Macro Research for Development: An IMF-DFID Collaboration
Topic 5. Financial Deepening for Macroeconomic Stability and Sustained Growth
Last Updated: March 16, 2015
Promoting well-managed financial deepening in low-income countries (LICs) can enhance resilience and capacity to cope with shocks, improve macroeconomic policy effectiveness, and support solid and durable inclusive growth.
Financial deepening and macro-stability has been identified as a priority area in the years ahead for the Fund, as reflected in its Financial Surveillance Strategy paper.
Managing Volatility and Supporting Low-income Country Growth
Enhancing macro-economic policy effectiveness Shallow financial systems limit fiscal, monetary, and exchange rate policy choices; hamper macroeconomic policy transmission; and impede opportunities for hedging or diversifying risk. This is of particular concern because LICs are vulnerable to external shocks, such as sharp swings in commodity prices and fluctuations in external financing. Limited policy space and instruments to mitigate the ensuing macroeconomic volatility often translate into large growth and welfare costs for these countries.
Fostering inclusive growth. More varied and accessible financial services also support growth and reduce poverty and inequality. Financial development enables bigger investments and more productive allocation of capital, which lead to higher income growth. At the same time, better and cheaper services for saving money and making payments allow firms and households to avoid the cost of barter or cash transactions, cut the costs of remitting funds, and provide the opportunity to accumulate assets and smooth income.
Current State of Play
Financial systems in LICs have grown and become more inclusive over the past two decades, but they still remain relatively small and undiversified (Chart 1). Encouragingly, although they have much lower levels of financial depth than high- and middle-income countries, low-income countries are experiencing financial deepening at rates far faster than higher income countries. But financial deepening will be of low quality if financial services are available to only a few firms or households. Access to finance is as pivotal as the depth of the financial system. Here again, there are encouraging signs, but more could be done.
Challenges for Deepening
How far can and should LICs go in promoting financial deepening? How realistic is it to expect LICs to deepen and diversify their financial systems to the levels observed in emerging market countries?
Structural characteristics of countries, policy factors, and exogenous influences (e.g., the technology available, sociopolitical conditions) determine the environment within which financial deepening may either flourish or stagnate.
• High fixed costs in financial provision explain why larger low-income country economies can sustain more diversified financial systems and why, for instance, small island economies tend to have shallow systems. Similarly, low national incomes, a high degree of informality, and low population density are factors that increase the costs and risks for financial institutions. These structural factors work to exclude large segments of the population from formal financial services and explain why many LICs have underdeveloped financial systems.
• A confluence of demand and supply factors constrains financial deepening in LICs (Chart 2). For example, low mobilization of deposits, financial illiteracy, and high fees and documentation requirements can limit financial intermediation. Similarly, for a wide variety of LICs persistent macroeconomic instability, weak collateral regimes, limited completion, and regulatory restrictions often act as barriers to the deepening and diversifying of their financial systems.
These impediments not only affect macro-financial stability but also reduce the growth dividends from deepening. At the same time, unsustainable expansion of financial systems can pose risks for stability. Weak and limited supervisory and regulatory frameworks and capacity, deficient early warning and resolution systems, and governance problems in LICs increase the risks of such fragility.
The considerable heterogeneity among LICs, however, suggests that there is no "one-size-fits-all" solution. Different areas and approaches may be needed to promote financial deepening generally.
Cross-country experiences in emerging market and low-income countries suggest that targeted and balanced initiatives to encourage competition, put in place information and market infrastructure, address collateral issues, limit excessively intrusive public sector interventions and dominance, maintain macroeconomic stability, and exercise appropriate macro-prudential oversight to avoid creating new sources of instability can help overcome specific impediments to increasing the depth, breadth, and inclusion of financial systems (Chart 3).
Papers and Calibrations
Efforts to strengthen the analytical and policy underpinnings of Fund advice on financial sector deepening in LICs continue. We are collaborating with Professor Robert M. Townsend of MIT who serves as an external advisor to help strengthen the Fund's analysis and policy advice in surveillance to member countries.
The team has developed a model-based approach to examine the relationships between financial deepening and inclusion, growth and inequality, and to provide policy recommendations. Country calibrations are under way as shown in the box below.
|Costa Rica||Democratic Republic of Congo|
- Professor Thorsten Beck (Tilburg), serving as an external advisor to a new IMF policy paper, helped in IMF's efforts to better monitor financial sectors in member countries (financial surveillance). Drawing upon this new empirical work and case-studies, pilot studies have been conducted in Benin and Senegal
- Professor Robert M. Townsend of MIT has agreed to serve as an external advisor to help strengthen the Fund's analysis and policy advice in surveillance to member countries
- Dabla-Norris, Era, Ji, Y., Townsend, R., and Unsal, D.F., 2015, “Identifying Constraints to Financial Inclusion and Their Impact on GDP and Inequality: A Structural Framework for Policy,” IMF Working Paper 15/22.
- Barajas, Adolfo, Chami, R., and Yoesfei, S. R., 2013, “The Finance and Growth Nexus Re-Examined: Do All Countries Benefit Equally?” IMF Working Paper 13/130.
- Adolfo Barajas, Beck, T., Dabla-Norris, E., and Yousefi, S.R., 2013, "Too Cold, Too Hot, or Just Right? Assessing Financial Sector Development Across the Globe" IMF Working Paper 13/81.
- Dabla-Norris, Era, and Narapong, S., 2013, "Revisiting the Link Between Finance and Macroeconomic Volatility." IMF Working Paper 13/29.
- Poghosyan, Tigran, 2012, "Financial Intermediation Costs in Low-Income Countries: The Role of Regulatory, Institutional, and Macroeconomic Factors." IMF Working Paper 12/140.
- International Monetary Fund, 2012, "Enhancing Financial Sector Surveillance in Low-Income Countries: Financial Deepening and Macrostability."