_Policy, Planning, and Research Working Paper Series_ 57 how, and under what condition to remove - price controls without bringing back inflation.

The chief advantage of controls is also their chief drawback. They can quickly reduce inflation, leading authorities to underestimate serious underlying imbalances. The repeated use of controls works against stabilization: anticipating freezes, firms set high prices. Anticipating re-imposition of controls, firms accelerate price increases. Controls should be removed gradually, when supplies generally are in excess, and tight fiscal and monetary policies should remain in place during flexibilization." This was not done in Argentina.

In the Austral plan, the removal of controlscoincidedwithaflexibilizationin the management of the main anchors of the system. Gradual decontrol of private prices followed by a sequenced adjustment in wages, public sector prices, and the exchange rate would have had a better chance of success, the author argues.

The removal of controls left the economy with no nominal anchors - no nominal variable to anchor the rate of inflation. Given necessary adjustments in prices and the exchange rate, money should have played a more active role and the authorities should have pursued a policy of untying devaluations from past inflation.

This paper is a product of the Macroeconomic Adjustment and Growth Division, Country Economics Department. Please contact Raquel Luz, room Nil059, extension 61761.

## 163. How Infrastructure and Financial Institutions Affect

Agricultural Output and Investment In **Indla** Hans P. Binswanger, Shahidur R. Khandker, and Mark R. Rosenzweig

> _Prices matter-but so do banks, markets, and infrastructure._

How do the decisions offarmers, financial institutions, and government agencies interact and affect agricultural investment and output in a region - and to what extent are these "actors"influenced by a region's location and agroclimatic endowments (for example, rainfall or the soil's moisture-holding capacity).

This paper is an attempt to quantify the relationships of key factors, using district-level time-series data from India.

Agricultural opportunities in a district are seen as the joint outcome of the agroclimatic endowments of the district and new technology that becomes available to it. Better agroclimatic opportunities improve output (relation 1), but also increase the economic return for a private farm investment-say, in a tractor (relation 2). Greater private profit in a wellendowed region induces farmers to press for more investment in infrastructure (relation 3). Financial institutions find it more profitable to locate where there is more demand for capital and more repaymentcapacity (relation 4) and where good infrastructure reduces their costs (relation 5). Private agricultural investment and use of input is more profitable the better the agricultural opportunities (relation 2), the better the infrastructure (relation 6), the cheaper the cost of financial services (relation 7), and the more favorable government's price and interest policies (relation 8). Exactly the same factors affect the output supply (relations 9, 10, 11). Traditional approaches to production function estimate the direct impact of capital stocks (investment) and input use on output (relation 12), ignoring many of the factors discussed here.

After comparing data on these factors, the authors conclude that:

* Agroclimatic factors continue to govern the rate atwhich districts can take advantage ofnew agricultural opportunities, and govern public, bank, and private investment decisions.

* Theavailabilityofbanks(credit)is more important than the real interest rate as a factor in aggregate crop output and farmers' demand for fertilizer. Rapid bank expansion in an area increased fertilizer demand by about 23 percent, rates of investment in pumps 41 percent, in milk animals 46 percent, and in draft animals about 38 percent. Despite their impact on investment and fertilizer use, the impact of banks on output appears to be fairly small (nearly 3 percent).

* Unsurprisingly, commercial banks prefer to locate in well-watered areas where the risk of drought or flood is relatively low. Bank expansion is facilitated by government investments in roads and regulated markets, which improve farmers' liquidity and reduce banks' and farmers' transaction costs.

* In the 1970s, expansion of regulated markets contributed 4 percent to growth of agricultural output and 17

percent to demand for fertilizers. Expansion of electrification increased output 2 percent in a decade by increasing investment levels for pumps and fertilizer. A primary education added a large 8 percent to crop output over the decade, primarily by increasing fertilizer demand nearly 30 percent.

This paper is a productoftheAgriculture Operations Division, Latin America and Caribbean Country Department II. Please contact Josefina Arevalo, room I7100, extension 30745

# 164. Intersectoral Flinancial **Flows** In **Developing** Countries

## Patrick Honohan and Izak Atiyas

_The business sector in developing countries relies on external funding for about halfof its investment. If the availability of investable funds is to be freed from its dependence on the vagaries of the international capital markets, developing country financial systems will have to attract more household savings with new types of instruments and adequate returns._

## Areview offlow offunds data for 17 developing countries reveals that most years in most countries:

* The household sector is a net lender, lending on average 7 percent of GNP - and more in countries that are more open and have higher income. The household sector typically saves more than twice what it needs to finance its accumulation of real assets, lending the rest to other sectors.

> * The business sector is a net borrower, borrowing on average 7 percent of GNP. Abouthalfofreal capital formation by business is externally financed.

* The government sector is sometimes a net lender but more often a net borrower.

Intersectoral flows in developing countries are achieved mostly through thebankingsystem. Therestofthefinancial system is typically relatively underdeveloped. Thus savings are channeled from the household to the business sector much more bymeans ofbank deposits and loans than through issue of equities.

The foreign sector cannot be relied upon as a passive or residual provider of funds to the domestic economy. A shortfall in foreign financing or an increase in government borrowing typically force the business sector to reduce its investment.