## _sdn1116

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---

### Executive summary — motivation and high-level conclusions
- Reforming the international monetary system (IMS) has been emphasized by policymakers, including in the April 2011 IMFC and G-20 communiqués.
- Financial depth is conceptually defined in three dimensions:
  - Access: sectors and agents can use a range of financial markets for savings and investment decisions, including at long maturities.
  - Market liquidity: financial intermediaries and markets can deploy larger volumes of capital and handle larger turnover without large movements in asset prices.
  - Risk-sharing: the financial sector can create a broad menu of assets for hedging or diversification.
- Stability trade-offs:
  - Benefits of deeper markets:
    - Greater capacity to intermediate capital flows without large asset price or exchange rate swings.
    - Reduced reliance on foreign savings.
    - Attenuated balance sheet mismatches.
    - Alternative funding during international stress.
  - Risks of deepening:
    - Can attract volatile capital inflows, complicating macroeconomic management.
    - Rapid deepening can produce credit booms and busts.
- Broader systemic implication:
  - Deepening can increase the ability of EMs to generate their own reserve-like assets, potentially reducing reliance on U.S. treasuries and contributing to a more multipolar IMS.
- Policy framing:
  - Because deepening is a long-term, multi-stage process with higher risks in early stages, near-term measures to strengthen the IMS remain crucial, including building a strong global financial safety net and developing a comprehensive and balanced approach for coping with volatile capital flows.
  - Support gradual, well-sequenced deepening, complemented by strengthened international arrangements and domestic policies for capital flow management and macroprudential oversight.

### Patterns of financial deepening and international monetary stability
- Two complementary analytical perspectives:
  - Markets-and-sector perspective: deepening implies broadening beyond core banking to capital markets and nonbank intermediaries (pension funds, insurance, foreign investors); prerequisites include credible legal systems, disclosure, and trading arrangements.
  - Balance-sheet perspective: deepening enhances capacity to manage the aggregate balance sheet smoothly and balance growth/adjustment to shocks; effectiveness depends on maturity and currency composition, sectoral ability to issue claims countercyclically, government lender-of-last-resort capacity, and prudent regulation/supervision.
- Metric used:
  - A simple balance sheet metric—the size of the aggregate balance sheet measuring total financial claims and counterclaims of an economy, domestic and external—is employed as a comprehensive metric for financial depth (Box 1). This metric is noted as more comprehensive than liquid liabilities or broad money (M2/GDP).
- Empirical pattern:
  - A growing divergence in financial depth between advanced markets (AMs) and emerging markets (EMs) over the past two decades indicates scope for catch-up by EMs.
  - International adjustment implications: slower growth of domestic claims in advanced deficit countries (slower credit growth lowers domestic demand) and faster growth in surplus economies and EMs (which would raise domestic demand) would be required for adjustment.

### Risks, crisis incidence, and policy responses
- Deepening-stage relationship with crisis dynamics:
  - Initial stages of deepening:
    - Crisis risks and costs are found to rise.
    - Policymakers tend to build reserve buffers, constrain capital mobility, and limit exchange rate flexibility.
  - Later stages of deepening:
    - Crisis incidence is found to decline.
    - Policymakers have tended to adopt more flexible exchange rates, open capital accounts, and keep smaller reserve buffers.
- Policy implication:
  - Strengthen global financial safety net and develop comprehensive approaches to cope with volatile capital flows while supporting well-sequenced domestic deepening.

### Box 1 — An Index of Financial Depth: definition, data, and key empirical findings
- Definition and construction:
  - The composite index of financial depth (IFD) measures the total stock of domestic financial assets (DA) and liabilities (DL) and foreign assets (FA) and liabilities (FL).
  - The index places a 1/2 weighting on foreign assets and liabilities so that when FA = FL the index reflects the total domestic and foreign liabilities of the economy.
  - Domestic liabilities are defined as total domestic financial liabilities, including broad money, resident claims on banks, domestic securities, and stock market capitalization.
  - The index was constructed with and without equities to side-step large valuation swings from equity markets.
- Data, coverage, and methodological notes:
  - The index was constructed for 50 countries—half AMs and half EMs—that collectively account for over 90 percent of global GDP.
  - Data on external assets and liabilities come from the updated and extended version of the Lane and Milesi-Ferretti (2007) dataset; these data are available through 2009.
  - Domestic claims data are drawn from datasets constructed by the World Bank and the Bank for International Settlements.
  - Limitations: the metric is simple and partial and should be complemented by measures of balance-sheet resilience (currency and maturity mismatches), prudential indicators, quality of regulation and supervision, institutional capacity, and market development.
- Key empirical findings and trends:
  - Global and country coverage:
    - Index constructed for 50 countries, through 2009.
  - Relative domestic vs. external depth:
    - External balance sheets in AMs have experienced a nearly 10-fold increase since 1970, compared with 3½ times in EMs.
    - Median AM net position narrowed to a net position of 15½ percent of GDP in 2009; EMs had a large net liability position of 40.1 percent of GDP in 2009.
  - Country-level highlights:
    - The index shows large balance sheets relative to GDP for important financial centers; Ireland exhibited a very rapid cyclical increase in balance sheet size by 2009.
    - China’s total financial claims are now comparable with those of large European countries as a share of global GDP.
  - Sectoral and market structure differences:
    - EMs remain largely bank based; capital flows intermediated through banks are the most volatile.
    - Median AM equity market capitalization was 120 percent of GDP in 2009—around twice that of EMs.
    - Bonds outstanding: at 200 percent of GDP at end 2010, the median value of bonds outstanding in AM markets was four times the median value in EMs.
    - For countries with data, median long-term bonds (maturities over a year) were 75 percent of GDP in AMs versus 33 percent of GDP in EMs.
    - Derivatives: average daily turnover in EMs where data are available was $1.2 trillion in April 2010 (6.2 percent of those economies’ GDP), compared to $13.8 trillion (36 percent of GDP) in AMs.
    - EMs have increasingly substituted FDI for debt liabilities: for the median EM, gross debt liabilities were 55½ percent of GDP in 2000 and just over 42 percent in 2009; FDI liabilities rose from 20½ percent in 2000 to over 40 percent in 2009.
    - Pension funds and insurance companies play a much larger role in AMs than in EMs and can facilitate long-term market development.
- Risks, crises evidence, and dynamics:
  - Crisis frequency and costs (based on Laeven and Valencia (2008), updated through end-2009; 49 crisis cases identified: 36 in EMs and 13 in AMs; 30 banking crises and 21 currency crises, with overlaps):
    - The unconditional probability of crises generally declines with financial depth, but rises slightly at very high levels of depth (reflecting the recent crisis).
    - The conditional probability of a crisis rises at early stages of deepening before falling off; historically, crisis incidence has been high at levels of depth associated with EMs (index lower than 3).
      - 83 percent of all EM crises occurred when the depth index was lower than 3; a further 11 percent occurred above 3 but below 4.5.
    - Even though frequency declines with deepening, average costs of crises remain high:
      - For EMs, the average two-year cumulative losses for levels of depth between 3 and 4½ are about 12¼ percent of precrisis GDP.
      - For EMs, the costs of currency crises at these levels are nearly 15½ percent of precrisis GDP.
    - Arcand, Berkes, and Panizza (2011) find finance has a negative effect on growth when credit to the private sector exceeds 110 percent of GDP.
  - Capital-flow volatility and financial depth (EMs, sudden-stop analysis):
    - The volatility of net capital outflows following a sudden stop declines unambiguously as depth rises—greater depth helps cushion against outflows.
    - For inflows, once depth exceeds 1½ further deepening is associated with greater volatility during the inflows phase, which then falls off when depth exceeds 3.
    - At levels of depth similar to AMs, relative volatility before and after sudden stops becomes negligible.
  - Stylized risk profile:
    - Crises can occur at any level of financial development; crisis risks and costs can re-emerge at greater levels of depth if regulatory frameworks and supervisory capacity lag balance-sheet expansion.

### Policy implications and recommendations (Box 1)
- Country-level policies during deepening:
  - Countries with lower levels of depth—and higher crisis risks and costs—tend to have less exchange-rate flexibility, more capital account restrictions, and higher reserves accumulation; reserves may serve as buffers against costly crises.
  - Precautionary reserve accumulation may increase if crisis risks and costs are perceived to be high, possibly delaying global adjustment.
  - As depth increases and crisis costs fall, policies could transition to reduced precautionary demand for reserves, greater openness in the capital account, and more flexible exchange rates.
- Measures to support safe deepening:
  - Complement the aggregate balance-sheet metric with indicators of balance-sheet resilience (currency and maturity mismatches), prudential indicators, quality of regulation and supervision, and market development.
  - Develop capital markets (equity, bond, derivatives) and institutional investors (pension funds, insurance) to foster long-term savings and risk sharing.
  - Manage the pace of balance-sheet expansion to limit excessive leverage and reliance on short-term financing.
- Multilateral and systemic policies to strengthen the IMS:
  - Resolve external imbalances through surveillance and policy cooperation (e.g., IMF surveillance and the G-20 Mutual Assessment Process).
  - Reform the global safety net to close gaps and limit the need for precautionary reserve accumulation.
  - Develop a coherent framework to cope with volatile capital flows to limit associated risks and costs.

### Appendix I — Facilitating financial deepening: policy areas and sequencing
- Macro policy framework:
  - A sound policy framework is essential for macroeconomic and financial stability and would support demand for domestic assets and enhance the credibility of the government as an issuer of debt securities.
- Market infrastructure:
  - A robust market infrastructure is necessary; a benchmark yield curve is a key requirement and sound public debt management policies are necessary to support it.
- Legal framework:
  - Strong and transparent legal frameworks are critical to investor protection and property and creditor rights.
  - Possible actions: codify and enforce accurate and timely accounting standards, build private-sector infrastructure such as exchanges and credit bureaus, and establish robust payments and settlements infrastructure.
  - Empirical support: sound institutions are positively related to financial development and long-term growth.
- Regulatory and supervisory regime:
  - Establish a sound regulatory and supervisory system with capacity to ensure financial stability.
  - Balance: regulation should foster prudent market conduct without hindering development; too rapid deregulation risks instability, while highly restrictive rules may hinder market development.
  - Regulatory priorities: address disclosure and transparency, limit market dominance, enforce risk management practices.
  - Sequencing: IMF (2002) provides an operational framework for sequencing financial deregulation and liberalizing cross-border capital flows.
- Cooperative mechanisms:
  - Regional cooperative solutions can aid development (for example, in Asia to develop local currency bond markets).
  - Effective focus areas: achieve a critical scale, build information systems and transparency, improve market infrastructure and regulation, and create a vibrant investor community.
  - Evidence: focused efforts on these impediments appear to have had a large impact (BIS, 2011).

*Source: _sdn1116 — Executive Summary, Box 1, and Appendix I (IMF staff analysis).*

### Executive Summary ......................................................................................................

### Executive Summary

### Motivation
- Reforming the international monetary system (IMS) has been emphasized by policymakers, including in the April 2011 IMFC and G-20 communiqués.
- Financial deepening in emerging markets (EMs) has received attention as a potential contributor to IMS stability.
- Conceptual definition of financial depth in the paper:
  - (i) Access: sectors and agents can use a range of financial markets for savings and investment decisions, including at long maturities.
  - (ii) Market liquidity: financial intermediaries and markets can deploy larger volumes of capital and handle larger turnover without large movements in asset prices.
  - (iii) Risk-sharing: the financial sector can create a broad menu of assets for hedging or diversification.
- Stability trade-offs highlighted:
  - Benefits: Greater capacity to intermediate capital flows without large asset price or exchange rate swings; reduced reliance on foreign savings; attenuated balance sheet mismatches; alternative funding during international stress.
  - Risks: Can attract volatile capital inflows, complicating macroeconomic management; rapid deepening can produce credit booms and busts.
- Broader systemic implication:
  - Deepening can increase the ability of EMs to generate their own reserve-like assets, potentially reducing reliance on U.S. treasuries and contributing to a more multipolar IMS.

### Patterns of Financial Deepening and International Monetary Stability
- Two complementary approaches to analyze deepening:
  - Markets-and-sector perspective: broadening beyond core banking to capital markets and nonbank intermediaries (e.g., pension funds, insurance, foreign investors); prerequisites include credible legal systems, disclosure, and trading arrangements.
  - Balance-sheet perspective: deepening enhances capacity to manage the aggregate balance sheet smoothly and balance growth/adjustment to shocks; dependent on balance sheet structure (maturity, rollover needs, currency composition), sectoral ability to issue claims countercyclically, government ability to act as lender of last resort, and prudent regulation/supervision.
- Metric used:
  - The paper employs a simple balance sheet metric—the size of the aggregate balance sheet measuring total financial claims and counterclaims of an economy, domestic and external—as a comprehensive metric for financial depth (Box 1).
  - This metric is noted as more comprehensive than liquid liabilities or broad money (M2/GDP).
- Empirical patterns summarized:
  - A growing divergence in financial depth between advanced markets (AMs) and EMs over the past two decades is documented, indicating scope for catch-up by EMs.
  - Over the past decade, this divergence reflects a lack of adjustment in the IMS, with implications for global imbalances:
    - International adjustment would require slower growth of domestic claims in advanced deficit countries (slower credit growth lowers domestic demand) and faster growth in surplus economies and EMs (which would raise domestic demand).

### Risks, Crisis Incidence, and Policy Responses
- Relationship between deepening stages and crisis dynamics:
  - Initial stages of deepening:
    - Crisis risks and costs are found to rise.
    - Policymakers tend to build reserve buffers, constrain capital mobility, and limit exchange rate flexibility.
  - Later stages of deepening:
    - Crisis incidence is found to decline.
    - Policymakers have tended to adopt more flexible exchange rates, open capital accounts, and keep smaller reserve buffers.
- Policy implication from observed patterns:
  - Because deepening is a long-term process, near-term measures to strengthen the IMS remain crucial, including:
    - Building a strong global financial safety net.
    - Developing a comprehensive and balanced approach for coping with volatile capital flows.

### Implications and Conclusions
- Financial deepening in EMs can, if properly managed, contribute to lowering global imbalances and reducing crisis incidence and costs over time.
- However, because deepening evolves over a multi-stage process with higher risks in early stages, policy frameworks should:
  - Support gradual, well-sequenced deepening.
  - Complement deepening with strengthened international arrangements (global financial safety net) and domestic policies for capital flow management and macroprudential oversight.
- Appendix I provides a brief overview of policies to promote deepening (note: not reproduced here).

*Source: _sdn1116 - Executive Summary*

### Box 1. An Index of Financial Depth

### Box 1. An Index of Financial Depth

### Definition and construction
- The composite index of financial depth (IFD) measures the total stock of:
  - domestic financial assets, DA, and liabilities, DL;
  - foreign assets, FA, and liabilities, FL.
- The index places a 1/2 weighting on foreign assets and liabilities so that when FA = FL the index reflects the total domestic and foreign liabilities of the economy.
- Domestic liabilities are defined as total domestic financial liabilities, including broad money, resident claims on banks, domestic securities, and stock market capitalization.
- The index was constructed with and without equities to side-step large valuation swings from equity markets.

### Data, coverage, and methodological notes
- The index was constructed for 50 countries—half AMs and half EMs—that collectively account for over 90 percent of global GDP.
- Data on external assets and liabilities come from the updated and extended version of the Lane and Milesi-Ferretti (2007) dataset; these data are available through 2009.
- Domestic claims data are drawn from datasets constructed by the World Bank and the Bank for International Settlements.
- Limits: the metric is acknowledged as simple and partial; it should be complemented by measures of balance-sheet resilience (currency and maturity mismatches), prudential indicators, quality of regulation and supervision (e.g., FSAPs), institutional capacity, and market development.

### Key empirical findings and trends
- Global and country coverage:
  - Index constructed for 50 countries, through 2009.
- Relative domestic vs. external depth:
  - The weighted sum of the index over the world provides a measure of global financial liabilities as a share of GDP; foreign assets sum to foreign liabilities globally.
  - External balance sheets in AMs have experienced a nearly 10-fold increase since 1970, compared with 3½ times in EMs.
  - Median AM net position narrowed to a net position of 15½ percent of GDP in 2009; EMs had a large net liability position of 40.1 percent of GDP in 2009.
- Country-level highlights (from constructed rankings and contributions):
  - The index shows large balance sheets relative to GDP for important financial centers; Ireland exhibited a very rapid cyclical increase in balance sheet size by 2009.
  - China’s total financial claims are now comparable with those of large European countries as a share of global GDP.
- Sectoral and market structure differences:
  - EMs remain largely bank based; capital flows intermediated through banks are the most volatile.
  - Median AM equity market capitalization was 120 percent of GDP in 2009—around twice that of EMs.
  - Bonds outstanding: at 200 percent of GDP at end 2010, the median value of bonds outstanding in AM markets was four times the median value in EMs.
  - For countries with data, median long-term bonds (maturities over a year) were 75 percent of GDP in AMs versus 33 percent of GDP in EMs.
  - Derivatives: average daily turnover in EMs where data are available was $1.2 trillion in April 2010 (6.2 percent of those economies’ GDP), compared to $13.8 trillion (36 percent of GDP) in AMs.
  - EMs have increasingly substituted FDI for debt liabilities: for the median EM, gross debt liabilities were 55½ percent of GDP in 2000 and just over 42 percent in 2009; FDI liabilities rose from 20½ percent in 2000 to over 40 percent in 2009.
  - Pension funds and insurance companies play a much larger role in AMs than in EMs and can facilitate long-term market development.

### Risks, crises evidence, and dynamics
- Crisis frequency and costs (based on Laeven and Valencia (2008), updated through end-2009; 49 crisis cases identified: 36 in EMs and 13 in AMs; 30 banking crises and 21 currency crises, with overlaps):
  - The unconditional probability of crises generally declines with financial depth, but rises slightly at very high levels of depth (reflecting the recent crisis).
  - The conditional probability of a crisis rises at early stages of deepening before falling off; historically, crisis incidence has been high at levels of depth associated with EMs (index lower than 3).
    - 83 percent of all EM crises occurred when the depth index was lower than 3; a further 11 percent occurred above 3 but below 4.5.
  - Even though frequency declines with deepening, average costs of crises remain high:
    - For EMs, the average two-year cumulative losses for levels of depth between 3 and 4½ are about 12¼ percent of precrisis GDP.
    - For EMs, the costs of currency crises at these levels are nearly 15½ percent of precrisis GDP.
  - Arcand, Berkes, and Panizza (2011) find finance has a negative effect on growth when credit to the private sector exceeds 110 percent of GDP.
- Capital-flow volatility and financial depth (EMs, sudden-stop analysis):
  - The volatility of net capital outflows following a sudden stop declines unambiguously as depth rises—greater depth helps cushion against outflows.
  - For inflows, once depth exceeds 1½ further deepening is associated with greater volatility during the inflows phase, which then falls off when depth exceeds 3.
  - At levels of depth similar to AMs, relative volatility before and after sudden stops becomes negligible.
- Stylized risk profile:
  - Crises can occur at any level of financial development; crisis risks and costs can re-emerge at greater levels of depth if regulatory frameworks and supervisory capacity lag balance-sheet expansion.

### Policy implications and recommendations
- Country-level policies during deepening:
  - Countries with lower levels of depth—and higher crisis risks and costs—tend to have less exchange-rate flexibility, more capital account restrictions, and higher reserves accumulation; reserves may serve as buffers against costly crises.
  - Precautionary reserve accumulation may increase if crisis risks and costs are perceived to be high, possibly delaying global adjustment.
  - As depth increases and crisis costs fall, policies could transition to reduced precautionary demand for reserves, greater openness in the capital account, and more flexible exchange rates.
- Measures to support safe deepening:
  - Complement the aggregate balance-sheet metric with indicators of balance-sheet resilience (currency and maturity mismatches), prudential indicators, quality of regulation and supervision, and market development.
  - Develop capital markets (equity, bond, derivatives) and institutional investors (pension funds, insurance) to foster long-term savings and risk sharing.
  - Manage the pace of balance-sheet expansion to limit excessive leverage and reliance on short-term financing.
- Multilateral and systemic policies to strengthen the international monetary system (IMS):
  - Resolve external imbalances through surveillance and policy cooperation (e.g., IMF surveillance and the G-20 Mutual Assessment Process).
  - Reform the global safety net to close gaps and limit the need for precautionary reserve accumulation.
  - Develop a coherent framework to cope with volatile capital flows to limit associated risks and costs.

*Source: IMF staff calculations and analysis in Box 1. An Index of Financial Depth (text and figures as provided).*

### Appendix I. Facilitating Financial Deepening

### Appendix I. Facilitating Financial Deepening

### Macro policy framework
- A sound policy framework is essential for macroeconomic and financial stability (World Bank-IMF Handbook, 2001; Eichengreen, 2008; Arvai and Heenan, 2008; Chami, Fullenkamp, and Sharma, 2009).
- A sound framework would:
  - support demand for domestic assets, and
  - enhance the credibility of the government as an issuer of debt securities.

### Market infrastructure
- A robust market infrastructure is necessary for financial deepening.
- Key elements and functions:
  - A benchmark yield curve is a key requirement for market development and facilitates the reliable valuation of financial assets.
  - Sound public debt management policies are necessary to support a benchmark yield curve (Arvai and Heenan, 2008; Chami, Fullenkamp, and Sharma, 2009).

### Legal framework
- A strong and transparent legal framework is critical to investor protection and property and creditor rights.
- Possible actions:
  - The regulator could codify and enforce accurate and timely accounting standards.
  - The private sector could build infrastructure such as exchanges and credit bureaus.
  - Establish a robust payments and settlements infrastructure.
- Empirical support:
  - The positive relationship among sound institutions, financial development, and long-term growth has been confirmed in many empirical analyses (Fergusson, 2006; Chinn and Ito, 2006).

### Regulatory and supervisory regime
- Establish a sound regulatory and supervisory system with the capacity to ensure financial stability.
- Balance to achieve:
  - Regulation should foster prudent market conduct without hindering development.
  - Too rapid a deregulation risks engendering instability (Reinhart and Rogoff, 2008; Rodrick and Subramaniam, 2009).
  - Highly restrictive rules may hinder financial market development (Chami, Fullenkamp, and Sharma 2009; Goswami and Sharma, 2011).
- Regulatory priorities:
  - Address disclosure and transparency among market participants.
  - Limit market dominance.
  - Enforce risk management practices.
- Sequencing:
  - IMF (2002) discusses linkages between financial sector development and capital account liberalization and sets out an operational framework for sequencing financial deregulation and liberalizing cross-border capital flows.

### Cooperative mechanisms
- Cooperative solutions can play a role, for example among countries in Asia to develop local currency bond markets.
- Effective focus areas for bond market development:
  - Achieve a critical scale.
  - Build information systems and transparency.
  - Improve market infrastructure and regulation.
  - Create a vibrant investor community.
- Evidence:
  - Efforts focusing on these impediments appear to have had a large impact (BIS, 2011).

*Appendix I. Facilitating Financial Deepening — _sdn1116*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2011/_sdn1116.pdf_