Financial systems and development

and grew even faster in 1988 than in 1987. Interest with their development strategies. Toward this
and exchange rates were less volatile than during end, they created new financial institutions to proearlier
phases of the recovery from the worldwide vide funding at low interest rates to the sectors
recession of 1982, and prices of the principal com- that were to be at the forefront of industrial develmodities
exported by developing countries rose by opment, or they directed existing institutions to do
an average of 20 percent.
so. The governments themselves borrowed heavi-
Some developing countries have taken advan- ly, both from the domestic financial system and
tage of the favorable world environment. Most from abroad, to finance budget deficits and the
countries in Asia did well; in several the gross na- needs of state-owned enterprises. In many countional
product (GNP) grew at an estimated annual tries banks were also directed to open rural
rate of 10 percent. Some countries, however, con- branches in order to mobilize deposits and provide
tinued to suffer from misdirected domestic poli- credit to widely dispersed smallholders.
cies, excessive indebtedness, and the economic During the 1960s this development strategy
shocks of the 1980s. The growth rates of many Af- seemed to be working: many developing countries
rican nations remained near zero. The heavily in- grew rapidly. But economic performance during
debted economies also continued to stagnate. The the 1970s wvas more mixed. Despite favorable
governments of creditor countries agreed at the terms of trade and an ample supply of cheap for-
Toronto summit to grant debt relief to the poorest eign financing, growth in some countries began to
and most heavily indebted countries, such as the slow. Except in Asia, only a few developing councountries
of Sub-Saharan Africa, and early in 1989 tries have grown rapidly in the 1980s.
took the first official steps to sanction debt relief for The interventionist approach was much less sucthe
middle-income countries. But despite a rise in cessful in promoting financial development. Under
the disbursement of funds to the highly indebted government pressure, banks did lend to state encountries
in 1988, net transfers to these countries terprises and priority sectors at below-market incontinued
to be negative.
terest rates, but spreads were often too small to
Future growth in the developing countries will cover the banks' costs. Many of the directed loans
depend in part on the policies of high-income were not repaid. Interest rate controls discouraged
countries. By ensuring the success of the Uruguay savers from holding domestic financial assets and
Round of trade negotiations, the high-income discouraged institutions from lending longer term
countries can create a favorable environment for or to riskier borrowers. In some countries, public
the exports of developing countries. Tighter fiscal borrowing from commercial banks displaced lendbut
easier monetary policy in high-income coun- ing to the private sector; in others, public borrowtries
would bring international interest rates ing financed by money creation led to rapid infladown,
which would ease the burden of debt. This tion. Many countries developed a market for
would benefit developing and high-income coun- short-term debt, but only a few have more than a
tries alike. But far more important will be the poli- rudimentary system for long-term finance. In sum,
cies pursued by the developing countries them- the financial systems of all but a few developing
selves. They can improve their growth prospects countries remain small and undeveloped.
by continuing to seek fiscal balance and trade re- In recent years the inability or unwillingness of
forms. The decline in foreign capital flows has borrowers to repay their loans has become a seriplaced
a premium on policies that encourage do- ous problem. Its roots lie in the shocks of the early
mestic saving and investment and direct the flow 1980s and in the industrial and financial policies
of resources to profitable activities-in other pursued over the past thirty years. Many countries
words, on policies that will improve the perfor- depended on commodity exports and foreign bormance
of domestic financial systems.
rowing to pay for the imported inputs essential to
their industrialization programs. For the highly in-
Origins of financial distress
debted countries in particular, foreign borrowing
became expensive as interest rates rose in the late
When the developing countries set out to modern- 1970s; it became virtually impossible as foreign
ize their economies in the 1950s and 1960s, their commercial banks ceased voluntary lending after
financial systems comprised mainly foreign- 1982. Deteriorating terms of trade and internaowned
commercial banks. These provided short- tional recession in the early 1980s further reduced
term commercial and trade credit. Governments countries' ability to pay for imports. Many coundecided
to remodel their financial systems to en- tries were forced to reduce their trade deficits. To
sure that resources were allocated in accordance promote exports, they devalued their currencies
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