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March 2002 Insights Issue #40Finance mattersFinancial liberalisation: too much too soon?An efficient and stable financial system is important for economic growth and poverty reduction. The financial crises that have afflicted many countries in recent times have been a costly and painful reminder of the disastrous consequences for development of weak financial markets. The recurrence of financial crises, at both the international and national levels, and the adverse effect they have had on economic growth and poverty levels, have highlighted the need for a policy framework which addresses the inherent vulnerability of financial markets to systemic instability and failure. Governments have always intervened in the financial sector and there are sound theoretical and practical reasons for doing so. Financial markets are characterised by problems of limited and unequal information, making them inherently imperfect and prone to failure. Financial regulation and supervision are therefore essential for efficient and stable financial market development. How should governments intervene? Have financial liberalisation and financial sector reform made financial systems more or less vulnerable to instability and systemic crises? How can the process be better managed? What is the best policy framework for supporting financial sector development in low-income countries? Repression to liberalisation For many years, governments followed a policy of financial 'repression', which relied on fixing interest rates below market levels and controlling the allocation of credit. The economic distortions induced by these policies were considerable. Financial systems remained under-developed, lending patterns were inefficient and failed to achieve their distributional goals. Negative real interest rates led to low savings and encouraged capital flight. Macro-economic performance also deteriorated - countries with large negative real interest rates experienced lower allocative efficiency and growth rates. In the state-owned banking sector, poor lending decisions (often politically influenced) and low repayment rates led to bank insolvency and large budgetary bailouts of depositors and creditors. A growing awareness of the economic costs of financial 'repression', led to financial 'liberalisation' as the dominant policy paradigm over the past two decades. Initially, the relaxation of controls on interest rates was the focus for financial reform which was often triggered by a financial crisis. The relaxation of controls on the financial sector was often part of a more general policy shift towards liberalisation of the domestic economy and opening up to the international economy. Liberalisation soon broadened therefore beyond interest rate liberalisation, to include a wide range of measures, constituting a programme of financial sector reform. For many countries, financial sector reform was adopted under World Bank sectoral or structural adjustment lending conditionalities, the key elements of which included: privatisation of banks, entry of new domestic and foreign entrants into the banking sector, bank restructuring and recapitalisation, opening up of the capital account, strengthening bank regulation and supervision institutions. Has financial liberalisation worked? The period of financial liberalisation coincided with, or was soon followed by, heightened financial instability, culminating in the dramatic financial crisis in East Asia in the second half of the 1990s. Clearly, financial liberalisation has not led to a smooth transition to a stable and efficient financial system. It would be wrong, however, to jump to the easy, but shallow, conclusion that financial liberalisation has 'failed'. Firstly, the fact that the period of financial liberalisation coincides with a period of increased systemic instability does not prove causality. Secondly, no process of change comes cheap: a reasoned assessment of the costs and benefits of the policy change is needed. And thirdly, what would have been the outcome without the policy change? Finally, the impact of financial liberalisation will differ between countries, depending on each country's economic and institutional characteristics. The more relevant research issue, therefore, relates to the design and timing of context-specific policy measures which will contribute to the development of an efficient and stable financial system. Could financial liberalisation have been managed better? If so, what policies are now needed? The articles in this issue discuss these questions by summarising the findings of recent research studies on the impact of financial liberalisation in developing countries. The commercial banks are the dominant component of the financial sector in low-income countries and are critical to the efficiency and stability of the financial system as a whole. Financial liberalisation was associated with a shift in prudential regulation from direct regulation of banks, by, for example, regular site visits, to an indirect approach based on the monitoring of bank capital to ensure that it remained adequate in relation to the risk being taken. Additional regulatory measures are also necessary to restrain the activities of the privatised and other newly-established private banks. The regulatory and supervisory framework may also need to be extended, to cover microfinance institutions which have developed significant deposit-taking capacity. Llewellyn highlights the potential problems of relying on a capital adequacy framework, as proposed in the Bank of International Settlements' new Basel Accord, as the main instrument for regulating bank activities. Systemic stability and the safety and soundness of banks need to be considered in a wider 'regulatory regime' framework which should include official supervision, market discipline, incentive structures for banks and corporate governance arrangements for banks. Murshed identifies four main obstacles to efficient banking regulation: a) information, contracting and monitoring problems, b) lack of supervisory personnel, c) high operational costs and d) poor credibility and regulation of regulatory bodies. The appropriateness of various policy measures for dealing with these constraints are discussed and ranked in terms of their suitability for low-income countries. What are the implications for financial regulation policy, of allowing microfinance institutions to offer a range of financing services beyond small-scale lending, asks Maimbo? Drawing on research in the microfinance sector in Zambia, he considers options open to the regulatory authorities. Top of the list is a flexible, graduated regulatory structure, which encourages microfinance institutions to voluntarily increase their capital base in order to engage in a set of permitted activities. The growth of commercial bank lending to the private sector following financial liberalisation has been disappointing. Drawing on the experience in a number of sub-Saharan African countries, Brownbridge identifies various policy interventions designed to strengthen commercial bank lending, particularly to small-scale borrowers and start-up enterprises. Financial liberalisation has resulted in increased foreign participation in the domestic banking sector. Murinde and Tefula examine the implications for sub-Saharan Africa and identify the main benefits (such as improvements in quality, pricing and supply of financial services, increased competition) and the costs (increased exposure to capital flight for example) of foreign banks. Capital account liberalisation has been a prominent component in financial liberalisation programmes. Fitzgerald argues that premature capital account liberalisation can be highly destabilising. Theory and experience indicate the desirability of scheduling capital account liberalisation after appropriate domestic financial liberalisation. To prevent massive capital inflows that threaten effective domestic policy and raise the probability of sudden reversal if capital flows, emerging market governments need to use market-based intervention instruments on short-term capital flows. Finally, using the case of Jamaica's policy response to the financial crisis of the mid-1990s, Tennant and Kirkpatrick compare the approach adopted to a hypothetical 'IMF model' policy prescription, arguing that financial crisis management programmes are more likely to succeed if they draw on natural stakeholders' expertise and knowledge. Too much, too soon? 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. 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. Much of the blame for post-liberalisation financial crisis lies, therefore, with the scale and sequencing of financial reform. What is needed is a more gradual and considered approach to financial liberalisation, which recognises that institutional strengthening, especially in the regulation and supervision capacity, is a pre-requisite for creating a more efficient and stable financial sector which can contribute fully to achieving economic growth and poverty reduction in developing countries. Colin Kirkpatrick T +44 (0)161 275 2800 See also 'Financial liberalization: how far, how fast?' Cambridge University Press by G. Caprio, P. Honohan, J. Stiglitz, 2001 'Finance for Growth. Policy Choices in a Volatile World', World Bank and Oxford University Press: Washington DC, 2001 'Financial regulation in developing countries', Journal of Development Studies 37/1 by M. Brownbridge and C. Kirkpatrick, 2000 |
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