Effect of Financial Liberalisation on Economic Growth - Essay Example

Effect of Financial Liberalisation on Economic Growth By Professor Class University City Date of submission Introduction Financial liberalization is a term used in describing a whole set of measures including the autonomy of the central bank from the government and adequate freedom of finance of moving into and out of the economy that implies there is full compatibility of the currency. It also includes abandoning of all the priority sectors lending targets and removal of all restrictions on the ownership of the bank. In the recent years, many emerging markets have been able lift restrictions on cross-border financial restrictions to help improve the performance of the economy. The conventional view behind lifting the restrictions are to receive the capital flows from the developed countries to assist in financing higher investments and growth, insuring against any aggregate shocks and reduction in consumption volatility. Furthermore, the lift also aimed at accelerating the development of the domestic financial markets that would allow countries achieve an efficient domestic allocation of capital and better method of sharing individual risks (Akyüz, 2014, 118). It is believed that financial liberalization helps in improving the financial development of a country, which in turn triggers economic growth. However, some researches indicate that liberalization might induce risk-taking behavior, which could in turn trigger banking crises. Capital account liberalization cannot occur under a given threshold. In the presence of the banking efficiency, the financial liberalization could result in major risks for the economic development process. Whenever the economy exists in a vulnerable region, every poor performance of the investment is likely to result in the banking crisis. As a result, such factors could delay the processes of development by periods relatively to the condition of the closed economy. Theoretical framework It is unquestionable that financial development and the consequent effect on the economic growth and development have been over the years the most inexhaustible areas of research. The introduction of financial liberalization in most countries emerged from the quest to develop a financial system that existed in the ancient centuries. The response of economic growth differs from one financial sector to another. Liberalization of the banking sector might assist in improving the efficiency of the banking system, which in turn could stimulate investments. Nevertheless, the practice could also raise the proportion of non-performing loans. Liberalization of the stock markets could help reduce the cost of capital and promote efficient capital allocation. With respect to the neoclassical theory, financial liberalization might help deepen the development of the domestic financial system and consequently improve efficiency (Arestis & Sawyer, 2005, 258). In addition, the practice might as well attract foreign investments and optimization of capital allocation, hence has a positive effect on the economic growth of the country. However, the financial crisis in most developing economies in the late 1990s and the most recent subprime crisis have been able to withdraw the reconsideration on the existing connection between economic growth and financial liberalization. Financial liberalization has diversified effect on the economic growth of the country; nonetheless, these effects depend on the nature and the degree of the financial sectors of liberalization. Within the banking sector, opening of the domestic markets, deregulation of both interest rates and credits, financial restrictions reductions, and improved efficiency of the banking system are likely to stimulate development and economic growth. In addition, in the stock market sector, improved financial development, reduced cost of capital and enhanced corporate governance are likely to spur the economic growth as well. Unfortunately, distortions such as informational asymmetries could adversely affect economic growth. With respect to the capital account sector, foreign direct investment (FDI), increased capital inflow, and greater foreign firm entry might lead to greater capital accumulation. However, negative implication of foreign liberalization might result from the volatility of the capital flow, incurred high inflation, and current capital account deficits. According to the neoclassical theory, financial liberalization plays an important role in eliminating the interest rates controls, government interference with the banking system, and privatization of the national banks of the country. Most researches argue that developing the financial sector is the key driver of economic development. Although mainstream academic studies indicate an existence of a progressive relationship between economic growth and financial liberalization, the developed countries are the major drivers of these effects. Besides, the hypothesis of the growth effect in the emerging markets is often mixed and fragile. From the economic theories, the purchasing power parity (PPP) determines the relatibve value of competing currencies. Such factors might result in inflation if no adequate measures are put in place. PPP in goods markets Absolute PPP: Ed/f = Pd/Pf In logs: ed/f = pd – pf Relative PPP: Δed/f = πd – πf Real ER: Qd/f = Ed/f.Pf/Pd In logs: qd/f = ed/f + pf - pf If PPP holds, Q = 1, q = 0 Banking sector liberalization About the banking sector, neoclassical theory notes that the effects of financial liberalization are often expected to facilitate the economic growth. The theoretical explanation, therefore, follows the rational that in most cases reforms often result in increased efficiency, which in turn contribute to growth. It is significant to note that efficient investment after the liberalization process. Eliminating credit deregulation and interest control directly assist in removing the constraints associated with financial system, stimulation of the bank lending, improvement in capital allocation, and increased quantity and efficiency. Besides the investment becoming efficient, the banking systems also become efficient. Financial liberalization assists in opening the banking markets such as the introduction of the foreign bank competition and privatization of the national bank, which helps in improving the functionality of the banking system and the quality of the financial services, offered. These practices have positive implications on the banking systems (East Asian Seminar in Economics, Itō, & Rose, 2008, 118). More importantly, banking liberalizations assist in reducing financial restrictions, stimulates investment, and enhances efficiency with the banking system. As a result, banking liberalization incurs economic growth. Although liberalization increases efficiency within the banking system, it has negative effects as well. Deregulating domestic banking system could lead to the increment in financial risks and the loan values provided to the people. Such activities could allow banks with moral hazard practices to exploit the citizens since there are no effective regulations that guide them. In addition, banks could also invest in assets that bear high to maintain larger market share. These negative practices reduce the quality of the assets resulting in sophisticated proportion due to the non-performing loans and proving of the uncertain debts. With regards to such situations, there is a great effect on the efficiency and growth. The high cost of acquiring the information by the locals could limit the foreign banks to cream skimming that relates to lending on the most profitable local firms. Stock market liberalization It is the aim of every business to occupy a space within the global market. Liberalization of the stock market has the ability to spur economic growth in different ways. Such liberalization practices reduce the cost of capital through a wider risk sharing practice and fostering domestic stock market development, which plays an important role in contributing to increment of investments that spur economic development. Whenever there is imperfection in the equity markets, the effects associated with external capital is likely to be more costly than the internal capital. Furthermore, shortages in the internal capital could lead to reduction in the investment below the optimal levels. With respect to the legal environment, liberalization plays a crucial role in enhancing the protection of the investors, which is one of the greatest sources of economic prospect (Mendoza & Quadrini, 2010, 116). However, the foreign investors might insist on having better corporate governance and protection of the investor. To some extent, these practices are likely to reduce indirectly the existing gap between internal and external finance cost, which promotes financial development, so does the economic growth. Any country practicing equity market liberalization gives foreign investors the opportunity of investing in domestic equity securities while it offers the domestic investors the rights of transacting in the foreign securities. Such practices also increase investment rates. Even though practicing equity market share offers several opportunities to the investors and economic development of a country, it has several shortcoming associated with it. Simultaneous liberalization of the stock market is viewed as a foundation of monetary security especially in relation to the financial market crisis. Most studies reveal that there are distortions embedded in the stock market, which play significant role in weakening the growth effect (Broner, Ventura, & National Bureau of Economic Research, 2010, 78). An example of the distortion includes information asymmetries, which prevents profitable investment of the foreign capital a factor that could adversely affect the economic growth. Capital accounts liberalization Liberalization of the capital account is likely to have an impact on the capital. In addition, it reduces the constraints and removes most of the trade barriers associated with capital flow. Most importantly, increment in capital inflow, greater entry of the foreign firms, and foreign direct investment (FDI) increase could lead to improvement in the capital accumulation. These practices could improve the employments rates of the country, which in turn might contribute to economic growth. Liberalization of the domestic capital account often attracts international portfolio of investment flow. Portfolio investment approach is an efficient frontier with an ability to improve the efficiency of the domestic financial market; as a result, it contributes to financial development. Furthermore, foreign direct investments to assist in the facilitation of transfer of technological expertise, which might in turn immensely, contribute to improvement in the domestic research and development (R&D) and capabilities. According to the endogenous growth theory, the efforts of R&D play a significant role in determining the long-run growth of an economy. However, some theories such as the neoclassical theory have a different perception on the economic growth. The theory implies there are negative effects associated with capital account liberalization. Capital flows are short term, volatile, and in most cases it subject to sudden withdrawal and various surges. Some researches indicate that openness of an emerging market often increases the level of uncertainty that make investors less attractive. Consequently, such effects are likely to facilitate capital flight. Most countries view foreign investors as momentum investors a factor that causes the in the foreign capital flow. In the late 1996 and early 1997, the capital inflows led to financial crisis that led to dramatic increment in the non-performing loans, deep contraction in the economy, deterioration in the quality of investment, and weakening of the balance sheets of the banks (Mathur, 2006, 207). According to the estimates of the World Bank, in 1999, the total output of five countries in Asia that were experiencing crises was 17% below the pre-crisis trend path. Capital inflows have the ability to appreciate the domestic currency, which could affect the trade balances making the deficits of the current account unstainable. Moreover, capital inflows might lead to rapid consumption of the fuels and increased inflation rates, which have the negative relation with economic growth. Empirical evidences About liberalization of the banking sector, the empirical studies reveal that partial and full liberalization has positive and negative growth effects respectively. With respect to the East Asian economic growth, partial liberalization of the banking sector offers beneficial characteristics. During the initial phase of the liberalization, there was development of the financial cycle, which marked the development of the intermediation and deepening of the financial sectors. Consequently, these practices temporarily kept the economic growth rates high. The East Asian countries also achieved the steady growth virtually, which greatly contributed to high savings and investments rates in the early 1980s to 1990s. However, with the growth of liberalization, the countries acquired full liberalization, which affected the economy. The occurrence of the financial crisis in these countries justifies the harmful effect of full liberalization. Moreover, crisis resulted in exorbitant economist cost. For example, in 1997, the banking crisis in Indonesia reached 55% of the country’s total GDP, in Thailand it was at 35% and 28% in Korea (Lee, 2003, 251). Such abnormal balances imply that full financial liberalization might be used in explaining the decline in both economic growths in the East Asian Countries. Moreover, such trade led to increased inflation rates in most Asian countries. Figure 1: Asian countries affected by financial liberalization Figure 2: comparison of financial liberalization effect in the Asian countries In the stock market liberalization, studies indicate that there is a positive relation between the stock market development and economic growth. The liberalization of the stock market spurs economic growth. The linkage amid these variables is often considered direct, robust, and instantaneous. Averagely, these studies indicate that liberalization of the stock market leads to 1% increment in the annual per capita GDP growth. With the focus on the emerging markets, the stock markets often become liquid offer the liberalization process. The effects of opening the market in the emerging markets are likely to offer benefits that outweigh the perceived risks that often result from the foreign portfolio flows. The increment in capital flows could increase the stock prices (Bekaert, Harvey, Lundblad, & National Bureau of Economic Research, 2004, 152). However, studies have different opinions on whether these effects are temporary or not. If these prices are temporary, then the incident might reflect "price pressure" phenomenon. However, if the price increments are permanent, then there might be a reflection of a long-lasting decline in the cost of the capital associated with sharing the benefits of stock openings in the emerging markets. Nevertheless, some empirical evidence support the hypothesis liberalization of the market equity shares could improve economic growth. Additionally, companies that depend much on the external finances in most cases experience increased growth owing to liberalization. Empirical studies indicate a positive effect on liberalization of capital account and economic growth. Whenever there is a change in capital liberalization, the real per capita GDP often experience growth. However, some studies indicate that there is no correlation between liberalization of the capital account and economic growth. With focus on the emerging markets, studies reflect a fragile and mixed growth effect hypothesis. However, most empirical studies indicate that the results capital account liberalization is greatly driven by the developed countries. In addition, there is restriction of the benefits of liberalization to more developed countries instead of the emerging markets. High-income countries often drive the positive effect (Fung, Ho, & Zhu, 2005, 189). Nonetheless, in some countries, liberalization of the capital account often results in an inverted U-shaped effect. According to such shapes, liberalization process has no affect both the rich and underdeveloped countries, but a substantial effect on the middle-income countries. More importantly to note is that liberalization often exerts positive effect on economic growth on most middle-income countries. However, it remains insignificant in both high and low-income states. Conclusion The paper focused the effects of liberalization on the various sectors of the economy. These sectors include banking, capital account, and stock market in which the major conclusion is that these factors affect the economic growth differently. However, it is important to note that the financial liberalization impact on the economic progress of a country depends on nature and the degree of the financial sector. The degree relates to full or partial nature of the sector in question. Interest rates and credit deregulation within the banking sector might increase the efficiency of the banking system, which could in turn spur investment and economic growth. Regarding stock market sector, financial liberalization might lead to reduction of cost capital, enhancement in the corporate governance, protection of the investors, and improved financial development. In addition, increased capital inflow and FDI contribute positively to the economic growth of a country. References Akyüz, Y. 2014. Liberalization, financial instability and economic development. London: Anthem Press. Arestis, P., & Sawyer, M. C. 2005. Financial liberalization: Beyond orthodox concerns. New York: Palgrave Macmillan. Bekaert, G., Harvey, C. R., Lundblad, C., & National Bureau of Economic Research. 2004. Growth volatility and financial liberalization. Cambridge, MA: National Bureau of Economic Research. Broner, F., Ventura, J., & National Bureau of Economic Research. 2010. Rethinking the effects of financial liberalization. Cambridge, MA: National Bureau of Economic Research. East Asian Seminar in Economics, Itō, T., & Rose, A. 2008. International financial issues in the Pacific Rim: Global imbalances, financial liberalization, and exchange rate policy. Chicago: University of Chicago Press. Fung, M. K., Ho, W., & Zhu, L. 2005. Financial Liberalization and Economic Growth: A Theoretical Analysis of the Transforming Chinese Economy. Pacific Economic Review, 12(7), 122-127. Lee, C. H. 2003. Financial liberalization and the economic crisis in Asia. London: RoutledgeCurzon. Mathur, V. 2006. Foreign trade of India, 1947-2007, trends, policies, and prospects. New Delhi: New Century Publications. Mendoza, E. G., & Quadrini, V. 2010. Financial globalization, financial crises, and contagion. Cambridge, MA: National Bureau of Economic Research. Read More