IV Financial Market Challenges and Economic Performance in Developing Countries

International Monetary Fund. Research Dept.

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Author: International Monetary Fund. Research Dept.

Language:: English

Keywords:: WEO; transition country; output gap; rising prices; rate of inflation; foreign direct investment; monetary policy; market; exchange market pressure; emerging market country; nominal exchange rate; spot market; market institution; Commercial banks; Capital inflows; Africa; Asia and Pacific

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Abstract

The sustained improvement in economic performance of the developing world as a whole in recent years has been marked by significant divergences among countries. For the strong performers, macroeconomic stability and market-oriented structural reforms, including more open trade and payments regimes, have laid the basis for substantial increases in their shares of world trade and income and for greater access to international capital markets. Among the factors highlighted by the experience of these successful countries is the importance of sound financial systems in mobilizing and allocating both domestic and foreign financial resources.

Large inflows of foreign capital have reflected the confidence of international investors in the underlying improvements in economic policies in many emerging market countries. While capital inflows have contributed to the financing of investment and helped to enhance longer-term growth prospects and living standards in most of the recipient countries, the increasing globalization of financial markets also underscores the need to maintain macroeconomic and financial stability—as illustrated by the Mexican crisis and recent problems in banking systems in a number of countries. These banking sector difficulties, which have been exposed in some emerging market countries by a reversal of capital flows, have made apparent the importance of avoiding the buildup of macroeconomic imbalances and of strengthening the domestic financial system. Not only is macroeconomic discipline essential to prevent unsustainable current account deficits, but also strengthened prudential supervision and regulation of financial systems, and improvements in payment systems are essential to sustain capital inflows and safeguard financial stability.

A variety of factors have contributed to the weak economic performance of the developing countries that have thus far lagged behind the strong performers, including in some cases unfavorable external conditions. A number of these impediments have been highlighted in past issues of the World Economic Outlook, including most recently fiscal problems. However, these countries generally share with the better performers the need to strengthen domestic financial systems, both to promote the mobilization and efficient allocation of domestic saving and investment and as a prerequisite for the successful liberalization of restrictions on cross-border financial flows. This chapter highlights the important role of the domestic banking system in financial intermediation and the allocation of financial resources. It also refers to the role of large external debt burdens in impairing economic performance among the highly indebted poor countries.

Challenges of Capital Market Integration

The substantial increase in net private capital flows to developing countries since the late 1980s has been distributed very unevenly in absolute terms among different countries and regions, but much less so when account is taken of differences in economic size. Thus the bulk of private capital flows has been directed to countries in Asia and the Western Hemisphere, with most of these flows being in the form of direct and portfolio investment (Chart 22). Meanwhile, capital flows to most countries in Africa and to the Middle East and Europe region have remained largely official, with some important exceptions: countries such as Egypt, Turkey, and, more recently, South Africa, have received large private flows. But in relation to GDP (or exports) the distribution of private flows is less uneven.

Again, the surge in private capital flows in recent years has been directed mainly at the so-called emerging market countries, partly reflecting their economic size. During 1990–95, 21 emerging market countries—mainly in Asia and Latin America—received over 65 percent of net private capital flows to developing countries, but these countries account for over 75 percent of both developing country GDP and total developing country exports. Although there are significant variations in the composition of private flows to these countries—the fast-growing east Asian economies account for an even larger share of foreign direct investment flows than of other flows—most countries in this group have relatively large stock and bond markets that are open to foreign investors and attract portfolio inflows. Moreover, a large number of equity and bond issues by domestic corporations in these countries are actively traded in international financial markets. Since 1993, emerging market countries’ bond and equity placements in the financial markets of the major industrial countries have averaged well over $60 billion a year, which amounts to over 30 percent of their total (gross) capital inflows.

The increasing globalization of financial markets has been spurred by the liberalization of financial markets in both source and recipient countries. In recent years, many developing countries have not only removed restrictions on payments for current account transactions—see Chart 23—but have also lifted controls on cross-border financial flows, especially controls on foreign inflows.²⁴ In fact, by the end of 1995 about 35 developing countries had fully opened their capital accounts. And although many countries still retain some restrictions on capital account transactions, the magnitude of gross capital flows, particularly to the emerging market countries, shows a substantial increase in the openness of developing countries to both current and capital account transactions (Chart 24). Greater openness of these financial markets, and the associated decline in transactions costs, has allowed industrial country investors to diversify their investment portfolios, enabling them not only to share in the relatively high returns offered on many emerging stock markets but also to reduce their portfolio risk by taking advantage of the relatively low correlation between returns in emerging markets and industrial countries.²⁵

Although external financial liberalization and the increased openness of domestic financial markets have contributed to greater capital market integration, the recent pattern of growth in capital flows has undoubtedly been influenced by the pattern of improvements in underlying economic fundamentals. A number of emerging market countries, especially the east Asian and some Latin American countries, such as Chile, have long track records of maintaining macroeconomic stability and pursuing structural policies that promote efficiency and growth, including outward-oriented trade policies. The liberalization of trade and exchange systems and structural reforms to promote private sector activity have resulted in strong expansion of exports and have helped to sustain rapid output growth in most emerging market countries. Capital flows to these countries seem likely to be sustained at relatively high levels in the medium term, given the prospect of their continuing rapid economic growth, associated high rates of return on foreign direct investment and portfolio equity investment flows, and their rising shares of world output.

The increased scale of private capital flows has eased the financing constraints on recipient countries and increased the potential payoffs to them from sound policies. At the same time, given the volatility of portfolio investment flows, it has also increased the need for caution and self-discipline in macroeconomic policy. The Mexican financial crisis provided a strong reminder of the potential for sudden changes in financial markets’ assessments of a country’s economic policies and prospects. It also illustrated the risk of contagion, particularly to countries relying extensively on foreign saving. To reduce these risks, it is essential for countries to ensure, in particular, that large capital inflows do not substitute for domestic saving, and that they do not give rise to excessive demand pressures and overheating. Recent financial crises have also exposed weaknesses in domestic financial systems in several countries. Indeed, in some countries high interest rates on bank deposits associated with weaknesses in banking systems have contributed to unsustainable capital inflows. A key challenge for policymakers in the emerging market countries will be to reduce their vulnerability to volatile capital flows and to ensure that weaknesses in the financial sector do not limit the ability of authorities to pursue macroeconomic policies needed to safeguard monetary stability.

Maintaining Macroeconomic Stability

Large net private capital inflows have tended to reduce domestic interest rates, raise aggregate expenditures, increase inflationary pressures, and widen current account deficits in all the major recipient countries. These consequences are attributable in part to exchange market policies that have attempted—with varying degrees of success—to limit the nominal appreciation of domestic currencies because of concern about the adverse effects of real exchange rate appreciations on external competitiveness. These pressures and concerns have presented many recipient countries with similar policy dilemmas. There have been marked differences in macroeconomic performance across the emerging market countries, however, especially between the major recipient countries in Asia and Latin America (Table 16). Although increased inflows of private capital have been associated with widening current account deficits in most recipient countries, the domestic counterparts of larger current account deficits—in terms of movements in private consumption, investment, and fiscal deficits—have developed differently. In Asia, the ratio of private consumption expenditure to GDP declined by almost 3 percentage points between the second half of the 1980s and the first half of the 1990s, while the ratio of private investment expenditure to GDP increased by over 3 percentage points. In most Latin American countries, by contrast, the share of consumption expenditure has increased by close to 3 percentage points of GDP in the 1990s while private investment has remained broadly similar to the level in 1986–90.

Table 16.

Selected Emerging Market Countries: Macroeconomic Indicators

(Annual averages, in percent of GDP unless otherwise noted)

^¹Argentina, Brazil, Chile, Colombia, Hong Kong, India, Indonesia, Israel, Korea, Malaysia, Mexico, Pakistan, Peru, the Philippines, South Africa, Thailand, Turkey, and Venezuela, China, Singapore, and Taiwan Province of China are excluded because of their large current account surpluses in the 1991–95 period.

^²For Indonesia, data for private saving are only available from 1988 onward. The data reported for 1986–90 are for 1988–90.

^³Annual percent change.

Table 16.

Selected Emerging Market Countries: Macroeconomic Indicators

(Annual averages, in percent of GDP unless otherwise noted)

	1986–90	1991–95
Selected emerging market countries¹
Net private capital flows	0.8	3.2
Current account balance	−0.8	−2.2
Central government fiscal balance	−4.2	−1.9
Private consumption	63.1	62.9
Private saving²	20.2	18.9
Private investment	16.9	18.5
Total saving	22.9	23.1
Total investment	23.7	25.5
Real GDP³	4.9	4.6
Consumer prices (median)³	15.7	12.1
Real effective exchange rate³	–1.6	0.1
Selected Asian emerging market countries
Net private capital flows	1.6	3.5
Current account balance	−1.2	−2.4
Central government fiscal balance	−4.4	−2.5
Private consumption	61.2	58.8
Private saving²	21.9	22.1
Private investment	17.6	21.0
Total saving	24.9	27.2
Total investment	26.2	29.7
Real GDP³	7.2	6.1
Consumer prices (median)³	6.0	8.7
Real effective exchange rate³	–6.5	–1.7
Selected Latin American emerging market countries
Net private capital flows	0.3	3.2
Current account balance	−0.6	−2.3
Central government fiscal balance	−4.1	−0.3
Private consumption	65.1	67.8
Private saving	16.9	14.0
Private investment	16.4	16.2
Total saving	20.7	18.2
Total investment	21.1	20.4
Real GDP³	2.2	2.9
Consumer prices (median)³	80.6	25.5
Real effective exchange rate³	2.6	2.2

^²For Indonesia, data for private saving are only available from 1988 onward. The data reported for 1986–90 are for 1988–90.

^³Annual percent change.

Table 16.

Selected Emerging Market Countries: Macroeconomic Indicators

(Annual averages, in percent of GDP unless otherwise noted)

	1986–90	1991–95
Selected emerging market countries¹
Net private capital flows	0.8	3.2
Current account balance	−0.8	−2.2
Central government fiscal balance	−4.2	−1.9
Private consumption	63.1	62.9
Private saving²	20.2	18.9
Private investment	16.9	18.5
Total saving	22.9	23.1
Total investment	23.7	25.5
Real GDP³	4.9	4.6
Consumer prices (median)³	15.7	12.1
Real effective exchange rate³	–1.6	0.1
Selected Asian emerging market countries
Net private capital flows	1.6	3.5
Current account balance	−1.2	−2.4
Central government fiscal balance	−4.4	−2.5
Private consumption	61.2	58.8
Private saving²	21.9	22.1
Private investment	17.6	21.0
Total saving	24.9	27.2
Total investment	26.2	29.7
Real GDP³	7.2	6.1
Consumer prices (median)³	6.0	8.7
Real effective exchange rate³	–6.5	–1.7
Selected Latin American emerging market countries
Net private capital flows	0.3	3.2
Current account balance	−0.6	−2.3
Central government fiscal balance	−4.1	−0.3
Private consumption	65.1	67.8
Private saving	16.9	14.0
Private investment	16.4	16.2
Total saving	20.7	18.2
Total investment	21.1	20.4
Real GDP³	2.2	2.9
Consumer prices (median)³	80.6	25.5
Real effective exchange rate³	2.6	2.2

^²For Indonesia, data for private saving are only available from 1988 onward. The data reported for 1986–90 are for 1988–90.

^³Annual percent change.

Differences in the split between consumption and investment expenditure mirror markedly different national saving patterns. Countries characterized by relatively high public sector saving, such as Chile, Korea, Malaysia, Singapore, and Thailand, have also managed to sustain very high private saving rates. By contrast, in countries where fiscal performance has been weak, such as Brazil, Colombia, Peru, South Africa, and Turkey, private saving rates have remained relatively low. Even if public sector dissaving has a positive effect on private saving—for example, through Ricardian effects, whereby the private sector anticipates future tax liabilities—the offset is unlikely to be more than partial.²⁶ Countries with large fiscal deficits therefore tend to be characterized by low national saving, and in these cases capital inflows may be attracted primarily because of relatively high interest rates; in such circumstances, there will also be a greater risk of sudden reversals. Although many emerging market countries found that they needed to tighten policies in the immediate aftermath of the Mexican crisis, the repercussions were felt most strongly in such countries as Argentina and, to a lesser extent Brazil, where fiscal imbalances had not been addressed forcefully or prospects of sustained adjustment and reform policies were uncertain.

Despite the widespread spillover effects of the Mexican crisis, especially the sharp slowdown in portfolio investment flows to other Latin American countries, capital flows to most emerging market countries recovered strongly during the latter half of 1995 and fears of a prolonged financial crisis in emerging markets subsided. However, the sustained increase in capital inflows has renewed concerns that they may exacerbate domestic demand pressures and increase the risk of overheating—as in the early 1990s. Avoiding the buildup of inflationary pressures is important for a number of reasons. Once actual inflation picks up, expectations of future inflation may rise correspondingly, increasing the output costs of disinflationary policies. In addition, evidence on the inverse relationship between economic growth and inflation suggests that the adverse effects of inflation can be significant even at relatively low inflation rates.²⁷ Widening current account deficits in some emerging market countries, and concerns about the sustainability of such deficits, may also increase the vulnerability of these countries to adverse external developments.

In most of the fast-growing emerging market countries in Asia, the emergence of overheating pressures suggests that economic performance in the medium term will depend both on prudent demand management policies and on further structural reforms and improvements in infrastructure to increase potential output. Estimates of potential output, although subject to wide margins of uncertainty, especially for the rapidly growing emerging market countries, provide a useful benchmark for assessing the sustainable rate of growth, while measures of the output gap—the difference between actual and potential output—are helpful in assessing inflationary pressures. There has been little empirical work on estimating potential output in developing countries, in part because data limitations on the underlying determinants of output—especially the capital stock, but also the labor supply—make it difficult to estimate formal production functions. Moreover, statistical techniques for estimating trend output growth cannot fully capture the effects of the rapid structural changes occurring in many developing countries. Nevertheless, recent estimates for emerging market countries based on longer-run trends in output suggest that whereas a number of countries had excess capacity—that is, negative output gaps—in the mid- to late 1980s, margins of slack have by and large been absorbed and that output has recently been growing very close to, or above, trend output (Box 3). Evidence of overheating based on estimates of the output gap may not always be conclusive, but it appears to be broadly consistent with increases in inflation and widening current account deficits in some emerging market countries (Chart 25).

Thus, in Indonesia, Malaysia, and Thailand, current account deficits have recently widened to levels that are relatively high by their historical standards. In 1995, the current account deficit in Malaysia, at about 9 percent of GDP, was about double the level in 1993, while Thailand’s current account deficit of over 8 percent of GDP compares with an average of just over 5 percent of GDP in the previous three years. Recent growth of demand also reflects growing shares of consumption and expenditures related to real estate, while structural bottlenecks have contributed to tighter labor markets, especially for skilled labor in the higher value-added industries, and put upward pressure on wages. In some Latin American countries, such as Argentina and Mexico, domestic demand contracted sharply following the slowdown in capital flows and the implementation of adjustment policies, but overheating remains a concern in countries such as Colombia.

Large-scale capital inflows have clearly complicated economic policy management in the recipient countries, but there are few hard and fast rules about how policymakers should react to such flows. The appropriate policy response depends on a number of factors, including the causes of the inflows—whether they are largely driven by external factors or by domestic fundamentals; if, for example, capital inflows are associated with an autonomous increase in the demand for money, the expansion of the domestic money supply will not be inflationary and in this case the inflows should be accommodated. The appropriate policy response may also depend on the composition of the inflows—whether they largely comprise portfolio flows or other flows that are easily reversible or debt creating—and on the capacity of domestic financial institutions to intermediate large foreign inflows.²⁸ The potential inflationary impact of capital inflows will also depend importantly on the exchange rate regime in the recipient country and the extent to which monetary authorities are able to sterilize the effect of the capital inflows on domestic liquidity: with a flexible exchange rate, large capital inflows should not give rise to any inflationary pressure but are likely to lead to an appreciation of the real exchange rate.

Box 3.

Assessing Overheating in Emerging Market Countries

In many of the emerging market countries that have managed to sustain rapid growth and a strong pace of industrialization over the past decade, buoyancy of demand has often exceeded the underlying expansion in the supply capacity, or potential output, of the economy and given rise to periodic bouts of overheating, with rising inflation, widening current account deficits, and other symptoms. Estimates of potential output and the implied output gap—the difference between actual output and potential output—can provide a useful indicator of the cyclical position of an economy and of emerging inflationary pressures. Although any empirical relationship between inflation and output gaps cannot by itself provide a model for explaining or forecasting inflation, evidence from industrial countries suggests that inflation typically rises when actual output is above potential output—so that the output gap is positive—and falls when the output gap is negative. There have been relatively few empirical studies providing estimates of output gaps for developing countries. For the emerging market countries, however, including the fast-growing Asian countries, some recent results suggest that these countries are subject to business cycles that may not be too dissimilar from cyclical fluctuations in industrial countries.¹

Potential output is the level of output at which an economy is operating close to its supply capacity and therefore the level at which increases in demand would tend to increase inflationary pressures. There are a number of different approaches to estimating potential output. A structural approach, involving the estimation of an aggregate production function relating output to capital and labor inputs, has the advantage of explicitly identifying the sources of output growth. In practice, however, data on both the capital stock and the labor supply are not readily available in most emerging market countries. An alternative approach is to use statistical smoothing techniques to approximate potential output as the trend in actual output. Although estimates of output gaps based on trend-fitting techniques are sensitive to the smoothing criteria and observations at the beginning and end of the sample period, trend estimates for many industrial countries have been found to be not markedly different from estimates based on production functions.

To provide an indication of current output gaps and thereby gauge the extent of overheating in some emerging market countries, the IMF staff has estimated trend output using the Hodrick-Prescott filter.² The technique estimates the trend component of movements in actual output. Thus one drawback of the technique is that the transitory nature of the impact on output of temporary supply shocks, such as droughts and changes in the terms of trade, are not fully captured by these estimates.

The results of the exercise suggest that, for most Asian countries, output gaps in recent years have been around ±3 percent of potential output. Among the Latin American countries, output fluctuations have been somewhat larger, with the output gap typically fluctuating in the ±5 percent range.³ In comparison with industrial countries the volatility of output appears to be considerably larger in many emerging market countries.

Econometric estimates by the IMF staff suggest that these estimates of the output gap have significant leading indicator properties for inflation in some emerging market countries (see chart above). Although the estimated impact of the output gap varies markedly among countries, current and lagged values of the output gap are in many cases strongly related to the deviation of current inflation from its expected value, with expected future inflation proxied by either past inflation or trend inflation. The estimates suggest that a positive output gap tends to be associated with a rise in inflation, while a negative output gap tends to reduce inflation.

The output gap estimates appear to provide relatively good indicators of future inflation for some Asian emerging market countries and also for Mexico. In China, Indonesia, Malaysia, and Thailand, the difference between current inflation and the trend of inflation is strongly correlated with the output gap, whereas in Korea, Mexico, the Philippines, and Taiwan Province of China, there is a more significant relationship between the output gap and the difference between current and past inflation rates. Although the dynamics of how changes in current and lagged output gaps affect inflation differ markedly among these countries—on average, the output gap affects inflation with a lag of about one year—the cumulative effects of output gaps on inflation are all significantly positive. It is also notable that inflation is influenced by changes in the output gap as well as its level. The speed at which output gaps are closed therefore also appears to affect inflation. Although these relationships cannot be used directly to forecast inflation, because it is also influenced by many other variables, including country-specific factors, these estimates nevertheless suggest that the output gap could be an important variable in a more complete model of the inflation process.

In contrast to the experience of the Asian countries, in most of the Latin American countries neither current nor lagged output gaps show any significant correlation with inflation using either of the two measures of expected inflation. Changes in monetary aggregates, however, play a significant role in explaining movements in the rate of inflation in most of these countries: adding current and lagged observations of the change in narrow money was found to increase the explanatory power of the regressions, but the correlations with output gaps remained insignificant.

See, for example, David T. Coe and C. John McDermott, “Does the Gap Model Work in Asia?” IMF Working Paper 96/69 (July 1996).

For further details of this approach, see Finn E. Kydland and Edward C. Prescott, “Business Cycles: Real Facts and a Monetary Myth,” in The Rational Expectations Revolution: Readings from the Front Line, ed. by Preston J. Miller (Cambridge, Massachusetts: MIT Press, 1994).

Output gaps are estimated using annual data for the following 19 emerging market countries; Argentina, Brazil, Chile, China, Colombia, India, Indonesia, Jordan, Korea, Malaysia, Mexico, Pakistan, Peru, the Philippines, South Africa, Taiwan Province of China, Thailand, Turkey, and Venezuela, However, for some of these countries, such as Brazil, Pakistan, Peru, and South Africa, the output gaps do not appear to be related to movements in inflation.

Under a fixed exchange rate, capital inflows will tend to increase domestic demand and raise domestic prices, thereby also leading to a real exchange rate appreciation. Improvements in fiscal positions—including in some countries, the establishment of fiscal surpluses, though these may be difficult to justify over long periods—would help to reduce demand pressures and also reduce the risk of abrupt reversals of capital flows. In some circumstances, controls on capital inflows, especially restrictions on portfolio investment inflows, may help to prevent excessive increases in liquidity, but such controls are unlikely to be effective over the long term. In any case, capital controls cannot be a substitute for addressing macroeconomic imbalances. In fact, the liberalization of restrictions on capital outflows, and other measures to liberalize the exchange and trade system, are likely to be more effective in reducing pressures arising from capital inflows.

In practice, the macroeconomic policy response to large capital inflows and overheating has typically consisted largely of monetary tightening, in part because fiscal policy instruments are not sufficiently flexible to be used for short-run macroeconomic management. However, higher interest rates associated with monetary tightening may only increase capital inflows further. A more appropriate way of stemming excess demand pressures would be to improve the underlying fiscal position, particularly in countries with large public sector deficits, such as India, Pakistan, South Africa, Turkey, and Venezuela. The policy dilemma is perhaps more challenging in countries that have avoided large fiscal deficits and are still faced with overheating pressures. For example, in Chile, Korea, Malaysia, and Thailand, where governments have long track records of prudent fiscal management, supported in some cases by balanced budget rules, fiscal policy has generally not been used as an instrument of countercyclical demand management. Recent policy responses to overheating in these countries have consisted mainly of monetary tightening, with interest rate increases supplemented in some countries by direct measures to limit credit growth or capital inflows. Monetary tightening, however, has not helped to reduce domestic absorption sufficiently to prevent current account deficits from widening further in many of these countries. This suggests that fiscal tightening—even to the extent of running larger structural fiscal surpluses in some cases—would be a more appropriate policy response. It would take upward pressure off interest rates—thereby helping to limit certain types of capital flows—and at the same time act to reduce the current account deficit.

Large capital inflows have often been attracted by the high returns on investment associated with rapid industrialization and sustained productivity gains, and by expectations that recipient countries’ real exchange rates will appreciate in the medium to longer run. Concerns about the sustainability of real exchange rate appreciations and external competitiveness have led a number of Asian emerging market countries to maintain relatively stable nominal exchange rates, especially vis-à-vis the U.S. dollar, although this has not prevented their nominal effective exchange rates from fluctuating—indeed from rising significantly since early 1995 as the dollar has risen against the yen. Furthermore, resistance to nominal exchange rate appreciation may not help to limit real exchange rate appreciation beyond the short term, since the domestic monetary expansion that tends to result from capital inflows when the exchange rate is fixed will put upward pressure on domestic prices. There is also little evidence that the recent widening of current account deficits in the Asian emerging market countries reflects a deterioration in external competitiveness, especially since their export growth has generally remained buoyant.

The Soundness of Banking Systems

The increasing openness of developing country financial markets and the large increase in foreign inflows intermediated through domestic banks have underscored the importance of banking and financial system soundness for maintaining financial and macroeconomic stability in these countries.²⁹ Weaknesses in the banking system, which is the predominant source of finance in most developing countries, are not only costly because of their wider repercussions on the real sector, but they also impair the effectiveness of monetary policy. Thus, when macroeconomic stabilization or the need to preserve external confidence calls for monetary policy to be tightened, concern about the effect of higher interest rates and reduced liquidity on the cost of funds and the loan portfolios of weak banks may delay—and be expected to delay—policy action, and thereby exacerbate the risk of sudden reversals of capital flows, which may precipitate a more serious banking crisis. Indeed, banking crises have often occurred following periods of rapid expansion in economic activity and the associated emergence of macroeconomic imbalances.

The effects of banking sector difficulties in developing countries can be particularly pervasive because their financial systems tend to be dominated by banks to a larger extent than in industrial countries. Despite the substantial growth of equity and securities markets in many emerging market countries, the proportion of financial intermediation conducted via the banking system remains high: in most Asian and Latin American countries, banks account for over 80 percent of financial intermediation. Weaknesses in the banking system, such as a high proportion of nonperforming loans and relatively high operating costs, impede efficient allocation of credit and reduce the ability of the banking system to mobilize saving. Inefficiencies in the banking sector also tend to widen the spreads between deposit and lending rates, and thereby reduce the level of investment. A common element of recent banking problems in a number of countries has been a marked widening of bank spreads, which in some countries, such as Brazil, Mexico, and Turkey, has entailed sharp rises in real lending rates. These can trigger large-scale liquidity problems for the private sector and thus depress economic activity. During the 1994 financial crisis in Turkey, high real interest rates were a key factor contributing to the severity of the economic downturn.

A fragile banking system may also magnify the amplitude of business cycles. Banks that face capital shortages and have inadequate reserves to cover non-performing loans may be forced to call other loans or sell assets and collateral in declining markets, further exacerbating a cyclical downturn. Moreover, even in countries where the ill health of the banking system is not the main factor precipitating a financial crisis, a weak banking system may contribute to or prolong a financial crisis and jeopardize economic recovery. Following the Mexican crisis, financial sector weaknesses appeared in other Latin American countries, such as Argentina, and the associated actual and potential fiscal costs have been important factors holding back recovery.

Because a fragile banking sector is vulnerable to higher interest rates, central banks in a number of countries have been faced with a trade-off between containing inflationary pressures and averting a widespread banking crisis, and often monetary policy actions (or inaction) have been motivated by banking sector concerns. During the Venezuelan banking crisis in 1994, the central bank expanded liquidity to assist domestic banks despite rapid inflation and large foreign exchange reserve losses. In the face of persistent exchange market pressures, the government sought refuge in a reintroduction of exchange controls, before adopting more recently a comprehensive adjustment and reform program supported by the IMF. Similarly, concern about the adverse effects of higher interest rates on banking sector losses may have contributed to the Mexican authorities’ reluctance during most of 1994 to raise interest rates more sharply to stem exchange market pressures.³⁰

In countries where the monetary authorities are concerned about protecting weak banks, the operation of monetary policy may be asymmetric: central banks may be more reluctant to tighten policy than to ease monetary conditions. In these countries, it may appear preferable for central banks to curb credit growth in the economy through moral suasion and direct controls on bank lending until the underlying weaknesses in the banking system are resolved. In some cases, direct controls may be necessary in the short term because domestic markets for treasury bills and other central bank securities are relatively small compared with the liquidity surges associated with inflows of foreign capital. Direct controls on bank lending, however, lose their effectiveness over the longer term: in countries where they have been applied, controls on banks have increased disintermediation and spurred the growth of nonbank credit and financial institutions.

Most major banking crises have been preceded by a deterioration in macroeconomic imbalances and in some cases, inadequate policy responses to macroeconomic shocks. But conversely, the effects of macroeconomic shocks have in many countries been exacerbated by structural weaknesses in the banking system. In many Latin American countries, banking crises in the 1980s and early 1990s were preceded by strong expansions in economic activity and bank lending. The quality of bank assets usually deteriorated in these cases as lending expanded rapidly, but this was not apparent until activity subsequently turned down.³¹ Adverse economic developments, such as a major recession, a decline in the terms of trade, or a sharp change in relative prices, will affect both assets and liabilities of banks. A sharp decline in the demand for bank deposits was a key factor in the recent banking crisis in Venezuela. Moreover, not only can macroeconomic imbalances trigger a banking crisis, but also the fiscal burden of supporting problem banks and resolving systemic weakness can lead to a further deterioration in macroeconomic imbalances: in Venezuela, the fiscal cost of the recent banking crisis is estimated to have amounted to over 15 percent of GDP already. A key policy lesson that is suggested by the banking sector problems experienced in Venezuela, as well as in other Latin American countries, such as Argentina and Brazil, is the importance of maintaining macroeconomic stability to limit the risks of systemic problems.

Disinflationary policies can also expose underlying weaknesses in bank balance sheets and thereby trigger banking crises. In some cases, banks may experience difficulties during the transition to a low inflation environment because interest rates that banks pay to obtain funds may rise more during a monetary contraction than the yields on bank assets, partly because banks may be hesitant to pass on interest rate increases to their borrowers to ease repayment difficulties. Policymakers can help to moderate such adjustment difficulties by avoiding sharp monetary contractions that entail steep rises in interest rates. The trade-off between macroeconomic stabilization and the avoidance of banking sector crises may therefore be a particularly acute dilemma in countries where banks were previously accustomed to operating in a high-inflation environment. Banks’ income in high-inflation countries is often derived from indexed lending rates, from relatively large transitory balances stemming from the incentive for banks to delay payments, from foreign exchange speculation, and from the inflation tax on underremunerated demand deposits. A decline in inflation will deprive banks of such inflation-dependent income, as well as expose fundamental weaknesses in bank portfolios. For example, banks in Brazil experienced sharp declines in income derived from the inflation tax during the successful implementation of the currency stabilization plan in 1994–95.

In most emerging market countries, the liberalization of financial markets and domestic institutions’ access to international capital markets are relatively recent phenomena. Deregulation, including more liberal regimes of bank licensing, has promoted competition, efficiency, and lower transactions costs in the financial sector partly by permitting banks to engage in new areas of banking business. But deregulation has also in many cases led to greater exposure to credit and foreign exchange risks, and increased the danger of banks being inadequately capitalized or poorly managed, with strong incentives to offer above-market interest rates to attract resources and engage in riskier loans. In most countries, prudential regulation and supervision capabilities have not kept pace with the increasing complexities of banking business. In some emerging market countries, capital adequacy requirements are set at levels no higher than those in industrial countries, despite greater riskiness of asset portfolios and substantially higher proportions of problem loans. Effective capital adequacy standards also require a comprehensive evaluation of bank assets to ensure that solvency problems are not concealed by poor accounting practices, such as inadequate provisioning for problem loans and the accrual of interest on nonperforming loans.

Strengthening prudential regulation and supervision is particularly important for the effective monitoring and control of the foreign exchange exposures of domestic financial institutions in countries that have liberalized capital account transactions. With freer access to international capital markets, and lower foreign interest rates, there may be a strong incentive for domestic enterprises to finance their activities through foreign currency borrowing, including from domestic banks. Such foreign exchange exposure, however, can exacerbate banking system difficulties if the domestic currency depreciates, since this would impair the ability of some borrowers to repay loans. In the recent Mexican crisis, the large volume of foreign-currency-denominated financial liabilities of domestic corporations—far in excess of their foreign currency earnings—contributed to the scale of the subsequent banking crisis. These episodes underscore the importance of prudential regulation and the effective monitoring of foreign exchange exposures, including those of nonfinancial domestic enterprises, when there are no restrictions on capital account transactions.

Financial System Requirements in Countries Lagging Behind

Many developing countries lagging behind the emerging market countries have improved their economic performance markedly in recent years on the basis of strong adjustment and reform programs. These include a number of countries in Africa where, after long periods of declining living standards, per capita income growth has been positive in recent years.³² Nevertheless, a large number of developing countries, including those that have achieved economic success in many respects, have seen little of the recent surge in capital flows to the developing world, especially of the foreign direct investment flows that have enabled recipient countries to access industrial country technologies and thereby improve productivity (Chart 26). This is partly a reflection of policy inadequacies: in particular, even though there have been widespread improvements in macroeconomic policies that have helped to reduce fiscal imbalances and inflation, structural reforms have in many cases not been sufficiently far reaching. Recent issues of the World Economic Outlook have focused extensively on the need for further structural reforms in product markets as well as in the public sector, where there is need for greater transparency in the operation of fiscal policy in most countries. Economic performance in many countries continues to be impaired by weaknesses in the financial sector, despite extensive liberalization efforts. While controls on domestic interest rates have been lifted in many developing countries, domestic financial institutions are often not sufficiently sound to provide the basis for deeper and wider financial intermediation. Moreover, financial sector weaknesses inhibit capital and financial account liberalization and greater access to international capital markets.

A well-developed financial sector contributes to growth by mobilizing savings and then efficiently allocating these resources among competing investment projects and other demands of funds. The positive correlations between indicators of financial development and economic growth over the long term reflect the importance of the financial sector (Chart 27). With banks dominating the financial systems of most developing countries, especially those that have been less dynamic economically, the structure and evolution of the banking system have provided the foundation for the development of the financial sector. For example, financial intermediation through the banking system—whether measured by the ratio of commercial bank liabilities to GDP or the ratio of private sector bank credit to GDP—has a strong positive correlation with economic growth. Further, financial depth, as measured by the ratio of quasi-imoney to GDP, also displays a strong positive relationship with economic growth. These positive correlations between indicators of financial development and economic growth have been documented in a number of recent studies.³³

To be sure, the close association that can be observed between economic growth and the level of financial development is likely to reflect two-way causation: not only is growth likely to be spurred by the greater availability of finance made possible by “supply-leading” financial development, but also the development of the financial sector is likely to be “demand driven” by economic growth through higher income and saving. The role of supply-leading financial development is clarified by the finding that the initial level of financial development is significant for subsequent growth: countries that have enjoyed a high level of initial financial development have tended to experience faster higher growth.³⁴

Given the central role of the financial sector in promoting growth, reform of this sector has been a critical ingredient in adjustment programs supported by the IMF and the World Bank. In the late 1980s and early 1990s, a number of the less dynamic developing countries, such as Ghana, Tanzania, Zambia, and Bangladesh, implemented market-oriented reforms to increase the efficiency and depth of their financial sectors. However, unsound banking practices have limited the benefits of increased financial intermediation in most of these countries.³⁵ Until the early 1990s, banks in Ghana were not subject to capital adequacy requirements. In Tanzania, prudential regulations remain weak, while the financial sector in Bangladesh is still plagued by antiquated contract and credit laws. And although the prudential framework in Zambia was improved in 1994, it still lacks adequate licensing standards. In many of these countries, the regulatory authorities also lack the capacity to deal effectively with insolvent institutions.

Apart from their impact on growth, weaknesses in the banking sector can also seriously impair the efficiency of indirect monetary policy instruments, even to the extent of making reliance on them impracticable. In an environment of unsound banking, interbank dealing will be limited as the stronger banks will be reluctant to deal with those whose portfolios carry a larger proportion of nonperforming assets. Consequently, the distribution of liquidity will be uneven, with the weaker banks finding it difficult to adjust their reserves and to respond to the monetary policy signals of the central bank. In Zambia, for example, a two-tier market has developed with the larger banks trading among themselves and smaller banks relying on central bank overdrafts. Once liquidity management through open market operations becomes unpredictable, central banks may be forced to use more direct instruments, at least temporarily. Moreover, if central banks persist in supporting unsound banks through overdrafts, the consequent liquidity injection could lead to inflationary pressures and exchange rate instability.

A weak banking system can also constrain the policy options of the authorities by impeding the liberalization of exchange controls, especially for financial and capital account transactions. If banks have built up large open positions by borrowing abroad to lend locally, or have lent domestically in foreign currency with the backing of local resources, monetary authorities may need to support the exchange rate to prevent bank failures, thereby shifting the burden of adjustment excessively onto interest rates and domestic prices. In some countries, difficulties in the banking sector have hindered the development of foreign exchange markets, despite the unification of multitiered exchange rates (Box 4). Given the importance of sound banking practices, improvements in prudential regulatory and supervisory frameworks and also in the legal infrastructure governing banking systems, especially laws regarding bankruptcy, have increasingly become essential prerequisites to comprehensive financial reforms in these countries.

Despite slippages due to unsound practices in the banking sector, financial reforms that have promoted the development of the financial sector and the extension of financial intermediation have been associated with improved economic performance. This is suggested by the positive correlation between indicators of financial development—such as reductions in the relative size of the central bank and increases in the depth and volume of intermediation provided by the commercial banking sector—and economic growth. However, among less dynamic developing countries, the benefits of financial intermediation in terms of growth often fail to accrue because of the continued use of the banking system for financing the budget. For example, in The Gambia, Kenya, and Malawi, in the aftermath of reforms undertaken in the mid- 1980s and early 1990s, while broad money growth increased substantially in relation to GDP, commercial bank lending to the private sector declined or in some cases grew at a much slower pace.

A key feature of the less dynamic developing economies has been the prevalence of the government in the financial sector, either directly through government-owned banks and other financial institutions or indirectly through administrative controls on interest rates and on bank lending (Box 5). In Ghana, for example, the government owns shares in virtually all banks, and in Bangladesh about two thirds of total deposits are held by state-owned banks, while in Tanzania and Guyana interest rates were controlled until the early 1990s, and in Zambia until the late 1980s. Countries that have maintained artificially low or negative real interest rates have also lagged behind in expanding the scope of financial intermediation (Chart 28). In contrast, the four newly industrializing Asian economies—Hong Kong, Korea, Taiwan Province of China, and Singapore—not only had a higher initial level of financial development, as indicated by higher ratios of broad money, quasi-money, and private sector bank credit to GDP, but also a higher rate of growth of financial intermediation. These countries have also been characterized by relatively limited public ownership of banks. Significantly, public sector involvement in financial markets has been pervasive in the least developed countries. For example, in the period 1990–95, central bank assets as a percent of the total assets of all financial institutions in the least developed countries were five times the level in the newly industrializing Asian economies and over 2½ times that in all developing countries (Table 17). During the same period, the ratio of public sector bank credit to private sector bank credit in the least developed countries was over 3½ times the level in the four Asian economies.

Table 17.

Developing Countries: Selected Financial Indicators

(Average of end-of-year stocks; in percent of GDP unless otherwise noted)

^¹Annual percent change.

^²The real interest rate is defined as the nominal interest rate on short-term bank deposits adjusted by actual inflation, in percent a year. Excludes Brazil.

^³As percent of total financial assets of the banking system.

^⁴Defined as bank credit to the public sector as a proportion of bank credit to the private sector.

^⁵Hong Kong, Korea, Singapore, and Taiwan Province of China.

^⁶Argentina, Brazil, Chile, China, Colombia, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, the Philippines, South Africa, Thailand, Turkey, and Venezuela.

^⁷Comprises the countries listed in footnote 2 of Chart 22.

Table 17.

Developing Countries: Selected Financial Indicators

(Average of end-of-year stocks; in percent of GDP unless otherwise noted)

		1976–82	1983–89	1990–95
Developing countries
Real GDP¹		4.5	4.9	5.7
Real interest rate²		–5.3	–2.5	–1.2
Broad money		17.7	19.8	18.3
Quasi-money		17.0	27.4	36.3
Bank credit to private sector		21.5	29.1	36.5
Central bank assets³		37.0	36.7	19.0
Financial bias⁴		0.3	0.3	0.3
	Newly industrializing Asian economies⁵
	Real GDP¹	8.4	8.9	7.1
	Real interest rate²	−2.2	3.2	0.5
	Broad money	15.7	22.3	24.5
	Quasi-money	31.7	47.4	67.4
	Bank credit to private sector	46.1	60.2	82.2
	Central bank assets³	27.3	18.3	11.4
	Financial bias⁴	0.1	0.1	0.1
	Selected emerging market countries⁶
	Real GDP¹	4.9	5.5	6.4
	Real interest rate²	−4.5	−0.5	0.4
	Broad money	14.8	13.6	13.6
	Quasi-money	16.5	23.1	28.1
	Bank credit to private sector	18.0	23.3	25.4
	Central bank assets³	39.8	33.4	16.3
	Financial bias⁴	0.3	0.3	0.3
	Least developed economies⁷
	Real GDP¹	3.1	2.7	3.4
	Real interest rate²	−4.5	−4.1	−2.4
	Broad money	14.0	15.5	14.0
	Quasi-money	5.6	9.2	12.5
	Bank credit to private sector	9.3	11.0	12.4
	Central bank assets³	64.4	77.8	56.7
	Financial bias⁴	0.8	0.6	0.3
Industrial countries
Real GDP¹		2.7	3.6	1.9
Real interest rate²		0.7	3.8	2.7
Broad money		61.2	66.4	70.0
Quasi-money		41.7	47.5	49.0
Bank credit to private sector		51.3	59.0	70.3
Central bank assets³		7.3	7.0	7.5
Financial bias⁴		0.2	0.2	0.2

^¹Annual percent change.

^²The real interest rate is defined as the nominal interest rate on short-term bank deposits adjusted by actual inflation, in percent a year. Excludes Brazil.

^³As percent of total financial assets of the banking system.

^⁴Defined as bank credit to the public sector as a proportion of bank credit to the private sector.

^⁵Hong Kong, Korea, Singapore, and Taiwan Province of China.

^⁶Argentina, Brazil, Chile, China, Colombia, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, the Philippines, South Africa, Thailand, Turkey, and Venezuela.

^⁷Comprises the countries listed in footnote 2 of Chart 22.

Table 17.

Developing Countries: Selected Financial Indicators

(Average of end-of-year stocks; in percent of GDP unless otherwise noted)

		1976–82	1983–89	1990–95
Developing countries
Real GDP¹		4.5	4.9	5.7
Real interest rate²		–5.3	–2.5	–1.2
Broad money		17.7	19.8	18.3
Quasi-money		17.0	27.4	36.3
Bank credit to private sector		21.5	29.1	36.5
Central bank assets³		37.0	36.7	19.0
Financial bias⁴		0.3	0.3	0.3
	Newly industrializing Asian economies⁵
	Real GDP¹	8.4	8.9	7.1
	Real interest rate²	−2.2	3.2	0.5
	Broad money	15.7	22.3	24.5
	Quasi-money	31.7	47.4	67.4
	Bank credit to private sector	46.1	60.2	82.2
	Central bank assets³	27.3	18.3	11.4
	Financial bias⁴	0.1	0.1	0.1
	Selected emerging market countries⁶
	Real GDP¹	4.9	5.5	6.4
	Real interest rate²	−4.5	−0.5	0.4
	Broad money	14.8	13.6	13.6
	Quasi-money	16.5	23.1	28.1
	Bank credit to private sector	18.0	23.3	25.4
	Central bank assets³	39.8	33.4	16.3
	Financial bias⁴	0.3	0.3	0.3
	Least developed economies⁷
	Real GDP¹	3.1	2.7	3.4
	Real interest rate²	−4.5	−4.1	−2.4
	Broad money	14.0	15.5	14.0
	Quasi-money	5.6	9.2	12.5
	Bank credit to private sector	9.3	11.0	12.4
	Central bank assets³	64.4	77.8	56.7
	Financial bias⁴	0.8	0.6	0.3
Industrial countries
Real GDP¹		2.7	3.6	1.9
Real interest rate²		0.7	3.8	2.7
Broad money		61.2	66.4	70.0
Quasi-money		41.7	47.5	49.0
Bank credit to private sector		51.3	59.0	70.3
Central bank assets³		7.3	7.0	7.5
Financial bias⁴		0.2	0.2	0.2

^¹Annual percent change.

^²The real interest rate is defined as the nominal interest rate on short-term bank deposits adjusted by actual inflation, in percent a year. Excludes Brazil.

^³As percent of total financial assets of the banking system.

^⁴Defined as bank credit to the public sector as a proportion of bank credit to the private sector.

^⁵Hong Kong, Korea, Singapore, and Taiwan Province of China.

^⁶Argentina, Brazil, Chile, China, Colombia, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, the Philippines, South Africa, Thailand, Turkey, and Venezuela.

^⁷Comprises the countries listed in footnote 2 of Chart 22.

Box 4.

Progress in the Development of Exchange Markets in Africa

There is little doubt that the allocation of foreign exchange by governments through nonmarket processes has in the past been one of the policies most damaging to growth in Africa. But in recent years, exchange regimes have changed dramatically in a number of African countries.¹ In many cases, the exchange rate is now market determined, with the liberalization of exchange restrictions having made exchange markets more efficient at reconciling the needs of buyers and sellers of foreign exchange. There remains, however, a severe lack of appropriate market institutions. Weaknesses in domestic banking systems have hindered the development of interbank markets for foreign exchange, and consequently countries that have sought to move toward market-determined exchange rates have, by and large, resorted to other institutional mechanisms—primarily bureaux de change and auctions—with interbank trading being relatively limited.² In some countries, these three institutional mechanisms have coexisted, while in other cases they have developed sequentially. For example, in the context of the liberalization efforts implemented since the mid-1980s, Uganda first introduced bureaux de change in 1990, established an auction for donor funds in 1992, and then replaced the auction with an interbank market in 1993. Zimbabwe, by contrast, went directly to an interbank market in January 1994, while Ethiopia has had an auction arrangement alone since May 1993, although the authorities have tolerated a parallel market.

Bureaux de change have two advantages in the early stages of exchange market liberalization. First, they facilitate the establishment of a competitive market: because their operations are relatively simple, because entry requires little finance and few skills, and also because economies of scale are limited, a large number of bureaux can be established rapidly. Evidence from the operation of bureaux de change in Ghana suggests that they are characterized by relatively narrow spreads between selling and buying rates, a feature of a competitive market.³ Second, partly because there are typically many bureaux and partly because they deal mainly in cash, it is difficult for the authorities to interfere with the market mechanism by influencing the exchange rate through arbitrary regulation or moral suasion. Hence, bureaux de change provide a good way of shifting the price-setting function out of the central bank into the market. In effect, their existence enhances currency convertibility. However, bureaux deal only in cash-based transactions, which are inevitably more costly than transactions effected by a well-functioning payments system based on checks or electronic transfers. (In industrial countries, of course, bureaux de change operate primarily for tourists and handle only a small share of the trade in goods and services.) Moreover, their small size limits the role they can play as stabilizing agents. For example, even in Zambia, where there are relatively few rules governing the bureaux market, each bureau may carry an overnight open foreign exchange position only to the extent of $100,000.

Auctions for foreign exchange are preferable to bureaux de change in that they do not have to be cash based and could cover a relatively large share of a country’s foreign exchange transactions, but they are more prone to official interference. When auctions are run by the central bank, the government has an opportunity to influence market outcomes, especially in countries where foreign exchange surrender requirements are high. (By contrast, auctions established in a number of countries of the former Soviet Union are much less prone to manipulation because surrender requirements have been eliminated or reduced.) In Nigeria, during the late 1980s, the auction was gradually subverted, and a fixed and highly overvalued exchange rate reemerged with a widening spread between the exchange rates in the official and parallel exchange markets. In Zambia during 1986, the central bank repeatedly changed the rules governing which bids were eligible, in order to restrict demand for foreign exchange. In many auction markets, participants have also faced the risk of not knowing whether they would succeed in getting foreign exchange or the price they would pay if successful. Moreover, because many of these auctions are held infrequently, firms wishing to buy foreign exchange may also require a high level of liquidity, to be able to pay in advance for foreign exchange.

An interbank market is the normal institution for foreign exchange transactions in all industrial and most nonindustrial countries. In an interbank market, banks trade with each other on behalf of their customers to match individual excess supplies with demands, in the process setting the price. And by taking positions in the market, they act as stabilizing agents. The absence of an interbank market in foreign exchange in most African countries is largely due to weak and underdeveloped banking systems, in part reflecting the history of state involvement in the financial sector, and weak institutional and legal arrangements. For example, a single, state-owned commercial bank has been dominant in Ethiopia and Tanzania. Moreover, the weakness of the banking system can be a source of destabilizing speculation. For example, in Zambia in 1995 the failures of several banks led to a “flight to quality” on the part of depositors. Depositors switched their portfolios not only to other banks but also into dollar-denominated deposits. Thus, a weakness in the banking system spilled over into currency depreciation. In such circumstances the effectiveness of the interbank market can be seriously undermined.

In general, when there are relatively few commercial banks, or substantial foreign exchange receipts channeled through the public sector, or high foreign exchange surrender requirements, the central bank typically is an active participant and a sufficiently large player to influence the market. In Uganda, when there were relatively few banks and news leaked to the private sector that the government was planning to switch from an auction to an interbank market, there was a substantial increase in bids for foreign exchange in the next auction. Private agents regarded an interbank market as more manipulable and less transparent than an auction, and so more likely to imply a return to de facto foreign exchange rationing. In Zambia, since interbank markets were introduced, there has been relatively little trading among the banks: in the fourth quarter of 1995, interbank trading amounted to only 5 percent of foreign exchange turnover. As a result, the central bank, which is effectively the market maker, has had to choose whether to set prices so as to match private demands and supplies, or to leave them unmatched and change its foreign exchange reserves, or even to attempt to influence private demands through moral suasion. When banks act as agents for the central bank in foreign exchange sales rather than as market makers, the price-setting function of an interbank market is not being performed.

The spreads charged in most African interbank markets tend to be much wider than in developed markets. It is hard to tell whether this reflects unavoidably higher costs associated with a smaller volume of transactions, higher default risks, or higher costs or profits arising from a low degree of competition. Moreover, the absence of forward markets for foreign exchange in most African countries means that importers and exporters bear much higher foreign exchange risk than in other regions where banks perform a risk-pooling function. For example, in 1994 traders in the newly liberalized Ugandan coffee market had shilling-denominated contracts for the future purchase of coffee and dollar-denominated contracts for its future sale. There was no market in which they could get forward cover for their exposure to exchange rate changes. The shilling appreciated strongly, and this imposed large losses on the coffee trading sector. Some traders in fact found it less costly to default on their delivery contracts, suffering the 10 percent penalty payments and damage to their reputation, than to take the exchange rate losses. Uncoverable exchange rate volatility thus acts, in effect, to deter trade.

In some sub-Saharan African countries, banks do provide forward cover, but the implicit spread between forward buying and selling rates is extremely wide because forward currency demands are not matched with supplies. For example, an importer may buy foreign exchange forward as follows. The importer’s bank buys dollars at the spot rate, depositing them until the future date when the firm wishes to take delivery. The bank lends the firm the domestic currency to make this purchase (subject to normal collateral and other requirements), charging it the domestic interest rate on borrowing. The firm is then credited with the interest earned on the dollar deposit, less the bank’s charge for the transaction. In such transactions, the implicit spread between forward buying and selling rates is equal to the sum of the spot market spread, any charges made by the bank, plus both spreads between the borrower and lender rates of interest in the domestic market and the dollar market. For example, in Uganda interest rate differentials of almost 15 percent add to the spread charged for the spot transaction an additional amount of over 3 percent for 3 months’ forward cover, almost 7 percent for 6 months’ cover, and about 14 percent for 12 months’ cover. Given that the spread in the spot foreign exchange market tends to be relatively wide—about 2.5 percent in many of these countries—the implicit spreads for forward foreign exchange contracts can be as high as 16.5 percent a year. Spreads this wide are roughly equivalent to average rates of collected tariffs and effectively increase the cost of international trade.

Banks in several African countries lack the skills to be stabilizing agents and have avoided taking positions in the foreign exchange market. Because the dominant player is the central bank, commercial banks may be particularly reluctant to take positions, as their success may depend more upon changes in policy than changes in the private demand and supply of foreign exchange. Even the long-established foreign banks are liable to be highly conservative and reluctant to take positions in the market.

In spite of the institutional weaknesses referred to here, there is no doubt that the establishment of market-based exchange arrangements has made a significant contribution to economic reform in Africa.

For an extensive discussion of exchange rate regimes in African countries and the wider benefits of market-based exchange arrangements, see Pierre Dhonte, Jean Clement, Mbuyamu Matungulu, and Dawn Rehm, “Economic Trends in Africa: The Economic Performance of Sub-Saharan African Countries.” IMF Working Paper 93/71 (September 1993).

For a recent review of exchange market institutions in selected African countries, see Paul Collier and Jan Gunning, “Exchange Rate Management in Liberalizing African Economies,” in Changing the Role of the State in Key Markets: Experience From Africa with Emphasis on the Socialist Economies, ed. by J. Paulson (Macmillan: Basingstoke, England, 1996).

For further details see K.A. Osei, Foreign Exchange Bureaux in the Economy of Ghana. African Economic Research Consortium, Research Paper 48 (1996).

Given the lack of well-developed domestic capital markets, governments in the less dynamic developing countries have often used the banking system to not only finance fiscal deficits at below-market interest rates, but also to provide subsidized lending to sectors with weak economic prospects, including public sector enterprises, often without adequate collateral. The result of such practices has been the creation of banks with “soft budget constraints” and asset portfolios characterized by large proportions of nonperforming loans: such banks often depend on continued access to overdrafts from the central bank to fund their activities. Moreover, in a repressed financial environment, even private banks are prone to accumulate nonperforming loans, and given the economywide repercussions of large-scale bank failures, most bank losses are absorbed by the budget or by the central bank through explicit or implicit deposit protection schemes. Consequently, losses of both publicly and privately owned financial institutions have ultimately been financed by the government, often through quasi-fiscal expenditures that do not show up in the central government accounts. In some cases, however, these losses are borne directly by the central bank and adversely affect the conduct of monetary policy. In developing countries, weak bank portfolios are pervasive—in the early 1990s nonperforming loans amounted to over 60 percent of loans in Kenya and about 35 percent of loans in Cameroon.

In dealing with problem banks, countries have used a number of restructuring techniques, ranging from recapitalization of banks to outright liquidation, and in some cases privatization. In 1989, eight failing institutions in Kenya were merged into a single “turnaround” bank, the Consolidated Bank Ltd., while in Sri Lanka, the government raised $500 million in the bond market to recapitalize two state-owned commercial banks. In Uganda, nonperforming loans of the country’s largest commercial bank, the Uganda Commercial Bank, amounted to about 70 percent of its assets in 1994. Despite initial restructuring efforts, the bank’s portfolio deteriorated further and delayed the government’s plan to privatize the bank.

Box 5.

Financial Repression

In a large number of developing countries, financial sector development has been hindered by extensive controls on financial intermediaries. In many countries, the interest rates that banks can offer on deposits and the rates they can charge on loans are determined by government directives. In addition, financial institutions are often required to lend to the central government and other public sector entities at below-market interest rates, or to provide foreign exchange at official exchange rates that overvalue the domestic currency for public sector debt-service payments or for imports by state-owned enterprises. Governments may also implicitly raise revenue by requiring commercial banks to hold underremunerated reserves with the central bank or by requiring foreign exchange proceeds of commodity exports to be repatriated at below-market exchange rates for foreign currency. All these policies—collectively referred to as financial repression—distort relative prices and impede efficient allocation of resources.

It is difficult to quantify the full extent of financial repression in those developing countries that maintain such practices because in most cases it is not possible to determine what the level of market interest rates would be without government controls on domestic interest rates and controls on cross-border capital flows. However, recent estimates using international interest rates as a benchmark suggest that governments are able to collect substantial revenue as a result of financial repression.¹ In Algeria, for example, during the 1970s and most of the 1980s, government revenue from financial sector controls is estimated to have amounted to over 4 percent of GDP a year. And in India, interest rate controls appear to have yielded close to 3 percent of GDP a year and accounted for over 20 percent of total tax revenue during the first half of the 1980s.

Developing Countries: Financial Repression and Economic Performance

^¹Excluding Brazil.

^²The real interest rate is defined as the nominal interest rate on short-term bank deposits adjusted by actual inflation, in percent a year.

^³In percent of GDP.

^⁴Argentina, Chile, China, Colombia, Hong Kong, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, the Philippines, Singapore, South Africa, Taiwan Province of China, Thailand, Turkey, and Venezuela.

^⁵See footnote 2 in Chart 26 for the list of countries included in this category.

Developing Countries: Financial Repression and Economic Performance

	1983–89	1990–95
Developing countries¹
Real interest rate²	–2.5	–1.2
Total investment³	24.9	27.9
Real GDP growth (a year)	5.1	6.1
Selected emerging market countries⁴
Real interest rate²	0.6	0.5
Total investment³	26.5	30.0
Real GDP growth (a year)	6.1	6.9
Least developed economies⁵
Real interest rate²	–4.1	–2.4
Total investment³	14.8	16.0
Real GDP growth (a year)	2.7	3.4

^¹Excluding Brazil.

^²The real interest rate is defined as the nominal interest rate on short-term bank deposits adjusted by actual inflation, in percent a year.

^³In percent of GDP.

^⁵See footnote 2 in Chart 26 for the list of countries included in this category.

Developing Countries: Financial Repression and Economic Performance

	1983–89	1990–95
Developing countries¹
Real interest rate²	–2.5	–1.2
Total investment³	24.9	27.9
Real GDP growth (a year)	5.1	6.1
Selected emerging market countries⁴
Real interest rate²	0.6	0.5
Total investment³	26.5	30.0
Real GDP growth (a year)	6.1	6.9
Least developed economies⁵
Real interest rate²	–4.1	–2.4
Total investment³	14.8	16.0
Real GDP growth (a year)	2.7	3.4

^¹Excluding Brazil.

^²The real interest rate is defined as the nominal interest rate on short-term bank deposits adjusted by actual inflation, in percent a year.

^³In percent of GDP.

^⁵See footnote 2 in Chart 26 for the list of countries included in this category.

One motivation for maintaining artificially low interest rates—resulting in negative real interest rates in some countries—has been to encourage investment by reducing the cost of borrowing. However, with few exceptions, such interest rate controls have not promoted investment, not least because they have discouraged financial saving. Countries that have maintained negative real interest rates over long periods have experienced lower investment and lower economic growth; this is especially clear for the least developed economies (see table above). By contrast, in countries where real interest rates have generally been positive or only mildly repressed, investment and growth have been significantly higher, such as in the emerging market countries. Financial liberalization during the 1990s has reduced the extent of financial repression in a large number of developing countries, and investment and growth have risen in many of them. Financial market reforms have increased the volume of financial intermediation and financial savings, especially by making interest rates more market determined, and have also led to more efficient allocation of financial resources. In countries where liberalization has been undertaken within a broader macroeconomic stabilization framework, fiscal consolidation has also helped to reduce banking sector credit to the government and made room for the expansion of lending to the private sector.

See, for example, Alberto Giovannini and Martha de Melo, “Government Revenue from Financial Repression,” American Economic Review, Vol. 83 (September 1993), pp. 953–63.

In countries where the public sector depends on the banking system for subsidized finance, neither such reforms as exchange and interest rate liberalization, and the curtailment or elimination of directed credit programs, nor the restructuring of loss-making banks, can be effective or sustained. In such countries, comprehensive fiscal reforms are needed that eliminate calls by the public sector on subsidized bank financing. For example, unless hard budget constraints are adhered to by the public sector, loss-making banks will continue to seek access to central bank overdrafts for liquidity. In Ghana, for example, it was only after a comprehensive public sector reform program was implemented, including privatization and the imposition of hard budget constraints along with restructuring of some banks—costing about 3 percent of GDP—that private sector credit growth increased and real interest rates turned positive.

Problems Facing the Heavily Indebted Poor Countries

Since the mid-1980s, a group of low-income developing countries have faced serious difficulties servicing their external debt. This group of 41 “heavily indebted poor countries,” as identified by the World Bank and the IMF, 33 of which are in sub-Saharan Africa, had a total debt of about $243 billion at the end of 1994.³⁶ A large proportion of this debt—about 64 percent—was owed to official bilateral creditors. Multilateral debt constituted about 19 percent of the total, while the remaining 17 percent was owed to private commercial creditors. Despite the large degree of concessionality extended by creditors—low interest rates, and long grace periods and maturities in repayment schedules—their level of indebtedness, about $190 billion in present value terms, was still equivalent to an average of over 430 percent of exports as compared with 130 percent for other developing countries. External debt burdens of the heavily indebted poor countries are, however, subject to a large degree of uncertainty. Ratios of debt to exports, and debt to GDP are in many cases distorted by adverse domestic conditions, such as droughts that sharply reduce agricultural output, civil strife, and regional conflicts.

The level of indebtedness and its composition varies widely among countries. At one end of the spectrum, four countries at the end of 1994 had a debt-to-export ratio below 200 percent, whereas at the other end three countries had debt-to-export ratios exceeding 1,000 percent (Chart 29). While countries such as Côte d’lvoire and Sierra Leone owed more than 40 percent of their total debt to private creditors, multilateral obligations accounted for more than half of the debt of such countries as Bolivia, Chad, Ghana, and Uganda. Furthermore, in sharp contrast to the debt crisis in the early 1980s, when the main debtors, mostly middle-income countries with large proportions of commercial debt, made substantial net transfers of resources to creditors (the average net transfer from Mexico to its creditors, for example, was about 5 percent of GDP over the 1984—88 period), most heavily indebted poor countries have continued to receive positive net transfers of resources from the donor community, with a median transfer of over 10 percent of GDP over the 1990–94 period (Chart 30).

The high and rising debt burden of the heavily indebted poor countries raises concerns about the ability of some of them to meet their large debt-service obligations. While there is no single criterion by which sustainability can be ascertained, a commonly used operational measure is to evaluate whether, under reasonable assumptions regarding growth rates of GDP and exports, and commodity price developments, the ratio of the present value of a country’s debt to its exports is expected to fall to 200–250 percent or less and the debt service-to-export ratio to 20–25 percent or less within five to ten years. Given the large stock of debt, the high debt-service burden, and the flat outlook for commodity prices in real terms, it is likely that a number of these countries will continue to have debt and debt-service ratios above these levels over the medium term. However, whether a country’s debt burden is sustainable or not depends to a large extent on the economic adjustment and reform policies it follows, and not only on external conditions, such as commodity prices, the interest rates they pay on their debt, and how effectively they take advantage of existing rescheduling and debt-reduction mechanisms available for commercial and bilateral debt.

In principle, a large stock of debt and the associated future debt-service obligations may deter private investors, especially foreign investors, because of the relatively high probability of the country defaulting on future repayments. And lower investment may reduce output and medium-term growth, thereby increasing the likelihood of such a default. While foreign direct investment has accounted for only a small proportion of capital flows to most heavily indebted poor countries, exceptions including Nigeria and Ghana, this is likely to reflect a number of factors, such as inadequate policy performance and the lack of an appropriate regulatory environment, as well as the high burden of debt. With regard to domestic private investment, since most of the debt is a liability of the government, the effect on investment of a debt overhang will depend on how fiscal revenue is raised to meet the debt service. If the government resorts to the inflation tax or increases corporate taxes, private investment is likely to suffer. Moreover, a debt overhang can also affect the pace of reforms. Reforms such as trade liberalization, privatization, and fiscal consolidation entail immediate political and economic costs with benefits that materialize mostly over the medium term. If policymakers perceive that foreign creditors will appropriate most of the future gains as a result of higher debt-service payments, then the presence of a debt overhang may reduce the incentives for pursuing reforms.

Although debt burdens of the heavily indebted poor countries remain high, both bilateral and multilateral creditors have provided debt relief in a number of ways. Bilateral creditors, notably through the Paris Club, have provided debt relief in the form of debt write-offs, flow reschedulings on increasingly concessional terms, and, more recently, debt-stock restructuring, while multilateral agencies have provided credit facilities with high degrees of concessionality, such as the IMF’s Enhanced Structural Adjustment Facility (ESAF) and the World Bank’s International Development Association lending programs. For most of these countries, these existing mechanisms, including in particular stock-of-debt operations under the Naples terms through the Paris Club, and at least comparable treatment from other nonmultilateral creditors, should be sufficient to tackle their high debt burdens. For the remaining countries, the Managing Director of the IMF and the President of the World Bank have jointly proposed a framework of action building on the existing mechanisms under which the international community would provide enhanced debt relief in response to the implementation of sustained comprehensive adjustment and reform policies. An action plan based on this framework will be proposed to the Interim and Development Committees at the October 1996 Annual Meetings of the IMF and the World Bank.

* * *

The experience of developing countries that have received large capital inflows shows that although foreign resources have supplemented domestic saving and contributed to these countries’ strong economic performance, the inflows have also in some cases increased countries’ vulnerability to external and domestic financial disturbances. The volatility of private capital flows, as experienced during the Mexican crisis and its spillover effects on other emerging market countries, underscores the importance of maintaining macroeconomic and financial stability. The Mexican crisis also demonstrated that while financial markets may not react at the first sign of deteriorating macroeconomic conditions, the magnitude of their eventual response can be substantial, involving large reversals of capital flows. Moreover, financial market indicators may not provide an adequate early warning signal. This suggests that policymakers need to guard against the buildup of macroeconomic imbalances and to address policy weaknesses long before financial market indicators suggest increased vulnerability.

For the emerging market countries, addressing weaknesses in domestic banking systems, including by improving the accounting practices adopted by banks and strengthening regulation and supervision capabilities, is an important prerequisite for maintaining macroeconomic and financial stability. Policymakers need to ensure that systemic weaknesses in the banking sector do not give rise to a difficult trade-off between maintaining low inflation and averting a banking crisis. In some cases, monetary authorities may be forced to delay increases in domestic interest rates and to aim for a more gradual disinflation policy because of a fragile banking system. This should not, however, delay sustained efforts to resolve banking sector problems. Emerging market countries will need to strengthen prudential supervision to monitor and regulate foreign exchange exposures of domestic financial institutions and to ensure that exchange rate movements associated with volatile capital flows do not exacerbate banking sector weaknesses.

Weaknesses in banking systems have also held back economic growth in countries that have not received private capital flows. Experience in all countries indicates that domestic investment is financed largely by domestic saving. For countries lagging behind, this implies that sustained efforts to liberalize and strengthen domestic financial markets will be needed to raise investment and growth. Economic policy improvements among the highly indebted poor countries will also be necessary to ensure that external debt burdens do not deter private investment, although sustained adjustment efforts in these countries will depend on further financial assistance from the international community.

For a detailed assessment of the extent of capital and financial account liberalization in industrial and developing countries, see Peter J. Quirk and Owen Evans, Capital Account Convertibility: Review of Experience and Implications for IMF Policies, IMF Occasional Paper 131 (October 1995).

Recent estimates by the international Finance Corporation indicate that the correlation between the return on the Standard and Poor’s index of the top 500 companies listed in the New York Stock Exchange and the return on the IFC composite index for emerging market countries has been less than 0.4 over the period 1990–95. See International Finance Corporation, Emerging Stock Markets Factbook, 1996 (Washington, May 1996).

For recent estimates of the extent that changes in public saving are offset by changes in private saving, see Paul R. Masson, Tamim Bayoumi, and Hossein Samiei, “Saving Behavior in Industrial and Developing Countries,” in Staff Studies for the World Economic Outlook (IMF, September 1995), pp. 1–27.

See Chapter VI for a detailed assessment of the relation between inflation and economic growth in both industrial and developing countries.

Annex IV provides a schematic assessment on how to identify the causes of capital inflows and the appropriate macroeconomic policy responses.

For an extensive discussion of the interrelation between sound banking systems and macroeconomic stability, see Carl-Johan Lindgren, Gillian Garda, and Matthew I. Saal, Bank Soundness and macroeconomic Policy (IMF, 1996).

See Guillermo Calvo and Morris Goldstein, “Crisis Prevention and Crisis Management after Mexico: What Role for the Official Sector?” paper presented at the Institute for International Economics Conference on Private Capital Flows to Emerging Markets After the Mexican Crisis held in Vienna in September 1995.

For an extensive review of banking crises in Latin America, see Liliana Rojás-Suarez and Steven R. Weisbrod, Fragilities in Latin America: The 1980s and 1990s, IMF Occasional Paper 132 (October 1995).

For an extensive discussion of adjustment policies and economic performance in sub-Saharan Africa, see Annex II of the May 1995 issue of the World Economic Outlook.

Empirical studies based on large samples of countries suggest that, in general, financial intermediation has a positive impact on growth. See for example. Tulio Jappelli and Marco Pagano, “Savings, Growth, and Liquidity Constraints,” Quarterly Journal of Economics, Vol. 109 (February 1994) pp. 93–109; Nouriel Roubini and Xavier Sala-i-Martin, “Financial Repression and Economic Growth.” Journal of Development Economics, Vol. 39 (July 1992), pp. 5–30; and Roben G. King and Ross Levine, “Finance and Growth: Schumpeter Might Be Right,” Quarterly Journal of Economics, Vol. 108 (August 1993), pp. 717–38.

A recent study suggests that inadequate financial development can represent a severe obstacle to growth, especially in countries that already have a relatively high stock of human capital. See J.C. Berthelemy and A. Varoudakis, “Thresholds in Financial Development and Economic Growth,” Manchester School of Economic and Social Studies. Vol. 63 (1995). Supplement, pp. 70–84.

Banking sector problems also limited the benefits of increased financial intermediation in Latin America during the 1960s and 1970s. For example, Jose De Gregorio and Pablo E. Guidotti, “Financial Development and Economic Growth,” World Development, Vol. 23 (March 1995), pp. 433–48, find a significant negative correlation between the extent of financial intermediation and growth for 12 Latin America countries in the period 1950–85. They attribute this to the absence of adequate banking regulations following liberalization, which reduced the efficiency of investment.

This compares with $1,921 billion for all developing countries. See World Bank, World Debt Tables, Vol. I (Washington: World Bank, 1996).

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Challenges of Capital Market Integration

Maintaining Macroeconomic Stability

The Soundness of Banking Systems

Financial System Requirements in Countries Lagging Behind

Problems Facing the Heavily Indebted Poor Countries

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