Poor countries have the least-developed financial systems – that has to change

Technology Eye | Aug. 26, 2016

The liberalisation of financial markets in the 1990s and 2000s is considered to have contributed to the 2007/2008 Global Crisis. But we can forget the important contribution of financial markets to economic development. In poor countries, investment, even foreign direct investment (FDI), is costly. Well-developed financial markets may help to fund such investment.

To achieve this, financial markets require depth, access, efficiency and stability (World Bank 2016c). 'Depth' means that financial institutions and financial markets are a sufficient size. 'Access' reflects the degree to which economic agents use financial services. 'Efficiency' means that financial institutions are able to successfully intermediate financial resources, and to facilitate transactions. Finally, 'stability' refers to low market volatility plus low institutional fragility.

By these criteria, financial markets in different countries have varying levels of development. Figure 1 displays the average levels of a composite indicator capturing depth, access, efficiency and stability of the financial system of each country (Donaubauer et al. 2016a based on Beck and Demirgüç-Kunt 2009 and World Bank database, Donaubauer et al. 2016b).

Figure 1 Composite indicator of financial market development

Note: The number of countries included varies considerably for different years. Classifications of countries according to World Bank (2016). Source: Donaubauer et al. (2016a); Donaubauer et al. (2016b); authors' own calculations.

Not surprisingly, high-income countries have the most developed financial systems. On average they improved until 2005, and declined only slightly thereafter. Low-income countries have the least-developed financial systems. Average financial market development for this group improved during the 1990s (a statistic that possibly reflects the low number of countries for which observations are available in this period), but it has declined since the financial crisis.

Economic development depends on the local financial system, but not solely on the local financial system. Enterprises from one country can draw on the financial resources of another through FDI, in the form of joint ventures or full foreign ownership. In particular, affiliates of multinational enterprises (MNEs) in developing countries can take advantage of the financial markets in a parent’s high-income country. Compared with purely domestic firms, MNE affiliates, in theory, are less likely to be credit-constrained, make greater use of firm-internal funds, make less use of external funds, and are less reliant on local financial institutions (Görg and Kersting 2016). Therefore, we would expect improvements in a host country’s level of financial development to increase the use of funding from sources external to the firm, more so for domestic than for foreign-owned firms.

Recent empirical studies show both effects: firms in developing countries benefited from improvements in domestic financial markets, and MNE affiliates have been less reliant on such improvements. Using a propensity score-matching approach, Görg and Kersting (2016) compare the behaviour of foreign-owned firms in emerging and developing countries to the behaviour of a control group of locally owned firms. Donaubauer et al. (2016b) analyse the effect of improvements in financial markets on the gravity-driven distribution of FDI stocks. From these two studies we learn that:

Well-developed financial markets, either in source or host countries, foster bilateral foreign direct investment (Görg and Kersting 2016, Donaubauer et al. 2016b). Better availability of external funds in the source country makes it easier to finance FDI. Well-developed financial markets in the host country may also contribute to FDI directly by hedging against exchange rate risks, and indirectly by facilitating the financial interactions of the foreign firm in the host country.Well-developed financial markets in source countries compensate for poorly developed financial systems in host countries by generating FDI flows. Conversely, the positive effect of a better-developed financial market in the host country diminishes if the source country already offers a positive financial environment (Donaubauer et al. 2016b).Enterprises that are part of MNEs are less constrained by lack of finance. They make less use of bank loans compared to purely domestic firms. Enterprises that have newly become part of an MNE reduce their bank loan funding compared to funding from internal sources (Görg and Kersting 2016).When the state of a local financial market improves, funding from sources external to firms gains importance over firm-internal funding, in line with theory. Domestic firms benefit from this improvement more than MNE affiliates who had less need for external funding (Görg and Kersting, 2016).

There are two conclusions. First, foreign-owned affiliates in developing countries face fewer financial constraints than purely domestic firms because they can draw on the resources of their parents, and of financial systems in the source country. Access to financial markets is crucial for activities such as exporting and innovating. Therefore, firms in developing countries strategically benefit if they become integrated in a MNE. This may also benefit the host economy.

Second, while well-developed financial markets help firms to fund investment, poor financial market development in developing host countries can be compensated by highly-developed financial markets in FDI source countries. This implies a reduced pay-off to financial market reforms in developing host countries. We should keep in mind the importance of financial institutions in the developed world for growth in the developing world when we discuss new rules for financial markets.

References

Beck, T. and A. Demirgüç-Kunt (2009). "Financial institutions and markets across countries and over time: Data and analysis", World Bank Policy Research Working Paper 4943. Washington, D.C.: World Bank.

Donaubauer, J., B. Meyer and P. Nunnenkamp (2016a). "A new global index of infrastructure: Construction, rankings and applications", World Economy 39(6): 236-259.

Donaubauer, J., E. Neumayer, P. Nunnenkamp (2016b). "Financial Market Development in Host and Source Countries and Its Effects on Bilateral FDI", Kiel Working Paper 2029, Institut für Weltwirtschaft.

Görg, H. and E. Kersting (forthcoming). "Vertical Integration and Supplier Finance", Canadian Journal of Economics.

World Bank (2016a). Global financial development database.

World Bank (2016b). World Development Indicators.

World Bank (2016c). The Little Data Book on Financial Development 2015/2016, Washington, DC.

SOURCE: World Economic Forum

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