6.3 Financial sector links between investment and diversification: Economic Report on Africa 2007
6.3 Financial sector links between investment and diversification: Economic Report on Africa 2007
investment and diversification. The contribution of private investment to desirable
diversification outcomes cannot be gainsaid. In that respect, the financial sector and
its role in financing private sector contribution to diversification is very critical.
Hitherto, the African experience with financial sector reforms has been almost similar
to the trade liberalization results. However, the failure of financial sector liberalization
to achieve the results expected can be explained from two angles. On the
one hand is the failure of liberalization in achieving an efficient financial sector able
to play its expected intermediation role for both short-and long-term credit, in an
optimal way. On the other hand, comes the failure to achieve reductions in interest
rates as was expected, given that interest costs are a major cost of doing business for
many private sector firms. These two points are elaborated here in order to point to
the need for a rethink of the financial sector architecture, in terms of both policy and
institutional frameworks so that proactive financial sector policies can contribute to
the deepening of diversification efforts.
With regard to the institutional structure of the sector, financial liberalization in
Africa failed to achieve the desired outcomes as a catalyst for financial sector deepening.
The key reason noted is that in the same way that trade policies were never seen
as part of an integrated financial sector, financial sector liberalization tended to treat
the sector in a compartmentalized manner. This was done to the extent that there
was unbalanced focus on some components such as commercial banking, neglecting
the significance of other dimensions such as development finance institutions and/or
other components that are key to capital markets deepening. The results were that
the financial sectors were not integrated, and focused on short-term credit issues
rather than on development finance and capital markets development, which would
be more relevant to diversification efforts. In this respect, given the importance of
the financial sector in diversification, it is important that African countries seek a
proactive financial sector policy that aims at integrated development of the whole
sector that can effectively and efficiently mobilize the sustainable, long-term capital
necessary for financing diversification programmes, and by extension, long-term
development.
The significance of proactive financial sector policies compared to what has been the
practice can be found in the results that were achieved in the past with interest rate
regimes. In many African countries, financial sector liberalization became characterized
by wide interest rate spreads. Thus, instead of liberalization resulting in more
efficient financial sectors, the results were interest rate regimes where the lending
rates rose and remained high over long periods of time, while the deposit rates fell,
and, in many cases, were negative in real terms. This discouraged the private sector
from undertaking productive investments, such as those required for deepening
diversification.
Additionally, the inability of the private sector in Africa to access cheap credit meant
that it was not possible to undertake initiatives that would lead to both horizontal
and vertical diversification. The high interest rates after liberalization also had the
negative effect of raising the interest costs of servicing existing debt. This resulted
in reduced profitability for most firms. Given that retained earnings also form a significant
component of financing diversification efforts in the private sector in most
African economies, financial sector liberalization had the indirect effect of limiting
these diversification efforts.
63 Financial sector links between investment and diversification Economic Report on Africa 2007 - To learn more about this author, visit United Nations Economic Commission for Africa's Website.
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With regard to financial sector policies, the starting point is the clear link between
investment and diversification. The contribution of private investment to desirable
diversification outcomes cannot be gainsaid. In that respect, the financial sector and
its role in financing private sector contribution to diversification is very critical.
Hitherto, the African experience with financial sector reforms has been almost similar
to the trade liberalization results. However, the failure of financial sector liberalization
to achieve the results expected can be explained from two angles. On the
one hand is the failure of liberalization in achieving an efficient financial sector able
to play its expected intermediation role for both short-and long-term credit, in an
optimal way. On the other hand, comes the failure to achieve reductions in interest
rates as was expected, given that interest costs are a major cost of doing business for
many private sector firms. These two points are elaborated here in order to point to
the need for a rethink of the financial sector architecture, in terms of both policy and
institutional frameworks so that proactive financial sector policies can contribute to
the deepening of diversification efforts.
With regard to the institutional structure of the sector, financial liberalization in
Africa failed to achieve the desired outcomes as a catalyst for financial sector deepening.
The key reason noted is that in the same way that trade policies were never seen
as part of an integrated financial sector, financial sector liberalization tended to treat
the sector in a compartmentalized manner. This was done to the extent that there
was unbalanced focus on some components such as commercial banking, neglecting
the significance of other dimensions such as development finance institutions and/or
other components that are key to capital markets deepening. The results were that
the financial sectors were not integrated, and focused on short-term credit issues
rather than on development finance and capital markets development, which would
be more relevant to diversification efforts. In this respect, given the importance of
the financial sector in diversification, it is important that African countries seek a
proactive financial sector policy that aims at integrated development of the whole
sector that can effectively and efficiently mobilize the sustainable, long-term capital
necessary for financing diversification programmes, and by extension, long-term
development.
The significance of proactive financial sector policies compared to what has been the
practice can be found in the results that were achieved in the past with interest rate
regimes. In many African countries, financial sector liberalization became characterized
by wide interest rate spreads. Thus, instead of liberalization resulting in more
efficient financial sectors, the results were interest rate regimes where the lending
rates rose and remained high over long periods of time, while the deposit rates fell,
and, in many cases, were negative in real terms. This discouraged the private sector
from undertaking productive investments, such as those required for deepening
diversification.
Additionally, the inability of the private sector in Africa to access cheap credit meant
that it was not possible to undertake initiatives that would lead to both horizontal
and vertical diversification. The high interest rates after liberalization also had the
negative effect of raising the interest costs of servicing existing debt. This resulted
in reduced profitability for most firms. Given that retained earnings also form a significant
component of financing diversification efforts in the private sector in most
African economies, financial sector liberalization had the indirect effect of limiting
these diversification efforts.
63 Financial sector links between investment and diversification Economic Report on Africa 2007 - To learn more about this author, visit United Nations Economic Commission for Africa's Website.
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