credit
facilities if and when they have surplus funds. The third category is what may be described as tied credit. Here the lender’s core busi-
ness activity lies outside the credit market, but he or she ties credit to the market where the core economic activity is located. The
last component is made up of group finance, or various activities such as those associated with cooperatives, that are engaged in the
mobilization of funds for the provision of individual credit. The main feature that sets group lending apart from the rest is the joint
liability. The point here is that if one member of the group defaults, the entire group is deemed to have defaulted. Consequently, the
independence of group members as far as access to credit is concerned often brings pressure on members that may be tempted to
default. The consequences of default by a member are so high that members do all they can to repay their loans. Group lending is
also able to draw on the social collateral that the group dynamics provide (Besley, 1995). In essence, group lending can help to reduce
the burden of asymmetric information, and can also help in the creation of the needed social collateral required to access credit. Thus
group lending has the potential of increasing access to credit for the poor in developing countries.

It has been demonstrated that the importance of each of the credit submarkets discussed above varies from one country to another
in the developing world. For instance, while tied credit is found to be a major feature of the informal credit market in India, rotating
savings and credit associations are the dominant forms of informal credit in Africa and parts of Asia. However, in Latin America
rotating savings and credit associations are not that common. Agenor and Montiel (1999) argue that group credit is used widely in
developing countries, and is found in both rural and urban communities in these countries.

Social collateral and the informal credit market

The notion of social collateral is based on the important role that trust plays in economic outcomes, more so in developing countries,
where formal institutions of finance are constrained. For instance, the presence of credit-rationing equilibrium means that in the
credit markets we do have a considerable size of demand for credit, which is unmet. As argued earlier, the excess demand for credit

36
to a large extent accounts for the existence of informal credit markets. It is in the informal credit market that social collateral and
inverted banking play important roles. This section of the lecture notes provides an introduction to the concepts of social collateral
and inverted banking. However, we do not consider the formal proofs of the theories. The proofs are not necessarily of interest at this
point in time. However, interested readers may follow up with the relevant references for more in-depth discussions and derivation
of the theoretical proofs. For instance, Karlan and Mobius (2008) discuss social networks and informal lending in poor communities
in Peru. The paper also sheds light on the theories underlying social networks which draw on social collateral.

The notion of social collateral is an integral part of social networks, which, in turn, has a special place in informal contract formula-
tion and enforcement. Drawing on historical anecdotal evidence that is quite popular in the literature of social networks, we illustrate
how social networks offer the capital for social collateral. The following example first appeared in Wechsberg (1966), however in the
current presentation it is as it is given in Karlan and Mobius (2008). A story is told about an influential merchant in Norway, who
had sent one of his ships to a shipbuilding yard in Amsterdam for repairs. The merchant needed that particular ship to undertake a
lucrative business venture, but the ship repairers would not release the ship until the cost of repairs, the equivalent of £200,000Brit-
ish pounds, had been paid. Now the trouble was that there was no way that the merchant sitting in Norway could raise the required
amount to be paid in Amsterdam before the weekend. In order to deal with the concern, the Norwegian merchant calls an acquaint-
ance in the financial district of London, a banker, to be precise, to seek help. The Hambros banker, seeing that it was getting near to
the close of business, asked the merchant in Norway to stay by the phone as he instructed a secretary to write a telex message to a
corresponding bank in Amsterdam: “Please pay 200,000 pounds telephonically to (name) shipyard on understanding that (name of
ship) will be released at once”.

In the above example, the merchant shipowner sitting in Norway borrowed 200,000 pounds on immediate notice from a bank in
Amsterdam with which he has no relationship. The merchant is made to pull this one off, by collateralizing two business associations.
The first is his connection with the banker in London, and the second is the relationship between the banker in London and the one
in Amsterdam. According to Coleman (1990), as cited in Karlan and Mobius (2008), the London banker played the role of “trust
intermediary” by standing surety for the Norwegian merchant. In the event that the merchant defaults, the bank in Amsterdam may
ask the one in London to cover the losses. This example illustrates the vouching role that intermediaries play and, more importantly,
the collateral function that they play in securing transactions. There are formal theories that have been developed, which draw on the
game-theoretic model of informal borrowing within a framework of social networks. The theory suggests that the maximum amount
lent in this kind of market is defined by the amount of trust between the borrower and the lender.

Usually, borrowers are expected to have some assets that they can collateralize when assessing loans. However, in most developing
countries, especially the poor ones, borrowers lack collateralizable assets. They, however, do have social networks that can offer social
collateral, probably not in the same fashion as in the Amsterdam example, but in a different form. For instance, in poor communities
there are various social groups that offer certain networks. These networks can be drawn upon to serve as collateral in cases where
asset-poor community members want to access loans from microfinance institutions.

Over the past four decades or so, microcredit has been offered within the context of microfinance to asset-poor households and,
in some cases, SMEs in developing countries. The asset-poor usually do not have access to credit from the conventional banking
industry, because they lack material collateral.

37
Through inverted banking, provision of credit to the asset-poor for raising their incomes (Rao, 2003) has been pursued over the years,
largely by microfinance institutions. In recent times, however, the provision of microcredit has come to be seen as sustainable busi-
ness, and not necessarily as charity. Consequently, following the success of the Grameen Bank and others, the microfinance industry
has grown in leaps and bounds, to the extent that some of the big players in the conventional banking industry are considering pro-
viding one or other form of microfinance service (The Economist, 2005). The leading multinational microfinance institutions include
ProCredit, Opportunity International, FINCA, ACCION, Women’s World Banking, and the notable Grameen Bank. However,
Opportunity International, FINCA and Grameen have the provision of credit as their core activity.

There appear to be two main strategic approaches to the supply of microcredit thus far. We have the individual credit path, and the
group credit path. While there is strong motivation for group lending (Besley and Coate, 1995), in practice, microcredit networks
such as ProCredit, a major service provider found in over 15 countries, are against group credit. ProCredit argues, among other
things, that group lending works well only in rural communities where there is greater homogeneity, and individuals are truly very
close. This closeness strengthens social trust. ProCredit also takes the position that individual borrowers need to be judged on their
own merit, and therefore should not be responsible for the failure of others.

Concluding remarks

A very high level of credit rationing characterizes credit markets in developing countries. Generally, the failure of the formal credit
market to meet the needs of borrowers explains, in part, the existence of a vibrant informal credit market. The reasons accounting for
the weak formal credit market are not far-fetched. These include, but are not limited to, the weak financial infrastructure and market
imperfections. Microfinance is increasingly assuming a greater role in meeting the credit needs of the large population outside the
formal banking system. However, the ability of the microfinance institutions to fill in the gap in credit provision is limited. Deliber-
ate government policy is required to help put in place the required infrastructure to reduce the high transaction costs and market
imperfections. It is such an effort that can help reduce the high level of credit rationing, and thus increase access to credit for the
financing of development.

Readings

Steijvers, T. and Voordeckers W. (n.d.), Collateral and credit rationing: a review of recent studies as a guide for future research, Has-
selt University, KIZOK Research Centre, Belgium.

The Economist (2005), A survey of microfinance: From charity to business, The Economist Newspaper, November 3, 2005.

The Economist (2005), A survey of microfinance: Micro no more, The Economist Newspaper, November 3, 2005.

38
 CHAPTER FIVE

EXTERNAL AID AND DEVELOPMENT

5.1 Introduction

As demonstrated earlier in the review of development finance institutions, external aid is one of the important sources of funds for
financing development. This section of the lecture notes presents a concise discussion of foreign or external aid, and its role in foster-
ing development. An attempt is also made to review the evolution of foreign aid. Also discussed is the trend in the volumes of aid
over the past five decades, as well as the theoretical and empirical arguments for and against aid as a growth stimulus. The section
ends with a look at the question of aid effectiveness, and the question of the fungibility of aid.

The origins of modern foreign aid date back to the colonial era, where the “mother country”, or “metropole”, sent grants and loans to
the colonial governments to build infrastructure and pay for imports (UNCTAD, 2006). From the 1940s, when the Marshall Plan
of aid was designed to help reconstruct Europe after the Second World War, various foci have been identified as drivers of aid until
now. Each of these foci dominated a given decade, so that, for instance, the emphasis in the 1970s was on supporting agriculture and
basic needs, the motivation for support in the 1980s was macroeconomic reforms, in the 1990s the issues of governance and poverty
were key motivations, and in the 2000s the focus was again on poverty, and the Millennium Development Goals.

5.2 Official development assistance

Official development assistance (ODA), or foreign aid, may take on several definitions. In the present circumstance, ODA is defined
as concessional capital flows from individual donor countries, particularly those that belong to the Development Assistance Com-
mittee (DAC), to recipient countries, usually low-income countries. The definition also includes concessional capital flows from the
multilateral institutions (such as the World Bank and the five other regional development banks). Also included in the ODA flows
are loans that are non-concessional in nature. These are facilities from the IMF, the Paris Club of creditors, and many others. The
DAC has 24 members, and these are mostly drawn from the OECD countries, or the rich world. The committee includes the US,
Japan, the EU, and many western European countries. South Korea, the newest member, joined the DAC later, in 2000.

Trends in ODA
The measuring of aid volumes needs to be done with caution, because not all reported aid is actually delivered to recipients. Thus the
“real aid” is often smaller than the nominal aid extended to developing countries, for many reasons. The UNCTAD (2006) report
14
states that in a study by ActionAid 60 percent of all bilateral donor assistance can be described as “phantom aid” , because the aid
never materialized for the intended poor in the developing countries.

14
According to ActionAid, this includes aid that is not targeted to poverty alleviation, double counting when aid is given in the form
of debt relief, when it is overpriced or simply ineffective for one reason or other, when it is tied to the procurement of goods and
services from the donor country, when it is associated with high transaction costs because it is poorly coordinated, etc.

39
And the aid was often directed to other purposes within the aid system. Nonetheless, the figures from the DAC concerning the
OECD countries are reckoned as the most authoritative, comprehensive figures concerning aid to developing countries. Over the
past five decades development assistance has grown steadily. Indeed, capital flows increased from around US$30bn in 1960 to over
US$90bn when they peaked in 2005 (see Figure 1). A review of the decadal averages suggests that the 2000s saw a relatively high
rate of increase in ODA flows per year, averaging six percent per year (see Table 6). The high volume of concessional capital flows in
the 2000s is understandable. It is over this period that we had the Monterrey Consensus in 2002, fashioned to increase ODA relative
to the 1990 levels, when there was a protracted decline in aid. There was also the “big push” for a doubling of aid to the developing
world. The increased advocacy for additional concessional capital flows to the developing world may in part explain the high volume
of capital flows.

Figure 1: Trends in total ODA, 1960–2009 [Constant 2008 US$]

 
Source: DAC Online

There has also been a significant inflow of aid from until recently non-traditional sources of ODA. These new non-DAC donors
have been described as “emerging donors”. They include countries such as China, India, Brazil, and Turkey. For example, China has
been very active in the provision of concessional loans to other less advanced developing countries, particularly those in Africa. The
government of China’s recent White Paper on the China-Africa Economic and Trade Cooperation suggests that the size of conces-
sional loans from China to the developing world for the two-year period up to 2008 was more than the capital flows from the World
Bank to developing countries.

At the bilateral level, the US has also pledged billions of dollars to developing countries, through her Millennium Challenge Cor-
poration (MCC), via the Millennium Challenge Account (MCA), which was created in 2004. As at the end of 2010, the MCC
had disbursed US$7.5bn to support country-determined projects in various sectors, such as agriculture, transport infrastructure, and
health, among others. The criteria for accessing this grant consist of a set of conditions that revolve around economic governance,
economic freedom, and a country’s investments in its citizens.

40
Table 6: Growth in ODA flows, 1960–2009

Source: Author’s computation based on data from the OECD statistical database

Reasons for providing ODA

The works of Maizels and Nissanke (1984), Ruttan (1989) and Rao (2003) identify a number of reasons that inform the provision of
foreign aid by rich countries. The donor country’s economic and strategic interest is usually served by the provision of aid. Sometimes
the provision of aid is motivated by a sense of moral responsibility towards poor countries, especially for countries which formerly
were colonizers, and who feel guilty at having colonized the country in question. In the paper by Ball (1996), cited in Rao (2003),
there are suggestions that the motivation for the US government’s aid programme under the PL480 for more than 20 years was
driven by America’s self-interest emanating from geopolitical considerations, and the need to get rid of agricultural commodity sur-
pluses. These factors underscored the provision of food aid to many African countries. A key example of the geopolitical considera-
tions that drove the giving of aid in the Cold War era was the pursuit of ideological dominance by the Eastern and Western bloc of
countries. The political considerations then grossly distorted the outcomes of aid to developing countries. Regarding the motivation
for the provision of aid, UNCTAD (2006) suggests that, while economic grounds appear to be the reasoning behind the supply of
foreign aid, “in practice it has been heavily influenced by commercial and political calculations of donors”. UNCTAD (2006) further
argues that, as far as the politicians and the general public in the richer countries are concerned, the aid is more of a humanitarian
gesture, and less of an economic stimulus to help facilitate faster economic growth.

On the theoretical front, the aid-savings-economic growth nexus has been identified as the basis for using aid to help jump-start
economic growth in developing countries (Riddel, 1987). However, Krueger (1986) argues that aid provision is more or less a zero-
sum game when the welfare of the giver and the recipient are considered. Thus, if the receiving country gained in welfare as a result
of the aid, the giving nation will lose out. Empirically, the role of aid in economic growth and, by extension, economic development
has been extremely contentious. In the next section we present some of the competing arguments that inform the debate.

5.3 Foreign aid and economic growth: The debate

Apart from the provision of aid in times of natural disasters, or in the form of humanitarian assistance, the usual argument has been
that aid will spur economic growth. The two-gap model suggested by Chinery and Strout (1966), which was based on the Harrod-
Domar model of economic growth, has been the dominant theoretical anchor of aid and economic growth. This approach has also
been described as the financing gap model (Rao, 2003). The thrust of this proposition is that foreign development assistance, in
addition to borrowed capital from overseas countries, are the two main drivers of economic growth. The point here is that the ad-
ditional capital from outside will help to plug the domestic gap between investment and savings that exists in developing countries.

41
Morrissey (2001), for instance, argues that aid increases the capacity to acquire capital goods, and also increases investment in physi-
cal and human capital. While other competing positions have been advanced for explaining why foreign aid has to be provided to
help developing economies grow, the evidence for and against the effectiveness of aid is inconclusive.

The literature on the growth outcomes of aid is extensive, and inconclusive to the extent that we have papers that say aid has a nega-
15 16
tive effect on growth, while others are of the view that the growth effect is positive . Yet others argue that aid has no significant
17
impact on growth, in other words it is neither negative nor positive. There are some nuances in the outcomes as well that need to
be noted. For example, Burnside (1997) argues that aid in a good policy environment can lead to economic growth. There are also
arguments that the motivation for the aid structure, or kind of aid, concerned (i.e. tied aid, technical assistance, or direct budgetary
support) is deemed to have differential effects on growth. However, by and large, one can conclude that the literature provides mixed
empirical results regarding the capacity of aid to foster economic growth.

There is also a range of advocacy groups all over the developed world and in the global NGO industry that argue either for or against
the provision of foreign aid by rich countries of the North to developing countries. Some of the advocacy groups in the US include
the Cato Institute and the Heritage Foundation, who argue strongly that aid does not work. Their main argument is that years of
extending aid to the developing world have not resulted in significant economic outcomes, and that aid needs to be discontinued.
They are of the view that only if governments in the developing countries institute good governance and ensure that there is eco-
nomic freedom will sustainable and significant growth be realized. The United Nations and other NGOs, on the other hand, have
been routing for increased aid volumes and an effort to ensure that there is increased aid effectiveness to help realize the intended
objectives of extending foreign aid to poor countries.

5.4 Aid effectiveness

It is common knowledge that foreign aid does not always end up being used for the purpose for which it is given; this phenomenon
is referred to as “aid fungibility”. Aid fungibility is the ability to indirectly divert donor funding to non-targeted expenditures. This
may be due to the fault of the giver and the receiver. One of the empirical studies that argue that foreign aid is fungible is the work
of Feyzioglu et al. (1998). In a more recent study that focused on Africa, Jones reviews the literature on the phenomenon and then
interrogates the issue empirically. The author ( Jones, 2005) reaches the conclusion that aid is slightly fungible at the macro level,
where funds are diverted to tax relief. However, a greater level of fungibility occurs at the meso level, where funds are moved from
one sector to another. Jones also indicated that multiplicity of donor agencies in a given country tends to increase the incidence of
fungibility. Interestingly, Jones suggests that fungibility may not necessarily be a bad thing for economic development.

Donors and recipient nations have long realized that for sustainable development, aid funding needed to be put to a more effective
use. This is more pertinent now, given the resurgence in aid volumes, following a decade of donor fatigue in the 1990s. The Paris
Declaration of March 2005 enjoined donor countries to pursue a set of actions to help improve the effectiveness of foreign aid.

15
Burnside and Dollar (2000), Brautigam and Knack (2004).
16
Gupta and Islam (1983), Hansen and Tarp (2000), Dalgard et al. (2004), Karas (2006).
17
Mosley (1980), Mosley et al. (1987), Jensen and Paldam (2003), Paldam (2009).

42
The whole idea of the Paris Declaration was to ensure good partnership between the donor community and the recipient developing nations
for better development outcomes. The thrust of the declaration was to ensure that developing countries took ownership of the strategies for
growth. They were also to improve their institutions and address corruption. Alignment of strategies of donor countries and organizations
with those of local systems, where possible, needed to be pursued. There was also a call for increased harmonization of the procedures and
processes of donor countries and organizations, in order to cut down on the transaction costs of recipient countries. Increased monitoring
and evaluation of the outcomes of development interventions was to be undertaken more vigorously. Lastly, it was agreed that donors and
recipient countries needed to be equally accountable for development outcomes emanating from external aid (OECD, 2010).

Following the Paris agreement, the Accra Agenda for Action in 2008 operationalized the Paris Declaration with four items on an agenda
to accelerate progress on aid effectiveness. These include:

(1) Aid predictability – under this point donors are encouraged to provide in advance a 3- to 5-year plan of intended aid dis-
bursement. This is expected to help recipient countries plan better for the use of the inflows.
(2) Use of country systems – the local or in-country administrative systems will be the first choice for aid disbursement, as
against a situation where the donor systems are the preferred disbursement channels.
(3) Relaxation of conditionality – the use of recipient country development objectives to determine how and when aid should
be spent is to be pursued. The hitherto followed aid policy of prescriptive conditions will be discontinued.
(4) Untying of aid – donors will ease restrictions that tie aid to the procurement of goods and services from the donor coun-
try. Developing countries that have received aid will be free to purchase goods and services with aid money from whomever and
wherever they can get the best value for money.

Concluding remarks

The effectiveness of external aid in the context of economic development in developing countries has attracted much attention in the lit-
erature lately. Given that the more endowed northern countries have provided external aid to developing countries for many decades, ques-
tions are being raised about the usefulness of aid as a stimulus for economic development. In both the theoretical and empirical literature
cogent reasons have been advanced by each side of the debate about the effectiveness of aid in fostering economic development. However,
the case for continued provision of aid by the rich world to the developing world appears to be the dominant position, to the extent that
the doubling of present aid levels has been suggested. Some of the proponents of the so-called “Big Push” campaign to ensure an increased
level of external aid include the United Nations Conference on Trade and Development (UNCTAD), Tony Blair’s Africa Commission,
and other NGOs and civil groups.

The argument for more aid notwithstanding, it is also noticeable that the importance of external aid as a source of development finance is
changing. For instance, in addition to the traditional sources of development aid, new donors are emerging. Notable among them is China.
India also provides external aid to countries in Africa, albeit on a much smaller scale than China. Brazil, a member of the BRIC group of
countries, also supports developing countries. Remittances from overseas have also assumed much importance as a source of development
finance in most developing countries, including India, a more resourceful developing country. There are also a number of new development
finance instruments, such as the Clean Development Mechanism (CDM) development finance instrument, which is concerned with cli-
mate change mitigation and control efforts. In sum, the value of external aid as an important source of development finance is diminishing
as new sources emerge.

43
Readings

Burnside, C. and Dollar, D. (2000), Aid Policies and Growth, The American Economic Review 90(4): 847-869.

Burnside, C. and Dollar, D. (2004), Aid Policies and Growth: Reply, The American Economic Review, June.

Cato Institute (2009), Cato Handbook for Policymakers, 7th edition, Washington, D.C.: Cato Institute.

44
 CHAPTER SIX

COUNTRY RISK ANALYSIS

6.1 Introduction

One of the important sources of capital for development finance is the capital market. This source of financing is outside the domain
of multilateral players, bilateral players, or philanthropy (see Development Finance System in Chapter 1). The international capital
market is a private initiative with no governmental influence, except legitimate regulatory initiatives. In order for one to access capital
on this market, certain things are required from the borrower. An important requirement is the state of country risk under which the
borrower operates. The country risk outcome is usually reflected in the sovereign credit rating. A favourable sovereign credit rating
suggests that a country, or private borrower from a given country, can access capital at a relatively more favourable cost. There are
many institutions that provide credit rating services (see Chapter 1).

6.2 Assessment of country risk

A number of approaches exist for the assessment of country risk. In general, there is the qualitative approach and the quantitative
approach. The qualitative approach dwells on a qualitative assessment of the financial, macroeconomic, legal, regulatory, and political
situation in a given country. Some of the rating agencies that use the qualitative approach include Euromoney and Beri SA. How-
ever, each of these has an in-house methodology. Euromoney uses a 32-person panel of eminent economists in international financial
institutions and another panel of political analysts to measure the short-term risk of destabilization. Outputs of the two panels are
then weighted and used in coming up with the ratings.

The Economist Intelligence Unit (EIU) and the International Institute of Finance (IIF) are some of the organizations that provide
information on country risk analysis on a regular basis. Financial institutions tend to consult these sources before making decisions
regarding the pricing of loans to countries or corporates. By contrast, the quantitative method for rating and scoring countries on
the country risk analysis tables may be based on the econometric approach and model-building efforts, or the analytical approach,
such as those that use crisis typology.

The outcome of a given country’s risk analysis is informed by a number of indicators that usually include, but are not limited to,
economic, financial, monetary, operating, and political risk conditions. Principal component analysis may also be used. Logit analysis,
as well as other non-linear analytical frameworks such as non-linear conditional analysis, may also be used. These approaches are
undertaken to reflect the impact of the various country risk indicators on the impact of creditworthiness and risk.

While country risk analysis can be helpful in providing information on the creditworthiness of countries, we need to highlight a
number of pros and cons associated with country risk ratings. The advantages include the fact that the analysis is simple, in the sense
that one is able to come up with a discrete measure of the risk associated with a given country at a point in time. It also affords lend-
ers and borrowers the opportunity to do cross-country comparisons. In addition, the credit rating is able to collapse a large number
of indicators or variables into a single grade or indicator.

45
The disadvantages are that country risk analysis has been criticized for being “reductionist”, overly simplistic, and of little predictive
value. It has also been described as having the tendency to set in motion a self-fulfilling process of perception of risk, either for good
or bad. The weighting inherent in the computations has also been criticized on the grounds that it has the tendency to overlook
important trends. Lastly, credit rating may stimulate the formation of “market consensus”, which usually leads to a herd instinct in
the market place.

The rating agencies, or the institutions that provide rating services, have also come under intense condemnation, especially in the
wake of the financial crisis that started in the US in 2007. Rating agencies are expected to be independent third parties that are
consulted when putting together financial deals. The purpose of the consultation is to reduce the asymmetric information between
the two sides of the market, i.e. the supply and demand sides of capital markets, using transparent and standardized assessment
criteria. However, the agencies have been criticized for operating with little accountability. They are also thought to be exhibiting
biases, either by ensuring that their assessment conforms to that of other agencies in the industry, or by perpetuating socio-cultural
biases of the countries from where they operate. The victimization of firms and countries that do not seek a rating has also been cited
as a shortcoming.

In recent years the renewed criticisms of the rating agencies have been borne out of the favourable ratings that financial institutions
such as Bear Stearns and Lehman Brothers had just before they faced problems in the wake of the 2007 financial crisis. There are
also other historical references, such as the high investment rating of AA assigned by Fitch and S&P to South Korea just before
the Asian financial crisis in 1998. It is said that South Korea was placed on the same rating as Italy and Sweden, even as at October
1997. However, when the crisis hit, the country was quickly downgraded to a junk-bond status.

Presented in the table below are credit rating from the Institutional Investor, a country-risk rating agency. The ratings represent the
assessment as at September 2007.

46
Table 7: Global credit rankings

Source: Institutional Investor:

http://www.iimagazinerankings.com/countrycredit/GlobalRanking.asp. Accessed on 21 March 2011.

Conclusions

Country-risk analysis is a very demanding task. It requires specialized skills and a reliable source of information and a standardized
or consistent approach. Generally, no matter the rating agency or approach adopted in undertaking country-risk assessment, a wide
range of factors ought to be considered. The most important of these are macroeconomic, social, political, and financial factors. The
assessment has to demonstrate in an unambiguous manner the strengths and weaknesses of a given country, in an effort to establish
the risk level and associated pricing for the asset in risk.

Reading

The Economist, (2011), Credit ratings: Downgrading expectations, The Economist, February 24, 2011.

47
 CHAPTER SEVEN

FINANCE AND SUSTAINABLE DEVELOPMENT

7.1 Introduction

There are various ways that sustainable development can be defined. However, the most apt definition is that offered by the au-
thoritative Brundtland report on sustainability . The thrust of the definition is that sustainable development is development which
meets the needs of the present generation, but not at the expense of future generations. The keywords in the definition, it has been
argued, are needs and limitations. Needs may be considered more broadly to encompass both those of the developing world, and
those of the developed world. Regarding the limitation aspect, here we are referring to the limits imposed by the finite nature of the
resources available within the confines of the current level of technology, and the environment’s ability to meet the needs of society.
We also have to be mindful of the notion of a system in discussing sustainability. Thus, people and space, in terms of time, are very
much interconnected.

Finance, whether it is corporate finance, development finance, valuation, or any other aspect of finance, has an important place in
public policy and economic outcomes. This is especially so because finance drives commerce, industry, agriculture, and, indeed, every
facet of economic activity. The financial problems that hit the world in 2007 following the US sub-prime mortgage crisis, and the
subsequent ripple effect in the real economy, demonstrate the far-reaching role of finance. It is also not difficult to figure out that
finance plays a role in determining whether society, including households, firms, and governments, will be successful in pursuing
an environmentally sustainable course. The purpose of this section is to examine the role of finance in helping to address the grave
environmental problems that confront the world, particularly in its development efforts.

7.2 Environmental issues, sustainable development, and finance

The past five decades have seen an increasing effort to bring the issue of economic development into the mainstream global discourse
on development. Following the first international conference on the environment in 1972, many significant landmarks regarding the
nexus between economic development and the environment have been achieved. In Table 8 a select number of the key initiatives
and their accompanying outcomes are identified. The initiatives include activities at the intergovernmental level, as well as activities
by the corporate world.

18
World Commission on the Environment and Development (WCED). 1987. Our common future. Oxford: Oxford University Press,
p. 43.

48
Table 8: Evolution of sustainable development issues, 1972–2005

49
7.3 Response by governments

The paramount financial issue, by far, in the 21st century is the problem of climate change. This phenomenon has been very much
highlighted because of the massive scientific evidence that has been collected by the Intergovernmental Panel on Climate Change
(IPCC) and academia over the last decade. The influential Stern Report released in 2006, which provides an estimate of the eco-
nomic cost of climate change in the world, has also helped in raising climate change issues, to the extent that they have now been
placed at the forefront of public policy, in both the developed countries and the developing countries. Several governments have
instituted measures to address climate change challenges.

Cogent arguments have been advanced in the literature regarding the efficacy of taxation and emission-charging schemes in helping
achieve environmental goals in a cost-efficient manner (Fullerton et al., 2008). This approach stands in sharp contrast to the standard
regulatory policies that focus on technology mandates or emissions control, among other things. However, it should be noted that
not all environmental concerns can be addressed by environmental taxation. Furthermore, like many other policy alternatives, there
are a number of pros and cons associated with environmental taxes and other related economic instruments.

An example of some of the advantages related to the imposition of tax to curb environmental pollution is that related to “static” ef-
ficiency gains through reallocation of abatement. For instance, there is the possibility of providing incentives to polluters to consist-
ently reduce emissions, even at levels below the current cost-effective level, because of the tax associated with each unit of residual
emissions, thereby encouraging the development of new technology that may have lower marginal costs below the tax rate (Fischer
et al., 2003). This is in sharp contrast to the situation where the regulatory authority legislation that polluters use particular tech-
nologies or ensure emission below a given limit may lead to compliance, but does not provide incentives to make further reductions
below the stipulated limit. The tax also has revenue-raising potential. The revenue benefit of environmental tax is also referred to as
the “double dividend”. An example of the shortcomings of environmental taxes is related to concerns about competitiveness. When
governments impose additional taxes to curb pollution, the cost structure of producers increases. This puts them at a disadvantage
with their international competitors, who do not face similar tax demands at home. (See Fullerton et al., 2008 for a detailed discus-
sion of a number of pros and cons of environmental taxes.)

Thus far, only two countries in the developing world, namely South Africa and India, have instituted some or other kind of pollution
tax. In both instances, the laws came into effect in 2010, on July 1 in India, and on September 1 in South Africa. By contrast, there
are environmental tax regimes in most developed countries in Europe, America, and Australia.

7.4 Response by business

Environmental issues are increasingly assuming greater importance in business, and these issues cut across a wide spectrum of busi-
ness activities. The business areas where sustainability has attracted much attention lately include the financial sector, as well as the
realty sector. For example, CFO (2008) reports that Herman Millers, a leading furniture manufacturer in the US state of Michigan,
has 95 percent of customers wanting to know whether sustainability issues are addressed in the procurement of timber, the state’s
major raw material. The use of clean energy is also an important concern in various sectors of the community. The same CFO report
suggests that the Bank of America, one of the leading banks in the USA, has set aside a huge sum of money to help reduce her carbon
footprint. Some financial institutions in the developing world are also pursuing measures to help deal with the sustainability issues,

50
in their own way. Nedbank in South Africa, for instance, has adopted the Equator Principles, aimed at dealing with environmental
sustainability. The Equator Principles are a set of principles that constitute financial sector benchmarks for determining, assessing,
and addressing social and environmental concerns in project finance. The Equator Principles have a large number of stakeholders.
These include, but are not limited to, development finance institutions, the International Finance Corporation (IFC), and NGOs,
among others.

The production of palm oil, a leading vegetable oil commodity, produced in countries in the tropics and used in the manufacturing of
many consumer goods, is faced with critical sustainability issues. The whole value chain involved in the palm oil industry is engaged
in a multi-stakeholder forum to address sustainability questions relating to palm oil production. Some of the stakeholders concerned
are financial institutions, producers of palm oil, as well as users, and development finance institutions, such as the World Bank and
International Finance Corporation (IFC). Some of the users concerned include Unilever and Procter and Gamble, the leading
names in fast-moving household consumer goods production. The thrust of the initiative is to ensure that palm oil is produced in a
sustainable way, such that climate change and deforestation concerns are not compromised. The multi-stakeholder forum, known as
19
the Roundtable on Sustainable Palm Oil (RSPO) , has developed a set of principles that feeds into a certification process, namely
Certified Sustainable Palm Oil (CSPO) accreditation, which is hoped to push stakeholders to address sustainability concerns.

Concluding remarks

Finance plays a role in the discourse concerning environmental sustainability. Because finance drives economic activity, attention has
now been drawn to how finance can contribute to ensuring the sustainability of the environment. Business’s response to the sustain-
ability question is still evolving. However, one of the efforts aimed at speeding up the process and supporting a meaningful response
is the Equator Principles. These have been developed to help the finance industry, especially those involved in project finance, to
place a higher premium on environmental risk.

Readings

EPA (2010), The Equator Principles, Equator Principles Association, http://www.equator-principles.com/documents/EP_Govern-

ance_Rules_June%202010.pdf.

The Green Political Organisation (2002), Sustainable Finance, Economic Briefing No. 2, The Earth Summit 2002, Johannesburg.

19
See www.rspo.org for more information.

51
LIST OF REFERENCES

Agenor, Pierre-Richard (1992), Parallel Currency Markets in Developing Countries: Theory, Evidence, and Policy Implications. Es-
say in International Finance No. 18, Cinchester: Princeton University.

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