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Central Banking, Financial Institutions and Credit Creation in Developing Countries

Discussion paper by Dullien, Sebastian/UNCTAD, 2009

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This paper examines how developing countries can embark on a sustained path of strong investment, capital accumulation and economic growth without capital imports. It is argued that the key lies in the Keynesian-Schumpeterian credit-investment nexus: Given certain preconditions, the central bank can allow a credit expansion which finances new investment and creates the savings necessary to balance the national accounts. It is further argued and confirmed in empirical data that one of the biggest impediments to such a process is formal or informal dollarization which limits the policy scope of the central bank. Moreover, a stable banking system with a broad outreach as well as a low degree of pass-through between the exchange rate and domestic prices seem to be a necessary condition for this process to work.

No. 193
January 2009






Sebastian Dullien

No. 193
January 2009

Acknowledgement: The author thanks a number of anonymous economists from the Division
on Globalization and Development Strategies in UNCTAD for their helpful comments. The
views expressed and remaining errors are the author’s responsibility.





JEL classification: 023, 011, 016

The opinions expressed in this paper are those of the author and are not to be taken as the official views
of the UNCTAD Secretariat or its Member States. The designations and terminology employed are also
those of the author.

UNCTAD Discussion Papers are read anonymously by at least one referee, whose comments are taken
into account before publication.

Comments on this paper are invited and may be addressed to the author, c/o the Publications Assistant,
Macroeconomic and Development Policies Branch (MDPB), Division on Globalization and
Development Strategies (DGDS), United Nations Conference on Trade and Development (UNCTAD),
Palais des Nations, CH-1211 Geneva 10, Switzerland (Telefax no: (4122) 9170274/Telephone no:
(4122) 9175896). Copies of Discussion Papers may also be obtained from this address.

New Discussion Papers are available on the UNCTAD website at http://www.unctad.org.





Abstract .........................................................................................................................1

I. INTRODUCTION ........................................................................................................1

II. RETHINKING THE SAVING-INVESTMENT NEXUS ........................................2

PROCESS ..................................................................................................................10

A. Impediments for financial institutions..................................................................13

B. Limits to central bank's credit creation ................................................................15

IV. SOME CROSS-COUNTRY EVIDENCE ................................................................22

AND STRENGTHENING THE FINANCIAL SECTOR.......................................26

VI. CONCLUSION...........................................................................................................28

ANNEX .......................................................................................................................29

REFERENCES ..................................................................................................................30





Sebastian Dullien


This paper examines how developing countries can embark on a sustained path of strong
investment, capital accumulation and economic growth without capital imports. It is
argued that the key lies in the Keynesian-Schumpeterian credit-investment nexus: Given
certain preconditions, the central bank can allow a credit expansion which finances new
investment and creates the savings necessary to balance the national accounts. It is
further argued and confirmed in empirical data that one of the biggest impediments to
such a process is formal or informal dollarization which limits the policy scope of the
central bank. Moreover, a stable banking system with a broad outreach as well as a low
degree of pass-through between the exchange rate and domestic prices seem to be a
necessary condition for this process to work.


Already about two decades ago, Robert Lucas (1990) asked: “Why Doesn’t Capital Flow
from Rich to Poor Countries?”, wondering why only very little capital in net term was
flowing from the industrial world to developing economies. In the past years, this trend has
even aggravated: Nowadays, in many cases, net capital flows have reversed and are now
flowing from developing and emerging countries towards the rich world, especially towards
the United States, United Kingdom, Australia and Spain. Not only China and other Asian
countries are showing current account surpluses (and hence net capital exports). Also a
number of Latin American countries have joined the group of current-account surplus-
countries. Nevertheless, at the same time, GDP in the developing world has been growing
with a speed and a persistency not seen for several decades. What is more, developing
countries which are exporting more capital seem actually to grow faster than countries of
similar endowments with lower capital exports or with capital imports (Gourinchas and
Jeanne, 2007).

However, while this phenomenon has gained more attention over the past years, as Prasad et
al. (2007) remark, this fact even seems to hold over a longer period. Over the whole period
from 1970 to 2000, developing countries and emerging markets with more favourable and
even positive current account positions (which implies net capital exports of these countries)
have recorded higher per-capita GDP growth rates.

In addition, the growth process of these capital-exporting countries has been rather capital
intensive: Even though not all countries have recorded an investment to GDP ratio as high as
in China, all of the fast growing emerging markets and developing countries with net capital
exports have shown impressive rates of domestic capital accumulation.

Against this background, the critical question is: If poor countries can develop and
accumulate capital domestically without capital inflows (or even with net capital outflows),
where do they get their capital from? And – since there are developing countries which did


not manage to embark on a growth trajectory with high capital accumulation – what are the
policies which can help countries to accumulate capital without capital import?

This paper argues that the answer to this question can be found in the Keynes-Schumpeterian
explanation for capital accumulation. In this approach, the financial system as a creator of
credit plays a central role for the accumulation of capital. If the right structures are in place,
the domestic financial system can provide inflation-free finance for investment without prior
savings from domestic residents or the import of capital from abroad. In an economy with an
under-utilized labour supply, the financial sector can create purchasing power which investors
can use to increase the capital stock while the incomes created in this process provide ex post
for the savings necessary to finance the investment.

The rest of the paper is structured as follows: Section II reviews the textbook approach to
saving, investment and capital accumulation and contrasts it with the Keynesian-
Schumpeterian approach to investments and savings. Section III takes a look at the
preconditions under which a country can embark on a self-financed path of high investment
and capital allocation. Section IV confirms some of the findings from the earlier sections with
some cross country data. Section V draws some policy conclusions and section VI concludes.


Most of the standard macroeconomic textbooks1 today argue in the exposition of long-run
growth that the central limiting factor to economic development is the lack of capital
endowment in less developed countries. This conclusion is usually reached both using a
traditional neoclassical growth framework based on Solow (1956) seminal work as well as
modern endogenous growth models which broaden the term “capital” to explicitly include
human capital and knowledge capital.

In these models, output is a function of production factors, namely labour supply L and the
capital stock K which are input to some production function of the form ( ) αα −= 1ALKy
with α denoting the weight of capital in the production process and A denoting technological

The capital stock K in these models is increased by investment. Investment in turn can only be
conducted if individuals decide to refrain from consumption and save some part of their
disposable income y and thus make resources available for investment. Increased savings then
increase the amount of loanable funds available in the economy which in turn are funnelled
by the financial system (which usually is not modelled explicitly) towards those firms which
wish to undertake investment.

In this framework, endogenous changes in the interest rate balance supply and demand of
loanable funds. If there is an excess of investment plans over savings, interest rates will
increase. Higher interest rates lead to more savings by the single household as the
intertemporal price of consumption today increases, thus increasing aggregate savings. At the
same time, as firms adjust their investment to the marginal productivity of capital, investment
demand will react negatively to rising interest rates, bringing supply and demand for loanable
funds into equilibrium.

1 For example, Mankiw (2006), but also Romer (2007) or Barro and Sala-I-Martin (2003). Note,
however, that textbooks which explicitly focus on development economics such as Thirwall (2006) or
Todaro and Smith (2003) focus much less on the neoclassical growth model.


From this approach, there would be only two possibilities for a developing country to increase
its capital stock: Either households decide to consume less and save more of their income or
the economy imports savings from abroad.2

Box 1


In the logic of the national accounts, an excess of domestic investment over saving has to be equivalent
to a surplus in the current account. The national income equation can be written in two ways. We know
that first national income can either be saved or consumed as is embodied in:

SCY +=
With Y denoting national income, C denoting consumption and S denoting savings.

At the same time, we know that national income is equal to aggregate demand which is defined as:

Im−++= ExICY
With I denoting investment, Ex denoting exports and Im denoting imports. Putting the two definitions
together and using the identity that the current account is the surplus of exports over imports
(CA = Ex – Im), we get

S = I + CA or I = S – CA
The two identities above already represent the different interpretation between the Keynesian-
Schumpeterian view and the neoclassical textbook approach: While according to the first view, saving
is determined by the income creation due to investment and external demand, advocates of the latter
claim that the household’s decision to save and to borrow or lend abroad determines domestic

These main conclusions even remain intact in the modern endogenous growth theory. While
the Solow model had assumed that technological progress A increases somehow exogenously,
the new growth theory aims at modelling explicitly how technical progress takes places. In
these models, capital usually has an even more important role than in the old growth theory.
One strand of the literature models increases in the technological progress as a positive
externality of capital accumulation. Another strand of the literature introduces knowledge
capital or human capital, both of which are accumulated by investment in certain activities
(such as research and development or education). Again, investment in human capital or
research and development is constrained by the amount of resources available. Only if
consumers first abstain more from saving or if firms import capital from abroad, overall
output can be increased.

This conclusion is strongly at odds with the successful development stories of the post-World
War II years (i.e. Germany and Japan) or of the past decades (i.e. the South-East Asian
“Tigers” or China), neither a drop in consumption, a sizeable fall in the growth rate of
consumption nor a net surge of capital inflows could be observed (see box 2 on Germany’s
and China’s growth performance during their most vibrant periods of catch-up growth).

The suspicion that there might be something wrong with the standard textbook theory of
capital accumulation in developing countries has lately further been confirmed by a number

2 Please refer to box 1 for the national account logic of saving, investment and the current account.


of empirical studies. In the most comprehensive study, Prasad et al. (2007) show in a sample
of 56 non-industrialized countries not only that net capital inflows over a long period (from
1970 to 2004) are in general associated with lower growth. They also test for a number of
possible explanations, i.e. whether this result is distorted by the fact that possibly some
successful countries started poor and had current account deficits, then grew fast and ended
up richer and running external surpluses. Here they find that in a smaller sample of countries
which experienced sudden “growth spurts”,3 investment started increasing before the start of
the growth spurt at a time when aggregate savings were smaller than aggregate investment,
with savings only subsequently increasing to a level above that of aggregate investment,
resulting in a current account surplus. Hence, capital exports were largest shortly after a
“growth spurt” started and petered out later in the growth process. They come to the
conclusion that “from a saving-investment perspective, the evidence seems to challenge the
fundamental premise that investment in non-industrial countries is constrained by the lack of
domestic resources” and go on that “investment does not seem to be highly correlated with
net capital inflows, suggesting that it is not constrained by a lack of resources” (Prasad et al.
2007: 179).

Prasad et al. try to reconcile these results with explanations which lead the textbook causation
from savings to investment intact. Thus, they look into explanations of exogenous
productivity shocks which lead to a stronger increase of domestic savings than of domestic
investment given underdeveloped structures of corporate governance or financial systems. A
second explanation proposed is that capital inflows cause negative externalities such as a
potential overvaluation of the exchange rate.

Box 2


At first sight, China and Germany do not have much in common economically. China is a developing
country which is at the moment experiencing a rapid transformation towards a more modern economy
with strongly growing per-capita income. Germany is a traditionally industrialized country which for
decades now has been among the world’s high-income countries.

Yet, Germany and China are two of the most impressive economic success stories of the past
100 years. After World War II, Germany managed to embark on a catch-up growth with propelled in
close to the top in per-capita in terms of European economies, a position, it had never been before.1
Within only 10 years from 1950 to 1960, per capita income in Germany relative to those in the United
States rose from 41 to 72 per cent which implied more than a doubling of German real per-capita GDP
in only one decade (see figure B.1). China has experienced a similar impressive growth since the
1990s: China’s per capita income relative to the United States rose from 6 per cent in 1990 to about
12 per cent in 2000 and continued to rise afterwards (see figure B.2). Just as in the case of Germany
40 years earlier, per-capita GDP in China in this period doubled (and continued its strong pace of
expansion after a short pause after the Asian crisis in 1998).

However, there is another interesting parallel between the German and the Chinese experience: As can
be seen in figure B.3, even the German capital stock was widely destroyed after World War II,
Germany embarked on the growth process without any net capital exports. In fact, over the growth
process, net capital exports even increased. When the current account turned negative in the early
1960s, the catch-up process also came to an end. In the 1980s, China still relied to a certain extent on
capital imports as can be seen in figure B.4. As is visible in figure B.2, during this time, the catch-up
process was in fact significantly slower than in later years. The most impressive growth experience of
the 1990s (and ever since) has been going hand in hand with high and growing net capital exports.

3 Prasad et al. (2007) use the definition of growth spurts from Hausmann et al. (2005) who looked for
periods in which strong growth was sustained for at least 8 years.


Box 2 (continued)

There are other interesting parallels: In both countries, changes in investment ratios seem not to have
been triggered by changes in household savings ratios, but have shown separate trends: In Germany,
the investment-to-GDP ratio rose from 1951 to 1954 from 20 to 25 per cent, and hovered between
23 and 25 per cent until the late 1960s. The household savings rate, on the other hand, started from a
very low level of just 4 per cent of disposable income in 1950 (which even translates into a lower share
of GDP as disposable income is only a share of GDP) a steady increase in the 1950s which lasted until
the mid-1970s and only peaked several years after the investment-to-GDP ratio had begun to decline.
With real wages increasing much stronger than household savings, this increase in the savings rate left
ample room for buoyant consumption growth during the period. Hence, the growth spurt came about
without a prior consumption restraint. As the government budget was fluctuating around a balanced
budget over the period, the only possible conclusion is that the (albeit over the time shrinking) gap
between household savings and corporate investment was financed by credit creation and retained
earnings from profits created thanks to strong productivity growth: According to Bundesbank data (see
figure B.5), from 1950 to 1960, domestic credit rose almost sixfold in nominal terms and from 27 per
cent to 55 per cent of GDP.

As can be seen in figure B.6, the investment-to-GDP ratio in China has even been trending downward
from 1985 to the early 1990s while the household savings rate has been increasing.2 The steep increase
in the investment ratio to a peak of 40 per cent in 1993 was followed by an increase in the household
saving rate to a peak of 33.8 per cent in 1994 before both variables trended somewhat downwards
again. Again as in the case for Germany, consumption in China grew vigorously over the period: The
data from the National Statistics Office does not show any year after 1990 in which real household
consumption grew by less than 4.5 per cent. Again, as in the case of Germany half a century earlier,
from 1990 onwards (with the exception of the single year 1993), the gap between household savings and
aggregate investment was financed by retained earnings and credit expansion: The ratio of domestic loans
to GDP by the banking sector rose from 86 per cent in 1990 to a peak of 150 per cent in 2003.

The strong growth of credit in both cases, however, does not mean that domestic credit was the only
source for finance of enterprises. In both cases, retained savings by the enterprises played an important
role (in China today, these retained savings are an important factor to explain the high national saving
rate). However, it can well be argued that the strong credit creation is a necessary condition for profit
growth in an economy: Only if credit creation helps to maintain a high level of aggregate demand,
firms will be able to make sufficient profits in the aggregate.

For the export sector, of course, the importance of domestic credit creation must be seen as much less
important as it earned its profits not from domestic demand stimulated by credit creation, but from
foreign demand. Nevertheless, one could also argue that there still is a significant effect of domestic
credit creation for the export sector: First, the investment by domestic firms helps diffuse technology
across the economy and hence to modernize the economy which can be expected also to have spillovers
into the export sector and improve competitiveness there. Second, even if domestic credit might have played
a smaller role in China’s export sector (given the fact that a large part of Chinese exports today comes from
foreign owned-enterprises and was hence initiated by FDI), for the Chinese owned part of these firms, part of
the initial investment was in fact financed by domestic bank credit. Without an initial investment, it would
have been close to impossible to earn profits to subsequently finance investment from.

Finally, the growth stories of both Germany and China show an important parallel: In both cases, both
domestic and external expansion run roughly in parallel, albeit there was a slight permanent positive
contribution from net exports. Different from other countries which experienced limited export booms,
the striking feature is that also domestic demand expanded briskly. This part of the growth process has
clearly been driven by strong credit expansion.

1 According to the data of Maddison (2007), Germany in fact used to have a per-capita GDP levels below the
average of Western Europe for all of the century before the rearmament in the late 1930s.
2 Measures for household saving rates in China are subject to ongoing disputes. However, most economists now
agree that survey data is rather unreliable and try to construct saving rates from data for deposits or flow of funds.
“Savings rate I” in the graph denotes the estimates from Modigliani and Cao (2004), while “Savings rate II”
denotes the estimate from He and Cao (2007) which is available only for a shorter period of time, but until 2002.


Box 2 (concluded)











1950 1954 1958 1962 1966 1970

Source: Own calculations, based on Henson et al., 2006;
and Bundesbank data.

Figure B.1
German real per capita GDP relative to the United States,

1950–1972, 100 = US









1980 1984 1988 1992 1996 2000 2004

Figure B.2
Chinese real per capita GDP relative to the United States,

1980–2004, 100 = US

Source: Henson et al., 2006.












1950 1954 1958 1962 1966 1970

Source: Own calculations, based on Bundesbank data.

Figure B.3
German current account balance, 1950–1972

(Per cent of GDP)












1980 1984 1988 1992 1996 2000 2004

Source: IMF.

Figure B.4
Chinese current account balance, 1980–2004

(Per cent of GDP)








1950 1954 1958 1962 1966 1970 1974 1978

Source: Bundesbank.

Figure B.5
Investment and household saving in Germany, 1950–1980

Investment to GDP ratio

Saving rate private household
(% of disposable income)








1985 1989 1993 1997 2001

Source: He/Cao, 2007; Modiglani/Cao, 2004; Chinese Statistics.

Figure B.6
Investment and household saving in China, 1985–2002

Household saving rate I
Household saving rate II

Investment to GDP ratio


However, their empirical observations can also be interpreted at hinting at a much more
fundamental problem with the causality between savings and investment proclaimed by
textbook theory. This thought is not new. The causation between saving and investment has
long been disputed and not yet been solved.4 Based on the works of Keynes and Schumpeter,
some economists argue that the causation does not run from saving to investment, but rather
from investment to saving.5 According to them, an autonomous increase in investment can in
fact create the savings necessary to finance this investment on a macroeconomic level.

In this view of the saving-investment nexus, aggregate credit expansion comes before saving.
The process of credit-expansion here starts with the wish of an entrepreneur to get some
means of payment to invest into some new equipment or simply to buy intermediary products
or hire workers in order to star, expand or start production. The financial system with the
support of the central bank then expands the money supply ex nihilo (“out of nothing”) and
lends the newly created liquidity to the firms. Money is then used by the entrepreneur to hire
workers and buy material for new production. As Schumpeter (1951: 107) puts it:

[c]redit is essentially the creation of purchasing power for the purpose of transferring it to
the entrepreneur, but not simply the transfer of existing purchasing power. The creation
of purchasing power characterizes, in principle, the method by which development is
carried out in a system with private property and division of labour.

While part of this monetary expansion might end up in higher prices if the entrepreneur has to
compete for scarce resources, some part of it ends in a net expansion of aggregate output as
formerly unutilized resources (i.e. unemployed workers) are put to work. As with a higher
degree of utilization of resources and a higher employment rate, absolute aggregate
disposable income increases, so does absolute aggregate saving even if the average saving
rate of private households remains constant. Savings and investment in this approach balance
via changes in nominal incomes and prices. If realized investment demand is higher than the
savings households plan to make even at the higher realized output and employment, prices
rise. In this case, aggregate nominal demand for consumption and capital goods is above the
aggregate supply for these goods at the old price level. The excess demand thus drives up
sales prices, which given an unchanged nominal income of private households leads to a
revision of real consumption plans. The increase in sales prices in turn leads to a
redistribution of real incomes from the household to the corporate sector. Thus profits in the
business sectors increase which in the national accounting end up as retained profits and
hence saving by the corporate sector.6 In the end, again, aggregate saving equals aggregate
investment, but the transmission channel is fundamentally different than in the textbook

4 See for a thorough exposition of the argument applied for the United States of America, Gordon
5 Priewe and Herr (2005: 149) call this approach therefore the “Keynesian-Schumpeterian approach to
finance and development”.
6 In addition, one could argue with different propensities to consume between workers and
entrepreneurs: With workers having in general a higher propensity to consume, the redistribution from
wage income to profits might lead to higher national savings rate even if profits are distributed to the
household sector.


Figure 1


Figure 1 contrasts these two views on the causation from savings to investment. While for the
predominate textbook approach, the decision of households to save a larger share of their
income (or some increased “import of savings” from abroad) is the seminal part of the
investment process, in the Keynesian-Schumpeterian perspective, it is the decision of the
entrepreneur to invest and the willingness of the financial system to expand the credit supply
which gets the investment process going.

The advantage of the Keynesian-Schumpeterian approach is that it can easily explain how
some developing countries have embarked on a positive growth trajectory without an ex ante
increases in the household saving rate and without capital inflows: A change in overall

Ex ante saving
(Neoclassical textbook view)

Ex post saving
(Keynesian-Schumpeterian view)

Households decide how to divide time
between work and leisure

This decision determines labour supply
for the economy

Labour supply determines aggregate
income y given constant capital stock

Household income is determined here

Part of income
is saved (S)

Part of income is
consumed (C)

S provides funds for investment

Banks distribute funds to firms

Firms invest (I is determined here)

Capital stock increases

Firms make investment plan

Banks decide whether to lend or not

Financial system (banks plus central
bank) creates money ex nihilo

Firms use money to buy capital goods
(I is determined here)

Capital stock K

Capital goods
producer hires
workers and

buys resources

Households earn income

Aggregate income y is determined

Part of income
is saved (S)

Part of income is
consumed (C)

Firms’ profits
and savings



demand conditions (i.e. by some real exchange rate undervaluation strategy7 or some
autonomous shift in the world market demand for a country’s goods) can be seen as the
trigger for an upward shift in investment plans by domestic enterprises and a credit expansion
by the domestic financial sector. Given that the pool of underutilized labour is large in almost
all developing countries (either in the form of open unemployment or in the form of hidden
unemployment in both the agricultural and the informal sector), this then leads to an increase
in employment in the modern sector which in turn leads to more incomes and savings. The
expansion of the production of the modern sector moreover brings about the penetration of
modern technology into the economy and hence an increase in productivity and goods supply,
also adding to higher incomes.8

If the initial demand impulse is created by some deliberate undervaluation strategy (either by
low nominal wage increases in an environment of fixed or quasi-fixed exchange rates or by a
devaluation and subsequent wage and price freezes), one would exactly see the pattern which
Prasad et al. (2007) are puzzled about: The strong investment growth (and subsequent GDP
growth) would coincide with a favourable current-account position. This would also fit nicely
into the fact that Prasad et al. (2007: 201) that in non-industrialized countries, growth spurts
have usually been preceded by a correction of some prior overvaluation (or in other words, a
real depreciation).

Figure 2











-25 -20 -15 -10 -5 0 5 10 15 20

Current account in per cent of GDP










r c


Moreover, if we take a look at the internationally available data, we can see that even though
current account deficit and hence capital imports are not systematically correlated to higher
GDP growth, the growth of private credit in fact is systematically correlated to higher
economic dynamics. figure 2 shows average current account balances in per cent of GDP and
average annual growth rates of per-capita GDP for the years 1990 to 2005. In contrast to

7 See i.e. Flassbeck et al. (2005) for a description of the Chinese undervaluation strategy.
8 Even if there is no unemployment and hence no underutilized labour, the Schumpeterian process of
internal credit creation poses a possibility for growth-enhancing credit creation: If the credit created
helps innovators with more advanced technologies to compete resources away from existing firms, this
might increase productivity in an underdeveloped economy (with a lot of room for productivity
improvements) so much that in fact the increase in aggregate supply ex post also helps to finance the
initial investment.


Prasad et al. (2007), the graph contains all 151 countries for which the data is available in the
IMF’s World Economic Outlook Database, including a number of tiny countries,
industrialized and non-industrialized countries and failed states. The positive correlation
between current account balances and growth shown by Prasad et al. (2007) now seems to be
less robust. However, what is clear is that there is definitely no negative correlation between
current account balances and economic growth as would be expected from textbook theory. In
contrast, if we take a look at the growth rate of inflation-adjusted credit to the private sector
and economic growth – divided by decades as for only very few countries data is available for
the whole period of 1980 to 2005 – in figure 3, we see a clear positive correlation between the

Figure 3









-20 -10 0 10 20 30 40 50

Annual private credit growth, per cent


l c







, p



2000-2005 1990-2000 1980-1990

Linear (2000-2005) Linear (1990-2000) Linear (1980-1990)


For the process of a credit-financed investment expansion described above, the financial
sector is of crucial importance. The Keynesian-Schumpeterian investment-saving nexus can
only work if the financial sector is able and willing to extend credit to companies which wish
to expand production and investment. In order for the process to work, different levels of the
financial sector thus have to interact smoothly and fulfil certain tasks. First, there are different
types of financial institutions (private, state-owned) which interact with borrowers and savers
(the lower tier of the financial system). They have to extend the loan and later provide
households options to save (part of) their income. Second, there is a central bank (the upper
tier of the financial system) which provides base money to the financial institutions to satisfy
their liquidity needs. While to a certain extent, financial institutions can extend credit and
broad money supply on their own, in the end they depend on the collaboration or at least the
accommodation of their monetary expansion by the central bank which has to allow an
increase in base money so that commercial banks can fulfil their reserve requirements.


Figure 4 shows this process more in detail with stylized T-accounts9 for the sectors of the
economy involved (firms, households, financial institutions and the central bank) for an
economy with a well-functioning financial system but underemployed resources:10 The
process starts with the firm asking for a loan of 100 pesos and being granted that loan from a
bank (labelled “financial institutions” as to prevent confusion with the central bank);
consequently, the bank books the loan to the firm as an asset in its own balance sheet and
credits the firm with a deposit while the firm books the loan as a liability and the deposit as an
asset (accounting record 1 in the figure). The deposit here is created out of nothing (“ex
nihilo”) and the broad money supply has increased.

Figure 4


Firm Household
Assets Liabilities Assets Liabilities
[1] Deposit at

+100 [1] Bank Loan +100 [3] Deposit at

+100 [3] Household


[3] Deposit at


[3] Capital good +100

Financial Institution Central Bank
Assets Liabilities Assets Liabilities
[1] Loan to firm +100 [1] Deposit from

+100 [2] Loan to

+100 [2] Reserves +100

[2] Reserves at
central bank

+100 [2] Loan from
central bank


[3] Deposit from


[3] Deposit from


In a second step, the bank needs to get the base money necessary for the credit expansion
(note that empirically, banks have to fulfil their reserve requirements only ex post so they
expand credit before getting the reserves necessary to back them). For simplicity, we assume
a minimum reserve requirement of 100 per cent on deposits, so the bank needs to get 100
pesos in central bank reserves. If the bank is solvent and has sound marketable securities, it
can borrow these reserves from the central bank either via the discount window or via open
market operations. For developing countries which do not have a working money market in
which the central bank conducts open market operations, we for a moment assume that the
commercial bank is provided with the base money necessary for credit creation by some
direct monetary policy instrument such as rediscount quotas via which it can borrow base

The bank books the credit from the central bank as a liability and the newly created central
bank reserves in its account at the central bank as an asset, the central bank books the credit to
the commercial bank as an asset and the newly created central bank reserves as a liability
(accounting record 2). Now, the central bank has created base money out of nothing and not
only the broad, but also the narrow money supply has increased.

9 This process of credit creation ex nihilo is covered in most textbooks on money and banking, i.e.
Mishkin (2007).
10 This part is based on Dullien (2004: 150ff).
11 The question of monetary policy instruments in the process of credit creation is covered more in
detail in section 3.2.


In a third step, the firm now uses the money to hire some formerly unemployed worker from
the household sector in order to produce some capital good (i.e. build a factory building).
Hiring the worker and paying him 100 pesos by bank transfer means a transfer of the deposit
from the firm’s account to the household’s account in the bank.12 At the same time, the firm
gets the capital good newly produced while the household’s net wealth increases by the
amount of wages paid (accounting record 3). Thus, the capital stock has been increased just
by employing formerly underutilized resources of the economy without any capital import
and just by extension of the money and credit supply. In the end, households have increased
their wealth by 100 pesos in bank deposits and the real capital stock has increased in value.
Savings equal investment.

If now the household starts spending some of its income (as can be expected in the real
world), we would see a further step in the income-creation: Demand for consumer goods
would increase. As long as consumer goods are produced domestically and firms can expand
their production, this would lead to a further increase in domestic employment, further
increasing aggregate income. However, as households save part of their income, also
aggregate saving increases, providing the ex post finance of the initial investment.

In the cases where demand runs into capacity constraints, an increase in prices could be
expected, depending on market power of producers and the ease by which they can expand
capacities. Those increases in prices lead to an increase in aggregate profits which the firms
can save and which they use ex post to finance their investment. In this case, the real wage
sum of the workers would not rise quite as much as in the first case. Instead, profits would
increase more strongly and as a consequence savings by the corporate sector would rise.13

In this process, one factor might mitigate the increase in prices: If the entrepreneur has been
successful in applying a new technology and hence produces more efficiently and hence at
lower costs than firms already in the market, he might earn some extra profits due to lower
costs even at constant prices. In this case, the innovative entrepreneur will earn the profits he
can use ex post to finance the investment. In both cases, in the end, aggregate saving again
equals aggregate investment, even if the process is slightly different.14

In the cases in which the innovative entrepreneur earns large extra profits or other firms with
monetary liabilities towards their banks earn higher profits in the credit-investment process,
even the stock of monetary assets need not to increase in the same amount as the initial credit
creation. In as far as the firms use the increased profits to pay back a credit formerly extended
to them by the banking sector, money is destroyed again and the overall money stock in the
economy does not increase. One could expect that empirically, newly created credit is partly
used to repay old loans and partly used to increase savings at the household level by
increasing incomes.

However, while the mechanism of the credit-investment process as described is quite
straightforward in an economy with a smoothly working financial system, for a typical
developing country it might run into obstacles. Both the lower tier of the financial system

12 Alternatively, one could assume that the firm changes its deposit into cash and hands it over to the
household. This would imply a slightly different accounting, but the basic outcome would be the same.
13 The later mechanism has already been explained by Keynes (1930). Modern textbook call this
“forced savings”. See i.e. Thirlwall’s (2006: 438ff) exposition on the Keynesian view of investment
finance in developing countries.
14 In fact, both in the catch-up processes in Germany as well as in China described in box 2, a large
share of investment has been financed ex post by corporate savings. According to He and Cao (2007),
corporate savings amounted to almost 40 per cent of total Chinese saving around the turn of the


(private and state-owned banks) as well as the upper tier (the central bank) can be constrained
in their ability to fulfil their role in the Keynesian-Schumpeterian credit-investment process.

A. Impediments for financial institutions

First, there are a number of challenges for the first step of the credit creation, the decision of
the lower tier of the financial system to extend credit to some enterprise which wants to
conduct some investment project. The first problem is that a number of entrepreneurs and
firms which in principle could conduct some profitable investment project have no or very
constrained access to formal credit. There are a number of reasons for this phenomenon. First,
in developing countries, the informal sector usually is of a larger relative size than in
developed countries. Firms in the informal sector often do not have the legal status as an
enterprise which makes financial institutions reluctant to lend to these entities. Moreover,
firms in the informal sector often do not have a fixed (or legalized) business location. This is
true not only for small vendors, but also for small craft industry. From the perspective of
financial institutions, the lack of a business location makes it more difficult to recover a loan
should the borrower not pay voluntarily. Finally, firms in the informal sector often lack
standard forms of collateral. This might not only stem from the fact that they often do not
have much capital to begin with, but also from the fact that the capital is often held in the
form of a non-fungible assets, i.e. a piece of land which is the owner lives on but which he
lacks a formal deed for.15 As these assets cannot be used as collateral in standard credit
contracts, formal financial institutions have often refrain from lending against such securities.

While microcredit has experienced impressive growth rates in the past decade and has been
widely lauded for its potential in economic development, it is questionable whether it is able
to overcome this problem by itself. Proponents of microfinance have long been arguing that
there is a large unmet demand for small-scale loans in developing countries. Robinson (2001)
argues that in the poor world, there might be as many as 1.8 billion people in 360 million
households who would have demand for microfinance products as well as the ability to serve
a loan but do not have access to such services yet. Moreover, according to this view,
microcredit can help significantly to alleviate poverty for those who are not extremely poor,
but at least for the economically active poor: Microcredit might provide the working capital
for small enterprises which allow them to buy some inventories and thus improve efficiency
and increase incomes earned. In addition, microloans might help to smooth consumption in
the wake of volatile cash flows. In fact, the strong growth of microfinance indicates that there
really is a large unmet demand for financial products for the poor. As a tool for development
strategies, microfinance has grown in importance as it was a move away from large-scale
investment projects towards decentralized projects.16 Finally, there was the promise that
microfinance might need initial support from international donors, but might in the end work
profitable by itself (Robinson, 2001).

However, microcredit has often three characteristics which limit its suitability for investment
in fixed capital. First, maturities in microcredit are often rather short, sometimes as little as
three to six months.17 Second, interest rates for microcredit tend to be rather high as high
monitoring and screening costs in the microfinance business forces financial institutions to
recover these costs from their customers. Real effective interest rates in most widely cited
programmes vary from 15 per cent annually for the Grameen bank in Bangladesh to 15 to
25 per cent for Rakyat Indonesia or almost 30 per cent on dollar-denominated loans for

15 See de Soto (2000) for an analysis of this problem.
16 See for a nice overview of this debate Nitsch (2002).
17 See Murdoch (1999) for several examples or Karlan and Zinman (2007) who show that even though
the demand for microcredit can be expected to react quite strongly to an increase in maturities offered,
usually short maturities are offered.


BancoSol in Bolivia.18 While these interest rates might be lower than those charged from
informal money-lenders, they might just be too high to be realistically earned with some
medium-sized fixed capital investment. In addition, loans in microcredit programmes are
usually too small to buy a substantive capital good. Hence, microcredit loans are most often
used as working capital in the service sector. While this kind of lending might improve the
economic conditions of those receiving the loans, it has rather limited impact on the formation
of fixed capital as is regarded central for capital accumulation and technological progress in
neoclassical growth models.

A second problem often observed in developing countries in the credit-investment process is
that loans are allocated according to political considerations or ties between bank managers
and the corporate sector. This practice is problematic for two reasons: First, even if the central
bank can create liquidity and the financial sector as a whole is thus not be constrained by a
lack of base money, banks in developing countries are often weakly capitalized. Legal
minimum capital-adequacy ratios hence limit the overall amount of loans provided by the
financial sector. If a large share of the loans is not allocated by economic merit, this means
the most innovative and efficient firms in fact might not have access to credit finance, while
some inefficient firms might be kept in the market by cheap credit. In addition, over an
extended period, allocating loans by political consideration or cronyism might exacerbate the
problem of an undercapitalized banking sector: Loan decisions not made on economic merit
can be expected to lead to a higher share of non-performing loans which on the one hand
depletes the capital base of the banks and on the other hand might force financial institutions
to charge higher interest rates to all of their borrowers. This in turn obstructs the medium- and
long-term ability of the financial system to play its role in the Keynesian-Schumpeterian
process of investment finance.

Of course, credit expansion for reasons beyond economic merit might for a while help
increasing economic growth. If credit expansion works toward the extension of productive
capacity, this process might go on for an extended period of time, even if borrowers in the
long run will not be able to pay back their loan. The downside in this case is the accumulation
of non-performing loans in the banking sector which in the end might lead to high fiscal cost.
This might actually be what has been observed in China: One could argue that a non-trivial
part of the loans by state-owned banks to state-owned enterprises over the past decade have
been extended for reasons beyond the microeconomic consideration of the banks. These loans
– while having supported economic growth and most likely having played a role in the
modernization of the economy – will in the future pose a heavy fiscal burden for the Chinese

However, the problem of personal ties and political factors influencing the loan decision does
not mean that financial institutions necessarily need to be privately operated as has long been
argued by the Bretton Woods institutions (i.e. World Bank 2001). Historical experience in a
number of countries such as Chile (in the deregulation attempt of the 1980s) or in Indonesia
(in the 1990s) show that a privatized banking sector does not necessarily allocate loans
according to economic merit of the borrower.19 Instead, in these countries, conglomerates
often just owned or acquired their own bank which in turn financed the conglomerate
irrespective of the true economic performance of the enterprises in question, which in turn
leads to problems closely resembling those of badly managed public financial institutions. In
fact, recent research points toward the fact that state-owned banks have stabilized the credit-
investment process in the wake of the Asian crisis (Amyx and Toyoda, 2006). Thus, what has
been learnt over the past years is that state-owned banks need an adequate governance
structure to play a constructive role in the economic development process. For example, the

18 Figures from Murdoch (1999).
19 For a comprehensive analysis of Chile’s experience, see Diaz-Alejandro (1985).


IDB (2005) lists a number of preconditions which should be insured in public banking such as
clearly defined social or economic objectives, a professional management with transparent
hiring structures, prudential regulation of state-owned banks and independence in day-to-day
business from elected politicians. These measures should ensure that state-owned (or
development) banks play a constructive role in the credit-investment process and ease the lack
of long-term financing which exists in many developing countries even for economically
viable projects.

A third problem at the level of commercial banks (not limited to the case of developing
countries, but often observed in countries which have liberalized their financial sector) is that
financial institutions in some instances extend credit mainly to households for the sake of the
financing of consumption or housing.

While most advocates of financial liberalization based on McKinnon (1973) or Shaw (1973)
often do not cover in detail the distinction between credit to households and credit to the
corporate sector, they implicitly recommend liberalization of lending to households as well, as
according to Fry (1989: 17) “[a] common feature of all the models in the McKinnon-Shaw
framework is that the growth maximizing deposit rate of interest is the competitive free-
market equilibrium rate” and the policy conclusions of this are that “economic growth can be
increased by abolishing institutional interest-rate ceilings, by abandoning selective or directed
credit programmes, by eliminating the reserve requirement tax, and by ensuring that the
financial system operates competitively under conditions of free entry”. However, starting
from a situation of a repressed credit demand from households, it is to be expected that in a
case of financial liberalization this demand is first fulfilled: As the financial repression has
created a very high shadow interest-rate which liquidity-constrained households are willing to
pay for consumer or housing credit, it is then extremely attractive for financial institutions to
move into this market.

This creates two problems: While consumer loans to households as well as loans for the
construction of new housing might increase overall economic activity and hence aggregate
incomes, it lacks a number of advantages of credit-financed investment in fixed assets other
than housing: First, in contrast to the investment in the productive capital stock, neither
consumption nor housing credit helps to increase the productive capacities of the economy,
making inflationary effects of credit creation much more likely. Second, extending loans for
consumption and housing construction does not help to disperse modern technology across
the economy of a developing country: As new growth theory is arguing, technological
progress is often embodied in new capital goods or accumulated by learning-by-doing of
workers in the investment process. Both things can rather be expected in manufacturing than
in construction. Investing in a new piece of machinery or some other piece of equipment
financed by credit-creation helps hence to improve the average level of technology in an

As a consequence of the different macroeconomic effects of strong credit growth to the
different sectors, strong credit growth to private households moreover is less sustainable. As
credit growth for investment purposes increase the aggregate productive capacities and hence
has the potential to lift the medium and long-term growth rate of an economy which allows
for a sustainable stronger credit growth, an increase in household debt does not. Hence, an
expansion of credit to the household sector will necessarily come to an end sooner or later
with possible detrimental effects on aggregate demand and growth.

B. Limits to central banks’ credit creation

A second set of potential problems is concerned with the creation of base money by the
central bank. As has been explained above, part of the Keynesian-Schumpeterian investment-
credit creation process depends on the ability of the financial sector to expand overall credit


which in turn depends on the ability of the central bank to increase the supply of base money
and distribute it to the commercial banks which are willing to extend credit to the non-
financial sector.

The first obstacle for developing countries in principle could lie in the way how base money
is distributed from the central bank to commercial banks. For most developing countries, the
technical process of money supply is quite different from that in developed countries: While
most industrialized countries rely on indirect instruments such as open market operations to
provide liquidity to the banking system, many developing countries lack deep financial
markets to conduct open market operations in and hence have to rely on direct monetary
policy tools such as bank-by-bank rediscount quotas or credit restrictions (Chandavarkar
1996: 3). However, closer examination shows that this structural difference might have less
impact on the credit-investment process than one could think. While open market operation
frees central banks from allocating reserves to different banks or regions by discretion and
hence uses market forces to do so, there are little a priori reasons why the allocation of
reserves by the fiat of the central bank should hamper the credit creation per se. Of course, the
absence of a working money market will result in some loan demand with higher expected
returns to the banking system being not satisfied. However, as the literature on adverse
selection, moral hazard and asset price bubbles underlines, loans with a higher expected
return are not always the most efficient from a macroeconomic perspective. Hence, a slight
distortion in the allocation of reserves and credit might not be severe from a macroeconomic
level. As long as credit or rediscount quotas are not misused to push the commercial banking
system into loans which are not economically viable, but the indirect monetary policy
instruments are used in good faith, they need not per se be an impediment to the credit-
creation process. Hence, market imperfections in the money market do not plausibly pose a
major obstacle for most developing countries to use the banking system to expand credit to its
corporate sector.

The second set of restrictions of the central bank in developing countries stem from structural
features in the economy and can be expected to be much more serious. The most obvious
impediment for such a credit expansion would be if the economy is officially dollarized20 as
in the case of Ecuador or Panama. In these cases, usually, a national central bank does not
exist anymore (or is charged with function not related to the supply of base money such as the
oversight of the national payment system). As base money can then only be imported, the
country in question is dependent on capital imports (yet not necessarily on net capital imports)
to finance a credit expansion.

A similar argument applies if the country in question has a currency-board arrangement. In
this case, the country has committed its central bank by law only to extend the supply of
domestic base money in exchange for foreign exchange reserves. The domestic supply of base
money is then completely (or overly) backed by foreign currency in the vault of the central
bank. Under this arrangement, again a completely domestically driven expansion of credit and
investment might early hit its limits: As soon as the banking sector has exhausted the potential
of loans at the given level of base money in circulation, the financial system by itself cannot

20 This chapter will use the term “officially dollarized” for the phenomenon that one country uses the
currency of another country as sole legal tender without being in a formal bilateral or multilateral
currency union which gives it a say in monetary policy decisions. According to this definition,
Montenegro’s economy would also be “dollarized” even though the country uses the euro, not the
dollar as official currency.


extend loans any further. As in the case of dollarization, the economy might then be
dependent on gross capital inflows to further extend credit supply.21

However, even if a country has a central bank which is not constrained in its emission of
domestic currency by a currency-board arrangement, this central bank does not necessarily
have the freedom to expand the supply of base money at will. As will be shown below, a
domestic credit expansion might lead to a depreciation of the domestic currency. Given the
structure of the economy or other exchange rate arrangements, the central bank might want to
take this effect of its credit expansion on the exchange rate into account.

If the country in question has a fixed exchange rate, an exchange rate band or a crawling
exchange rate, the expansion of money supply is limited to what is compatible with the
exchange rate target. If the country in question does not have a fixed exchange rate, a high
degree of foreign-currency denomination of the liabilities in the economy might force the
central bank to prevent a strong depreciation even if domestic economic considerations made
a strong monetary expansion and a depreciation desirable. If the country’s firms, government
and financial institutions are indebted in foreign currency and do not have corresponding
assets denominated in foreign currency, a depreciation might lead to a reduction of net wealth
and a contraction of demand. In the case of a depreciation of the domestic currency, the debt
burden of firms, households and the government rises as the nominal debt in domestic
currency increases while the income flows remain relatively unchanged. In the case of strong
devaluations, this might even lead to the bankruptcy of firms or financial institutions and in
the consequence to a banking crisis, as has been seen in the number of countries which
experienced “twin crisis” (a currency and a banking crisis at the same time) over the past
decades. Thus, central banks might be limited in their ability to expand credit by the
requirement to defend the exchange rate.

To understand which structural factors make this constraint more or less binding, we need to
have a look at the determination of exchange rates and the mechanism by which a domestic
credit expansion might put pressure on the exchange rate. The exchange rate is determined by
the supply and demand for foreign currency. Two factors are the main determinants of this
supply and demand: The supply and demand of foreign currency arising from external trade
relations (import and exports) and the supply and demand of foreign currency for investment
motives (including speculative motives). The process of domestic credit-financed investment
expansion influences both factors: First, as the increased investment also increases domestic
incomes, import demand will be stimulated depending on the degree to which capital goods
and consumer goods are imported. A country with very little domestic manufacturing industry
to start with might actually see a rather large increase in imports stemming from increased
investment demand, while a well-diversified economy might see only a small increase in
imports. Second, with an increase in aggregate incomes and aggregate savings, households
might increase their demand for foreign assets and hence again the demand for foreign
currency, again putting downward pressure on the exchange rate.

In modern exchange rate theory, the exchange rate is usually seen as a relative asset price for
domestic and foreign investment.22 Each household can decide to hold its wealth in different
assets, i.e. domestic money, domestic bank deposits, domestic bonds, domestic stocks, real
estate, real fixed capital or (unless restricted by capital controls) foreign currency, foreign

21 Of course, with a fractional reserve system (minimum reserve requirements below 100 per cent), a
dollar gained by (gross) capital inflow can support more than one dollar in aggregate credit expansion
due to the credit multiplier.
22 See for a simple textbook exposition Krugman and Obstfeld (2006: 13).


deposits, foreign bonds or foreign stocks.23 As has been argued above, investment finance by
monetary expansion leads to an increase in the supply of monetary assets. In the stylized
example above, the household in the end just held the newly created money supply as part of
its wealth.

If, however, the household decides not to hold its wealth in domestic currency but to buy
foreign currency, this could create pressure on the exchange rate. Similarly, if the households
do not have confidence in the stability of the domestic currency and no access to foreign
assets, they might not be willing to hold currency but decide to buy real estate, precious metal
or similar goods as a store of value. This might put upward pressure on real estate prices or on
prices of those goods which are used as an inflation hedge. As these goods usually have a dual
role both as inputs into the production and as inflation hedges, pushing up their prices might
lead to higher overall inflationary pressure. Consequently, as Charles Goodhart (1989: 33)
notes, while credit and the money supply can be created endogenously by the credit process, it
is not clear whether the newly created money is finally demanded by the general public which
is a precondition for a stable equilibrium (emphasis as in the original text):

I will accept always any money offered me in payment for some sale at an agreed price,
so that any addition, e.g. caused by a bank loan, is always snapped up, but it does not
mean that I will want to hold that amount of extra money in ultimate equilibrium.
Demand for money, in the sense of the optimal amount that I would want to hold in
equilibrium in a given context, is not the same thing as – or determined by – the credit-
counterpart supply of money. The credit market is distinct and different from the money
market […]

I agree that at any moment the actual supply of money is determined, under present
circumstances, primarily in the credit market – as the credit-counterparts approach
indicates – and that it is willingly accepted. But I deny that this actual stock is necessarily
also demanded in the equilibrium sense outlined above.

Thus, the crucial question is: Are households really willing to hold (part of) their newly
earned income in domestic monetary assets? Only if they are willing to do so, the central bank
is free to accommodate the credit-creation of the lower-tier financial institutions. Hence, for
the ability of the central bank to accommodate a domestic credit-financed investment process,
three factors are of crucial importance:

(i) The degree to which the central bank has to look after the exchange rate and
prevent depreciations;

(ii) The extent to which an expansion of domestic income leads to higher import

demand and hence a higher demand for foreign currency; and

(iii) The degree to which households decide to hold additional savings in domestic
currency instead of foreign assets or in inflation hedges.

The first of these aspects is best covered by recent research. The publication of the seminal
work by Calvo and Reinhart (2002) which found that most developing countries use their
interest rate policy or foreign exchange interventions to prevent large swings in the exchange
rate even if they officially have proclaimed to have a floating exchange rate has triggered a
vast amount of research looking into possible reasons for the “fear of floating”. Early work
has focused on the question in how far foreign debt denominated in foreign currencies

23 For the average household in a developing country, the most likely holding of foreign asset will be in
the form of foreign currency, i.e. physical dollar bills the use of which is very hard to restrict by capital


(“original sin”) might have caused the fear of floating. Hausmann et al. (2001) for example
find that countries which are unable to borrow abroad in their domestic currency are much
more reluctant to accept a freely floating exchange rate, as a change in the exchange rate
might increase the debt burden and might even push a country towards a position in which the
external debt is not sustainable anymore.24

Honig (2005) has extended the analysis towards the question in how far domestic liability
dollarization also has an influence on the fear of floating. Honig argues that if domestic banks
accept dollar deposits from domestic residents, they take on foreign exchange risk. Even if
they make dollar loans to domestic companies, this does not eliminate foreign exchange
exposure, but only transfers the risk from the bank to the borrower. Large exchange rate
swings might lead to credit defaults as the firms usually earn revenue in domestic currency
and might not be able to repay their foreign-currency loan should the domestic currency
depreciate sharply. While removing exchange rate risk from the banks’ balance sheets,
making loans in foreign currency thus significantly increases default risk. Consequently, to
guard the stability of the financial system and the business sector, the central bank will have
to limit exchange rate fluctuations. In his empirical cross-country analysis, he finds strong
support for this hypothesis: An increase in dollar-denominated credits (and to a lesser extent
of dollar-denominated deposits) in a country’s banking sector significantly reduces the
probability of the country allowing its currency to float freely.

Therefore, from a central bank perspective, the less dollar liabilities (both external and
domestic) exist in an economy, the less is the risk that a fluctuation in the exchange rate
wrecks havoc with the government’s, the corporate sector’s or the financial sector’s balance
sheet and hence the larger is the freedom to accommodate a domestic credit and investment

Coming to the question in how far an expansion of domestic demand increases the demand
for import and hence the trade-related demand for foreign asset, there is ample literature with
estimates of the income elasticity of import demand. Applying this research to the scope for
domestic credit-finance of the investment process would mean that the larger the income
elasticity of import demand, the smaller a central bank’s scope for such an expansionary
policy. Usually, the income elasticity of demand is estimated to be larger than 1 for most
developing countries25. However, there is a vast difference between developing countries. For
China, Tang (2003) estimates the income elasticity of import demand at only 0.73, while
Shahe Emran and Shilpi (2007) find a value of 1.25 for India and Melo and Vogt (1984) a
value of 1.9 for Venezuela. The literature on how to explain international differences of
income elasticity on import demand is rather sketchy. While Melo and Vogt (1984) claim that
trade-liberalization leads to higher income elasticity of demand (a finding that is confirmed by
Mah, 1999), there is little systematic cross-country research on this topic. However, it would
be plausible to argue that a well-diversified economy which produces a wider scope of
consumer and capital goods would have a lower income elasticity of import demand.
Moreover, one could assume that poor countries the consumers of which do not yet consume
many sophisticated manufactured goods have a lower income elasticity for import demand
than medium-income countries.

24 The experience of Brazil in the year 2002 is an example for this mechanism: When in the run-up of
the 2002 presidential, speculators pushed the real to record-low levels against the United States dollar,
the government debt rose to levels which were close to those considered to be unsustainable. As
Williamson (2002) wrote at that time, a further loss of confidence could have easily pushed the country
into default. A rescue package of the IMF however, helped to stabilize the currency and thus prevented
25 See i.e. figure 1 in Lo et al. (2007: 135).


The third factor important for the credit creation process, the willingness of the household
sector to hold monetary assets denominated in domestic currency instead of putting savings
into foreign assets or real assets as inflation hedges are somewhat less well covered by recent
research. However, portfolio theory building on the seminal work by James Tobin (1958) or
Harry Markowitz (1952, 1959) provide a sensible starting point for this analysis. According to
this theory, money has to be seen as an asset which has also additional characteristics as the
ability to being used as a means of payment.26 Rational investors diversify the risks related to
their investments by allocating different shares of their wealth into different kinds of assets.
Thus, they will hold a share of their wealth in money depending on the rate of return of
money (that is, nominal interest paid on deposits minus inflation), the rates of return on other
assets, the volatility in the returns of each asset and the investors’ expected need for liquid
needs for payment purposes. The larger this share, the more can the central bank
accommodate the credit supply by the financial sector without risking a depreciation of the
exchange rate or an increase in the prices for inflation hedges and hence problems in the
banking sector or the ignition of a inflation-wage spiral which would lead to a further
debasement of the domestic currency.

For determining which measure for the return on assets as well as for the volatility of return to
use, it is important to remember the basics of portfolio theory. Portfolio theory builds on the
notion that the individual tries to maximize expected utility in different future states of an
uncertain world. However, usually it is not money which is seen as providing utility by itself,
but real consumption paid for with the money. Hence, what is important is the return and
volatility of return in terms of potential consumption.

It is quite obvious that trying to increase the return on monetary assets in an economy by
increasing interest rates is not a suitable path for a central bank to increase the scope for
financing investment with monetary expansion. While central banks could of course use their
monetary policy instruments to increase interest rates, this would also lower the demand for
credit and the investment activity of enterprises and would thus be incompatible with
increasing the scope for the Keynesian-Schumpeterian credit-investment process. In addition,
higher interest rates lead to the problem of adverse selection among the borrowers which in
turn might lead to more credit rationing in the financial sector.

Hence, the factors to target would be the volatility of real return of monetary assets and the
liquidity value of domestic monetary assets. As argued above, the average household deciding
on whether to hold his assets in domestic money or in foreign currency cares whether the
domestic currency can give a reasonable degree of price stability for the goods it is
consuming. Hence, a reasonably low and stable rate of consumer price inflation can be
expected to increase the willingness to hold domestic currency. Second, if a large share of
consumer goods is imported and there is a large pass-through from changes in the exchange
rate to consumer price inflation, foreign currency becomes more attractive as it can be
expected to lose less value should there be erratic fluctuations of the exchange rate. Schelkle
(2001: 185ff) shows in a portfolio model that for reasonable assumptions, the share of foreign
assets held by individuals is a positive function of the correlation between exchange rate
movements and the domestic price level. This conclusion provides some rationale for
heterodox price controls in the wake of large exchange rate swings such as the freeze of utility
rates legislated by the Argentinean Government after the devaluation of 2001–2002: By

26 For the following discussion, money will be used as to describe a broad monetary aggregate
including both cash in circulation as well as liquid liabilities by the financial sector fixed in nominal
terms. The argument thus does not distinguish between cash and demand deposits as they are very
close substitutes in the eyes of the private household. Moreover, as can be easily shown in the balance
sheet approach used above, a change of deposits into cash by the household would not have
macroeconomic implications as it is shown in the annex to this paper.


keeping the inflation rate of goods for daily consumption low relative to the depreciation,
Argentina managed to induce people to keep their assets in domestic currency and hence
prevented the depreciation-hyperinflation spiral which many commentators at that time
predicted for Argentina. In the end, the Argentinean financial sector contracted much less
than those of other crisis countries as i.e. Indonesia in the Asian crisis. As shown in figure 5,
in Indonesia, the ratio of credit to the private sector to GDP fell from 63 per cent before the
crisis to around 20 per cent after the crisis – a contraction by 68 per cent. In Argentina, the

ratio fell from 24 to 10 per cent – a
contraction by less than 60 per cent.

These considerations also point to
another problem of some (but not all)
developing countries: In poorer
countries, wealth owners often do not
consider the national consumer price
index as central for their own
consumption possibilities. Instead, they
often spend a disproportionate share of
their income on imported luxury goods.
In addition, they consider trips to the
United States or Europe for medical
treatment or they wish to send their
children to college in the industrialized
countries. All of these purchases have to
be paid for by foreign currency or their
prices are at least linked to the exchange
rate. Hence in these cases, wealth
owners can be expected to prefer a
smaller share of domestic monetary
assets in their portfolio.

What is closely related to the question of the consumption value of domestic currency is the
question of the liquidity value of holding domestic monetary assets. As Roy (2000) argues
following Whalen (1966) and Tsiang (1989), individuals hold money in their portfolios for
precautionary motives: They want to be prepared to meet sudden expenses or liabilities not
anticipated in payment date or size. As long as there are liquidation costs for assets different
from money and significant costs of illiquidity, economic agents will keep a certain share of
their wealth in the asset generally accepted as means of payment. However, in an economy in
which contracts and other payments are dollarized, the domestic currency loses liquidity value
relative to foreign assets, as sudden expenses or liabilities occur in foreign currency. Hence,
the more informally dollarized an economy, the less will a rational household save in
domestic currency should its income and savings increase. As Roy (2000: 120) argues, in a
dollarized economy, households are confronted “with an exchange rate risk [for holding]
domestic currency, not foreign currency”. Thus, being confronted with a dollarized economy
does not only make the economy more vulnerable for exchange rate fluctuations as argued
above, but in addition it might lead to a larger depreciation of the domestic currency for a
given expansion of the domestic credit and money supply. Therefore, even informal
dollarization can be expected to be detrimental to the Keynesian-Schumpeterian credit-
investment process.

Both the argument of the real purchasing power as well as the liquidity value of the domestic
currency as determinants of the individuals’ willingness to hold domestic assets also gives
support for trying to guard a somewhat undervalued exchange rate: If there is a sizeable
probability of some appreciation in the future, it is only rational for risk-averse individuals to
hold domestic monetary assets. First, an appreciation would make their imports cheaper and

Figure 5










-6 -5 -4 -3 -2 -1 0 1 2 3 4 5

Years relative to start of crisis



t o
f G




a Start of crisis defined as year 1997 in the case of

Indonesia and 2001 in the case of Argentina.


hence defend the purchasing power of domestic monetary assets relative to foreign currency.
Second, a possible appreciation of the domestic currency in the future significantly diminishes
the value of foreign currency holdings for precautionary motives: If there is a significant
chance that the savings in foreign currency lose value relative to possible unanticipated
expenses or liabilities (which usually will come up in domestic currency), individuals will
most likely decide to hold their precautionary savings in domestic currency.


The conclusions above about the structural features of an economy which allow for a
domestically financed credit-investment process can also be confirmed when we take a look
at the developing, emerging and transition countries which over the past decade have shown
the fastest accumulation of capital. Table 1 presents all countries with an investment-to-GDP
ratio of 25 per cent or more for the years from 1993 to 2003.27 For a closer inquiry, a number
of very tiny countries (with less than 200,000 inhabitants) or countries with special factors
distorting the investment figures have been dropped so that we are left with 20 small,
medium, or large economies with a investment-to-GDP ratio of 25 per cent or more. The
countries which are further inquired are printed in bold type in table 1, while for the countries
dropped from further inquiry, a short explanation is given.

Table 2 gives additional structural information on these high-investment countries. Column 3
of the table reports the average current account balance in per cent of GDP for the years 1993
to 2003. A negative figure denotes a deficit in the current account which by definition means
a net capital import of the same magnitude. A positive figure here shows a sustained current
account surplus and hence a corresponding net capital export. Column 4 reports the ratio of
self-financed investment to GDP. This is the sum of the investment-to-GDP ratio and the
current account balance and hence the aggregate savings-to-GDP ratio ex-post achieved.
Column 5 reports the share of dollar-deposits in the banking system as reported in Levy
Yeyati (2005), a widely used measure for gauging dollarization with the last year available
reported in column 6. Column 7 reports the pass-through coefficient for a change in foreign
prices to the domestic price level as reported in Devereux and Yetman (2003). Column 8
finally shows the share of the population with access to bank accounts as reported in
Demirgüç-Kunt et al. (2008).

What is first interesting to note is that the top of the league of countries with high investment-
to-GDP ratio is made up from countries which have completely self-financed their strong
capital accumulation from 1993 to 2003: Here, we find the five Asian countries: China, the
Republic of Korea, Singapore, Malaysia and Thailand. Further down the league, but also
among the self-financers, we find Hong Kong (China), Gabon and the Islamic Republic of

A second group with investment-to-GDP ratios just slightly below those of the first group
contains a number of countries which mainly have experienced rapid capital accumulation
with foreign capital. This group is mainly made up of central and eastern European transition
countries: Slovakia, the Czech Republic, Estonia and Belarus, but also contains the Caribbean
countries: Jamaica and Dominica, the Central American countries: Honduras and Nicaragua
and the Asian countries: Viet Nam and Mongolia.

27 Unfortunately, for some of the countries no data after 2003 was available. In order to keep the data
comparable, the time span for this inquiry was moved to 1993 to 2003, rather than taking the latest data
for some countries into account. However, the vast majority of countries experiencing a strong capital
accumulation from 1993 to 2003 have continued to do so until today.


Table 1



to-GDP ratio
1993–2003 Remark

Equatorial Guinea 0.79 Oil discovery in 1996, large inflows of foreign investment

as a result, now much lower investment
Lesotho 0.50 Construction of a large water project by foreigners which

makes up large share of gross fixed investment
Saint Kitts and Nevis 0.45 Tiny – about 42,000 inhabitants
Antigua and Barbuda 0.44 Tiny – about 83,000 inhabitants
Grenada 0.37 Tiny – about 110,000 inhabitants
China 0.34 Included
Democratic Republic of the Congo 0.34 Oil discovery
Republic of Korea 0.33 Included
Singapore 0.33 Included
Malaysia 0.31 Included
Saint Vincent and the Grenadines 0.31 Tiny – about 110,000 inhabitants
Thailand 0.29 Included
Slovakia 0.29 Included
Czech Republic 0.29 Included
Jamaica 0.28 Included
Viet Nam 0.28 Included
Mongolia 0.28 Included
Qatar 0.28 Included
Hong Kong (China) 0.27 Included
Estonia 0.27 Included
Gabon 0.27 Included
Dominica 0.27 Included
Iran (Islamic Rep. of) 0.27 Included
Honduras 0.26 Included
Tunisia 0.25 Included
Nicaragua 0.25 Included
Belarus 0.25 Included
Sri Lanka 0.25 Included
Saint Lucia 0.25 Tiny – 160,000 inhabitants

Note: Countries in bold are included in the further inquiry. Countries in normal type are excluded. Reasons for exclusion are given
in the right column.

When we compare the structural data on the financial sector of these countries, we find that
there is a sharp difference in the degree of the dollarization in the respective financial sectors
of the self-financing countries and those that have relied on capital imports. All of the Asian
countries on top of the league that have self-financed their capital accumulation show a very
low degree of deposit dollarization with China recording a maximum of slightly above 5 per
cent. All of the following countries that have relied on capital imports, in contrast, show
significantly higher degrees of dollarization with the Czech Republic marking the minimum
with roughly 10 per cent and Nicaragua recording a degree of dollarization of more than
70 per cent. There is only one exception to this rule: Hongkong (China), which as an offshore
financial centre shows a high degree of dollarization while it has managed to finance all of its
capital accumulation by itself.


Table 2






balance in
per cent of



as share of

in per cent

Year for
column (5)

through of

prices to


Access to

system in
per cent of

(1) (2) (3) (4) (5) (6) (7) (8)

China 0.34 1.90 0.36 5.6 2003 0.19 42
Republic of Korea 0.33 1.58 0.34 4.0 2001 0.02 63
Singapore 0.33 16.68 0.49 -0.48 98
Malaysia 0.31 4.03 0.35 3.3 2004 0.03 60
Thailand 0.29 1.88 0.31 1.3 2001 0.03 59
Slovakia 0.29 -5.26 0.24 14.0 2004 83
Czech Republic 0.29 -4.38 0.24 10.2 2004 85
Jamaica 0.28 -5.27 0.23 37.6 2004 0.48 59
Viet Nam 0.28 -4.27 0.23 29.8 2004 29
Mongolia 0.28 -2.99 0.25 46.2 2004 25
Qatar 0.28 -0.18 0.27 22.8 2004
Hong Kong (China) 0.27 2.18 0.30 47.8 2004
Estonia 0.27 -7.66 0.20 26.6 2004 86
Gabon 0.27 8.46 0.36 0.22 39
Dominica 0.27 -18.74 0.08 25.1 2004 0.22 66
Honduras 0.26 -4.12 0.21 35.5 2004 0.52 25
Tunisia 0.25 -3.53 0.22 -0.01 42
Nicaragua 0.25 -22.07 0.03 70.3 2004 7.14 5
Belarus 0.25 -4.19 0.21 48.0 2004 16
Sri Lanka 0.25 -3.53 0.21 23.8 2004 -0.01 59

Source: Data for columns (2) and (3) are from the IMF International Financial Statistics and the WEO Database. Self-finance

capability as share of GDP equals national savings and is computed by the sum of column (2) and (3). Data on financial
dollarization in column (4) comes from Levy Yeyati (2005). Data on pass-through of import prices on domestic prices is
taken from Devereux and Yetman (2003). Data for the access to banking services comes from Demirgüç-Kunt et al. (2008).

At first sight, one could suspect that this correlation has a strong regional component: After
all, the fast-growing (and self-financing) Asian countries on the top of the league have all low
degrees of dollarization while the Latin American countries show a high degree of
dollarization. Yet, on closer examination, this is not entirely true: Viet Nam, which is often
seen as the next Asian tiger (and might share a lot of structural similarities to other countries
in the region), has a quite high degree of dollarization in the banking system – and has
consequently relied on the import of capital for its domestic investment spree. A similar point
holds for Mongolia which also as an Asian country has experienced a high degree of
dollarization and net capital inflows.

It is also interesting to note that all the self-financing countries with high investment-to-GDP
ratios have low values for the pass-through of foreign prices on the domestic price level,
ranging from 0.03 for Thailand and Malaysia28 to only 0.19 for China. As far as data is
available, the pass-through is significantly higher for most of the countries which had to rely
on foreign capital.

28 Neglecting the negative value for Singapore.


Finally, the countries which have managed to embark on a self-financed process of strong
capital accumulation systematically show a rather high degree of access to the banking
system: Among the self-financers, China has the lowest degree of access to the banking
system with an estimated 42 per cent of the population having access to banking services. All
other of these Asian countries have a significant higher degree of access to banking.29 This
contrasts sharply with the high investment-to-GDP ratio countries in Latin America:
Honduras and Nicaragua show a rather low degree of access to the banking system with
25 and 5 per cent. As has been argued above, it is important that people decide to hold their
savings in domestic monetary assets. If they have access to banking, this is much more likely
especially in the cases when there is moderate inflation as access to banking might help
protect the purchasing power of savings by offering indexed products or some interest
payments on savings.

Widening the view towards other countries not in the group of high investment-to-GDP ratios,
the combination of different pass-through effects with a higher degree of dollarization, a
stronger orientation of wealth owners in their consumption habits towards the United States of
America and a different history of over and undervaluation might explain why Latin America
and Asia differ substantially in the amount of loans to the private sector the financial sector is

Taking the factors for the central bank’s constraints of domestic credit financing discussed
above into account for explaining the two impressive cases of catch-up-growth in China and
Germany, we see thus that China has been in fact in a very favourable position to finance
investment by domestic credit creation. First, coming from a socialist state of attempted
autarchy, there has been very little foreign debt denominated in foreign currency. Second,
with very little consumer goods imported, the income elasticity of import demand was rather
low. In addition, domestic households did not deem the exchange rate overly important for the
protection of their savings’ purchasing power as they mostly consumed domestically
produced goods. Finally, China embarked on a sustained growth process from a position of
undervaluation, making an appreciation likely and hence making domestic monetary assets
attractive. Finally, capital controls have effectively restricted most Chinese households from
investing abroad, hence inducing them to hold their savings in domestic monetary assets.

A similar argument can be made for Germany after World War II. With foreign debt set at
14.5 bn German Marks in 1953, less than 10 per cent of GDP, foreign currency debt was low.
Legislation in Germany was set in a way that discouraged foreign currency transactions. In
addition, the (fixed) exchange rate was set at a level that Germany was quickly accumulating
a surplus in foreign trade which soon put upward pressure on the exchange rate. Residents’
portfolio investments abroad were significantly limited during the first years of the catch-up

While these two cases of course might have been cases with an extremely favourable position
for some domestic expansion, to a certain degree a number of developing countries might
have the scope for some credit expansion. Moreover, thoughtful structural policies might be
able to expand this scope.

29 For details, please refer to table 2.



Based on the analysis above, there are a number of policy conclusions for developing
countries which want to enable their financial system and central bank to accommodate a
domestically financed investment expansion. First, there are a number of microeconomic
financial sector issues in which the right policies might expand the ability of banks and the
central bank to fulfil their tasks in this process. Second, there are a number of macroeconomic
factors the right policy might be able to influence to expand the space for domestic credit

From a microeconomic point of view, some basics need to be in place for the banking system
to work. For example, it is important that property rights are clearly defined and that
paperwork necessary to collateralize real assets can easily and cheaply be done. Moreover, it
is important that there are clear and reasonably timely procedures in place for the case that a
bank needs to foreclose a loan and needs to sell the collateral. Hence, the general rule of law
and a working judicial system are important.

In addition, it is of foremost importance to regulate and monitor the financial system in a way
that on the one hand it is able to extend with a sustainable pace the credit supply to innovative
and potentially profitable companies to conduct investment. Second, in order to induce
households to hold their money in domestic monetary assets, regulation and oversight has to
guarantee the stability and hence the trust in the financial system. From this point of view,
either having an implicit government guarantee for deposits or introducing an explicit deposit
insurance would be a good idea. However, as is known from the research on financial
development, a deposit insurance creates a moral hazard problem: With depositors knowing
that their deposits will be safe, they tend to monitor the banks less. In addition, bankers might
chose assets with a higher risk as they try to maximize their return. Consequently, if the
introduction of a deposit insurance is not to have negative effects on the medium- and long-
term stability of the financial system, it needs to be well regulated and monitored (Cull et al.,

Especially important from the considerations above seem to be prudential rules that prevent
banks from investing in risky activities. As poor private households can be expected to be
rather risk-averse when it comes to the investment of their savings, the stability and reliability
of their bank seems to be much more important for the question of holding domestic deposits
than small changes in the real return on such assets. A central necessity here would be the
definition and enforcement of capital adequacy standards which guarantee that the bank
owner has an incentive not to engage in overly risky activities.

Considering the fact that credit for consumptive purposes or housing construction can be
expected to yield much less macroeconomic benefits than loans to the corporate sector, one
should also think about regulating the banking sector in a way that its credit creation remains
biased to the corporate sector. One possibility would be to introduce higher capital
requirements for mortgage or consumer credits. Especially countries that have not yet
liberalized the market for private mortgages and consumer credit should be extremely careful
doing so quickly as this might lead to an especially strong credit creation in this sector.

As has been argued above, foreign borrowing by banks and other financial institutions
increases the vulnerability of the financial sector to exchange rate fluctuations and hence
limits the scope of the central bank to allow some depreciation in the credit-investment
process. Hence, legal restrictions on the financial systems’ borrowing from abroad in foreign
currency could also make sense and expand the scope for domestic financing. An alternative


could be to allow borrowing in foreign currency only to finance activities of companies which
will earn foreign currency (i.e. in the export sector).

On the macroeconomic side, one of the most important factors is to prevent dollarization in all
of its forms. First, if an economy is officially dollarized, the central bank loses its ability to
expand the supply of base money in order to accommodate the credit process. Hence,
governments which want to preserve this policy space should avoid official dollarization. A
similar argument holds for a currency board: As such a currency regime also restricts the
ability to accommodate credit expansion, it should also be avoided.

However, even if the economy is not officially dollarized, unofficial dollarization of
transactions or the dollarization of financial assets and liabilities in the financial sector or the
existence of foreign debt denominated in foreign currency in the corporate, household or
government sector can severely limit the scope of monetary policy. For the question of
dollarization short of introduction a foreign currency as legal tender, most research hints that
it is related to inflation: A large body of literature shows that expected depreciations
following high inflation can explain to a certain extent a process of dollarization.30 Moreover,
recent literature hints that there is a hysteresis or ratchet effect in dollarization:31 If economic
agents have once started to use foreign currency for domestic transactions or in deposit and
loan contract, this process seems to a certain extent to be not self-reversing.32 Hence,
macroeconomic policy should try to limit bouts of inflation and large depreciations. As large
depreciations sometimes are needed if there has been a large overvaluation before, this would
call for a management of the exchange rate to limit large swings in the exchange rate.
Moreover, as far as the limits of a large depreciation on domestic inflation are concerned, the
fact that an inflationary bout may have permanent effects strengthen the argument for non-
orthodox means of inflation control such as income policies.33

In addition, there might be some argument for legally restraining the use of foreign currency.
In the regressions run by De Nicoló et al. (2005), countries with restrictions on the domestic
use of foreign currency show a significant lower degree of dollarization. However, for
countries with high inflation, legal restrictions for the use of foreign currency in general come
with the side-effect of a reduced financial depth. Hence, as De Nicoló et al. (2005: 1718) put
it: “The road to reducing dollarization and its risks should be based on a two-lane approach
that both discourages the use of the dollar and enhances the attractiveness of the local
currency as a medium of intermediation and medium of exchange”. Thus, a combination of a
sound macroeconomic environment with reasonably low and stable rates of inflation and
restrictions on domestic holdings of foreign currency might help to keep dollarization low and
at the same time allow for credit creation in the domestic banking system.

For the question of debt denominated in foreign currency, the research on “original sin” also
gives some hints which policies can be used in order to limit the exposure. Again, there is
some evidence that high past inflation increases the degree of original sin (Hausmann and
Panizza, 2003), so that the conclusions from above might also be valid for preventing the
foreign debt denomination in foreign currency. Second, original sin seems to be strongly
correlated with the size of an economy. The larger an economy, the less original sin can
generally be observed. Hausmann and Panizza (2003) argue that the larger a currency relative

30 See i.e. Clements and Schwartz (1993) or Agénor and Kahn (1996) or De Nicoló et al. (2005).
31 See i.e. Sturzenegger (1997), Uribe (1997) or Kamin and Ericsson (2003).
32 The literature uses the term of “irreversible”. However, this term is rather misleading as there are
certain cases in which dollarization has successfully been reverted. For example, in Argentina,
legislation in the financial crisis brought the share of dollarized deposits in the banking sector down
from 73.6 per cent in 2001 to less than 4 per cent in 2004 (data from Levy Yeyati 2005).
33 See Flassbeck et al. (2005) for a description on how these policies have been successfully used in
China after the depreciation in the mid-1990s.


to world financial markets, the less possibility has an investor who wants to diversify her
portfolio to do so without including that currency into the portfolio. This conclusion also hints
at the possibility to increase the scope for domestic credit expansion by strengthening
monetary and financial regional cooperation.34 If regional monetary and financial integration
agreements manage to stabilize the intra-regional exchange rates, this might decrease the
shocks to domestic inflation and increase the liquidity value of domestic monetary assets. In
addition, if assets of the region become closer substitutes in the eyes of global investors
thanks to more stable exchange rates, regional monetary integration might have the effect that
it makes the region’s currency together more attractive for inclusion into the investors’
portfolio and hence reduce original sin.

Finally, a slight undervaluation position seems to be advisable given the arguments above: As
long as there is the expectation of some future appreciation of the domestic currency, holding
domestic currency is more attractive than holding foreign assets at the same interest rate.
Hence, if a country has the ability to use monetary policy, capital controls, exchange rate
policies and income policies to secure a position of (some) undervaluation, this setting can be
expected to expand the scope for domestic credit creation and investment finance.


This paper has argued that developing countries neither need capital imports nor have to
lower consumption of their citizens to make resources available for investment to attain a high
investment-to-GDP ratio. Instead, if some preconditions are met, a developing country can
use its financial system and its central bank to use credit creation to increase investment. This
investment then leads to increased absolute aggregate savings which ex post can finance the
investment conducted.

While this is not the only way to achieve rapid capital accumulation and hence economic
growth, empirically it seems to be preferable to a strategy of importing capital for a higher
investment growth. Not only do recent empirical findings in the literature (Prasad et al., 2007)
hint that capital imports may come with harmful side-effects. Relying on domestic resource
mobilization also has the advantage that it shields developing countries from the danger of
sudden stops in capital flows, a phenomenon which has been regularly observed in the past.

While there might be a number of preconditions for a domestically financed sustained credit-
investment process, the most important seems to be to prevent any type of dollarization. To
this end, it is advisable for developing countries to prevent bouts of high inflation and sustain
some position of undervaluation.

34 See UNCTAD (2007) for more thoughts on regional monetary and financial cooperation. See also
Fritz and Mühlich (2006) for a discussion of South-South monetary integration.



A changing deposits into cash

Cash and deposits can be seen as very close substitutes from the point of view of a household.
As can be easily shown, for the credit-investment process described in section III, it does not
make much difference whether a household decides to hold its wealth in cash or bank deposits
as long as the central bank is free to print cash (that means it must not be constrained by a
dollarized economy or a currency board arrangement. Figure A.1 shows what happens if the
household decides to hold the money earned in the credit-investment process in cash instead
of deposits. In this case, the household would go to the bank and demand its deposit to be
converted to cash. The bank would go to the central bank and convert its reserves into cash.
Finally, it would pay the cash to the household while cancelling its deposit (accounting
record 4). The balance sheet of the commercial bank has shortened while deposits in the
central bank’s and the households’ balance sheets are substituted for cash. As can easily be
seen, this process does not change the net wealth of any of the actors and leaves the result of
an increased capital stock by credit financing intact.

Figure A.1


Firm Household
Assets Liabilities Assets Liabilities

[1] Deposit at

+100 [1] Bank Loan +100 [3] Deposit at

+100 [3] Household


[3] Deposit at

-100 [4] Deposit at


[3] Capital good +100 [4] Cash +100

Financial Institution Central Bank
Assets Liabilities Assets Liabilities

[1] Loan to firm +100 [1] Deposit from

+100 [2] Loan to bank +100 [2] Reserves +100

[2] Reserves at
central bank

+100 [2] Loan from
central bank

+100 [4] Reserves -100

[4] Reserves at
central bank

-100 [3] Deposit from

-100 [4] Cash in


[4] Cash +100 [3] Deposit from


[4] Cash -100 [4] Deposit from




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No. Date Author(s) Title

192 November 2008 Enrique Cosio-Pascal The emerging of a multilateral forum for debt
restructuring: The Paris Club

191 October 2008 Jörg Mayer Policy space: What, for what, and where?

190 October 2008 Martin Knoll Budget support: A reformed approach or old wine in
new skins?

189 September 2008 Martina Metzger Regional cooperation and integration in sub-
Saharan Africa

188 March 2008 Ugo Panizza Domestic and external public debt in developing

187 February 2008 Michael Geiger Instruments of monetary policy in China and their
effectiveness: 1994–2006

186 January 2008 Marwan Elkhoury Credit rating agencies and their potential impact
on developing countries

185 July 2007 Robert Howse The concept of odious debt in public international

184 May 2007 André Nassif National innovation system and macroeconomic
policies: Brazil and India in comparative

183 April 2007 Irfan ul Haque Rethinking industrial policy

182 October 2006 Robert Rowthorn The renaissance of China and India: Implications
for the advanced economies

181 October 2005 Michael Sakbani A re-examination of the architecture of the
international economic system in a global setting:
Issues and proposals

180 October 2005 Jörg Mayer and
Pilar Fajarnes

Tripling Africa’s Primary Exports: What? How?

179 April 2005 S.M. Shafaeddin Trade liberalization and economic reform in
developing countries: Structural change or de-

178 April 2005 Andrew Cornford Basel II: The revised framework of June 2004

177 April 2005 Benu Schneider Do global standards and codes prevent financial
crises? Some proposals on modifying the
standards-based approach

176 December 2004 Jörg Mayer Not totally naked: Textiles and clothing trade in a
quota free environment

175 August 2004 S.M. Shafaeddin Who is the master? Who is the servant? Market or


No. Date Author(s) Title

174 August 2004 Jörg Mayer Industrialization in developing countries: Some
evidence from a new economic geography

173 June 2004 Irfan ul Haque Globalization, neoliberalism and labour

172 June 2004 Andrew J. Cornford The WTO negotiations on financial services:
Current issues and future directions

171 May 2004 Andrew J. Cornford Variable geometry for the WTO: Concepts and

170 May 2004 Robert Rowthorn and
Ken Coutts

De-industrialization and the balance of payments
in advanced economies

169 April 2004 Shigehisa Kasahara The flying geese paradigm: A critical study of its
application to East Asian regional development

168 February 2004 Alberto Gabriele Policy alternatives in reforming power utilities in
developing countries: A critical survey

167 January 2004 Richard Kozul-Wright
and Paul Rayment

Globalization reloaded: An UNCTAD Perspective

166 February 2003 Jörg Mayer The fallacy of composition: A review of the

165 November 2002 Yuefen Li China’s accession to WTO: Exaggerated fears?

164 November 2002 Lucas Assuncao and
ZhongXiang Zhang

Domestic climate change policies and the WTO

163 November 2002 A.S. Bhalla and S. Qiu China’s WTO accession. Its impact on Chinese

162 July 2002 Peter Nolan and
Jin Zhang

The challenge of globalization for large Chinese

161 June 2002 Zheng Zhihai and
Zhao Yumin

China’s terms of trade in manufactures,

160 June 2002 S.M. Shafaeddin The impact of China’s accession to WTO on
exports of developing countries

159 May 2002 Jörg Mayer, Arunas
Butkevicius and
Ali Kadri

Dynamic products in world exports

158 April 2002 Yılmaz Akyüz and
Korkut Boratav

The making of the Turkish financial crisis

157 September 2001 Heiner Flassbeck The exchange rate: Economic policy tool or
market price?

156 August 2001 Andrew J. Cornford The Basel Committee’s proposals for revised
capital standards: Mark 2 and the state of play


No. Date Author(s) Title

155 August 2001 Alberto Gabriele Science and technology policies, industrial reform
and technical progress in China: Can socialist
property rights be compatible with technological
catching up?

154 June 2001 Jörg Mayer Technology diffusion, human capital and
economic growth in developing countries

153 December 2000 Mehdi Shafaeddin Free trade or fair trade? Fallacies surrounding the
theories of trade liberalization and protection and
contradictions in international trade rules

152 December 2000 Dilip K. Das Asian crisis: Distilling critical lessons

151 October 2000 Bernard Shull Financial modernization legislation in the United
States – Background and implications

150 August 2000 Jörg Mayer Globalization, technology transfer and skill
accumulation in low-income countries

149 July 2000 Mehdi Shafaeddin What did Frederick List actually say? Some
clarifications on the infant industry argument

148 April 2000 Yılmaz Akyüz The debate on the international financial
architecture: Reforming the reformers

146 February 2000 Manuel R. Agosin and
Ricardo Mayer

Foreign investment in developing countries:
Does it crowd in domestic investment?

145 January 2000 B. Andersen,
Z. Kozul-Wright and
R. Kozul-Wright

Copyrights, competition and development:
The case of the music industry

144 Dec. 1999 Wei Ge The dynamics of export-processing zones

143 Nov. 1999 Yılmaz Akyüz and
Andrew Cornford

Capital flows to developing countries and the
reform of the international financial system

142 Nov. 1999 Jean-François

Financial development, human capital and
political stability

141 May 1999 Lorenza Jachia and
Ethél Teljeur

Free trade between South Africa and the European
Union – a quantitative analysis

140 February 1999 M. Branchi,
A. Gabriele and
V. Spiezia

Traditional agricultural exports, external
dependency and domestic prices policies: African
coffee exports in a comparative perspective

Copies of UNCTAD Discussion Papers may be obtained from the Publications Assistant, Macroeconomic
and Development Policies Branch (MDPB), Division on Globalization and Development Strategies
(DGDS), United Nations Conference on Trade and Development (UNCTAD), Palais des Nations, CH-
1211 Geneva 10, Switzerland (Fax no: +41(0)22 917 0274/Tel. no: +41(0)22 917 5896).

New Discussion Papers are accessible on the website at http://www.unctad.org.