EC3040 Economics of LDCsModule B Topic 3

Financial sector issues

Finance and development

1. Financial systems growth and poverty reduction

2. Financial crises

3. Microfinance

4. Macroeconomic stability and international finance

5. The debt problem

1. Financial system development and growth: Outline

• How it was discovered that finance causes growth

• Some evidence on finance and poverty

• Measuring finance:

– Weakness of banking depth

– An alternative based on second generation evidence

Elements of the financial system

• Banks (and bank-like institutions such as building societies, credit unions, microfinance institutions). Intermediaries

• Markets (stock market, bond market, foreign exchange market)

• Financial instruments (bank deposits, bank loans, bonds, equities…)

• Other financial firms providing ancillary services (payments technologies, credit rating agencies…)

Intermediaries

• Pool resources from depositors and lend the proceeds to borrowers (including government and its agencies)

• Provide risk-sharing services for depositors, creditworthiness appraisal and monitoring for borrowers

• Also provide other services including payments (cheques, domestic and international transfers…)

• Intermediaries, especially banks, form a much larger share of the financial system in developing countries than in advanced economies.

Simplified balance sheet of a bank

Assets Liabilities Liquid asset reserves Deposits Loans and Advances Capital (residual)

Beck, Demirguc-Kunt, Levine, 2001

Beck, Demirguc-Kunt, Levine, 2001

Beck, Demirguc-Kunt, Levine, 2001

But: Post hoc ergo propter hoc?

0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50

Shallow (<0.15)

0.15 to 0.25

0.25 to 0.5

Deep (>0.5)

Ratio of liquid liabilities to GDP in

1960

Average per capita GDP growth 1960-2000

Updated from Levine, 2005

The discovery that finance affects growth (and not just the other way around)

How can we get around chicken-and-egg problem of causality

• Is the correlation between financial depth and economic growth causal?

• If so, which is the direction of causation?• Richer countries produce deeper financial systems• But do deeper financial systems also generate growth?

• Method of instrumental variables (remember dead bishops) – Suppose we have data on something that helps explain financial

depth, but has no causal impact on growth (for example, the nature of the legal system -- stronger protection for creditors vis-à-vis debtors helps financial system)

– Replace actual financial depth by its predicted value

Valid instruments(A simplified note on econometric methodology)

• Correlated with explanatory variables

• Not independently relevant to explaining dependent variable

• Predicted value from regression of explanatory variables on instruments used to explain dependent variable (growth)

– Example: legal origin

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

rage

GD

P g

row

th 1

960-

95

Actual

Model

Naive

China: Provincial Banking Depth and Growth

5%

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

40% 60% 80% 100% 120%

State-bank deposits as % provincial output

Pro

vin

cia

l gro

wth

ra

te

Pitfalls of relying on banking depth as the main measure of financial development 1

Korea: Money and Growth

0

20

40

60

80

100

120

140

160

180

1961 1966 1971 1976 1981 1986 1991 1996 2001

ba

nki

ng

de

pth

4

5

6

7

8

9

10

11

cen

tre

d 5

-ye

ar

ave

rag

e G

DP

gro

wth

M2 % GDP Pvt Credit % GDP GDP Growth

Pitfalls of relying on banking depth as the main measure of financial development 2

Where do banks invest their resources?

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

East Asia &Pacific

Europe &Central Asia

HighIncome

LatinAmerica &Caribbean

Middle East& NorthAfrica

South Asia Sub-Saharan

Africa

Claims on Private Sector Claims on Govt. Claims on SOEs Foreign Assets Liquid Assets

Banking is expensive: Net Interest Margins

0 .05 .1 .15Net Interest Margin

7. Sub-Saharan Africa

6. South Asia

5. Middle East & North Africa

4. Latin America & Caribbean

3. Europe & Central Asia

2. East Asia & Pacific

1. High Income

Sample size: 142 countriesTime period: 2004Source: Financial Structure Database, 2006 (The World Bank)

Regional Distributions