The Great Divide and Beyond: Financial Architecture in Transition

A growing and deepening divide has opened up between transition countries where economic development has taken off and those caught in a vicious cycle of institutional backwardness and macroeconomic instability. This “Great Divide” is visible in almost every measure of economic performance: GDP growth, investment, government finances, growth in inequality, general institutional infrastructure and increasingly in measures of financial development. Strategies for financial development have differed dramatically across countries and over time, offering interesting opportunities to study the links between real and financial sector development. Even in the countries that have made it across the divide, like the Czech Republic, Hungary, Poland, Slovenia and the Baltic states of Estonia, Latvia and Lithuania, a remarkable diversity of policies for financial development has been pursued. Yet, strikingly, today the basic financial architectures of these frontrunners are remarkably similar. These financial systems are strongly dominated by commercial banks, which are increasingly foreign owned and which lend primarily to government. Stock markets are highly volatile and illiquid, and their sustainability is in question as the numbers of listed firms are stagnating or even falling. Enterprises rely primarily on internally generated funds, and the bulk of external long-term finance comes from foreign direct investment. The Great Divide in economic and financial development and the convergence in financial architecture among the successful countries raise fundamental questions about how financial development interacts with economic growth. Is it