Why Developing Countries Need More Boring Finance

Posted by on 18 April 2009

The global financial crisis that we are facing today has forcefully shown the destructive potential of finance. Instead of being a lubricator of economic growth, the financial sector is now dragging down the real economy. Yet as counter-intuitive as it might seem at first, one of the messages that policy makers in developing countries and emerging markets should take away from the current mess is that their economies need deeper financial markets, including capital markets, not less.

When examining the causes of the crisis, it is important to recognise that the crisis was first and foremost a consequence of inadequate supervision and regulation of financial firms (or in part even the complete lack of regulation, as in the shadow financial sector). The crisis is a long overdue reminder that perfect markets do not exist. It is astonishing how the efficient market hypothesis could rise to such prominence given the long and well-documented history of financial manias, panics and crashes (e.g., Kindleberger and Aliber 2005; Garber 2000). Irrational behaviour and phenomena such as speculative bubbles, collective mood swings, herd behaviour, bandwagon effects, panic trading, or trading by agents caught in liquidity shortage have been long known in financial markets.

Nonetheless, many of those in charge – with former Fed chairman Alan Greenspan being the most prominent example – seriously came to believe that the best regulation is the self-regulation of financial markets; a belief that led to the devastating consequences that we are facing today. The Wall Street-Treasury complex, as Jagdish Bhagwati (1998) has called the close personal exchange between high finance and the U.S. government, certainly did not help to improve the regulatory framework in the U.S.

What is to blame are not financial markets as such, but financial markets in which actors were driven by wrong incentive structures and that had completely detached from the “real economy” – not least because regulators allowed excessive risk taking and a huge shadow financial sector to develop. Those countries whose financial regulators did not allow domestic banks and firms to invest in what Warren Buffet once famously dubbed weapons of financial mass destruction (and what is now commonly referred to as toxic assets) were proven right. Not long ago, Y.V. Reddy, the governor of the Reserve Bank of India until September 2008, had been blamed as a party pooper for not allowing Indian banks to play along the glitzy game of international finance and invest in risky assets abroad. Today he is praised as a hero with foresight.

When demanding more financial market development in developing countries and emerging markets it is thus imperative to demand at the same time the development of public institutions in these countries in charge of financial market regulation and supervision that are up to the task. Financial sector reform is a continuous process that needs to be in tune with macroeconomic realities and the state of maturity of institutions and markets. Innovative financial products, as great their potential benefits might be, should simply not be allowed if they are too complex for regulators to appraise their risk. If financial markets are sufficiently regulated and supervised, the risk of crisis can be minimised, while the gains of improved financial intermediation be yielded.

Empirical analysis has documented a robust correlation between finance and growth and a causality running from financial development to economic growth. The developmental effects of a deepening of financial markets are high particularly for those economies which face severe financing constraints of small and medium enterprises. Moreover, financial inclusion of households that hitherto had no access to the formal financial sector will improve the opportunities for those at the bottom of society in developing countries. The provision of basic banking services, including through innovative yet simple services like mobile phone banking, should therefore be a priority for poorer societies. Yet there is also a strong case for the development of capital markets, bond markets in particular, in developing and emerging economies.

When looking at the causes of the crisis beyond the regulatory failure, we come to a further reason why the development of financial markets, and capital markets in particular, in developing and emerging economies is important. The small size or even lack of capital markets in much of the developing world has caused investors from these countries, both private and public, to invest large chunks of their money in Western (and especially the U.S.) financial markets. The “global savings glut”, as Ben Bernanke put it, was not only a result of a high savings propensity and current account surpluses, especially of Asian economies, but also a consequence of a lack of liquid and safe investment opportunities in their domestic financial systems. The investment flows from developing and emerging economies added to the already high level of liquidity in U.S. financial markets that was a result of the lax monetary policy implemented by the Greenspan Fed after the burst of the dotcom bubble of the late 1990s. The excess liquidity fostered the build-up of high leverage in the U.S. financial system, which later proved fatal.

But the problem doesn’t stop here. While parts of the investments where parked in the U.S. financial markets, often in low-yielding treasury bills, other parts were funnelled back into the countries of origin. This “round tripping of capital” – which describes a situation where savings from one country are invested in the U.S. financial markets because the domestic financial sector doesn’t offer sufficient long-term investment opportunities, and are then lend back by foreign financial firms at higher rates to the country of origin – already proved problematic in the run-up to the Asian financial crisis of 1997-98, as it created the currency mismatch problems which threw several East Asian economies into deep trouble after devaluation of their currencies.

This time it has been different, because many developing and emerging economies have paid attention to avoid these currency mismatches so that foreign currency borrowing has been less problematic in the current crisis (with the major exception of several Central and Eastern European countries). Nonetheless, outsourcing financial intermediation to the U.S. financial markets proved problematic again. With banks and investment funds in the U.S. receiving assets from Asian and other savers and subsequently investing parts of these assets in emerging market stocks and bonds, partly in local currency, the recipient countries made themselves vulnerable to the effects of the U.S. financial crisis, even though the direct exposure to toxic assets was small. After the collapse of Lehman in September 2008, the liquidity problems of U.S. (and Western European) financial firms forced them to withdraw their holdings all across the board, which caused stock markets and currencies of emerging markets to plummet and liquidity in these markets to dry up. So once again the reliance on financial intermediation through Western financial markets proved fatal as it strengthened the transmission of the crisis. Moreover, with international credit markets being mostly dysfunctional at the present time, the underdevelopment of domestic markets is felt much more severely as governments and firms cannot access easy credit in international markets any longer.

Developing domestic markets and reducing dependency on foreign financial markets will not only be more efficient and reduce the costs of domestic financing, it will also reduce the risk associated with currency mismatches and of a sudden outflow of capital. This is not to say that international financial integration has to offer no benefits. But integrating into international financial markets at the expense of domestic financial market building is clearly no good strategy. Further efforts to develop both the banking sectors and capital markets in developing and emerging economies are not only conducive to economic growth, but will also help to strengthen economic resilience. Again, what developing countries certainly do not need (and it is indeed questionable whether developed countries need them) is highly leveraged financial sectors that have lost touch with the real economy. But more solid banking – what Paul Krugman (2009) recently called “boring banking” – and bond markets which help the financing of private businesses and households is certainly needed.

Ulrich Volz is a senior economist at the German Development Institute in Bonn.


Bhagwati, J.N. (1998):”The Capital Myth: The Difference between Trade in Widgets and Dollars”, Foreign Affairs, May/June, pp. 7-12 (http://www.foreignaffairs.com/articles/54010/jagdish-n-bhagwati/the-capi...).

Garber, P.M. (2000): Famous First Bubbles: The Fundamentals of Early Manias. MIT Press, Cambridge, MA.

Kindleberger, C.P. and R.Z. Aliber (2005): Manias, Panics, and Crashes: A History of Financial Crises, 5th Edition, John Wiley & Sons, Hoboken, NJ.

Krugman, P.R. (2009): “Making Banking Boring”, New York Times, 9 April (http://www.nytimes.com/2009/04/10/opinion/10krugman.html).