3.5.1 The external sector
Proponents of financial liberalisation rapidly extended their reform pro- posals from the domestic to the external sector. In this regard, Stiglitz et al.
(2006) give the following rationale, which they dispute, for this move:
1 Free markets are inherently superior to restricted markets, and this is just as much the case for capital flows as it is for trade.
2 Developing countries are generally capital-poor, so the flow of capital from developed countries – in search of higher marginal returns – will enable more productive investments to be undertaken with beneficial effects on growth and thus poverty levels.
3 Liberalising the capital account is stabilising, since countries are able to access a broader range of sources of capital – i.e. a domestic downturn leading to a scarcity of internal financial resources can be offset by accessing external sources of funds.
4 CAL is also good for domestic investors as it enables them to broaden their investment portfolios beyond the local market, thus improving the risk/return trade-off through portfolio diversification.
5 Open capital accounts increase the likelihood of ‘responsible’ policies being followed as, through ‘market discipline’, countries that do so will be rewarded, and those that do not will be ‘punished’.
The authors argue strongly that these arguments are ill-founded – at best they refer to particular rather than general cases – and that the problems that have accompanied financial liberalisation are not all the result of in- appropriate sequencing. Rather they are the predictable consequences of certain key features of the financial system that proponents of across-the- board liberalisation ignore:
1 Fundamentally, they are out of touch with developments in modern eco- nomic theory, which question the notion that market solutions are always optimal. In particular:
(a) Market failure is pervasive in all markets, and particularly so in financial markets (Stiglitz, 1994).
(b) Given this, government intervention can often be – at least in prin- ciple – welfare-enhancing.
2 CAL does not necessarily lead to higher growth by attracting funds that can be used for investment purposes. It is just as likely to do the opposite, and lead to widespread capital flight from the country.
3 Even if CAL did attract short-term capital flows there is no evidence that flows of this kind will lead to higher growth through the funding of investment. Experience suggests that they are more likely to be used to boost consumption and lead to asset price bubbles in non-traded sectors such as the property market in pre-1997 Thailand.
4 External capital flows are not stabilising, as argued by proponents of CAL, but are the exact opposite. External capital flows to developing countries are highly procyclical, thereby tending to amplify pre-existing booms, leading to overheating and financial crises, and the exacerbation and lengthening of economic contractions.
5 As well as short-term volatility, external capital flows also exhibit medium-term waves of volatility, often driven by bouts of ‘irrational exuberance’ about the wonders of investing in developing countries, followed by equally irrational pessimism about the prospects of such markets.
6 The fact that capital flows are driven by short-term factors means that they cannot provide the market discipline that proponents suggest, although they certainly do restrict policy autonomy. Indeed, capital flows to developing countries can rise as economic fundamentals are deterior- ating and vice versa. For most investors, the focus is on maximising short-term profits in markets that are liquid enough to allow for a rapid exit at the first sign of trouble. Furthermore, the ‘punishment’ doled out by international investors is often not directed at those most deserving of it, but is more likely to impact upon countries striving to implement orthodox policy reforms, since these are the countries that had attracted capital inflows in the first place.
For Stiglitz et al. (2006) the core argument against the wholesale liberalisa- tion of the capital account is that it almost always increases instability and risk, but does not necessarily increase growth. Furthermore, this is more the result of the nature of the international financial system than of short- comings in the countries that are recipients of capital flows. This suggests that, however well sequenced and adroitly managed, full capital account liberalisation may still result in damaging consequences. In particular, while short-term capital inflows may temporarily buoy up the economy in a super- ficial sense – such as raising asset prices and thus producing the sense of increasing wealth – they also greatly increase the potential for crisis. The
negative effects of rapid capital outflows, however, are an unalloyed disaster for developing countries.
Moreover, when we consider the impact upon levels of poverty, it is clear that increasing instability within these countries will hit the poor and vulner- able first and hardest: those with the most precarious jobs will be the first to lose them in an economic downturn; in the absence of a social security safety net provided by the state, there is no mechanism to support affected families and facilitate a transition to other employment; and, with little or no savings or access to financial products such as insurance, the cumulative results can be catastrophic for individuals and their families.
When we weigh the evidence on the benefits of external financial liberalisa- tion it is clear that to blindly follow the path of liberalisation may not be the best option. Indeed, if after carefully weighing the likely costs and benefits in their own particular case, countries do choose to liberalise then the process must be carefully sequenced and managed, and the option of retaining con- trols over some kinds of inflows – particularly short-term flows – should be seriously considered. As with much else in this book, there is no one answer that is suitable for all countries in all circumstances: Singapore is not China.
In this regard it is interesting to note the change of position taken on capital account liberalisation by the IMF. As recently as September 1997 the Fund was seeking to alter its Articles of Agreement to include a mandate to promote capital account liberalisation. The timing, to say the least, was not ideal. By 2003, however, the IMF took a far more cautious line on CAL, very much stressing the importance of getting the preconditions and sequencing right before the process should be undertaken.
Although caution would appear to be called for when considering liberal- isation of the external sector, it has been suggested that, in the domestic sphere there is more consensus. Even here, however, there are dissenting voices, which have grown stronger in recent years. What are the issues in this regard?
3.5.2 The domestic sector
While it is the case that liberalised domestic financial systems can be far more effective than repressed systems, the majority of the evidence in this regard relates to developed economies. As pointed out above, it is certainly true that, within developing countries, very different historical, cultural, institutional and geographical characteristics mean that liberalising reforms will lead to very different outcomes. However, it is also the case that important differ- ences between developed and developing economies, in the aggregate, mean that what is appropriate in the developed world may not be so in developing countries. In this regard, the far greater importance of the banking sector in developing countries – where capital markets are generally underdeveloped – is a key distinction. The approach to this sector is therefore of fundamental importance.
For Honohan and Stiglitz (2001) financial regulatory regimes, particularly the prudential supervision of banks, in developing countries are increas- ingly modelled on forms prevalent in developed countries. In particular, the authors note the trend towards minimalist, arm’s-length prudential regula- tion, which relies on the assessment and approval of the risk control pro- cedures of financial intermediaries and the imposition of small amounts of risk-adjusted ‘accounting capital’ to influence behaviour, and they cha- racterise this trend as: ‘dangerously complacent for developing countries’
(ibid.: 31).
For the authors, the problems with such an approach are that:
1 It fails to take account of how imperfectly bank capital is measured in many developing countries, as well as the fact that senior management have an incentive to obfuscate in this regard, so as to minimise the quantity of capital needed to be set aside for regulatory purposes.
2 It overrates the accuracy with which the risk associated with the alloca- tion of this capital – i.e. the risk-weighted capital – is measured. For example, the underestimation of risks encourages banks to raise their exposure to this ‘underpriced risk’.
3 It overemphasises the accounting measures of capital at the expense of the more important interaction of capital and banks’ franchise value.
4 More generally, principal–agent problems14 are endemic in the financial systems in developing countries, which prevents the incentives of key actors becoming aligned and distorts the real-world impact of policy changes.
The result of these features is that the supervisory approach is too often one of box-ticking, rather than a more meaningful attempt to promote the stability of the financial sector. In part this is an inevitable consequence of the limited supervisory expertise in many countries – coupled with inade- quate resourcing of this key sector – but the result is often that the tendency of banks to take on excessive risk is not constrained to the extent that it should be. Given the greater importance of banking in the developing world, the result of these shortcomings is often severe in terms of the incidence of banking crises, as well as the more general effectiveness of the banking sector in performing its vital intermediation role in the economy.
Honohan and Stiglitz (op. cit.) thus argue for a process of ‘robust financial restraint’ rather than full-scale financial liberalisation, of which more will be said when we deal with issues of financial regulation in subsequent chapters.
With regard to the desirability of some level of financial restraint, Caprio et al. (2001) make more general points about the shortcomings of the market mechanism. In particular, the authors argue that:
1 Free markets do not always produce a socially efficient allocation of credit within the economy.
2 Asymmetric information15 is pervasive in all markets, but a particular feature of financial markets. The result is often credit rationing16 with interest rates remaining at below market-clearing levels;17 and therefore 3 Government intervention in the financial sector can lead to superior
outcomes.
Caprio et al. (2001) thus argue that liberalisation may not produce optimal outcomes, no matter how well designed and sequenced. The authors accept, of course, that government intervention in the financial system is also no panacea: the outcome of the widespread use of financial repression is ample testimony to this fact. However, they do argue – and the evidence would suggest that they are right – that well-designed, targeted, and time-limited interventions in the allocation of credit and dispersal of risk throughout the economy can lead to superior outcomes in certain circumstances.
For the authors, an effective directed credit scheme would have the following characteristics:
1 It would be of small size relative to total credit within the economy.
2 Subsidies associated with the programme would be relatively small.
3 The responsibility for selecting specific investment opportunities (within set parameters) and for the monitoring of borrowers would be left to the banking sector.
4 Crucially, any such scheme should incorporate a ‘sunset provision’, whereby it would be wound up after a specified time period had elapsed.
Caprio et al. (op. cit.) argue that the approach taken in Japan met all of these criteria except for the last one: the relative size of the directed credit programme undertaken by the Japanese Development Bank continued to expand in the 1970s, although its effectiveness had largely been exhausted.
Despite this shortcoming, the programme in Japan is widely seen as being effective, at least during its early years.
The effectiveness of the East Asian ‘developmental state’ model, where credit was directed towards key sectors and ‘national champions’, has been much debated. Those arguing for more proactive government involvement in the development process point to the success of many East Asian economies which appeared to have followed this path, often contrasting their success with the lack of progress in countries that had taken a more laissez-faire approach. Others argue, somewhat implausibly it must be said, that the region’s success was due to its openness and outward orientation, particularly to the focus on export-led growth, and that the economies of the region thrived in spite of – not because of – their directed credit schemes.
With regard to the influence of financial repression in the region, Stiglitz and Uy (1996) argue that ‘repression’ in East Asia worked, and its success was based on the fact that it differed from that in other developing regions in six key ways:
1 There was a willingness to change credit policies rapidly in the event of failure.
2 More directed credit was channelled through the private sector than through government schemes.
3 Performance criteria were used to guide directed programmes.
4 The use of direct subsidies was strictly limited.
5 The proportion of directed credit allowed in the system was restricted.
6 There was strong and effective monitoring of the performance of recipi- ents of directed credit.
The success of the East Asian region’s economies suggests strongly that full-scale financial liberalisation is not the only – or perhaps even the best – means of spurring growth and development, particularly during the early stages of the process. Furthermore, it seems probable that the features of the directed credit schemes described by Stiglitz and Uy above did play a role in generating this success.
What does this cumulative evidence offer policy-makers today, when con- sidering the merits or otherwise of financial liberalisation versus financial repression?
Some policy implications and concluding remarks
We have seen in this chapter that both governments and markets can and do fail. The financial repression of the post-war era was largely a rational response to the market failure that had preceded it in the 1920s and 1930s.
Furthermore, the demise of financial repression was itself inevitable in the context of widespread government failure to limit, target and manage the process properly.
Where ‘repression’ worked it was time-limited, strictly focused and res- tricted and rationally planned with the incentives of key actors largely aligned.
Where it did not, in contrast, it became a self-defeating and self-reinforcing source of rent-seeking and economic stagnation.
Liberalisation ‘shock-therapy’ has clearly failed, as evidenced by the exam- ple of Russia after the collapse of the Soviet Union – placing blind faith in market mechanisms to achieve optimal outcomes regardless of the historical and institutional context is a recipe for disaster.
As ever, therefore, we must seek a middle way that takes account of a country’s level of development and its institutional context. For example, it is unlikely that full-scale liberalisation will be appropriate in the poorest devel- oping countries, where market failure is endemic, regardless of how well it is sequenced and paced. As Caprio et al. (2001) argue, the more prevalent are market failures, the stronger the case for government intervention in the financial system.
As countries develop and domestic market failures are addressed, scope for increasing the pace of financial liberalisation would seem justified, though
again the particular characteristics of each country – not dogma dressed up as technical and impartial advice – should be the key determinant. Ultim- ately, a liberalised domestic financial sector is the most appropriate destin- ation of middle-income developing countries, though, as we have seen, it may well require governments to influence the allocation of credit in the economy if this stage is to be reached.
When we turn to the external sector, however, matters are less clear cut. A strong case can be made that capital account liberalisation is good for high- income developed countries – though the opposite case could also be made.
It is very difficult to construct a compelling case that the same is true for developing countries, particularly if we rely on empirical rather than theor- etical evidence. Over the long term, there may be some benefits in terms of the efficiency with which capital is allocated, but this only holds in periods when the international financial markets are stable and the domestic financial system is robust. Conversely, openness to international capital movements in times of financial turmoil is clearly negative, regardless of how soundly a country has structured its domestic financial system.
To conclude, early stages of development seem to call for focused govern- ment intervention in the domestic financial system. As market failures are addressed and countries develop, domestic liberalisation becomes more beneficial – it is crucial that the government’s role is strictly limited in terms of both time and size relative to the private sector in this transition period.
There is a strong case for the poorest developing countries to open their economies to FDI flows, but no case for them to do so for short-term capital flows. This case only becomes relevant at much higher levels of income, and even then the evidence suggests that policy-makers should retain the option of imposing capital controls as circumstances demand.
4 The domestic fi nancial system
An overview
Introduction
Thus far, we have considered the key functions and institutions of the finan- cial sector in Chapter 1, examined the relationship between financial sector development, economic growth and poverty reduction in Chapter 2, and assessed issues of financial repression and liberalisation in Chapter 3.
Throughout it has been stressed that the individual circumstances of each country exert a powerful influence on policy outcomes, such that there are few if any examples of policies that are universally applicable in the same form. In the same vein, it is also the case that there is no single, ideal ‘end-state’ for financial sector development – a variety of financial sector structures can and do function well, just as a similar variety of systems do not.
Furthermore, whilst there are important differences between financial sys- tems in developed and developing countries, which we shall come to shortly, there are also major differences between the types of system that have emerged within countries at similar levels of development. For example, Japan and Germany are often described as having ‘bank-based systems’, as banks play the key role in mobilising savings, allocating capital, monitoring the decision-making of corporate managers, and providing risk management instruments. In contrast, the USA, for example, is more often described as a
‘market-based system’, as the capital markets share these functions with the banking sector in a more balanced manner.1
These differences are highlighted in Table 4.1. The table illustrates the greater relative importance of banking in Japan and Germany – where bank deposits are 121% and 97% of GDP respectively – compared to the situation in the USA, which sees bank deposits at 59% of GDP. In contrast, stock market capitalisation is 135% of GDP in the USA, but just 75% and 43%
respectively in Japan and Germany.
As well as these statistical manifestations, a key difference in approach is the nature of financial relationships: in Japan and Germany, for example, banks are more likely to forge long-term relationships with corporate borrowers, where considerations beyond the immediate state of the com- pany’s balance sheet – such as the long-term prospects of the company