Why do commodity-dependent developing countries have typically lower levels of financial development than their peers?

The literature has proposed many possible explanations, but it typically does not dwell on the deep mechanisms that drive such an outcome. In this paper, we argue that one of the main causes is the shocks to commodity prices. We test the hypothesis on 68 commodity-rich developing countries over the period 1980-2014, and we find strong evidence of the financial development resource curse through the channel of commodity price shocks, after controlling for other explanations found in the literature.

The findings are robust to the different types of commodities, the nature of the shocks, various indicators of financial development, and alternative econometric methods. We also show how the impact of these shocks can be mitigated through good quality of governance.

Introduction

It has been well-established in the literature that resource-abundant economies typically suffer from lower financial development. This is particularly the case in fuel exporters. Several hypotheses have been advanced for this outcome, for instance, lack of integration of commodity sector to the rest of the economy, poor governance especially the higher levels of mismanagement of financial and human resources in commodity-rich countries, including prevalence of rent-seeking behavior.

However, to the best of our knowledge, no work has explicitly considered commodity price shocks as a potential cause of the financial development resource curse in resource-dependent countries. This paper contributes to the literature by analyzing another channel that has not been sufficiently explored. This is the channel through which resource abundance can impede financial development, namely the impact of commodity price shocks. We draw on Kinda et al. (2016) who established that commodity price shocks often lead to financial sector fragility, and sometimes even financial crises. They find strong evidence that commodity price shocks weaken the financial sector notably by increasing nonperforming loans (NPLs), reducing provisions to bank non-performing loans, lowering bank liquidity, and reducing bank profits. They show that these effects operate through the reduction in growth rates, government revenue, and savings, and the increase in unemployment, debt in foreign currency, and fiscal deficits.

In this paper, we hypothesize that commodity price shocks lead to weak financial development. To do this, we conduct an empirical study based on a sample of 68 commodity-rich developing countries over the period 1980-2014. In line with the previous literature, this paper’s approach to financial sector development is limited to the banking sector. Specifically, we use four indicators to measure the development of the financial sector: domestic credit to the private sector over GDP, bank deposits over GDP, liquid liabilities over GDP, and domestic credit to the private sector to bank deposits (a proxy for the effectiveness of financial intermediation). In addition, we explore whether the quality of institution matters. We use the GMM estimator to deal with the endogeneity issues of all right-hand variables in our baseline model.

The main findings of this paper are the following. First, we find additional robust evidence of the financial development resource curse through the channel of commodity price shocks. The effect of commodity price shocks – whatever their nature – on the various indicators of the financial sector development is always negative. This implies that commodity price shocks tend to undermine the development of the financial sector. Second, we show that the impact of these shocks can be mitigated. Countries with good institutions tend to avoid the financial development resource curse as they are able to ensure better law enforcement and limit the misuse of the commodity windfalls.

Montfort Mlachila is the IMF’s Senior Resident Representative in South Africa. Rasmané Ouedraogo is an Economist at the IMF.

IMF Working Papers describe research in progress by the authors and are published to elicit comments and to encourage debate. The views expressed herein are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.