Risks and Returns: Managing Financial Trade-Offs for Inclusive Growth in Europe and Central Asia

"Risks and Returns: Managing Financial Trade-Offs for Inclusive Growth in Europe and Central Asia" argues that striking the right balance across all dimensions of financial development (stability, efficiency, inclusion, and overall depth) is crucial for achieving and sustaining inclusive growth.

Emerging Europe and Central Asia, perhaps now more than ever, faces the urgent need for financial sector reforms. Reforms are needed not only to make the region more resilient to financial shocks but also to support efforts to strengthen income growth, particularly that of the middle- to lower-income earners, many of whom since the global financial crisis have questioned the benefits of greater economic and financial integration.

Over the last 20 years, the region has confronted two major financial crises and is currently facing major banking stresses and currency pressures, if not full-blown crises, particularly in countries directly or indirectly dependent on oil exports.

Moreover, the region now has to cope with greater policy uncertainty as Britain seeks a new relationship with the European Union (EU), the refugee crisis puts pressure on policy makers to slow migration, and many countries face new internal political dynamics.

The general sense of prolonged growth stagnation since the 2008 global financial crisis and lack of real (or perceived) improvement in standards of living of lower-income earners has led to an increasing level of dissatisfaction with the status quo, reflected in the changing regional political dynamics. Indeed, for the majority of lower- and middle-income households in Emerging ECA, real income levels have declined, or not increased appreciably, since they hit their peak in 2007.

Although improving financial sector development cannot solve all these problems, it can help support stability and inclusive growth. This, in turn, may help build a consensus for complementary policies that support inclusive sustainable growth, rather than a reflexive inward tug toward isolationism and away from the liberalization and integration policies that began during the early 1990s.

This report argues that financial development must go beyond improving the access to and pricing of credit. It should help build a broad-based and balanced financial system of both bank and non-bank markets, one that enables responsible financial inclusion of firms and individuals and enhances financial efficiency and stability.

Striking the right balance across these dimensions of financial development - stability, efficiency, inclusion, and broad depth - is crucial for finance to support inclusive and sustainable growth through improved transactions, savings mobilization, screening of projects, monitoring of firm managers, and risk management.

Finding the right balance in financial development also involves trade-offs that are often overlooked, much to the peril of policymakers. Too much credit and overly generous support for financial inclusion (even if well-meaning) have led to financial bubbles and crises. Likewise, too much financial sector repression to achieve stability has generated financial exclusion and inefficiencies with negative consequences for economic opportunities and growth.

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David Gould, Martin Michael Melecky