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 providea 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- petitive environment. 13. CJ& 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 YoonJe Cho, Warren L. Coats, Jr., Eirik Evenhouse, Barbara Kafka, Catherine Mann, Gerhard PohI, DimitriVittas, 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 workwas 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 projectionspre- sented in Chapter 1 and the statistical appendix. It is also responsible for the WorldDevelopment 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 assistancewas 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