The Impact of Good Governance on the Relationship between Resource Abundance and Financial Development in Oil Countries

One of the effective factors on economic growth and development is financial development. Indeed, today the level of economic development is determined by the level of financial development in the countries. Hence, many studies try to identify effective factors in financial development. Natural resource abundance is one of the factors that has effect on financial development of countries. From the 1980s, most studies have only investigated the relationship between natural resource abundance and economic growth. They only try to explain the reason of the resource curse. In these studies the effect of resource abundance on financial development is neglected. But it is claimed that one of the reasons of slow economic growth in resource abundant countries is the low level of financial development.
There are five mechanisms through which resource abundance can impact financial development. The first mechanism is the Dutch disease. The exploitation of natural resources tends to shift factors of production away from the manufacturing sector. Thus, resource abundance tends to shrink the traded sector. But trade is found to play an important role in financial development. Therefore, resource abundance which weakens the traded sector may have a negative impact on financial development. Second, governments’ access to huge amounts of oil rents reduces the government's need for financing through taxes. In these circumstances a government has no obligation against people and the people have also less demand for accountability in order to define and guarantee property rights and economic security. Weak property rights leads to poor business environment. As a result, investment incentives are reduced. Secure property rights increase the incentives of innovations and creativity. Since entrepreneurs are the main demanders of credit in financial markets, undermining property rights leads to weaken financial markets. Third, economic rent of resource abundance increase opportunities for rent-seeking and corruption. Rent seeking can cause corruption in government, business of people and distortion in allocation of recourse. Corruption may induce a lack of confidence in the government and hence undermine its policy credibility. Because of low policy credibility, it will be difficult for the government to implement some financial reforms. In addition, rent seeking leads to reduced incentives of creativity and innovations. In these conditions, economic creators prefer to gain high rent by abusing weak institutions. Since entrepreneurs are potential promoters of financial development, if the number of entrepreneurs is reduced by resource booms, financial development may also slow down because the demand for it is weakened. Forth, resource abundance tends to weaken private and public incentives to accumulate human capital. Empirical studies show that there is a negative link between human capital and natural resource abundance. Since human and physical capital complement each other in firms, weakening human capital reduce physical capital and investment. In addition, resource abundance reduces social capital. Since social capital determines the level of trust in society and trust is the basis of the financial contracts, resource abundance reduces the level of financial development. Fifth, establishment of democracy is not easily possible in resource abundant countries and power is only in the hands of particular groups and rent seekers. There are lots of scholars like Clague, Keefer, Knack and Olson (1996) and Olsson (1993) that examined the relationship between democracy and financial development. They show that democratic regimes provide better field of protection of property rights, contract enforcement and encourage more investment than authoritarian regimes. Thus, democracy promotes financial developments.
Beside above mechanisms it should be emphasized that environmental factors can have impact on the relationship between natural resource abundance and financial development. It is expected that resource abundance reduce financial development in the countries with weak institutional quality. In contrast, mentioned mechanisms do not work in the countries with high level of institutional quality. In other words, resource abundance cannot have a negative impact on financial development in the countries with good institutional quality. World Bank introduces governance indicators to show institutional quality of countries. Three researchers named Kufmann, Kraay and Lobaton (1999) create these indicators. They combined the results of various international institutions such as EIU, ICRG, Heritage Foundation and Freedom House about economic, political and social situations and then introduced new indicators as governance indicators. These indicators include voice and accountability, political stability, control of corruption, regulatory quality, government effectiveness and rule of law.
In this paper, countries with respect to good governance indicators are categorized into three groups. They include countries with high, medium, and low institutional quality. In this study, using the panel data method for 22 selected oil exporting countries over 1996-2009, the effect of resource abundance on two financial development index (i.e., private credit by deposit money banks and other financial institutions/ GDP and M2/GDP) is examined. Among 22 countries, 5 of them have weak institutional quality, 8 of them have medium institutional quality, and 9 of them have high institutional quality.
The results indicate that the relationship between resource abundance and two financial development indices is positive and significant in countries with high governance, but negative in countries with low and weak governance. The results also indicate that there is no significant relationship between resource abundance and financial development in countries with the average level of governance. Therefore improving institutional quality seems necessary to enhance financial development in oil economies.