Government intervention in the determining of the price and allocation of credit was termed as ‘financial repression’ by McKinnon and Shaw in early 1970s. Interest rates control by government, credit controls, barriers to entry to financial sector, state control of banking sector, government ownership of banks and restrictions on capital flows are six elements of financial repression identified by Williamson and Mahar (1998). Financial liberalization is one of the main reform strategies of developing economies during the globalization process.
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Proponents of financial liberalization argue that financial repression is the cause for lower growth rates that otherwise would be higher if open market would decide the flow of capital to projects. Assumed costs associated with repression are described as follows (Caprio et al., 2001): (1) deteriorating growth rates for countries with high levels of financial repression; (2) widespread bank insolvencies as the result of low quality lending; (3) limited access to financial resources for individuals and small firms, whereas wealthy elites take advantageous position in financial repressed system; (4) increased dependence on external financing because of negative real interest rates which results in capital flight; (5) Excessive use of capital-intensive production techniques, because artificial low real interest rates makes those projects attractive; (6) reduced monitoring and financial resource allocation functions of financial intermediaries as the result of state allocation of financial resources to inefficient state-owned enterprises; (7) increased risk for external crises, as the result of deteriorating fiscal balances, increased external financing or money printing.
McKinnon and Shaw argued that low interest rates or negative interest rates have negative effect on savings rates, which leads to lower amount of funds available for investment through financial intermediaries. Additionally, it results in inefficient allocation of resources as low-yielding investment opportunities would be considered as good investment. It was predicted that after capital account liberalization, capital would be allocated efficiently around the world to the investment opportunities that offer highest rate of return, thus increasing global growth rates and growth rates within individual countries. Furthermore, by being able to invest both internally and externally investors were able to diversify their investment, which would result in lower risks.
2. Financial liberalization: from theory to practice
Arestis and Demetriades (1999) state that theoretically financial liberalization can promote economic development by increasing savings, investments, and the productivity of capital. However, much of the evidence from financial liberalization episodes from both developing and developed economies points to significant destabilizing consequences, including incidents of severe financial crises.
2.1 Liberalization: interest rates and savings rates
Countries that went through liberalization process, after removal of artificial ceilings on interest rates, experienced high rise of real interest rates. While it is broadly accepted that negative real interest rates have negative effect on saving and investment, this does not mean that high real interest rates have positive impact on savings and investment. For poor developing countries regardless of interest rates level, savings rates will be insensitive to changes as major part of the population lives on near subsistence income (Campbell & Mankiw, 1990 ?).
Reynoso (1989) states that the rate of savings increase as interest rates move from extreme negative rates to slightly less than zero, but as the interest rates become positive saving rates goes down (Williamson and Mahar, 1998). Chapple (1991) finds that savings rates both at individual and corporate level fell after the implementation of financial liberalization. Bayoumi (1993) found the same effect in UK after financial deregulation in the 1980s. Demetriades and Devereux (1992) examine sixty-three countries from 1961 to 1990 and find that real interest rates are negatively correlated with investment. However, Gelb (1989) finds very weak positive relation between real interest rates and investment.
Modestly positive real interest rates in middle-income developing countries may be optimal for maximising savings rates; whereas very negative or high real interest rates are associated with lower savings rates for developing countries.
2.2 Liberalization and financial depth
Several measures have been proposed to analyze the depth of the financial sector. Mostly those measures focus on ratios of broad money aggregates (M2, M3) to the size of economy such as money/GDP ratio, which measures the level of the ‘monetization’ in the economy. The broad money measures are used in the studies, because broad money increases in the faster way in the presence of financial deepening, whereas narrow money (M1 – i.e. notes and coins) increase at the same rate as the growth of the economy. Williamson and Mahar (1998) in their studies of thirty-four developed and developing countries find that financial depth increased in all developed countries, except of France, after the liberalization process. With the exception of Philippines, Turkey and Venezuela other developing countries which were analysed in their studies also experienced substantial or moderate financial deepening.
2.3 Liberalization and the efficient allocation of domestic financial resources
One of the key arguments for proponents of the financial liberalization was that process would lead to more efficient allocation of financial resources on commercial basis to most productive enterprises, which in turn would increase the level of the productivity and growth rate of the economy. The number of country level (?) analysis supports this view. The studies of Indonesia by Siregar (1992) and Ecuador by Jaramillo (1992) find that credit allocation was shifted to more technologically advanced and efficient firms. Number of studies in Korea (Atiyas, 1992), Mexico (Gelos, 1997), Argentina (Morriset, 1993) and Turkey (Pehlivan, 1996) state that financial liberalization led to greater access and improvement of allocation of credit to smaller firms that have been disadvantaged in repressed system. Galindo, Schiantarelli and Weiss (2007) found strong evidence that liberalization in twelve developing countries resulted in an increase in the efficiency of the allocation of resources.
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2.4 Liberalization and the efficient allocation of international financial resources
It was predicted that as the result of liberalization, there would be reallocation of global funds from developed countries to developing world, because enterprises in developing and emerging economies had a higher potential for growth.
2.5 Liberalization of capital flows
Liberalization of capital flows is also one of the topics in the economic literature with greatest disconnection between the economic theory and the empirical cases. Neoclassical theories suggest that free flows of external capital should be equilibrating and help smooth a country’s consumption and production paths. However, in the real world, liberalization of capital flows has constantly been associated with serious economic and financial crises in Asia and Latin America in the 1990s. There is a large body of empirical work presenting the close link between the liberalization of the financial system and economic and financial crises particularly in developing countries. The recent Asian crisis, for example, is an excellent case for examining the role of capital account liberalization in causing or accelerating the region’s financial meltdown. In a recent study by Williamson and Drabek (1998), it is indicated that the only difference between the countries that did or did not have economic crisis is the status of their capital account. Their finding is also in parallel with Stiglitz’s (2000) study concluding that the growth benefits of capital account liberalization are obscured by the costs of associated volatility. It is now well known that, premature financial liberalization seriously contributed to the occurrence and the depth of the crises in countries like Thailand, Korea and Indonesia even if it was not the origin of the crises. On the other side, India and China, two of the economies with controlled capital accounts, managed to avoid the crisis and sustained their economic growth.
Theoretically, it is possible that the instability caused by capital account liberalization is more than compensated for by faster long-run economic growth due to greater availability of capital inflows (Fisher 1997; Summers 2000). Although this statement is frequently suggested by the proponents of liberalization reforms, the results of empirical studies on the effects of capital account liberalization on economic growth are mixed. While Edison, Levine, Ricci and Slock (2002) do not find a strong relation between international integration and economic growth, Borensztein, De Gregorio and Lee (1998) find that there is a positive link between FDI and economic growth when the education level is high in the host country. In contrast, Mody and Murshid (2002) find that there is a one-to-one relation between the capital inflows and the domestic investment, but the link becomes weaker over time.
2.6 Liberalization and financial crises
Development of the more sophisticated financial sectors by the contribution of foreign banks and investors is expected to lead to a sustainable economic growth in these economies. However, free capital mobility which is another outcome of the financial integration has led to a highly unstable international financial environment leaving the developing economies in deep financial turmoil.
Williamson and Mahar (1998) find in their study of thirty-four countries that went through the process of liberalization, that all of them experienced some form of systemic financial crisis during the period of 1980 and 1997. Even though, crises in twenty-one of these countries followed directly after the liberalization process, and while not all of them were caused by liberalization, it seems very likely that substantial proportion certainly was. Research made by Griffith-Jones and Gottschalk (2004) estimated US$ 1.25 trillion loss in eight countries that had suffered financial crisis, which further worsened situation with poverty in those countries. Eichengreen (2004) estimates that as the result of the currency and banking crises levels of developing countries income fell by 25%. Such fact proves again that financial liberalization process should be implemented only after the establishment of strong regulatory and supervisory mechanisms of the financial sector.