FINANCIAL REPRESSION (PAPER 7)

Financial repression refers to the notion that a set of government regulations, laws, and other non-market restrictions prevent the financial intermediaries of an economy from functioning at their full capacity (McKinnon (1973) and Shaw (1973)…PAPER 1).

Generally, financial repression consists of three elements. First, the banking system is forced to hold government bonds and money through the imposition of high reserve and liquidity ratio requirements. This allows the government to finance budget deficits at a low or zero cost. Second, given that government revenue cannot be extracted that easily from private securities, the development of private bond and equity markets is discouraged. Finally, the banking system is characterized by interest rate ceilings to prevent competition with public sector fund raising from the private sector and to encourage low-cost investment (PAPER 1).

The policies that cause financial repression include interest rate ceilings, liquidity ratio requirements, high bank reserve requirements, capital controls and restrictions on market entry into the financial sector, credit ceilings or restrictions on directions of credit allocation, and government ownership or domination of banks (PAPER 7).

Economists have commonly argued that financial repression prevents the efficient allocation of capital and thereby impairs economic growth. While theoretically an economy with an efficient financial system can achieve growth and development through efficient capital allocation, McKinnon and Shaw argue that historically, many countries, including developed ones but especially developing ones, have restricted competition in the financial sector with government interventions and regulations. According to their argument, a repressed financial sector discourages both saving and investment because the rates of return are lower than what could be obtained in a competitive market. In such a system, financial intermediaries do not function at their full capacity and fail to channel saving into investment efficiently, thereby impeding the development of the overall economic system (PAPER 7).

This paper aims to analyse the concept of financial repression and reasons why it is seen and detrimental to economic growth……explain sections below.

Rationale for and types of financial repression

The key reason for the government to implement financially repressive policies is to control fiscal resources. By having a direct control over the financial system, the government can funnel funds to itself without going through legislative procedures and more cheaply than it could when it resorts to market financing. More specifically, by restricting the behaviour of existing and potential participants of the financial markets, the government can create monopoly or captivate rents for the existing banks and also tax some of these rents so as to finance its overall budget. Existing banks may try to collude with each other and to interrupt possible liberalization policies as long as they are guaranteed their collective monopoly position in the domestic market.

In some countries, governments require banks to meet high rates of the reserve ratios, and use the reserves as a method to generate revenues. Since reserves earn no interest, they function as an implicit tax on banks and restrict banks from allocating a certain portion of their portfolios to productive investments and loans. If high reserve requirements are combined with interest ceilings and protective government directives for certain borrowers, savers who are usually unaware of the requirement policy become the main taxpayers because they face reduced rates of interest on their savings. Inflation can aggravate the reserve tax because it reduces the real rates of interest.