Economic Trends And Impacts: Banking Sector Lending Behaviour And Efficiency in Selected Escwa Member Countries

Distr. GENERAL 10 October 2005 EESC WA/EAD/2005/7 ORIGINAL: ENGLISH

ECONOMIC AND SOCIAL COMMISSION FOR WESTERN ASIA

ECONOMIC TRENDS AND IMPACTS BANKING SECTOR LENDING BEHAVIOUR AND EFFICIENCY IN SELECTED ESCWA MEMBER COUNTRIES ISSUE No. 3

United Nations New York, 2005

References have, wherever possible, been verified.

ISSN. 1727-5822 ISBN. 92-1-128293-4 UNITED NATIONS PUBLICATION Sales No. E.05.II.L. 16

Preface

The series "Economic Trends and Impacts" analyses macroeconomic and institutional developments in ESCWA member States that are major determinants of their overall economic and social performance. The main purpose of the series is to identify the major obstacles to a sustainable and equitable development process in the region. The studies in this series are based on comprehensive empirical analysis and include policy recommendations to enhance the capacity of policymakers to develop appropriate strategies and programmes. The study in issue No. 1 analysed the impact of different types of external macroeconomic shocks on the ESCWA region. A quantitative assessment was made of the magnitude and persistence of external shocks related to oil prices, inflation rates, world output and interest rates, and a framework for macroeconomic policy design was set up to reduce the transmission of these shocks to the ESCWA members' economies. Issue No. 2 examined recent banking and stock market trends in ESCWA member countries, with a special focus on Islamic banking. In addition, the study investigated the implications of the Basel I1 Capital Accord (introduced in January 2001 to replace the 1988 Basel Accord) for the banking system in the ESCWA member countries and presented policy recommendations for increasing the stability of the financial system. The study in the present issue No. 3 provides an in-depth analysis of financial sector development in selected ESCWA member countries over the past two decades. With the focus on the intermediation role of banks, the study identifies key problem areas in banking efficiency and in the allocation of capital funds in these countries. On the basis of the empirical findings, the study concludes with a set of policy recommendations for establishing a sound banking and financial system.

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CONTENTS Preface ................................................................................................................................................... Abbreviations and explanatory notes .................................................................................................... Executive summary ............................................................................................................................... Introduction ...........................................................................................................................................

Chapter I. FINANCIAL DEVELOPMENT ISSUES ............................................................................ A . Financial development and economic growth ................................................................... B . Financial development and poverty reduction .................................................................. C . Review of prior research on financial development in the Arab world ............................

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I1 STYLIZED FACTS FOR SELECTED ESCWA MEMBER COUNTRIES ....................

A . The financial sector and financial liberalization ...............................................................

B . Financial structure: banking versus capital market-based systems ................................... C. Measuring financial development: financial deepening and resource mobilization .........

D . The structure of the banking sector: ownership and concentration ................................... E . Bank credit: credit to the private . . versus public sector and allocation of credit according to economic activity .......................................................................................... F . Financial intermediation.................................................................................................... G. Possible factors affecting banking credit and resource mobilization ................................ I11. MEASURING BANKING SECTOR EFFICIENCY: STOCHASTIC FRONTIER ANALYSIS .......................................................................................................

A. B. C. D. E. F.

Why analyse banking sector efficiency? ........................................................................... Impact of financial liberalization on bank efficiency........................................................ Methodology and the model .............................................................................................. Data analysis and variables ............................................................................................... Empirical results ................................................................................................................ Determinants of the degree of inefficiency .......................................................................

IV. IMPACT OF PRIVATE CREDIT DEVELOPMENT ON ECONOMIC GROWTH: EMPIRICAL EVIDENCE ....................................................................................................

A Data and methodology....................................................................................................... B. Estimation results .............................................................................................................. V

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CONCLUSIONS AND POLICY RECOMMENDATIONS ..............................................

I. Country tables .......................................................................................................................... I1. Stochastic cost frontier model ..................................................................................................

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CONTENTS (continued)

Page LISTOF TABLES Total liabilitieslmarket capitalization in Egypt. Jordan. Lebanon. Oman and the United Arab Emirates ..................................................................................................... Financial depth indicators. 1980-2003........................................................................................ Concentration in the banking system in selected ESCWA member countries of total assets held by the largest three banks .......................................................................................... Concentration in the banking system in selected ESCWA member countries of total deposits held by the largest three banks ...................................................................................... Structure of the banking system in selected ESCWA member countries. 2003 ......................... Interest rate spreads in Egypt. Lebanon. Jordan. Oman and the Syrian Arab Republic. 2002 ............................................................................................................................................. Ratio of non-performing loans to total loans in Egypt. Jordan. Lebanon. Oman and the United Arab Emirates ..................................................................................................... Variables of the cost function ..................................................................................................... Total assets of selected ESCWA member countries ................................................................... Ratio of banks7total assets reported by Bankscope to total assets of the banking sector as reported by the International Monetary Fund ......................................................................... Descriptive statistics on banking systems of selected ESCWA member countries for 1996-2003.............................................................................................................................. Average cost inefficiency............................................................................................................ Description and definition of variables ....................................................................................... Tobit regression results ............................................................................................................... Description and definition of variables ....................................................................................... Correlation analysis..................................................................................................................... Fixed-effects estimation of the relation between financial development and economic growth .........................................................................................................................

LISTOF FIGURES I.A.

Financial structure. Egypt ...................................................................................................

I.B.

Financial structure. Jordan ..................................................................................................

I.C.

Financial structure. Lebanon ..............................................................................................

I.D.

Financial structure. Oman ...................................................................................................

I.E.

Financial structure. United Arab Emirates .........................................................................

I1. Ratio of money supply M2 to GDP in selected ESCWA member countries...................... I11. Ratio of total deposits to GDP in selected ESCWA member countries (1980-2003) ........

IV. Financial depth: ratio of M1 to M2 in selected ESCWA member countries (1980-2003) ........................................................................................................................

CONTENTS (continued) Page V . Ratio of private credit to GDP in selected ESCWA member countries (1980-2003) ........ V1. Ratio of private credit to total claims in selected ESCWA member countries (1980-2003) ........................................................................................................................ V11. Ratio of private credit to total deposits in selected ESCWA member countries (1980-2003) ........................................................................................................................ VI1I.A.

Distribution of bank credit by economic sector in Egypt ...................................................

V1II.B.

Distribution of bank credit by economic sector in Jordan ..................................................

V1II.C.

Distribution of bank credit by economic sector in Oman ...................................................

VII1.D.

Distribution of bank credit by economic sector in the United Arab Emirates ...................

IX . Deposits. private credit and public credit in Egypt. Jordan. Lebanon. Oman. the Syrian Arab Republic and the United Arab Emirates ................................................... X . Interest rate differential in selected ESCWA member countries. 1980-2003 .................... XI . Trend of average cost inefficiency over time ..................................................................... References .............................................................................................................................................

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ABBREVIATIONS AND EXPLANATORY NOTES

AD1A BLOM CEE CPI DEA DFID GCC GDP GMM HPAEs IFS IMF MDGs MENA NPL OECD ROA ROE SFA WTO

Abu Dhabi Investment Authority Banque du Liban et d'Outre Mer Central and Eastern European consumer price index data envelopment analysis Department for International Development (United Kingdom) Gulf Cooperation Council gross domestic product generalized method of moments high-performing Asian economies International Financial Statistics International Monetary Fund Millennium Development Goals Middle East and North Africa non-performing loan Organisation for Economic Cooperation and Development return on assets return on equity stochastic frontier analysis World Trade Organization

References to dollars ($) are to United States dollars, unless otherwise indicated.

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Executive summary

Bank loans are the most important source of financing for firms, particularly in countries where capital markets are not fully developed. In addition, by making loans accessible and facilitating transactions, the financial sector can play a crucial role in mitigating risk and vulnerability. Such financial services, when invested in income-generating activities, will also enhance the ability of households and individuals to gain access to basic social services such as education and health, thereby exerting a direct impact on poverty reduction. For these reasons, and also because of its important role in promoting the United Nations Millennium Development Goals (MDGs), financial development merits greater attention in many countries in the region. The present study seeks to answer three basic questions. First, did financial policy reforms lead to financial development in terms of size and activity? Secondly, to what extent has the financial sector policy reform resulted in more efficient banks in the Economic and Social Commission for Western Asia (ESCWA) region? Thirdly, are the development and efficiency of financial intermediaries key determinants of economic growth in the economies of the ESCWA members? All these questions are of obvious policy significance to the economies in the ESCWA region, where the financial sector, and the banking sector in particular, have a major role to play in fostering economic growth. Therefore, based on the empirical results, this study reviews some of the policy instruments that might be used to correct the deficiencies in financial intermediation, particularly with regard to widening the access to credit and other financial services, especially for the resource-poor. The study shows that banks dominate and are still the core of the financial system in the ESCWA region. Given that the banking sector is the main vehicle for executing the monetary policy decisions that affect overall economic activity and prices through market interest rates and liquidity, the building of an efficient and sound banking sector is critical to ensuring a healthy financial system in the region. The effectiveness with which a country's financial system transforms direct savings into productive activities has a significant impact on economic growth. The manner in which savings are channelled into productive activities is largely dependent on a country's financial institutions and their effectiveness, that is, on the financial structure. While this study shows an expansion in the financial system and a steady growth in private credit, the fact that the poor tend not to have access to banks and other formal financial institutions implies that aggregate credit expansion may not necessarily have benefited the poor in this region. In general, the poor often do not have access to a continuing and reliable source of funds, and thus are compelled to rely on the more risky and unstable informal sector. Their limited access to credit constrains their ability to increase their income and to contribute to economic growth. While in developed countries this problem is mitigated by the use of collateral and credit rating systems, in developing countries the result of the lack of collateral and the absence of credit agencies is that many potential borrowers, especially women, are denied access to credit. For this reason, as well as in cases in which private financial institutions shy away from lending because of profitability considerations, specialized State banks have a role to play. This policy recommendation is based on the fact that the externalities created by these banks, in terms of income generated because of their services, far outweigh any losses they may incur. Apparently because of this, State policy banks are still cited as a success factor in the pro-poor growth policy frameworks of a number of countries. The study also shows that much of the observed expansion of credit to the private sector has been used to finance current consumption spending instead of being invested to foster capital accumulation and to increase future consumption possibilities. As low investment rates constitute a major obstacle to economic development in the ESCWA region, Governments and Central Banks in the region should address the existing bias against bank lending for productive investment projects. Another important finding of this study is that banks in the ESCWA region, particularly in Egypt and Jordan, appear to have high concentration ratios and profitability, indicating a persistently low level of

competition. This non-competitive behaviour leads banks to perform above their minimum cost frontiers, which could possibly hinder financial intermediation. Several other factors are thought to have also affected banks' behaviour, either because they constitute indirect barriers to entry or because they have a tendency to reduce competition between banks. These factors include: the problem of non-performing loans; weak rules and regulations; and banks' reliance on government debt as a steady source of income, which appears to have limited competition between banks and put upward pressure on interest rates. However, given the level of banking inefficiency in the ESCWA region, the financial health of the banking sector by itself might not be enough to promote financial intermediation. Therefore, in order to promote financial intermediation, policymakers should give high priority to three important issues: the problem of the high costs of financial intermediation; the significant problem of non-performing loans; and the limited access to credit for the resource-poor. To solve these problems, the countries in the region need to develop information systems on borrower reliability; strengthen the enforcement of contracts; and improve access to credit and the availability of financial services for the poor, including those in remote and rural areas. In addition, the results of the correlation and panel data analysis imply that regulatory changes that support and facilitate the private monitoring of banks have a tendency to enhance bank performance, reduce non-performing loans and boost banking sector efficiency and stability. Finally, micro financing and obtaining property rights to land in urban areas can also help poor households to gain access to credit. As there is a marked gender bias in access to credit in the ESCWA region, these measures should specifically target women.

Introduction

Financial repression has destructive consequences for the depth and institutional strength of the banking system. With financial repression, financial depth becomes very shallow, particularly under the influence of negative real interest rates, the deficiency of commercially viable outlets for banks' funds and credit misappropriations directed by governments. Financial repression, particularly interest rate ceilings and rate of exchange controls, reduces economic growth.' However, it also reduces the cost of financing government deficit and, therefore, ending financial repression and liberalizing financial markets. Its use could result in extremely high real interest rates, which can be just as destructive. Consequently, a good and properly sequenced framework for the transition from financial repression to financial liberalization is of paramount importance .2 For nearly two decades now, the new model of economic development has been emphasizing the minimum role of the State and allowing free markets to play a bigger role in resource allocation. Fiscal policy, trade restrictions and financial repression are the most drastically transformed areas of policy-making as a result of the policy reforms implemented in nearly all developing countries, including countries in the ESCWA region. Several policy reforms of the financial sectors3 that were implemented throughout the 1980s in several countries in the ESCWA region involved financial liberalization and institutional reform. These policy reforms were carried out to ensure enhanced efficiency in the banking sector and a greater integration of this sector with the rest of the world. Financial liberalization in developing countries has resulted in significant changes in the financial sectors of these countries. In addition to the nationalization and the restrictions on private banks, the Governments of most ESCWA member countries, except Lebanon, predetermined lending targets to priority sectors and imposed low ceilings on interest rates on credit. Against this backdrop, while some countries of the region (except Lebanon, which always had a liberalized financial market) initiated financial liberalization programmes in the mid-1990s, others continued to accelerate the process of financial reforms that they had already started. Depending on the degree and the extent of financial development in each country, these financial liberalization programmes included liberalization of credit allocation and interest rates and tightening of rules and regulations aimed at prudential oversight. Furthermore, in order to create opportunities for portfolio diversification and offshore financing, Governments also opened capital accounts. Central Banks moved away from direct to indirect instruments of monetary policy, became more independent and focussed on lower rates of inflation. Moreover, in countries where the public sector was dominant, privatization of public banks and enterprises changed the way banks operated and the nature of bank clients. As a result, significant changes occurred in the financial systems of the countries in the ESCWA region during the 1980s and 1990s. In order to understand how these significant changes affected financial development, particularly the banking sector in the ESCWA region, this study examines what happened to banks' efficiency and resource mobilization and credit allocation in six countries (Egypt, Jordan, Lebanon, Oman, Syrian Arab Republic and United Arab Emirates) from 1980 to 2003, and presents some possible explanatory factors for these developments. In addition, based on empirical results, this study looks at some of the policy instruments that might be used to correct deficiencies in financial intermediation, particularly by widening access to credit for the resource-poor. It should be noted that there is no homogeneously established definition of financial development, and this is particularly true given the specificities of different countries. Another difficulty is the need for a

'

For empirical evidence of the negative impact of financial repression on economic growth, see N. Roubini and X. Sala-i-Martin, Financial Development, the Trade Regime and Economic Growth, NBER Working Paper No. 3876 (Cambridge, MA, National Bureau of Economic Research, 1991).

*

For a careful analysis of the speed and sequencing of financial reform, as well the question on how best to move from financial repression to a market-oriented financial system, see ESCWA, Development and Institutional Reform of Financial Markets: Issues and Policy Optionsfor the ESC WA Region (EIESCWA/EAD/2004/5), 1991 . The financial sector is made up of all the wholesale, retail, formal (from banks, stock exchanges and insurers to credit unions), semi-formal (microfinance institutions) and informal institutions (moneylenders) in an economy offering loans, deposits and other financial services to consumers, businesses, government and other financial institutions.

uniform measure to allow comparison for a cross-country study such as this one. However, there are many various aspects of a "developing" financial sector (DFID, 2004). For instance, a financial market is considered to be developing and maturing if the following criteria are present: (a) The range of institutions that operate in the financial sector is increasing; (b) The diversity of financial services that are accessible and the quantity of money that is intermediated throughout the financial sector are increasing at a good rate; (c) The capital distributed by private sector financial institutions to private sector enterprises, (rather than government-directed lending by State-owned banks) is increasing to a healthy degree; (d) The supervision, regulation and stability, as well as the efficiency and competitiveness, of the financial sector are improving; (e) An increasing proportion of the population is gaining access to credit and financial services. In this study, two major aspects for the measurement of financial development will be examined. One is financial depth, in terms of the size and activity of the financial system, and the other is its efficiency, in particular banking efficiency. Therefore, one of the goals of this study is to provide empirical evidence of the pattern of cost-efficiency level of the banking sectors, as well as determinants, in the selected countries in the ESCWA region. There are several factors that affect financial development. The first to be identified in the literature were economic factors, in particular macroeconomic policies, inflation and how wealthy countries are in terms of per capita gross domestic product (GDP). Recent literature has found that institutional factors, particularly the legal and regulatory system, play a major role in determining the degree of development of the financial system. However, this study will not focus on institutional and macroeconomic factors since they have already been extensively addressed in the literature. It will concentrate instead on those factors that are related to the financial system itself. These determinants include financial liberalization; financial structure: bank versus capital market financing; and the structure of the banking system: ownership and concentration. In this context, this study seeks to answer three very basic questions. First, did policy reform lead to financial development in terms of size and activity? Secondly, to what extent have the financial sector policy reforms resulted in more efficient banks in the ESCWA region? Thirdly, what is the impact of the development of financial systems on economic growth? All these questions are of obvious policy significance to the economies of the ESCWA region, a region in which the financial sector, especially the banking sector, has a great role to play in fostering economic growth. In general, the coexistence of three distinct ownership groups characterizes banking sectors in the ESCWA region, namely: public, domestic private, and foreign. In addition to banking sectors, financial systems in the ESCWA region also include insurance companies, finance houses, other banking institutions, and stock markets. However, the banking system is by far the largest component of the financial system in all the countries profiled in this study. Moreover, as this study shows, many of these financial institutions remain underdeveloped. Therefore, the answer to the question of how effective the financial sector reforms have been in addressing the consequences of the pre-reform financial policies, in particular whether financial liberalization has been successful in fostering the development of a more competitive, efficient and sound financial system, is of paramount importance for policy makers. The importance of the second question rests on the fact that the degree to which the banks in the region are operating close to optimum scale for minimizing costs will affect their capacity to cope with the imminent competition from larger foreign banks due to the globalization of financial markets. In addition, by influencing the interest rate spread, banking inefficiency will also affect the costs upon which the banking sector supplies its services to different economic sectors.

The assertion that the development and efficiency of financial intermediaries are key determinants of economic growth has been addressed in the literature. Research has revealed that countries with higher levels of financial development experience higher productivity and consequently higher GDP per capita growth rates. This work is based on the fact that financial intermediation entails costs caused by asymmetric information between managers of financial institutions and potential investors. This imperfection in financial markets causes higher intermediation costs and consequently reduces investment, which in turn hinders economic growth. A well-developed financial market can nonetheless help to overcome these asymmetries through information-gathering and by monitoring managers. Therefore, the third objective of this study is to examine whether this assertion holds true for countries in the ESCWA region. Viable financial institutions, particularly banks, are the keystone in creating a vibrant private sector and thus play a vital role in economic development. Their intermediation role is essential because they can perform transactions and facilitate savings mobilization. As a result of providing these services to an economy, banks can enhance resource allocation and accelerate economic growth. According to this view, economic growth results from capital accumulation; thus banks can influence economic growth primarily by increasing domestic saving rates and by attracting foreign capital inflows in a market economy. This is in fundamental contrast to an economy in which financial institutions are regulated and burdened with financial repression. Therefore, the task of developing a strong banking and financial sector should be first among other priorities if the performance of the economy and the private sector is to improve. In addition, bank loans are the most important source of financing for firms, particularly in countries where capital markets are not fully developed. If access to bank credit is constrained, then potentially profitable projects cannot be carried out and economic activity will suffer. Therefore, the ability of businesses to obtain financing is critical to their success. Moreover, there is a general consensus in recent research that financial development promotes economic growth and creates employment opportunities for the poor, thereby contributing to poverty alleviation. It is also widely recognized that growth is a necessary, although not always sufficient, condition for sustained poverty alleviation. Cross-country studies have revealed that while there are major differences in the relation between growth and poverty reduction across countries, incomes of the poor have a tendency to rise with average incomes. That means that, by facilitating transactions and making loans and other financial services accessible, the financial sector can play a crucial role in reducing risk and vulnerability. Such services will increase the ability of individuals and households to obtain access to basic social services such as education and health, which will have a more direct impact on poverty reduction. As this study demonstrates, there is much evidence to suggest that financial sector development is important for economic growth and poverty reduction and that, even if other conditions are satisfied, without the development of this sector, progress may be hindered. The study begins its analysis by showing that the financial markets in the ESCWA region are bankbased rather than capital market-based. This is demonstrated in a review of the average size (relative to GDP) of bank deposits, credit extended by banks to the private sector and to the public sector, and the allocation of credit to different sectors of the economy. The fact that the financial markets of the ESCWA member countries are bank-based rather than capital market-based will be examined in more detail below. These banking sectors differ widely, not only among themselves but from banking sectors in the developed countries, because of their past. In general, they are to a higher degree concentrated, State-owned (in certain countries), but also with some degree of foreign penetration. Nevertheless, a competitive banking system is necessary to ensure that banks are effective forces for financial intermediation, channelling savings in potential investment projects and thus fostering higher economic growth. This study assesses financial sector development in the ESCWA region, both in the banking system and in the capital markets. Chapter I provides an overview of the voluminous theoretical and empirical literature on the relation between financial sector development, growth and poverty reduction, with the intention of explaining and clarifLing these linkages and assessing the importance of financial sector

development. However, the study does not concentrate on the linkage between financial sector development and poverty reduction, owing to lack of data on poverty and income inequality. In chapter 11, stylized facts are used to assess financial development and the main factors involved. This chapter reviews briefly the financial sector reforms and policies and reforms implemented in six countries (Egypt, Jordan, Lebanon, Oman, Syrian Arab Republic and United Arab Emirates) and analyses their impact on financial development. This is followed by an analysis of the ownership structure of the banking sector and concentration ratios in each of the selected countries, as well as an overview of the main trends in the financial system over the period 1980-2003. Since the focus here is on the mobilization of savings and the allocation of these financial resources to the private sector, which plays the major role in the financial sector, the chapter analyses data on bank credit, in particular credit extended to the private versus the public sector, and the allocation of private credit according to economic activity. Given the importance and the central role of bank credit in private sector financing in the ESCWA region, the chapter concludes with an analysis of the determinants of supply and demand for bank credit. Such an analysis is important to understanding recent trends in private credit activity in the ESCWA region, and thus to proposing appropriate policies. Chapter I11 focuses on the efficiency of banks. One objective of the financial liberalization programme is to enhance the efficiency of banks through the creation of a flexible and competitive banking sector in which banks have more control over the utilization of their resources. Given that there is an inextricable link between financial sector development and economic growth, that bank intermediation is the essential provider of credit, and that a financial liberalization process is under way, the study employs a stochastic frontier analysis in this chapter to investigate whether the financial liberalization in these countries has succeeded in achieving the objective of improving the efficiency of commercial banks in the ESCWA region. More specifically, the relation between bank ownership, profitability and concentration and efficiency is examined during 1996-2003, which is a period subsequent to the adoption of financial liberalization measures in these countries. The second part of the chapter undertakes further analysis of banking sector inefficiency indicators by examining their potential determinants. Chapter IV examines, on the basis of empirical findings, whether the development and efficiency of financial intermediaries have an impact on economic growth in the ESCWA region. For this purpose, a fixed-effects panel data analysis is employed. In addition to the countries profiled in the preceding chapters of the study, this chapter includes Bahrain, Kuwait, Saudi Arabia and Yemen in the estimation sample. This addition helps to improve the statistical reliability of the results. In order to assess the impact of financial development on economic growth, the model controls for other possible growth determinants such as lagged GDP, human capital, trade openness and the size of the public sector. Chapter V summarizes the findings of the previous chapters and presents policy recommendations for increasing the efficiency of the banking system in the countries reviewed and for improving the allocation of capital funds.

I. FINANCIAL DEVELOPMENT ISSUES

This chapter is a select review of the considerable theoretical and empirical literature on the relation between financial sector development, growth and poverty reduction. The chapter clarifies the linkages between these factors and assesses the importance of financial sector development. It also examines the recent theoretical and empirical work on financial development and its impact on growth in the Middle East and North Africa (MENA) region, including the ESCWA member countries. A. FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH Over the past few decades, the relation between financial development and economic growth has received a great deal of attention in economic literature. Although significant theoretical and empirical studies substantially advanced understanding of the finance-growth nexus, they did not lead to a broad consensus on some of the major aspects of the role that financial markets play in the process of economic development. One of the ongoing debates centres on the direction of causality between finance and growth, posing the question of whether financial development is one of the main determinants of economic growth or merely follows economic development. A second key area of research pertains to the advantages and disadvantages of different types of financial systems (bank-based versus market-based) in the context of economic development, and the question of whether they should be considered complements or substitutes. This section summarizes the current state of knowledge on the finance-growth nexus by reviewing the most seminal theoretical and empirical contributions.' The review prepares the ground for the subsequent analysis of financial development in the ESCWA region. From a microeconomic perspective, the emergence of financial markets and institutions can be attributed to the existence of market frictions in the form of information and transaction costs. Financial intermediation plays a role in reducing the costs associated with the individual savings and investment decisions in an economy. Ultimately, financial systems are expected to contribute to a more efficient allocation of resources, which should positively affect economic growth. The recent theoretical finance literature has highlighted the channels through which financial systems ameliorate information and transaction costs. Levine (2004) distinguishes between five basic functions of financial systems. First, financial intermediation mobilizes and pools savings. It thereby not only fosters capital accumulation in the economy but also contributes to a better resource allocation as it allows exploiting economies of scale and overcoming investment indivisibilities (see for example Acemoglu and Zilibotti, 1997). Secondly, financial markets facilitate the trading, diversification and management of risk. As demonstrated, for example, by Greenwood and Jovanovic (1990) and Acemoglu and Zilibotti (1997), cross-sectional diversification of risk through financial markets induces a portfolio shift towards higher-return projects and thus promotes economic growth. Financial markets also reduce liquidity risk as they allow the transformation of liquid financial assets, which are preferred by savers, into long-term capital investments. Thirdly, financial intermediaries ameliorate information costs on investment opportunities and thus improve the allocation of capital. In the absence of financial intermediaries, individual investors would face very high information costs when trying to make the best use of the available capital. Hence, the average return on the projects that receive financing would be relatively low (see, for example, Greenwood and Jovanovic, 1990). Fourthly, financial intermediaries that function efficiently improve the monitoring of investment activities and enhance corporate governance. Effective monitoring and corporate governance increase the benefits from projects that accrue to owners (see, for example, Shleifer and Vishny, 1996). Owing to the existence of market frictions such as high transactions costs and information asymmetries, diffused shareholders may be prevented from exercising adequate control over the managers of firms. The problem of corporate governance can be ameliorated by smoothly functioning financial arrangements. Finally, financial systems ease the exchange of goods and services by lowering transaction costs. Greenwood and Smith (1997) developed a model wherein financial institutions reduce transaction costs, promote specialization and lead to productivity gains that translate into higher growth.

For a more comprehensive overview of the literature, see R. Levine, Finance and Growth: Theory and Evidence, NBER Working Paper 10766 (Cambridge, MA, National Bureau of Economic Research, 2004).

Financial development in a country can thus be characterized as an improvement in the way the country's financial system fulfils these basic functions. In general, the above mechanisms suggest that financial development should have a significant positive impact on economic growth as it fosters capital accumulation and leads to productivity gains thanks to a better allocation of resources. In the literature, this direction of causality is often referred to as the "supply-leading hypothesis". Through the expansion and sophistication of financial institutions, the amount and quality of the supply of financial services increases, and this in turn promotes economic growth. However, the view that financial development is a key determinant of economic growth has been challenged from different angles throughout the past few decades. First, it was pointed out that, from a theoretical perspective, improvements in resource allocation would not necessarily lead to higher economic growth (see, for example, King and Levine (1993). In fact, under certain conditions, higher returns on savings that result from financial sector development can reduce savings rates to such an extent that overall growth slows.' Similarly, if development of the financial sector lowers the liquidity constraints of individuals, the overall savings rate may decline, leading to weaker economic growth (Jappelli and Pagano, 1994). Secondly, a number of economists support the so-called "demand-following hypothesis" (see, for example, Ireland, 1994)! According to this hypothesis, causality between the two phenomena runs the other way, namely from economic growth to financial development: in the process of a growing economy, individuals demand more and better financial services, which then fosters financial development. In other words, financial development is seen as a mere by-product of growth in the real side of the economy, which is determined by other factors. Joan Robinson illustrated this point of view in the most concise way, claiming that "where enterprise leads, finance follow^".^ A third group of economic researchers, including Nobel Laureate Robert Lucas, deny a quantitatively important causal relation between financial development and economic growth. Instead, they regard them as largely independent phenomena. According to this view, financial development may help to predict economic growth as financial markets develop in anticipation of economic activity. However, finance is not regarded as a fundamental cause of economic growth. Finally, as highlighted by, among others, Greenwood and Smith (1997) and Harrison, Sussman, and Zeira (1999), causality between the two variables might run in both directions. That is, financial development and economic growth may mutually cause each other.' The problem of causality between financial development and economic growth has attracted a lot of attention in the recent empirical literature, particularly owing to its important policy implications. If there is convincing evidence that financial development has a significant impact on economic growth, policy makers should give high priority to all policies that affect the functioning of the financial system. If, in contrast, empirical work supports either the demand-following hypothesis or the hypothesis of rather independent phenomena, development policies should focus on areas that are expected to drive economic growth. In general, the finance literature cites Goldsmith (1969) as one of the pioneers of empirical research on the finance growth nexus (see, for example, De Gregorio and Guidotti, 1995; and Levine, 2004). Both Goldsmith (1969) and subsequent studies have documented a significant positive correlation between financial development and economic growth. However, it was not until the emergence of the endogenous growth theory in the early 1990s that economists attempted to shed light on the direction of causality. Since then, a large number of empirical studies have tried to assess the qualitative and quantitative impact of financial development on economic growth by using different types of econometric approaches and a variety of indicators to measure financial development. In a seminal study, King and Levine (1993b) analysed cross-

'

The overall impact of higher returns on the savings rate depends on the relative strength of the implied income and substitution effects that work in different directions. According to A. Darrat, "Are financial deepening and economic growth causally related? Another look at the evidence", International Economic Journal, vol. 13, No. 3, 1999, the terms "supply-leading hypothesis" and "demand-following hypothesis" were coined by Patrick in 1966. Cited in R. Levine, Finance and Growth: Theory and Evidence, p. 1. According to the so-called "stage of development hypothesis", supply-leading financial development is a key determinant of real economic growth in the early stages of development, whereas at later stages financial development mainly follows real growth.

country data for 77 countries over the period 1960-1989. They used three different indicators to measure financial development: the amount of liquid liabilities divided by GDP; credit to private enterprises divided by GDP; and the ratio of bank credit divided by bank credit plus Central Bank domestic assets. Controlling for other variables that affect long-run growth, King and Levine found a strong positive relation between each of the financial indicators and economic growth. While King and Levine also showed that the initial level of financial depth was a good predictor of subsequent rates of economic growth even after controlling for other growth-enhancing factors, they did not formally address the causality issue. Levine and Zervos (1998) extended the empirical analyses by including several measures of stock market development. They found that both the initial level of stock market liquidity (measured by the turnover ratio) and the initial level of banking development (measured by bank credit to the private sector as a share of GDP) were robustly correlated with future economic growth. The stock market size, (measured by market capitalization divided by GDP), in contrast, showed no significant correlation with growth. Again, the authors did not deal explicitly with the issue of causality. In order to fill this gap, Levine, Loayza, and Beck (2000) estimated a generalized method of moments (GMM) equation with panel data, using measures of legal origin as instrumental variables for financial development. Concerning the measurement of financial development, they introduced the new indicator "private credit", which is defined as the value of credits by financial intermediaries to the private sector divided by GDP. Financial intermediaries comprise both deposit money banks and other financial institutions. Levine, Loayza, and Beck (2000) found evidence of a strong link between financial development and economic growth. Their results indicated that the evolution of private credit had a particularly large impact on the growth performance in their sample. In a recent panel study that included both developed and developing countries, Rioja and Valev (2004) found a non-linear impact of financial development on growth: poor countries with very underdeveloped financial markets gained very little from small improvements in financial intermediation. For middle-income countries that had reached a certain threshold of financial development, the effect was much larger. In addition to cross-country and panel studies, a substantial amount of literature has employed time-series techniques to investigate the financegrowth relationship. Using basically Granger-type causality tests and vector autoregressive procedures, the majority of these studies provide support for the hypothesis that causality runs from financial development to growth (see, for example, Xu, 2000; and Christopoulos and Tsionas, 2004). Overall, recent empirical evidence from cross-country, panel and time-series studies suggests that financial development is an important determinant of economic growth. However, the impact may be nonlinear. This could be especially true in countries with very low institutional quality, where financial deepening may not translate into higher economic growth. In addition to assessing the relation between the level of financial development and economic growth, recent theoretical and empirical finance literature has addressed the question of whether the financial structure affects growth. A substantive body of research has examined the relative strengths and weaknesses of bank-based and market-based financial systems in the process of economic development. Proponents of bank-based systems generally emphasize the weaknesses of markets in providing the basic functions of financial intermediation. As pointed out by Stiglitz (1985), an inherent problem of (atomistic) markets is the incentive for free riding. In markets that function well, because individual investors can easily and quickly observe the information acquired by others, this reduces incentives to invest in obtaining information. As a result, the resource allocation and economic performance in a country are likely to be worse than in the case of a bank-based system, where information is privatized and therefore research incentives are larger. In addition, the recent literature on corporate governance has highlighted the problems of financial markets to monitor and control managers effectively (see, for example, Shleifer and Vishny, 1996). This may also have a negative impact on the economic performance in a country. Advocates of a market-based system, in contrast, claim that powerful banks are able to extract rents from firms. This reduces the efforts of firms to seek the most profitable investment opportunities (see, for example, Rajan, 1992). Furthermore, close ties between banks (bank managers) and firms may impede the functioning of corporate control mechanisms and may thus exert a negative impact on the overall resource allocation in an economy.g

For a more extensive review of the arguments for and against a bank-based financial system, see R. Levine, Finance and Growth: Theory and Evidence.

While the debate on the relative strengths of bank- and market-based systems has attracted a great deal of interest in the finance literature over the past few years, some believe that the financial structure is only of secondary importance to the economic development of a country. Advocates of this view claim that what ultimately matters for economic growth is the access of the economic agents to a smoothly functioning financial system, be it bank- or market-based (see, for example Merton and Bodie, 2004). According to another view, which is gaining ground, banks and markets should be regarded as complementary financial institutions in the process of economic development. Stock markets, for example, may not only facilitate risk management and provide additional liquidity, but may also alleviate the negative impact of very powerful banks on the allocation of resources in a country. Recent trends that involve promoting stock market development in a number of traditionally bank-dominated developing countries can be considered as efforts to make use of the complementary functions of the two systems. Until recently, empirical work on the financial structure concentrated mostly on the experiences of developed countries. Researchers mainly focused on Germany and Japan as examples of bank-based systems, and on the United States of America and the United Kingdom of Great Britain and Northern Ireland as cases of market-based systems (see, for example, Allen and Gale, 1995). However, several new studies such as that by Levine (2002) expanded the coverage to include a large number of both developed and developing countries in the analyses. While more evidence is required to determine the role of bank-based and market-based systems in the development process, most cross-country studies suggest that the financial structure does not have a firstorder impact on economic growth (see Levine 2002). After controlling for the overall level of financial development, information on the type of financial system does not contribute significantly to explaining cross-country growth differences. Using a dynamic panel data approach for 40 developed and developing countries, Beck and Levine (2004) showed that banks and stock markets independently have a positive impact on economic growth. This result supports the view that banks and stock markets provide different financial functions in an economy. In a study based on industry-level data for 36 countries, Tadesse (2001) found that the relative performance of bank-based vis-a-vis market-based systems varies between financially developed and financially underdeveloped economies. Among the group of countries with underdeveloped financial markets, industries from bank-based systems outperformed industries from market-based systems, whereas the opposite result was obtained in the countries with developed financial markets. An important policy implication is therefore that the financial structure of an economy has to be in line with the existing legal and institutional framework. In countries with weak institutions, a bank-based financial system is likely to provide better financial intermediation services than a market-based system. Under these conditions, policy efforts should therefore rather concentrate on first strengthening the banking system before fostering the development of capital markets.'' B. FINANCIAL DEVELOPMENT AND POVERTY REDUCTION Three specific channels through which the development of the financial sector might affect poverty are identified in the three subsections below. 1. The channel of expanded access of the poor to credit andfinancial services In the same manner that financial services boost overall growth (saving mobilization, risk management, and facilitation of transaction), increasing the supply of credit and other financial services that can be accessed by the poor and the previously rnarginalized will enhance the income growth of the poor and consequently reduce poverty (Jalilian and Kirkpatrick, 200 1). Advocates of financial liberalization assert that it leads to financial deepening and improved access to credit for previously excluded savers and borrowers. The supply of credit for a given level of deposits 'O With regard to financial liberalization sequencing, see ESCWA, Development and Institutional Reform of Financial Markets: Issues and Policy Optionsfor the ESCWA Region.

increases owing to reduction in reserves requirements. A rise in the interest rates that typically follows financial liberalization increases savings, thus resulting in more loanable funds being available to the previously disadvantaged. Moreover, banks tend to extend more credit to traditionally marginalized segments of the population as a result of increased competition owing to removal of barriers to entry. Diagne and others (2000) and DFID (2004) identified the following channels through which access to credit affects household welfare outcomes. The availability of credit and saving facilities can allow the poor to build up funds in a safe place over time to facilitate the financing of larger future expenditure or investment. In addition, this accumulation of funds allows for the growth of assets and reserves that can be used to maintain levels of consumption during episodes of unexpected fluctuations in income. Savings mobilization also generates an opportunity for re-lending back the money into the community. The new and expanded access to credit not only can reinforce productive assets of the poor through investment in new technologies that enhance productivity but also can lead to expansion of small businesses. Diagne and Zeller (2001) discussed how access to credit could affect agricultural households. They argue that while returns on crops are received after the crops are harvested, the periods of crop planting and vegetative growth entail expenditure on food and non-food items. Therefore, access to credit will not only allow poor farm households with no savings to purchase essential consumer items and production inputs, but will also reduce the opportunity costs of capital-intensive assets, thus encouraging the adoption of labour-saving, higheryielding technologies and increasing labour, productivity and land yield. The availability of credit can diminish the susceptibility of the poor to shocks when savings are nonexistent and therefore increase their risk-bearing ability and alter their risk-coping strategies. According to Eswaran and Kotwal (1990), the mere knowledge that credit will be accessible to smooth consumption against income shocks if a potentially profitable yet risky investment should end up badly, can make the household more willing to take on more risky investment projects or technologies. Such behaviour will intensify the utilization of productivity-enhancing new technologies. Moreover, wider access to financial services and credit is more likely to reduce the proportion of low-return and low-risk assets (such as jewellery) used by the poor as a way to store valuables, and allow them to invest in higher risk, yet higher return, assets that will lead to income enhancement (DFID 2004). Nevertheless, the poor in developing countries frequently do not gain continuing and reliable direct access to formal sources of financial services, and are compelled to depend as an alternative on a limited choice of typically intermittent, shorter in duration, and more costly informal services." This limits the aptitude of poor people to participate fully in markets and consequently constrains their ability to contribute to economic growth.12Beck and others (2004) claim that the poor mainly depend on informal or family relations for capital, so that improvements in the formal financial sector mainly help only the rich. This view is also shared by Arestis and Caner (2004), who state that "financial liberalization that expands the formal sector at the detriment of the informal sector, can hurt the poor in a big way in view of the fact that the poor operate mainly in the informal sector" (Arestis and Caner, 2004, p. 18). However, the model developed by Greenwood and Jovanovich (1990) predicts that only at the early stages of economic development, when only the rich can afford to access and profit from financial markets, is it the case that financial development intensifies income inequality. At later higher stages of development, an increasing proportion of the population joins the financial coalition. Aghion and Bolton (1997) developed a model of growth and income inequalities in the presence of asymmetrical information. They show that moral hazard with no collateral to

"

One of the many definitions of formal and informal financial markets included in a 1996 study in which the literature on formal and informal intermediation was surveyed is the following: financial markets are defined as formal when they are under the control of and subject to the regulation of a central monetary authority and of related financial laws. Therefore, financial markets are defined as informal when they operate outside such control. The major informal financial markets comprise friends and relatives, moneylenders, trade credit and pawnbrokers and pawnshops. (See H. Schrader, Informal Finance and Intermediation, Working Paper No. 252 (University of Bielefeld, Faculty of Sociology, 1996.) l2 M. Zeller and M. Sharma showed in a 1998 study that the poor in Egypt acquire a smaller share of their loans from the formal sector than the non-poor and that while formal financial institutions have a relatively dense coverage, the informal sector's role remains significant in Egypt. (See M. Zeller and M. Sharma, Rural Finance and Poverty Alleviation, Food Policy Report (International Food Policy Research Institute, 1998.)

access bank credit on the part of the borrower is the main source of the emergence of persistent income inequalities. Therefore, financial sector development that eliminates transactions and information costs will allow poor and middle-class borrowers to obtain more bank credit, thus improving the production efficiency of the economy. The reasons why the poor in developing countries have little access to credit and other financial services are summarized in Holden and Prokopenko (2001). First, macroeconomic instability and the deficiencies in regulation and supervision of financial institutions might lead to lower demand for deposit facilities. In addition, the supply of these facilities may be insufficient owing to high fixed costs and low economies of scale associated with opening bank branches in remote rural areas. The second reason may be a consequence of the regulation and supervision of financial institutions. While, on the one hand, in some countries exceptionally liberal licensing policies might lead to a large number of weak financial institutions, on the other hand, very restrictive policies may reduce competition. The third reason is difficulty in credit risk management. In addition, DFID (2004) highlights the problems caused by imperfect information (moral hazard and adverse selection). This problem in developed countries is somewhat alleviated through the use of credit assessment mechanisms, and the use of collateral. However, in developing countries, potential borrowers are incapable of presenting viable collateral. Therefore, the informal sector, through the use of social collateral, can overcome some of these problems. Matin and others (1999) pointed out other reasons, such as the high transaction costs faced by small borrowers, patronage, arbitrariness and corrupt practices. This failure of the formal financial sector in serving the poor has given rise to innovations that led to the development of micro financing. However, while micro financing institutions play a role in providing financial services to the poor, they cannot mobilize funds on a large scale in the same way that formal financial institutions can." Empirical evidence on whether financial liberalization influences the demand for credit by the poor or not is rather limited." Beck and others (2004) found that financial development reduces poverty by easing credit constraints on the poor, and reduces income inequality. Zeller and Sharma (1998) summarized research in a number of African and Asian countries and found that improved access to credit can increase household income, improve food security and make possible the adoption of equipment and machinery that were otherwise not viable. Chigumira and Masiyandima's (2003) results indicate that financial liberalization in Zimbabwe may have led to an increase in savings but has not benefited the poor in terms of increased access to credit, as much of the increase in credit was channelled to the already established borrowers. They attribute this to the unstable macroeconomic environment, which resulted in high lending rates and the low internal rates of returns for the intended projects. Another study on the impact of financial liberalization on the demand for credit and loan repayment was conducted by Amonoo and others (2003). The study concludes that in Ghana the rise in the interest rates that followed financial sector liberalization had a negative impact on demand for private credit as well as on loan repayment. Atieno (2001) concludes that improving terms and conditions of commercial banks in favour of small-scale enterprises would significantly facilitate the accessibility of small-scale enterprises to credit. 2. The economic growth channel The existence and strength of the association between financial development and poverty hinges on the existence and strength of the associations between (a) financial development and growth; and (b) growth and poverty. The first link, financial development and growth, was reviewed in section A above, and 13

For more on the reasons on why subsidized agricultural credits have seldom benefited the poorer farmers among poorer people, see I. Matin, D. Hulme and S. Rutherford, Financial Services for the Poor and Poorest: Deepening Understanding to Improve Provision (Institute for Development Policy, University of Manchester, 1999). Their review of the literature shows that, in addition to the above-mentioned reasons, they include the urban-biased credit allocation and high default rates, which prevented these interventions from becoming financially viable. 14

For a good analysis of how to measure the extent of household access to credit, see A. Diagne, M. Zeller and M. Sharma, Empirical Measurements of Households' Access to Credit and Credit Constraints in Developing Countries: Methodological Issues and Evidence, IFPRI FCND DP No. 90 (International Food Policy Research Institute, 2000).

included many reasons why financial sector development can have a positive impact on economic growth. The second link, growth and poverty, is reviewed below. Klasen (2003), in his summary of studies on linkages between poverty, inequality and economic growth, identified two venues wherein economic growth can benefit the poor (pro-poor growth). The first direct way is when economic growth favours the sectors and regions where the poor live (rural areas) and uses the factors of production they possess (labour and sometimes land). The second, or indirect, way, works through "public redistributive policies, i.e. taxes, transfers and other government spending" (Klasen, 2003, P. 8)Using cross-country analysis for a sample of 80 countries covering four decades, Dollar and Kraay (2000) and Kraay (2004) showed that the incomes of the poor tend to rise proportionally with average per capita income. According to Dollar and Kraay, the policy implication of their findings is that growth is not all that is needed to improve the lives of the poor. "What we do learn is that growth generally does benefit the poor and that anyone who cares about the poor should favour the growth-enhancing policies of good rule of law, fiscal discipline, and openness to international trade" (Dollar and Kraay (2000), p. 27). Besley and Burgess (2003) reviewed the relation of economic growth and income distribution to poverty reduction. They concluded that in order to cut poverty by half by 2015, developing countries need a GDP per capita growth rate of 3.8 per cent, which is more than twice the 1.6 per cent average growth rate achieved from 1960 to 1990.15In addition, Besley and Burgess calculated that a decline in the Gini coefficient of inequality by one standard deviation would cut poverty in developing countries by 67 per cent and by 45 per cent in the MENA region. l6 While this represents evidence of how financial development can affect poverty in an indirect way, Jalilian and Kirkpatrick (2001) attempted to examine the link between financial development and poverty reduction through the growth channel in a direct way. They tested the relation using panel data for 26 countries, including 18 developing countries and 8 developed countries. Their measures of financial sector development were bank deposit money assets and net foreign assets. Their results imply that a 1 per cent change in financial development increases growth in the incomes of the poor in developing countries by approximately 0.4 per cent. Clarke, Xu and Zou (2002) empirically examined the link between financial sector development and the level of income inequality using data from 9 1 countries between 1960 and 1995. Their findings provided evidence that there is a negative relation between financial sector development (measured by credit to the private sector by financial intermediaries, and claims on the non-financial domestic sector by banks as their measures of financial sector development) and income inequality. That is, financial sector development lowers inequality in a way that "a 1 per cent increase in private credit reduces inequality by 0.3 per cent". (Clarke, Xu and Zou, 2002, p. 14). Honohan (2004) found that private credit to GDP is empirically associated with lower poverty ratios. The estimated coefficient suggests that a 10-percentage point change in the ratio of private credit to GDP should reduce poverty ratios by 2.5 to 3 percentage points. While Clarke, Xu and Zou (2002) and Honohan (2004) studied the impact of financial development on the level of inequality and on the level of poverty respectively, Beck, Demirgug-Kunt and Levine (2004) tested whether there is a link between financial sector development and changes in income inequality and changes in poverty. Using data on 52 developing and developed countries over the period 1960 to 1999, they found that the income of the poorest quintile of the population grew faster than average GDP per capita in countries with higher financial sector development and that income inequality fell more rapidly. l 5 It is interesting to note that T. Besley and R. Burgess found that the historical rate of economic growth of 4.3 per cent for the Middle East and North Africa for the period 1960 to 1990 exceeded the rate of 3.8 per cent needed to halve the poverty rate by 2015. (See T. Besfey and R. Burgess, Halving Global Poverty (London School of Economics, 2003).

MENA countries included in the 2003 study by Besley and Burgess on Halving Global Poverty included Algeria, Egypt, Islamic Republic of Iran, Jordan, Morocco, Tunisia and Yemen.

Several studies have found proof of the significant relationship between financial development and child labour and educational attainments. Poor families with high levels of income volatility could expand their sources of income by permitting their children to work instead of going to school. Since financial services and access to private credit can assist families in adapting to unanticipated changes in income in other ways, financial sector development works to diminish the incidence of child labour and improve school attendance. Jacoby and Skoufias (1997) found that households in Indian villages without access to credit had a greater propensity to cut their children's schooling than those households with greater access to credit. Dehejia and Gatti (2002) showed that in countries with underdeveloped financial markets, child labour rates were higher than in those with financial markets that functioned well. Using panel data from Tanzania, Beegle and others (2003) showed that transitory income shocks led to increased child labour and that access to credit mitigated the effects of those shocks. That is, access to credit acts as a substitute for child labour. 3. Thefinancial crises channel Many economists agree that financial liberalization has produced unsatisfactory outcomes and has failed to meet the desired expectations.17In a number of countries where financial markets were liberalized too early owing to the failure to recognize their imperfect characteristics and the failure to adopt the proper sequencing of financial sector reforms in the overall reform programme, financial liberalization has led to financial crises.18 It is probable that such crises affect the poor more severely. Arestis and Glickman (2002) suggested that risks to economic growth originating from an unstable financial sector are intensified in open liberalized developing economies when financial liberalization is an important factor in this process. They proposed some restrictions on capital flows to limit their potential adverse impact. In addition, based on the experience of the High Performing Asian Economies (HPAEs), they argued that a policy of moderate financial repression at positive interest rates (to raise aggregate demand) is another indispensable measure to protect against financial instability in developing countries. These policies would be more effective if accompanied by increased Central Bank supervision of bank balance sheets. Arestis and Caner (2004) reviewed the different ways in which financial liberalization can lead to financial crises. They argued that, in the presence of moral hazard and adverse selection in capital markets, especially when there is no restriction on capital flows, banks tend to lend vigorously, which leads to overborrowing and overinvestment. Consequently, savings decline and the current account deficit grows quickly. If the outcome of the reform turns out to be less favourable than anticipated, uncertainty about investment returns increases and firms may have trouble repaying loans, thus putting the banking system in serious trouble. Kaminsky and Schmukler (2003) provided evidence of the increased likelihood of eventually being hit by financial crises after liberalization. They composed a chronology of financial liberalization in 28 mature and emerging economies since 1973. Their results indicated that, in the short run, financial reform is followed by more pronounced boom-bust cycles. Baldacci and others (2002) identified several channels through which financial crises affect poverty and income distribution. First, crises usually lead to a fall in earnings due to job losses and a decline in demand. Secondly, crises lead to changes in prices, which have some effect on income distribution. For example, the decline in the prices of non-tradables caused by currency depreciation will lead to a fall in the earnings of those who work in that sector, especially if they are net consumers of tradables. Thirdly, a crisis that is followed by a contractionary fiscal policy might lead to cuts in social programmes, resulting in limited access of the poor to some essential social services at a time when their earnings are falling. Based on Mexican macro and micro level data, Baldacci and others (2002) showed an increase in poverty due to a financial crisis. "Along with the increase in the incidence of poverty, the poverty gap widened, leading to an increase in the depth of poverty". As the overall income distribution shifted to the -

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For a good review of the literature on financial liberalization and banking crises, see M. Brownbridge and C. Kirkpatrick, Financial Regulation in Developing Countries, Working Paper No. 12 (University of Manchester, Institute for Development Policy and Management, 2000). l7

Most notably in East Asia during the 1980s and 1990s.

left, owing to the decline in average real consumption resulting from the crisis, the poorest 10 percent of the poor became poorer" (Baldacci and others, 2002, p. 35). Another channel through which crises may affect the poor more is the labour-hoarding channel. Agtnor (2002) argued that unskilled workers are frequently the first to lose their jobs as firms hoard their skilled and trained workers following a crisis. This is connected to the high cost of training and hiring and firing skilled labour.

C. REVIEWOF PRIOR RESEARCH ON FINANCIAL DEVELOPMENT IN THE ARABWORLD While theoretical and empirical research on the finance-growth nexus has expanded rapidly over the past decade, relatively little work has been done on financial development and its impact on growth in the MENA region. One of the major reasons for the lack of comprehensive research is that most of the Arab countries did not introduce financial sector reforms until the 1990s, much later than many East Asian and Latin American countries. Until then, financial systems in most MENA countries were heavily regulated and dominated by the public sector, which severely hampered an efficient allocation of resource^.'^ However, over the past decade, the majority of Arab countries have gradually moved towards more liberalized financial systems. This has stimulated interest in the macroeconomic effects of the liberalization process, and several authors have recently examined financial sector development in MENA countries as well as its relationship to economic growth. Although empirical evidence is still scarce, the results of these studies highlight some important features of financial sector development in the MENA region. As demonstrated by Nashashibi, ElHage and Fedelino (2001), Eltony (2003), and Creane and others (2004), the MENA region in general experienced significant improvements in various aspects of the financial intermediation process over the past two decades. Using a broad range of indicators to measure financial development, these studies showed that most Arab countries had made considerable progress in reforming their financial sectors. However, as all of these studies relied on descriptive analyses of available financial data, they did not establish a causal link between the financial liberalization reforms of the 1990s and the observed improvements in the different measures of financial development. Nashashibi, ElHage and Fedelino (2001) and Eltony (2003) focussed on standard measures of financial development that included interest rate spreads, monetary and credit aggregates, and market capitalization. Creane and others (2004) broadened the concept of financial development by also taking into account institutional capacity, financial openness, regulation and supervision, and the degree of competition in the financial sector. Based on a comparison with other world regions, the latter study indicated that the MENA region has major shortcomings concerning institutional quality and non-bank financial development, whereas it performs relatively well in financial openness, and in regulation and supervision. All three of the above-mentioned studies stressed the unbalanced nature of financial development within the region. While some MENA countries, including Egypt, Jordan, Morocco, and the GCC countries are quite advanced, others such as Algeria, Tunisia and the Syrian Arab Republic are still in the early stages of financial development. A number of recent studies, including Darrat (1999), Boulila and Trabelsi (2004), Achy (2003), and Ben Naceur and Ghazouani (2003) empirically investigated the relationship between financial sector development and economic growth for different samples of MENA countries. In general, these studies did not find clear evidence for the hypothesis that financial development has been an important determinant of growth in this region. Darrat (1999) used a time-series approach to explore the causality issue between financial deepening and economic growth in Turkey, Saudi Arabia, and the United Arab Emirates. His financial depth measures included the ratio of currency to M1 and the ratio of M2 to GDP. Overall, Darrat (1999) reported weak support for the hypothesis that financial deepening promotes growth. However, the strength of his results not only varied considerably between the three countries but also depended on the indicator used to measure financial depth. Boulila and Trabelsi (2004) applied different time-series techniques to analyse the finance-growth nexus in a sample of 16 MENA countries. They used three different indicators to measure financial development: M3 (liquid liabilities) divided by GDP; credit to the private P

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--

-

p P -

- -

See the next chapter for a review of the financial liberalization process in some of the MENA countries.

13

sector divided by GDP; and the difference between M3 and M1 divided by GDP. In general, Boulila and Trabelsi (2004) did not find any evidence that financial development had had a positive impact on economic growth in the region. Their results rather suggested that causality runs from growth to financial development. For some countries, the authors reported a bi-directional causality. Achy (2003) used panel data from Egypt, Jordan, Morocco, Tunisia, and Turkey to examine the impact of financial development on private savings, investment and growth in the MENA region. Focusing on the contribution of commercial banks in financial intermediation, he used four different indicators of financial depth in his econometric analysis: (a) total liquid liabilities of financial intermediaries as a share of GDP; (b) deposit money bank assets as a share of total assets; (c) private credit by deposit money banks as a share of total domestic credit; and (d) private credit by deposit money banks as a share of GDP. In order to capture the role of financial liberalization, Achy (2003) also constructed an index including information on various dimensions of the financial liberalization process, such as reduction of reserve requirements, interest rate liberalization and pro-competition policies. The basic findings of Achy's panel data analysis can be summarized as follows. When controlling for other possible determinants of private savings and investment, financial depth and financial liberalization tended to have a negative impact on both variables in the five MENA countries. In the estimated growth equations, the coefficients on the financial depth indicators and on the financial liberalization index were insignificant. This suggests that financial development does not contribute to explaining the growth experience in these countries. Ben Naceur and Ghazouani (2003) used a dynamic panel model to investigate the relationship between stock markets, banks and growth in 10 MENA countries. While the authors measured bank development only by bank credit to the private sector, they used three different indicators to assess stock market development: market capitalization divided by GDP; value of trades of shares on national stock markets divided by market capitalization; and value of trades of domestic stocks divided by GDP. In general, Ben Naceur and Ghazouani (2003) found no relationship between financial development and economic growth for their sample. In the case of stock markets, they attributed this result to the fact that capital markets in the MENA region are still underdeveloped and have not yet reached a threshold that will allow them to stimulate economic growth. As for the banking sector, the authors explained their finding by the dominance of the public sector in credit allocation. Overall, recent empirical evidence on the MENA region suggests that the improvements in financial development over the last decade have not yet had a positive impact on economic growth.20

20 Possible explanations for the missing link between financial development and economic growth in this region are presented in the context of the empirical analysis in chapter IV of this study.

11. STYLIZED FACTS FOR SELECTED ESCWA MEMBER COUNTRIES Section A below briefly describes the financial reforms implemented in selected ESCWA member countries during the past few decades, and assesses the current state of freedom in the financial sector. A. THEFINANCIAL SECTOR AND FINANCIAL LIBERALIZATION 1. Egypt Overall, Egypt's experience in liberalizing its financial sector has been successful despite some imbalances in the past few years. In contrast to many other developing countries, liberalization in Egypt was not followed by a major financial crisis. The apparent success of Egyptian financial reforms can mainly be attributed to the fact that the implementation process was performed gradually and cautiously, taking into consideration existing market deficiencies (Arestis, 2003). A review of the history of liberalization in Egypt reveals that a comprehensive liberalization process did not start before the 1980s. In fact, during the 1960s, the entire banking system was nationalized, including foreign bank branches. The institutions were placed under the ownership of four banks: the National Bank of Egypt; Banque Misr; Banque du Caire; and the Bank of Alexandria. During the 1970s, governors adopted the so-called "Open Door Policy", which started, to a certain extent, the liberalization of the economy and was aimed at attracting inflows of foreign capital. The leading role of the Government was partially replaced by the private sector, and Central Bank policy indirectly helped to increase private savings and released more funds for the private sector. New financial institutions such as joint venture banks, foreign bank branches, offshore institutions and others were established during this decade (Eltony, 2003). More recent financial reforms were gradually adopted in the 1980s, but intense implementation of liberalizing reforms was not carried out until after 1990. During the 1980s, policymakers attempted to improve the process of financial intermediation; nevertheless, during that period, State-owned banks continued to dominate the financial sector. The Government was still imposing interest rate ceilings as well as high ratios of required reserves. However, the 1990s witnessed a strong move towards liberalization. Since the early years of that decade, Egypt has intensified its efforts to implement economic and financial reforms in the context of structural adjustment programmes, which were to a certain extent in accordance with the prescriptions of the International Monetary Fund (IMF) and the World Bank. The first five years of the decade were characterized by a restructuring of the banking and financial sector as well as capital markets, reductions in the fiscal deficit and monetary restraints, an introduction of various financial liberalization measures and a major restructuring of the capital and foreign exchange markets. Exchange rate controls were abolished, which encouraged capital flows. In 1992, interest rate ceilings were removed for the private and public sectors and lending limits to the private and public sectors were eliminated. Treasury bill issues were introduced on a weekly-auction basis in an attempt to initiate a market for these financial assets for which interest rates are determined by the forces of supply and demand. The financial liberalization process continued during the second half of the 1990s. This period was characterized by price and trade liberalization as well as by increased efforts of privatization and deregulation. In addition, new laws encouraged foreign bank entry, and public sector companies were permitted to deal with all banks without prior permission from a public sector bank. The cautious approach adopted by the Egyptian authorities allowed the financial liberalization process to be successfully introduced in the country without inducing major crises (Al-Mashat, 2001). However, in recent years Egypt has suffered from some instability in the foreign exchange market. After abandoning the peg to the United States dollar in mid-2000, the Egyptian pound depreciated significantly, causing problems for companies that tried to obtain foreign currency for doing business. Although the long-term effects of pound depreciation are expected to be positive for the Egyptian economy, some significant short-term adjustment costs are likely to have hindered the pace of economic growth and liberalization.

2. Jordan During the 1970s and 1980s, the Government of Jordan was extensively involved in regulating banking sector activity, which led to an imbalance in financial markets and in the economic structure of the country. The Government was also extensively involved in regulating banking, but not in ownership. Bank loans were highly restricted, creating a movement towards informal activities, and market entry and interest rates were heavily regulated. In 1989, the country suffered from a banking crisis, known as the "Petra Bank Crisis", after a merger between Petra Bank and Jordan Gulf Bank. During the crisis, widespread speculation on the Jordanian dinar and the United States dollar pushed the monetary market to the edge of collapse (Maghyereh, 2004). The liberalization process in the financial sector started in the early 1990s, when the Jordanian authorities took several steps in response to the IMF and World Bank economic adjustment programme. In 1993, restrictions on interest rates were removed, Government direct lending was reduced, product deregulation was expanded, and restrictions on foreign transactions decreased. In 1997, further liberalization was implemented, including: further deregulation of interest rates; greater autonomy given to bank management; higher capital adequacy requirements; further liberalization of foreign exchange transactions; and allowing a higher degree of foreign investment. Credit controls were largely removed; however, preferential credit facilities remain for agriculture, handicrafts and exports. Several empirical studies found that the liberalization reforms implemented in Jordan were followed by higher degrees of efficiency and better management (Lee, 2002). 3. Lebanon Lebanon has been a liberal financial centre since the 1960s, with interest rates market-determined, the Central Bank operating independently, and an absence of credit controls. However, despite the relative development of the banking system, interest rate spreads remain at high levels, around 5-7 per cent (see annex 1, table A.5) and required reserve ratios are also relatively high when compared with the other countries in the region (Nashashibi and others, 2001). For instance, the required reserve ratio is 25 per cent for current deposits, 15 per cent for time and saving deposits, and 15 per cent for foreign currency deposits, while the reserve ratio for all types of deposits in Jordan is 8 per cent. While the Lebanese banking system is generally classified as liberal, the Economist Intelligence Unit reports that more than 60 per cent of bank credit goes to the Government owing to the high level of debt accumulated in the past decade. This leads to a crowding out of private sector loans. The Lebanese banking sector is also characterized by an elevated number of domestic banks. Foreign representation is important and takes either the form of a foreign bank maintaining branches in Lebanon (10 banks) or equity stakes in several local banks. According to the United States Department of Commerce, "the banking system is sound and enjoys a high capital adequacy ratio of about 19 per cent, more than double the ratio as set by Base1 1 (eight per cent)" (cited by the Heritage Foundation). 4. Syrian Arab Republic The Syrian Arab Republic's financial activity is highly limited, as many forms of financial repression exist in the country's market. First, the Government owns the major banks in the Syrian Arab Republic, and most banks lend only to the public sector. The few banks that lend to the private sector give higher priority to the Government and make it very difficult for private companies to obtain loans. Secondly, interest rates have been fixed for many years without reference to inflation or liquidity conditions. The different State banks fix different rates for different categories of borrowers. Thirdly, the country still lacks investment banks and private insurance companies (Heritage Foundation, 2005). However, over the past few years, the Syrian Arab Republic has started to initiate a cautious liberalization process. In 2003, the Syrian Cabinet gave licences to several foreign banks, among them Banque du Liban et d'Outre Mer (BLOM), Banque EuropCenne pour le Moyen-Orient (BEMO), and Audi and Byblos Banks. In January 2004, the affiliate of Lebanon's BLOM Bank opened its doors for business in the Syrian Arab Republic. It was the first private bank to operate in the country since the early 1960s. However, the development of private banking in the Syrian Arab Republic will be hindered by the monetary policy restrictions (such as restrictions on free movement of capital), the weak regulatory framework, United States sanctions in the context of the so-called

Syrian Accountability Act, and the Government set exchange rate as well as the limited investment opportunities. In June 2005, the Syrian Government passed a law that opened the insurance sector to foreign companies. This new law is primarily aimed at reorganizing and modernizing the insurance industry. 5. Oman Oman has done a considerable amount of work on strengthening and transforming its financial system into a modern and liberalized one. The banking sector consists of commercial banks, specialized banks and other financial intermediaries. The banking system is dominated by three local banks, which have a market share of around 70 per cent (Creane and others, 2004). Restrictions imposed by the Central Bank on personal loans are being gradually abolished. In 1999, the Central Bank of Oman limited private banks' personal loans to 30 per cent of their loan books with the aim of reducing the concentration of the banks' credit risk to the personal credit sector. However, in August 2000, the Central Bank of Oman increased the personal loans ceiling to 35 per cent, and in December 2001 it further enhanced the limit to 40 per cent (Heritage Foundation).

6 . United Arab Emirates In the United Arab Emirates, the developed banking sector consists of 41 commercial banks, of which 25 are foreign, as well as several other specialized banking institutions such as investment and Islamic banks. Commercial banks are not allowed to participate in non-banking activities and cannot lend more than 7 per cent of their capital to a single foreign institution or invest more than 25 per cent of bank funds in commercial bonds or shares. The Central Bank operates to a large extent independently, and interest rates are fully liberalized. Credit controls are removed, but a limit of 30 per cent of total loans is imposed on personal loans (Creane and others, 2004). The Government largely backs the major projects of the country. This has increased the participation of international investment banks because they are associated with a lower risk of default. The country has no corporate income tax, but there is a 20 per cent tax on foreign bank profits. In order to obtain membership in the World Trade Organization (WTO), the United Arab Emirates was supposed to eliminate any kind of restriction on new foreign bank entry to the country by 2003. However, the country could not meet the deadline and postponed it to 2005 (Heritage Foundation).

B. FINANCIALSTRUCTURE: BANKING VERSUS CAPITAL MARKET-BASED SYSTEMS The effectiveness with which a country's financial system transforms direct savings into productive activities has a significant impact on economic growth. The manner in which savings are channelled into productive activities hinges significantly on a country's financial institutions and their effectiveness, that is, on the financial ~ t r u c t u r e The . ~ ~ description of the changes in policies involving the financial sector in the ESCWA region over the period 1980-2003 implies that the financial structure in these countries changed significantly over that period. Following the criteria proposed by DemirgupKunt and Levine (1999), the present section examines the financial structure, simply defined as the relative importance of bank versus market-based institutions in selected countries in the ESCWA region. The relative size of banks, bonds and capital markets is assessed, as well as how they evolved over the period 1990-2003. Economic theory assigns a specific role to banks in monitoring corporate activities. Economies of scale in monitoring cause banks to be more efficient monitors than individual market participants. Alternatively, as Carlin and Mayer (1999) note, the advantage of securities markets is their role in aggregating diverse views of a large number of market participants. The superiority of securities markets 21 R. Stulz defines financial structure as "the institutions, financial technology, and rules of the game that define how financial activity is organized at a point in time". (See R. Stultz, Does Financial Structure Matter for Economic Growth? A Corporate Finance Perspective Reese Chair of Banking and Monetary Economics, Ohio State University, and National Bureau of Economic Research, 2000, p. 5).

thus lies in their ability to promote investments when there are legitimate grounds for differences of opinion. However, securities markets are inefficient when good investment decisions require the costly accumulation of available information on, for instance, the performance and quality of borrowers. The old debate as to whether capital market financing or bank financing is better for economic growth appears to have reached consensus, as shown by recent emerging research.22 As noted in chapter I, the evidence shows that the choice between a capital-based and a bank-based structure is not vital for financial development; what is vital are the institutional factors behind the financial structure, in particular the legal setting as well as the degree of efficiency of the structure selected.23 There is mounting evidence that most successful cases of financial development have fairly balaneed mixtures of capital markets and bank financing, given that they have a tendency to function as complements rather than substitute^.^^ That is, there is no relationship between a country's degree of economic development and its financial structure since the same function of a financial system can be performed by different institutions and according to different rules (Stulz 2000). However, financial structure can advance or hold back financial development. The fact that policies can have a direct effect on the financial structure and an indirect effect on financial development implies that policymakers can legislate changes in the financial structure but they cannot legislate changes in the degree of financial development of a country. As highlighted in ESCWA (2004), financial sectors in most ESCWA member countries are commonly characterized by the dominance of the banking sector and the relative underdevelopment of capital markets and non-bank financial institutions. Stock markets of the ESCWA members had collective listings of 734 companies as of July 2003 and combined market capitalization of US$ 255 billion, which accounts for approximately 0.6 per cent of the world's total stock market capitalization (ESCWA 2003). The relative role of bank loans, stocks and bonds in providing external financing for the private sector differs among the ESCWA member countries profiled, as shown in figures 1.A-E below. The figures show the evolution of the overall financial system in the ESCWA region from 1990 to 2003, depending on the availability of data. For all the countries, the financial system (banking sector, stock market and bond market) as a percentage of GDP is growing, mostly in terms of the share of bank assets. The relative importance of the different players in the financial system began to matter after 1990, when the relative sizes of the banking sector, the stock market and the bond market grew at notably different speeds, with the stock market taking off rapidly in Egypt and Oman, and the bond market taking off rapidly in Lebanon.

22 For more on this debate, see A. Demirguc-Kunt and R. Levine, Bank-based and Market-based Financial Systems: Crosscountry Comparisons (Washington, D.C., World Bank, 1999).

23 For the role of legal systems and institutions in explaining differences in financial development, see T. Beck and R. Levine, Legal Institutions and Financial Development, World Bank Policy Research Working Paper 3 136 (Washington, D.C., 2003). 24 One study found no correlation between the ratio of banks' assets to equity market capitalization plus bonds outstanding and GNP per capita for 34 countries, implying that banks and capital markets are complements rather than substitutes in promoting economic development. (See J. R. Barth, D. E. Nolle, H. L. Root and G. Yago, Choosing the Right Financial System for Growth (Milken Institute, 2000)).

Figure I.A. Financial structure, Egypt

Figure I.B. Financial structure, Jordan

Figure I.C. Financial structure, Lebanon

Figure I.D. Financial structure, Oman

Figure I.E. Financial structure, United Arab Emirates

Source: Data on market capitalization and bonds are taken from the World Development Indicators (WDI). Data on assets and GDP are taken from the International Financial Statistics (IFS), several issues. In the case of Lebanon and the United Arab Emirates, data on GDP are taken from the ESCWA National Accounts Studies of the ESCWA Region.

To find out how the financial systems have changed in the sample countries, it is important to look at the relative size of banks in comparison with stock markets. Specifically, the study uses the ratio of bank liabilities (banks and non-banks) to stock market capitalization. A decrease in this ratio implies that the stock market has gained importance relative to banking institutions. According to the available data (see table l), the ratio classifies the financial systems of Egypt, Jordan, and Oman as having a relatively balanced structure, while it classifies those of the United Arab Emirates, and particularly Lebanon, as less balanced.25 The high ratios for these countries are primarily the result of relatively small and underdeveloped stock markets, and not because their banks are very well developed. The dominance of banking institutions in the region results mainly from the proliferation of family-owned enterprises in the private sector and their historical dependence on bank financing. Their reluctance to adopt equity financing has hindered the growth of regional capital markets. Another interesting observation is the decline in the ratio in Egypt. While this result is in line with the reviewed literature on the relation between the degree of development of capital markets and economic development, it is difficult to determine the direction of causality. TABLE1. TOTALLIABILITIES/MARKET CAPITALIZATION IN EGYPT,JORDAN, LEBANON, OMANAND THE UNITEDARABEMIRATES (Total liabilities and market capitalization in billions of US dollars) Egypt 30.2 14.8 8.1 4.0 3.9 4.0 3.4

1990 1992 1995 1997 200 1 2002 2003

Jordan 2.7 2.5 2.3 2.2 2.8 2.7

Lebanon

Oman

44.1 10.0 37.2 35.8 38.5

3.7 2.5 1.1 3.1 2.6 2.2

United Arab Emirates

9.6

Sources: World Development Indicators (WDI) for market capitalization and International Financial Statistics, International Monetary Fund for Total Liabilities. Notes: Total liabilities in Egypt and Jordan include total liabilities of deposit money banks and other banking institutions. Owing to lack of data on other banking institutions, the remaining countries only include total liabilities of deposit money banks. Market capitalization refers to the companies listed on the national stock exchange.

25

For the year 2002 this ratio was 0.9 in Chile, 3.4 in the Republic of Korea, and 3.6 in Poland.

The data clearly indicate that banks are the dominant intermediaries in the ESCWA member countries profiled. While non-bank intermediaries and capital markets have developed in several ESCWA member countries, the banking sector is still the pillar of financial intermediation in the entire ESCWA region. FINANCIAL DEVELOPMENT: FINANCIAL DEEPENING C. MEASURING AND RESOURCE MOBILIZATION

One of the most important issues in assessing financial development is how to obtain a satisfactory measure of financial development. The literature frequently delineates financial development as the improvement in quality, quantity and efficiency of financial intermediary services. This procedure entails the combination of many activities and institutions. Because the degree of financial deepening is more difficult to quantify and it cannot be captured by a particular measure, this study has utilized various frequently used measures of financial development. To measure the monetary effects of financial liberalization, three yearly indicators are used: two different monetary aggregates and the ratio of total deposits to GDP, as a quality measure of financial development. Monetary aggregates provide a set of variables that are used to measure the degree of financial development (see, for example, De Gregoriol and Guidotti, 1995; and Lynch, 1996). In the literature, the most frequently used measure of financial development is a ratio of some broad measure of money stock, to the level of nominal income (King and Levine, 1993a,b; Arestis and Demetriades, 1997). This straightforward indicator measures the degree of monetization in the economy. The monetization variable is intended to illustrate the real size of the financial sector of a growing economy in which money provides valuable saving and payment services. Narrow money balances should rise in proportion to economic transactions, while broad money should rise at a faster rate if financial deepening is taking place (Lynch, 1996). The measures of financial development used in this study address the stock-flow problem of financial intermediary balance sheets items being measured at the end of the year, while nominal GDP is measured over the year. To circumvent any inconsistency when employing a ratio of a stock and a flow variable, a number of authors have attempted to deal with this problem by calculating the average of the financial development measures in year t and t-l and dividing by GDP in year t (King and Levine 1993a). Nonetheless, this does not solve the distortion brought on by inflationary environments. Levine et al. (2000) propose deflating end-of-year financial measures by end-of-year consumer price indices (CPIe). Next, this study calculates the average of the real financial balance sheet items in year t and t-l and divides them by nominal GDP in year t deflated by the average C P I ~ . ~ ~ All variables are expressed in national currencies and were obtained from the International Financial Statistics (IFS) and statistics of Central Banks of the countries profiled. The data set used consists of yearly observations spanning the period 1980-2002, but some years are dropped because of lack of data in some countries. 1. Monetary aggregate M2 The most frequently used conventional proxy to measure the degree of financial intermediation is the ratio of a less liquid monetary asset, normally M2 or M3, to the level of nominal G D P . ~Because ~ of the rising trend in financial innovation in the various financial systems, a broader measure of money stock (M3) should be employed in order to capture the extent and the degree of financial intermediation in the ESCWA region. However, none of the countries in this study publish data on M3. Therefore, the first proxy of the degree of financial deepening is the ratio of the stock of broad money (M2) to GDP. 26 A financial measure is computed using the formula 0.5 * [Measure,/CPIe,+Measurettl/CPIettl J / GDP/CPIat; where CPIe is the end of the year consumer price index, CPIa is the average consumer price index of the year, and GDP is the gross domestic product. 27 For instance, some who propose the use of a less liquid monetary aggregate (M2 or M3lGDP) as an indicator of financial development, include J. De Gregorio and P.E. Guidotti in "Financial development and economic growth, World Development, March 1995.

This indicator, suggested by Kar and Pentecost (2000) and used, for example, by Darrat (1999), Nashashibi and others (2001), and King and Levine (1993a,b), measures the size of the financial market. Throughout the process of development, the ratio M2lGDP has a tendency to rise as access to banking and alternative instruments of store of value (investment and savings) spread. Therefore, an increase in this variable signifies a larger financial sector and therefore an expansion in the financial intermediary sector relative to the rest of the economy. However, as markets mature, the ratio M2lGDP tends to decline as other financial instruments not included in M2 are developed and become increasingly available. Figure I1 illustrates the evolution of this aggregate over the years 1980-2003 for a group of ESCWA member countries: Egypt, Jordan, Lebanon, Oman, United Arab Emirates and Syrian Arab Republic. While the ratio (M2lGDP) rose in Egypt, Jordan, Lebanon and Syrian Arab Republic, the increase in this ratio was limited in Oman and the United Arab Emirates (figure 11). In 2002, that ratio in Lebanon was close to 209.6 per cent (annex I, table AS)?' An excessively high ratio of M2 indicates that financing relies too heavily on the banking system in the course of economic development and thus the risk concentration is higher than desired. The ratio of M2 to GDP has grown fastest in Egypt and Jordan, but from a relatively low initial level in 1981.

Sources: IMF, International Financial Statistics, several issues. Data on GDP in Lebanon and the United Arab Emirates and data on CPI in Lebanon, the United Arab Emirates and Oman are taken from the ESCWA National Accounts Studies of the ESCWA Region. Notes:

The figure presents the average ratios for the periods 1980-1989 (1980s) and 1990-1999 (1990s), and the most recent observations. For Lebanon, Oman and the United Arab Emirates, reliable data are not available before 1986.

* The last observation corresponds to the year 2002. M2 includes Mland time, saving and foreign currency deposits. The ratio of M1 to GDP is calculated by using the formula given in footnote 26. End of Year CPI is not available for Lebanon and the United Arab Emirates. Accordingly, only the average CPI is used in the calculation.

28 Lebanon's very high M2 to GDP ratio contrasts sharply with its low M1 to GDP ratio. The major reason for this pattern is the fact that the US dollar is used as a secondary currency in the Lebanese money market. While M1 only includes currency in circulation and demand deposits in Lebanese pounds, M2 also comprises foreign currency denominated deposits.

Looking at the size of M2, table 2 shows that Jordan has the second highest mean of M2/GDP, 103.2 per cent, after Lebanon, followed by Egypt with 78.2 per cent. Oman has the lowest monetary sector relative to the size of the economy with a mean of 29.9 per cent. While the relatively low ratio in the Syrian Arab Republic may reflect the weak access to the banking system, the relatively low ratio in the United Arab Emirates (with a mean of 55 per cent) seems to point to the influence of other important financial instruments. Moreover, the labour markets in Oman and the United Arab Emirates are characterized by large shares of expatriate workers. Significant capital outflows in the form of workers' remittances lower money demand relative to the level of national income in theses countries.

TABLE2.

Egypt Jordan Lebanon Oman Syrian Arab Republic United Arab Emirates

Mean Standard deviation Mean Standard deviation Mean Standard deviation Mean Standard deviation Mean Standard deviation Mean Standard deviation

FINANCIAL DEPTH INDICATORS, 1980-2003

M2lGDP 78.2 4.2 103.2 17.0 159.8 34.7 29.9 4.0 58.5 8.9 55.0 5.1

MllM2 26.8 12.9 40.2 9.7 10.7 6.9 33.3 6.9 77.5 10.1 24.2 4.5

Total deposits1 GDP 76.0 10.7 84.1 16.2 164.8 57.7 28.9 5.0 38.8 8.0 58.6 5.8

Private creditlGDP 36.7 12.7 67.0 8.5 69.9 22.6 28.8 8.8 8.5 1.5 46.6 5.6

Private creditltotal claims 51.7 10.6 87.2 4.2 63.1 13.1 91.9 4.4 22.7 3.7 81.7 3.8

Private creditltotal deposits 47.5 12.3 80.8 8.8 46.5 8.5 92.3 15.4 22.2 5.9 81.1 12.9

Sources: IMF, International Financial Statistics, several issues. Data on GDP in Lebanon and United Arab Emirates are taken from the ESCWA National Accounts Studies of the ESCWA Region. Notes:

M1 includes demand deposits in local currency and currency in circulation.

M2 includes Mland time, saving and foreign currency deposits. Total deposits include total resident deposits, demand deposits, time and saving deposits, post office deposits, central government deposits and restricted deposits. Total Claims include claims on central government, non-financial public enterprises, private sector, official entities and other financial institutions. Data on total deposits, private credit and total claims in Egypt and Jordan include deposit money banks and other banking institutions. Owing to lack of data for other banking institutions, the remaining countries only include data of deposit money banks. The ratios of M2 to GDP, Total Deposits (TD) to GDP and Private Credit (PC) to GDP are calculated according to the formula given in footnote 26.

2. Bancarization ratio (total deposits/GDP) In developing countries, currency is a sizeable part of the broad money stock that is held outside the banking system. Mainly, a rising ratio of broad money to income may indicate an additional use of currency rather than an increase in the volume of bank deposits. Currency in circulation is in general more intended to finance current transactions and is held, particularly in developing countries, outside the banking system. For that reason, in order to get a more representative measure of financial development that is more illustrative of financial services and activities, currency in circulation must not be included in broad money measures. One such measure is the ratio of financial system deposit liabilities to income as a quality measure for financial development, which equals the deposit liabilities of the financial system (demand and interest-bearing

liabilities of banks and no-bank financial intermediaries). Specifically, lines (24+25+44+45)29are taken from the International Financial Statistics (IFS), and the sum is divided by the nominal GDP.~'The exclusion of the currency in circulation focuses on getting the quasi-liquid assets regarded as the major source of funding investment. A rise in this deposits (liabilities) ratio of financial savings to GDP may be interpreted as an improvement in bank deposits and other financial assets outside the banking sector, which are more likely to be used for asset accumulation and therefore economic growth. As shown in figure 111, the ratio of total deposits to GDP increased during the period 1980-2003 in all the countries profiled except Lebanon, showing an increase in bancarization and success of banks in attractin de osits and providing financial services to households, in the form of savings and payment services! ThPe high ratio in Lebanon for the period 1986-1990 has to be taken with some caution as this period was characterized by ongoing conflicts and very high inflation rates. Again, the increase in this ratio has been limited in Oman and the United Arab Emirates. The stagnation over time in Oman and the United Arab Emirates may indicate that a successful financial deepening has been achieved through the development of other financial instruments outside the banking sector in these countries. However, these two countries may have achieved a relatively successful deepening despite either extensive use of cash, or low bancarization levels. Probably their relatively low ratios also imply the individual's preference to hold financial deposits abroad.32 The Syrian Arab Republic's relatively lower financial depth (57.3 in the year 2003) indicates that a low proportion of its liquid liabilities are intermediated by banks, the widespread use of cash and the limited access to the domestic banking system. In addition, this low ratio might be explained by Syrian deposits abroad, especially in Lebanon and Jordan. These factors could clearly be indicative of how efficiently resources are mobilized. However, the Syrian Arab Republic's rising trend in this ratio shows a promising increase in bancarization. As can be seen in table A.2 of annex I to this study, Jordan had the largest growth in the ratio of deposits to GDP (103 per cent in 1981-2002), followed by the Syrian Arab Republic (102 per cent for the same period). A slowing of deposits growth to GDP after the year 2000 occurred in Jordan and Oman (relative to growth in the 1990s). Looking at how large bank deposits are compared with cash across countries, table 2 above shows that Lebanon has the highest mean (164.8 per cent) followed by Jordan with 84.1 and Egypt with 76 per cent.

29 Lines 24 and 25 represent respectively demand deposits and time and saving deposits of deposit money banks. Lines 44 and 45 represent respectively demand deposits and time and saving deposits of other banking institutions. 30 P. Demetriades and K. Hussein, in "Does financial development cause economic growth? Time-series evidence from 16 countries", Journal ofEconomic Development, 1996, used only bank deposit liabilities divided by GDP. R. King and R. Levine, in "Finance, entrepreneurship, and growth: theory and evidence, Journal of Monetary Economics, 1993; and in "Finance and growth: Schumpeter might be right", The Quarterly Journal of Economics, 1993, used the ratio of liquid liabilities to income. 3 1 Total depositsIGDP is computed using the formula 0.5 * [total deposits,/CPI, t total deposits,-JCPI CPI is the consumer price index (CPI, 1987 = 100) and GDP is the gross domestic product.

GDP,/CPI,; where

32 In fact, foreign investment activity in both the United Arab Emirates and Oman is developed. In the United Arab Emirates, much of financial deepening is linked to world markets via ADIA (Abu Dhabi Investment Authority), which controls the investments of Abu Dhabi and manages an estimated US$360 billion in overseas investments. Oman has established a State General Reserve Fund (SGRF) in which about 10 per cent of annual oil revenues are accumulated (and presumably invested) and into which the nation has ploughed back higher revenues from oil. The SGRF, established in 1980, is serving as a source of income for future generations and as a mechanism for economic stabilization.

Sources: IMF, International Financial Statistics, several issues. Data on GDP in Lebanon and the United Arab Emirates are taken from the ESCWA National Accounts Studies of the ESCWA Region. Notes: * Last observation corresponds to year 2002.

Total deposits include total resident deposits, demand deposits, time and saving deposits, post ofice deposits, central government deposits and restricted deposits. Total Deposits in Egypt and Jordan include deposits of deposit money banks and other banking institutions. Owing to lack of data for other banking institutions, the remaining countries only include deposits of deposit money banks. The ratio of Total Deposits (TD) to GDP is calculated by using the formula given in footnote 26.

3 . Money liquidity ratio (MlIM2)

The third proxy of financial development is the money liquidity ratio (Ml/M2), which combines the first two indicators." This ratio also represents the sophistication of the financial market and how it succeeds in mobilizing savings, particularly the banking sector. A decrease in the ratio (MlIM2) implies a higher degree of diversification of financial institutions, as well as a greater availability or use of bank deposits as a medium of exchange. As shown in figure IV, the money liquidity ratio ( M l M 2 ) has fallen as financial innovation has progressed in all the countries. The development in this ratio (see annex I, table A.3) indicates a greater accessibility and ease of use of non-currency forms of transaction media and a higher diversification of financial institutions. Table 2 above indicates that Lebanon has by far the lowest mean of MllM2 among the countries profiled (10.7 per cent). While this might indicate that the banking habit is strong, it also reflects a significant proportion of foreign currency-denominated deposits in the banking system, which are included in the M2 monetary aggregate. The Syrian Arab Republic has the highest mean of 77.5 per cent, followed by Jordan with a mean of 40.2 per cent, implying both that currency is a more popular medium of exchange to finance current transactions and that there is limited access to banking services, especially in the Syrian Arab 33 While N. Nashashibi, M. ElHage and A. Fedelino used this ratio in their 2001 analysis, A. Darrat and M. Haj used (M21M1) in their 2002 analysis. (See N. Nashashhibi, M. ElHage and A. Fedelino, Financial Liberalization in Arab Countries (Washington, D.C., International Monetary Fund, 2001); and A. Darrat and M. Haj, Economic Fluctuations in MENA; Does Financial Market Development Matter? (Louisiana Tech University, 2002)).

Republic. In addition, the ratio in the Syrian Arab Republic is also high in part because of restrictions by the Government, which in return limited real returns on financial savings.

Sources: IMF, International Financial Statistics, 2002 and 2004 yearbooks. M1 includes demand deposits in local currency and currency in circulation. M2 includes M1and time, saving and foreign currency deposits.

The three indicators of financial development offer suggestive evidence that the role of financial intermediaries has expanded over the past three decades in the ESCWA member countries profiled. In general, the increase in total deposits relative to GDP, in the three different measures of financial development, reflects a variety of factors: (a) Inflation has indeed fallen significantly in all the countries analysed. Countries with double digit inflation initially (Egypt, Lebanon and the Syrian Arab Republic) reduced inflation to single digits, and the other countries with single-digit inflation initially (Jordan, Oman and the United Arab Emirates) more than halved inflation rates (see annex I, table A.4). Amongst the more important types of uncertainty likely to have an impact on interest rates, and consequently on bank credit, is the expected inflation. If inflation is expected to be high, the purchasing power of a given amount of borrowed funds deteriorates rapidly. The supplier of funds or banks will seek protection against the erosive power of inflation by charging higher interest rates. Thus higher expected inflation results in higher interest rates with negative impact on fund intermediation by financial institutions; (b) Financial liberalization led to a decline in interest rates paid to depositors and charged by borrowers (see annex I, table AS)." High interest spreads may increase the cost of credit, which deters investment or lowers the rate of return on deposits. As a result, little intermediation of funds takes place; (c) The extensive use of foreign currency-denominated deposits, especially in Egypt and Lebanon; (d) The relative development of capital markets and the use of new instruments such as certificates of deposits and bonds; 34

The intermediation role is reviewed in section F of this chapter.

(e) There are other reasons that might explain the changes in the measures of financial development. One of them is linked to the likelihood of tax evasion. Taxes move people to transact in cash in order to evade their obligations to government. In addition, the ratio MllM2 reflects the importance of the informal economy in a country. The larger the latter, the bigger the amount of cash in circulation. Another reason might be inefficiency of the banking system,)5 indicated by the large interest rate spreads recorded in the ESCWA member countries during 1980-2003 (see annex I, table A.5). The interest rate differential or spread is a measure of the cost of financial intermediation. Therefore, the larger the spread, the bigger the MllM2 ratio; the opportunity cost of holding currency (part of M1) will be less relative to bank deposits (part of M2). The third reason is that of private sector exclusion in developing countries in general, where banks prefer to buy Treasury Bonds rather than to finance firms. The reason for this is that holding Treasury Bonds is less risky, and it is at the same time a sound investment when compared with financing firms. This issue will be reviewed in more detail in section E below. In arguing against using monetary aggregates to assess financial development, Shan (2003), noted that broad monetary aggregates are not suitable measures of financial development if the researcher is seeking to investigate how financial development will possibly result in economic growth. Levine and Zervos (1998) argued that a broad monetization ratio simply measures financial deepening and does not measure whether the liabilities are those of banks, other financial intermediaries or the Central Bank, nor does this indicator distinguish where the financial system distributes capital. In other words, they suggested that increases in broad monetization ratios are not automatically linked to increases in credit, and credit is undoubtedly one of the features of financial development that may well bring about economic growth. Section D below reviews the issue of credit indicators.

D. THESTRUCTURE OF THE BANKING SECTOR: OWNERSHIP AND CONCENTRATION The analysis of the financial structure in the selected ESCWA member countries, reviewed in section B of this chapter, noted that the banking sector plays a dominant role in the financial system of these countries in follow-up, further characteristics of the banking sectors of these countries are analysed below.

1. Bank concentration Advances in information technology, globalization and deregulation have caused drastic changes in the structure of the banking industry. Innovations and increased competition have reduced margins in traditional banking activities and led to mergers between banks and other financial institutions. Moreover, prospects for future consolidation activity seem to justify the concern about its effects on competition in the local retail market and on banking performance and financial stability in general. The degree of competition in the banking sector can matter for the efficiency of the production of financial products, the quality of financial services and the degree of innovation. It can also affect the access of firms and households to financial services and external financing, which in turn affects overall economic stability and economic growth, although not a11 of these relationships are clearly obvious. (a)

Concentrationand access to credit

To date, both theoretical and empirical contributions have provided contradictory conclusions regarding the relation between concentration and access to finance. The structure-conduct-performance paradigm (fewer and larger firms are more likely to engage in anti-competitive conduct) argues that there is a negative relation between bank concentration and access to credit.36The basic assumption is that as banks become more concentrated, lending decreases because banks prefer to lend to large and established firms rather than small and start-up firms (new entrants). As a result, the incentive for banks to lend to severai 35

The issue of banking efficiency is reviewed in more detail in chapter 111.

36 See, for example, A. N. Berger and T. H. Hannan, "The price-concentration relationship in banking", Review of Economics and Statistics, 1989; T. Hannan, "Bank commercial loan markets and the role of market structure: evidence from surveys of commercial lending", Journal of Banking & Finance, 1991; and D. Neumark and S. Sharpe, "Market structure and the nature of price rigidity: evidence from the market for consumer deposits", Quarterly Journal of Economics, 1992.

firms in the same industry is reduced, making access to credit more difficult for new entrants and creating higher financing obstacles. By contrast, the alternative efficiency or information-base hypothesis (high concentration endogenously reflects the market share gains of efficient firms) suggests that there is a positive relation between bank concentration and access to credit.37 It contends that banks with market power (high bank concentration) usually have more incentives to set up long-term relationships with young borrowers, since they can share in future surpluses. This means that new entrants have easier access to credit. Vives (2001) argues that some degree of market power is desirable in banking and may be beneficial because it moderates risk-taking incentives. A bank with market power has more incentives to reduce the information asymmetry problem prevailing in banking and establish relationship banking with its customers. (b)

Concentration and efficiency

A number of papers have investigated the relation between concentration and performance in banking. As in the case of concentration and competition, there is no clear relation between concentration and bank efficiency. Consolidation can reduce competitive pressure and allow bank managers to supply less effort, or alternatively it may increase efficiency. For example, a merger between firms serving overlapping or identical markets may increase efficiency by eliminating duplication of activities. Consolidation can also increase efficiency if banks are too small and hence unable to fully exploit economies of scale, or if the merged banks are very different in terms of technology and efficiency ex ante. Empirical studies focusing on developed countries find no evidence in support of the idea that consolidation improves efficiency; hence cost reduction cannot be used as a justification for the existence of large banking conglomerates.38The evidence for developing countries is more limited. (2)

Banking concentration in selected ESC WA member countries

Tables 3 and 4 analyse the market concentration in banking for the countries profiled in the study. Concentration is measured by the percentage of total assets and deposits respectively that are held by the largest three banks in each country. Both tables 3 and 4 indicate that concentration in the banking systems of Egypt, Jordan, Oman and United Arab Emirates is high (more than 70 per cent), suggesting more of an oligopolistic market structure in banking which, in turn, is likely to affect banking efficiency, an issue tested empirically in chapter 111below. However, the figures show that the banking sector in Lebanon is much less concentrated than in the other ESCWA member countries. DemirgupKunt and Levine (1999) reported that there is no convincing evidence in the literature on the determinants and implications of bank concentration in developing countries. They argue that concentration could be explained by a number of indicators, including financial sector development and financial policies and regulations. In addition, they found that concentrated banking systems tend to have many restrictions on banking activities. In the case of ESCWA member countries, banking firms are mostly family-owned businesses that cater for their personal interests. One factor that might explain the low concentration ratio in Lebanon is that the practice of private banking in Lebanon is a longstanding tradition promoted by the enacting of a bank secrecy law, large investment in human capital, and traditional foreign bank presence. However, banking sectors in the other countries profiled were generally dominated by State-owned institutions for a long period of time, which made it more difficult for new firms to compete in the industry after liberalization.

37 See, for example, M.T. Smirlock, T. Gilligan and W. Marshall, "Tobin's q and the structure-performance relationship", American Economic Review, 1984; and W. Shepherd, "Tobin's q and the structure-performance relationship: comment", American Economic Review, 1986. 38 See, for example, S.A. Rhoades, "The efficiency effects of bank mergers: an overview of case studies of nine mergers", Journal of Banking and Finance, 1998; and A. Berger, I. Hasan and L. Klapper, Further Evidence on the Link between Finance and Growth: An International Analysis of Community Banking and Economic Performance (Wharton Financial Institutions Center, Berkley Research Center, Stem School of Business, and Development Research Group, The World Bank, 1999).

The high concentration ratio in the ESCWA region raises concerns about possible effects on bank competition, borrowing cost, bank efficiency and financial stability, and possible effects on credit availability. That is, it is expected that this departure from perfect competition in the credit market introduces inefficiencies that would compel banks to increase interest margin and reduce firms' access to credit.

TABLE3. CONCENTRATION IN THE BANKING SYSTEM IN SELECTED ESCWA MEMBER COUNTRIES: TOTAL ASSETS HELD BY THE LARGEST THREE BANKS

(Percentage)

E!ZYPt Jordan Lebanon Oman United Arab Emirates

1996 78.28 92.84 36.36 69.94

1997 79.76 87.32 35.89 70.45 85.89

1998 93.31 87.22 34.48 84.13 62.62

1999 91.87 87.08 31.93 72.52 74.04

2000 71.95 85.14 31.89 81.05 61.91

2001 71.50 84.52 36.00 79.04 68.31

2002 66.36 85.77 34.71 81.34 69.31

2003 67.58 85.43 38.14 78.21 69.15

Average 77.58 86.92 34.93 77.08 70.18

Source: ESCWA secretariat calculations based on BankScope data.

TABLE4. CONCENTRATION IN THE BANKING SYSTEM IN SELECTED ESCWA MEMBER COUNTRIES: TOTAL DEPOSITS HELD BY THE LARGEST THREE BANKS

(Percentage) Egypt Jordan Lebanon Oman United Arab Emirates

1996 79.10 93.36 36.81 70.98

1997 79.86 87.47 36.98 70.94 86.92

1998 94.24 87.48 35.67 85.61 63.87

1999 91.62 86.95 32.79 73.07 74.99

2000 71.24 85.61 32.24 81.25 64.37

2001 71.93 85.53 36.13 78.78 68.74

2002 66.97 86.08 35.00 81.02 69.58

2003 67.57 85.96 38.56 77.82 70.22

Average 77.82 87.31 35.52 77.43 71.24

Source: ESCWA secretariat calculations based on BankScope data.

2. The ownership structure of banking systems The 1990s and early 2000s altered the ownership of large shares of the banking systems from government to private control and from domestic to foreign control in developing countries in general. These changes occurred as Governments privatized many of their State-owned banks and reduced barriers to foreign entry.39 Major policy and research questions are raised on the effect of these changes on bank performance, on the reallocation of their portfolio funds between loans and other assets, and the efficiency of the banking sector in general. The following subsection presents arguments for and against foreign bank ownership as well as privatization of State-owned banks. (a)

Foreign ownership

Foreign-owned banks are usually part of large banking organizations that often set up branches in countries where their multinational customers have foreign affiliates. They generally have superior access to international capital markets and to communication and information technologies. Foreign banks are also able to diversify risks and offer services not easily provided by domestic banks, although they could face problems in managing from a distance and in coping with different regulatory and economic environments. Their advantages make the presence of the foreign bank valuable during banking crises since the bank can diversify against country-specific risks that can severely hinder the banking system's development. Foreign banks are less sensitive to local shocks than domestic banks, and they do not follow the business cycle of the host country; therefore, they can provide a change in the downwardly directed trend of the domestic economy. They help countries not only during crises but also in the post-crises periods as they recapitalize their banking systems and provide the basis for a revival of bank credit. The higher level of diversification of 39 According to statistics published by the Bank for International Settlements (available at: www.bis.ordpubl), foreign lending corresponded at year-end 2003 to 35 per cent of total bank lending in developing countries. The presence of foreign banks is particularly important in Latin America and Eastern Europe and less important in East Asia, Africa and the Middle East.

exposures and the improvement of risk management that foreign banks add to an economy creates a higher degree of financial stability. Foreign ownership in developing nations is generally associated with more competitive national systems, greater overall credit availability and a reduction in interest rate spreads that compels domestic banks to be more efficient. The increased competitiveness of the banking sector not only enhances efficiency but also stimulates innovation, contributes to stability, and improves the effectiveness of monetary policy implementation. This is due in large part to the fact that foreign investors bring state-of-the-art technology and human capital with them, forcing domestic banks to undergo major structural reforms to enable them to compete on an equal platform. In support of this, many studies present strong evidence that foreign banks have a positive spillover effect on real growth in loans and are associated with greater efficiency for the whole banking system.40 However, according to another theory, greater presence of foreign banks in domestic financial sectors may lead to financial sector instability arising from increased competition, considerable capital outflows and cyclical conditions in the home countries of foreign banks.41Moreover, it is argued that, with the presence of international banks, information available to the local supervisors might be reduced, leading to a shift in decision-making and risk management to foreign banks, while external shocks affecting the international bank become more easily transmitted to the host market. In addition, the tendency of credit risk may increase via their foreign currency-denominated lending. In general, empirical studies reach different conclusions regarding the impact of foreign bank entry in different regions of the world. For instance, Latin American countries benefited from the presence of foreign banks during their crises while Asian countries relied to a much lower extent on them during the 1997 crisis. In the Central and Eastern European (CEE) countries, it is difficult to determine whether foreign bank entry is beneficial and helps in the enhancement of the financial and banking sectors. An analysis conducted by Naaborg and others (2004) showed that up to 2000 (a period of increased foreign bank entry), the level of financial development had increased moderately and the composition of the financial structure did not change a lot, that is, credit supplied to the private sector increased modestly. Foreign banks help the financial development of the CEE countries because they take on the role of a creditor and lend to the private sector more than the domestic banks do. Nevertheless, public credit of foreign banks still exceeds private credit. In the MENA region, most of the countries are slowly opening domestic markets to foreign bank entry. Most of the Arab countries are still reluctant to open up domestic markets because of the threat of foreign competition that could lead to costly failures, a slowdown in macroeconomic performance and an increase in the volatility of exchange rate management. However, econometric evidence indicates that higher financial liberalization is positively related to higher foreign bank presence in the region. Financial liberalization was more pronounced and well implemented in countries such as Lebanon, Morocco and Egypt, where entry of foreign banks is higher than in the other countries.

(b)

State ownership andprivatization

The main issues regarding State ownership of banks involve credit availability as well as efficiency. State-owned banks often pursue objectives such as developing specific industries or regions and expanding exports. Their portfolio allocations are not designed to maximize profits, and they are usually subsidized by the Government. As such, empirical studies show that State-owned institutions carry high non-performing loans and have low efficiency because they reduce access to credit, hinder financial system development and slow economic 40 See, for example, D. Grigorian and V. Manole, Determinants of Commercial Bank Performance in Transition: An Application of Data Envelopment (Washington, D.C., World Bank, 2002); and I. Hasan and K. Marton, Development and ESJiciency of the Banking Sector in a Transitional Economy: Hungarian Experience (Bank of Finland, 2000).

4 1 See, for example, J. Peek and E. Rosengren, "Collateral damage: effects of the Japanese bank crisis on real activity in the United States", American Economic Review, 2000. 42 See, for example R. La Porta, F. Lopez-de-Silanes and A. Shleifer, "Government ownership of banks", Journal of Finance, 2002; and J . R. Barth, G. C. Caprio and R. Levine, Choosing the Right Financial System for Growth (Milken Institute, 2004).

However, there are many businesses, geographic locations and entrepreneurs that are in dire need of financial services, but that lack the resources to become economically viable enterprises through private financial undertakings. The State banks have a role to play, at least in these situations when private financial institutions shy away because of profitability considerations. The externalities of the State banks in these cases, in terms of incomes created because of their services, far outweigh any losses they may incur. Apparently because of that, State banks are still cited as a success factor in the pro-poor growth policy frameworks of a number of countries.43 With respect to the effects of privatizing State-owned banks in developing nations, research is still in an embryonic stage. Greater prudence in lending, coupled with a reduction in the volume of non-performing loans, is usually reported after privatization, thus improving bank performance and cost efficiency. (c)

Structure of selected ESC WA members ' banking sectors

Table 5 shows the structure of the banking systems in Egypt, Jordan, Lebanon, Oman and United Arab Emirates for the year 2003. The figures indicate that the structure of the individual banking systems vary among the countries under study. The total number of commercial banks ranges from 9 in Oman to 47 in Lebanon, and foreign bank participation varies from 13 per cent in Lebanon, 15 per cent in Egypt, 20 per cent in Jordan, 60 per cent in the United Arab Emirates and to 100 per cent in man.^^ It also seems that commercial banks face varying degrees of competition with non-conventional banking firms (Islamic banks) and other non-commercial financial institutions (investment and specialized banks). Further, the disparity in banking structures and the differences in foreign bank participation among the countries profiled are likely to affect banking efficiency.45

TABLE5. STRUCTURE OF THE BANKING SYSTEM IN SELECTED ESCWA MEMBER COUNTRIES, 2003 Commercial banks

Of whichforeign banks

Investment banks Specialized banks Islamic banks Total

Egypt 33 5 5 5 3 46

Jordan

Lebanon

Oman

15 3 5 3 2 25

47 6 8 1 l 57

9 9 3 2 3 17

United Arab Emirates* 41 25 2 1 2 46

Source: Directory of Arab Banks and Financial Institutions. * Figures from the Central Bank.

E. BANKCREDIT: CREDIT TO THE PRIVATE VERSUS PUBLIC SECTOR AND ALLOCATION OF CREDIT ACCORDING TO ECONOMIC ACTIVITY

Since the focus here is on the mobilization of savings and the allocation of these financial resources to the private sector as the major role of the financial sector, this section analyses data on bank credit, in particular credit extended to the private versus the public sector, and the allocation of private credit according to economic activity.

1 . Bank credit: private credit and its share This section assesses the banking sector's development in selected ESCWA member countries over the past two decades by taking a close look at the evolution of credit extended to the private sector. Recent 43 For more on this, see P. Holden, and V. Prokopenko, Financial Development and Poverty Alleviation: Issues and Policy Implications for Developing and Transition Countries (International Monetary Fund, 2001); and T. McKinley, The Macroeconomics of Poverty Reduction, Initials Findings of the UNDP Asia-Pacific Regional Programme (New York, 2003). 44

A better indication of foreign bank activity is foreign banks' total assets to total assets of the banking sector. However, such data are unavailable. 45

The subject of banking efficiency is addressed in more detail in chapter 111.

theoretical and empirical research has demonstrated that an effective mobilization of domestic savings and an efficient allocation of resources depend on the extent to which the private sector can obtain loans. According to the McKinnon and Shaw model, the stock of credit to the private sector is ultimately responsible for the quality and quantity of capital accumulation (investment) and consequently for economic growth.46It is argued that loans extended to the private sector promote investment and productivity growth to a much greater extent than do credits to the public sector. In recent years, financial sectors have experienced rapid development resulting from financial liberalization and deregulation, technological innovations and the introduction of new financial products, including extensive use of credit cards, telephone and Internet banking. These changes, particularly the abandonment of credit rationing, are believed to have facilitated larger stocks of credit being created by financial systems. Moreover, the introduction of financial liberalization and deregulation reforms should have primarily fostered the extension of credit to the private sector. In order to provide a comprehensive assessment of the role of private credit in the six ESCWA member countries profiled over the past two decades, three different indicators were considered. They were: the ratio of private credit to GDP; the ratio of private credit to total domestic credit; and the ratio of private credit to total deposits. Table 2 above presents summary statistics on these indicators. (a)

Ratio of private credit to GDP

The first indicator used to measure banking sector development in the ESCWA region over the past two decades is the ratio of private credit to GDP. This ratio is defined as credit extended by deposit money banks and other financial institutions to the private sector divided by G D P . ~The ~ recent empirical literature on the role of financial intermediation in economic development has highlighted the suitability of this indicator to measure the level of financial intermediation (see, for example, De Gregorio and Guidotti (1995); Demetriades and Hussein (1996); Levine and Zervos (1998); and Beck and Levine (2004)). In addition, as De Gregorio and Guidotti (1995) argued, private credit has an obvious advantage over measures of monetary aggregates such as M1, M2, and M3 since it more precisely represents the actual quantity of funds directed to the private sector. Thus, the ratio of private credit to GDP is more directly associated with investment and economic growth than the monetary aggregates. An increase in the ratio of private credit to GDP can be interpreted as a sign of more financial services and thus as an improvement in financial intermediation. The main advantage of this indicator is the fact that it isolates credit from private financial intermediaries to the private sector, as it includes neither credit extended by the Central Bank nor credit from private banks to the public sector. As shown in figure V below, the ratio of private credit to GDP increased significantly over the period 1980-2003 in all the countries profiled except the Syrian Arab Republic. Owing to the dominant role of public enterprises, credit to the private sector in the Syrian Arab Republic remained at very low levels throughout the entire period under consideration. The average ratio of private credit to GDP in the Syrian Arab Republic over the period 1980-2003 was only 8.5 per cent (see table 2 above). Until the first half of the 1990s, the private credit to GDP ratio had also been low in Egypt and Oman. However, since then both countries experienced a strong increase in private credit (see annex I, table A.6). In Egypt, the sharp increase from around 20 per cent to 60 per cent of GDP can be directly attributed to the financial liberalization reforms, which started at the beginning of the 1990s and strongly encouraged bank lending to the private sector. In Oman, the private credit to GDP ratio increased significantly between 1996 and 1999. A main factor behind this increase was the strong expansion of personal loans during that period. In the next section, a closer look is taken at the allocation of bank credit to the different sectors of the economy. In the United Arab Emirates, the private credit to GDP ratio was on a slight upward trend between 1990 and 1997. The 46 For more, see A. Darrat, "Are financial deepening and economic growth causally related? Another look at the evidence", 1999; and M. Kar and E. Pentecost, Financial Development and Economic Growth in Turkey: Further Evidence on the Causality Issue (Loughborough University, Department of Economics, 2000).

47

Specifically, this study takes lines 22 and 42 from the IMF International Financial Statistics to calculate private credit.

subsequent strong increase from 45 to 60 per cent was followed by a sudden drop of the ratio at the end of 1990s. During the past few years, the private credit to GDP ratio has increased again, returning to the trend observed in the period 1990 to 1997. Overall, the private credit to GDP ratio in the United Arab Emirates has been less volatile than in the other ESCWA member countries except the Syrian Arab Republic, with a standard deviation of only 5.6 per cent.

Sources: IMF, International Financial Statistics, several issues. Data on GDP in Lebanon and the United Arab Emirates are taken from the ESCWA National Accounts Studies of the ESCWA Region. Notes: Private Credit in Egypt and Jordan include claims of deposit money banks and other banking institutions. Owing to lack of data for other banking institutions, the remaining countries only include private credit of deposit money banks. The ratio of Private Credit (PC) to GDP is calculated by using the formula given in footnote 26.

Over the entire time span considered here, the private credit to GDP ratio in Jordan has been high relative to the other ESCWA member countries profiled. After a steady increase from around 45 per cent to almost 80 per cent between 1981 and 1989, the ratio dropped significantly in the aftermath of Jordan's financial crisis in 1989. However, the liberalization process that followed the financial crisis stimulated lending to the private sector again and led to another cycle of a gradually increasing private credit to GDP ratio. Lebanon experienced a sharp drop in the ratio of private credit to GDP at the beginning of the 1990s. Since then, the ratio has steadily increased and is now the highest among the ESCWA member countries profiled. At the same time, the volatility of the private credit to GDP ratio is also significantly higher in Lebanon than in the other ESCWA member countries, with a standard deviation of 22.6 per cent. (b)

Ratio of private credit to total domestic credit

The second indicator for banking sector development used in this study is the ratio of private credit to total domestic credit extended by private banks and other financial institution^.^' This indicator captures the asset allocation of banks as it explicitly measures the extent to which loans are directed to the private sector rather than to Government- or State-owned enterprises. As highlighted by King and Levine (1993a,b), financial systems that allocate a larger part of total credit to the private sector are likely to be more efficient in selecting investment projects, exerting corporate control, pooling risk, and mobilizing savings than financial systems that basically channel credit to the Government and to public enterprises. 48 Total domestic credit is calculated by adding the values given in lines 22% 22bx, 22c, 22d, 42c and 42d of the IMF International Financial Statistics.

Sources: IMF, International Financial Statistics, 2002 and 2004 yearbooks Notes: The figure presents the average ratios for the periods 1980-1989 (1980s) and 1990-1999 (1990s), and the most recent observation.

* Last observation corresponds to year 2002. Total Claims include claims on central government, non-financial public enterprises, private sector, official entities and other financial institutions. Data on private credit and total claims in Egypt and Jordan include claims of deposit money banks and other banking institutions. Owing to lack of data for other banking institutions, the remaining countries only include private credit of deposit money banks.

Figure V1 shows how the ratio of private credit to total domestic credit in the six ESCWA member countries evolved over the past two decades. The figure presents the average ratios for the periods 1980-1989 (1980s) and 1990-1999 (1990s) as well as the most recent observations. The share of private credit in total domestic credit is high in three out of the six ESCWA member countries profiled in this section (see annex I, table A.7). In Jordan, Oman and the United Arab Emirates, more than 80 per cent of total loans extended by private banks are directed to the private sector (see also table 2 above). This indicates that the banking systems in these countries have a clear orientation towards the private sector. Egypt is the only sample country where the share of private credit in total domestic credit has increased considerably since the 1980s. Again, this finding can be directly attributed to the recent financial liberalization process, which enhanced the private sector's access to bank credit. However, figure V1 shows that in 2003 Egypt's private financial institutions still extended around 35 per cent of their total credit volume to the Egyptian Government and to State enterprises. This results in a significant crowding out of credit to the private sector, which is likely to have a negative effect on the resource allocation in the economy. In the case of Lebanon, the problem of crowding out of private loans by credit to the public sector is particularly pressing. Over the past two decades, the ratio of private credit to total domestic credit has fallen from 75 per cent to only 50 per cent, mainly because public debt exploded during this period. The strong crowding out effect has definitely had a negative impact on Lebanon's economic growth in the past few years. It is thus of vital importance for the Lebanese economy to address the issue of chronic budget deficits in order to secure the private sector's access to bank credit and stimulate private sector-led growth. Finally, the Syrian Arab Republic remains a country with a very weak role for the private sector, as illustrated by the low private credit of total credit ratio of around 25 per cent in 2003 (see annex I, table A.7).

(c)

Ratio of private credit to total deposits

The ratio of private credit to total deposits of the financial sector is a third measure that can be used as an indicator for financial development.49This indicator incorporates information on the liability side of the balance sheet by indicating the share of savings that is allocated to private sector credit. Figure V11 below shows that the ratio of private credit to total deposits increased significantly only in Egypt and Oman over the past two decades, while it decreased in Jordan and Lebanon. In Oman, the ratio is now above 100 per cent, while in the Syrian Arab Republic it is below 20 per cent. Overall, the private credit to total deposit ratios in the six ESCWA member countries are relatively low when compared with those in the newly industrializing countries in East Asia and in some countries in Latin America, such as Chile. This can basically be attributed to two factors: first, as demonstrated above, there is a considerable crowding out of private loans by credit to Governments and State enterprises in some of the ESCWA member countries profiled, especially the Syrian Arab Republic, Lebanon, and Egypt (see annex I, table A.8). Secondly, banklending behaviour in the ESCWA region is generally more cautious and conservative than in most emerging market economies. While this may reduce the risk of banking crises, it certainly leads to a less efficient resource allocation, as some profitable investment projects do not receive financing.

Sources: IMF, International Financial Statistics, 2002 and 2004 yearbooks. Notes: The figure presents the average ratios for the periods 1980-1989 (1980s) and 1990-1999 (1 990s), and the most recent observation.

* Last observation corresponds to year 2002. Total deposits include total resident deposits, demand deposits, time and saving deposits, post office deposits, central government deposits and restricted deposits. Data on private credit and total deposits in Egypt and Jordan include claims of deposit money banks and other banking institutions. Owing to lack of data for other banking institutions, the remaining countries only include private credit of deposit money banks.

49 Total deposits are calculated by adding the values given in lines 24, 25, 26b, 26d, 44, 45, 45i and 46b of the IMF International Financial Statistics.

2. Composition of bank credit extended to the private sector: allocation of credit according to economic activity

As documented above, bank credit to the private sector as a share of GDP has increased significantly since the beginning of the 1990s in all ESCWA member countries under consideration except the Syrian Arab Republic. This subsection examines which economic sectors benefited from the increased availability of financing through banks. In particular, the issue of whether banks in the region have primarily financed investment activities or private consumption during the period of credit expansion is addressed. Figures V1II.A-D show the distribution of bank credit by economic sector in Egypt, Jordan, Oman and the United Arab Emirates. Owing to a lack of reliable data, Lebanon and the Syrian Arab Republic are not included in this part of the analysis. The selection of years for which the distribution of bank credit is presented was determined by the availability of data from the Central Banks in the four countries. The classification of economic sectors also varies between the four countries. In Egypt, bank credit to the private sector is divided into the four sectors of agriculture; industry; trade and services; and personal loans. For Jordan and the United Arab Emirates, construction is given as a separate economic sector. Moreover, the Central Banks in these two countries do not present separate data on personal loans, which are subsumed under the category "others". In the case of Oman, credit to six different sectors is addressed, namely: (a) agriculture and allied activities; (b) mining, quarrying, and manufacturing; (c) construction; (d) trade and services; (e) personal loans; and ( f ) others. In all countries, the shares of the different economic sectors add up to 100 per cent. Owing to country differences in the classification and availability of data, the focus here is on time-series aspects of the distribution of bank credit rather than on cross-country differences. Before turning to a country-specific analysis, a number of general stylized facts of credit allocation in the four ESCWA member countries involved are highlighted. First, the above-mentioned figures illustrate that credit to the agricultural sector only accounts for a very low percentage of total credit extended to the private sector in all of the countries. Secondly, in Jordan, Oman and the United Arab Emirates, the industry and mining sector receives a relatively small share of total credit, indicating a weak industrial basis in these countries. Thirdly, the importance of the construction sector as a recipient of bank credit has diminished significantly over the period under consideration in the three countries where separate data for the construction sector are available (Jordan, Oman and the United Arab Emirates). Fourthly, the trade and services sector obtains the largest share of total bank credit in all countries except Oman, where its share has fallen below the personal loans sector. Fifthly, the share of personal loans has increased considerably over the past few decades and currently accounts for a large portion of total credit to the private sector in all the countries profiled except Egypt. In Jordan and the United Arab Emirates, the increased use of credit used to finance current private consumption is reflected in a higher share attributed to the category "others". This last aspect of the credit allocation in the four ESCWA member countries profiled in this section deserves special attention, as it highlights one of the major problems associated with the financial development process in the region. The financial sector reforms of the early 1990s undoubtedly contributed to a significant increase in the funds available for the private sector. However, as illustrated in figures VII1.A-D, much of the credit to the private sector has been used to finance current consumption spending instead of being invested to foster capital accumulation and to increase future consumption possibilities. As low investment rates constitute a major obstacle to economic development in the region, the Governments and Central Banks in the region should address the existing bias against bank lending for productive investment projects. Egypt undertook major reforms to liberalize its financial sector during the 1990s. As can be seen in figure VIII.A, this resulted in significant changes in the sectorial distribution of bank credit. From 1991 to 2003, the share of credit extended to the industrial sector remained almost constant, whereas the categories "trade and services'' and "personal loans" increased their respective shares of total bank credit substantially at the expense of the agricultural sector. In 1991 around 16 per cent of total bank credits were extended to the agricultural sector. By 2003, this number had decreased to only 2 per cent. The very low share of credit extended to agriculture stands in sharp contrast to the high share of employment in this sector. In 1998, 39 per cent of Egypt's workforce was employed in agriculture (Rivlin, 2003). As the reduced availability of bank credit hampered investment in agriculture, unemployment rates in some rural areas increased significantly during the 1990s (see, for example, Radwan (2002)). The share of personal loans in total credit almost quadrupled during 1991 and 1996 during the first stages of the financial liberalization process.

However, it decreased substantially between 1996 and 2003. Accounting for only 1 5 per cent of total credit to the private sector, personal loans in Egypt are well below the shares observed in the other ESCWA member countries profiled in this section.

Source: Central Bank of Egypt. Note: The graph displays the sectorial distribution of total bank credit to the private sector.

Source: Central Bank of Jordan, available at: www.cbj.~ov.io,Yearly Statistical Series. Notes: The graph displays the sectorial distribution of total bank credit to the private sector. The category "others" includes credit to professionals and private individuals.

Source: Central Bank of Oman, available at: www.cbo-oman.org, Annual Report. Note: The graph displays the sectorial distribution of total bank credit to the private sector.

Source: Central Bank of the United Arab Emirates, available at: www.cbuae.gov.ae, Annual Report. Note: The graph displays the sectorial distribution of total bank credit to the private sector.

Jordan has also been experiencing a process of financial liberalization since the early 1990s. The changes in the allocation of credit between 1985 and 2004 can be seen in figure V1II.B. The most salient results are the reduction of the share of credit extended to the construction sector and the corresponding increase of the category "others" which includes personal loans. The shares of agriculture as well as of the industry and mining sector, in contrast, did not change significantly during the period. In Oman, the allocation of credit to the private sector changed substantially between 1986 and 2003, as illustrated in figure VII1.C. The construction and the trade and services sector experienced strong declines in their respective shares of total bank credit. The shares of the industrial sector, and especially of personal loans, in contrast, increased significantly. Personal loans now account for more than 40 per cent of total bank credit to the private sector, surpassing the shares of the other categories. The strong expansion of personal

loans can partially be attributed to the interest rate ceiling on personal loans set by the Central Bank of Oman. In 1999, this rate was set at 13 per cent per annum and then gradually lowered to l 0 per cent in 2004. As a consequence, demand for personal loans in Oman has continued to outstrip supply over the past few years. Moreover, it is likely that credit in the form of personal loans has crowded out credit for business activities. In its 2004 annual report, the Central Bank of Oman recognized the problem of bank credit bias towards consumer spending, noting that "what is important is to enhance aggregate supply of goods and services in Oman, and this can be possible mainly through higher lending for productive investments" (Central Bank of Oman, Annual Report 2004, p. 78). In the United Arab Emirates, there has been an evolution of the credit allocation to the private sector similar to the one in Jordan. Figure VII1.D shows that major changes between 1992 and 2003 only occurred in the construction sector and in the category "others". As in the case of Jordan, more credit is now extended to households in the form of personal loans, which is reflected in the strong increase in the category "others". In contrast, credit to the construction sector diminished significantly over the past decade. Credit to the industrial sector has remained on a very low level, while it is the country's trade and service sector that receives the bulk of bank credit. The banking sector in the selected ESCWA member countries can be described as follows: (a) High market concentration (measured either by the share of total assets or total deposits of the largest three banks) with little competition (see tables 3 and 4 above) has led to high intermediation costs and consequently to high costs of capital for entrepreneurs. This high interest spread between lending and deposit rates in all of the selected ESCWA member countries is an indication of the low competitive nature of banks (see annex I, table A.5); (b) On average, bank credit to the private sector declined relative to GDP in Jordan, and increased in the United Arab Emirates after the year 2000. However, this ratio stayed roughly stable in Lebanon, Oman and the Syrian Arab Republic (figure V). This pattern of growth in the ratio of banksy private credit to GDP largely reflects the growth pattern of total deposits as well as the relative increase in banks' holdings of public debt; (c) High excess liquidity (low credit extension to private sector relative to total deposits) in the financial system was mainly because of low domestic investment rather than higher than normal rate of savings (figure IX). While the growth in real bank credit to the private sector kept pace with total deposits growth in Egypt and Jordan, real bank credit to the private sector has remained at low levels in the Syrian Arab Republic and at high levels in Oman; (d) In addition, a larger share of the credit extended to the private sector is increasingly being granted to households to finance current consumption instead of productive investment (figures V1II.A-D); (e) In some countries, low total deposits relative to GDP may be attributed to inefficiencies in banking operations resulting in long waiting times wasted in bank transactions and often higher charges for services, thus raising the opportunity cost of banking. As a result, some people may opt for holding bank accounts in other countries;

(f) Bank credit to the Government and public enterprises rose in Egypt and Lebanon after the year 2000, from 25.46 per cent of GDP to 31.92 per cent in Egypt, and from 90.5 to 94.8 per cent of GDP in Lebanon. This ratio was stable in the other countries (annex I, table A.9), ranging from 29.2 per cent in the Syrian Arab Republic to 5.3 per cent of GDP in Oman. However, public bank credit to total claims is possibly a more important indicator of banks' intermediation between savers and the private sector than the ratio with respect to GDP, which may have a greater negative impact on intermediation in a smaller banking system. Relative to total claims (annex I, table A. 10) of the banking sector, public credit decreased from its high levels of the 1990s in Egypt and Jordan, and increased in Lebanon from 11 per cent in 1980 to 48 per cent of total claims in 2003. In Oman and the United Arab Emirates, the ratio was roughly constant. In the Syrian Arab Republic, banks' credit to the public sector represented 75.14 per cent of total claims in 2003 and about 47.56 per cent of total deposits (annex I, table A.l l), the highest ratios among the countries profiled in this study. Government deficit was an important factor in the rise in banks' holdings of government debt, especially in Lebanon. To a certain degree, the rise in the ratio could be attributed to the fact that government debt became more attractive for two reasons: the rise in the real interest rates on

government debt following financial liberalization and because of the zero risk weighting associated with banks' holdings of government debt for the purposes of capital adequacy requirements. Figure M.Deposits, private credit and public credit in Egypt, Jordan, Lebanon, Oman, the Syrian Arab Republic and the United Arab Emirates (1980-2003) (Millions of national currency)

Source: IMF, International Financial Statistics, several issues.

F. FINANCIAL INTERMEDIATION The level of interest rates affect people's behaviour by affecting economic decisions with regard to how much people are willing to save, and how much businesses are willing to invest. An informative indicator of a banking system's success in intermediating funds between savers and investors is the spread between deposit and lending rates (De Nicolo and others, 2003). That is, the interest rate differential or

spread is a measure of the cost of financial intermediation. The pattern and the extent of lending in the ESCWA region can be associated with the intermediation cost. As can be seen in table 6 below, in 2002 interest rate spreads in the five countries profiled in this study were higher than those in developed countries. RATE SPREADS IN EGYPT,LEBANON, JORDAN,OMANAND TABLE6. INTEREST THE SYRIAN ARABREPUBLIC, 2002 (Percentage)

Egypt Jordan Oman Syrian Arab Republic OECD*

Real lending rate 11.1

Real deposit rate 6.56

Interest spread 4.5

8 4.6

3 0.5

5 4.1

Concentration ratios Total deposits Total assets averageA depositsM 77.82 77.58

Source: IMF, International Financial Statistics, several issues. * Cihak and Podpera (2005), International Monetary Fund. Notes: A M

Concentration in the banking system of total assets held by the largest three banks (see table 3). Concentration in the banking system of total deposits held by the largest three banks (see table 4).

Over time, interest rate spreads in the ESCWA region have shown only a slow, if any, decreasing trend (figure X). According to the theory, interest rate spreads, which represent the cost of intermediation in a competitive environment, should fall as the level of intermediation increases. As shown in the past decade (see annex I, table AS), interest rate spreads declined considerably in Lebanon while they remained mostly stable in the other countries profiled. Over the whole period, Oman had the lowest average spread, followed by Jordan, while Lebanon recorded the highest spread. Lebanon showed the highest variability on the spread as reflected by its standard deviation. The different development in Lebanon is likely due to differences in the macroeconomic environment and to inflation (annex I, table A.4).

Figure X. Interest rate differential in selected ESCWA member countries (1980-2003)

Source: IMF, International Financial Statistics, 2002 and 2004 yearbooks. Central Bank of Jordan, available at: www.cbi.nov.io, for the Jordanian interest rate differential in the period 1980-1987. Notes: The interest rate differential is the difference between lending and deposit rates. Lending rates in Jordan for the period 1980-1987 are the interest rates on loans and advances. Deposit rates in Jordan for the period 1980-1987 are time deposit interest rates.

While financial liberalization has led to declines in interest rates paid to depositors and charged by borrowers (annex I, table A.5), for a given rate of inflation, phase of economic activity and interest rate, the level of interest spread is influenced by other factors: administrative costs; rents accumulating from banks' market power on both deposit and lending sides; and credit risk. High interest spreads may increase the cost of credit, which deters investment or lowers the rate of return on deposits, as a result of which little intermediation of funds takes place. With such high spread rates, firms are often compelled to finance investment through retained earnings or resort to savings of friends and family, postponing, if not eliminating, large-scale or longer-term projects. In addition, the large interest spread also reflects the non-performing loan (NPLs) problem in the region (table 7). At first, NPLs may not appear to have serious negative effects. Banks remain liquid, and depositors continue to keep their confidence in the system. Eventually, however, the size of the problem grows, particularly if banks are allowed to accumulate interest on their NPLs. Over time, the efficiency of the banking system is comprehensively destabilized as the function of extending new loans to productive enterprises takes second place to dealing with a portfolio of bad loans whose collectibility is very low. TABLE7. RATIOOF NON-PERFORMING LOANS TO TOTAL LOANS IN EGYPT,JORDAN, LEBANON, OMANAND THE UNITEDARABEMIRATES (Percentage)

Jordan Lebanon Oman United Arab Emirates

1996

1997

1998

1999

2000

2001

2002

2003

Average

3.84 11.01 12.96

6.97 21.80 8.05 3.98

9.14 12.31 6.07 10.66

9.49 19.10 6.85 9.80

13.82 21.82 8.90 11.97

18.89 20.35 13.37 9.57

14.84 26.58 15.71 7.62

13.36 25.29 20.59 5.58

11.29 19.78 11.56 8.46

3'ource: Bankscope database. Two dots (..) indicate that data is not available.

As shown in table 7, NPLs in the ESCWA member countries profiled increased in all these countries from 1996197-2003 onwards. While NPLs in Lebanon as a share of total loans were the highest among the countries in the ESCWA region (25.29 per cent) in 2003, the ratio soared in Jordan from 3.84 per cent in 1996 to an eight-year high of 13.36 per cent of total loans in 2003, representing the highest growth rate. Extending loans is one of the main outputs provided by a bank; however, a loan is an output that entails risk. There is always an ex ante risk for a loan to become non-performing. Non-performing loans are undesirable outputs to any bank that extends loans, as they diminish the bank's performance. Controlling NPLs is consequently vital for both an individual bank's performance and an economy's financial reliability. Other macroeconomic and microeconomic factors that play a role in explaining high intermediation costs include the following: (a) In order to fight inflation, reserve requirements tend to increase, making it necessary for banks to charge higher interest rates on capital that is left to productive use; (b) Higher interest rates reflect uncertainty in the macroeconomic environment. Persistent fears of inflation andlor devaluation force banks to raise interest rates margins in order to offset a potential erosion of capital; (c) High operating expenses and taxes absorb a significant portion of intermediation income; (d) High interest spread suggests that banks have relatively high profit rates, which is a symptom of deficiencies in competition and high concentration ratio (see tables 3 and 4 above).

G. POSSIBLEFACTORS AFFECTING BANKING CREDIT AND RESOURCE MOBILIZATION Given the importance and the central role of bank credit in private sector financing in the ESCWA region, analysis of the determinants of the supply and demand for credit is important for understanding the recent trends in private credit activity in the ESCWA region. In all the countries profiled in this study, where capital markets are a relatively unimportant source of financing for the private sector (see section B above) domestic credit is to a large extent contingent on banks' lending capacity. This lending capacity of banks is a function of total deposits and the banks' own capital. There are two views on what determines how much private credit a financial system would offer to the private sector (Djankov and others, 2004). According to the first view, what is relevant for the feasibility of private credit is the power of creditors. Lenders are more willing to extend credit when they can more easily force repayment, seize collateral, or even gain control of the firm. Adequate regulations and practices concerning creditors' rights, including efficient court systems able to enforce contracts and the power of creditors' rights in a timely manner, are key factors in fostering the supply of credit. According to the second view, what is important for lending is information. Lenders are more willing to extend more credit when they know more about potential borrowers and their credit history. Lenders often require collateral in order to assess creditworthiness. This functions as a risk-signalling mechanism, reduces the incentive to default and offers insurance for lenders, thereby encouraging credit supply. Collateral requirements have been identified as a key determinant of the lender's decision to ration loans (Zeller, 1994). The majority of lenders demand physical collateral such as land, a policy that also affects tenants, wage labourers, small-scale enterprises and especially the poor. This policy also turns out to be particularly harmful to women in the region. Given the historical asymmetry of property ownership and the gender bias in inheritance laws, the ability of Arab women to obtain credit is often severely restricted. Moreover, it was found (Beck and others, 2003) that bank concentration (a characteristic of all of banking sectors of the sample countries) increases financing obstacles and decreases the possibility of receiving bank finance. Thus entry of more efficient banks that gain market share stimulates the supply of credit. The high spread between deposit and lending rates is an indication of this low effective competition among banks in the ESCWA region (see table 6 above and annex I, table AS). In addition, the literature identified two macroeconomic factors that are likely to influence the growth of private sector credit (Cottarelli and others, 2003). First, the process of crowding out, where a rising bank credit to the Government, especially in Lebanon and the Syrian Arab Republic, discourages the supply of credit to the private sector. The second factor is capital inflows. Banks can expand their accessible loanable funds not only through domestic deposits, but also by attracting net credit from abroad. The access to net foreign credit is likely to increase through the entry of foreign banks. The access to net foreign credit is also likely to increase if it is facilitated into a country in the context of reduced risk premia (economic and political), expectations of real exchange rate appreciation, and interest rate differential in favour of the host country, Macroeconomic shocks can also affect demand for deposits and therefore supply of credit. The demand for deposits may shrink because of an increase in the risks of expected depreciation, associated with an unsustainable balance of payments. Worrying fiscal developments or tight monetary policy may drive expectations of inflation and devaluation, thus leading to a contraction in the demand for bank deposits and a rise in interest rates. In return, this might lead to a private sector credit crunch. Moreover, general economic conditions play an important role in influencing demand for bank credit, which is influenced by those who borrow funds, a group that includes all businesses, households and Government. When economic activity is growing and the outlook favourable and encouraging, households demand more credit to finance current and future consumption for homes, automobiles and other big-tickets items. With a favourable outlook, consumers expect higher future incomes and consequently are generally more willing to contract future debt. Under favourable economic conditions, businesses become optimistic and look for funds to finance additional investment in production, plant and equipment required to satis@ this increase in demand. However, when sales are sluggish and the future looks grim, consumers and businesses tend to reduce major

purchases, and lenders become concerned about the repayment ability of prospective borrowers and are therefore reluctant to lend. As a result, both the supply of and demand for credit may fall. In addition, macroeconomic policies play an important role in explaining bank credit and resource mobilization, as macroeconomic storability is crucial to the development of the financial sector. Macroeconomic policies in the countries profiled in this study have been characterized by periodic financial slippages in financial discipline, leading to the build-up of sizeable government debt, especially in Jordan and Lebanon. It is intuitive to assume that both the size and the quality of financial intermediation have been negatively affected by the uncertainty associated with the unstable macroeconomic environment. This assumption is supported by the decline in the ratio of private credit to total claims and the ratio of private credit to total deposits. Political uncertainty aggravates credit and liquidity risks, thus affecting the supply and demand of bank credit. This higher risk has an effect on the growth of a stable deposit base, on capital inflows and foreign direct investment and complicates long-term investment decisions. A low propensity of banks to lend domestically may also be attributed to problems involving credit risk management capacity, liquidity management, and the demand for creditworthy investment projects. This is mainly reflected in the increasing levels of non-performing loans (see table 7 above). This is largely due to institutional factors such as the weak enforcement of creditors' rights and the lack of a central credit information system as well as the weak cooperation between banks in sharing customer information. Banks may suffer from an overly bureaucratic approach, overstaffing, unprofitable branches and poor customer service, all of which lead to higher administrative costs, reducing profits for depositors and consequently the supply of bank credit. In addition, these factors result in higher interest rates where small enterprises and middle-class borrowers cannot afford bank credit at high interest rates they may not be able to repay (see table 6 above and annex I, table AS). Another factor that may account for low and inefficient intermediation is the presence of an uncompetitive market structure (tables 3 and 4 above). According to Buchs and Mathisen (2005, IMF), there is no one-to-one relationship between concentration and competition. A highly concentrated banking system gives rise to market power for banks. However, monopolistic or oligopolistic trends are more likely to lead to an equilibrium characterized by higher intermediation costs and diseconomies of management than would be experienced under a competitive structure. Therefore, non-competitive behaviour is compatible with the incidence of wide interest spreads, which tend to discourage potential depositors, as well as potential borrowers, and result in low lending ratios. Alternatively, market size may present an opportunity for economies of scale and gathering of information, in addition to economies of scope combining different lines of product. What is relevant for the net result on competition is the level of contestability in the market.50 That is, in spite of market power, the threat of potential competition, or the lack of it, can to a large extent affect the conditions of competitiveness. All of the above factors that possibly tend to slow growth in bank credit result in a vicious circle. Without solving these problems, the economy cannot achieve the desired growth potential. In fact, uncertainty and the lack of confidence prevalent in the financial sector will further aggravate the deceleration in bank credit, resulting in a lower level of new investment and more business failures and non-performing loans (see table 7 above).

50 A contestable market requires low barriers to entry and, in a perfectly contestable market, a total absence of barriers to entry is required. Examples of barriers to entry include: patents; copyrights; special licences; high fixed costs; and legal and illegal marketing barriers constructed by existing firms with market power.

111. MEASURING BANKING SECTOR EFFICIENCY: STOCHASTIC FRONTIER ANALYSIS One of the objectives of a financial liberalization programme is to enhance the efficiency of commercial banks by creating a flexible and competitive financial sector in which banks have more control over their own resource utilization, and by increasing the banks' integration with the rest of the world. This chapter employs a Stochastic Frontier Analysis to evaluate the success of financial liberalization in the ESCWA member countries profiled with regard to improving the efficiency of commercial banks. A. WHYANALYSE BANKING SECTOR EFFICIENCY? Financial systems in ESCWA member countries are still in the initial phases of development and are dominated by bank-financed credit mechanisms or bank intermediation. As such, banks are the main suppliers of credit to private and public investment projects as well as government deficits. This justifies the concerns of policymakers to design appropriate policies for a more efficient and stable banking system. Banks that function well boost the growth prospects of small and medium enterprises and improve the efficiency with which credit is allocated. The success of banking hinges on the ability to identifl the financial services that the public demands, produce those services efficiently, and sell them at a competitive price. Consequently, the most important strategic theme in banking currently revolves around cost management and the efficient utilization of employed inputs per unit of output, a concept closely related to productivity. To that end, the stream of research on bank efficiency published during the past decade devoted much attention to issues related to X-inefficiency,herein referred to as cost inefficiency?l The concept of X-inefficiencywas first introduced by Leibenstein (1966), who noted that, for a variety of reasons, people and organizations normally work neither as hard nor as effectively as they could. Cost inefficiency thus refers to deviations from the cost-efficient frontier that depicts the lowest production cost for a given level of output. Researchers find that X-inefficiency appears to vary substantially across banks (Berger and Humphrey, 1997). On average, deviations from minimum cost or X-inefficienciesare found to be very large, in the neighbourhood of 20 to 25 per cent of total costs for industrialized countries, and they seem to dominate the effect of scale and product mix inefficiencies which generally amount to less than 5 per cent of costs (Berger et al., 1993). In other words, managerial ability to control costs or maximize revenues has greater impact on the cost structure of the financial institution than does the choice of scale and scope of production. Thus, in comparison with scale and scope economies, managerial efficiency, or the concept of X-inefficiency,appears to be a much more important policy and strategic consideration. Recently, technological innovations and globalization have intensified banking competition and posed new challenges for both banks and regulators to promote competition and increase the efficiency of the banking industry. However, the Asian crisis of 1998 also demonstrated that financial liberalization could undermine the safety of the financial sector. Despite these concerns, few attempts have been made to examine the effects of financial liberalization on the efficiency of the banking systems in emerging markets in general and in the ESCWA region in particular. Given the inextricable link between financial sector development and economic growth, since bank intermediation is the essential provider of credit, and in view of the fact that a period of financial liberalization process is under way, this section seeks to examine the efficiency of the banking sector in selected ESCWA member countries. More specifically, the relation between bank ownership, profitability, See, for example, F. Kaparakis, S. M. Miller and A.G. Noulas, "Short-run cost inefficiency of commercial banks", Journal of Money, Credit, and Banking, 1994; S. H . Kwan and R. A. Eisenbeis, An Analysis of IneSJicienciesin Banking: A Stochastic Cost Frontier Approach (Federal Reserve Bank of San Francisco, 1996); R. A. Eisenbeis, G. D. Ferrier and S. H. Kwan, The Informativeness of Stochastic Frontier and Programming Frontier ESJiciency Scores: Cost Efficiency and Other Measures of Bank Holding Company Performance (Federal Reserve Bank of Atlanta, 1999); A. N. Berger, "The integration of financial services industry: where are the efficiencies?Worth American Actuarial Journal, 2000; and A. Rouabah, Economies dYEchelle,Economies de Diversijkation et ESJicacite' Productive des Banques Luxembourgeoises: Une Analyse Comparative des FrontiBres Stochastiques sur Donne'es en Panel, Banque Centrale du Luxembourg, 2002.

concentration and efficiency is examined during the period 1996-2003, is a period following the adoption of financial liberalization measures in these countries. Because of data limitation, the cross-country analysis covers five banking sectors in Egypt, Jordan, Lebanon, Oman and United Arab Emirates and seeks to test the following hypotheses: Hypothesis 1: Bank efficiency has improved since the deepening of the liberalization process. Hvpothesis 2: Highly profitable banks are more cost-efficient than banks with low profitability. Hypothesis 3: Bank efficiency is enhanced in more competitive market structures. Hypothesis 4: Large banks are more cost efficient than small banks. Hypothesis 5: Foreign participation has a positive impact on bank efficiency. B. IMPACTOF FINANCIAL LIBERALIZATION ON BANK EFFICIENCY Financial liberalization has brought substantial changes in the financial sectors of many countries. Early empirical studies on financial liberalization emphasized the macroeconomic impact on the level of savings and investment in the economy (Caprio and others, 1999). They were followed by a large body of research on the impact of financial liberalization on the efficiency of financial institutions. Empirical evidence on the impact of financial liberalization on the efficiency of the banking sectors of industrialized economies is both extensive and mixed. Recent examples include research by Berger and Mester (200 l), Humphrey and Pulley (1997), on United States banking; Grifell-Tatje and Lovell (1996) and Kumbhakar and others (2001) on Spanish banking; Mendes and Rebelo (1999) on Portuguese banking; Dietsch (1993) on French banking; Garden and Ralston (1999) on Australian banking; and Fukuyama and others (1999) on Japanese banking. Studies investigating the deregulation experience in the context of developing economies in general report a positive impact of liberalization on bank efficiency. Leightner and Lovell (1998) argued that the case study of Thailand represents a success of financial liberalization. Gilbert and Wilson (1998) showed that liberalization efforts of the Republic of Korea in privatizing and deregulating the financial industry had led to significant improvements in productivity.52Kumbhakar and Sarkar (2003) used data on India and found that the performance of private banks had improved between pre- and post-deregulation periods although public banks had not responded well to the deregulation measures. The performance of Turkish banks was analysed by Isik and Hassan (2003), who concluded that efficiency improved after the implementation of financial liberalization. A recent study by Ataullah and others (2004) showed that the overall technical efficiency of the banking industry of India and Pakistan gradually improved subsequent to a period of financial liberalization . Few studies, however, conclude that liberalization has no significant impact on bank performance. Research on the Tunisian experience by Chaffai (1997) reported that banks, on average, became less efficient subsequent to liberalization. Further, the findings by Hao and others (2001) suggested that financial deregulation had little or no significant impact on the level of sample bank efficiency in the Republic of Korea. Despite the vast literature on cost efficiency in the United States, European and Australian banking markets, and the rising empirical research in the context of developing countries, few studies have been conducted on the efficiency of the banking sector in the ESCWA region. Lee (2002) used the simple comparative ratio analyses and classical regressions to investigate the impact of financial liberalization and foreign bank entry on the efficiency of banking systems in the MENA region. The findings suggest that foreign bank entry and privatization of State-owned banks accelerated by financial liberalization led to financial sector development by contributing to net profitability, better capitalization for domestic banks and higher overall banking efficiency. Two other studies investigated the impact of financial liberalization on banking efficiency using more sophisticated methodologies described in section C below. Consistent with 52 It should be noted that improvement in bank efficiency resulting from financial liberalization is not a sufficient condition for securing financial sector stability, as was demonstrated by the Asian crises in 1997.

this study, the two papers viewed commercial banks as intermediaries that transform inputs (labour, fixed capital and deposits) into interest-earning assets (loans, liquid assets and fee income). The first study, made by Maghyereh (2004), estimated the efficiency scores of eight banks operating in Jordan over the period 1984-2001. The findings confirm the hypothesis that liberalization policies have had a positive impact on banking efficiency and that large banks are more efficient than small banks. The second study, by Al-Jarrah and Molyneux (2004), was broader in scope. It was conducted on a sample of 82 banks operating in Jordan, Egypt, Saudi Arabia and Bahrain that were grouped together in one sample while adding dummies for countries over the period 1992-2000. The variables included were comparable to those of Maghyereh (2004), although several control and environmental measures were included. The results showed an average cost efficiency of around 95 per cent for all banks. Islamic banks were found to be the most cost-efficient, and investment banks the least efficient. Contrary to Maghyereh (2004), however, the second study found little evidence to suggest that the major economic and financial reforms adopted by Jordan, Egypt, Saudi Arabia and Bahrain over the past decade had had a noticeable impact on banking sector efficiency. C. METHODOLOGY AND THE MODEL

Three methodologies are generally used in standard efficiency measurement, traditional ratio analysis, Data Envelopment Analysis (DEA) and Stochastic Frontier Analysis (SFA). Ratio analysis examines the financial statements of individual firms; it involves calculating performance measures and comparing them with a benchmark.') The ratio analysis has been criticized for being too simplistic. The shortcomings of such a descriptive and static analysis of the data are overcome with the use of more sophisticated techniques such as the DEA and the SFA, which are used extensively in the literature.54 The DEA approach uses a nonparametric technique to produce efficiency scores of Decision-Making-Units (Charnes and others, 1978). It is a linear programming technique that does not require the specification of an a priori functional form for the production function being analysed. It is particularly useful when the sample consists of a small number of banks and when it is not possible to include input prices in the analysis. Finally, the SFA is a parametric technique that adds more statistical sense to efficiency estimation because of the stochastic nature (or randomness) of the sample being tested (Berger and Humphrey, 1997). The DEA approach is criticized on the grounds that it does not make distributional assumptions for the error term. This in turn may lead to an overestimation of inefficiency, especially when statistical noise is not averaged out over time (Allen and Rai, 1996). As noted below, the parametric methodology adopted in the study a stochastic frontier analysis has the advantage of considering the distribution of both error composite terms. Economic efficiency is defined in terms of total cost, and the knowledge of cost functions is important for optimal decision-making, given a certain state of technology. However, a fundamental difficulty with analysing banking technology and its characteristics is the specification of an appropriate measure of output. Banks provide a wide array of services but do not produce physical outputs, and no theoretical or empirical consensus exists as to their measurement (the number andlor the value of accounts). Studies that examine the cost structure of banking markets distinguish between the "production" and the "intermediation" approach.55 In the "production approach", which characterized much of the literature up to the early 1980s, banks are viewed as firms that employ certain inputs (capital and labour) to produce various outputs (deposit and loans accounts) as measured by the respective number of accounts. The financial institution is then defined as a producer of services for account holders. In the alternative "intermediation approach", banks are considered as financial intermediaries between surplus units and deficit units. They produce intermediation 53 Major performance and cost efficiency measures include return on assets and equity, profit margin, net interest margin, non-interest margin, overhead ratio and loan loss provision ratio.

54 For a survey of both methods, see A. N. Berger and L. J. Mester, Effciency and Productivity Change in the US. Commercial Banking Industry: A Comparison of the 1980s and 1990s (Federal Reserve Bank of Philadelphia, 1997), and Inside the Black Box: What Explains Dfferences in the Effciency of Financial Institutions? (Federal Reserve Bank of Philadelphia, 1997).

55 See, for example, P. Molyneux, V. Altunbas and E. Gardner, Efficiency in European Banking (West Sussex [United Kingdom], John Wiley and Sons, 1996).

services (rather than identifiable physical products) through the collection of deposits and other liabilities and the transfer of these sources of funds into interest-earning assets such as loans and investments (Colwell and Davis, 1992). Labour, capital, interest and other operating costs are considered as essential elements in collecting deposits and purchasing funds, and output is generally measured by the dollar value of accounts. In this study, it is not possible to follow the production approach owing to the lack of information about the number of credit and deposit accounts of the banks under study. Further, there is an increasing consensus in the literature that the intermediation approach constitutes a better instrument to study bank efficiency (Berger and Humphrey, 1997). Banks are therefore specified as intermediaries that operate in a competitive market and employ a multiple input-output technology. Outputs are defined as the values of the various categories of interest-bearing assets on the balance sheet, while deposits and borrowed funds are included together with capital and labour as inputs. The implicit assumption in the SFA is that the objective of bank managers is cost minimization. Thus, X-inefficiency in banking results from excessive costs in the production process. The stochastic frontier regression model is a linear regression model with non-normal asymmetric disturbance (Aigner and others, 1977; and Meeusen and Van Den Broeck, 1977). The idea is to estimate a theoretical least cost function for the industry that belongs to the best practice firm. Cost efficiency gives a measure of how close a bank's cost is to what a best-practice bank's cost would be for producing the same output under the same conditions. Specifically, the stochastic cost frontier has the following general (log) form at time t:

Where

Ci Yi, W.,

=

E;

=

= =

measures the expenditures or variable costs incurred by bank i, (YI , . ..,Ymi)2 0 is a vector of m outputs produced by bank i5q (Wli,. ..,Wni)2 0 is a vector of n input prices faced by bank i57, error term

Equation (1) shows that total cost is a function of output levels and input prices. The dependent variable, total costs (C), represents all financial costs incurred in the form of interest expense and noninterest costs, which comprise the vast majority of total banking costsS8.Three output variables, Y,, are considered: loans to customers and discounts (Yl); deposits with banks (Y2);and other earning assets (Y3),so that all financial assets are considered to be outputs.59The estimated function uses three input prices, W,. They represent the unit price of capital (Wl) or the cost of premises and fixed assets measured as total occupancy expenses divided by fixed plant and equipment; the unit cost of funds (W2) defined as total interest expenses divided by banks7 and customer deposits; and the unit cost of labour (W3), defined as total wages and salaries divided by total assets." The error term Ei includes two components: E ~ T ~ ~ + u ~ . The first component viI is a two-sided noise component that is time dependent and captures the effects of uncontrollable (random) factors, while ui is a one-sided non-negative cost-inefficient term that represents controllable factors. The component ui designates inefficiency that may raise costs above the best-practice level, and vi, denotes the random error that incorporates measurement error and luck, which may temporarily give banks high or low costs. The total error Ei is thus asymmetric and positively skewed. Table 8 provides a description of the variables used in the cost function.

56

Loans, interbank deposits, other earning assets, non-interest income and off-balance items are considered as bank outputs.

57

The cost of deposit funds, labour and fixed capital are the major input prices of a bank.

58

Economic costs are not considered since it is difficult to quantifjl opportunity costs and externalities.

59

Additional tests for robustness included separately non-interest revenues and off-balance sheet items as outputs.

60

Total assets are used as a proxy for the number of full-time employees in calculating the cost of labour.

TABLE8. VARIABLES OF THE COST FUNCTION Svmbol C

Input prices W1 W2 W3 Output quantities YI y 2

y3

Definition Total operating plus interest costs, includes costs of deposits, purchased funds, labour and general operating expenses. Unit price of capital Unit cost of funds (including customer and bank deposits) Unit price of labour Loans to customers and discounts Deposits with banks Other earning assets (bank acceptances, marketable securities, miscellaneous debtor accounts and regularization accounts)

The most popular functional form used in a stochastic framework to estimate a cost frontier is the translog function because it fits well those data that are close to the mean in terms of output size or mix (McAllister and McManus, 1993). The flexibility of the translog model serves as an advantage for banking efficiency studies because it is difficult to identify exactly the functional form that fits the banking cost and production technology (Kaparakis and others, 1994). The form of the stochastic frontier model and additional assumptions underlying the estimations are presented in annex I1 to this study. For each country, a separate cost function is estimated. The cost efficiency ratio may be thought of as the proportion of costs or resources that are used efficiently. For example, a bank with a ratio of 0.70 (70 per cent efficient) equivalently wastes 30 per cent of its costs relative to a best-practice firm facing the same conditions. Cost-efficiency ranges over [0,1], and equals 1 for a best-practice firm within the observed data. Such relative efficiency is a more appropriate concept than absolute efficiency, that is, ratio analysis.

D. DATAANALYSIS AND VARIABLES The banking sectors in Egypt, Jordan, Lebanon, Oman and United Arab Emirates differ widely in terms of both size and structure. Table 9 shows that, over the period examined in this study, the average size of the banking sector measured by total assets for deposit money banks varied from as little as US$ 10 billion for Oman to more than US$ 84 billion for Egypt.

TABLE9. TOTALASSETS FOR SELECTED ESCWA MEMBER COUNTRIES (Millions of US dollars) Egypt Jordan Lebanon Oman United Arab Emirates

1996 69599 11049 23 095 6 179 49 087

1997 77599 11880 28 876 8 546 53 453

1998 83776 12396 35 228 9262 6 1 848

1999 89680 14056 38 854 10253 63 103

2000 91842 15787 43 214 10 625 70 036

2001 86135 17381 45 707 1 1 525 75 320

2002 94756 18674 50 163 1 1 602 84 446

2003 84441 19543 57 565 12 116 93 678

Average 84729 15096 40 338 10 014 68 87 1

Source: International Financial Statistics, International Monetary Fund and Central Banks.

The efficiency analysis requires data from bank-level financial statements (costs, inputs and outputs). Such bank level data are not provided by official sources such as central banks or the IMF. Instead, they are retrieved from the private BankScope database provided by Fitch-IBCA (International Bank Credit Analysis Ltd). The BankScope database is used in a number of cross-country studies and has comprehensive coverage in most countries. Since the analysis resorts to microdata published by a private source and might cover all banks; a possible discrepancy is likely to result with those published by either Central Banks or the IMF, which usually cover the whole banking sector at the macro level. Table 10 below checks how representative

of the entire banking sector is the sample of each country by reporting the percentage of the sum of total assets of banks published by BankScope, against those published by the IMF. The figures indicate that the BankScope database covers between 40 and 50 per cent of the banking sector in Egypt, Oman and the United Arab Emirates. In the case of Lebanon, both sources (BankScope and IMF) provide almost identical figures, implying comprehensive coverage of banks by BankScope. However, when checking a third data source, the Central Bank of Lebanon, total assets of the banking sector were found to differ from those reported by the IMF International Financial Statistics, and the average total asset percentage dropped from 97 to 62 per cent. A greater problem was faced with the data representation for ~ordan? The figures provided by BankScope which, in principle, does not cover the entire banking sector, are found to exceed the figures supplied by the International Financial Statistics. Moreover, when figures published by the Central Bank of Jordan were used, the sample average total assets percentage dropped but still exceeded 100 per cent. To verify sample data on individual banks' total assets retrieved from BankScope, a comparison was made of those total assets with those published in banks7 annual reports; the figures were found to coincide.

TABLE10. RATIO OF BANKS' TOTAL ASSETS REPORTED BY BANKSCOPE TO TOTAL ASSETS OF THE BANKING SECTOR AS REPORTED BY THE INTERNATIONALMONETARY FUND (Percentage)

Egypt Jordan Lebanon Oman United Arab Emirates*

1996 29.62 173.27 91 -57 54.38

..

1997 32.81 183.95 96.56 76.41 15.46

1998 35.20 182.83 97.18 43.55 53.16

1999 52.10 173.70 100.75 63.43 42.96

2000 43.29 174.74 98.09 47.63 52.19

2001 54.77 169.08 93.30 47.13 42.79

2002 2003 Average 54.05 50.78 44.08 157.34 158.82 171.72 99.34 98.19 96.87 42.55 41.63 51.06 41.71 41.10 41.34

Source: The total assets were retrieved from the IMF International Financial Statistics, while the sample was drawn from BankScope. Note: * For the United Arab Emirates, the BankScope database covers fewer banks in 1997 than in the following years.

The country samples consist of unbalanced panel data on individual commercial banks. All microdata were converted to United States dollars using end-of-year exchange rates. The BankScope data sample does not cover the entire banking sectors in the five ESCWA member countries. Specialized, investment, and Islamic banks are excluded from the analysis for purposes of regional comparison. The analysis thus focuses on commercial banks for which data are available in the BankScope database. All cost and input price terms are normalized by the last input price, W3,to impose linear homogeneity on the model. All the variables are logged and have one added for every firm to avoid taking the natural logarithm of zero. Descriptive statistics on inputs and outputs are presented in table 11 below. Statistics on total assets show a smaller variability in bank size in Oman and the United Arab Emirates compared with the other countries profiled. The large standard deviation relative to average total assets suggests that banking in Egypt, Jordan and, to a lesser extent, Lebanon is not homogeneous in the sense that small banks are operating alongside large banks. This disparity forces banks to compete on unequal ground and suggests the possibility of a greater merger wave in the future for banks operating in Egypt, Jordan and Lebanon. This finding is verified with statistics on loans as well.

61

* Ratio of banks' total assets reported by bankscope to total assets of the banking sector as reported by central banks.

Jordan Lebanon

1996 146.03

1997 152.70 61.10

1998 153.62 63.38

1999 149.86 64.20

2000 151.47 62.44

2001 147.22 59.21

2002 137.79 62.85

2003 140.16 62.37

Average 147.36 62.23

It is also interesting to note that lending behaviour differs among ESCWA member countries as well. Banks operating in Jordan and Lebanon lend around one third of their sources of funds owing to either conservative lending policies or to limited investment opportunities. Commercial banks in Egypt lend a higher proportion of their assets (around 50 per cent); banks in Oman and the United Arab Emirates, however, lend more than 60 per cent of their total assets. This suggests that banks in Jordan, Lebanon and Egypt have alternative uses of funds, as is confirmed by their relatively high proportion of "other earning assets" to total assets. It seems that commercial banks in Jordan and Lebanon, and to a lesser extent in Egypt, prefer less risky and therefore less rewarding activities than lending, possibly indicating a source of cost inefficiency.

TABLE1 1 . DESCRIPTIVE STATISTICS ON BANKING SYSTEMS OF SELECTED ESCWA MEMBER COUNTRIES FOR 1996-2003 (Millions of US dollars)

Country Egypt* (24 banks)

Jordan (10 banks)

Lebanon (42 banks)

Oman (7 banks) United Arab Emirates (14 banks)

Statistic Mean Min Max Standard dev. Mean Min Max Standard dev. Mean Min Max Standard dev. Mean Min Max Standard dev. Mean Min Max Standard dev.

Total assets

Loans

3 142.1

1 961.0

Deposits with other banks

852.3

Other earning assets

1 157.3

Customer deposits

2 622.1

Interest expense

104.0

Personnel expenses

Other expenses

24.7

17.8

Total cost**

137.2

Source: Bankscope database. Notes: * Personnel expenses are not provided separately in the financial statements. Rather, they are combined with "other expenses".

**

Note that for the minimum and maximum values and for the standard deviation, the sum of interest, personnel, and other expenses does not necessarily equal total cost. Minimum and maximum values may represent different banks at different periods of time.

A close look at the cost structure of banks indicates that the average proportion of total cost given in the last column of table 11 relative to total assets, given in the first column of the table, is the lowest for the United Arab Emirates (around 4 per cent). The corresponding ratio in Jordan is 5.5 per cent, in Oman 6.0 per cent and in Lebanon and Egypt 7.5 per cent. This finding is verified with the ratio of average cost to average loans (less than 7 per cent for the United Arab Emirates, around 8 per cent for Oman, 14 per cent for Egypt and Jordan, and more than 28 per cent for Lebanon). The figures suggest that the banking sectors in Egypt, Jordan and Lebanon are likely to be more cost-inefficient than the banking sectors in Oman and the United Arab Emirates.

E. EMPIRICAL RESULTS Table 12 reports the cost-inefficiency scores calculated over the period 1996-2003 for the selected ESCWA member countries.62As the Bankscope data sample does not completely cover the banking sectors in the five ESCWA member countries under study, the results have to be interpreted with some degree of caution. TABLE12. AVERAGE COST INEFFICIENCY (Percentage) Egypt Jordan Lebanon Oman United Arab Emirates

1996 19.05 68.66 50.35 4.07

..

1997 19.17 68.12 50.57 3.39 13.95

1998 17.26 64.71 47.71 2.85 9.43

1999 20.77 61.60 46.96 2.26 6.41

2000 21.32 54.19 46.08 1.88 4.57

2001 22.03 53.41 47.14 1.57 3.16

2002 23.19 54.52 46.57 1.33 2.21

2003 23.77 51.87 44.56 1.11 1.56

Average 20.82 59.64 47.49 2.3 1 5.90

Source: ESCWA secretariat calculations.

The reported results were the average inefficiency estimates for the banking sector on a yearly basis for each of the countries profiled. It should be noted that, for any given year, banking inefficiency varies greatly among different banks, but only the average scores were reported. For instance, for the year 2003, the minimum, maximum and standard deviation of the calculated inefficiency estimates for Egypt were 7.1 5, 34.77 and 6.23 per cent respectively, which resulted in an average score of 23.77 per cent. Similarly, for Lebanon in the year 2003, the minimum, maximum and standard deviation of the calculated inefficiency estimates were 3.29, 72.93 and 16.40 per cent respectively, which gave an average figure of 44.56 per cent. For the United Arab Emirates, however, smaller variation was reported as the minimum, maximum, standard deviation and average inefficiency estimates were 1.29, 1.91,0.21 and 1.56 per cent respectively. The figures in table 12 show a gap between the average cost efficiency of Oman and the United Arab Emirates on one side, and Egypt, Jordan and Lebanon on the other side. The inefficiency of the Omani banking sector decreased steadily between 1996 and 2003 to a very low level of l . l per cent, suggesting that Omani banks were spending only around 1 per cent more on resources than a bank on the cost frontier for the same level of output. Banking in the United Arab Emirates showed improvement in terms of cost efficiency; an average of less than 6 per cent of inputs was wasted relative to a best-practice bank. The cost inefficiency of Egypt remained stable at around 20 per cent; Jordan and Lebanon witnessed a relative decrease in their respective cost inefficiency over the years examined, although they were still at very high levels. It should be kept in mind, however, that these results only serve as a reference since they measured bank efficiency in comparison within their own frontiers. It cannot be concluded, therefore, that banks in the United Arab Emirates are more efficient than Egyptian banks and less efficient than banks in Oman. The findings confirm the observations of section D above regarding the predicted inefficiency levels of the countries under study. Many small banks are operating alongside very large banks in Jordan and Lebanon, and to a lesser extent Egypt, a situation that forces them to compete on unequal ground. Lending activity in these countries seems both limited and conservative; most of the asset portfolios of these banks are invested in relatively riskless securities. In view of the fact that these banks incur high costs relative to their asset size, a high proportion of bank resources (deposits, labour and fixed capital) are wasted in their intermediation function as a financial institution compared with the banking sectors in Oman and the United Arab Emirates.

" Alternative cost frontiers are also estimated for robustness checks (not reported). Other bank output variables such as offbalance sheet items and non-interest revenues are included; the estimation provided consistent results and "rankings" among the countries under study.

Research that uses the same methodology (SFA) and variables as those employed in the present study concurs that X-inefficiencies in banking account on average for 10 to 30 per cent of banking costs in the United States, Australia and European countries (Berger and others, 1993; Esho, 2001 ; and Rouabah, 2002). However, research on bank efficiency for developing economies using the SFA is much less conclusive. To illustrate, a cross-section study on the banking sector in India (Srivastava, 1999) reports an average of less than 4 per cent cost inefficiency.63 In contrast, research using the DEA methodology reports an average cost inefficiency of 20 per cent for India (Bhattacharyya and others, 1997), and another paper finds 35 and 55 per cent cost inefficiency for India and Pakistan respectively (Ataullah and Le, 2004). Studies on Chile (using the SFA technique) find an average of 9 per cent cost inefficiency for the 1990s (Fuentes and Vergara, 2003), an average of 30 per cent for Mexico (DEA methodology, Taylor et al., 1998), a 13 to 45 per cent range for Croatia (SFA technique, Kraft and Tirtiroglu, 1998), 26 to 50 per cent cost inefficiency for banks in Thailand (DEA methodology, Intarachote, 2002), and a ratio of 20 per cent cost inefficiency for banks in Turkey employing the same estimation technique used in this study. Empirical findings on banking sectors in Arab countries report an average of 45 per cent cost inefficiency for Tunisia (DEA technique, Cook and others, 2000), and 9 per cent for Jordan (DEA technique, Maghyereh, 2004). It seems, therefore, that many studies have investigated banking sector efficiency using varying time periods, methodologies and countries. There is still no consensus on the sources of the sizeable variation in measured efficiency or on the average level of cost efficiency in the banking industry.64The only research that covers two of the countries included in this study and uses the SFA technique is the above-mentioned paper by Al-Jarrah and Molyneux (2004), which reported an average of 6 and 11 per cent inefficiency for Egyptian and Jordanian banks respectively compared with 20 and 60 per cent for this study. The figures are considerably different from those reported in table 8 above owing to a different period covered (1992-2000 compared with 1996-2003 herein), type of banks included (commercial, Islamic, investment and specialized banks compared with only commercial banks in this study), number of banks considered (37 and 14 for Egypt and Jordan compared with 24 and 10 respectively), and definition of bank output (including additional bank outputs such as off-balance sheet items and non-interest income). Instead this study estimates separate cost frontiers for each banking sector considered. It is expected that liquidity, capital requirements, competitive pressures and overall business conditions differ among ESCWA member countries so that grouping them together is likely to lead to sample bias. Both studies, however, provide the same "relative ranking" for Egypt and Jordan. F. DETERMINANTS OF THE DEGREE OF INEFFICIENCY

1 . Tobit regressions The purpose of this section is to take a step further in analysing banking sector inefficiency indicators by looking at their potential determinants, and to test the five hypotheses stated above. The first hypothesis examines whether bank efficiency has improved since the deepening of the liberalization process. The period of study covered the years 1996 through 2003, which is a post-liberalization period in ESCWA member countries. Owing to unavailability of data, it was not possible to extend the analysis to the pre-liberalization period as well. At best, the data make it possible to observe the trend in cost inefficiency subsequent to liberalization, which is a gradual and lengthy process. The results in table 12 indicate an improvement in cost efficiency for Jordan, Lebanon, Oman and the United Arab Emirates, and a worsening of the inefficiency level for Egypt (see figure XI). 63 It is important to note that cross-country comparison of eficiency levels needs to be interpreted with caution. Efficiency scores are difficult to interpret because the "regulatory and economic environments faced by financial institutions are likely to differ importantly across nations and because the level and quality of service associated with deposits and loans in different countries may differ in ways that are difficult to measure" (A. N. Berger and D. B. Humphrey, "Efficiency of financial institutions: international survey and directions for future research", European Journal of Operational Research, 1997, p. 17).

This finding is confirmed by A. N. Berger, N. D. Hancock and D. B. Humphrey, "Bank efficiency derived from the profit hnction", Journal ofBanking & Finance, 1993.

Figure XI. Trend of average cost inefficiency over time

Source: ESCWA secretariat calculations.

Previous literature on bank efficiency investigated its possible determinants by accounting for ownership, loan quality, profitability, market structure, size and other macroeconomic variables? It should be noted that the idea is to identify factors that can affect the difference in the degree of inefficiency across the banking systems of ESCWA member countries. A series of second-stage panel data fixed-effects Tobit regressions are employed to explore the relation between cost inefficiency and other bank-specific features such as risk and return indicators, concentration, lending activity, capitalization and bank size. The dependent variable is the bank inefficiency estimate calculated in section E above for each bank included in the sample and across the five countries profiled. To control for firm-specific features and other related portfolio positions and management practices, the Tobit regression model includes a bank's (a) return on assets (profitability); (b) volume of non-performing loans to total loans (loan quality or credit risk); (c) total assets as a share of total assets of the banking system of its country of origin (market concentration); (4) loan size relative to total assets (lending pattern); (e) equity as a share of total assets ( capitalization); and (f) logarithm value of total assets (bank size). The exogenous variables were obtained from BankScope. A definition and description of the variables can be found in table 13. TABLE13. DESCRIPTION AND DEFINITION OF VARIABLES Variable name Profitability Credit risk Concentration Loan portfolio size Capitalization

Description Pre-tax return on assets, return on assets and return on equity (calculations based on data from BankScope) The ratio of non-performing loans to total loans and loan loss provisions to total loans (calculations based on data fi-om BankScope) A measure of the degree of concentration in banking, calculated as the fraction of assets (deposits) held by each commercial bank (calculations based on data from BankScope) The ratio of bank loans to total assets (calculations based on data from Bankscope) The ratio of bank equity capital to total assets. (calculations based on data from BankScope)

The coefficient of the return or profitability variable is expected to be negative, since higher profitability for the banking sector is assumed to enhance cost efficiency (Miller and Noulas, 1996). For concentration, as noted in chapter 11, section D above, the literature shows no clear theoretical relationship between concentration and bank efficiency; therefore the sign of the estimated regression coefficient can be either positive or negative. Similarly, the literature shows no clear relation between bank size and cost - -

65 See, for example, T. Coelli, D. S. P. Rao and G. E. Battese, An Introduction to Efficiency and Productivity Analysis (Boston, Kluwer Academic Publishers, 1998) and A. Maghyereh, "The effect of financial liberalization on the efficiency of financial institutions: the case of Jordanian commercial banks", Savings and Development, 2004.

efficiency? It can be argued that large banks are more cost-efficient than small banks because they benefit from economies of scale and scope, or alternatively, they could be operating a large number of branches or using expensive technology, thus leading to greater inefficiencies. In terms of the impact of lending behaviour, given that the main function of a commercial bank is to intermediate funds between surplus and deficit units, it is predicted that a larger volume of lending will increase banking efficiency. However, commercial loans vary in size, repayment schedule, risk, transparency of information, type of collateral and covenants. To that end, the volume of non-performing loans as a share of total loans is included as a control for loan quality. Higher credit risk is likely to increase bank inefficiency; hence a positive relationship is predicted between non-performing loans and cost inefficiency. Finally, banking efficiency is likely to be affected by its level of financial capital (Berger and Mester, 1997). A bank's capital level directly affects costs by providing an alternative to deposits as a funding source for loans. Furthermore, a bank's insolvency risk depends on its financial capital available to absorb losses, which means that there will probably be a negative relation between bank capitalization and cost inefficiency. Table 14 reports the Tobit regression results of five estimated models. All of the estimated parameters have the predicted signs. The findings suggest that, for the countries profiled in the study, risk and return measures are the major determinants of banking efficiency. Different estimates of the coefficients of bank profitability are highly significant across the estimated models, implying that an increase in bank profitability would be accompanied by a rise in cost efficiency. The results thus lend support to hypothesis 2, namely that higher profitability banks have higher efficiency. Similarly, greater lending activity and better capitalization are found to be significant determinants of bank efficiency across the five estimated models. However, a large share of non-performing loans significantly decrease cost efficiency, suggesting a risk-return trade-off in the banking sector. Banks that spend less resources on credit underwriting and loan monitoring could be more efficient, but at the expense of more problem loans.

TABLE14. TOBITREGRESSION RESULTS Variable Constant ~rofitabili+ Credit riskbJ

Model 1 0.83 1 (0.053)*** -3 .035 (0.533)***

~oncentration~l

Model 2 0.87 1 (0.053)*** -2.802 (0.533)*** 0.00006 (0.00002)***

Loan portfolio size Capitalization Bank size

-1.338 (0.140)*** -0.045 (0.0067)***

-1.393 (0.139)*** -0.049 (0.0067)***

Model 3 0.895 (0.044)*** -1.513 (0.457)***

Model 4 0.872 (0.053)*** - 1.542 (0.458)***

-0.733 (0.046)*** -0.940 (0.120)*** -0.0 19 (0.006)***

-0.07 1 (0.09 1) -0.728 (0.046)*** -0.927 (0.121)*** -0.016 (0.007)**

Model 5 0.924 (0.053)*** - 1.262 (0.456)*** 0.00007 (0.00002)*** -0.056 (0.089) -0.735 (0.046)*** -0.989 (0.120)*** -0.0 19 (0.007)***

Source: ESCWA secretariat calculations. Notes: Standard errors corrected for heteroscedasticity using the White method are given between parentheses. *, **, and *** indicate significance at the 10, 5 and 1 per cent level respectively. a/The tests are run using pre-tax return on assets (ROA), ROA and return on equity (ROE) for robustness. The results are consistent but not reported. b/The tests are run using the volume of non-performing loans to total loans and loan loss provisions to total loans. The results are consistent but not reported. -c/The tests are run using total assets concentration and deposits concentration for robustness. The results are consistent but not reported.

'' See, for example, L. J. Mester, "Measuring efficiency at U.S. banks: accounting for heterogeneity is important", European -

p

-

Journal of Operational Research (Federal Reserve Bank of Philadelphia, 1996); and S. H. Kwan and R. A. Eisenbeis, An Analysis of Inefficiencies in Banking: A Stochastic Cost Frontier Approach (Federal Reserve Bank of San Francisco, 1996).

With respect to market structure, the coefficient of bank concentration is not found to be a significant determinant of cost efficiency in banking, and hypothesis 3 is rejected. Its negative sign, however, suggests that banks that operate in more concentrated markets are likely to be more cost-efficient than those that face more competitive conditions, thus providing a justification for bank mergers. Finally, the results show a significant negative relation between bank size and cost inefficiency. It seems that large banks in the countries profiled are more cost-efficient than small banks; hence the findings lend support to hypothesis 4.

2. Correlation analysis

A correlation analysis is used to test the fifth hypothesis regarding foreign ownership and bank efficiency.67The idea is to incorporate into the analysis additional determinants of cost efficiency that were not considered by the previous regressions because of difficulties with obtaining a consistent series over the years of study. Such variables (defined in table 15) cover foreign ownership, capital market development, banking sector size relative to GDP, GDP per capita, and structural and regulatory indicators of the general business environment. The exogenous variables were obtained from a variety of sources, including Fitch7s BankScope database, the Heritage Foundation, Lee (2002) and the World Development Indicators. A definition and description of the variables can be found in table 15. TABLE15. DESCRIPTIONAND DEFINITION OF VARIABLES Bank size GDP per capita Foreign ownership Capital market development Property rights

Political stability

Regulation

The natural logarithm of total assets. (Calculations based on data from Bankscope) Logarithm of per capita GDP expressed in constant 1995 US dollars averaged over the period 1996-2003. Source: World Bank Indicators Foreign representation in the country. Source: Directory of Arab Bank (2004) A measure of capital market development. Source: Lee (2002) An indicator of freedom from government influence over the judicial system Commercial code defrning contracts Sanctioning of foreign arbitration of contract disputes Government expropriation of property Corruption within the judiciary Delays in receiving judicial decisions Legally granted and protected private property The index is averaged over the period 1996-2003, with higher values indicating a worsening in property rights. Source: Heritage Foundation's Index of Economic Freedom An indicator of the political stability of a country. The index ranges from -2.5 to +2.5 and is averaged over the period 1996-2003 with higher values indicating more political stability. It measures perceptions of the likelihood that the government in power will be destabilized by possibly unconstitutional andor violent means. Source: Kaufmann et al. (2003). Licensing requirements to operate a business Ease of obtaining a business licence Corruption within the bureaucracy Labour regulations, such as established workweeks, paid vacations, and parental leave, as well as selected labour regulations Environmental, consumer safety, and worker health regulations Regulations that impose a burden on business Higher values imply that the government impedes creation of new businesses and more corruption prevails. Source: Heritage Foundation's Index of Economic Freedom

Data on foreign bank participation are available on a per country basis and not on a yearly basis.

57

Foreign bank ownership is calculated as the fraction of the banking system's assets that are 50 per cent or more foreign-owned. This variable has been used in the literature to investigate the impact of the banking structure on performance, stability and efficiency.68 As noted in chapter 11, section D above, financial liberalization and incentives to attract foreign banks are based on the premise that there are net gains from foreign entry in the domestic banking system. Levine (1997) suggests that foreign banks help promote capital inflows and competition and can play an important role in improving the functioning of the payments system, mobilizing domestic savings and improving resource allocation, thus modernizing and increasing the efficiency of the financial system. In this respect, the presence of foreign banks leads to better disclosure requirements which, together with a better regulatory environment and improved definition of property rights, ultimately have a positive effect on a country's growth performance. To this end, a variable measuring property rights taken from the Heritage Foundation is included in the correlation analysis. The index was averaged over the period 1996-2003, with a lower score indicating better protection of property rights in the country. Another variable employed is the index of political stability. Political stability is a major factor that can affect the level of economic development of a country and of its financial sector. This indicator is one of six governance indices provided by Kaufmann and others (2003), with higher scores indicating more political stability.69 It captures the idea that the quality of governance in a country is compromised by the likelihood of overthrowing the Government in power, which could eventually undermine the efficiency of the banking sector. The regulatory framework for conducting business in the country is proxied by the regulation index that is published on a yearly basis by the Heritage Foundation, with a higher score indicating less business protection and more corruption in the economy. Additional variables covered by correlation analysis are a measure of the general level of development of the capital market taken from Lee (2002),7O banking sector size relative to GDP,~* and the general level of development of a country as represented by per capita G D P . ~Correlation ~ analysis results are listed in table 16. The results of the analysis lend support to hypothesis 5, namely that foreign participation in the domestic banking markets enhances banking efficiency. Greater competition from non-banks also positively affects cost efficiency. Competition arising from capital markets appears to be desirable and does not undermine the efficiency of the banking sector. However, large banking sectors relative to the economy have an adverse effect on bank efficiency. This is particularly true for Lebanon, Jordan and Egypt, where the size of the banking sector accounts for 245, 170 and 110 per cent of GDP respectively, compared with 90 and 56 per cent for the United Arab Emirates and Oman respectively.73A negative association is reported between GDP per capita and cost inefficiency, indicating that the higher the level of economic development of the country, the better the level of banking efficiency. The remaining variables also provide insightful information regarding the relation between cost efficiency and the structural set-up of a country. It is interesting to note that banking efficiency is improved in an environment that enforces property rights protection, that provides an appropriate regulatory framework for conducting business, and that is politically stable.

See, for example, D. Grigorian and V. Manole, Determinants of Commercial Bank Per$ormance in Transition: An Application of Data Envelopment Analysis, 2002; and I. Hasan and K. Marton, Development and EfJiciency of the Banking Sector in a Transitional Economy: Hungarian Experience, 2000. 69 The six governance indicators are: voice and accountability; political stability; government effectiveness; regulatory quality; rule of law; and corruption. 70 Capital market development is measured as the product of three ratios including stock market capitalization to GDP, stock market total value traded to GDP and stock market turnover to GDP. "

IMF statistics on deposit money banks.

72

Data on GDP per capita are retrieved from the World Bank Indicators.

73

Data are retrieved from IMF statistics, 2004.

TABLE16. CORRELATION ANALYSIS

Percentage of foreign ownership Capital market development Banking sector to GDP GDP per capita Property rights freedom Regulation Political stability

Banking inefficiency

Percentage of foreign ownership

Capital market development

-0.788 -0.585 0.843 -0.573 0.418 0.399 -0.7 13

0.306 -0.755 0.682 -0.514 -0.695 0.904

-0.440 0.82 1 -0.863 -0.883 0.653

Banking sector to GDP

-0.262 0.499 0.321 -0.786

GDP per capita

-0.661 -0.890 0.786

Property rights freedom

0.850 -0.831

Source: ESCWA secretariat calculations.

The analysis of the inefficiency results shows that banks that have a good performance record are reported to be more cost-efficient than banks that do not engage in profitable investment opportunities. This result survives after controlling for other bank-specific and macro variables. A positive relationship is also consistently reported between capital adequacy, bank size and cost efficiency as well. However, banking sectors that tend to intermediate financial instruments rather than act as loan-deposit institutions waste a high percentage of their resources. This is the case of Egypt, Jordan and Lebanon, which in general adopt conservative and tight lending policies compared with Oman and the United Arab Emirates. The same is true for banking sectors that carry a large volume of problem loans relative to their asset size, which results in an adverse effect on cost efficiency. A lower level of loan quality or a higher level of credit risk significantly decreases cost efficiency. Governments in the ESCWA region need to address the problem of high nonperforming loans in order to make commercial banks more efficient in generating loans and advances for economic growth. At present, commercial banks may not feel threatened by a high volume of nonperforming loans, since small banks eventually merge with larger financial institutions and Central Banks generally intervene to support banks that are "too big to fail". A major policy recommendation is therefore that appropriate safety nets and deposit insurance schemes should be designed with a view to the problems that are likely to result from the information asymmetry problem inherent in banking. Particular attention, however, should be made not to give incentives for increased moral hazard. The analysis shows that ESCWA member countries will gain in terms of greater banking efficiency if they strengthen financial sector development. Commercial banks have greater incentives to operate efficiently as they face more competition from the deepening of capital markets. Similarly, efficiency benefits are likely to result from tight competition with foreign banks. Commercial banking efficiency in the ESCWA region will thus increase with the relaxation of foreign bank entry requirements and encouragement of capital inflows. In addition, these results imply that on the structural level, Governments in the ESCWA region need to develop an adequate legal system that encourages banks to engage in greater lending activity. To this end, a major policy recommendation is to ensure a rigorous regulatory framework to protect property rights, encourage the establishment of business organizations and fight corruption. Further, politically stable environments enhance commercial banking efficiency, which ultimately results in a better allocation of resources and promotes economic growth. Finally, with regard to the limitations of the analysis, only cost aspects of the intermediation of funds are considered. Banks improve their efficiency by maximizing profits as well as minimizing costs. Banking is a service industry in which it is difficult to control for output quality, and where customers are generally willing to pay a premium for better service quality. A bank may appear to be cost-inefficient, but it can also be at the same time revenue- or profit-efficient. Thus, future research on the ESCWA region should combine cost efficiency with profit efficiency for effective policy intervention.

IV. IMPACT OF PRIVATE CREDIT DEVELOPMENT ON ECONOMIC GROWTH: EMPIRICAL EVIDENCE

In this chapter, the relationship between financial development and economic growth in the ESCWA region is examined. Following the recent empirical literature on the finance-growth nexus, a panel model was set up that account for unobserved country-specific effects and controls for other potential determinants of economic growth in the region. A. DATAAND METHODOLOGY In order to analyse the link between financial development, in particular private credit, and economic growth in the ESCWA region, a panel data set with annual observations on 10 ESCWA member countries was constructed, covering the period 1980-2003. Four more countries were included in the new panel data set (Bahrain, Kuwait, Saudi Arabia and Yemen) in addition to the countries profiled in the chapters above (Egypt, Jordan, Lebanon, Oman, Syrian Arab Republic and United Arab Emirates). This made it possible to obtain a larger sample size and to increase the statistical reliability of the results. Owing to missing data, the panel data set is unbalanced. Specifically, reliable data were not available for Lebanon during the period 1980-1989, for Kuwait during the period 1990- 1995, and for Yemen during the period 1980-1990. The panel approach makes it possible to exploit both the cross-section and the time-series dimension of the data. The study accounts for unobservable country-specific effects by estimating a fixed-effects model with constant slopes and different intercepts according to the country. The choice of a fixed-effects model rather than a random effects model is based on the results of a Hausman test suggesting that the correlations of the random effects with the regressors are statistically significant. The reduced form model relates the growth rate of real per capita GDP to an indicator of financial development, controlling for other factors that are likely to affect economic growth. Owing to limited availability of data, the study uses annual observations instead of data averaged over five years which would have the desirable property of abstracting from business cycle phenomena. Data on growth of GDP per capita were taken from the World Development lndicators online database. Since banks dominate the financial intermediation process in the ESCWA region, the study followed Levine and Zervos (1998) and Beck and Levine (2004) and used the ratio of bank credit to the private sector in relation to GDP as a proxy for financial development. As emphasized in chapter I1 above, this indicator is regarded as superior to alternative measures such as monetary aggregates M2 or M3 since it isolates credit extended by commercial banks to the private sector. Data on private credit were taken from several issues of the IMF International Financial Statistics Yearbooks. As highlighted by Beck and Levine (2004), simply dividing annual private credit by GDP would result in an inaccurate measurement induced by inflation, as private credit is a stock variable and GDP is a flow variable. The following formula was used to calculate the private credit to GDP ratio:

where PC is private credit and CPIa and CPIe are the average and end-of-year consumer price indices respectively. GDP and CPI data were taken from several issues of the IMF International Financial Statistics Yearbooks; however, some data for Lebanon, the United Arab Emirates and Oman were taken from the ESCWA National Accounts Studies as they were not available in the International Financial Statistics Yearbooks. That included data on GDP for Lebanon (1980-2002) and the United Arab Emirates (1999-2002) and data on CPI for Lebanon (1986-2002), the United Arab Emirates (1986-2002) and Oman (1986-2002). In order to test the impact of financial development on real GDP per capita growth in the ESCWA region, it is necessary to control for other potential determinants of economic growth in the regressions (lagged GDP per capita, human capital, size of the public sector and trade openness). To account for convergence, real GDP per capita with a lag of one period as an explanatory variable was included. As data

on average years of schooling were unavailable for almost all of the sample countries, net primary school enrolment rates from the World Bank World Development Indicators were used to control for human capital accumulation. Owing to the restricted number of observations, current rather than lagged values of this indicator were used. As highlighted by Hakura (2004), the size of the public sector appeared to be an important determinant of growth in the ESCWA region. The ratio of government final consumption expenditure to GDP was used as a proxy for the size of the public sector. Finally, following recent panel studies such as those by Beck and Levine (2004) and Allen and Ndikumana (2000), the sum of exports and imports divided by GDP was included in the set of regressors in order to measure trade openness. The ratio of government final consumption expenditure to GDP and trade as a percentage of GDP data was taken from the World Bank World Development Indicators. In contrast to Beck and Levine (2004), this set of explanatory variables excluded the inflation rate and the black market premium, since recent empirical work on the Arab region did not find that there was a significant impact of those variables on economic growth. Certainly, political and military conflicts have negatively affected economic growth in the region over the past few decades. However, the sample excluded data on Lebanon, Kuwait, and Yemen during years of conflict. Thus, the results of the analysis are not expected to suffer from a severe bias due to the effects of military conflicts. To summarize, the reduced-form model has the following form:

where y, is real per capita GDP in country i for period t, a is the country specific intercept, PCR is the private credit to GDP ratio, X is the set of explanatory variables other than lagged per capita GDP and private credit as a share of GDP (government consumption, trade openness, school enrolment), and E is an error term that is assumed to be white noise.

Table 17 presents the results of the fixed-effects panel regressions. The t-statistics of the coefficients are given in parentheses. Each of the six regressions includes the private credit to GDP ratio and the lagged value of real GDP per capita as explanatory variables. The first three regressions (columns 1 to 3) controlled sequentially for government consumption, trade openness and school enrolment, while regressions 4 to 6 each include two of the three additional explanatory variables. TABLE17. FIXED-EFFECTS ESTIMATION OF THE RELATION BETWEEN FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH

Regressors

Private credit Lagged GDP per capita Government consumption Trade openness

(1 0.0 1 (0.46) -0.42*** (-6.26) -0.15*** (-3.30)

-0.05

(-1.02)

School enrolment Unweighted Number of observations

(2) 0.02 (0.82) -0.34*** (-5 .25)

0.23 184

0.2 1 183

Source: ESCWA secretariat calculations. Notes: t-values are in parentheses. *, **, *** indicate significance at the 10, 5 and 1 per cent level. All variables are included in logarithmic form.

(3) 0.04

(4) 0.002

(5) 0.04

(6) 0.05

Overall, the fixed effects regressions failed to find a significant correlation between banking sector development and economic growth in the ESCWA region. While, in each of the six regressions, the coefficient for private credit to GDP ratio was positive, the t-statistics were not significant even at the 10 per cent level. Moreover, the coefficients were very small. This result was in line with other empirical studies that used panel data to examine the relation between financial sector development and economic growth in MENA countries (see, for example, Ben Naceur and Ghazouani (2003) and Achy (2003)). While the majority of panel studies that cover a broad sample of developed and developing countries, such as Levine, Loayza, and Beck (2000) and Beck and Levine (2004), found evidence of a strong link between financial development and economic growth, this was not the case in studies that covered only the MENA countries. Improvements in financial development over the past decade in most of the countries were not associated with higher rates of economic growth. Several factors might explain this result. First, recent work, for example by Rioja and Valev (2004), suggests a non-linear impact of financial development on growth. Countries that are below a certain threshold of financial development gain very little from small improvements in financial intermediation, while the positive effects are much stronger for countries above this threshold. The ESCWA sample includes countries that are still at very early stages of financial development, especially the Syrian Arab Republic and Yemen. Secondly, as shown above, credit allocation in many ESCWA member countries is still strongly biased towards the government and public sector enterprises. Moreover, the economic structure in most GCC countries is dominated by the oil sector in which the public sector holds a major stake. Given the key role of the public sector in the economic and financial structure of ESCWA member countries, the impact of credit to the private sector on overall economic growth can only be limited. Thirdly, chapter I1 demonstrated that a large fraction of the private credit expansion in the past decade was in the form of personal loans, thus stimulating current consumption rather than productive investment. Fourthly, the ESCWA measure of financial sector development is purely quantitative and does not contain information on the way any additional funds are used. Institutional weaknesses and the high political instability in the region may have led to a very inefficient allocation of credit and thus hampered economic growth. Finally, and perhaps not least importantly, the strong dependence of the ESCWA region on developments in the oil markets has resulted in an erratic and unbalanced growth pattern over the past few decades. Given the more stable evolution of private credit, the use of annual data instead of period averages may have biased the relationship between financial development and growth. Concerning the other potential growth determinants included in the reduced-form model, the results are in line with expectations. The coefficient on lagged GDP per capita is negative and significant at the 1 per cent level in each of the six regressions, indicating robust convergence in per capita income among ESCWA member countries. The size of the public sector, measured by government consumption as a share of GDP, appears to have a negative effect on economic growth. The respective coefficient is significant at the 1 per cent level in two out of three regressions (columns 1 and 4 in table 17 above). This result corroborates the findings of Hakura (2004), who identified very large public sectors as one of the major reasons for the poor growth performance of MENA countries in the past decades. Pritchett (1999) and Hakura (2004) pointed out that very large public sectors have a negative effect on economy-wide productivity levels, as they tend to distort national labour markets and discourage private business activities. Moreover, high and rising public consumption levels in the region constrain public investment, hindering capital accumulation and thus lowering economic growth. According to the estimations of this study, higher school enrolment ratios are weakly associated with higher economic growth in the ESCWA region. Several studies have attempted to explain the weak link between education and growth in Arab countries. For example, Pritchett (1999) pointed to the distorted labour markets and the low quality of education as probably the most important reasons for this phenomenon. Finally, the results suggest that trade openness has not been a major determinant of economic growth in the ESCWA region. The respective coefficients are small, and the sign depends on the other variables included in the regression. Again, this result is in line with other empirical studies on the growth determinants of the region. The results of this chapter confirm the premise that improvements in financial intermediation have not yet had a significant positive impact on economic growth in the ESCWA region. However, this finding does not mean that financial development is irrelevant to economic growth in this part of the world. Rather, it should be taken as an incentive for individual countries to strengthen the regulatory and supervisory

framework in the financial sector. Eventually, improvements in the institutional environment for the private sector should result in a more efficient allocation of credit, thus stimulating economic growth. In order to shed further light on the relation between financial development and growth in the region, the panel data set could be estimated by applying recent generalized method of moments techniques that resolve some of the statistical weaknesses of standard panel estimation methods.

V. CONCLUSIONS AND POLICY RECOMMENDATIONS

The purpose of this study was to study the topic of bank behaviour and present a regional perspective on the banking system in the six ESCWA member countries profiled, namely Egypt, Jordan, Lebanon, the Syrian Arab Republic, Oman and the United Arab Emirates, by analysing bank behaviour and performance. For purposes of clarification, it should be noted that reforms are still at an initial stage in the Syrian Arab Republic while reforms in some other countries, such as Jordan and Egypt, have been under way for a longer period. It should also be noted that the financial system in Lebanon has always been liberal. In general, the development of key variables shows: (a) an expansion in the size and activity of the financial system; (b) a slight change in the composition of the financial system, with banks still dominating financial systems; (c) high interest rate spreads relative to those in developed countries; (d) a relative expansion of private credit; (e) the largest share of private credit going to current consumption such as personal loans and services; (f) an increased tendency by Governments to resort to domestic banks to finance growing fiscal deficits; (g) a large exposure of portfolios of commercial banks to government treasury bills markets; (h) increasing levels of non-performing loans; (i) banks performing above their minimum cost frontier and 6) although statistically insignificant, a positive relation of private credit to economic growth. Because non-bank financial intermediaries and markets for corporate securities are limited and underdeveloped in most ESCWA member countries, banks still dominate and are still the core of the financial system in the region. In addition, the banking sector is the main vehicle for transmitting monetary policy actions to overall economic activity and prices through interest rates and liquidity. Therefore, building an efficient and sound banking sector is one of the most critical aspects of an efficiently functioning financial system in the region. In return, the basic elements for an efficient and sound financial system include a stable macroeconomic environment, a dynamic private sector, and supportive legal framework that provides for both strong internal governance in financial institutions and external discipline by market forces. Therefore, in order to establish and maintain a sound banking system, prices and other nominal variables should evolve in a stable manner. Moreover, to maintain the stability of a healthy financial system, economic activity should expand at a reasonable pace, which allows banks to finance profitable projects. This requires designing growth-promoting policies, in particular pro-poor and pro-employment policies that pay special attention to the needs of women in the region given that their employment and labour participation rates are low. These policies will bring about the political and social stability that enhance economic growth perspectives. However, given the level of banking inefficiency in the ESCWA region, the financial health of the banking sector by itself might not be enough to promote financial intermediation. Therefore, in order to promote financial intermediation, the countries in the region need to develop systems of reliable borrower information; strengthen enforcement of contracts, and improve access to credit and the availability of financial services for the poor and in remote and rural areas. In addition, the development of non-banking financial institutions and markets such as corporate and government securities markets, as well as equity markets, can also be used to address weaknesses in the banking sector by applying market discipline to banks. The resulting competition causes financial intermediation to be more efficient and acts as a check on the behaviour of banks by increasing the depth of markets and breadth of the services offered. During the period 2000-2003, commercial banks' deposits rose relative to GDP in all six countries profiled, reflecting a fall in inflation and financial liberalization. However, much of this growth in loanable funds was absorbed by banks' increased holdings of government debt, with the exception of the United Arab Emirates. Consequently, private credit relative to GDP declined in Jordan, while the ratio remained constant in Lebanon, Oman and the Syrian Arab Republic. Only Egypt and the United Arab Emirates experienced an increase in the private credit to GDP ratio over this period.

With the ESCWA region's non-bank financial intermediaries underdeveloped, the above events during the period 2000-2003 raise future issues of deposit growth, such as the crowding out of credit to the private sector and the risk structure of bank portfolios with an increased dependence on governr1:ent solvency. The growth of government debt in banks' portfolios in all six countries profiled, particularly during 2000-2003, and the large share of government debt in the portfolios of banks in Egypt, Lebanon and the Syrian Arab Republic (as measured by public credit as a share of total deposits and as a share of GDP or as a share of total claims) reflect government deficits and their impact on the supply of government debt. In addition, they reflect the attractiveness of government debt to banks, because of the liberalization of interest rates and probably the low-risk weights assigned to government debt instruments in capital requirements of banks. The study shows that the allocation of bank credit to the real sector is certainly hindered by overissuing of treasury bills and government bonds. As a result, the lack of credit compels firms to finance investment through retained earnings or resort to savings of friends and family, postponing, if not eliminating, large-scale or longer-term projects. Consequently, the large exposure of portfolios of commercial banks to government debt increases the probability of making banks, particularly banks in Lebanon, insolvent. Three policy implications emerge from these trends. First, in order to create more scope for credit to the private sector, the growth of deposits needs to increase, and credit extended to the government needs to grow less rapidly. In Lebanon, and to some extent in Jordan, the possibility of increasing deposits through lower inflation and further financial liberalization has already been exhausted. This might not be the case for the rest of the countries profiled in this study, where cautiously pushing ahead further for a well-sequenced financial liberalization might lead to an increase in total funds to the private sector. The other possibility is in attracting foreign credit, a possibility that seems low in the short term for most countries in the region because of a decline in foreign investors due to political instability. With no increase in credit available for the private sector, economic growth is expected to stay low, and crowding out from the public sector will probably create further pressure on credit for private sector development, especially when deposits growth rates do not increase faster than public credit growth rates. Secondly, portfolios of banks in Egypt, Lebanon and the Syrian Arab Republic have become increasingly dependent on government solvency. For this problem, some have recommended an increase in the risk weighting of government debt to banks. This policy is expected to lead to a decrease in the attractiveness of government debt, an increase in the price governments have to pay in order to borrow, and would require an increase in banks' capital (Hanson, 2003). While in the short run this policy might decrease demand for government debt instruments by banks, it would definitely result in an increase in the interest rate demanded by banks to hold government debt, thus resulting in a crowding out of private investors. In this case, a policy recommendation would be to contain fiscal deficits and achieve sustainable debt levels, especially in Lebanon and Jordan. This policy is expected to result in a decline in interest rates, resulting in higher private investment. However, if this increasing trend in public credit continues, then the loan portfolios of banks become riskier since better borrowers might borrow from the international market while the remaining pool of borrowers who are inherently riskier do not have access there. One option to mitigate this trend is to improve risk evaluation. Thirdly, small and medium-size borrowers, and the poor, increasingly need to compete with government for bank credit. Therefore, limiting government debt is one option to improve access to credit for those segments that are important for development. Another policy option is to increase the attractiveness of small borrowers by improving the legal system related to collateral execution and credit information. That is, improving credit information will not only allow banks to improve the allocation of credit but will also improve borrowers' incentives to repay promptly, in order to develop their intangible asset of a good credit rating. This is an important policy option, particularly for those who lack the proper collateral, especially the poor and women. In general, women face institutional restrictions in acquiring property through inheritance, as well as social customs that limit their access to credit.

The study also showed a significant non-performing loans problem in Lebanon, Oman and Jordan. As a percentage of total loans, the ratio of non-performing loans ranged from 13.36 to 25.29 per cent in these three countries. Data on non-performing loans in Egypt and the Syrian Arab Republic, which have large publicly owned enterprises, are not available. Resolving the problem of non-performing loans and the negative impact on banking efficiency requires the strengthening of creditors' rights. As the case of China suggests (Unteroberdoerster, 2004), without reforming publicly owned enterprises, especially in Egypt and the Syrian Arab Republic, where State-owned banks maintain an exposure to publicly owned enterprises, the non-performing loans problem of the banking sector is at risk of concurrently increasing with the deepening of the financial system. In addition, the study showed that a small number of large banks dominate the financial system in Egypt, Jordan, Oman and United Arab Emirates. In addition, the study showed that interest rate spreads in the ESCWA region are still very high relative to those in developed countries. High concentration ratios compel banks to respond to any increase in non-performing loans by increasing spreads between lending and deposit rates while denying credit to new, potentially creditworthy borrowers and profitable projects. Such measures can cause the deposit base to flow abroad and put additional strain on borrowers, thus resulting in a weak and potentially destabilized financial system. In return, a weak financial system tends to lower economic activity and increase the portion of non-performing loans to total loans, thus jeopardizing financial stability. The problem of the high costs of financial intermediation in all the countries in the region needs to be addressed. Some options include reducing tax and reserve requirements. In addition, the following measures should be taken: (a) establishment of a credit risk mechanism; (b) improvement in the efficiency of the legal system; (c) creation of special courts; (d) improvement in creditors' rights; (e) establishment of credit information systems that make all information available to creditors; and (f) development of legal and regulatory frameworks to facilitate the sharing of information on borrowers between financial institutions, credit information agencies and the Central Bank. Another important finding of this study is that banks in the ESCWA region, particularly in Egypt, Jordan and Lebanon, appear to behave in a non-competitive manner and are thus operating above their minimum cost frontiers, hindering financial intermediation. This result is consistent with the apparently high concentration ratios and high profitability of banks, indicating persistently low levels of competition. Several other factors are thought to have also affected banks' behaviour, either because they constitute indirect barriers to entry or because they have a tendency to reduce competition among banks. These factors include: the problem of non-performing loans; weak rules and regulations; and banks' reliance on government debt as a steady source of income, which appears to limit competition between banks and put upward pressure on interest rates and costs. An important policy implication arising fiom these findings is that accomplishing effective fiscal consolidation, with the intention of protecting public investment while containing current expenditure, may be a precondition for increasing the efficiency of banks and deepening financial systems in the ESCWA region. Containing fiscal deficits and achieving sustained debt levels are expected to reduce interest rates, resulting in higher domestic investment. In addition, it is expected that sustained and successful fiscal zdjustment would reduce the dependence of banks on government debt instruments as a source of highyielding and low-risk assets. This would increase competition between banks, which may result in greater efficiency through bank consolidation. In addition to excessive exposure to government debt, other factors that affect banking efficiency through their contribution to high interest rate spreads should also be addressed. The problem of non-performing loans should be made a high priority for policymakers in order to improve efficiency and bank intermediation. This requires stronger bank regulation and supervision as well as strengthening creditor rights. The efficiency and health of the financial sector are crucial to economic growth. Since many ESCWA member countries are reforming and privatizing their banking sectors, it is imperative that they supplement such process with parallel regulatory and institutional changes with the aim of aligning the overall incentives environment to lead to an enhancement of banking sector efficiency. Policies aimed at enhancing financial sector performance, are expected to promote efficiency and growth by reducing information, monitoring and

transaction costs. The results of the correlation and panel data analysis reported in chapter IV, which have been corroborated by recent research, imply that regulatory changes that support and facilitate the private monitoring of banks have a tendency to enhance bank performance, reduce non-performing loans and boost banking sector efficiency and stability. In order to enhance the efficiency of banking sectors, ESCWA member countries should also encourage the entry of foreign and regional banks. Despite the risks associated with foreign banks highlighted in chapter 11, the literature confirms that the entry of foreign banks increases competition as well as local lending opportunities and boosts the efficiency of domestic banks. Consequently, foreign banks create significant benefits for host countries, given that they do not exclude those with limited access to credit and other financial services, such as small businesses and the poor who lack proper collateral. However, this requires designing and implementing policy measures that encourage market entry of foreign banks, lending to small firms and the establishment of new branches in rural areas. While this study shows a positive relation between financial intermediary development (measured by bank credit to the private sector) and economic growth, it was not statistically significant; this finding is consistent with results from recent research on the topic. Given this positive relation, the importance of financial sector development should not be underestimated and has to be one of the main strategies to achieve sustainable economic growth in the long term. Building sound and stable financial sectors requires liberalizing the financial system, the adoption of internationally acceptable codes and standards, strengthening prudential regulation and supervision and training staff to manage and regulate these institutions. In addition, while this study shows an expansion in the financial system and a steady growth in private credit, the fact that the poor tend not to have access to banks and other formal financial institutions implies that aggregate credit expansion may not necessarily have benefited the poor in this region. In general, the poor in developing countries often do not have access to a continuing and reliable source of funds, and thus are compelled to rely on the more risky informal sector. This limited access to credit constrains their ability to increase their income and to contribute to economic growth. This gap in the formal sector provisioning is partially attributed to government excessive fiscal deficits and to the problem of imperfect or asymmetrical information. While in developed countries this problem is mitigated by the use of collateral and credit rating systems, in developing countries the result of the lack of collateral and the absence of credit agencies is that many potential borrowers are denied access to credit. Though the informal sector can lessen these problems by using social collateral and enforcement mechanisms, these solutions tend to rely on small-scale community ties (DFID, 2004). While microfinance institutions can provide credit to the poor, and in particular improve women's access to credit, they cannot in general mobilize funds on a large scale in the way the banks or the formal sector can. Therefore, barriers to widening access to credit by the formal sector, particularly banks, must be addressed. This requires a focus on ways to encourage and remove barriers to broader banking provision. It also means that greater attention needs to be paid to incentives and the regulatory space and that banks have to widen access to credit in the redesign of regulatory reforms. That is, ways of expanding access to credit for the poor must be identified in order to reduce poverty. Despite its limited capacity to mobilize funds on a large scale, one innovation concerning widening poor men and women's access to credit is the introduction of micro-finance institutions into the region. These institutions not only target the poor; they also depend on peer selection and peer monitoring to overcome the requirement for collateral. In addition, obtaining property rights over land in urban areas can also help poor households to gain access to credit, increase labour supply and improve productivity, thus promoting equity.74 A pro-poor financial policy also needs to address the cost of credit. High lending rates act as a binding deterrent against productive investment, especially for the poor and small and medium-size enterprises. 74 For more on the importance of property rights and contracts, see P. Holden and V. Prokopenko , Financial Development and Poverty Alleviation: Issues and Policy Implications for Developing and Transition Countries 200 1; and T. Besley and R. Burgess, Halving Poverty, 2003.

Facilities with low-cost credit, short-term and long-term, are scarce and are often of a very limited capacity. Complications in the bureaucratic procedures of lending contribute to keeping the fixed costs of borrowing unduly high for the poor. The role of the State in financial intermediation, and specifically in policy and development lending, is being downsized in many countries in the ESCWA region. Sectorial State policy banks, such as the industrial banks, agricultural banks and housing banks, are being gradually phased out in spite of lack of a viable substitute for them in long-term investment lending. As all economists agree, demand and need correspond to each other only when the required resources back the latter. There are many sectors, businesses, geographic locations and entrepreneurs in dire need of financial services but without the command of adequate resources to make them economically viable enterprises for private financial undertakings. State banks have a role to play, at least in these areas where the private financial institutions shy away because of profitability considerations. The externalities of the State banks in these cases, in terms of incomes created because of their services, far outweigh any losses they may incur. Apparently, because of that, State polic banks are still cited as a success factor in the pro-poor growth policy frameworks of a number of countries.7Y Finally, an important condition for efficient financial development and poverty reduction is macroeconomic stability. Macroeconomic instability decreases demand for money and complicates the ability to make accurate credit assessments of borrowers. Excessive and volatile rates of inflation also contribute to higher poverty rates since the poor have limited capability to hedge and endure a disproportionately big share of the negative effects of inflation (Holden and Prokopenko, 2001). While macroeconomic policies intended to reduce instability should not be underestimated, they are not the only condition needed for effective financial development and poverty alleviation. Since the relation between growth and poverty reduction is not automatic, growth is simply a necessary but not sufficient condition for poverty reduction. In addition to macroeconomic stability, strengthening of regulations and supervision, and promotion of the establishment of credit assessment and information mechanisms, another policy instrument that might be used to expand financial services, particularly to the poor, is government involvement in financial institutions. The implications of this study for the ESCWA region are clear. Economies of the ESCWA members should strengthen institutions in order to create conducive conditions for financial markets to develop. An active and dynamic banking system will not grow when there is uncertainty in enforcing contracts. It is imperative to foster the development of banks that lend to the private sector rather than to finance the State. Barriers to free entry should be lowered for foreign banks in order to promote the inflow of foreign funds and state-of-the-art knowledge in banking practices. If such conditions prevail, the results for economic growth are expected to be positive.

75

For more on this, see P. Holden and V. Prokopenko, Financial Development and Poverty Alleviation; and T . McKinley, The Macroeconomics of Poverty Reduction, Initial Findings of the UNDP Asia-Paclfic Regional Programme, 2003, p. 24.

Annex I

COUNTRY TABLES

Egypt 70.8 72.5 78.2 78.0 76.7 80.4 82.1 83.3 77.9 76.4 82.7 77.6 81.5 80.4 78.8 75-7 74.5 73.7 74.2 73.O 77.8 83.3 88.6

TABLEA I . M21GD ' (Perce tage) United Arab Syrian Arab Republic Jordan Lebanon* Oman Emirates 42.0 75.3 46.6 72.9 54.1 81.5 66.4 85.2 72.5 89.5 71.2 90.1 69.2 62.4 27.4 100.5 55.1 61.3 154.8 30.1 113.8 54.1 61.8 210.3 28.8 132.1 53.3 49.4 25.4 200.5 128.5 5 1.2 54.3 28.2 144.9 133.1 55.3 54.0 25.4 115.0 116.0 63.3 54.1 25.9 122.4 111.2 61.6 54.1 26.4 121.8 102.1 56.6 97.1 53.9 27.3 125.3 51.3 52.0 l 3 1.9 26.9 98.2 5 1.3 50.6 30.2 143.6 95.6 52.4 57.3 38.5 152.6 93.8 55.2 52.1* 36.6 171.8 101.0 56.5 46.1* 188.7 30.5 109.0 67.0 203.O 56.0* 32.8 112.2 76.8 63.4* 114.1 209.6 34.3 33.4 121.7

Sources: IMF, International Financial Statistics, several issues.

'OSITSIGDP Percentage)

Egypt Jordan Lebanon* 55.3 52.8 58.7 52.1 63.2 59.3 63.6 63.9 63.O 69.2 68.4 71.5 342.0 74.6 79.5 148.8 77.6 84.4 197.4 73.O 92.5 72.7 185.0 86.9 81.1 133.2 97.6 79.2 108.0 91.2 82.5 114.4 89.9 80.1 115.4 87.8 79.7 120.8 86.3 78.3 126.9 89.9 78.0 138.6 90.2 77.2 148.4 89.9 79.4 168.1 96.1 80.2 185.2 103.7 86.7 198.9 107.3 94.0 205.2 107.4 100.8

Oman

United Arab Emirates

24.6 27.1 26.3 23.5 26.4 23.8 24.2 24.7 25.5 25.9 30.4 39.4 37.4 3 1.0 33.0 34.4 33.5

Syrian Arab Republic 28.4 36.4 42.0 48.0 50.2 48.7 47.6 35.7 30.6 28.8 29.7 31.5 38.5 39.0 36.1 33.1 34.0 34.7 36.3 38.7 48.2 57.3

* Data are taken from the National Accounts Studies, ESCWA.

Notes: M2 includes M1 and time, saving and foreign currency deposits.

Total deposits include total resident deposits, demand deposits, time and saving deposits, post office deposits, central government deposits and restricted deposits. Total deposits in Egypt and Jordan include deposits of deposit money banks and other banking institutions. Owing to lack of data for other banking institutions, the remaining countries only include deposits of deposit money banks. M 2 2 I l *0.5 (+ M 2 (-+ TD T D ~ I ) * ~ . ~ TD, CPI, c p r ; , The ratios of M2 to GDP and total deposits (TD) to GDP are calculated by using the following formulas: M2' = * 100 * 100 GDP, GDP t GDP, GDP t P

cpr:

cpr;

where CPIa is the consumer price index at the end of the respective year and CPIe is the average consumer price index of the respective year. Average CPI data for Lebanon (1986-2002), the United Arab Emirates (1986-2002) and Oman (1986-2002) are taken from the National Accounts Studies, ESCWA End of Year CPI is not available for Lebanon and United Arab Emirates. Accordingly, only the average CPI is used in the calculation.

69

Egypt 56.94 48.77 46.04 42.72 40.6 1 39.91 35.38 32.00 29.5 1 26.34 2 1.76 17.50 17.50 17.76 19.16 18.78 18.99 19.70 21.84 20.49 17.13 12.10 12.93 10.07

TABLEA.3. M l /M2 (Percentage) United Arab Syrian Arab Jordan Lebanon Oman Emirates Republic 59.24 26.74 3 1.26 47.60 92.1 1 59.29 22.28 30.83 90.34 47.19 55.97 28.95 22.84 89.15 43.58 53.74 20.9 1 25.1 1 88.64 42.45 18.09 49.85 18.97 87.28 36.68 45.14 16.96 19.05 87.27 35.07 43.15 9.35 17.67 86.89 35.8 1 40.75 4.68 18.38 86.29 36.45 42.00 18.49 8.41 83.24 32.37 40.22 17.50 11.65 32.4 1 82.80 18.55 11.77 40.66 33.34 8 1.84 19.58 12.54 40.56 80.35 32.83 40.9 1 21.55 10.19 79.08 33.98 39.22 26.56 74.03 7.29 34.32 38.44 25.99 7.3 1 7 1.36 33.68 36.30 6.82 25.59 7 1.O3 31.17 32.30 6.06 25.61 70.03 30.8 1 31.83 5.58 26.76 69.05 27.02 5.1 1 29.69 28.13 67.52 23.73 5.04 28.15 27.48 66.15 22.54 4.85 29.88 26.83 65.43 22.85 4.47 28.70 25.23 60.32 26.72 27.10 4.48 28.24 59.97 28.68 29.04 70.64 4.40 30.99 28.53

N RATES (P wentage) 4. INFLAI b United Arab Emirates Jordan Lebanon Oman

7.7 1 7.39 5.16 3.68 3.16 0.00 -0.19 466.67 37.47 6.5 1 25.72 47.74 16.17 62.88 48.26 8.13 4.10 80.83 3.39 39.78 7.59 3.52 2.34 10.25 8.93 6.53 3.01 7.66 3 .O3 0.20 0.6 1 0.70 -0.89 0.70 1.30 1.80 1.19 1.77 2.4 1

2.69 5.22 3.37 4.34 4.69 -2.29 -0.30 0.4 1 2.43 0.89 -0.49 -0.89 0.50 -1.19 -1.10 -0.6 1 -0.4 1

3.OO -1 1.82 3 .g6 1.24 5.26 6.79 4.66 5 .O4 4.38 2.70 2.04 2.00 2.15 1.37 2.17 1.41

Syrian Arab Republic 18.29 14.43 6.3 1 9.32 17.05 35.76 59.5 1 34.86 11.34 19.35 9.04 10.95 13.29 15.26 7.99 8.3 1 1.87 -0.83 -3.70 -3.85 3.OO 0.97

Sources: IMF, International Financial Statistics, 2002 and 2004 yearbooks. Average CPI data for Lebanon (1986-2002),the United Arab Emirates (1986-2002)and Oman (19862002) are taken from the National Accounts Studies, ESCWA. Notes: M1 includes demand deposits in local currency and currency in circulation: M2 includes Mland time, saving and foreign currency deposits.

l ABLE A

1980 1981 l982 l983 l984 l985 l986 l987 1988 1989 1990 1991 1992 1993 1994 1995 l996 1997 l998 1999 2000 200 1 2002 2003 Average

-

F

. INTEREST RATE SPREAD (Percents e Jordan

Lebanon

Oman

TA XA.6. PR ,ATE CREDI' GDP (PI ,centage) United Arab Syrian Arab Egypt Jordan Lebanon* Oman Emirates Republic

Syrian Arab Republic 5.OO 5.OO 5.00 5.00 5.OO 5.OO 5.00 5.00 5.00 5.00 5.OO 5.00 5.OO 5.OO 5.OO 5.OO 5.OO 5.OO 5.00 5.OO 5.00 5.OO 5.OO 5.00 5.OO

21.3 25.4 28.1 29.1 29.4 32.2 33.3 32.6 29.8 28.1 27.5 24.0 25.9 28.3 33.2 37.6 42.0 47.3 54.1 56.1 59.0 60.7 59.1

5.3 6.1 7.5 8.9 8.5 7.7 7.7 6.6 7.2 7.4 8.2 9.4 11.1 10.8 10.8 10.0 9.9 9.6 9.2 8.3 8.3 8.2

Sources: IMF, International Financial Statistics, several issues. * Data are taken from the National Accounts Studies, ESCWA. Data on interest rate differential in Jordan (1980-1987) are taken from the Central Bank of Jordan. Notes: Private credit in Egypt and Jordan includes claims of deposit money banks and other banking institutions. Owing to lack of data for other banking institutions, the remaining countries only include private credit of deposit money banks. (-+-)*OS pc, pc,-, The ratio of private credit (PC) to GDP is calculated by using the following formula: CPIle CPI,-, -PC, -

GDP,

-

GDP, CPIp

*l00

where CPIe is the consumer price index at the end of the respective year and CPIa is the average consumer price index of the respective year. Average CPI data for Lebanon (1986-2002), the United Arab Emirates (1986-2002) and Oman (1986-2002) are taken from the National Accounts Studies, ESCWA. End of year CPI is not available for Lebanon and the United Arab Emirates. Accordingly, only the average CPI is used in the calculation.

71

Egypt 30.91 47.00 50.40 52.56 50.01 49.83 5 1.27 50.47 49.1 1 49.06 48.39 38.83 35.40 37.36 43.04 49.47 52.18 55.62 63.21 68.03 69.48 69.16 65.17 64.67

Jordan 84.17 82.72 80.63 78.54 76.76 74.87 76.10 72.53 74.01 74.1 1 75.08 76.04 76.6 1 79.90 82.45 85.32 85.01 86.78 83.95 82.65 8 1.33 80.99 79.34

Lebanon 89.01 83.53 70.03 69.57 74.02 67.25 77.4 1 91.10 70.96 61.13 69.22 60.09 60.79 59.5 1 53.03 56.49 5 1.27 53.86 51.01 49.0 1 48.87 49.03 46.13 5 1.72

Oman 98.88 99.82 97.77 96.48 97.12 91.11 92.68 88.09 95.28 95.76 93.40 87.42 83.80 86.42 92.40 93.46 89.65 93.22 92.83 89.15 89.23 86.83 88.20 86.28

United Arab Syrian Arab Emirates Republic 88.89 16.32 89.70 13.14 87.44 16.58 87.06 19.44 87.00 22.70 76.86 25.62 84.78 25.04 82.63 24.9 1 84.30 18.62 85.15 21.57 23.25 83.25 8 1.67 24.50 8 1.46 25.91 79.23 19.62 77.60 26.27 79.39 27.09 83.62 26.72 86.02 26.24 86.23 25.78 83.81 24.05 86.71 22.98 88.90 2 1.26 86.47 22.68 82.76 24.86

Egypt

32.48 43.08 43.48 45.58 46.0 1 47.28 47.03 42.57 4 1.39 40.25 37.32 30.43 30.1 1 32.64 38.05 45.27 50.5 1 56.87 65.45 70.68 69.27 67.03 62.29 55.42

Jordan Lebanon

Oman 90.08 75.00 68.79 71.91 72.67 80.06 85.10 83.81 86.67 83.97 85.13 80.07 86.84 88.03 93.87 95.83 96.96 104.28 117.61 120.52 115.47 113.90 109.56 108.19

united Arab Syrian Arab Emirates Republic 100.45 20.73 99.47 16.65 92.06 16.94 90.97 18.78 69.48 18.21 66.45 15.64 68.15 16.06 68.88 16.12 2 1-63 70.28 69.97 25 S2 72.96 25 .g2 69.93 28.73 7 1.23 3 1.O3 74.37 27.05 28.64 79.46 79.63 31.16 29.60 87.56 28.57 95.27 110.74 26.92 98.90 23.76 88.50 19.49 75.34 15.35 73.28 13.43 72.77 15.73

Source: IMF, International Financial Statistics, 2002 and 2004 yearbooks. Notes: Total claims include claims on central government, non-financial public enterprises, private sector, official entities and other financial institutions. Total deposits include total resident deposits, demand deposits, time and saving deposits, post office deposits, central government deposits and restricted deposits. Private credit in Egypt and Jordan include claims of deposit money banks and other banking institutions. Owing to lack of data for other banking institutions, the remaining countries only include private credit of deposit money banks. Total claims in Egypt and Jordan include claims of deposit money banks and other banking institutions. Owing to lack of data for other banking institutions, the remaining countries only include total claims of deposit money banks. Total deposits in Egypt and Jordan include deposits of deposit money banks and other banking institutions. Owing to lack of data for other banking institutions, the remaining countries only include total deposits of deposit money banks.

72

Egypt

Jordan

32.62 26.69 26.50 27.70 29.49 3 1S 6 32.18 32.83 30.94 29.6 1 35.61 40.88 45.23 42.1 1 38.50 36.25 35.75 32.13 28.23 25.46 26.14 29.77 3 1-92

9.4 1 10.79 14.27 17.26 20.37 20.43 23.2 1 25.85 26.70 24.05 22.73 18.69 17.49 14.95 13.O5 12.86 12.01 12.30 14.84 16.54 17.85 19.01 17.99

Lebanon*

Oman

2.2 2.1 1.o 1.2 2.3 3.5 3.8 2.7 1.9 2.4 2.8 3.3 4.5 4.4 5.2 5.5 5.3

TABLEA. 10. PUBLICCREDIT/TOTAL CLAIMS (Percent(

'ercentage) United Arab Syrian Arab Emirates Republic

Egypt 69.09 53.00 49.60 47.44 49.99 50.17 48.73 49.53 50.89 50.94 51.61 61.17 64.60 62.64 56.96 50.53 47.82 44.38 36.79 3 1.97 30.52 30.84 34.83 35.33

30.8 35.2 34.1 33.5 27.0 22.6 23 .O 24.5 28.6 25.7 25.9 27.9 38.9 37.5 29.6 27.3 27.5 27.3 27.7 26.9 29.2 29.2

Jordan

Lebanon 10.99 16.47 29.97 30.43 25.98 32.75 22.59 8.90 29.04 38.87 30.78 39.91 39.21 40.49 46.97 43.51 48.73 46.14 48.99 50.99 51.13 50.97 53.87 48.28

Oman 1.12 0.18 2.23 3S 2 2.88 8.89 7.32 11.91 4.72 4.24 6.60 12.58 16.20 13.58 7.60 6.54 10.35 6.78 7.17 10.85 10.77 13.17 11.80 13.72

Emirates

9

Syrian Arab Republic 83.68 86.86 83.42 80.56 77.30 74.38 74.96 75.09 81.38 78.43 76.75 75.50 74.09 80.38 73.73 72.91 73.28 73.76 74.22 75.95 77.02 78.74 77.32 75.14

Sources: IMF, International Financial Statistics, several issues. * Data are taken from the National Accounts Studies, ESCWA. Notes: Public credit includes claims on central government and on non-financial public enterprises. Total claims include claims on central government, non-financial public enterprises, private sector, official entities and other financial institutions. Public credit in Egypt and Jordan includes claims of deposit money banks and other banking institutions. Owing to lack of data for other banking institutions, the remaining countries only include totaI claims of deposit money banks. Total claims in Egypt and Jordan includes claims of deposit money banks and other banking institutions. Owing to lack of data for other banking institutions, the remaining countries only include total claims of deposit money banks. PuC PuC (-+ +) * 0.5 CPI, CPI ,-, formula: The ratio of public credit (PuC) to GDP is calculated by using the following P U C , -= * 100 GDP, GDP , CPI where CPIe is the consumer price index at the end of the respective year and CPIa is the average consumer price index of the respective year. Average CPI data for Lebanon (1986-2002), the United Arab Emirates (1986-2002) and Oman (1986-2002) are taken from the National Accounts Studies, ESCWA. End of Year CPI is not available for Lebanon and the United Arab Emirates. Accordingly, only the average CPI is used in the calculation.

73

TABLEA. 11. PUBLICCREDIT/TOTAL DEPOSITS (Percentage)

Egypt

Jordan

Lebanon

Oman

72.6 1 48.57 42.79 41.14 45.98 47.60 44.70 4 1.77 42.89 4 1.79 39.80 47.95 54.95 54.73 50.37 46.25 46.29 45.38 38.09 33.21 30.43 29.88 33.29 30.27

16.75 18.83 22.37 25.49 28.45 30.38 27.00 31.10 30.10 27.48 27.90 19.85 21.18 17.86 16.24 14.04 14.55 12.11 15.14 15.73 16.16 17.10 18.28

7.84 11.48 25.1 1 26.53 21.93 25.66 11.96 3.6 1 14.65 24.47 19.59 25.92 27.98 27.56 36.47 36.02 43.40 39.48 45.80 49.63 48.18 44.57 47.75 33.45

1.02 0.13 1.57 2.62 2.15 7.8 1 6.72 11.33 4.30 3.72 6.0 1 11.53 16.79 13.83 7.72 6.7 1 11.19 7.59 9.09 14.67 13.94 17.27 14.66 17.21

United Arab Emirates

Syrian Arab Republic 106.30 110.00 85.23 77.80 6 1.99 45.39 48.06 48.57 94.49 92.79 85.57 88.53 88.71 110.81 80.40 83.89 81.18 80.3 1 77.48 75 -05 65.32 56.87 45.77 47.56

Source: IMF, International Financial Statistics, 2002 and 2004 yearbooks. Notes: Public credit includes claims on central government and on non-financial public enterprises. Total deposits include total resident deposits, demand deposits, time and saving deposits, post office deposits, central government deposits and restricted deposits. Public credit in Egypt and Jordan includes claims of deposit money banks and other banking institutions. Owing to lack of data for other banking institutions, the remaining countries only include claims of deposit money banks. Total deposits in Egypt and Jordan includes deposits of deposit money banks and other banking institutions. Owing to lack of data for other banking institutions, the remaining countries only include deposits of deposit money banks.

Annex I1

STOCHASTIC COST FRONTIER MODEL The stochastic cost frontier model is of the following standard form: r

when taking inefficiency into consideration, the cost function becomes:

The standard symmetry restrictions that apply are: pi. = pi where p is a coefficient that captures the cross relationship between outputs and input prices. Homogeneity of degree +l in input prices requires imposition of the additional restrictions: n

n

n

All costs and input prices are normalized by the last input price W3 (unit price of labour) to impose linear homogeneity. The translog specification is estimated following Battese and Coelli (1992) by assuming that the xinefficiency component of the total error term U,is i.i.d (independently and identically distributed) truncated at zero of the ~(pp;).

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