Journal of International Development

J. Int. Dev. 14, 389–391 (2002)

BOOK REVIEWS

Financial Integration and Development: Liberalization and Reform in sub-Saharan Africa

by MACHIKO NISSANKE and ERNEST ARYEETEY. (London and New York:

Routledge, 1998, Routledge Studies in Development Economics, pp. xivþ 330, £65 h/bk).

This study reports the results of a major research project undertaken by the authors in collaborationwith the Overseas Development Institute, the World Bank, the School of Oriental and AfricanStudies and researchers associated with the African Economic Research Consortium. The mainobjective of the project was ‘to explain the limited effects of financial reform so far undertaken insub-Saharan Africa’. The findings are based on fieldwork undertaken in four countries: Ghana,Malawi, Nigeria and Tanzania.

While liberalization and institutional reform have been part of African governments’ policyagendas since the 1980s, the authors acknowledge that this does not appear to have affected the keyperformance indicators: economic growth rates, savings rates, private investment rates or financialdeepening. The need to explain why this has not happened is not surprising given the orthodox viewthat financial liberalization is a necessary condition for economic growth. The authors rightly takeissue with the financial repression school on empirical grounds and follow the more sophisticatedStiglitz–Weiss school. This emphasizes information costs and asymmetries which generate marketfailure in the financial sector and therefore require some limited financial repression. The authorsdraw attention to the instability effects of rapid financial liberalization, especially in Asia, and rightlystress the importance of developing an institutional framework which can support full financialmarket liberalization.

An important focal point of the authors’ enquiry is the fragmentation of financial markets not onlyinto formal, semi-formal and informal sub-sectors, but also across the sub-sectors. Financialliberalization ought to result in the increasing integration of previously fragmented sectors as theysupply and compete for funds in the same liberalized market. Increasing competition for funds atliberalized interest rates should lead to an increase in the channelling of small saver funds into theformal sector, either through existing informal financial institutions, or directly via formalmediation. Focusing on financial integration as the key issue allows the authors to investigateexisting links between fragmented sectors and the bottlenecks impeding greater links. This allowsthem to identify possible policies which might remove barriers to increasing the effectiveness offinancial reforms.

What do the authors find? First, that there has effectively been a ‘post-liberalization credit-crunch’. An inadequate information base makes formal lenders highly risk-averse in the newclimate. Given their inheritance of non-performing loans resulting from previous credit-rationingpolicies, this inability to manage risk results in a high-level of liquidity. Finance to the risky privatesector is replaced by finance to the government sector which offers high-yielding securities.Meanwhile, the study reports that the informal financial sector is growing because real economygrowth has been in the small scale private sector which is only able to borrow informally. Soironically, financial liberalization has led to both increased financing of the government sector andgrowth of the informal financial sector because of the high degree of fragmentation. The structuralcharacteristics of the formal and informal institutions support this process. The formal lenders regardinformal agents and small-scale borrowers as too risky and too costly and unreliable in terms ofgaining information and the quality of the information gained. Informal lenders are converselyeffective at getting information about their clients because of their local knowledge.

The authors emphasize the institutional constraints limiting the financial sector. The constraintsinclude problems of contract enforcement resulting from a poor legal framework and a lack ofregulatory and supervisory agencies and mechanisms. These increase risks to both lending

Copyright # 2002 John Wiley & Sons, Ltd.

institutions and agents who save with these institutions. The analysis of the institutional character-istics of both formal and informal sectors once again shows the lack of any linkages between the two.One interesting linkage absence entails the failure of formal lenders to use informal lenders’knowledge of clients thereby integrating informal lenders into the formal system. Even whereinformal lenders deposit funds in non-interest bearing accounts, these are short-term deposits forsafekeeping and consequently banks do not lend these funds on for investment because of theirgenerally risk-averse behaviour and conservative policy on reserve deposit ratios. Market segmenta-tion also results in gaps in provision which the authors suggest match the gaps in economic structureexemplified by the undersized small and medium scale industrial and service sector.

In identifying policy solutions to market fragmentation the authors distinguish between theimportance of overall macroeconomic policies which create stability, and policies which directlyaffect the financial sector, especially creating an adequate regulatory and supervisory framework andbuilding institutions for financial deepening. The authors favour a gradualist approach towardsexchange rate and interest rate liberalization coupled with institution building especially in the areaof regulation and supervision. They favour the development of more flexible banking institutionsrather than relying on the development of capital markets to provide investment funds. Theyemphasize the importance of developing systems of risk-sharing across institutions and borrowers toencourage the socialisation of loans, drawing on developed country and south-east Asian experience.

In advocating an improved regulatory framework, the authors are careful to distinguish betweenformal and informal sector regulation. Over-regulation of the informal sector either formalizes it ordrives it underground. Encouraging informal agents increasingly to integrate with the formal sectorwill require a lighter regulatory framework for the former. The authors propose a layered approach toregistration and regulation in which size of operations and degree of integration with the formalsector determines the extent of regulation and supervision. There is a clear recognition here that theadvantages of the informal sector may be lost if it is over-regulated, and there may be strongarguments for promoting self-regulation as a transitional regulatory form. There are several sensibleproposals for increasing linkages between informal agents and formal institutions. These includesetting competitive deposit rates to encourage longer term informal agent deposits with banks andenabling banks to lend on to smaller borrowers through informal lenders, with the pooling ofinformation helping to reduce problems of asymmetry.

This is a very well researched and rich book that provides considerable insights into the workingof financial markets and the constraints on their development. It not only provides an excellent set ofcase-study surveys, but derives an extremely sensible and thoughtful set of policies towardsgenerating effective financial reforms and practice. The study is well immersed in the realities ofthe African economies it covers and avoids the wishful thinking embodied in much of the neo-classical orthodoxy. It is to be hoped that the sub-Saharan African economies can sustain sufficientpolitical and economic stability for the policy proposals set out here to have a chance of working.

PETER LAWRENCEDepartment of Economics

Keele University, UKPublished online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/jid.855

Southeast Asia into the Twenty First Century: Crisis and Beyond edited by ABDUL

RAHMAN EMBONG and JURGEN RUDOLPH (Penerbit UKM, Malaysia: 2000,

pp. 231, RM25.00).

This book consists of ten chapters on the causes and consequences of the Asian crisis of 1997. Amajor contribution of the book is that it puts explicit focus on non-economic aspects of the Asiancrisis, such as political leadership, corporate ownership and control—or so-called ‘Asian values’.Acknowledging a unique response of the Malaysian economy to the crisis, the book devotes twochapters to Malaysia, shedding light on the importance of political leadership in restoring confidenceamong economic agents after the crisis. Another merit of the book is that it extends discussionsbeyond the ‘five crisis economies’ as commonly cited (Thailand, Indonesia, South Korea, thePhilippines and Malaysia) to the transitional economies of Vietnam, Laos, Burma and Cambodia.

390 Book Reviews

Copyright # 2002 John Wiley & Sons, Ltd. J. Int. Dev. 14, 389–391 (2002)