The importance of correctly sequencing the process of financial liberalisation was brought to light by the experience of pioneer liberalisers in Latin America in the 1970s. Both Argentina and Chile liberalised rapidly by removing con- trols over interest rates and privatising and injecting competition into the banking sector. However, this process was undertaken at a time of severe macroeconomic instability and before an appropriately robust framework of financial regulation and supervision was in place. The capital account was also liberalised in the same environment. In the early 1980s, both countries experienced significant economic turbulence and crises (Williamson and Mahar, 1998).
Almost immediately, economists focused in on the sequencing of reforms as the key issue, and a consensus began to develop as the appropriate sequencing in this respect (ibid.):
1 stabilise the macroeconomic environment;
2 remove restrictions on international trade;
3 develop robust and effective framework of financial regulation and prudential supervision;
4 remove controls over interest rates;
5 eliminate credit controls;
6 remove barriers to competition;
7 liberalise capital account.
When we compare the approach taken in Argentina and Chile in the 1970s to this ideal sequence, it is perhaps not surprising that these two countries ran into difficulties. However, it is very easy to be wise after the event, and it should be remembered that this ‘consensus’ only emerged after these two countries had gone through the first stage of liberalisation.
On reflection, however, it does seem intuitively obvious that countries attempting to liberalise their financial sectors are more likely to succeed if they do so in an environment of at least relative macroeconomic stability.
Similarly, it must be sensible to develop an effective framework of regulation and supervision of the financial sector before it is freed from government control. Finally, it is clearly logical for capital account liberalisation to be the last piece of the jigsaw, since if it were the first, inflows would be
likely to be misdirected to unproductive parts of the economy – as was the case under financial repression. Furthermore, channelling such inflows through an unreformed, and possibly insolvent, banking sector, with little experience of intermediating funds on a commercial basis, is clearly a recipe for disaster.
At the time, however, when financial repression had largely failed, and liberalisation was hailed as the only course for the future by the IMF and by the high proportion of government economists trained in neo-classical economics in developed country universities, it would be surprising if the sequencing was perfect.
Williamson and Mahar (1998) demonstrate that this was indeed the case for the majority of liberalising countries from the 1970s onwards. For example, while Chile, New Zealand, Peru and Turkey combined financial liberalisation with a broader package of measures aimed at macroeconomic stability, Argentina, Brazil, Egypt, Mexico and Venezuela began to liberalise during periods of high instability and before any stabilisation measures had been introduced. Also, half of the countries entered the liberalisation pro- cess with a long track record of government fiscal deficits at more than 5%
of GDP.
The literature also suggests that trade reform is an important precondition for financial liberalisation, as it enables capital to flow to genuinely efficient and productive firms, and not just to ostensibly profitable, but inefficient firms, sheltering behind trade barriers. In this regard, the majority of developed countries did indeed introduce trade reforms ahead of financial liberalisa- tion, as did Korea, Mexico, Sri Lanka and Thailand. For the remainder, many countries introduced trade reforms simultaneously with financial liber- alisation, while a smaller number – Australia, Colombia, Indonesia, Malaysia and South Africa – embarked upon the process of financial liberalisation before restrictions on imports were lifted. With regard to the privatisation of the banking sector, the record is mixed, though few countries followed the literature and embarked on this process before financial liberalisation. Rather, the removal of the state from the banking sector generally occurred at or around the same time as financial liberalisation (ibid.).
The next stage of our ideal sequence sees a robust framework of financial regulation and supervision13 put in place before financial liberalisation. Here, the record suggests that most countries did not view this as a particularly important component of the reforms. For developing countries, only Israel, Morocco and Peru tightened up the prudential supervision of banks ahead of financial liberalisation, while a number of countries attempted to perform both tasks simultaneously. The bulk of countries, however, only seriously attempted to improve the regulatory and supervisory framework some years after financial liberalisation had begun (ibid.).
We have seen that, although these reforms should ideally precede the liberalisation of interest rates, this was generally not the case. However, the one area where the ideal sequence given above was generally followed was in
leaving the liberalisation of the capital account till last. For Williamson and Mahar (op. cit.) this was the only aspect of the ‘conventional wisdom’ regard- ing the sequencing of financial liberalisation that was followed by the majority of formerly repressed countries in their sample.
Furthermore, not only did the majority of countries leave capital account liberalisation (CAL) until the other reforms had been implemented, most also only did so when (most of) the preconditions for successful CAL were in place.
For Williamson (1993) preconditions for the liberalisation of capital inflows are:
1 trade liberalisation at least two years previously;
2 a fiscal deficit below 5% of GDP for three years previously;
3 domestic financial liberalisation two years previously;
4 opening of banking sector to domestic and foreign competition two years previously;
5 government ownership of banking sector reduced to less than 40% two years previously;
6 a robust system of prudential regulation and supervision in place.
For Williamson and Mahar (op. cit.), while most of these preconditions were in place, the fourth and sixth preconditions were less often met. That is, many countries opened their economies to unrestricted capital inflows – including short-term flows – before the domestic banking system had been exposed to competitive forces and before a robust system of prudential regulation and supervision was in place.
When we consider the broader process of financial liberalisation in developing countries, it is therefore clear that many of the preconditions now considered to be essential were not in place in many countries before the process began. In particular, the importance of exposing the domestic banking sector to competition, and to having an effective regulatory and supervisory framework in place before liberalisation, was clearly not given enough weight. It is interesting to note, of course, that these two fea- tures of the banking system perform the same task in many ways: both ‘dis- cipline’ the banking sector. If we accept that, in general terms, banks have a tendency to take on excessive risk then mechanisms must be put in place to prevent this.
As has been stressed, however, it is important to avoid the danger of being wise after the event. These sequencing issues may seem rather obvious now – particularly in the light of the Asian financial crisis of the late 1990s – but in the 1980s and early 1990s there was far less talk of the importance of such matters. Indeed, as the IMF’s own Independent Evaluation Office (IEO) reported in 2005, the Fund was often a ‘cheerleader’ for capital account liber- alisation and tended to emphasise the positive consequences that could result and to place far less – if any – emphasis on the potentially negative implications. However, the report also argues that the Fund did not ‘insist’
upon CAL, but rather supported forces within governments that were intent on this course of action. The importance of Western-trained neo-classical economists rising to positions of influence within the policy-making bodies of many developing countries should not be underestimated here, as is discussed in Box 3.4.
Box 3.4 Neo-liberal economists and the promotion of capital account liberalisation
Chwieroth (2007) provides a fascinating study of the role of neo-liberal economists in the process of capital account liberalisation in developing countries. Using a sample of 1,500 high-ranking economists (finance ministers) and central bank governors in emerging market economies, Chwieroth tests quantitatively for the relationship between a neo-liberal perspective (which he associates with academic training at universities with a strong neo-classical tradition, predominantly in the US) and the probability of capital account liberalisation being implemented as a policy measure.
In the first stage of the study, Chwieroth tests to see whether the appointment of a neo-liberal finance minister or central bank governor is itself a ‘random’ event. Interestingly, he finds that such appointments are correlated with the need to establish international economic policy credibility, but only in the case of finance ministers. In the second stage of the research, Chwieroth (p. 456) controls for the factors that may have influenced the original appointment of the finance minister and finds strong evidence that:
Even when the possibility of nonrandom selection is taken into account, the coefficient measuring the influence of a neoliberal policymaking team is signed as expected and significant. This find- ing strongly suggests that neoliberal economists matter for policy choices independent of the processes leading to their appointment.
The very unusual approach taken in this study suggests strongly that capital account liberalisation is not simply foisted onto reluctant gov- ernments by idealogues from the IMF, for example. Rather the inculca- tion and diffusion of economic ideas – particularly when taken as the only feasible or ‘credible’ option – through the conduit of shared academic experience is a strong force in shaping policy outcomes.
Many ‘mistakes’ were thus made in the process of liberalisation. However, as stressed above, this is unsurprising in many ways, as liberalisation itself may have been seen as something of a panacea to other ills, and perhaps
promoted as such by those with the ear of developing country policy-makers who in turn may have been sympathetic to such views given their own academic backgrounds.
Before bringing this chapter to a close by considering what lessons should be imparted to countries being urged to liberalise today, the next section considers one final question: even if all of the ‘mistakes’ described above could be avoided, is full-scale financial liberalisation the best course to take for all countries and in all circumstances?