The theory of financial liberalization in developing countries came to dominate financial policy discussion since the early 1970s due to the seminal contributions by Mckinnon (1973) and Shaw (1973). The core of this hypothesis is that government intervention in developing countries control of interest rates, ceilings on lending rates, credit rationing to borrowers at below market clearing rates, and wide spread use of inflationary taxes has repressed the development of the financial sector.
Developing countries often pursued policies that kept interest rate artificially low, even negative in real terms, and in the process discourage financial savings. This has hindered financial deepening, and at times led to financial disintermediation. Moreover, when financial savings were made through the financial institutions, they were allocated to preferred sectors, (agriculture, manufacturing, mining and quarrying) and privileged groups of borrowers at below the market clearing rate in an attempt to subsidize the ir cost of capital. This has generally led to an implicit taxation on savers without necessarily encouraging efficient capital formation and economie growth.
The driving force behind these financial policies in most of the developing countries is fiscal in nature. Government makes wide use of inflationary taxes to finance their fiscal deficits and finance projects and public enterprises that are its priority areas. This policy stance is not condemnable; however, the problem emerges when public sector expenditure is not sustainable, competition is limited and projects are not operating based on proper economie criteria. However, when govemment drains the meager financial resources available in the economy, it tends to crowd out the private sector and distorts the smooth functioning of the financial sector to mobilize and allocate financial resources
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-m an efficient manner. Projects that are funded with artificially cheap capital would cause more problems and resource misallocation unless they are given clear and hard constraints to eventually move to sustainable financial position.
The main argument in the theory of financial liberalization revolves around the relation between financial sector development and economie growth. Does financial market development exert a causal influence on economie growth performance? Do financial liberalization measures lead to financial sector development or is it simply the reflection of the stage of economie development itself? Is it a prudent po licy option to liberalize the financial sector in developing economies?
It should be noted that effective government intervention in the financial sector is necessary and successful in sorne developing and developed countries by allocating resources in sorne strategie and leading industries with significant positive extemalities.
Moreover, the govemment administered allocation of financial resources could induce higher economie growth in developing countries (Stiglitz and Uy, 1996). When financial control was accompanied by sound macroeconomie fundamentals, coupled with effective and transparent selection criteria of beneficiary sector and firms, as was the case in East Asian countries, the cost of financial repression was over compensated by positive extemalities and crowding-in effects of the subsidized undertakings. Moreover, the wide spread market failures in the financial sector and the tendency of the market to undersupply financial information and regulation necessitate selective and effective policy intervention.
Financial sector liberalization is intended to reduce financial resource misallocation and bring about financial development and hence accelerate and sustain economie growth.
Liberalization is a continuous process that requires constant follow-up and appropriate measures at the margin with more information and understanding of the operation of the sec tor.
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-In developing countries, where the degree of monetization of the economy is generally low and financial intermediation is shallow, liberalization measures alone may not address both financial deepening and monetization of these economies. The main argument in favour of financial liberalization states that interest rate liberalization
' elimination of reliance on inflationary taxes and reduction in credit rationing provide incentives for economie agents to increase their rate of saving and investment. These measures encourage the mobilization of financial saving and improve the efficiency of investment by allocating financial resources for the most productive sector and borrowers
Thus, the McK.innon-Shaw model posits that a more liberalized financial system will induce an increase in saving and investment and therefore promote economie growth.
The McK.innon-Shaw school favours financial liberalization and argues that financial repression in the form of ceilings on interest rates which causes real rates to be negative distorts the econorny in the following ways (Fry, 1997): a low level of interest rates:
I. Encourages individuals to increase present consumption and reduce saving for future consumption below the socially optimal leve!;
II. Causes both an under supply of loanable funds and credit rationing;
III. Generates investment in low yielding projects or in inflation hedges rather than in the accumulation of financial savings, causing investment to be constrained by saving and the choice of capital intensive but less productive projects due to the low costs of funds.
IV. Leads to financing of low risk (and therefore low yield) projects since the financial institutions (Fis) are barred from charging the high risk premium associated with high return projects.
In addition, a low leve! of lending rates causes under-investment in the collection of information about projects or borrowers. The govemment can further distort the financial market by offering relatively high rates on governrnent bonds in order to borrow money
from financial institutions; this government borrowing crowds out private borrowing or investment (Schreft and Smith, 1997).
The central argument by McKinnon (1973) and Shaw (1973) is that financial repression which involves indiscriminate distortion of financial priees by the government reduces the real rate of growth and the real size of the financial system relative to non financial magnitudes (Fry, 1997). Their claim is that a repressed financial system interferes with market mechanism in the allocation and mobilization of financial resources in various dimensions. For instance, in a financially repressed economy, the real interest rate on saving is negative and the volume of financial saving is low. Financial intermediaries that collect savings do not allocate the resources efficiently among competing uses and firms are discouraged from investing because of unattractive investment policies which reduces returns on investment or make them excessively unstable.
The structuralist paradigm maintains, however, that deregulation of interest rates; a concomitant part of any financialliberalization package raises the cost of borrowing and therefore, at least in the short-run, may lower economie growth. They pointed out that financialliberalization always induces a vicious cycle of stagflation, qui te different from neo-classical perspective. They argued, the availability of loanable fund will decrease with high interest rates after liberalization programme and thus economie growth will be retarded (Taylor, 1991).
The liberalization measures, also, tend to increase financial fragility and susceptibility to exogenous shocks over which domestic policies have limited control (Demmiriguc-Kunt and Detriagiache, 1998). These features necessitate putting in place sound regulatory and supervisory measures and their effective enforcement to reduce, if not to elimina te, crises in the banking and financial institutions. The main challenge of the reforming countries is developing a dynamic risk management system that identifies opportunities and assesses risks as well as providing early wamings signal to prevent financial sector vulnerabilities to excessive risk.
FIGURE 3: SA VING AND INVESTMENT UND ER FIN AN CIAL REPRESSION
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e common element in the Mckinnon -Shaw is discussed in the diagram presented e ow:
REAL
INTEREST RATE
INVESTMENT SAVING
In the diagram (Figure 3), the vertical axis represents real interest rate while the horizontal axis represents investment. Saving, S (Y1) at income level Y1 is a function of real rate of interest (McKinnon, 1973; Shaw, 1973:77). The line F represents financial repression, signifying administratively determined nominal bank lending and deposit rates which hold the real rate of interest below the equilibrium level r,. · At this point, actual investment is limited to 11, which i.s equal to the amount of saving at the real interest rate r1• A rise in the interest rate ceiling from F to p* (i.e. from r, to rz) raises
savings and investment. It also rations out low yielding investments which are no longer profitable at the higher interest rate r2. Accordingly, the average efficiency of investment also rises. The level of incarne increases in this process and shifts the savings function to S (Y2).
The policy prescription m the Mckinnon and Shaw model is therefore to ra1se institutional interest rates or reduce the rate of inflation. The optimal result is to abolish interest rate ceilings to induce investment and raise further the average efficiency of investment. This is the concept of financial liberalization which emphasizes the removal of government ceilings on interest rates and other controls on financial intermediaries, so that real interest rates are kept positive, close to the open market levels, and attractive enough to induce financial savings into the stream of loanable funds. This involves the abolition of mandatory credit to the preferred sectors. Liberalization of the financial sector by eliminating interest rate ceilings and other restrictions promotes economie growth because market determined interest rates induce savings and more efficient allocation of capital.
The main issue of economie development is to se.arch for the major determinants of economie growth. Providing evidence on this causal influence is crucial not only for economists but also for policy makers which are permanently looking for optimal reform decisions tending to promote financial intermediary development. The success of the liberalization policies implemented in each country depends on the level of development ofthe financial sector generally.