2.2 Theoretical Review
Many countries have witnessed huge strides towards liberalization of the financial markets. This reform was mainly adopted in view of promoting growth in the country. Thus, this has motivated many studies on the link between financial liberalization and economic growth.
The first part of this thesis consists of defining financial liberalization, which will be then contrasted with financial repression. Then, the paradigm behind financial liberalisation and the pros and cons as well as the possible solutions are considered.
2.2.1 Financial Liberalisation
From the point of view of Kaminsky and Schmukler (2003), financial liberalization consists of the deregulation of the foreign sector capital account, the domestic financial sector, and the stock market sector viewed separately from the domestic financial sector.
Also, full financial liberalization occurs when at least two of the three sectors are fully liberalized and the third one is partially liberalized. The liberalization of the capital account is captured by the regulations on offshore borrowing by financial institutions and by non-financial corporations, on multiple exchange rate markets and on capital outflow controls. In a fully liberalized capital account regime, banks and corporations are allowed to borrow abroad freely
According to Huw Pill (1997), financial liberalization entails the abolition and reduction of explicit controls on the pricing, allocation of credit and direct government intervention in bank credit decisions respectively. Financial liberalization does not mean “free banking.” Governments continue to intervene in several areas of the financial sector such as, banks are under the supervision for prudential reasons, some banks may be in the public and the government may be a major borrower.
Financial liberalization refers to measures directed at diluting or dismantling regulatory control over the institutional structures, instruments and activities of agents in different segments of the financial sector (Chandrasekhar, 2004). These measures can relate to internal or external regulations as shown below.
Internal financial liberalization normally includes some or all of the following measures:
The reduction or abolition of controls on interest or interest assigned by financial agents;
The withdrawal of the role of government activity in the transfer of financial intermediation from “development banks” into regular banks, and privatizing publicly owned banks, following the reason that their presence does not contribute to a dominant market signals in the distribution of capital;
The reduction of conditions for the participation of both firms and investors in the stock market by weakening or eliminating the listing conditions,
Reduction in the control of the investments that can be executed in financial resources
The expansion of the ways from and instruments through which firms or financial agents can access funds;
The liberalisation of the rules governing which financial instrument must be used.
External financial liberalization mostly includes amendments in the exchange control system. External financial liberalization measures broadly cover the following:
Measures to allow foreign residents to hold domestic financial assets held, or in the form of debt or equity;
Measures which allow citizens to hold foreign financial assets
Measures allowing foreign currency assets to be freely held and traded within the domestic economy.
2.2.2 Financial Repression (Mc Kinnon-Shaw)
Financial repression, contrary to financial liberalization, refers to the idea of a set of government regulations, laws and other restrictions that are present in the market to avoid any financial institute economy to operate at full capacity. The policies that cause financial repression includes strop interest rates, liquidity requirements, high bank reserve requirements, capital controls, restrictions on access to the financial sector, credit ceilings or restrictions on lines of credit allocation and management of property or the dominance of banks.
McKinnon (1973) and Shaw (1973) were the first to spell out the notion of financial repression. Financial repression is a problem because, according to them, repressing the monetary system chips the domestic capital market with highly adverse consequences on quality and quantity of real capital accumulation.
This would happen primarily through four channels:
reduction in the flow of loanable funds held by the banking system has forced investors to rely on self-finance
partial interest in the flow of bank credit varies from one industry or a subordinated debt declined to others;
the process of self finance is itself impaired; if the real yield on deposit is negative, firms cannot easily accumulate liquid assets in preparation for making discrete investments and socially costly inflation hedges look more attracive as a means of internal finance; and
Significant financial deepening outside the suppressed banking system is impossible if the companies are dangerously illiquid or inflation is high and unstable robust open markets stocks and bonds
2.2.3 Legal and Institutional Framework for Financial Liberalisation
Legal, regulatory and prudential economic environment is crucial for the promotion and anchoring of financial markets and the institutional framework. The ultimate function of financial markets is to mobilise knowledge and resources through credit and insurance industry to accelerate the process of economic growth. The function is performed by two different but related components.
A component is the money market. This market basically trades in short-term debt instruments to meet the needs of most users of these funds, as governments, banks and similar institutions. It also includes the interbank market, investment banks, commercial banks, central banks and other dealers.
The second component is the capital market. Its role is to mobilise long-term capital market debt and equity channels and long-term prolific assets. Capital markets also help to strengthen the corporate financial structure and improve the overall liquidity of the financial system. The capital market may be fragmented into monetary intermediaries, non-monetary intermediaries, and securities markets.
2.2.4 Review of growth effects of Financial Liberalisation
Theoretical evidence of the effect of financial liberalization on economic growth can be traced as far as Bagehot (1873). He proposed that the financial system plays a critical role in the adoption of better technologies through effective mobilizing of resources and thus encourages economic growth. There are a number of ways through which financial liberalization may impact growth.
220.127.116.11 Interest rate mechanism
One of the earliest models in favour of financial liberalisation was done by Mc Kinnon and Shaw in 1973. They attributed the poor economic growth in developing countries to financial repression. They believed that liberalisation of financial markets would expand the real supply of total credit, envourage high volume of investment and regulates the real interest rate to its equilibrium level of savings which, in term, impacts positively economic growth. To Huw Pill and Mahmood Pradhan (1995), following financial liberalization, positive real interest rates provide an incentive for borrowers to invest in more productive instruments, thus improving the productivity of the economy all together. High real interest rate stimulates financial and total domestic savings and then stimulates the private investment (Athukorala, 1998).
18.104.22.168 Capital account liberalisation
Fischer and the International Monetary Fund (1997) pointed out that firstly capital account liberalisation is an inevitable step on the path of development. Secondly, it should be adapted as free capital movements ease the effective distribution of global savings and help channel resources to their most productive use, thereby increasing economic growth and prosperity. From the point of view of an individual country, the benefits are two-way: increases in the potential pool of investable funds, and local residents access to foreign capital markets. From the perspective of the international economy, open capital accounts support the multilateral trading system, expansion of channels through which developed countries and developing countries seemed to trade and investment financing and higher levels of income achieved.
Neoclassical arguments emphasize gains from liberalization and international capital mobility (Fisher, 1998; Cooper, 1999; Dooley, 1996). According to these theories, financial market openness increases investment and helps enhance the efficiency of resource allocation by improving risk diversification and the fiscal discipline of the government (Guitan, 1997; Dornbush, 1998).
External financial liberalisation by releasing the movement of foreign capital has benefited many developing countries by achieving significant economies of scale and a reallocation of domestic resources, increasing the productivity of capital and labor factors, acquiring new technologies and accessing economic growth. (Ricardo Eichengreen, Henry, Eswar Prasad & Raghuram).
Finally, when capital markets are imperfect and financial limitations exist, which is the case of most developing countries, external financing is usually more expensive than internal financing, and investment is more susceptible to cash flow. Financial liberalization may affect economic growth by reducing capital market imperfections which in turn reduce the external finance premium (Hubband and Gilchrist 1998).
22.214.171.124 Financial intermediation
Schumpeter (1934) was among the first to identify that banks promote technological innovation in their role as financial intermediaries. His thesis focuses on the ability of banks to allot savings more efficiently. King and Levine (1993) suggest that financial institutions play a key role in evaluating prospective entrepreneurs and financing the most promising ones: ‘Better financial systems improve the probability of successful innovation and thereby accelerate economic growth’.
Levine (1997) provides an excellent review of the literature on the effectiveness of intermediaries in ameliorating informational asymmetries, reducing transaction costs, and facilitating contracting, and concludes that the level of financial intermediary development has a large and causal effect on long run economic growth. Two messages emerge in his paper: domestic banking system development has a large effect on economic growth and secondly it influences growth primarily by affecting total factor productivity growth.
Also, authors such as Goldsmith (1969), McKinnon (1973) and Shaw (1973) highlighted the role of financial intermediation in the supply of capital accumulation necessary for economic growth. With the reduction of friction in financial markets, domestic savings and an increase in foreign capital is attracted.
The ‘new growth’ theory (the endogenous growth model) incorporates the role of financial factors within the framework of new growth theory, with financial intermediation considered as an endogenous process. A two-way causal relationship between financial intermediation and growth is thought to exist. The growth process encourages higher participation in the financial markets, thereby facilitating the establishment and promotion of financial intermediaries. The latter enable a more efficient allocation of funds for investment projects, which promote investment itself and enhance growth (Greenwood and Jovanovic, 1990).
126.96.36.199 Stock market
A well functioning stock market can affect economic growth largely through its influence on the efficiency of capital allocation. Boot and Thakor (1997) argued that as stock markets become more liquid, agents may have greater incentives to expend resources in researching firms. In larger more liquid markets, it is easier to profit from new information by trading in well-functioning markets. This improved information enhance resource allocation with corresponding implications for economic growth.
A liberalised stock market may lead to growth by stimulating greater corporate control by facilitating takeovers as stipulated by Stein (1988). In addition, it makes it easier to tie managerial compensation to stock price performance (Jensen and Murphy 1990), hence enhancing managerial incentives and thereby boosting resource allocation.
Stock markets may also influence risk diversification and avoid liquidity risk. Liquid equity markets make long term investment more attractive because they allow savers to sell equities quickly and cheaply if they need access to their savings. Simultaneously, companies enjoy permanent access to capital raised through equity issues. By easing longer term, more profitable investments, liquid markets improve the allocation of capital and thereby enhance productivity growth (Ross Levine 1997).
2.2.5 Arguments against Financial liberalisation
188.8.131.52 Financial liberalization and economic growth
In demonstrating that a positive relationship exists between financial liberalization and economic growth, the thesis under scrutiny ignores a number of aspects: hedge effects and curb markets; lack of perfect competition, asymmetric information and liquidity constraints; and public finance aspects and low interest rates for development. The structuralist theory (Taylor, 1983; Van Wijnbergen, 1983) suggests that the higher interest rates, which follow financial liberalization, might leave unchanged or, indeed, decrease the total supply of funds.
The neoclassical growth model postulates no direct link between financial openness and growth. It presumes that the sole determinant of long-run growth in per capita income is the exogenously determined technology, which suggests that the long-run economic growth cannot be influenced by interacting with other countries.
184.108.40.206 Savings and investment
In the McKinnon/Shaw model savings is seen to take place before investment. But savings can only fund investment ex post, and it would be more accurate to perceive as investment occurring prior to savings. Savings cannot finance capital accumulation; this is done by the banking sector, which provides loans with which investment expenditure is financed, without necessitating increases in the volume of deposits (Studart, 1995). A second problem with the McKinnon/Shaw model is the assumption that deposits create loans. In modern banking systems, loans create deposits not the other way round (Arestis and Howells, 1996).
220.127.116.11 Financial crises
The financial crisis literature tests whether financial liberalization increases the risk of financial crises. Kaminsky and Reinhart (1998), Detragiache and Demirguc-Kunt (1998), Glick and Hutchinson (2001) found that the penchant to banking and currency crises increases in the aftermath of financial liberalization.
18.104.22.168 Capital Flight
According to Gridlow (2001) the principal of the South African Reserve Bank College “Developing countries in the 1980s and early 1990s had been led to believe that foreign investment in the form of equities and bonds traded on the local markets was more long term in nature than foreign bank lending they attracted in the 1970s. However, huge flight of capital from the promising markets at times in current years has exploded that legend.
2.2.6 Proposed Solutions
After the debate of financial globalization was explained in the form of its pros and cons, it can be claimed that in most of the cases, drawbacks of financial interdependence is not a problem in itself but is a management problem. A country is not ready to fully open up for foreign capital inflows, banks and people do not take adequate steps to prevent negative side effects and fall into a vicious circle of lending, borrowing, profiting, and endlessly taking on risks, which, obviously, sooner or later results into adverse outcomes.
22.214.171.124 The Role of the Governments
It is vital that governments stick to reforms needed to improve financial sector and assure stability in it and remain consistent. The government should not interfere in the work of regulators and supervisors, but provide adequate resources and support for them (Mishkin 1999).
Although financial liberalisation is desirable, its modality, design and phasing are no less important. In shallow financial markets, full liberalisation does not appear to be the first best policy. Until other non-bank capital market develops and functions effectively and substantial progress is made in regard to structural adjustments in trade, industry and the legal system underlying the financial system as a whole, a second best policy may be to have a diminishing degree of government intervention in the financial markets spread over a period of time, deriving guidance from the market-related indicators. The government intervention is market destroying or market-promoting. While the former type of government intervention eventuated in financial repression in the past in many a developing country, the latter may assist them to reach in course of time a fully liberalised, efficient and progressive financial system. (Yoon Je Cho and Deena Khatkhate 1989).
On the basis of the analyses of Lipsey and Lancaster (1956), showing that as long as there are some distortions on other market, the elimination of the distortions in one market inevitably do not improve welfare. Partisans of financial liberalisation came up with the idea of sequencing. The literature of optimal sequential order of reforms tries, to fill a vacuum concerning the study of deregulation effects in a context of imbalance. Actually, the new theory spells out that for the establishment of order between the commercial and financial reforms, it is vital to define the necessary sequences within each reform.
The table below sets out the reforms of liberalization of the various sectors: the figure in each box indicates the order of reforms recommended by the majority of authors (Edwards 1986, 1990; McKinnon 1982, 1991b; Krueger 1986).
-liberalization of prices
-elimination of implicit and explicit taxes and
– liberalization of current transactions
– creation of foreign currency exchange market and currency convertibility
-banking privatization and structure domestic
– restructuration /privatization of the domestic bank system
– creation /reactivation of the money market
– control elimination on capital
– total currency convertibility
2.3 Empirical Evidence
Most empirical studies that tried to explore the relationship between financial liberalization and economic growth have used a standard growth regression modified by the enclosure of a measure of financial liberalization
2.3.1 Empirics favouring financial liberalisation
126.96.36.199 Interest rate Mechanism
In one of the earlier studies of the effect of financial repression, Lanyi and Saracoglu (1983) perfectly dealt with the causality issue by dividing 21 developing countries into three groups. Lanyi and Saracoglu give a value of 1 to countries with positive real interest rates, 0 to countries with moderately negative but ‘not punitively negative’ real interest rates, and -1 to countries with severely negative real interest rates. Given the fact that deposit rates were fixed by administrative organisations in all the countries posting negative deposit rates, one can argue that these rates are exogenous to the growth process. The cross-section regression reported by Lanyi and Saracoglu (1983) indicates a positive and significant relationship between the average rates of growth in real gross domestic product (GDP) and the interest rate dummy variable for the period 1970-80.
The World Bank (1989, pp. 30-2) uses the same methodology as Lanyi and Saracoglu for a sample of 34 developing countries. First, it shows in tabular form that economic growth in countries with strongly negative real deposit rates (lower than – 10 % on average over the period 1974-85) was substantially lower than growth in countries with positive real interest rates. Second, the World Bank also reports a regression showing a positive and significant cross-section relationship between average growth and average real interest rates over the period 1965-85
Roubini and Sal-martin(1992) using pooled time series regression found that the growth rate of countries with positive real interest rates were 1.4 percent higher than countries with real interest rates less than -0.5
188.8.131.52 Financial liberalization and economic growth
King and Levine (1993) examine links between finance and growth in a cross-section of 77 developing countries over the period 1960-89. They construct four financial indicators: (a) liquid liabilities divided by GDP (usually M2 divided by GDP); (b) domestic assets in deposit money banks divided by domestic assets of both deposit money banks and the central bank; (c) domestic credit to the private sector divided by aggregate domestic credit; and (d) domestic credit to the private sector divided by GDP. King and Levine also construct four growth indicators: (a) average rate of growth in per capita real GDP; (b) average rate of growth in the capital stock; (c) the residual between (a) and 0.3 of (b) as a proxy for productivity improvements; and (d) gross domestic investment divided by GDP.
King and Levine (1993) show that each financial indicator is positively and significantly correlated with each growth indicator at the 99% confidence level. The same positive relationship is illustrated by dividing the 77 countries into four groups with respect to the growth indicators; countries are divided into those with average per capita income growth above 3 %, greater than 2 but less than 3, greater than 0.5 but less than 2 and less than
0.5%. There are about 20 countries in each group. In each case, the average value of the financial indicator declines with a move from a higher to a lower growth group. Multivariate analysis produces much the same picture.
As cited by Mackinnon (1993), the results emerging from these cross country regressions can be interpreted as supporting the argument that better functioning financial systems motivates faster economic growth.
Hallwood and MacDonald (1994) employed the data of 80 developing countries on the same model, to investigate the relationship between financial depth and economic growth. They found that a high level of economic growth in developing countries is associated with greater financial depth.
184.108.40.206 Capital Account Liberalisation
Klein and Olivei(1999), using the same methodology as King and Levine, estimated the effect of capital account liberalization on economic growth. They found that capital account liberalization had a substantial impact on output growth and concluded that capital account liberalization positively affects economic growth in highly industrialized economies. However they argue that there is little evidence of capital account liberalization promoting financial depth, and therefore economic growth in developing countries. Hence, they propose that policy reforms in developing countries should require capital account liberalization to come at a late stage, when adequate institutions and sound macroeconomic policies are in place.
Quinn (1997) protects the idea that opening the capital account promotes economic growth. This point of view was confirmed by Eichengreen & Mussa (1998) by asking “How should liberalization be scheduled and anticipated to ensure that the benefits dominate”. Edwards (2001) examines whether the effect depends on the level of development, using the interaction term of opening and conditioning variables, and finds that the level of growth is important for the policy to succeed in the 1980s.
Edward’s findings have been questioned by Edison, Klein, Ricci and Slock (2002). The latter concluded, in contrast with Edwards, that the relationship between capital account liberalization and growth is stronger in emerging markets(in Asia in particular) rather than in developed countries.
More recently, Bekaet, Harvey & Lundblad (2010) study the bond between financial liberalization (capital account and equity market) and the growth in two components, growth of authorized capital and growth of the total factor productivity. The econometric estimates a panel of 71 countries between 1980 and 2006 by the OLS by using a rough measurement of capital account liberalization of Quinn. It reveals that the financial opening affects all the two channels positively but has a greater impact on the productivity of factor than the investment.
220.127.116.11 Stock market Liberalisation
Using firm level data from 30 countries, Demirguc-Kunt and Maksimovic(1996) argued that firms with greater access to more financially developed stock markets grow at a faster rate than those without such access. In determining the impact of equity market liberalization on growth, Bekaert et al. (2000, 2001) conducted two studies. Initially the study comprised of 35 emerging market economies which was then expanded to 95 countries. The studies used official dates of stock market liberalisation and a panel estimation of a standard growth equation augmented by the liberalisation indicator. In both studies, the liberalization indicator is consistently positive and statistically significant across countries. They found that the liberalization coefficient was positive and significant and concluded that financial liberalization increases the growth rate of real per capita GDP by 1.1%.
18.104.22.168 Financial Intermediation
An attempt to examine the role of Southern Africa financial intermediation in an economic union was made by Allen and Ndikumana (1998). Using four indicators of financial intermediation and three different panel techniques-simple OLS regressions; regressions including country-specific fixed effects; and regressions including a high-income dummy, they found a positive correlation between financial development and the growth of real per capita GDP for the Southern Africa Development Community (SADC).
2.3.2 Negative impact of financial liberalisation
22.214.171.124 Banking Crises
This evidence has been supported by more systematic work that looks into the relation between financial liberalization and financial fragility (Demirguc-Kunt and Detragiache, 1998; Fischer and Chenard, 1997). They study the empirical relationship between banking crises and financial liberalization in a panel of 53 countries for the period 1980-95 in a multivariate logit model. They find that banking crises are more likely to occur in liberalized financial systems, even if institutional factors reduce the likelihood of banking crises. Baldacci, De Mello, and Inchauste Comboni (2002) observe increased incidences of financial crises following liberalization in Mexico. Kaminsky and Schmuckler (2001), Tornell et.al. (2004) carry out similar studies, using panel data from emerging markets, and conclude that liberalization results in larger booms and crashes.
126.96.36.199 No significant effect of capital account liberalisation
Rodrik (1998) casts doubt on the effect of capital account liberalization on growth. In a sample that includes almost 100 countries, developing as well as developed, he finds no significant effect of capital account liberalization on the percentage change in real income per capita over the period 1975 to 1989.
Stiglitz, Greenwald and A. Weiss (1994) argue that information asymmetries, which are especially common to financial markets and transactions in developing countries, can be detrimental to liberalization. Hellman, Murdok, and Stiglitz (2000) argue, the competition induced by financial liberalization lowers bank profits, erodes banks’ franchise values, and diminishes their incentives for making good loans, accentuating moral hazard problems.
2.3.3 Guarded Supporters
The third group consists of advocates for liberalization, who suggest that there are several conditions, not yet met by most developing countries, which are necessary to ensure the success of liberalization. Aghion, Bacchetta, and Banarjee (2000) develop a mathematical model to show that economies at an intermediate level of financial development are more susceptible to macroeconomic shocks. Full liberalization in such economies may lead to destabilization, characterized by chronic phases of growth and capital flight. Rodrik and Velsasco (1999) argue that openness to international capital flows can harm a country if appropriate controls, bundled with a strong macroeconomic and regulatory environment, are not in place. Johnston (1997) argues that governments should develop strong institutions for monetary policy and exchange rate management pre liberalization.
2.4 Prerequisites for financial liberalisation
Uncontrolled high positive real interest rates, possibly triggered by fiscal instability, indicate a poorly functioning financial system. Inadequate prudential supervision and regulation enable distress borrowing to crowd out borrowing for investment purposes by solvent firms, so producing a contagion effect (Stiglitz and Weiss, 198I; McKinnon, 1993; Fry, 1995; Rojas-Suairez and Weisbrod, 1995). Funds continue to be supplied because of explicit or implicit deposit insurance. The end result is financial and economic paralysis.
This international experience indicates that there are five prerequisites for successful financial liberalisation (Fry, 1995):
Adequate prudential regulation and supervision of commercial banks, implying some minimal levels of accounting and legal infrastructure.
A reasonable degree of price stability.
Fiscal discipline taking the form of a sustainable government borrowing
requirement that avoids inflationary expansion of reserve money by the
central bank either through direct domestic borrowing by the
government or through the indirect effect of government borrowing that
produces surges of capital inflows requiring large purchases of foreign
exchange by the central bank to prevent exchange rate appreciation.
Profit-maximising, competitive behaviour by the commercial banks.
A tax system that does not impose discriminatory explicit or implicit
taxes on financial intermediation.
Despite being criticised over the years, financial liberalisation had a relatively early impact on development through the work of the IMF and the World Bank. When the implementation of financial liberalisation remedies did not confirm their theoretical premises, there occurred a revision of the main doctrines of the theory. Initially, the response of the proponents of the financial liberalisation thesis was to argue that where liberalisation failed it was because of the existence of implicit or explicit deposit insurance coupled with inadequate banking supervision and macroeconomic instability (McKinnon, 1988a, 1988b; 1991; Villanueva and Mirakhor, 1990; World Bank, 1989). Those conditions were conducive to excessive risk-taking by the banks, which can lead to `too high’ real interest rates, bankruptcies of firms and bank failures. That led to the introduction of new elements into the analysis of the financial liberalisation thesis in the form of preconditions, which should have to be satisfied before reforms would be contemp
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