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Financial Markets Development
August 1988
>> This Is USAID >> USAID Policy Papers >> Financial Markets Development
[Download original document] The purposes of this policy paper are to (a) describe USAID's policy on financial markets development, and (b) provide guidance on the development of USAID's programs and projects in financial markets. Executive Summary
Effective financial markets are indispensable to the pursuit of sustained, broad-based economic growth. Unfortunately, financial markets development is one of the most complex areas in the development field. Whether financial systems are relatively simple or highly complex, they perform the same broad functions and share the same key characteristics.
- The primary role of the financial system in any economy is to mobilize resources 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.
- 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.
- Efficient financial markets promote more widespread ownership of assets in a society.A larger number of citizens in a developing country will thereby have an opportunity to participate in, and enjoy the benefits derived from, the growth of their country's economy.
USAID should promote a system of financial markets that is integrated and relatively undistorted, one that relies heavily on competitive financial institutions, and on policies to facilitate competition. This system should be capable of effectively mobilizing private savings, allocating that savings to investments yielding maximum returns, and maximizing the participation of the general populace. USAID supports developing countries' efforts to (a) design, adopt, and implement policies conducive to the development of efficient, deep, and integrated financial markets, relying primarily on market rates of interest and other terms for the efficient mobilization of private savings and allocation of credit, and (b) build and promote competition between viable private, profit-making financial institutions. USAID can be a catalyst for financial liberalization in developing countries through both the policy dialogue process and project assistance.
USAID can draw upon a broad range of resources to help developing countries build more effective financial markets. Different countries, depending on their stages of economic and financial markets development, may require different kinds of assistance. The primary policy approaches discussed in the policy paper are summarized below.
- USAID too often has designed and implemented projects without adequately taking into account broader issues involving the financial systems in developing countries. In addition many Missions manage a variety of "credit" projects and other financial markets activities simultaneously. Missions contemplating, or maintaining a continued presence in, financial markets activities should prepare a comprehensive financial markets development strategy paper before or in conjunction with pursuing additional financial markets activities.
- Failure to consider the macroeconomic setting may obscure the forces behind financial developments and lead to inappropriate policy recommendations. Improvements in policies affecting financial markets is an important objective for Missions that are active in the financial markets arena. In those countries in which the macroeconomic policy environment is not conducive to efficient performance of private financial institutions, USAID should (a) urge the host government to adopt more appropriate policies and (b) consider postponing initiation or replenishment of financial markets activities until evidence exists that the host government is prepared to improve the policy environment.
- Domestic private savings should provide the major source of loan resources for financial institutions. Inappropriate policies inhibit prospective savers from relying on the formal financial system. USAID should help developing countries develop and implement policies to encourage, mobilize, and monetize domestic savings.
- Over-reliance on directed credit results in often severe misallocations of scarce investment resources that undermines the strength and viability of financial institutions and retards the growth of financial assets. USAID discourages developing countries from relying excessively on directed credit. USAID should encourage developing countries to rely on market mechanisms to allocate capital to its most productive uses.
- In many developing countries, governments hold nominal interest rates constant. During periods of inflation, real interest rates fluctuate with inflation, and will become negative if the inflation rate exceeds the nominal rate. When the outright removal of all statutory ceilings to deposit and lending interest rates is not feasible, USAID should encourage the host government to adopt specific reforms that permit interest rates to adjust (within an acceptable time frame) to market levels in a deliberate and timely way.
- In many cases, the existing legal and regulatory framework restricts the growth of financial techniques and limits the ability of financial institutions to maximize their profits by seeking higher yield investments elsewhere. USAID should engage in policy discussions and offer technical assistance, as appropriate, to reduce imprudent, and strengthen prudent, legal and administrative controls on financial institutions, and streamline and simplify the regulatory and supervisory responsibilities of government agencies.
- Strong institutions are essential parts of effective formal financial systems. Improvements in the institutional framework are a means of attaining the objective of broad-based economic growth. The most effective place for USAID to concentrate its resources, after policy reform, is in assistance to promote the institutional development of financial intermediaries that operate in a free, competitive market and other institutions that operate in the financial system.
- USAID has been active in helping developing countries improve their financial systems through the provision of credit. USAID will not take an equity position in a private enterprise. The interest rate to be charged on USAID resources to ultimate borrowers (a) shall, at a minimum, be at or near the prevailing interest rate paid on U.S. Treasury obligations of similar maturity at the time of obligating such funds, to the maximum extent practicable, and (b) should not be less than terms prevailing locally or a rate that approximates the opportunity cost of capital in that country. At a minimum, the interest rate to ultimate private borrowers should be significantly positive in real terms, i.e., when adjusted for inflation. USAID funds provided to financial institutions should carry an interest rate that (a) is at least equal to the cost of local, nonconcessional sources of capital; (b) approximates the cost of lendable resources of comparable maturities from the local private capital market (if such resources exist); and (c) is based on the appropriate rate to the ultimate borrowers.
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Last Updated on: July 11, 2001 |
