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Finance & Development
A quarterly magazine of the IMF
March 2003, Volume 40, Number 1

Banking on Development
Susan Creane, Rishi Goyal, A. Mushfiq Mobarak, and Randa Sab

Further reform of financial sectors holds promise for the MENA countries

As the MENA countries look for ways to jumpstart growth, further financial sector reform should be made a priority. A more developed financial system—with lower information and transaction costs—facilitates a more efficient allocation of resources. It also leads to a more rapid accumulation of physical and human capital and faster technological progress by enabling the identification and funding of better investment projects; mobilizing savings; monitoring managers; and allowing investors to trade, hedge, and diversify risk.

Over the past three decades, MENA policymakers have gradually reformed their financial sectors. While they have made progress, their efforts have been eclipsed by reform and growth in other parts of the world, and, in much of the region, a great deal remains to be done. In what areas has progress been made? What further reforms are needed? How do the MENA countries stack up against the rest of the world? To answer these questions, we undertook a study of financial sectors in the region and, in the process, developed new indices to measure financial development in the MENA region.

A snapshot

Our study began with the collection of over 100 quantitative and qualitative statistics for 20 MENA countries (excluding, for lack of data, Afghanistan, Iraq, Somalia, and the West Bank and Gaza). The data, for 2000 or 2001 depending on availability, were organized under six themes, each of which reflects a different facet of financial sector development: (1) development of the monetary sector and monetary policy; (2) banking sector size, structure, and efficiency (including the role of the government in the sector); (3) quality of banking regulations and supervision; (4) development of the nonbank financial sector; (5) openness of the financial sector; and (6) institutional environment. A cross-country analysis of the data suggests some common trends and weaknesses, pinpointing future areas for reform.

Monetary policy. For the most part, indirect monetary policy tools are employed, interest rates are freely determined, and government securities exist. However, the limited development or nonexistence of secondary markets for government securities hinders the broad use of open market operations by the central bank. And a few countries lack a comprehensive framework for designing and conducting monetary policy.

Banking sector. In a few countries, such as those belonging to the GCC, the banking sector is well developed, profitable, and efficient. But in nearly half the region, the banking sector is not well developed and is dominated by the public sector. Public sector banks are characterized by government intervention in credit allocation, losses and liquidity problems, and wide interest rate spreads. In more than half the countries in the region, the banking sector is highly concentrated, with assets of the three largest banks accounting for over 65 percent of total bank assets, and the entry of new banks is difficult. And in many parts of the region, modern banking and financial skills are lacking.

Regulation and supervision. Many countries, such as the GCC countries, Jordan, Lebanon, Morocco, and Tunisia, have strengthened banking supervision and regulation and established up-to-date procedures to collect prudential information on a regular basis and inspect and audit banks. They have taken steps to conform to the international standards set by the Basel Committee on Banking Supervision, such as increasing capital-adequacy ratios and reducing nonperforming loans. However, in most countries, nonperforming loans still account for 10–20 percent of total loans.

Nonbank financial sector. In most of the region, the nonbank financial sector—the stock market, corporate bond market, insurance companies, pension funds, and mutual funds—is not well developed. And, even in countries with such markets, trading is usually limited. The development of these markets is especially hindered by the lack of a clear and stable legislative framework and legal limitations on ownership. Housing finance is one area where most MENA countries have developed institutions, primarily through specialized housing banks. However, high fiscal costs are associated with implicit subsidies on sales of public land to public developers and, in some cases, with soft loans to low- and middle-income households by state-owned development and housing banks.

Financial openness. MENA countries have gradually opened up their current and capital accounts. Nearly half the countries have open financial sectors, although many maintain restrictions on foreign ownership of assets and repatriation of earnings. Some countries, such as Algeria, Iran, Mauritania, Pakistan, and Syria, have multiple currency rates or parallel exchange markets.

Institutional environment. In much of the MENA region, the quality or efficacy of institutions, including the judicial system, bureaucracy, law and order, and property rights, is poor. For instance, in several countries, the judicial system is susceptible to political pressure and long delays, resulting in poor legal enforcement of contracts and loan recovery. Property rights enforcement also tends to be weak, hindering commercial activity and investment and hence growth.

New measurement tools

The next step in our study was to develop new indices or measures of financial sector development for the MENA region, using the qualitative and quantitative data collected for the study. Typically, financial development is measured by a small set of quantitative variables, such as the ratio of broad money (M2) to GDP and the ratio of private sector credit to total credit, but simple quantitative measures, taken individually, do not necessarily capture what is broadly meant by financial development. The financial structure of a country is composed of a variety of markets and financial products, and development encompasses not only monetary aggregates and interest rates but also financial openness, regulation and supervision, and institutional capacity (such as the strength of creditor rights). Moreover, the simple quantitative measures may give a misleading picture of financial development. While a higher ratio of broad money to GDP is generally associated with greater financial liquidity and depth, the ratio may decline rather than rise as a financial system develops because people have more opportunities to invest in longer-term or less liquid financial instruments.

We constructed a first index—the comprehensive index—which is a single measure of financial development for a specific period of time, 2000–2001. It combines six different indices, each of which is a composite of four to nine different indicators based on the above-mentioned themes (see box). This overall index allows us to group countries in three categories: high, medium, and low financial development (see table). On average, countries at higher levels of financial development outperform countries at lower levels in all six aspects of financial development (Chart 1). But countries in the highest third of financial development for the region receive particularly high marks for regulation and supervision and for financial openness. Countries in the middle third also score fairly well in these two areas. However, throughout the region, countries fare poorly on indicators for a strong institutional environment and for the development of the nonbank financial sector.

Chart 1: What do the rankings tell us?

Constructing indices of financial development

Comprehensive index. The development of this index closely followed work done by Gelbard and Leite (1999) for sub-Saharan Africa. We began by scoring each of the dimensions of financial development. Whenever possible, quantitative data, appropriately rescaled, were used to score a country. These data included the ratio of commercial bank assets to total central bank and commercial bank assets and the ratio of broad money to GDP. In cases where qualitative data were used, a 0-1-2 scoring mechanism was adopted. All scores were rescaled so that they fell in the 0 to 2 range, with higher scores corresponding to higher levels of financial development. Next, weights were assigned to each of the 36 variables used in the construction of this index. To ensure robustness, the index was calculated using assigned weights, equal weights among the six themes, and equal weights among each of the components within the six themes. We found that the grouping of countries into high, medium, and low financial development categories was robust to the different weighting schemes, although the relative ranking of countries within each grouping changed slightly.

Alternative index. This index is related to the one developed by Beim and Calomiris (2001) and is based on quantitative data only. To construct the index, we selected four variables commonly used in the literature. The four variables were ratio of broad money to GDP; ratio of the assets of deposit-money banks to the total assets of the central bank and deposit-money banks; reserve ratio; and ratio of credit to private sector by deposit-money banks to GDP. These variables measure the size of the financial sector, the importance and relative ease with which commercial banks provide funds, and the extent to which funds are provided to the private as opposed to the public sector. We then aggregated these variables using a statistical technique called Principal Components Analysis. Aggregating not only captures different aspects of financial development in a single measure but also reduces biases or errors that may plague a particular data series. Furthermore, in keeping with the standard practice of averaging the variables in either 5-year panels or 10-year panels to smooth out business cycle fluctuations and focus on trends, we averaged the data in 10-year panels to obtain observations for the 1960s, 1970s, 1980s, and 1990s.


The comprehensive index allows MENA countries to be ranked according to their level of financial development (2000–2001).1

Level of financial development
Saudi Arabia
United Arab Emirates
Iran, I.R. of
Syrian Arab Republic

   Source: Authors.
   1Based on the comprehensive index of qualitative and quantitative data; the index ranges from 0 to 10, with 10 being the highest level of financial development. Within each category, the countries are arranged in alphabetical order.

A global ranking

How have the financial systems within the MENA countries developed over time, and how does MENA compare with other regions? Since information on the comprehensive index is not available at the required level of detail either for the MENA countries over time or for other countries, we developed an alternative index based solely on quantitative information that is widely available (see box). Within MENA, the rankings of countries under both the comprehensive and the alternative indices closely track each other. This gives us further confidence in using the alternative index to make intertemporal and interregional comparisons of financial development. Furthermore, the alternative index produces rankings of financial development for 144 countries. The rankings are similar to those developed elsewhere in the literature, such as in Beim and Calomiris (2001).

According to the alternative index, most MENA countries experienced financial development from the 1960s through the 1980s, and many continued to experience financial deepening in the 1990s (Chart 2). However, in a few countries, political instability resulted in a deterioration of the index.

Chart 2: How does MENA compare?

The MENA region ranked well below the industrial countries in financial development but above most other developing regions. However, it is interesting to note that, although the MENA region ranked well above the newly industrialized economies of East and Southeast Asia in the 1960s, it fell far behind in the 1980s and the 1990s.

For MENA policymakers trying to compete in an increasingly globalized world, the challenge now is to concentrate efforts where financial development has been weakest, as suggested by our comprehensive index. This means less government interference in the financial system, which will require cutting back on public ownership of financial institutions and minimizing monetary financing of budget deficits, investing in human resources (including strong management and financial skills), and strengthening the legal environment. These measures will not only improve confidence but also facilitate greater investment and growth.

  David O. Beim and Charles W. Calomiris, 2001, Emerging Financial Markets (Boston: McGraw-Hill).
  Enrique A. Gelbard and Sergio Pereira Leite, 1999, "Measuring Financial Development in Sub-Saharan Africa," IMF Working Paper 99/105 (Washington).
  Mohsin S. Khan and Abdelhak S. Senhadji, 2000, "Financial Development and Economic Growth: An Overview," IMF Working Paper 00/209 (Washington).
  Ross Levine, 1997, "Financial Development and Economic Growth: Views and Agenda,"
Journal of Economic Literature, Vol. 35 (June), pp. 688–726.
  Karim Nashashibi, Mohamad Elhage, and Annalisa Fedelino, 2001, "Financial Liberalization in Arab Countries," in
Macroeconomic Issues and Policies in the Middle East and North Africa, ed. by Zubair Iqbal (Washington: International Monetary Fund).
  Paul Wachtel, 2001, "Growth and Finance: What Do We Know and How Do We Know It?"
International Finance, Vol. 4 (Winter), pp. 335–62.

Susan Creane is Assistant to the Director, and Rishi Goyal is in the Economist Program, in the IMF's Middle Eastern Department.

A. Mushfiq Mobarak is an Assistant Professor in the Department of Economics at the University of Colorado at Boulder.

Randa Sab is an Economist in the IMF's Western Hemisphere Department.