2.2 Theoretical Review

Many countries have witnessed huge strides towards liberalization of the financial markets. This reform was mainly adopted in view of promoting growth in the country. Thus, this has motivated many studies on the link between financial liberalization and economic growth.

The first part of this thesis consists of defining financial liberalization, which will be then contrasted with financial repression. Then, the paradigm behind financial liberalisation and the pros and cons as well as the possible solutions are considered.

2.2.1 Financial Liberalisation

From the point of view of Kaminsky and Schmukler (2003), financial liberalization consists of the deregulation of the foreign sector capital account, the domestic financial sector, and the stock market sector viewed separately from the domestic financial sector.

Also, full financial liberalization occurs when at least two of the three sectors are fully liberalized and the third one is partially liberalized. The liberalization of the capital account is captured by the regulations on offshore borrowing by financial institutions and by non-financial corporations, on multiple exchange rate markets and on capital outflow controls. In a fully liberalized capital account regime, banks and corporations are allowed to borrow abroad freely

According to Huw Pill (1997), financial liberalization entails the abolition and reduction of explicit controls on the pricing, allocation of credit and direct government intervention in bank credit decisions respectively. Financial liberalization does not mean “free banking.” Governments continue to intervene in several areas of the financial sector such as, banks are under the supervision for prudential reasons, some banks may be in the public and the government may be a major borrower.

Financial liberalization refers to measures directed at diluting or dismantling regulatory control over the institutional structures, instruments and activities of agents in different segments of the financial sector (Chandrasekhar, 2004). These measures can relate to internal or external regulations as shown below.

Internal financial liberalization normally includes some or all of the following measures:

The reduction or abolition of controls on interest or interest assigned by financial agents;

The withdrawal of the role of government activity in the transfer of financial intermediation from “development banks” into regular banks, and privatizing publicly owned banks, following the reason that their presence does not contribute to a dominant market signals in the distribution of capital;

The reduction of conditions for the participation of both firms and investors in the stock market by weakening or eliminating the listing conditions,

Reduction in the control of the investments that can be executed in financial resources

The expansion of the ways from and instruments through which firms or financial agents can access funds;

The liberalisation of the rules governing which financial instrument must be used.

External financial liberalization mostly includes amendments in the exchange control system. External financial liberalization measures broadly cover the following:

Measures to allow foreign residents to hold domestic financial assets held, or in the form of debt or equity;

Measures which allow citizens to hold foreign financial assets

Measures allowing foreign currency assets to be freely held and traded within the domestic economy.

2.2.2 Financial Repression (Mc Kinnon-Shaw)

Financial repression, contrary to financial liberalization, refers to the idea of a set of government regulations, laws and other restrictions that are present in the market to avoid any financial institute economy to operate at full capacity. The policies that cause financial repression includes strop interest rates, liquidity requirements, high bank reserve requirements, capital controls, restrictions on access to the financial sector, credit ceilings or restrictions on lines of credit allocation and management of property or the dominance of banks.

McKinnon (1973) and Shaw (1973) were the first to spell out the notion of financial repression. Financial repression is a problem because, according to them, repressing the monetary system chips the domestic capital market with highly adverse consequences on quality and quantity of real capital accumulation.

This would happen primarily through four channels:

reduction in the flow of loanable funds held by the banking system has forced investors to rely on self-finance

partial interest in the flow of bank credit varies from one industry or a subordinated debt declined to others;

the process of self finance is itself impaired; if the real yield on deposit is negative, firms cannot easily accumulate liquid assets in preparation for making discrete investments and socially costly inflation hedges look more attracive as a means of internal finance; and

Significant financial deepening outside the suppressed banking system is impossible if the companies are dangerously illiquid or inflation is high and unstable robust open markets stocks and bonds

2.2.3 Legal and Institutional Framework for Financial Liberalisation

Legal, regulatory and prudential economic environment is crucial for the promotion and anchoring of financial markets and the institutional framework. The ultimate function of financial markets is to mobilise knowledge and resources through credit and insurance industry to accelerate the process of economic growth. The function is performed by two different but related components.

A component is the money market. This market basically trades in short-term debt instruments to meet the needs of most users of these funds, as governments, banks and similar institutions. It also includes the interbank market, investment banks, commercial banks, central banks and other dealers.

The second component is the capital market. Its role is to mobilise long-term capital market debt and equity channels and long-term prolific assets. Capital markets also help to strengthen the corporate financial structure and improve the overall liquidity of the financial system. The capital market may be fragmented into monetary intermediaries, non-monetary intermediaries, and securities markets.

2.2.4 Review of growth effects of Financial Liberalisation

Theoretical evidence of the effect of financial liberalization on economic growth can be traced as far as Bagehot (1873). He proposed that the financial system plays a critical role in the adoption of better technologies through effective mobilizing of resources and thus encourages economic growth. There are a number of ways through which financial liberalization may impact growth.

2.2.4.1 Interest rate mechanism

One of the earliest models in favour of financial liberalisation was done by Mc Kinnon and Shaw in 1973. They attributed the poor economic growth in developing countries to financial repression. They believed that liberalisation of financial markets would expand the real supply of total credit, envourage high volume of investment and regulates the real interest rate to its equilibrium level of savings which, in term, impacts positively economic growth. To Huw Pill and Mahmood Pradhan (1995), following financial liberalization, positive real interest rates provide an incentive for borrowers to invest in more productive instruments, thus improving the productivity of the economy all together. High real interest rate stimulates financial and total domestic savings and then stimulates the private investment (Athukorala, 1998).

2.2.4.2 Capital account liberalisation

Fischer and the International Monetary Fund (1997) pointed out that firstly capital account liberalisation is an inevitable step on the path of development. Secondly, it should be ad