docx_20111102_Kninon_Shaw

1ABSTRACT The Mckinnon-Shaw Hypothesis: Thirty Years on: A Review of Recent Developments in Financial Liberalization Theory by Dr Firdu Gemech and Professor John Struthers University of Paisley The Mckinnon-Shaw Hypothesis, in its’ various forms, is now thirty years old. Over that period literally hundreds of empirical studies have been completed examining the hypothesis in many different contexts. Initially, the hypothesis focused on the effects of so-called “Financial Repression” (low or negative real interest rates) on savings and investment levels in developing countries. In more recent times, researchers have extended the debate to consider other effects of financial repression on: economic growth; financial crises and poverty (for example the effects of overvalued exchange rates). Currently, significant research is being conducted on the potentially destabilizing effects of financial liberalization (the converse of financial repression) on global financial markets. This paper attempts to survey the literature on the Mckinnon-Shaw Hypothesis and tries to draw out some of the recurrent themes of this literature. The paper also highlights the continuing relevance of the original hypothesis to on-going debates concerned with the effects of financial liberalization. CONTACT Dr Firdu Gemech 00 44 141 848 3393;firdu.gemech@paisley.ac.uk Professor John Struthers 00 44 141 848 3364; john.struthers@paisley.ac.uk Division of Economics and Enterprise Paisley Business School University of Paisley Paisley PA1 2 BE Scotland * Paper presented at Development Studies Association (DSA) Annual Conference on “Globalisation and Development”, Glasgow, Scotland, September 2003 2 An Overview of Recent Developments in Financial Liberalization Theory The literature on Financial Liberalization policies in developing countries has a long pedigree. This literature commenced with the seminal work of Mckinnon and Shaw in 1973 which focused on Financial Repression (see below) and the need for developing economies to allow real interests rates (along with other financial indicators) to be determined by market forces. Though originally focusing on interest rates, the Financial Repression approach also incorporated the adverse affects of high reserve ratios and government directed credit programmes, which together contributed to low savings, credit rationing and low investment. In later years, the literature can be classified into: First Generation approaches (represented by the work of Krugman (1979); Second Generation approaches (Obstfeld, 1996) ; and Third Generation approaches again represented by the work of Krugman (1998;1999) In this evolving literature, it is possible to detect a clear lineage stemming from the original Mckinnon-Shaw contribution, albeit one which represents an increasingly sophisticated theoretical and empirical development of the original hypothesis. This paper will trace the development of this body of thought as well as highlight possible further theoretical developments. It will also highlight some of the future directions that this research might take and the potential policy implications therein. I. Theoretical Underpinnings 1. Liberalization as a catalyst for higher saving, (McKinnon-Shaw) McKinnon (1973) and Shaw (1973), analysed the benefits of (if not eliminating) Financial Repression, at least reducing its impact on the domestic financial system within developing countries. Their analyses- (sometimes referred to as the Complementarity Hypothesis)- concluded that alleviating financial restrictions in such countries (mainly by allowing market forces to determine real interest rates) can exert a positive effect on growth rates as interest rates rise toward their competitive market equilibrium. According to this tradition, artificial ceilings on interest rates reduce savings, capital accumulation, and discourage the efficient allocation of resources. Additionally, McKinnon pointed out that Financial Repression can lead to dualism in which firms that have access to subsidized funding will tend to choose relatively capital-intensive technologies; whereas those not favored by policy will only be able to implement high-yield projects with short maturity. Another effect of Financial Repression, to which the original hypothesis made only scant reference, stemmed from the implicit “credit rationing” effect which results from the Feast and Famine consequences of excessive government intervention in money and credit markets in developing countries. Given that real interest rates are prevented from adjusting to clear the market, other “non-market” forms of clearing have to take their place. These can include various forms of “queuing” arrangements to “ration” the available credit such as auctions, quantitative restrictions (for example quotas), as well as 3different types of “bidding” systems which themselves may be open to nepotism or even outright corrupt practices. In essence, these manifestations of Financial Repression mean that not only is the quantity of savings (and investment) low, or at the very least irregular; it also means that the level of activity which does occur is of poor quality. This is really what the term Financial Repression entails. If the real interest rate is not allowed to clear the money and credit markets, both the overall level as well as the quality of savings and investment will be repressed. The quantity and the quality effects compound each other. In a Feast and Famine environment, the typical borrower may borrow too much (too little) and this very tendency will reinforce the Feast and Famine problem itself. The early hypotheses of McKinnon and Shaw assumed that liberalization, which would be associated with higher real interest rates--as controls on these are lifted--would stimulate saving. The underlying assumption is, of course, that saving is responsive to interest rates. The higher saving rates would finance a higher level of investment, leading to higher growth. Therefore, according to this view, we should expect to see higher saving rates (as well as higher levels of investment and growth) following financial liberalization. (see Appendix for the relevant equations of the McKinnon-Shaw model) 2. Liquidity constraints, credit channels, and financial liberalization ( Campbell -Mankiw) As a further development of the Financial Repression literature Campbell and Mankiw (1990) concluded that it is reasonable to assume that not all households have access to credit markets, and hence, some households have no ability to smooth consumption over time. Thus, for such liquidity-constrained households, consumption decisions are entirely determined by current income. On theoretical grounds, it has been shown that a relaxation of liquidity constraints will be associated with a consumption boom and a decline in aggregate saving. More specifically, Campbell and Mankiw postulated that there are two types of households in the economy: One type of household, λ , is liquidity constrained and their consumption is entirely determined by the evolution of current income, while the remaining type (1 − λ) , has free access to capital markets and can smooth their consumption intertemporarily. Such a theoretical development led these authors to challenge the implicit Mckinnon-Shaw assumptions that were based on a homogenous household set in which it was assumed that all relevant households had free access to capital markets within the domestic economy. 3. The role of subsistence consumption (Ostry and Reinhart) This development was based on the Stone-Geary utility function where the intertemporal elasticity of substitution (which determines the sensitivity of consumption to real interest rates) is determined by permanent income and subsistence consumption. According to this view, increases in real interest rates will affect consumption/saving decisions in varying degrees. In countries where the representative household is close to subsistence consumption, consumption(and saving) will not be sensitive to changes in the real rate of interest. Only in wealthier countries would consumption decline (and saving increase) 4following an increase in real interest rates. Hence, in this analysis the magnitude of the increase in saving following the higher real interest rates associated with financial liberalization will depend on the level of income (which was used as a proxy for how close are actual consumption levels to subsistence levels). II. The Empirical Literature The broad empirical literature varies greatly in terms of both empirical approach and country coverage. The McKinnon-Shaw hypothesis literally spawned hundreds of such empirical studies across many different contexts, countries and time periods. The empirical literature, in general, suggests that the relationship between saving rates and real interest rates is at best ambiguous. Yet surprisingly, and somewhat perversely, financial liberalization also has a mixed track record regarding saving rates. Indeed, in the studies reviewed here, in most of the cases liberalization appears to lead to a decline in the saving rate. a) Saving and real interest rates There is little consensus in the empirical literature on the interaction between saving and the real rate of interest. Some researchers have been unable to detect much of an effect of changes in real interest rates on domestic saving in developing countries. For example, Giovannini (1985), who examined this issue for eighteen developing countries, concludes that for the majority of cases, the response of consumption growth to changes in the real rate of interest is insignificantly different from zero and that one should therefore expect negligible responses of aggregate saving to the real rate of interest. In a model with a single consumption good, Ostry and Reinhart (1992) confirm these findings. Only when a disaggregated commodity structure that allows for traded and nontraded goods is assumed, do these authors find higher and statistically significant estimates of the sensitivity of consumption to interest rates. In a similar vein, Ogaki, Ostry, and Reinhart (1996), present evidence that consumption in developing countries may be more related to subsistence considerations -particularly in the case of extremely low-income countries - than to intertemporal consumption smoothing. The rationale here is that if households must first achieve a subsistence consumption level-allowing intertemporal considerations to guide their decisions only for that portion of their budget left after subsistence has been satisfied - then the intertemporal elasticity of substitution and the interest-rate sensitivity of private saving will be close to zero for countries at or near subsistence consumption levels, but will rise thereafter. b) Liberalization and saving 1. Bandiera, Caprio, Honohan, and Schiantarelli (2000), construct an index of financial liberalization on the basis of eight different components: interest rates; reserve requirements; directed credit; bank ownership; prudential regulation; securities markets deregulation; and capital account liberalization. Their data spans from 1970-94 for Chile, Ghana, Indonesia, Korea, Malaysia, Mexico, Turkey and Zimbabwe. Among the key findings of the estimation of their benchmark model is that, there is no evidence of any 5positive effect of the real interest rate on saving. Indeed in most cases the relationship is negative, and significantly so in the cases of Ghana and Indonesia. Furthermore, the effects of the financial liberalization index on saving are mixed: negative and significant in Korea and Mexico, positive and significant in Turkey and Ghana. The long run impact of liberalization is, however, sizeable. Corresponding to the realized change in the index, the estimated model indicates a permanent decline in the saving rate of 12% and 6% in Korea and Mexico, and a rise of 13% and 6% in Turkey and Ghana. Based on an estimate of augmented Euler equations (a la Campbell-Mankiw) , Bandiera et al present some evidence of the presence of liquidity constraints. It was not possible, however, to confirm whether financial liberalization removes these constraints. The Euler equation results may suggest, at best, that financial liberalization has had little impact on the amount of credit available to consumers through the formal financial sector. The general conclusion that emerges from this study is that there is no systematic and reliable real interest rate effect on saving; whilst the effects of liberalization have a mixed record. 2. Bayoumi (1993), examined the effects of financial deregulation on personal saving. Within an overlapping generations framework, the author argues that deregulation produces an exogenous short-run fall in saving, some of which is recouped over time. Also, deregulation increases the sensitivity of saving to wealth, current income, real interest rates and demographic factors. Using data on the eleven standard regions of the United Kingdom, the author finds that household saving showed an exogenous decline associated with financial innovation — saving also became more sensitive to wealth, real interest rates and current income; though the results imply that much of the decline in savings in the 1980's was caused by the rise in wealth. Financial deregulation also played a significant direct role. In particular, the author concludes that an autonomous fall of 2.25% in the personal saving rate may be attributed to deregulation alone. 3. Jappelli and Pagano (1994), investigate the role of capital market imperfections on aggregate saving and growth. The analytical framework of their paper is a simple overlapping generations model, within the context of which it is shown that liquidity constraints on households (but not on firms) can raise the saving rate; strengthen the effect of growth and may increase welfare. Using a panel of OECD countries for the 1960 to 1987 period, the authors conclude that financial deregulation in the 1980's has contributed to the decline in national saving and growth rates in the OECD countries and expressed concern regarding the welfare implications of further liberalization within the European Union. 4. Koskela, Loikkanen and Viren (1992), describe the institutional aspects of housing markets and analyze the evolution of prices of owner-occupied housing and their interaction with the household saving ratio in Finland in the 1970's and 1980's. The volatility of house prices in relation to income can be traced to a large extent to major changes in financial market conditions. The evidence they present suggests that financial market conditions - as measured by the household’s indebtedness rate, the after tax rate of return on housing, and the “thinness” of rental markets - have all had a positive effect on housing prices. Yet, household saving was affected negatively by the rate of change of 6real house prices, and positively by the after tax nominal interest rate. Taken together, their findings imply that financial conditions, and the liberalization of the mid-1980's in particular, contributed to the decline in the household saving ratio in these countries. 5. Loayza, Schmidt-Hebbel, and Serven’s (2000), produced results, which suggest that the direct effects of financial liberalization are detrimental to private saving rates. The real interest rate has a negative impact on the private saving rate. Its income effect probably outweighs the sum of its substitution and human wealth effects. A 1% increase in the real interest rate reduces the private saving rate by 0.25% in the short run. The indicator of financial depth (M2/GNP) has a small and statistically insignificant impact on the private saving rate. The flow of private domestic credit relative to income has a negative and significant coefficient; relaxing credit constraints reduces the private saving rate. When the flow of private credit rises by 1%, the private saving rate declines by 0.32% on impact. The authors suggest that though they do not find direct positive effects of financial liberalization on the saving rate, if financial reform has a positive impact on growth, it has a potentially important indirect positive effect on the saving rate. 6. Reinhart and Tokatlidis (2001), in a study of 50 countries (14 developed and 36 developing) report that financial liberalization appears to deliver: higher real interest rates (reflecting the allocation of capital toward more productive, higher return projects.); lower investment, but not lower growth (possibly owing to a shift to more productive uses of financial resources); a higher level of foreign direct investment; and high gross capital flows. Liberalization appears to deliver financial deepening, as measured by the credit and monetary aggregates--but, again, low income countries do not appear to show clear signs of such a benefit. As regards saving, the picture is very mixed. In some regions, saving increased following financial sector reforms; but in the majority of cases saving declined following the reforms. Indeed, it would appear that what financial liberalization delivers is greater access to international capital markets, although this appears to be uneven across regions and income groups. III. First Generation Models: The Financial Crises Literature Financial crises are attributed to rapid reversals in international capital flows prompted chiefly by changes in international investment conditions. Flow reversals are likely to trigger sudden current account adjustments, and subsequently currency and banking crises. A second generation of currency crises models (Krugman, 1979) explained the collapse of exchange rate regimes on the grounds that weak fundamentals lead foreign investors to pull resources out of the country, and as a consequence the depletion of foreign reserves (see Appendix for a summary of the key equations of the Krugman model). A Second Genration of models (Obstfeld, 1996) suggests that currency crises may also occur despite sound fundamentals, as a result of self-fulfilling expectations, speculative attacks and changes in market sentiments. More recently, there have been important developments in this area of research, most of them using the “event analysis 7methodology”. A summary of two studies is presented below (see Appendix for relevant equations). The Third Generation Models (Krugman, 1998, 1999) attempt to stylize the causal mechanics underpinning the 1997 Asian currency crisis as the First and Second Generation models did not fully explain these phenomena. One version of the Third- Generation model attributes the crisis to implicit guarantees offered by domestic banks in developing countries leading to a massive influx of short-term capital which turns out to be unsustainable. This invariably results in an asset price bubble that is destined to burst and reverse the capital inflows. Another version identifies the existence of ‘Fragile Financial Institutions’ as the cause of the build up of unhedged short-term borrowing denominated in foreign currency. A sudden change in market sentiment causes panic and investor responses which bring about a reversal in these capital flows. This transforms an illiquid asset into insolvency and ultimately a currency peg collapse (See Appendix for relevant equations) In a key empirical study Kaminsky and Schmukler (2001) examined the short-run and long-run effects of financial liberalization on capital markets by constructing a comprehensive chronology of financial liberalization in 28 developed and emerging economies since 1973. They used three measures of financial liberalization: (a) capital account liberalization (capital mobility); (b) domestic financial system liberalization (regulations on deposit interest rates, lending interest rates, allocation of credit, and foreign currency deposits) and, (c) stock markets liberalization (evolution of regulations on the acquisition of shares in the domestic stock market by foreigners, repatriation of capital, and repatriation of interest and dividends etc). The authors arrived at the following broad conclusions: 1. While liberalization has been an uninterrupted process in most developed markets, it has been characterized by reversals in emerging markets, in which capital controls and restrictions are at times reintroduced. They also found that the pattern of liberalization varies across regions, with developed countries liberalizing first their stock markets and developing economies opening first their domestic financial sector. 2. Although liberalization leads to excessive financial booms and busts in the short-run, these booms and busts have not intensified in the long run. In fact, despite the claim that financial integration leads to volatile capital markets around the world, stock market cycles become less pronounced after liberalization. The short-run effects of liberalization vary across developed and emerging markets. The evidence from emerging markets reveals larger booms and crashes in the immediate aftermath of liberalization. In contrast, the evidence from developed markets, with larger bull markets but less pronounced bear markets in the aftermath of deregulation, supports the view that liberalization is beneficial even in the short run. 83. To explain the contrasting short and long-run effects of financial liberalization, the authors collected information on the quality of institutions as well as data on the laws governing the functioning of the financial system. The evidence suggests that as the quality of institutions improves, financial cycles become less pronounced. Perhaps due to lack of correct incentives, countries do not tend to improve their financial systems before liberalization, disregarding the typical policy prescriptions. Baldicci, de Mello and Inchauste (2002) in a new approach considered the impact of financial crises (defined as large scale nominal currency depreciation and successful speculative attack) on the incidence of poverty and on the distribution of income in Mexico. The authors identified the following channels through which financial crises affect poverty and income distribution: • A slowdown in economic activity following a crisis leading to a fall in earnings of both the formal and informal-sector workers. Reduced working hours and real wage cuts adversely affect the earnings of the poor. • Relative prices change after a currency depreciation leading to an increase in the price of imported food (and domestic food prices). This in turn adversely affects poor individuals and households that are net consumers of food. • Spending cuts (fiscal retrenchment) affect the volume of publicly provided crucial social services and limits the access of the poor to these services at a time when their incomes are declining. • Changes in asset prices (wealth effects) following changes in interest rates and real estate prices affect the wealth of the better off. IV. Arguments for and against financial liberalisation policies (a) For In what appears to be a parallel world, many authors still praise the advantages of liberalization. It is claimed that financial liberalization helps to improve the functioning of financial systems, increasing the availability of funds and allowing cross-country risk diversification. • Obstfeld (1998) argues that international capital markets can channel world savings to their most productive uses irrespective of location. • Stulz (1999) and Mishkin (2001) claim that financial liberalization promotes transparency and accountability, reducing adverse selection and moral hazard while alleviating liquidity problems in financial markets. These authors argue that 9international capital markets help to discipline policy makers, who might be tempted to exploit an otherwise captive domestic capital market. The benefits of financial liberalization can therefore be grouped into increased access to domestic and international capital markets, and increased efficiency of capital allocation. (b) Against • Critics of financial liberalization policies have argued that the efficient markets paradigm is fundamentally misleading when applied to capital flows. In the theory of the second best, removing one distortion need not be welfare enhancing when other distortions are present. 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 honor 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. • Stiglitz (1994) argues in favor of certain forms of financial repression. He 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. • 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. • Finally, 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 10institutional development in the country. In this sense, the arguments that Stiglitz (1994) makes in favor of government intervention in financial markets in the form of prudential regulation and supervision are convincing. The main argument is that the government is, de facto, the insurer of the financial systems, and hence a financial collapse can have significant fiscal repercussions. V. Measurement problems (a) Proxies for repression (and liberalization) • Several empirical studies have tried to address the extent to which financial liberalization affects growth. Researchers have followed two distinct empirical approaches. One approach is to proxy financial liberalization with outcome variables; the other approach focuses on explicit policy measures. Regarding outcome variables, several measures have been suggested to proxy financial repression. Early empirical literature focused on the value of real interest rates as an indicator of repression. The presumption was that countries with negative real interest rates were financially repressed, while those with positive ones were liberalized. In short, it was found that countries with negative real interest rates exhibit lower growth rates compared with those with positive real interest rates. However, De Gregorio and Guidotti (1993) claim that real interest rates are not a good indicator of financial repression, and that a better indicator of repression, or lack thereof, is the ratio of credit to the private sector to GDP or a similar measure of financial development (actually financial widening rather than financial deepening). • Similar concerns were expressed regarding the measurement of financial deepening. Prior to international financial liberalization, broad money offers a good indication of the banking system’s scope for credit expansion, since domestic bank deposits are the main source of finance for bank lending. When capital controls are abolished, however, capital inflows — in the form of deposits made by foreign residents in domestic banks — add to the funds banks have available for credit expansion but do not increase broad money (since they are excluded from it by definition). Money based measures of financial deepening may therefore be misleading when capital inflows are important. • Capital flows are not the only reason why money and credit-based measures of financial deepening may diverge. In general, government borrowing from the banking system will, for a given level of broad money, reduce the amount of credit available to the domestic private sector. If private sector activity is more productive than government expenditure, then this crowding out of private borrowing may have strong negative repercussions for economic performance that would not, however, be reflected in the conventional measure of financial deepening. . 1. Liberalization as a catalyst for higher saving, (McKinnon -Shaw) McKinnon (1973) and Shaw (1973), analysed the benefits of (if not eliminating) Financial. Firdu Gemech and Professor John Struthers University of Paisley The Mckinnon -Shaw Hypothesis, in its’ various forms, is now thirty years old. Over that period