4.3 The case of imperfect information
In practice, the assumption of perfect information is unrealistic as borrowers tend to be better informed about their investment projects than potential outside investors (lenders). This information asymmetry and the inability of lenders to monitor borrowers costlessly lead to “agency costs” that increase the cost of external financing (Bernanke and Gertler 1989). With imperfect information, capital is only available at a higher real interest rate. The supply curve may even become positively sloped at some point as the level of external financing increases. In other words, the supply of capital may no longer be infinitely elastic in a small open economy. This is because greater reliance on external funds lowers the equity stake of borrowers, which gives them more incentive to engage in risky investment projects and increases lenders’ potential losses from adverse selection. To compensate for these additional risks lenders will demand a higher rate of return.
With imperfect information the supply of capital curve may also become backward bending or downward sloping, i.e. lenders reduce their supply of funds as interest rates increase (Figure 2). The supply curve becomes backward bending when there exists an interest rate that maximises the expected return to lenders and beyond which they will be unwilling to supply funds to some borrowers. This is because adverse selection increases the likelihood that loans will be made to bad credit risks, while moral hazard lowers the probability that a loan will be repaid. As a result, lenders may decide in some circumstances that they would rather not make a loan and credit rationing may occur.
There are two forms of credit rationing: some loan applicants may receive a smaller loan than they applied for at the given interest rate, or they may not receive a loan at all, even if they offered to pay a higher interest rate. Jaffee and Russell (1976) develop a theoretical model in which imperfect information and uncertainty can lead to rationing in loan markets, where some agents do not receive the loan they applied for. Stiglitz and Weiss (1981) develop a model of credit rationing, where some borrowers receive loans and others do not. The empirical evidence on credit rationing is discussed in the next section.
Higher financing costs lower investment and economic growth. However, the effects are difficult to measure. It has been empirically shown that real (i.e. inflation adjusted) interest rates (of different maturities) and the cost of capital have only quantitatively small effects on total spending and investment. Moreover, it is difficult to explain the timing and composition of economies’ responses to changes in interest rates solely in terms of cost of capital effects (Bernanke and Gertler 1995). However, these aggregate effects can hide an unequally distributed impact that can harm smaller firms more extensively than larger firms. For example, Gertler and Gilchrist (1994) found that small firms account for a significantly disproportionate share of the manufacturing decline and slowdown in inventory demand that follows a tightening of monetary policy.
The empirical finding of quantitatively small effects of the cost of borrowing on total economic activity is supported by the results from theoretical general equilibrium models (see, for example, Claus 2003). What seems crucial though is the effectiveness of financial systems in allocating resources to best uses, i.e. the degree to which financial systems overcome information asymmetry between borrowers and lenders. Using a general equilibrium model that is calibrated for New Zealand, Claus (2004) shows that a decline in the degree of information asymmetry increases the long-run level of steady state investment, capital and output. Asymmetric information and other credit market frictions also amplify and propagate conventional interest rate effects, underscoring the importance of financial institutions in minimising the imperfect information problem.
Asymmetric information may be of greater significance in small open economies than in large closed economies. This is because small economies tend to have a large number of small firms (in terms of the size of their balance sheets). Small firms are more affected by asymmetric information than large businesses because of economies of scale in acquiring and monitoring information. Moreover, in small economies financial markets may be less liquid and savers/lenders may not be able to quickly and easily convert assets into purchasing power, if they need to access their savings. In open economies additional information asymmetries may arise between domestic and foreign borrowers and lenders.
If the degree of information asymmetry is large in small open economies, the reliance on bank borrowing, all else equal, should be large as well. This is because financial intermediaries are better able to overcome the imperfect information problem than financial markets. The New Zealand data provide some support of this hypothesis. For example, in a study of business practices and performance, Knuckey et al (2002) found that 51 percent of firms in New Zealand in 2002 “used banks to fund some proportion of their innovation of expansion activities in the three years prior to the survey, with 22 percent of respondents using banks to fund more than 50 percent of their activities”.
Moreover, firms facing substantial asymmetric information can be expected to issue the “safest” security first, i.e. the one whose value changes least when inside information is revealed to the market. That is, firms will choose to issue debt and, only as a last resort, equity (Denis and Mihov 2003). The proposition suggests that the Modigliani and Miller (1958) theorem that firms are indifferent between issuing debt or equity does not hold.[16]
Finally, imperfect information may be an impediment to international capital mobility. With imperfectly integrated capital markets, domestic interest rates will be influenced by factors, such as the depreciation rate of the domestic capital stock, productivity and labour force growth and the domestic savings rate, in addition to foreign interest rates and changes in the exchange rate. Observed “home bias” in investment portfolios (i.e. investors holding less of their wealth in foreign assets than is optimal for diversification) suggests that there may be some barriers to capital mobility. However, the empirical evidence suggests that smaller countries may be somewhat less affected by home bias, which seems to be the case for New Zealand.[17]
