This paper talks about the theory of financial repression and application of its provisions, as in the cases of India and China. Financial repression refers to government intervention in the financial environment by substituting regular market variables and mechanisms with its own…
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This essay describes the concept of financial repression, and illustrate the mechanism of its action, using the cases of different countries. The studies conducted by experts confirm that the restrictions imposed on the financial sectors of these two countries have indeed negatively impact on their respective economies giving credence to the McKinnon-Shaw hypothesis.
Financial repression must have been fundamentally influenced by Keynesian economics as well as provoked by the instability of the early 20th century events. Financial repression is underpinned by the theory that the state should intervene in financial matters to ensure lesser demand for money that should be channeled instead to the capital/labour sector.
It was McKinnon and Shaw, who called attention of the world to the negative effects of such practices. Their hypothesis recommended the liberalisation of the financial sectors from such restrictions to stop stagnation and initiate economic growth.
They asserted that financial repression causes economic stagnation and that countries must therefore liberalise their financial sectors. This assertion is confirmed by other studies and models as well. Nonetheless, a number of cases exists that point to a contrary finding such as the cases of Korea and Malaysia that were both placed under financial repression in the 1980s to avert financial collapse. This paper presented the cases of India and China, both of which are considered emerging global super economies, where the provisions of the theory proved to be accurate.
The existence of financial repression can be deduced from the presence of the following factors: unsystematic distortions in financial prices such as interest and exchange rates; interest rates with ceiling caps and nominal interest at fixed rates, which lead to low or even negative real interest rates; high reserve ratios; guided credit programmes, and; ineffective credit rationing (Bhole 16). Gupta (2004), however, narrowed down the elements of financial repression into interest rate ceilings, high reserve requirements and compulsory credit allocation. The consequences of these intermediary measures are: the implementation of high reserve and liquidity ratio for the purpose of easing budget deficits forcing banks to hold government bonds and money; private bond and equity markets remain undeveloped because of the difficulty of getting government money from private securities, and; government measures adopted to discourage private financial entities from competing with the public sector and to spur low-cost investment characterise the banking sector with interest rate caps (2). Financial repression is an economic tool usually employed by developing countries and was popular before the last quarter of the 20th century. It was said to be a knee-jerk reaction to the events of the first half of that century. History shows that the first half of the 20th century was blighted by two financial catastrophic events: the Wall Street Crash in 1929, and; the Great Depression, which was instigated by the Crash. These two events were themselves thought to be two of the underpinning reasons for the outbreak of WWII. The lesson that these events brought was that command economies were more stable and that the state can take the
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