Econ 3011

Economics
of Financial
Institutions
Question 3:Financial Liberation vs
Financial Repression

620080063
Over the last few decades, many countries have gradually moved away from their repressive

financial systems. They have become more liberalized, which entails the reduction of

government interference in the financial system and includes a reduction in required reserve

ratios, elimination of interest rate ceilings as well as the elimination of other constraining

policies. Several arguments exist that support and oppose both financial repression and

liberalization strategies employed by nations. Despite this however, several economists still

argue that liberalization is the better option for achieving sustainable economic growth.

Financial repression is regarded as the options and capability expressed by the government in

"not allowing the financial sector to operate at its full potential by introducing all kinds of

regulations, laws, and other nonmarket restrictions to the behaviour of banks and other

general financial intermediaries". Prior to the liberalization era, repression was argued to be

crucial in controlling the determination of interest rates, enabling authorities to better manage

the supply of money by tailoring both financial markets and private bank activities to better

suit social needs in addition to servicing government debts at a low cost (Roubini and Sala-i-

martin, 1995). Furthermore, reserve requirements placed on banks supplied funds for the

government to finance deficits at a lower cost than through the use of bonds and equity.

Interest rate ceilings were implemented in an attempt to prevent the financial institutions

from taking advantage of the mortgagee or lendee. Stiglitz (1994) claims that repression can

have several positive effects such as: improving the average quality of the pool of loan

applicants by lowering interest rates; increasing firm equity by lowering the price of capital;

and accelerating the rate of growth if credit is targeted towards profitable sectors such as

exporters or sectors with high technological spillovers. However, these claims can be

doubtful given that they increase the power of bureaucrats, who can be less capable than

imperfect markets, to allocate financial resources.

In addition to these potential benefits, countries that have a higher occurrence of tax evasion,

have been known to yield higher degrees of financial repression (Gupta, 2008). In essence, if

the government did not receive substantial income through taxation on private businesses,

then it may opt to raise money by issuing public bonds and force financial institutions to buy

into these bonds. The interest rate ceilings would also ensure that the government could

source funds cheaply in the market. Therefore, it could be said that the government represses

the financial market in order to gain access to easily obtainable assets such as bank savings,

which are supposedly crucial for the public budget (Fry, 1995). Block and Tang (2003) also

reason that the potential revenue that the government stands to gain through inflation tax is

another incentive for the government to implement repressive policies. McKinnon (1973) and

Shaw (1973) argue that policies of financial repression represent direct and indirect forms of

financing for the public sector.

Studies have also found that financial repression contributed to a significant share of the

company's GDP through revenues derived from seigniorage and inflation tax (Giovanni and

De Melo,1990) . Financial repression has been found to contribute from 5% to 30% of

revenues derived by the government (Roubini and Sala-i-Martin, 1995). These occurrences

illustrate that the government actively curbs the amount of services that financial companies

can provide to the economy.

The policies of financial repression have been argued to have an adverse impact on economic

growth within a nation by affecting its capital efficiency (Goldsmith, 1969). This is claimed

to be as a result of inflation and the lower competitive capacity of industries operating within

the nation. They are not obliged to compete for funds in the market place or take investment

risks that may force them to invest in positive net present value projects, thereby reducing

growth potential and operational efficiency, all of which affect capital efficiency.
Two other effects of financial repression were expressed by McKinnon and Shaw (1973).

According to them, repression affects how efficiently customer savings are converted to

investment purposes. For instance, due to restrictions imposed on financial intermediaries,

they are not allowed to freely determine interest rates which decreases the motivation for

people to save. It also affects the loan rates that the intermediaries would charge to debtors

for providing loans, since there are interest rate ceilings already in place. These illustrate that

financial limitations imposed affect the free movement of capital between savings deposit and

investment loans, which are usually the norm in financially liberal regions.

Secondly, financial repression is said to affect the "equilibrium level of savings and

investments". Thereby illustrating that in most cases there is a higher level of investment

loans granted, than savings deposit received, due to the inability of financial institutions to

offer higher rates to attract savings. This occurrence would substantially increase the risk

associated with granting loans, as the intermediary may not have sufficient deposits to

finance loans granted.

Financial repression has also been known to have adverse effects on income generated by

governments. This is because restrictions in the activities of financial intermediaries, for

instance in raising equity, offering high interest rates or providing investment banking

services, could reduce the amount of income these companies earn, thereby reducing the

income tax attributable to the government (Giovanni and De Melo, 1990). Though in

countries with severe tax evasion and high corruption, this could be the reason why financial

repression is enacted in the first place, however, it restricts the activities of firms that could

otherwise contribute to financial development, and also poses a severe setback in the advent

that the country intends to liberalize its economy (Roubini and Sala-i-martin, 1995).
Borio (2005) also argues that financial repression results in the misallocation of resources and

inefficiencies in the operations of the country's economy. An example of this occurred in

Chinas pre liberalization era, in which, the activities of the banking institutions had no effect

whatsoever on the China's macroeconomic performance (Hsiao, 1971). Prior to China joining

the World Trade Organization it still had restrictions on competition, whilst separate interest

rates were in existence for private companies and state owned enterprises (Fund et al, 2000).

This led to situations whereby state owned enterprises funded their operations by planning

their interest rates, often much lower than the prevailing market rates, whilst non-government

institutions were subjected to higher interest rates (Portes, 1994). Dong (1994) also provided

evidence to illustrate how local governments intervened in the activities of bank branches and

influenced them to provide loans that funded unprofitable state owned enterprises, and since

these banks could not freely bankrupt state owned enterprises, they were left at a

disadvantage due to these financial repression measures (Portes, 1994). Uncanny politics also

favoured the allocation of funds to unprofitable state owned enterprises, while the profitable

ones were left with little or no adequate funding (Cull and Xu, 2000). Empirical results

additionally illustrated that a vast majority of bank loans were usually granted to state owned

enterprises, while those of private individuals, whether domestic or foreign only constituted

about 9.8%. The intervention of the government within Chinese financial markets, through

repressive measures, led to practices such as bribery and corruption, which resulted in a lack

of efficiency within these markets - a substantial barrier to economic growth.

This has been found to occur in other developing countries, even in those that have opted to

liberalize their markets such as India (Fry, 2005). They imposed restrictions on their financial

markets, and are now having to relax such in order to compete effectively in international

markets within both product and service related industries. According to Roubini and Sala-i-

martin (1995), these policies that have repressed the financial sector and adopted favouritism
for government owned enterprises, affects non-government establishments in such a way that

funds are not freely accessible, thereby restricting the potential for growth in the private

sector and entrepreneurship opportunities for small businesses, both of which invariably

result in a lack of growth in the economy with respect to human development.

Nations have been discouraged from adopting repression except in adverse tax evasion

situations, due to the fear that it may hinder economic growth. These arguments have lighted

that a liberalization of financial markets would benefit the growth of the financial markets

and economy. It would provide adequate loans to businesses at competitive rates, which

would enable them to invest in positive net present value investments and also drive them to

utilize capital and assets efficiently. Financial market growth would also provide

employment, improve the competitive nature of businesses, and provide substantial capital to

aid private sector development in various industries (Chang, 2002).

Empirical evidence shows that the liberalization of several developed countries occurred

throughout the 20th century and pushed several reforms in financial markets through 1980

and 1990. McKinnon (1973) and Shaw (1973) also noted that removing financial restrictions

would allow financial intermediaries to develop, whilst reducing market friction which has

been known to increase the capital accumulation, decreasing external financing costs for

firms hence leading to economic growth (Bloch and Tang, 2003).

The development of banks within a nation has also been known to boost economic growth

due to savings of individuals that are attracted through higher interest rates, and then

channelled to businesses that need funds to boost their operations and finances. This allows

individuals to reduce risks associated with holding cash by holding them in the bank, whilst

also enabling businesses that are short of cash to access available bank loans at competitive

rates. Economic growth can even occur when the level of aggregate savings is reduced, due
to the ability of financial markets to increase the efficiency of investments (Borio, 2005). In

line with these arguments, Blackburn and Hung (1998) illustrate that the development of

financial markets is an "indispensable part of the growth process rather than a precondition

for economic growth", thereby illustrating that for economies to grow, either through an

internal focus on human development, or external focus on market liberalization, financial

markets must be developed, as opposed to these markets being repressed.

Though financial liberalization has been widely encouraged, there are arguments stating that

financial market development and ensuing monetary regimes are responsible for the booms

and busts in credit and asset prices in countries that have adopted such policies. One example

of this is the Asian Financial Crisis in the 1990s during which many developing countries

opened up financially, attracting foreign loans and investments. In developing East Asia,

short-term commercial bank loans were the dominant form of capital inflow as Asian

securities markets were underdeveloped. At first, this caused domestic booms and asset

market inflation. But later, as the market sentiment turned for the worse and foreign investors

pulled their money out, the balance of payments came under a severe pressure. Speculative

attacks rapidly depreciated Asian currencies, and an inability to rollover the short-term bank

loans since foreign banks demanded immediate repayment occurred. The domestic banking

sector froze up and domestic demand fell sharply, causing a disastrous recession.

This shock was amplified by the balance-sheet vulnerability caused by the weaknesses of

Asian banks, non-banks and corporations. Firms in developing East Asia were highly

dependent on bank loans for working and investment capital and had high debt/equity ratios.

Moreover, the local banks and nonbanks were exposed to two kinds of balance-sheet

mismatches. They borrowed in USD and lent to domestic projects in local currency. In

addition, they borrowed in short term loans but lent to long-term domestic projects. When the

currency depreciation began, the balance sheets of these financial institutions were
immediately hit and bad debt increased. When foreigners demanded repayment, they had no

foreign cash. This is a liquidity problem, but as the crisis deepened, it created insolvency as

well.

In addition, the collapsing domestic demand, which was caused by panic, credit crunches and

wrong policy prescriptions, damaged the real sector and led to the accumulation of bad debt.

This further deteriorated the quality of the balance sheets of financial institutions.

According to this view, the Asian crisis was primarily caused by the wrong speed and

sequencing of external financial liberalization. Countries liberalized capital accounts too

quickly and without preparation, which caused over borrowing and bubbles. Furthermore, the

government did not properly monitor what was happening.

China, India, Vietnam, Myanmar and Cambodia were not affected by the Asian crisis as much

as Korea and ASEAN4 (Thailand, Indonesia, Philippines Malaysia) despite the fact that their

domestic systems are much worse. They were not directly hit because they did not open up

financially, claim economists.

Additionally, critics of financial liberalization policies have argued that the efficient markets

paradigm is misleading when applied to capital flows. If the capital account is liberalized

while import competing industries are still protected, for example, or if there is a downwardly

inflexible real wage, capital may flow into sectors in which the country has a comparative

disadvantage, implying a reduction in welfare. If information asymmetries are endemic to

financial markets and transactions, in particular in countries with poor corporate governance

and low legal protections, there is no reason to think that financial liberalization, either

domestic or international, will be welfare improving (Stiglitz, 2000). Moreover, in countries

where the capacity to honour contracts and to assemble information relevant to financial

transactions is least advanced, there can be no presumption that capital will flow into uses
where its marginal product exceeds its opportunity cost. Focusing on the development of the

domestic financial sector, capital account liberalization that allows firms to list abroad has

been identified as a factor leading to market fragmentation, and can tend to reduce liquidity in

the domestic market thereby inhibiting its development. Liberalization has also been linked to

macroeconomic instability. The financial reforms carried out in several Latin American

countries during the 1970s, aimed at ending financial repression, often led to financial crises

characterized by widespread bankruptcies, massive government interventions, nationalization

of private institutions and low domestic saving (Diaz-Alejandro (1985). Demirguc-Kunt and

Detriagiache (1998), however have shown that the likelihood of a crisis following

liberalization decreases with the level of institutional development in the country. The main

argument is that the government is,the insurer of the financial systems, and hence a financial

collapse can have significant fiscal repercussions.

Therefore Giovanni and De Melo (1990) state that financial reforms should estimate the

amount that the government stands to lose in financial repression revenue, and consider it a

trade-off between tax evasion and economic growth associated with financial liberalization.

Gupta (2008) also states that reforms easing financial repression should accept liberalization

with ample amount of financial regulation, which monitors market practices and ensures the

economy, is adequately hedged against future uncertainties in global financial markets.

To conclude, despite the inordinate weaknesses of both financial repression and liberalization,

theoretically the benefits of financial liberalization seem to far outweigh those of financial

repression. Despite the overwhelming theoretical evidence, practical applications of financial

liberalization have resulted in financial sector crashes in various developing countries.

Economists claim that these meltdowns could have been prevented if the transition into a

liberalized economy had been slowly implemented. When combined with some level of

regulation this can set the groundwork for a prosperous economy.

References

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Developments in Financial Liberalization Theory by Dr Firdu Gemech and Professor John
Struthers. Retrieved March 30, 2017, from https://pt.scribd.com/doc/58947587/The-
Mckinnon-Shaw-Hypothesis-Thirty-Years-on-A-Review-of-Recent-Developments-in-
Financial-Liberalization-Theory-by-Dr-Firdu-Gemech-and-Professor-Joh
Demirg-Kunt, A., & Detragiache, E. (n.d.). Financial Liberalization and Financial Fragility.
Financial Liberalization, 96-122. doi:10.1017/cbo9780511625886.005
Z., & Balassa, B. (1989, September 30). Financial liberalization in developing countries.
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