I. Introduction

International Monetary Fund
Published Date:
December 2008
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This paper assesses the development of essential financial markets in smaller economies and policies to improve them. Money, foreign exchange, government securities, and equity markets are considered here as essential because they provide the most basic level of financial services and, along with banks, serve as the foundation for the development of other financial markets.1

Smaller economies are defined as countries with GDP and per capita GDP below thresholds that can be seen as marking limits on the potential development of their financial markets.2 The approach to country coverage is to look at GDP (size) and GDP per capita (level of development), choose cutoff points based on available indicators of market development, and categorize the countries below these cutoff points as smaller economies. Descriptive data suggest that both size and level of development are correlated with financial market development (Table 1.1). A review of basic information on financial markets suggests that most countries below the thresholds of $40 billion for GDP and $10,000 for GDP per capita have relatively undeveloped financial markets, and in many cases, are lacking markets altogether. Most of the developing countries above these thresholds have developed stock, money market, and foreign exchange markets and almost all issue international bonds. There are some countries, especially the larger ones, that have achieved success in developing essential financial markets. The 107 smaller economies account for 2 percent of world GDP, while their total population is 960 million, or 15 percent of the world total. The concept of smaller economies also covers regional groupings of countries with relatively small economies.

Table 1.1.GDP, GDP Per Capita, and Financial Market Development in Developing and Emerging Market Countries(In U.S. dollars)
Stock MarketForward Foreign Exchange MarketMoney/GDPã50 percent
GDP (Billions of U.S. dollars)GDP per capita (U.S. dollars)GDP (Billions of U.S. dollars)GDP per capita (U.S. dollars)GDP (Billions of U.S. dollars)GDP per capita (U.S. dollars)
Countries with markets25.42,42813.62,0438.33,791
Countries without markets3.99144.71,1697.4860
Sources: World Bank; IMF, Annual Report on Exchange Arrangements and Exchange Restrictions database; IMF, International Financial Statistics database.Note: Based on 156 developing and emerging market countries.
Sources: World Bank; IMF, Annual Report on Exchange Arrangements and Exchange Restrictions database; IMF, International Financial Statistics database.Note: Based on 156 developing and emerging market countries.

The smaller economies encompass a wide range of countries (Table 1.2). About 12 smaller economies (Bolivia, Bulgaria, Croatia, the Baltics, Jamaica, Jordan, Lebanon, Syrian Arab Republic, Trinidad and Tobago, and Tunisia) have some developed markets and have either joined the ranks of emerging market countries or have the potential to do so. At the other end of the spectrum, 36 smaller economies have a population of less than one million, indicating that the economies of scale will be difficult to attain.

Table 1.2.Smaller Economy Countries
Afghanistan, I.R. ofGabonNiger
AlbaniaGambia, ThePanama
AngolaGeorgiaPapua New Guinea
Azerbaijan, Rep. ofGrenadaRwanda
BelizeGuineaSão Tomé and Príncipe
BhutanGuyanaSerbia & Montenegro
Bosnia and HerzegovinaHondurasSierra Leone
BotswanaJamaicaSolomon Islands
BulgariaJordanSri Lanka
Burkina FasoKenyaSt. Kitts and Nevis
BurundiKiribatiSt. Lucia
CambodiaKyrgyz RepublicSt. Vincent and the Grenadines
CameroonLao PDR
Cape VerdeLatviaSudan
Central African Rep.LebanonSuriname
ComorosLibyaSyrian Arab Republic
Congo, Dem. Rep. ofLithuaniaTajikistan
Congo, Republic ofMacedonia, FYRTanzania
Costa RicaMadagascarTimor-Leste
Côte d’IvoireMalawiTogo
DjiboutiMaliTrinidad and Tobago
Dominican RepublicMauritiusTurkmenistan
El SalvadorMongoliaUruguay
Equatorial GuineaMozambiqueUzbekistan
EstoniaNamibiaYemen, Republic of

The potential benefits provided by active and effective essential financial markets in smaller economies are considerable. Effective markets allow monetary operations to become more market-based, and government financing can benefit from cheaper and more stable financing. They enhance portfolio diversification and facilitate risk transfer—which is especially important for smaller economies because they are highly vulnerable to shocks. Companies, which face serious financing constraints in smaller economies, enjoy a wider choice of financing instruments and the economy benefits from improved corporate governance. These markets also serve as the foundation for more sophisticated financial products. They mobilize long-term savings into productive investment opportunities more efficiently, including by providing alternatives to the bank financing that dominates in smaller economies. Further development of smaller economy financial markets could bring them above the threshold, which brings benefits from financial globalization.3 Finally, policymakers benefit greatly from the relatively impartial information provided by financial market prices.

However, the small size of markets in most smaller economies shows that they are not enjoying these benefits relative to emerging market countries. The available data, which are reported in detail in the annexes, show that these markets are smaller and less liquid in smaller economies than in emerging market countries and advanced countries.

Market underdevelopment can be attributed to inherent and controllable factors (see Chapter II). To some degree, market underdevelopment reflects intrinsic obstacles, such as the small size of smaller economy financial systems, and the small size and high degree of concentration of the economies of many smaller economies. But there are also structural (excess liquidity and high dollarization) and institutional (limited number and competitiveness of smaller economy market players and a dearth of reliable company financial information) obstacles that can be addressed in the long run. Market development can also be impeded by policy rigidities that are under the direct control of the authorities.

This paper aims to help formulate policies to address the controllable impediments to market development. The limited benefits provided by these markets in many smaller economies mean that there could be a high payoff to policies that develop them. Positive lessons can be drawn from the experience of smaller economies. Because very little hard cross-country data on essential financial markets are available for smaller economies, this paper draws on FSAP reports and technical notes, central bank websites and reports, and work done in the IMF and elsewhere.

The paper is meant to inform regular financial market surveillance and technical assistance, and be helpful to central banks and government agencies. Currently, there is relatively little guidance based on cross-country experience for country-specific policy work. However, a number of new country initiatives have begun, including Making Finance Work for Africa initiated by the G-8 and World Bank, and the Action Plan for Developing Local Bond Markets in Emerging Market Economies and Developing Countries of the G-8, World Bank, and IMF. This paper aims to support and complement these efforts.

The overarching theme of this paper is that market development policies for smaller economies should be realistic and tailored to their often unique circumstances. The policy strategy should begin with ensuring that an active market is viable and worth the development costs to the public sector. In the early stages of market development, public agencies take the lead in coordination with the market players. As markets mature, market players should take over, with governments focusing on removing obstacles and overseeing stability issues. Enhanced effectiveness of monetary and fiscal policy is a clear motivation for market development policies.

The contribution of this paper is in its coverage and integrated and policy-oriented approach to the development of essential financial markets in smaller economies. Bossone, Honohan, and Long (2001) address financial system development in small countries but focus mainly on banks. Similarly, Gulde and others (2006) and Honohan and Beck (2007) focus on financial sector development in Africa, but, again, they are primarily concerned with banks. Demirgüç-Kunt and Levine (2002) report extensive data on and analyze banking sector and stock market development in developing countries, but they do not cover money, foreign exchange, and secondary government securities markets. Gray and Talbot (2006) discuss development of these markets but their work is not targeted at smaller economies. A number of papers, referenced in the following chapters, have addressed development of one of these markets, although the focus is usually on emerging markets. Previous work on regional market integration in smaller economies has been concerned with particular regions as opposed to the international experience.4 Thus, this paper appears to be the first to take an integrated approach to the development of the four essential financial markets in smaller economies.

The next chapter of this paper lays the background by documenting the impediments to financial market development in smaller economies. Then, the chapters broadly follow the logical progression of market development. The foreign exchange market is the most fundamental market and is thus considered in Chapter III. Chapter IV covers money and government securities markets together, in light of their development synergies. Equity markets are considered next because they often follow the development of the others. Regional integration, which often involves multiple markets, is addressed last. Annexes, by documenting the available information on essential smaller economy financial markets, are key to the paper. The stylized facts, based on the available cross-country data and information sources and case studies, are presented in Annexes I to IV, which cover foreign exchange, money and government securities, equity markets, and regional integration, respectively.

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