Strong financial sector key to sustained economic growth in the Baltics

• Pages: 87-88

Page 87

There is consensus among economists that a well- functioning financial system is important to long- term economic growth and stability. In the Baltics, economic growth was, until recently, generated in large part by the privatization of state-owned enterprises. This process relied less on the financial system and more on financing provided mainly through foreign direct investment.

But with privatization largely completed and EU membership just around the corner, the financial sectors in the three Baltic countries are poised to take on a more important role. In the words of Alfred Schipke, chief author of the Occasional Paper: "Economic growth, which was very strong over the past decade, was supported by foreign direct investment and internally generated funds. But with privatization now largely complete, the financial system will have to play a more important role in ensuring that savings are channeled to those who want to invest."

Market infrastructure and corporate governance frameworks are fairly modern, and all three countries have seen significant improvements in their institutional and legal frameworks, as legislation has been introduced to comply with the terms of the acquis communautaire (the EU's body of law). The three countries have also enacted legislation that complies with international best practices in accounting and auditing.

But can the three governments do more to help banks and capital markets prepare for the future? Some economists have argued they should take steps to develop their fledgling capital markets to reduce their heavy reliance on bank-based financial intermediation.

Market- or bank-based financing?

When describing how funds are channeled from savers to investors, economists distinguish between bank- and market-based (bond- and equity-based) financial systems. In small economies with less developed financial systems, corporate bond and equity financing is often not a viable alternative to bank financing for a number of reasons. Retail investors often refrain from investing in the stock market for fear of being exploited by insider trading and prefer instead to use bank deposits for their savings. And bond and equity markets are often underdeveloped because there are not enough large enterprises to make corporate issues of debt or equity cost- efficient. This is the case in the Baltics, where bank- based financing still prevails.

Does it make a difference in terms of economic growth whether a country's financial system is mainly bank- or market-based? One view holds that bank-based systems are better placed...