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Chapter 1Introductory aspects

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Introduction

In recent years, there has been increasing interest in the economicsliterature in the role ofFinancial intermediaries in promoting economic growth. Recent papers

have shown thatImproved financial market development is associated with growth,using a variety ofmethodologies and datasets.1 One of the basic explanations for thispattern is that the financial sector serves to reallocate funds fromthose with an excess of capital, given their investment opportunities,to those with a shortage of funds relative to opportunities!. "hus, aneconomy with well#developed financial institutions will be better ableto allocate resources to pro$ects that yield the highest returns. "hisallocative role of financial institutions in promoting development wasthe focus of Ra$an and %ingales 1&&'!, who found that industrial

sectors with a greater need for external finance developdisproportionately faster in countries with more developed financialmarkets.

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Chapter 2

Theoretical aspects

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Theories of Trade Credit Provision"here are numerous theories that provide explanations for theprovision of credit bysuppliers. "hese theories often pertain to particular aspects of marketstructure and(or product characteristics, and suggest that certainindustries may have a greater ability to utili)e trade credit than others.*ince we will be using an industry#specific measure of trade creditintensiveness, we will begin by outlining these basic theories of tradecredit provision, with particular reference to industry specificity. +osttheories of trade credit provision fall into one of the followingcategories 1! comparative advantage in li-uidation, ! price

discrimination by suppliers, /!warranty for product -uality, and 0!customi)ed products. First, several authors have suggested that creditprovision will be more likely in circumstances where there is easierresale of the product being sold, since this will allow the seller to sei)eand resell its product if default occurs see, for example, +ian and*mith 1&&! and Frank and +aksimovic 1&&'!!. ase of resale willclearly be related to a number of characteristics of these inputsdepreciation2 firm#specificity2 inventory stocks. 3n implication of thistheory is that industries that utili)e undifferentiated raw materials,and that are re-uired to hold large amounts of raw materialsinventories relative to finished goods inventories! will be better able to

obtain trade credit financing where necessary."he second theoryinvolves price discrimination as a motive for trade credit provision bysuppliers. 4rennan, +aksimovic and %e)hner 1&''! present thisargument, claiming that low competition among suppliers in an inputmarket may create incentives to discriminate among cash and creditcustomers. "his would happen if, first, the demand elasticity or thereservation price! of credit customers is lower than that of cashcustomers, and second, if there is adverse selection in the credit

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market. In addition, trade credit could be used as a strategicinstrument in the oligopolistic supplier market. 5epending on thedegree of competition in the input market, some industries maytherefore be more prone to price discrimination by their suppliers. Ifsome industries are 6naturally7 concentrated e.g., because of high

fixed costs!, and use of inputs are reasonably similar within a givenindustry, access to trade credit from upstream firms will also besimilar. In support of this, an early study by 8ryor 1&9! finds that therank ordering of industrial concentration is highly correlated among 1developed countries.3nother theory of credit provision comes from a model in a recentpaper by :unat;;;!. In this paper, supplier#customer relationships that have tailormade products, learning by doing, or other sources of sunk costs, willgenerate a surplus that will increase with the length of the relationship."his will increase amount of credit that suppliers are willing to provide,

since it ties firms to particular suppliers, thereby increasing the scopefor punishment of nonpayment. *imilar to the


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is weak, firms will not have legal recourse in the case of creditnonpayment. "his is of concern, since we are claiming that trade creditexists as a substitute for bank financing where the latter is scarce. >ewill argue, however, that even though weak creditor protection andimperfect information will affect both formal intermediaries and trade

credit providers, trade creditors may mitigate these problems betterthan formal lenders for several reasons."hese include advantages in 1! information ac-uisition, ! therenegotiation(li-uidation process, and /! enforcement. "he first set ofadvantages stems from the fact that suppliers are thought to have acost advantage over banks in ac-uisition of information about thefinancial health of the buyers. For example, +ian and *mith 1&&!argue that monitoring of credit#-uality can occur as a byproduct ofselling if a manufacturer7s sales representatives regularly visit theborrower. 4iais and ?ollier 1&&/! assume that suppliers have differentsignals about the customer7s probability of default than do banks, and

furthermore, that the bank will extend more credit if it observes theoffering of the trade credit by supplier. 3lternatively, *mith 1&'9!argues that the choice of the trade credit terms made can be used as ascreening device to elicit information about buyers7 creditworthiness."he other arguments follow directly from the preceding discussionbecause of advantages in the li-uidation process, described above,the supplier would lend to a customer even if the bank would not.Finally, sunk costs and repeated interaction as in the model by :unat;;;! discussed above! may generate surplus split among thesupplier and the customer and this surplus will give supplier anadvantage over the bank lending in enforcement."hese models taken

together provide theoretical grounds for arguing that in the situationswhen bank credit is unavailable, trade credit could serve as a weak!substitute.

5eterminants of the "rade :redit :hannel>hat are the characteristics of trade credit@ >hy do Arms use trade credit and whatis the implication of that for the economy@ venthough a Arst attempt to addressthese-uestions dates back to +elt)er 1&B;!, it was until recent that more and moreresearchersshowed interest in the topic. specially since Ra$an and %ingales 1&&C! documentedthewidespread use of trade credit, this literature took a ight.

"rade credit can be thought of as a short#term loan provided by suppliers to theircustomers upon purchase of their products. It is automatically created when thecustomers

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delay payment of their bills to the suppliers. "rade credit is typically more expensivethanbank credit, especially because customers do not use the early payment discount8etersenand Ra$an, 1&&9!.1 +ore recently, however, +iwa and Ramseyer ;;'! estimate thatthe

price of trade credit lies much more in range with the rates that banks would charge.3ccording to ?uariglia and +ateut ;;B! , 19.0D of total assets and BB.0D of short13 common form of trade credit is E(1; net /;. E(1; means that the buyer gets a Ddiscount forpayment within 1; days. E=et /; means that, in case the buyer does not take the percentdiscount within 1;days, the full payment is due within /; days. "he fact that the buyer in some cases prefers todelay payment anextra ; days rather than to take the D discount, deAnes an implicit annual interest rate of0/.&D 8etersenand Ra$an, 1&&92 =g et al., 1&&&!.

0term debt of B;& GH -uoted Arms between 1&' and ;;; was funded by tradecredit.

*imilarly, 4erger and Gdell 1&&'! show that trade credit accounts for almost 1BD oftotalassets of small G* businesses in 1&&/. On the other hand, Ra$an and %ingales 1&&C!

Andthat in 1&&1, trade receivables amounted up to 19.'D of total assets for G* Arms,D forGH Arms, and more than CD for Italy, France and ?ermany. 5ue to the signiAcantrolethat trade payables and trade receivables play on the Arm


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same logic, 4iais and ?ollier 1&&9! argue that proAtability is positively related totradecredit receivables since proAtable Arms should have a higher capacity to grant fundstotheir customers. Kowever, many authors have found a pu))ling negative relationshipbetween proAtability and trade receivables. 4urkart and llingsen ;;0! do not And

this negative relation surprising at all. In their theory, more proAtable Arms have ahighexpected return on investment, implying that these Arms will be better oA with everyeuroinvested and therefore these Arms will be more reluctant to divert a euro intoreceivables.Finally, Lan Koren ;;9! and Fabbri and Hlapper ;;'! argue that the provision oftrade credit is related to market power, which, in turn, is likely to depend on productandsectoral characteristics. 3 customer who possesses strong market power canincrease hiscustomer surplus by demanding to buy the goods on credit. ven suppliers that arecreditconstrained will extend trade credit when their customers have market power.3ccording

Cto Lan Koren ;;9! the relationship between customer market power and tradecreditthat the customer receives is stronger when the supplier is more risky and when the

Armsinteract in a country with a poorly developed Anancial sector or a low enforceabilitydueto a weak legal system.

. "he "rade :redit :hannel and Firm 8erformanceIn a model without bank loans, 4ougheas et al. ;;&! show that, for a given li-uidity,an increase in production will re-uire an increase in trade credit. 3 higher production

is associated with higher production costs which, for a given unsuAcient! amount ofli-uidity, implies that the Arm will need to take more trade credit. *o trade creditworks asalternative means to Anance production. 3lso :unat ;;9! argues that fast growing

Armsmay Anance themselves with trade credit when other types of Anance are notsuAcientlyavailable. 3ccording to Fisman and Jove ;;/! this reasoning extends to the overalldevelopment of the Anancial sector. "hey And evidence that industries that use moretrade credit, relatively grow faster in countries with poorly developed Anancialmarkets.+ore empirical support of a link between trade credit and Arm performance comesfrom

4oissay and ?ropp ;;9!, who show that Arms that are confronted with a li-uidityshortage shock!, try to overcome this distressed situation by passing on one fourthof theshock to their suppliers by taking more trade credit.4esides taking credit from their suppliers, Arms simultaneously oAer a lot of tradecredit to their customers. In fact, most Arms have higher amounts of trade creditreceivablethan trade credit payable *ee Figures C and B in the 3ppendix!. Firms use tradereceivables as a tool for price discrimination +elt)er, 1&B;!. >hen it is not possibleto

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discriminate on the basis of price, for instance due to legal restrictions, Arms canchooseto sell more on credit as a competitive tool. 8etersen and Ra$an 1&&9! showed that

Armswith high proAt margins, i.e. those that would beneAt most from making additionalsales

via price discrimination, indeed have higher accounts receivable. +ore recent,4ougheaset al. ;;&! argue that accounts receivable are important for the performance ofinventorymanagement. For a given aggregate demand, higher production increasesinventoriesin their model2 and minimi)ation of the inventory! costs implies that Arms willincreasetrade credit receivables oAered in order to sell more and conse-uently hold lessinventories.Furthermore, accounts receivable are proven to be a useful tool when there existsconsiderable uncertainty about the -uality of a Arm


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The theoretical case for a bank-based system4esides debates concerning the role of financial development ineconomic growth,financial economists have debated the comparative importance ofbank#based and market#based financial systems for over a century

?oldsmith, 1&B&2 4oot and "hakor, 1&&92 3llen and ?ale,;;;25emirguc#Hunt and Jevine, ;;1c!. 3s discussed, financialintermediaries can improve the i! ac-uisition of information on firms,ii! intensity with which creditors exert corporate control, iii! provisionof risk#reducing arrangements, iv! pooling of capital, and v! ease ofmaking transactions. "hese are arguments in favor of well#developedbanks. "hey are not reasons for favoring a bank#based financialsystem.Rather than simply noting the growth#enhancing role of banks, thecase for a bank#basedsystem derives from a criti-ue of the role of markets in providing

financial functions.In terms of ac-uiring information about firms, *tiglit) 1&'C!emphasi)es the free#riderproblem inherent in atomistic markets. *ince well#developed markets-uickly reveal information to investors at large, this dissuadesindividual investors from devoting resources toward researching firms."hus, greater market development, in lieu of bank development, mayactually impede incentives for identifying innovative pro$ects thatfoster growth.1; 4anks can mitigate the potential disincentives fromefficient markets by privati)ing the information they ac-uire and byforming long#run relationships with firms ?erschenkron, 1&B2 4oot,

?reenbaum, and "hakor, 1&&/!. 4anks can make investments withoutrevealing their decisions immediately in public markets and thiscreates incentives for them to research firms, managers, and marketconditions with positive ramifications on resource allocation andgrowth. Furthermore, Ra$an Gsing examples from the G.*. in the 1'th:entury, >right ;;, p./;#/! shows how securities marketparticipants tended to free#ride off of the information collected bybanks in making credit decisions and %ingales 1&&&! emphasi)e thatpowerful banks with close ties to firms may be more effective atexerting pressure on firms to re#pay their debts than atomisticmarkets.On corporate governance, a large literature stresses that

markets do not effectively monitor managers *hleifer and Lishny,1&&9!. First, takeovers may not be an effective corporate controldevice because insiders have better information than outsiders. "hisinformational asymmetry mitigates the takeover threat as a corporategovernance mechanism since ill#informed outsiders will outbidrelatively well#informed insiders for control of firms only when they paytoo much *tiglit), 1&'C!. *econd, some argue that the takeover threatas a corporate control device also suffers from the free#rider problem.

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If an outsider expends lots of resources obtaining information, othermarket participants will observe the results of this research when theoutsider bids for shares of the firm. "his will induce others to bid forshares, so that the price rises. "hus, the original outsider whoexpended resources obtaining information must pay a higher price for

the firm than it would have paid if Nfree#riding firms could not bid forshares in a li-uid e-uity market. "he rapid public dissemination ofcostly information reduces incentives for obtaining information, makingeffective takeover bids, and wielding corporate control ?rossman andKart, 1&';!.

"hird, existing managers often take actions Ppoison pills P that detertakeovers and thereby weaken the market as an effective disciplining

device 5e3ngelo and Rice, 1&'/!. "here is some evidence that, in theGnited *tates, the legal system hinders takeovers and grantsconsiderable power to management. Fourth, although intheory shareholder control management through boards of directors,an incestuous relationship may blossom between boards of directorsand management Mensen, 1&&/!. +embers of a board en$oy theirlucrative fees and owe those fees to nomination by management."hus, boards are more likely to approve golden parachutes tomanagers and poison pills that reduce the attractiveness of takeover."his incestuous link may further reduce the effectiveness of the marketas a vehicle for exerting corporate control 3llen and ?ale, ;;;!.

:hakraborty and Ray ;;0! examine bank#based and market#basedfinancial systems in an endogenous growth model, concluding thatbanks can partially resolve the tendency for insiders to exploit theprivate benefits of control. "he li-uidity of stock markets can alsoadversely influence resource allocation. Ji-uid e-uity markets mayfacilitate takeovers that while profiting the raiders may actually besocially harmful *hleifer and *ummers, 1&''!. +oreover, li-uidity mayencourage a myopic investorclimate. In li-uid markets, investor can inexpensively sell their shares,so that they have fewer incentives to undertake careful P andexpensive P corporate governance 4hide, 1&&/!.

Evidence on Finance and Growth

3 substantial body of empirical work on finance and growth assessesthe impact of theoperation of the financial system on economic growth, whether theimpact is economically large, and whether certain components of the

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financial system, e.g., banks and stock markets, play a particularlyimportant role in fostering growth at certain stages of economicdevelopment. "his section is organi)ed around econometricapproaches to examining the relationship between finance and growth."hus, the first subsection discusses cross#country studies of growth

and finance. "he second subsection presents evidence from panelstudies, pure time#series investigations, and country case#studies. "hethird subsection examines industry and firm level analyses thatprovide direct empirical evidence on the mechanisms linking financeand growth. "hen, I summari)e existing work on the relationshipbetween financial structures P the degree towhich an economy is bank#based or market#based P and economicgrowth. Finally, I mention recent research on whether financialdevelopment influences income distribution and poverty. "heorgani)ation of the empirical evidence advertises an importantweakness in the finance and growth literature there is fre-uently an

insufficiently precise link between theory and measurement. "heoryfocuses on particular functions provided by the financial sector Pproducing information, exerting corporate governance, facilitating riskmanagement, pooling savings, and easing exchange P and how theseinfluence resource allocation decisions and economic growth. "hus, Iwould prefer to organi)e the empirical section around studies thatprecisely measure each of the functions stressed by theory. *imilarly,while empirical studies focus on measures of the si)e of banks or stockmarkets, 8etersen and Ra$an 1&&9!, 5emirguc#Hunt and +aksimovic;;1!, and Fisman and Jove ;;/! show that firms fre-uently act asfinancial intermediaries in providing trade credit to related firms. "his

source of financialintermediation may be very important, especially in countries withregulatory restrictions on financial intermediaries and in countries withundeveloped legal systems that do not effectively support formalfinancial development. "his further advertises the sub#optimalconnection between theory and measurement in the finance andgrowth literature.>hile fully recogni)ing this problem, many of the biggest advances inempirical studiesof finance and growth have been methodological. "hus, I organi)e thediscussion around

econometric approaches. >hile serious improvements have beenmade in measuring financial development, which I discuss below,future research that more concretely links the concepts from theorywith the data will substantively improve our understanding of thefinance and growth link.

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:hapter /

8ractical aspects

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Bond Market is a place or incidence of transaction in which any kind of bonds changes hands.

References to the "bond market" usually refer to the government bond market, because of its

size, liquidity, lack of credit risk and, therefore, sensitivity to interest rates. Because of the

inverse relationship between bond valuation and interest rates, the bond market is often used

to indicate changes in interest rates or the shape of the yield curve.

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Bond markets in most countries remain decentralized and lack common echanges like stock,

future and commodity markets. !his has occurred, in part, because no two bond issues are

eactly alike, and the number of different securities outstanding is far larger.

!he ecurities #ndustry and $inancial Markets %ssociation classifies the broader bond marketinto five specific bond markets.

& 'orporate

& (overnment ) %gency

& Municipal

& Mortgage Backed, %sset Backed, and 'ollateralized *ebt +bligation

& $unding

Bond markets link issuers having longterm financing needs with investors willing to place funds

in longterm, interestbearing security. Bangladesh has both the issuers and the investors in

place but it still has not been able to link them effectively through a bond market.

!he positive effect of developing a domestic bond market on the economy is wellknown. +n

the one hand, bond markets are essential for a country to enter a sustained phase of

development driven by marketbased capital allocation and increased avenues for raising debt

capital. +n the other hand, the central position occupied by domestic bond markets in

markedly increasing the resilience of a country-s financial system and insulating it against

eternal shocks, contagion and reduction of access to international capital markets is

established.

'apital markets are essentially about matching the needs of investors with those that need

capital for development. Bangladesh has no shortage of both such parties, a young and dynamic

population that increasingly wants, and is able to, make provision for lifetime events, to save

for children-s education, for the possibility of ill health and ultimately for old age and

retirement. +n the other side of the equation, Bangladesh has a pressing need for investment

resources to bolster its stretched infrastructure resources, to build more power stations,

bridges, ports and gaspipelines to empower the people in the development of enterprise and

the creation of obs. *ebt markets are an etremely effective mechanism for matching the long

term needs of savers with those of entrepreneurs. !erm capital is a precious commodity and it

has been a frustration to see the process of long term savings, such as provident funds and life

insurance contracts, being invested in short term instruments such as bank deposits, a process

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we call /reverse term transformation- but we could equally call it 0reverse alchemy1 in which

the gold of term capital is turned into the lead of short term liabilities.

%s a development institution it is our goal to establish sustainable capacity. %s Bangladesh has

led the world in its development of the microfinance industry, we have impressed others withour ability to mobilize funds for productive purposes at the community level in the villages.

2hat we need to see now is a similar degree of success at the institutional level in terms of

mobilizing resources for infrastructure and other uses of long term funds. #t is much more

useful that !aka funds are mobilized to fund proects whose sole revenue source will be in

!aka. Bangladesh should play a larger role in mobilizing its own capital resources and reducing

the dependency upon donor institutions such as 2orld Bank, #M$ and %*B etc.

Bond markets in most countries are built on the same basic elements3 a number of issuers with

longterm financing needs, investors with a need to place savings or other liquid funds in

interestbearing securities, intermediaries that bring together investors and issuers, and an

infrastructure that provides a conducive environment for securities transactions, ensures legal

title to securities and settlement of transactions, and provides price discovery information. !he

regulatory regime provides the basic framework for bond markets and indeed, for capital

markets in general. 4fficient bond markets are characterized by a competitive market

structure, low transaction costs, low levels of fragmentation, a robust and safe market

infrastructure, and a high level of heterogeneity among market participants.

%n important element of a domestic bond market is the government bond market.

*evelopment of a government bond market provides a number of important benefits if the pre

requisites to a sound development are in place. %t the macroeconomic policy level,

government securities market provides an avenue for domestic funding of budget deficits and

avoids a buildup of foreign currencydenominated debt. % government securities market can

also strengthen the transmission and implementation of monetary policy, including the

achievement of monetary targets or inflation obectives, and can enable the use of market

based indirect monetary policy instruments. !he eistence of such a market not only canenable authorities to smooth consumption and investment ependitures in response to shocks,

but if coupled with sound debt management, can also help governments reduce their eposure

to interest rate risk 5 a situation that is looming large in the 6ational avings 'ertificates

market, currency, and other financial risks. $inally, a shift toward marketoriented funding of

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government budget deficits will reduce debtservice costs over the medium to long term

through development of a deep and liquid market for government securities.

!he prerequisites for establishing an efficient government domestic currency securities market

include a credible and stable government7 sound fiscal and monetary policies7 effective legal,ta, and regulatory infrastructure7 smooth and secure settlement arrangements7 and a

liberalized financial system with competing intermediaries. ince pension and life insurance

reform helps in the development of government securities market, starting the process of

pension and insurance reform now might be prudent because of the time it takes to feel the

positive impact of such reforms on the capital market.

!he current emphasis on localcurrency bond markets stems mainly

from their riskmanagement benefits, as highlighted by the %sia and

the !equila crises. #ssuing bonds can reduce the types of interest

rate, foreign echange, and refunding eposures that created those

crises and can help ensure that emerging market borrowers have

more shock absorbers8more tools8to limit the impact of those

eposures. $oreign investment is clearly a plus for economic development but it does create

certain risks. ince financial sector crises will never be eliminated, and, at least for many years

to come, flows into emerging markets will be large in relation to the markets in which they are

investing, any rapid outflow will create serious problems for the borrowing country. 4merging

market countries must find ways to manage the risks, and hence benefit from international

capital flows. !hey need to be able to reduce eposures to foreigncurrency borrowing and also

absorb the associated shocks and volatility, so that small problems will not escalate into

broadly based social catastrophes, harming people who were in no way directly involved in the

markets.

9ocalcurrency bonds dampen the effect of crises created by international capital flows by

locking in interest rates and localcurrency funding. !his allows borrowers to hold on to their

funds and positions and work their way through a crisis. But, as happened in %sia, many

borrowers want to rely on shortterm, foreigncurrency funding because when their economy

and local currency is strong, such borrowing creates a double benefit to their net worth3 the

borrower-s liabilities fall while its assets and revenues rise. !he flip side is that when times

turn bad, borrowers get a double hit on their net worth3 liabilities rise and assets fall, causing

strains and in some cases defaults. !he solution to this problem is to use funding structures

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that have a neutral effect on net worth, as in the case of bonds. !he difficulty lies in

convincing borrowers that good times may turn bad, and in getting them to incur the potential

opportunity cost from locking in stable funds and rates.

9ocal bond markets also support maor trends that stem from

economic and financial sector growth. $or issuers, infrastructure

development is creating demands throughout %sia and other parts

of the world for largescale, longerterm funds that banks cannot

often provide. :rivatization, securitization ;particularly for housing

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grow as quickly as equity markets can. $urthermore, bond markets

need more sophisticated market participants. #ssuers need to

be able to manage their cash flow to make repayments. Bond markets

typically need dealers and market makers, which means creating

a new class of intermediaries who can take positions and manage

their risks.

$#6*#6(3

!he obstacles to bond market development can be divided into three

broad categories3 those around and across the market, and those

inside the fiedincome markets.

%round and %cross the Market

!he obstacles in this group stem from the political situation, the

macroeconomic situation, and the broader financial system.

!he :olitical ituation3

!he :eople-s Republic of Bangladesh has

been a parliamentary democracy since eptember =>>=. !he present

government is headed by the %wami 9eague which has an absolute

maority, but the opposition party has stepped up its nationwide

program of strikes, processions, and mass meetings. !hese activities

have weakened the government-s intentions to foster changes such

as the development of the financial market.

#n addition, certain commercial and financial regulations are

outdated in that they tend to focus on institutions rather than functions.

(overnance and accountability are lacking in certain areas,

and there are elements of inefficiency in the financial system, mainly

concerning the stateowned banking sector. %lthough the government

is aware of these problems, it has been slow to improve governance

and develop strong institutional capacity. !he problems created

by these weak institutions are compounded by an increasingly confrontational political

environment. %t the same time, the government has committed itself to launching financial

reforms that could help accelerate the country-s rate of growth. !he main goal of these

reforms is to reduce the direct controls on the financial system, and to deregulate and

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introduce a new set of marketoriented approaches to financial sector activity. !he Bangladesh

6ational Budget for =>>>5?@@@, for eample, earmarks funds for the creation of a central

depository system ;'*< to help streamline trading at the stock echanges and improve

authentication.

$urthermore, a proposal is under scrutiny that would amend

the !rust %ct to allow provident and pensions funds to invest in the

capital market. !o achieve that goal, it will be essential to ease the

badloan situation, which is draining the country of its monetary

resources. But certain factions in Bangladesh oppose those aims and

commitments. ince no one has stepped forward to 0champion reform,1 the government

appears unwilling and unable to undertake

the requisite changes in due time. Because the political environment

is so fragile, laws and regulations are not being fully enforced.

Macroeconomic ituation3

Bangladesh-s macroeconomy was fairly strong throughout the =>>@s, with growth rates

averaging a respectable A, and inflation averaging a modest >5=@. !he primary fiscal deficit

during the past five years has averaged about A.A of (*:, which has generally been within

sustainable limits. ;Cowever, the consolidated public sector deficit, taking into account losses

incurred by stateowned enterprises, is much higher and underscores the need for improved

fiscal management, although foreign echange reserves have become more stable recently

owing to impressive eport performance and reduced imports.< Ceightened foreign investor

interest in the country-s natural gas sector has opened up tremendous possibilities. But despite

these positive elements there are some serious constraints on the development of active

corporate bond markets in Bangladesh. $irst, Bangladesh is one of the poorest countries in the

world, with approimately =?A million inhabitants, of which about D@ million live below the

poverty line. %lthough its (6: growth rates8in the range of E5A year8are attractive, they

suggest that it will take Bangladesh ?A years to double its per capita income. #n order to reduce

the incidence of poverty to about ==, as it hopes to do, Bangladesh will have to achieve

economic growth rates of F.A or more a year. %ccording to several studies ;see, for eample,

2orld Bank, 0Bangladesh, Gey 'hallenges for the 6et Millennium,1 %pril

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economy and crowding out as Bangladesh continues to channel vast monetary resources into

servicing bad loans. (iven that macroeconomic changes can happen in short periods of time

and that nonperforming loans, which account for a third of the loan portfolio, can create

financial sector vulnerability, the badloan situation could trigger a severe liquidity crisis

nationwide. #t can take decades to build a fiedincome market in the wake of such crises. !his

issue clearly needs immediate and focused attention.

#f the country-s positive macroeconomic trends continue into the

future, the fiscal deficit and badloan situation will ease up and these

factors would pose less threat to the financial market.

Broader 9aws and Regulations3

'ertain omissions or drawbacks of the broader laws and regulations directly affect

development of the fiedincome market. $irst, with regard to the ownership of land, the law

provides for the registration of deeds rather than of ownership, which makes it impossible to

take land as collateral for bond issuance. econd, the law makes arbitration a cumbersome and

slow process7 moreover, foreign arbitration awards are not enforceable in Bangladesh. !hird, in

terms of obtaining issuers, there is no privatization law to lend transparency and authority to

the privatization process, although one is at present being drafted. $ourth, Bangladesh-s laws

represent a miture of codified British common law and legal principles from various religious

heritages. %lthough

the court system derives from a common law tradition, Bangladesh

courts are limited in their ability to function effectively.

#n view of these constraints, the legal system can move only so fast in amending the laws and

enacting new ones, even though the

government acknowledges the need for such changes. 'ontract laws

and commercial codes seem to be fair, but ensuring that they are

observed is difficult because of a weak adudication system.

Broader $inancial ystem3

!he broader financial system includes the banking sector, nonbanking sector, government

securities market, and shortterm money markets.

Banking sector. Bangladesh-s banking system, which is dominated by

stateowned 6'Bs, creates two serious problems for a local corporate

bond market.$irst, the system provides lowcost loans to stateowned

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enterprises, which account for a large part of the corporate

sector. !his undermines development of the corporate bond market

because other financial institutions are unable to compete with these

0underpriced loans.1 #ndeed, the stateowned enterprises constitute

a large part of the 6'Bs- business. !o complicate matters,development

financial institutions ;*$#s< also provide lowcost loans, priced

at a small percentage over bank deposits for similar maturities.

econd, the banking sector is faced with a substantial number of

bad loans7 nonperforming assets account for about H@ of total assets.

%lthough these nonperforming assets can be said to create a

need for an active bond market, to the etent that banks are constrained in new lending and

thereby cannot meet the funding needs

of corporate borrowers, they also rob the bond market of needed

investors. Iet the stateowned banks ust keep on making bad loans.

6onbanking sector. !he nonbanking portion of the financial sector consists of two small stock

echanges ;*haka and 'hittagong>D, which left the public suspicious of corporate institutions because it is

hard to get them to disclose their figures. %t that time, the stock echange eperienced a

hefty runup in prices owing to a large inflow of funds from retail investors. !his inflow, drawn

by the prospect of easy money, was a new eperience for the Bangladesh people, but it lasted

only the second half of =>>D. #n those si months the inde soared from A@@ to HA@@ and the

market came crashing down to about

D@@. !he stock market has not recovered yet3 in May =>>> the inde

hit a DHmonth low, at about EDA. !he average daily turnover in the

spring of =>>> was about JK= million to JK? million. !he weak

operating performance by listed companies and low confidence in

the market overall has made it difficult for the market to recover.

#n sum, the nonbanking sector has not evolved in a way that

would allow it to play an active role in the financial system. 6or, as

discussed in the section on intermediaries, is it prepared to play an

active and skilled leadership role in developing and participating in

an active fied income market.

(overnment securities market3

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!he government securities market in Bangladesh is small, does not provide much of a yield

curve to support a corporate bond market, and does not provide intermediaries with skills and

a profit base to support the corporate bond market.

%t present, the government issues longterm savings certificates athigh interest rates and government bonds, and it only has marketoriented rates for !bills.

%t the shorter end of the market, !bills are auctioned weekly

for >= days and the Bangladesh Bank ;BB< occasionally issues paper

for =L@ days, HDA days, and F?@ days. 'ommercial banks participate

in auctions weekly for >=day !bills, whereas the others are

issued occasionally. %ccepted bids are noted in the newspapers. !he

market is small, with outstandings of about JKL@@ million. !here

is no secondary market and no market for repurchase agreements

;0repos1


24/34

high benchmark interest rate foundation for corporate securities.

!hat matters because it is very hard to compete with riskfree government debt.

%t present, Bangladesh law and the government-s fiscal and monetary

policy combine to create a financial market monopoly for ('s

and 6'Bs, which in turn keeps alternate financial intermediation

from emerging. Bangladesh needs a healthy nonbank financial institution ;6B$#< sector to

increase mobilization and make competitive

financing available in a fiedincome market. !o achieve that end, it

must break the 6'Bs- monopoly. %lthough the government is aware

of this problem and has put forward some relevant reforms, there

are no real incentives to speed up the process, maybe because of

political considerations.

hortterm money markets3

Money markets provide another foundation for bond markets. !he money markets in

Bangladesh are quite small. !here is an interbank market, in which commercial banks borrow

and lend to adust their short positions ;the size of this market is not publicly known


25/34

submitted to the Minister of $inance for approval and then passed

on for approval from Ministry of 9aw. $urthermore, potential issuers

have to look at various sets of regulations and follow a long and

cumbersome procedure.

!hird, although the 4' requires listed companies to meet international standards on

accounting and auditing, accounting information appears to be of doubtful quality and

reliability.

$ourth, the ecurities and 4change %ct of =>>H confers vast

regulatory authority on the state, and is regarded as a constraint on

capital market development. !here is a board of policymakers. !hree

of its members are appointed by the state, another is from the Ministry of $inance and one

from the central bank, and the chairman is

appointed by the government.

$ifth, in the present system, a company can float debentures up

to a maimum amount of its current asset value and has to register

its assets in the name of the !rustee as ecurity. Cence there is no

provision for floating unsecured debentures.

'entral Market #nfrastructure3

#n the absence of a secondary market in fiedincome securities, no effort has been made to

build up a central market infrastructure to support it. Bangladesh only has a telephone market

for !bill trading and central market infrastructure at the stock echange for trading equities

and debentures. #n the !bill market, the counterparts call each other and settle transactions

without any transparency in real time for other participants in the market. %t the stock

echange, the debenture market is fully automated. !he debenture market has a somewhat

more transparent ordermatching system in that bids and offers are entered in the computer

and then matched automatically.

Bangladesh has no central depository system, though one is epected

to start operating in ?@@@. !oday, clearing and settlement are

done manually, which creates various risks to completing a transaction. %lso lacking are a

credit rating agency, research and information companies, and market information on screens7

market

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participants are referred to other media, such as the daily financial

newspaper, and thus eperience a delay in obtaining essential eco

nomic information. %ccording to some participants, even that information is often unreliable.

Market :articipants3

Market participants can be divided into issuers, investors, and intermediaries.

#ssuers3

!he foremost impediment here is that Bangladesh lacks a

significant number of potential, goodquality issuers. #ts economy

continues to be agriculturally based7 agriculture accounts for nearly

H@ of the country-s (6:, and more than F@ of the labor force is

engaged in agricultural activities. !he industry and service sectors

contribute ?@ and A@, respectively, but compared with landholdings, the average size of

industrial and commercial enterprises is rather modest.

Most private sector enterprises are small and ownerrun, many

are of 0cottage size1 and most are in the garment industry, which to

date depends largely on shortterm bank loans for financing. !hese

enterprises could benefit from longerterm funding but are neither

large enough nor well known enough to issue bonds. Most of the

largescale industrial units and commercial enterprises are state

owned. !heir shares are not listed, and they do not offer debentures

since their financing needs are met by the government or by the

stateowned 6'Bs. !hese stateowned firms generally stay outside

the capital market. !he privatization program for stateowned companies works too slow to

influence the market.

econd, although Bangladesh has a debenture market, to date

only a small number of wellknown issuers have used the market

;see table ?


27/34

!hird, companies find that issuing debt is costly, both in monetary

and nonmonetary terms. !he interest rate distortion due to the

('s mentioned earlier raises the ongoing cost of borrowing, while

various upfront costs amount to about F of the value of the issue

;these include registration costs8that is, stamp duties8totaling about

?.A of the issue value


28/34

#n addition, no protective laws are in effect to ensure that investors

will get their dividend and capital back. Missing are higher audit

standards together with 4' regulations on disclosure standards in

prospectus along with arbitrary institutions.

$urthermore, most investors lack a trading mentality and ust

buy and hold because of 9R requirements or because they do not

know how to trade.

$ew foreign investors are attracted to this, mainly because of

the weak disclosure by the borrowers. %s for the general public, it

has little understanding of debt products, and the intermediaries are

not much help because few engage in research on markets, companies and industries to

encourage investment.

#ntermediaries3

#ntermediaries in Bangladesh lack many of the skills

needed to foster an active local corporate bond market. %s mentioned

earlier, commercial banks dominate the financial sector and

not enough intermediaries are skilled in securities. $ew are able to

identify issuers and investors and bring them to the market. !hey

provide little or no research analysis on industries or companies to

encourage investment in the local debt market. !oo few private

merchant banks are able to conduct financial advisory and trust services.

6or do any feel motivated to become a market maker for an

issue. Cence the market is illiquid, with large spreads. %t the same

time, the fee structure and pricing are high enough to allow intermediaries to make money,

but because transactions are so limited, the intermediaries seldom make money. 4ven if they

are able to participate, intermediaries are reluctant to take any risk in dealing.

:rospects of a bond market in Bangladesh3

*espite the earlier setbacks the bond markets in Bangladesh is ready

to take off. !he need for a bond market in Bangladesh deserves

attention because of the following3

&$oreign aid flow is diminishing and the trend is epected to

continue.

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29/34

&pecialized banks are not in a position to supply desired level of

long term fund.

&'ommercial banks have strategically cut down their long term

lending.

&!he concept of prudent asset mi is most likely to generate demand

for investment grade bonds.

&!he :rovident $unds and #nsurance 'ompanies $unds are not generally allowed to invest their

funds in stock market instruments. !here is a bright possibility that these funds may be

permitted to invest a part of their funds in marketable instruments subect to prudential

guidelines, which may necessitate supply of lucrative debt

instruments.

&Reduction in the interest on (ovt. savings instruments and

withdrawal of certain savings instruments is epected to boost

demand for debt instruments.

&!he registration fee for trust deed has been reduced from ?.A ;on

the amount of debentures< to !k. ?A@@.@@ providing a very

significant incentive.

& !here are now credit rating agencies to provide rating prospective

issuer.

&%ny interest paid by investor on money borrowed for investment in

debentures is deducted from total income.

nterest income not eceeding !k. ?@@@@ received by an individual

investor on debentures approved by 4' is ecluded from total

income..

&!he interest on ero coupon bond approved by 4' at the hand of the recipient is ta eempt

upto !k. ?A@@@.@@. uch interest eceeding

!k. ?A@@@.@@ is subected to ta N =@ deducted at source. Banks and other financial

institutions and insurance companies which are the

mainstay of demand for bonds will now pay =@ ta on interest on

such bonds instead of EA ta payable on other income

R4'+MM46*%!#+63

Recent developments and events have already created an environment

conducive to fosterage of the debt market. % number of financial

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institutions have sold bonds or debentures to institutions. $urther,

an #slami Bank has decided to issue perpetual bond subect to

approval of relevant authorities. #t is also epected that quite a

number of institutions will float bonds through securitisation in

the near further.

% sustainable bond market needs enabling policies. !he following

actions and policy measures are seen important to promote a bond

market in Bangladesh.

&%ll issues of debentures be rated by independent rating agency

prior to issue. 'ompanies issuing bondsOdebentures to public may be

rated periodically to keep track of issuing companyPs financial

position.

&:ublic utilities and infrastructure proects be asked to raise a

part of debt through issue of marketable bonds.

ndustrial companies with good track record be advised to issue

marketable bonds instead of relying on bank financing.

&4isting public utilities and infrastructure proects be advised to

securitise debts by issuing marketable bonds.

&4isting industrial companies be encouraged to replace a portion of

bankO*$# loans with marketable bonds.

&!o facilitate liquidity of marketable bonds, discounting facilities

may be provided by financial institutions.

& ystems of market makers ;specialists< may be evolved to

facilitate market for marketable bonds.

&Bond maturities be diversified between one year and seven years as to give investors with

different maturity profiles the option of

purchasing debentures with different maturities.

&!he methods of revolving underwriting facility ;RJ$< may be

introduced so that companies can issue shortterm debentures

whenever necessity arises. RJ$ is a system in which a consortium of

underwriters make commitment to the issuing company to purchase all

the unsold portions of the shortterm debentures which may be issued

from time to time during a certain period ;e.g. five years< up to

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certain maimum amount.

&'oupon rates and all other issuing conditions of debentures be

determined by market forces.

& 'oupon rates may differ according to the rating of the issuer

accorded by independent rating agency.

n order to make longterm investment more attractive, issuers may find it useful to increase

the coupon rate as years go by, e.g. >

percent in the first year, =@ percent in the second year, == percent

in the third year and so on. uch increasing coupon rate methods

will be useful, especially if the investor is given the right to

call for redemption of the bonds at the end of each year so that he

may choose to hold them to enoy a higher coupon rate.

nterest received by individual investors on bondsOdebentures

approved by 4' may be fully eempted from ta.

& #nvestment in bondsOdebentures approved by 4' may be given

taeempt status up to a certain limit.

&!he ta ratesOrelief available to investors on ero coupon bonds

may be etended to all other bondsOdebentures approved by 4'.

#f all the above things can be done, then this could pave the path for a wellfunctioning bond

market that can change the eisting bankoriented financial system to a multilayered system,

where capital markets can complement bank financing.

R4$4R46'43

Qeff Madhura. 0$inancial Markets and #nstitutions1 ;Fth 4dition


32/34

Conclusions

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"his paper reviewed theoretical and empirical work on the relationshipbetween financialdevelopment and economic growth. "heory illuminates many of thechannels through which the emergence of financial instruments,markets and institutions affect ## and are affected by economic

development. 3 growing body of empirical analyses, including firm#level studies, industry#level studies, individual country#studies, time#series studies, panel#investigations, and broad cross#countrycomparisons, demonstrate a strong positive link between thefunctioning of the financial system and long#run economic growth.>hile sub$ect to ample -ualifications and countervailing views notedthroughout this article, the preponderance of evidence suggests thatboth financial intermediaries and markets matter for growth evenwhen controlling for potential simultaneity bias. Furthermore,microeconomic#based evidence is consistent with the view thatbetter developed financial systems ease external financing constraints

facing firms, whichilluminates one mechanism through which financial developmentinfluences economic growth. "heory and empirical evidence make itdifficult to conclude that the financial system merely and automatically## responds to economic activity, or that financial development is aninconse-uential addendum to the process of economic growth.In the remainder of this :onclusion, I discuss broad areas needingadditional research. Interms of theory, *ection II raised several issues associated withmodeling finance and growth. Kere I simply make one broadobservation. Our understanding of finance and growth will be

substantively advanced by the further modeling of the dynamicinteractions between the evolution of the financial system andeconomic growth *mith, ;;!. xisting work suggests that it is not$ust finance following industry. 4ut, neither is there any reason tobelieve that it is $ust industry following finance. "hus, we needadditional thought on the co#evolution of finance and growth."echnology innovation, for instance, may only foster growth in thepresence of a financial system that can evolve effectively to help theeconomy exploit these new technologies. Furthermore, technologicalinnovation itself may substantively affect the operation of financialsystems by, for example, transforming the ac-uisition, processing, and

dissemination ofinformation. +oreover, the financial system may provide differentservices at different stages of economic development, so that thefinancial system needs to evolve if growth is to continue. "hese aremere con$ectures and ruminations that I hope foster more carefulthinking. In terms of empirical work, this paper continuouslyemphasi)ed that all methods have their problems but that one problemplaguing the entire study of finance and growth pertains to the proxies

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for financial development. "heory suggests that financial systemsinfluence growth by easing information and transactions costs andthereby improving the ac-uisition of information about firms, corporategovernance, risk management, resource mobili)ation, and financialexchanges. "oo fre-uently empirical measures of financial

development do not directly measure these financial functions. >hile agrowing number of country#specific studies develop financialdevelopment indicators more closely tied to theory, more work isneeded on improving cross#country indicators of financialdevelopment.

ReferencesInternational conomics, C9 1;9#1/1.4eck, ". ;;/!, NFinancial 5ependence and International "rade,Review of International conomics, 11 &B#/1B.

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