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Financial Markets Development
August 1988
>> This Is USAID >> USAID Policy Papers >> Financial Markets Development The nature and performance of financial systems in developing countries must be judged in relation to an individual country's level of development. Whether these financial systems are relatively simple or highly complex, they perform the same broad functions and share the same key characteristics. These functions and characteristics are discussed below. II. The Functions and Key Characteristics of Financial Markets
A. Mobilizing Domestic Resources
The primary role of the financial system in any economy is to mobilize resources for productive investment. The financial system provides the principal means to transfer savings from individuals and companies to private enterprises, farmers, individuals, and others in need of capital for productive investment. An efficient financial system channels resources to activities that will provide the highest rate of return for the use of the funds. These resources stimulate economic growth; they provide enterprises with the ability to produce more goods and services and to generate jobs.***Well-functioning and well-developed financial systems encourage savings and allocate resources to higher-yielding investments. Savers can make their surpluses available in investors by, in effect, purchasing financial assets (from a variety of debt and equity claims including entries in a savings passbook from a commercial bank). The financial system mobilizes savings and increases liquidity by providing asset holders with attractive (in terms of yield, risk, and liquidity) financial claims. In the absence of developed financial systems, only investments financed by individual savers or closely-knit groups of individuals would be possible. Many high-yielding investments would not be undertaken and some capital would be invested in activities yielding low returns.
Well-developed formal financial markets offer to savers and investors a variety of short- and long-term savings and investment instruments (often, but not always) through qualified financial intermediaries that enable individuals to make reasonable judgments about the risk and rewards of saving or investing their funds. These instruments effectively package risk and returns so that individuals who wish to participate in appropriate markets can do so, taking into account their own perceived capacity to accept risk. Individuals are able to borrow funds on terms commensurate with the expected risk and return of the investments they wish to make.
Financial systems transform the size, maturity, and risk characteristics of assets. For example, to reduce their risk, investors who wish to finance the acquisition of long-lived capital prefer to borrow at long term. For similar reasons (to reduce their risk), savers seldom are willing to tie up their funds for the long term. Financial systems mediate, inter alia, between the short-term perspectives of these savers and the long-term perspectives of these investors. They do so through (1) direct term transformation of maturities by borrowing short and lending long, and (2) indirect term transformation by buying and selling long-term instruments prior to maturity in secondary markets.
Another way to mobilize domestic resources is through the development of the equity or securities market. Equity financing provides an alternative to debt financing; it also offers new opportunities for investors and for broadening the ownership of economic assets. Expanding popular participation is essential to accomplishing the aims of USAID's policies.
B. The Role of Government
The growing inadequacy of financial systems as countries develop often leads to government intervention in the financial system. To the extent that government involvement in financial systems is misdirected, the development of efficient financial markets will be inhibited and the costs of financial intermediation will be increased. Monetary and financial regulatory policies that stifle financial intermediation, creating "financial repression," are the policies primarily responsible for poorly functioning domestic monetary systems and capital markets, and thus for poor rates of growth. Interest rate ceilings on deposits and loans, combined with inflationary rates of monetary expansion, are the most important policies creating financial repression. Other policies adding to this repression are exchange controls, taxation, credit allocation, and heavy reserve requirements.Government restrictions on freedom of entry almost always reduce the quantity and quality of financial services available to the economy, and thus hinder or distort economic growth. In contrast, competition in banking and financial intermediation tends to limit the spreads between the interest paid by borrowers and that received by depositors. This serves as an incentive for increasing saving and provides more funds, more cheaply, to investors. This competition, when combined with the adoption of liberalized financial sector reforms,enhances the efficiency with which intermediation is carried out.
At the same time, government plays a key role in assuring that financial markets operate effectively. Governments in developing countries can and should facilitate financial markets development and provide a policy and regulatory environment that encourages the appearance of competitive forces, encourages the use of a variety of debt and equity instruments, promotes the growth of different kinds of institutions offering a wide range of financial instruments and services to potential savers and investors, and protects the interests of savers by reducing their risks. Such actions would serve to decrease the transactions costs associated with financial intermediation.
Government should play an important role in the area of private ownership and property rights. Private ownership and property rights arrangements are important elements in determining the extent of an individual's participation in financial markets. When private property rights exist, an individual has exclusive right to use and derive the income from . assets, to transfer the assets voluntarily to others, and to be assured that contracts of exchange are enforceable. The absence of these rights makes it difficult for private enterprises and individuals to participate in the financial system.
The proper role of government is heavily conditioned by one key characteristic of financial markets. Unlike markets in goods and most services (in which there is A simultaneous exchange of value), financial markets involve sale and purchase transactions that are separated in time. In a financial market, the product is exchanged for a commitment (for example, in the savings market, a promise to repay savings deposits plus interest), that is, for a promise to act in the future. Although a certain amount of risk is part of any economic transaction (witness the admonition "caveat emptor"), assessing and coping with risk is the essential component of every financial market transaction. The nature of the product involved is in large part determined by the personal characteristics of the actors involved in the transaction. In the early stages of financial markets development, personal judgments of creditworthiness lie at the core of all financial transactions.
The types of policy approaches available could generally be classified in four categories:
- "purely" competitive, where government policy is to rely on market forces with limited government involvement even in matters related to supervising, and establishing solvency requirements for key participating institutions;
- competitive but heavily regulated for soundness through extensive use of supervision and solvency rules;
- administered market, where government intervenes by allocating finance and structuring institutions, but lets markets set prices within these parameters; and (4) managed, where government decisions replace market relationships and the enforcement of supervision and solvency policies is minimal.
The mix or balance of policy approaches could differ in a given market through time and among different markets in a given country. Government policies now generally favor administered or managed systems in many of the developing countries in which USAID operates. Recently, however, several developing countries have liberalized their financial markets. They have implemented reforms to reduce the extent of government intervention through inter alia state ownership of banks, directed credit programs, and subsidized interest rates. As a result, financial markets in these countries are less distorted and more integrated; they respond more readily to market signals rather than administrative directives.
C. Efficiency and Depth
Financial markets can be effective to the extent that they are efficient and deep. Governments regulate financial markets to promote efficiency and to avoid volatility.Efficient financial markets (1) mobilize funds from savings with, at the margin, the lowest opportunity cost (adjusted for perceptions of risk) and (2) distribute those funds to investments that offer, at the margin, the highest potential returns (adjusted for perceptions of risk). Taken together, these are the two characteristics of allocational efficiency. Efficient financial markets also mobilize and allocate funds at minimal cost. This is the characteristic of operational efficiency. It is also important to keep in mind that if there are inefficiencies in the market, then prices or costs would not reflect the real information relevant for financial decision-making (price discovery efficiency).
The depth of financial markets is a measure of their strength: deep financial markets are inherently less fragile than shallow financial markets. A commonly used indicator of formal sector financier depth is the ratio of broadly defined money (currency plus demand deposits) to gross domestic product. A low ratio suggests that the formal financial system is a poor mobilizer of funds; combined with strong demand for funds by the public sector, a low ratio makes credit to the private sector very scarce. In many developing countries, formal financial markets are shallow; relatively few people have access to these markets, and the range of available financial instruments is limited. Friends, relatives, and moneylenders are the primary sources of external finance in a very shallow system. Savings tend to be placed in real assets such as gold or cattle as a store of value. As the system develops, more options are available for yields, maturities, and risks, leading to higher household welfare.
As the system financial develops, prospective investors increasingly can turn to local financial institutions, national financial organizations and, ultimately, international banks and securities markets for additional funds. Each step leads to a more efficient allocation of capital. The resulting increase in the availability of equity and debt funding will enable developing economies to move towards more balanced capital structures of enterprises.
Shallow, formal financial markets do not adjust well to external shocks without collapsing or displaying excessive fluctuations; they are markets in which, inter alia, severe market gyrations are fairly common, institutions too often collapse, and "secure" instruments are not, in fact, safe havens for savings. Shallow financial markets also are rather easily subject to manipulation. Low-income developing countries, with their shallow financial markets, have been found to rely relatively more heavily on administrative allocation systems than high-income developing countries.
However, in most of the developing countries in which USAID operates, government policies now appear overly concerned with curbing volatility and inadequately concerned with promoting operational and allocational efficiency. The quest for greater efficiency in the financial markets of developing countries typically means relying more heavily on market forces rather than on administrative controls.
There is a risk-due to heightened market volatility involved in the timing and sequencing of introducing liberal reforms. The recent experience of the Southern Cone countries of Latin America is instructive. The main lessons of that experience are:
- financial liberalization should be accompanied by effective supervision of both public and private institutions to avoid fraud, circumvention of sound financial practices, and misuse of funds;
- financial authorities should devalue an overvalued currency, before attempting to reform domestic financial markets. Failing to do so will lead to "excessive" borrowing in anticipation of a real devaluation;
- financial authorities should consider carefully the likely effects of rapid reductions in existing interest rate subsidies. Depending on the context, a sudden shift to high real rates may trigger widespread defaults and lead to a collapse of the banking system; and
- financial authorities should pay particular attention to the sequence-the timing-of reforms. For example, authorities may wish to liberalize the international current (trade) account before liberalizing the capital account. Otherwise, depending on the context, the result may be destabilizing short-term capital inflows that could stimulate rapid unwarranted appreciation of the domestic currency.
D. Integration
Effective financial markets are integrated in two dimensions. First, integration can be "vertical." Vertically integrated financial systems are those in which the three principal market clusters (formal domestic markets, informal markets, and international markets) are closely linked. Second, integration can be "horizontal." Horizontally integrated financial markets are those in which market interest rates typically array themselves around a basic reference rate.Vertically integrated financial systems incorporate informal and international financial markets with formal domestic financial markets. Informal financial markets are especially important in USAID-recipient countries because these markets provide the credit and savings mobilization functions for a major portion of USAID's target groups (see section IV.B.6.).
Informal financial markets are highly segmented; moneylenders generally exercise spatial monopoly power. Informal financial markets clearly are "interlinked" markets, in that informal financial transactions spill over into transactions in the local land and labor markets (for example, local money lenders often are members of the landed elite and often hire labor at differential rates depending on the indebtedness of that labor). Although assessing the degree to which these interlinked informal financial markets are integrated with formal domestic financial markets is difficult, linkages between the two markets are greater than may be readily apparent. Informal financial markets have links with formal credit through their lines of credit with commercial and development financial institutions. In addition to serving microenterprises and informal sector enterprises, informal financial intermediaries supply those credit requirements of formal sector enterprises that cannot be met by formal financial institutions.
An effective financial market system also should connect domestic financial markets to international financial markets (and to the related commodity trading systems). The presence of effective financial markets in developing countries will encourage foreign investors to consider providing capital (in the form of both debt and equity) for productive investment. Over time, integration with international financial markets will (1) narrow the differences in the cost of funds between markets in different countries and between different instruments, and (2) spread the risks associated with exchange rate and interest rate fluctuations among a larger number of market participants.
In horizontally integrated and efficient formal financial markets, the reference rate, typically the inter-bank rate, is the market rate of a short-term, low-risk financial instrument. Such an instrument is easily available to financial institutions. It typically provides the basic liquidity for the formal financial system, and central banks often use it to gauge the tightness of monetary policies. Two markets sometimes are closely integrated because intermediaries operate simultaneously in both; for example, commercial banks operate in both the savings (deposit) and the loan markets. On the other hand, in most developing countries, the government bond market and the market for housing loans probably, not be very tightly integrated.
E. Promoting Widespread Ownership
Efficient financial markets promote more widespread ownership of assets in a society. A larger number of citizens in a developing countries will thereby, have an opportunity to participate in, and enjoy the benefits derived from, the growth of their country's economy. Development of the equity, securities market, for example, provides a means of distributing the ownership of securities more widely among the public, which increases the probability that business ownership will not be confined to a small number of wealthy families or to big industrial-financial conglomerates. Another way to build up widespread ownership is the establishment of contractual savings arrangements through pension funds.
*** Private enterprises are defined as privately-owned, for-profit business entities. They should be distinguished from private voluntary organizations (PVOs) that are private, nonprofit entities.
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Last Updated on: July 11, 2001 |
