Financial Development in Low-Income Countries: Old Questions or New Problems?
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The IMF Research Bulletin, a quarterly publication, selectively summarizes research and analytical work done by various departments at the IMF, and also provides a listing of research documents and other research-related activities, including conferences and seminars. The Bulletin is intended to serve as a summary guide to research done at the IMF on various topics, and to provide a better perspective on the analytical underpinnings of the IMF’s operational work.

Abstract

The IMF Research Bulletin, a quarterly publication, selectively summarizes research and analytical work done by various departments at the IMF, and also provides a listing of research documents and other research-related activities, including conferences and seminars. The Bulletin is intended to serve as a summary guide to research done at the IMF on various topics, and to provide a better perspective on the analytical underpinnings of the IMF’s operational work.

Thierry Tressel

Over the last few decades, many low-income countries (LICs) have liberalized their highly repressed financial systems. Financial reforms have led to the elimination of interest rate controls and directed credits, and to the introduction of indirect instruments of monetary policy. However, limited access to financial services remains a pervasive phenomenon in low-income countries. This paper selectively surveys recent IMF research on the development of financial systems in low-income countries, including LICs’ experience with financial liberalization, the determinants of financial reform, the relationship between financial deepening and growth, and the factors explaining the lack of access to formal finance.

Detragiache and Ueda (2004) and Khan and Senhadji (2000) survey a large body of literature that establishes that financial development is essential for economic growth, McKinnon (1973) and Shaw (1973), who were among the first to argue that financial repression was hampering the development of low-income countries by preventing them from exploiting valuable investment opportunities, are seminal to this literature. Since the 1980s, the IMF has supported the dismantling of controls and restrictions on financial systems as part of its programs. IMF researchers have examined the state of financial systems in low-income countries, including the countries’ experiences with financial liberalization.

Over the last few decades, financial liberalization has taken place worldwide, and along many dimensions (Abiad and Mody, 2003). Low-income countries have been no exception. Mehran and others (1998) explain that, by the late 1980s, sub-Saharan African countries recognized the debilitating effects of financial repression and started to liberalize their financial systems. The authors find that while substantial progress was made in the 1990s both in establishing market-based monetary policy instruments and in strengthening banking supervision, many problems remained unaddressed. According to Gelbard and Leite (1999), these problems include wide interest rate spreads, insufficient capital adequacy ratios, ineffective judicial system, and high nonperforming loans. They also find that access to credit by the private sector has not improved on average.

Why do countries decide to liberalize or repress their financial systems? Although there is little research on the political economy aspects of liberalization of financial systems in LICs, examining the experience of developed countries can shed some light on the challenges ahead. Rajan and Zingales (2003) develop a theory in which incumbents oppose financial market development because it breeds competition. Their theory helps explain the reversal of financial market development in the twentieth century. Moreover, they find that trade openness is correlated with financial deepening when the capital account is open, a finding consistent with their theory based on the politics of interest groups. Abiad and Mody (2003) study the determinants of financial reforms along six dimensions of policy reform—credit controls, interest rate controls, entry barriers, regulations, privatization, and restrictions on international financial transactions—in a sample of countries that includes several low-income countries. They find that, at relatively high levels of financial repression, IMF program conditionality appears to have a strong influence on reform, which declines thereafter, and trade openness appears to hasten reforms. They also show that financial reforms are to some extent self-sustaining. Finally, they find that balance of payments crises make reforms more likely, while banking crises have the opposite effect by triggering the nationalization of banks. Demirgüç-Kunt and Detragiache (1998) find, however, that financial liberalization in a poor institutional and regulatory environment contributes to financial fragility even while improving financial development.

Financial liberalization has fostered competition in the banking system in several countries (Dell’Arricia, 2003). In India, financial liberalization lowered intermediation costs and profitability of commercial banks, and led to a decline in industry concentration (Koeva, 2003). Barajas, Steiner, and Salazar (1999) find, in Colombia, a positive effect of financial liberalization and foreign bank entry on bank operational efficiency. Hardy and Bonaccorsi di Patti (2001) conclude that financial liberalization in Pakistan improved the welfare of depositors and led to intensified competition. Macroeconomic indicators of financial deepening, however, have improved only modestly in African countries, according to Favara (2003). In Sudan, reforms have not addressed systemic problems in the financial system, including bank restructuring (Kireyev, 2001). Mlachila and Chirwa (2002) document an increase in real interest rates following liberalization, which is partially attributed to high monopoly power in Malawi.

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Recent research suggests that the relationship between financial deepening and growth may be more complex than generally thought. Favara (2003) finds that the link between finance and growth is weak, and concludes that finance matters only at intermediate levels of economic development. Similarly, Gaytan and Rancieres (2004) conclude that the impact of finance on growth generally increases with income levels, and that financial deepening is weakly correlated with economic growth in low-income countries. In a sample of middle- and low-income countries in the Middle East and North African region, Creane and others (2004) find no effect of financial deepening on growth, while an institutional variable is strongly significant. One potential explanation is that indicators of financial deepening may be weakly correlated with the capacity of the financial system in identifying and financing profitable projects. Abiad, Oomes, and Ueda (2004) in fact find that financial liberalization, rather than financial deepening, improves allocative efficiency. Noting these limitations, Townsend and Ueda (2001, 2003) calibrate a model for Thailand, instead of relying on growth regressions, and find that gradual financial deepening both reinforces and is reinforced by growth.

Financial systems in low-income countries are highly segmented between formal and informal lending institutions. Several factors over and above financial repression may limit the penetration of organized bank lending in poor and rural areas. Tressel (2003) develops a theory in which informal and semiformal lenders have an advantage in collecting local information that allows them to lend in environments with poor enforcement of property rights. Thus, in low-income countries, organized banking and informal lending appear to complement, rather than be substitutes for, one another, even though financial deepening is necessary for economic growth.

References

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IMF Research Bulletin, September 2004
Author:
International Monetary Fund. Research Dept.