Finance: Research, Policy and Anecdotes

One of my oldest working papers has finally found a home in the Journal of International Money and Finance. In Follow the money: Does the financial sector intermediate natural resource windfalls?, with Steven Poelhekke, we explore why financial sectors in resource-rich economies are underdeveloped.

A priori, theory provides contrasting hypotheses: On the one hand, the resource absorption hypothesis argues that natural resource wealth, through financial deepening, provides a broader funding basis for financial institutions and markets and increases demand for financial services. On the other hand, the financial resource curse hypothesis argues that natural resource abundance undermines financial sector development if resource-related wealth is shifted out of the domestic financial system, either into foreign investment conduits and offshore sovereign wealth funds or into non-financial wealth, such as real estate. Finally, the modified financial resource curse hypothesis posits that the capacity of financial systems to absorb and intermediate natural resource windfall gains depends on the ability of banks to easily set interest rates and compete with each other, the ability of new entrants – both domestic and foreign – to enter the market and sufficient liquidity in capital market to support the banking system in allocating resources to their best uses and to more sectors of the economy.

Using a panel dataset of over 100 countries over the period 1970 to 2017, we test the short-run relationship between exogenous (as driven by world prices) natural resource price shocks and financial development indicators to control for reverse causation and omitted variable bias. We find that compared to countries with a similar increase in GDP, countries that experience resource windfalls and thus higher GDP see relatively slower growth in both financial sector deposits and private sector lending.  This smaller role for the financial sector is accompanied by a stronger role of governments in channeling financial capital into the economy and a relative increase in foreign asset holdings of banks.  Importantly, our findings are driven by countries that repress their financial systems.

Overall, our findings are consistent with the modified financial resource curse hypothesis. And while our results relate short-term changes in resource windfalls and financial development indicators, this lack of financial deepening adds over the years to less developed financial systems in resource-rich economies compared to non-resource countries at similar income levels.  Our findings also speak to the literature on natural resource curse and shows the importance of the financial sector as mechanism through which natural resource rents can impede the development of a country.

Overview