The of interest. Shaw’s argument on the other

Published by admin on

The argument for financial liberalisation is that various forms of financial repression impede the development of financial markets. The consequences, it is argued, are a reduction of the flow of funds to the formal financial sector and a distortion of the allocation of resources, leading to lower levels of saving, investment and output growth than otherwise would be the case. The importance of the growth of the money economy and financial deepening for economic development along the lines indicated above have been stressed for a long time.

McKinnon (1973) and Shaw (1973) first highlighted the dangers of financial repression in a rigorous way, and argued the case for maximum financial liberalisation. Their views became highly influential in the thinking of the IMF and World Bank in the design of programmes for financial restructuring of countries as part of Structural Adjustment Programmes. Their arguments, however, emphasise different points.

McKinnon’s argument is that money holdings and capital accumulation are complementary in the development process. Because of the lumpiness of investment expenditure and the reliance on self-financing, agents need to accumulate money balances before investment takes place. Positive (and high) real interest rates are necessary to encourage agents to accumulate money balances, and investment will take place as long as the real rate of return on investment exceeds the real rate of interest.

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!

order now

Shaw’s argument on the other hand stresses the importance of financial liberalisation for financial deepening, and the beneficial effect of high interest rates on encouragement to save and discouragement to invest in low yielding projects. The increased liabilities of the banking system, resulting from higher real interest rates, enables the banking system to lend more resources for productive investment in a more efficient way. Their argument, which is graphically illustrated in Appendix 2, was that the interest rates of the banking system should be liberalised to achieve faster economic growth.

Low interest rate ceilings unduly restrict the real flow of lendable funds, depressing the quantity and quality of productive investment. Financial liberalisation which leads to higher interest rates can increase lendable funds by attracting more household savings to bank deposits. This in turn leads to greater investment and faster economic growth. Financial liberalisation in their view will lead to higher economic growth, because: 1. Higher interest rates will increase total credit intermediation through banks.

Higher interest rates will increase the allocative efficiency of credit by shifting funds from inefficient investments (through self-finance or rudimentary informal credit markets) to more efficient investments through organised allocators (banks). 7 Gibson and Tsakalotos (1994) conclude: “There is a clear need for reform of the financial systems of many developing countries, both to increase the efficiency of existing financial markets and to develop new markets to enable the financial system to serve better the needs of the real economy.

Only through liberalisation will the needs of the real economy be met and hence development occur”. 8 More recent economist, such as Holden and Rajapatirana (1995) take this theory further arguing that initial financial liberalisation, such as the deregulation of interest rates, the closing of development banks, the elimination of directed credit, and policies to enhance the efficiency of the banking system, need to be supplemented by an effective regulatory and supervisory framework that will foster development of the financial sector and maintain its solvency.

One of the aspects of the post-Keynesian critique10 of the financial liberalisation model is high interest rates and stagflation. This ignores the adverse effect that high real interest rates can have on costs and the level of demand in an economy, which may lead to stagflation. High interest rates not only discourage investment, but may also lead to currency overvaluation by attracting capital from overseas, which leads to a fall in exports, and also increase the cost of servicing Economic Development in Africa.

Currency overvaluation and cuts in government expenditure are both deflationary. In Latin America in the 1970s, financial liberalisation went wrong because there was an explosion of government debt, economic instability and excessively high real interest rates, which led to bankruptcies, bank failures and prolonged government debt, which leads to cuts in government expenditure. An economy that has undertaken financial liberalisation also becomes vulnerable to crises.

11 When short-term funds flow in, they tend to cause an appreciation of the exchange rate, the consequence of which is to make imports cheaper relative to home production and hence lead to deindustrialisation. But if this is avoided through central bank intervention which supports the exchange rate by holding foreign exchange reserves, then that in turn enlarges liquidity in the economy, which is typically used either for an expansion of luxury consumption or for an expansion of investment in the domestic non-tradeables sector such as real estate, or for financing speculative booms in asset markets, especially the stock market.

When short-term funds begin to flow out, there is both a downward pressure on the exchange rate and a collapse of asset prices, which reinforce one another, and cause an avalanche of outflow. Efforts by the central bank to manage the foreign exchange market by raising the interest rate to induce short-term funds to stay or to come back, have very little effect, or even have the opposite effect of further enhancing outflows by aggravating the asset-market collapse. On the other hand, interest rate increases lead to a contraction of the real economy.

Thus, while the inflow of short-term funds, generally, has little impact by way of increasing the growth rate of the real economy, the withdrawal of short-term funds does affect the real economy adversely. And while the inflow of short-term funds occurs over a period of time, the outflow can be sudden, concentrated, and extremely destabilising, causing acute misery to the people, as has been seen in the case of the East and South-East Asian countries. The experience with financial liberalisation reveals a strong correlation between liberalisation and financial crisis.

This can be explained partly by the exposure of existing inefficiencies and distortions in the financial structure, and partly by a failure to develop a strong regulatory and supervisory framework, prior to liberalisation. 12 Weaknesses in the initial conditions affect the ability of the privatised banks and new market entrants, to operate on broadly commercial principles. Borrowers are often unable to service their loans, due to poor quality lending and high interest rates.

Liberalisation of the capital account increases the inflow of foreign capital, but at the same time threatens the stability of the financial institutions, by increasing the exchange rate and domestic lending risks. The existing regulatory and supervisory system may be unsuited to a market-based environment. Consequently, across-the-board, ‘big-bang’ financial liberalisation and financial sector reform increase the likelihood of systemic crisis, where the institutional and human resource environment is weak.

Categories: Currency


I'm Iren!

Would you like to get a custom essay? How about receiving a customized one?

Check it out