Recent evidence suggests that financial development, in particular the amount of credit to the private sector, is correlated with subsequent economic growth (Levine, 2004). This is particularly true in sectors relying on external finance (Black and Strahan, 2002; Rajan and Zingales, 1998), and appears essential for new entry (Perotti and Volpin, 2004).
This evidence supports reforms which encourage financial development. While lack of funding is not the sole obstacle for potential entrepreneurs (Johnson et al, 2002), access to external financing provides resources to overcome generic entry barriers. Policies promoting financial development, such as improved investor protection and financial liberalization which in principle increase the quantity and quality of external finance, appear therefore well justified.
Many financial liberalizations are indeed successful at expanding capital markets and promote investment (Henry, 2003). They also appear to improve consumption smoothing, as there is on average a decline in volatility of consumption following liberalizations. Yet this result is reversed in countries with poor investor protection or poor accountability (Bekaert, Harvey and Lundblad, 2004). In fact, liberalization has had a mixed success in developing countries. While it produces rapid expansion in credit and foreign investment, and raise short term economic growth, in many countries it has been followed by severe banking crises after external shocks. These crises, often coupled with sharp currency devaluations (as in Mexico, South East Asia, and Russia), inflicted massive losses to investors and taxpayers, and contributed to deep recessions. Yet financial development should have just strengthened the ability of firms to resist external shocks.
What explains this variation in outcomes ? Specifically, when does liberalization lead to financial vulnerability ? Poor institutions are currently perceived to be the cause of policy failure (Acemoglu et al, 2003). Indeed, liberalization is more likely to be followed by banking crises in countries with poor institutions or low transparency (Demirguc Kunt and Detragiache, 1998; Mehrez and Kaufmann, 1999; Keefer, 2001).
In this paper we argue that poor political institutions allow the capture of the design and implementation of financial policy by incumbent interest groups. For instance, financial reforms could be designed primarily to expand access for existing firms (financial deepening), rather than to expand the range of financial services and borrowers, facilitating new entry (financial broadening). There is a natural conflict on financial development facilitating entry, specifically via investor protection, between more established and emerging classes (Rajan and Zingales, 2003, Perotti and Volpin, 2005). The local legal environment matters even after liberalization, as market investor decisions depend on the reliability of financial claims.
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