3.3.1 Liberalisation and interest rates
Unsurprisingly, given that financial liberalisation was largely proposed to remove artificial ceilings on interest rates, countries that have undergone a process of liberalisation saw real interest rates rise significantly.
However, in many cases interest rates did not move to modestly positive levels, but rather rose sharply to very high levels, often remaining there for some time. Figure 3.1 below illustrates this process with regard to Turkey. As we can see, real interest rates were negative in Turkey throughout the 1970s, reaching more than 100% in 1980. Following liberalisation in the early 1980s, however, nominal rates rose sharply taking real rates into strongly positive territory for the first time in a decade.
While it is broadly accepted that negative real rates of interest did have many negative effects as described by McKinnon and Shaw, this does not mean that very high rates of interest lead to positive outcomes. Below we consider the impact of interest rates on, first, the rate of saving and, second, investment rates.
3.3.2 Liberalisation and savings rates
Intuitively, it seems obvious that higher rates of interest paid on deposits will elicit higher rates of savings. However, one flaw in this prediction of the MSH that was highlighted quite early was the fact that it assumes all individuals
Figure 3.1 Real interest rates in Turkey, 1973–1983.
have equal access to credit markets. Campbell and Mankiw (1990) suggest that, in reality, some individuals will match this description, while others may have no access and therefore have no ability to smooth consumption over time by saving and borrowing.
Furthermore, for those at or near subsistence incomes, saving is not a viable option regardless of the rate of interest, which suggests that for the poorest developing countries, where a significant proportion of the population may be close to subsistence incomes, savings rates will be relatively insensitive to changes in interest rates.
Although a huge literature has developed to examine the link between real interest rates and savings, the question remains relatively ambiguous, with studies often producing contradictory results. For example, Fry (1978, 1980, 1995) finds that in a sample of fourteen Asian developing countries, higher real interest rates are positively associated with higher national savings rates, though the strength of the relationship is weak and not robust to changes in time periods or countries. However, the direction of causality is far from clear even in this limited relationship, with other studies suggesting that high regional savings rates were caused by factors other than movements in real interest rates. The contradictory and inconclusive nature of many studies in this area led to more nuanced work which examined the relationship for different levels of interest rate and in different time periods. Reynoso (1989) finds that savings increase rapidly as real interest rates move from extremely negative to slightly less than zero, but the strength of this relationship tails off as rates become positive, and then turns negative as real interest rates rise further (Williamson and Mahar, 1998).
Surprisingly, however, a considerable number of studies suggest that increases in the real rate of interest lead to a fall in the savings rate, rather than an increase. These effects are found most clearly in countries at higher levels of development, with the results suggesting that where interest rates are liberalised in a context of wider financial sector development, the greater financial options available may lead to a lowering of savings rates. For example, Chapple (1991) finds that individual and corporate savings rates declined in New Zealand following financial liberalisation, and Bayoumi (1993) finds a similar effect for the UK following financial deregulation in the 1980s.
Many other studies find little or no link between real interest rates and savings in developing countries, particularly the poorest, which is most likely related to low aggregate incomes and the ‘subsistence income’ effect described above.
To the extent that this evidence tells us anything, it is that:
1 modestly positive real interest rates in middle-income developing coun- tries may be optimal for maximising savings rates;
2 both very negative and high real rates are associated with lower savings rates in the same group of countries;
3 for the poorest developing countries, there is little if any relationship between interest rates and the level of national savings; and
4 higher real interest rates – in the context of broader financial deregula- tion/liberalisation – are associated with lower rates of saving in high- income economies.
As we saw in Section 3.3.1, however, financial liberalisation in developing countries has often been associated with sharp increases in real interest rates.
The evidence on the link between interest rates and investment rates sug- gests that very high interest rates have a negative relationship with rates of investment.
For example, Greene and Villanueva (1991) examine twenty-three develop- ing countries from 1975 to 1987 and find that real interest rates are negatively correlated with investment. Demetriades and Devereux (1992) find similar results for sixty-three countries from 1961 to 1990, while Gelb (1989) finds a positive – though very weak – relationship between real interest rates and investment (Williamson and Mahar, op. cit.).
It is perhaps not surprising that high real rates of interest are associated with lower rates of investment, though the similar relationship between inter- est rates and savings rates in developed countries is less intuitively obvious.
What is clear, however, is that the optimal outcome – mildly positive real interest rates – has not tended to follow financial liberalisation. Rather, we have tended to see very high real interest rates in most liberalising economies, particularly the less developed ones.
3.3.3 Liberalisation and financial depth
A number of different measures of financial depth have been proposed in the literature. In general terms, these measures focus on ratios of broad monetary aggregates to the size of the economy, which provide a snapshot of the importance of the financial sector.
The most straightforward of these measures – variants of which are the most commonly used indicators – is the money/GDP ratio, which measures the level of ‘monetisation’ in the economy. Studies may use either ‘narrow money’ (M1) or ‘broad money’ (M2/M3).3 The rationale for using the broad money measures is that although narrow money – i.e. notes and coins in circulation – should increase at the same rate as the growth of the economy, broad money should increase at a faster rate in the presence of financial deepening; that is, as financial intermediation increases and credit is allocated to the private sector with greater magnitude. With a limited number of excep- tions, most studies confirm that this is in fact what has occurred: financial depth has tended to increase following liberalisation.
In their panel of thirty-four developed and developing countries, Williamson and Mahar’s (1998) findings on financial depth are summarised in Table 3.2 below. As we can see, financial depth increased in all developed
countries following liberalisation, with the exception of France. For develop- ing countries, financial depth increased substantially or moderately in most of the countries considered. However, the Philippines, Turkey and Venezuela all saw financial depth fall after liberalisation.
3.3.4 Liberalisation and the efficient allocation of (domestic) financial resources
As we have seen, one of the key arguments in favour of financial liberalisation was that it would lead to a more efficient allocation of resources, which in turn would increase the rate of growth. Whereas in repressed economies credit was often directed towards inefficient state enterprises, a liberalised financial sys- tem would see finance allocated on a straight commercial basis, with the financing of only the most productive ventures raising levels of productivity and growth throughout the economy. Thus, financial sector development need not increase the quantity of investment to have a positive impact upon growth, but may also do so through raising the average quality of investment.
Table 3.2 Liberalisation and financial depth:
M2/GDP ratios, 1980–1996
Country Before
liberalisation After liberalisation
United States 60 70
Canada 52 59
Japan 84 113
UK 37 46*
France 70 65
Australia 36 61
New Zealand 25 37
Indonesia 16 39
Korea 33 41
Malaysia 42 85
Philippines 28 46
Singapore 58 83
Thailand 54 74
Argentina 14 19
Brazil 12 40
Chile 9 34
Venezuela 31 23
Turkey 14 24
India 42 46
Pakistan 39 42
Source: Williamson and Mahar, 1998.
* UK’s definition of M2 changed in 1987. Under new formulation depth ratio increased from 81% in 1987 to 109% in 1996
We saw in Chapter 2 that it is this aspect of financial sector development that, for many commentators, explains the econometrically demonstrated link between financial sector development (FSD) and economic growth.
This perspective has been supported in theoretical work where models are developed which explain the positive impact upon growth of FSD in terms of greater allocative efficiency.4 In this regard, Gregorio and Guidotti (1992) estimate that three-quarters of the correlation between financial intermedi- ation and growth can be explained by a more efficient pattern of credit alloca- tion (Williamson and Mahar, 1998).
What has been the real-world experience at the country level, however? A number of country level case studies have been generally supportive of the view that financial liberalisation results in a more efficient allocation of investment.
In the case of Ecuador, for example, Jaramillo et al. (1992) find that after liberalisation there was a greater supply of credit to more technologically effi- cient firms. Studies of Indonesia find a similar shifting of credit after liberalisa- tion, which again tended to favour more technologically efficient firms.5 In Korea, Atiyas (1992) finds that liberalisation led to a greater access to credit by smaller firms, who may have been disadvantaged in the previous repressed regime, where credit was focused on the large conglomerates, or chaebols. Simi- larly, improvements in the allocation of credit are found in studies of Mexico (Gelos, 1997), Argentina (Morisset, 1993) and Turkey (Pehlivan, 1996).6
For multi-country studies similarly supportive results are found. Chari and Henry (2002) examine the impact of liberalisation at the firm level in Jordan, Korea, Malaysia and Thailand, and find that in each case the average firm saw an increase in James Tobin’s q7 as well as an increase in the level of investment after liberalisation. The results are supported in an IMF study of the same countries by Abiad, Oomes and Ueda (2004). Finally, Galindo, Schiantarelli and Weiss (2007) report robust evidence that liberalisation in twelve developing countries resulted in an increase in the efficiency with which investment funds are allocated, particularly that the correlation between the supply of credit and the economic fundamentals of borrowing firms is higher after liberalisation.
3.3.5 Liberalisation and the efficient allocation of (international) financial resources
We have seen that, in line with the predictions of advocates of financial liberalisation, the process has been associated with a more efficient allocation of financial resources at the domestic level. However, it was also predicted that liberalisation of capital accounts would see a similar reallocation of global investment funds. In particular, there would be a shift in the allocation of global capital from the developed countries towards developing and emerg- ing economies that have greater potential for growth.
Figure 3.2 shows net private capital flows to all developing and emerging economies from the early 1990s to 2006. As can be seen, there is certainly no
secular trend of increasing flows, as might be expected in the aftermath of an era of extensive financial liberalisation.
Rather, what we see are cyclical ‘booms’, where capital flows increase sig- nificantly, followed by lengthy ‘busts’, where the predictions of an increasing flow of capital from the developed to the developing world are turned on their head, and capital begins to flow from the developing world to the developed world.
Figure 3.3 looks at the same period broken down by type of capital flow and focusing on portfolio flows (i.e. equities and bonds) and international bank lending. Foreign direct investment (FDI), which was large (averaging a little Figure 3.2 Total private capital flows to developing and emerging economies, 1993–
2006.
Source: IMF WEO.
Figure 3.3 Portfolio flows and bank lending, 1993–2006.
under US$200 billion per year) and remarkably stable throughout the period is excluded. We are interested in determining whether international investors and bankers have increasingly sought out financial investment opportunities in the wake of liberalisation and so we concern ourselves with arm’s-length financial flows rather than FDI, which responds to different drivers.
As we can see, once FDI is removed, the direction of financial flows since 1993 is largely from developing to developed countries. Clearly, the data is strongly affected by the Asian crisis of 1997–1998, with the negative banking flows in particular reflecting these events. However, in many ways this is the exception that proves the rule: one aspect of financial liberalisation that was not predicted – not by its advocates anyway – was the sharp increase in financial crises that has occurred.
Before considering issues of capital account liberalisation in more depth, the next section gives a broad outline of the impact that liberalisation has had upon the incidence of financial crises.
3.3.6 Liberalisation and financial crises
In 1985, Carlos Diaz-Alejandro argued that financial liberalisation would inevitably lead to an increased risk of financial crises in developing countries.8 The evidence suggests that, on balance, he was right. Willamson & Mahar (1998) find that of the thirty-four countries they consider which underwent a liberalisation process, all experienced some form of systemic financial crisis between 1980 and 1997.
However, crises in only twenty-one of these countries followed directly after the liberalisation process, and while not all of these were necessarily directly caused by financial liberalisation it seems very likely that a substantial proportion certainly was.
When weighing up the benefits and costs of financial liberalisation – par- ticularly of the capital account – it is essential to take the increased likelihood of crises into account. Too often policy-makers have received advice on financial liberalisation that has focused largely on the potential rewards, skirt- ing over potential drawbacks. This practice has become less widespread since the Asian financial crisis of the late 1990s however, where the dangers in this regard were made all too clear. The subject of financial crises will be dealt with comprehensively later in this book, but now is an opportune time to sketch out the consequences of such events.
Research by Griffith–Jones and Gottschalk (2004) estimates the impact of crises on emerging markets output. Examining data for eight countries that have suffered serious financial crises, the authors conclude that their combined loss of output following a crisis totalled US$1.25 trillion. This foregone out- put corresponds to 65% of the combined GDP of Latin America and the Caribbean, and 54% of that for the East Asia and Pacific region. Effects of this magnitude clearly impact upon poverty levels in the countries concerned:
in Indonesia, for example, poverty levels rose from 7–8% of the population
in 1997 to 18–20% in 1998 (Suryahadi et al., 2000) as a result of the Asian financial crisis. Looking at the last quarter of the twentieth century, Eichengreen (2004) estimates that currency and banking crises have reduced the incomes of developing countries by approximately 25%.
It should be noted, however, that although the risk of a crisis increases significantly after liberalisation, it is not inevitable. As we shall see, the risk in this regard is strongly related to the strength of regulation and supervision of the financial system, which suggests that liberalisation should proceed only after such reforms have been undertaken. These issues of sequencing of liber- alisation will be discussed more fully in the following sections of this chapter.
Before this, however, the next section explores the issues surrounding cap- ital account liberalisation in more depth.
3.3.7 Capital account liberalisation and growth
Many of the reforms instigated throughout the process of financial liberalisa- tion are relatively uncontentious. For example, it is widely accepted that allowing the private sector to allocate scarce investment resources according to the relative merits – i.e. the prospective rate of return – of competing investment projects will result in a more efficient outcome than if this func- tion is performed by government, assuming that the private sector is equipped to perform this role. Having said that, as we shall see later in this chapter, this consensus does not hold in all circumstances: recent advances in both theory and practice suggest that there are many situations where the market mechanism is likely to fail to deliver optimal outcomes, justifying targeted government intervention.9
When we come to capital account liberalisation, however, any consensus evaporates. Until relatively recently the debate has been largely polarised, with supporters of capital account liberalisation advocating its implementa- tion in all circumstances, while, at the other extreme, opponents have argued that it is a mistaken and damaging reform in all circumstances. As with much in economics, positions taken on this debate are often more ideological than pragmatic, with perspectives being shaped as much theologically as empiric- ally. To the extent that this is the case, opinions are not readily changed, regardless of the weight of evidence.
Before attempting to separate some light from the great quantity of heat that this process has produced by weighing the evidence on both sides, we need to first establish the context in which this debate has arisen.
(a) Capital account liberalisation: the theoretical benefits
Despite the fact that capital account liberalisation has increasingly been seen as a pillar of orthodox economic theory, there is little in the way of unequivocal evidence to support it. The case in favour has generally been something of an offshoot of better-established policy reform proposals, notably those in
favour of free trade. That is to say, the theoretical support for free trade is a central tenet of economic theory, where the fundamental principles of comparative advantage mean that removing barriers to trade is widely viewed as a win-win policy: even if only one country unilaterally removes trade restrictions, the aggregate benefits to the country as a whole should still out- weigh the costs, though there would certainly be losers as well as gainers in different parts of the country and sectors of the economy.
Given the central place this perspective holds in the field of economics, there has been a tendency to equate the case for capital account liberalisation with that for current account liberalisation: if all benefit from the free movement of goods and services, surely the same is true for the free movement of capital?
Intuitively, the case is straightforward: just as the allocation of capital within the domestic economy according to the strictures of commercial logic leads to a more efficient allocation of funds, the same should hold inter- nationally. Domestically, the process should raise productivity and growth, by focusing scarce investment resources on those ventures that will yield the highest rate of return. Internationally, global capital should similarly seek out the most productive ventures, thus raising productivity at the global level and boosting global growth.
However, as Eichengreen and Leblang (2003) point out, this argument only holds in a ‘first-best’ world, and it should certainly not be assumed that the real world we inhabit fits this category. In particular, the predictions of advo- cates of capital account liberalisation are likely to be undermined in the presence of weaknesses in the domestic financial system, which may be amplified by an open capital account, and/or weaknesses in the interna- tional financial system that prevent the smooth and rational flow of capital described in stylised fashion above, but rather increase the likelihood of financial crises.
If it is the case that capital account liberalisation will only be positive with well-developed domestic financial sectors, and similarly well-developed, orderly international financial markets, what does empirical work tell us about the impact in practice? In particular, remembering the guiding prin- ciple of this book, has capital account liberalisation been associated with higher rates of growth in developed, developing and emerging economies?
(b) Capital account liberalisation: what is the evidence?
Modern empirical work to explore the link between capital account liberal- isation and growth began in earnest in the early 1990s, and early results were not encouraging for advocates of reform.
Alesina et al. (1994) examined twenty developed countries for the forty years preceding 1990 to assess the relationship between capital account liberalisation (CAL) and growth, and found insignificantly small effects. The study was extended to sixty-one countries in Grilli and Milesi-Ferretti (1995), with similarly negative results. Rodrik (1998) also found no relationship with