Stable democracies are more likely to enjoy sustained financial development

What do countries need for sustainable financial development? This is the question asked in new column at VoxEU.org: “Mother, can I trust the government?” Stable democracies are more likely to enjoy sustained financial development by Marc Quintyn and Geneviève Verdier.

In the article it is argued that protection of property rights is necessary but not sufficient condition for financial development. Using a sample of 160 countries from 1960 to 2005, Quintyn and Verdier find that checks and balances on power and political stability are also vital ingredients. There is research that shows that effective enforcement of property rights is an institution contributing to financial development – more so than other legal institutions. This does, however, raise the question what is the ultimate source of effective protection of property right? Quintyn and Verdier write,

A number of authors have argued that political institutions represent this ultimate source. They argue that effective protection of property rights can only be established in an environment where political institutions are willing to limit their own powers, through systems of checks and balances (Haber et al. 2008). Political institutions that provide checks and balances instil the necessary confidence in market participants that allows a country’s financial system to develop healthily. So far, a limited number of studies have supported this view (see Bordo and Rousseau (2006), Keefer (2008), Roe and Siegel (2008) and Tressel and Detragiache (2008).

In a recent paper (Quintyn and Verdier 2010), we test this hypothesis and find that most long-lasting episodes of financial deepening indeed have occurred in countries with high-quality political institutions.

Our research analyses a standard measure of financial development – the ratio of private sector credit to GDP – from a different perspective than the typical time-series analysis. For a sample of 160 countries over the period 1960-2005 we identify periods during which countries experienced an acceleration in financial development. We identify a total of 209 such accelerations – defined as the ratio growing more than 2% annually for a minimum of 5 years – and estimate the impact of economic and institutional conditions around the take-off, on the likelihood of such an event. Episodes of financial acceleration range in length from 5 years (the imposed minimum) to as long as 22 years. Obviously, the nature of these periods can be different. The literature generally identifies three types of accelerations:

• Type 1. At beginning of a cyclical upturn, credit typically expands faster than output, due to the need to finance investments and higher working capital. Such episodes are associated with the working of the conventional accelerator;
• Type 2. Excessive credit expansions or “credit booms” may result from inappropriate responses of market participants to changes in risks over time, sometimes following financial liberalisation. In the best case, the boom comes to a soft landing, in the worst case it results in a banking (and real sector) crisis;
• Type 3. Longer periods of “financial deepening”, with rates of expansion of the financial system typically lower than type 1 or 2, but sustainable for a longer period of time, leading to a more sophisticated financial system.

To test the political-institutions hypothesis, we have a special interest in analysing the conditions under which sustained accelerations (type 3) are likely to occur. Based on the literature on lending booms, we identify ype-3 takeoffs as those lasting 10 years or longer, allowing us to compare the prevailing economic and institutional conditions at the start of short-lived and longer-lived periods of financial deepening.1 Of the 209 episodes, 161 are short episodes and 48 are long one – just over one-fifth of the total.

The significance of having experienced (at least) one long episode of financial acceleration for financial development is obvious from Figure 1. A majority of countries that now have highly developed financial systems experienced a long episode of acceleration (black bars) at some point over the past 50 years. On the other hand, a sustained acceleration is no guarantee for success as reversals seem to have occurred in a number of countries.

Figure 1. Cross-country disparities in the ratio of credit to private sector GDP (2005) (each bar represents a country)

Quintyn and Verdier continue,

How does an episode of financial acceleration become a period of financial deepening? We consider the hypothesis that a set of factors – macroeconomic variables (real GDP growth, inflation, GDP per capita), financial reforms (index of financial liberalisation from Tressel and Detragiache, 2008), the quality of political institutions (from Polity IV) – explain the probability of a take-off at time t. The dependent variable in our probit analysis is a dummy that is 1 in the years associated with a financial acceleration and 0 otherwise.2 All explanatory variables are lagged to reduce the risk of endogeneity.

Our main results [ ... ] show that the drivers of short and long episodes are different. Financial liberalisation has a significant and large impact on the probability of a take-off. However, the effect differs according to the duration of the take-off. The likelihood of a short episode increases significantly following successive efforts to liberalise the financial system. In contrast, mainly contemporaneous financial liberalisation seems to matter for long episodes. The impact of improved bank supervision seems rather weak across the board.

Our results lend strong support for the political institutions view. The Polity variable has a significant and negative effect on the probability of a take-off lasting less than ten years and, contrasting with this, a significant and positive impact on sustained episodes of financial development. This suggests that countries with checks and balances in the political system are more likely to experience genuine financial deepening. Recent regime changes (positive or negative) do not seem to increase the likelihood of short or long episodes significantly. This confirms that political stability and a confidence-enhancing institutional setup are important for financial development.

To further investigate the importance of political stability for financial development, we also considered the durability of the political regime. The results [ ... ] show that the durability of a democratic regime, in other words, a combination of stability and quality of the polity, greatly increases the probability of a sustained period of financial development.

• Bordo, Michael and Peter Rousseau (2006), “Legal-Political Factors and the Historical Evolution of the Finance-Growth Link”, NBER Working Paper 12035.
• Campos, Nauro and Fabrizio Coricelli (2009), “Financial Liberalization and Democracy: The Role of Reform Reversals”, CEPR Discussion Paper 7393, 41pp.
• Gourinchas, Pierre-Olivier, Rodrigo Valdés and Oscar Landerretche (2001), “Lending Booms: Latin America and the World”, Economia, Spring, 47-99.
• Haber, Stephen, Douglass North and Barry Weingast (2008), Political Institutions and Financial Development, 1-9 in Haber, Stephen, Douglass North and Barry Weingast (2008), Political Institutions and Financial Development, Stanford University Press.
• Hilbers, Paul, Inci Otker-Robe, Ceyla Pazarbasioglu and Gudrun Johnsen (2005), “Assessing and Managing Rapid Credit Growth and the Role of Supervisory and Prudential Policies”, IMF Working Paper 05/151.
• Keefer, Philip (2008), “Beyond Legal Origin and Checks and Balances: Political Credibility, Citizen Information and Financial Sector Development”, 125-155, in Haber,
• Stephen, Douglass North and Barry Weingast (2008), Political Institutions and Financial Development, Stanford University Press.
• Quintyn, Marc and Geneviève Verdier (2010), ““Mother, can I trust the Government?” Sustained Financial Deepening – A Political Institutions View”, IMF Working Paper 10/210
• Roe, Mark, and Jordan Siegel (2008), “Political Instability: Its Effects on Financial Development, Its Roots in the Severity of Economic Inequality”, SSRN, July.
• Tressel, Thierry and Enrica Detragiache (2008), “Do Financial Reforms Lead to Financial Development? Evidence from a New Dataset”, IMF Working Paper 08/265.