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Financial Development and Economic Growth
A P P L I C AT I O N
Recent research has found that an important reason why many developing coun-
tries or ex-communist countries like Russia (which are referred to as transition
countries) experience very low rates of growth is that their financial systems are
underdeveloped (a situation referred to as
financial repression
).
5
The economic
analysis of financial structure helps explain how an underdeveloped financial sys-
tem leads to a low state of economic development and economic growth.
The financial systems in developing and transition countries face several difficul-
ties that keep them from operating efficiently. As we have seen, two important tools
used to help solve adverse selection and moral hazard problems in credit markets
are collateral and restrictive covenants. In many developing countries, the system of
property rights (the rule of law, constraints on government expropriation, absence
of corruption) functions poorly, making it hard to make effective use of these two
tools. In these countries, bankruptcy procedures are often extremely slow and cum-
bersome. For example, in many countries, creditors (holders of debt) must first sue
the defaulting debtor for payment, which can take several years, and then once a
favourable judgement has been obtained, the creditor has to sue again to obtain title
to the collateral. The process can take in excess of five years, and by the time the
lender acquires the collateral, it may have been neglected and thus have little value.
In addition, governments often block lenders from foreclosing on borrowers in polit-
ically powerful sectors such as agriculture. Where the market is unable to use col-
lateral effectively, the adverse selection problem will be worse because the lender
will need even more information about the quality of the borrower in order to screen
out a good loan from a bad one. The result is that it will be harder for lenders to
channel funds to borrowers with the most productive investment opportunities.
There will be less productive investment and hence a slower-growing economy.
Similarly, a poorly developed or corrupt legal system may make it extremely diffi-
cult for lenders to enforce restrictive covenants. Thus they may have a much more
limited ability to reduce moral hazard on the part of borrowers and so will be less
willing to lend. Again the outcome will be less-productive investment and a lower
growth rate for the economy. The importance of an effective legal system in pro-
moting economic growth suggests that lawyers play a more positive role in the
economy than we give them credit for (see the FYI box, Let the Lawyers Live!).
Governments in developing and transition countries often use their financial
systems to direct credit to themselves or to favoured sectors of the economy by
setting interest rates at artificially low levels for certain types of loans, by creating
so-called development finance institutions to make specific types of loans, or by
directing existing institutions to lend to certain entities. As we have seen, private
institutions have an incentive to solve adverse selection and moral hazard prob-
lems and lend to borrowers with the most productive investment opportunities.
Governments have less incentive to do so because they are not driven by the profit
motive and so their directed credit programs may not channel funds to sectors that
will produce high growth for the economy. The outcome is again likely to result
in less-efficient investment and slower growth.
5
See World Bank,
Finance for Growth: Policy Choices in a Volatile World
(World Bank and Oxford
University Press, 2001) for a survey of the literature linking economic growth to financial development
and a list of additional references.
C H A P T E R 8
An Economic Analysis of Financial Structure
185
In addition, banks in many developing and transition countries are owned by
their governments. Again because of the absence of the profit motive, these
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