Financial systems and development

The task of financial reform
At the onset of industrialization in the developing Figure 4.4 Prices, production, and bank credit
countries, financial markets were inadequate to in Colombia
meet the demands placed upon them. This justified
some form of government intervention. But
Relative prices and production,
extensive directed credit programs at subsidized 1975 to 1983
interest rates proved an inefficient way to over- Index (1975 100)
come market failures and redistribute income. 130
Macroeconomic instability, combined with credit
and interest rate controls, made matters worse. 1d
Most governments neglected to address the under- to nontradables prices
lying weaknesses of their financial systems. This
inattention to the conditions necessary for finan- 110 A Ratio of nontradables
cial development did not significantly impede pRotio o tradables
growth during the 1970s. Favorable terms of trade / production
and cheap foreign funding enabled developing 100
countries to finance growing investment expendi-
N
tures despite the small size of their financial systems.
But as events of the 1980s demonstrated, 90 I
financial institutions were left weak and vulnerable 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984
to change.
In the early 1980s most developing countries Share of nontradables in total bank credit,
confronted deteriorating terms of trade, falling ex- Percent 1975 to 1984
port volumes, rising international interest rates, 77
and a sudden curtailment of foreign lending.
Many countries no longer had the foreign exchange
to finance large current account deficits or 74
the fiscal resources to continue subsidizing inefficient
industries. In countries that were forced to
devalue to discourage imports and stimulate exports,
71
firms in the nontraded goods sector became
less profitable, and the debt service obligations of 68
enterprises that had borrowed in foreign currency
increased. Fewer and more expensive imports hurt
company profitability, as did the collapse in de- 65 I 1
mand in the countries that adjusted to the shocks 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984
by tightening their monetary and fiscal policies.
Many firms were unable to service their debts. Source: Hinds 1988.
Other aspects of trade adjustment, such as lower
import restrictions or tariffs, had similar effects:
they reduced the profitability of previously protected
enterprises and added to the nonperform- ministered interest rates is certain to cause finaning
assets of financial institutions. In turn, many cial disintermediation, and to do much other
financial intermediaries became insolvent.
economic harm besides.
Now, more than ever, developing countries need Granting that sound macroeconomic policy is esto
rely on domestic resources to finance develop- sential, financial sector reform can make an imporment.
The importance of sound macroeconomic tant contribution to development. Chapters 5
policies for building efficient financial systems can- through 9 will examine different aspects of the task
not be overemphasized. Large public sector defi- of building better financial systems in developing
cits that demand financing from shallow domestic countries. Chapter 5 begins by looking in more
financial systems invariably lead to inflation or detail at the distress of financial institutions and
crowd out private sector borrowing. The interac- the first steps to be taken in reshaping financial
tion of high and unstable inflation and rigidly ad- systems.
69