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Expanding Financial Sectors in Low-Income Countries

Mobile phone money transfer in Ntulele, Kenya: financial system access in low-income countries is broadening (photo: Shashank Bengali/MCT)

FINANCIAL DEEPENING

Expanding Financial Sectors in Low-Income Countries

By Era Dabla-Norris
IMF Strategy, Policy, and Review Department

June 4, 2012

  • Financial sector development can help foster sustainability, spur growth
  • Paper assesses scope for sustainably "deepening" financial systems
  • Pilot studies to be conducted to inform IMF policy advice

Low-income countries can strengthen overall economic stability and spur growth by building stronger and more diversified financial and banking sectors, according to a new policy paper from the International Monetary Fund.

The paper, which also discusses the types of policies that can help promote “healthy” financial sector development, says low-income countries should promote “financial deepening” to underpin economic growth and improve living standards.

Financial deepening refers to the process of enhancing and broadening financial systems by increasing the depth, liquidity, efficiency, and volumes of financial institutions and markets, diversifying domestic sources of finance, and extending access to banking and other financial services.

Part of the IMF’s efforts to strengthen its overall financial sector monitoring—or financial surveillance—in member countries, the paper highlights the linkages between financial deepening, macroeconomic policy effectiveness, and stability in low-income countries.

“There are important linkages between the degree of financial depth and the effectiveness of a country’s macroeconomic policies. This paper is an important first step in systematically highlighting these linkages,” said IMF Deputy Managing Director Min Zhu. “I am hoping that our bilateral surveillance in low-income countries will increasingly focus on these linkages to help countries better manage volatility and achieve strong durable growth.”

Many still excluded

Access to financial systems in low-income countries has broadened over the past two decades, with more people using banks, for example, but they remain small and relatively undiversified, with large segments of the population often excluded from formal financial services.

The paper points out that shallow financial systems limit fiscal, monetary, and exchange rate policy choices, and impede opportunities for hedging or diversifying risk, which are helpful in coping with sharp swings in commodity prices and fluctuations in external financing.

Promoting sustainable financial deepening can engender greater resilience and capacity to cope with external shocks, enhance policy effectiveness, and support sustained growth.

At the same time, the process of deepening itself can create new risks—such as those that arise from growing financial interconnectedness or the challenges from unregulated financial innovation—which need to be effectively managed.

Challenges for deepening

The paper attempts to assess the plausible scope for financial deepening in developing countries using a range of analytical tools and case studies. Structural characteristics of countries, policies, and other factors such as available technology and sociopolitical conditions, determine the environment within which financial deepening may flourish or stagnate.

High fixed costs in financial provision explain why larger low-income economies can sustain more diversified financial systems and why, for instance, many small island economies have shallow systems. Similarly, low income levels, high levels of informality, and low population density are among factors that increase the costs and risks for financial institutions.

Low deposit mobilization, financial illiteracy, and high fees and documentation requirements can limit financial intermediation and use of banks. Similarly, persistent macroeconomic instability, weak collateral regimes, limited completion, and regulatory restrictions are common impediments to deepening and diversifying financial systems.

At the same time, excessive risk taking by institutions and market participants can lead to unsustainable expansions. Weak and limited supervisory and regulatory frameworks and capacity, deficient early warning and resolution systems, and governance problems increase risks of fragility in low-income countries, which need to be managed.

Going forward

Pilot studies will be conducted across a range of low-income countries to focus attention on the linkage between financial deepening and macroeconomic policy effectiveness. In parallel, efforts will be made to close information gaps, better integrate diagnostic technical assistance with surveillance, and to continue to collaborate with the World Bank.

A conference on this topic will be held in Washington in the second half of 2012. There are also plans to have a South-South conference in Africa for policymakers to learn from each others’ experiences.


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