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Unedited Event Transcript

Rethinking Financial Deepening: Stability and Growth in Emerging Markets

Ratna Sahay, International Monetary Fund

Peter Fisher, Center for Global Business and Government, Tuck School of Business, Dartmouth


William R. Cline, Peterson Institute for International Economics

Peterson Institute for International Economics, Washington, DC

June 23, 2015

Peter Fisher: Good afternoon. Welcome to lunch here. My name is Peter Fisher. I am a

Member of the Board of the Peterson Institute and I’m also a Senior Fellow at the Tuck School of Business at Dartmouth; and I won't bother with my prior affiliations. I’m presiding today. Welcome.

We’re here, as you all know, to discuss Rethinking Financial Deepening; the new staff discussion report from the IMF on Stability and Growth in Emerging Markets.

Today, we are having an on the record luncheon presentation, followed by a panel discussion and questions from, you, the audience. We are being webcast live. To repeat again, this is on the record. So let me explain how things will now unfold.

Ratna Sahay, the Deputy Director of IMF’s Monetary and Capital Markets Department, will be presenting the staff findings, along with Martin Čihák, an Advisor to the Monetary and Capital Markets Department; they will present a summary of their work. And then Bill Cline, a Senior Fellow here at the Peterson Institute, will provide some comments on their work, and then we’ll all reconnoiter on stage and have some questions among ourselves and open up it up to questions from you. So without further ado, let me turn over the podium.

Ratna Sahay: Good afternoon everybody. It’s a real pleasure to see a lot of old friends here and we're really honored to have you here.

Let me just thank Peterson Institute for having us. We, of course, think it’s an important topic worth debating, so we are just contributing to the debate.

So let me just begin by motivating the work that we started at the Fund. And I have at least three of my coauthors here, Adolfo Barajas, Papa N’Diaye, and Martin, who’s going to be presenting with us.

So there are many questions that came to our mind. And really the one, at least in my mind and different coauthors had different motivations, was are there any 1 particular lessons that emerging markets could learn from the 2008 crisis? And then, a related question was is there a tradeoff between financial development and stability, as we saw in the US and some other advanced economies? Does the face of financial development matter? That’s another one. And do the presence of foreign banks matter? It seemed to matter a lot in Europe. What rule does regulation play in all of this? There’s a lot of focus on regulatory refunds now.

And then, this very first question on the top left-side, is private credit a good measure? We only realized that after having done a lot of work using standard measures and saying, “Wow, we’ve got to throw out all our results because this is not a good measure,” and I'll come to that soon.

But just to give you some background. Of course, we're not the first to have look at this relationship between financial development and growth. Since the 1980s, there was a lot of conceptual work, which linked the two and there were very good reasons why there is a—one can expect a positive relationship between finance and growth, and then relate, as you well know, to mobilizing and pulling savings, facilitating trade exchange, of course, allocating capital productively and many other things.

But more recently there has been a lot of development, especially on the empirical side. So during the 1990s, people really came to the conclusion that there’s a very robust link, empirical link, between finance and growth. And this seemed to have been robust across countries, across income levels, as well as across regions. And now than when new work started in the 2000s right up to now, there appeared to be a weakening link between finance and growth. There was non-linearities that were being observed in the data and also there was a lot of variation in this relationship across countries. And as you can see on the right-hand chart, this relationship between GDP growth and financial debt, as measured by private credit to GDP ratio, it’s very clear that at low debts GDP per capita growth was low, but at higher debts it was high. And that is the result that got shattered in more recent times.

So I want to give you the bottom-line of some of our key contributions and findings. What I would like to advertise here is this mean measure of financial development that we came up with, we created an index. And as I said, we felt a very urgent need to actually come up with a broader measure; and I’ll show you why. And what do we do with this measure? We basically explore this relationship of financial development, not just with economic growth, but coming from the IMF we were also concerned about economic and financial stability. So those are the two main areas that we focused on.

So focusing basically now on what were the specific questions we ask and what were the answers? So at a very basic level, do we see a positive contribution of financial development to growth using our new index? And we find yes. The

–  –  –

A third question we asked is what about the relationship between financial development and stability? Is there a positive link? And the answer broadly was yes. However, again, in this case, the relationship weakens at higher levels of financial development. And given that the main motivation of this paper was to look at emerging markets we asked a very precise question; are emerging market special? Is there something different about the emerging markets? And we find that after using several controls, there was nothing that was special about the emerging markets. Our digressions could explain any type of country.

So following from that we asked ourselves is there a need to rethink the policy advice that the IMF itself gives to emerging markets or other countries? And the answer was yes, and you’ll see how.

So just to motivate then our index, we just looked at just the pure data on capital market development in relation to bank deposits, so financial institutions. Because as you know, traditional measures that have been used to capture financial development have really been a private credit to GDP ratio or stock market capitalization. The former is the one that’s been used most often.

So the key point of this chart, which looks at this ratio, is to tell you that bankrelated measures are not a good proxy for financial development. Why? Because as GDP grows and countries become richer, the importance of domestic private bond market and the stock market is actually much more than the financial institutions; and that is the shaded region on the top.

So I’m going to take you through the road-map and that’s basically we’ll talk a little bit about the index that we come up with. And then Martin is going to talk us through the regressions that we ran and the findings that we have.

So talking about the index that we come up with we looked at the US. So on the left-hand side you see, we tracked bank credit to private sector and the total assets of banks and non-banks from 1980 to now, 2013. And it’s very interesting to see that bank credit to the private sector is more or less constant and had we used that measure we would not have captured financial development in the US. So that is to motivate why we need to go beyond just private credit.

And on the right-hand side we also think that there are many dimensions to financial development beyond debt. Financial access is one of them. And again, we just plotted a chart to look at what financial access and debt looks like across these countries. And as you can see here, on the vertical axis we measure access, which is percent of adults with accounts and on the horizontal axis we have the traditional measure, bank credit to private sector. And it’s very clear that both, for example Korea and Vietnam, have the same so-called financial debt, but Korea 3 has very high financial access, very close to a 100, whereas Vietnam only has less than 25%. So this was really to motivate why we thought there was a need to come up with a new index which captured the many facets of financial development.

So we come up with this index and this index has I would say two broad components. One is we look at financial institutions and that is one sub-index, but within that we look at debt access and efficiency. Similarly, we have financial markets and then we look at debt, access, and efficiency. And we can go into the details later on if you’re interested how we come up with this measure, but we start with basically looking at different measures of debt across about 180 countries that we had in our sample, of which there were 26 advanced economies, 89 emerging markets, and 71 low-income countries, over the period of 1980 to

2013. And once we get this range of measures at the sub-sub-index and then we just normalize it to zero and one, we of course, cut off the extreme ends, we take 95% of the data. So we start at the bottom and then we start building up and finally come up with the financial development index.

So you might want to ask us why should we believe in your index; how do we know that it tells anything? And that’s the next chart.

So we track the financial development index for the advanced economies as a whole for emerging markets and for low-income countries. And as you can see, it kind of conforms without priors, that advanced economies are much more advanced and they’ve grown. Next come emerging markets and then finally the low-income countries.

But here is the other interesting finding and that is during this period from the 1990s right up to the crisis, you see really an acceleration in this index, in financial development, and that coincides of course with the Greenspan Era, with the repeal of the Glass Steagall Act.

And then there was a lot of investment banking growth, internet banking came into being, financial innovations. And also, European Cross Border Lending that we are very familiar with. And then it’s also interesting to see that right at the end of the gray section there is some de-leveraging that you witnessed straight after the crisis and you see that happening. So that gave us a little bit of confidence that at least our measure tells the story that most of us have priors too.

And then,= I’m just going to present a couple of charts, just to give you a peer group comparison. So on the left-hand side is a measure of financial institutions across debt, access, and efficiency for the three separate income groupings, advanced emerging and low-income. In the center you have the financial markets, across similar measures for the three groups, and then the overall rating.

–  –  –

Martin Čihák: Thank you Ratna. My name is Martin Čihák. I’m an adviser at the IMF. And I’ll walk you through some of the econometric analysis that we’ve done using these stylized facts and having them in the back of our minds.

So we looked at the relationship between financial development as defined by our index, economic growth and stability. And what we did in some way was building on the body of work that's been around for quite a while, so we didn’t invent a completely new approach, but we tried to combine some previous econometric work by Ross Levine, Thorsten Beck, and other authors, and combined with our broader definition of financial development.

–  –  –

5 So I should say these controls for the usual variables we used in this type of financial deepening regressions. So it’s initial GDP per capita, government spending per capita, FDI to GDP trade openers, secondary enrollment. So after taking all into account we still find a highly nonlinear effect.

What it means is that the benefits for growth of financial deepening increase as countries have greater financial sector, but the effect, which is maximum around the midpoint of the range and then the effects, the marginal effect becomes negative.

We also look at the confidence banter on this estimate and we can say with 95 degree of confidence, it's between 0.4 and 0.7. And so, it doesn’t mean that if you’re in the range of US or Japan that you have an overall negative effect on the growth rate, but the effect on the growth rate is not as large as it could be. I should say this is all conditional on all the other variables, including the institutional framework and I’ll get back to it.

Now, the interesting thing is there something in our design that would so drive this non-linearity? What is driving it? Why are we finding it? So we looked at the very sub-components of the index and we also looked at the GDP growth. So we tried to decompose in growth regressions, of course, it doesn’t go through labor, it doesn’t go through capital, it doesn’t go through TFP. An interesting thing we found is this non-linearity doesn’t appear when you look at capital accumulation or labor accumulation. So it seems that this non-linearity is driven by the effect on the total effect of productivity, which becomes, again, which slows down and becomes marginally negative around about 0.45.

So this shows that the effect, the positive effect of finance. It tends to break down, perhaps because some functions that the financial sector perform are still there and some other functions don’t. So for example, basic accumulation of savings, transaction still works, but as the financial system gets large perhaps some of the effects it performs in terms of allocation of capital or corporate control, are not as efficient as they are at the lower levels.

Interestingly, we also looked at the sub-components and we find that this was the results that we’re finding are really driven by the deepening, by the depth of the overall index. So when we ran the same estimates for the access for our proxy, for financial access, we didn’t find the nonlinear effect significant. Similarly, for efficiency there is no hump-shaped curve, so it’s really driven by financial sector depth.

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