USAID Policy Paper

# Financial Markets Development

**Bureau for Program and Policy Coordination**

**U.S. Agency for International Development**

**Washington, D.C. 20523**

**August 1988**

**FINANCIAL MARKETS DEVELOPMENT** III.A3 (TM 1:46)

**POLICY PAPER**

**Table of Contents**

*Section Page*

EXECUTIVE SUMMARY i

I. INTRODUCTION 1

II\. THE FUNCTIONS AND KEY CHARACTERISTICS OF

FINANCIAL MARKETS 1

A. Mobilizing Democratic Resources 1

B. The Role of Government 2

C. Efficiency and Depth 4

D. Integration 5

E. Promoting Widespread Ownership 6

III\. STATEMENT OF USAID POLICY AND OBJECTIVES

FOR FINANCIAL MARKETS DEVELOPMENT 6

IV\. COMPONENTS OF USAID POLICY 6

A. Financial Markets Development Strategy 6

B. Policy Dialogue 7

1\. Macroeconomic Policies 7

2\. Encouraging and Mobilizing Domestic

Private Savings 8

3\. Credit Allocation Policies 9

4\. Legal and Regulatory Constraints 10

5\. Tax Policies 11

6\. Informal Financial Markets 12

C. Institutional Strengthening and Development 13

D. USAID Credit Policy 14

1\. The Provision of Equity and Grants by USAID 14

2\. Interest Rates to Private Enterprises and

Other Ultimate Borrowers 15

3\. The Relationship Between Donor Funds and

the Cost of Capital to Financial Intermediaries 16

4\. Targeting and Guarantying Loans 18

5\. Lending Through PVOs and Nonprofit Entities 19

E. Financial Training and Standards Development 20

F. New Financial Instruments and Institutions 20

*Annex* Glossary of Financial Market Terms 22

**FINANCIAL MARKETS DEVELOPMENT**

**POLICY PAPER**

**EXECUTIVE SUMMARY**

The purposes of this policy paper are to (a) describe USAID\'s policy on
financial markets development, and (b) provide guidance on the
development of USAID\'s programs and projects in financial markets.

Effective financial markets are indispensable to the pursuit of
sustained, broad-based economic growth. Unfortunately, financial markets
development is one of the most complex areas in the development field.
Whether financial systems are relatively simple or highly complex, they
perform the same broad functions and share the same key characteristics.

 The primary role of the financial system in any economy is to mobilize
resources for productive investment. An efficient financial system
channels resources to activities that will provide the highest rate of
return for the use of the funds. These resources stimulate economic
growth; they provide enterprises with the ability to produce more goods
and services and to generate jobs.

 Governments in developing countries can and should facilitate
financial markets development and provide a policy and regulatory
environment that encourages the appearance of competitive forces,
encourages the use of a variety of debt and equity instruments, promotes
the growth of different kinds of institutions offering a wide range of
financial instruments and services to potential savers and investors,
and protects the interests of savers by reducing their risks.

 Efficient financial markets promote more widespread ownership of
assets in a society.A larger number of citizens in a developing country
will thereby have an opportunity to participate in, and enjoy the
benefits derived from, the growth of their country\'s economy.

USAID should promote a system of financial markets that is integrated
and relatively undistorted, one that relies heavily on competitive
financial institutions, and on policies to facilitate competition. This
system should be capable of effectively mobilizing private savings,
allocating that savings to investments yielding maximum returns, and
maximizing the participation of the general populace. USAID supports
developing countries\' efforts to (a) design, adopt, and implement
policies conducive to the development of efficient, deep, and integrated
financial markets, relying primarily on market rates of interest and
other terms for the efficient mobilization of private savings and
allocation of credit, and (b) build and promote competition between
viable private, profit-making financial institutions. USAID can be a
catalyst for financial liberalization in developing countries through
both the policy dialogue process and project assistance.

USAID can draw upon a broad range of resources to help developing
countries build more effective financial markets. Different countries,
depending on their stages of economic and financial markets development,
may require different kinds of assistance. The primary policy approaches
discussed in the policy paper are summarized below.

 USAID too often has designed and implemented projects without
adequately taking into account broader issues involving the financial
systems in developing countries. In addition many Missions manage a
variety of \"credit\" projects and other financial markets activities
simultaneously. Missions contemplating, or maintaining a continued
presence in, financial markets activities should prepare a comprehensive
financial markets development strategy paper before or in conjunction
with pursuing additional financial markets activities.

 Failure to consider the macroeconomic setting may obscure the forces
behind financial developments and lead to inappropriate policy
recommendations. Improvements in policies affecting financial markets is
an important objective for Missions that are active in the financial
markets arena. In those countries in which the macroeconomic policy
environment is not conducive to efficient performance of private
financial institutions, USAID should (a) urge the host government to
adopt more appropriate policies and (b) consider postponing initiation
or replenishment of financial markets activities until evidence exists
that the host government is prepared to improve the policy environment.

 Domestic private savings should provide the major source of loan
resources for financial institutions. Inappropriate policies inhibit
prospective savers from relying on the formal financial system. USAID
should help developing countries develop and implement policies to
encourage, mobilize, and monetize domestic savings.

 Over-reliance on directed credit results in often severe
misallocations of scarce investment resources that undermines the
strength and viability of financial institutions and retards the growth
of financial assets. USAID discourages developing countries from relying
excessively on directed credit. USAID should encourage developing
countries to rely on market mechanisms to allocate capital to its most
productive uses.

 In many developing countries, governments hold nominal interest rates
constant. During periods of inflation, real interest rates fluctuate
with inflation, and will become negative if the inflation rate exceeds
the nominal rate. When the outright removal of all statutory ceilings to
deposit and lending interest rates is not feasible, USAID should
encourage the host government to adopt specific reforms that permit
interest rates to adjust (within an acceptable time frame) to market
levels in a deliberate and timely way.

 In many cases, the existing legal and regulatory framework restricts
the growth of financial techniques and limits the ability of financial
institutions to maximize their profits by seeking higher yield
investments elsewhere. USAID should engage in policy discussions and
offer technical assistance, as appropriate, to reduce imprudent, and
strengthen prudent, legal and administrative controls on financial
institutions, and streamline and simplify the regulatory and supervisory
responsibilities of government agencies.

 Strong institutions are essential parts of effective formal financial
systems. Improvements in the institutional framework are a means of
attaining the objective of broad-based economic growth. The most
effective place for USAID to concentrate its resources, after policy
reform, is in assistance to promote the institutional development of
financial intermediaries that operate in a free, competitive market and
other institutions that operate in the financial system.

 USAID has been active in helping developing countries improve their
financial systems through the provision of credit. USAID will not take
an equity position in a private enterprise. The interest rate to be
charged on USAID resources to ultimate borrowers (a) shall, at a
minimum, be at or near the prevailing interest rate paid on U.S.
Treasury obligations of similar maturity at the time of obligating such
funds, to the maximum extent practicable, and (b) should not be less
than terms prevailing locally or a rate that approximates the
opportunity cost of capital in that country. At a minimum, the interest
rate to ultimate private borrowers should be significantly positive in
real terms, i.e., when adjusted for inflation. USAID funds provided to
financial institutions should carry an interest rate that (a) is at
least equal to the cost of local, nonconcessional sources of capital;
(b) approximates the cost of lendable resources of comparable maturities
from the local private capital market (if such resources exist); and (c)
is based on the appropriate rate to the ultimate borrowers.

**I. INTRODUCTION**

Effective financial markets are indispensable to the pursuit of
sustained, broad-based economic growth.[^1] Unfortunately, financial
markets development is one of the most complex areas in the development
field. Policy perspectives differ, often sharply, and the costs of
establishing and implementing poor policies are high.

The purposes of this policy paper are to (1) describe USAID\'s policy on
financial markets development, and (2) provide guidance on the
development of USAID\'s programs and projects in financial
markets.^\*^[^2] USAID should promote a system of financial markets that
is integrated and relative undistorted, one that relies heavily on
competitive financial institutions, and on policies to facilitate
competition. This system should be capable of effectively mobilizing
private savings, allocating that savings to investments yielding maximum
returns, and maximizing the participation of the general populace.

**II. THE FUNCTIONS AND KEY CHARACTERISTICS OF FINANCIAL MARKETS**

The nature and performance of financial systems in developing countries
must be judged in relation to an individual country\'s level of
development. Whether these financial systems are relatively simple or
highly complex, they perform the same broad functions and share the same
key characteristics. These functions and characteristics are discussed
below.

**A. Mobilizing Domestic Resources**

The primary role of the financial system in any economy is to mobilize
resources for productive investment. The financial system provides the
principal means to transfer savings from individuals and companies to
private enterprises, farmers, individuals, and others in need of capital
for productive investment. An efficient financial system channels
resources to activities that will provide the highest rate of return for
the use of the funds. These resources stimulate economic growth; they
provide enterprises with the ability to produce more goods and services
and to generate jobs.^\*\*^[^3]

Well-functioning and well-developed financial systems encourage savings
and allocate resources to higher-yielding investments. Savers can make
their surpluses available in investors by, in effect, purchasing
financial assets (from a variety of debt and equity claims including
entries in a savings passbook from a commercial bank). The financial
system mobilizes savings and increases liquidity by providing asset
holders with attractive (in terms of yield, risk, and liquidity)
financial claims. In the absence of developed financial systems, only
investments financed by individual savers or closely-knit groups of
individuals would be possible. Many high-yielding investments would not
be undertaken and some capital would be invested in activities yielding
low returns.

Well-developed formal financial markets offer to savers and investors a
variety of short- and long-term savings and investment instruments
(often, but not always) through qualified financial intermediaries that
enable individuals to make reasonable judgments about the risk and
rewards of saving or investing their funds. These instruments
effectively package risk and returns so that individuals who wish to
participate in appropriate markets can do so, taking into account their
own perceived capacity to accept risk. Individuals are able to borrow
funds on terms commensurate with the expected risk and return of the
investments they wish to make.

Financial systems transform the size, maturity, and risk characteristics
of assets. For example, to reduce their risk, investors who wish to
finance the acquisition of long-lived capital prefer to borrow at long
term. For similar reasons (to reduce their risk), savers seldom are
willing to tie up their funds for the long term. Financial systems
mediate, inter alia, between the short-term perspectives of these savers
and the long-term perspectives of these investors. They do so through
(1) direct term transformation of maturities by borrowing short and
lending long, and (2) indirect term transformation by buying and selling
long-term instruments prior to maturity in secondary markets.

Another way to mobilize domestic resources is through the development of
the equity or securities market. Equity financing provides an
alternative to debt financing; it also offers new opportunities for
investors and for broadening the ownership of economic assets. Expanding
popular participation is essential to accomplishing the aims of USAID\'s
policies.

**B. The Role of Government**

The growing inadequacy of financial systems as countries develop often
leads to government intervention in the financial system. To the extent
that government involvement in financial systems is misdirected, the
development of efficient financial markets will be inhibited and the
costs of financial intermediation will be increased. Monetary and
financial regulatory policies that stifle financial intermediation,
creating \"financial repression,\" are the policies primarily
responsible for poorly functioning domestic monetary systems and capital
markets, and thus for poor rates of growth. Interest rate ceilings on
deposits and loans, combined with inflationary rates of monetary
expansion, are the most important policies creating financial
repression. Other policies adding to this repression are exchange
controls, taxation, credit allocation, and heavy reserve requirements.

Government restrictions on freedom of entry almost always reduce the
quantity and quality of financial services available to the economy, and
thus hinder or distort economic growth. In contrast, competition in
banking and financial intermediation tends to limit the spreads between
the interest paid by borrowers and that received by depositors. This
serves as an incentive for increasing saving and provides more funds,
more cheaply, to investors. This competition, when combined with the
adoption of liberalized financial sector reforms,enhances the efficiency
with which intermediation is carried out.

At the same time, government plays a key role in assuring that financial
markets operate effectively. Governments in developing countries can and
should facilitate financial markets development and provide a policy and
regulatory environment that encourages the appearance of competitive
forces, encourages the use of a variety of debt and equity instruments,
promotes the growth of different kinds of institutions offering a wide
range of financial instruments and services to potential savers and
investors, and protects the interests of savers by reducing their risks.
Such actions would serve to decrease the transactions costs associated
with financial intermediation.

Government should play an important role in the area of private
ownership and property rights. Private ownership and property rights
arrangements are important elements in determining the extent of an
individual\'s participation in financial markets. When private property
rights exist, an individual has exclusive right to use and derive the
income from . assets, to transfer the assets voluntarily to others, and
to be assured that contracts of exchange are enforceable. The absence of
these rights makes it difficult for private enterprises and individuals
to participate in the financial system.

The proper role of government is heavily conditioned by one key
characteristic of financial markets. Unlike markets in goods and most
services (in which there is A simultaneous exchange of value), financial
markets involve sale and purchase transactions that are separated in
time. In a financial market, the product is exchanged for a commitment
(for example, in the savings market, a promise to repay savings deposits
plus interest), that is, for a promise to act in the future. Although a
certain amount of risk is part of any economic transaction (witness the
admonition \"caveat emptor\"), assessing and coping with risk is the
essential component of every financial market transaction. The nature of
the product involved is in large part determined by the personal
characteristics of the actors involved in the transaction. In the early
stages of financial markets development, personal judgments of
creditworthiness lie at the core of all financial transactions.

The types of policy approaches available could generally be classified
in four categories:

\(1\) \"purely\" competitive, where government policy is to rely on
market forces with limited government involvement even in matters
related to supervising, and establishing solvency requirements for key
participating institutions;

\(2\) competitive but heavily regulated for soundness through extensive
use of supervision and solvency rules;

\(3\) administered market, where government intervenes by allocating
finance and structuring institutions, but lets markets set prices within
these parameters; and (4) managed, where government decisions replace
market relationships and the enforcement of supervision and solvency
policies is minimal.

The mix or balance of policy approaches could differ in a given market
through time and among different markets in a given country. Government
policies now generally favor administered or managed systems in many of
the developing countries in which USAID operates. Recently, however,
several developing countries have liberalized their financial markets.
They have implemented reforms to reduce the extent of government
intervention through *inter alia* state ownership of banks, directed
credit programs, and subsidized interest rates. As a result, financial
markets in these countries are less distorted and more integrated; they
respond more readily to market signals rather than administrative
directives.

**C. Efficiency and Depth**

Financial markets can be effective to the extent that they are efficient
and deep. Governments regulate financial markets to promote efficiency
and to avoid volatility.

Efficient financial markets (1) mobilize funds from savings with, at the
margin, the lowest opportunity cost (adjusted for perceptions of risk)
and (2) distribute those funds to investments that offer, at the margin,
the highest potential returns (adjusted for perceptions of risk). Taken
together, these are the two characteristics of allocational efficiency.
Efficient financial markets also mobilize and allocate funds at minimal
cost. This is the characteristic of operational efficiency. It is also
important to keep in mind that if there are inefficiencies in the
market, then prices or costs would not reflect the real information
relevant for financial decision-making (price discovery efficiency).

The depth of financial markets is a measure of their strength: deep
financial markets are inherently less fragile than shallow financial
markets. A commonly used indicator of formal sector financier depth is
the ratio of broadly defined money (currency plus demand deposits) to
gross domestic product. A low ratio suggests that the formal financial
system is a poor mobilizer of funds; combined with strong demand for
funds by the public sector, a low ratio makes credit to the private
sector very scarce. In many developing countries, formal financial
markets are shallow; relatively few people have access to these markets,
and the range of available financial instruments is limited. Friends,
relatives, and moneylenders are the primary sources of external finance
in a very shallow system. Savings tend to be placed in real assets such
as gold or cattle as a store of value. As the system develops, more
options are available for yields, maturities, and risks, leading to
higher household welfare.

As the system financial develops, prospective investors increasingly can
turn to local financial institutions, national financial organizations
and, ultimately, international banks and securities markets for
additional funds. Each step leads to a more efficient allocation of
capital. The resulting increase in the availability of equity and debt
funding will enable developing economies to move towards more balanced
capital structures of enterprises.

Shallow, formal financial markets do not adjust well to external shocks
without collapsing or displaying excessive fluctuations; they are
markets in which, *inter alia*, severe market gyrations are fairly
common, institutions too often collapse, and \"secure\" instruments are
not, in fact, safe havens for savings. Shallow financial markets also
are rather easily subject to manipulation. Low-income developing
countries, with their shallow financial markets, have been found to rely
relatively more heavily on administrative allocation systems than
high-income developing countries.

However, in most of the developing countries in which USAID operates,
government policies now appear overly concerned with curbing volatility
and inadequately concerned with promoting operational and allocational
efficiency. The quest for greater efficiency in the financial markets of
developing countries typically means relying more heavily on market
forces rather than on administrative controls.

There is a riskdue to heightened market volatility involved in the
timing and sequencing of introducing liberal reforms. The recent
experience of the Southern Cone countries of Latin America is
instructive. The main lessons of that experience are:

 financial liberalization should be accompanied by effective
supervision of both public and private institutions to avoid fraud,
circumvention of sound financial practices, and misuse of funds;

 financial authorities should devalue an overvalued currency, before
attempting to reform domestic financial markets. Failing to do so will
lead to \"excessive\" borrowing in anticipation of a real devaluation;

 financial authorities should consider carefully the likely effects of
rapid reductions in existing interest rate subsidies. Depending on the
context, a sudden shift to high real rates may trigger widespread
defaults and lead to a collapse of the banking system; and

 financial authorities should pay particular attention to the
sequencethe timingof reforms. For example, authorities may wish to
liberalize the international current (trade) account before liberalizing
the capital account. Otherwise, depending on the context, the result may
be destabilizing short-term capital inflows that could stimulate rapid
unwarranted appreciation of the domestic currency.

**D. Integration**

Effective financial markets are integrated in two dimensions. First,
integration can be \"vertical.\" Vertically integrated financial systems
are those in which the three principal market clusters (formal domestic
markets, informal markets, and international markets) are closely
linked. Second, integration can be \"horizontal.\" Horizontally
integrated financial markets are those in which market interest rates
typically array themselves around a basic reference rate.

Vertically integrated financial systems incorporate informal and
international financial markets with formal domestic financial markets.
Informal financial markets are especially important in USAID-recipient
countries because these markets provide the credit and savings
mobilization functions for a major portion of USAID\'s target groups
(see section IV.B.6.).

Informal financial markets are highly segmented; moneylenders generally
exercise spatial monopoly power. Informal financial markets clearly are
\"interlinked\" markets, in that informal financial transactions spill
over into transactions in the local land and labor markets (for example,
local money lenders often are members of the landed elite and often hire
labor at differential rates depending on the indebtedness of that
labor). Although assessing the degree to which these interlinked
informal financial markets are integrated with formal domestic financial
markets is difficult, linkages between the two markets are greater than
may be readily apparent. Informal financial markets have links with
formal credit through their lines of credit with commercial and
development financial institutions. In addition to serving
microenterprises and informal sector enterprises, informal financial
intermediaries supply those credit requirements of formal sector
enterprises that cannot be met by formal financial institutions.

An effective financial market system also should connect domestic
financial markets to international financial markets (and to the related
commodity trading systems). The presence of effective financial markets
in developing countries will encourage foreign investors to consider
providing capital (in the form of both debt and equity) for productive
investment. Over time, integration with international financial markets
will (1) narrow the differences in the cost of funds between markets in
different countries and between different instruments, and (2) spread
the risks associated with exchange rate and interest rate fluctuations
among a larger number of market participants.

In horizontally integrated and efficient formal financial markets, the
reference rate, typically the inter-bank rate, is the market rate of a
short-term, low-risk financial instrument. Such an instrument is easily
available to financial institutions. It typically provides the basic
liquidity for the formal financial system, and central banks often use
it to gauge the tightness of monetary policies. Two markets sometimes
are closely integrated because intermediaries operate simultaneously in
both; for example, commercial banks operate in both the savings
(deposit) and the loan markets. On the other hand, in most developing
countries, the government bond market and the market for housing loans
probably, not be very tightly integrated.

**E. Promoting Widespread Ownership**

Efficient financial markets promote more widespread ownership of assets
in a society. A larger number of citizens in a developing countries will
thereby, have an opportunity to participate in, and enjoy the benefits
derived from, the growth of their country\'s economy. Development of the
equity, securities market, for example, provides a means of distributing
the ownership of securities more widely among the public, which
increases the probability that business ownership will not be confined
to a small number of wealthy families or to big industrial-financial
conglomerates. Another way to build up widespread ownership is the
establishment of contractual savings arrangements through pension funds.

**III. STATEMENT OF USAID POLICY AND OBJECTIVES FOR FINANCIAL MARKETS
DEVELOPMENT**

USAID supports developing countries\' efforts to develop financial
markets. USAID will encourage these countries to (1) design, adopt and
implement policies conducive to the development of efficient, deep, and
integrated financial markets, relying primarily on market rates of
interest and other terms for the efficient mobilization of private
savings and allocation of credit, and (2) build and promote competition
between viable private, profit-making financial institutions. The
primary source of capital for economic growth should be private domestic
resource mobilization. USAID can be a catalyst for financial
liberalization in developing countries through both the policy dialogue
process and project assistance.

**IV. COMPONENTS OF THE USAID POLICY**

USAID can draw upon a broad range of resources to help developing
countries build more effective financial markets. Different countries,
depending on their stages of economic and financial markets development,
may require different kinds of assistance. If that assistance is needed
to overcome existing constraints in the policy environment, then that
assistance should be designed to help resolve, and not compensate for,
those constraints. The policy described in this policy paper is
Mission-directed, flexible, and closely guided by detailed and
comprehensive country studies. It is expected that Missions will
concentrate on policy reforms that emphasize greater reliance on
competitive, market-based allocation systems and on project assistance
to and through private sector institutions. USAID/W will help Missions
with technical assistance and other assistance mechanisms where it can.

**A. Financial Markets Development Strategy**

**Missions contemplating, or maintaining a continued presence in,
financial markets activities should prepare a comprehensive financial
markets development strategy paper before or in conjunction with
pursuing additional financial markets activities.** This strategy paper
should (1) develop a framework for financial markets activities based
upon host country conditions and the policy and institutional issues
raised in this policy paper, and (2) discuss how existing and proposed
USAID-supported financial markets interventions in a country interrelate
under this framework.

A review of USAID\'s credit projects suggest that USAID too often has
designed and implemented projects without adequately taking into account
broader issues involving the financial systems in developing countries.
For example, USAID often provided credit through public and private
development banks, credit unions, and PVOs without exploring the need to
mobilize domestic financial resources. USAID projects often implicitly
accept interest rate ceilings and administratively determined credit
allocation mechanisms as incidental constraints on specific projects. In
particular, too little attention may have been paid to the reasons why
formal credit was not available.

Many Missions manage a variety of \"credit\" projects and other
financial markets activities simultaneously (involving, e.g.,
micro-enterprise loans, agricultural credit, mortgage credit, and
exchange rate reform efforts). These projects are often channelled
through an uncoordinated subset of financial institutions, at a variety
of interest rates and conditions. Such efforts may promote a more
fragmented domestic financial market than might exist without USAID\'s
assistance.

**B. Policy Dialogue**

**Improvements in policies affecting financial markets is an important
objective for Missions that are active in the financial markets arena.**
Missions must assess realistically the influence they have in
encouraging host country governments to adopt sensitive reform packages.
It may be difficult to leverage significant financial policy reforms
with sharply limited resources or through a single project affecting
only a very narrow part of the financial system.

**Missions should solicit a broad range of local private sector views to
ensure that suggested policy changes are responsive to the broader needs
of the private sector as well as to the requirements of economic
efficiency, and encourage a continuing dialogue between government and
the private sector.** In a number of developing countries, important
elements of the business community believe that their governments do not
adequately understand their needs and their roles in the development
process. Missions may wish to encourage host governments to publicly
develop a strategy to promote their financial markets through an
appropriate set of policies. Such a commitment, as well as a continuing
dialogue on matters relating to financial markets development, may
improve saver and investor confidence.

**Missions should coordinate their efforts in financial markets
development with multilateral agencies and other bilateral donors.**
Multilateral agencies and other bilateral donors are working with many
developing countries to help improve their financial systems.
Multilateral agencies in particular often are especially well-positioned
to advocate politically sensitive policy reforms.

**1. Macroeconomic Policies**

**In those countries in which the macroeconomic policy environment is
not conducive to efficient performance of private financial
institutions, USAID should (a) urge the host government to adopt more
appropriate policies and (b) consider postponing initiation or
replenishment of financial markets activities until evidence exists that
the host government is prepared to improve the policy environment.** If
a Mission wishes to initiate or replenish a financial markets activity
when the macroeconomic policy framework is inadequate, suitable
documentation should clearly demonstrate that the Mission has analyzed
the effect of the existing policies on the activity\'s ability to
achieve its purpose. Failure to consider the macroeconomic setting may
obscure the forces behind financial developments and lead to
inappropriate policy recommendations. Among the policies that may need
attention are monetary policy, fiscal policy, exchange rate policy,
import and export barriers, credit controls, and access to foreign
exchange. The reform of a particular policy should be undertaken
carefully and in concert with other actions.

**Missions should encourage developing countries to adopt investment
policies that attract foreign investors and increase the contribution of
foreign and local investment to economic growth.** Opening markets to
foreign direct investment provides ways for these countries to diversify
their economies and increase their capital inflows. Efforts to attract
foreign investment will, if properly conceived, also mobilize local
investment. USAID\'s policies on foreign investment are presented in the
Trade Development Policy Paper (July 1986).

**2. Encouraging and Mobilizing Domestic Private Savings**

**USAID should help developing countries develop and implement policies
to encourage, mobilize, and monetize domestic savings. USAID should
encourage developing countries to eliminate interest rate ceilings,
which inhibit capital formation and individual savings and encourage
capital outflow, and adopt policies that allow interest rates to
fluctuate in response to market forces.**

Domestic private savings should provide the major source of loan
resources for financial institutions. Inappropriate policies inhibit
prospective savers from relying on the formal financial system. Instead,
they hold more traditional forms of wealth such as land, animals,
jewelry, or gold. The result is an aggregate level of savings less than
that which could be achieved given improved financial markets policies.
Inadequate information, distrust of large and centralized institutions,
and various cultural considerations are other important factors that
inhibit savers from relying more fully on formal financial markets.

Empirical evidence strongly supports the assertion that the poor in
developing countries save. The poor often rely on informal institutions
such as investment clubs, savings societies, and rotating credit
associations for saving. The informal institutions involved frequently
are effective mechanisms for channelling those mobilized savings to
productive uses. Mobilization of domestic private savings is dependent
on efficient financial markets and profitable uses of the mobilized
funds.

Several actions are needed if a savings mobilization effort is to be
successful. Two are particularly important. First, effective interest
rates paid to savers should be sufficient (normally positive in real
terms, that is, adjusted for inflation) to attract an increasing inflow
of funds from private savers; artificially low interest rates produce a
bias in favor of current consumption and therefore reduce the incentive
to save. Second, the services offered by financial institutions must be
easily accessible and otherwise attractive to savers.

Combining savings and lending activities of financial intermediaries
offers many benefits, and demonstrates the importance of savings to
institutional viability. It reduces some costs, including those of
establishing credit-worthiness, since financial intermediaries will have
better information on and be better acquainted with borrowers through
their role as savers. Saver-dominated financial institutions also tend
to show steady growth in assets and liabilities, lower loan delinquency,
and greater efficiency and financial viability. Borrower-dominated
financial institutions tend to show higher rates of loan delinquency,
poor rates of growth, perennial liquidity problems, and other weaknesses
associated with dependence on external sources of funds.

**3. Credit Allocation Policies**

**a. Directed Credit**

**USAID discourages excessive reliance on directed credit. USAID should
encourage developing countries to rely on market mechanisms to allocate
capital to its most productive uses.**[^4]

Administrative allocation mechanisms are particularly appealing to
governments of very low income countries where money markets are
typically very shallow and highly fragmented (between geographic
regions,urban and rural borrowers, different loan purposes, large and
small enterprises, and classes of borrowers). Governments generally
pursue these mechanisms because of political, social, or distributional
considerations.

Over-reliance on directed credit results in often severe misallocations
of scarce investment resources that undermines the strength and
viability of financial institutions and retards the growth of financial
assets. Persistent and usually subsidized directed credit programs
typically do not adequately reach their intended beneficiaries, limit
the access to (and make more costly) credit of firms not in
government-designated \"priority\" sectors, create \"moral hazard\" on
the part of private investors who operate under the expectation that
government support will ward off failure, reward inefficient
capital-intensive patterns of investment, require administrative burdens
that most developing countries are particularly ill-equipped to handle,
and discourage savings intermediation. In addition, the allocation of
credit may often be compensating for deliberate or accidental
inadequacies in the host government\'s own policy actions.

**b. Government-controlled Interest Rates**

**When the outright removal of all statutory ceilings to deposit and
lending interest rates is not feasible, USAID should encourage the host
government to adopt specific reforms that permit interest rates to
adjust (within an acceptable time frame) to market levels in a
deliberate and timely way.**

In many developing countries, governments hold nominal interest rates
constant. During periods of inflation, real interest rates fluctuate
with inflation, and will become negative if the inflation rate exceeds
the nominal rate.

Countries that have consistently maintained positive interest rates and
have an adequate number of institutions that issue attractive financial
instruments show a higher rate of growth in their financial assets and
have deeper financial intermediary systems than countries that have low
and/or widely fluctuating levels of real interest on deposits. Positive
market-determined real interest rates generally are associated with the
development of sound and self-sustaining financial systems.

Interest rate ceilings often are imposed by governments to protect the
borrower from \"unscrupulous\" lending practices. Yet, lending to large
numbers of small and widely dispersed borrowers (e.g., small, rural
entrepreneurs) normally involves relatively high administrative costs
per loan that cannot be passed on to the end-borrower because of the

interest rate ceiling. Consequently, it becomes unprofitable for
financial institutions to lend to these borrowers.

Imposing interest rate ceilings, no matter how well-intentioned, often
results in reductionsnot increasesin the availability, of formal
credit for specific target groups. Local financial institutions handling
the subsidized credit can be expected to allocate the credit in
accordance with their appraisal of risk and profitability for themselves
and thereby improve the quality, but not expand the dispersion, of their
loans. Subsidized interest rates also encourage greater use of
capital-intensive production techniques by making loans for capital
equipment less costly, and, consequently, decrease employment per unit
of capital employed.

**c. Credit Collateral Requirements**

**USAID should encourage financial institutions to seek alternatives to
fixed and high collateral requirements (such as adopting flexible
collateral requirements, charging higher interest rates, lending to
groups of borrowers, or establishing special small loan windows).**

Formal lending institutions (e.g., banks, credit unions, savings and
loans, and finance companies) frequently establish loan collateral
requirements that effectively direct credit to favored groups of
individuals or enterprises. Collateral requirements often are very high
(ranging from 150% to 200% in most developing countries) and may be
limited to certain types of collateral (e.g., land). Where interest
rates are artificially low, collateral acts as a screening mechanism to
discriminate among prospective borrowers. High collateral requirements
also may be derived from lender concern about political and economic
uncertainty and a lack of familiarity with certain potential borrower
groups.

**4. Legal and Regulatory Constraints**

**USAID encourages host country governments to review the legal and
regulatory framework affecting their financial systems. USAID should
engage in policy discussions and offer technical assistance, as
appropriate, to (a) reduce imprudent, and strengthen prudent, legal and
administrative controls on financial institutions; (b) streamline and
simplify the regulatory and supervisory responsibilities of government
agencies; and (c) improve the capabilities of regulatory bodies to
enforce appropriate laws and regulations.**

In many cases, the existing legal and regulatory framework is designed
to ensure proper banking practices. However, some controls often
restrict or repress the growth o@ financial techniques and limit the
ability of financial institutions to maximize their profits by seeking
higher yield investments elsewhere. These controls include, *inter
alia*, time limits on deposits; maximum amounts for certain deposits;
restrictions on the types of institutions that can receive certain types
of deposits; and entry requirements in the banking sector. Some of these
measures manifest themselves as implicit taxes on financial
intermediaries (see section IV.B.5).

Legal codes and regulations of developing countries are often inadequate
on such issues as security of assets, title to property, property
transfer, taking possession of collateral on loans in default, and
sharing ownership of assets. The result is that under existing laws (a)
it is often difficult to broaden the range of financial instruments and
securities available in the market; (b) there are limits on when and at
what price companies can issue securities in public offers (inhibiting
public offerings), and interest that can be paid (discouraging savings);

\(c\) securities cannot be easily transferred among holders, and often a
company has the power to refuse transfer; and (d) investors have
inadequate rights and protections.

Proper government regulation is beneficial to lenders, borrowers, and
investors. For example, regulation of securities may increase investor
confidence in equity shares. Reasonable standards of investor
protection, such as adequate accounting standards and rules of financial
disclosure, protect securities investors and are critical to the
successful functioning of a capital market. Fair enforcement of
contracts protects investors, lenders, and borrowers. Deposit insurance
encourages individuals to save and deposit their funds. The removal of
market entry barriers and the resulting increased competition in
providing financial services generally increases the quantity and
quality of financial services available to savers and investors.
Responsible regulation of private banking and other financial
institutions may remove some of the host government\'s excuses for
nationalization of financial institutions and resistance to
privatization of state-owned financial institutions.

It should be recognized also that the judicial and enforcement systems
are weak and inadequate to settle disputes. Enforcement of rules and
regulations can be just only with a fairly administered adjudicatory
mechanism including means of appeal.

**5. Tax Policies**

**As part of their financial markets development strategy, Missions
should review their host country\'s tax structures to assess their roles
in the development of the financial system. Missions should encourage
host governments to change restrictive tax laws and adopt tax policies
that provide a suitable tax environment for financial markets
development.**

In some countries, tax measures inhibit financial markets development
and restrict capital formation by increasing the cost of financial
intermediation and reducing the financial system\'s flexibility due to
the reduced amount of funds available for lending and, in turn, for
investing. Financial intermediation is subject to explicit and implicit
tax measures that are not applied to other sectors of the economy. For
example, some governments impose an explicit transactions tax on the
value of each financial transaction undertaken by a financial
institution. Implicit taxes consist primarily of requirements for the
maintenance of high reserve levels and forced portfolio investments on
low yielding government securities.

In addition, special tax preferences for certain forms of investment
discourage savers from investing in those that are not so favored.

A number of tax measures may improve financial intermediation and
capital formation. These include, *inter alia*, lowering the explicit
and implicit taxes levels imposed on financial intermediaries, and
adopting lower marginal tax rates for corporations (which promotes
economic efficiency and equity investment, and may reduce capital
outflows), and for individuals (which encourages savings rather than
consumption). In the absence of lower tax rates, numerous measures can
be explored that could encourage greater savings and investment. These
efforts will involve substantial policy debate, as financial markets
development may conflict with other host government goals, such as
raising short-term tax revenue.

**6. Informal Financial Markets**[^5]

**USAID should encourage the host government to adopt specific reforms
that increase access to formal sources of credit. USAID should sponsor
studies on the nature and functions of informal financial markets. As
appropriate, those lessons should inform the design of projects and
programs involving formal financial markets.**

In many developing countries, the common requirements and practices of
formal financial institutions make access to credit and other financial
services difficult and expensive. As a result, there remain in place
often sizeable informal financial markets. Typically, informal financial
markets comprise professional and nonprofessional money lenders (often
relatives and friends), local bankers-cum-merchant middlemen, private
pawnshops and finance firms, personal and business fixed fund and
rotating savings and credit associations, landlords, and the more
prosperous agriculturalists. Although heterogenous in composition, these
intermediaries share some typical economic characteristics including the
predominance of cash transactions, freedom from official registration
and regulation, ease of entry or exit, small scale of operations, and
the multiple-interest relationship (financial and sociocultural) between
lenders and borrowers. They are found in both rural and urban areas, and
can be national in scope, such as the curb market in South Korea, or
international in scope, such as the Hundi system prevalent throughout
South Asia.

Informal financial markets transactions generally take place in an
unregulated environment. Some elements of these transactions may be very
efficient. They have at best limited connections with monetary
authorities (for example, they are not subject to reserve requirements
and governments exercise no direct fiscal controls over their
activities). However, information of the nature and functions of
informal financial markets is woefully inadequate. Important lessons may
be derived from careful study of their behavior.

The activities of moneylenders in informal financial markets are often
abhorred since interest rates charged in the informal financial markets
often are higher and for shorter

terms than in the formal markets. Yet,growing evidence suggests that the
implicit and explicit costs and difficulties associated with formal
credit sources often are higher than are the nominally higher costs for
funds obtained in the informal markets.

USAID\'s assistance to the informal sector has historically been in the
form of project-based credit and technical assistance. Although many
USAID programs directed at micro-enterprises and informal sector
enterprises have demonstrated that these enterprises are reliable
borrowers and can be reached cost-effectively, studies have shown that
providing credit alone to microenterprises only rarely produced
self-sustaining gains; increases in income were short-lived.

Informal sector enterprises often face a policy and administrative
environment that contains serious market access and entry barriers. Some
macroeconomic policies have a negative impact on informal enterprises
and serve as entry barriers to the formal sector. These issues should be
addressed within the framework of USAID\'s assistance to the informal
sector.

USAID should also continue to encourage formal financial institutions to
serve the same clientele served by the informal financial markets. In
the process, the more efficient formal markets gradually displace less
effective informal markets. The best examples are those involving the
extension of formal financial systems to better serve the growing
financial demands of small farmers and small-scale entrepreneurs. This
approach depends for its success on the truth of an assumption that
formal financial markets are more effective than informal institutions
under appropriate circumstances. Although this assumption is generally
borne out over the long run, it may not be correct in some markets in
the short run.

To facilitate graduation to commercial borrowing, USAID should foster
the involvement of formal financial institutions in the informal system.
For example, it may be useful to have a representative from a local
private bank involved in an USAID-sponsored informal sector lending
program conducted through a PVO. This might facilitate an informal
enterprise\'s graduation from the USAID program to commercial banks by
increasing the bank\'s familiarity with the borrower (and much of that
segment of borrowers) while establishing a credit history in which the
bank has confidence.

**C. Institutional Strengthening and Development**

Strong institutions are essential parts of effective formal financial
systems. The most effective place for USAID to concentrate its
resources, after policy reform, is in assistance to promote the
institutional development of financial intermediaries that operate in a
free, competitive market and other institutions that operate in the
financial system. It should be kept in mind that improvements in the
institutional framework are not ends by themselves, but only a means of
attaining the objective of broad-based economic growth.

Although particular country situations differ, private sector financial
institutions are generally more efficient than public institutions for
channelling assistance to individual private enterprises and for
mobilizing domestic resources in support of financial markets because
they:

 have to depend to a greater extent on their capacity to attract
nonconcessionary savings and to engage in new financial activities
because of their more limited access to concessionary resources;

 are more innovative in reducing transaction costs and spreading the
costs of bearing risks; and

 have been able to better avoid projects of dubious profitability
(although sometimes to an imprudent extreme).

**USAID should give priority attention to strengthening the private
financial system (through which USAID resources should be channelled)
and those private institutions that have a reasonable prospect of being
self-sustaining. It is preferable to expand the capabilities of existing
private financial institutions rather than establish new institutions.**
USAID should encourage well-run, existing financial institutions to add
new types of financial activities to their traditional operations rather
than create new institutions to accomplish particular development
objectives. Diversification allows institutions to overcome the problems
of scale associated with over-specialization, especially in low-income
countries with small financial markets.

Greater attention should be directed to structuring assistance to
financial institutions to improve their (1) prospects for viability
after USAID\'s assistance has been terminated, and(2) operations in ways
that would enhance their own financial strength, growth prospects, and
contribution to savings mobilization and credit allocation performance.
Examples of measures meriting close attention include cost controls,
loan application appraisal techniques, reasonable collateral and other
safeguards to protect loan contracts, good collection records, business
services, and deposit-taking functions. For self-sustaining viability,
financial institutions in developing countries should move toward
mobilizing their funds from the domestic economy.

Missions should be alert to the risks of over-emphasizing the
supervision of the uses of credit, as this sometimes results in the
neglect of potentially more important objectives of credit projects.
External assistance, in the form of technical assistance or staff
training (rather than capital for making loans) may help these
institutions develop their own capabilities.

In a free market, financial institutions generally organize themselves
according to the opportunities they see to meet the different needs of
savers and users of funds as well as the changing patterns of savings,
fiscal conditions, and institutional arrangements. USAID\'s programs and
projects should be sufficiently flexible to allow for the disbanding of
inefficient entities, restructuring, or the merger of institutions as
appropriate. For example, institutions may, properly merge or go out of
business when there is insufficient market demand to support many
separate institutions.

**On a case-by-case basis, USAID may help to establish new financial
institutions (including special purpose institutions) in areas where
private institutions have not been established despite a favorable
policy environment and other supporting factors. However, USAID should
carefully study each situation and weigh available alternatives prior to
proceeding with the new entity. Where existing private financial
institutions are capable of performing the desired activity, the
establishment of a new trust or trust fund to serve as a financial
intermediary for on-lending or equity investment should be avoided.**

An unwarranted increase in the number of financial institutions can
reduce the success of institutional development. Since financial systems
in most developing countries are shallow, special purpose institutions
could affect adversely the ability of commercial institutions to attract
natural clients. The creation of parallel and costly institutional
structures should, therefore, be discouraged, particularly in smaller
countries.

Before establishing new financial institutions, USAID should review the
existing financial system to determine whether: (1) financial
intermediation is being provided at a reasonable cost; (2) financial
institutions are providing an appropriate mix of services for market
demands; (3) the level of competition among various institutions is
adequate; (4) the financial stability and structure of the various
institutions is appropriate for their types of financial activities; and
(5) experienced management is available.

**D. USAID Credit Policy**

USAID has been active in helping developing countries improve their
financial systems through technical assistance, training, studies,
policy dialogue, and the provision of credit. USAID\'s credit programs
and projects (1) support new development finance institutions; (2) help
existing banks expand their traditional short-term lending operations to
aid medium- and long-term lending; (3) increase the credit resources
available for financing priority development activities; (4) eliminate
impediments to capital movement among regions or sectors; and (5) open
up access to formal credit to disadvantaged borrowers.

**1. The Provision of Equity and Grants by USAID**

**As established in section 635(g) (3) of the Foreign Assistance Act of
1961, as amended, and section V.D. of the Private Enterprise Development
Policy Paper, USAID will not take an equity position in any private
enterprise**[^6] **Grants to private enterprises in developing countries
are permitted to finance direct training and technical assistance,
although such assistance should be programmed in a way that provides
competitive access for many enterprises rather than one
enterprise.^\*^**[^7]

Owners\' equity is important during the start-up phase of an
intermediate financial institution (IFI) or other private enterprise as
it provides permanent finance with no contractual payments. Owners\'
equity is the financial stake put at risk by each of the owners,
originating from each owner\'s desire to earn a return on his share of
equity higher than alternatives for which he could have used the
funds.^\*\*^[^8]

A number of reports have characterized USAID\'s involvement in IFIs as
providing \"quasi-equity.\" The quasi-equity instruments usually
referred to, such as debentures, are debt instruments. Any confusion
between equity and quasi-equity may have arisen because USAID, in the
short run, may perform like an owner of equity by insisting that a
portion of an IFI\'s on-lending portfolio (generally the capital
available from USAID) contain loans to an USAID target group.

**2. Interest Rates to Private Enterprises and Other Ultimate
Borrowers**

**The interest rate to be charged on USAID resources to ultimate
borrowers (a) shall, at a minimum, be at or near the prevailing interest
rate paid on U.S. Treasury obligations of similar maturity at the time
of obligating such funds, to the maximum extent practicable (it should
be borne in mind that use of the U.S. Treasury rate is moderately
concessional); and (b) should not be less than terms prevailing locally
or a rate that approximates the opportunity cost of capital in that
country.^\*\*\*^**[^9] **If interest rates, collateral requirements, or
repayment periods are administratively imposed by the government, the
terms agreed to in USAID- supported activities will be part of a planned
effort to encourage governments to move progressively toward market
terms. At a minimum, the interest rate to ultimate private borrowers
should be significantly positive in real terms, i.e., when adjusted for
inflation.**

Where practicable, the interest rates and associated fees charged to the
sub-borrower by an IFI should cover all of the IFI\'s costs of lending,
such as the costs of funds mobilized or borrowed; the normal premiums
for the higher risks of term loans or devaluation risks for loans
denominated in foreign currency; a loan loss reserve; the administrative
costs of providing loans to end borrowers (which usually are high as
USAID generally tries to service the credit demands of a large number of
small borrowers); any extraordinary costs of non-bank services furnished
the sub-borrowers or of supervising the sub-loans; and a reasonable
profit margin for the IFI. Interest rates to be charged on USAID\'s
direct loans to private enterprises should be set within the context of
this effort.

Special circumstances for concessional assistance are discussed the
Private Enterprise Development Policy Paper (section V.D.); however,
concessional rates should not be used to encourage private enterprises
to undertake activities that are not commercially feasible at market
rates. If there is little expectation that a needed product or activity
is not commercially viable, then Missions should consider the use of a
contracting mechanism to one or several firms to undertake the
particular activity, rather than introduce new distortions into the
financial market.

Experience shows that in countries in which private business is
overshadowed by subsidized state-owned enterprises (SOEs), the financial
market is severely handicapped and limited. SOEs often consume much of
the total domestic credit available. When USAID extends credit to SOES,
loans to SOEs will be at the same rate charged to private enterprises,
and are to be provided in the context of the privatization guidance
contained in the Private Enterprise Development Policy Paper (section
V.F.).

**3. The Relationship between Donor Funds and the Cost of Capital to
Financial Intermediaries**

**a. Interest Rates**

**USAID funds provided to financial institutions should carry an
interest rate that (1) is at least equal to the cost of local,
nonconcessional sources of capital; (2) approximates the cost of
lendable resources of comparable maturities from the local private
capital market (if such resources exist); and (3) is based on the
appropriate rate to the ultimate borrowers. All IFIs (regardless of
whether the owners are public or private, joint public/private, or PVOS)
should be treated as private enterprises for the purpose of determining
interest rates on loans to them because they are selling services in
commercial markets and are capable of earning revenue.**

Market-based interest rates on loans to IFIs are an essential component
of financial markets development. Historically, USAIDprojects that
provided low interest (or interest-free) loans to IFIs have developed
maintenance of capital value problems in later years. These relatively
low nominal interest rates were often combined with moderate to high
level of inflation and resulted in negative real rates of interest.
Consequently, these projects have built-in automatic financial drains.
Interest rate subsidies lead to substantial recurrent cost problems. It
is difficult to wean IFIs from subsidies.

A financial institution\'s usual sources of capital for on-lending are
equity capital, debt instruments, borrowings from the Central Bank, and
retained earnings. The provision of donor funds provides three initial
benefits. First, donor funds provide additional capital to a financial
system that has little or no access to external funds and cannot meet
capital demand with its domestic resources. Second, the addition of
donor funds to the capital base decreases the aggregate cost of funds in
the economy. Third, donor funding to the financial sector provides new
foreign exchange to the Central Bank.

When a donor provides capital to an IFI at terms below that which the
IFI must pay to attract depositors, the IFI may deemphasize its
acquisition of deposits from local sources and seek to increase its
access to additional donor resources as deposits become relatively more
expensive. At the same time, a relatively large spread between USAID\'s
loan terms to the IFI and the on-lending terms may enable IFIs to
operate profitably with a significant percentage of their loan portfolio
in arrears or default, and will reduce the pressure on the institution
to expand volume and services. This large spread may reduce the
IFI\'s-overall market effectiveness and efficiency, and discourage its
aggressiveness in other financial activities. USAID needs to balance
this cost against the goal of wanting these IFIs to develop a more
aggressive risk profile in their loan portfolios.

**USAID needs to make more realistic determinations of the costs of
carrying out USAIDrequired activities when developing credit projects.
If it is necessary to make adjustments (concessional assistance) in the
terms of USAID\'s assistance to the IFI to hedge agreed-upon risk
(although not necessarily the total risk) or cover the costs arising
from meeting USAID\'s programmatic objectives, then the value of the
adjustments shall be equal to, but not greater than, the actual costs
incurred by the IFI.**[^10] This will enable the IFI to cover the costs
of USAID-sponsored activities and earn a return that, since it is
comparable to other returns earned by the IFI, not discourage the IFI
from pursuing its non-USAID activities (such as deposit-taking).

If the cost of the institution-building activities (such as training IFI
employees) occurs primarily in the early, stage of an IFI project, it
may make sense to identify such costs as separate components of a
project and to finance these with grant funds, rather than have such
costs spread over the term of loan repayment. This approach may be
preferred if it is desired that the institution-building activities
should proceed before the on-lending activities can generate revenues.
Another approach is to provide technical assistance to reduce loan
transaction costs in the credit delivery system. A concessional loan
would not be appropriate for handling long-term differences in
transaction costs between loans to different types of end-borrowers.

If the USAID loan to the IFI is to be concessional, then the grant
component of the loan should be identified, analyzed, and its value
fully reflected in program or project documents. USAID must justify
fully, on a case-by-case basis, the use of loan subsidies (and, as
appropriate, grants) to IFIs (including PVOs that act as IFIS).

If the spread between the cost of the funds from USAID and the IFI\'s
on-lending rate is too large, then the IFI receives a windfall profit.
If the spread is too small, then the IFI will not disburse the funds, or
will not disburse them to the clientele targeted by USAIDThus, the
interest spread is a critical financial parameter in an IFI project.
Missions may wish to consider lending their funds to an IFI at a
floating interest rate if USAID\'s funds are to be disbursed over a long
period of time.

**b. Foreign Exchange Risk**

The issue of foreign exchange risk presents a special problem. There are
certain situations in which private financial institutions are unwilling
to accept dollar loans because of the risk of devaluation. They are also
afraid that they will be unable to convert their local currency
repayments into dollars because of foreign exchange limitations. There
are several ways to deal with this problem.

USAID often utilizes a two-step loan that passes its financing through a
host country\'s government entity (e.g. Central Bank) before the funds
are on-lent to ultimate borrowers. The dollar loan is made directly to
the government which assumes responsibility for its ultimate repayment
and the dollars or the local currency equivalents are then on-lent
through the IFI to the ultimate borrowers. This procedure allows
internal on-lending arrangements to be structured so that the government
can continue to bear all the risk of devaluation, or can pass all or a
part of the risk to the IFI and then to the ultimate borrowers. In this
two-step process, the interest rate charged to the IFI by the government
entity could reflect the real cost of loanable capital to the IFI within
that developing country, including the foreign exchange risk.
Alternatively, the foreign exchange risk can be shared in varying
proportions between two or all three of the participants. It should be
noted, however, that in some instances the involvement of the host
government in the transaction may discourage private IFIs from
participating in the USAID-sponsored activity.

The USAID dollar loan also may be made directly to the IFI. The loan
arrangement should be structured to adequately protect the IFI from the
high risk of future currency devaluation and to insure the IFI\'s
solvency. Therefore, the credit program should be structured so that all
or most of the risk is shifted forward to the sub-borrowers. In
high-risk situations this could restrict on-lending to export activities
that would earn the foreign exchange needed for repayment.

In both the two-step or direct loan approach, the charges to the end
borrower of a loan denominated in local currency may include a
contribution to a reserve fund held by the IFI that could be used to
offset any deficiency in the local currency loan service receipts in the
event of devaluation. Also, in both approaches, the on-lending rate to
the ultimate borrower should still be determined by the guidance in
section IV.D.2. Many ultimate borrowers do not require dollars. In these
instances, they are unwilling to accept the foreign exchange risk
associated with dollars. USAID should utilize local currency financing
wherever possible in credit projects.

**c. Parastatal Financial Institutions**

Many governments own or control many of the suppliers of finance in
their respective countries. Missions should refer to the Private
Enterprise Development Policy Paper (sections V.D. and V.F.) for
additional guidance on dealing with parastatal financial institutions.
The guidance in section V.D. states that \"USAID funds provided to
financial institutions should avoid introducing government ministries or
parastatals into the on-lending approval process where such involvement
does not now exist. Furthermore, such projects should seek to extract
government ministries and parastatals from the process if they are now
so involved.\"

**4. Targeting and Guarantying Loans**

**Targeted credit projects typically enlarge the role of government in
financial markets and further distort, or continue to displace, market
allocation of capital. Missions should consider such projects (a) after
they have determined that there are no policy, institutional, or
cultural constraints discouraging the extension of credit to the target
group, or (b) as a way of encouraging host governments to correct policy
and other constraints where they exist and helping private financial
institutions develop some expertise and experience with delivering
financial resources to intended target groups (possibly with the
concomitant provision of training and technical assistance).**

Directed credit projects appear to be attractive mechanisms for
assisting USAID\'s target groups. However, there is some skepticism over
whether targeting of USAID loan resources actually accomplishes its
intended purpose.

The fungibility of money makes it difficult, if not impossible, to
attribute measurable increases in the output or incomes of targeted
borrowers to USAID credit activities. In addition, directed credit
activities ma@, contravene efforts designed to improve the market
behavior and performance of the financial system and mitigate the
likelihood that, over time, USAID\'s directed assistance will be
replaced by the capability and interest of the indigenous financial
system itself to service the needs of the target group. Great care must
be exerted to ensure that USAID\'s assistance is designed in a way that
does not discourage or preempt private sector initiative in this area
(especially where this initiative has developed without USAID
assistance). Studies have also found that the costs associated with the
administration of targeted loans through rural finance institutions, for
example, are many times larger than the estimated private lender costs
for the simpler task of establishing creditworthiness of borrowers.
Finally, the time associated with monitoring and record keeping for the
donor diverts the time and skills of the financial institution\'s staff
away from profit-generating activities.

USAID-sponsored guaranty activities also risk distortions of market
forces and the efficient allocation of capital. For instance, USAID\'s
objective in a guaranty project designed to redirect credit to rural
enterprises (covering the extra risks of lending to the target group),
usually requires that credit be redirected away from urban enterprises
and towards rural activities. This may reduce much-needed investment
funds in urban areas where unemployment rates are extremely high.

Yet, guaranties may be appropriate when the general policy and
institutional environment is supportive and lenders retain their
traditional inhibitions in developmentally important areas (such as
encouraging new, higher-risk, longer-term lending, or lowering or
changing collateral requirements). Since guaranty programs should
facilitate break-throughs in new lending patterns and are not meant to
substitute for unaddressed structural inadequacies in financial markets,
the case for their introduction must be well-justified and the size and
duration of such programs should be limited.

**5. Lending through PVOs and Nonprofit Entities**

**USAID should rely upon PVOs and non- or not-for-profit groups for
lending only when private, for-profit financial intermediaries capable
of performing the desired activity do not exist, or when PVOs are used
as part of a Mission\'s financial markets strategy to involve the
private financial banking system in on-lending to the target group (in a
way that does not discourage or preempt private sector initiative in
this area). PVOs or other non- or not-for-profit groups are not to be
utilized for making equity investments. PVOs should lend at rates
consistent with the guidance stated in section IV.D.2.**

Some private voluntary organizations (PVOS) have special advantages in
working with micro and small-scale enterprises because the PVOs are
flexible and in touch with the poor and their problems. Some PVOs can
offer financial assistance to enterprises or individuals not reached by
formal sector credit markets and can collaborate with banks and local
financial institutions to establish credit systems for those needing
small or short-term loans. The use of PVOs and a combination of
technical assistance and credit are often effective in reaching USAID
target groups such as rural enterprises and women.

Establishing financially autonomous institutions to manage credit,
training, and technical assistance programs and projects often is an
important component of a good financial markets development project. To
the extent that PVOs act as IFIs, they should follow lending and
repayment collection practices based on market-oriented and capital
preservation principles. In situations where there has been no
experience with lending to micro and small-scale enterprises, PVOs can
demonstrate to financial institutions how lending to the poor may be
profitable. Where feasible, USAID-financed projects should include
mechanisms to graduate beneficiary enterprises from utilization of
resources provided from PVOs to borrowing from formal sector
institutions.

**E. Financial Training and Standards Development**

USAID should emphasize to a developing country\'s public and private
sectors the importance of (1) adopting adequate training requirements
for accountants and auditors; (2) establishing generally accepted
accounting principles and auditing standards, and comprehensive uniform
financial reporting and public disclosure requirements; and (3)
maintaining a proper balance between self-regulation and public
regulation of these matters. USAID also should support efforts to train
accountants, auditors, and others involved in finance. Adequate
accounting, financial analysis and reporting, and auditing are critical
to a properly functioning market-based financial system. Without these
skills, it is not possible to determine the true position and
profitability of enterprises. Accounting and auditing principles should
be standardized and widely accepted.

**F. New Financial Instruments and Institutions**

As economies develop, credit demands become more complex and the
expanding demand for physical capital requires credit that varies by the
length of time required (short-, mid- or long-term) as well as the
end-use (consumer, investment, risk capital, venture capital, mortgage,
etc.). Where delivery and marketing systems and government policies are
satisfactory, formal financial institutions generally evolve to satisfy
these more complex needs. However, in most developing countries the
strength of demand for different types of credit exceeds the financial
sector\'s capacity to diversify and develop the institutions needed to
respond.

**As appropriate, Missions should develop and pursue a policy dialogue
agenda with host governments that encourages development of capital
markets and associated intermediaries in, for example, equity
securities.** In most poor developing countries, securities markets are
effectively absent and their development is not a high priority. Capital
market intermediaries (primarily primary and secondary securities
markets) are often inadequate for the development of new equity
instruments and the transfer of equity shares and bond instruments. Even
in some relatively sophisticated countries securities markets are
extremely thin: transactions in stocks are negligible; medium and long
term bond markets are shallow; and institutional investors are not a
major presence. Therefore, capital markets have little opportunity to
contribute to savings mobilization and economic growth and enhance the
country\'s participation in international capital or equity transfers. A
sustained effort to develop securities markets may be warranted in many
USAID-assisted developing countries. Some preliminary work to promote
the concept of securities markets development may be useful in the
poorer developing countries.

**USAID encourages developing countries to develop and utilize new debt
and equity instruments for directing scarce capital resources into
productive investments.** Among the instruments and techniques for
mobilizing capital for productive investments that should be explored
are commercial paper and bonds, term lending[^11], debentures,
government securities, trade (or supplier) credit, debt-equity swaps,
mortgage bonds, agricultural production contracts, variable interest
rate structures, and deposit insurance. These and other financial
instruments enable the financial market to spread risk among a variety
of instruments, thereby reducing exposure to market volatility, and to
be more flexible and responsive to the users of financial instruments.

**Missions should ensure that the proper policy conditions exist for
venture capital activities prior to, or in concert with, the provision
of any support to venture capital firms. Funds lent to venture capital
firms should be at market rates; grants or equity contributions are not
permitted.**

In some USAID-assisted developing countries; USAID may wish to explore
activities involving venture capital. These activities may wish to
emphasize the policy environment. Among the impediments that should be
addressed in support of venture capital activities are: (1) the lengthy
government approvals process required for the start of new ventures; (2)
unfavorable tax laws; (3) failure to give adequate legal recognition to
venture capital firms; (4) requirements for court or government approval
to merge or sell out the company when successful; (5) absence of an
adequately organized or liquid securities market into which the venture
capitalist may sell his shares; (6) government control of when public
offerings may be conducted and at what price; and, for foreigners, (7)
restrictions on repatriation of profits.

An alternative to fixed-rate loans for venture capital activities may be
variable-rate loans based on the internal rate of return or equivalent
financial performance of the venture capital enterprise. This
arrangement would reflect the relatively high degree of risk and
uncertainty attendant in venture capital approaches in developing
nations, and would avoid burdening the venture with a large fixed
obligation that might inhibit risk taking.

**USAID supports the use of debt/equity conversion programs as an
important financial markets instrument.**

Debt, equity conversions, or the capitalization of foreign obligations,
are gaining considerable momentum in business and policy circles. A
debt/equity conversion (commonly referred to as a debt equity swap) is
essentially, through a series of complex and interrelated steps, the
conversion of an external debt obligation into an equity stake in a
company.

Debt-equity conversion programs contribute to economic growth in several
ways, including the promotion of policy reforms that support growth and
investment, and the reduction or containment of immediate foreign
exchange debt servicing burdens. Use of debt/equity swaps also has the
effect of increasing levels of private investment in productive
enterprises, facilitating financial arrangements for privatization,
encouraging the return of flight capital, and rebuilding confidence
between commercial banks and debtor countries.

The cumulative impact of debt/equity swaps depends on available
opportunities for investment in developing countries, the depth of their
capital markets, and the ability of local economy to absorb additional
credit.

**ANNEX**

**GLOSSARY OF FINANCIAL MARKETS TERMS**

*Asset*Anything that is owned by an individual or business that has
commercial or exchange value. Assets may consist of specific property or
claims against others, in contrast to obligations due others. The
principal asset categories are: *current assets*, the sum of cash and
short term investments, accounts receivable (trade and other),
merchandise inventories, advances on merchandise, and listed securities
not in excess of market value; *fixed assets*, permanent assets required
for the normal conduct of a business (furniture, land, buildings) and
generally referred to as illiquid or capital assets: and *deferred
assets*, assets that are not, in the ordinary course of business,
readily convertible into cash, subject to current settlement.

Assets may also be classified as tangible and intangible. *Tangible
assets* include physical or material assets, e.g., real estate,
buildings, machinery, and cash, as distinguishable from *intangible
assets* that represent rights or economic benefits that are not physical
in nature, e.g., goodwill, patents, franchises, and copyrights.

*Bankers\' acceptance*A bill of exchange drawn on or accepted by a bank
to pay specific bills for one of its customers when the bill becomes
due.

*Collateral*Security given by a borrower to a lender as a pledge for
payment of a loan. Principal kinds of collateral are real estate, bonds,
stocks, and chattels. Although any kind of property that has a ready and
stable market may be employed as collateral, the collateral value of
different kinds of property is subject to wide fluctuation depending
upon the readiness and steadiness of the market and the ease of title
transfer.

*Commercial paper*All classes of short-term negotiable instruments
(notes, bills, drafts, checks, deposit certificates, and
acceptances)that arise out of a commercial transaction.

*Common Stock*Securities that represent an ownership interest in a
corporation. That part of the capital stock of a corporation that
represents the last claim upon assets and dividends.

*Convertibles*Securities (generally bonds or preferred stocks) that are
exchangeable at the option of the holder into other securities of the
issuing firm.

*Credit controls*-Quantitative and qualitative control exercised by the
monetary authorities over the volume and nature of credit and over
interest rates. These controls can affect the quantity and cost of
credit available to domestic and foreign borrowers in the country\'s
capital markets, and can strongly influence the direction of the
national economy.

*Debenture*A classification for all forms of unsecured, long-term debt
whether for corporate or civil obligations, although it is usually
applied to a certificate of debt issued by a corporation.

*Equity*The net worth of a business, consisting of capital stock
(preferred and common), additional paid-in capital, retained earnings,
and, occasionally, certain net worth reserves, and/or adjustments. When
used in a financial sense, equity means the value of property beyond the
amount of all claims and liens against it.

*Financial markets*The money and capital markets of the economy. Money
markets buy and sell short-term credit instruments generally for working
capital to enterprises that require funds to manage their current
affairs. Capital markets buy and sell long-term credit and equity
instruments generally for fixed or permanent capital formation that
enables businesses to be established or to expand their operations.

*Foreign exchange rate*The price of one currency in relation to that of
another, or the number of units of one currency needed to purchase one
unit or another.

*Intermediation*The investment process in which savers and investors
place funds in financial institutions in the form of savings accounts
and the financial institutions in turn use the funds to make loans or
other investments.

*International financial markets*An all-encompassing term that refers
to all international or multinational markets for short-, medium-, and
long-term securities and loans, forward and swap contracts, financial
futures, and foreign currencies.

*Letter of credit*Instrument by which a bank substitutes its own credit
for than of an individual, firm, or corporation, to the end that
domestic and foreign trade may be more safely, economically, and
expeditiously conducted.

*Loan*A business transaction between two legal entities whereby the
lender agrees to \"rent\" funds to the borrower, to be repaid with or
without interest.

*Net worth*The owner\'s equity in a given business, represented by the
excess of the total assets over the total amounts owing to outside
creditors at a given moment of time.

*Preferred stock*Corporate stock whose owners have some preference as
to assets, earnings, etc., not granted to the owners of common stock of
the corporation.

*Primary markets*The \"market\" in which financial assets (i.e.,
stocks) are originally issued.

*Risk*The possibility of loss; specifically, the chance of nonrepayment
of debt.

*Secondary market*The \"market\" in which primary market instruments
(e.g., stocks) are traded after they have been issued by corporations in
the primary market.

*Securitization*The broad process whereby capital financing occurs
through securities issuance rather than bank financing.

*Subordination*Acknowledgement by a creditor, in writing, that the debt
due him from a specified debtor shall have a status inferior or
subordinate to the debt which the debtor owes another creditor.

*Term loan*A loan provided for an extended period of time, generally
with a maturity greater than one year and for such purposes as an
increase in working capital or the purchase of equipment or other fixed
assets.

*Trade credit*Credit on goods purchased by a company from its supplier
(also called supplier credit or accounts receivable credit). The use of
trade credit brings different types of companies, including many
nonfinancial companies, into the credit system and may, in fact,
increase a firm\'s sophistication in the uses of credit.

*Trade finance*The financing, usually characterized as short-term, of
import-export trade transactions.

*Venture capital*Capital to provide funds for start-up situations
(\"seed capital\") or for existing high-risk small businesses suffering
from capital deficiencies but having high profit potential as emerging
growth companies.

*Yield*The rate of return from one\'s investment in a specific security
or specific piece of property.

**USAID Policy Papers and Policy Determinations**

The following reports have been issued in a series. These documents with
an identification code (e.g. PN-AAM‑323) may be ordered in microfiche or
paper copy. Please direct inquiries regarding orders to:

USAID Document and Information Handling Facility

7222 47th Street

Suite 100

Chevy Chase, MD 20815

[TitlePolicy Paper]{.underline} [Date]{.underline} [Fiche
\#]{.underline}

Domestic Water and Sanitation May 1982 PN-AAM-323

Food and Agricultural Development May 1982 PN-AAM-322

Nutrition May 1982 PN-AAM-321

Recurrent Costs May 1982 PN-AAM-319

Population Assistance September 1982 PN-AAM-320

Private and Voluntary Organizations September 1982 PN-AAM-318

Women in Development October 1982 PN-AAL-777

Pricing, Subsidies, and Related Policies November 1982 PN-AAN-373

in Food and Agriculture

Approaches to the Policy Dialogue December 1982 PN-AAM-431

Basic Education and Technical Training December 1982 PN-AAM-190

Health Assistance December 1982 PN-AAL-817

Institutional Development March 1983 PN-AAN-108

Co-Financing May 1983 PN-AAN-457

Local Organizations in Development March 1984 PN-AAQ-157

Energy July 1984 PN-AAQ-160

Urban Development Policy October 1984 PN-AAQ-158

Shelter February 1985 PN-AAQ-162

Private Enterprise Development (Revised) March 1985 PN-AAQ-163

International Disaster Assistance May 1985 PN-AAQ-164

Cooperative Development April 1985 PN-AAQ-165

Trade Development July 1986 PN-AAV-461

Health Assistance (Revised) December 1986 PN-AAV-462

[TitlePolicy Determination]{.underline} [Date]{.underline} [Fiche
\#]{.underline}

PD #1Narcotics August 5, 1982 PN-AAM-443

PD #2Mixed Credits September 29, 1982 PN-AAM-444

PD #3Voluntary Sterilization September 1982 PN-AAM-445

PD #4Title XII October 5, 1982 PN-AAM-446

PD #5Programming PL 480 Local February 22, 1983 PN-AAM-591

Currency Generations

PD #8Participant Training July 13, 1983 PN-AAP-273

PD #9Loan Terms Under PL 480 Title I September 27, 1983 PN-AAN-753

PD #10Development Communications February 17, 1984 PN-AAP-616

PD #11Using PL 480 Title II Food Aid for July 26, 1984 PN-AAQ-159

Emergency or Refugee Relief

PD #12Human Rights September 26, 1984 PN-AAQ-161

PD #13Land Tenure May 9, 1986 PN-AAQ-166

PD #14Implementing USAID Privatization Objectives June 16, 1986
PN-AAQ-167

PD #15Assistance to Support Agricultural Export September 13, 1986
PN-AAV-460

Development

PD #16Program Financing Arrangements with October 9, 1987 PN-AAV-463

Independent Organizations

PD #17Microenterprise Development Program October 10, 1988 PN-AAV-466

Guidelines

[^1]: ^\*^ ^\*^ A financial system is composed of many financial
    markets, each offering different types of financial services,
    serving different sets of customers, and operating in particular
    geographic areas. Markets can be classified as involving debt
    instruments, equity instruments, or foreign exchange (or some hybrid
    involving more than one of these, e.g., letters of credit). The
    policy approaches and principles described in this policy paper are
    applicable to the development of all financial markets.

[^2]: ^\*^ ^\*\*^ The policy guidance presented in this paper apply to
    the use of all USAID resources (DA, ESF, PL 480, U.S.-owned local
    currency) and, when practicable, host country-owned local currency.
    References to forms of USAID activities (such as \"project\" and
    \"program\") are used interchangeably in this policy paper. The
    policies presented in this document should be applied in concert
    with those in the USAID policy papers on Private Enterprise
    Development (revised March 1985) and Pricing, Subsidies, and Related
    Policies in Food and Agriculture (November 1982); the Guidelines on
    Terms of Aid (revised October 1985); and the guidance contained in
    cables 1986 STATE 259310 and 259314 on the private enterprise local
    currency lending program described in sections 106 and 108 of the
    Food Security Act of 1985. Additional guidance on the Housing
    Guaranty Program is provided in the Shelter Policy Paper (February
    1985).

[^3]: ^\*^ ^\*\*\*^ Private enterprises are defined as privately-owned,
    for-profit business entities. They should be distinguished from
    private voluntary organizations (PVOs) that are private, nonprofit
    entities.

[^4]: ^\*^ ^\*^ The \"market-determined\" or \"market-clearing\" rate
    for credit is used throughout this paper, even though its common
    meaning (the rate at which the supply and demand for credit are in
    balance with a minimum of government interference) is often not
    applicable in developing countries where governments exert a great
    deal of control over financial and related markets.

[^5]: ^\*^ ^\*^ The informal sector refers to those business entities
    that operate outside formal economic and governmental structures and
    range in size from the small and labor-intensive enterprise to
    relatively large and capital-intensive enterprises. Women are widely
    represented in the informal sector, particularly at the small-scale
    range of the spectrum.

[^6]: ^\*^ ^\*^ Section 635(g) (3) of the FAA restricts USAID from
    directly purchasing equity securities, although USAID does have
    limited authority to purchase convertible debt securities and may
    convert them or otherwise obtain equity securities through such
    means as the enforcement of liens and pledges. Legislative guidance
    on this subject extends back to the Mutual Security Act of 1954, as
    amended, and the Development Loan Fund, one of USAID\'s predecessor
    agencies.

[^7]: ^\*^ ^\*\*^ This language refers to private enterprises that are
    not IFIs. A permitted use for grants to IFIs is discussed in section
    IV.D.3.a. below.

[^8]: ^\*^ ^\*\*\*^ A donor, such as USAID, has two immediate problems
    in trying to use its funds as equity. First, a donor\'s principal
    motive is not to earn more than an average return on its funds.
    Second, a donor sees itself as a catalyst to an IFI or a private
    enterprise, not a long-term member of the board. USAID cannot act as
    an owner of equity unless it internalizes market-based,
    entrepreneurial behavior in its involvement in the business entity.
    USAID would then have to direct its funds to the business entity
    that offers USAID the best prospects for the highest return.

[^9]: ^\*^ ^\*\*\*\*^ The opportunity cost of capital represents the
    value of the best alternative use of the capital, or the opportunity
    that is sacrificed for a particular use of the capital.

[^10]: ^\*^ ^\*^ These costs generally include the costs of analyzing
    and monitoring loans and maintaining a loan loss reserve. The
    adjustments to USAID\'s assistance generally include grants, reduced
    interest rates, or extended grace periods. Programmatic objectives
    may include making credit available to private enterprises that
    would not be able to obtain formal financing in the absence of USAID
    support (additionality), encouraging an IFI to provide term loans,
    or providing services to a borrower that are not normally part of a
    loan agreement (such as business advisory services). Determining
    these costs may be a difficult task; Missions may wish to obtain
    expert assistance to conduct the appropriate analyses.

[^11]: ^\*^ ^\*^ Private lending institutions in many developing
    countries avoid making long-term loans because they lack access to
    resources with the longer maturities appropriate for supporting term
    lending. They also consider such lending to be less profitable or
    more risky than alternative investment opportunities, and often face
    an uncertain policy environment. Other major factors that limit the
    ability of these financial institutions to undertake long-term
    financing are the institutions\' own shallow resource bases;
    preferences for fast recovery of funds; inexperience with term loan
    instruments; and limited local markets for large, long-term
    financial assets. Furthermore, the unreliable accounting practices
    commonly followed by many private enterprises contribute to the
    reluctance of commercial financial institutions to extend credit to
    new and unfamiliar entrepreneurs.