Our analysis also found that the institutional environment is a key driver of financial development. A look at some of the best-known cross-country databases, such as the International Country Risk Guide’s ratings or the Heritage Foundation’s index of economic freedom, shows that East Asian countries on average score notably above Middle Eastern and North African countries on these variables, including government involvement, protection of property rights, and ease of loan recovery. And, excluding the region’s best performers (the Gulf Cooperation Council or GCC countries, Lebanon, and Jordan), the gap is sharply wider.
Our paper does not specifically analyze the impact of sharia on financial development, but some countries, such as Sudan, have recently developed quite interesting instruments and markets. Sudan’s financial development index rating, including on the monetary development theme, improved sharply in our 2002-03 survey, compared with 2000-01, which we associate with the government’s policy of macro-economic stabilization and reform.
Constructing new financial development measures
The IMF study surveys IMF country economists on financial development issues in 20 Middle Eastern and North African countries during 2000-03 on six main themes: banking sector development, nonbank financial development, regulation and supervision, financial openness, and institutional quality, as well as the monetary sector and monetary policy. The research team also drew on macroeconomic and financial time-series data from the IMF’s International Financial Statistics and World Economic Outlook, and the World Bank’s World Development Indicators, as well as measures of institutional development from the PRS Group’s International Country Risk Guide and the Heritage Foundation. To better assess financial sector development in each country according to the six themes, the authors applied this data to develop new indices that go beyond the simple and “standard” quantitative indicators and monetary aggregates used in the existing literature on financial development in the report.
Comparisons across themes are more challenging, since they entail absolute rather than relative rankings and depend on the rating scale as well as data availability. So it is easier to contrast a country’s performance on a particular theme with another country’s performance on the same theme than it is to compare any one country’s performance across two different themes.
Nevertheless, the finding that countries scored relatively well on regulation and supervision, yet relatively poorly on overall institutional strength, may not be all that puzzling when one considers the role of public financial institutions. Countries in which the financial sector is dominated by public sector institutions rated well on regulation and supervision relative to their institutional environment index, arguably because, by definition, such financial systems are regulated and supervised.
Weak institutional environments in many cases reflect inadequate systems for protecting and enforcing property rights. And some countries with banking sectors dominated by large foreign banks that are supervised by home authorities in countries with more developed financial sectors scored relatively better on financial supervision than on their institutional environments. Also, data limitations constrained us from measuring potentially important differences in countries’ loan classification standards and capital quality.
Macrostabilizing measures, such as following prudent fiscal and monetary policies—including maintaining low inflation—should be complemented by a structural environment that enables financial development. Countries should concentrate their efforts on those areas that have been weakest. For some countries, this means the government should reduce its involvement in the financial system, including by cutting back on public ownership of financial institutions, reducing its intervention in credit allocation, and minimizing monetary financing of budget deficits. At the same time, it should enhance competition, invest in human resources, promote nonbank financial development, and strengthen institutional quality, particularly the legal environment. In several countries, reforms should also seek to improve the quality of the judicial system, reduce bureaucracy, and strengthen property rights.
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