Back Matter

Back Matter

Niamh Sheridan, Alfred Schipke, Susan George, and Christian Beddies
Published Date:
January 2004
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Appendix Financial Systems and Growth

The following reviews the key channels through which the financial system is related to economic growth. This appendix also reviews the questions of whether there is empirical evidence concerning the relationship between financial sector development and economic growth and, if so, whether there is any evidence for a causal relationship. Finally, this section looks at whether a particular structure of the financial system is superior in terms of growth prospects.

The Role of Financial Intermediaries and Capital Markets

The primary role of the financial system is to facilitate transactions and the allocation of resources across agents and over time. The role for financial intermediaries arises in the presence of market imperfections, such as information asymmetries, which give rise to transaction costs and the cost of obtaining information. By reducing these costs, more transactions can occur, improving the allocation of resources. Levine (1997) discusses the basic functions of financial intermediaries as well as capital markets and the channels through which they enhance economic growth. Each function can influence growth through its impact on investment decisions either by increasing the level of investment or by increasing the efficiency of those investments and thus the rate of technological improvement.

One basic function of capital markets is to facilitate the trading, hedging, diversifying, and pooling of risk. An important risk faced by agents considering an investment project is that they will not be able to sell their assets to meet current consumption needs. By increasing the ease and speed with which assets can be converted into purchasing power, capital markets increase liquidity and reduce the risk of illiquidity for an individual investor. While the impact of increased liquidity on the overall level of savings, and therefore on investment, may be either positive or negative, the reduced risk of illiquidity enhances productivity. By encouraging investment in longer-term projects with higher returns, which in the absence of capital markets would not be undertaken, the average return on investment in the economy increases and with it so does productivity.

The financial system facilitates the acquisition of information and the allocation of resources. High information costs can hinder the flow of capital to its most productive use. The financial system can lower the costs of obtaining information for an individual in two ways. By grouping together, i.e., forming intermediaries, individuals can spread any fixed costs of obtaining information, and in well-developed secondary markets published prices are an important source of information.

Capital markets provide a way for agents to monitor managers in the firms in which the agents have invested; this can increase the level of investment and also the productivity of investment. Individual investors need a way to ensure that the funds they have invested are being properly managed; however, such monitoring can be very costly for the individual investor. Well-developed collateral and financial contracts can lower monitoring and enforcement costs. Additionally, financial intermediaries can spread the monitoring cost across groups of individuals. Bencivenga and Smith (1991) have shown that financial arrangements that improve corporate control lead to higher levels of investment and faster growth.

Another role of the financial system is to mobilize savings; by pooling the savings of individuals, firms can undertake large investment projects not possible without the resources of several investors. In the presence of economies-of-scale, the productive capacity of the economy is increased. Finally, financial intermediaries facilitate the exchange of goods and services by reducing transaction costs. The greater the ease with which goods and services can be traded, the higher the degree of specialization, which in turn implies higher productivity.

Empirical Evidence on Financial Market Development and Growth

There is a wealth of empirical research investigating the relationship between economic growth and financial system development. Much of the re-search has taken place during the 1990s and was spurred by the influential studies of King and Levine (1993a) and (1993b). Those studies examined the relationship between economic growth and measures of financial sector development using the familiar methodology of cross-country growth studies.49

Figure A.1 shows the variation of specific indicators of financial development in 1985 across 116 countries divided into four groups by real GDP per capita. The first is a measure of the size of the financial intermediation sector; the second measures the extent to which commercial banks rather than central banks are allocating credit; while the third and fourth indicators concern the allocation of credit, measuring the portion of credit allocated to the private sector and the amount of credit extended relative to GDP. All these measures have a strong positive relationship to GDP and show that financial markets are larger and more market oriented in richer countries than in poorer countries, with a much smaller proportion of credit being extended by central banks and a much greater proportion being extended to the private sector in richer countries. Regression analysis showed that these indicators have a strong positive and economically important relationship with average real GDP growth, the rate of capital accumulation, and total productivity growth.

Figure A.1.Financial Development and Real Per Capita GDP in Country Groups, 1985

Source: Levine (1997).

1Depth = Ratio of liquid liabilities of the financial system to GDP.

2Bank = Ratio of bank credit (domestic deposit money banks) to combined bank credit and central bank credit.

3Private = Ratio of claims on the nonfinancial private sector to total domestic credit.

4Privy = Ratio of gross claims on private sector to GDP.

5RGDP = Real GDP per capita in U.S. dollars.

Moreover, the studies show that the initial value of financial depth proves to be a significant predictor of future growth, capital accumulation, and productivity growth. This result is important because it addresses the issue of causality and suggests that the development of the financial system can increase economic growth rates. The evidence on causality, however, is not conclusive because there are a number of econometric problems associated with the methodology, one of which is the issue of simultaneity bias. A number of studies have applied various approaches to deal with this issue, and, broadly speaking, the conclusions are robust to the methodology employed. For countries with longer samples of adequate data, Vector Autoregression (VAR) techniques may be employed, as in Wachtel and Rousseau (1995) and Wachtel (2001), and these studies find evidence of a causal relationship. A causal relationship is also found using panel VAR techniques in cross-country studies, see for example Beck, Levine, and Laoyza (2000). The consensus that emerges from these studies is that there is a robust causal relationship between financial development and economic growth. As noted by Khan and Senhadji (2000), however, the size of the measured effect varies with different indicators of financial development, estimation method, data frequency, and the functional form of the relationship.50

Characteristics of Financial Markets and Growth

Thus far, the discussion has focused on evidence concerning the relationship between broad aggregates that measure various aspects of financial development and growth. Results from such studies are quiet, however, on specific actions that policymakers might undertake in order to promote the development of the financial system. Nevertheless, there are a number of studies that examine the relationship between specific characteristics of financial systems and economic growth, and these are briefly reviewed below.

One of the functions of capital markets and financial intermediaries discussed above was their role as a source of liquidity. Levine and Zervos (1996) examine the relationship between stock market liquidity and economic growth rates, capital accumulation and productivity by employing two measures of liquidity in the study: the value-traded ratio, which equals the value of shares traded on a country’s stock exchange relative to GDP, and the turnover ratio, which equals the value of shares traded relative to stock market capitalization. Using a standard approach of other cross-country studies and including the level of banking sector development (bank credit to the private sector relative to GDP) as a control variable, Levine and Zervos found evidence of a positive relationship between liquidity and long-run economic growth. Hence, one could argue that governments ought to implement policies that foster the deepening of capital markets.

The discussion on the functions of financial intermediaries emphasized the role of information. Un-fortunately, difficulties in devising methods by which to measure how easy it is to obtain information preclude the conduct of empirical studies that examine the relationship with macroeconomic variables. Nonetheless, a large number of studies at the micro level have established that when outsiders find it difficult to evaluate an individual firm, e.g., in the absence of a bond rating, there is an increased reliance on internal sources of financing. This result would be consistent with government measures to increase transparency.

Finally, the question of whether the general structure of the financial system has implications for economic growth has received considerable attention, as reflected in studies such as the one by Claessens, Djankov, and Klingebiel (2001) and by Demirgüç-Kunt and Levine (1996). These studies show that as countries become more wealthy, there is an increase in the size (measured by assets or liabilities relative to GDP) of the financial intermediation sector. Also, the importance of commercial banks in the allocation of credit grows, the nonbank sector increases in size, and the size and liquidity of the stock markets increase. It is worth noting, however, that Levine (1997) cautions against drawing conclusions regarding patterns of financial development and linking financial structure to economic growth. One aspect of financial structure that has commanded considerable attention is the question of the relative merits of bank-based versus market-based systems. This is an important issue for the Baltics, and Section III reviews this debate and discusses the merits of both bank-based and market-based systems. Some recent studies have argued that the structure is not relevant: what is important is the efficiency of the legal system and other aspects of the institutional framework (Beck, Levine, and Loayza, 2000; Levine, 2002; and Beck and Levine, 2002). Studies such as these examine how differences in the legal and regulatory systems can impact financial sector development and economic growth. Levine generally finds that countries with better contract law and accounting and reporting infrastructure have more developed financial systems and growth. He also highlights the importance of strengthening the rights of investors and improving the efficiency of contract enforcement. This view—the financial services view—emphasizes the quality of the services produced by the financial system.


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In addition, Lithuania’s currency board arrangement has been resilient despite the appreciation of the dollar vis-à-vis the euro during the period of the dollar peg and likewise during the recent appreciation of the euro vis-à-vis the dollar ever since the country repegged its currency to the euro at the beginning of 2002.


In what follows, the term “financial system” covers both bank and nonbank, that is, market-based financing.


See Berglöf and Bolton (2002) and ECB (2002).


Initially, there were also problems with the legal system and the ability of banks to enforce collateral.


A new banking license was issued by the Bank of Estonia in 1999—the first time since 1993.


The Latvian state still owns 100 percent of the shares of the Mortgage and Land Bank (4.1 percent of the banking system’s total assets in mid-2003) and there are no plans to divest the bank at this time.


Including household mortgage loans (21 percent of loans outstanding).


The banking system in Lithuania, however, incurred losses in 2001 because that year marked significant consolidation in the Lithuanian banking system, including write-offs of a large share of bad debts.


In addition to its large leasing sector, Estonia also has a substantial factoring market. Factoring involves the secondary sale, at a discount, of a company’s accounts receivable, shifting the associated risk of carrying the debt to the factor. This market was equal to 1.7 percent of GDP in 2001.


In Latvia, the number of companies decreased to 25 in 2000 (of which 17 were nonlife insurance companies) from 42 in 1994. In Estonia, partly due to bankruptcies, the number of companies fell to 14 (of which 8 were nonlife) in 1999 from 22 in 1998. Lithuania, in turn, had 30 insurance companies in mid-2003, of which 21 were nonlife.


See ECB (2001).


In per capita terms, Estonia issued bonds worth US$972, Lithuania US$642, and Latvia US$210. Hungary takes the lead among the accession countries, with bonds issued worth US$2,189 per capita.


For a detailed comparison between the European Union and EU accession countries, see ECB (2003).


The figures include eurobond issues by the government.


The yield on that bond turned out to be fairly favorable at 5.2 percent.


In addition to Lithuania, countries such as Bulgaria and the Czech and Slovak Republics used voucher privatization as an active tool to develop secondary markets. See also Claessens, Djankov, and Klingebiel (2001), and Berglöf and Bolton (2002).


The same has happened for Hansa-LTB, and also may happen for Nord-LB Lietuva, formerly the Lithunian Agricultural Bank.


Other countries that sought to develop their stock market through initial public offerings were Hungary, Poland, and Slovenia.


See Appendix for an overview of the literature


Higher spreads also reflect the more risky investment environment in transition economies.


Unlike tax distortions that favor bank financing, high reserve requirements should, in principle, favor financing via capital markets.


In Estonia, banks are now allowed to hold 50 percent of required reserves in quality euro assets. Since 2003, reserve requirements in Latvia are only one percentage point above those in the euro area.


There may also be implicit obstacles—other than legal or regulatory impediments—to fostering capital market development. Most notably, monetary operations that are conducted to a large extent through open market operations, such as repo operations, tend to support capital market deepening, as opposed to discount operations (Germany versus the United States).


One can turn the argument around because banks may substitute for bond markets to provide funds if the latter dry up, as evidenced after the Russian default in 1998.


In addition, Sutela (2001) argues that the lack of portfolio investment opportunities, i.e., limited scope for short-term capital flows, may have helped the Baltics to sustain their exchange rate regimes without major disruptions, despite sizable current account deficits and a liberal capital account regime.


On January 3, 2000, the Baltic List, which lists Baltic blue chip securities, was launched by the Tallinn, Riga, and Vilnius stock exchanges. The list consists of up to 15 of the largest firms that figure on the official lists of the three exchanges, with no more than 7 originating from one country. The composition of the list is reviewed quarterly by the exchanges.


See, for example, BIS (2002), which presents some arguments for debt market development as well as country experiences.


There is, however, a limit to this argument in that excessive government borrowing crowds out private sector activity. The costs associated with that policy may well outweigh the benefits that a sound government debt market brings with it.


The effectiveness of sterilization in a small open economy will, of course, be limited.


Latvia, for example, had to rely mostly on foreign exchange operations to manage bank liquidity because sufficient high-quality collateral became available only after the government began to issue larger amounts of securities.


On pension reform in the Baltics, see also Schiff and others (2000).


Switching to the second pillar is optional in Lithuania and mostly optional in Estonia. In Estonia, the second pillar is mandatory for people who were born after 1983 and who enter the labor market.


See French and Poterba (1991).


Once the equity restriction was relaxed, the Chilean stock markets experienced a continuous boost both in terms of total market capitalization and in terms of turnover ratios. Investments in foreign assets were allowed only from the early 1990s onward.


Of course, at first approximation national savings remain unchanged. This would imply that the loss in social security taxes would lead to a higher fiscal deficit. Since even under a fully funded pension system pension contributions are mandatory, employers would be forced to acquire domestic assets. In such a scenario, asset prices would not be affected. Without pension regulation that would force employees to acquire government securities, however, some of the available funds could shift into other domestic assets. Furthermore, assuming that Ricardian equivalence does not hold, a reduction in social security taxes could be associated with the perception of an increase in wealth and therefore lead to an increase in consumption. This, in turn, would lower national savings.


In addition, if at the time of the reform the country’s financial institutions lack adequate models of risk assessment, pension fund mangers might also be inclined to assume excessive risk.


Instead of imposing restrictions on investments in foreign assets, the focus should be on prudential requirements, such as open foreign exchange positions.


Depending on where the securities are being issued and traded, the foreign investments are limited to 20–30 percent of pension fund assets.


Here ownership matters. A large domestic player might never reach the scope to deter entry by a large foreign institution because of the size of the country.


Such a transmission could have occurred, for example, as a result of the banking crisis in Sweden in 1992.


The assets of the subsidiaries are highly concentrated in their respective home countries or at least for the Baltic region overall.


The transmission of shocks from the parent bank to the subsidiary should be reflected in a correlation of the respective share prices. Using daily share prices for both Swedbank (Sweden) and Hansabank (Estonia), the correlation turned out to be insignificant. This is true for both an unadjusted series and a series that took into consideration the market performance in the two countries.


Despite this principle, though, numerous provisions in the European Union allow host country intervention in the interest of the general good. For example, Article 11 of the Investment Services Directive (ISD) allows the host country to impose local rules of conduct in addition to those enforced in the home country of the parent company. This in effect has allowed national regulators to discriminate against foreign institutions, thereby limiting competition somewhat.


See ECB (2002).


The same applies to Bulgaria, another accession country with a currency board.


Another reported side effect of the policy is that banks are gaining experience in monitoring and active participation in European capital markets.


The standard regression model with the growth of per capita real GDP as the dependent variable is estimated using panel data. The explanatory variables include conditioning variables, such as the log of initial real per capita GDP and initial secondary school enrollment rate, among others, and a measure of financial sector development (the variable of interest).


Much of the work on this topic assumes a linear relationship between financial market development and economic growth. One exception is Khan and Senhadji (2000) who allow for a simple form of nonlinearity by specifying a quadratic relationship. A statistically significant negative coefficient is found on the quadratic term, which could suggest that there exists an optimum level of financial development. Another possibility is that there may exist a threshold effect—that countries need to reach a certain level of financial development before there are effects on growth, as argued by Berthélemy and Varoudakis (1996).

Recent Occasional Papers of the International Monetary Fund

228. Capital Markets and Financial Intermediation in The Baltics, by Alfred Schipke, Christian Beddies, Susan M. George, and Niamh Sheridan. 2004.

227. U.S. Fiscal Policies and Priorities for Long-Run Sustainability, Martin Muhleisen and Christopher Towe, editors. 2004.

226. Hong Kong SAR: Meeting the Challenges of Integration with the Mainland, edited by Eswar Prasad, with contributions from Jorge Chan-Lau, Dora Iakova, William Lee, Hong Liang, Ida Liu, Papa N’Diaye, and Tao Wang. 2004.

225. Rules-Based Fiscal Policy in France, Germany, Italy, and Spain, by Teresa Daban, Enrica Detragiache, Gabriel di Bella, Gian Maria Milesi-Ferretti, and Steven Symansky. 2003.

224. Managing Systemic Banking Crises, by a staff team led by David S. Hoelscher and Marc Quintyn. 2003.

223. Monetary Union Among Member Countries of the Gulf Cooperation Council, by a staff team led by Ugo Fasano. 2003.

222. Informal Funds Transfer Systems: An Analysis of the Informal Hawala System, by Mohammed El Qorchi, Samuel Munzele Maimbo, and John F. Wilson. 2003.

221. Deflation: Determinants, Risks, and Policy Options, by Manmohan S. Kumar. 2003.

220. Effects of Financial Globalization on Developing Countries: Some Empirical Evidence, by Eswar S. Prasad, Kenneth Rogoff, Shang-Jin Wei, and Ayhan Kose. 2003.

219. Economic Policy in a Highly Dollarized Economy: The Case of Cambodia, by Mario de Zamaroczy and Sopanha Sa. 2003.

218. Fiscal Vulnerability and Financial Crises in Emerging Market Economies, by Richard Hemming, Michael Kell, and Axel Schimmelpfennig. 2003.

217. Managing Financial Crises: Recent Experience and Lessons for Latin America, edited by Charles Collyns and G. Russell Kincaid. 2003.

216. Is the PRGF Living Up to Expectations?—An Assessment of Program Design, by Sanjeev Gupta, Mark Plant, Benedict Clements, Thomas Dorsey, Emanuele Baldacci, Gabriela Inchauste, Shamsuddin Tareq, and Nita Thacker. 2002.

215. Improving Large Taxpayers’ Compliance: A Review of Country Experience, by Katherine Baer. 2002.

214. Advanced Country Experiences with Capital Account Liberalization, by Age Bakker and Bryan Chappie. 2002.

213. The Baltic Countries: Medium-Term Fiscal Issues Related to EU and NATO Accession, by Johannes Mueller, Christian Beddies, Robert Burgess, Vitali Kramarenko, and Joannes Mongardini. 2002.

212. Financial Soundness Indicators: Analytical Aspects and Country Practices, by V. Sundararajan, Charles Enoch, Armida San José, Paul Hilbers, Russell Krueger, Marina Moretti, and Graham Slack. 2002.

211. Capital Account Liberalization and Financial Sector Stability, by a staff team led by Shogo Ishii and Karl Habermeier. 2002.

210. IMF-Supported Programs in Capital Account Crises, by Atish Ghosh, Timothy Lane, Marianne SchulzeGhattas, Aleš Bulíř, Javier Hamann, and Alex Mourmouras. 2002.

209. Methodology for Current Account and Exchange Rate Assessments, by Peter Isard, Hamid Faruqee, G. Russell Kincaid, and Martin Fetherston. 2001.

208. Yemen in the 1990s: From Unification to Economic Reform, by Klaus Enders, Sherwyn Williams, Nada Choueiri, Yuri Sobolev, and Jan Walliser. 2001.

207. Malaysia: From Crisis to Recovery, by Kanitta Meesook, Il Houng Lee, Olin Liu, Yougesh Khatri, Natalia Tamirisa, Michael Moore, and Mark H. Krysl. 2001.

206. The Dominican Republic: Stabilization, Structural Reform, and Economic Growth, by a staff team led by Philip Young comprising Alessandro Giustiniani, Werner C. Keller, and Randa E. Sab and others. 2001.

205. Stabilization and Savings Funds for Nonrenewable Resources, by Jeffrey Davis, Rolando Ossowski, James Daniel, and Steven Barnett. 2001.

204. Monetary Union in West Africa (ECOWAS): Is It Desirable and How Could It Be Achieved? by Paul Masson and Catherine Pattillo. 2001.

203. Modern Banking and OTC Derivatives Markets: The Transformation of Global Finance and Its Implications for Systemic Risk, by Garry J. Schinasi, R. Sean Craig, Burkhard Drees, and Charles Kramer. 2000.

202. Adopting Inflation Targeting: Practical Issues for Emerging Market Countries, by Andrea Schaechter, Mark R. Stone, and Mark Zelmer. 2000.

201. Developments and Challenges in the Caribbean Region, by Samuel Itam, Simon Cueva, Erik Lundback, Janet Stotsky, and Stephen Tokarick. 2000.

200. Pension Reform in the Baltics: Issues and Prospects, by Jerald Schiff, Niko Hobdari, Axel Schimmelpfennig, and Roman Zytek. 2000.

199. Ghana: Economic Development in a Democratic Environment, by Sergio Pereira Leite, Anthony Pellechio, Luisa Zanforlin, Girma Begashaw, Stefania Fabrizio, and Joachim Harnack. 2000.

198. Setting Up Treasuries in the Baltics, Russia, and Other Countries of the Former Soviet Union: An Assessment of IMF Technical Assistance, by Barry H. Potter and Jack Diamond. 2000.

197. Deposit Insurance: Actual and Good Practices, by Gillian G.H. Garcia. 2000.

196. Trade and Trade Policies in Eastern and Southern Africa, by a staff team led by Arvind Subramanian, with Enrique Gelbard, Richard Harmsen, Katrin Elborgh-Woytek, and Piroska Nagy. 2000.

195. The Eastern Caribbean Currency Union—Institutions, Performance, and Policy Issues, by Frits van Beek, Jose Roberto Rosales, Mayra Zermeño, Ruby Randall, and Jorge Shepherd. 2000.

194. Fiscal and Macroeconomic Impact of Privatization, by Jeffrey Davis, Rolando Ossowski, Thomas Richardson, and Steven Barnett. 2000.

193. Exchange Rate Regimes in an Increasingly Integrated World Economy, by Michael Mussa, Paul Masson, Alexander Swoboda, Esteban Jadresic, Paolo Mauro, and Andy Berg. 2000.

192. Macroprudential Indicators of Financial System Soundness, by a staff team led by Owen Evans, Alfredo M. Leone, Mahinder Gill, and Paul Hilbers. 2000.

191. Social Issues in IMF-Supported Programs, by Sanjeev Gupta, Louis Dicks-Mireaux, Ritha Khemani, Calvin McDonald, and Marijn Verhoeven. 2000.

190. Capital Controls: Country Experiences with Their Use and Liberalization, by Akira Ariyoshi, Karl Habermeier, Bernard Laurens, Inci Ötker-Robe, Jorge Ivan Canales Kriljenko, and Andrei Kirilenko. 2000.

189. Current Account and External Sustainability in the Baltics, Russia, and Other Countries of the Former Soviet Union, by Donal McGettigan. 2000.

188. Financial Sector Crisis and Restructuring: Lessons from Asia, by Carl-Johan Lindgren, Tomás J.T. Baliño, Charles Enoch, Anne-Marie Guide, Marc Quintyn, and Leslie Teo. 1999.

187. Philippines: Toward Sustainable and Rapid Growth, Recent Developments and the Agenda Ahead, by Markus Rodlauer, Prakash Loungani, Vivek Arora, Charalambos Christofides, Enrique G. De la Piedra, Piyabha Kongsamut, Kristina Kostial, Victoria Summers, and Athanasios Vamvakidis. 2000.

186. Anticipating Balance of Payments Crises: The Role of Early Warning Systems, by Andrew Berg, Eduardo Borensztein, Gian Maria Milesi-Ferretti, and Catherine Pattillo. 1999.

185. Oman Beyond the Oil Horizon: Policies Toward Sustainable Growth, edited by Ahsan Mansur and Volker Treichel. 1999.

184. Growth Experience in Transition Countries, 1990–98, by Oleh Havrylyshyn, Thomas Wolf, Julian Berengaut, Marta Castello-Branco, Ron van Rooden, and Valerie Mercer-Blackman. 1999.

183. Economic Reforms in Kazakhstan, Kyrgyz Republic, Tajikistan, Turkmenistan, and Uzbekistan, by Emine Gurgen, Harry Snoek, Jon Craig, Jimmy McHugh, Ivailo Izvorski, and Ron van Rooden. 1999.

182. Tax Reform in the Baltics, Russia, and Other Countries of the Former Soviet Union, by a staff team led by Liam Ebrill and Oleh Havrylyshyn. 1999.

181. The Netherlands: Transforming a Market Economy, by C. Maxwell Watson, Bas B. Bakker, Jan Kees Martijn, and Ioannis Halikias. 1999.

Note: For information on the titles and availability of Occasional Papers not listed, please consult the IMF’s Publications Catalog or contact IMF Publications Services.

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