Chapter

3. Sustaining Financial Development in Emerging Europe

Author(s):
International Monetary Fund. European Dept.
Published Date:
November 2007
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Financial development has advanced to varying degrees in emerging Europe. Macroeconomic stability and good institutional quality and law enforceability appear to have been key forces. Building on recent progress, further reforms are needed to complete the establishment of deep, liquid, diversified, and stable financial markets. This will yield benefits in terms of efficiency, risk diversification, and resilience in the face of possibly volatile external capital flows. Going forward, the EU integration process is likely to drive reforms in EU members. In non-EU emerging economies, the focus should be on reinforcing the foundations of financial development, including the rule of law, creating a well-functioning government securities market, establishing stronger corporate governance and creditor rights protection, and promoting a favorable environment for the emergence of institutional investors. Reforms need to be tailored to specific country circumstances as illustrated in the boxes presented in this chapter.

What Is the State of Financial Development?

Financial development in emerging Europe has progressed considerably since the early 1990s, with banks dominating. Thus bank credit remains the most important form of financial intermediation. After its dramatic expansion of the past few years, bank credit is now roughly in line with the ranking implied by per capita income levels in most countries (Figure 35). Securities markets are less developed, with significant differences across countries. On one side of the spectrum are countries like the Czech Republic, Hungary, Poland, and Turkey, where at least two different segments—government securities and equities—are relatively well developed. On the other side are countries, such as Belarus, where all capital market segments are still in their infancy.

Figure 35.Bank Credit to the Private Sector and Per Capita Income, 2006

Sources: IMF, International Financial Statistics ; and IMF, World Economic Outlook.

Notes: Euro area average excludes Luxembourg and Slovenia. EM = emerging market. Country names are abbreviated according to the ISO standard codes.

The depth and liquidity of the government securities market mainly reflect current and past public sector financing needs. Hence, Central European countries and Turkey have well-established government securities markets. Improving corporate governance in emerging Europe is only beginning to set the stage for the development of the corporate securities market. The outstanding stock of nonfinancial corporate debt securities has remained below 5 percent of GDP everywhere (Figure 36). Even in countries where corporate issues have grown more significantly in the past few years, such as Russia and Ukraine, they are concentrated in a few sectors. Trading volume in the secondary market is generally too low to provide adequate liquidity and continuous price discovery. The market for securities issued by financial institutions is somewhat deeper and expanding faster than the nonfinancial corporate bond market.

Figure 36.Outstanding Debt Securities, 2006

(Percent of GDP)

Sources: Bank for International Settlements; Standard & Poor’s; Bloomberg L.P.; national authorities; and IMF, World Economic Outlook.

Note: Euro area average excludes Luxembourg and Slovenia. EM = emerging market.

Equity markets have grown rapidly in the past few years, especially in Southeastern Europe and Russia, where market capitalization has reached surprisingly high levels. Nevertheless, liquidity—as measured by the turnover ratio23—is typically low throughout the region (Figure 37). The free float—the portion of shares available to the investing public—is often small, and trading is concentrated in a few stocks. Capitalization tends to be concentrated in a small number of companies, even in countries with relatively well-developed markets—like the Czech Republic, Hungary, Poland, and Turkey.

Figure 37.Equity Market Turnover and Capitalization, 2006

Sources: Datastream; Standard & Poor’s; Bloomberg L.P.; and IMF, World Economic Outlook.

Note: Euro area average excludes Luxembourg and Slovenia. EM = emerging markets. Country names are abbreviated according to the ISO standard codes.

Nonbank financial institutions, including pension funds, mutual funds, and insurance companies, are mostly just beginning to emerge (Figure 38). In countries that introduced pension and regulatory reforms early on, pension fund assets are already high by regional standards, and even in comparison to some advanced economies.

Figure 38.Institutional Investor Size, 2006

(Percent of GDP)

Sources: National authorities; OECD; Investment Company Institute; Swiss Re; and IMF, World Economic Outlook.

Notes: 2005 or 2006, based on data availability. Euro area average excludes Luxembourg and Slovenia.

For instance, pension fund assets in percent of GDP are higher in Croatia, Hungary, and Poland than in Germany and Italy. The presence of mutual funds and insurance is small virtually everywhere. Mutual fund assets are over 5 percent of GDP only in the four largest Central European countries, plus Croatia and Estonia. Similarly, insurance premiums exceed 3 percent of GDP only in five emerging economies.24

Which Factors Are Key?

A stable macroeconomic environment is essential for financial development. The level and volatility of inflation can be used to gauge overall macroeconomic stability. High and volatile inflation obscures the signaling role of price changes, creates uncertainty about returns on investment, and discourages demand for financial assets.25 Not surprisingly, therefore, empirical research finds that high inflation rates have a negative impact on financial development. A study on emerging Europe in particular, conducted as background to this chapter, indicates that high inflation was associated with lower bank credit to the private sector during 1995–2006, and that single-digit rates, as opposed to higher rates, favored private credit development. Rising income levels, and the associated increasing complexity of economic structure, also contributed to financial deepening.

Good institutional quality and law enforceability by the judiciary and the entire legal system are the foundations of financial development. Only if property rights are strongly respected can the financial sector effectively trade and intermediate claims on assets and use collateral to extend credit.26 Conversely, the financial sector can hardly flourish in an environment of corruption, low-quality bureaucracy, and an inadequate rule of law, as these jeopardize investor protection and contract enforceability. Our empirical analysis on emerging Europe confirms a positive and significant relationship between indicators of institutional quality and bank credit (Figure 39).

Figure 39.Bank Credit and Institutional Quality

Sources: Freedom House; International Organization of Securities Commissions; and IMF, International Financial Statistics ; IMF, World Economic Outloook.

Notes: Institutional quality index is the sum of property rights, control of corruption, bureaucracy quality, and rule of law indices. It ranges from 0 to 4. Euro area average excludes Luxembourg and Slovenia. Country names are abbreviated according to the ISO standard codes.

The development of equity and corporate debt securities markets requires appropriate legislation and strong corporate governance, including adequate disclosure of corporate activities and proper accounting rules and practices.27 Similarly, the development of private credit intermediation and the debt securities market depends on adequate creditor rights protection through collateral and bankruptcy laws, as well as credit information disclosure.28 In our empirical study on emerging Europe, a measure of creditor rights protection is found to have been significantly associated with higher bank credit during 1999–2006.29

How Can Progress Be Sustained?

While all emerging European economies have made important advances in setting the foundations for financial development, looking forward it is useful to distinguish between two groups of countries:

  • The members of the European Union, where the ongoing process of creating a single market in financial services can be expected to continue to fuel further comprehensive reforms. Changes in securities market legislation, regulatory and supervisory frameworks for both bank and nonbank institutions, clearing and settlements systems, and other important financial areas are all being driven by the harmonization process across all EU members. Not only that, but EU financial integration is likely to shape overall financial development, providing both opportunities and challenges.
  • The emerging economies that are not part of theEuropean Union, where reforms will need to be domestically driven, even though European integration and financial globalization more generally can be expected to continue to foster financial development. At this stage, these countries should focus on reinforcing the foundations for financial development, including the rule of law, creating a well-functioning government securities market, establishing stronger corporate governance and creditor rights protection, and promoting a favorable environment for the emergence of institutional investors.

Financial Development in EU Countries: The Role of Integration

Although emerging economies that joined the European Union have carried out comprehensive reforms to comply with the acquis communautaire, much remains to be done. Further strengthening of institutional quality will allow these economies to catch up with advanced economies in this respect (Figure 40). The regulatory and supervisory frameworks for banking, insurance, and securities are already stronger than in non-EU emerging economies, but compliance can be further improved to fully meet international standards (Cihák and Tieman, 2007). It will also be important for financial development to continue to reinforce creditor rights protection through collateral and bankruptcy laws, as well as information disclosure (Figures 41 and 42), and to upgrade corporate governance regulation and practices (Figure 43).

Figure 40.Institutional Quality Index, 2006

Sources: Freedom House; and International Country Risk Guide, 2006.

Notes: Institutional quality index is the sum of property rights, control of corruption, bureaucracy quality, and rule of law indices. It ranges from 0 to 4. Euro area average excludes Luxembourg and Slovenia. EM = emerging market.

Figure 41.Borrowers and Lenders Legal Rights Index, 2006

Source: World Bank, Doing Business database.

Notes: The index measures the degree to which collateral and bankruptcy laws protect the rights of borrowers and lenders. Index has been rescaled to assume values between 0 and 1. Euro area average excludes Luxembourg and Slovenia. EM = emerging market.

Figure 42.Credit Information Index, 2006

Source: World Bank, Doing Business database.

Notes: The index measures rules affecting the scope, accesibilty and quality of credit information available through private and public credit registries. The index has been rescaled to assume values betweeen 0 and 1. Euro area average excludes Luxembourg and Slovenia. EM = emerging market.

1/ In Croatia a bank credit registry began operations in May 2007.

Figure 43.Corporate Governance (Compliance with OECD Principles), 2004

Source: European Bank for Reconstruction and Development (2005).

For EU emerging economies, the EU financial integration process is likely to be the main force propelling and shaping financial development. The European Union is heading toward a single market in financial services,30 which creates both an opportunity and a challenge for emerging economies. On the one hand, it will allow better diversification of financing and investment options and strengthen competition. On the other, it will raise exposure to the potential risks associated with cross-border movements in capital flows. In this respect, rapid and full implementation of the relevant EU Directives will be key to making further progress in terms of laws, regulations, and practices, strengthening the financial sector, securing domestic and foreign investor confidence, and establishing emerging economies as important players in the EU financial market.

EU members also need to adapt their financial development strategy to take into account the opportunities as well as the constraints created by financial integration. For example, as countries move toward euro adoption, companies’ increasing access to foreign resources raises questions about the need for domestic currency – denominated corporate bond markets. For small countries, in particular, the increased competition associated with financial integration imposes strong pressure to find niche markets with a local comparative advantage. For these countries, joining regional markets, rather than developing national ones, might be the most sensible option, especially with respect to certain segments, like the securities market (Box 8).

Box 8.National versus Regional Exchange Markets: Implications for Emerging Europe

The operation of a national financial exchange has traditionally been seen as a sign of financial sector sophistication. A nationally based exchange can have advantages: traded assets are subject to the same legal and tax system, secure and rapid settlement is facilitated, exchange and investment regulations are homogeneous, and, perhaps most important, market participants have ready access to information on listed companies and the macroeconomic context. Many countries in emerging Europe have established national exchanges, some of which are very small.

With increasing financial integration, these markets face more competition and, therefore, need to change strategy if they want to survive, as large local corporations seek listings overseas, investors have free access to all European markets, and trading is diverted abroad.1 Moreover, the new EU Markets in Financial Instruments Directive, an important step toward the creation of a securities market in Europe, is likely boost competition even further (Haas, 2007b).

Indeed, the globalization of financial markets, technological innovation, and the desire for international diversification of portfolios have already led market operators to consolidate or intensify collaboration, especially in small and medium-sized markets. For example, the merger of the Nordic-Baltic exchanges has created the regional OMX Market. The Warsaw Stock Exchange (WSE) signed an agreement with the multinational exchange Euronext that allows WSE members access to Euronext products and vice versa, and enables dealers to trade products from each exchange on a single screen. In 2004 the Vienna Stock Exchange acquired a stake in the Budapest Stock Exchange and entered into an index cooperation project with it.2 Although the consolidation process typically takes a few years, the examples of OMX and others offer useful experience. However, because exchanges are largely private sector owned, there are obvious limits to how much policymakers can drive the process or set the timetable.

Even though many of the original reasons for having national exchanges have been weakened by EU integration, as well as by the associated regulatory convergence, combined with improvements in information technology and general financial market globalization, authorities may still be concerned that small and medium-sized firms are unlikely to be able to list overseas and may find it difficult to raise capital in local stock markets amid declining market activity. Thus, perhaps the most fruitful approach may be to concentrate on further improvements in, and homogenization of, the legal and institutional framework in these countries to facilitate smaller companies’ access to venture capital or private equity firms, commercial banks, or nonbank financial institutions, and possibly second-tier listing at a regional exchange.

Note: This box is based on Iorgova and Ong (2007).1Berglöf and Bolton (2002); and Claessens, Lee, and Zechner (2003).2 Cooperation agreements have since also been signed with the stock exchanges in Zagreb, Belgrade, Sarajevo, Sofia, Montenegro, Banja Luka, and Macedonia.

Financial Development in Non-EU Countries: Priority Reforms

Reinforcing the foundations

Attaining low inflation in a durable manner will be critical for financial development. While all economies have made great progress toward price stability, a few still need to address the threat of high and volatile inflation. Belarus, Russia, Serbia, and Turkey experienced double-digit inflation, on average, during 2003–06, and inflation in Moldova and Ukraine is likely to be more than 10 percent in 2007.

Non-EU emerging European economies have also made significant progress in protecting property rights, creating high-quality bureaucracy, controlling corruption, and establishing the rule of law. Nevertheless, institutional quality and law enforceability need to be brought closer to the EU average (Figure 40). Enforcing contracts needs to be made less costly and time-consuming by improving the efficiency of court systems and unburdening the judicial processes.31

Non-EU emerging economies have also taken major steps to develop a sound and efficient banking sector. Indeed, only Belarus has yet to liberalize interest rates and credit allocation (Figure 44). All countries in this group have functioning payments and settlement systems, put in place fairly good accounting and disclosure standards, and established frameworks for bank prudential supervision and regulation broadly in line with international standards (Figure 45).

Figure 44.Banking Reform and Interest Rate Liberalization Index, 2006

Source: European Bank for Reconstruction and Development.

Note: Index has been rescaled to assume values between 0 and 1.

Figure 45.Regulatory and Supervisory Power Index, 2003

Source: Barth and Levine (2006).

Notes: Each index has been rescaled to assume values between 0 and

1. Euro area average excludes Luxembourg and Slovenia. EM = emerging market.

However, weaknesses in implementation of written rules and regulations need to be addressed to minimize risks to financial stability. For example, Moldova could benefit by improving the transparency of the ownership structure of its banks to secure full enforcement of prudential limits for connected lending and large exposures. Further reforms would also be desirable in the areas of bank regulation and supervision. In Russia, risks could be reduced by tightening the regulation and enforcement of large exposure limits and connected lending. In Bosnia, unifying bank supervision into a single, independent country-wide agency is necessary for effective supervision. In Belarus, the banking supervisor should shed its shareholdings in banking institutions to limit actual or apparent conflicts of interest.

Building the government securities market

A well-functioning government securities market could be the catalyst for further financial market development.32 A liquid government securities market provides a market-determined term structure of interest rates and, therefore, facilitates the pricing of other financial instruments, including corporate bonds and derivatives. In Ukraine, for example, the pricing of corporate securities would be greatly facilitated by the establishment of a yield curve for government bonds. Moreover, government securities can be used as collateral to reduce credit risk and as relatively safe assets to resort to during periods of heightened uncertainty. Also, building the government securities market entails the creation of an extensive legal, informational, and institutional infrastructure that can benefit the entire financial system.

Developing a government securities market requires the joint commitment of the government and the central bank to a coherent strategy. Such a strategy would involve regular issuance of securities; central bank use of government paper for monetary policy operations to enhance liquidity; public debt management practices to create clear benchmarks for different maturities; and adequate market infrastructure, including trading, depository, and settlement systems. Hungary, for instance, successfully implemented a consistent and integrated approach that helped establish a deep and liquid government securities market. Other countries, like Ukraine, for example, would benefit from a strong commitment to build a government securities market (Box 9).

Box 9.Developing the Government Securities Market

Hungary’s Success …

Hungary’s government securities market is one of the most developed, liquid, and sophisticated markets in the region. The driving force behind the development of this market was the authorities’ commitment to a coherent strategy involving macroeconomic stabilization, the creation of a suitable legal and regulatory environment, the use of government securities for monetary operations, and improvements in debt management. Gradual capital account liberalization also helped make the market deeper and more liquid.

The first steps in market development were taken in the early 1990s with the liberalization of interest rates and the enactment of the Central Bank Act, which laid the foundation for the complete phaseout of central bank deficit financing. In 1993, the non-interest-bearing public debt was swapped into marketable government bonds. Throughout the 1990s, the monetary authorities gradually adopted indirect instruments of monetary policy. Government securities began to be used as collateral in central bank refinancing activities with financial institutions and for open market operations, which helped make the government securities market deeper, more liquid, and attractive to investors.

In the early 1990s, new legislation on securities, as well as the establishment of the Securities Supervisory Agency,1 the Central Clearing House and Depository, the Treasury, and the Government Debt Management Agency, paved the way for the smooth operation of the government securities market. Measures to encourage the emergence of institutional investors broadened the investor base. Legislation on mutual and pension funds also took effect in the early 1990s. A mandatory funded pillar was introduced with the 1998 pension reform. Long-term local currency–denominated government securities were also made available to nonresidents in 1994.

In 1995, the authorities demonstrated their commitment to macroeconomic stability by implementing a stabilization package in response to widening budget and current account deficits. Fiscal adjustment, a onetime devaluation of the forint, and a shift from an adjustable fixed exchange rate to a crawling band with a preannounced devaluation rate formed the basis for sounder macroeconomic development and greater investoṛ confidence. As the anti-inflationary commitment of the monetary authorities gained credibility, helped by the adoption of an inflation-targeting framework, the yield curve could be extended significantly.

Since the mid-1990s, debt-management strategies have been implemented with a view to enhancing the functioning of the primary market and increasing transparency and liquidity in the secondary market. A system of primary dealers was launched in 1996. Debt instruments were standardized to reduce fragmentation. Benchmark securities were introduced, and their yields started being published daily. Liquidity in the secondary market was further enhanced by the liberalization of the capital account, culminating in 2001 with the removal of all foreign exchange restrictions, including those on short-term portfolio transactions.

. . . Can It Be Transferred to Ukraine?

Ukraine’s government securities market has so far remained shallow and illiquid. Marketable securities amounted to just over 2.1 percent of GDP at end-2006. The term structure of government securities is very fragmented, leaving several gaps in the yield curve.

Developing a deep and liquid government securities market will require a strong commitment by the authorities to an integrated and credible debt management and market development strategy. The primary market could be fostered by conducting regular auctions under transparent rules and according to a preannounced issuance program, creating a small number of liquid benchmarks, and issuing securities in sufficient size to achieve adequate liquidity in the secondary market. The price-setting mechanism at the auctions will need to be modified to ensure that yields are not kept artificially low but, rather, reflect market-based outcomes. Discontinuing the use of private placements of government debts would also be beneficial. In addition, it would be useful to deepen the cooperation between the central bank and the ministry of finance including by defining the role of the central bank in the secondary market. Moreover, using government securities for monetary operations would strengthen market liquidity.

Achieving and maintaining low inflation will be essential because inflationary expectations affect the government’s ability to extend the yield curve beyond very short maturities. This is particularly critical for Ukraine, because inflation has been volatile and above the levels observed in neighboring countries. Furthermore, the development of the government securities market could be enhanced by broadening the investor base and introducing a system of primary dealers once a clear debt management strategy has been developed and the level of primary issuances increased.

Note: This box is based largely on Csajbók and Neményi (1998) and Arvai and Heenan (2005).1 The Securities Supervisory Agency later became the Hungarian Financial Supervisory Authority.

Developing corporate finance

Stronger creditor protection and corporate governance are essential to establish credit and corporate securities markets. The institutional and legal frameworks governing the valuation of collateral and the protection of creditor rights need to be improved, particularly in Belarus, Russia, and Turkey (Figure 41). Accessibility and quality of credit information through credit registries could also be enhanced, especially in Albania, Moldova, Russia, and Ukraine (Figure 42). For corporate governance, progress is needed, especially in Belarus, Bosnia and Herzegovina, and Ukraine (Figure 43). Adequate securities legislation has yet to be put in place in Albania and Belarus. Again, Ukraine provides a good case study of how enhancing institutional quality and corporate governance can help develop corporate finance (Box 10).

Box 10.Institutional Quality, Corporate Governance, and Financial Development: The Case of Ukraine

The Ukrainian corporate debt securities market has grown dramatically in recent years. Corporate debt securities issuance revived in 2001–02, and has accelerated since 2005. In 2006, total issues amounted to 4.1 percent of GDP. However, market liquidity is rather low. The emergence of the market has been encouraged by the increased funding needs of Ukrainian companies, coupled with weaknesses in banking sector intermediation, including the limited capacity to fulfill corporates’ long-term funding needs owing to the scarcity of long-term hryvnia funds for banks, wide interest rate spreads, and the lack of domestic syndicated lending.

In addition, the equity market has grown considerably in the past few years. Market capitalization reached 40.4 percent of GDP in 2006, up from less than 4 percent in 1999. However, the number of listed companies is very small, and concentration rather high; the 10 largest companies account for 68 percent of total market capitalization. Moreover, the free float is small (about 5 percent of market capitalization), and market turnover extremely low (see Figure 37 in the main text).

A number of reforms could support further healthy development of the corporate debt and equity securities market. First, institutional quality and law enforceability need to be strengthened, as court proceedings are generally cumbersome and lengthy (see Figure 40 in the main text). It would be important to also reinforce corporate governance, because at present the quality of the legislation defining the responsibilities of the board, the rights of shareholders, and disclosure and transparency are below international standards (see Figure 43 in the main text). Deficiencies could be addressed in the area of securities market regulation and supervision, as well as in the clearing and settlement system. The trading and registrar systems could also be upgraded. Creating a benchmark yield curve on government securities would facilitate corporate bond pricing. Enacting a joint stock company law would help equity market development.1 Furthermore, the institutional investor base for the securities market could be enhanced through legal, regulatory, and supervisory reforms favoring mutual funds development and by expediting pension reform, which could boost the emergence of pension funds.

Note: Zsofia Arvai contributed to this box.1 A new Joint Stock Company Law is currently before parliament.

Expanding the range of players in the financial system

Creating a diverse class of institutional investors (including pension funds, mutual funds, and insurance companies) would greatly contribute to financial market development and liquidity. These investors would provide a stable source of demand for financial instruments, and stimulate competition and efficiency in primary markets. The emergence of institutional investors can be fostered by enhancing the regulatory and supervisory framework for nonbank financial institutions. The supervisory framework could take the form of an integrated supervisory agency or several agencies, provided that cooperation and information flows were secured. In countries that have not yet reformed their pension systems, such as Albania and Belarus, consideration could be given to mandatory or voluntary fully funded schemes that could contribute to pension fund development. The case of Hungary offers an example of how legislative and regulatory changes, as well as pension reforms, can expand the range of institutional investors (Box 9).

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