Macroeconomic and Financial Management Institute (MEFMI) Measuring Financial Development: The Case of MEFMI Region. Liku Irene Kamba Bank of Tanzania

Transcription

1 Macroeconomic and Financial Management Institute (MEFMI) Measuring Financial Development: The Case of MEFMI Region by Liku Irene Kamba Bank of Tanzania Mentor: Mr. Subhrendu Chatterji A Technical Paper Submitted in Partial Fulfillment of the Award of MEFMI Fellowship July 2010

2 TABLE OF CONTENTS ABSTRACT... 4 CHAPTER ONE Introduction Statement of the Problem Significance of the study Objectives of the Study General objective Specific objectives Research Questions Scope of the Study Data collection: Procedure and Administration Expected Results CHAPTER TWO LITERATURE REVIEW Financial Development in Sub Saharan Africa Measuring financial development with respect to stages of financial development Measuring financial development using monetary aggregates Research Methodology Financial Development Indices The Comprehensive Financial Development Index Weightings of the Variables The Traditional Financial Development Index CHAPTER THREE STUDY FINDINGS AND ANALYSIS

3 3.0 General Observations Study Findings Banking Sector Size and Efficiency Theme Development of Nonbank Financial Sector Theme Quality of Banking Regulation and Supervision Development of the Monetary Sector and Monetary Policy Financial Sector Openness The Composite Financial Development Index The Traditional Financial Development Index Comparison of Results from the Traditional and Composite Financial Development Indices CHAPTER FOUR CONCLUSION AND RECOMMENDATIONS Conclusion Recommendations REFERENCES

4 ABSTRACT A developed and well-functioning financial sector is a key component of an economy, facilitating the exchange of goods and services, mobilizing savings, allocating resources and helping diversify risks. Member countries in the Macroeconomic and Financial Management Institute of Eastern and Southern Africa (MEFMI) need an efficient and robust financial sector for delivering sustainable economic growth. The study aimed at documenting the progress achieved by countries in the MEFMI region in revamping their financial sector from 2000 to 2008, provide detailed procedures on how to create indices that capture the development of some individual components of the financial sector and offer a common measure of financial sector development in the MEFMI region. The study used the Composite Financial Sector Development Index and the Traditional Financial Development Index to measure financial sector development and gave a clear picture of the progress made by Tanzania, Uganda and Zambia over the last eight years and the current level of financial sector development. The Composite Financial Sector Development Index portrays the three countries at a similar stage of development and earmarks the banking sector, non bank financial sector and issues surrounding the openness of the financial system as areas that require more effort to achieve the best results with the reforms in place. The Traditional Financial Development Index showed great progress in the last eight years in the area of banking sector size and efficiency as well as financial depth of the three countries. The study proposes using both the Composite Financial Sector Development Index and the Traditional Financial Development Index as the common measure for the region. 4

5 CHAPTER ONE 1.0 Introduction A developed and well-functioning financial sector is a key component of an economy, facilitating the exchange of goods and services, mobilizing savings, allocating resources and helping diversify risks. A financial sector refers to all the wholesale, retail, formal and informal institutions in an economy offering financial services to consumers, businesses and other financial institutions. It includes banks, stock exchanges, contractual savings institutions, credit unions, microfinance institutions and money lenders (DFID, 2004). Financial development is considered by many economists to be of paramount importance for output growth. Greenwood & Smith (1997) argue that a developed financial sector plays an important role in allocating investment capital to high return activities while Levine (1997), Pagano (1993) and Gertler (1988) argue that a developed financial sector has a special function of alleviating information problems, reducing liquidity risk, reducing monitoring costs, and channeling credit to certain classes of borrowers. Member countries in the Macroeconomic and Financial Management Institute of Eastern and Southern Africa (MEFMI) need an efficient and robust financial sector for delivering sustainable economic growth. This can be done through mobilizing and allocating resources to their most productive uses thereby lowering the transaction costs of economic activity through provision of efficient payments mechanisms and making available long-term capital. 5

6 1.1 Overview of Financial Sector Development in the MEFMI Region Frequently, the financial sector in the MEFMI 1 region economies as with other developing countries do not perform at their optimum. They share the same characteristics: 1. Investors are more attracted to the short-end of the market (1 year to 5 years) due to market uncertainties resulting from inadequate information flow that characterizes most markets in the developing countries that are inefficient, lack of efficient secondary markets, as well as uncertainty about future government policies. 2. The financial markets and financial institutions do not meet the capital needs of the economy. In this case, there is a general lack of availability of long-term finance for infrastructure and industry development and financial instruments that meet the needs of poor people that constitute the majority. 3. There is lack of financial linkages between institutions and markets, impairing efficiency in allocating resources as explained by the presence of informal financial organizations. 4. Financial services offered are usually overly expensive due to lack of competition, inadequate access to technology and know how and incentives that do not address the needs of the markets. Cost is also increased by the sub-scale nature of many financial sectors. 1 MEFMI member countries include; Tanzania, Kenya, Uganda, Rwanda, Zambia, Malawi, Zimbabwe, Lesotho, Namibia, Swaziland, Botswana, Mozambique and Angola. 6

7 5. The financial sectors are susceptible to shocks due to the weaknesses in governance and lack of appropriate regulations and supervision. 1.2 Statement of the Problem Financial sector development has been regarded as a necessity towards achieving sustainable economic growth. As countries in the MEFMI region consider ways to promote rapid and lasting economic growth, further financial sector reforms affecting all aspects of financial development need to be addressed. The theory postulates that, policies aimed at enhancing financial sector performance will result in lower information, transaction, and monitoring costs, thus improving allocative efficiency and raising output (Levine, 1997; and Khan and Senhadji, 2000). Supporting evidence is typically based on a broad cross section of countries, where financial development is measured by a small set of statistical indicators. 2 However, comparatively little work has been done on (1) how to measure the specifics of financial sector development, taking into account the variety of markets and institutions that the financial sector is composed of; and (2) creating measures of financial development in the MEFMI region that go beyond simple aggregate macro-indicators. Going beyond simple standard quantitative indicators, such as the ratio of broad money (M2) to GDP, is necessary to identify and prioritize among different areas of financial sector reform (Creane, S., Goyal, R., Mobarak, M., Sab, R. 2007). The simple indicators, though easily available and applicable to cross-regional comparisons, do not necessarily capture what is broadly meant by financial development. Financial sector development is 2 These indicators usually included the ratios of broad money to GDP and of credit to the private sector to GDP. 7

8 a comprehensive concept, capturing not only monetary aggregates and interest rates, but also regulation and supervision, degree of competition, financial openness, institutional capacity, market structure and range of financial products. Noting the significance of measuring the progress made in the region s financial sector, it is necessary to use a common measure of financial sector development. This will ensure that all efforts at developing the financial sector are measured within the region and that countries are ranked based on their performance against the financial sector development indices. 1.3 Significance of the study The study provides useful insights into the understanding of the level of financial sector development in the MEFMI region as well reveal the picture as to how these markets have evolved over time. The study offers detailed procedures on how to create indices that capture the development of some individual components that are normally left out when measuring financial sector development and illustrates the practicability of the comprehensive financial development index and the traditional index to suit the needs of the region; and in doing so, offers a common measure of financial sector development. The ranking of countries financial markets shall benefit the stakeholders (regulators, responsible ministries and financial institutions) by offering a clear insight on the status of the markets in the region in terms of each country s performance against the index, the analysis of which allows us to take a closer look at the financial structure of the respective countries and to draw conclusions on the appropriate reforms required to further promote financial development in the region. 8

9 1.3 Objectives of the Study General objective The general objective of the study is to document the progress achieved by countries in the MEFMI region in revamping their financial sector over the last eight years from 2000 to 2008 by measuring financial development in the region Specific objectives 1. To offer a common measure of financial sector development in the MEFMI region. 2. To develop procedures to create indices that capture the development of some individual components of the financial sector in the region. 1.4 Research Questions The following are the guiding research questions: 1. What is the level of financial sector development in the region? 2. Why measure financial development in the region? 3. What is the best approach in measuring financial development in the MEFMI region? 4. Can the best approach be institutionalized and applied by the stakeholders in the region? 1.5 Scope of the Study In the context of the proposed research problem, the study measures financial development in the MEFMI region in order to highlight the progress made after implementing financial sector reforms within the region. The study covers three countries in the MEFMI region namely: Tanzania, Uganda and Zambia because of their shared financial sector characteristics which as stated by Gelbard and Pereira, 1999 are 9

10 minimally developed. The study covers the period during which, most countries in the MEFMI region undertook financial sector reforms. 1.6 Data collection: Procedure and Administration The research uses both secondary and primary data. Primary data was collected in the form of a survey that was carried out using structured questionnaires administered to the respective countries central banks and through discussions with relevant officials at the respective central banks in order to ensure practicability and applicability of the financial development indices applied in the study. 1.7 Expected Results 1. To offer a common measure of financial sector development in the MEFMI region. 2. To document the progress achieved by countries in the MEFMI region in restoring their financial sectors over the last eight years. 3. Dissemination of the index among prospective users. 10

11 CHAPTER TWO LITERATURE REVIEW 2.1 Financial Development in Sub Saharan Africa For decades, most sub-saharan African countries have had relatively simple financial systems geared toward financing foreign trade. Financial development in sub-saharan Africa has often suffered on account of misguided efforts to speed up economic growth through government intervention. In many countries, the provision of credit is seen as a powerful instrument of economic development. Nationalization of the banking system often resulted to inefficient resource allocation through for example directed lending, inflationary refinancing by the central bank of commercial bank operations, and absorption by the government (directly or through the central bank) of banking losses. The banking system provided few satisfactory services, had a high proportion of non-performing loans, often to public enterprises, and quickly became undercapitalized 3. Most sub-saharan African countries believed that it would be possible to accelerate economic development by identifying promising sectors and using subsidized credit and selective credit controls to promote them. Interest rates were maintained at levels that were negative in real terms, and widespread regulations forced banks to provide credit to priority sectors at subsidized rates. The result was often misallocation of resources and credit rationing. The priority sectors seldom showed a performance that justified the measures taken, and growth rates in the early 1980s were generally insufficient to raise 3 This happened even in countries where the banking system remained in private hands after independence. 11

12 income per capita. Attempts at inflationary financing further damaged economic development in many countries. The collapse of the interventionist policies in the mid-1980s prompted many countries to embark on a reform agenda that included liberalizing interest rates, eliminating credit controls, restructuring and privatizing commercial banks, adopting indirect instruments of monetary policy, and developing financial markets 4. These policies were generally implemented within Fund-Supported structural adjustment programs. However, not all countries moved quickly enough with the reform process, and in a number of cases financial sector problems were allowed to recur, with the result that a new round of financial reforms had to be implemented in the mid-1990s. 2.2 Measuring financial development with respect to stages of financial development There are three stages of financial development as identified by Pill and Pradhan (1995): a financially repressed economy; a domestically liberalized economy and an internationally liberalized economy This characterization of financial liberalization corresponds in a stylized way, to the optimal order of economic liberalization advocated by McKinnon (1982 and 1993), among others. During the initial phasecorresponding to the transition from a financially repressed economy to a domestically liberalized economy-domestic controls on interest rates are removed, allowing marketclearing rates to be established. Capital account restrictions are abolished only in the final stages of the liberalization program. 4 A review of status of financial sector reforms in sub-saharan Africa is provided in Mehran and others (1998) 12

13 Using a simple Fisherian model, Pill and Pradhan look into four indicators of financial development: (a) broad money, (b) base money, (c) bank credit to the private sector, and (d) real interest rates. They conclude that private sector credit is the only indicator that can be expected to be directly correlated with financial development. Real interest rates in the domestically liberalized economy stage are likely to be higher than in the internationally liberalized economy stage. Broad money is also expected to be higher in the domestically liberalized economy than in the other two stages. 2.3 Measuring financial development using monetary aggregates Measuring financial development using the monetary aggregates has been proven to be difficult in most literature. Pill and Pradhan (1995) explain that conventional measures of financial deepening, such as the level of real interest rates and the ratio of broad money to GDP, may give misleading signals about the success of financial reforms and its implications for real activity. They assert that these indicators overlook important factors, such as the openness of the country to capital flows, the extent of public borrowing from the domestic financial system, the development of non-bank financial intermediation, and the competitiveness of the banking sector. Current literature identifies the existence of a legal environment that protects the rights of creditors and enforces contracts as another factor that has been overlooked while measuring financial development using the monetary aggregates. As explained by La Porta and others (1997), such an environment tends to be associated with more developed and efficient debt and equity markets. Therefore, by analyzing the institutional environment and the incentive structure in which bank managers, auditors, and depositors 13

14 operate, one may be able to draw conclusions about the level of financial development of a country. The relationship between base money and financial development cannot be determined a priori, as it is determined by the authorities choice of fiscal and monetary policy. While credit to the private sector is the most appropriate financial deepening indicator among the generally available ones, it is not perfect either. Its relationship to financial development could be affected by financial innovation, in particular by the emergence of non-bank credit, and by commercial bank lending to other financial intermediaries. Pill and Pradhan speculate that a better (but seldom available) indicator would be nonbank credit to the private sector. They test their findings for a sample of countries in Africa and Asia. Results seem adequate for Asia. For Africa, however, all financial variables, including the preferred private sector credit indicator, move erratically, even in the post liberalization period, and they appear to have little explanatory power for developments in the real economy. It seems that a wide, private sector credit aggregate is the preferred financial indicator in countries where financial liberalization has created a well-behaved commercial banking sector and the capital account in the balance of payments has been open. For other countries, none of the usual financial deepening indicators seem adequate. Other studies have also used monetary aggregates as a measure of financial development. King and Levine (1993a) relate real GDP per capita growth to nine different indices of 14

15 financial deepening: (a) narrow money to GDP; (b) broad money to GDP; (c) quasi money to GDP; (d) central bank domestic credit to GDP; (e) commercial bank domestic credit to GDP; (f) gross claims on the private sector to GDP; (g) commercial banks domestic credit to total domestic credit; (h) claims on non-financial private sector to total domestic credit; and (i) claims on the private sector by non-deposit money banks to GDP. Johnston and Pazarbasioglu (1995) use a combination of three variables to reflect the different aspects of financial development: the interest cost of capital (real interest rate), the volume of intermediation (the ratios of credit to the private sector to GDP and of broad money to GDP) and financial sector efficiency (gross spread between the average lending and deposit rates and ratio of base money to deposits). Other indices of financial deepening are also used in the literature: Goldsmith (1969) uses the ratio of financial institutions assets to GDP; Fry (1988) uses rural population per rural bank branch; and Levine and Zervos (1998) use measures of stock exchange liquidity (total value of shares traded divided by GDP and the turnover ratio). Rother (1999) uses the money multiplier and the ratio of private sector credit to base money. Creane, Goyal, Mobarak and Sab (2007) apply the alternative financial development index to measure financial development and run a comparison with the comprehensive financial development index to ascertain the validity and relevance of either method. The alternative financial development index consists of four commonly used indicators of financial development, namely; (i) ratio of broad money (M2) to GDP, (ii) ratio of the assets of deposit money banks to assets of the central bank plus deposit money banks, 15

16 (iii) reserve ratio and (iv) ratio of credit to the private sector by deposit money banks to GDP. The variables measure the size of the financial sector, the importance and relative ease with which banks provide funds, and the extent to which funds are provided to the private (as opposed to the public) sector. 2.4 Research Methodology Financial Development Indices The study draws on the approach applied by Creane, Goyal, Mobarak and Sab (2007) to measure financial development using a comprehensive financial development index. The comprehensive index is organized in six themes or sub-indices, each of which is meant to capture a distinct component of financial development: (i) the banking sector size, structure and efficiency; (ii) the development of non-bank financial sector; (iii) the quality of banking regulation and supervision; (iv) the development of monetary sector and monetary policy; (v) financial sector openness; and (vi) institutional environment. The alternative financial development index comprises of four variables namely: (i) ratio of broad money (M2) to GDP, (ii) ratio of the assets of deposit money banks to assets of the central bank plus deposit money banks, (iii) reserve ratio, and (iv) ratio of credit to the private sector by deposit money banks to GDP The Comprehensive Financial Development Index Creane, Goyal, Mobarak and Sab (2007) used measures of banking sector size, structure and efficiency; non bank financial sector development; the quality of banking regulation and supervision; monetary sector development and monetary policy; financial sector 16

17 openness and institutional environment for MENA 5 countries for and Following a similar approach, the study uses the comprehensive index organized in six themes for The monetary sector development and monetary policy theme examines the extent to which the government uses indirect monetary policy instruments, as opposed to direct controls, on interest rates and credit allocation. It furthermore considers the efficiency of markets for government securities and the provision of liquidity by the financial system. The banking sector development theme examines the size, structure and efficiency of the banking sector. Among other things, it investigates the profitability of banks, bank competition and concentration, payments systems, ease of private sector access to bank credit, and frequency of non-cash transactions. The non-bank financial sector development theme explores the development of alternative sources of capital as well as markets for financial products and services. These include stock markets, mortgage or housing finance institutions, corporate bond markets, loan syndications, insurance companies, mutual funds, and pension funds. They reflect the variety of products and markets that allow a financial system to fulfill its functions such as: enabling firms and households to raise finance in cost effective ways, mobilizing finance, monitoring managers and diversifying risk. 5 The MENA region covers the Inslamic State of Afghanistan, Algeria, Bahrain, Djibouti, Egypt, the Islamic Republic of Iran, Iraq, Jordan, Kuwait, Lebanon, Libya, Mauritania, Morocco, Oman, Pakistan, Qatar, Saudi Arabia, Somalia, Sudan, the Syrian Arab Republic, Tunisia, the United Arab Emirates, West Bank and Gaza and the the Republic of Yemen. 17

18 The regulation and supervision theme assesses banks performance with respect to minimum capital adequacy requirements. Among other items, it evaluates the prudential monitoring of banks and the transparency and openness of the regulatory environment. The financial openness theme assesses the appropriateness of the exchange regime and examines whether there are significant restrictions on the trading of financial assets or currency by foreigners and residents. Restrictions on current account transactions could substantially hinder trade in goods and services as well as the development of capital markets by narrowing the investor base and limiting the development of new financial markets instruments. The institutional environment theme tries to judge the quality of institutions, such as law and order, property rights, bureaucratic quality, accountability of the government, and the ease of loan recovery through the judicial system that influence the performance of the financial system. The application of the comprehensive financial development index is illustrated in Table 2 below Weightings of the Variables The comprehensive financial development index is a weighted average of the 23 different indicators whereby each indicator has been assigned weights selected on the basis of its importance in measuring financial development as highlighted on the existing literature. More weight has been placed on the banking sector size and efficiency subcomponent (35 percent) as illustrated in Table 1, because of the dominance of the banking industry in the 18

19 financial sector and its intermediation role which plays a major part in the development of the financial sector. Table 1: Themes and Weights for computing Comprehensive Financial Development Index Themes and Components Weightings Section A: Banking Sector Size, Efficiency 35 percent Development and profitability of the banking sector 6 Privatization of banking sector 5 Ratio of credit to private sector by deposit money banks to GDP 5 Deposit money bank assets/banking sector assets 4 Reserve ratio 3 Interest rate spreads 4 Concentration in the banking sector 5 Presence of foreign banks 3 Section B: Development of Nonbank Financial Sector 20 percent Stock market (6 percent) 6 Housing finance (2 percent) 2 Other nonbank financial markets and instruments 6 Interbank transactions 6 Section C: Quality of Banking Regulation and Supervision 15 percent Basel capital adequacy ratio requirements 6 Prudential monitoring of banks 3 Nonperforming loans 6 Section D: Development of the Monetary Sector and Monetary Policy 20 percent Ratio of M2 to GDP 7 Indirect instruments of monetary policy 5 Interest rate liberalization 2 Government securities 6 Section E: Financial Sector Openness 10 percent Appropriate market determined exchange rate 3 Restrictions on foreign currency purchases by residents 2 Restrictions on the financial activities of non-residents 3 Forward exchange market 2 Source: Creane, Goyal, Mobarak & Sab (2007) 19

20 2.4.3 The Traditional Financial Development Index The study applies the Traditional financial development index to measure financial development and run a comparison with the comprehensive financial development index to ascertain the validity and relevance of either method for the MEFMI region. The Traditional financial development index consists of four commonly used indicators of financial development, namely; (i) ratio of broad money (M2) to GDP, (ii) ratio of the assets of deposit money banks to assets of the central bank plus deposit money banks, (iii) reserve ratio and (iv) ratio of credit to the private sector by deposit money banks to GDP. The index concentrates solely on the banking sector size and efficiency and the development of the monetary sector and monetary policy. In this case, the variables measure the size of the financial sector, the importance and relative ease with which banks provide funds, and the extent to which funds are provided to the private (as opposed to the public) sector. The index will cover a period from 2000 to 2008, illustrating the evolution of these markets over time. 20

21 CHAPTER THREE STUDY FINDINGS AND ANALYSIS 3.0 General Observations The study observed data over a period of eight years from 2000 to During this time, most countries in the MEFMI region were undergoing financial sector reforms. The subindices were compiled on the basis of a questionnaire survey that was carried out by the researcher in relevant institutions in the three respective countries (Tanzania, Uganda and Zambia). Less guidance was provided on judgmental questions, except that interest was placed in the considered opinion of practitioners in the respective institutions. Among the limitations of the indices worth noting are: i. The choice of attributes included is judgmental and conditioned by data availability. ii. The nature of questions posed in the survey is such that the answer could be affected by the respondent s subjective assessment of the situation. iii. All attributes are assumed to be equally important when computing the indices, an assumption that may not match reality. 3.1 Study Findings The main analysis of the survey data-set compiled through the composite index is suggestive of common strengths, trends and weaknesses in specific areas of the financial sector across the region and points to areas in greater need of reform. It is evident that the countries under survey perform generally well in the five sub-indices but more has to be 21

22 done to strengthen the institutional environment and promote nonbank financial sector development and make monetary policy tools effective Banking Sector Size and Efficiency Theme The banking sector size and efficiency theme had eight variables and was given more weight (35%) than other components. The Banking sector is among the sectors undergoing reforms, with the major reforms being the privatization of Governmentowned banks. The number of banks owned by the government in the three countries has gone down tremendously, while the number of private banks (both domestic and foreign) increased substantially. The size of the banking sector is seen to be adequate, with Tanzania having 29 commercial banks, Uganda, 23 commercial banks and Zambia with 26 commercial banks. It should be noted however, that the commercial banks are still concentrated in the urban areas while the rural areas are left with no solid financial services. The banking sector as a whole is generally efficient with over seventy five percent of all banks in the three countries reporting profits and having no record of bank crises in the past three years from The level of private credit is seen to have increased over time on an average rate of 1.2% in Tanzania, 1.17% in Uganda and 2.34% in Zambia, with the ratio of credit to private sector by deposit money banks to GDP reaching a high of 26% in Tanzania, 24% in Uganda and 28% in Zambia. It is worth noting that personal loans backed by salaries dominate the commercial banks loan portfolios with almost 60% of the total loans value. 22

23 Interest rate spreads are noticeably still high but have gone down in the course of five years going below 10% but still above 6% in the three countries as a result of increased competition in the banking sector. Under the Banking Sector Size, Efficiency component of the financial index with a ten point scale, Zambia emerged with 5.92 points, followed by Tanzania and Uganda with 5.64 points and 5.37 points respectively. This illustrates the current level of banking sector development in these countries and the need for more reforms to further deepen and widen the financial markets especially by creating a conducive environment to enable financial services to be offered in the rural areas. Table 3.1a: Banking Sector Size, Efficiency (35%) Tanzania Uganda Zambia Binary Weighted Binary Weighted Binary Weighted Development and profitability of the banking sector Privatization of commercial banks Credit to the private sector by deposit money banks as a share of GDP Deposit money bank assets/ banking sector assets to GDP Reserve ratio Banking sector competition Market concentration in the banking sector Presence of foreign banks Development of Nonbank Financial Sector Theme The nonbank financial sector is still emerging and in need of more reforms, particularly on the legal and regulatory infrastructure. Currently reforms are underway on pension, insurance and land issues in Tanzania and Uganda. 23

24 Stock markets are present in but with very low turnover ratios of less than three percent in the countries under review. The number of listed companies at the exchanges is still low despite cross-listings, and the level of activity is also on the low side partly due to investors preference to buy and hold securities to maturity and illiquid secondary market for government and corporate bonds. There are no housing financial institutions in Uganda and Tanzania while Zambia has an upcoming mortgage market that is still at a nascent stage. The interbank market in these countries is active but segmented on the basis of the participants size and nature (foreign banks Vs local banks and big banks Vs small banks). In this case lines of credit are established on that basis. In Zambia half the transactions in the interbank market is collateralized. The countries performance under this component is as seen on table 3.1b. Table 3.1b: Development of Nonbank Financial Sector (20%) Tanzania Uganda Zambia Binary Weighted Binary Weighted Binary Weighted Stock market development Housing finance Other nonbank financial markets and instruments Interbank transactions Quality of Banking Regulation and Supervision Commercial banks in these countries to a large extent comply with Basel capital adequacy ratio requirements. In Tanzania, an element that was missing under Basel 1 was 24

25 Capital Charge for Market Risk which has already been taken into consideration in the reviewed Capital Adequacy Regulations. Commercial banks share of non performing loans to total loans is seen to be on a decreasing trend, with figures being below 15% which is still high, posing a risk to the stability of the system, contributing to high lending rates and hampering the development of the interbank financial markets. Table 3.1c: Quality of Banking Regulation and Supervision (15%) Binary Tanzania Uganda Zambia Weighted Binary Weighted Binary Weighted Basel capital adequacy ratio requirement Prudential monitoring of banks Nonperforming loans Development of the Monetary Sector and Monetary Policy The M2 to GDP ratio of the three countries has been increasing through the course of eight years at an average annual rate of 5% for Tanzania, 1.6% for Uganda and 2.4% for Zambia. In 2008, Tanzania had a ratio of 22% compared to 21% and 16% for Zambia and Uganda respectively. When gauging against the HIPC benchmark 6 for the M2/GDP ratio of 28.5%, the three countries are below the benchmark; indicating lack of financial depth and thus the overall size of the financial sector. 6 The World Bank WDI 2001 indicates M2/GDP ratio of 28.5% as a benchmark for the highly indebted poor countries (HIPC) 25

26 The three countries under review use repos, Treasury bills, Central Bank papers and Treasury bonds as monetary policy instruments. The maturities range from 35 days to 364 days for Treasury bills and 2 years to 15 years for Treasury bonds. Uganda uses Treasury bonds for monetary policy implementation only, unlike Tanzania and Zambia that use Treasury bonds for budgetary financing purposes. Tanzania and Uganda are under the Primary dealership system in which case, Uganda has seen better results with it than Tanzania where the system has failed to maintain an active secondary market for government bonds. Uganda and Zambia have no investor restrictions on government securities, while Tanzania restricts foreigners from participating in the government securities auctions. This has negatively affected the performance of government securities auctions and limited the growth of the investor base. Repos are currently used for fine tuning excess liquidity from the market, with government securities used as collateral. All three countries use vertical as well as horizontal repos using both Treasury bonds and Treasury bills as underlying instruments. Table 3.1d: Development of the Monetary Sector and Monetary Policy (20%) Binary Tanzania Uganda Zambia Weighted Binary Weighted Binary Weighted Ratio of M2 to GDP Indirect instruments of monetary policy Interest rate liberalization Government Securities

27 3.1.5 Financial Sector Openness Under this component of the index, the three countries performed fairly well with Zambia scoring higher than the rest. Exchange rates in all three countries are market determined, with the respective Central Banks intervening for sterilization purpose and to ensure the market operates in an orderly manner. Tanzania is the only country out of the three with foreign currency restrictions, particularly on residents. The forward exchange market in the three countries is still at an early stage of development and the use of derivatives as hedging instruments is yet to be seen. Table 3.1e: Financial Sector Openness (10%) Tanzania Uganda Zambia Binary Weighted Binary Weighted Binary Weighted Appropriate market determined exchange rate Restriction on foreign currency purchases by residents Restrictions on the financial activities of nonresidents Forward Exchange market

28 3.1.6 The Composite Financial Development Index The Overall performance of the three countries against a scale of one to ten of the index illustrates a significant revelation that the countries are on a similar level of financial development with Zambia scoring 6.85, followed by Tanzania and Uganda with 6.53 and 6.52 respectively. Table 3.2: The Composite Financial Development Index Sub Indices Scale (1 10) Tanzania Uganda Zambia Banking Sector Size, Efficiency (35%) Development of Nonbank Financial Sector (20%) Quality of Banking Regulation and Supervision (15%) Development of the Monetary Sector and Monetary Policy (20%) Financial Sector Openness (10%) The Traditional Financial Development Index The Traditional Financial Development Index applied four commonly used indicators of financial development, namely; (i) ratio of broad money (M2) to GDP, (ii) ratio of the assets of deposit money banks to assets of the central bank plus deposit money banks, (iii) reserve ratio and (iv) ratio of credit to the private sector by deposit money banks to GDP. The eight year trend from 2000 to 2008 illustrates the evolution of the financial sectors in the respective countries, clearly portraying progress, particularly on the increased size of the financial sector, the ease with which banks provide funds, and the extent to which funds are provided to the private (as opposed to the public) sector. Banking sector size and profitability has been measured by the ratio of broad money to GDP, ratio of credit to private sector by deposit money banks to GDP and the ratio of 28

29 Deposit money bank assets to banking sector assets. Figures 1, 2 and 3 clearly portray the progress and performance of the countries over the eight year period from 2000 to When examining the trend on the three ratios it is evident that the ratios have been going up since 2000, suggesting that the reforms implemented have had a positive impact on the development of the financial sector. Summing up the performance of the three countries from Figures 1, 2 and 3, Tanzania s banking sector is seen to be more developed and profitable, followed by Zambia then Uganda. Figure 1: Ratio of Broad Money to GDP Figure 2: Ratio of Deposit money bank assets to banking sector assets 29

30 Figure 3: Ratio of Credit to the Private Sector to GDP The trend on the ratio of broad money to GDP as shown in Figure 4 portrays Zambia and Tanzania with higher ratios than Uganda. In this case, Zambia recorded an average of 21 percent, followed by Tanzania with 19 percent and Uganda with an average of 14 percent. This shows that Zambia s financial sector is deeper than the other two countries and that there s still more work that needs to be done to deepen the markets in the countries under review. Figure 4: Ratio of Broad Money to GDP 30

31 3.1.8 Comparison of Results from the Traditional and Composite Financial Development Indices The Traditional Financial Development Index measures the level of financial development over a period of time, while the Composite Financial Development Index measures the current level of financial sector development. The two indices should be used concurrently in order to give a clear picture of the current level of development and the progress made over a number of years. Results from the Composite Index clearly put Zambia ahead of Tanzania and Uganda in the overall performance, while the Traditional Index places Tanzania ahead of the other two countries with a wider and more profitable banking sector size, and Zambia is seen to have a deeper financial sector than the others. The differences in results from the two indices are likely as a result of the structural reforms in the Comprehensive Index not fully reflecting the results at the macro-level by the time the study was completed, but nevertheless require further investigations. 31

32 CHAPTER FOUR CONCLUSION AND RECOMMENDATIONS 4.1 Conclusion Several issues have been discussed in the study, clearly showing why it is important to measure financial development and indicating the significance of doing so in the MEFMI region. The overall objective of the study was to document the progress achieved by countries in the MEFMI region in revamping their financial sector over the period 2000 to 2008, by measuring financial development in the region. Other objectives were to offer a common measure of financial sector development in the MEFMI region as well as developing procedures to create indices that capture the development of some individual components of the financial sector in the region. The study used the Composite Financial Sector Development Index and the Traditional Financial Development Index that gave a clear picture of the progress made by the three countries over the last eight years and the current level of financial sector development. The Composite Financial Sector Development Index portrays the three countries at a similar stage of development and earmarks areas where each country has to put more effort to achieve the best results with the reforms in place. The index ranks Zambia first with a score of 6.85 followed by Tanzania and Uganda with scores of 6.53 and 6.52 on a scale of one to ten respectively. Among the areas that need more effort are the Banking sector, non bank financial sector and issues surrounding the openness of the financial system. 32

33 The Traditional Financial Development Index showed progress in the last eight years in the area of banking sector size and efficiency as well as financial depth of the three countries. Tanzania s banking sector was found to be wider and more profitable than the other two countries, while Zambia s financial sector was seen to be deeper than Tanzania and Uganda. The study reveals the use of the Composite Financial Sector Development Index and the Traditional Financial Development Index concurrently as the best approach to measure the current level of financial sector development and progress made in the financial sector over time. It offers a challenge to the MEFMI region to utilize the index to know the current level of financial sector development and measure the progress made over time. 4.2 Recommendations In order to achieve the desired level of financial sector development in the region, the study recommends the following: 1. Using the composite financial sector development index, every year, countries in the region should measure the current level of financial sector development, identify the key problem areas and prioritize the measures based on their significance to the development of the financial sector in the region. In this case, countries should put more effort in developing the Banking sector through raising awareness on the benefits of saving, putting in place functional payments and settlement systems and by creating an enabling a conducive environment for banks to perform efficiently. 33

34 2. The nonbank financial sector which comprises of institutional investors and other financial institutions should be further developed in order to widen the existing investor base. This can be done by reviewing the legal and regulatory frameworks that limit the performance of the institutional investors in the financial markets. In this case legal and regulatory reforms are much needed in order to have a function nonbank financial sector. 3. Countries with a partially liberalized capital account should cautiously and sequentially liberalize in order to widen their investor base while preventing market disruptions that may arise otherwise. 4. In order to develop the secondary market for government securities, countries should look into the primary dealership system and the benefits it offers, particularly to the secondary market of these securities. 5. For the Financial Sector Development Index to be relevant and useful in the region, it needs to be dynamic. In this case, the future versions of the index should reflect the technological advancements on the banking system, payments and settlements system, particularly on cellular and internet banking. The index should also capture the liquidity and turnover in secondary debt markets once these markets start functioning effectively. 6. It is important that future research for measuring the level of financial sector development using the composite index takes into account the level of banking sector penetration or access to finance. This will give a clear picture of the percent of population with access to financial services offered by banks and other financial services. 34

35 REFERENCES 1. Chatterji, S. (2001). The domestic architecture of financial sectors in developing countries: an overview through the eyes of a financial sector diagnostic framework. 2. Creane, S., Goyal, R., Mobarak, M. & Sab, R. (2007). Measuring Financial Development in the Middle East and North Africa: A New Database. 3. Demirguc-Kunt, A., & Levine, R (1996). Stock market development and financial intermediaries: stylized facts. World Bank Economic Review. 4. Department for International Development (2004). The importance of Financial Sector Development for Growth and Poverty Reduction. 5. Gelbard, A. & Pereira, S. (1999). Measuring Financial Development in Sub- Saharan Africa. 6. Gertler, M. (1998). Financial structure and aggregate economic activity: an overview. Journal of Money, Credit and Banking. 7. Greenwood, J., & Smith, B. D. (1997). Financial markets in development and the development of financial markets. Journal of Economic Dynamics and Control. 8. La porta, Rafael, and others, 1997, Legal Determinants of External Finance, journal of Finance, Vol. 52 (July) 9. Levine, R. (1997). Financial development and economic growth: views and agenda. Journal of Economic Literature. 10. Mehran, Hassanali, and others, 1998, Financial Sector Development in Sub- Saharan African Countries, IMF Occasional Paper No Ndikumana, L (2000). Financial determinants of domestic investment in Sub- Saharan Africa: evidence from panel data. 35

36 12. Odedokun, M. O. (1996). Alternative economic approaches for analyzing the role of financial sector in economic growth: time-series evidence from LDCs. Journal of Development Economics. 13. Pagano, M. (1993). Financial markets and growth: an overview. European Economic Review. 14. Pill, Huw, and Mahmood Pradhan, 1995, Financial Indicators and Financial change in Africa and Asia, IMF Working Paper 95/ World Bank website: Bank of Tanzania website: Bank of Uganda website: Bank of Zambia website: 36

37 Annex 1 Data definition, Weights and s for computing Financial Development Index Themes and Components Definition/ Methodology Section A: Banking Sector Size, Efficiency (Weight 35 percent) Development and profitability of the banking sector (7 percent) This measure examines whether there is large public ownership, government financing need, or weak supervision: whether there were banking crises in the past 15 years; whether bank management capacity is adequate; whether banks are solvent; whether banks have been capitalized. Privatization of banking sector (4 percent) Ratio of credit to private sector by deposit money banks to GDP (6 percent) Deposit money bank assets/banking sector assets (4 percent) The score is 0 if banking sector as a whole is inefficient; 1 if some banks are profitable, but significant portion of banking sector is still inefficient or suffers losses; 2 if vast majority of banks are profitable/efficient. Private banks are associated with higher financial development, stronger supervision and less government intervention. The is 0 if there is substantial presence of public institutions in the banking sector with no efforts at privatization; 1 if there is substantial presence of pubic institutions in banking sector, but some privatization has occurred; 2 if banks are largely private A proxy for the extent of activity of financial intermediaries. Private credit captures the financial intermediation with the private nonfinancial sector. This is a relative size indicator that measures the importance of deposit money banks relative to the banking sector 37