International Monetary Fund

Please send us your feedback

Macro Research for Development: An IMF-DFID Collaboration

Topic 5. Financial Deepening for Macroeconomic Stability and Sustained Growth

Last Updated: April 02, 2014

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.

Policies Matter

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 Outreach

• A new IMF policy paper highlighted these issues and also discusses the types of policies that can help promote "healthy" financial sector development. The paper, part of the IMF's efforts to better monitor financial sectors in member countries (financial surveillance), drew upon new empirical work and case studies and benefited from Professor Thorsten Beck (Tilburg) serving as an external advisor on the project. Following up on the paper, pilot studies have been conducted in Benin and Senegal to enhance financial sector surveillance. Other pilots underway include Ghana, the WAEMU region, Haiti, and Bhutan.

• Efforts to strengthen the analytical and policy underpinnings of Fund advice on financial sector deepening in LICs continue. 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. The Consortium for Financial Systems and Poverty (CFSP), based at the University of Chicago and led by Professor Townsend, is a private research organization of leading economists that will partner with us in several ways:

  • Forming a network of experts in this area that would convene periodically.
  • Strengthening in-reach and outreach by organizing joint conferences and workshops along with other relevant partners, targeting a broad range of audiences, including policymakers, academics, and the informed public.
  • Promoting knowledge-sharing events for policy makers from developing countries to learn from each others' experiences.
  • In addition to the above listed efforts, the Fund hosted a conference of leading academics and researchers on "Financial Deepening, Macro-Stability and Growth in Developing Countries" in Washington in September 2012. The conference, jointly organized by the Fund, the World Bank, he CFSP), and DFID, attracted a large internal and external audience.

Model Calibrations
Country Status
Colombia Completed
Egypt Completed
Kenya Completed
Malaysia Completed
Mozambique Completed
Philippines Completed
Uganda Completed


  • 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


Working Papers

Published Papers