Financial systems and development

GOVERNMENT. As well as being regulators of tem to serve development or other goals. They
their financial systems, governments are among have directed credit, often at subsidized interest
their clients. All governments use payment ser- rates, to priority sectors. Many developing country
vices. In most developing countries, governments, governments own banks or other financial institulike
businesses, are net borrowers, and they use tions and thus play a direct role in allocating rethe
financial system as a source of funding for cur- sources. Monetary policy is conducted through the
rent and capital spending. In industrial countries, financial sector (see Box 2.6). The influence of govgovernment
deficits are financed mainly by selling ernments on the amount and pattern of investsecurities
to the public. In developing countries ment has therefore been much greater than their
they are usually financed by borrowing from own investment spending would suggest.
banks. In Sierra Leone, Zaire, and Zambia, for example,
more than 70 percent of bank credit has Providers of financial services
gone to the government in recent years, and in
Mexico 55 percent. Much of that credit was sup- Financial systems differ from country to country,
plied by the central banks, which thereby in- yet there are many similarities. In addition to the
creased the stocks of reserve money in these coun- central bank, most countries have five main classes
tries. The inflation caused by excessive monetary of financial institution: deposit and credit institugrowth
has greatly retarded the development of tions, contractual savings institutions, collective
the financial sector in developing countries, espe- investment institutions, securities markets, and incially
since interest rates have often been held formal financial enterprises. (Chapters 7 and 8 disdown.
cuss the services provided by these parts of the
Governments have also used the financial sys- financial system in more detail.) Casualty insurg
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Box 2.6 Monetary policy
Governments intervene in finance partly to control the market operations. When the central bank buys a secusupply
of money and credit. When the budget deficit is rity, it pays with a check drawn on itself, thereby inlarge,
governments often cover it by creating money. creasing its liabilities. Open market operations cannot
Excessive creation of money to cover budget deficits is be used in a system without an established govern- I
the most common cause of inflation. When the fiscal ment bill market. Monetary control with open market t
deficit is not a consideration, the objective of monetary operations leaves the allocation of credit to market '
and credit policy is usually to maintain stable prices. forces.
Governments have various tools to control the mone- The degree of integration with world financial and
tary aggregates. Perhaps the most common technique capital markets also affects the execution of monetary
in developing countries is for the central bank to spec- policy. An open and fully integrated economy that
ify credit ceilings for each commercial bank. Such ceil- chooses to maintain fixed exchange rates would have
ings have been criticized because they discourage com- to maintain the money supply at the level demanded at
petition and the mobilization of deposits. the "world" price level and interest rate. Any other
Another approach is for the central bank to fix the quantity of money would result in changes in the foramount
of deposit liabilities that can be created by the eign exchange reserves of the central bank. The central
banking sector by imposing reserve requirements and bank's purchase or sale of foreign exchange would recontrolling
the quantity of reserves available to banks. place open market operations as the tool for determin-
Central banks often control the level of reserves ing bank reserves and, hence, the money supply.
through the refinancing facilities they provide to com- A fixed exchange rate constrains the central bank's
mercial banks. But if refinancing is used to channel ability to create money and is thus a potential source of
credit to preferred sectors, it cannot easily be used for monetary discipline. A market-determined exchange
monetary control as well. Other countries use the rate restores a measure of domestic monetary indepenmovement
of government deposits between commer- dence. With either fixed or floating exchange rates,
cial banks and the central bank to control the level of central banks will need to set reserve requirements at
reserves. In countries with more developed financial levels comparable to those in other countries if banking
systems, central banks adjust bank reserves, and hence business is not to be driven abroad. Noninterestthe
money supply, through the purchase or sale of gov- earning reserve requirements are a tax on banks and as
ernment securities. These transactions are called open such will affect their competitiveness.
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