Financial Sector Assessment

Sequencing Financial Sector Reforms

The development of a financial sector necessarily involves a wide range of policy actions, and structural and institutional reforms. Those actions and reforms cover the design of instruments and operational arrangements for markets; the licensing and restructuring of institutions; and the development of the associated legal, information, and liquidity infrastructure. Given the multitude of policy actions and operational reforms to be imple­mented, the following question naturally arises: What principles and criteria should be considered in setting policy priorities among various policy and institutional reforms? All financial sector assessments present the findings in priority, showing high-priority actions of some urgency for the short term and then listing medium - and long-term structural measures. How should such priorities be set?

Sequencing is the setting of priorities among financial sector measures, and the appro­priate sequencing and coordination of reforms is important for the following reasons:

• Inappropriate sequencing of reforms could cause excessive risk taking and financial instability.1

• Limited institutional capacity necessarily requires some prioritization of reform ele­ments.

• Given the numerous policy and operational reforms in each area of financial policy, setting priorities could facilitate and encourage the adoption of reforms; hence, this aspect of financial sector assessments is important.

The sequencing of financial sector policies assumes great importance when issues of capital account liberalization (capital account opening) are under consideration. Recent experience with financial crisis clearly suggests that the mistaken sequencing of capital account liberalization contributed to the speed and severity of crisis in many countries
(World Bank 2001). While there is no consensus on the net effect of capital account liberalization on growth, poverty, and volatility, there is consensus that (a) the effect of financial liberalization (financial opening) on growth depends on institutional quality; (b) the growth effects of financial liberalization could be large and statistically significant for a wide range of countries (in the middle range of incomes and institutional quality); and (c) the development of adequate institutional capacity appears to be an important and necessary precondition for coping with volatility and reaping net gains from liberal­ization (Obstfeld and Taylor 2004). However, building institutions raises issues of institu­tional design and of the scope of reform strategies—priorities and sequencing—that need to be understood (IMF 2003a). Thus, sequencing of financial sector reforms is among the core elements of reaping the benefits of capital account opening. Key considerations in such sequencing are discussed in this chapter.

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Financial Sector Assessment

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