Pathfinding Paper 5

Financial frictions, financial market development, and structural transformation – Joseph P. Kaboski 

Financial systems in poor countries differ from those found in rich countries. Poor countries exhibit low levels of financial development with lower levels of external finance relative to GDP. Within these lower levels of external finance, credit plays a disproportionate role and informal sources of credit are especially prevalent in developing countries. Outside equity plays a smaller role, as do formal security markets. Moreover, the availability of formal finance can exhibit sizable swings depending on flows of international capital.

The lives of firms also differ in important ways that relate to the financial system. Even in developing countries, firm size distributions tend to exhibit thick tails; larger firms are significant drivers of aggregate productivity, employment, and labour demand, and yet they appear to grow slower in developing countries. They have higher returns to capital, and entry into larger scale sectors may also be financially constrained. The extent to which larger firms are financially constrained is therefore important. At the same time, small, microentrepreneurs, particularly those of high ability, are also often financially constrained, and consequently also face high returns to investment. “Necessity entrepreneurs” are prevalent in developing countries and an important component of their high rates of entrepreneurship, however, 

With this background, this paper will first address the current state of the literature examining the nature of these financial markets, the micro frictions faced by firms, the mechanisms by which firms currently cope with them and how this these issues relate to economic growth and structural transformation. It will then consider the need for more comprehensive data in the area. Lastly, the paper will discuss the areas that need to be addressed moving forward including: the underlying characteristics that lead to financial underdevelopment; the use of theory to inform optimal policy guidance; the impact of credit subsidy programmes on aggregate growth and the income distribution; and the type of policies to best promote financial development in the presence of financial frictions.