“HOW CAN FINANCE TRANSFORM ECONOMIES TO HIGHER LEVELS OF DEVELOPMENT AND HOW TO AVOID THE PITFALLS OF EXCESSIVE FINANCIALISATION?” Debate at the World Bank Headquarters Washington D.C. 12 th April, 2014 Presentation by Prof. Njuguna Ndung’u, CBS Governor, Central Bank of Kenya

Outline 1. Finance and Economic Development 2. Some Pitfalls of Financialisation 3. Kenya's Experience’s 4. How to avoid the Pitfalls of Excessive Financialisation 2

1. Finance and Economic Development 1. Financial deepening: Diversifies financial services and products. facilitates risk-sharing and enhances efficiency in allocation of capital. 2. Financial inclusion: Access to financial services and markets mobilises capital accumulation and makes credit affordable. Equity is enhanced through improving physical accessibility of financial services – savings rise. Inefficient financial structures are replaced – informal credit sources are replaced. 3. Financial integration/globalization: Ease of international capital flows in real time. Promotes better financial infrastructure and efficient payments system, and mitigates information asymmetry. Enhances product specialization and efficiency in trade. Facilitates risk sharing. 3

2. Some Pitfalls of Financialisation 1. Regulatory structure: avoiding regulatory arbitrage 2. Financial derivatives: May not be transparent as seen in the sub-prime mortgage toxic asset crisis. Over leveraged capital – dependence on borrowed capital. Financial derivatives crowd out futures trading in other assets such as metals and agricultural products. 3. Money Laundering: A consequence of globalization as people could move illicit funds. 4. Rapidity of proliferation of distress during a crisis – such as the Asian financial flu. 5. Currency wars associated with world recessions and protectionism. 4

3a.Kenya’s Experience Financial sector is driving growth  Financial intermediation growth has consistently outpaced overall 12 month real GDP growth since 2008  The pattern is now clear, financial sector has pulled the overall economic growth with it. 5

3b.Kenya’s Experience: Financial depth has risen 1. Kenya’s financial depth has been rising with increasing financial inclusion – financial depth currently stands at over 43 percent (M2/GDP proxy). 2. Since 2003, the bond market development has been enhanced: The bond programme has led to the marketing of longer dated Treasury bonds such the 30-year maturity paper, Specific bonds like infrastructure bonds have been issued. Establishment of a secondary market for bonds in Nairobi Securities Market 3. A yield curve has developed. 4. The Central Bank Rate has signaled monetary policy stance and worked well to coordinate short-term interest rates. 6

3b.Kenya’s Experience: A yield curve has developed… 7

3c.Kenya’s Experience: Financial inclusion has been expanding since 2006 Agency banking introduced in 2010 – has enhanced the level of formal financial inclusion in unserved and underserved areas. Microfinance Institutions operationalised in 2008 – has ensured a closer reach to low income segments. This has stimulated savings mobilization, financial inclusion and growth. Financial access surveys in the last eight years show improvements. Mobile Financial Services have been enhanced since March, 2007: This has narrowed the financial infrastructure gap where costs of distance and time are very high for formal banking services. Facilitated trade-transfers across large distances cheaply. Provided a safe storage mechanism- A platform for transfer of payments, savings and credit. Facilitate availability of market information 8

3c.Kenya’s Experience: Financial integration and globalization 1. Modernization of the National Payment System has enhanced flow of funds in the economy and helped in reduction of costs in doing business. 2. Credit Reference Bureaus promoting credit accessibility and facilitating reduction of risk. 3. The East African Payments System started in November 2013 where local currencies are used. 4. Guidelines have been prepared to facilitate monitoring of swaps/derivatives. 9

4. Avoiding the Pitfalls of Excessive Financialisation 1. Strengthen institutions to:  Enhance the regulatory framework that can readily identify weaknesses and emerging vulnerabilities; analyse and price risks; provide appropriate incentives (and penalties) to induce prudent behaviour in the market place.  Back anti-money laundering legislation with appropriate penalties.  Avoid regulatory arbitrage between various regulators. 2. Strengthen financial supervision including stress testing – but moving towards macro-prudential supervision. 3. Monitor Capital flows to mitigate against sudden capital reversals that can create volatility in the financial system 10

4. Avoiding the Pitfalls of Excessive Financialisation… 4. Build and use foreign exchange reserves to diffuse currency attacks and exogenous shocks on the current account of balance of payments. 5. Improve legal and financial infrastructure  Enhance appropriate definition of property rights and contract enforcement apparatus  Removal of policies that impede competition without directing particular outcomes.  Develop legal and regulatory frameworks in tandem with financial innovation 6. Monitor the growth of both private and public sector debt. 11