Nine
Financial Repression and Liberalization
Yung Chul Park
1
Introduction
During the past two decades, a growing number of developing countries
have followed a strategy of export-led industrialization in preference to one of import
substitution. In the process, they have made attempts to liberalize their economies by
removing trade restrictions and exchange controls and by deregulating domestic financial,
labor, and other markets. These liberalization efforts have been hailed as a sign that
developing countries have come to accept the liberal economic policies advocated by many
economists.
During the 1970s, however, many countries found it too difficult to
carry out liberalization policies and gave up early on. Some countries in Latin America
pushed on in their liberalization efforts, only to find a decade later that they could
liberalize neither their trade nor the financial regime. These experiences have made other
countries reluctant to embark on any move toward a liberal economy in recent years.
In many developing countries, liberalization of financial markets has
turned out to be much more difficult than deregulation of the trade regime, as it has
complicated macroeconomic control during the transition period by raising real interest
rates. This chapter attempts to investigate why major financial deregulation efforts have
all ended in failure, and why in general it has been so difficult to liberalize the
financial systems in developing countries. At the outset, it should be emphasized that in
many cases the failure may have been caused by external events and the
The author is indebted to Larry Krause for
his many helpful discussions and detailed comments on the first draft of this essay.
333
implementation of inappropriate macroeconomic policies simultaneously
with the liberalization attempt.
This chapter does not address these general issues. Instead, it focuses
on whether some inherent characteristics of the financial sector are inconsistent, or
interfere, with full-scale financial liberalization, and whether there are institutional
and market arrangements inappropriate for deregulation. For this purpose, section 2
discusses the rationale behind public regulation, and more properly, repression, of the
financial sector in developing countries. (The public-good characteristics of the
financial system and the distrust of the market mechanism seem to be the major reasons for
repression.) This section also explains the evolution of economists' thinking on the role
of finance, and the differences in economic performance that led to the accommodation of
liberal financial policies in developing countries in the 1970s.
Section 3 analyzes the consequences of monetary reform, which is a
partial financial deregulation, and also the major attempts at full-scale financial
liberalization in Latin America. This section provides some explanations of why a variety
of monetary reforms were successful while full deregulation met with failure. Concluding
remarks are found in a final section.
2
Financial Repression in Developing Economies
2.1
Public Regulation of the Financial System
The financial system is an economic sector that uses productive
factors to produce the services of a payments system, financial intermediation, and access
to securities markets. It also provides financial products that meet the diverse tastes,
needs, and circumstances of lenders and borrowers. It has its own industries such as
commercial banking, investment banking, and insurance and also a superstructure of
regulatory authority. The monetary system is one of the financial industries.
In most developing countries, open markets for primary securities such
as stocks, bonds, mortgages, and commercial bills are insignificant. As a result, for all
practical purposes, the banking system (broadly defined to include a variety of depository
institutions) governs the financial system and is usually the only capital market
available.[1]
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Financial intermediaries perform the two closely related functions of
processing information and risk (Greenbaum and Higgins 1983). By centralizing the
collection and processing of information, the intermediaries can minimize the resources
used. This cost advantage allows them to provide information about borrowers for resale to
their clients (depositors) at a profit. In this sense, the financial intermediary serves
as a broker. Risk processing, the second function of the intermediation firm, relates to
qualitative asset-transformation. The financial intermediary is able at low transaction
cost to transform large denomination assets, such as bank loans and investments, into
smaller and more liquid ones, such as bank deposits.
The intermediary firm can exploit opportunities for expected profit
because it is able to pay interest rates on its liabilities (such as deposits) that are
lower than the rates earned on loans and investments. This role of asset-transformer
requires the intermediary firm to hold a mismatched balance sheet consisting of short-term
liabilities and long-term assets. The mismatched balance sheet, in turn, requires that the
financial intermediary deal with the risk of interest-rate changes (interest-rate risk),
and the risk of borrower default (credit risk).
Unlike other economic sectors, the financial system has always been
subject to substantial public regulation in both developed and developing countries. Entry
into financial industries requires government charters. The capitalizations, ownership,
types of assets and liabilities, deposit and lending rates, and other activities of the
financial intermediary are governed by regulations and sometimes by law. A natural and
important question arises as to what characteristics and roles of the financial system
make it so unique and different from other sectors that it is the object of public
regulation.
The basic rationale for the regulation of the financial sector rests on
the argument that both the payments system and the public confidence in the financial
institutions and instruments on which the financial system is built bear the qualities of
a public good.[2] Financial intermediaries (in particular,
depository institutions) supply part of the circulating exchange media and are the
institutions through which central bank mon-
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clary control operations are transmitted to the economy at large.
There is a widely accepted view that the payments system is a public good. "The use
of a common monetary unit of account and the adoption of generally acceptable media of
exchange in this numeraire carry important positive externalities," observes Tobin
(1985, 20). Since free market competition by itself cannot achieve and protect these
social benefits,[3] the government should supply the store-of-value
characteristics of a monetary unit of account such as currency and should allow the
banking industry to supply inside money (deposits) as a convenient substitute for
currency. Because unfettered competition among the intermediaries is likely to increase
the probability of bank failure and hence the risks of default and breakdown of the
payments system, banks, it is argued, should be regulated.
There are two reasons why laissez-faire finance may not achieve or
protect the positive externalities the financial system generates. One is that financial
industries, and fractional reserve banking in particular, are inherently unstable and
therefore subject to interruptions and breakdowns. The other is that informational
asymmetries among participants may also leave financial markets vulnerable to market
failure.
There is a common belief that the financial system is inherently
unstable. This instability, which could undermine the safety of the payments system and
generate other negative externalities, may necessitate financial regulation. Two related
reasons for the instability are suggested in the literature.
One reason is associated with the role of banks as asset-transformers.
In a banking industry characterized by a fractional reserve system, liquidity creation
through the transformation of illiquid assets into liquid liabilities gives rise to the
possibility of multiple equilibria, one of which is a bank-run equilibrium (Diamond and
Dybvig 1983). When (for whatever reason) depositor confidence in a bank that is solvent is
lost, all depositors including those who would prefer to leave their deposits in if they
were not concerned about the bank failing withdraw immediately, thereby precipitating a
liquidity crisis. The bank must liquidate all assets, which are sold at a loss. News of
withdrawals could trigger more withdrawals at other banks by contagion, and the run on one
bank could
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lead to the failure of other healthy banks, ultimately causing the
recall of loans and consequently the termination of productive investment.
Another reason for the inherent instability stems from the technology of
intermediation, which requires little specific physical or financial capital. Natural
barriers to entry into the banking industry are small, so adjustments in banking service
output must occur through the entry and exit of banking firms.[4]
This type of output adjustment generates undesirable externalities, as it involves
breaches of contract and hence is considerably more disruptive than output changes by
existing firms.
In an effort to protect the safety and soundness of the payments system,
and to minimize the negative externalities, governments insure deposits, act as lenders of
last resort, and impose other regulations on the banking system. The deposit insurance
system and the lender-of-last-resort function may, however, encourage banks to assume more
risk than they otherwise would. The moral hazard problem associated with these guarantees
provides another justification for public regulation of banks.
The notion of asymmetric information (different information sets for
different individuals) has also been suggested as providing a rationale for the regulation
of financial systems. The asymmetrical information problem is thought to be particularly
serious in rental markets, such as labor, and financial markets where heterogeneous
services are exchanged. For example, buyers of health and other insurance know more about
their health and propensity to be involved in an accident than does the firm that insures
them against those risks. Borrowers usually know more about their capacity to repay and
honesty than do the lenders who accommodate them.
The presence of asymmetric information could result in the failure of
markets. According to Greenbaum and Higgins, the vulnerability of financial markets to
failure owing to informational asymmetries may provide a signaling and screening role for
government to reduce the problems of observability, breaches of contract, and moral hazard
that are likely to be large in financial service markets (1983, 224 25). Because of
informational asymmetries, it is often stressed that for efficiency, the financial system
must be built on confidence in the integrity of both financial instruments and
institutions and trust that financial contracts will be honored and that a legal framework
exists for their enforcement. The
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confidence needed to resolve informational asymmetries is a public
good, and the role of financial regulation is to provide that public good (B. M. Friedman
1985).
Deregulation of financial firms, so that they are free to pay whatever
interest is required to obtain funds and to charge whatever interest is bearable to
borrowers, is certainly desirable on grounds of market efficiency. However, as Milton
Friedman and A. J. Schwartz (1986) point out, it is an open question whether complete
deregulation, or free banking, is desirable or feasible without government restrictions on
banking activities. It is not likely that the market itself will be able to provide a
stable financial system.
What, then, is the solution to this dilemma? The answer seems to be
appropriate prudent regulation of financial intermediaries by such methods as forcing the
intermediaries to keep honest and open books, forcing them to diversify their lendable
resources by limiting exposure to single borrowers, and prohibiting self-dealing.
2.2
Government Control of the Financial System in Developing Economies
The financial sectors in developing countries are not only regulated,
but heavily "repressed," if one uses the terminology of McKinnon (1973) and Shaw
(1973). In many developing economies, governments impose on depository institutions (which
constitute the major component of the financial system) a maze of interest restrictions on
both deposits and loans, reserve requirements, and guidelines for credit allocation. When
inflation is taken into account, bank deposit rates can be highly negative, and hence
provide little incentive for savers to hold their wealth in the form of bank deposits. The
bulk of limited bank credit is rationed and channeled to preferred industries and large
borrowers with real-asset collateral. In response to interest restrictions, both savers
and investors leave the organized financial sector and carry out their financial
transactions through informal unregulated money markets.
Why are the financial systems in developing countries so heavily
repressed? The public-good nature of the system (as discussed above) explains the control
or prudent regulation in part, but there are also several other reasons, unique to
developing economies. Shaw (1973, 92) cites historical apathy to usury, lack of effective
control over the growth in nominal money, and misinterpretation of the role of financial
repression. He also points out that the claim that market forces do not work in developing
countries has also contributed to repressive financial policies.
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Indeed, it is the widely held belief that financial markets are so
imperfect that they cannot be relied upon for an efficient allocation of resources.
Usually, the fragmentation of financial markets between regions and among would-be
borrowers and the oligopolistic financial market structure (characterized by the ownership
of dominant financial institutions by a handful of large businesses) are cited as the
principal factors causing the market imperfections. It is also argued that financial
markets, even if they are competitive and efficient, may "fail" to finance those
projects with the greatest social merits because their private returns are low.
Governments in developing countries intervene extensively in the
allocation of credit, in the apparent belief that without such intervention, credit
allocation would not reflect social and economic priorities, often set by the governments
themselves. In general, when a government assumes the role of the leading sector in
economic development, it is only natural that it should repress the financial system by
controlling interest rates and management of financial intermediaries so as to dictate the
allocation of financial resources in the desired direction.
Efficiency and equity are not the only considerations that lead to
government intervention in credit allocation in developing countries. Markets for labor,
foreign exchange, and commodities are also subject to a variety of imperfections, and are
often as heavily regulated as financial markets. The imperfections in, and control of,
other markets often mandate alternative allocations of resources, and consequently invite
government intervention in credit allocation.
In the absence of markets for primary securities, banks are the only
source of outside financing, and access to bank credit could mean not only expansion, but
the very survival of private enterprises. In setting up an interventionist policy regime,
therefore, government control over the allocation of credit becomes the critical tool for
formal and informal coercion and compliance (Jones and Sakong 1980, chap. 4). Government
authorities do not necessarily have to exercise their controlling power; a mere threat to
cut off the supply of credit is often enough to make private corporations comply with
government wishes. In countries with less than democratic governments, policymakers find
it necessary to retain the credit supply control in order to rein in the large industrial
conglomerates that they may have helped create by providing subsidized credit in the first
place.
While one could make a strong argument that an allocatively neutral
system is neither desirable nor optimal, the heavy emphasis on the use
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of finance as the instrument of government in promoting economic
development may have compromised, or conflicted with, prudential regulation of financial
institutions. Perhaps it is that the need for prudent regulation is not well understood in
developing countries. In fact, developing countries may have more of a problem with banks
failing to keep honest books, being involved in self-dealing, concentrating their lending
among a limited number of borrowers, and committing other improprieties in part because
they are regulated by development planners, not by independent and well-trained bank
examiners. It should be pointed out that oversight of development efforts rests with the
planning agency, not the banking supervisory authorities. Prudent regulation is even more
necessary in developing countries, where government control of financial institutions
often provides the breeding ground for corruption.
2.3
From Financial Repression to Financial Liberalization
During the 1950s and 1960s, there were two lines of thought in the
literature on the relationship between financial variables and real economic activity in
developing economies. The main stream of development economics, heavily influenced by
Keynesian theory, very much ignored the role of finance. The prevailing view then was that
interest rates should be kept at a relatively low level to stimulate capital formation.
This view, therefore, implicitly advocated an expansionary monetary policy as a means of
promoting economic growth in developing countries.
A similar message was carried through in the monetary-growth models that
flourished in the 1960s. In these models, real cash balances were treated as a substitute
for physical capital. Economic agents could therefore satisfy their savings objectives by
accumulating either real cash balances or capital. Inflation, which is a tax on holding
money, would discourage the holding of money and encourage the accumulation of capital.
Given the propensity to save, inflation would then increase the rate of growth of GNP as
it sped up capital formation. Long (1983) argues that the monetary-growth models provided
a rationale for an inflationary policy and the theoretical underpinning to the aggressive,
expansionary fiscal policy that allocated a large share of resources to development
expenditures in the 1950s and 1960s.
In the 1960s, while various development strategies and models ignored
the potential contributions of the financial sector in the development process, a group of
economic historians was examining the historical experiences of financial development to
search for clues that might
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shed light on how finance affects real economic activity (Cameron
1967; Cameron 1972). In a classic contribution, Goldsmith found that as real income and
wealth increase, in the aggregate and per capita, the size and complexity of the financial
superstructure grow. However, he could not determine the direction of the causal
mechanism. The underlying causality is likely to differ from country to country, and
within individual countries from stage to stage in industrialization (1969, 48).
The causality could, in theory, run in both directions. The growth and
diversity of financial instruments, markets, and participants could stimulate savings and
investment, and also improve the allocative efficiency of the economy. Through these
channels, financial growth could contribute to economic development. On the other hand,
financial development may simply reflect economic growth whose main causes must be sought
elsewhere. Gerschenkron (1962) was one of the early writers to emphasize the major role of
banking in the process of industrialization. Examining the historical experiences of
Central Europe, Germany, and Russia, he argues that the banking system, or broadly the
financial system, could play a key role at certain stages of economic development, as it
serves as the prime source of both capital and entrepreneurship.
The leading role of financial intermediaries was further elaborated by
Patrick (1966) who developed the hypotheses of supply-leading and demand-following
finance. The demand-following phenomenon implies that as the economy grows, it generates
additional and new demands for financial services, which bring about a supply response in
the growth of the financial system. In opposition to this passive financial response,
Patrick suggests, the creation of financial institutions and the supply of their financial
assets, liabilities, and related financial services in advance of demand for them could
not only accommodate but also induce growth by generating incentives to savers to increase
their rate of savings and to entrepreneuers to invest more. Emphasizing the relevance of
the supply-leading hypothesis in the earlier stage of economic development, Patrick
advocates realistic interest policies and the promotion of the efficiency of financial
intermediation through private market mechanisms in developing countries well before
financial liberalization became a new orthodoxy.
Inflationary development policies did not help promote capital formation
or economic growth in many developing countries in the 1960s. Nor did the inward-looking
development strategy. In fact, many developing countries that adopted import-substitution
strategies, in which trade flows were restricted and financial prices (including interest
rates
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and exchange rates) were distorted, witnessed a marked slowdown in the
real rate of growth and suffered from a high rate of inflation and balance-of-payments
difficulties.
In sharp contrast, countries that undertook trade liberalization and
monetary reform aimed at encouraging the holding of financial assets by paying positive
real interest rates were successful in stabilizing their economies while sustaining rapid
growth. Brazil, Taiwan, and Korea are examples of renewed growth by following an
outward-looking development strategy. The experiences of these countries, together with
historical case studies of financial development, led to a rethinking of finance and
growth that by the mid 1970s culminated in a general acceptance of monetary reform and a
move toward financial and overall economic liberalization in developing countries.
As Sjaastad (1983) and Edwards (1985) point out, the economic
liberalization that swept the Southern Cone countries Argentina, Chile, and Uruguay during
the 1970s was a clear reaction to the failures of the preceding economic philosophies,
which had replaced the allocative function of the price system with that of
redistribution. Pervasive government intervention, distorted relative prices, and
restrictive trade and financial regimes were blamed for poor economic performances, which
in turn set the stage for overall economic liberalisation.[5]
Finally, there was the rapid pace of financial deregulation in advanced
countries, which undoubtedly helped sustain the momentum for financial liberalization in
developing countries. During the 1970s, the high and variable rate of inflation, coupled
with financial and technological developments, provided strong incentives for financial
innovation. This eventually led to a rapid pace of financial deregulation and dramatically
changed the nature of the financial sector in advanced economies. The process of financial
innovation and deregulation in the United States, the United Kingdom, and other developed
countries appears to have strengthened the position of, and given more confidence to, the
supporters of financial liberalization in developing countries.
3
Consequences of Monetary Reform and Financial Liberalization
3.1
Monetary Reform
McKinnon (1973) and Shaw (1973) were the two most influential
economists in advancing the cause of financial liberalization in the early 1970s. They
provided a theoretical basis for, as well as empirical evidence of, the benefits from a
liberal financial regime in developing countries. Combining a number of national
experiences, including those of Brazil, Korea, and Taiwan, McKinnon (1973) develops a
framework in which a monetary reform an exogeneous increase in bank deposit and lending
rates close to an equilibrium level is shown to be conducive to a high rate of capital
accumulation and economic growth through financial deepening.[6]
In most developing countries the insignificance of institutionalized
markets for primary securities implies that the financial instruments for saving in these
countries are limited to currency, demand, and time and savings deposits, the sum of which
is often defined as broad money or M2 . According to McKinnon (1973), an
increase in the nominal interest rate on time and savings deposits controlled by the
monetary authorities would induce savers to increase their rates of saving, because the
increase means a higher rate of return on savings adjusted for the risk, convenience, and
liquidity of savings instruments.
After interest-rate reform, more investment resources will be allocated
through the banking system than before. This is because in response to the higher rate of
return to savings, owners of wealth are likely to save more in terms of M2 (a
flow effect) and also move out of inventories, precious metals, foreign currencies, and
lending to informal credit markets; the liquidity thus generated will flow into bank
savings deposits, which become more attractive saving instruments than before (a portfolio
shift effect). Assuming that banks have scale economies in collecting and processing
information, they will be more efficient in seeking out borrowers with investment projects
yielding high real returns. Since investment opportunities with high yields abound in
developing countries, the high real cost of financing would not discourage, but
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rather stimulate, investment through a greater availability of credit.
Interest-rate reform thus has the effect of enhancing growth both by increasing the
savings ratio and by reducing the capital-output ratio (Long 1983).
The effect of an exogenous increase in the real interest rate on
savings, which can be either positive or negative in theory, is essentially an empirical
issue.[7] The economics literature abounds with empirical studies
examining the relationship between saving and a variety of measures of the real rate of
interest. Fry (1978, 1980) shows empirically that for a sample of developing countries,
saving is positively affected by real deposit rates of interest, as is real M2
demand. However, many other empirical studies find that the impact of real interest rates
on saving is negligible, though all of these studies are subject to theoretical and
estimation problems of one kind or another (Mikesell and Zinser 1972; Giovannini 1983).[8]
While the interest sensitivity of saving remains a controversial
empirical question, others have emphasized the efficiency gains from the high interest
rate policy (Patrick 1966; Galbis 1977). Improvements in the process of financial
intermediation, such as those brought about by higher real interest rates, could result in
a high rate of economic growth because they help shift resources from low-yielding
investments to investments in the modern technological sectors. This efficiency
improvement is claimed to be sizable in developing countries where disparities in the
rates of return to capital are wide and indivisibilities of physical capital are
substantial.
The validity of this argument rests, of course, on the assumption that
banks have a comparative advantage in gathering and analyzing information on alternative
investment projects. This may not always be true, however. As McKinnon himself points out,
banks may have little
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experience in identifying borrowers who can pay high real interest
rates on their loans (1981, 383).
There are also more serious problems than the lack of experience in
credit allocation among bank officers. In the absence of asset portfolio regulations,
banks could utilize the increased availability of credit to finance consumption rather
than investment spending.[9]
In countries where informal credit markets are extensive and efficient,
high deposit rates could result in an overall credit contraction. This is because high
deposit rates induce a shift of resources out of informal financial markets with no
lending restrictions and into the organized banking sector where reserve requirements and
credit ceilings are strictly enforced (Taylor 1983, 197). Improvement in efficiency hinges
critically on who controls the banking system. In many developing countries financial
markets are dominated by a few oligopolistic commercial banks, which are often connected
with large industrial groups through ownership or management. These commercial banks often
channel a large share of their resources to the firms with which they are affiliated (Long
1983). Given these market distortions, high interest rate policies may not result in any
improvement in the allocation of credit, because the banks could simply supply more
credit, after a monetary reform, to large industrial groups that are favored clients at
the banks but not necessarily efficient.
A monetary reform can invite greater direct government involvement in
credit allocation, as it did in Korea, unless it is accompanied by a relaxation of other
regulations governing bank-asset management. Insofar as the government has a strong
inclination to intervene in resource allocation, the increased availability of credit,
which means an allocation of more resources through the banking system than before, will
persuade policymakers of a greater need to tighten their grip on the banking industry. The
effects of a monetary reform on the autonomy of the financial system could be more
negative than positive.
3.2
Financial Liberalization
According to Shaw (1973) and McKinnon (1973), monetary reform is a
step toward a fully liberated financial sector and should be distinguished from full
financial liberalization. No country, developed or developing, has ever attempted to
establish laissez-faire finance. Beginning in the mid 1970s, however, the Southern Cone
countries of Latin America
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(Argentina, Chile, and Uruguay) embarked on a course of extensive and
radical economic liberalization. The important element was financial deregulation in which
state-owned financial intermediaries were privatized, interest rates were freed to be
determined in financial markets, controls over banks' asset management were lifted, and
foreign banks were allowed to operate in domestic financial markets.
As noted in the preceding section, a variety of monetary reforms are
claimed to have succeeded in a number of developing countries in the 1960s. McKinnon and
Shaw suggest that if a monetary reform (a partial liberalization) can mobilize domestic
savings and allocate them to efficient uses, as has been claimed, full financial
liberalization may produce the optimal result of maximizing investment and further raising
the average efficiency of capital investment.[10] Contrary to this
expectation, the financial liberalization efforts of the Southern Cone countries ended in
renationalization of banks, reimposition of banking regulations, and chaotic financial
markets. Because of their radical nature and traumatic results, the liberalization
experiences of the Southern Cone countries have generated a great deal of research
interest and subsequently produced a voluminous literature (which is still growing) on
just what went wrong in these countries.[11] In this section an
attempt will be made to identify some of the characteristics of, and institutional
arrangements in, the financial sector that doomed the liberalization efforts. It will also
be argued that the success of monetary reform does not necessarily imply a similar success
of full-scale financial liberalization.
The economic liberalization in the three Southern Cone countries was
undertaken from an exceedingly difficult situation, characterized by serious inflation,
unemployment, and current account problems. Not surprisingly, economic liberalization was
pursued simultaneously with a stabilization program. Consequently, it is difficult to
determine the extent to which liberalization efforts should be held responsible for the
failure. Sjaastad (1983) and Edwards (1985) argue that the economic crises all three
countries encountered in the early 1980s did not arise from trade and financial
liberalization, but from the implementation of stabilization programs. They are in a
distinct minority. Most other observers claim that economic liberalization in particular,
misguided financial
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deregulation in an undisciplined manner played a major role in
determining the magnitude of the crises in all three countries.
A careful reading of the available studies on the Southern Cone
experiences of economic liberalization in the 1970s suggests that financial deregulation:
(1) complicated macroeconomic management, inasmuch as it created
incentives for destabilizing behavior on the part of banking firms;
(2) did not help mobilize domestic savings despite a marked increase in
real interest rates to over 3 percent per month and diversification of financial
instruments;
(3) did not help establish competitive market structure in the financial
sector, but instead resulted in the domination of financial intermediaries by large
nonfinancial economic groups;
(4) did not produce efficiency gains, partly because of distortions in
credit allocation associated with (3); and
(5) dried up long-term finance.
One lesson to be drawn from the Southern Cone experience is that banks
and financieras (expanded finance companies) do not always intermediate between savers and
investors as is widely perceived in the financial literature, but sometimes transfer net
savings of one group to finance consumption of other groups. During the deregulation
period, Chilean banks and financieras actively competed with retailers and department
stores for customers seeking consumer loans. In Uruguay the increased availability of
credit from financial intermediaries went to finance consumer credit, with the consequence
that consumer credit as a percentage of commercial bank credit rose from 4 percent two
years earlier to 12 percent in 1981 (Hanson and de Melo 1985).
In all three countries, it appears, the financial intermediaries were
active in financing the purchases of imported consumer durables by making credit available
for such purposes. Unregulated, financial intermediaries knowingly or unknowingly can
easily be drawn into speculation in real estate, commodities, and stock. The subsequent
increase in asset prices stimulated consumption spending in Chile, as it implied an
increase in private wealth (Harberger 1984).
Financial deregulation produced an undesirable effect in that it dried
up long-term finance in the three countries. Even at the height of the financial boom,
maturities of both deposits and loans at the banks were less than six months
(Diaz-Alejandro 1985). In the meantime, savers became increasingly sensitive to changes in
interest rates, and more receptive to new kinds of instruments yielding higher rates of
return than the
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existing ones. On the other hand, private firms were hardly in a
position to finance their fixed investment at a real interest cost of over 3 percent per
month. Simply to avoid bankruptcy and ride out the rough period in the hope that interest
rates would eventually come down, they continued to borrow at the short end of the market
and had their short-term loans rolled over. Given the high variable real interest rates,
banks, in order to avoid the default and interest rate risk, did not want to make any
long-term loans. Banks had the incentives to match the maturities of their assets and
liabilities. In the process, they became less like financial intermediaries and more like
finance companies and securities brokers.
While these undesirable consequences of financial deregulation were
serious enough, most analysts of the Southern Cone experience point out that the
undisciplined behavior of financial intermediaries was critical in bringing down the
entire liberalization program (Diaz-Alejandro 1985; Harberger 1984; Corbo and de Melo
1985).
At the center of the controversy lie the moral-hazard consequences of
financial deregulation, a universal problem inflicting the financial system with a
deposit-insurance system. When deregulated, financial intermediaries did not behave in the
prudent manner expected of them either in Argentina, which had a deposit-insurance system,
or in Chile, which did not. The harshest indictment of the financial deregulation comes
from Harberger (1984): "Chile could well have avoided the problem that started in
mid-1981 had the banks been better regulated" (249). "I think that the biggest
mistake of the policymakers ultimately lay in overlooking the need to keep the banking
system under a strict discipline" (248).
During the liberalization period financial intermediaries in both Chile
and Argentina took excessive risks and extended too many bad loans, and the insurance
system, as the argument goes, was the major cause of their irresponsible behavior. Over
time, these institutions accumulated a large stock of nonperforming loans. Instead of
writing off these loans as bad debts, they rolled them over and let interest rates
accumulate along the way, thereby increasing their bankruptcy probabilities (Harberger
1984).
With the rapid accumulation of nonperforming loans and the subsequent
profit squeeze, some of the intermediaries experiencing financial difficulties began to
offer higher interest rates to compete for new deposits, which were needed to make up the
shortfall on interest payments to depositors. They were able to attract new deposits,
because
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depositors were hardly concerned about the insolvency possibility of
these institutions because payment of their deposits was guaranteed by the government
(Fernandez 1985; Corbo 1985). The competition among intermediaries for deposits was in
part responsible for a high real interest rate in excess of 3 percent per month during the
latter part of the 1970s in Chile.[12]
Early in the deregulation process, some banks in Argentina and Chile ran
into trouble and had to be liquidated. Practically all depositors were rescued in
Argentina, and even though there was no institutionalized insurance system in Chile, the
government was forced to bail out the insolvent banks by taking over their bad debts. The
bailout sent out a clear signal to domestic residents as well as foreign banks that the
government would in the end assume the nonperforming loans of financial intermediaries.
With this implicit guarantee, foreign banks became more aggressive and at the same time
less stringent in extending loans to these countries (Harberger 1984). Domestic firms took
the government's bailout operation as a sign that the government would in the end
socialize their debts and began distress borrowing (Fernandez 1985).
A disturbing question, then, is why the banking institutions did not
write off the bad loans instead of accumulating them. The moral hazard is one reason, but
there are other explanations. One, pertaining to the Chilean case, points out that writing
off the loans would have meant a loss in banks' competitiveness. The reduction in capital
and surplus that is inevitable with writing off bad loans automatically reduced the legal
limits on lending, deposits, and borrowing from abroad, which were expressed as multiples
of capital and competitiveness. These legal limits made banks extremely reluctant to
dispose of their bad loans (Harberger 1984).
Another explanation finds fault with the pace of financial deregulation,
which in all three countries, may have been too rapid and abrupt for banking institutions
to adjust to new market arrangements. Bank managers and officers under government
ownership and control had seldom been guided by profit motive in their management, had had
little
349
experience in, or for that matter reason to, seek out creditworthy
borrowers, and had not established any efficient procedure for evaluating loan
applications and supervising credit use. When they plunged into free competition, it was
not altogether clear whether the officers of the newly liberated financial intermediaries
were prepared or trained to withstand the rigors of the competitive market.
A third explanation focuses on the large share of nonperforming loans in
the asset portfolios of many of the denationalized or decontrolled banks in both Chile and
Argentina even before the liberalization began.[13] As Harberger
(1984) notes, hundreds of Chilean corporations that had been in the hands of the
government were generating substantial losses and were on the verge of technical
bankruptcy around the mid 1970s when they were denationalized. At that point, the Chilean
banks began to pile up a stock of bad loans. With this past legacy, Chilean banks were in
a disadvantageous position to compete for deposits with the newly established
intermediaries, such as financieras after the relaxation of the entry barriers. These old
banks were paying very high market rates on all deposits while incurring large losses on
nonperforming loans. For the survival of these institutions, the government should have
taken measures to relieve the banks of this bad debt burden before proceeding to a rapid
liberalization.
Many corporations in government hands in both Argentina and Chile before
the economic liberalization was set in motion were in a very weak financial position, and
a reasonable assumption would be that the banks under government control were directed to
support these unhealthy firms by making generous amounts of credit available at a
subsidized interest rate. A large part of the loans extended to the troubled firms
eventually became nonperforming. Consequently the governments in both countries bore some
responsibility for the accumulation of bad debts. Financial deregulation did not absolve
the economic authorities from their past mistakes.
Furthermore, it was not clear who should be held accountable if and when
those loans made by the government became nonperforming. As long as this ambiguity
remained, it appears, banking institutions were less inclined to dispose of the bad loans,
since they could always blame the government for their problems with bad debts and ask for
assistance. Thus the past legacy of government intervention in credit allocation
350
was an important source of, and at least aggravated, the nonperforming
loan problem that eventually led to banks' bankruptcy.[14]
A fourth explanation, which is the most important one from the
perspective of this chapter, blames the close association of financial intermediaries with
nonfinancial firms. In my view, the control of banks and financieras by a few industrial
conglomerates was primarily responsible for the lack of discipline in the banking industry
in the Southern Cone countries. To further substantiate this point, a typical case of the
interpenetration of economic and financial power in developing countries, and how this
acts as a constraint on financial liberalization, will be sketched.
The real sector of many developing economies is often dominated by a
limited number of industrial groups and large public enterprises. Since they account for a
large share of total output, a large part of bank credit is then allocated to these groups
and enterprises. Because of the limited availability of equity financing and subsidized
low interest rates, large corporations rely heavily on bank credit financing, and hence
are highly leveraged.
As noted before, economic liberalization is usually undertaken in a
crisis atmosphere, when the rate of inflation often exceeds several hundred percent a
year, and industrial capacities are underutilized and layoffs are widespread. This means
that the large industrial groups and public enterprises are also experiencing financial
difficulties, so that the banks that extended credit to these corporations will also find
themselves in a weak financial position. Most likely, the banks will start accumulating
bad loans.
Suppose financial deregulation is undertaken under these difficult
circumstances. As part of the deregulation, the ownership or management control of the
banks is turned over to the private sector. An important question in this regard, then, is
who, in the end, will control these banking firms? Private investors will find that bank
shares are not a very attractive instrument for their savings because of the poor
financial condition of the banks. On the other hand, large industrial groups and
corporations will be very anxious to acquire a controlling interest of at least one bank,
because they know that those who control the banks will also control themselves.
351
In denationalizing, governments in developing countries lay down a
number of restrictions designed to prevent industrial groups from gaining control of the
banks by limiting bank stock ownership. Despite all sorts of stringent ownership
regulations, the large conglomerates find ways, mostly through cross ownership
arrangements, in which they can control the management of the banks.[15]
Once they take over the institutions, they start using the banks as a private means for
mobilizing resources. It is therefore not surprising that as long as these groups are
borrowing just to remain in business, the banks will be forced to support them at any
cost.
The moral hazard associated with deposit insurance and bailout was
certainly a factor contributing to the imprudent bank behavior during the deregulation
transition period in Argentina and Chile. However, it is debatable whether better
regulation of bank activities would have mitigated the problem as long as the banks were
controlled by a few industrial groups and conglomerates, in particular when these groups
believed that the government could not afford to let them go bankrupt.
Freer entry into financial industries is not necessarily a solution to
the concentration problem. As noted in the preceding section, completely free entry may be
undesirable for the stability and soundness of the financial system. Even when new banks
and other intermediaries are chartered to promote competition in financial markets, the
government must establish and enforce certain ownership regulations to ensure a wide
dispersion of the stocks of the new institutions. Otherwise, it is likely that these new
institutions will also be taken over by the industrial conglomerates that control the
other banks and intermediaries.
An interesting question arises at this stage of discussion. Why did
major financial liberalization efforts meet with failure, whereas partial deregulation
monetary reform has succeeded, or at least has not resulted in a breakdown of the
financial system?
In developing countries, money is the most attractive instrument of
private wealth accumulation because, as McKinnon points out, it is a means of payment
sanctioned by the state. McKinnon is also right in saying that financial instruments other
than money cannot be easily
352
marketed, because lenders know little or nothing about either the
honesty or the repayment capability of potential borrowers in developing economies a case
of market failure owing to informational asymmetries (1973, 38). Money is a riskless asset
because economic agents believe that their deposits are insured regardless of whether
there is a formal insurance system or not, and that the government will bail out banks
when they are in trouble. Perhaps, as Diaz-Alejandro (1985) notes, they may know that
domestic political and judicial systems are not compatible with laissez-faire finance.
More important, however, is the fact that government intervention in credit allocation
carries with it an implicit promise that the government will protect depositors from the
risk of bank default.
A liberal reform will not make marketing of nonmonetary financial assets
any easier than before (remember that the problem is informational asymmetries and
uncertainty), but it could impair the viability of the payments system and will reduce the
value of deposits as an attractive financial instrument. That is, the efficiency gains
from liberalization may be partially or fully offset by the loss of the value of deposits
as an instrument of capital accumulation. If the government authorities retain the
deposit-insurance system and lender-of-last-resort function, a full-scale financial
liberalization will most likely produce serious moral hazards and other problems. This
seemingly unavoidable trade-off between efficiency gains (if they could be realized, that
is) and safety of the payments system associated with financial deregulation may explain
why the success of monetary reforms does not ensure a similar success of full-scale
liberalization efforts.
4
The Importance of Financial Markets and the Order of Economic Liberalization
In most developing countries, the financial system is hardly the only
sector that is regulated. Virtually all markets including the foreign exchange, labor, and
commodity markets are subject to a maze of controls that vary in the degree of severity
and enforcement. If the policy objective is to liberate all of these controlled markets,
one must ask whether all markets can, and should, be liberalized simultaneously and
immediately, or whether individual markets should be decontrolled in a predetermined
sequence gradually over a period of time. Because economic theory tells us very little
about optimal transition paths, analyses of the order of liberalization have been
empirical and unavoidably judgmental.
353
While one could make a strong case for an immediate and simultaneous
liberalization on theoretical as well as practical grounds (Krueger 1983), it appears that
an immediate full liberalization of all markets is neither feasible nor desirable because
of the existence of externalities, market imperfections, adjustment costs, and other
political constraints. If, indeed, total and simultaneous removal of all controls is not
optimal, then questions arise as to the chronological order in which individual markets
should be deregulated, the speed at which controls should be dismantled, and the welfare
effects of partial liberalization.
Concerning the timing issue, many economists would agree that trade and
financial liberalization should proceed in stages rather than all at once. The celebrated
Chilean trade liberalization in the 1970s took almost six years to bring down the average
tariff rate to 10 percent in 1979, from 94 percent in 1973. In order to minimize
adjustment costs and certainly to placate domestic opposition, it would be desirable to
preannounce and carry out on schedule a trade liberalization program so that exporters,
importers, and producers of import-competing goods could restructure their investment and
production.
As for financial deregulation, entry of new financial intermediaries
should be gradual and deposit rates must be deregulated slowly, though lending rates could
be freed immediately. If the financial system were deregulated suddenly and completely,
new entrants into financial industries would offer rates of interest higher than those
paid by existing institutions such as banks in order to compete for deposits.
Consequently, they would force the existing banks to pay market rates on all deposits (old
as well as new), notwithstanding that the existing banks earned market rates only on their
new loans. As a result, the existing banks would incur substantial capital losses on
existing assets, which would have to be borne by the owners of the banks. If the capital
loss were large relative to the net worth of the banks, bankruptcy might result (Mathieson
1980). Meltzer (1985) therefore advocates gradual deregulation of the financial sector.
In general, given the existence of other controlled markets that are
interrelated, it is impossible to determine whether removal of distortions in a single
market will enhance welfare. However, Krueger (1983) argues that liberalization of any
market is likely to be welfare-improving, except for liberalization of the capital account
and agricultural prices when the exchange rate is overvalued in a country that has a
comparative advantage in tree crops.
354
The sequencing of individual market liberalization for an optimal
transition to a fully liberalized economy is also a complex issue, as it has welfare as
well as macroeconomic implications. Although the sequencing issue has been raised only
recently, there appears to be a consensus among economists that the capital account should
not be opened up until current account transactions and domestic financial markets are
deregulated. One of the main reasons for cautioning against opening the capital account
has to do with the destabilizing capital flows triggered by the liberalization, which have
in many countries led to a real exchangerate appreciation or depreciation that complicates
macroeconomic policy management. On the other hand, opening the capital account at the
very end of a liberalization program can be justified on theoretical grounds. Krueger
(1983) and Frenkel (1982) suggest that trade liberalization prior to the opening of the
capital account is preferable on welfare grounds. That is, either sequence will entail
welfare losses, but the loss associated with liberalizing the current account first is
likely to be smaller.[16]
Another argument emphasizes the difference in the speed of adjustment in
the asset and commodity markets. The speed of adjustment is much faster in financial
markets than in commodity markets. Financial asset portfolios are flexible and portfolio
decisions can be easily changed, whereas because of time lags, the structure of
production, investment, and trade adjust slowly to new arrangements. Therefore, if the
capital account is opened first, portfolio decisions are likely to be consistent with the
undistorted condition in the long run, whereas because of trade restrictions, real
investment decisions will be distorted. Once the trade account is liberalized, the real
investment decisions will be reversed. Since the faster speed of adjustment in financial
markets to new information means that the financial adjustment will have at most a
temporary effect on the production and investment structure, it is easier and cheaper from
a social point of view to reverse wrong portfolio decisions than real investment
decisions. Thus, it follows that the real side of the economy should be liberalized first.
Such an order of liberalization
355
also has the virtue of providing policymakers with the opportunity to
observe the market's reaction and to correct policy mistakes that are bound to arise.
Both welfare considerations and the difference in the speed of
adjustment suggest that the real and financial sectors of the economy should be separated
in any market liberalization. Furthermore, they suggest that the real side of the economy
should be decontrolled as quickly as is consistent with other major social objectives, and
that the capital account should be opened up only after trade liberalization.
Analysts are almost unanimous on the trade capital account ordering of
liberalization, but little is known about the appropriate sequencing of the opening up of
the trade account on the one hand and domestic financial deregulation on the other.
McKinnon (1982) seems to argue that domestic financial deregulation should precede the
liberalization of current account transactions. However, the arguments for decontrolling
the capital account at the last stage of the liberalization process suggest that the
desirable ordering may be the opposite.
In what follows, it is argued that both sequencing schemes are likely to
produce adjustment problems with equally serious negative welfare implications. My
conclusion is that it makes little difference a priori whether domestic financial
deregulation is preceded or followed by trade liberalization, and therefore that
developing countries should liberalize whichever sector they find more convenient to
liberalize at the moment. However, it should also be noted that practical considerations
related to macroeconomic policy management seem to suggest that trade-first liberalization
may be safer, and hence preferable.
McKinnon's argument for domestic financial decontrol before trade
liberalization appears to be based on the proposition that "the case for free trade
is dear when the domestic capital market is working freely" (McKinnon 1973, 132).[17] That is, economic arguments for restricting foreign trade become
superfluous and misleading once financial liberalization is under way. Under a liberalized
financial regime, any firm
356
will be able to borrow more easily than before as long as it has good
prospects and tariff revenues are not needed to subsidize new domestic producers. I shall
show below, however, that McKinnon's ordering is not optimal.
Domestic financial markets will adjust promptly to new arrangements
induced by domestic financial deregulation, but the commodity market will send out wrong
relative price signals and will induce real investments in the wrong industries insofar as
the current account remains regulated. In fact, a liberalized domestic financial market
could exacerbate the wrong investment decisions, because now firms with artificially good
prospects brought about by trade restrictions may be able to borrow more easily than
before.
Furthermore, it is not altogether clear whether a liberalized domestic
capital market would throw out correct interest-rate signals. To show this, let us assume
that domestic factor markets are fully liberalized and competitive. In a small open
economy with controlled capital account transactions, however, the existing wage-rental
ratio is likely to differ rather substantially from the one that will be established after
liberalization of the capital account. This is because controls on capital will continue
to distort domestic portfolio decisions and restrict the inflow of foreign capital below
the level that may be most efficient.
The future liberalization of both current account and capital account
transactions will therefore lead to a reversal of investment decisions, inasmuch as
liberalization will change domestic relative prices and interest rates. Once again, it is
difficult to determine whether a domestic financial liberalization in the presence of
trade restrictions and foreign-exchange controls would be welfare-improving.
The preceding argument, however, is not totally convincing. A fairly
obvious point is that a liberalized current account will send out correct relative price
signals but a repressive financial regime could interfere with the expected movement of
resources (triggered by trade liberalization) to the sectors with the highest rates of
return to capital, thereby negating the benefits of freer trade. Financial market controls
credit rationing, interest-rate ceilings, and entry restrictions not only result in an
inefficient allocation of resources, but also interfere with mobility of capital between
industries and sectors.
Financial intermediaries long entrenched in a regulatory environment and
seldom guided by profit motives are often unable to respond to the new incentive structure
produced by trade liberalization. Removal of trade restrictions generates incentives to
shift resources out of
357
import-competing industries and into the exportables sector if it is
accompanied by a real depreciation of the exchange rate. However, export industries are
new, investment in these industries is often perceived to be subject to high risks, and
new exporters often do not have viable credit records or collateral. For these reasons,
and because of simple inertia, the controlled financial intermediaries may be unable or
unwilling to finance the new investment projects in the exportables sector, and as a
consequence could not facilitate the sectoral resource shift expected of a trade
liberalization. Furthermore, real wage rigidity often restricts labor mobility and results
in massive unemployment when trade restrictions are quickly removed. A regulated financial
system could thus compound a situation that is bad enough already.
Even when financial intermediaries' unresponsiveness to new arrangements
and information is discounted, it is not clear it a trade liberalization will improve
welfare and resource allocation. In developing economies, some industries are protected in
domestic markets, others are given interest and tax subsidies, and still others are
favored by financial institutions in credit allocation. In a financially repressed regime,
where banks are often the major source of industrial financing, access to bank credit
could be critical for both a firm's expansion and its survival.
Preferential treatment in credit allocation is an immeasurably valuable
subsidy, which cannot easily be quantified. Elimination of some distortions through trade
liberalization will therefore end up favoring some industries and discriminating against
others more than before, and could conceivably increase the variations in the effective
rates of protection across industries. Hence it does not necessarily lead to a more
efficient allocation of resources.
On the appropriate order of liberalization of domestic financial markets
and the trade account, I have presented a rather obvious argument, but it nevertheless
points to the futility of the market-sequencing discussion. The rationale for liberalizing
financial markets is to allow the allocation of resources taking place through financial
markets to better respond to incentives created elsewhere in the economy.
To the extent that the incentives are wrong because relative prices are
distorted by the trade restrictions, the advantage of financial liberalization, which aims
at developing a more effective set of responses on the part of the financial system to new
information, will be lost. Conversely, a trade liberalization may provide correct
incentives as it removes distortions in the relative price structure. However, a
controlled financial
358
system is not able to better respond to the set of correct incentives,
and thereby does not allow realization of the benefits of free trade.
What conclusions can one draw from the preceding discussion? One
conclusion is that neither the trade nor the financial regime can be deregulated
immediately. Economic and political constraints suggest that liberalization reform can
only be carried out, if at all, in a piecemeal fashion over a period of time in both
financial and commodity markets. Since neither sequencing (trade first and finance later,
or the opposite order) is a priori desirable from the point of view of welfare improvement
and the minimization of adjustment costs, trade and financial liberalization should begin
at the same time, though conceivably allowance could be made for the difference in the
speed of deregulation. If, for whatever reasons, it is not possible to liberate both
regimes simultaneously, it does not in theory make much difference which regime is
decontrolled first. The experiences of Korea and of her countries that have followed an
export-led industrialization strategy suggest, however, that trade-first liberalization is
preferable provided that the government intervenes in financial markets in such a way as
to channel more financial resources to export-oriented industries, as Korea was able to do
in the 1960s.
There are two other reasons why the trade-first sequencing may be
desirable. One, economists do not know enough about how banks and other financial
intermediaries would behave in a laissez-faire environment. In many cases, including the
Southern Cone experiences, financial deregulation has invariably led to high real interest
rates, often above the expected real rate of return to capital. The causes of such an
increase in real interest rates are not fully known. Until we understand more about the
full impact of financial deregulation, caution is in order in liberalizing financial
markets.
Another reason for advocating trade liberalization prior to domestic
financial deregulation is that with a more effective control over monetary aggregates,
economic authorities will be better able to deal with some of the macroeconomic problems
(such as current account deteriorations) that may be brought about by the trade
liberalization. As Krueger (1983) points out, most of the trade liberalization efforts in
developing countries have been undertaken in a crisis environment with a very high rate of
inflation, and have been accompanied by stabilization policies designed to slow down
inflation. The failure of the liberalization programs can largely be attributed to failure
in stabilizing the economy. In view of this experience, the postponement of financial
deregulation
359
may be desirable in the sense that it provides the authorities with
one more effective policy instrument to combat inflation, thereby increasing the
probability of success of the trade liberalization program.
5
Summary and Concluding Remarks
There is considerable empirical evidence showing that developing
countries following outward-looking development strategies and liberal economic policies
have in general outperformed those pursuing restrictive trade and financial policies or
attempting to develop their industries through import substitution. Despite this ample and
clear evidence, a large number of developing countries are still trapped in a maze of
controls over economic activity.
A number of developing countries that attempted to liberalize their
economies in the 1970s had to give up the reform programs shortly after their inception
for a number of economic and political reasons. Some countries managed to push through
liberal reforms, but a decade later they were faced with economic crises of unprecedented
proportions. Discouraged by these experiences, other developing countries have been
extremely reluctant to undertake economic liberalization.
In comparison to trade liberalization, full deregulation of the
financial system has been much more problematic than expected, as it hampers macroeconomic
control during the transition period. The purpose of this essay has been to investigate
why it has been difficult to liberalize financial markets in developing countries, and why
some major liberalization efforts ended in failure. In particular, this essay focuses on
whether there are inherent characteristics and institutional arrangements of the financial
sector that interfere with or limit the scope of liberalization.
In developing countries the financial system is not only regulated, but
heavily repressed. One frequent explanation for the repression is that financial markets
are so imperfect that they do not mobilize resources as much as they should and therefore
do not allocate in an efficient manner. Even when they are competitive, it is argued,
allocations through the financial market conflict with equity considerations. Without
government intervention some sectors receive more financial resources than socially and
economically desirable, while others may be left out of the allocation process.
Unlike other sectors of the economy, the financial system in particular,
the payments system has strong public-good characteristics and
360
carries positive externalities. In general, free market competition
may not be able to realize and protect the benefits of a stable financial system. In this
regard, of particular importance to our analysis is that the banking industry, which
constitutes the main component of the financial sector in developing countries, is
inherently unstable. Without public regulation, the payments system could be subject to
breakdowns and interruptions owing to bank failures.
Financial markets are, in general, vulnerable to failure owing to
informational asymmetries, which again are likely to be more serious in developing
economies. In the absence of state intervention, it is difficult to develop public
confidence in financial institutions and instruments, a critical ingredient for building a
stable financial system. In order to protect the safety and soundness of the payments
system, governments institute deposit insurance systems and also act as lenders of last
resort. These guarantees create moral hazards, thus providing further justification for
regulating the financial system.
A third factor that interferes with financial liberalization is the high
degree of business concentration (a limited number of affiliated enterprises accounting
for a disproportionately large share of all markets), a feature many developing countries
have in common. Eager to sustain rapid growth through the exploitation of such
technological factors as increasing returns to scale, minimum efficient size of firm, and
indivisibilities in production processes, policymakers of developing countries often
allocate a large share of their limited resources to a handful of private enterprises,
thereby allowing the formation of powerful industrial groups. Needless to say, they
account for a large part of the domestic bank credit, and exercise dominant influence in
practically all markets.
As long as these market imperfections in the real side exist, financial
deregulation is not likely to develop a competitive market structure in the financial
system largely because industrial groups usually find ways in which they can control
management and credit allocation of banking institutions even when bank ownership
regulations are strictly enforced.
The concentration problems could easily frustrate financial deregulation
when the deregulation is undertaken from a difficult macroeconomic situation, in which
most business groups will also find themselves in precarious financial situations. When
the banking industry is deregulated, the business groups will make certain that they
secure a controlling interest in the banks, because the credit supply could easily
determine their fate. Once they take control of banks, they will use these
361
intermediaries as private means for mobilizing resources. As a result,
when the large business groups are in trouble, so are the banks. When the groups are
driven to distress financing just to remain in business, the connected banks will pay
whatever interest rates markets will bear to attract depositors.
Relaxation of the barriers to entry into the banking industry is not an
answer to the concentration problem. It has already been established that entry into the
banking industry cannot be completely liberalized. Even when entry requirements are
relaxed, the business groups can exercise their market power to block the establishment
of, or to control, new entrants. Opening the bank intermediation market to foreign
competition will not help mitigate the problem. Foreign bank branches could in fact add to
the instability, since inasmuch as their actions are dictated solely by considerations of
profit, they are freer to move in and out of the market, and could also serve as conduits
for capital flight.
A fourth factor that often constrains financial liberalization is the
use of discretionary credit allocation as a major tool for coercion and compliance.
Because of the critical importance of access 10 bank credit, control of credit allocation
has been shown to be the most effective means of ensuring the compliance of the private
sector with government commands. In general, authoritarian regimes in developing countries
will find the use of credit allocation as a major means of enforcing command irresistible.
Many governments in developing countries have promoted business concentration to achieve
rapid growth by their credit allocation policies. It is indeed an irony that they have to
use credit policy to rein in the business groups they helped create in the first place.
If laissez-faire finance is indeed neither feasible nor desirable, is
there an alternative system? What is needed is prudent regulation of banks on the part of
government in order to strike a balance between competitive efficiency and safety of the
banking system. However, policymakers, who in developing countries have a propensity to
activist development policies, could easily succumb to the temptation of crossing the fine
line of prudent regulation by intervening in credit allocations. In so doing, the
government becomes a public monopoly in the only capital market available, that is. the
bank credit market.
The public-good nature of the financial system may also explain why
monetary reform a partial liberalization has been successful in mobilizing savings and in
allocating them to efficient uses, whereas fullscale financial liberalization has not.
Financial deregulation may succeed initially in inducing savers to save more and also in
terms of financial
362
assets. As the deregulation proceeds further, however, it is at some
point bound to threaten the soundness and safety of the financial system in particular,
the payments system. Once public confidence in the system is eroded and the moral hazard
begins to spread, financial liberalization efforts will in all likelihood come to an end.
Especially when liberalization efforts are made in economically difficult situations, the
moral hazards triggered by the accumulation of nonperforming loans virtually assure
disaster.
In view of these potential problems with financial liberalization, what
is the most effective way of liberalizing domestic financial markets without impairing the
payments system? This chapter argues that there are certain institutional reforms
developing countries should undertake before moving to full financial liberalization.
The first and most important reform is to institute safeguards to keep
large business groups and banks at arm's length from each other, in order to prevent such
groups from dominating the hanking system. The second necessary reform is to separate the
monetary and intermediation functions of banks, as Tobin (1985) suggests. This can be done
by creating several categories of deposit liabilities backed by specific earmarked assets,
one of which is 100 percent reserve deposits at the central bank. Deposit insurance is
then limited to certain other liabilities.
The third reform is the development of nonbank financial intermediaries,
such as mutual funds, trust, finance, and insurance companies, and pension funds, which
could be subject to less government control.[18] Before embarking
on full liberalization of a system dominated by the banking industry, it may be necessary
to invest in developing nonbank financial intermediaries and markets for primary
securities to increase the depth, breadth, and resilience of the system. Liberalization
may begin with these institutions, so that they can compete in, and eventually integrate
with, the organized financial system and informal credit markets. This will build up more
pressure for further liberalization and eventually force deregulation of the banking
sector.
This chapter has also examined whether there is any appropriate order in
which domestic financial deregulation and trade liberalization should be carried out.
While there is no doubt that capital account deregulation should be undertaken, if at all,
at the very last stage of any liberalization program, little can be said about the
desirability of liberalizing domestic financial markets prior to trade liberalization or
vice
363
versa. If, for whatever reason, it is not possible to liberalize both
regimes simultaneously, developing countries are well advised to liberalize whichever is
convenient, because in theory it does not make much difference which is deregulated first.
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