Tackling Poverty and Delivering Growth: The Importance of a Sound Financial System, Remarks by Anne O. Krueger, First Deputy Managing Director, IMF
December 4, 2004
Tackling Poverty and Delivering Growth: The Importance of a Sound Financial System
Remarks by Anne O. Krueger
First Deputy Managing Director
International Monetary Fund
to the Lagos Business School
December 4, 2004
Good afternoon. I’m very pleased to be here in Nigeria and to have this opportunity to visit the Business School.
My visit to Lagos has, inevitably, been a brief one. But over the past couple of days I have had the opportunity to meet with a number of people. I was fortunate that President Obasanjo returned from the United States in time for us to meet this morning. I also met with Finance Minister Okonjo-Iweala and other members of her economic team over lunch. Yesterday I enjoyed Governor Soludo’s hospitality at lunch, and I am pleased to see him here today.
But it is important to have the opportunity to meet with Nigerian citizens from many walks of life. I am therefore grateful for the chance to meet with you today.
I believe this is an important juncture in the Nigeria’s economic development. This is a country blessed with considerable natural and human resources; but at the same time it is one that faces enormous challenges. The government is committed to meeting those challenges through the National Economic Empowerment and Development Strategy—NEEDS. This process of economic reform is already showing returns. Macroeconomic stability is already showing results and further payoffs will follow. Implementation of NEEDS should make possible significantly higher, and sustainable, growth rates and, in turn, raise living standards and reduce poverty.
The broad reforms embodied in NEEDS come at an unusually favorable juncture. The outlook for the global economy is better than it has been for some time, in spite of continuing geopolitical concerns. An expanding world economy cannot be a substitute for reform at home, of course. But it can mean that the gains from reforms are greater. And as economic reforms are implemented, so Nigeria will gain far more from the global upturn than it otherwise could.
Sound macroeconomic policies can end the instability associated with high inflation which distorts relative price signals, focuses on short-term gains at the expense of greater longer term returns and arbitrarily skews economic benefits in favor of certain groups in society at the expense of others. Sound policies can also help make an economy less vulnerable to shocks, and more resilient in the face of changing circumstances, whether these be falling oil prices or a global downturn.
I want today to say something about the importance of economic growth in reducing poverty; and I also want to say something about the crucial role that a sound, well-regulated financial sector can—and must—play in achieving more rapid and sustainable growth.
Growth and poverty reduction
One of the most striking aspects of the contemporary debate on economic development is the very wide consensus on what is needed to achieve sustained growth and so raise living standards and reduce poverty.
By now there is almost universal recognition that lasting and substantial poverty reduction can be achieved only in the context of a growing economy. The evidence—both historical and contemporaneous—is clear: rapid, sustained growth is the route to rising living standards and falling poverty. And higher growth rates are the consequence of policy reforms that encourage enterprise, enable the private sector to respond to the appropriate incentives and ensure the most efficient allocation of resources within an economy. Such policy reforms take serious commitment. They require perseverance. And they are helped by the credibility that policymakers earn as a result of that commitment and perseverance.
Look at the experience of 19th century Britain, with the commitment to free trade that followed repeal of the Corn Laws and the recognition of the benefits of free movement of capital, not to mention an increasingly sophisticated financial system that facilitated more rapid growth.
Look, more recently, at the experience of Korea in the second half of the 20th century. From the 1960s, Korea’s real per capita GDP grew by as much every decade—somewhere in excess of 7% a year—as Britain had achieved in the whole of the nineteenth century. Korea’s remarkable economic performance was no accident, however. It was the result of radical policy reforms that opened up the economy to the rest of the world, that exposed the domestic economy to competition, that encouraged exports and that were implemented with a single-mindedness on the part of policymakers that has rarely been equaled.
In the 1950s, Korea was the third poorest country in Asia; not seen by many as a viable economy without indefinite reliance on foreign aid. It is now one of the richest countries in its region, the living standards of its citizens having risen spectacularly after decades of equally spectacular growth rates.
These are not isolated examples. Turkey and Brazil are now experiencing more rapid growth as a direct result of reforms undertaken in recent years. And it is estimated that in the 1990s alone, something like 200 million people escaped poverty, and most of them were in China and India both of which experienced more rapid growth as the consequence of reforms.
So the benefits of economic growth are there for all to see. And we know a great deal about how governments and their citizens can work to achieve the sustained growth rates needed to tackle poverty.
Going for growth
Policy reform is needed at both the macro and the microeconomic level. Neither alone is sufficient to deliver sustained growth over a long period. Without a proper macro framework in place, growth opportunities are stifled by the wrong signals and incentives. Without reform at the micro level, economic actors are unable to respond to those incentives.
Macroeconomic stability is vital. Without low and stable inflation, careful control of the public finances, a manageable public debt burden, sustainable levels of government spending: without these, governments can have little hope of strong sustainable growth and poverty reduction. Too much inflation encourages a short-term approach, bringing profits for holding inventory and insufficient reward for production. It also blurs price signals.
But putting the right policy framework in place does bring results. Here in Nigeria and elsewhere in Africa, the potential benefits that sound macroeconomic policies can bring are beginning to emerge. Inflation is lower; growth has begun to pick up. There is every reason to think that, with the right policies in place, economies in Africa can experience the higher growth rates that have brought such significant rewards in other parts of the world.
So macroeconomic stability is a necessary condition for growth. Let me repeat, though: it is not of itself, sufficient. To be truly effective, reforms must extend right across the policy spectrum. They need to encompass legal and institutional change, property rights, a commercial code and labor market reforms aimed at greater flexibility.
A strong case can be made for arguing that a commitment to, and implementation, of trade liberalization stands apart from the rest of these reforms, though. The global expansion seen during the second half of the twentieth century reminded us just how important a part free trade plays in stimulating rapid economic growth. Of course, trade has been a vital force in economic development from the days of the early Mediterranean traders, the exploits of Marco Polo, through the Industrial Revolution of the 19th century, and right up to the present time.
The global economic expansion that followed the Second World War was spectacular, even by historical standards. And it was accompanied by—indeed, it was driven by—an equally unprecedented expansion in world trade. Just look at the figures. In 1950, world merchandise exports accounted for about 8% of world GDP; today that figure is close to 26%. And world trade continues to grow faster than global GDP. In our current World Economic Outlook, we estimate that in 2004 world trade will have increased by 8.8% percent, while global GDP is projected to have grown by 5%.
This expansion of global trade was driven by the progressive lowering of trade barriers—both tariff and non-tariff barriers—and this was facilitated by the multilateral framework established by the creators of the IMF and its sister institutions.
Trade continues to be the engine of global growth. It enables producers to have access to inputs at the lowest possible price. It ensures that scarce resources are used effectively. It means that individuals and firms can move up the value-added chain as learning accumulates.
I think it is fair to say that no country has experienced sustained rapid growth without opening itself up to the rest of the world. And it is important to remember that many of the benefits from trade liberalization accrue directly to the country doing the liberalizing—whether or not that liberalization is unilateral. Yes, liberalization in concert with others—multilateral liberalization—will bring even greater benefits. But waiting to liberalize until others are ready carries a significant cost compared with unilateral opening. Korea didn’t liberalize as part of a multilateral negotiation, though it has subsequently participated in GATT and WTO trade negotiations.
A satisfactory outcome to the Doha Round of trade negotiations is important, and we in the IMF have been doing all we can to support the WTO. A Doha agreement that brought a significant further lowering of trade barriers would make possible even more rapid growth than would unilateral liberalization. This is true above all for developing economies that have most to gain from a deal. The World Bank estimates that about two thirds of the benefits of a Doha round agreement would accrue to developing economies; and a large part of those benefits would come from the reduction of trade barriers between developing countries. But the potential benefits would be largely lost for countries that resisted opening their own economies to trade.
But developing countries could reap many of those gains simply by liberalizing unilaterally. The evidence is overwhelming.
Reforms feed on each other. The benefits of macroeconomic stability can be frittered away if trade is restricted or if other reforms are neglected. We have learned that structural economic reforms are also vital in facilitating sustained growth.
But if reforms are pursued on all fronts at the same time, the returns to any one reform are greatly magnified. Trade liberalization brings even more benefits to the liberalizing country if it takes place in tandem with reforms to bring about more labor market flexibility for example. Gaps in reform programs can mean that the benefits are reduced relative to what is attainable.
A sound financial system
Which brings me to the financial system. The importance of the financial system in facilitating economic development has long been accepted. We have always known that banks and other financial institutions have a key role to play in the efficient allocation of resources and the analysis of credit risk that make rapid growth possible. We have always known, too, that as economies grow more sophisticated, the financial sector must follow suit; it must become broader and deeper.
And yet we somehow underestimated just how critical financial sector soundness could be. The Asian financial crisis of 1997-98 brought home what the consequences of underlying weaknesses in the financial sector could be, and how much pain they could inflict.
Korea was one of the countries worst affected, and offers a striking example of the extent to which financial sector weakness can undermine economic stability and growth and so harm efforts to reduce poverty. From the 1960s, as I noted, the Korean economy had grown at a spectacular pace. This growth had been driven by exports—3% of GDP in the early 1960s, 35% or more by the early 1990s. Korea had been the first emerging market economy to exploit the benefits of the international capital markets, in the 1960s.
But Korea’s export growth had in part been fuelled by a focus on credit for the export sector. Exports had hitherto been too low and represented profitable business for the banks. But the rate of return on bank assets declined, from about 3% over a long period, to a negative real rate of return in the mid-1990s. This acted as a brake on economic growth. And significant contingent liabilities had been built up because of mis-matched exposures as a result of dollar borrowing because people had assumed the exchange rate would remain stable and had looked elsewhere for attractive borrowing opportunities. The situation had become unsustainable, and, in the absence of reform, a crisis was inevitable. The crisis came when the financial markets recognized the extent of the problem, and reacted accordingly.
Investment is a vital ingredient in the process of economic growth. But investment needs to be productive; it needs to go where it can do most good. Financial institutions must be able to allocate resources in an economy by assessing competing demands for funds and analyzing risk. Decisions about which activities to finance and which not—which will bring the best risk-adjusted return, in other words—can have a crucial long-term impact on economic prospects.
As economies grow, credit allocation in all sectors—primary, manufacturing and services— becomes more complex. Banks and financial institutions need to keep pace with the demands placed on them. They too need to diversify and expand.
I mentioned Britain’s growth experience in the 19th century. It is no coincidence that in the nineteenth century the world’s most successful financial centre was in the then most successful economy. London had developed expertise in assessing risk and in allocating financial resources efficiently. The British economy needed increasingly sophisticated financial services that could keep pace with its expansion. But London’s success as a financial center in turn made rapid growth more possible; and it also made possible more rapid growth in those parts of the world—North and South America, for example—that relied on London’s superior financial skills.
Economic growth brings fresh challenges, of course: success has to be managed. Even the most advanced industrial economies are continuously having to adapt as they and the global economy evolve. Policy reforms are necessary to ensure that markets continue to have the incentives needed for them to adapt accordingly.
And those new challenges that growth brings with it also place new demands on the financial sector.
How the financial sector faces up to the changing demands on it is partly a matter for the financial institutions themselves; but it is also a matter for policymakers who need to ensure effective regulation that provides the right incentives.
Like every sector of the economy, the financial sector needs—and benefits from—competition. Competition drives down costs, and increases efficiency. The more efficient and competitive the financial system is, the lower are the spreads between deposit and lending rates. Well-run banks that can assess risk and allocate resources efficiently outperform those less-skilled in this regard. Effective competition reduces borrowing costs and diversifies financial risk within the economy. Competition will also drive the broadening and deepening of the financial sector, reducing reliance on banks as other financial institutions develop to fulfill specific needs.
The central role that the financial sector plays in fostering growth and maintaining financial stability means that proper, effective regulation is important. Competition needs to be genuine and effective. Banks need to be properly capitalized so that they and the banking system as a whole avoid undue risk.
The level of non-performing loans (NPLs) needs to be carefully monitored. Too high a level of NPLs implies inefficient allocation of resources, poor risk management and ultimately hampers growth by depriving more productive activities of resources. The system needs to be transparent, so that risks can be properly monitored. Financial intermediation needs to be broad and deep, so that risks are diversified.
These are challenges that every country faces. It is easy for policymakers pre-occupied with the struggle to reduce poverty and establish macroeconomic stability to be distracted from the need to monitor the financial sector and ensure that it develops to meet the requirements of a growing economy.
But a weak financial sector can undermine the primary objectives of economic policy in two ways. It can generate financial instability which can itself inflict considerable harm on an economy. And it can hamper growth by failing to keep pace with the changing needs of firms and individuals and by allocating resources inefficiently.
The history of Western economic development is one of financial sector development as well, and everything we have learned shows that economic growth and financial sector health are now more closely linked than ever before.
The role of the IMF
The learning process I have described is one in which the IMF has been actively involved. We too have been learning from experience and adapting the way we work as a result. In the aftermath of the crises of the 1990s, we have put in place a number of changes. In particular, we place much more emphasis on monitoring the financial sector and assessing possible risks to the health of national financial systems.
In co-operation with the World Bank, we look closely at regulatory frameworks, financial sector competition, transparency, the levels of financial intermediation and so on. As part of this development of our surveillance work, the Financial Sector Assessment Program (FSAP) was introduced in 1999 jointly with the World Bank. Some of you may be familiar with this. The FSAP aims to help member governments strengthen their financial systems by making it easier to detect vulnerabilities at an early stage and to identify key areas which need further work.
FSAPs aren’t about examining the balance sheets of individual banks, or even the banking sector as a whole. They are focused entirely on the policy and regulatory framework. Their purpose is to help our member countries ensure that domestic regulators and supervisors are able to make accurate judgments about the health of the banks and other financial institutions under their jurisdiction.
A large number and a wide range of our member countries have now had an FSAP program. The feedback we get is overwhelmingly positive. Even the authorities in those industrial countries with highly developed financial sectors that have had FSAPs have found them to be useful.
The FSAP also forms the basis for Financial System Stability Assessments (FSSAs) in which IMF staff address issues directly related to the Fund's surveillance work. These include risks to macroeconomic stability that might come from the financial sector and the capacity of the sector to absorb shocks. Is the level of NPLs a cause for concern? Are the banks well-regulated and sound? How would the financial sector be affected by sharp rises in interest rates—would this lead to a rise in NPLs? Again, these FSSAs cut across the full breadth of our membership.
As you know, Nigeria participated in an FSSA exercise two years ago, one which we believe was valuable in highlighting the opportunities for improving the health and performance of the financial sector and thus the contribution it can make to the long-term growth prospects for the Nigerian economy.
The way forward
I know from my discussions over the past couple of days that the Nigerian authorities are committed to meet head-on the economic challenges they face. Poverty reduction is clearly a priority, and the government recognizes that a stable macroeconomic framework is an essential element of any economic program aimed at delivering long-term growth which in turn is the only enduring means of poverty reduction.
Like many countries, Nigeria is working to strengthen its financial sector. It is clear from the recent announcements of the central bank that the authorities recognize the important role that the financial sector can play both in delivering financial stability and, over the longer term, more rapid growth. Measures to strengthen the banking system by raising minimum capital requirements, introducing risk-based supervision and the zero tolerance policy for mis-reporting by banks are all welcome moves. The Fund, as ever, stands ready to provide technical assistance in the development and implementation of financial sector reforms.
I started by saying that this is an important juncture in Nigeria’s economic development. I would go further and say that this is an auspicious moment. With NEEDS, the government has committed itself to a wide-ranging reform program that, if implemented fully, should make a significant contribution to achieving more rapid and sustained rates of growth, and so reducing poverty.
The generally favorable external environment is one that makes it easier to introduce reform and increases the potential benefits. The current global economic expansion is an opportunity to press ahead vigorously with reform, and permits a larger payoff sooner—thus reducing resistance to change.
This country faces enormous economic challenges if it is to experience the sustained rapid growth needed to reduce poverty and achieve the Millennium Development Goals. But the signs are encouraging. The government has recognized the importance of creating a stable macroeconomic framework that can best foster longer term growth prospects.
Engagement with the rest of the world is vital for growth and prosperity in any economy. Trade and investment are essential for growth; and history has taught us over and over again that an open economy, one that encourages commerce and rewards entrepreneurship, offers the only long term prospect of growth, rising living standards and poverty reduction.
It is my view that Africa can reap the same economic rewards that other countries have attained by adopting similar goals and making a similar commitment to full participation in the world economy. Nigeria has much in its favor, not least the dynamism of its people. It has a government committed to exploiting these advantages for the good of all its citizens. I look forward to seeing some of the benefits of those reforms on my next visit here.