Gaukhar Dauletbayeva,

Master Science of International Finance Management

Baitursynov Kostanay State University, Kazakstan

Kamshat Saginbekova, PhD in economics

KAZNEXT, Kazakstan

The role of financial system

for developing countries

Until the 1980s, the meaning of effective financial system for developing countries did not receive proper attention. Countries saw the reasons for law level of development in the lack of capital. The inflow of foreign financial means in the developing countries did not meet the expectations, since there was a lack of stable national financial system, and it was incapable. First of all, available stable financial institutions and local savings were kept “under the mattress” or in jewelry [7, P. 9]. On the other hand, ONE of the most important preconditions for stable and capable national financial system is both the access to the international markets of long-term capital and foreign direct investments.

It is recommended (necessary) to differentiate the meanings of “Financial sector” and “Financial system”. Financial sector is understood as a part of economy that proposes opportunities for financing and investments to other sectors, as well as consulting and broking services related hereto [8, P. 3]. Financial system is characterized as the system of supply and demand, and, therefore, besides the system of demand, it covers the financial sector, as well as the system of supply and the financial market (Picture 1) [10, P. 7].

If we consider the financial system from a business point of view, it consists of three subsystems: financing of business activity, including the financial sector, control over business activity and strategy of business activity.

Financial sector originates from the financing, and it acts both as a condition and as a part of financing of business activity. In accordance with model of redistribution and processing of information, there are two polar opposite opportunities for financing of business activity: financing though the financial market and financing though banks. This differentiating corresponds to the difference between the financial system supported by the financial market and the financial system supported by banks [12, P. 15].

Picture 1: Financial system*

*Source: Issing, O. (2003), P. 7.

Control over business activity or Corporate Governance is a part of the financial system and determined as “the totality of rules and mechanisms those determine which stakeholders and to what extent exert influence on important decisions in firms” [14, P. 172]. Insider and Outsider Systems are distinguished in the aspect of corporate governance. Outsider System is characterized by active market, Insider System – by high level of banks’ voting right [9, P. 75].

Financial resources have direct impact on firms’ activity. Investors, following their interests, exert influence on the decision making process in firms, and, therefore, on their strategy. Hence, firms’ strategy is a component of the financial system, and it is in casual relationships with the aforesaid parts of the financial system.

Transaction costs and information costs are present on imperfect markets. The main goal of the financial system is to allocate financial resources in space and time. The functions of this goal are as follows:

- Risk management is related to the most important function of the financial system. Effective financial system adopts the risks of business entities through financial leverages. They are based on the forms which reflect various levels of national economy [11, P. 6]. The latest financial innovations were developed in the industrial countries, which encourage to receive corporate advantages in transfer of risks (e.g., Swaps, Futures, Options). The meaning of insurance instruments is obvious in this case. For example, in a number of developing countries, holding of assets in foreign currency or purchasing of futures contracts is forbidden for entrepreneurs. The same is for farmers in these countries, who have no access to global futures markets, and, thus, have no opportunities for insurance of the risks connected with fluctuations of world market prices of goods manufactured. It leads to low production volume because of low investment volume. Financial system could contribute to avoiding of risks by redistributing it to other market players [8, P. 19]. Allen and Santemoro consider the risk management function as the main purpose of financial institutions [2, P. 1472].

- Mobilization of savings is presented as the second function of the financial system. On the one hand, investments in entities are possible through allocation of small savings. On the other hand, mobilization provides creditors with opportunity to participate in assets of entities and firms through purchasing of shares and other securities on the securities market and increase of savings [8, P. 27]. Financial deepening is reached through the investment of savings in the financial system, as a matter of fact, by increasing the cost of financial assets in national economy. Rapid growths of the economy, high level of investments, as well as high financial level, are the result of high volumes of savings [5, P. 155].

- Allocation of resources is the central function of the financial system. National economy has different stages, at which there appears a high level of demand or supply for capital. In this case, a risk of opportunistic behavior arises due to asymmetric distribution of information, and creditor is presented as the “Principal” and debtor – as the “Agent”. Financial institutions play the role of intermediaries in redistribution of regional and sector resources and bring into balance the interests of players (savers and investors). Development of financial system – modern national economy in the first place – is connected with reliability of contract relations between creditor and debtor [11, P.12].

- Monetary function is understood as the provision of effective financial infrastructure with acting payment system. On the one hand, the central bank and commercial banks provide other economic sectors with payment means, and, at the same time, they maintain low level of transaction costs. On the other hand, this function provides cashless flow of funds. Bank assets – monetary assets on current accounts in the first place – are regarded as the means of payment and exchange, and, therefore, they are accepted as money. In addition, unconditional recognition of the bank assets owned by the central bank provides the clients of commercial banks with opportunity to have required amount of cash at any time [6, P.72].

Developing countries show typically weak “informal” financial system, which is characterized by limited alternatives of investments and financing [1, P. 23]. Specific characteristics of the “informal” system include: indirect financing through commercial banks, weak development level of the securities market, lack of insurance and investment funds. Such market is characterized by stable position of commercial banks, activity of which is regulated by the Government.

“Informal” sector prevails in many developing countries and the countries with transitional economy, where savers and investors stand outside the organized financial market and take part in underdeveloped credit relations, in spite of existing special financial institutions. Personal loans prevail in this case, given directly to a natural person or through intermediaries [15, P. 47]. Chandavarkar describes the work of the “informal” sector as: “(...) all legal but officially unrecorded and unregulated institutional finance” [3, P.79]. He distinguishes the following corporate advantages of the “informal” financial sector [4, P. 133]:

- Access to loans for the population groups, which were not serviced by the institutions of the “formal” financial sector;

- “informal” and fast granting of a loan;

- flexible schedule for reimbursement of a loan and its use;

- low costs of loan servicing;

- personal and trust relations between the creditor and debtor.

Nevertheless, the following problems arise in the “informal” sector:

- very high interest rates due to monopolistic position of creditors;

- narrow choice of the main financial services;

- obstacle for development of innovations, such as new financial instruments and proposal of new financial services;

- lack of long-term lending and preference to short-term loans;

- unpredictable and unforeseen relations between the creditor and debtor, and, therefore, high probability of debtor’s dependence on creditor.

In spite of the abovementioned disadvantages, “informal” sector should be regarded as the motivation for innovations of the financial leverages connected with the “formal” sector [13, P. 210]. It may be a drag, for example, in reforming of financial institutions or in transition to the right of ownership, but, nonetheless, it has some advantages, depending on peculiarities of every certain country [16, P.451].

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