Information about Asia and the Pacific Asia y el Pacífico

Chapter 6. Financial Sector Deepening and Transformation

Alfred Schipke
Published Date:
April 2015
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Information about Asia and the Pacific Asia y el Pacífico

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Era Dabla-Norris, Yasuhisa Ojima and Marco Arena 

Financial deepening is a multidimensional concept. It can be viewed as the process of enhancing and broadening financial systems by increasing the depth, liquidity, efficiency, and volumes of financial institutions and markets, as well as diversifying of domestic sources of finance and extending access to banking and other financial services.

Countries in frontier and developing Asia1 have implemented significant financial reforms during the past decades, including financial market liberalization, bank privatization, and efforts to build the capacity of central banks and financial authorities to conduct prudential regulation and supervision of the financial system. As a result, coupled with macroeconomic stability and growth and favorable global conditions, financial systems in frontier and developing Asia have grown and inclusion has broadened. Still, most systems remain small and relatively undiversified, and access to financing for much of the population is limited, which suggests considerable scope for further deepening

Well-managed financial deepening in frontier and developing Asia can enhance macroeconomic stability by increasing resilience to external shocks and helping promote and sustain inclusive economic growth (see also Chapter 5 on Inclusive Growth). However, the deepening itself can create new risks that need to be effectively managed (see Chapter 7 on Financial Sector Vulnerabilities). This chapter addresses the following questions: Why does financial deepening matter for frontier and developing Asia? What is the current state of play? How can sustainable financial deepening best be promoted?2

Why Financial Deepening Matters

Limited financial system depth and breadth can pose challenges for maintaining macro-financial stability, managing macroeconomic volatility, and promoting inclusive growth. This section sheds light on the benefits of financial deepening for frontier and developing Asia, focusing on its links to growth, poverty, inequality, and macroeconomic volatility.

Growth, Poverty, and Inequality

Financial system development and economic growth influence each other positively. A significant body of empirical research suggests that financial development drives economic growth (Levine 2005; Levine, Loayza, and Beck 2000). Financial development enables larger investments, including in much-needed infrastructure, and a more productive allocation of capital, leading to higher economic growth. In the absence of well-developed and inclusive financial systems, individuals must rely on their limited savings to invest in their education or become entrepreneurs, and small enterprises must rely on their limited earnings to pursue growth opportunities. Slower and less inclusive economic growth will result. At the same time, financial system development can be viewed as a byproduct of economic expansion, which creates wealth and opportunities that, in turn, provide the impetus to enlarge and further develop the financial system.

But the benefits of financial deepening extend beyond financing investment and include better and cheaper services for savings and making payments. These services allow firms and households to reduce transaction costs and provide the opportunity to accumulate assets and smooth income, thus reducing poverty and inequality. These issues are of concern to policymakers in frontier and developing Asia given still-high poverty levels, almost double those in emerging market Asian countries (Table 6.1). Evidence suggests that financial development can reduce income inequality by boosting the growth rate of the income share of the poorest quintile. Studies find that about 40 percent of the impact of financial development on the income growth of the poorest quintile results from a reduction in income inequality (Beck, Demirgüç-Kunt, and Levine 2007).3 Financial development is also strongly associated with poverty alleviation across the world. It has been found to lead to faster reduction in the percentage of the population living on less than $1 a day.4

Table 6.1Poverty Level in Emerging Market Asia and Frontier and Developing Asia
Frontier and Developing Asia1Emerging Market Asia2
Median (% of population)24.813.1
Average (% of population)27.012.9
Source: World Bank, World Development Indicators, latest available numbers per country.Note: Poverty headcount ratio at $1.25 a day (purchasing power parity, percent of population).

Bangladesh, Bhutan, Cambodia, Lao P.D.R., Nepal, Timor-Leste, Vietnam.

China, India, Indonesia, Malaysia, Philippines, Sri Lanka, Thailand.

Source: World Bank, World Development Indicators, latest available numbers per country.Note: Poverty headcount ratio at $1.25 a day (purchasing power parity, percent of population).

Bangladesh, Bhutan, Cambodia, Lao P.D.R., Nepal, Timor-Leste, Vietnam.

China, India, Indonesia, Malaysia, Philippines, Sri Lanka, Thailand.

Macroeconomic Volatility

Deeper and more diversified financial systems can help strengthen an economy’s resilience and capacity to cope with shocks and mitigate macroeconomic volatility through different channels (Figure 6.1).5 Deep financial systems can alleviate liquidity constraints on firms and industries, thus reducing the volatility of investment and output. Similarly, access to insurance arrangements and saving opportunities allow households to better smooth consumption intertemporally. Shallow financial systems in frontier and developing economies can limit fiscal, monetary, and exchange rate policy choices; hamper macroeconomic policy transmission; and impede opportunities for hedging or diversifying risk (IMF 2012). This is of particular concern because many countries in frontier and developing Asia are vulnerable to external shocks, such as sharp swings in the terms of trade, fluctuations in external demand, natural disasters, and volatile external financing.

Figure 6.1Financial Development and Consumption Volatility, 1980–2009

Sources: IMF staff calculations and World Economic Outlook database.

Enhancing macroeconomic policy effectiveness

Shallow financial systems can constrain a country’s choice of macroeconomic policy regimes (such as exchange rate and monetary regimes) and the effectiveness of fiscal policy. Furthermore, feedback loops may occur: policy stances can themselves affect financial deepening (for example, exchange rate flexibility can foster creation of new products and expertise in foreign exchange markets). Moreover, the scope for maintaining macroeconomic stability and implementing countervailing policies in the event of external shocks is constrained by underdeveloped financial systems.

  • Exchange rate regime: A country’s choice of exchange rate regime reflects a variety of considerations, but financial underdevelopment can constrain the available options. Research has shown that financial depth has a significant impact on a country’s choice of exchange rate regime, with less financially developed countries more likely to choose pegs (Obstfeld and Taylor 2004; Lin and Ye 2011).6 Almost two-thirds of frontier and developing Asian economies have de facto fixed regimes (Figure 6.2; also see Chapter 9 on Monetary Policy Frameworks). However, exchange rate flexibility can also pose challenges in the absence of deep financial markets, fueling exchange rate and output volatility, with the attendant costs for stability and growth. These effects can be particularly pronounced for natural-resource-based economies subject to high terms-of-trade and real exchange rate volatility.
  • Monetary policy: Both the choice of instruments for monetary policy implementation and the efficacy of the transmission mechanism in combating inflation are related to a country’s level of financial development. For instance, although indirect instruments are increasingly prevalent, frontier and developing Asian countries, like other low-income countries, are more likely to use direct instruments (such as interest rate and credit controls) than are advanced economies or emerging markets. Frontier and developing Asian countries are also more likely to rely on direct controls and statutory liquidity ratios as opposed to market-based instruments (such as secondary market operations—Figure 6.3). Pervasive excess liquidity in the banking system (which puts all banks on the sell side of money markets) in some frontier and developing Asian economies—and thin credit and government securities markets—limit the influence of policy rates, undermining policy transmission. Moreover, although shallow markets may not preclude the adoption of monetary frameworks such as inflation targeting, they render their operation more challenging.
  • Fiscalpolicy: Deep and diversified financial markets ensure more stable sources of government financing and can create an enabling environment for fiscal consolidation. In instances in which thin domestic debt markets and variable foreign financing leave little room to maneuver, fiscal policy itself can amplify the impact of shocks, fueling volatility. The lack of financial market depth can also constrain fiscal policy in a way that hinders the implementation of countercyclical fiscal policy prescriptions (Figure 6.4). For instance, budget deficits and higher government borrowing can amplify private sector crowding-out effects when financial markets are shallow.

Figure 6.2Exchange Rate Regime in Frontier and Developing Asia

Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions.

Figure 6.3Use of Monetary Policy Instruments

(By income group)

Sources: IMF, Information System for Instruments of Monetary Policy (ISIMP), a database containing the results of a biannual survey of monetary policy instruments covering 140 countries. See also IMF (2012).

Notes: Direct = direct controls; FX = foreign exchange; FX swap = foreign exchange swaps; GB = operations in government bond markets; OMO = open market operations; Repo = repurchase operations; RR = reserve requirement; SF = standing facilities; SLR = statutory liquidity requirements.

Figure 6.4Countercyclical Fiscal Policies in Low-Income Country and Financial Development

(Change between 2007–09)

Sources: IMF, World Economic Outlook database; and World Bank.

Managing capital flows

Frontier and developing Asian economies have become substantially more financially integrated internationally since 1990. De facto financial globalization—measured by gross external assets and liabilities as a percent of GDP—has almost doubled since the mid-1990s (Figure 6.5). A high degree of financial integration can confer significant benefits in economic growth and risk sharing, and even help develop the financial sector and deepen capital markets. However, the volatility of capital inflows can create challenges for macroeconomic and prudential policy. Although frontier and developing Asian economies are relatively less open financially than many emerging market Asian economies, these issues are likely to become more pressing as countries liberalize their capital accounts. Lack of depth in local banking and financial markets has been found to increase the risks associated with large capital flows.7 Shallower markets allocate capital less efficiently, potentially contributing to boom-bust cycles in credit, investment, and the broader economy. They also, by definition, have a lower capacity to absorb inflows without large changes in asset prices and real exchange rates (FSB, IMF, and World Bank 2011).

Figure 6.5Financial Globalization, 1980–2009

(Percent of GDP)

Source: Lane and Milesi-Ferretti (2010).

Note: Financial globalization is sum of gross external assets and liabilities.

Financial stability

Financial systems in frontier and developing Asia are less interconnected than systems in more mature economies, which explain, in part, their resilience to the global financial crisis. But the absence or illiquidity of markets can still expose them to potentially large shocks and instability and complicate risk management.8

  • Foreign currency risk: Realized risks to market participants are higher in underdeveloped financial systems. Although some countries in frontier and developing Asia have markets for currency forwards (Bangladesh, Vietnam), they remain relatively rare. Absent currency forwards, other derivatives or natural hedges and direct (through net open positions) and indirect (resulting from credit in foreign currency to domestic borrowers) exposure of financial institutions increases vulnerability to currency risk, particularly in dollarized economies (Cambodia, Timor-Leste). Credit risk is also heightened because borrowers who experience currency mismatches on their balance sheets are more vulnerable to unexpected exchange rate fluctuations.9
  • Liquidity management: Shallow financial markets can complicate liquidity management in financial institutions. For instance, thin domestic money markets increase the costs to banks of adjusting their liquidity positions and managing their portfolios. These potential costs help explain why banks in frontier and developing countries maintain relatively high proportions of liquid assets to meet sudden or unexpected obligations (such as a liquidity ratio exceeding 60 percent in Papua New Guinea)—another contributor to higher costs. Furthermore, short and uncertain liabilities constrain asset maturities, reducing banks’ ability to withstand shocks and more easily transmitting financial shocks to the broader economy.
  • Concentration risks and resource allocation: The narrow range of formal actors and economic activity, coupled with minimal scope for diversification in shallow markets, leads to a concentration of banks’ exposures to a limited number of counterparties. This concentration amplifies attendant credit and interest rate risks and can exert pressure on bank profitability and solvency if external factors deteriorate (such as during an economic downturn or the default of a large customer). Historically, concentration of credit risks in bank loan portfolios has been one of the major sources of bank distress in frontier and developing economies.

Current State of Financial Deepening

Stylized Facts

The environment in which frontier and developing Asian economies’ financial systems operate has changed radically since 1990. Better policy and economic management and implementation of wide-ranging financial sector reforms—combined with a favorable external environment in the run-up to the global financial crisis and ample global liquidity—have fostered financial sector development.

This section takes stock of recent trends in financial deepening in frontier and developing Asia and assesses whether these trends are in line with relevant comparators—Asian emerging market economies and other frontier and developing economies.10

Financial systems in frontier and developing Asia remain largely bank based. One indicator of financial structure, proxied by the ratio of stock market capitalization to private credit, shows the larger weight of the banking sector relative to markets in the median frontier and developing Asian economy, particularly in comparison with emerging market Asia (Figure 6.6A, panel 1). This also suggests that banks are the main players in the chain of payments and financial markets, including money and foreign exchange markets. This is not surprising given that relationship-based systems—via financial intermediation through banks—tend to prevail at early stages of financial development.11 As financial systems develop, however, they tend to move toward activities favoring more arm’s-length transactions.

Figure 6.6Banking Size and Efficiency in Frontier and Developing Asia

Source: Lane and Milesi-Ferretti (2010).

Note: CIS = Commonwealth of Independent States; EM = emerging market; FD = frontier and developing; LAC = Latin America and Caribbean; MNA = Middle East and North Africa; SSA = sub-Saharan Africa.

Banking Systems

Several indicators of size and efficiency show that frontier and developing Asia’s banking systems have deepened since 1990, but the nature of banking remains mostly short term, as evidenced by the maturity structure on the asset and liability sides of bank balance sheets.

  • Depth: Indicators of depth, measured by private credit and total bank deposits as percentages of GDP, display a clear upward trend in frontier and developing Asian economies, particularly since 2000. For instance, private credit in Lao P.D.R., Mongolia, and Vietnam has almost tripled since 2002 and has quadrupled in Bhutan and Cambodia, albeit from a low base. As can be seen in Figure 6.6A, panels 2 and 3, banking system depth in the median frontier and developing Asian economy is rapidly converging to levels observed in the median emerging market Asian economy. However, considerable heterogeneity can be observed in patterns of banking sector deepening. For instance, in 2010, the ratio of private credit to GDP in the median frontier and developing Asian economy was more than three times that of a country in the bottom 10th percentile.
  • Efficiency: In line with the rapid growth in credit to the private sector, intermediation efficiency, as proxied by the loan-to-deposit ratio, has increased in recent years (Figure 6.6A, panel 4). Furthermore, interest margins in frontier and developing Asia (Figure 6.6B, panel 5) have declined since the mid-1990s and are similar to those in emerging markets. Bank concentration in frontier and developing Asia (Figure 6.6B, panel 6) is also significantly lower than that in other regions, such as sub-Saharan Africa, Latin America and the Caribbean, and the Middle East and North Africa. Taken together, these developments suggest that reforms during the past few decades have served to increase efficiency.
  • The role of state-owned banks: One notable feature of banking systems in frontier and developing Asian economies is the large share of state-owned banks (Figure 6.7—see also Chapter 7 on Financial Sector Vulnerabilities). State-owned banks span a diverse range: (1) state-owned commercial banks (in Bangladesh, Bhutan, Lao P.D.R., Mongolia, Nepal, and Vietnam); (2) state-owned development banks (Bhutan Development Bank, Development Bank of Mongolia, Vietnam Development Bank); and (3) specialized state-owned banks (Rural Development Bank of Cambodia, Vietnam Bank for Social Policy). The prevalence of state-owned banks reflects both policy choices and a historical legacy of supporting the development of homegrown banks at their early stages (such as in Bhutan) to align growth with national objectives (in Bangladesh and Vietnam) and implement financial crisis management (the state bank in Mongolia). Several countries’ banking systems initially started as mono-banks (such as in Vietnam) or a nationalized system (Bangladesh—Ahmed and Al-Hassan 2011).

Figure 6.7State-Owned Banks in Frontier and Developing Asia

(Percent, share of total assets)

Source: Authors’estimates.

Note: Based on 2011 data except for Cambodia (2009), Bangladesh, Timor-Leste, and Papua New Guinea [all for 2010).

State-owned banks can be effective in coping with market failures by overcoming good borrowers’ collateral problems and lack of credit histories, for example, and by providing public goods for productive investment (Levine 2011). However, they are often susceptible to government failure. For example, La Porta, Lopez-de-Silanes, and Shleifer (2002) find that higher government ownership of banks in 1970 was associated with slower subsequent financial development and lower growth of per capita income and productivity. In frontier and developing Asia, many state-owned banks suffer from undercapitalization and higher levels of nonperforming loans than other banks.

Financial Markets

Liquid and deep domestic debt markets can be useful vehicles for diversifying the funding of governments, households, and corporations; attracting the financing required for huge infrastructure needs; broadening the range of assets available for local institutional and retail investors; and providing an additional channel for financial intermediation. Evidence, however, points to a natural sequencing with which various segments of the financial system develop, with capital markets typically following banking.12 Consistent with these observations, financial markets and other players in frontier and developing Asia, although growing, remain smaller, less numerous, and less liquid and provide a narrower range of services than those in emerging markets.

  • Equity markets: Stock market capitalization has grown in frontier and developing Asia, especially in the past few years, but remains significantly lower than in emerging market Asia (Figure 6.8, panel a). The number of listed companies is also small in many frontier and developing Asian economies (20 in Bhutan, 1 in Cambodia, 2 in Lao P.D.R., 6 in Maldives). In general, liquidity remains low and access to equity markets concentrated in a limited number of enterprises, with banks and nonbank financial institutions constituting a large share of listings. Available data about stock market turnover ratios (annual trading volume relative to the size of the market) show substantial variability among frontier and developing Asian economies. At about 140 percent of GDP, the ratio is very high in Vietnam, while it is only about 2 percent in Nepal. The shallowness of equity markets renders them susceptible to sudden price movements and greater disruptions, which can undermine confidence in their integrity (IMF 2012).
  • Bond markets: The small size and liquidity of equity markets is mirrored in the bond side of capital markets. Domestic government bond markets are mostly centered on primary markets (Figure 6.8, panel b), with secondary markets largely undeveloped. Some frontier and developing Asian economies have started to issue treasury bills (T-bills) through securitization of overdrafts from the central bank (Maldives, Nepal); other countries are in the process of developing T-bill auction systems (for example, Mongolia). Several countries have successfully issued longer-term domestic government bonds (Bangladesh, Vietnam) aimed at boosting infrastructure development. At the same time, the authorities need to remain vigilant about issues of fiscal dominance. For instance, excess supply of government securities in conjunction with large fiscal deficits can hinder healthy bond market development. International sovereign bond issuance has also increased during the past decade, but is limited to a few countries (for example, Mongolia and Vietnam).
  • Other markets: Available evidence suggests that money markets (interbank markets) in frontier and developing Asia are still shallow as measured by the scale of their operations and the number of participants. Official foreign exchange market turnover data are not available for most countries in frontier and developing Asia, but evidence suggests that most have already established interbank foreign exchange markets. But these markets are still at an early stage of development and comprise over-the-counter transactions among authorized dealers (Figure 6.8, panel d). Some exceptions are Papua New Guinea, which has a brokerage system, and Vietnam, which has market-making arrangements. Forward exchange rate markets are still nascent, as indicated by the IMF’s Annual Report on Exchange Rate Arrangement and Exchange Rate Restrictions database, which shows the presence of foreign exchange forward markets in only five frontier and developing Asian economies (Bangladesh, Mongolia, Nepal, Papua New Guinea, Vietnam).
  • Institutional investors (insurance, pension): As providers of financial services for long-term saving and risk sharing (such as health, life, property, and employment shocks), insurance markets and pension funds can facilitate the growth of capital markets (IMF 2012). Contractual saving institutions are, however, in their infancy in most frontier and developing Asian countries. Available data suggest that the insurance-assets-to-GDP ratio is less than 2 percent in most low-income countries, whereas some countries, including Vietnam, exceed the median value for emerging markets (Figure 6.8, panel f). However, insurance companies in frontier and developing Asia typically focused on the non–life segments of business, and the life segment typically constitutes a small share of their business. Similarly, pension fund assets remain small in most countries (Nepal is a notable exception; Figure 6.8, panel e), with pension funds typically not matching their long-term liabilities with their investment strategies.

Figure 6.8Financial Markets in Frontier and Developing Asia

Source: Authors’estimates.

Note: EM = emerging market, FD = frontier and developing, LIC = lower-income country, PNG = Papua New Guinea.

Financial Inclusion

Access to and use of financial services by a large share of households and enterprises is an important dimension of financial development. In tandem with the recent growth in private sector credit, financial inclusion in frontier and developing Asia has broadened, but continues to lag emerging market Asian economies significantly and remains limited, particularly for small and medium enterprises, suggesting considerable scope for making finance more inclusive.

  • Household access to financial services: Use of banking services in frontier and developing Asian economies is relatively better. Account penetration rates, measured by the presence of an account at a formal financial institution, are higher than in the median low-income country, but lag emerging market Asia and other middle-income countries (Figure 6.9, panel a). The use of savings and health insurance products also continues to lag emerging market Asian countries (Figure 6.9, panels d and f). One area in which frontier and developing Asian economies appear to be trailing other low-income countries is in the use of mobile phones to make payments (Figure 6.9, panel b). In other parts of the world, use of this technology has proved an effective way for poor households to reduce transaction costs, facilitate payments, and increase the use of formal financial intermediaries (IMF 2012).
  • Firms’ access to financial services: Evidence from the World Bank’s Enterprise Surveys suggests that access to finance is more limited in frontier and developing Asia than in emerging market Asia (Figure 6.10). In particular, relative to countries in frontier and developing Asia, surveyed firms in emerging markets are about one-third as likely to report being credit constrained, and twice as many report having either a bank loan or a line of credit. Moreover, a higher share of small and medium enterprises than larger firms in frontier and developing Asian economies report credit constraints as a major obstacle to their growth and operations than in emerging markets.

Figure 6.9Financial Inclusion in Frontier and Developing Asia: Household (2011)

Source: Demirgüç-Kunt and Klapper (2012).

Note: The income group classifications are those used by the World Bank. FD Asia data are available from Bangladesh, Cambodia, Lao P.D.R., Mongolia, Nepal, and Vietnam. EM Asia data comprise China, India, Indonesia, Korea, Malaysia, Philippines, Singapore, Sri Lanka, and Thailand. FD = frontier and developing, EM = emerging market, LIC = lower-income country, MIC = middle-income country.

Figure 6.10Share of Firms that Report Access to Credit as Constraint

(By firm size, average 2002–10)

Source: World Bank enterprise surveys.

Benchmarking Financial Systems

The previous section described stylized facts about financial deepening in frontier and developing Asia, showing that although countries have made considerable progress, more remains to be done. The question then arises of how much, if at all, frontier and developing Asian economies should facilitate financial deepening. How realistic is it to expect frontier and developing Asian economies to deepen and diversify financial systems to the levels observed in emerging market economies in Asia?

To address these questions, financial deepening in frontier and developing Asia is systematically benchmarked after controlling for a number of possible economic and structural determinants (such as income per capita, size, demographic variables). In particular, the behavior of selected financial indicators is tracked in relation to a “structural benchmark” level, based on a statistical methodology developed by the World Bank (Feyen and others, 2011).13 A “gap” is defined for each financial indicator in country i and year t as the difference between the benchmark and the actual level. A positive (negative) gap value thus indicates under- (over-) performance.

The analysis reveals the interesting result that many countries in frontier and developing Asia have deepened by more than would have been expected from their structural characteristics alone. The median gap in the ratio of private credit to GDP for the median frontier and developing Asian economy was very small in 2001. During the subsequent decade, this gap became significantly negative (Figure 6.11, panel a). This overperformance is particularly striking in comparison with the median emerging market Asian economy, for which gaps in private credit increased during the decade following the Asian crisis of the late 1990s, suggesting that the median emerging market Asian economy is underperforming relative to levels predicted by its structural characteristics (Figure 6.11, panel b).

Figure 6.11Benchmarking—Financial Depth

Sources: Authors’estimation based on World Bank Fin Stats (2012) data set.

Notes: Benchmark values are obtained from a regression that controls for structural factors (economic development, demographics, population density, and other fundamentals). BGD = Bangladesh, BTN = Bhutan; CAM = Cambodia; CHN = China; IDN = Indonesia; IND = India; LAO = Lao P.D.R.; MDV = Maldives; MNG = Mongolia; MYS = Malaysia; NPL = Nepal; PNG = Papua New Guinea; PHL = Philippines; THA = Thailand; TLS = Timor-Leste; VNM = Vietnam.

A closer inspection of these results indicates that the overperformance of private credit relative to the benchmark in the median emerging market Asian economy is driven largely by the behavior of a few countries. Figure 6.11, panel c illustrates that Bhutan, Mongolia, Nepal, and Vietnam have financial systems that are considerably larger than predicted by their structural characteristics. Moreover, observed levels of stock market capitalization in Bangladesh, Nepal, and Papua New Guinea in 2010 are much higher than predicted by their structural fundamentals (Figure 11, panel d). Overperformance relative to the benchmark can be an indication of sound macroeconomic and financial sector policies, but many of these countries have also witnessed a rapid increase in deepening, which can pose risks to stability (see also Chapter 7 on Addressing Financial Sector Vulnerabilities).

As evidenced from the experience of emerging markets during the Asian crisis and the experience of advanced economies during the global financial crisis, rapid deepening can fuel credit and asset price booms and can have destabilizing macroeconomic effects, particularly in the absence of appropriate financial oversight and policies. Indeed, research suggests that a private-credit-to-GDP ratio 90–100 percent above the structural benchmark is 50 percent more likely to be associated with a credit boom (Barajas and others 2013). In addition, this type of boom is almost always a “bad” or subpar boom—that is, one that ends in low-growth episodes or even banking crises. Particular attention should thus be paid to strengthening prudential and supervisory oversight and macroeconomic management in these frontier and developing Asian economies.

Benchmarking indicators of financial inclusion also points to the considerable cross-country heterogeneity within frontier and developing Asia, although most countries have more inclusive financial systems than the median low-income countries. With respect to account penetration, as proxied by commercial bank accounts per thousand adults and the number of branches, many countries are lagging the benchmark levels expected to find in countries with similar structural characteristics (for example, Cambodia, Lao P.D.R., Papua New Guinea), while others (for example, Maldives, Mongolia) are overperforming (Figure 6.12, panels a and b). The evidence on firms’ access to funding from official sources is also mixed (Figure 6.12, panels c and d). Several countries struggle to provide credit to small firms (for example, Lao P.D.R., Timor-Leste), suggesting considerable scope for greater financial access to ensure that entrepreneurship can thrive and create jobs.14

Figure 6.12Benchmarking—Financial Inclusion

Sources: Authors’ estimation based on World Bank Fin Stats (2012) dataset.

Notes: ECA = Europe and Central Asia; LAC = Latin America and the Caribbean; LIC = low-income country; MENA = Middle East and North Africa; SSA = sub-Saharan Africa.

How to Promote Financial Deepening

The discussion in the previous sections points to sizable cross-country heterogeneity within frontier and developing Asia, suggesting differing areas and approaches for deepening. In frontier markets, where financial intermediation has grown rapidly, the main challenge is to deepen capital markets sustainably and encourage long-term investing while strengthening financial oversight. In most countries in the group, broadening financial inclusion to allow for greater risk sharing and intertemporal consumption smoothing (as provided by saving and credit services)—and even simple payment services—and financing for small and medium enterprises remain critical policy challenges.

Many of the impediments to financial deepening in frontier and developing Asia today prevailed, or continue to be present, in emerging market Asia to varying degrees. Broadly speaking, efforts and actions to deepen and broaden the financial system and increase access to financial services can be organized around three interrelated elements: (1) policies to ensure stable macroeconomic environments, (2) institutional and infrastructure reforms to create enabling frameworks for markets and private initiatives, and (3) regulatory and oversight policies to address inefficiencies and risks generated by markets and market players.15

  • Sustaining macro-stability: Consolidation of fiscal positions through reforms (reducing fiscal dominance) and greater central bank autonomy, and the resulting enhanced policy credibility and reduced uncertainty over investment returns, can play a critical role in increasing both the demand for and supply of financial services. The absence of these factors, for instance, typically increases the risks of holding bonds, stymieing local bond market development. Financial repression, through artificially suppressed interest rates, further reduces their attractiveness. Similarly, fiscal dominance can lead to an issuance volume exceeding the absorption capacity of the existing investor base (banks, insurance companies, pension funds). This not only stunts bond market development, but also raises financial stability concerns as the sovereign and bank balance sheets become intertwined.
  • Public policy for institutional reform and infrastructure: Interventions that support technological innovation, encourage competition, and create infrastructures to promote participation (such as the Asian Bond Market Initiative) can help achieve economies of scale and reduce costs in financial services provision. At the same time, removal of inefficient regulations and compulsory lending policies, and market-supporting reforms to build up missing market segments, can have a positive impact on financial system development.
    • Undertaking operational reforms: Reforms to remedy deficiencies in the market micro-structure can facilitate price discovery and market development. In many frontier and developing Asian economies, the absence of well-functioning interbank money markets, primary market structures (such as nontransparent and noncompetitive participation), and a longer-term investor base (insurance, pension, and mutual funds) places a drag on bond market development.16 Experiences from emerging market economies suggest that market-friendly intervention instruments and a sound repurchase agreement framework can help develop money and interbank markets, which, alongside improvements in the underlying market infrastructure (such as trading platforms, custody, and clearing and settlement systems), aids in the development of debt and equity markets.
    • Rationalizing state-owned banks: Managing and gradually reducing the dominance of state-owned banks through prudential regulation, strong supervision, and well-timed privatization (ideally accompanied by improved governance and management) can contribute to the efficiency of banking systems. State-owned banks should have a clear mandate to cope with market failures on a noncommercial bank basis. They should not be a source of cheap credit, but should instead serve as funding vehicles for productive investments.17
    • Addressing information gaps: An area in which countries in frontier and developing Asia are clearly lagging emerging market Asia is in the strength of their informational and contractual institutions (Figure 6.13). Country experiences suggest that policy interventions to strengthen informational and contractual frameworks, such as building or upgrading credit registries and strengthening collateral and risk insurance, can play an instrumental role in fostering financial deepening and increasing access to financial services by small and medium enterprises.
    • Promoting inclusion by overcoming scale barriers: Frontier and developing Asia is also lagging other low-income countries and emerging markets in the use of mobile technology for payments and financial services. The successes of M-Pesa in Kenya and Smart Money in the Philippines suggest that the use of mobile technology, supported by flexible regulation, can help lower costs and promote broader access to payments services for underserved segments of the population (in rural areas, for example).
  • Public policy for risk oversight and management. Proactive policies to oversee market activity, support continuous risk monitoring, and mitigate systemic risks are essential for the benefits of financial deepening to materialize, particularly in light of the rapid growth of credit in many frontier and developing Asian countries.
    • Given the dominance of banks in financial systems in frontier and developing Asia, and their linkages to capital (stock and bond) markets, ensuring the good performance of banks and managing the risks to and from the banking system through prudent regulation and strong supervision are critical. A sound banking system can also provide a solid platform for capital market development, while minimizing associated risks.
    • The experience from the Asian crisis of the late 1990s suggests that the pace of financial liberalization and associated deepening needs to be carefully calibrated to the prudential oversight capacity. With greater foreign bank penetration, promoting cross-border supervisory cooperation and information sharing will become increasingly important for managing risks.
    • Policies to broaden financial access require a concomitant widening of the regulatory and supervisory perimeter to minimize regulatory arbitrage and financial system risks. Moreover, as seen in India, policies that seek to broaden financial access too aggressively can have ramifications for consumer indebtedness, requiring a commensurate strengthening of consumer protection.

Figure 6.13Credit Information Gap

Source: World Bank, Doing Business database (2013).

Note: Data for emerging Asia includes China.


Financial deepening is an imperative for frontier and developing Asia for several reasons. First, financial development can drive economic growth in these economies. Second, better financial services will allow firms and households to reduce transaction costs and provide opportunities for smoothing income, thus reducing poverty and income inequality. Third, financial deepening can help strengthen these economies’ resilience and capacity to cope with shocks and mitigate macroeconomic volatility.

Financial systems in frontier and developing Asia remain at a nascent stage of development. They are largely bank based, and although banking systems have deepened and efficiency has increased, the share of state-owned banks remains large. Financial markets in frontier and developing Asia, although growing, remain smaller, less numerous, and less liquid. In particular, stock markets have grown, especially over the past decade, but remain significantly smaller and less liquid than in emerging market Asia. Available data suggest that bond markets and money markets and insurance and pension institutions remain immature, suggesting further scope for developing capital markets. Financial inclusion in frontier and developing Asia has also broadened, but continues to lag emerging market Asia.

Some countries in frontier and developing Asia, however, have deepened by more than would have been expected from their structural characteristics alone, implying risks to stability. Rapid deepening can fuel credit and asset price booms and destabilize an economy, particularly absent appropriate financial oversight and policies. To maximize the benefits, country efforts and actions to deepen and broaden the financial system and increase access to financial services should be centered around three interrelated pillars: (1) policies to ensure stable macroeconomic environments, (2) institutional and infrastructure reforms to create enabling frameworks for markets and private initiatives, and (3) regulatory and oversight policies to address inefficiencies and risks generated by markets and market players.


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Frontier and developing Asia in this chapter refers to 11 countries: Bangladesh, Bhutan, Cambodia, Lao P.D.R., Maldives, Mongolia, Myanmar, Nepal, Papua New Guinea, Timor-Leste, and Vietnam.


This chapter draws on the analysis in IMF (2012).


This sheds light on the distribution channel of financial development. They also find that the channel is the strongest among rich countries.


For instance, Honohan (2004) finds that financial depth is negatively associated with headcount poverty, even after taking account of mean income and inequality.


Research suggests that countries with more developed financial systems experience smaller fluctuations in real per capita output, consumption, and investment growth over the medium term. The empirical analysis also points to a U-shaped relationship between financial depth and volatility, with higher financial depth exacerbating volatility at levels observed in many advanced economies (Dabla-Norris and Narapong, 2013).


Lin and Ye (2011) find that this effect is large: a one standard deviation increase in the measure of financial development leads to a 20 percentage point decline in the probability of choosing a fixed exchange regime. They also find that the more developed a country’s financial markets are, the more likely it is to exit from a fixed exchange rate regime.


It is important to acknowledge that the deeper domestic bond markets in emerging markets (Brazil, South Africa, Turkey, and so on) also experienced the greatest volatility during summer 2013.


Remember that there are risks stemming from financial deepening (such as excessive credit growth and non-deposit-financed credit expansion).


In Cambodia, for instance, where dollar deposits at banks are only partially covered by liquid dollar assets, banks are exposed not only to foreign exchange risk, but also to liquidity risk. Similarly, in Mongolia, about a third of deposits are denominated in foreign currency, adding to liquidity pressures (IMF 2012).


Although the concept of financial deepening is defined through services provided to the economy, it is measured using quantitative indicators referring to the size, efficiency, liquidity, and reach of financial systems. These indicators are usually specific to different segments of the financial sector that specialize in the provision of different financial services.


Bank-based systems can have a comparative advantage in reducing market friction associated with asymmetric information and immature legal systems because banks may produce private information and may valuate assets as collateral for their lending, drawing on their relationships (Rajan and Zingales 2001).


de la Torre, Feyen, and Alain (2011) find that financial activities that are the least prone to market friction emerge and develop first (such as deposit collection in banking). Activities that are subject to strong friction require more time. Debt and equity securities markets are strongly boosted by scale and network effects and typically take longer to develop. See also Demirgüç-Kunt, Feyen, and Levine (2012).


The benchmarks are derived as the predicted values from quantile (median) regression analysis that accounts for a country’s structural variables: income, country size, population density, age-dependency ratio, and other structural characteristics that affect financial development (such as dummies to capture whether a country is an offshore center, oil exporter, or country in transition). Note that the regression model does not account for factors that directly capture financial policy. Instead, the objective is to account for factors that lie outside the policy purview (at least in the short term). Deviations of the actual from the expected level of financial development can then be explained by the impact of policies and institutional quality in a country.


Lack of access to finance is a key constraint to job creation, particularly for small and medium enterprises, which tend to be more labor intensive than large firms. Studies have shown that access to finance has the largest employment effects for small and medium enterprises, which are also the most credit constrained (IFC 2013).


This section draws on the analysis in IMF (2012) to document the role of public policy in facilitating deepening.


Furthermore, experience from emerging market economies suggests that equity markets often mature once the relevant supportive financial markets develop, because the infrastructure, liquidity, and institutions that arise from foreign exchange, money, and government securities markets also facilitate the development of stock exchanges. Similarly, corporate bonds, in addition to the effects noted above, are also affected by the level of development in the government bond market, given its role as an asset-pricing reference.


It should be noted that the provision of low-cost loans to state-owned enterprises by state-owned banks in many frontier and developing Asian economies can also slow the development of corporate bond markets.

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