Arnaud Mehl and Adalbert Winkler The finance-growth nexus and financial sector environment: new evidence from Southeast Europe Arnaud Mehl and Adalbert Winkler Directorate General International and European Relations European Central Bank Dubrovnik, 27 June 2003

Scope and motivations of the paper Give evidence on the finance-growth relation since the early 1990s in Southeast Europe (SEE): - Bulgaria, Romania + Moldova - Albania, Bosnia & Herzegovina, Croatia, FYR Macedonia, Serbia & Montenegro Motivations: - Few empirical studies on finance-growth nexus in transition - SEE countries under-researched (=/= CEE countries) - Substantial change in financial sector environment - Countries moving closer to the EU, with some implications on banking reform 24/11/2018

=> Real start now of financial development? Main results No evidence of growth-supportive effects of financial depth in SEE since the early 1990s Contrasts with conventional wisdom on finance-growth nexus Interpretation: reflection of banking sectors’ poor environment in the largest part of the last decade Financial sector environment has improved in recent years => Real start now of financial development? 24/11/2018

The finance-growth nexus in the literature: brief overview Positive (and causal) relation between finance and (future) growth Standard econometric specification: Real GDP per capita growth = Control variables + Financial depth indicator Finance’s contribution to growth is through productivity improvement 24/11/2018

Applying the standard empirical framework to SEE Specific challenges to transition economies: 1 - The standard set of controls may not apply 2 - Short time series 3 - Instability in earlier years of transition & war Modelling framework: 1 - Data for the 8 SEE countries over 1993-2001 2 - Financial depth: monetisation & intermediation 3 - Controls: inflation & private sector to GDP 24/11/2018

Empirical evidence Financial depth is not significantly correlated with real GDP per capita growth in SEE Results insensitive to: 1 - Endogeneity (IV estimation) 2 - Initial conditions (country fixed-effects) 3 - Set of control variables 4 - Robust estimation 5 - War dummy 24/11/2018

A conceptual framework to interpret the evidence Financial development: quantity and quality FINANCIAL DEPTH Shallow Deep Socialist financial system Non-developed financial sector Poor Financial sector prone to inflation and crises ENVIRONMENT QUALITY Stable financial sector but not actively growth-supportive Developed and growth supportive financial sector Good 24/11/2018

Applying this framework to SEE countries’ experience (1) Up to the late 1990s - Deep financial sector, poor environment: 1 - Insufficient restructuring of state-owned banks and poor governance 2 - Lax regulation on licensing new private banks and connected lending 3 - Lack of human capital and credit technology 4 - Inadequate banking supervision 5 - Poor institutional and legal environment 24/11/2018

Applying this framework to SEE countries’ experience (2) The crises years - Shallower financial sector, persistently poor environment: 1 - Outbreak of financial crises 2 - Shrinking of financial depth 3 - Output losses 24/11/2018

Applying this framework to SEE countries’ experience (3) The late 1990s - Improved environment: 1 - Hardening of budget constraints 2 - Tightening of banking supervision and regulation 3 - Banking sector consolidation and opening to foreign investors 24/11/2018

Today, financial sectors in SEE are liquid... 24/11/2018

…but intermediation, crucial to growth, remains overall low... 24/11/2018

…due to a number of factors: Cautious lending behaviour Characteristics of non-financial private sector Time required to adjust to the new environment Room for improvement in the legal framework Short maturity of deposits and potential of currency mismatch High demand for liquid and risk-free assets 24/11/2018

although, in some countries, credit has recently been more dynamic 24/11/2018

Conclusion (1): Interpreting SEE countries’ experience FINANCIAL DEPTH Shallow Deep Socialist financial system Non-developed financial sector Poor Financial sector prone to inflation and crises ENVIRONMENT QUALITY Stable financial sector but not actively growth-supportive Developed and growth supportive financial sector ? Good 24/11/2018

Conclusion (2): implications No growth-effects of finance due to financial sectors’ specific evolution However in some countries financial development may have started Address bottlenecks to financial intermediation in most countries Monitor rapid credit growth in some countries 24/11/2018