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AN efficient and vibrant financial system contributes much to economic development. It mobilizes savings and allocates them to investments by private entrepreneurs. It also screens borrowers, manages risks, and operates the payment and settlement systems. And it ensures that dynamic parts of the economy are well funded. Getting financial systems in low-income countries from where they are to where they should be will not be easy, because financial reforms are among the most difficult to formulate and implement.

Financial reforms must begin by stopping the hemorrhaging of state enterprises that lies at the root of the fiscal deficit and the problems of the banking system. State enterprises account for a good part of the assets of public sector dominated banking systems in low-income countries, and many of these loans are nonperforming. Such loans are a major drain on the banking systems, which are unable to enforce financial discipline on either state enterprises or privileged borrowers. The state enterprises must be liquidated or privatized into a competitive environment. Only then can the banking system be improved. Similarly, a major effort has to be made to privatize the banks. Since this is likely to be difficult and time-consuming, it is best done in conjunction with promoting new entry—the diversification of institutions, mechanisms, and instruments is a prerequisite to competition and to lasting financial deepening. Also needed is a major effort to strengthen prudential regulation and supervision, enhance and multiply information flows, and strengthen accounting and auditing standards. This in turn requires training—to create the critical mass of human resources to strengthen the financial system.

India, Pakistan, and Sri Lanka are making good progress toward building solid financial systems. This has been spurred by the development of a vibrant private sector, the inflow of foreign direct investment, and expanded trade opportunities. And this has attracted new banks and nonbank financial institutions that compete with public sector banks and take market share away from them. Such developments underscore the importance of creating an environment that fosters the growth of strong and creditworthy borrowers—a precondition for a robust and competitive financial system.

Financial reforms must stop the hemorrhaging of state enterprises that lies at the root of the fiscal deficit and the problems of the banking system

Despite some progress, financial systems remain weak in Sub-Saharan Africa, Bangladesh, and economies in transition. Broad money as a percentage of GDP is often used as a measure of financial deepening. In Sub-Saharan Africa, broad money averages between 20 and 25 percent of GDP, compared with 40 percent in Pakistan, 60 percent in India, and 80 percent in China. Even in oil-rich Nigeria, it has been as low as 18 percent of GDP, and in Ghana, despite a decade of macroeconomic adjustment, 17 percent of GDP. These countries must accelerate difficult structural and institutional reforms in the financial sector if their private sectors are to develop.