Financial systems and development

Box 7.4
Housing finance
The formal financial sector in most developing coun- tries inflation, interest rate controls, and the instability
tries finances only a small share of housing investment. of financial markets have deterred long-term lending of
Mortgage credit from the formal sector was 28 percent any kind. Inadequate legal systems diminish the value
of all housing investment in a sample of eleven devel- of housing as collateral and hence also diminish
oping countries, compared with more than 60 percent lenders' willingness to provide mortgage finance. And
in OECD countries. The difference partly reflects the policymakers have been concerned that increased fishallowness
of financial systems in developing coun- nance for housing might drive the cost of housing even
tries. Years of financial repression not only have mini- higher.
mized the role of the formal sector in housing finance, Shelter is a basic human need. Secure ownership of a
but have raised housing prices because negative real house can raise the welfare of the household that lives
interest rates favored investments in real assets. In in it. Moreover, when a house is purchased through a
another sample of eleven developing countries the mortgage, the buyer becomes, in effect, a contractual
average ratio of house value to annual household in- saver: the buyer is paying the lender for the right to
come was 5.5, compared with 3.0 in five high-income live in the house while saving for its purchase. And
countries. when the title to a house can be easily transferred, the
Several other factors explain the lack of smoothly household gains a relatively riskless form of collateral.
functioning markets for housing finance in developing Furthermore, a housing loan, which is fungible with
countries. Countries have often given little priority to other household resources, may provide the funds that
housing finance. Because housing is a large invest- would permit the household to undertake a productive
ment, it requires long-term finance, and in many coun- investment.
a growing number of developing countries, sales has since revealed too many errors of the first
to individuals of corporate securities and shares kind-funding low-yielding projects. With time,
in mutual funds have begun to increase. As macro- economies have become more complex, informaeconomic
stability is restored in other countries, tion flows have improved, and financial managers
investors' interest in securities will continue to have become more skilled. In most countries both
grow.
sorts of error can be minimized by leaving more
decisions to a diverse and competitive financial
Building financial institutions and markets
system that responds to market signals. The primary
role of government then shifts to making
In planning for the future it is important to have a market signals more meaningful and, in particular,
clear and consistent objective for finance. The key to preventing its own actions from distorting
objective of the financial system is the provision of them.
financial services at prices that reflect their cost. On occasion the government may have a role to
The financial system can also be used in modera- play as a promoter of financial institutions and
tion for other objectives. In the past, however, de- markets in order to create a diversified and comveloping
country governments have tried to do too petitive financial system. Many high-income and
much-using the financial system to finance the developing countries have used fiscal incentives to
government budget deficit, redistribute income, favor particular institutions and markets. Such inand
serve as a tool in implementing their develop- centives may be justified to encourage financial diment
strategies. Multiple and often conflicting ob- versity, particularly if the existing markets are
jectives have impaired the financial system in dominated by large banks and are uncompetitive.
many developing countries.
Fiscal incentives, however, should be used only
Financial markets are never perfect. In allocating moderately, should have clear objectives, and
credit they can make two sorts of mistakes: fund- should be withdrawn once those objectives are
ing low-yielding projects and failing to fund high- achieved. In the long term, countries should opt
yielding ones. In the early stages of development, for regimes that do not favor one type of instrudeveloping
country governments, fearing that the ment or institution over others.
costs of failing to fund good projects were likely to Countries must also choose the range of permisbe
high, intervened to direct credit. Perhaps that sible activities for financial institutions. Banks in
assessment was sound at the time, but experience many high-income countries are operating increas-
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