Why are governments drawn to regulate financial markets to the point of financial repression? It appears that post-Communist governments may have inhibited the development of financial institutions to ensure adequate flows of external capital to favored enterprises rather than to finance deficits.
Financial systems in developing countries tend to be "restricted" or "repressed" through burdensome reserve requirements, interest-rate ceilings, foreign-exchange regulations, rules about the composition of bank balance sheets, or heavy taxation of the financial sector.
Why are governments drawn to regulate financial markets to the point of financial repression?
To address this question, Denizer, Desai, and Gueorguiev explore preliminary evidence from the post-Communist economies of Eastern Europe and the former Soviet Union, where financial regulations have rarely been examined systematically.
They find that the public-finance framework has limited ability to explain financial repression in the transition economies, given the peculiar financial lineage of the socialist state. The weak distinction between "public" and "private" spheres of finance in transition economies means that the deficit often conveys little information about the governments' real fiscal activities.
It is more fruitful to examine how political institutions, by shaping the incentives politicians face, affect financial policy.
Their findings suggest that post-Communist governments may adopt repressive financial controls—not to finance deficits more cheaply than would be the case under financial liberalization, but to maintain the authority and ensure the survival of those in power. In countries where pre-reform elites are plentiful in legislative bodies, where interparty competition is low, and where governing parties are well-represented in parliaments, elites have been able to perpetuate a system of implicit subsidies by "softening up" the financial sector—especially commercial banks—to ensure the continued flow of cheap credit to specific borrowers.
The main beneficiaries of these policies—large formerly state-owned industries with tight financial links to the largest commercial banks—are thus able to convert their well-established claims on public resources into preferential access to credit lines.
In other words, financial repression in transition economies may simply serve to solidify main-bank, main-firm relations. These results would lend support to the claim of smaller, cash-starved Eastern European entrepreneurs that the commercial banks have "taken over the role of the old planning ministries."
This paper—a joint product of the International Finance Corporation's Central Asia, Middle East, North Africa Department, and the Private Sector Development Department - is part of a larger effort to understand the workings of financial markets in transition economies. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Tseday Hailu, room F3P-198, telephone 202-974-4396, fax 202-473-8446, Internet address thailu@worldbank.org. Cevdet Denizer may be contacted at cdenizer@ifc.org. (33 pages)
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