The Role of Finance in Fostering Sustainable Growth

Presentation for the TÜSİAD-KOÇ UNIVERSITY ECONOMIC RESEARCH FORUM

INTERNATIONAL CONFERENCE ON SUSTAINABLE GROWTH STRATEGIES FOR TURKEY

FRIDAY, 17 JUNE, 2005-ISTANBUL

By Stijn ClaessensProfessor of International Finance, University of Amsterdam, Senior Adviser, Operations and Policy Department, Financial

Sector Vice-Presidency, The World Bank

Structure of Presentation

• Finance and growth: the evidence

• What makes for financial sector development?

• Special issues for middle-income countries?

• What does changing world of finance imply?

• Why do countries not reform?

Finance and growth

• Financial system is important for growth. Much evidence finance matters for real sector growth, productivity, investment, cost of capital, etc.– At the firm, sector and economy level– Especially for SMEs and the emergence of new firms– Specific channels shown, also using experiments

• Some questions remain, however– On causality, missing/omitted variables

• Only recently evidence on the links between finance and poverty

Finance and growth

-4

-2

0

2

4

6

8

0 1 2 3 4 5 6Private credit as percentage of GDP

Average GDP growth 1960-95

Model

Naive

Growth and financial developmentNaïve and model-based relationship

-4

-2

0

2

4

6

8

0 2 4 6

Private credit as % GDP (log)

Ace

ra

ge

GD

P g

ro

wth

19

60

-9

5

Actual

Model

Naive

Finance and firms/SMEs

• While large SME sector characteristic of successful economies, SMEs do not “cause” growth, nor do SMEs alleviate poverty or decrease income inequality

• Rather overall business environment–ease of firm entry and exit, sound property rights, and proper contract enforcement– influences economic growth

• Finance, however, accelerates growth by removing constraints on small firms, more so than for large firms

• Finance allows firms to operate on a larger scale and encourages more efficient asset allocation. Financial and institutional development helps leveling the playing field

Finance and the poor

• Finance helps growth and growth helps poverty reduction. Finance helps poverty through growth

• Finance can help distribute opportunities fairer (the more concentrated income, the higher poverty)

• Cross-country studies:– Beck, Demirgüç-Kunt and Levine 2004: controlling for reverse

causality: financial development => less income inequality

– Clarke, Xu, Zou, 2002: inequality decreases as finance develops

– Honohan 2004: financial depth explains poverty (less than $1 or $2). But, microfinance penetration no special effects on poverty

Inequality declines as finance develops

Finance and volatility

• Evidence that better developed financial systems share risks better, are more stable, less prone to crisis– Evidence at household, firm, sector and economy level.

– Specific channels been shown, also using experiments, e.g., allowing for (interstate, international) diversification, introduction of new hedging tools

– Finance importantly relaxes credit constraints with shocks

• Some questions remain, however– On causality, missing/omitted variables, what is volatility?

– Some evidence quantity of finance alone can add risks

Finance and volatility

What drives financial sector development?

Financial development has been shown to depend on:

1. Good property rights and laws combined with a judicial system that enforce those

2. Access to credible information on borrowers and consumers and on financial intermediaries

3. Proper regulation and supervision of financial intermediaries and markets

4. A competitive/contestable market structure

Finance and fundamentals

• Importance of effective legal system for financial market

development, external financing, dividend patterns, growth,

firm valuation, etc.

– Well documented for equity and creditor rights (La Porta

et al., Levine et al., Rajan and Zingales, etc.)

– Includes a well functioning judicial system

• Structure (bank versus markets) matters less than having the

right fundamentals (Demirguc-Kunt & Levine). Banks

complement securities markets, in corporate governance role

Creditor rights, rule of law and depth of the financial system

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1 2 3 4

Creditor Rights * Rule of Law

Shareholder protection, rule of law and capital market development

0

10

20

30

40

50

60

70

80

Market capitalization/GDPpercent

Lowest quartile(lowest ranking in shareholder and rule of law)

Highest quartile(highest ranking in shareholder and rule of law)

Stock markets and banks complement in growth

0

1

2

3

4

Illiquid Liquid

Initial stock market liquidity

Per capita growth,1976-93

Low bankingdevelopment

High bankingdevelopment

Source: Demirgüç-Kunt and Levine, 1996.

Finance and fundamentals

• Information is essential– Quality of accounting/auditing and credit bureaus key

components of informational infrastructures• Regulation and supervision requires balance between

market discipline and government role.– Without checks and balances, too much power in the

hand of supervisors retards financial development and creates risks

• Contestability in financial system key – Entry (of foreign banks) have helped stability, efficiency

and access while state-owned banks have hindered

Foreign banks can help infinancial sector development • Borrower’s perceptions across 36 countries

– Financing obstacles lower in countries with high levels of foreign bank penetration

– Strong evidence that even small enterprises benefit and no evidence they are harmed by foreign banks

– Channel is both competition and direct provision of financial services by foreign banks

• Latin America study– Foreign banks with small local presence do not

appear to lend much to small businesses – But large foreign banks in many cases surpass large

domestic banks

Financial sector development and macro/fiscal and real sectors

• Financial sector development depends on stable macro-economic environment and little crowding out– Moderate, positive real interest rates

– Low fiscal deficits to avoid banks holding only government paper

• Financial services input for real sector and vice-versa. Scope for vicious and virtuous relationships. Development and effectiveness of financial and real sector depends on many similar factors, yet still separate finance reform

– Additional positive effect of finance on growth

– Financial sector represent allocation of control rights, link to political economy of reform in general

Current finance research questions

• How do financial systems evolve?

• How to tailor financial sector development approaches to country circumstances?

• What are special issues for emerging markets?

• What does changing world (of finance) imply?

• Implications for public policy

• What drives (financial sector) reform?

How do financial systems evolve?

• Are certain financial market structures more attractive at some levels of development? – More concentrated banking systems more attractive at

lower levels of development? – How does the balance between banks and markets

preferably change as countries develop? – When to develop non-bank financial markets, e.g., bond

markets, securitized markets?

• How to classify countries’ financial systems, market versus bank or horizontal versus vertical? What does it imply for financial development?

How to tailor approaches to countries?

• Consistency of reform rather than speed is key• Many country-specific requirements and tradeoffs

– E.g., degree of competition and access to financing relate differently when information more obscure

• Limits to what government/regulation can achieve– Much evidence that government is poor regulator, e.g.,

more power does harm if checks and balances missing; minimally paid supervisors unlikely to resist corruption; securities markets: private better than public oversight

– Regulations to vary. Are all standards good? Core 25, Basle II, IOSCO, etc., will not always work

What are special issues for emerging markets?

• Finance based on the same principles and finance industries undergoing similar changes as ROW

• Countries generally benefit from reform and lib. – Institutional weaknesses more severe, limits benefits– Can lead to crises, especially when integrating. Causes

of crises shift, however, tools to predict may fail – No fixed, a-priori pre-conditions for successful reform– Often deeper causes: political economy, moral hazard,

low pay, corruption, etc. Rebalance government role

• Issues of size and special nature of banks and safety net: need to consider government capacity

Many financial systems are small

Size of financial system (M2, billion of dollars)

0.01

0.1

1

10

100

1000

10000

167 countries

log scale

Deposit insurance rapidly expanded

0

20

40

60

80

1934 1962 1966 1969 1974 1977 1980 1983 1985 1987 1989 1993 1995 1997 1999

Cumulative frequency of explicit DI systems established

Source: Kane, World Bank, 2000.

What does changing world imply?• Financial services are changing rapidly

– Globalization: capital flows, cross-border financial services, listing in financial centers, foreign bank entry

– Deregulation: within markets, geographic, including cross-border, across markets and products

– Technology: advances in information, particularly internet and increased remote delivery

• Factors are changing financial services industries structures and altering forms of provision – Banks and finance becoming less special; increasingly

more substitutes available; more remote delivery possible; local markets less relevant; lines between products and financial institutions blurring

What does changing world imply?

• Nature of the firm altering – Intangibles, new economy, network-type assets more

important for production and productivity

• Investments to be financed changing – Investors invest in “ideas”, rather than fixed assets– Ideas need more protection for investors

• Implications for financial sector– Fewer fixed assets: makes debt more difficult– Higher risk: requires other financing structures – More VC-type and more equity markets as VC to exit– Greater importance of corporate governance

Implications for public policies • Revisit “enabling environment” for finance

– Greater emphasis on property rights (laws and enforcement), information infrastructure, etc.

– Do not expect market, but neither government to solve all problems: focus on core role of government

– Revisit current prudential and institutional-oriented approaches implied by standards and reduce safety net

– More need for consumer/investor protection as financial services become more like other products

– Revisit tools/approaches used for managing risks

Revisit especially competition policy• More active competition policy possible/needed

– Finance and banks particularly less special

• New paradigm to be developed and applied– To go beyond institutional and functional approaches;

to be both global and horizontal and sector-specific.

– Approach to resemble other network industries

• Countries can benefit from committing to pro-competitive framework– Credibility more at a premium, competition policy

authorities weaker, political economy more adverse

– WTO, FTA-type of arrangements help (more)

Why do countries not reform?

• Countries do not adopt most efficient institutions

– Institutional change in general slow, although some transition economies, crisis countries are exceptions

• In many dimensions unclear whether globalization will allow for convergence in effective institutions

– Financial markets are subject to global competition, yet very imperfect convergence and at high costs

– Firms and markets can adapt to weaker environments, but alternative mechanisms have limits and costs

In general institutions are rigid

• Institutions and rules are rigid and path dependent– Best example is legal origin which has long-lasting

effects, from colonization centuries ago to today • Property rights not only institutional difference, though

– Regulation of labor markets, ease of entry for new firms; restraints on executive, degree of democratic institutions, degree of corruption; quality of regulation

• Institutions are highly correlated. Suggests deeper factors

– Settler’s mortality; social capital; natural factor endowments; physical environment; ethic heterogeneity; culture; religion; others?

What drives institutional (financial sector) reform?

• Institutions are quite stable and by some measure can explain level of development.

• What still triggers changes? How do institutions evolve and in turn affect (financial sector) development? – When do countries reform? What is the role of real

sector changes? How does competition—real, financial—affect legal and financial systems?

– Is there a channel from ownership to reform? Any benefits of certain privatization models?

– Why does it often take a crisis? Are crises blessings in disguise? What is role of political economy?

Can financial crises spur reform?

• Are financial and real sector crises blessing in disguise? Do political changes cause crises and thus reform, in financial sector especially? What type of crises “work” best: growth or financial crises? What measures enacted in crises actually stuck and made a difference?

• Are financial crises (only) cause for international financial institutions to get busy with financial sector? Is finance a too long term investment?

• Has the link between finance and poverty not made clearly? Has the link to inequality and lack of access not been shown sufficiently?

How can other reforms support financial reform?

• If financial sector reform is difficult, are there other, indirect ways to get desired outcomes?

• Competition—openness to trade, capital flows, entry in financial and corporate sectors, ability of corporations to list in other markets—affects systems in two ways– Competition can deliver functional convergence, but in

what areas? Can corporations “hire” corporate governance by cross listing in foreign markets? Are foreign-owned banks a substitute or complement?

– Competition can overcome/weaken political economy constraints. More generally, real sector reform interacts with financial sector reform

Can ownership changes provide political support?

• Need for middle-class to push for and support reform, including financial sector reform

• Can degree of general public ownership (directly) affect incentives to push for some reforms?

• Channel from ownership to reform. When ownership, control and political economy structures not change, reforms not deep enough and insiders hijack reforms. With extensive ownership changes, reform more likely deeper

• Benefits of certain privatization strategies. With large state-ownership, after crisis/transition, certain ownership distribution encourage reforms

Ownership concentration and institutional development

Philippines

Thailand

Taiwan

Malaysia

Indonesia

Korea

Hong KongSingapore

Japan

0

2.5

5

7.5

10

0 10

203040506070Ownership by top 15 families (%)

Efficiency of judicial systemRule of law Absence of corruption