Financial Liberalization and Financial Market Development in Developing Countries
There are two conflicting views of financial liberalisation. On the one hand, financial liberalisation strengthens financial development and contributes to higher long-run growth. Alternatively, liberalisation induces excessive risk-taking, increases macroeconomic volatility and leads to more frequent crises. Throughout this paper I will discuss the relationships between financial liberalisation, economic growth, stability, and financial market development, focusing on emerging market countries; specifically India and Mexico in the context of the increasing use of the domestic currency in emerging markets and the issue of access to finance.
Financial liberalisation is broadly defined as the removal of government intervention from financial markets, with the main objective to build a more efficient, robust, and deeper financial system, which can support the growth of private sector enterprises.
In the last three decades several developed and developing economies have engaged in the liberalisation of their financial systems. This has resulted in a shift in the philosophical underpinnings of economic policies, which previously gave markets a greater role in the development of domestic financial markets (Masci, 2008).
Countries eased bank interest rate ceilings, lowered both compulsory reserve requirements and entry barriers, reduced government interference in credit allocation decisions, and privatised many banks and insurance companies. Furthermore, countries actively supported the development of local stock markets, and encouraged entry of foreign financial intermediaries (Imf.org, 1998).
In several developing countries, financial liberalisation is a deliberate attempt to move away from “financial repression” as a policy to fund government fiscal imbalances and subsidize priority sectors, a move strongly advocated by the work of McKinnon and Shaw (1973). According to McKinnon and Shaw, financial repression can lead to low and often negative interest rates, reduce private financial savings, thereby decreasing the resources available for capital accumulation. From this perspective, through financial liberalisation, developing countries could stimulate domestic savings and growth, and reduce excessive dependence on foreign capital flows. The McKinnon and Shaw orthodoxy on financial repression brought about a shift of emphasis in policy priorities to such an extent that it influenced the thinking of the World Bank and International Monetary Fund (IMF) (Imf.org, 1998).
Financial Liberalisation and Financial Fragility
The positive view of financial liberalisation is clouded by the marked increase in financial fragility experienced by developing countries in the 1980’s and 1990’s. In many cases, for example Chile, the banking sector problems emerged shortly after the financial sector was deregulated.
Financial liberalisation gives banks and other financial intermediaries more freedom of action, thus increasing the opportunities to take risk. This tends to increase financial fragility due to limited liability, further compounded with other forms of implicit and explicit guarantees, and bankers’ appetite for risk is likely to be far greater than is socially acceptable. This may result in Bank insolvency, and the increased risk of systematic banking crises (Imf.org, 1998).
Liberalisation can lead to faster economic growth. However, it can also increase the financial vulnerability of a country, even leading to a financial crisis.
In the 1980’s and 1990’s following widespread financial liberalisations, several emerging market countries witnessed financial fragility and crises. In particular banking sectors around the world were hit by a remarkable number of problems, which erupted in systematic crises, as documented in studies by Caprio (1995) and Garcia and Saal (1998). These experiences suggest that the benefits of financial liberalisation should be weighed against the costs of increased financial fragility (Imf.org, 1998).
The liberalisation of the current account can favour excessive borrowing at both government and corporate level at an initial overvalued exchange rate, which if it cannot be sustained will prompt a financial crisis where excessive borrowing would have to be repaid at a devalued exchange rate. Ultimately, corporate bankruptcies, banking problems, and runs on banks occur, particularly when the rapid credit growth and inflows slow, real growth declines, and real interest rates rise. These problems have been linked to unsustainable fiscal policy and the defence of unsustainable currency pegs with extended periods of high interest rates. Both Glutch and Hutchinshon argue that banking and currency crises, constitute a phenomenon that is concentrated in financially liberalised emerging markets (Imf.org, 1998).
Source: Caprio et. Al. 2003. (Www1.worldbank.org, n.d.)
The graph above illustrates the estimated financial costs of restructuring after selected crises. Costly crises have occurred in Mexico, the East Asian “Miracle” countries, Russia, Brazil, and some Eastern European and African countries as reflected in the graph.
The Mexico experience is a prime example of what can go wrong with financial liberalisation. Pre-reform, Mexico was a classic case of financial repression. The government maintained interest rate ceilings on bank assets and liabilities and controlled lending quotas to what it deemed high priority economic sectors. In the 1980s, Mexico undertook major structural reforms characterised by a drastic opening of the economy, an extensive privatisation program and a major deregulation effort aimed at liberating the financial system. Over a decade later, the use of a predetermined exchange rate to eliminate inflation, combined with very large capital inflows that were intermediated by a weak banking system, generated a situation of exchange rate overvaluation, a vulnerable financial sector and ultimately a collapsed currency. In 1991, as part of the liberalisation process and an effort to raise fiscal resources, Mexico opted to privatize banks. At the time, the privatization was acclaimed as a resounding success, attracting higher prices than predicted. Despite being open only to domestic purchasers, the sale was considered technically well designed and executed. However, the macroeconomic (Tequila) crisis of 1995 took the lustre off this success: loan defaults increased sharply with the collapse of the peso and a rise in interest rates. Failing banks were discovered to have made poor loans under the relaxed regulatory framework, often to politically powerful groups connected to their controlling owners (Edwards, 1996). The Mexican Peso crisis in December 1994 sent shock waves throughout the worlds’ financial communities. The Mexican government was forced to renationalize its failed banks, and clean up their balance sheets at an estimated cost of more than US$70 billion. The government protected the depositors, but taxpayers were left to foot a huge bill, estimated at 18 percent of GDP. The Mexican experience illustrates that privatization in these environments does not always work and often required costly re-nationalizations (Edwards, 1996).
Mexico’s experience with financial liberalisation provides an interesting case for at least two reasons. Firstly, economic theory suggests that financial liberalisation strengthens economic growth. Mexico’s path toward financial liberalisation has been a challenge and includes several failed attempts, which, until recently, prevented the development of its banking sector and limited the growth of financial credit to the private sector, which is necessary for economic development. Secondly, Mexico’s experience can also provide lessons about the effectiveness of aggressive openness reforms targeted at improving competition in the banking industry and at increasing credit to the private sector, namely the elimination of all restrictions on foreign ownership of banking assets in 1997, which allowed foreign banks to dominate the sector (Murillo, 2009).
At first glance, the experience of Mexico challenges the argument that liberalisation promotes growth. However, Mexico did in fact benefit from financial liberalisation, between 1987 and 2000 non-oil exports increased from $12 billion to $150 billion and the share of trade in GDP grew from 26% to 64%. A key shortcoming to the program, is that it was not accompanied by a badly needed judicial and structural reform. A key lesson to draw from Mexico’s experience is that liberalisation is not a smooth process, rather it takes place in boom- bust cycles. Ultimately, crises are the price that must be paid to attain rapid growth in the presence of contract enforceability crises (TORNELL, 2004).
Economic Growth and Financial Liberalisation
Experience suggests that international financial liberalisation can be a mixed blessing. International borrowing helps individual countries smooth consumption and finance productive investment. Foreign investment, particularly foreign direct investment, can facilitate the transfer of technological and managerial expertise. Portfolio investment and foreign bank lending can also contribute to the strengthening of the domestic financial market. Some proponents have argued that, by increasing the rewards for good policies and offsetting with penalties for bad policies, capital flows can promote more disciplined macroeconomic policies (McLean and Shrestha, 2003).
India is an example of a successful liberalizer and demonstrates that moderate and sequenced liberalisation is the safest way to proceed. India gradually liberalisedits financial sector in the 1990s, with particular success in capital markets, while avoiding any major crisis. India’s financial sector was similar to Mexico’s as it was highly repressed prior to the liberalisation process. Using the index in Chart 1, it can be seen that the Indian financial sector was quite repressed until 1980 compared to other Asian economies.
(Gupta, Kochhar and Panth, 2011)
Lack of financial freedom in addition to increasing macroeconomic instability, slowed deposit growth. Most interest rates were administered, and the aim of a plethora of controls was to make funds available for different government programs. The government fixed the exchange rates and there was scarcity of foreign exchange. Neither the current nor the capital account of the balance of payment was convertible. Reforms freed markets and developed underlying institutions, but it has been a gradual process with graded restrictions on foreign entry.
Financial liberalisation was part of a greater reliance on the private sector succeeding the 1991 foreign exchange crisis. Interest rates were raised and progressively freed, bank regulations and supervision were enforced, and nonbank financial corporations (NBFCs) were allowed under easier regulations. Together, these financial reforms aimed to increase investment, “to improve resource mobilisation and to allocate credit to its most efficient uses” (Goyal, 2012).
There have been remarkable benefits of financial liberalisation in India, most noticeably in increased competition and improved efficiency. After a 1991 capital market crisis, regulations were strengthened, listings were liberalised, foreign investors were allowed in, and infrastructure was significantly improved (Shah and Thomas 1999; Nayak 1999).
Source: Reserve Bank of India data.
- CPI. Consumer price index.
- GDP. Gross domestic product.
The chart reflects the growth in bank deposits of nationals and non-resident Indians, as well as the sharp growth in NBFC deposits after 1992. It further illustrates, how large capital inflows, and higher growth have led to low interest rates and better bank performance in the Indian economy (Www1.worldbank.org, n.d.).
The stock, bond, and commercial paper markets became among the most vibrant in developing countries, providing approximately one-fourth of India’s corporate funding from 1992 to 1996 (Reserve Bank of India 1998) with listings increasing from 2,000 in 1991 to over 5,000 (Standard and Poor’s 2003).
Source: Compiled with data from Reserve Bank of India and Securities Exchange Board of India.
Figure 1 demonstrates how the equity market in India has developed since liberalisation in 1991. The number of listed companies on the two indices, the Bombay Stock Exchange (BSE) and the National Stock Exchange of India (NSE) has been rising progressively and stood at 4,921 on the BSE the highest among all global indices, and 1,402 on the NSE by the end of 2008 (Tucker, 2009).
Further evidence of India’s liberal success was the acceleration in annual GDP growth approximately 4-5% percent per annum throughout the 1980s and 1990s, while the Indian economy has continued to grow during the past decade at a rate of 8.5% since 2005.
Although India’s approach to financial liberalisation has served it well, three primary challenges in the capital account liberalisation of India can be identified.
- Fiscal Sustainability: The high and rising ratio of outstanding public debt to GDP with the total outstanding public debt exceeding 80 percent of GDP in early 2000’s.
- Weakness in the administration of justice and the absence of proper bankruptcy law, which, despite efforts at improvement, still contributes to nonperforming loans and limits access to credit.
- The potential vulnerability of the financial sector to capital account crisis as capital outflows are liberalised (TORNELL, 2004).
Financial repression has eased substantially with the deregulation of interest rates and substantial removal of directed credit allocation. It has this paved the way for integration among various segments of the financial system. The removal of financial repression has enhanced the efficiency and potential growth of the Indian economy. Liberalising, strengthening markets and improving institutions and policy form a package. Research has found that only countries with strong domestic institutions, markets and government finances, receive the full benefits from foreign inflows. The cautious and calibrated approach has meant that India’s capital account liberalisation progressed in fits and starts but the net effect is that, over time, the capital account has become increasingly open and India has been rapidly integrating into international capital markets.
India and Mexico’s experiences demonstrate the different aspects to financial liberalisation. On the one hand, financial liberalisation can negatively impact the stability in the banking sector, but it can also spur economic growth. I am in favour of a gradual approach, which involves a cautious and calibrated path to capital account opening, this has certainly served India’s economy well and reduced its vulnerability to financial crises.
My analysis of financial liberalisation has confirmed that macroeconomic stabilization and fiscal discipline, as well as labour market reform, should be initiated before financial liberalisation is implemented. Furthermore, it is imperative that institutional development is emphasised early on in the liberalisation process, whereby strong and independent banking supervision of financial intermediaries should accompany financial liberalisation.
However, strong institutions cannot be created overnight, thus the path to liberalisation should be gradual, and considered in the context of an overall strategy for domestic financial market development. Policymakers should weigh the positive effects of liberalisation on financial development and economic growth carefully against the negative effects of a banking crisis. In this respect, an improper sequence of reforms can lead to banking and debt crises and to disintermediation, thus undoing the potential benefits of economic growth.[bookmark: _Hlk4167316] Research suggests that countries coming from a background of financial repression have greater gains on the front of financial development and growth that surpass the losses from possible financial crises. The “gradualist” approach to reform should be considered on a case-by-case basis, taking into consideration the political economy of the country and to what extent a gradual process of reform can be captured or reversed by those who would suffer most from the financial liberalisation (Masci, 2008).
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