Financial Reform, Inflation, and Investment Behavior in Developing Countries: Evidence from Peru
Raising real interests rates is a central element of financial reforms in developing countries. This chapter presents a theoretical model in which higher levels of inflation risk reduce private real capital formation. Using Peruvian data the negative relationship between inflation volatility and private investment is confirmed. Since inflation variability increases with the level of inflation, financial reforms should include measures to reduce inflation, if private real capital formation is to be stimulated effectively.
In the 1980s foreign capital inflows into many developing countries declined dramatically, so that these countries had to finance investment mostly by domestic resources. The financial sector can play an important role in helping to increase domestic resource mobilization and the efficiency of resource use ( World Bank 1989). However, extensive government regulation, hampers efficient intermediation in many developing countries. Therefore, the importance of financial reforms is frequently stressed in theoretical and empirical literature. 1 Raising real interests rates is usually a central element of the reform proposals. Basically, real interest rates may be raised by lowering inflation rates or increasing nominal interests rates. Most analyses advocating financial reforms do not distinguish between these probabilities. Typically, lifting interest-rate controls is favored, because governments are thought to be unable to control inflation (e.g., Moore and Chowdury 1981).
This chapter challenges the view that the different means to raise real interest rates are symmetrical in their impact on the success of financial reforms. It can be demonstrated that savings mobilization can be improved by lowering inflation or by full indexation of the financial sector ( Corsepius 1989). However, the principal aim of financial liberalizations is to increase the volume and the allocative efficiency of investment. Thus in the following it is shown that only the dampening of high inflation rates can assure that financial liberalization leads to more fixed invest-