Financial Systems in Mediterranean Partners and the EURO-Mediterranean Partnership

This study presents an in-depth analysis of the MPs financial systems. It first describes the main functions and features of the MPs financial systems, and then analyzes the quantitative and qualitative linkages between MPs financial systems and economic growth. Country profiles are presented to outline the key characteristics of the current financial systems in 7 MPs economies. Financial sector regulation and practices in the MPs compared to international standards/norms are also evaluated, emphasizing the gap between the applied standards of MPs’ financial system relative to EU/international standards. In particular, considerations of prudential regulation (for example, Basel II), the mechanisms of informational efficiency and control, MED banks profitability, the contribution of the banking systems in providing credits to the private sector and in raising capital for new investment projects, and an evaluation of credit risk and credit risk management practices, are carefully highlighted. Recommendations for the development of the regulatory framework of the respective MPs financial markets with the purpose of serving the inter-connected objectives of economic growth and financial integration and liberalization are also highlighted. The issue of MED stock markets efficiency is explored to see whether funds are being efficiently allocated to productive investments. The issue of stock market integration in the MED region is also studied for the purpose of establishing whether these markets are regionally integrated. A more formal econometric analysis is conducted to understand the main determinants of growth and financial developments in the MED region highlighting the role of financial instruments in economic development of MPs.

The main results and policy recommendations of the study are as follows:

(1) Although the MED banking system is still playing an important and major role in channeling funds to various sectors of the economy, it is still not providing the kind of services and financial products that are needed to further sustain growth.

(2) MED banks still need to introduce new financial products to better develop its credit markets.

(3) Informational efficiencies of credit markets in the MED region are much lower than averages in other emerging economies worldwide. This factor is also hindering the expansion of credit markets in the region.

(4) The MED banking system is suffering from the lack of proper evaluation of investment projects and bank managers. In most instances funds are not channeled to the most productive projects and the costs of financing these projects are often higher than those present in more developed economies.

(5) A lot of preparation is still required on the part of MED banks before they can fully enjoy the benefits of the New Basel II Accord. Banks will have to still review their current credit processes, expand the range and significance of their risk management functions, and upgrade their Information Technology (IT) systems.

(6) MED financial markets still need to be more transparent. The disclosure of financial information is still weak and sometime totally absent. This is one of the reasons why until now MED stock markets have not yet been able to properly and efficiently channel funds to productive investments. The MED banking system is still the major source of funds for many of MED projects undertaken.

(7) MED countries are devoting genuine efforts to develop their accounting systems for better transparency and information disclosure. With the exception of Egypt and Morocco, it was shown that net external liabilities of the financial sector are relatively low for all the MED economies. This is due to high restrictions on capital flows to the MED region.

(8) With the exception of Egypt, Morocco, and Tunisia, all exchange rate systems in the MED region are either fixed to the dollar or to a basket of currencies. This would constitute a problem if the capital account were liberalized at a fast pace. If that were the case, then short-term capital would flow in and out very quickly causing currency depreciations a disruption of the financial system and a loss of foreign currency reserves.

(9) MED’s capital markets are showing positive performances in recent years particularly in terms of growth, liquidity and transparency. More investment is being attracted to the region and markets are heading towards more openness. However, much more can still be done to reach full liberalization.

(10) MED stock prices are weak form efficient. A strong form efficient financial market helps reduce information costs, overcome problems of asymmetric information, improve resource allocation and enhance growth by ensuring that capital is allocated to projects with the potentially highest returns. MED financial markets still need to be more transparent. The disclosure of financial information is still weak and sometime totally absent. This is one of the reasons why until now MED stock markets have not yet been able to properly and fully channel funds to productive investments.

(11) The MED banking system is still the major source of funds for many of MED projects undertaken. We were also able to confirm that that the MED region is maturing and on the verge of becoming the next ‘emerging region’. Our results have also cast doubt about the extent to which the MED markets are regionally integrated. Although, this is hindering the intra-regional flow of capital and growth in the MED region, however, in the case of a crisis erupting in one of the region’s financial market, its effects might be dampened quickly and financial losses minimized.

(12) It was also shown that Egypt, Jordan, Greece and Turkey have moderate financial markets developments with low liquidity and turnover, highly concentrated ownership, and limited types of traded financial instruments. However, the selected sample witnessed a significant improvement in the financial sector during the last two decades. This includes an increasing number of listed securities, trading value, market capitalization for shares and bonds, as well a the introduction of new products such as mutual funds and derivates instruments in the Northern part of the sample.

(13) Panel data regression models with growth as the dependent variable have shown that financial depth contributes significantly to GDP growth in the MED region. This result is in line with those of King and Levine (1993), who found a positive association between financial system development and economic growth in a cross-country context. It was also shown that national savings has a positive, significant and robust coefficient. This presents clear evidence that while the 7 MED countries are generating enough savings to contribute to growth, they did not succeed in using those savings through an efficient financial market to further stimulate investment and growth.

(14) Other empirical results show that the coefficients on investment and inflation are negative and insignificant which is not consistent with our expectations and related literature. The coefficient estimate of external debt as a share of GDP was negative and statistically not significant, which indicates that the burden of external debt may have contributed negatively to the observed slow growth in MENA countries. Debt obligations absorb an important fraction of resources that could be mobilized for investment purposes. The results on the other variables need to be interpreted with extreme cautious due to the potential heterogeneity in growth patterns among the seven countries.

(15) Financial reforms are indeed taking place although at a slow pace in the MED region. However, because of its relatively protected capital account, financial reform can take place without a financial crisis looming in the horizon. Removing barriers to capital flows should be slow and move in conjunction with financial reforms.

The MED region is now expected to move fast on those financial reforms, which will enable it to open up for foreign capital, an essential element for deeper integration with the EU and for sustained growth.  This at a time when the emerging MED region is expected to take the lead in attracting European international capital which took various hits after the crisis in East Asia, Japan, Russia and Latin America, the events of September 11th in the US, and the very recent US financial crisis.