II. Impediments to Financial Market Development in Smaller Economies

International Monetary Fund
Published Date:
December 2008
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This chapter assesses the available evidence on obstacles to financial market development that are common to smaller economies.5 The choice of these obstacles is based on the case studies, the analysis of this paper, and the experience of IMF staff. The importance of them for smaller economies is gleaned by comparing available indicators for smaller economies with those for emerging market and advanced countries.

Intrinsic Obstacles

Intrinsic obstacles are largely beyond the control of policymakers, but have a material bearing on potential market development. Thus, they must be recognized and factored into policy decision making.

Number and Competitiveness of Market Players

A reasonable number of potential market players is a necessary condition for a functional financial market. Markets require enough buyers and sellers to form both sides of market transactions on a regular basis. Further, the greater the number of players, the less the need for a market maker to maintain expensive inventories. Banks and nonbank financial intermediaries (NBFIs) will dominate foreign exchange, money, and government securities markets, while companies comprise the issuer side of the equity market.


Banks can be expected to play a crucial role in the financial market development of smaller economies.6 Banks are the linchpin of all but the most advanced financial systems because they transmit payments, dominate the money market and usually foreign exchange markets, play an important role in the government securities market, and foster financial stability. In addition, banks sometimes establish subsidiaries (mutual funds, pension schemes, leasing, brokers) to exploit financial market development.

The banking systems of smaller economies have fewer players and less competition (Table 2.1). The median number of banks for smaller economies is six, or less than half that of emerging market countries. The three largest banks account on average for about three-fourths of total bank assets in smaller economies for which data are available. This is higher than for emerging market countries, and suggests that competition is likely to be weaker. Interestingly, the share of state banks is smaller and the share of foreign banks higher in smaller economies vis-à-vis emerging market countries, which would seem to support financial market development (La Porta, López-de-Silanes, and Shleifer, 2002; and Mishkin, 2006).

Table 2.1.Banking Sector Structure
Share of Total Assets
Number of Banks (2002)Three largest (2002)Public banks (2002)Foreign banks (2002)Bank Branches Per Capita (2004)
Smaller economies
Standard deviation90.740.160.365.0
Number of countries110766666638
Emerging market countries
Standard deviation250.610.240.286.3
Number of countries4242424236
Advanced countries
Standard deviation2920.220.120.2719.4
Number of countries28882824
Note: For number of banks, data are available for 66 smaller economies; estimates for the others are obtained by regressing the number of banks in the 66 smaller economies (both in logs) and using the regression parameters to estimate the number of banks in the remaining countries.
Note: For number of banks, data are available for 66 smaller economies; estimates for the others are obtained by regressing the number of banks in the 66 smaller economies (both in logs) and using the regression parameters to estimate the number of banks in the remaining countries.

Many smaller economies have just the minimum number of banks, or less, that can be regarded as sufficient for an effective money market. According to IMF (2005a), the minimum for efficient money markets is four or five banks—as long as none dominates the market. About 20 smaller economies have only four or five banks, which barely qualifies them as having the potential for an efficient money market (Figure 2.1). A finer breakdown of the number of banks for smaller economies shows that 34 of them have fewer than four banks, suggesting that market efficiency for them is a major challenge.

Figure 2.1.Smaller Economies: Number of Banks

Sources: Micco, Panizza, and Yáñez (2004) for 66 smaller economies; data for the others are estimates based on GDP.

Insurance Companies

Insurance companies are also key financial market players. Insurance companies typically hold a large amount of government securities and often play a large role in primary and secondary equity markets. Larger insurance companies can be expected to use the money and foreign exchange markets to manage liquidity.

Insurance companies in smaller economies are fewer in number and the sector is smaller in size compared with emerging market countries (Table 2.2). Insurance industry data are available for only about one-third of smaller economies and two-thirds of emerging market countries. Thus, the aggregate figures are probably underestimated for these two groups—and especially so for the smaller economies. The available data indicate that the median size of smaller economy insurance sectors is half that of emerging market countries. In addition, there are significantly fewer insurance companies in smaller economies than in the other countries, indicating a higher degree of concentration and thus a less competitive industry.

Table 2.2.Selected Countries: Size of Insurance Sector
Total Assets, 2003
In billions of U.S. dollarsRatio to GDPNumber of Companies
Smaller economies (37)
Emerging market countries (33)
Advanced countries (28)
Source: Insurance Information and Statistics database. Note: Number of countries in parentheses.
Source: Insurance Information and Statistics database. Note: Number of countries in parentheses.

Pension Funds

The available data suggest that pension funds are much smaller in smaller economies compared to emerging market countries (Table 2.3). This puts smaller economies at a disadvantage, because pension funds have made an important contribution to local bond market development in many emerging market countries, particularly in Latin America and Central Europe (IMF and World Bank, 2003). The small size of pension funds limits capital market development in Central America.

Table 2.3.Pension Fund Assets(Share of GDP)
Smaller economies
Bolivia (2003)20.9
Botswana (2004)16.1
Bulgaria (2003)2.3
Costa Rica (2003)1.8
El Salvador (2003)11
Estonia (2001)2
Ethiopia (2004)1.4
Fiji (2003)69.3
Gabon (2004)1.1
Ghana (2004)8.1
Kenya (2004)13.2
Panama (2003)3.6
Rwanda (2004)7.1
Seychelles (2004)8.3
Sri Lanka (2001)14.6
Tanzania (2004)4
Uganda (2004)2.5
Uruguay (2003)11.4
Zambia (2004)7
Zimbabwe (2004)2.3
Emerging market countries
Chile (2003)64.5
Peru (2003)10.6
Slovak Republic (2003)9.4
Sources: OECD (2005); and Chan-Lau (2004).
Sources: OECD (2005); and Chan-Lau (2004).

Diseconomies of Scale for Infrastructure and Regulation

The financial systems of many smaller economies may be too small to make it worthwhile to pay the fixed costs of infrastructure and regulation.7 The essential financial markets all use high fixed cost/low marginal computer-based technological real-time gross settlement systems (RTGS), central securities depositories (CSDs), electronic trading platforms, and other components of infrastructure systems.8 The combined market players in smaller economies are often too small to afford these systems. For example, RTGS payment systems often incur an up-front fixed cost of $1 million, which is quite a large sum in comparison to payment system volume in small countries.

Broad money comparisons make the point that the financial system of smaller economies is much smaller than that of emerging market countries. Broad money is the only widely available measure of the size of a financial system.9 The median of the smallest quartile of smaller economies’ broad money is only $253 million, while the next quartile is $756 million (Table 2.4). This suggests that smaller economies are much more likely to fall below the threshold that would make it worthwhile to pay the fixed costs of infrastructure and regulation.

Table 2.4.Smaller Economies and Emerging Market Countries: Broad Money(In millions of U.S. dollars)
Smaller economies (107)
First quartile median253
Second quartile median756
Third quartile median2,204
Fourth quartile median8,237
Emerging market countries (42)
First quartile median9,341
Second quartile median38,254
Third quartile median82,354
Fourth quartile median246,323
Source: IMF, World Economic Outlook.Note: Number of countries in parentheses.
Source: IMF, World Economic Outlook.Note: Number of countries in parentheses.

Concentration of the Economy

The concentration of the economies of smaller economy countries limits opportunities for diversification. Agriculture accounts on average for about one-fifth of smaller economy country GDP, which is about twice the ratio of emerging market countries (Table 2.5). The high degree of production concentration limits the opportunities for diversification within a country, thus constraining the exchange of risks needed for domestic market development. Further, concentration can undermine macroeconomic instability, which induces reallocation of resources away from risky projects that warrant financing and can raise inflation. Boyd, Levine, and Smith (1997) find that economies with average rates of inflation exceeding certain thresholds have significantly less well developed financial systems.

Table 2.5.Selected Countries: Agriculture Share of GDP, 2004(In percent of GDP)
Smaller economies (82)
Emerging market countries (38)
Advanced countries (21)
Source: World Bank.Note: Number of countries in parentheses.
Source: World Bank.Note: Number of countries in parentheses.

Strong domestic and external seasonalities can induce all banks to be on one side or the other of financial markets. This is the case in The Gambia and Zambia.

Limited Number and Small Size of Companies

Companies in smaller economies tend to be few in number and small. In most smaller economies, the corporate sector is composed of a relatively limited number of small and medium-sized enterprises (SMEs).10 In addition, in some of these countries some sectors of the economy are still in government hands, thus limiting the size and potential of the corporate sector. The potential for equity market development will be constrained in the face of a limited number and size of potential equity market issuers.

In particular, the regulatory and infrastructure costs of equity issuance for individual smaller economy companies may outweigh the benefits, owing to the companies’ small size. The regulatory framework for equity markets usually includes a disclosure regime and a framework for corporate governance. Compliance with disclosure obligations usually requires the development of specific information technology (IT) capabilities, and more rigorous procedures and controls to ensure the reliability of financial information, including external auditing. In many jurisdictions, issuers are also required to have personnel specifically assigned to regulatory compliance and investor relations, all of which entails additional costs. For smaller economies the regulatory framework could be very costly vis-à-vis market potential, thus preventing the entrance of participants—both issuers and intermediaries.

In many smaller economies, companies are still family-owned, which complicates their compliance with a corporate governance framework and limits the floating of shares.11 In Central America, most of the firms that could reach a critical size where equity issuance would be a possibility belong to family groups that have a strong aversion to minority shareholders of any size. Even if family-owned firms list, they will float only a small portion of their shares.

Structural Obstacles

Structural obstacles can be addressed by policy but only over a long period of time. They are often longstanding and rooted in macroeconomic and financial policies. However, they can be addressed, albeit over the long run.

Structural Excess Liquidity in the Banking Sector

In many smaller economies, structural excess liquidity inhibits money market development by removing incentives to borrow in the short term. Structural excess liquidity can be defined as a long-lasting surplus of bank cash over and above the amount required to be held as reserves or for payment purposes. Structural excess liquidity data are generally not reported and analysis of this issue for smaller economies is quite limited. However, IMF (2005a) and Saxegaard (2006) suggest that structural liquidity surpluses are pervasive across smaller economies. Structural excess liquidity undermines money market development by putting all banks on the supply side of the market.

For most smaller economies, structural excess liquidity is rooted in a mismatch between bank liquidity and the credit absorption capacity of the domestic economy. Most studies of structural excess liquidity are concerned with whether and how emerging market countries should sterilize excess liquidity arising from capital inflows (Khan and Reinhart, 1995). Smaller economies, in contrast, have relatively closed capital accounts and low credit, and thus for them structural excess liquidity has more to do with low credit absorption capacity.


The relatively high level of dollarization in smaller economies impedes money and foreign exchange market development. Smaller economies have a qualitatively higher incidence of dollarization, as measured by the share of foreign currency deposits in total deposits, compared to other countries (Table 2.6). Dollarization undermines local money and foreign exchange markets by reducing the share of liquidity denominated in local currency.

Table 2.6.Selected Countries: Foreign Currency Deposits to Total Deposits, 2001(In percent)
Smaller economies (47)
Emerging market countries (30)
Advanced countries (13)
Source: De Nicoló, Honohan, and Ize (2003).Note: Number of countries in parentheses.
Source: De Nicoló, Honohan, and Ize (2003).Note: Number of countries in parentheses.

Capital Account Openness12

An open capital account is generally seen as conducive to financial market development. Mishkin (2006) argues that the presence of foreign financial institutions leads to improvements in the quality of domestic prudential supervision and could be instrumental in the reform of domestic regulatory institutions. A more closed capital account impedes the capital, expertise, and technology that foreigners can contribute to local market development. At the same time, limited market development gives foreigners less reason to invest in local markets and can raise financial vulnerabilities, thus leading to tighter restrictions.

Portfolio equity inflows play a smaller role in smaller economies relative to emerging and advanced countries. The median stock of smaller economy portfolio equity inflows is only 0.1 percent of GDP, which is an order of magnitude lower as a share of GDP than the inflows of emerging market countries and just a fraction of what advanced countries receive (Table 2.7).

Table 2.7.International Investment Position Data, IMF Member Countries, 2003(Share of GDP)
Portfolio equityForeign direct investmentPortfolio and other investment debtFinancial derivativesTotalTotal AssetsNet External Position
Small and medium developing countries (75)
Standard deviation3.229.439.00.247.637.761.2
Emerging market countries (40)
Standard deviation5.328.4132.40.4143.5200.3126.6
Advanced countries (28)
Standard deviation792.6533.6507.910.81839.31863.977.9
Source: Lane and Milesi-Ferretti (2006).Note: Number of countries in parentheses.
Source: Lane and Milesi-Ferretti (2006).Note: Number of countries in parentheses.

Interestingly, foreign direct investment inflows are comparable between smaller economies and emerging market countries, possibly because direct ownership circumvents many of the legal and institutional shortfalls of smaller economies. Portfolio and other investment debt data are higher for smaller economies, but these figures include official flows and thus are not driven by market forces.

Smaller economies also appear to have tighter de jure capital account restrictions. The capital account restriction measure of Chinn and Ito (2005), which is available for a broad set of countries, indicates that smaller economies have more restrictive policies (Table 2.8).13

Table 2.8.Selected Countries: Capital Account Openness(Index increases in openness)
Smaller economies (101)
Emerging market countries (42)
Advanced countries (27)
Source: Chinn and Ito (2005).Note: Number of countries in parentheses.
Source: Chinn and Ito (2005).Note: Number of countries in parentheses.

Perhaps surprisingly, smaller economies do not on average have more extensive capital controls than emerging market countries do. Indeed, fewer smaller economies have controls on most types of capital transactions compared with emerging market countries (Figure 2.2), and controls on invisible transactions are comparable between the two country groups. Thus, relatively strict capital controls would not appear to explain the relative thinness of smaller economy foreign exchange markets. Indeed, it may be the case that capital inflows are low for smaller economies for fundamental reasons—including underdeveloped financial markets—and thus capital controls have a weak relationship with foreign exchange market development.

Figure 2.2.Emerging Market Countries and Smaller Economies with Floating Arrangements: Controlled Transactions

(Percent of identified types of transactions subject to controls)

Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions database.

Institutional Obstacles

Institutional obstacles are those that can be dealt with by policy reforms in the short and medium run.

Lack of Proper Information Disclosure

Access to reliable financial information is crucial generally for financial markets and especially for securities markets. Credible financial information relies on the existence of high-quality accounting standards, a skilled and trained accounting profession, and adequate accounting procedures and controls at the level of the companies. In addition, as part of the checks and controls, there is a need for high-quality auditing standards and a reasonable number of skilled independent auditors.

However, many smaller economies lack reliable company financial information. The World Bank’s business disclosure index indicates that smaller economies have poorer disclosure practices (Table 2.9). In many cases the problem relates to the size of the companies, as well as the fact that they are family-run, which has prevented them from developing adequate accounting policies and procedures. In addition, small countries may lack sufficient accounting and auditing professionals. In particular in the case of auditing, this problem might affect the ability of the regulator to enforce independence requirements. In addition, in many emerging and developing countries taxation might deter companies from full financial transparency. Also, in many emerging and developing markets, accounting and auditing standards are not of high quality, yet the implementation of high-quality standards, such as the International Financial Reporting Standards (IFRS), would pose challenges for companies in smaller economies, for which the burden of compliance might be significant. The International Accounting Standards Board is in the process of developing IFRS for SMEs, which would at least solve this part of the problem.

Table 2.9.Business Environment Indicators, 2005
Business Disclosure Index1Rigidity of Employment Index2Cost of Business StartUp Procedures (In percent of GNI per capita)Time Required to Start a Business (Days)Start-up Procedures to Register a Business (Number)
Smaller economies (41)
Emerging market countries (34)
Advanced countries (26)
Source: World BankNote: Number of countries in parentheses.

0 = less disclosure to 10 = more disclosure.

0 = less rigid to 100 = more rigid.

Source: World BankNote: Number of countries in parentheses.

0 = less disclosure to 10 = more disclosure.

0 = less rigid to 100 = more rigid.

A Contract-Enforcing Legal Framework and Infrastructure

Financial market development rests on the existence of a sound and well-applied body of contract law. Parties to a financial market transaction assume certain obligations and responsibilities that are specified in a contract. The participants’ willingness to transact requires that the contract is clear, and that breaches of the contract are dealt with transparently, impartially, and on a timely basis. This requires not just supporting laws and by-laws, but also judges with the appropriate technical expertise. Transactions involving a credit to or participation in a corporation require a well-developed framework for corporate law.

Interestingly, smaller economies do not seem to have a markedly less effective legal framework compared with emerging market countries (Tables 2.9 and 2.10). World Bank surveys indicate that the median of quantitative indicators for the legal framework of smaller economies and emerging market countries are quite close in most areas, with faster insolvency resolution in smaller economies. Not surprisingly, the advanced countries score much better than the others. These comparisons suggest that, below the advanced country level, the size and level of development matter little for the effectiveness of the legal framework in support of financial contracts.

Table 2.10.Selected Countries: Indicators of the Effectiveness of the Legal Framework
Procedures to Enforce a Contract (Number)Procedures to Register Property (Number)Time Required to Enforce a Contract (Days)Time to Resolve Insolvency (Years)
Smaller economies (85)
Emerging market countries (39)
Advanced countries (24)
Source: World Bank.Note: Number of countries in parentheses.
Source: World Bank.Note: Number of countries in parentheses.

Policy Rigidities

Distortionary tax policies in many smaller economies limit financial market development. Although transaction taxes and tax withholding reduce the demand for securities and may negatively affect financial market development, in many smaller economies such taxes are still considered an effective revenue source given the high volume of financial transactions and the relative ease with which the organized financial sectors can be taxed (Árvai and Heenan, 2008). Tax withholding is used because of its ease of implementation, low compliance cost, and effectiveness in preventing tax evasion, but it has shortcomings as well. In particular, a withholding tax for nonresident investors can reduce foreign participation in the secondary market.

Interest rate controls impede bank and market development in some smaller economies. This is the case in Africa in particular, where such controls remain in effect in many countries (Gulde and others, 2006). Interest rate floors make banks reluctant to accept further deposits, particularly where there is high bank liquidity and nonremunerated required reserves. Maximum lending rates prevent banks from adequately pricing lending risk, which can contribute to weak lending and structural excess liquidity.

Lack of Political Will and Vested Interests

The influence of politically driven policies on financial markets is also more prevalent in smaller economies. Often, government, regulatory, and central bank policies are driven by influential interest groups and politicians. Similarly, allocation of the resources of the financial sector is often determined by favoring certain interest groups, thereby creating inefficiencies and distortions, and impeding the development of the financial markets. In many countries, a small number of the elite, who are politically well connected, enjoy access to capital, distorting the efficient allocation of resources. A higher share of managers surveyed by the World Bank rank corruption as a major business constraint in smaller economies, relative to emerging market countries (Table 2.11).

Table 2.11.Smaller Economies and Emerging Market Countries: Corruption(Percent of managers surveyed ranking corruption as a major business constraint)
Smaller economies (35)
Emerging market countries (23)
Source: World Bank, World Development Indicators.Note: Number of countries in parentheses.
Source: World Bank, World Development Indicators.Note: Number of countries in parentheses.

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