Financial Systems and Economic
Development:Critical Issues and
Policy Implications for African
Charles Amo Yartey
Faculty of Economics and Politics
University of Cambridge
2. Financial development and economic growth
3. Financial systems and economic growth
4. Financial development in Africa
5. Financial liberalisation in Africa
6. Policy implications for African countries.
1. The services provided by the banking system are
critical for economic growth (Schumpeter)
“Where enterprise leads finance follow” (Robinson)
2. Stock market development is a natural progression in
the growth process. (The World Bank)
When the capital development of a country becomes the
by product of the activities of a casino the job is
likely to be ill done. (Keynes)
Contribution of the paper
We provide two main contributions to the
1. A non technical survey and synthesis
of the finance and growth literature.
2. We analyse important policy
implication of the literature for
2. Financial development and
a. Mechanisms through which finance works
The traditional growth theories saw no role for finance in the
According to the new growth theory finance can influence
growth in three ways;
– Increasing the efficiency of the intermediation process
– Increase the productivity of capital
– Increasing the savings rate.
Promoting entrepreneurship (Rajan and Zingales 1998)
Encourage new entry of firms which breeds competition
b. Financial development versus
Financial structure can be defined as the institutions,
financial technology, and the rules of the game that
define how financial activities are organised at a
particular time period.
Financial development refers to the development of
well functioning financial markets and intermediaries.
Financial development depends on the financial
structure of the economy.
Indicators of financial development include M2/GDP;
stock market capitalisation/GDP; bank asset/GDP
3. Financial systems and
3a. The stock market and economic growth
The stock market can promote economic growth
Raising the savings rate.
Increasing the level of investment.
Ensuring that past investments are
efficiently used (the takeover mechanism).
3b.The other side of stock
Stock market liquidity by reducing uncertainty can
Stock market liquidity may also negatively influence
Empirical evidence shows that the takeover
mechanism does not perform a disciplinary function.
The operation of the takeover mechanism leads to
short termism and low investment.
3c. Bank-based systems and
Promoting effective corporate governance
Providing stable and efficient long term finance
Permitting a higher investment than would be possible
under stock market based system.
Promoting long term perspective by preventing a free
market for corporate control.
Encouraging more rapid sectoral mobility.
3d. The other side of bank
Banks may hinder the ability of new innovative
firms to obtain external financing.
The market power of the banks reduces the
incentive of firms to undertake profitable
Banks might also continue to finance unprofitable
Banks may collude with managers against creditors
and minority shareholders.
The availability and quality of financial services are
important, not so much who provides them (the
financial services view).
It is not financial structure but overall financial
development that promotes growth
It is the overall quality of the financial system as
determined by the efficiency of the legal system that
promotes growth (the legal based view).
4. Financial development in Africa
Indicators of financial development have stagnated or
witnessed slow growth in SSA since 1980.
M2/GDP and credit/GDP were lower in the 1990s than
Credit to the private sector/GDP in 2002 was 131.7 in
South Africa, 11.8 in Benin , and 4.1 in Chad.
The low credit to GDP is a source of concern.
Empirical evidence in Africa show a positive effect of
financial development on growth.
Stock Market Development in Selected African Countries
Market Capitalization/ GDP (%)
Small size: Average capitalisation ratio is 27 percent excluding South Africa and
South Africa has about 90 percent of the combined market capitalisation.
Low liquidity: turnover ratio is about 2.7 in Ghana and 37.4 in South Africa
Reasons for the Underdevelopment of
the financial system in Africa
Historical financial repression
Most African government adopted financial
repression policies after independence
Public sector’s demand for low cost finance led to
pressures to hold down interest rates.
Income distributional goals led to directed credits.
The effect of financial repression is bank insolvency,
low savings, and inefficient allocation of resources.
5. Financial liberalisation in
A typical programme of financial liberalisation has three
Removal of interest rate ceiling
Reducing quantitative controls
Removal of capital controls
Other aspects of financial liberalisation include:
Improving supervision and regulation
Removal of entry barriers.
Why financial liberalisation has not
achieved the expected results
Financial liberalisation led to the expected positive real
The expected results of increased investments and savings
have not been plentiful.
The thesis assumes that savings determine investment and
that resources are fully used.
Financial liberalisation may lead to financial fragility.
Financial liberalisation should be accompanied by good
How do we promote financial development?
Countries with well developed legal and regulatory
infrastructure tend have well developed financial
For external finance to develop investors need to be
protected by laws and regulation.
Resolution of political risk can be important in stock
Macroeconomic stability is necessary .
Encourage savings and investment by appropriate
Bank based or market based
Stock market often lead to short termism which may
adversely affect competitiveness and growth.
Evidence show that over the long run bank based systems
outperformed market based systems in terms of savings
investment and growth.
The economic development of Italy and Japan occurred
without any help from the stock market
Bank based systems are
Because they are better able to deal with problems of
There is no necessary progression from bank based system
to a stock market economy.
African countries should contend with the development of
the banking system through appropriate prudential
If the banking system is weak and unreliable a stock
market is likely to add to the fragility.
Regulation and supervision are key for financial stability