An Alternative Rationale for Financial Dualism: Note

Abstract

Financial repression is a policy of imposing effective ceilings on interest rates that banks are allowed to charge firms, for the purpose of stimulating investment. Critics (for example, Lanyi and Saracoglu 1983 and Fry 1988) make two charges. First, the low interest rates discourage savings, thereby limiting total investment. Second, the low interest rates together with government allocation policies tend to direct investment toward low marginal productivity projects while higher marginal productivity projects go unfunded. Furthermore, financial repression is usually accompanied by an active black market for loans, known as the curb market. The system of a free curb market operating alongside a financially repressed banking system is referred to as financial dualism. Curb markets are generally thought to be an undesirable consequence of financial repression because they permit tax evasion and limit monetary policy effectiveness (Chandavarkar 1985). However, the government does little to discourage them. Recently, new structuralists (van Wijnbergen 1983 arldiaylor 1983) have argued that the curb market is more efficient at providing needed financial intermediation than the banking system because it is not subject to reserve requirements.l In this paper, we abstract from this issue and develop an alternative rationale for the permissive policy of governments toward the curb market. We show that financial dualism can stimulate total investment, compared to the free market level, and that it need not sacrifice high productivity projects for low productivity ones.2 The proof is conducted in the context of a standard portfolio balance model, generalized to allow savings to depend on interest.