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### I. INTRODUCTION — purpose and structure
- Financial development associated with improved economic performance through efficient intermediation, risk diversification, and long-run growth.
- Strong local markets provide stable financing for private and public sectors and help cope with volatile external capital flows.
- Paper structure:
  - Section II: extent of financial development in emerging Europe, focus on debt securities, equities, banks, pension funds, mutual funds, insurance.
  - Section III: literature review and new evidence on determinants of financial development in emerging Europe.
  - Section IV: overview of reforms needed to foster financial development.
  - Section V: country case studies on Hungary (successful government securities market) and Ukraine (reforms needed).
  - Section VI: conclusions and policy implications.

### II. INDICATORS OF FINANCIAL DEVELOPMENT IN EMERGING EUROPE
- Bank credit:
  - Bank credit remains the most important form of financial intermediation.
  - In 2006, credit to the private sector reached an average level of 45.9 percent of GDP.
  - Comparisons: Latin America emerging markets average 30.1 percent; Asian emerging economies 69.5 percent.
- Nonbank financial institutions:
  - Pension funds, mutual funds, and insurance companies are mostly nascent.
  - Mutual fund assets remain below 5 percent of GDP in all countries except the four largest central European countries, Croatia, and Estonia.
  - Insurance premiums exceed 3 percent of GDP only in five economies: Croatia, Czech Republic, Hungary, Poland and Slovenia.
- Equity markets:
  - Excluding Bosnia-Herzegovina, Montenegro, Croatia, Malta and Russia, average market capitalization is 31.4 percent of GDP.
  - Euro area average market capitalization is 59 percent of GDP.
  - Foreign investors often account for over 50 percent of equity holdings in several countries.
- Debt securities:
  - Outstanding stock of non-financial corporate debt securities was less than 5 percent of GDP in all countries as of 2006.
  - Market for securities issued by financial institutions is somewhat deeper and expanding faster than nonfinancial corporate securities.
- Government securities markets:
  - Depth and liquidity largely explained by public sector financing needs; central European countries and Turkey have well-established government securities markets.

### III. DETERMINANTS OF FINANCIAL SECTOR DEVELOPMENT — literature synthesis
- Key determinants:
  - Macroeconomic stability: high and volatile inflation reduces demand for financial assets; relationship may be nonlinear with thresholds.
  - Income and economic complexity: financial depth grows with rising income.
  - Institutions and law enforcement: property rights, judiciary performance, control of corruption, rule of law, bureaucracy quality matter.
  - Corporate governance and creditor protection: company laws, disclosure, accounting, collateral and bankruptcy laws, credit information disclosure foster securities and credit markets.
  - Institutional investors: mutual funds, pension funds, insurance companies provide stable demand and foster primary market development.
  - Access to international markets and capital account liberalization: can broaden investor base and pressure for reforms; effects conditional on institutional thresholds.
- Sequencing and timing:
  - Financial openness contributes to domestic financial development only after a threshold of legal/institutional quality is attained (view supported by literature cited).

### IV. EMPIRICAL FINDINGS — determinants of private sector credit in emerging Europe (1995–2006)
- Simple correlations (1999–2006):
  - DMB Credit correlates with Bureaucracy quality 0.8; Law and order 0.6; Property rights 0.3; Control of corruption 0.7; Per capita income 0.7; Inflation -0.5; Creditor protection 0.5.
  - (Table heading notes: DMB Credit in percent of GDP; institutional indices rescaled 0–1.)
- Cross-country two-stage least squares (1999–2006) — selected significant coefficients (t statistics in parentheses):
  - Log (per capita income): 12.4*** (3.6); 13.3*** (4.4); 10.5*** (3.2).
  - Law and order: 58.7** (2.8); 42.1* (2.1); 54.9** (2.9).
  - Control of corruption: 55.5** (2.2) in one specification.
  - Bureaucracy quality: 45.3*** (4.9) in one specification.
  - Creditor protection 1998: 22.1* (2.2) in one specification.
  - Inflation: -0.2** (2.2); -0.3** (2.2) in other specifications.
  - Adj. R2 across reported specifications: 0.7; 0.8; 0.8; 0.53; 0.6. No. of observations: 17, 16, 17, 17, 17.
- Panel regressions (1995–2006 and subperiods) — selected coefficients and diagnostics:
  - D(Ln(Per capita income)), lagged: 8.9***; 8.8*; 13.0* (sample- and specification-dependent).
  - Inflation: -0.002*** (absolute t 5.4).
  - Inflation <10 percent: 0.1** (2.3); 0.1*** (2.8).
  - D(Property rights), lagged: 0.3*** (3.5); 0.6** (2.2).
  - D(Bureaucracy), lagged: 0.3* (1.7).
  - Libor euro: -0.03*** (2.4).
  - Time effects: No / Yes / Yes depending on column. Country effects: Yes in all reported regressions.
  - Adj. R2: 0.5; 0.2; 0.2. Sample periods: 1999-2006; 1997-2006; 1995-2006. No. of observations: 147; 187; 168.
- Methodology:
  - Cross-country regressions estimated by two-stage least squares using initial values as instruments.
  - Panel estimates use lags; D represents first difference operator; robust standard errors used for t statistics.

### V. WAY FORWARD — policy implications and reform priorities
- Country groupings and policy orientations:
  - EU emerging economies:
    - Harmonization with the acquis communautaire will drive reforms in securities legislation, regulatory/supervisory frameworks, clearing and settlement systems.
    - Rapid and full implementation of EU Directives is key.
    - Trade-offs for euro adoption: need for domestic currency-denominated corporate securities markets; small countries may benefit from regional market integration (examples cited).
    - Institutional quality improved but remains below advanced economy levels; creditor rights, credit information, and corporate governance need strengthening.
  - Non-EU emerging economies:
    - Reforms must be domestically driven; focus on reinforcing foundations for financial development, strengthening corporate governance and creditor rights, creating well-functioning government securities markets, and promoting institutional investors.
- Reinforcing foundations (non-EU focus):
  - Macroeconomic stability essential; many countries progressed, but some still face high/volatile inflation.
  - Inflation observations:
    - Belarus, Russia, Serbia, and Turkey experienced double-digit inflation on average during 2003-06.
    - Inflation in Moldova and Ukraine is likely to be more than 10 percent in 2007.
  - Institutional quality weakest in Albania and Belarus; property rights low in Bosnia and Herzegovina and Macedonia.
  - Enforcing contracts: enforcing a debt contract costs on average 50 percent more in non-EU than in EU emerging economies.
- Banking sector recommendations (selected, country-specific):
  - Moldova: improve transparency of bank ownership to enforce prudential limits for connected lending and large exposures.
  - Russia: tighten regulation and enforcement of large exposure limits and connected lending.
  - Bosnia: unify bank supervision into a single independent country-wide agency.
  - Belarus: banking supervisor should divest shareholdings in banks to avoid conflicts of interest.
- Building the government securities market — requirements:
  - Joint government and central bank commitment.
  - Regular issuance of securities and public debt management to create benchmarks.
  - Central bank use of government paper for monetary policy to enhance liquidity.
  - Adequate market infrastructure: trading, depository, settlement systems.
  - Hungary cited as successful integrated approach; Ukraine identified as needing strong commitment.

### V. CASE STUDIES — overview
- Two country examples:
  - A. Developing the government securities market: the experience of Hungary.
  - B. Securities market development in Ukraine.
- Objective: illustrate specific reforms to advance securities markets development.

### A. Developing the government securities market: the experience of Hungary
- Findings and evolution:
  - Market evolved from negligible Treasury bills in 1990 to a deepened domestic market with diversified instruments and extended maturities.
  - Non-marketable debt was gradually replaced by marketable instruments.
  - Early drivers: rollover and exchange rate risk concerns leading to lengthening maturities and local currency bonds.
  - Later drivers: monetary policy and financial market development objectives.
  - Key lesson: joint commitment of the government and the central bank was critical.
- Core components of strategy:
  - (i) Market-based monetary policy instruments.
  - (ii) Suitable legal and regulatory environment.
  - (iii) Macroeconomic stabilization.
  - (iv) Improvements in debt management.
  - Gradual capital account liberalization broadened investor base.
- Institutional building blocks and milestones:
  - Liberalization of interest rates; Central Bank Act; swap of non-interest bearing debt into marketable bonds in 1993.
  - Adoption of indirect monetary instruments; government securities used as collateral.
  - Establishment of Securities Supervisory Agency, Central Clearing House and Depository, Treasury, Government Debt Management Agency.
  - Legislation on mutual and pension funds in early 1990s; voluntary pension funds in 1995.
  - Long-term forint-denominated government securities made available to nonresidents in 1994.
  - Primary dealers launched in 1996; benchmarks and published yields; removal of all foreign exchange restrictions in 2001.
- Selected indicators (Table 4 highlights):
  - GDP growth (percent): Average 1990-93 = -4.8; Average 1994-95 = 3.2; Average 1996-99 = 3.7; Average 2000-05 = 4.5; 2006 = 3.9.
  - Inflation (percent): Average 1990-93 = 27.2; Average 1994-95 = 23.6; Average 1996-99 = 16.5; Average 2000-05 = 6.5; 2006 = 3.9.
  - Current account balance (percent of GDP): Average 1990-93 = -1.9; Average 1994-95 = -6.7; Average 1996-99 = -5.9; Average 2000-05 = -7.4; 2006 = -6.9.
  - General government balance (percent of GDP): Average 1990-93 = -5.0; Average 1994-95 = -7.4; Average 1996-99 = -4.1; Average 2000-05 = -6.4; 2006 = -9.7.
  - General government debt (percent of GDP): Average 1990-93 = 76.9; Average 1994-95 = 85.1; Average 1996-99 = 64.2; Average 2000-05 = 56.7; 2006 = 66.2.
  - Indicator of interest rate liberalization and banking reform (EBRD): Average 1990-93 = 0.5; Average 1994-95 = 0.8; Average 1996-99 = 0.9; Average 2000-05 = 1.0; 2006 = 1.0.
  - Indicator of interest rate liberalization (Abiad, Detragiache and Tressel, 2007): Average 1990-93 = 1.0; Average 1994-95 = 1.0; Average 1996-99 = 1.0; Average 2000-05 = 1.0; 2006 = 1.0.

### B. Securities market development in Ukraine
- Macro-financial background:
  - Severe output contraction and hyper-inflation in early transition period.
  - Reforms after 1995: interest rate liberalization, phasing-out of directed credit and credit ceilings.
  - 1998-99 crisis: increased inflation, government debt restructuring, reduced international market access.
  - Post-1998-99: sustained output growth, current account surpluses, prudent monetary and fiscal policies, reduction in public debt ratios, build-up of foreign reserves, better inflation control and remonetization.
  - 2003 Eurobond issue re-established access to international markets.
  - Legal reforms: new civil and commercial codes and amendments to the securities law.
- Selected indicators (Table 5 highlights):
  - GDP growth (percent): Average 1993-1997 = -12.5; Average 1998-99 = -1.1; Average 2000-05 = 7.4; 2006 = 7.1.
  - Inflation (percent): Average 1993-1997 = 1219.7; Average 1998-99 = 16.6; Average 2000-05 = 11.4; 2006 = 9.0.
  - Broad Money, excluding foreign currency deposit (percent of GDP): Average 1993-1997 = 12.2; Average 1998-99 = 12.4; Average 2000-05 = 24.1; 2006 = 35.3.
  - Broad Money, including foreign currency deposit (percent of GDP): Average 1993-1997 = 16.0; Average 1998-99 = 16.2; Average 2000-05 = 30.8; 2006 = 48.4.
  - Current account balance (percent of GDP): Average 1993-1997 = -2.9; Average 1998-99 = 1.1; Average 2000-05 = 5.9; 2006 = -1.7.
  - General government balance (percent of GDP): Average 1993-1997 = -6.8; Average 1998-99 = -2.6; Average 2000-05 = -1.7; 2006 = -1.3.
  - Indicator of interest rate liberalization and banking reform (EBRD): Average 1993-1997 = 0.4; Average 1998-99 = 0.5; Average 2000-05 = 0.6; 2006 = 0.8.
  - Indicator of interest rate liberalization (Abiad, Detragiache and Tressel, 2007): Average 1993-1997 = 0.6; Average 1998-99 = 1.0; Average 2000-05 = 1.0; 2006 = 1.0.
- Government securities market — status and constraints:
  - Public sector debt (incl. guarantees and arrears) declined from 66.7 percent of GDP in 1999 to 15.8 percent of GDP at end-2006.
  - External debt (percent of GDP): 1999 = 49.9; 2000 = 33.1; 2001 = 26.3; 2002 = 24.1; 2003 = 21.6; 2004 = 19.2; 2005 = 14.1; 2006 = 12.5.
  - Domestic debt (percent of GDP): 1999 = 16.8; 2000 = 14.0; 2001 = 12.3; 2002 = 11.6; 2003 = 9.0; 2004 = 6.3; 2005 = 4.6; 2006 = 3.3.
  - Marketable public securities (percent of GDP): 1999 = 0.3; 2000 = 0.1; 2001 = 0.3; 2002 = 1.0; 2003 = 1.3; 2004 = 2.0; 2005 = 3.1; 2006 = 2.1.
  - At end-2006, nearly 80 percent of public debt was foreign currency-denominated.
  - Marketable securities amounted to just over 2.1 percent of GDP at the end of 2006.
  - Term structure was fragmented; primary auctions irregular and often failed to find buyers; secondary market volatile.
- Implications of underdevelopment:
  - Lack of benchmark issues and yield curve complicates pricing of financial instruments.
  - Shortage of government securities as collateral hampers interbank money market development.
  - Absence of a yield curve weakens monetary policy transmission and deprives authorities of information on inflation expectations.
  - Central bank used own papers (certificates of deposits) to sterilize foreign exchange reserve accumulation.
- Recommended measures to develop government securities market:
  - Strong commitment to integrated and credible debt-management and market development strategy.
  - Foster primary market: regular auctions under transparent rules, preannounced issuance program, create a small number of liquid benchmarks, issue securities in sufficient size.
  - Modify auction price-setting so yields reflect market-based outcomes.
  - Discontinue private placements of government debt.
  - Deepen cooperation between central bank and Ministry of Finance; define central bank’s role in secondary market.
  - Use government securities for monetary operations to strengthen market liquidity.
  - Achieve and maintain low inflation to allow extension of the yield curve.
  - Broaden investor base and introduce primary dealers once issuance strategy and volumes are in place.
- Corporate bond and equity markets — status and reforms:
  - 2006 total corporate bond issues amounted to 4.1 percent of GDP, but market liquidity is rather low.
  - Some outstanding corporate bond issues are “non-market issues” (e.g., real estate companies settling in square meters).
  - Equity market: market capitalization reached 40.4 percent of GDP in 2006, up from less than 4 percent in 1999.
    - The 10 largest companies account for 68 percent of total market capitalization.
    - Free float is about 5 percent of market capitalization.
    - Market turnover is extremely low.
  - Reforms recommended:
    - Strengthen institutional quality and law enforceability; court proceedings are generally cumbersome and lengthy.
    - Reinforce corporate governance: improve legislation on board responsibilities, shareholder rights, disclosure and transparency.
    - Address securities market regulation and supervision deficiencies; improve clearing and settlement systems; upgrade trading and registrar systems.
    - Create a benchmark government yield curve to facilitate corporate securities pricing.
    - Enact a joint stock company law (a new Joint Stock Company Law is currently before Parliament).
    - Enhance institutional investor base via legal, regulatory, and supervisory reforms favoring mutual funds and expedite pension reform.

### VI. CONCLUSIONS AND POLICY IMPLICATIONS
- Findings:
  - Financial development has advanced to varying degrees in emerging Europe.
  - Institutional quality, creditor protection, low and stable inflation, and rising per capita income are key drivers of bank credit expansion.
- Policy implications and priorities:
  - Further reforms needed to establish deep, liquid, diversified, and stable financial markets.
  - EU members: integration and harmonization provide opportunities to expedite financial development.
  - Other emerging economies should:
    - Maintain control over inflation.
    - Strengthen institutional quality and enforceability of laws and regulations.
    - Create a well-functioning government securities market.
    - Reinforce corporate governance and creditor rights protection.
    - Promote the emergence of institutional investors.

### EXPANDING THE RANGE OF PLAYERS IN THE FINANCIAL SYSTEM (Section V)
- Create a diverse class of institutional investors (pension funds, mutual funds, insurance companies) to contribute to market development and liquidity.
- Foster emergence of institutional investors by enhancing regulatory and supervisory framework for nonbank financial institutions.
- Supervisory framework may be an integrated agency or several agencies, provided cooperation and information flows are secured.
- Consider mandatory or voluntary fully funded pension schemes in countries that have not yet reformed their pension systems (examples: Albania and Belarus).
- Hungary cited as an example where legislative, regulatory changes and pension reforms promoted institutional investors.

### REFERENCES — selected notes and data definitions
- Empirical and theoretical literature cited includes works by Abiad, Detragiache, Tressel; Acemoglu, Johnson and Robinson; Claessens; La Porta et al.; Djankov et al.; and country/sector studies by IMF, EBRD, World Bank and others.
- Definitions and data sources (selected):
  - Inflation: annual change in the average CPI index. Source: WEO.
  - Per capita income: PPP per capita income. Source: WEO.
  - Deposit money bank credit (Percent of GDP): Source: International Financial Statistics.
  - Property rights, Bureaucracy quality, Rule of law, Control of corruption: indices rescaled to 0–1 from Heritage Foundation and International Country Risk Guide.
  - Creditor protection index: Pistor, Raiser and Gelfer (2000).
  - Libor euro: London Interbank Office Rates on six months deposits in euro. Source: International Financial Statistics.
  - Financial integration: sum of total financial external assets and liabilities (percent of GDP). Source: Lane and Milesi-Ferretti, IMF Working Paper 06/69.
  - Trade openness: sum of exports and imports (percent of GDP). Source: International Financial Statistics.

*Source: _wp07245 - References..............................................................................................................*

### References..............................................................................................................

### _wp07245 - References..............................................................................................................

### I. INTRODUCTION — purpose and structure
- Financial development is associated with improved economic performance through efficient intermediation, risk diversification, and long-run growth.
- Strong local markets provide stable financing for private and public sectors and help cope with volatile external capital flows.
- Paper structure:
  - Section II: extent of financial development in emerging Europe, focus on debt securities, equities, banks, pension funds, mutual funds, insurance.
  - Section III: literature review and new evidence on determinants of financial development in emerging Europe.
  - Section IV: overview of reforms needed to foster financial development.
  - Section V: country case studies on Hungary (successful government securities market) and Ukraine (reforms needed).
  - Section VI: conclusions and policy implications.

### II. INDICATORS OF FINANCIAL DEVELOPMENT IN EMERGING EUROPE
- Bank credit:
  - Bank credit remains the most important form of financial intermediation in emerging Europe.
  - After rapid expansion, bank credit roughly aligns with per capita income rankings (Figure 1).
  - In 2006, credit to the private sector reached an average level of 45.9 percent of GDP.
  - Comparisons: Latin America emerging markets average 30.1 percent; Asian emerging economies 69.5 percent.
- Nonbank financial institutions:
  - Pension funds, mutual funds, and insurance companies are mostly nascent.
  - Pension fund assets (percent of GDP) are higher in Croatia, Hungary, and Poland than in Germany and Italy (qualitative).
  - Mutual fund assets remain below 5 percent of GDP in all countries except the four largest central European countries, Croatia, and Estonia.
  - Insurance premiums exceed 3 percent of GDP only in five economies: Croatia, Czech Republic, Hungary, Poland and Slovenia.
- Equity markets:
  - Rapid growth in Southeastern Europe and Russia; market capitalization in several countries reached high levels.
  - Excluding Bosnia-Herzegovina, Montenegro, Croatia, Malta and Russia, average market capitalization is 31.4 percent of GDP.
  - Euro area average market capitalization is 59 percent of GDP.
  - Liquidity (turnover ratio) is generally low; free float is often small; trading concentrated in few stocks; foreign investors often account for over 50 percent of equity holdings in several countries.
- Debt securities:
  - Outstanding stock of non-financial corporate debt securities was less than 5 percent of GDP in all countries as of 2006.
  - Corporate bond secondary market activity is limited; primary corporate issues concentrated in a few sectors where they exist.
  - Market for securities issued by financial institutions is somewhat deeper and expanding faster than nonfinancial corporate securities (Figure 5).
- Government securities markets:
  - Depth and liquidity largely explained by public sector financing needs; central European countries and Turkey have well-established government securities markets.

### III. DETERMINANTS OF FINANCIAL SECTOR DEVELOPMENT — literature synthesis
- Key determinants identified in literature:
  - Macroeconomic stability: high and volatile inflation reduces demand for financial assets; relationship may be nonlinear with thresholds.
  - Income and economic complexity: financial depth grows with rising income.
  - Institutions and law enforcement: property rights, judiciary performance, control of corruption, rule of law, bureaucracy quality matter for market development.
  - Corporate governance and creditor protection: company laws, disclosure, accounting, collateral and bankruptcy laws, credit information disclosure foster securities and credit markets.
  - Institutional investors: mutual funds, pension funds, insurance companies provide stable demand and foster primary market development.
  - Access to international markets and capital account liberalization: can broaden investor base and pressure for reforms; effects conditional on institutional thresholds.
- Sequencing and timing:
  - Views differ on optimal sequencing of trade opening, capital account liberalization, and domestic financial liberalization.
  - Some evidence that financial openness contributes to domestic financial development only after a threshold of legal/institutional quality is attained.

### IV. EMPIRICAL FINDINGS — determinants of private sector credit in emerging Europe (1995–2006)
- Simple cross-country correlations (1999–2006) indicate positive associations between DMB credit and:
  - Per capita income.
  - Institutional quality measures: bureaucracy quality, control of corruption, rule of law, property rights (Table 1).
- Cross-country and panel regressions (Tables 2 and 3) — key results:
  - Indicators of institutional quality are positively and significantly related to DMB credit, controlling for reverse causality.
  - Creditor protection at the beginning of the period is associated with higher private credit over 1999–2006 (cross-country).
  - Inflation has had a negative impact on private credit; panel analysis indicates single digit inflation favors bank credit over 1995-2006.
  - Rising per capita income positively impacts bank credit.
  - International interest rates (LIBOR on euro-denominated deposits) show a negative and significant relation with bank credit (Table 3).
  - Additional explanatory variables (financial integration, trade openness, financial liberalization indicator, domestic interest rates, GDP growth, institutional investor size) were not significant in many specifications.
- Selected numerical results preserved exactly from regressions:
  - Table 1: DMB Credit correlates with Bureaucracy quality 0.8; Law and order 0.6; Property rights 0.3; Control of corruption 0.7; Per capita income 0.7; Inflation -0.5; Creditor protection 0.5. (Table heading notes: DMB Credit in percent of GDP; institutional indices rescaled 0–1.)
  - Table 2 (cross-country two-stage least squares, 1999–2006): Examples of significant coefficients (t statistics in parentheses):
    - Log (per capita income): 12.4*** (3.6); 13.3*** (4.4); 10.5*** (3.2) in different specifications.
    - Law and order: 58.7** (2.8); 42.1* (2.1); 54.9** (2.9).
    - Control of corruption: 55.5** (2.2) in one specification.
    - Bureaucracy quality: 45.3*** (4.9) in one specification.
    - Creditor protection 1998: 22.1* (2.2) in one specification.
    - Inflation: -0.2** (2.2); -0.3** (2.2) in other specifications.
    - Adj. R2 across reported specifications: 0.7; 0.8; 0.8; 0.53; 0.6. No. of observations: 17, 16, 17, 17, 17.
  - Table 3 (panel regressions, 1995–2006 and subperiods):
    - D(Ln(Per capita income)), lagged: 8.9***; 8.8*; 13.0* (sample- and specification-dependent).
    - Inflation: -0.002*** (absolute t 5.4).
    - Inflation <10 percent: 0.1** (2.3); 0.1*** (2.8) in two specifications.
    - D(Property rights), lagged: 0.3*** (3.5); 0.6** (2.2) in two specifications.
    - D(Bureaucracy), lagged: 0.3* (1.7) in one specification.
    - Libor euro: -0.03*** (2.4) in one specification.
    - Time effects: No / Yes / Yes depending on column.
    - Country effects: Yes in all reported regressions.
    - Adj. R2: 0.5; 0.2; 0.2. Sample periods: 1999-2006; 1997-2006; 1995-2006. No. of observations: 147; 187; 168.
- Methodological notes preserved:
  - Cross-country regressions estimated by two-stage least squares using initial values as instruments.
  - Panel estimates use lags; D represents first difference operator; robust standard errors used for t statistics.

### V. WAY FORWARD — policy implications and reform priorities
- Two country groupings and policy orientations:
  - EU emerging economies:
    - Ongoing harmonization with the acquis communautaire will continue to drive reforms in securities legislation, regulatory/supervisory frameworks, clearing and settlement systems.
    - EU financial integration offers opportunities and challenges; rapid and full implementation of EU Directives is key.
    - As countries move toward euro adoption, trade-offs arise regarding the need for domestic currency-denominated corporate securities markets; small countries may benefit from regional market integration (examples: OMX, Warsaw–Euronext agreement, Vienna–Budapest cooperation).
    - Institutional quality in EU emerging economies has improved but remains below advanced economy levels (Figure 6); creditor rights, credit information, and corporate governance need strengthening (Figures 7–9).
  - Non-EU emerging economies:
    - Reforms must be domestically driven; focus areas include reinforcing foundations for financial development, strengthening corporate governance and creditor rights, creating a well-functioning government securities market, and promoting institutional investors.
- Reinforcing foundations (non-EU focus):
  - Continued macroeconomic stability is essential; many countries have made progress on growth and price stability, but some still face high/volatile inflation.
  - Inflation observations:
    - Belarus, Russia, Serbia, and Turkey experienced double-digit inflation on average during 2003-06.
    - Inflation in Moldova and Ukraine is likely to be more than 10 percent in 2007 (Figure 10).
    - Average 2003-06 vs 2007 projection shown in Figure 10 (data source WEO).
  - Institutional quality has improved but remains below EU averages; weakest institutional quality in Albania and Belarus (Figure 6); property rights low in Bosnia and Herzegovina and Macedonia (Figure 11).
  - Enforcing contracts:
    - Enforcing a debt contract costs on average 50 percent more in non-EU than in EU emerging economies (Figure 12).
    - Judicial and related reforms needed to improve enforceability and firm confidence.
  - Banking sector:
    - Non-EU economies have largely liberalized interest rates and credit allocation (except Belarus).
    - Payments and settlement systems, accounting and disclosure standards in place; regulatory capital requirements and supervisory authority powers broadly in line with advanced countries as of 2003 (Figure 14).
    - Implementation weaknesses remain; country-specific supervisory recommendations include:
      - Moldova: improve transparency of bank ownership to enforce prudential limits for connected lending and large exposures.
      - Russia: tighten regulation and enforcement of large exposure limits and connected lending.
      - Bosnia: unify bank supervision into a single independent country-wide agency.
      - Belarus: banking supervisor should divest shareholdings in banks to avoid conflicts of interest.
- Building the government securities market:
  - A liquid government securities market provides a market-determined term structure, facilitates pricing of other instruments, can be used as collateral, and supports monetary policy operations.
  - Requirements for development:
    - Joint government and central bank commitment.
    - Regular issuance of securities.
    - Central bank use of government paper for monetary policy to enhance liquidity.
    - Public debt management to create benchmarks for maturities.
    - Adequate market infrastructure: trading, depository, settlement systems.
  - Hungary cited as an example of successful integrated approach; Ukraine identified as a country that would benefit from a strong commitment to build a government securities market.
- Developing corporate finance:
  - Stronger creditor protection needed, particularly in Belarus, Russia, and Turkey (Figure 7).
  - Credit information accessibility and quality should be enhanced, especially in Albania, Moldova, Russia, and Ukraine (Figure 8).
  - Corporate governance:
    - A 2004 assessment indicates Belarus, Bosnia and Herzegovina, and Ukraine exhibited major inadequacies in compliance with OECD Principles (Figure 9).
    - Laws on the books must be complemented by law enforcement; EBRD 2005 survey revealed shortcomings in several countries.
    - Ukraine provided as a case study where enhancing corporate governance and institutional quality could improve corporate finance (see Section V).

### VI. CONCLUSION — summary implications
- Institutional quality, creditor protection, low and stable inflation, and rising per capita income are key drivers of bank credit expansion in emerging Europe.
- EU integration will continue to shape reforms in member emerging economies; non-EU economies should focus on strengthening domestic institutions, market infrastructure, and governance to foster broader financial development.
- Building liquid government securities markets and improving creditor protection, credit information, and corporate governance are priority reforms to deepen credit and corporate securities markets.

*Source: _wp07245 - References..............................................................................................................*

### Section V).

### Section V)

### Expanding the range of players in the financial system
- Creating a diverse class of institutional investors (including pension funds, mutual funds, and insurance companies) would greatly contribute to financial market development and liquidity.
- The emergence of institutional investors can be fostered by enhancing the regulatory and supervisory framework for nonbank financial institutions.
- The supervisory framework could take the form of an integrated supervisory agency or several agencies, provided that cooperation and information flows were secured.
- In countries that have not yet reformed their pension systems, such as Albania and Belarus, consideration could be given to mandatory or voluntary fully funded schemes that can contribute to pension fund development.
- The case of Hungary offers an example of how legislative and regulatory changes as well as pension reforms can promote institutional investors.

### V. CASE STUDIES — overview
- This section provides two country examples:
  - A. Developing the government securities market: the experience of Hungary.
  - B. Securities market development in Ukraine.
- The previous sections discussed general reform areas; these cases illustrate specific reforms to advance securities markets development.

### A. Developing the government securities market: the experience of Hungary
Findings and evolution
- Hungary’s government securities market became one of the most developed, liquid and sophisticated in the region, evolving from a negligible stock of Treasury bills in 1990 to a deepened domestic market with diversified instruments and extended maturities.
- Non-marketable debt was gradually replaced by marketable instruments and liquidity increased.
- Early drivers (early 1990s): concerns about rollover risk and exchange rate risk led to lengthening maturities and issuance of local currency denominated bonds.
- Later drivers: monetary policy and financial market development objectives (use of indirect instruments of monetary policy, information on inflation expectations, and support for development of other financial sector segments).
- Key lesson: joint commitment of the government and the central bank was critical.

Core components of Hungary’s coherent strategy
- (i) Move toward a monetary policy framework relying on market-based instruments.
- (ii) Creation of a suitable legal and regulatory environment.
- (iii) Macroeconomic stabilization.
- (iv) Improvements in debt management.
- Gradual capital account liberalization also contributed to broadening the investor base and enhancing market depth and liquidity.

Early steps and institutional building blocks
- Liberalization of interest rates and enactment of the Central Bank Act enabled phase-out of central bank deficit financing.
- In 1993 the non-interest bearing debt of the budget was swapped into marketable government bonds.
- Monetary authorities adopted indirect instruments of monetary policy; government securities were used as collateral in central bank refinancing and open market operations.
- New legislation: securities and stock exchange laws; establishment of the Securities Supervisory Agency (later the Hungarian Financial Supervisory authority), the Central Clearing House and Depository, the Treasury, and the Government Debt Management Agency.
- Measures to broaden investor base: legislation on mutual and pension funds in early 1990s; government supported mutual funds via personal income tax allowances; creation of voluntary pension funds in 1995.
- Long-term forint-denominated government securities were made available to nonresidents in 1994.

Macroeconomic stabilization and market consequences
- In 1995 authorities implemented a stabilization package: fiscal adjustment, a one-time devaluation of the forint, and shift to a crawling band with a preannounced devaluation rate, creating sounder macroeconomic development and increased investor confidence.
- Decreasing inflation rates provided favorable conditions for market development and enabled significant extension of the yield curve.

Debt management and market infrastructure reforms
- A system of primary dealers was launched in 1996.
- Debt instruments were standardized to reduce fragmentation; benchmark securities were introduced and their yields started being published daily.
- Liquidity was further enhanced by gradual capital account liberalization, culminating in 2001 with the removal of all foreign exchange restrictions, including those on short-term portfolio transactions.
- Transparency measures: publication of the annual financing plan and auction calendar in advance; primary dealers required to submit detailed secondary market data to the debt management agency and make them public.
- Maturity extensions: Two- and three-year bonds launched in 1996; five- and ten-year bonds introduced in 1997 and 1999, respectively; first auction of a 15-year bond held in 2001.

Selected indicators (Table 4 highlights)
- GDP growth (percent): Average 1990-93 = -4.8; Average 1994-95 = 3.2; Average 1996-99 = 3.7; Average 2000-05 = 4.5; 2006 = 3.9.
- Inflation (percent): Average 1990-93 = 27.2; Average 1994-95 = 23.6; Average 1996-99 = 16.5; Average 2000-05 = 6.5; 2006 = 3.9.
- Current account balance (percent of GDP): Average 1990-93 = -1.9; Average 1994-95 = -6.7; Average 1996-99 = -5.9; Average 2000-05 = -7.4; 2006 = -6.9.
- General government balance (percent of GDP): Average 1990-93 = -5.0; Average 1994-95 = -7.4; Average 1996-99 = -4.1; Average 2000-05 = -6.4; 2006 = -9.7.
- General government debt (percent of GDP): Average 1990-93 = 76.9; Average 1994-95 = 85.1; Average 1996-99 = 64.2; Average 2000-05 = 56.7; 2006 = 66.2.
- Indicator of interest rate liberalization and banking reform (EBRD): Average 1990-93 = 0.5; Average 1994-95 = 0.8; Average 1996-99 = 0.9; Average 2000-05 = 1.0; 2006 = 1.0.
- Indicator of interest rate liberalization (Abiad, Detragiache and Tressel, 2007): Average 1990-93 = 1.0; Average 1994-95 = 1.0; Average 1996-99 = 1.0; Average 2000-05 = 1.0; 2006 = 1.0.

### B. Securities market development in Ukraine
Macro-financial background and post-crisis recovery
- Ukraine’s financial development experienced severe output contraction and hyper-inflation in the early transition period.
- Important reforms after 1995 included interest rate liberalization and phasing-out of directed credit and credit ceilings.
- The 1998-99 crisis increased inflation and required government debt restructuring, reducing access to international markets.
- Post-1998-99: sustained output growth, current account surpluses and prudent monetary and fiscal policies enabled sharp reduction in public debt ratios, build-up of foreign reserves, better inflation control and remonetization.
- The 2003 Eurobond issue re-established access to international markets.
- Reforms included new civil and commercial codes and amendments to the securities law to strengthen legal framework for financial intermediation.

Selected indicators (Table 5 highlights)
- GDP growth (percent): Average 1993-1997 = -12.5; Average 1998-99 = -1.1; Average 2000-05 = 7.4; 2006 = 7.1.
- Inflation (percent): Average 1993-1997 = 1219.7; Average 1998-99 = 16.6; Average 2000-05 = 11.4; 2006 = 9.0.
- Broad Money, excluding foreign currency deposit (percent of GDP): Average 1993-1997 = 12.2; Average 1998-99 = 12.4; Average 2000-05 = 24.1; 2006 = 35.3.
- Broad Money, including foreign currency deposit (percent of GDP): Average 1993-1997 = 16.0; Average 1998-99 = 16.2; Average 2000-05 = 30.8; 2006 = 48.4.
- Current account balance (percent of GDP): Average 1993-1997 = -2.9; Average 1998-99 = 1.1; Average 2000-05 = 5.9; 2006 = -1.7.
- General government balance (percent of GDP): Average 1993-1997 = -6.8; Average 1998-99 = -2.6; Average 2000-05 = -1.7; 2006 = -1.3.
- Indicator of interest rate liberalization and banking reform (EBRD): Average 1993-1997 = 0.4; Average 1998-99 = 0.5; Average 2000-05 = 0.6; 2006 = 0.8.
- Indicator of interest rate liberalization (Abiad, Detragiache and Tressel, 2007): Average 1993-1997 = 0.6; Average 1998-99 = 1.0; Average 2000-05 = 1.0; 2006 = 1.0.

Government securities market — status and constraints
- Public sector debt (incl. guarantees and arrears) declined from 66.7 percent of GDP in 1999 to 15.8 percent of GDP at end-2006.
- External debt: 1999 = 49.9; 2000 = 33.1; 2001 = 26.3; 2002 = 24.1; 2003 = 21.6; 2004 = 19.2; 2005 = 14.1; 2006 = 12.5 (percent of GDP).
- Domestic debt: 1999 = 16.8; 2000 = 14.0; 2001 = 12.3; 2002 = 11.6; 2003 = 9.0; 2004 = 6.3; 2005 = 4.6; 2006 = 3.3 (percent of GDP).
- By type — marketable public securities (o/w marketable): 1999 = 0.3; 2000 = 0.1; 2001 = 0.3; 2002 = 1.0; 2003 = 1.3; 2004 = 2.0; 2005 = 3.1; 2006 = 2.1 (percent of GDP).
- At end-2006, nearly 80 percent of public debt was foreign currency-denominated.
- Marketable securities amounted to just over 2.1 percent of GDP at the end of 2006.
- The term structure was very fragmented with numerous maturity dates; primary auctions were irregular and often failed to find buyers; the secondary market remained volatile.

Implications of underdevelopment
- Lack of benchmark issues and a yield curve complicates pricing of financial instruments including corporate bonds and may delay development of other market segments.
- Commercial banks cannot diversify portfolios using government bonds where other market segments are small and illiquid, contributing to sustained credit growth and financial dollarization.
- Shortage of government securities to use as collateral hampers development of the interbank money market.
- The absence of a yield curve weakens transmission of monetary policy across maturities and deprives authorities of information on inflation expectations, important for a planned move to an inflation targeting framework.
- The central bank resorted to its own papers (certificates of deposits) to sterilize higher than expected accumulation of foreign exchange reserves.

Recommended measures to develop the government securities market
- Strong commitment to an integrated and credible debt-management and market development strategy.
- Foster the primary market by:
  - Conducting regular auctions under transparent rules and according to a preannounced issuance program.
  - Creating a small number of liquid benchmarks.
  - Issuing securities in sufficient size to achieve adequate liquidity in the secondary market.
- Modify the auction price-setting mechanism so yields reflect market-based outcomes rather than being kept artificially low.
- Discontinue private placements of government debt.
- Deepen cooperation between the central bank and the Ministry of Finance and define the central bank’s role in the secondary market.
- Use government securities for monetary operations to strengthen market liquidity.
- Achieve and maintain low inflation to allow extension of the yield curve beyond very short maturities.
- Broaden the investor base and introduce a system of primary dealers once a clear debt-management strategy and sufficient primary issuance levels are in place.

Corporate bond and equity markets — status and reforms
- Corporate debt securities issuance revived in 2001-02 and accelerated since 2005; 2006 total issues amounted to 4.1 percent of GDP, but market liquidity is rather low.
- Part of outstanding corporate bond issues are “non-market issues,” placed by low credit quality real estate companies that often settle debt in square meters of property.
- Equity market: market capitalization reached 40.4 percent of GDP in 2006, up from less than 4 percent in 1999.
  - The 10 largest companies account for 68 percent of total market capitalization.
  - Free float is about 5 percent of market capitalization.
  - Market turnover is extremely low.
- Reforms to support development:
  - Strengthen institutional quality and law enforceability; court proceedings are generally cumbersome and lengthy.
  - Reinforce corporate governance: improve legislation on board responsibilities, shareholder rights, disclosure and transparency.
  - Address securities market regulation and supervision deficiencies, and improve clearing and settlement systems.
  - Upgrade trading and registrar systems.
  - Create a benchmark yield curve on government securities to facilitate corporate securities pricing.
  - Enact a joint stock company law (a new Joint Stock Company Law is currently before Parliament).
  - Enhance institutional investor base through legal, regulatory, and supervisory reforms favoring mutual funds development, and expedite pension reform to boost pension funds emergence.

### VI. CONCLUSIONS AND POLICY IMPLICATIONS
Findings
- Financial development has advanced to varying degrees in emerging Europe.
- Macroeconomic stability, and good institutional quality and law enforceability appear to have been important factors.

Policy implications and priorities
- Further reforms are needed to complete the establishment of deep, liquid, diversified, and stable financial markets.
- For EU members, the integration process provides a unique opportunity to expedite financial development via harmonization requirements and competition pressure.
- Other emerging economies can advance financial development by:
  - Maintaining control over inflation.
  - Strengthening institutional quality and enforceability of laws and regulations.
  - Creating a well-functioning government securities market.
  - Reinforcing corporate governance and creditor rights protection.
  - Promoting the emergence of institutional investors.

*Source: _wp07245 - Section V).*

### REFERENCES

### _wp07245 - REFERENCES

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### Definitions and Data Sources
- Inflation: annual change in the average CPI index. Source: WEO
- Per capital income: PPP per capita income. Source: WEO
- Deposit money bank credit (Percent of GDP): Source: International Financial Statistics.
- Property rights scores the degree to which a country’s law protect private property rights and to which its government enforces these laws. More specifically, this index assesses the likelihood that private property will be expropriated and evaluates the independence of the judiciary, the existence of corruption within the judiciary, and the ability of individuals and businesses to enforce contracts. The index has been rescaled to assume values between 0 and 1. Source: Heritage Foundation.
- Bureaucracy quality measures the ability of a country bureaucracy to be somewhat autonomous from political pressure and to operate without drastic shift in policy or interruption in services when governments change. The index has been rescaled to assume values between 0 and 1. Source: International Country Risk Guide.
- Rule of law is an indicator of the strength and impartiality of the legal system, as well as the popular observance of the law. The index has been rescaled to assume values between 0 and 1. Source: International Country Risk Guide.
- Control of corruption measures the degree to which corruption within the political system is restrained. The index has been rescaled to assume values between 0 and 1. Source: International Country Risk Guide.
- Creditor protection index measures the extent to which collateral and bankruptcy laws safeguard lenders rights. Source: Pistor, Raiser and Gelfer (2000).
- Libor euro: London Interbank Office Rates on six months deposits in euro. Source: International Financial Statistics.
- Financial integration: sum of total financial external assets and liabilities (percent of GDP). Source: “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004", by Philip R. Lane and Gian Maria Milesi-Ferretti, IMF Working Paper 06/69.
- Trade openness: sum of exports and imports (percent of GDP). Source: International Financial Statistics.
- Lending rates, Deposit rates: Source: International Financial Statistics.

*Content derived from _wp07245 - REFERENCES.*

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