Laura Wallace
Published Date:
May 1997
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Basant Kapur

I think both of the papers on financial sector reform are very thought-provoking, but I propose to confine my comments to the paper by David Cole and Betty Slade since my own past research has focused on the problems of the less-developed countries rather than on the somewhat different problems of the formerly socialist economies. Cole and Slade advocate an evolutionary approach to financial sector reform based on their recognition that many developing countries, particularly in Africa, do not currently have in place full-fledged market-based financial systems.

My comments will be organized around four broad themes, which follow the order of the Cole and Slade paper. First, on monetary policy management, Cole and Slade recommend that the central bank allow bank deposit rates to be set by individual banks within a range of, “for example, 0-10 percentage points above the national inflation rate of the most recent 3-6 months.” The range for allowable bank loan rates could correspondingly be, for example, 5-20 percentage points above the recent inflation rate. Similarly, they propose “a crawling peg exchange rate linked to the differential rates of inflation of the home country and its main trading partners over the past 6–12 months,” with bands around the central rate. They also advocate central bank participation in the interbank and foreign exchange markets and the opening of a rediscount window.

One missing feature in these proposals is any reference to a nominal anchor for the system. Unanticipated shocks to money demand or supply, for example, could lead to short-run variations in the domestic inflation rate, which would then be “validated” by automatic adjustments of the rate of crawl of the exchange rate. So there may be a problem of indeterminacy of the equilibrium price level.

Another missing feature is any reference to the relationship between interest rates and the rate of change of the exchange rate. The greater the degree of financial capital mobility enjoyed by the country, the less domestic interest rates can be set independently of the rate of crawl of the exchange rate without triggering potentially destabilizing capital inflows or outflows.

If capital mobility is imperfect, there is greater scope for domestic variations in interest rates, but it must then be recognized that interest rates are an important control instrument. They have to be carefully manipulated to achieve an efficient time path of disinflation of highly inflationary economies, and in this process, too, they have to be coordinated with the trajectory of exchange rate changes. Once disinflation is achieved, interest rates have to be kept at reasonable positive levels in real terms and must, as earlier mentioned, be monitored to ensure that they do not get too much out of synchronization with the exchange rate crawl.

My own preference would be, therefore, to organize the discussion of monetary policy management around a target rate of disinflation and around maintenance of a low steady-state inflation rate. The Asian experience has shown that sustained low inflation rates in the neighborhood of about 3–10 percent a year are conducive to sustained economic growth. Central bank management of the monetary base and the exchange rate, as well as the fiscal policy stance, should, in my view, be geared to this primary objective. Once a low steady-state rate of inflation is achieved, commercial banks could be given leeway to set deposit and lending rates, perhaps within bands, as suggested by Cole and Slade, but prior to that the central bank may need to more actively manipulate interest rates, along with the exchange rate, in the process of implementing an efficient stabilization and disinflation strategy. Failure to do so could well result in erratic swings in deposit and lending rates that would interfere with an orderly stabilization program.

Second, on the issue of prudential management of banks and Cole and Slade’s proposed new approach to reserve requirements, the novel feature here is their proposal for the establishment of a solvency reserve requirement that could be 50 percent of the bank’s capital. Such a reserve would presumably serve two main functions: first, as suggested, it could be used by the central bank to help meet the obligations of a defaulting bank; and, second, the prospect of its forfeiture in the event of default would increase the cost of default to the bank’s owners and thus strengthen their incentive to refrain from actions that increase the likelihood of default.

I must confess to being somewhat dubious about the efficacy of the solvency requirement. As Cole and Slade point out, the solvency requirement would amount to only 5–6 percent of the total assets of an established bank that had large third-party, including deposit, liabilities. It is not clear that such a small percentage provides much of a disincentive to misuse of the bank’s assets by its owners and managers for their own benefit, should they be so inclined.

For new banks, the solvency requirement would weigh much more heavily, but it is not clear, especially if they were domestic banks, that they could afford to have such a large proportion of their capital immobilized in the vault of the central bank and unavailable for productive deployment. The danger then is that the establishment of potentially viable new domestic banks would be discouraged in favor of existing banks and foreign banks with access to much larger capital resources.

My view, therefore, is that there really is no substitute for the slow, hard route of improving the transparency and accountability of the financial system. As the authors point out, this requires vastly improved accounting, legal, and communications systems and a strengthened regulatory and supervisory framework. Since we are dealing here with issues of values and ethics as well, it also requires that attention be paid to strengthening the corporate culture of banks, especially in terms of the moral stance and outlook of bank owners and managers, and this in turn may require linking the corporate culture to the values and ideology of the society at large. Here I must indicate my strong agreement with the thrust of Tetsuji Tanaka’s concluding paragraph. In addition, case studies of successful banks in the developing world could provide valuable insights and inspiration.

On a somewhat different issue, the regulatory and supervisory improvements may also need to deal with the issue of market structure and competition policy, particularly when, as is often the case, the banking system is oligopolistic or cartelized.

Third, Cole and Slade discuss the issue of financial services in rural areas. While provision of convenient and safe deposit facilities is undoubtedly very important, I cannot agree with the authors that the provision of production credits is of secondary importance. This is particularly true in regard to the provision of production credits to the rural poor. Formal financial institutions have been notably unsuccessful in meeting the credit needs of the rural poor, owing to the high transactions costs, broadly defined, relative to the size of the loans that are entailed.

Over the past decade or so, however, great progress has been achieved by so-called community-based lending programs in meeting this need. The most prominent example is, of course, that of the Grameen Bank in Bangladesh, but there are other examples as well: in Asia, the Badan Kredit Kecamatan and the Bank Rakyat Indonesian Unit Desas in Indonesia, and the Bank of Agriculture and Agricultural Cooperatives in Thailand; in Africa, a joint liability program in Zimbabwe, the Credit Solidaire in Burkina Faso, and the Smallholder Agricultural Credit Administration in Malawi.

The distinctive feature of all these institutions is that the community is brought into the process of screening loan applicants or in helping to ensure loan repayments. For example, in the case of the Grameen Bank, borrowers are asked to form credit groups, and if one member of a group defaults, the whole group is liable for the defaulting member’s repayment. There is, thus, strong social pressure on members of these self-formed groups not to default.

In the case of the Indonesian institutions, local officials, community leaders, and village heads are brought into the borrower selection process, and, again, there is social pressure on the borrowers who have been so selected not to default. Experience with these community-based lending programs has to date been generally highly positive. Positive real lending rates have been sustained, outreach has grown substantially, and the rates of loan repayment have been high. Transaction costs are low and the rural poor are able to obtain small sums of credit, which are, nevertheless, very helpful in enabling them to upgrade their productive activities. There appears to be considerable scope, therefore, for a vastly enlarged role for such programs in less-developed countries.

Fourth, and last, on the promotion of capital markets, Cole and Slade argue that this should be done after the banking system is reasonably well developed. There is merit to this point of view, although a countervailing argument is provided in the well-known paper by Yoon Je Cho, “Inefficiencies from Financial Liberalization in the Absence of Well-Functioning Equity Markets,” published in the Journal of Money, Credit and Banking in May 1986. Essentially, Cho argues that the fixed-fee nature of debt contracts, coupled with asymmetric information between sources and users of funds, could well result in the banking system passing up investment projects that are perceived by it to be risky but that should, on a social cost-benefit calculus, be taken up. However, equity finance would not be subject to this limitation, as it is not based on fixed-fee contracts. Cho also recognizes that full-fledged equity markets may take time to develop, and he suggests allowing banks to take equity positions in the corporate sector (i.e., universal banking), although he recognizes that this, too, may create problems.

A possible compromise would be to allow banks to set up venture capital funds, either on their own or jointly with other sources of finance. This would not require the banks to convert themselves wholesale into universal banks, but it would help to ensure a supply of valuable equity finance for potentially worthwhile projects, even before fully developed equity markets are in place.

As a brief summing up, I would like to say that I am sympathetic to Cole and Slade’s position that the transition to a market-based system of monetary management, involving open-market operations in treasury bills or similar instruments, may take time. However, I believe that even accepting this as a short-run constraint, more can be done than their paper seems to suggest, and my comments have essentially been aimed at filling in what I consider some of the main gaps in their discussion.

Patrick Downes

Listening to David Cole’s caution about rushing headlong into market-based systems of monetary management brought to my mind the views that Keynes had about the type of people that should run the IMF—he said that they should be cautious bankers. I had the feeling that we were failing him [Keynes] seriously until Basant Kapur came to our rescue a little bit by emphasizing that financial reforms have to be coherent and grounded in macrostabilization programs. But I should mention in passing that Keynes also had the view that the Board of the World Bank should be imaginative expansionists! I hope we are neither cautious bankers nor imaginative expansionists.

The Kyrgyz Republic

Before coming to the paper by David Cole and Betty Slade let me address Tetsuji Tanaka’s paper. I have three main comments. First, the restructuring of the financial sector and the economy at large is a huge undertaking in any state of the former Soviet Union. The transformation in the Kyrgyz Republic started four or five years ago, and it is well under way. It requires major economic reforms in a host of related areas, including rebuilding economic and trading relations with other countries on a comparative advantage basis, and the legal, regulatory, and institutional framework to support these changes. Policies have to be formulated in conformity with the particular realities of that individual country, but given the wide scope of necessary reforms—and financial sector reforms have a significant influence on the success of the stabilization efforts—speed and depth are most important to ensure success in this process.

Second, the task of reform is far from over, and a price must be paid for the transformation. Tanaka makes that quite clear, although the shock therapy that he talks about in a sense was already administered when the existing system of economic, trade, and financial relations with other countries broke down. However, in the light of some recent economic developments and statistics, I am somewhat more optimistic about prospects in the Kyrgyz Republic than Tanaka. While industrial output continued to decline in 1995, agricultural production rebounded following the dismantling of the state agricultural production system. The services and trade sectors have also expanded rapidly with the liberalization of the trade and exchange system; the authorities estimate that the emerging private sector not yet covered in official statistics already amounts to 10-20 percent of GDP. In terms of the success that the Kyrgyz Republic has had in controlling inflation, I think it has now joined the group of countries that have succeeded in getting inflation down to 20–30 percent a year. Interest rates, of course, are positive in real terms, and, as Tanaka has said, the currency, the som, has been pretty stable in recent times. Moreover, in 1995, for the first time in five years, GNP actually rose.

But I think the jury is still out. There is a lot of work to be done, and that brings me to the third point—the appropriate degree of government intervention in markets. This is unique in every country and is related, as Tanaka says, to the maturity of the markets. But it is clear that the government in the Kyrgyz Republic has a strong commitment to developing markets and appropriate regulatory institutions; we have to allow some time for these measures to take hold, and it is going to take time. The financial reform process is a continuous one, and it would be a waste of resources to develop market institutions and implement financial reforms and not adhere to them.

Finally, in the countries of the former Soviet Union, there is no shortage of voices calling for reinstitution of heavy state intervention in the economy. It seems, therefore, that a more activist stance is called for in championing the cause of free markets in countries like the Kyrgyz Republic, even more so perhaps than in Africa, where the historical experience has been quite different. Indeed, this championing of the cause of free markets is vital to ensure that the country remains on course. There are some very difficult decisions to be made, for example, in relation to restructuring the banking system and the enterprise sector.

What lessons can we draw from the experience of the Kyrgyz Republic? Tanaka refers to the work and business ethic, and that is clearly very important. Another lesson perhaps that may have some relevance for African countries is the sense in which the financial sector reforms were grounded in a macroeconomic stabilization program, and I think that clearly establishes the interlinkages, or the symbiosis, between financial sector reform and other structural reforms and progress toward stabilization. Kapur has flagged this also in his comments on the Cole and Slade paper.

The Speed of Reform

Moving to the Cole and Slade paper, it is an interesting paper, nicely crafted and thoughtful in many respects, and designed, I think, to challenge the conventional thinking about financial sector reform. As the paper is intended to be general, it cannot be expected to apply fully to the broad variety of situations in African countries; indeed, many have recorded solid progress with financial reforms in recent times. It quite rightly calls attention to the fact that financial reforms sometimes fail, at least temporarily, because the authorities attempt to go too fast or because some of the concomitant reforms are not present, such as fiscal consolidation and effective banking supervision capability.

But I believe that Cole and Slade do not quite accurately describe the current market-based “orthodoxy,” if we can call it that—especially when they refer to the IMF Occasional Paper by Alexander and others on adoption of indirect monetary instruments.1 Indeed, what the paper advocates is a gradual—“belt and braces,” if necessary—approach to the adoption of indirect instruments and financial reform in general, but we are convinced that the market-based system is the right way to go. Of course, there are prior or concomitant reforms that need to be addressed (e.g., fiscal discipline, a sound and competitive banking system and a proper regulatory framework, insulation of monetary policy from deficit financing, and promotion of money markets and primary and secondary government securities markets).

So we do advocate a cautious approach on financial reforms, but caution should not be interpreted in the sense of being a delayed approach. Our view is that financial reform measures should be taken as soon as they can be taken, and I think this captures something that Kwesi Botchwey said this morning as well—that is, the importance of spelling out these structural measures in the context of an overall macroeconomic approach to stabilization.

Turning to the actual measures that have been suggested in the Cole and Slade paper, I agree very much with Kapur’s comments, so I will touch only on a few issues. On the proposal for a crawling peg system within a band, I doubt such an exchange rate system can be prescribed for all African countries—it has to be very much a case-by-case approach—and I would emphasize the importance of coordinating interest and exchange rate policies.

Then there is the proposal on solvency and liquidity, which purports to be a substitute in a sense for a more conventional system of banking supervision. I quite agree that the banking supervision norms of the Group of Ten countries are not necessarily a good fit for developing countries in Africa. There is a need to develop guidelines that could draw on the best practices in developed countries but that are adjusted to the conditions in developing countries where risk is often higher. The IMF and the World Bank have done some work in this area in the last few years, and there is a need for follow-up. But I doubt that the arrangement proposed in the Cole and Slade paper can substitute for a prudentially based banking supervision framework.

Coming to the proposal for a band—a floor and ceiling—on interest rates, this is nothing new in financial reform. It has been an intermediate stage of financial reform that has been in vogue for a number of years, and it is a good idea. But there is always a danger: when one is stipulating floors and ceilings, one is still close to administering rates—or at least on a slippery slope in that direction—and competition and resource allocation distortions can ensue. There may, of course, be cause to delay interest rate liberalization if bank supervision is inadequate, but I would be skeptical of any suggestion to impose controls on a system that has already been liberalized.

On controlling the supply of reserve money, the paper has some interesting ideas but, again, I felt what was missing—and Kapur put his finger on it quite clearly—was how this fits into both a macroeconomic framework and an anti-inflation stabilization program with a suitable nominal anchor. There seems to be no mention in the paper of how fiscal deficits of the government are going to be dealt with. Burgeoning fiscal deficits have been responsible for derailing many financial reform programs, certainly as much as, if not more so than, soundness problems in the banking system.

I have the feeling that quite a number of the measures that are being suggested—and Kapur has dealt with these—seem to put financial reforms in a type of holding pattern, leaving the underlying distortions possibly not addressed. In that case, the distortions most likely will become chronic and the ultimate cost—most frequently to the public purse—of, for example, sorting out problems in the bank portfolios will increase. Competition only works if there is a willingness to allow problem enterprises and banks to fail. Indeed, I think a number of African countries have postponed implementing solutions to banking soundness problems, only to see the problems grow.

On managing reserve money, several of the instruments that have been suggested—that is, the central bank getting involved in the interbank market and moving government deposits to banks to influence the reserves—raise concerns in my mind about the credit risk aspects of these arrangements as there is a danger of moral hazard. I would rather see a central bank promoting, but not participating in, the development of an active interbank market.

But overall my concerns are with what is missing in the framework—that is, the coordination of monetary and fiscal policies, a marriage that must exist in developing countries as they progress to develop financial markets. The government has to borrow money, and encouraging the government to borrow at a market rate and in the marketplace seems a more sensible way to proceed than what has happened in many countries—the government borrowing directly from the central bank at low or no interest rates and engaging in monetary financing and obliging banks to take up low-interest government debt, very often crowding out the private sector. Indeed, I think one of the most serious problems in a number of African countries has been excessive borrowing by governments from central banks with inflationary consequences and building up huge quasi-fiscal losses that have not been addressed. Finally, I do not see how the measures proposed would protect the system from catastrophe, at least any more so than the more direct approach of relying on market-based interest rates and exchange rates, and developing financial markets.

Let me sum up. I concur with Kapur on his approach to a lot of the issues raised in the Cole and Slade paper. Certainly, it is appealing to think in terms of a cautious approach to financial sector reform in African countries and, as one participant here remarked, to remember that it took Japan 50–100 years. But I wonder if African countries can afford to wait that long. With economic globalization and the integration of financial markets, there is a danger that countries in Africa, the poorer countries, may be marginalized and left behind—all the more so as official aid flows start to dry up and the large private capital flows increasingly gravitate to emerging market countries. So there is a battle to be joined here, a task to be addressed. I think the problems of unsound banking systems and misallocation of resources, whether through directed credits, subsidized credit, unrepresentative interest rates, or excessive government borrowing from the central bank, must be brought out into the open and dealt with in a transparent fashion. And adopting—gradually if necessary—financial liberalization and reforms and a market-based approach to monetary management using indirect instruments is the best way to go. If problems occur when financial reforms go off the rail, especially as a result of fiscal profligacy, it is important that the costs are clear and transparent so that they can be addressed.

Tadahiko Nakagawa

I would like to commend the two speakers. In particular, I fully agree with Tetsuji Tanaka’s remark that the financial sector is one of the most important social infrastructures and that appropriate government intervention in the financial sector, including by the central bank, is crucial. I also share the view expressed by David Cole when he spoke about the need for a gradual approach to financial reforms in African countries.

Let me briefly present the experiences of the Export-Import Bank of Japan (JEXIM) with client governments in assisting financial sector reform. My comment is basically focused on the area of long-term financing because the scope of financial sector reform is so vast and it is very difficult for me to elaborate in depth on all of the areas.

I would like to examine our financial assistance in Tunisia and Hungary. Although these cases are not simply or automatically applicable to the countries you represent here around this table, I think we could find some common ground to explore in the future for attaining financial reform.

Two-Step Loans in Tunisia

In the case of Tunisia, we have tried to support financial sector reform with structural adjustment loans, cofinanced with the World Bank. At the same time, we have lent money to the Tunisian Development Bank in the form of so-called two-step loans—JEXIM lends the money to a bank (or banks) in a particular country, and then the bank onlends the money to individual enterprises. This type of loan, or “onlending,” is aimed at supporting the investment activities of mainly small and medium-sized private firms (preferably in priority exporting sectors). It fills a vacuum, in that countries in an early stage of development lack both a capital market and the necessary long-term financing for investment.

Back in March of 1996, we visited Tunisia to appraise our first and second two-step loans. We found that through loans of approximately $170 million ($70 million committed in 1989 and $100 million in 1993), we were able to support more than 100 projects—helping to create 10,000 jobs (mainly in tourism and manufacturing)—for a value added of about $200 million.

Even more impressive was the strong institutional building that had taken place in the client bank since 1989. The bank has a very fine team of credit analysts and risk management personnel, and I was delighted to learn that they had introduced a preliminary Asset Liability Management System—a system that is not even quite completed in our own bank. I was impressed by the talented team that explained specific kinds of projects to us, virtually every one of which has been a success.

Thanks to this preliminary postoperation evaluation study, we have determined that although a market approach serves as a sound basis for financial reform, some types of creative interventions and controls—in this case, our two-step loans—can help support or complement the market system.

Two-Step Loans in Hungary

In the case of Hungary, we started a similar two-step loan in 1992 and conducted a relatively comprehensive postoperation evaluation in 1995. The loan was for approximately $130 million, ultimately supporting 1,000 projects through ten banks—roughly half of which were very traditional banks (formerly government-owned banks), with the remaining foreign owned. Thus, in Hungary, as in Tunisia, we felt that our two-step loans really helped pave the way for future financial reform in a country at a transitional stage of development.

In Hungary, one of the most difficult questions has been determining the appropriate margin for the intermediary banks—that is, the fee paid to the banks that do the onlending to the private sector. This is still an unsolved problem. Some of the Hungarian banks (basically foreign-owned ones) are quite satisfied with the 2 percent margin that was fixed at the time, because they are dealing with established multinational corporations. However, other banks (basically, existing local Hungarian banks with an enormously high cost structure) would like wider margins so that they can lend to so-called new entrepreneurs—who are vitally important for the future of the country but are not perfectly creditworthy and lack sufficient collateral.

We think that the question of margins will be one of the central issues in our future discussions. For a country such as Hungary, which has an enormous shortage of long-term financial resources, it might be worthwhile for the intermediary banks to assume a certain amount of risk (managed risk) with a wider margin. Indeed, we might support this type of initiative in the future.


Based on these two transactions, we can conclude that the financial sector is critical for the development of private enterprise. Moreover, securing long-term financing is the key to supporting the fixed direct investments of those companies that are, in turn, critical for economic growth. And what is important is some kind of market-friendly intervention—in these cases, our two-step loans—at a transitional stage of financial reform in a country.

Although we have not yet tried these types of transactions in the sub-Saharan African countries, we are contemplating doing so, if it is feasible and reasonable.


William E. Alexander, Tomás J.T. Baliño, and Charles Enoch, The Adoption of Indirect Instruments of Monetary Policy, IMF Occasional Paper No. 126 (Washington: International Monetary Fund, 1995).

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