Experiences with Financial Liberalization

Experiences with Financial Liberalization

RECENT ECONOMIC THOUGHT SERIES Editors: Warren J. Samuels Michigan State University East Lansing, Michigan, USA William Darity, Jr. University of North Carolina Chapel Hill, North Carolina, USA Other books in the series: Magnusson, Lars: MERCANTILIST ECONOMICS Garston, Neil: BUREAUCRACY: THREE PARADIGMS Friedman, James W.: PROBLEMS OF COORDINATION IN ECONOMIC ACTIVITY Magnusson, Lars: EVOLUTIONARY AND NEO SCHUMPETERIAN APPROACHES TO ECONOMICS Reisman, D.: ECONOMIC THOUGHT AND POLITICAL THEORY Burley, P. and Foster, J.: ECONOMICS AND THERMODYNAMICS: NEW PERSPECTIVES ON ECONOMIC ANALYSIS Brennan, H.G. and Waterman, A.C.: ECONOMICS AND RELIGION: ARE THEY DISTINCT? Klein, Philip A.: THE ROLE OF ECONOMIC THEORY Semmler, Willi: BUSINESS CYCLES: THEORY AND EMPIRICS Little, Daniel: ON THE RELIABILITY OF ECOONOMIC MODELS: ESSAYS IN THE PHILOSOPHY OF ECONOMICS Weimer, David L.: INSTITUTIONAL DESIGN Davis, John B.: THE STATE OF THE INTERPRETATION OF KEYNES Wells, Paul: POST-KEYNESIAN ECONOMIC THEORY Hoover, Kevin D.: MACROECONOMETRICS: DEVELOPMENTS, TENSIONS AND PROSPECTS Kendrick, John W.: THE NEW SYSTEMS OF NATURAL ACCOUNTS Groenewegen, John: TRANSACTION COST ECONOMICS AND BEYOND King, J.E.: AN ALTERNATIVE MACROECONOMIC THEORY Schofield, Norman: COLLECTIVE DECISION-MAKING: SOCIAL CHOICE AND POLITICAL ECONOMY Menchik, Paul L.: HOUSEHOLD AND FAMILY ECONOMICS

Experiences with Financial Liberalization edited by Kanhaya L. Gupta Professor of Economics University of Alberta ~. " Springer Science+ Business Media, LLC

Library of Congress Cataloging-in-Publication Data Experiences with financial liberalization/edited by Kanhaya L. Gupta. p. cm.-(recent economic thought series) Includes index. ISBN 978-94-010-6257-2 ISBN 978-94-011-5370-6 (ebook) DOI 10.1007/978-94-011-5370-6 1. Finance-Developing countries. 2. Monetary policy-developing countries. 1. Gupta, Kanhaya K. (Kanhaya Lai), 1935- II. Series. HG195.E96 1997 332'.09172'6-dc21 96-48563 CIP Copyright 1997 by Springer Science+Business Media New York Originally published by Kluwer Academic Publishers, New York in 1997 Softcover reprint ofthe hardcover Ist edition 1997 AII rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, mechanical, photo-copying, recording, or otherwise, without the prior written permission of the publisher, Springer Science+Business Media, LLC Printed an acid-free paper.

For J. John Lang

Contents Contributing Authors Acknowledgment Preface ix xiii xv The African Experience From Financial Repression to Liberalization: The Senegalese Experience 3 Jean-Claude BertM/emy 2 Financial Repression and Seigniorage in Ghana Ebenezer Asem and Kanhaya L. Gupta II The Asian and Latin American Experience 3 Financial Deregulation in Australia: A Success Story? Peter J. Drake 4 Interest-Rate Liberalization and Monetary Control in China Maxwell J. Fry 19 43 45 69 5 Financial Reform, Institutions, and Macroeconomic Adjustment: The Destabilizing Effects of Financial Liberalization in the Philippines, 1970 to 1992 101 Rob Vos

viii CONTENTS 6 Financial Liberalization and Stabilization Policies: The Experience of Chile 131 Kate Phylaktis III 155 The Central and East European Experience 7 Rubles, Rubles, Everywhere... Cash Shortages and Financial Repression in the Economies of the Former Soviet Union 157 Patrick Conway 8 Financial Systems in Transition: The Role of Banks in Corporate Governance 187 Irena Grosfeld 9 Financial Reforms and Commercial Bank Behavior in Poland 217 Kanhaya L. Gupta and Robert Lensink IV 241 The Middle East Experience 10 Financial Liberalization Under External Debt Constraints: The Case of Turkey 243 Nazim Kadri Ekinci Index 267

Contributing Authors Ebenezer Asem is a graduate student in economics at the University of Alberta, Edmonton, Canada. Jean-Claude Berthelemy is Professor of Economics at the University of Paris 1 (Sorbonne) and is currently Head of Research at the OECD Development Centre in Paris. Expert on African economies, he has written extensively on development issues such as debt, finance, macroeconomic policies, and agriculture. His recent contributions include a monograph on financial development policy and growth published by the OECD Development Centre. Patrick Conway is Professor of Economics at the University of North Carolina in Chapel Hill. He centers his research efforts on the issues of developing and transitional economies facing the world market and has published widely in the academic press. He has written two monographs, entitled Economic Shocks and Structural Adjustment: Turkey After 1973 and Currency Proliferation: The Monetary Legacy of the Soviet Union. He has also worked with the Peace Corps and the U.S. Department of State and has been a visiting scholar with the World Bank and the International Monetary Fund. Peter J. Drake has been Vice-Chancellor of Australian Catholic University since its foundation in 1991. He was previously Deputy Vice-Chancellor at the University of New England, Armidale, where he was also Professor of Economics from 1972 to 1990. He has held positions in economics at the University of Melbourne and was Hallsworth Research Fellow at the University of Manchester and Nuffield Fellow at the University of London. Professor Drake is the author of Money Finance and Development,

x CONTRIBUTING AUTHORS Economic Growth for Australia, Financial Development in Malaya and Singapore and many published articles in the fields of money, trade, and economic development. Nazim Kadri Ekinci teaches at the Middle East Technical University, Ankara, Turkey. MaxweD J. Fry is the Tokai Bank Professor of International Finance at the University of Birmingham. He has published widely on monetary and financial aspects of economic development, both in academic journals and as books. Among his many books are Money, Interest and Banking in Economic Development (Johns Hopkins University Press, 1988, 2nd ed. 1995), Central Banking in Developing Countries: Objectives, Activities and Independence (with C.A.E. Goodhart and Alvanro Almeida, Routledge, 1996), and Emancipating the Banking System and Developing Markets for Government Debt (to be published by Routledge in 1997). He also has had assignments with various countries and organizations including the ADB, the International Monetary Fund, the World Bank, and the OECD. Irena Grosfeld is Professor at the Centre National de la Recherche Scientifique, Departement et Laboratoire d'economie TMorique et Appliquee (DELTA) in Paris. She has published articles on privatization, enterprise restructuring, and financial reforms in Central and East European economies. Her publications include "Modelling Planners' Investment Behavior: Poland 1956-1980" (1986), "Reform Economics and Western Economic Theory: Unexploited Opportunities" (1990), "Comparing Financial Systems: Problems of Information and Control in Economies in Transition" (1994), "Triggering Evolution: The Case for a Breakthrough in Privatization" (1995), "Defensive and Strategic Restructuring in Central European Enterprises" (with G. Roland, 1995). Kanhaya L. Gupta is a Professor of Economics at the University of Alberta, Edmonton, Canada. His recent related publications include Financial Liberalization and Investment (with Robert Lensink, 1996) and Interest Rates and Budget Deficits: A Study of the Advanced Economies (with B. Moazzami, 1996). Robert Lensink is Associate Professor in Macro Economics at the Department of Economics, University of Groningen, the Netherlands. His areas of specialization are economic development and international macroeconomics. He has authored and coauthored four books and many articles

CONTRIBUTING AUTHORS xi around this subjects. His most recent books are Financial Liberalization and Investment (with K.L. Gupta, Routledge, 1996) and Financial Development and Economic Growth (edited with Hermes, Routledge, 1996). Kate Phylaktis is Reader in International Finance and Director of the Research Centre in Financial Development at the City University Business School, London. She has published numerous research papers on foreignexchange controls, money demand, and exchange-rate determination, especially in high-inflation economies; on the behavior of black market exchange rates; and on the financial structure of developing countries. She is the author of "Financial Data of Banks and Other Financial Institutions," "International Finance and the Less Developed Countries" (with M. Pradham), and "The Banking System of Cyprus, Past, Present and Future." Rob Vos is a Senior Lecturer at the Institute of Social Studies at Hague. His main teaching and research areas include international finance, stabilization policies, income distribution and poverty, and general equilibrium modeling. His works in these areas have been published as books and articles. His latest publication is The Philippine Economy: Stray Cat of East Asia (with J. Yap, Macmillan and St. Martin's Press, 1995).

Acknowledgment As usual, my very special thanks to Charlene Hill for her excellent secretarial help in putting together this volume.

Preface This volume is yet another one in the series "Recent Economic Thought" published by Kluwer Academic Publishers under the general editorship of Professors William Darity, Jr. of the University of North Carolina at Chapel Hill and Warren J. Samuels of Michigan State University, East Lansing. The nature and the scope of the current volume are relatively straightforward. It tries to provide a broad spectrum of experience with policies relating to financial liberalization around the globe over the last two to three decades. As far as I am aware, broad international coverage of this topic has not been undertaken in another single volume. There is no denying that the most widely prevalent economic ideology today is that of free-market or deregulated economies. While there are many aspects to policies that go under the rubric of economic liberalization, my concern in this volume is with policies relating to financial liberalization, particularly its domestic aspects. There is by now a sizeable body of theoretical and aggregative empirical literature in this area. But generally missing are works that document and analyze the experiences of individual countries or sets of countries. This kind of evidence is important in its own right but is particularly so for lessons to be drawn for the future, for there is no denying that aggregative econometric studies, which are the norm in the empirical field, cannot substitute for countrywide studies. The aim of this volume is to add to the relatively small body of this literature. I have endeavored to include representative works from different areas of the world, particularly works relating to countries where published studies are not readily available. As far as possible I have tried to draw contributors from different parts of the world. This will have the virtue, hopefully, of allowing different perspectives to emerge.

xvi PREFACE The studies being reported in this volume are very much in the spirit of the series. Ever since the publication of McKinnon's (1973) and Shaw's (1973) seminal works, few areas of government policy have attracted more attention or been more controversial than the question of financial deregulation, particularly its domestic aspects, both in developed and in developing countries and now in transition economies as well. After two decades of extensive debate, there is as yet no consensus even on whether financial development causes real growth, growth causes development, or they cause each other! Similar disagreements exist about the sequencing of reforms. For example, what should be the order of reforms-all sectors deregulated simultaneously or in some optimal sequencing? How does financial liberalization fit in with general macroeconomic stabilization? Is all government intervention in financial markets undesirable? If so, then how do we deal with financial market failures caused by asymmetries of information? Why in some countries have policies of "financial repression" yielded positive results, whereas in other countries policies of financial liberalization have failed? The list goes on. The basic point is that this area is rife with controversies that have become even more acute since the demise of the former Soviet Union. As the articles in this volume show, there may not be a unique answer to many of these questions. The answers may be country-specific or circumstances-specific. At the end of the day, we may find that instead of searching for some grand, universally applicable paradigm, we may have to learn to accept the uniqueness of each country and design policies to fit its needs and aspirations rather than to fit them into some predefined model. If the volume contributes to our understanding of the complexities and the uniqueness of individual experiences, I believe it will have more than served its purpose. The chapters are divided into four parts by geographical regions. Part I deals with the African region. Its two chapters deal with very different aspects of financial liberalization. In Chapter 1, Jean-Claude Berthelemy offers a case study of Senegal, which serves as a representative case study of countries in the Franc Zone. He documents in considerable detail the historical reasons for the crisis in the banking sector and then goes on to offer an explanation for the failure of the policies of financial liberalization, particularly with respect to interest rates, to ameliorate the situation. The basic argument hinges on the role of hysteresis. The policies of financial repression that were followed from 1960 to the 1980s continued to have adverse effects well after they had been abandoned. In Chapter 2 Ebenezer Asem and Kanhaya L. Gupta deal with an altogether different aspect of the policy of financial liberalization. The chapter examines the implications of different aspects of the policy of

PREFACE xvii financial liberalization for seigniorage in Ghana. In 1988 Ghana embarked on comprehensive financial-sector reforms to complement the Economic Recovery Program initiated in 1983. The main goal of the reforms was to scrap the system of direct credit controls and replace it with an indirect monetary control in which financial institutions were free to make decisions strictly on the basis of economic criteria. The measures included interest rate deregulation, removal of direct credit ceilings, swapping of nonperforming assets of banks for Central Bank bills and withdrawal of government participation in the financial sector. We know from the analytical literature that seigniorage depends, among other things, on the mode of control and the behavior of the financial system, and therefore the reforms can be expected to influence seigniorage. Since seigniorage constitutes an important source of revenue for the government in Ghana, it is important to understand the way it is affected by the financialsector reforms. The chapter addresses this question first theoretically and then empirically. Part II examines the experiences of countries in Asia and Latin America. The four chapters in this section include case studies of Australia, China, the Philippines, and Chile. Chapter 3 by Peter J. Drake looks at the situation in Australia's financial sector as it existed until the 1970s. Until then the system was highly rigid and regulated. However, thereafter and particularly since 1983 the system became greatly liberalized. A variety of forces accounted for this development. Drake examines the winners and losers of the reforms and claims that on the whole the history of financial deregulation in Australia must be considered a success story. But Drake also cautions about unbridled freedom of economic behaviour to the neglected of concerns for social justice and the environment. Chapter 4 by Maxwell J. Fry is a plea for the early introduction of financial liberalization policies, particularly those relating to the deregulation of interest rates, which are currently set by administrative fiat, in China. He argues that the current system of monetary control-namely, the use of credit ceilings-and the development of a market-driven economy have led to various inconsistencies. After discussing the pros and cons of liberalized versus regulated interest rates, he goes on to suggest that deregulated interest rates will be beneficial for the Chinese economy because they will allow for better monetary control, lead to lower and more stable inflation, encourage higher savings rates, and lead to a more efficient allocation of resources. In Chapter 5 Rob Vos examines the case of the Philippines, which he likens more to countries in Latin America than to the Asian tigers. His main theme is why the Philippines did not display the sustained and rapid growth

xviii PREFACE of the fast-growing East Asian economies. Vos's approach is to identify factors that are a prerequisite for the success of financial liberalization policies. He then shows how these prerequisites were not met and how the financial reform policies instead had a destabilizing effect. At the same time he goes on to suggest that the experience of the Philippines is not too different from countries that suffered from banking crises following financial reforms. He discusses the measures that can be taken to avoid such outcomes. The final chapter in this section, Chapter 6, deals with Chile. Kate Phylaktis provides a broad-based survey of the stabilization and liberalization policies in Chile since 1973 when Chile first launched an ambitious program of economic liberalization. Phylaktis takes us through different phases of the various policies and their outcomes. Her survey leads her to draw a number of conclusions, which relate to the order of reforms and stabilization policies and support the popular belief that stabilization should precede liberalization. She also suggests that liberalization of domestic financial markets should precede that of the foreign sector. In the domestic sector, before any form of deregulation is introduced, special attention should be paid to the supervision and the regulation of the banking industry. Finally, she emphasizes the importance of credibility in the pursuit of government policies. Chilean government's failure to act decisively in the face of major economic disruptions caused considerable skepticism about the sustain ability of its liberalization policies. However, she concludes that without the reforms the stabilization policies of the more recent years would not have succeeded. Part III deals with the experiences of the Central and the East European countries. Its three chapters each deal with a different aspect of the financial reform program. Chapter 7 by Patrick Conway deals with the problem of cash shortage that was experienced by the countries in the former Soviet Union immediately after independence. He discusses alternate explanations for this phenomenon but claims that the most plausible explanation lies in terms of the role played by financial repression, which is indicative of financial market distortions. This claim is demonstrated by the use of a three-sector model and some descriptive evidence. The examples of Georgia and the Ukraine are cited to show that merely treating the symptoms rather than dealing with the financial-market distortions led to more problems. On the other hand, the case of Estonia is presented as the example where the problem was solved by dealing with the cause and not the symptom. Estonia introduced successful financial-sector reforms. In Chapter 8 Irena Grosfeld tackles a very different issue. Her chief concern is with the form of financial institutions that should be introduced

PREFACE xix in economies in transition. She suggests that these countries need information about investment opportunities. Thus, her question is whether the banks are the most appropriate form of financial institution that can generate such information. She expresses serious reservations on this account. In particular, she argues against the ability of a banking system to perform this role if it is too closely tied with the firms. She suggests that too much commitment by the banks to firms will reduce their ability to provide this sort of information. She then goes on to discuss alternate forms of financial institutions that might play this role. The Czech Republic and Poland are used as examples to support her arguments. Chapter 9 by Kanhaya L. Gupta and Robert Lensink also deals with the commercial banking sector, but its focus is very different from that of the Grosfeld paper. They examine the portfolio behavior of commercial banks in Poland with a view to simulating the effects of financial liberalization policies on this behavior. The chapter specifies, estimates, and simulates the model. It captures special features of the Polish economy. For example, it explicitly distinguishes between domestic and foreigncurrency-denominated deposits and the effects of changes in default rates on the lending behavior of banks. Simulation results seem to confirm the significance of these factors and suggest that models that assume perfect substitutability between the domestic and foreign-currency-denominated deposits may be misleading. The last part of the volume deals with the Middle East experience. Chapter 10, by Nazim Kadri Ekinci, is a detailed description of the experience of Turkey with financial liberalization policies, which started in 1980. After the initial success of the domestic financial liberalization policies, the situation worsened. Domestic financial liberalization policies failed because of mistakes in the external financial liberalization program as well as long delays in creating an adequate regulatory and supervisory institutional framework for the banking system. The problem was exacerbated by continuing large budget deficits and large public-sector external debt, which led to what he calls the "internal transfer problem." The chapter goes on to discuss the serious consequences of this particular issue in the Turkish context. References McKinnon, R.I. (1973). Money and Capital in Economic Development. Washington, DC: Brookings Institution. Shaw, E. (1973). Financial Deepening in Economic Development. New York: Oxford University Press.

Experiences with Financial Liberalization edited by Kanhaya L. Gupta Professor of Economics University of Alberta... " Kluwer Academic Publishers Boston/DordrechtiLondon