World Development Report 1989 Financial Systems and Development World Development Indicators / / / I World Development Report 1989 Published for The World Bank Oxford University Press Oxford University Press NEW YORK OXFORD CORBY LONDON TORONTO NEW DELHI BOMBAY CALCUTTA MADRAS SELANGOR SINGAPORE HONG KONG TAIPEI TOKYO BANGKOK KARACHI LAHORE MELBOURNE AUCKLAND CAPE TOWN JOHANNESBURG DURBAN NAIROBI DAR ES SALAAM KAMPALA JAKARTA IBADAN © 1989 by the International Bank for Reconstruction and Development / The World Bank 1818H Street, NW, Washington, D.C. 20433 U.S.A. First printing June 1989 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior permission of Oxford University Press. Manufactured in the United States of America. The denominations, the classifications, the boundaries, and the colors used in maps in World Development Report do not imply on the part of The World Bank and its affiliates any judgment on the legal or other status of any territory, or any endorsement or acceptance of any boundary. ISBN 0-19-520787-4 clot hbound ISBN 0-19-520788-2 paperback ISSN 0163-5085 The Library of Congress has cataloged this serial publication as follows: World development report. 1978- [New York] Oxford University Press. v. 27 cm. annual. Published for The World Bank. 1. Underdeveloped areasPeriodicals. 2. Economic development Periodicals. I. International Bank for Reconstruction and Development. HC59. 7. W659 330.9' 172'4 78 -6 7086 This book is printed on paper that adheres to the American National Standard for Permanence of Paper for Printed Library Materials, Z39.48-1984. This Report is the twelfth in the annual series as- among Asian countries, although per capita in- sessing major development issues. Like its prede- comes will continue to rise rapidly. cessors, the Report includes the World Develop- The decline in foreign capital inflows means that ment Indicators, which provide selected social and countries will need to rely primarily on domestic economic data for more than a hundred countries. resources to finance investment. Financial systems Chapter 1 reviews recent trends in the world econ- can play an important role in this regard: by mobi- omy and their implications for the future prospects lizing savings and allocating them to the most of developing countries. Chapters 2 through 9 ex- profitable activities, the financial sector enables so- amine the role of financial systems in develop- ciety to make more productive use of its scarce ment, the special topic of this year's Report. The resources. The financial systems of many develop- main points of the Report are summarized below. ing countries are in need of restructuring, how- Economic growth rates among the developing ever. Their present condition reflects the approach countries have varied considerably. In Asia, where to development taken by many countries in the the majority of people live, per capita incomes dur- 1960s and 1970s, an approach that emphasized ing the 1980s have risen more rapidly than in the government intervention to promote economic 1960s and 1970s, but in Latin America and the Ca- growth. Today many countries are revising their ribbean, Europe, the Middle East, and North Af- approach to rely more heavily on the private sector rica per capita incomes have risen by less than 1 and on market forces. For the financial sector this percent a year, and in Sub-Saharan Africa they implies a smaller role for government in the alloca- have actually declined. The external environment tion of credit, the determination of interest rates, has had an adverse impact on growth, but domes- and the daily decisionmaking of financial interme- tic policies have been more important. Countries diaries. Relaxation of these economic and opera- striving to adjust their economies have had consid- tional controls calls for an effective system of pru- erable success in reducing external imbalances but dent regulation and supervision. In most countries less success with internal balance. In the first half improvements in the legal and accounting systems of the 1990s, per capita incomes are expected to will be required to strengthen the financial increase only slowly in Sub-Saharan African coun- structure. tries. The highly indebted countries will grow The industrial and financial policies followed in more rapidly, particularly if there are reductions in the 1970s and 1980s, together with the economic their external debt. Growth is expected to slow shocks of the 1980s, have left many developing 'U countries' financial institutions insolvent. Still, that the pace and sequencing of liberalization many institutions continue to lend to their most should depend on the initial structure of a coun- impaired customers and to accrue unpaid interest. try's financial system and the degree of macroeco- The allocation of scarce resources to insolvent nomic stability. Countries with unstable econo- firms has delayed adjustment. Restructuring the mies and price systems that do not reflect the insolvent firms and institutions is an important scarcity of resources will need to deregulate their part of the adjustment process. financial systems gradually. In countries without Restructuring the financial system provides a fully liberalized markets, policymakers should unique opportunity to reconsider what sorts of in- make sure that interest rates reflect market forces stitutions will be best suited to the economic envi- and that directed credit programs are limited to a ronment of the 1990s. Although commercial banks modest share of total credit. When a country lacks will continue to dominate financial systems in macroeconomic stability, decontrol of external fi- many developing countries, greater emphasis than nancial transactions may cause destabilizing capi- in the past should be placed on ensuring the avail- tal flows. Hence, although the objective is an open ability of a broad array of financial services. Many market, countries should not remove all capital countries should develop contractual savings sys- controls until other economic and financial reforms tems, and the more advanced should develop se- are in place. curities markets. Governments should provide a Like previous World Development Reports, this tax and regulatory environment that is neutral is a study by the staff of the World Bank, and the with regard to different types of financial activities. judgments in it do not necessarily reflect the views Informal financial institutions have proved able to of the Board of Directors or the governments they serve the household, agricultural, and microen- represent. terprise sectors on a sustained basis. Measures that link informal institutions to the formal financial system will improve that service and ensure a com- 13. CJ& petitive environment. In recent years some countries have experi- mented with varying degrees of financial liberali- Barber B. Conable zation. Their experience with both domestic liber- President alization and full or partial decontrol of the capital The World Bank account has been mixed. Nevertheless, it suggests June 1, 1989 This Report has been prepared by a team led by Millard F. Long and comprising Yoon Je Cho, Warren L. Coats, Jr., Eirik Evenhouse, Barbara Kafka, Catherine Mann, Gerhard PohI, Dimitri Vittas, Robert Vogel, and Robert Wieland. The team was assisted by Anastasios Filippides, Lynn Steckelberg Khadiagala, Clifford W. Papik, Anna-Birgitta Viggh, and Bo Wang. The work was carried out under the general direction of Stanley Fischer. Many others in and outside the Bank provided helpful comments and contributions (see the biblio- graphical note). The International Economics Department prepared the data and projections pre- sented in Chapter 1 and the statistical appendix. It is also responsible for the World Development Indicators. The production staff of the Report included Les Barker, Pensri Kimpitak, Cathe Kocak, Victoria Lee, Walton Rosenquist, Nancy Snyder, and Brian J. Svikhart. Library assistance was pro- vided by Iris Anderson. The support staff was headed by Rhoda Blade-Charest and included Trinidad S. Angeles and Maria Guadalupe M. Mattheisen. Clive Crookwas the principal editor. iv Definitions and data notes ix Financial systems and development: an overview 1 The economic background 1 Origins of financial distress 2 Prerequisites for financial development 3 Institutions and markets 3 The path to reform 4 Outline of the Report 5 Adjustment and growth in the 1980s and 1990s 6 The international economic environment 6 Structural adjustment policies and challenges 10 Development issues 14 Growth prospects 19 2 Why does finance matter? 25 Finance and growth 26 Risks and costs of finance 32 Government intervention 35 The structure of the financial system 37 3 The evolution of financial systems 41 Development of payment systems 41 Development of trade finance 42 The impact of large-scale industrialization 44 Financial crises 45 Financial systems in developing countries 47 Financial regulation after World War II 49 Financial innovation since the 1970s 51 Current policy concerns in industrial countries 52 V 4 Financial sector issues in developing countries 54 Government intervention in credit allocation 55 Macroeconomic policies and financial development 61 The task of financial reform 69 5 Financial systems in distress 70 Economic consequences of financial distress 72 Roots of financial distress 75 Lessons of financial restructuring 77 6 Foundations of financial systems 84 Financial contracts and debt recovery 84 Developing the legal foundations 85 Timely and accurate accounts 90 Prudential regulation of financial institutions and markets 91 7 Developing financial systems 96 Financing investment 96 Building financial institutions and markets 102 Priorities for reform 111 8 Issues in informal finance 112 Informal financial arrangements 113 Semiformal finance 116 Improving finance for the noncorporate sector 118 9 Toward more liberal and open financial systems 122 Recent experiences with financial reform 122 Lessons of reform 127 Components of financial reform 128 Conclusions of the Report 132 Bibliographical note 133 Statistical appendix 145 World Development Indicators 155 Boxes 1.1 Project 1992 and the developing countries 16 1.2 Debt concepts 18 1.3 Foreign equity investment 24 2.1 Life without money 26 2.2 Transaction costs and the supply of credit 30 2.3 Real interest rates and growth 32 2.4 Swapping risk 34 2.5 Deposit insurance 36 2.6 Monetary policy 38 3.1 Marco Polo discovers paper money 42 3.2 Trade financing in Renaissance Italy 43 3.3 Financial swindles 46 3.4 Financial underdevelopment in Nigeria 48 3.5 Indigenous banking in India 48 3.6 Universal banking 50 4.1 Directed credit in Turkey 56 4.2 Lending program for small enterprises in Ecuador 58 vi 4.3 Credit and income redistribution in Costa Rica 59 4.4 The Botswana Development Corporation 60 4.5 The inflation tax 63 4.6 Taxation of financial intermediation in the Philippines 64 4.7 The curb market 67 4.8 Financial indexation in Brazil 68 5.1 Examples of financial distress 71 5.2 Bank solvency and liquidity 73 5.3 How good bankers become bad bankers 77 5.4 The U.S. savings and loan crisis: the lessons of moral hazard 78 5.5 Can banks "muddle through"? 79 5.6 Restructuring a large corporation: a Mexican example 83 6.1 Civil and commercial law in Korea 86 6.2 Financial and economic effects of land tenure in Thailand 87 6.3 Islamic banking 88 6.4 Commercial law enforcement in Pakistan 89 6.5 Elements of a bank supervision system 92 6.6 Investment funds in Egypt 94 7.1 The structure of investment and the capital stock 97 7.2 Corporate finance in theory and practice 99 7.3 The financial history of a Pakistani firm 100 7.4 Housing finance 102 7.5 Bank modernization: Indonesia's experience 104 7.6 Banks in Guinea 105 7.7 Pension funds as a source of term finance 107 7.8 Capital markets in India 108 8.1 Informal finance in Niger 113 8.2 Rotating savings and credit associations 114 8.3 The Grameen Bank: an alternative approach to noncorporate finance in Bangladesh 117 8.4 The Badan Kredit Kecamatan: financial innovation for the noncorporate sector in Indonesia 120 9.1 Financial liberalization in New Zealand 125 9.2 Financial reform in Korea 126 Text figures 1.1 Growth of real GNP in developing countries by region, 1965 to 1988 7 1.2 Real GNP per capita in developing countries by region, 1965 to 1988 7 1.3 Growth of output and trade, 1980 to 1988 9 1.4 Growth of export volume in developing countries by region, 1965 to 1988 10 1.5 Real commodity prices, 1970 to 1988 11 1.6 Saving and investment rates in developing countries by region, 1965 to 1987 12 1.7 Real effective exchange rates in developing countries by region, 1978 to 1988 17 1.8 Domestic and external liabilities in selected developing countries, 1975, 1981, and 1987 22 2.1 Average saving and investment rates and sectoral surpluses and deficits for fourteen developing countries 28 2.2 Indicators of financial depth 31 3.1 The evolution of financial assets in selected countries, 1800 to 1987 45 4.1 Central government borrowing by source, 1975 to 1985 62 4.2 Real interest rates in developing countries and the United States, 1967 to 1985 65 4.3 Financial savings and the real deposit rate in Argentina and Thailand, 1970 to 1987 66 4.4 Prices, production, and bank credit in Colombia 69 5.1 Ratio of new credit to investment in selected developing countries, 1973 to 1979 and 1980 to 1986 74 5.2 Central bank losses and new domestic credit in selected developing countries, 1980 to 1987 75 vii 7.1 Shares of medium- and long-term credit in total credit outstanding from commercial banks and other financial institutions in selected developing countries, 1970 and 1986 98 7.2 Stock indexes in selected developing countries and the United States, 1987 and 1988 110 Text tables 1.1 Selected economic indicators in the adjustment-with-growth and low scenarios 20 1.2 Growth prospects in the adjustment-with-growth and low scenarios 21 1.3 Selected capital flows to developing countries, 1981 and 1987 23 2.1 Saving and growth in developing countries, 1965 to 1987 27 2.2 Average sectoral surpluses in fourteen developing countries, selected years 29 2.3 Growth rates and other economic indicators for country groups with positive, moderately negative, and strongly negative real interest rates, 1965 to 1973 and 1974 to 1985 31 2.4 The institutional structure of selected financial systems, 1985 39 4.1 Average annual inflation rates, 1965 to 1987 63 4.2 Real loan interest rates for selected countries, 1980 to 1986 66 7.1 Equity market indicators, 1987 109 Statistical appendix tables A.1 Population growth, 1965 to 1987, and projected to 2000 145 A.2 Population and GNP per capita, 1980, and growth rates, 1965 to 1988 146 A.3 Population and composition of GDP, selected years, 1965 to 1988 146 A.4 GDP, 1980, and growth rates, 1965 to 1988 147 A.5 GDP structure of production, selected years, 1965 to 1987 148 A.6 Sector growth rates, 1965 to 1987 148 A.7 Consumption, investment, and saving, selected years, 1965 to 1987 149 A.8 Growth of export volume, 1965 to 1988 150 A.9 Change in export prices and terms of trade, 1965 to 1988 151 A. 10 Growth of long-term debt of low- and middle-income economies, 1970 to 1988 152 A.11 Investment, saving, and financing requirement, 1965 to 1987 153 A.12 Composition of debt outstanding, 1970 to 1987 154 C' vul
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