Financial market development is most often conflated with financial liberalization in debates on economic development. Financial deregulation had therefore become a central pillar of the Washington Consensus world view. Capital account liberalization was advocated as an unqualified requirement for developing countries.
Since the Global Financial Crisis, the IMF has been at the forefront of questioning several prevailing orthodoxies. The latest comes this working paper by Sami Ben Naceur and RuiXin Zhang which draws the distinction between various dimensions of financial development and points to certain less than benign effects of financial liberalization, especially its effect on income distribution. Specifically, going beyond the conventional focus on financial deepening, they focus on four other dimensions of financial sector development - access, efficiency, stability, and liberalization. They find,
The results suggest that most financial development dimensions can help reduce income inequality and poverty. However, external financial liberalization tends to have the opposite effect on the global average. In addition, our evidence suggests that banking sector development has a stronger positive effect on income distribution than stock market development.
They have interesting prescriptions for policy making, including giving priority to banking sector development over capital markets and caution with capital account liberalization,
Observing the benefits of financial development on both economic growth and income distribution, policymakers need to steer the development of the financial system in a progrowth and pro-poor direction. Financial reform policies aimed at expanding financial access and depth, as well as enhancing financial efficiency and stability, should all be encouraged. These policies may include relaxing credit and interest controls, and improving banking and securities market supervision. However, given that external financial liberalization aggravates poverty, capital account liberalization should proceed in a carefully designed and well-sequenced fashion in a stable macroeconomic environment to avoid offsetting the poverty-reducing gains with the development of other dimensions of the financial sector. It is also important to develop an effective regulatory system for financial institutions and to enhance financial infrastructure (credit information, and collateral and insolvency regimes) in order to limit risk taking of banks. Given that the development of financial institutions has a greater impact than the development of the stock market, policymakers may give priority to banking sector improvement when considering poverty and income inequality alleviation.
This is very sound advice to countries like India which has very narrow traditional banking market and where commentators have tended to prioritize capital market development and external liberalization. Reflecting the very low financial market depth, compared to our even our peers leave aside more developed economies, banking sector assets as a share of GDP is among the lowest in India. Worse still, it has been stagnating for the past decade, including in the high-growth years in the middle of last decade.
There is only so much you can intermediate with such a narrow traditional banking sector. This goes back to another structural deficiency in our savings balance sheet - over 70% of household savings are held in illiquid property and gold, far higher than elsewhere. These are plumbing issues that need to be addressed before we navigate into the deeper end of the financial development pool.