The Role of Finance in Fostering Sustainable Growth Presentation for the T

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The Role of Finance in Fostering Sustainable
GrowthPresentation for the TÜSIAD-KOÇ
UNIVERSITY ECONOMIC RESEARCH FORUMINTERNATIONAL
CONFERENCE ON SUSTAINABLE GROWTH STRATEGIES FOR
TURKEYFRIDAY, 17 JUNE, 2005-ISTANBUL

• By Stijn Claessens
• Professor of International Finance, University of
  Amsterdam, Senior Adviser, Operations and Policy
  Department, Financial Sector Vice-Presidency, The
  World Bank

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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?

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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

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Finance and growth
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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 environmentease 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

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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 gt
  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

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Inequality declines as finance develops
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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

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Finance and volatility
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What drives financial sector development?

• Financial development has been shown to depend
  on
• Good property rights and laws combined with a
  judicial system that enforce those
• Access to credible information on borrowers and
  consumers and on financial intermediaries
• Proper regulation and supervision of financial
  intermediaries and markets
• A competitive/contestable market structure

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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

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Creditor rights, rule of law and depth of the
financial system
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Shareholder protection, rule of law and capital
market development
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Stock markets and banks complement in growth
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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

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Foreign banks can help infinancial sector
development

• Borrowers 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

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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

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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?

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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?

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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

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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

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Many financial systems are small
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Deposit insurance rapidly expanded
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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

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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

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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-orien
  ted 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

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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)

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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

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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
• Settlers mortality social capital natural
  factor endowments physical environment ethic
  heterogeneity culture religion others?

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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 competitionreal,
  financialaffect 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?

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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?

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How can other reforms support financial reform?

• If financial sector reform is difficult, are
  there other, indirect ways to get desired
  outcomes?
• Competitionopenness to trade, capital flows,
  entry in financial and corporate sectors, ability
  of corporations to list in other marketsaffects
  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

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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

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Ownership concentration and institutional
development