Financial development at risk

Raghuram Rajan, Erik Berglöf, 10 October 2008



Wall Street is under attack in the US Congress and among European policymakers. Less attention has been paid to the backlash against capitalism – the US variant in particular – in emerging markets.

Statements at the recent session of the United Nations General Assembly were full of recriminations against financial speculation in food commodities and the potential impact of the financial crisis on capital flows to the poor. The countries most directly vulnerable are those that have opened themselves up most to international capital. No one, however, will be insulated from the impact. The greatest casualty might be financial development.

Populist outrage at the gyrations of financial markets and at anecdotes about exploitative practices by financiers is not new. Financiers make easy targets, especially when boom turns to bust, and what was applauded as calculated risk-taking turns out to be foolish greed. The problems in the financial sector in the US fit long-held deep-rooted stereotypes of the “Main Street” populists across the world.

Unfortunately, the critics have a point. The main advantage of sound financial systems is supposedly better allocation of resources and risks. Yet the most sophisticated financial system in the world has grossly misallocated resources – not once, but twice over the last decade.

First came the dot-com bubble. That could be explained away as irrational exuberance over a new, uncertain, technology. But now we have a crisis centred on old-style housing (albeit with the new technology of structured finance). And because the US financial sector is seen as the vanguard of the free enterprise system, it strengthens critics’ arguments against the institutions of capitalism themselves. With the roots of capitalism still fragile in many countries, the backlash could be devastating.

In developed countries, there will be a search for appropriate regulatory and supervisory responses to the lessons learned from the crisis. This will be driven by political impulses, no doubt, but modulated by a sense that there is much in financial markets that we have benefited from. But in poorer countries, politicians do not have a long history of such positive experience with markets or free enterprise more generally. The problems in the financial sector in the US allow “Main Street” populists in emerging markets not just to retread their critiques of financial markets but also to hold free enterprise and trade guilty by association.

The criticism of financial markets is not without justification, but it is often misdirected. Even though the world is still struggling to understand how to regulate sophisticated financial systems, it has learnt considerably more about how to manage less sophisticated ones. As a result, the achievements of the emerging markets’ financial systems over the last decade have indeed been impressive.

Since the Asian and Russian crises, financial regulation and supervision, as well as corporate governance and transparency, have all improved. Governments have made tremendous advances in managing their finances while central banks have charted more independent policy.

Indeed, the correct response to the global crisis in emerging markets should be to accelerate reforms that strengthen the financial and regulatory infrastructure with due precautions to avoid, as best as possible, the misaligned incentives that lie at the root of the current crisis. Instead, key reforms are being reversed. In India, politically motivated mass-loan waivers, which ruined credit culture in the past, are reappearing.

In most other countries, the backlash has not gone that far yet, but a recent EBRD/World Bank Survey shows deep-rooted distrust of many market institutions, including the banks, and wide-spread nostalgia for many of the debilitating instruments of central planning, in many countries of the former Soviet Union.

As always, many of the actions against the financial sector are being proposed in the name of the poor, even though the true beneficiary, in one way or the other, is the politician himself. Ironically, in much of the world, the financial sector is finally reaching out to the poor, as improvements in technology and growth in legal infrastructure promise new solutions to age-old problems.

In Africa, for instance, banks and cell phone companies are drawing ever larger parts of the population into the payment system. Financial innovations like crop insurance and microfinance are promoting the diffusion of new seeds and fertilisers, and futures markets are facilitating hedging and price discovery. In India, a new law promises to facilitate the growth of grain warehouses and electronic warehouse receipts that will allow a farmer to store his harvest, as well as obtain finance against it, until he is ready to sell. It will probably do more for agricultural credit than decades of state intervention.

In the industrialised economies of Central and Eastern Europe, which started their transformation into market economies essentially without financial systems, it took almost a decade for fragile banks to truly extend credit beyond the government, large corporations, and rich individuals. But now well-capitalised institutions, often backed by foreign parents, actively support the restructuring of privatised enterprises, extend loans to risky small entrepreneurs, and finance mortgages of people wanting to buy their own home. As a result of better financial access, people trust their banks. In the Baltic States, they trust them even more than their political and legal institutions.

All this progress may be at risk, especially if the global financial squeeze lasts longer and goes deeper than currently expected. Financial access will contract and with it the support for financial institutions and markets. Emerging markets will re-enact internal battles for their economic soul that we thought had been conclusively decided. While outsiders will have only marginal influence, it is important that industrial country governments not fan the flames of anti-market sentiment by choosing the present time to reconsider their position on trade and capital flows. For, unfortunately, the experience from previous crises in history suggests that the veneer of market institutions is thinner than we think.

Topics: International finance
Tags: anti-market backlash, emerging markets, financial development

Chief Economist, EBRD and CEPR Research Fellow

Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Graduate School of Business