VoxEU Column Development International Finance Politics and economics

Interest groups and government capabilities matter for financial development

For some commentators, the recent financial crises are a sign that financial development has gone too far. Yet there are still countries where such concerns are the stuff of dreams. This column focuses on why the level of financial development in poor countries remains so low and what policymakers can do about it.

The debate on the benefits and limits of financial development has come to the fore with the global financial crisis. The fact that the epicentre of the global financial crisis was in countries with developed credit markets has led some commentators to argue that financial development may have gone too far. However, much less attention has been paid to the fact that financial markets remain underdeveloped in many developing and emerging markets. In particular, the penetration of credit to the private sector in the economy is much lower in developing countries – including some emerging markets – than in most developed countries.

Why such low levels of financial development?

Why do so many countries have low financial development? The literature stresses two explanations. One has to do with structural conditions that either limit demand or hinder the ability of some countries to meet rising demand (limited supply). Deficiencies in demand are determined by the stages of country development – economies in the early stages of industrialisation and economic development do not have the need for deep and highly sophisticated financial markets. Deficiencies in supply are tied to underlying structural conditions of a society that creates impediments for the formation of viable financial sectors. A particularly influential strand of the literature focuses on the role of the legal system (La Porta et al. 1997). Although compelling, some of the implications that arise from this set of explanations do not square well with the evidence, at least as unique explanations.

Another strand in the literature looks at how the workings of political institutions shape political actors’ incentives to provide financial development. The literature focuses on two interconnected explanations. On the one hand, it concentrates on the role of interest groups as obstacles for financial development. In this way, incumbent interest groups that may see their profits eroded would oppose the policies that would foster financial deepening (Rajan and Zingales 2003a). On the other hand, the government may also have the incentive to limit financial development in order to draw resources from banks and credit markets, regardless of the structure of interest groups in society (Haber et al. 2008). Consequently, even though favouring financial development may be welfare-enhancing, government officials in some countries may prefer to maintain a lax financial institutional environment which does not promote credit, in case they need to draw funds from the system.

The political economy of financial development

In a recent paper joint with Oscar Becerra (Becerra et al. 2012), we build on these contributions and provide a unified political economy story of financial development that hinges on the interaction between heterogeneous interest groups and government policymaking capabilities.

  • First, we depart from previous contributions by allowing incumbents to be heterogeneous in terms of their position regarding financial development. This heterogeneity of incumbents comes from the fact that within an economy, there are sectors that are intrinsically more dependent on credit.1 Consequently, under some conditions, this heterogeneity in terms of how much each firm (in each sector) depends on the availability of credit generates heterogeneous behaviour in terms of firms’ positions regarding financial development. For those incumbents who are very dependent on credit, even though financial development may erode their profits by fostering competition, it may also boost their profits by providing them with cheaper resources to operate and expand their operations. If these sectors are big enough actors in the economy, then the resistance of incumbents against greater financial development may be muted. For the whole economy, the overall level of opposition to financial development that governments may face would depend on the combination of how dependent on credit the economic sectors in that economy are and the ‘‘size’’ of these economic sectors. In other words, opposition to financial development in a given country hinges on the relative size of the economic sectors that rely most heavily on financial credit.
  • Second, we combine incumbents’ interests and their potential effect on policymaking with the ability of the government to avoid distorting financial markets financial development. Building on insights from the political economy literature, we argue that in countries where governments have lower state capacities, public officials are more pressed to direct credit to finance their own operations, thereby curtailing credit flows to the private sector. All in all, this implies that the availability of credit for the private sector – a key feature of financial development – will tend to be lower in lower-capabilities environments.

Therefore, the testable hypothesis of the paper is that financial development should be higher in those countries in which interest groups might have a lower incentive to block its development and where the government has less need to abuse the financial system in order to finance its operations. In other words, what is needed for financial development is the combination of low opposition from incumbents and high government capabilities; one without the other may not be enough.

In order to test the main implications of the model, we use a sector-level panel dataset and build several variables that describe in detail the level of financial development, interest groups heterogeneity in terms of their attitudes towards financial development, and government policymaking capabilities for a number of countries. We find evidence that the combination of low opposition to financial development from industries together with the heterogeneity in government capabilities explain part of the variance in financial development observed across countries. The results are robust to a battery of robustness checks.

Policy implications: Is a broader approach needed?

The policy implications of these results are also novel regarding the previous literature. In order to promote financial development, the consensus from the legal origins literature prescribes changes to the legal codes and the consensus from political institutions literature prescribes far-reaching institutional reforms designed to limit the authority of public officials. The results in our study indicate that it is not enough to tinker with certain specific rules; a broader approach may be warranted.

  • First, reforms should affect the long-term incentives of political actors to invest in their capabilities. How to reach this goal may be a matter of discussion for a whole volume. Preliminary evidence seems to indicate that politicians would be more eager to invest in the capabilities of government when the conditions are helpful for intertemporal cooperation – basically, when the basic institutional structure of a country provides actors with long-term horizons, open and transparent policy arenas, and enforcement mechanisms (Spiller and Tommasi 2007). On the contrary, institutions such as electoral systems that reward short-term political gains will not be conducive to long-term investments (Scartascini 2008, Scartascini and Tommasi 2009, and Saiegh 2010).
  • Second, it may also be necessary to influence the incentives and the power structure of interest groups. Two alternatives may work.
    • On the one hand, governments and international organisations may find it useful to help in the organisation of those groups that would benefit from greater financial development. That is, governments and international organisations should be very proactive in reducing the collective action costs for firms in sectors that are highly credit dependent. Moreover, by helping in the set up of encompassing associations, they may achieve this objective while also moving these associations into a self-sustaining path of endogenous investments in their capabilities (Schneider 2010).
    • On the other, it may make sense for countries to make strategic bets on those economic areas that would provide greater industrial complexity while weakening the opposition for financial development. This way, an important development constraint may be lifted (Hausmann and Rodrik 2003, 2006; Hausmann et al. 2007).

Becerra, O, E Cavallo and C Scartascini (2012), “The politics of financial development: The role of interest groups and government capabilities”, Journal of Banking & Finance, 36:626-643.

Haber, S, D North and B Weingast (2008), Political Institutions and Financial Development, Stanford University Press.

Hausmann, R, J Hwang and D Rodrik (2007), “What you export matters”, Journal of Economic Growth, 12:1-25.

Hausmann, R and D Rodrik (2003), “Economic development as self-discovery", Journal of Development Economics, 72:603-633.

Hausmann, R and D Rodrik (2006), “Doomed to choose: industrial policy as Predicament”, Working paper, Centre for International Development.

La Porta, R, F Lopez-de-Silanes, A Shleifer and R Vishny (1997), “Legal determinants of external finance”, Journal of Finance, 52:1131-1150.

Rajan, R and L Zingales (1998), “Financial development and growth”, American Economic Review, 88:559-586.

Rajan, R and L Zingales (2003a), “The great reversals: the politics of financial development in the twentieth century”, Journal of Financial Economics, 69:5-50.

Rajan, R and L Zingales (2003b), “Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity”, Crown Business, New York.

Saiegh, S (2010), “Active players or rubber-stamps? An evaluation of the policymaking role of Latin American legislatures”, in C Scartascini and E Stein, M Tommasi (eds.), How Democracy Works: Political Institutions. Actors and Arenas in Latin American Policymaking, Inter-American Development Bank and David Rockefeller Center for Latin American Studies, Harvard University.

Scartascini, C (2008), “Who’s who in the policymaking process: an overview of actors, incentives, and the roles they play”, in E Stein and M Tommasi (eds.), Policymaking in Latin America: How Politics Shapes Policies, Inter-American Development Bank and David Rockefeller Center for Latin American Studies.
Harvard University.

Scartascini, C and M Tommasi (2009), “The making of policy: institutionalized or not?”, Working paper, Inter-American Development Bank.

Schneider, BR (2010), “Business politics and policymaking in contemporary Latin America”, in C Scartascini and E Stein, M Tommasi (eds.), How Democracy Works: Political Institutions. Actors and Arenas in Latin American Policymaking, Inter-American Development Bank and David Rockefeller Center for Latin American Studies, Harvard University.

1 As developed originally in article by Rajan and Zingales (1998).

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