Progress in Emerging Markets is Being Put at Risk

Erik Berglöf and Raghuram Rajan

Finance ministers of the Group of Eight leading economies have commissioned a study on the role of financial market speculation in recent oil price rises. In India, the regulator recently suspended trade in futures markets for several commodities, blaming speculators for price rises. The global credit crisis has made the financial sector vulnerable to populist attacks. The greatest casualty may be financial development.

In developed countries there is a sober search under way for appropriate regulatory and supervisory responses to the lessons learnt from the crisis. But in poorer countries politicians are unwilling to leave regulation to the regulators. The problems in the financial sector in the US allow populists in emerging markets not just to retread their critiques of financial markets but also to hold free enterprise and trade guilty by association.

These critics have a point, although it is misdirected. The world is still struggling to understand how to regulate sophisticated financial systems, but it has learnt more about how to manage less sophisticated ones. As a result, the achievements of emerging market financial systems over the past decade have been impressive. Since the Asian and Russian crises, financial regulation and supervision, as well as corporate governance and transparency, have all improved. Governments have made tremendous advances in managing their finances, while central banks have charted more independent policy. These advances help explain why we have not so far seen more collateral damage in emerging markets.

Indeed, the correct response in emerging markets to the global crisis should be to accelerate reforms that strengthen the financial and regulatory infrastructure, while taking care to avoid, as far as possible, the misaligned incentives that lie at the root of the crisis. Instead, important reforms are being reversed. In India, politically motivated mass loan waivers, which ruined credit culture in the past, are reappearing. A recent European Bank for Reconstruction and Development/World Bank survey showed deep distrust of many market institutions, including banks, and widespread nostalgia for the debilitating instruments of central planning in many countries of the former Soviet Union.

Many of the actions against the financial sector are proposed in the name of the poor, even though the true beneficiaries are the politicians themselves. Ironically, in much of the world the financial sector is at last reaching out to the poor, as improvements in technology and the growth in legal infrastructure promise new solutions to age-old problems. In Africa, banks and cell phone companies are drawing ever larger parts of the population into the payment system. Financial innovations such as crop insurance and micro-finance are promoting the diffusion of new seeds and fertilisers, and futures markets are facilitating hedging and price discovery. In India, a new law promises to aid the growth of grain warehouses and electronic warehouse receipts that will allow a farmer to store his harvest, and obtain finance against it, until he is ready to sell. It will probably do more for agricultural credit than years of state intervention.

In the industrialised economies of central and eastern Europe, which started their transformation into market economies essentially without financial systems, it took almost a decade for fragile banks truly to extend credit beyond the government, large companies and rich individuals. But now well-capitalised institutions, often backed by foreign parents, actively support restructuring of privatised enterprises, extend loans to risky small entrepreneurs and finance the mortgages of people wanting to buy their own homes. As a result of better financial access, in the Baltic states people trust their banks even more than their political and legal institutions.


All this progress may be at risk, especially if the global financial squeeze is longer and deeper than expected. Financial access will contract and with it the support for institutions and markets. Emerging markets will re-enact battles for their economic soul that we thought had been decided. It is important that industrial countries’ governments do not fan the flames of antimarket sentiment by choosing the present time to reconsider their position on trade and capital flows. For the experience of previous crises suggests that the veneer of market institutions is thinner than we think.