Area VII
Freedom of Exchange in Capital and Financial Markets

A Ownership of Banks: Percent of Deposits Held in Privately Owned Banks (weight .271)

B Extension of Credit: Percent of Credit Extended to Private Sector (weight .212)

C Interest Rate Controls and Regulations that Lead to Negative Interest Rates (weight .247)

D Restrictions on the Freedom of Citizens to Engage (weight .271)
in Capital Transactions with Foreigners

Taken together, the four components in this area provide a good indication of the degree to which countries use market forces rather than political considerations to allocate capital. When capital is allocated by a private banking sector to private investors at interest rates determined by market forces (including global financial markets), a country will earn a higher rating in this area. The absence of these conditions will lead to lower ratings.

Banks are the major financial intermediaries in most countries. They utilize the savings and chequing deposits of their customers to extend loans, primarily to investors. When banks are owned and operated by the government, political considerations are likely to play a larger role in the allocation of capital. Thus, countries with a large government-owned banking sector are given lower ratings for Component VII-A.

While VII-A indicates who is extending the loans, VII-B reveals to whom they are extended. When market forces are used to allocate capital, most of the credit will be extended to private investors. Thus, the ratings for Component VII-B are directly related to the share of domestic bank credit extended to the private sector. The larger the share of total domestic credit allocated to the private sector, the higher a country's rating.

Governments may also affect the allocation of credit through the imposition of interest rate controls. Interest rate controls coupled with inflationary monetary policy are particularly damaging. When the inflation rate exceeds the fixed interest rate, negative real interest rates occur. Countries that follow policies that result in negative real interest rates (and/or wide gaps between the borrowing and lending rates) are given lower ratings. (See the "Explanatory Notes and Data Sources" section for additional details on the ratings for this component.)

Many countries place limitations on domestic investments by foreigners, limit the freedom of their citizens to make investments abroad, or both. The greater the restrictions on the mobility of capital, the lower the rating for this component. (See note for Component VII-D in the "Explanatory Notes and Data Sources" section for additional details.)

The numbers above in parentheses e.g., (weight .271), represent the portion of the area rating that is determined by a specific component. These values were determined by principal component analysis. The area ratings are presented on the following page.

Area VII Graphic: Freedom of Exchange in Capital and Financial Markets, 1997

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Last Modified: Wednesday, October 20, 1999.