Regulation and economic growth
Giovanni di Placido, Analysis and Research Director BBVAMF
We have all read about the political and military disintegration of the Roman Empire at the hands of the Germanic tribes, preceded by civil wars, social uprisings, plagues, depopulation, etc. However, there is some consensus that all these phenomena were in turn preceded by an economic crisis with high inflation, shortages, recession and a reduction in trade that led to different areas of the empire closing their economies and aiming at self-sufficiency.
The development of the microfinance sector does not just depend on institutions building up innovative, sustainable, low-cost business models but also on the regulatory environment in which they operate, which must be suitably tailored to their specific characteristics, size and risks
The Roman Empire had enjoyed a long boom, reaching the height of its splendour under Augustus and Tiberius. Many historians consider what later came to be called the “decadence” of the empire to be the outcome of regulatory intervention and confiscatory tax regimes.
The debate about regulation and its impacts on the economy stretches back to ancestral times, and is one of the most controversial issues in economic policy.
Opinions and theories about regulation tend to be formed according to people’s ideological approach to economics. These range over a wide spectrum. There are those who favour fully-fledged intervention, arguing for direct government involvement in key productive activities in order to correct market failings by, for example, encouraging industrialisation through the substitution of imports and extending public ownership of companies. At the other extreme, there are those who argue for a total deregulation.
At present, there is a strong consensus around the idea that regulations can be the most efficient way to promote economic growth and development by acting on incomplete markets, re-balancing information asymmetries, mitigating entrance barriers and establishing constraints when economic transactions relate to what could be considered public goods.
Institutionalisation plays a central role in regulation. In developing countries, it is not sufficient to build up sets of efficient regulatory standards. The problems they face are not simply s the designs of regulatory instruments. Often, the greatest challenges lie in the quality and capacity of the regulatory institutions themselves.
Even when the regulatory framework is underpinned by sound institutions, the relationship between regulation and growth is always complex. Regulation does not have a one-on-one, linear impact on growth but acts on two fundamental drivers behind it: investment and productivity.
Regulation can have a positive impact on growth by eliminating market shortcomings and improving economic efficiency, simultaneously boosting both investment and productivity. However, it can also have a negative impact, creating substantial compliance costs and unwanted side-effects that distort markets. The overall impact of regulation on growth will have much to do with trade-offs between the two.
The regulations ensuing on the last financial crisis provide us with a clear example of this. In general terms, the need for a regulation will depend on the perception of the latest crisis and in this century, many saw the crisis as the outcome of excessive deregulation, a trend that began under the conservative governments of the nineteen-eighties. Their conclusion was that under-regulated markets are neither efficient nor stable.
As a consequence, this led to a significant increase in regulation, with regulators, very naturally, targeting the stability of the financial system as a whole. However, the search for greater stability imposed high costs on institutions that had to comply with the new standards.
Without entering into the dynamics and pertinence of the new regulatory frameworks, we can observe the evidence showing that where regulation has been most restrictive, the economy has grown less and risks have not been mitigated. Rather, an environment of uncertainty has been created around new regulatory requirements, which has been negative for institutions, experiencing an increase in risks.
Thus, we now see how important it is to reach a correct analysis of the impacts of regulation, in order to stop it from constraining economic growth. In a low-growth or recession scenario, fear leads individuals to reduce consumption and businesses to reduce investment. This ends up weakening the economy, which confirms these fears and leads to further reduction. The economy enters into a vicious circle, in which risks increase in line with regulatory costs.
At a more general level, literature using aggregate measures for regulation (eg, the World Bank Doing Business Indicators) concludes that the differences between countries’ growth rates can be partly explained by differences in degree of regulation.
However, the correlation is non-linear. The benefits of reducing the intensity of regulation are greater for highly regulated countries and lower for more lightly regulated countries. This leads us to suspect there must be an optimal level of regulation associated with acting on incomplete markets , resolving information asymmetries and the impact of externalities and mitigating barriers to new market-entrants. This is specially relevant for emerging economies.
Regulators’ decision-making should incorporate consideration of a trade-off between the benefits of regulation and economic growth, and take into account regulations’ potentially negative impact on the creation of firms and entrepreneurial initiative in general.
In general, large companies operating in large markets tend to be more able to afford compliance costs than small ones, as there is a high fixed-cost component associated with compliance. New start-ups face a similar penalty.
It is not just chance that the most regulated industries have a lower percentage of start-ups and slower rates of job creation, above all in small enterprises, compared to less regulated sectors.
Such matters become more relevant still in emerging economies, where regulators often fail to take into account the side-effects of regulation on different market-segments, often imposing high costs of entry. This explains the preponderance of the informal economy in developing countries, due to important asymmetries between regulated and unregulated markets.
Regulation in such cases constitutes a burden on small companies, hampering their growth and leading to higher rates of underemployment, poverty, gender inequality and precarious employment. And in the end, this has a negative impact on aggregate productivity of the economy and its growth potential.
Many of the people and small businesses acting in such environments find themselves excluded from the financial system. Financial inclusion is essential to reduce vulnerability and achieve more inclusive economic growth. The causes of exclusion would seem to include high delivery costs, market faults due to asymmetries in access to information and imperfect disclosure, the absence of property rights and collateral rights, etc. This is where microfinance comes into its own.
The development of the microfinance sector does not just depend on institutions building up innovative, sustainable, low-cost business models but also on the regulatory environment in which they operate, which must be suitably tailored to their specific characteristics, size and risks. Governments should aim to build up the right kind of regulatory and supervisory framework that can minimise opportunity costs and distortions while fostering innovation.
Avoiding the inefficiencies associated with over-regulation or “regulatory repression” could help the microfinance industry to develop. A paradigmatic example of this is interest-rate caps.
There are recurrent concerns voiced about the level of interest charged by microfinance institutions, above all in comparison with other institutions in the financial system. It is thought that high interest rates may reflect inefficiencies and suggest that the microfinance institutions are lacking sensitivity towards the plight of poorer borrowers.
Yet, since the loans given by such institutions are so small, they bear high delivery costs due to the characteristics of the markets, these costs tend to be high for the amount of the loan.
Many regulators have opted to cap interest rates. However, in all markets where this has happened, and above all when they fail to factor in rational operating costs, such caps have led to operations being cut back in the poorest, most isolated communities, leading institutions to concentrate on urban areas and increase the average amount lent in order to make their loan books more efficient and profitable.
Additionally, they push the youngest institutions out of the market, encouraging greater concentration of players. For new institutions, operating costs tend to account for some 56% of their gross portfolio, while the longer-established institutions can gradually bring this down to around 18%. As the industry consolidates, there is a convergence towards lower interest rates on the loans. Caps limiting the maximum rate tend to fix a level that is too low for microfinance to be sustainable, thereby limiting poorer people’s access to financial services and expelling newcomers from the market. In the end, it is people in the lowest-income brackets are excluded, precisely the people that the regulation initially set out to protect.
One of the core principles of regulation is that it should foster efficiency, efficacy and simplicity in the markets that it targets. Respect towards these principles will encourage regulations that can positively impact the stability of the markets regulated, the growth of the economy and the well-being of the people in it, which should be the main concern of any regulator.
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