Why financial liberalization

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Depending on the level of development, a country might be better off postponing financial liberalisation. The conventional view on financial liberalisation posits that countries receiving capital inflows from advanced economies would have better insurance against aggregate shocks and reduced consumption volatility. After the resolution of the debt crisis of the s, many emerging markets turned to financial liberalisation, thinking that it would provide a fast track to development.

However, decades later, the evidence on the effects of this policy is at best mixed. Capital often seems to flow in the wrong direction, the impact on investment and growth is not clear and financial liberalisation seems to have increased both output and consumption volatility. IGC researchers Broner and Ventura revisit the topic of financial liberalisation under a new viewpoint, backed by real-world evidence: the effects of financial liberalisation depend on the level of economic development of the country, on whether it has developed or underdeveloped financial markets, and on whether it has high or low-quality institutions.

The authors argue that the conventional view fails to anticipate the full effects of financial liberalisation on debt enforcement — it ignores interactions between foreign and domestic debt by assuming that domestic debt would be enforced even if the foreign one would not. The main problem with non-discriminatory debt enforcement is that defaults will affect both foreign debt and the domestic one, since defaults will induce domestic savers to send parts or all of their savings abroad.

As a result, financial liberalisation might decrease domestic sources of financing, leading to higher gross capital flows but with an ambiguous effect on net capital flows and overall development financing. Liberalization can lead to faster economic growth.

But it can also increase the financial vulnerability of a country, even leading to a financial crisis. The justification for government intervention in financial markets in the forms of financial repression and direct intervention through public sector banks - based on their assumed market failure- in line with a more or less stringent command economy, is that the government can direct resources to encourage the takeoff of the country and concentrate those resources in sectors and companies that favor economic growth and development.

However, financial repression has several negative effects on economic growth, which McKinnon[16] and Shaw[17], among others, have pointed out:. The expected benefits of financial liberalization—and particularly a liberalized capital account—are the ability to undertake investments in excess of the level of domestic savings which is especially important for Latin American countries with low savings rates and finance economic growth; the technology transfers associated with foreign direct investment; and the increased competition in the financial sector due to the removal of barriers and also as a result of the entry of foreign banks.

Conversely, the abolition of financial repression and the reduction or elimination of public sector banks stimulate competition, and market based allocation of credit, domestic savings, investment, and growth. Therefore, by favoring financial development, financial liberalization increases the long-run growth rate of the economy. King and Levine[18] link financial market development to the insights of Schumpeter[19] about the role of finance in encouraging entrepreneurship.

The process of liberalization also implies that foreign banks can enter the domestic market of an emerging market country by establishing branches as well as acquiring existing domestic banks.

According to the literature, the entry of foreign banks leads to various positive effects, including advances in technology, and ultimately increases competition within the financial systems. The entry of foreign banks, particularly in Latin America, has been beneficial in many respects. In some countries e. However, the expectation that financial liberalization would bring competition and access to finance has not fully materialized also considering that banks tend to lend to known risks and the various international requirements — e.

Financial repression has also prompted a sizable amount of research, which focuses on the role of financial development in giving a lift to economic activity by accelerating productivity, as well as by mobilizing savings.

A large number of empirical studies have been undertaken on the relationship between financial development and growth and they have concluded that the relevant ratios measuring financial market development—e.

Stability and financial crises represent the other side of financial liberalization. Opponents of financial liberalization argue that it would lead to financial crises Caprio and Summers[24]; Stiglitz[25]. The opening of the current account may favor excessive borrowing—at both the government and corporate levels—at an initial overvalued exchange rate e. Glick and Hutchinson[26] argue that banking and currencies crises constitute a phenomenon that is concentrated in financially liberalized emerging markets and does appear to emerge in advanced economies.

In this respect, they suggest that banking crises provide leading information about the possibility of currency crises i. Following the previous literature, Glick and Hutchinson[27] suggest that currency devaluation is a rational policy option to reduce bank runs in a country with a fixed exchange rate; and that bank crises are prompted by moral hazard, financial liberalization that makes foreign borrowing easier, and large macroeconomic shocks, e.

In the s and s, following widespread financial liberalization, several industrial and emerging market countries witnessed financial fragility and crises. In Chile, in , banking sector problems emerged shortly after the financial sector was deregulated. Argentina—a country that had undertaken far-reaching financial liberalization measures—in faced one of the most devastating financial crises in its history. While the predominant view is that financial liberalization—i. Stiglitz[29] argues that endemic information asymmetries in the financial markets will not be solved by financial liberalization.

Stallings and Studart[30] look at the ownership of banks including foreign banks , performance, and institutions—not otherwise defined—and assert that the performance of the banking sector and of public sector banks, particularly in Latin America,[31] depends on the strength of institutions. They argue that the economic and neoliberal reforms—undertaken in South Korea both before and after the crises—have replaced the traditional South Korean model of a state-led, bank-based financial system, leading to financial restructuring with continuous corporate problems and a declining rate of capital accumulation.

An alternative strategy of a reform of state-led, banks-based growth that is thoroughly democratized would have left the South Korean economy better off. This approach is advocated for other emerging market countries.

A number of factors influence the fragility of the financial system, e. Financial liberalization has a negative impact on the stability of the banking sector, and the magnitude of this effect depends on the other weaknesses in the economy, including those mentioned above.

Under these circumstances, a solid regulatory and supervisory environment Stiglitz[34] —particularly for the banking sector—mitigates the effects of financial liberalization, for example, by putting constraints on lending to already-overleveraged corporations and preventing moral hazard.

The legal environment—e. These considerations lead to the policy recommendation that the objective of financial sector development should be pursued following some sequencing see World Bank[35], , chapter In that context, macroeconomic stabilization and fiscal discipline, as well as labor market reform, should be initiated before financial liberalization is implemented. By the same token, strong and independent banking supervision of financial intermediaries should accompany financial liberalization Karacadag, Sundararajan, and Elliott[36].

Given that institutions require time to make effective changes and adjust to them, financial liberalization process should be considered in the context of an overall strategy for domestic financial market development and should be gradual.

Policymakers may weigh the positive effects of liberalization on financial development and economic growth 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 on the side of economic growth.

Financial liberalization is also expected to discipline excessive dependence on foreign capital flows by developing domestic financial markets. Kose and others[39] show that developing countries benefit from financial liberalization with many nuances and that financial liberalization and globalization do not lead to financial crises.

Specifically, the estimation results find that, although growth is the primary determinant of the level of capital inflows, equity market liquidity and financial openness also help attract capital inflows.

Moreover, financial openness is associated with lower capital inflow volatility. These results, which are consistent with the views expressed by institutional investors, point to the advantages of focusing on the medium-term goal of improving the quality of domestic financial markets.

By adopting such a focus, emerging market countries will be in a better position to maximize the benefits of capital inflows while dealing with their potential volatility. The main reason for financial liberalization is to allow market forces to operate and create the conditions for an integrated global financial market, which nurtures a solid domestic financial market.

In fact, capital account convertibility allowed companies and banks to borrow in foreign currency—following the encouragement of lenders who thought they would get out before the crisis struck, if conditions worsened. Most of the banking lending was short term, and the bond market—both for government and corporations—was nonexistent. The crises of Mexico in —95, the East Asian meltdown of , and the subsequent crises in Russia and Latin America i.

These researchers also find evidence that emerging market countries with a higher self-financing ratio e. In the last several years, and focusing particularly on the Latin America and the Caribbean region,[44] there has been a significant improvement of external and internal macroeconomic and fiscal conditions, especially in the management of government debt. Several indicators—external debt service as a proportion of exports or interest payments, public debt as a proportion of tax revenues, public debt as a proportion of GDP—point in the positive direction.

Under these circumstances, and following the lessons of the crises of the late s early s, Latin American countries—like Asian countries—show a strong commitment to develop domestic financial markets in domestic currency with long-term tenure and to increase the self-financing ratio. According to the Bank for International Settlements, domestic bond markets for government debt have grown substantially in selected countries and in Latin America, i. However, several emerging market countries—particularly those that are more advanced—have made substantial progress in developing their domestic government bond markets with longer maturities.

Solid government yield curves—nominal and also liquid—of up to 20 years- exist in many countries in Asia and Latin America e. Overall, as the Committee on the Global Financial System indicates local currency bond markets helps financial stability. Cifuentes, Desormeaux, and Gonzalez and Jeanneau and Verdia[49] offer substantial contributions for the cases of Chile and Mexico, respectively, about the passage from financial repression to more complete financial markets.

Although the excess borrowing of government remains a problem and a significant part of government paper is still short term, the control of inflation, fiscal discipline, and stable and predictable macroeconomic policies represent noteworthy achievements in many emerging market countries.

Vulnerabilities still exist in connection with the significant portion of debt denominated in foreign currencies, and with the large short-term share of public debt.

Also, a devaluation of the domestic currency[50] would prompt an increase in interest rates and in the cost of debt in domestic currency and a decline in the prices of government paper. These vulnerabilities are even more significant if we consider that an increasingly large portion of domestic debt is sold to foreign investors, who would react negatively e. The impact of the increased use of the domestic currency on financial stability deserves increased attention also in relation to the differential treatment that the new Basel II capital establishes for banks with respect to exposure in domestic or foreign currency.

This is also important for the rating agencies, which normally assign better ratings to credits in domestic currency than in foreign currency. Financial strengthening is evident in many emerging market countries and particularly in Latin American countries.

This improved situation derives from the reforms undertaken, especially in the regulatory and supervision environment undertaken at global and national levels, e. Balance sheet and market indicators are positive, and asset quality, profitability, and loan loss coverage improved.

On average, the financial soundness indicators for many emerging market countries are good and comparable to those in industrial economies. For instance, for Latin America, in , nonperforming loans were at the level of 5 percent; the return on assets for banks was 1. Latin America Advanced economies Selected emerging markets In , some of these indicators have improved for selected emerging markets.

Moreover, the interest rate spread—on average—in Latin America and the Caribbean is about 6 percent, while it is 3 percent in Europe and 2 percent in Asia. In addition, the Latin American and Caribbean region has not so far witnessed a solid long-term capital market development in domestic currency, which is much more under way in Asia than in Latin America and the Caribbean.

Several countries still depend on long-term external financing. In turn, this may spin a recession and a deterioration of payments of the public and private sectors, affecting the willingness and ability to pay as well as the ratings assigned. Moreover, a large part of the population in Latin America and the Caribbean does not have access to financial services.

The development of domestic financial currency as a primary source of financing is expected to open lending opportunities for banks, improve access to finance, and have a crucial impact on the improvement of the ability to pay that would reinforce the financial systems.

An advance in this direction would favor the implementation of Basel II[52], generating more efficient financial markets.