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3. Boosting Financial Sector Development

Author(s):
Montfort Mlachila, Ahmat Jidoud, Monique Newiak, Bozena Radzewicz-Bak, and Misa Takebe
Published Date:
September 2016
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Sound macroeconomic fundamentals have been driving financial development in sub-Saharan African countries, while weak institutional quality has been hindering it in many countries of the region. Improvements in legal frameworks and corporate governance seem to be the most promising avenues to boost financial development in the region.

A Summary Review of the Literature

Various past contributions to the literature investigated the factors that boost financial sector development.

  • A first strand of the literature focuses on macroeconomic fundamentals as a driver for financial development. Early studies, such as Gurley and Shaw (1967) and Goldsmith (1969), show that economic growth encourages banking sector development as economic expansion boosts demand for financial services. Boyd, Levine, and Smith (2001) suggest that there is a significant negative relationship between inflation and financial development, given information asymmetries that intensify with higher inflation and prevent financial development.
  • A second strand of the literature focuses on international integration as a driving force behind financial development. For instance, Svaleryd and Vlachos (2002) show that there is a positive relationship between financial development and liberal trade policies—with causation running in both directions. Klein and Olivei (2008) empirically confirm that countries with more open capital accounts exhibit a significantly higher increase in financial depth than others. Separately, Rajan and Zingales (2003) study the issue from a political economy perspective, and conclude that international trade and financial liberalization encourage financial development by weakening the power of incumbents, who are likely opposed to the liberalization on concerns over greater competition eroding their rents.
  • A third strand of the literature focuses on institutional quality as a driving force. Acemoglu, Johnson, and Robinson (2004) claim that better economic institutions improve distribution of financial resources and help financial development. Along this line, Djankov, McLiesh, and Shleifer (2005) empirically show that better institutional frameworks—such as creditor protection—are positively related to higher ratios of private credit to GDP. More recently, Sahay and others (2015b) show that greater financial development is positively associated with better regulatory frameworks—especially those protecting property and creditor rights. Institutional quality has also been a point of focus in studies focusing on sub-Saharan Africa. Gulde and others (2006) argue that the deficiency in property rights protection is one of the main impediments to the region’s banking sector development. Anayiotos and Toroyan (2009) provide evidence that institutional factors affect financial depth and access to financial services in sub-Saharan Africa more than such commonly used explanatory variables as asset quality and profitability. Separately, Singh, Kpodar, and Ghura (2009) study the different level of financial development between the CFA (Communauté Financière Africaine) franc zone (WAEMU and CEMAC) and the rest of sub-Saharan African countries, and suggest that the difference in financial development can be attributed to a different quality of institutions. More recently, Mlachila, Park, and Yabara (2013) show that weak judicial enforcement is one of the major impediments to the region’s banking system development.

Combining the second and the third strands mentioned above, David, Mlachila, and Moheeput (2015) show that, in contrast to other developing countries, there is a weak link between international integration and financial development in the region, and this can be explained by relatively weak institutions in the region. Their research supports the evidence by Tressel and Detragiache (2008), who show that financial liberalization policies increase financial development only in the countries with well-developed political institutions and limited power of the executive, and Chinn and Ito (2005), who suggest that international financial integration contributes to financial development only when countries achieve a certain level of legal and institutional quality.

Macroeconomic Fundamentals Driving Financial Development8

We show that macroeconomic fundamentals are the main drivers of financial development in the region. Drawing on the existing literature, this section analyzes the drivers of financial development in developing countries, with a special focus on sub-Saharan Africa. In particular, following the literature highlighted above, we investigate the effects from two key aspects of globalization—trade and financial integration,9 with the following key findings (Table 3):

Table 3.Sub-Saharan Africa: Drivers of Financial Development
GMM
Financial development index (t-1)0.549 ***
[0.017]
Capital account openness0.005 **
(de facto index, t-1)[0.002]
Trade openness index0.044 ***
(total trade/GDP, t-1)[0.006]
Real GDP per capita (t-1)0.087 ***
[0.007]
Inflation rate (t-1)−0.021 ***
[0.003]
ICRG country risk rating0.123 ***
[0.016]
SSA * capital account openness (t-1)0.009 ***
[0.003]
SSA * trade openness (t-1)−0.042 ***
[0.009]
SSA * inflation rate (t-1)−0.017
[0.014]
SSA * ICRG country risk rating−0.105 ***
[0.033]
−0.714 ***
Constant[0.046]
Observations1,809
Number of countries82
Source: IMF staff estimates.Note: Based on panel regressions of data for 1980–2013 for about 90 developing countries (excluding oil exporters), although the number of observations vary depending on the variable. Interaction terms with sub-Saharan Africa (SSA) only show the incremental impact for the region’s countries. In other words, the overall impact on sub-Saharan African countries should be evaluated by the sum of the coefficients for all developing countries and the coefficients on interaction terms. Including oil exporters does not qualitatively change the core results. ICRG = International country risk guide. Robust standard errors in brackets; *** p < 0.01, ** p < 0.05, * p < 0.1.
Source: IMF staff estimates.Note: Based on panel regressions of data for 1980–2013 for about 90 developing countries (excluding oil exporters), although the number of observations vary depending on the variable. Interaction terms with sub-Saharan Africa (SSA) only show the incremental impact for the region’s countries. In other words, the overall impact on sub-Saharan African countries should be evaluated by the sum of the coefficients for all developing countries and the coefficients on interaction terms. Including oil exporters does not qualitatively change the core results. ICRG = International country risk guide. Robust standard errors in brackets; *** p < 0.01, ** p < 0.05, * p < 0.1.
  • Macroeconomic fundamentals have a positive impact on financial development in developing countries in general and sub-Saharan Africa in particular. High inflation—a proxy for macroeconomic instability—has a negative effect on financial development.10 In addition, we find that the income effect is significant, indicating more scope for financial development as the middle class starts to emerge in sub-Saharan African countries.
  • International trade integration, measured by the share of total exports and imports of goods and services in GDP, positively affects financial development in developing countries. Contrasting the theory of financial development by Rajan and Zingales (2003), however, the effect almost disappears in sub-Saharan Africa.
  • Similarly, international financial integration, measured by the share of international assets and liabilities as a share of GDP that reflects a country’s de facto degree of capital account openness, positively affects financial development in developing countries—more in sub-Saharan African countries.
  • Lower country risk appears to be conducive to financial development in developing countries, with a diminished effect in sub-Saharan Africa. This finding might suggest that financial market participants demand a higher risk premium in sub-Saharan African countries, even for the same risk rating. As a result, further institutional reform to address country-specific bottlenecks in financial market information infrastructure can further stimulate financial development.

Weak Institutional Quality Inhibiting Financial Development

While we confirm above that macroeconomic fundamentals are the main drivers of financial development in the region, the level of financial development stays below the benchmark in many sub-Saharan African countries (as discussed in chapter 1). Although we find a diminished effect of institutional quality on financial development compared with other developing countries, recent studies suggested that institutional quality is one of the leading explanations.

We therefore examine the relationship between some key institutional quality measures and the overall financial development level using recent data. The results in Figure 8 highlight that some types of institutional indicators, such as judicial independence and strength of investor protection, are associated with financial development, suggesting that improving institutional quality helps countries catch up in financial development. However, other factors also play a role. For example, some of the oil exporters (Angola, Nigeria) outperform the benchmarks as inflows of oil revenues into the financial system may have induced financial development despite relatively weak institutional quality.

Figure 8.Sub-Saharan Africa: Financial Development and Institutional Quality in 2013

Source: IMF staff estimates.

Note: CEMAC = Economic and Monetary Community of Central Africa; WAEMU = West African Economic and Monetary Union; AGO = Angola, BEN = Benin, KEN = Kenya, MUS = Mauritius, NAM = Namibia, RWA = Rwanda, SEN = Senegal, ZAF = South Africa.

Some Institutions Seem to Matter More Than Others

Sub-Saharan African countries could reap the benefits by focusing on improving legal frameworks and corporate governance. To assess why some countries are facing larger gaps in financial development relative to the benchmark, we assess whether institutional quality can explain countries’ distance to the financial benchmark level. The results highlight that overall institutional quality appears to be only weakly related to the degree of underdevelopment (Figure 9).11 While the overall level of institutions may not be strongly associated with the distance to the benchmark, specific aspects of institutional quality may matter for the degree of financial underdevelopment.

Figure 9.Sub-Saharan Africa: Distance to the Benchmark and Institutional Quality1

1 The distance and institutional quality are the average in the period of 2011 and 2013.

Source: IMF staff estimates.

To test for this hypothesis and to derive more specific policy implications, we analyze the effect of different institutional indicators in more detail.12 The results reveal that many indicators of institutional quality can help reduce the degree of underdevelopment (that is, the distance to the benchmark) (Table 4). In particular, they suggest that sub-Saharan African countries could reduce the degree of financial underdevelopment by improving legal frameworks and corporate governance.

Table 4.Sub-Saharan Africa: Top Ranking of Coefficients between the Distance to the Benchmark and Detailed Institutional Quality
Coefficient with
the distance to theRanking of
Detailed institutional qualitybenchmarkR-squared1/coefficient
Protection of minority shareholders’ interests0.0614 **0.1531
Strength of auditing and reporting standards0.0468 **0.1582
Efficiency of legal framework in challenging regs.0.04240.0733
Efficiency of legal framework in settling disputes0.04000.0794
Transparency of government policymaking0.03850.0445
Efficacy of corporate boards0.03790.0406
Property rights0.03460.0727
Judicial independence0.0343 **0.1198
Intellectual property protection0.03260.0649
Irregular payments and bribes0.03260.0799
Ethical behavior of firms0.03090.03211
Strength of investor protection0.0251 *0.11812
Source: IMF staff estimates.

Coefficients are ranked from high to low, as higher coefficients help to improve financial development in a more efficient way. *** p < 0.01, ** p < 0.05, * p < 0.1.

Source: IMF staff estimates.

Coefficients are ranked from high to low, as higher coefficients help to improve financial development in a more efficient way. *** p < 0.01, ** p < 0.05, * p < 0.1.

More specifically, in the area of legal frameworks, protecting minority shareholders’ interests and strengthening judicial independence and investor protection are important for achieving a country’s benchmark level of financial development. In the area of corporate governance, strengthening of auditing and reporting standards appears essential, and individual country studies support this finding. For example, Cui, Dieterich, and Maino (2016) and Newiak and Awad (2015) find that specific constraints in financial market infrastructure, such as high collateral requirements and the lack of property registry, have impeded financial deepening and inclusion in West Africa. Drawing on the above findings, the next section presents the opportunities related to Islamic finance.

Increasing the Potential of Islamic Finance

The previous section shows that some aspects of institutional weaknesses appear to be a stumbling block for sub-Saharan Africa’s financial development. In this context, Islamic finance is attracting increasing attention as a potential way to help mitigate the institutional barriers and promote financial development in the region.

In simple terms, Islamic finance refers to the provision of financial services in line with Islamic ethical principles and law (Shari’ah). Accordingly, Islamic financial products are geared to financing productive and job-creating activities, excluding activities that are deemed harmful to society, such as through excessive uncertainty. Islamic financial products can be classified in three main categories: (1) debt-like financing in the form of sales or deferred payments, (2) equity-like financing in the form of profit-and-loss sharing, and (3) financial services.13

Over the past two decades, the share of Islamic finance has remained low in sub-Saharan Africa. Islamic financial products took up only about 15 percent of total financial assets in sub-Saharan Africa at the end of 2014, and the region accounts for only 1 percent of global Islamic finance assets (Figure 10). The relatively small size of Islamic finance compared with conventional finance points to great growth potential. Moreover, it appears that there is a negative correlation between financial inclusion and the size of the Muslim population (Figure 11). In this context, Islamic finance is particularly expected to increase access to financial services for Muslim populations currently underserviced by conventional finance—only 24 percent of Muslims have a bank account compared with 44 percent for non-Muslims (Demirguc-Kunt, Klapper, and Randall 2013).

Figure 10.Sub-Saharan Africa: Breakdown of Islamic Finance Assets

(Percent of total assets, end-2014)

Source: Islamic Financial Services Industry Stability Report 2015.

Figure 11:Access to Financial Services

Source: World Bank (2014b) Global Findex 2014; and Pew Research Center.

Recent empirical work indicates that Islamic banking is conducive to economic growth and financial inclusion in low- and middle-income countries, including in sub-Saharan Africa (Imam and Kpodar 2015; Kammer and others 2015). The Islamic finance principles of risk-sharing and asset-based financing (that is, the strong link of credit to collateral) are considered to help promoting macroeconomic and financial stability through better risk management by both financial institutions and their customers. Particularly, Sukuks, the Islamic bonds that are structurally similar to asset-backed securities, are considered to be well-suited for infrastructure financing, thereby supporting long-term growth and economic development.14 Islamic finance principles are also considered to serve SME financing well, thereby promoting inclusive growth.

Nonetheless, Islamic finance poses particular challenges in terms of regulation, supervision, and monetary policy owing to the specific feature of its transactions. For example, the regulation and supervision frameworks should take into consideration Islamic finance specificities such as profit-sharing investment accounts and Shari’ah governance.

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