Deepening Rural Financial Markets: Macroeconomic, Policy and Political Dimensions

Topic :

This paper examines key features of a macroeconomic environment, policy framework, and government and donor interventions conducive to rural financial deepening. The paper also explores typical difficulties, encountered in political arenas, in the adoption of the required macroeconomic and policy framework. In particular, the paper addresses specific consequences for rural financial market development of the programs for macroeconomic stabilization, structural adjustment, financial liberalization, and improvements in the framework of prudential regulation and supervision implemented by many developing countries in the past two decades.

To examine the nature of the challenges involved in deepening rural financial markets, the paper builds on recognized lessons from the failures of rural credit programs during the period of protectionism-financial repression (1950s-early 1980s) and from the shortcomings of the period of financial liberalization (1980s-2000s), and it identifies new types of tasks for both governments and donors as well as conditions for improved outcomes for all participants in rural financial markets. In addition, the paper considers entirely new types of challenges, resulting from greater instability in international financial markets and from contagion through exogenous systemic shocks, which have added complexity to processes of financial development, at large, and of rural financial deepening, in particular.

The paper incorporates a new vision about the role of the state in the promotion and regulation of financial markets. Price –interest rate– controls and administrative credit allocations are no longer favored. Direct production of financial services by the state has been seriously questioned. Instead, given an appropriate regulatory framework, competition is encouraged. A new critical role for the state is, indeed, acknowledged. There is a growing recognition that the establishment of a physical and institutional infrastructure that facilitates the smooth operation of financial markets is indispensable for rural financial deepening. Many components of this physical and institutional infrastructure contain elements of public goods and, without state intervention, they would be underprovided.

Beyond a conducive policy framework, the paper emphasizes the importance of innovations in financial technologies, in allowing a cost-effective expansion of the frontier of rural financial services. In addressing this question, the paper explores the challenges that governments and donors face in promoting alternative types of changes in financial production functions. On the one hand, these state efforts may be needed, in response to the potentially strong externalities that emerge in most processes of knowledge generation and human capital formation. On the other hand, these state efforts may be extremely problematic, in view of the difficulties of correctly anticipating the most cost-effective types of new knowledge.

In addition to the Introduction, the paper contains five sections. Section II identifies different motivations behind a growing interest in rural financial deepening and the threats that may result from an incorrect understanding of the role of finance. Section III acknowledges the emergence of new views, policy environments, and experiences in rural finance and derives lessons for the future. Section IV discusses changes in perspective about both the role of finance in rural development and the role of the state in promoting financial deepening. Section V identifies three gaps in the provision of rural financial services (inefficiency, insufficiency, and lack of feasibility gaps) and suggests different types of approaches to fill each one of these gaps. Section VI discusses in detail specific state interventions needed to promote the demand and the supply of financial services.

This is a demanding paper primarily suited to those who wish to gain a deep understanding of the complex issues involved in the development of rural financial markets. It should be essential reading for students and researchers engaged in the business of interpreting and communicating key information for policy-makers.

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