Note: This is a summary of the article “The Scope and Limits of Financial Liberalisation in Developing Countries: A Critical Survey” written by Heather D. Gibson & Euclid Tsakalotos in 1994.
Financial liberalization results in a move towards a more market-oriented system. There are two main components of liberalization: first, allowing interest rates to be determined at the market and second, allowing financial intermediaries to get greater control over their liabilities. There are some common reasons behind financial liberalization. These reasons can be summarized as follows: First, domestic liberalization is considered as part of a general trend towards less government intervention. Second, domestic liberalization is considered as necessary for growing international liberalization. Finally, financial market regulation causes dissatisfaction due to interest rate cartels, bureaucratic procedures, corruption, and so on.
Financial intermediation is very important in the development process. This is because; thanks to financial intermediation, savers and investors come together and also, the payments system of the country improves through facilitation of the usage of national currency instead of barter. The advantages of financial intermediaries can be summarized as follows: First, they reduce transaction costs because savers do not need to seek out suitable borrowers. Second, they increase liquidity through borrowing short term and lending long term. Third, they reduce the information costs because they have an expertise about where to invest and how much to invest. Fourth, they provide diversification through including different types of borrowers. Fifth, they are able to finance large amounts of investment projects. Sixth, they decrease inefficiencies through channeling investments into the most productive areas of the economy. Therefore, it is more beneficial to channel savings into investments via financial intermediaries.
On the other hand, if there is a government intervention through either controlling interest rates or applying credit allocation programs, then financial repression occurs. The regulations for financial intermediation cause some problems. First, informal curb markets (unofficial money markets) become more common. Second, bank deposits become unattractive compared to real assets thus, the role of financial intermediaries is decreased. Third, savings are reduced and as a result, investment and growth are reduced. The theoretical models of McKinnon-Shaw also show the disadvantages of financial repression and state that financial liberalization increases savings and by this way, increases investment and growth. According to McKinnon-Shaw, interest rate ceilings decrease savings, reduce the quantity of investment by creating unsatisfied investment demand, and reduce the quality of investment by encouraging banks to choose low-return projects to avoid high risks. If there are no interest rate ceilings, then efficiency of investment will rise because the investment projects with higher rates of return will be chosen and the rate of economic growth will be higher. As it is understood, McKinnon-Shaw model is based on the assumption that savings determine investment.
Most developing countries apply liberalization during stabilization programs. Stabilization programs try to reduce inflation in the country. However, liberalization results in an increase in interest rates and by this way an increase in capital inflows which undermines the attempt at reducing inflation. Since most developing countries are open economies, the exchange-rate policy of the country becomes vital while undertaking liberalization/stabilization programs.
The experience of South Korea shows that financial liberalization accompanied with positive government intervention has resulted in an economic growth. On the other hand, the experience of Chili shows that financial liberalization in unstable macroeconomic environment has resulted in economic problems. These country examples make it clear that liberalization is not enough at all for success because financial markets are characterized by severe market failures”. Thus, government should take some part in this process also. For instance, there should be a proper supervision over banks so that banks should not take excessive risks which causes moral hazard problem. Also, there should be proper exchange rate policies and macroeconomic stability. Moreover, government should ensure that domestic financial liberalization comes after domestic real liberalization and before external real and financial liberalization.
In conclusion, I totally agree with authors because simple liberalization strategy is not enough for development. Besides applying financial systems reform, it is also crucial to develop appropriate financial institutions in order to reach sustainable development in the long run. Therefore, developing countries should use strategies which integrate both the measures of financial liberalization and development of financial institutions.
On the other hand, according to McKinnon there are two main problems in financial liberalization of developing countries: fragmentation and uncertainty of capital markets. Former affects the economic development negatively by government intervention to help some individuals or sectors of economy at the expense of others; while latter limits the time and quantity of money can be barrowed. McKinnon states that in order to combat these problems “careful monetary and financial policies and a benign view of institutions that facilitate borrowing and lending over time” are necessary.