4.2.1 Macroeconomic stability
Countries with a historical tradition of macroeconomic instability – particu- larly of high rates of inflation – are more likely to have underdeveloped finan- cial systems. The reasons for this are relatively intuitive, in that high rates of inflation undermine confidence in money itself as a store of value, discourage the development of financial intermediation in the formal financial system, and encourage the acquisition of real rather than financial assets.6
Without confidence in the system there can be no financial sector develop- ment: macroeconomic stability is thus central to this task.
4.2.2 Legal framework/origins
It has become increasingly recognised in recent years that the nature of a country’s legal framework is a major influence upon the development of its financial system. Furthermore, in many developing countries, the legal framework itself is often a product of the country’s colonial legacy. In the early 1970s, Robert Mundell argued7 that Anglophone countries in sub- Saharan Africa were likely to have better-developed financial sectors than their Francophone counterparts in the region. In more recent years, empirical evidence has suggested that this is indeed the case, with countries whose legal framework is based on English common law also tending to be more market- based than those based on French civil law.8
The explanation often given9 is that English common law stresses the importance of protecting shareholder and creditor rights, which is positive for financial sector development in general, and capital market development in particular. Conversely, French civil law places less stress on these rights, and more on the power of the state, with the result that former French col- onies tend to have less-developed financial systems, often dominated by a limited number of banks. Moreover, given the emphasis on the discretionary power of the state, contract enforcement in the French tradition is often less strictly adhered to, which again has a negative impact upon financial sector development and may lead to higher levels of corruption.
4.2.3 Geography and climate
An alternative viewpoint to that focusing on the impact of legal traditions, but which also stresses the importance of the colonial era, proposes that the low quality of institutions in many former colonies – and the consequent obstacles to financial sector development – is more the result of climate and the prevalence of disease.10 That is, in countries where the climate was unsuited to European colonists, who were highly vulnerable to local diseases, there was less emphasis placed on long-term institution building. Rather, the focus was on the short-term exploitation of natural resources – not least human beings – driven by the desire to extract as much profit from the colony in as short a time as possible, rather than the taking of a long-term view of its economic and political development.
It is likely that both of these factors had some influence on subsequent financial sector development. However, the fact that financial sectors tend to be more developed in Anglophone than in Francophone sub-Saharan Africa, despite the same climatic conditions, suggests that, even if the climatic factors did retard institution building, this was less the case in countries where the English legal tradition was imposed.
4.2.4 Regulation
We saw in the previous chapter that the existence of a robust system of financial regulation and supervision is now recognised as a crucial pre- requisite for the liberalisation of the financial system, and the absence of one is strongly associated with the development of financial crises. More generally, however, the existence (or more often the lack of it) of particular forms of regulation has a strong impact upon the nature of financial sector develop- ment. These impacts emerge through a number of channels. For example:
(a) Countries with strong accounting standards are less likely to have under- developed financial systems, which are more likely to be market-based.
(b) Countries that restrict the rights of banks to engage in non-banking financial services are more likely to have underdeveloped financial systems.
(c) Countries with deposit insurance systems are less likely to have market- based financial systems.
In many ways, issues of regulation are similar to those relating to the legal framework, of which the regulatory system can perhaps be seen as a subset.
Consistently applied and enforced regulations enhance stability and spread confidence: both vital for financial sector development and, ultimately, economic growth.11
However, as was also pointed out in the previous chapter,12 it is unlikely to be optimal to simply import arm’s-length developed country forms of regula- tion into the very different environment of many developing countries. In the following chapter on the reform of the domestic system, we will explore the implications of this in some depth.
4.2.5 Contractual savings institutions
Contractual savings institutions such as pension funds and insurance com- panies are vital for developing and sustaining the financial system in developed markets. For example, 84% of the shares on the London Stock Exchange are held by institutions of this type. What role can these institutions play?
First, given the nature of their liabilities (i.e. generally very long-term) they may seek investments of a similar maturity so that their assets and liabilities are matched. Consequently, they tend to have strong demand for shares and long-term bonds. This provides a source of longer-term investment funds, which has a positive impact on capital market development and, ultimately, economic growth in the longer term. When these factors are combined with the scale of these institutions, this also affords them the opportunity to exert significant leverage over corporate behaviour, which again may have a posi- tive impact upon growth.13
Contractual savings institutions remain relatively small in developing
countries, and many reforms have been proposed to alter this situation. We will be examining these issues in the next chapter, in the context of domestic reform, but to lay the foundation for this, it is important to stress the poten- tial importance of contractual savings institutions at this stage.
4.2.6 Private ownership
When considering issues of the growth of contractual savings institutions and the development of capital markets the subject of private ownership is clearly pivotal.
While the growth of contractual savings institutions will raise the demand for equities in developing countries, there obviously needs to be sufficient supply to meet this demand. In this regard private ownership is clearly fundamental, and the privatisation of previously state-owned enterprises that we have seen in recent decades has certainly boosted this supply.
Figure 4.1 above depicts regional and total privatisations from 1988 to 2003, which grew steadily through the 1990s reaching a peak in 1997 and declining thereafter. Over this period, almost eight thousand separate privat- isations were carried out, generating more than US$400 billion in revenues for developing country governments.
Table 4.7 relates these revenues to regional and total GDP over the period.
As we can see, privatisations amounted to a little over 0.5% of total develop- ing country GDP, but there were considerable disparities between the regions.
Latin America and Eastern Europe were the regions that, relative to GDP, saw the highest level of privatisations with 0.78% and 0.62% respectively. In contrast, South Asia and sub-Saharan Africa saw the least, with 0.19% and 0.22% respectively.
Figure 4.1 Regional privatisations, 1988–2003.
Source: World Bank Privatization Database and author’s own calculations.
These figures do not allow us to consider the pattern of privatisations – both in terms of sectors and over time – as well as issues of political economy that relate to the process and its effects. Box 4.1 discusses these issues with respect to Latin America, where recent reversals of support for economic liberalisation make this a particularly pertinent subject.
Box 4.1 Privatisation and backlash in Latin America
Privatisation has been an important feature of economic reforms in Latin America. As we have seen, privatisations equalled 0.78% of the region’s GDP from 1988 to 2003, with the total level of privatisations peaking at US$37.7 billion in 1998. The main sectors targeted for pri- vatisation are shown in the figure below, weighted according to their overall value over the period.
Sectoral breakdown on privatisations in Latin America, 1988–2003.
Table 4.7 Regional privatisations as percentage of GDP, 1988–2003
Region % of GDP
Sub-Saharan Africa 0.2190
Middle East & North Africa 0.3351
South Asia 0.1914
Eastern & Central Europe 0.6186
East Asia 0.3076
Latin America & Caribbean 0.7773
Total 0.5016
Source: World Bank Privatization Database, World Development Indicators and author’s own calculations.
As we can see, by far the largest sector is infrastructure, which includes public utilities such as electricity, gas and water, as well as transport and telecommunications. In terms of the relative size of the privatisations (to GDP) the countries of Latin America were the most ‘enthusiastic’
privatisers of state assets, particularly in the late 1980s and 1990s. How- ever, much of this was driven through by right-of-centre governments and was also often integral to IMF/World Bank structural adjustment programmes.
More recent years have seen the return to power of left-of-centre governments throughout Latin America, often coming to power on a wave of popular support – or popular discontent with the free market policies implemented by their predecessors. By 2005 privatisations had almost ground to a halt in the region. In part, of course, this is related to the fact that there may be little left to privatise. However, it is also the case that – if anything – the process has now gone into reverse: the epicentres of this are in Venezuela, Bolivia and Ecuador.
The Venezuelan President Hugo Chavez came to power on a wave of populist sentiment, promising to take back the country’s ‘national assets’. Chavez has indeed taken greater control – in one form of another, often stopping well short of full nationalisation – of the coun- try’s oil and gas assets. On his re-election in 2007 he promised to extend this to the national telephone company and the power sector. Rafael Correa in Ecuador has been equally unilateral, dictating terms of the country’s external debt, renegotiating oil contracts and talking of a twenty-first century socialism. In Bolivia, Evo Morales has perhaps gone furthest of all, seizing control over state gas reserves, and sending in troops to enforce the order. Furthermore these trends are not restricted to ‘strategic sectors’ such as oil and gas.
In 2005, Bolivia also cancelled the contract of the privatised water provider Aguas del Illimani, a subsidiary of the $53 billion French company Suez. The move was highly popular with the people, not least because of the high charges that the company had introduced. Fur- thermore, this widespread dissatisfaction with the record of privatised utilities can be seen in many Latin American countries, where there is increasing resentment at escalating costs and, more subtly, the feeling that profits should not be made through the provision of such basic services.
It will be very interesting to see how this process develops in Latin America and beyond, but we do appear to have seen the high water- mark of privatisations pass. The view that ‘market forces’ are always and everywhere superior has been undermined. The ‘public good’ elem- ent of many essential services has resurfaced. The vital importance of strong regulation of monopoly providers – whether they be in private or public hands – has never been more relevant.
It should also be noted that this process of the divesting of state assets through privatisation raises major regulatory issues, since the now private industries – often in a natural monopoly position – are no longer directly controlled by the state, but must be regulated in the public interest. As with many of the more descriptive elements of this chapter, these issues will be considered in Chapter 5 when we consider reform of the domestic financial system in developing countries.
To summarise the key points thus far:
• Financial sector development is associated with economic growth.
• Macroeconomic stability is an essential prerequisite for financial sector development.
• Countries with an English common law tradition, strong protection for shareholder rights, good accounting standards, low levels of corruption and no explicit deposit insurance tend to be more market-based.
• Countries with a French civil law tradition tend to have underdeveloped financial systems and be more bank-based.
• Effective regulatory regimes are crucial for financial sector development.
• Contractual savings institutions are important for developing key aspects of the financial system, notably stock and bond markets.
• Private ownership is crucial in ensuring that there is a sufficient supply of local equities to meet this demand.
• The privatisation of state enterprises has an important role to play in this regard, but the process raises serious political and regulatory issues.
We have seen that different countries at different levels of development and with different legal traditions are likely to have different forms of financial sector development, and the relative size and efficiency of the different aspects of their financial system will also vary significantly.
What lessons does this hold for developing countries wishing to develop particular aspects of their financial sectors?