_Policy, Planning, and Research Working Paper Series_ _17_

### ity is argued for.

This paper is a background paper for the 1988 World Development Report. Please contact Rhoda Blade-Charest, room S13-060, extension 33754.

# **38. Intergovernmental Grants In Developing Countries**

This is a background paper for the 1988 World Development Report. Please contact Rhoda Blade-Charest, room S13060, extension 33754.

# **39. Fiscal Policy In Low-income Africa**

1988 World Development Report. Please contact Rhoda Blade-Charest, room S13060, extension 33754.

# 40. **FinancIal Deregulation and the Globalization of Capital Markets**

## Eugene L. Versluysen

### Stephen A. O'Connell

### Larry Schroeder

_The method a central government uses to transfer funds to local jurisdictions can greatly affect a country's development efforts. But the effects of the transfers are seldom analyzed, resulting in intergovernmental grant systems that fail to achieve their desired objectives._ A country's grant system is the product of its political environment. Such systems tend to develop over time in response to current political needs and then become institutionalized. Since they have developed in a haphazard fashion over time, grant 'systems" commonly are not systems at all. Hard-pressed government ministries seldom undertake any thorough analysis of these arrangements, hence their overall impact is unknown in spite of the importance of this use of resources.

Grants from central governments become more important sources of local revenue as local governments are expected to playlargerroles in the provision of public services.

Grants are usedin hopes ofachieving a wide variety of goals. One common rationale for intergovernmental grants is to redistribute national income or equalize living standards by helping governments deliver public services in economically depressed areas.

Sincetransfersmaybe seenlocallyas "costless" gifts from the higher level of government, there is little pressure on localities to mobilize resources of their own or to spend the funds efficiently. Few developing countries have the resources to conduct audits to ensure the accountability of local government spending.

The goal of assisting decentralized decisionmaking by transferring funds to local units can also conflict with the objective that central government revenues be spent efficiently. Decentralization implies local control over the use of funds; the desire for effective use of centrally collected funds calls for considerable oversight of local spending.

_Fiscal restraint, a precondition for economic recovery in much of Africa, should go hand-in-hand with improved public sector efficiency in delivering basic human services and upgrading infrastructure._ In many African nations, the fiscal balance is extremely fragile, so fiscal restraint is necessary for stabilization and adjustment efforts to succeed.

Governments tend to increase public expenditures when export commodity revenues are high -and maintain public spending even after revenues fall. This is a formula for building unmanageable debt. Botswana and Cameroon, which exercised restraint during boom times, are exceptions to the rule in Africa.

Inflation, driven by public spending, has serious consequences such as the erosion of the real value of taxes, adding to public deficits. However, attempts to reduce inflation through fiscal austerity may have undesirable side effects, if austerity is pursued in the wrong way when public sector real wages are driven down below subsistence, productivity is reduced.

Low public sector productivity results in poor delivery of human services, the deterioration of infrastructure, and low generation of revenue, hindering economic growth.

Fiscal deficits drove real exchange rates up in the late 1970s and early 1980s - and fiscal policy should now facilitate real depreciation adjustment by pulling deficits down.

External aid has often supported unsustainable fiscal policy. Far from lessening the need for structural adjustment, it should now be used for rehabilitation and infrastructure development.

Market-oriented exchange rates are not a substitute for fiscal restraint, but a complement. Flexible rates alone failedin Zambiaand SierraLeone. Combined with prior fiscal restraint, however, they succeeded in Ghana.

This is a background paper for the _Rapid financial deregulation and the globalization of capital markets have led to dangerous financial volatility that could have a destabilizing impact on major economies. To reduce this volatility, new regulation may be needed._ Financial deregulation in recent years has vastly increased the ability of financial markets to allocate international capital efficiently. It has also sparked explosive growth in financial transactions and resulted in a restructured, more competitive, and less costly financial services industry.

But deregulation has proceeded so rapidly that the volume of purely financial transactions now greatly exceeds that of transactions driven by international trade in goods and services. Financial activity is now "delinked" from other factormarketsandincreasinglydrivenby speculation for short-term profits rather than by broader economic activity.

This new pattern has led to growing economic uncertainty and instability. Markets now run around the clock and respond sorapidly that there is a growing danger of chain reactions that could precipitate global market failures.

Deregulation has also made the conduct of national monetary policy more difficult and the monitoring of markets more complex. For the United States, deregulation has increased the abillity to borrow abroad, thus contributing to fiscal laxity. In that country, there is a need for a single regulatory agency to coordinate the supervision ofrelated financial activities - to lessen the risk of compounded market failures.

Some countries, such as England, have moved to strengthen the capitalization ofbanks and securities firms. Others (Canada, France, Italy, and Spain) are making progress. But there is acute need for improvement in the United States, where many large banks are undercapitalized in relation to their exposure on LDC loans.

Regulators in the major trading nations need to address the possibility of a