Financial liberalization in developing countries is typically associated with measures that are designed to make the central bank more independent, relieve ‘financial repression’ by freeing interest rates and allowing financial innovation, and reduce directed and subsidized credit, as well as allow greater freedom in terms of external flows of capital in various forms (Gosh 2005). It is argued that the elimination of ‘financial repression’ and the strengthening of financial development will ultimately lead to higher long-run growth (King & Levine 1993), enabling the development process to proceed much more rapidly. So much so that financial liberalization in developing countries has been touted as a ‘necessary and significant part of an economic policy package’, once promoted by what was called the “Washington Consensus”.
But to what extent is financial liberalization a good thing? Frequently it has paved the way for exchange rate instability and has sometimes even ended in a full blown currency crisis. Often financial liberalization will lead to excessive risk-taking and an increase in macroeconomic instability meaning that economic crises are much more likely to happen. Furthermore, when financial crises do hit, developing countries now face the added risk of contagion, not only on a regional basis, but on a world wide basis, hitting countries with no apparent macroeconomic instabilities. Liberalization may have helped many developing countries achieve higher growth but it could be argued the current models in place for financial liberalization are not only short-sighted inherently floored.
Part II. Models for Financial Liberalization
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Before the problem of financial liberalization was the problem of financial repression.
This refers to a set of government laws, regulations and other non non-market restrictions that prevent the financial institutions in an economy from operating efficiently. Such policies may include government monopolization of the banking system, restricting the growth of financial institutions by requiring private banks to keep excessively high reserve and liquidity ratio requirements. Restrictions might also be put on the direction of credit allocation, forcing banks to lend to those sectors that are seen to be top priority. In addition, banks may also be forced to lend to the government in order to fund a government deficit.
Governments may choose to engage in financial repression in order to hold down interest rates as an offset of currency value. This theoretically leads to a more competitive trade regime due to the relative value of cheap money. However, once inflation is taken into account, artificially low interest rates may cause the ‘real’ interest rate to become negative discouraging the acquisition of interest-sensitive financial assets. It is therefore no surprise that economists have frequently argued that financial repression prevents the efficient allocation of capital and in so doing impairs the level of saving, investment and output growth of an economy.
The two main arguments in favour of financial liberalization come from Economists McKinnon and Shaw who assert that among other measures: high reserve ratios, implicit credit programs and interest ceilings will lead to lower investment ratios and will therefore have a negative impact on growth. According to them, the financial market should be liberalized in order to promote efficiency. Their arguments follow thusly:
McKinnon argues that in the development process capital accumulation and money holdings are positively related. He goes on to say that because of the reliance on self-financing, people need to accumulate money balances before investment can take place. Therefore, high interest rates are needed in order to encourage people to save. Under these assumptions investment will take place as long as long as the real rate of return on investment exceeds the real rate of interest.
Shaw’s argument stresses theÂ importance of an increase in the provision ofÂ financial services, also known as financial deepening. Like McKinnon, He also argues for the necessity of high interest rates in order to discourage investment in low-yielding projects and to encourage saving. In Shaw’s argument, the existence of high interest rates will increase the liabilities of the banking system which will enable the banks to lend more resources for productive investment in a more efficient way.
This diagram helps illustrate the point for financial liberalization. Here investment is drawn as a negative function of the real interest rate due to diminishing marginal efficiency of investment. Saving is drawn as being positively related to the real interest rate because the higher the interest rate, the higher the incentive to save. In the absence of interest rate controls the equilibrium level of investment is shown by i*.
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The line r1 represents a nominal interest rate ceiling that may be imposed by a government (a form of financial repression). This causes the real deposit rate to remain below equilibrium at i1. Due to the fact that previous saving is needed to generate investment, this restricts investment to i1 also.
However, suppose there was no ceiling on the loan rate of interest, the bank could charge an interest rate of r2 to investors. This would allow the banks to collect significant profits, shown by the gap between r2 and r1. Furthermore, at r2 there is no unsatisfied demand for investment funds.
If the interest rate ceiling did apply to loans as well as deposits, investment demand would also be restricted to i1. Now there is unsatisfied demand for investment which is represented by the gap between A and B. This will inevitably lead to credit rationing meaning banks will tend to favour less risky projects which are subject to lower rates of return, lowering the overall productivity of investment.
Now let’s increase the interest rate ceiling from r1 to r3 and observe the effects. Firstly, savings will increase from i1 to i3 which in turn leads to a higher level of investment. Now, investment demand is only unsatisfied by the amount of A1 to A2, ergo credit rationing is reduced and investment productivity rises.
From this viewpoint it is easy to see how the argument for financial liberalization follows. If the market were fully liberalized (r*) saving and investment would reach their optimal, equilibrium rate of X. There is no unsatisfied demand for investment and credit rationing has been eliminated.
Part III. Criticisms
As convincing as the arguments for financial liberation are, they aren’t without their criticisms. The first critique of this theory is one of financial saving. It is argued that although a liberalised exchange rate will increase financial savings, financial savings aren’t the only type of savings. It is suggested that after liberalization the total level of saving may actually remain unchanged because of a substitution between financial assets and other types of assets. As with any price change, a change of the interest rate would have both substitution and income effects. The substitutions effects may promote saving by making current consumption more expensive in ‘real’ terms. But the income effect will deter saving because with higher interest rates, the same income can be obtained with less saving, meaning the two effects could in theory cancel each other out.
It should also be taken into account the effect high interest rates have on the level of costs and demand in an economy. Changes in interest rates tend affect several components of the aggregate demand curve. The most immediate effect is usually on capital investment. When the interest rate rises, the increased cost of borrowing tends to reduce capital investment leading to a decrease in total aggregate demand. Furthermore, higher interest rates increase the total cost of the purchase and the general cost of borrowing, throughout the economy. This could lead to stagflation, a period of slow growth and rising unemployment. In addition high interest rates not only discourage investment but they can also lead to currency overvaluation by attracting capital from overseas. This will lead to a fall in exports, as well as an increase in the cost of repaying government debt, which consecutively leads to government spending cuts.
A further criticism draws attention to the fact that current models for financial liberalization only really seem to view banks as being saving depositories. That is, the supply of loans is presumed to depend entirely on the amount of deposits held by the bank. Meaning the supply of loans only increases when the amount of deposits increase i.e. the supply of credit is determined exogenously. However, since banks have the ability to simply ‘create’ credit as they see fit, it is increasingly likely that supply of loans will actually be determined by the demand for loans rather than the supply of deposits. i.e. the supply of credit is determined endogenously. If this is true it is the incentives for investment that are more important and not the incentives for saving. Therefore a lower interest rate may be more suitable under thes circumstances.
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A final argument to make is the fact that if interest rates are not controlled, and are allowed to reach their market clearing level we could actually see an increase in the problem of credit-rationing. This is due to a problem of adverse selection. Because of Asymmetric information between borrowers and lenders, borrowers tend to know more than lenders about the risks involved in a loan. It is therefore arguable that banks may still choose to practice credit rationing, deciding not to lend to projects that offer high returns due to a higher given risk.
Part IV. Case Study
In the early 1980s, interest rate ceilings and other regulations affecting financial assets were lifted in Thailand, Indonesia, and the Philippines. Thereafter, the economies of Southeast Asia maintained high interest rates which attracted foreign investors looking for a high rate of return. Later, in the 1990’s Thailand opened up its capital markets. For the first time, local businesses could borrow money from foreign banks, which offered lower interest rates. In just four years, loans to Thai businesses had tripled to over $200 billion. American and European Governments encourage the inflow of money. During this time the economies of South East Asia had experienced extremely high growth rates of 8-12% of GDP. This phenomenon was widely acclaimed by financial institutions such as the IMF and World Bank and was dubbed the ‘Asian economic miracle’. However, economist Paul Krugam disputed the idea of an Asian economic miracle arguing that historically the source of East Asia’s economic growth had been capital investment.
Furthermore, Thailand’s central Bank had kept its currency artificially high, fuelling the speculative bubble. Thailand’s currency was pegged to the dollar but when the US began to raise U.S. interest rates to head off inflation Thailand’s own exports became more expensive and less competitive in the global markets. This caused their export growth to slow dramatically. In the spring of 1996 their current account position had started to deteriorate.
By early 1997, South East Asia’s rapid economic Boom was starting to overheat. The Baht came under relentless market pressure and in July 1997 and the Thai Government was forced to float the baht. Furthermore, Thailand’s huge burden of foreign debt had effectively rendered it bankrupt even before its currency collapsed. With its economy in a virtual free-fall, Thailand received and emergency loan from the IMF. When that didn’t work the Thai Government asked Washington for even more help. The American Government decided not to intervene in Thailand, thinking that it was not going to have a spill over effect
No one expected an economy as small as Thailand’s to spark a global crisis. However, global markets worried that other Asian countries might have similar ‘hit and falls.’ Like the bank runs we’ve seen in more recent times, money began to poor out of the region. Contagion began and $116 billion flowed out of Asian Markets.
Contagion spread to Thailand’s neighbours. Malaysia’s economy has seemed stable. Suddenly, it too was facing relentless pressure from global markets. Contagion next hit Indonesia, the most populous country in the region. Its government collapsed and its cities descended into chaos.
The IMF arranged huge loans for Indonesia and other Asian nations on the condition they cut government spending, raise interest rates and eliminate corruption. The market forces were simply too powerful for the IMF or any Government to contain. In late 1997 Contagion reached Korea, one of the most successful economies in the world.