LESSONS OF EXPERIENCE - Financial Liberalization and Endogenous Growth : The Case of Nigeria

3.3.1 Lessons from the Southern Cone Countries

The justification for financial liberalization is the financial repression hypothesis, which stipulates that interest rate ceilings and state interventions in credit allocation are detrimental to the availability and quality of savings and investment (Mckinnon, 1973, Shaw, 1973, Fry, 1982). This hypothesis underwent a re-assessment following the experiences of the Southern Cone countries, Argentina (1977-80), Chile (1975-81) and Uruguay (1977-82).

For instance, Dornbusch and Reyneso (1989) are convinced that the financial repression paradigm is a "kernel of truth and a vast exaggeration." The consensus seems to be that financial reform in itself, as envisaged in the financial repression paradigm is desirable, but where it has failed, it was either due to the design and sequence of the reform measures (Mckinnon, 1988), or caused by adverse factors such as external shocks and macroeconomie policies during the process (Corbo et al, 1986).

The financial liberalization in the Southern Cone resulted in exceptionally high levels of real interest rates, and in diverging spreads between deposit and lending rates. These were symptomatic of inappropriate bank management and eventually affected trade reforms adversely.

(i) HIGH LEVEL OF REAL INTEREST RATES

In all the three countries real interest rates increased to levels above LIBOR plus the rate of expected devaluation. In Chile, the average real lending rate was 41.0 percent per annum between 1975-81, in Argentina 17.0·percent per annum between 1977 and 1980, while in Uruguay the lending rate averaged 15.0 percent per annum between 1977 and

1982. Although these higher interest rates were partly caused by overvalued exchange rates which created expectations of devaluations and initially strict monetary policies, a more fundamental cause was weak supervision which raises the issue of moral hazard and adverse selection problems amongst banks and their clients.

Under inadequate supervision, adverse selection of borrowers may occur because the probability of repayment of a loan is negatively related to the interest rate charged by the bank. To attract deposits, especially when facing increased competition in the wake of financial liberalization, many banks increased deposit rates to very high levels and often interest was paid upfront to attract new deposits. High interest rates may be a symptom of distress borrowing if it is accompanied by high and variable inflation, an overvalued exchange rate and large and unsustainable government deficits.

In the Southem Cone, as a result of the weaker supervision, less risk averse firms entered the banking industry, especially through large conglomerates obtaining majority shares holding in commercial banks (Tybout, 1985). These banks were then encouraged to make high risk loans to its holding firm or its subsidiaries, and when loans could not be repaid, it was rolled-over a process known as "ever greening", since it does not appear on the banks books as non performing loan.

In Bolivia, in 1985-86, high real interest rates were observed after financialliberalization.

These were caused by high banking operating costs. For instance, after a decline in inflation as a result of stabilization, most banks found themselves overstaffed and burdened with high operating costs, a legacy of a high inflation environment. As a result many banks reduced their personnel and closed branches, but still needed to impose high lending rates in order to meet the high unit operating cost Moretti (1992).

(ii) SPREAD BETWEEN DEPOSIT AND LENDING RATES

A second visible effect of financial liberahzation on bank management in the Southem Cone was that spread between borrowing and lending rates increased dramatically about

13 percent in the three countries during the liberalization periods (Ramos, 1988:56). In the southern Cone, and later Bolivia, this was mainly caused by high operating transaction and default costs. High operating and transaction costs were incurred because banks assumed that the majority oftheir assets had short term maturities. This was due to the fact that most of their deposits were of a short duration (less than 30 days). In essence, banks in the southern Cone became brokerage firms rather than asset transformation firms, and thus no financial deepening in the normal sense of the word took place.

For long-term projects, short-term loans were rolled over frequently, which increased transaction costs. High default cost was due to a large and increasing proportion of non-performing loans relative to total assets. In order to remain solvent banks increased the wedge between lending and deposit rates.

From the above, the southern Cone countries in effect adopted a "debt led" growth strategy, by borrowing heavily abroad (Bianchi, 1988:23). They frequently made use of resources offered by private international banks. These favourable external circumstances allowed inappropriately bank risk management to continue unabated until the early 1980s, when the international environment changed abruptly. The consequent decline in the southern Cone's term of trade, the increase in real international interest rates and the sharp decline in the net inflow of capital finally triggered a massive collapse in the financial system of these countries.

3.3.2 The East Asian Financial Crises

The East Asian financial crises were related to non-conventional adverse macroeconomie fundamentals: imprudent financial liberalization, over indebtedness in short-term liabilities and excessive domestic investment in manufacturing sector with excess capacity and in non-tradable sectors. Also, the herd-like behaviour in international capital

markets played a prominent role in the onset of the crises. Ail Asian economies except (Japan, partly China and Taiwan) displayed in 1996-97 four main weaknesses.

•

The East Asian economies pursued, albeit in different degrees, a premature and indiscriminate financialliberalization in the 1990s involving both domestic and extemal opening. Interest rate controls and restrictions on corporate debt financing and cross border borrowing were lifted. A salient feature was that liberalization proceeded without an adequate prudential supervision and regulation of financial activities. Therefore the crises might be well characterized as "crises of under-regulation Chang (1998). Under-regulation allowed banks and non-bank financial institutions to over lend to private firms, to over borrow from abroad, to engage in risky activities and to present a growing maturity and currency mismatch between assets and liabilities.

• The second feature was over-indebtedness in foreign liabilities (mainly private, denominated in foreign currencies, short-term and unhedged). According to World Bank's data, total foreign debt to GDP amounted in 1996 to 64 percent in Indonesia, 56 percent in Thailand, 52 percent in Malaysia and 51 percent in Philippines. Bank lending financed to a great extent by foreign borrowing to lend domestically at high rates was profitable with adverse impact on the

•

private sector.

The third weakness was over investment, especially in the manufacturing sector with excess capacity, inflated real estate and booming stock markets. An increased share of bank lending was directed to speculative investment in real estate, equities and other financial assets. For instance, real estate exposure of domestic banks was very high (30-40 percent of total lending) in Malaysia and Thailand.

•

The forth point was the herding behaviour in the global financial markets (financial panics) that prompted a massive currency depreciation and a tremendous fall in stock indexes. According to the Institute of International Finance, net private capital inflows to the five troubled East Asian economies (Indonesia, Malaysia, the Philippines, South Korea and Thailand) increased for US$37.9 billion in 1994 to US$102.3 billion in 1996 but registered a figure of only US$0.2 billion in 1997 and minus US$27.6 billion in 1998 (IIF, 1999).

The ensuing liquidity squeeze, as foreign creditors were less willing to roll over their loans, was intensified by domestic residents' reluctance to hold deposits in domestic currencies.

3.4 PRE-REQUISITE FOR SUCCESSFUL FINANCIAL LIBERALIZATION

Financial liberalization entails the abolition of explicit contrais on the pricing and allocation of credit. Direct government intervention in bank credit decisions is brought to an end. Liberalization may also involve the abolition of controls on international capital movements. However, government policies will continue to play a central role in determining how the financial sector performs. Financial liberalization does not mean

"free banking". Govemment will continue to intervene in the financial sec tor in a number of ways: banks will be supervised for prudential reasons; sorne banks may be publicly owned; and the govemment may be a major borrower. How successful the authorities perform their role as supervisor, owner, or customer will be an important determinant of the success of reforrn. Moreover, financial libera1ization is only one component of a successful development strategy. Appropriate macroeconomie policy, institutional development, and structural reforrn must accompany financial liberalization and create the stable context required for it to succeed.

1) Initial Macroeconomie Condition

In the generally successful Asian cases, the macroeconom1c imbalances were largely eliminated before financial reforms were introduced. Balance of payments

and fiscal deficits were manageable, and inflation was relatively low. The Asian countries that were exceptions to this rule (Philippines and Sri Lanka) were notably less successful in expanding their financial sector following reforms. For example, in Indonesia, where macroeconomie conditions were favourable, the ratio of broad money to GDP rose dramatically, from a pre-liberalization level of 9 percent in 1983 to well over 40 percent in 1991. In contrast, in Siri Lanka, the ratio was largely unchanged.

2) The Regulation and Supervision of Banks

The World Bank report (1989 p.127) advised that a direct intervention in the financial sector must be replaced by an adequate system of laws and regulations to effectively monitor the operations of financial institutions with particular reference to their loan portfolio and project selection. The insolvency in the financial system of the Sou them Cone countries was considered as partly an outcome of the failure to provide adequate prudential regulation and banking supervision by these govemments. In Chile, for example, it was noted that banks were privatized without an adequate framework of prudential regulation which allowed them to be acquired by industrial groups which used them to source .funds for themselves and subsidiary companies. If the legal, accounting, management, and supervisory infrastructures of the financial sector are weak, then the deregulation alone is unlikely to generate the expected benefits and, in fact, highly destabilizing forces may be unleashed.

3) The Speed of the Reforms

If the reform process is implemented too quickly, firms that entered into implicit contracts and arrangements under the old rules may face heavy losses under the new dispensation and may become distressed. A gradualliberalization process may also impose Iosses but it will allow firms time to adjust and financial institutions time to develop new skills required under the new system. The benefits associated with financial reform are contingent on

~he

financial system being "well behaved

"throughout the liberalization process.

4) Competition among Banks

Similarly, if competition among banks in the newly deregulated financial sector is weak, liberalization may result in lower real deposit rates rather than the anticipated movement toward modestly positive, equilibrium levels. Monopolistic banks can exploit the opportunity offered by the abolition of interest rate controls to widen their margins between deposit and lending rates to increase profits.

5) Deposit Insurance

The existence of deposit insurance has the effect of strengthening public confidence in the banking system but at the same time may result in "moral -hazard" problem.

Deposit insurance should be free, that is, financial institutions should be properly assessed on rnonthly, quarterly and annual basis through onsite and offsite exarninations to determine their risk portfolios and sound management. This may reduce their pruning to "moral hazard" while retaining public confidence in the financial system.

From the explanation giVen above, it can be concluded that economie reforms undertaken in an unstable macroeconomie background (inflation, exchange rate volatility interest rate instability) can worsen the instability, as noted in the Latin Arnerican countries and sorne Asian economies. The process of graduai and phased reforms (Korea) is likely to produce better results than that carried out suddenly and quickly (Argen tina, Chile and Uruguay). The ratio of Government deficit to ~GDP should be minimal or totally eliminated (Korea and Taiwan) before the process of reform commences. Financial liberalization can only be successful if irnplemented after monetary stability has been attained, the sequence involves putting the institutional and macroeconomie conditions in place before liberalization and finally deposit insurance should be explicit to restore confidence in the financial system.

As discussed in Chapter two, the financial liberalization which was implemented in Nigeria started in a very unstable economie environment. The excessive government fiscal deficits exacerbated high inflationary pressure in the economy. The banking system was inadequately regulated and supervised thus culminating in the eruption of financial crises and its contagion effect which degenerated in to distress in the financial sector of the economy. The Nigerian Deposit Insurance Corporation (NDIC) was established in 1988, two years after the commencement of the financial liberalization programme thus increasing the susceptibility of the financial institutions to the question on the issue of moral hazard. The inability of the financial system to impact positively on the econorny can to sorne extent be attributable to sorne of these initial macroeconomie and institutional frameworks.

4.1 INTRODUCTION

CHAPTER FOUR EMPIRICAL ANALYSIS

In this chapt er we present the model specification and estimation using _ the Pagano endogenous growth model in order to investigate the impact of financialliberalization on economie growth in Nigeria. In section 4.2 we begin with the issue related to methodology, model specification and explanation of the variables in the model. In section 4.3 we present the estimation procedures, section 4.4 examines sources of data while section 4.5 deals with econometrie analysis. Section 4.6 contains the interpretation of the results.

4.2 METHODOLOGY

4.2.1 Specification of the Theoretical Model

In this section, the Pagano endogenous growth model adopted by (Ghatak and Siddiki, 1997) in the study of financial liberalization and èndogenous growth in Bangladesh is applied. The model incorporates human capital (HC) since financial liberalization increases the quality of HC by financing education to financially constrained households (Gregorio 1996). Endogenous growth theory (NGT) predicts that HC is one of the main engin es of economie growth- a common feature in LDCs. The Pagano model predicts that FL increases: (i) savings and investment, (ii) the proportion of saving that goes to investment and (iii) the efficiency of investment by improving competitiveness, availability of information regarding the investment projects. Using the AK version of endogenous growth model, Pagano postulates that the above three factors in turn increase the rate of economie growth. The extended model predicts that there is an additional efficiency gained caused by the accumulation of HC resulting from FL. To explain the model, it is assumed that aggregate output is a linear function of the aggregate capital stock:

Yt = AKt ⁽¹⁾ Where Yt is aggregate output, A represents the marginal productivity of capital, K¹is the aggregate capital stock and t is time. This production function represents a competitive economy with the presence of externality or spillover effects. Bach firm faces constant retum to scale, but the economy as a whole shows increasing retums to scale with respect to Kt. Suppose the population is stationary and the economy produces a single good which can be consumed or invested. Also assuming that the rate of depreciation of investment is zero and gross investments:

It = Kt+I-Kt ⁽²⁾

Kt+I=lt+Kt

This is a one-sector economy with no government and external sectors. Assume that financial institutions channel a proportion f of saving,

S~o

to investment,

I~o

i.e. the proportion (1-f) of saving that is lost in the process of intermediation. Therefore the capital market equilibrium condition is:

jSt= It ⁽³⁾

Using equations (1) and (2), the growth rate at time t+l can be written as follows:

Yt + ₁_ Yt = AK.t + 1 - AK.t = Kt + 1 -Kt = Kt + 1 _ 1

gt+l = Yt AK.t Kt Kt

lt+Kt lt Ait gt ⁺1

=

- - - 1 = -

=

-Kt Kt AKt

(4)

Where gt+I is the growth rate ofincome at time t+I Define the steady state as.

a period where A remain constant . In this case, there will be a state in which output and capital per worker are no longer changing, known as a steady state, we set:

Substituting equation (3) and (4):

g=A-=Afs lt Yt

from equation (S),the steady growth rate (g) can be written as follows:

lng =ln A+ lns + lnf

(5)

(6) for g to be positive it follows that A> 0

where g

=

Afs. Taking the logarithms of equation (6) distinguishes three channels: f, s, and "A", through which Financial liberalization could influence growth. The transmission mechanisms are explained below.

a) CHANNELING SAVING TO INVESTMENT

Financial institutions collect private savings and direct them into investment. Fis cannot generally transform all savings into investment since transaction costs and profits absorb sorne of the funds. A portion (I-f) ofsaving remains out ofinvestment. FLin the form of the expansion of bank branches and licencing of new banks, as well as a reduction in reserve requirements boost competition among Fis, which reduces their commissions and fees, the difference between lending and borrowing rates and hence there is a rise in f.

The structural equation for f can be written as follows:

(7) Infi

= f

o + jtlnFDR +ut

where FDrt represents a vector of government financial policies which help or hinder financial development and competition. The variable ft represents factor which enhances financial development. Such outcomes are positive when policies reduce reserve requirements, restrictions on new banks or branches and hence boost the financial markets, vice versa.

b) IMPROVING THE ALLOCATION ON INVESTMENT

The Fis plays a second role by improving the efficiency of funds by channeling them towards more productive projects and by promoting education and training. The Fis increase the efficiency of investment in the following ways: firstly, Fis provide information on more productive opportunities. Secondly, Fis help in channeling funds towards more risky but productive projects by risk sharing and portfolio diversification Paul (1992). The Fis also help in providing funds towards long run and productive projects and reduce premature liquidation by fulfilling unexpected future liquidity demands Diamonds and Dybvig (1983). Finally, Fis can facilitate education and training of financially constrained young agents by providing study loan. Renee the second equation can be written as follows:

InA= Ao + A1In(!::::. y)+ .fuinHC +Ut, with A1. fu > 0

!:::.K

(8)

where the difference operators Y!::::./ !:::.K is the ratio of incrementai capital (GDP) to output ratio (ICOR), u

1 is an identical and independently distributed error term, HC is human capital. FL improves the efficiency of investment, which is reflected in the IOCR. FL improves the quality of HC. Both effects increase "A". According to the financial liberalization paradigm as postulated by Mckim10n (1973) and Shaw (1973), a more liberalized financial system will induce an increase in investment and therefore promote economie growth. The endogenous growth model predicts that there is an additional efficiency gained caused by the accumulation of human capital (HC) resulting from financialliberalization.

C) EFFECTS ON THE RATE OF SAVING

As predicted by the Mckinnon and Shaw hypothesis, FL in the form of an increase in real deposit rates to induce savings in financial assets instead of investing in inflation hedges. Thus, FL increases private savings, i.e. bank deposits will in turn increase credit allocation, investment and economie growth. The behavioural equation for the saving ratio can be as follows:

In s

=

0+ S1 In DRst+Ut,with S1 >0

(9)

Where So and S1 are initial and marginal savings, DR51 represents real deposit rates.

The policy prescription by Mckinnon and Shaw for financially repressed economy is to raise institutional interest rates orto reduce the rate of inflation. The concept of financial liberalization emphasizes the removal of ceiling on interest rates and other contrais on financial intermediaries, so that real deposit rates are kept positive to attract more

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