The existence of financial institutions

Read the case “Financial Development and Economic Growth” (Mishkin and Eakins, 2012; pp. 152), identify key issues that keep financial systems in developing and transition economies from operating efficiently. What is the one issue (of those) that you think affects the Vietnam’s financial development the most? And what should be done about it?

The case:

Recent research has found that an important reason many developing countries or ex-communist countries like Russia (which are referred to as transition countries) experience very low rates of growth is that their financial systems are underdeveloped (a situation referred to as financial repression).1 The economic analysis of financial structure helps explain how an underdeveloped financial system leads to a low state of economic development and economic growth.

The financial systems in developing and transition countries face several difficulties that keep them from operating efficiently. As we have seen, two important tools used to help solve adverse selection and moral hazard problems in credit markets are collateral and restrictive covenants. In many developing countries, the system of property rights (the rule of law, constraints on government expropriation, absence of corruption) functions poorly, making it hard to use these two tools effectively.

In these countries, bankruptcy procedures are often extremely slow and cumbersome. For example, in many countries, creditors (holders of debt) must first sue the defaulting debtor for payment, which can take several years; then, once a favorable judgment has been obtained, the creditor has to sue again to obtain title to the collateral. The process can take in excess of five years, and by the time the lender acquires the collateral, it may well may have been neglected and thus have little value.

In addition, governments often block lenders from foreclosing on borrowers in politically powerful sectors such as agriculture. Where the market is unable to use collateral effectively, the adverse selection problem will be worse, because the lender will need even more information about the quality of the borrower so that it can screen out a good loan from a bad one. The result is that it will be harder for lenders to channel funds to borrowers with the most productive investment opportunities.

There will be less productive investment, and hence a slower-growing economy. Similarly, a poorly developed or corrupt legal system may make it extremely difficult for lenders to enforce restrictive covenants. Thus, they may have a much more limited ability to reduce moral hazard on the part of borrowers and so will be less willing to lend. Again the outcome will be less productive investment and a lower growth rate for the economy. The importance of an effective legal system in promoting economic growth suggests that lawyers play a more positive role in the economy than we give them credit for (see the Mini-Case box, “Should We Kill All the Lawyers?”)

Governments in developing and transition countries often use their financial systems to direct credit to themselves or to favored sectors of the economy by setting interest rates at artificially low levels for certain types of loans, by creating development finance institutions to make specific types of loans, or by directing existing institutions to lend to certain entities. As we have seen, private institutions have an incentive to solve adverse selection and moral hazard problems and lend to borrowers with the most productive investment opportunities. Governments have less incentive to do so because they are not driven by the profit motive and thus their directed credit programs may not channel funds to sectors that will produce high growth for the economy. The outcome is again likely to result in less efficient investment and slower growth.

In addition, banks in many developing and transition countries are owned by their governments. Again, because of the absence of the profit motive, these state-owned banks have little incentive to allocate their capital to the most productive uses. Not surprisingly, the primary loan customer of these state-owned banks is often the government, which does not always use the funds wisely for productive investments to promote growth.

We have seen that government regulation can increase the amount of information in financial markets to make them work more efficiently. Many developing and transition countries have an underdeveloped regulatory apparatus that retards the provision of adequate information to the marketplace. For example, these countries often have weak accounting standards, making it very hard to ascertain the quality of a borrower’s balance sheet. As a result, asymmetric information problems are more severe, and the financial system is severely hampered in channeling funds to the most productive uses.

The institutional environment of a poor legal system, weak accounting standards, inadequate government regulation, and government intervention through directed credit programs and state ownership of banks all help explain why many countries stay poor while others, unhindered by these impediments, grow richer.