Small Steps

• Author: Mark Stone/Seiichi Shimizu
• Position: Deputy Division Chief/Senior Economist in the IMF's Monetary and Capital Markets Department
• Pages: 50-51

Page 50

The fine balance of developing financial markets in small economies: payoffs with a dose of realism

Financial markets in smaller economies have the potential, in theory, to provide important benefits. These include more effective monetary and fiscal policies, higher risk transfer, increased corporate financing, and greater integration into the world economy. But the analytical foundations for what it takes to develop financial markets in smaller economies is limited because cross-country research so far has focused on financial market development in advanced and emerging market countries. Moreover, the policies needed to develop financial markets in smaller countries tend to be more country specific because small economies are quite different from one another (see box).

This article addresses that analytical gap and suggests policies for developing "essential" financial markets-foreign exchange, money, government security, and equity-in small economies. These markets are essential because they provide the most basic level of financial services. This article also outlines a sequence of steps that small countries can follow, while recognizing that one-size-fits-all approaches do not work for these countries.

Shallow markets

Financial markets in small economies are generally smaller and provide a narrower range of services compared with those in larger economies. Foreign exchange markets in small economies have much lower turnover compared with emerging market countries, and fewer than 50 percent conduct forward transactions (a purchase or sale of currency in the future according to an exchange rate determined beforehand). Money markets are thin, with most dominated by overnight interbank cash transactions. Just 25 percent of small economies have secondary government security markets developed enough to involve foreign institutions. Only 40 percent of small economies even have a stock exchange, and trading on many of those exchanges is so low that the economic impact is minimal. Regional integration, so far, has had mixed success in deepening markets. Still, there are positive examples, and some small economies (Croatia and Jordan) have fairly developed markets that provide a wide array of benefits.

Why are financial markets in small economies under-developed? Many small economies face intrinsic obstacles that are...