Financial Markets and Economic Growth, by Anne O. Krueger, Special Advisor to the Managing Director
IMF News, September 29, 2006
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- Authors: Anne O. Krueger Special Advisor
- Published: September 29, 2006
Evolution of development thinking and context
- Mid-20th century view: world divided into "developed" and "underdeveloped" countries with low per capita incomes, low life expectancies, low literacy, little capital stock, and low savings rates.
- Early policy prescription: capital accumulation as key; government-led accelerated investment in industry to overcome a "vicious" circle of low savings and low capital.
- 1960s shift: increased emphasis on "human capital" (education, health, nutrition) alongside physical capital.
- Trade policy evolution:
- Early protectionism, import licensing, and high tariffs produced chronic "foreign exchange shortages" and disincentives for exports.
- By the late 1980s, prescription shifted to reducing trade barriers and adopting an open economy strategy.
- East Asian experience:
- Hong Kong, Singapore, South Korea, and Taiwan ("tigers") exhibited sustained rapid growth; South Korea more than doubled per capita income every decade by 1990.
- Other Asian economies (China, Thailand, Malaysia, Indonesia) followed similar high-growth patterns in the 1980s.
- Financial crises history:
- Earlier crises often linked to overvalued exchange rates and exchange controls.
- The "Asian crises" of 1997 revealed that highly successful countries could still founder when faced with capital outflows and external shocks.
- Consensus lessons: fixed exchange rate regimes can remove shock absorbers; need to assess debt sustainability and ensure consistency between monetary/fiscal policy and exchange rate regimes.
Role of the financial sector in development
- Financial sector importance increases with economic complexity:
- In simple, subsistence economies family finance and informal credit rationing may suffice.
- As manufacturing, agriculture, and services diversify, the ability to identify and fund the best projects requires more developed financial intermediation.
- Financial markets must broaden and deepen as economies grow:
- Banks must become more sophisticated at assessing risk and return.
- Development of other financial sources (equity, bond markets) is necessary to sustain long-term, rapid growth.
- Historical examples:
- 19th-century London and 20th-century New York developed financial centers that supported and exported financial services and capital.
- Recent growth in hedge funds illustrates continuing complexity in financial markets.
- Financial crises of the 1990s emphasized that financial sector health is bound up with overall economic performance.
Korean experience (illustrative case)
- Context and turnaround:
- Korea was one of the poorest countries in the 1950s; reform program (late 1950s–1960s) turned Korea into an open economy.
- Real GDP grew at an average annual rate above 10 percent for the entire decade starting in 1963.
- Real per capita income in 1995 was estimated to be close to 9 times what it had been in the early 1960s.
- Trade statistics:
- 1960: exports 3 percent of GDP (88 percent primary commodities), imports 13 percent of GDP.
- 1970: exports 14 percent of GDP.
- 19890: exports 33 percent of GDP. (textual source)
- Between 1960 and 1969, dollar export earnings grew at an average annual rate of 41 percent.
- Chaebol dynamics:
- Chaebol were family-owned conglomerates central to export-driven growth; export incentives were uniform and mandated access to low-interest credit.
- Early real rates of return for chaebol averaged 35 percent or more.
- Over subsequent decades rates of return declined: slightly above 4 percent in the latter part of the 1980s, under 2 percent in the early 1990s, and negative by 1997.
- By the mid-180s the largest 30 chaebol were growing around 20 percent annually, and the largest 5 at 30 percent. (textual source)
- Between 1985 and the crisis: assets were 14 times higher for the largest 30 and 19 times higher for the big 5.
- By 1997, the largest 5 chaebol accounted for about 40 percent of manufacturing sector assets.
- Chaebol exhibited high leverage: in the manufacturing sector as a whole debt was about 3.5 times equity in the mid-1990s; chaebol were even more highly leveraged.
- Banking sector issues:
- Banking remained tightly controlled even as trade liberalized; credit rationing persisted and interest rate deregulation began only in the late 1980s.
- Bank assets rose sharply in the five years prior to the crisis, but net banking income had peaked in the early 1990s; rate of return on bank assets and on equity fell continuously.
- Nonperforming loans (NPLs) did not significantly increase prior to the crisis largely because of "evergreening"; NPLs rose sharply after the crisis began.
- Foreign currency borrowing was used to sustain rapid domestic credit expansion, but the fundamental problem was deterioration in domestic portfolio quality.
- Outcome:
- Korea underwent a severe crisis in 1997-1998; domestic vulnerabilities made the system a "disaster waiting to happen."
- Reforms were undertaken and output rebounded to precrisis levels within 18 months; growth rates were solid thereafter.
Lessons from Korea and broader evidence
- Key lessons:
- A well-regulated, transparent banking system and attention to balance-sheet soundness and currency mismatches are essential.
- As economies pass early development stages, financial markets (banking, bond, equity) must develop pari passu with the rest of the economy.
- Continued credit rationing leads to excessive reliance on bank credit, underdevelopment of equity and bond markets, and unsustainable leverage.
- Evidence from cross-country research (Prasad, Rajan and Subramanian):
- Foreign capital inflows tend to spur growth in industrial countries (after controlling for standard growth-determining variables).
- In low-income countries the evidence suggests a perverse link, including net capital flows from poor countries to richer ones; this perverse link is not found for direct foreign investment.
- Conclusion: lack of financial development or propensity for overvaluation amid rapid inflows limits absorptive capacity for foreign resources.
Policy implications and recommendations
- For rapidly growing countries, prioritize development of a healthy financial sector:
- Strengthen the rights of borrowers and lenders.
- Develop credit rating systems (private credit bureaus).
- Lower the costs of obtaining credit (not by reducing the interest rate).
- Streamline means for settlement of disputes and improve enforceability of contracts.
- Increase efficiency of bankruptcy proceedings; reduce the cost of collateral.
- Establish an efficient and implemented regulatory framework.
- Promote competition within the banking system and arms-length lending practices.
- World Bank cross-country indicators (examples preserved from source):
- Borrowers' and creditors' rights scale: 1 to 10 (highest). Examples: US 10, Australia 9, Argentina 3, Mexico 2, some countries 1 and even 0.
- Private credit bureau coverage: Brazil coverage about half the population; Costa Rica less than 5 percent; more than half of 55 countries surveyed had no private credit bureau coverage at all.
- Cost of creating collateral (as percent of per capita income): less than 0.1 percent in the United States and the Untied Kingdom; Korea 8.1 percent; Japan 2.7 percent; India 11.7 percent; Nigeria 20.7 percent; Morocco 62.2 percent.
- Time to legal enforcement (examples): around 6 months (250 days in the Untied States, 75 days in France); developing country examples: 591 days in Bolivia, 425 in India, and 1,000 in Poland.
- Practical implications:
- A reasonably open capital account requires a fairly efficient domestic financial system; otherwise distortions and vulnerabilities will be transmitted via the capital account.
- For countries committed to growth, proactively addressing financial-sector weaknesses is preferable to waiting for a crisis to force reforms.
Anne O. Krueger, Special Advisor to the Managing Director; Tokyo, September 28, 2006 — Speech: "Financial Markets and Economic Growth."