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Because FECO is extremely concentrated, it is recommended that a new patient start with a dose of oil about half the size of a grain of rice and wait up to 90 minutes to experience the effects and determine a more proper dosage — this process is called “titrating” and is absolutely essential when using cannabis medicines.

Some legal medical cannabis dispensaries, such as Harborside Health Center in Oakland, Calif., offer high-CBD blends of FECO oil, which is great for patients who find the effects of THC to be uncomfortable.

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Human bodies all come equipped with an endocannabinoid system — a network of receptors found throughout the body (brain, organs, connective tissue, glands and immune cells) that have the explicit purpose of binding with the cannabinoids found in whole-plant cannabis to perform a variety of tasks where they are found.

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The key difference between RSO and FECO is that FECO is extracted using food-grade ethyl alcohol while traditional RSO is extracted with Naptha, a combustible petroleum product found in lighters and napalm (a powerful chemical weapon used in warfare).

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cent in 1988. Excep;! Liouidity Z.4; An important characteristic of Botswana’s financial development has >>e-> Tbe accumulation of excess financial resources within the banking * >-” This is mainly due to a substantial increase in the deposit base of .rcal banks which has not been accompanied by an equally rapid IT1 credit extended to the private sector. Excess liquidity, as The commercial banks are very much the lead sector in this – 27 – defined and discussed in more detail in Chapter III, has been increasing over most of the neriod since 1982 and currently represents almost one third cf the total assets of the commercial barking system, while total liquidity accounts fDr almost half of total asseLs. This is largely attributed to the low absor’itive capacity of the economy as well as the sheer intlow of financial resources into Botswana over this period. 2.50 In addition to the excess liquidity in the commercial hanking system, there is a substantial amount of private deposits with the BOB. The total excess liquidity of the banking system was around P736 milliorn at the end of 1988, and with the incorporation of Government deposits, the total liquidity of the entire economy was in excess of P3.0 billion. C. Flow of Funds within the Financial System 2.51 This section on the flow of funds, comnmences with anr savings, beginning with an examination of domestic savings principal sectors (Governnent, non-financial parastatals corporations and households). Household savings patterns are th-.: in greater detail in a separate sub-section. Lastly, a fI .-_ analysis is developed adding both the external sector and lht-: intermediaries to the preceding analysis, thereby showing the tit .. -s and uses of funds within the Botswana economy. Analysis of the Structure of Savings 2.52 Sector-wise Composition of Savings Table 2.7 domestic financial saving balances by sector in th.r Bonswana c C i. 1984 and 1987. The table is derived from rhe tables rn gr: savings and usage by sector shown in Annex 2.3. Both tlh intermediaries and the external sector have been exc1uciod. to the external sector, it can be said that eotzswana as a wa: I a net saver. Savings of foreigners witliin the Botswalio relatively small whereas Botswana’s foreig:: exchange reserves a.- With regard to the four sectors depicted in tlhe Table 2.7, !I,: situation is slightly more complex. The Government has externa .. but no external savings and this reduces its ret savlngs posi:I.: high levels shown in the table. Nonetheless, the Government’ .: would still remain very high and in a strong surplus posio-. borrowings were included. The net savings position of the para, : . be worsened by the inclusion of the extelnal sector as they hax.e s .. ,. external borrowings. The largest effect, however, would be orl tle. .:-. corporate sector whic;i, due to the act iv-tes o,f ,e rt- l’a-. within the economy, would make the entire se-tor signrfCanly ‘r. The largeso external private borrower in this regard is the t . mining company with total external horrow ings exl ceeanr P1 ‘ 2.53 Table 2.7 indicates the rather ur: :e ro i,r, I’ currently finds itself. in most deve-);rang e t. i and the private corporate sector wh_-ch arc in defic it , ard finance frcm the household sector, In a study on savings and th. – 28 – funds carried out or Indial6/, it was found that households were by far the largest contributors to savings within the economy, representing between 70 ta 80 percent of total domestic savings in the 1950s and 1960s17/. The other two secLors (Government and private corporate), were substantially smaller contributors to total net domestic savlngs. 2.54 In the Botswana context, however, it is the Government which is the largest net saver in the economy, sometimes saving more than 100 percent of the total. The second largest contributor to net domestic savings has been the private corporate sector. This largely reflects the role of Debswana in the economy, which in turn swamps the effect of the domestic savings habits of the other companies in this classification. The parastatal sector is a large deficit sector and the only sector of the four which has consistently been in deficit over these three time periods. 2.55 The household sector. on the other hand, has not been a large net saver. With tne exception of the anomaly of 1984 when the deficit position of the corporate sector distorted the overall figures, the proportion of household savings to total net domestic savings has been less than five percent of the total. This, in turn, partly reflects the very high levels of Government and private corporate savings. It is interesting to note, however, that despite the high rates of growth in the savings of Government and the private corporate sector, net domestic savings of the household sector have been growing even faster (63.8 percent per annum) over this period. This may well point to a general financial deepening within the economy. Rather than merely a large increase in the amount of savings held by a limited number of individuals, there has been gro,rth in the number of current and savings account holders in the commercial banking system. Table 2.8 shows that the rnumber of current account holders has increased by 12.4 percent per annum over the seven year period, while the number of savings account holders have increased by 9.1 percent per annum over the same period. This indicates that a growing number of Botswana are saving in financial institutions. 2.56 Lastly, Table 2.7 shows the relationship between net domestic savings and gross capital formation. An important feature of this period has been an increase in the proportion of gross fixed capital formation which is covered by net domestic savings. This is largely, however, the result of a very skewed distribution of savings habits, with the largest contribution, in absolute terms, coming from the Government. As a consequence, these savings are not necessarily available to finance private sector capital formation. The anomalies in 1984 are a case in point. In that year net Government savings were almost equal to total gross capital formation (i.e. P392.6 million compared to P408.5 million), however, the deficit position of 16/ V.V. Bhatt, ‘Savings and Flow of Funds Analysis: A Tool for Financial Planning in India’. 17/ This is further supported by more generalized work undertaken by iFonahan P. and Atiyas I., (1989) “Intersectoral Financial Flows in Developing Countries’, PPR Discussion Paper No. 164, World Bank. – 29 – the parastatal and private corporate sectors in that particular year meant that there had to be a net capital inflow from abroad to finance this gap. This would not have been necessary with a well-integrated financial system. 2.57 Pattern of Household Sector Savings Annex 2.4 categorizes household savings into their various component parts. The most obvious breakdown in the Botswana context is the division between savings in financial assets and savings in cattle. This table indicates that whereas the growth in total financial assets held by households over the period from 1980 to 1987 has increased by over 30 percent per annum, the corresponding growth in savings in the form of cattle assets is estimated to have increased at less than 5 percent per annum over this eight year period. Table 2.7: Nut Domestic Financial Saving Balances by Sector (P thousands) 1980 Z 1984 Z 1987 z growth Sector 1. Government 109,061 72 392,579 161 1,858,708 83 49.95 2. Parastatals (non-f’l) (15,839) -10 (163,466) -67 (160,159) -7 39.17 3. Private Corporate 54,443 36 (36,808) -15 436,596 19 34.64 4. Household 3,423 2 51,078 21 108,304 5 63.80 5. Aggregate Saving 151,088 100 243,383 100 2,243,449 100 47.02 Stock Gross Capital Formation 317,900 408,500 584,748 (Annual Flow) (5) as a proportion of 47.5 59.6 383.7 Gross Capital Formation Note: Balances as of end calendar year. Government includes central and local Government as well as parastatals. This table does not include borrowings between financial intermediaries or borrowings outside of the financial sector i.e. through the Government’s PDSF. Figures for Gross Capital Formation in 1980 and 1984 are the annual averages of the 1979/80 and 1980/81 years and the 1983/84 and 1984/85 years. The data for 1987 are proiected on the basis of the known growth rate between 1979/80 and 1985/86. 2.58 Financial Sector Savings of the Household Sector With :egard to household financial sector savings, the greatest growth has occurred in the area of life assurance, pension and provident fund savings. Whereas these two forms of household savings accounted fcr only 8.3 percent of total savings of the sector in 1980, by 1987 they accounted for 24.7 percent. Life assurance grew at almost 40 percent per annum while pensions and provident funds grew at over 60 percent per annum over the eight years. This reflects – 30 – a growing awareness of the relative attractiveness of these particular forms of savings, which in turn is indicative of a growing financial sophistication and deepening within the economy as a whole. Table 2.8: Number of Current/Savings Accounts at Commercial Banks (1980 and 1987) Current Savings Accounts Accounts December 1980 21,900 63,100 December 1987 49,700 115,900 growth per annum 12.42 9.1% 2.59 Claims on the Government and private corporate sector are small and relatively insignificant. Although the Government issued Treasury Bills in the earlier part of this period, these issues were small and were largely outside the household sector. The growing surplus position of tne Government since the early 1980s, obviated the need to raise financial resources from this source and hence new issues of Treasury Bills were suspended from December 1981. The one outstanding Government bond issue was scheduled for early redemption in December 1988. On the other hand, there are an increasing number of firms which are going public with share issues and raising resources from the general public. Although it is difficult to ascertain the value of household savings in such forms, it is known that the development of this type of financial instrument is relatively new, with four of the existing five companies with public share issues going public in the period between 1984 and 1987. A growing financial awareness and sophistication as well as the development of secondary markets in such instruments is likely to lead to a rapid increase in this type of household savings in the future. 2.60 By far the majority of household savi ,s continues to occur in the form of claims on the commercial banking system and other deposit taking institutions although their share in total financial assets held by the household sector has declined from 91.6 percent to 73.4 percent over the period under review. This decline has largely emanated from the non-bank financial institution (NBFI) sector, which has grown at less than 20 percent per annum over this period compared to over 30 percent for the commercial banking system. The proportion of total household savings in NBFIs has roughly halved to 16.9 percent of household’s total financial. savings, while the contribution of savings in commercial banks has declined by less than 3 percent to represent 56.5 percent of the total in 1987. This appears to indicate that the NBFIs are not playing an important role in the financial deepening of the economy of Botswana and that, in fact, their role is declining in relative importance. – 31 – 2.61 Cattle Savings of the Household Sector For purposes of comparison, rough estimates of household savings in the form of cattle are presented. Cattle represent an important component of non-financial savings for households, though by no means the only one. The reliability of the data on non-financial savings is questionable, but it does provide broad orders of magnitude. The estimates of household savings in traditional forms have been calculated on the basis of 30 percent of the total national cattle herd. This percentage is based upon two sources: the work of the Rural Income Distribution Survey (CSO 1975); and information reported in a study by Colclough and McCarthy. 2.62 In terms of the total rural population, Colclough and McCarthy identified three groupings: those that own no cattle at all (45 percent of all rural households); those who own small herds of less than 50 cattle (a further 40 percent of rural households); and the remainder who are large, mainly commercial cattle owners who own three quarters of the national herd and who comprise 15 percent of total rural households. The middle group, which owns one quarter of the national cattle herd are described as: . all cattle owners having up to about fifty head. On the whole these households have little difficulty in ploughing their lands, using their own, exchanged, hired or mafisa’d cattle. Thus they face fewer physical constraints to arable production. On the other hand, these farmers are not wealthy enough to acquire exclusive ownership of a borehole for watering their cattle, and consequently have to use the heavily overgrazed areas surrounding communal watering points’. 2.63 Using the above definition as a proxy for the number of cattle which still represent traditional savings (i.e. the number of cattle held by traditional cattle owners in a herd size of 50 beasts or less), more recent information from the “1986 Botswana Agricultural Statistics” indicates that cattle in such herds comprised 35.7 percent of the total. 2.64 Although it is inevitable that the percentage of the cattle herd in this category will be constantly changing (and thereby possibly accounting for the differences in these two sets of observations), a constant figure of 30 percent has been used in Annex 2.4 as a guide to the amount of the total herd which represents household savings. Another reason for the divergence in the two data sets may relate to the fact that the first survey covered “ownership” whilst the second survey covered “holdings”. This proportion (30 percent) has been multiplied by the 70 percent of average price of a beast paid by the Botswana Meat Commission in the three representative years, to arrive at the total amount of savings held in cattle. 18/ 2.65 Based on these calculations, in 1980, savings in cattle were equivalent irn value to 320 percent of financial assets held by households, 18/ The 70 percent figure is based on income tax conventions. The value of the household cattle stock may be lower than this because of the poorer quality of much cattle owned by households. – 32 – but by 1987 this ratio had declined to only 68 percent.19/ This overall deciine reflects several developm’ents in the Botswana economy including the adverse effects of a long period of drought and its effects on the size of the national cattle herd; the development of alternative savings instruments for the household sector (mainly life assurance and pensicns and provident funds); as well as a genetal overall financial diepening within the economy. 2.b6 Flow of Funds Anallsis In conducting an antlysis of the flow of funds in Botswana, the period from 1980 to 1987 has been used. This eight year period covers the development of the Jwaneng diamond mine and hence incorporates the effects of the massive inflow of financial resources which resulted from that development. The economy is sub-divided into five sectors, namely households, firms, parastatals, Government (both central and local) and the external sector. The financial intermediaries are sub-divided into three groups: commercial banks; the Bank if Botswana; and non-bank financial institutions. The NBFIs include the Financial Services Company, the National Development Bank, the Botswana Savings Bank, the Botswana Puilding Society, the Botswana Cooperative Bank, and Tswelelo (Pty) Limited. ‘;he analysis also attempts to identify financial flows between the three groupings of financial intermediaries. The sources of funds of each of the three groupings of intermediaries are represented by the assets side of their balance sheet, while the uses of funds side is essentially represented by their liabilities. Although ‘flows’ for each of the three periods 1980/84, 1984/87 and 1980/67 are given in the annex tables, it is only the flow cver the later period which is used in the subsequent analysis (see Annex 2.5). 2.67 It has not always been possible to have a totally consistent data set as available information has not always been for exactly the same accounting periods. Nonetheless, every effort has been made to ensure that it is as consistent as possible. In addition, data constraints are such that it has not been possible to have the pension and provident funds as a separate financial intermediary. This flow is, however, indicated as a flow from households to firms outside of the financial intermediation system. Household data has been augmented co ensure consistency with the foregoing section on the pattern of househcld sector savings. This has involved adding in “traditional” forms of savings and also adding pension and provident funds and life assurance as an extra, but separate, flow in the system. 2.68 The flows which occur outside of the domestic financial system have been more difficult to identify and measure. These include both Government lending activities and external lending. Annex 2.6 shows these two components. Government lending includes lending to both financial and non- financial parastatals, as well as to local town councils. External borrowings, both private and public also occurs. Although public external borrowings are reasonably well documented, the information on private 19/ The data from the latter year probably over estimates the contribution of household savings held as cattle, as this was the last year of a devastating six year drought during which a bigher proportion of the cattle of smaller scale farmers are likely to have died. Hence, the contrioution of cattle was probably even lower in the latter period than what is indicated here. – 33 – external borrowing is lesR well known. The largest known external borrower in the economy is the BCL copper/nickel mine which borrowed heavil v in the early 3980s due to the continued depression of the prices for copper and nickel. It’s external borrowings as _-t December 1987 were in excess of P1.28 billion, making it. a very large borrower in the economy. As the Government has a large equity stake in the BCL mine, a portion of these external bo.rowings are also indieectly borrowing by the Government, although this is difficult to identifv and separate. For the purposes of this exercise, all ECL borrowings have been treaced as borrowings by ‘firmso.20/ Outside of BCL, inf3rmation on private sector borrowings is virtually non-existent. However, based upon the little information that is known, an additional P100 million has been added to BCL’s known borrowings at the end of 1987 to take into account other rrivate sector external bovrowers. This should, however, only be treated as a guesstimate. 2.59 Chart 1 depicts Slow of funds fiom 1980 – 1987. All numbers are in millions of pula and if a number is less than P1.0 million, it has been treated as azer:.-, alLhough a connecting liie has still been drawn to indicate that a flow does exist. Sources are depicted on the left and uses on the right hand s,de of the diagram. The numbers on the left-hand-side of the sources section are the total financial flows which do not flow through financial 4ntermediaries. Hence in the .ase of the wforeign’ sector, P1,441 million represents the addition of P424 niillion gcing to NBFIs, Government and parastacals, as well as the P1,017 million going to firms. The numbers on the right-hand-side of the sources section are the total amount of financial resou.ces from that pi.rticular sector which is deposited in domestic financial intermediaries. Similarly, with the uses section – the niumbers on the left hand side are financial resources from domestic financial ir,termediaries, whereas the numbers on the r.ight are financial resources from non-firanci’,! (or external) sources. As indicated above, pension and provident funids as well as life assurance from households are treated flows outside of the f.inancial system. The numibers o the left of the names of the financial intermedi&ries are the inflows from savers in the economy, whereas the numbLrs to the right are the outflows from these intermediaries. 2.70 This flow of funds analysis is illuminating for several reasons. Firstly, the diagram c:early higtilights the largest flows within tbe economy. These tend to bte (on the sources side) from the Government and fi)m.s imainly Debswana) to the BOB. At P1,764 million and P336 million, these eie the largest flows into the financial system. On the opposite side, the s’ngle largest flow in the entire system is the flow to the external sector, almost entirely in the form of foreign exchange reserves. This indicates how effective the Government has been, to date, in preserving the foreign exchange windfall which it has experienced from the mineral sector since the early 1980s. 20/ During this period BCL was being refinanced from abroad and its equity being written down. – 34 – a

Lp cit II t i-s difficult to attribute economic success to a specific structtirt of financial organization, and the contribution of financial sector I ibera izacti4on, on its own, to growth, is likely to be small. 32/ There is soane ev–dence to suggest that severe repression

-l Ir X e I; C i;’? . E __l_l I X-‘ ‘ – 35 – 2.71 Another interesting feature of the flow of funds diagram is the fact that, apart from the Government’s accumulated savings with the BOB and the BOB’s subsequent investment of foreign exchange reserves in the external sector, the major flows actually occur outside of the financial system. Every domestic sector, with the exception of the household sector, is a large borrower from the external sector. In addition, the Government is also a major lender, operating outside of the financial system, providing loans to the parastatal sector in particular. This highlights the relatively small role that the. domestic financiai system is playing in financial intermediation an Botswana. If one were to remove the Government (including the BOB), as well as the external sector, then the remaining flows would be very small indeec. 2.72 This corfirms earlier analysis which indicated that the Government was by far the la;-gest surplus sector in the economy. The only other net surplus sector is -.he household sector which is a substantially smaller net saver than the Government. On the other side, the external sector is the largest deficit sEctor and largely represents the counterpart to the Government’s strong surplus position in terms of foreign exchange holdings. In common with many cther developing countries, the parastatal sector is also in a large net ceficit position. Lastly, the ‘firms’ sector is substantially in deficit.. Tr..s largely represents the deficit position of one large mining company (BCL) whose r.et borrowing pos;.tion (mostly from external sources), more than cffsets the strong surplus position (mostly held domestically), of the other major mining company (Debswana) operating in Botswana. 2.73 One challenge for the authorities will be to ultimately redirect more of the traditional forrms of savings from cattle ownership into the domestic financial system. Although this has not been one of the more major flows in the system (and the data on this form of savings must be treated with caution), it does represent a significant proportion of the current total flows into the commercial and NBFI banking systems. This redirection is important now because of environmental concerns and will become still more important as the Government’s strong net savings position in the economy reduces over time. 2.74 Another important aspect of financial development will be to utilize the financial system more by directing more of the existing financial flows through it. More of the large flows which -:urrently by-pass the system could be redirected through the system to assist in the future development of a stronger and potentially more useful financial system. 2.75 The large number of NBFIs operating in Botswana contrasts markedly with the relatively small flows both into and out of their system. Although this may not be a particularly bad thing, the structure of this sector and the appropriateness and the form in which services are provided from these institutions, requires examination if it is to play a future role in financial deepening within the economy. 2.76 In the future, the direction and the size of these flows are expected to change in a fairly radical manner. For instance, as the Government’s ability to continue being a large net saver declines, there will be a reversal of the flows from the Government to the BOB. This in turn will – 36 – imply a corresponding reversal of the current flow from the BOB to the external sector. With time it is also anticipated that the flow of resources from households through pension and provident funds to firms will increase markedly. This will be an important flow which could ultimately be used to fund the future activities of Government. Overall, despite the limitations of data and some consequent inconsistencies, the flow of funds picture provides some illuminating information and a good overall perspective of Botswana’s financial system. III. STRENGTHS AND WEAKNESSES OF THE FINANCIAL SYSTD( A. The Role of Financial Systems J.n Development 3.01 Only a few societies, notably those of Ancient Egypt and the Incas, were able to develop up to a certain point without some type of money. These were centralized, command economies, which had no need of the price mechanism to guide decisions. 21/ The institutions of money and finance facilitate the process of specialization, exchange, and the decentralization of decision making which is basic to the process of economic growth and development. Coinage appeared around 700 b.c. Fiat money, which seems to have first appeared in China and was reported on by Marco Polo, represented an advance over commodity money in that it saved on the resources needed for the physical production of money, transferring their equivalent to government in the form of A rent for the monopoly of money creation. But financial systems as we understand them today, with a range of institutions and habitually-used instruments, emerged only slightly before the industrial revolution, and their spread seems to have been associated with the process of industrial development. 22/ 3.02 The outputs of a financial system are less apparent than those of, say, a steel plant. They are best thought of as intermediate serviceE. although some, such as insurance policies, could be considered as final services. Modern financial systems offer a wide range of services, to households, firms, and the Government. In broad terms, these services involve: overcoming the limitations of self-finance; transforming maturities between savings and investment; transforming risks through buying, selling and diversifaction; and a means of payment and settling transactions. Some services are quite unrelated to the holding of financial deposits and lending, such as safekeeping facilities. Yet the most apparent services offered are a range of savings media with yield, liquidity and risk characteristics which make them attractive to a wide range of savers, and credit facilities for borrowers. 21/ For a more extensive discussion of mnany of the topics covered in this chapter, see World Bank: World Development Report, 1989. 22/ Goldsmith Raymond, 1987, Premodern Financial Systems – 37 – 3.03 In overcoming the limitations of self-finance, financial systems make available the resources of surplus agents (where savings exceed investment) to deficit agents, and thereby make possible the efficient intertemporal allocation of resources for both. Fi-ms and Governments are typically savings-deficit agents, but also hold financial balances; households are a savings surplus sector but also borrow, notably to finance housing. Although countries differ widely, in a representative developing country, the financial assets of households exceed their debt by 6.6Z of GDP, firms are in deficit by 7.32, and Government by 1.6Z of GDP; this leaves the foreign sector in surplus of 2.4Z of GDP. Taken as a whole, the business sector relies on borrowed funds for the equivalent of half of its capital formation. At present, Botswana’s configuration is very different to this pattern. 3.04 By mobilizing savings aud intermediating between savings-surplus and savings-deficit systems, finance permits more efficient allocation of resources, both across units and over time. Suitable intermediaries and instruments can also diversify, allocate and price risk, and th?s allows a wider range of potential investments to be considered. Financial markets also offer governments a range of instrumental services. The powerful and wide- ranging tool of monetary policy influences macroeconomic rhythm. Governments can also usc financial policies to intervene selectively in their economies, and most do so to a greater or lesser extent. The financial sectur offers a convenient tax base to government, which also may collect the monopoly rent from fiat money. A final type of service to government, which is noted out of many, is the precautionary cushion of foreign exchange reserves. Without access tc the international financial system, many governments and private agents would be forced into the costly holdings of large stocks to guard against floods, drought or other disruptions. Foreign reserves are for governments or nations what precautionary domestic financial balances are for individuals or firms within the economy, which are faced with fluctuations in their expected time-profile of earnings. 23/ 2,l Households and firms would also need to hold larger physical stocks in the absence of financial assets: hoarding of intermediate inputs is sometimes observed in cases of poorly functioning financial systems. – 38 – Table 3.1: Financial Assets (Average Percentage 1965-1986) Currency/ Country Groups GDP Ml/GDP M2/GDP U.S. 4.7 19.1 62.7 Other Industrial Market Economies 6.9 24.9 60.2 Upper Middle Income Countries 6.5 ;8.4 36.2 Lower Middle Income Countries 7.8 17.0 27.9 Low Income Countries 9.1 22.7 39.6 Low Income Less China and India 8.8 17.8 25.2 Source: IMF International Financial Statistics 3.05 Cross-section and time series analyses show that, as countries develop, their formal financial systems become deeper and more sophisticated. Table 3.1 offers a picture of the cross-section relationships between levels of development and fiaancial deepening (as expressed by a simple measure of financial assets to GDP). Systems typically evolve from currency and simple deposit-taking and short-term trade finance, through longer-term deposits and loans, to include a range of short-term negotiable papers, longer-term bonds and equities. About twenty developing countries now have equity markets of some significance, although these are generally thin and volatile and the proportion of equity actually available for trading may be small. 24/ Quasi- equity, such as preferred shares, convertibles, “junk” bonds or bonds with stock warrants attached are very rare in developing markets. 3.06 Relative to developed markets, those of developing countries have some other characteristic features. The state usually plays a major role in the allocation of financial resources and state-owned intermediaries typically account for at least half, and sometimes all, of the assets of the system. State ownership is especially pronounced in Africa, where the alternative is all too often foreign ownership. Developing countries’ systems are usually more extensively regulated, with interest rates and credit allocation heavily influenced by government policy. On the other hand, prudential regulation and supervision of financial institutions is usually far weaker in developing countries, as are capital market and insurance regulations addressing investor protection and conflict-of- interest. Accounting and auditing systems are usually weaker in developing 24/ Some firms may be in surplus, so that the leverage of many individual firms may exceed the sectorwide figure Fcr more discussion of the flow of funds see Honohan P. and Atiyas I., 1988. “Intersectoral Financial Flows in Developing Countries” CECFP, World Bank, m?meo. – 39 – countries, and they frequently do not follow generally accepted principles, and information disclosure is far less complete. As a result of these features, and also of macroeconomic instability and historical patterns of ownership concentration, capital market development has been retarded in many countries, whose financial systems are dominated by deposit money banks. 3.07 Also, financial systems ir. many developing countries are, in major part, technically insolvent, sometimes many times over. The causes of insolvency are several–poor supervision, unregulated enitry, poor management, fraud, excessive macroeconomic instability, and government direction of credit and interest rate policies. Financial system restructuring and reform is now a priority of many governments, because it is needed to allow the real sectors of the economy to adjust to polie!y reforms. Without financial reform, credit continues to flow to distressed Lorrowers, which crowd out the potentially viable firms which reform is intended to encourage, and a. the same time, the (possibly implicit) liability of the government mushrooms as the portfolios of intermediaries deteriorate. 25/ 3.08 As noted above, in most countries, the allocation of financial resources is through a mix of the market mechanism and allocation by the government. It is difficult to be specific as to the precise proportions of these processes which is optimal for economic development. In this area there are differences of opinion, even within individual institutions such as the World Bank. In order for a financial market to allocate resources perfectly (in the sense implied by models of competitive equilibrium), information must be complete and widely available, and the number of participants should be large enough to generate competitive pressures. These conditions are not completely fulfilled in any country–indeed, the very existence of banks and debt (as opposed to equity) contracts is partly attributable to the existence of imperfections of information. In general, the more developed the country, the more strongly the case can be made for market allocation of financial resources. In less developed countries, certain markets may not exist at all, notably those for long-term and equity resources. 26/ 3.09 The first question is then whether Government intervention, for example, by setting up specialized development institutions or targeting portions of commercial credit, can improve the allocation of resources. Some countries which have enjoyed conspicuous economic success, such as Korea, have also relied heavily on credit programs to influence the pattern of incentives. And in some cases, such as Brazil, the long-term financing of a substantial industrial sector has been effected through specialized 25/ Long M, 1987, “Crisis in the Financial Sector’ Paper delivered to the Reserve Bank of India: Hinds, M, 1988, “Economic Effects of Financial Crises’ PPR Working Paper No. 104, World Bank; Honahan P and Gelb A H, 1989, ” Financial Sector Reforms in Adjustment Programs.’ PPR Discussion ?aper No. WPS 169, World Bank. 26/ Of course, other conditions are needed for market allocation to be optimal, such as the absence of externalities and a desirable pattern of income distribution. – 40 – institutions disbursing earmarked funds at below-market rates. But the record of many countries suggests that efforts of this type will be counterproductive if pushed too far, and that they have had adverse results in many countries: to cite only a few, Tanzania, Philippines, Nigeria, India, and NJepal. Even though commercial banks are in bad shape in many countries, the financial condition of development banks is, on the whole, even worse, and very few have been able to demonstrate sufficient viability to raise funds from market sources. In most cases this appears to reflect a high proportion of non-viable projects as well as institutional weakness in collecting debts from viable borrowers. 27/ Externalities or social consiuprations are often cited as justifying these losses. But the expected losses have rarely been appraised and factored in ex ante and covered by up- front subsidies; more common seems to be their use in ex post rationalization of programs which generate large, and unexpected, losses. 28/ This does more than render the Government liable for unpredictable calls for *esources. It seriously weakens the accountability of the development institutions which fail to operate successfully as banks and also fail to follow up on the impact of their programs on their clients. 3.10 A second question concerns the appropriate developmental role of the commercial banking system. Here it is possible to distinguish two configurations of financial organization, which differ in the roles played by intermediaries and the capital markets. The so-called ‘market-based’ systen. characteristic of Britain and the US, assigns the role or the banking system mainly to shorter-term finance, with reliance on the bond and equity ;,.a.’Es for funding longer-term. investments. In contrast, in the ‘bank- based’ systems of Germany and Japan, the banks traditionally play a larger role in funding such investments. They may be exposed to correspondingly greater risks from their individual clients (but like other banks their portfolio is diversified) The arguments for such a system rest on the propositions that: (a) banks should be well-placed to diversify risks, and (b) banks have comparative advantage in assessing clients because of their continuous credit relationship with 27/ A review of the World Bank in 1983 indicated that out of some 153 development banks used by the World Bank as conduits for industrial sector loans up to 1983, only about 1C to 15 were Judged as sound enough to potentially raise funds from market sources; over one-third had verv serious financial problems. 28/ In principle there is no reason why losses up t- a specifiEci extent cannot be budgeted for and provided ir. the form of explicit subsidies. These could cover higher than normal intermediation costs (such as those on sral. loans), reduced interest charges and a higher than normal rate of loss due to riskier project lending. However, the ma or subsidies effecte_ through directed credit programs have often arisen by oversight

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. financial systems by interest, r-ates heldI well below inflation and extensive allocation of credit by Gcvernment is associated with poorer economic performance. A number of studies t