Arguments for and against Financial Liberalisation - Essay Example

? Critically discuss arguments for and against financial liberalisation In the last few decades, statistical figures show transformations in the socio-economic sector of Republic of Korea (ROK, Korea) which had suddenly transformed from having regressive and poor socio-economic conditions, into an advanced industrial society. During this time period, its rate of economic growth had persistently remained higher than the global or the regional averages (Amsden, 1992), and this was mainly owing to the policies of financial market liberalization that brought a huge inflow of foreign capital. At this time, Korea also underwent significant demographic changes, where the majority of its population started residing in urban areas. While demonstrating the Korean changes Chang (1999, 31) used the term ‘compressed modernity,’ thus, aptly summarising these rapid changes. The high growth phase that lasted for almost four decades finally came crashing down in 1997, owing to the rippling effects of the Asian financial crisis that took place at around the same time in 1997- 98. After this episode, the Korean government brought in many financial changes, and while continuing with intensified financial market liberalization it followed the various recommendations given by the IMF with aims to improve the situation. Since the applications of these reforms, IMF had touted Korea’s macroeconomic recovery as being highly successful in nature. This is evident in a letter by the IMF’s Managing Director’s letter praising Korea's successful reforms which claims, "the close cooperation between Korea and the IMF over the last few years has been exemplary and in many respects serves as a model for other countries" (News Brief No. 01/82, 2001). A majority of the researches on Korea’s recovery after the Asian crises, had attributed it to the polices of financial liberalisation and open markets. However, the financial market liberalization, which is counted to be at the base of the Korean reforms after the 1997 fiasco, had a rather complex structure, and did not follow the simple criterion of the free market structure as are generally viewed through the conventional perspective. This complex process reflects various varying factors of economic and also political interests at work, that are emulating and interacting constantly with each other, and was a result of reforms brought in by the Korean government that kept on changing, while also following the financial norms created by the former dictatorial regime. In this article, in view of the South Korean economy, studies will focus on the basic query as to whether financial liberalisation is actually the primary reason behind any country’s economy growth. Discussion What is financial liberalisation: Financial liberalization pertains to the adoptions of different measures in order to remove or lessen the stringent state regulatory mechanisms, which tend to control the functioning of the various financial institutions, and monitor the instrumental and agent activities within the various segments of the country’s economic market. These measures can be of two types, as regards a country’s internal or external regulations (Ghosh and Chandrasekhar, 2003). While working towards internal financial liberalization, certain typical measures are followed, that may vary in certain degrees from country to country, as per the requirements, which are listed below (Ghosh, 2005, 2-4): A major step towards internal financial liberalisation includes elimination or alleviation in the controls on the return rates and interest rates, as are charged by the various operating financial agents, primarily the banks. However, the main central bank still continues to monitor and regulate the rate structures by its own functions in the liberal market economy and also through the process of adjusting the discount rates, offered by the other financial institutions. in an economy that operates under financial liberalisation the ‘interest rate ceilings’ are very often removed, thus allowing stiff competition between financial institutions that aim to attract both potential loan receivers (debt) and money depositors (opening an account in the bank/investing money in that financial firm). this results in a condition where there occurs a ‘price competition squeeze’ which finally forces the financial institutions desperate to maintain good returns, to focus on the figures pertaining to volume In cases of financial liberalisation, the state removes itself from the role of an intermediary in the financial sector, while there is a large-scale privatization of the nationalised banks, citing their inability to function with a market dominated by liberal financial policies. Along with this, there also occurs the changeover of the “development banks” into normal banks; and all these modifications are consorted with a marked decrease in directed credit and a dismissal of the necessity to make allocations for special credits to certain sectors that had been marked as ‘priority.’ These priority areas may range from government sectors, agricultural sectors, or any other small-scale producing sectors, and sectors considered as important for various developmental or strategic purposes. Financial liberalisation also pertains to relaxed conditions where there can active participation from both the financial investors and the corresponding financial firms within the stock market arena. These conditions are achieved by removing or alleviating the ‘listing conditions,’ providing unrestricted liberty in price fixing of the new issues, by giving complete freedom to various ‘middlemen,’ like the brokers, and by easing conditions pertaining to investments on borrowed funds and also borrowing against existing shares within the market economy. Financial liberalisation pertains to the easing of the controls over investments addressed by the various financial firms, and, more specifically the removal of all perceived barriers between the banking and non-banking sectors. it has been observed that in most cases when finance has not been liberalised, the state attempts to keep the different divisions of the financial sector like mutual fund business, merchant banking, and the insurance as segregated sectors. Under such conditions, the agents within one sector are disallowed from investing in another segment of the same financial sector, in order to avoid conflicts’ of interests and cause losses in business. However, when financial liberalisation takes place, there occurs a removal of the segregating barriers, which ultimately leads to the formation of universal banking type or what is termed as “financial supermarkets.” With financial liberalisation comes the extension of the access sources through which the various financial firms or agents can easily receive their funds. This leads to the growth of various bodies such akin to GDRs (Global Depository Receipts) or ADRs (or American Depository Receipts, where there occurs release of various primary issues within US market economy, by organisations that are not based in the US), or GDRs (Global Depository Receipts). Financial liberalisation pertains to the relaxation of the norms that govern the types of financial mechanisms released and acquired, within the operating financial systems. This leads to breakdown of the traditional norms where the banking system formed the primary ‘intermediary bearing risk’ body. In a conservative financial system, banks have always taken comparatively less individual liabilities that were liquid in nature and with short maturities, and these liabilities projected lower earnings and capital risks. The bank used these liabilities to make non-liquid, large, rather ‘risky’ investments that were of longer maturities and since the state accorded protection to the banking sectors, with strong regulatory mechanism in place, safeguarding its viability, given the risks that the banks undertook. With financial liberalization, there occur removals of all the accorded protections, thus, highlighting the move to creating financial assets of a risky nature to the hands of the institutions that are suitable and also willing to play with it. financial liberation is equivalent of removal of norms (as regards, accounting rules, capital adequacy, and other associated rules) that made adherence to all statutory guidelines compulsory; and the central bank now plays the role that is merely supervisory in nature. External financial liberalization signifies changes within the ‘exchange control’ rules. “Typically, full convertibility for current-account transactions accompanying trade liberalization have been either prior or simultaneous reforms, which are then complemented with varying degrees of convertibility on the capital account” (ibid). Thus, in cases of external liberalisation certain new measures are formed that gives access to the foreign residents to hold financial assets (equity/ debt) which are domestic in nature. There is also more freedom for the national firms to receive foreign commercial loans, even without any guarantee or supervision by the respective states. There are removals or lessening of norms pertaining to the regulatory controls on the ingression of new financial organisations, which are made subject the fulfilment of certain pre-specified rules in the arena of capital investments. However, there is no internal competition in this regards, as it involves liberty to buy out financial firms, for both the foreign and national players operating within the same financial sector. Financial liberalisation of this kind also grants permissions to the investors of a foreign origin, into the domestic market where they can play in hedge funds and pension funds, and invest in the domestic debt and equity markets, resulting in a process of consolidation. External liberalisation may also involve processes that allow national firms or individuals to own financial assets of a foreign origin, though it is not common in practice. Countries that get excess capital inflows that do not translate into domestic investments, thus resulting in large foreign-exchange reserves (often unnecessary), have instead used it in mechanisms that focuses on decreasing the exchange rate pressures. In this context, we will now study the effects of trade liberalisation of South Korean economy primarily after the 1997 economy crash. South Korean economy prior to and after the Asian crises: In the years 1960-1995, when Korea decided to opt for financial liberalisation, its “investment rates that averaged 25% of GDP and average per capita growth rates exceeding 6.0% per year” (Demetriades and Luintelb, 2001) changed the economic profile of the country. From being “a relatively underdeveloped state [it turned] into a highly industrialised economy with living standards comparable to those in many Western countries” (ibid). During this period, South Korea, adopted various financial policies that hindered the liberties of the various financial institutions that functioned with the objective of fixing the interest rates and granting funds for loans. The policies were framed with the objective of obtaining finances at a low cost for various industries deemed necessary for a sustainable economic growth, thus removing all forms of financial repression pertaining to high reserve requirements, interest rate ceilings and directed credit programmes (McKinnon, 1981; Fry, 1997). Thus, Korea adopted policies that composed of the typical reforms recommended by the World Bank and IMF that advocated the financial ‘liberalisation’ of domestic economic markets. To achieve this, South Korea removed the interest rate restrictions, privatised all national banks, and all forms of state intervention were removed from the processes pertaining to the allocation of funds for loan. The South Korean experience with the financial constraints is significant owing to the reason that it not only coincided with unprecedented growth in the economic sector, but also taking into account the fact that though it ‘practiced’ financial liberalisation, the South Korean government actually maintained extensive control over the credit pricing and allocation. The government also took measures to ensure that the various priority sectors, like, shipbuilding, steel, electronics, automobile manufacturing, electronics, etc., that received special support as regards receiving bank credits. Besides these, the Korean Ministry of Finance also maintained close control over the lending and deposit rate structures. The South Korean move towards achieving financial liberalisation that started during the 1960s aimed, at elevating the market role within the existing financial system (World Bank, 1989). Many researchers contended the suggestions that these reforms decreased the state’s role controlling the processes and activities that took place with the financial system of the country (Amsden and Euh, 1993; Harris, 1988). Thus, we find a complex situation, where we are forced to ask whether the ‘invisible’ financial restraints kept in place by the intervening state contributed to the miraculous growth of the Korean economy, or could the growth would have been even better without the restraints? some theorists argue that the financial restraints did not hinder growth in any form, though there is a lack of evidence to support his theory (Park, 1994). However, there is a way to achieve economic growth despite having certain financial restraints and it is through the system of financial development. In this context, we will now examine the reasons behind the Korean unprecedented economic growth, in order to find out ad to where financial liberalisation is indeed necessary for a domestic market to thrive. McKinnon-Shaw approach to the question: A close look at the McKinnon-Shaw literature will show us that the relationship between financial and economic development is primarily based on Gurley and Shaw's ‘debt-intermediation hypothesis.’ As per this hypothesis, an elevation in the monetary stock in relation to the degree of actual economic activity tends to increase the levels of intermediation in the financial arena, which further acts by increasing the ‘productive investment’ and the ‘per-capita income.’ It further adds that the “nominal interest rate controls inhibit capital accumulation because they reduce the real rate of return on bank deposits, thereby discouraging financial saving” (Demetriades and Luintelb, 2001, 465). Additionally, greater reserves requirement tend to exert have degrading influence on the intermediation by widening the gap between deposits and borrowing rates. “Thus, higher real interest rates encourage capital accumulation and real economic activity, largely through an increase in the extent of financial intermediation” (ibid). The McKinnon-Shaw approach also shows that the greater ‘real’ interest rates have an elevating effect on the “average productivity of the aggregate capital stock” by discouraging the investors on putting their money on projects with low returns (Fry 1997; World Bank, 1993). In the McKinnon/Shaw framework, the banking institutions are assumed to perform under a perfect ‘competitive conditions’ where the deposits can be transformed into loans without any cost (McKinnon, 1973). However, it is not possible in real scenario to provide a perfect competitive condition for the banks and in many LDCs we can perceive the ascendency of a small number of banks reflecting collusive behaviour within the banking industry (Fry, 1997). This shift away from the perfect conditions creates certain important implications on the manner in which financial development of a country is affected by the financial restraints. As for example, within the structure if a monopoly bank that must work under deposit rate controls, one must assume that the bank has the appropriate technology that can be used for influencing deposit volumes without bringing in any changes in the deposit rate. thus here one must also assume that there is the presence of certain savings outside the banking system “that could be attracted to the banking system not only through higher deposit rates but also through an improvement in the non-pecuniary attributes of bank deposits” (Demetriades and Luintelb, 2001, 6). Fig 1: The MonoBank Model showing an increase in the deposit rate. This graph “depicts a downward sloping demand for bank loans along with the associated marginal revenue curve. The slope of the demand schedule for bank loans reflects the availability and convenience of substitutes to bank loans, such as curb market loans”( Demetriades and Luintelb, 2001, 465 & 466). In such cases, the mono-bank optimises its profits by choosing lending rate “im” for which the loan volumes are “Lm.” Now if one assumes that the state government fixes the lending rate ceiling at the level “i1”; then the marginal revenue curve goes flat up to point A the position, where the fixed ceiling rate curve joins the demand curve. Then the curve again, moves downwards to join the marginal revenue curve (point B) after which we find that the 2 curves coincide. Here, we observe that the optimum profit position is one, where the L1, (new loan volume), is greater than minus the fixed ceiling. Thus, we can deduce by the constraints of the lending rate ceiling by the state government assists in raising the bank and deposit volumes. Under this framework, we can also examine the “sensitivity of financial deepening to changes in the level of the administered deposit rate” at cases when there is also a ceiling rate fixed for lending rates. This condition was commonly observed during the rise in South Korean economy, and the mono-bank model as proposed by McKinnon (1973), reflects the South Korean experience well. This model is particularly important when it is assumed that the deposit rates were fixed under formal state control until the 1980s, and unofficially until the late 1990s. As a result, this mono-bank model, under the assumptions of fixed ceiling rates and changing levels of state intervention can give a clear insight into the South Korean picture. As per Park and Kim (1994) in the South Korean context, “during the most repressive period…the commercial banks were little more than government agencies delegated the tasks of mobilizing savings and allocating them according to directives and guidelines issued by the government” (p. 215). The privatisation of the nationalised banks in the Korean context slowly started during the early 1980s, the government started releasing its control over the interest rates, thus allowing the banks to achieve optimum monopoly profit, and raising the interest rates while also restricting the output rates (Park and Kim, 1994). Thus, one can conclude at this time, the degree of state authority over the Korean banking system was inversely proportional to the banking system’s ability to work as a profit producing monopoly cartel. Thus, one can presumable that it produced a positive relationship between the level of state authority over the Korean banking systems and the nature of the financial development. This situation can be explained in the fig 2 where the depicted point A is the banking system equilibrium position, under the objective of producing volume optimisation (under conditions of ‘zero loss’ constraint). Point B is the equilibrium position that will be taken by a bank cartel, if there were no restrictions to its optimizing the profits. The depicted Intermediate points can be assumed as reflecting the various changing levels in the state authority over the existing Korean banking system. Fig 2: The mono-bank model: volume maximising vs. profit maximising (Demetriades and Luintelb, 2001, 469). Thus, by here again by creating a situation that is akin to the Korean banking system model, it has been shown that state control over the banking systems do not have much of demeaning effect on the financial development of market economy. Here Demetriades and Luintelb, 2001 gives us an interesting insight into the “financial restraints by utilising information from annual reports of the Bank of Korea pertaining to interest rate controls and reserve requirements. We record two types of interest rate controls: a ceiling on the deposit rate (DRC) and a ceiling on the lending rate (LRC). These controls are measured by dummy variables that take the value 1 if a control is present and 0 otherwise. Data on the required reserve ratios on time deposits (RRTD) and demand deposits (RRDD) are also collected” (ibid, 15). Table 1: Financial development models Sample period: 1956–1994 (39 observations); instrumental variable estimation (instruments for yt: xt, ?kt). Variable definitions: L1 and L2 are narrow and broad measures of financial depth respectively. FR1t is weighted principal component index of financial restraints; FR2t: equally weighted index of financial restraints; LRC: interest rate ceiling; x: the logarithm of real exports per capita. Diagnostics: AR(1) is a Lagrange Multiplier test for first-order serial correlation distributed as chi-square (1). Sargan's test is a test of the validity of the instruments distributed as chi-square (1). The first stability test is a Wald test for a structural break. The second stability test is Chow's test for the stability of regression coefficients. Figures in parentheses are standard errors. One and two asterisks denote significance at 5% and 1% levels, respectively. AR(1) and Sargan's tests are not applicable to Model B, the estimates of which are obtained after correcting for first-order moving average errors. The Durbin–Watson test of the reported estimates suggests no serial correlation (Demetriades and Luintelb, 2001, 474). Here a comparison of the models A, B and C as developed by Demetriades and Luintelb, (2001) shows us that in South Korea the repression of the ceiling rates by the state government did not have any negative effects on the financial development. The result was in fact a positive financial development that boosted the economic growth by decreasing the bank cartel ability to act as a profit-optimising monopolist. Conclusion Here using the studies made by Demetriades and Luintelb in 2001 and with the help of assumptions on the nature of the monopoly banking system, using the McKinnon/Shaw framework, and with figures collected from the Korean banking system over the entire period framing the economic boom in the country, it could be proven that financial liberalisation is not always necessary for the economic growth and development of the country. Financial development can also be achieved with state controlled growth and development. Bibliography Amsden, A. 1992. “The South Korean economy: is business-led growth working?” In, D. N. Clark (Ed.) Korea Briefing, 1992, 71-95. Amsden, A. and Euh, Y. 1993. South Korea's financial reforms: good-bye financial repression (maybe) hello new institutional restraints. World Development 21, pp. 379–390. Abstract. Chang, K. 1999. Compressed Modernity and its Discontents: South Korean Society in Transition. Economy and Society 28 (1): 30-55. Demetriades, P., and Luintel, K., 2001. Financial restraints in the South Korean miracle. Journal of Development Economics, 64 (2), pp. 459-79. Fry, M. 1997. In favour of financial liberalisation. Economic Journal 107 442, pp. 754–770. Ghosh, J. October 2005. The Economic and Social Effects of Financial Liberalization: A Primer for Developing Countries. DESA Working Paper No. 4 ST/ESA/2005/DWP/4 Ghosh, J., and Chandrasekhar, C. (eds.), 2003. Work and Well-being in the Age of Finance. New Delhi: Tulika. Harris, L., 1988. “Financial reform and economic growth: a new interpretation of South Korea's experience.” In, Harris, L. et al., New Perspectives on the Financial System. London: Croom Helm. McKinnon, R. 1973. Money and Capital in Economic Development. Washington, DC: Brookings Institution, McKinnon, R. 1981. “Financial repression and the liberalization problem in less developed countries.” In, Grassman, S., and Lundberg, E., (Eds.) The Past and Prospects of the World Economic Order. New York: Macmillan Press, 356–386. News Brief No. 01/82, August 22, 2001. IMF Managing Director Congratulates Korea on Early Repayment of 1997 Stand-By Credit. IMF. Retrieved from, http://www.imf.org/external/np/sec/nb/2001/nb0182.htm Park, Y., ad Kim., 1994. “Korea: development and structural change of the financial system.” In, Patrick and Park, (Eds.) The Financial Development of Japan, Korea and Taiwan: Growth Recession and Liberalization. Oxford: OxfordUniversity Press. World Bank, 1989. World Development Report 1989. Oxford Univ. Press, New York. World Bank, 1993. The East Asian Miracle: Economic Growth and Public Policy. Oxford Univ. Press, New York. World Bank, 1999. World Development Finance, Basle. Read More