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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 Claessens Professor 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 Growth and financial development Naïve and model-based relationship Average GDP growth 19608 895 Acerage GDP growth 1960-95 6 6 Naive 4 4 Actual Model 2 2 Model Naive 0 0 -2 -2 -4 -4 00 1 2 3 4 4 Private credit as percentage of GDP 2 Private credit as % GDP (log) 5 6 6 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 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 1 2 3 Creditor Rights * Rule of Law 4 Shareholder protection, rule of law and capital market development p e r c e n t M a r k e t c a p i t a l i z a t i o n / G D P 8 0 7 0 6 0 H i g h e s t q u a r t i l e ( h i g h e s t r a n k i n g i n s h a r e h o l d e r a n d r u l e o f l a w ) L o w e s t q u a r t i l e ( l o w e s t r a n k i n g i n s h a r e h o l d e r 4 0 a n d r u l e o f l a w ) 5 0 3 0 2 0 1 0 0 Stock markets and banks complement in growth High banking development 4 3 Per capita growth, 1976-93 2 Low banking development 1 0 Illiquid Liquid Initial stock market liquidity 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 in financial 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 macroeconomic 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) log scale 10000 1000 100 10 1 0.1 0.01 167 countries Deposit insurance rapidly expanded Cumulative frequency of explicit DI systems established 80 60 40 20 0 1934 1962 1966 1969 1974 Source:Kane, World Bank, 2000. 1977 1980 1983 1985 1987 1989 1993 1995 1997 1999 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 procompetitive 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 stateownership, after crisis/transition, certain ownership distribution encourage reforms Ownership concentration and institutional development