Financial sector development - Sida

• the poor state of the financial system in target countries. It will take considerable time
to develop new financial institutions which are capable of satisfying the demand for
capital resources from the public and private sectors
• the ”crowding out” effects of the public sector are still impeding the necessary growth of
the private sector in the majority of Sweden’s recipient countries (without foreign capital
inflows these effects would last longer)
• the difficulties in attracting substantial amounts of foreign private capital (official
development finance may however be used in innovative and catalytic ways in order to
speed up the increase of these flows)
• the short supply of indigenous risk capital in target countries. This makes it difficult for
domestic entrepreneurs to develop viable and sustainable financial institutions
As to the magnitudes of capital needed in the future it may be mentioned that annual
private investments in developing countries in 1995 amounted to about USD 700 billion,
which in turn correspond to about 18 per cent of GDP (World Bank 1997). Even if a major
portion of the future capital requirements would be supplied from domestic sources and
one third would come from foreign private sources, there is considerable scope for official
development finance - particularly in the least developed countries.
The justifications for using aid funds for financial assistance in favour of commercially
oriented financial institutions may be grouped as follows:
Market failures, i.e. the institutions are not able to attract funds, be it equity funds or credit
lines for on-lending, in the market. The main reasons include overall shortage of capital
willing to take medium or long-term risks, and the lack of track record from banking
operations etc.
Pluralism and competition. Support to a financial institution may be used as a measure to
promote competition in a monopolistic or oligopolistic type of market.
Demonstration and experimentation. Financial assistance (often in combination with
technical assistance) may be undertaken in order to promote the introduction of new types
of financial services, sometimes implying the establishment of new institutions (which
been successfully tried in other countries or regions) and sometimes for the development
of new financial instruments and products.
Catalytic effects in the capitalisation of financial institutions. Donor contributions,
particularly in relation to equity investments, may have important effects in the
capitalisation of recipient institutions. As the equity capital forms the basis for the firm’s
lending capacity, such investments may be particularly important for mobilising financial
resources. Capital ratio requirements are also often part of the regulating framework. It
could therefore be argued that the multiplier effect of equity investments is generally larger
than that of loans. A capital investment without a repayment obligation on the part of the
recipient or without any particular collateral serves as an indication that the investor has
confidence in the recipient institution and its capacity to conduct its business in a manner
acceptable to the investor. This may create confidence with other investors, lenders and
business partners.
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