Financial Development: The Policy Issues

1. Financial Development:The Policy Issues ECN 4149 Current Issues in Financial Economics Law Siong Hook Universiti Putra Malaysia

2. Finance and Growth: Summary of the Evidence • A positive long-run association between indicators of financial development and growth (or level of GDP per capita). • Less sure about causality • Normally expect to see bi-directional causality • Reverse causality may indicate weaknesses in financial system • Irrespective of causality, well functioning financial systems can help to promote growth • Conclusion: Better, if not more, finance is likely to result in more growth

3. What Factors Promote Financial Development? Removing obstacles to financial development: • Financial Repression/ liberalization • Government ownership of banks • Legal and institutional factors • Political economy factors • Globalization factors

4. ‘Financial Repression’ • McKinnon (1973) and Shaw (1973) saw interest rate controls, directed credit, high reserve requirements and capital controls as a source of ‘financial repression’ • Financial repression, by depressing real interest rates, reduces saving and hinders financial deepening • Results: Investment suffers in both quantity & quality terms

5. r I S r0 r* r1 S I I1 I, S I0 = S0 I* = S* Financial Repression: The McKinnon-Shaw Model

6. Financial Liberalization:The Traditional View • The removal of controls expected to boost saving and financial deepening through higher real interest rates • Greater saving raises investment • Higher real interest rates encourage firms to undertake more productive investment projects • Abolition of directed credit facilitates more efficient allocation of credit by banks

7. Evidence from Financial Reforms • Latin America (Diaz-Alejandro JDE 1985) : ‘Good-bye financial repression, … …hello financial crash’ • Liberalizations of the 1970s and 1980s in Colombia, Uruguay, Venezuela, Argentina, Brazil, Chile, Mexico, Turkey, Israel, Philippines and Indonesia resulted in financial fragility and crisis • Real interest rates soared to +20%, accumulation of bad debts, bank failures • Investment suffered, speculation flourished • GDP per capita fell, poverty increased

8. Analysis of Financial Fragility in the 1970s and 1980s Consensus view: • Lack of macroeconomic stability • large fiscal deficits • high inflation (price distortions) • Inadequate prudential controls • under-capitalized banks took on excessive risks • Incorrect sequencing of reforms • price distortions led to inefficient credit allocation

9. Sequencing Literature • Aims at addressing flaws in traditional model through appropriate sequencing of reforms (McKinnon, 1991). Specifically, suggests that before financial liberalization ensure: • Macroeconomic stability (low inflation, fiscal deficit under control) • Real sector reforms: (trade liberalization, privatization of public enterprises) • Effective system of prudential bank supervision (competent supervisors independent from political authorities)

10. Financial Fragility: Econometric Evidence Demirgüç-Kunt and Detragiache (IMF, 1998) study the determinants of banking crises in 53 countries using appropriate econometric techniques • Probability of banking crisis depends on • growth (–), GDP/cap (–), real r (+), inflation (+), • interest rate liberalization (+) • effect of liberalization not immediate (3-4 years) • strong institutions (law & order, bureaucratic quality, contract enforcement) reduce the impact of liberalization on crisis probability

11. The ‘twin’ (banking and currency) crises • Kaminsky and Reinhart (1999) suggest that financial liberalisation and/or increased access to international capital markets have played a major role in the first phase of ‘twin’ crises • Fin lib fuel lending booms and asset price bubbles • “…capital inflows on occasion can be too much of a good thing” p.46

12. The Asian financial crisis Stiglitz (2000) suggests that premature financial and capital market liberalization was at the root of the crisis • Global economic arrangements fundamentally weak [e.g IMF as international lender of last resort (ILLR)] • The destabilising influence of fin lib may be long-lasting

13. East Asian Stock Markets

14. The Thai Bubble

15. The Asian financial crisiscontinued… Stiglitz (1999) suggests that the tight monetary policies recommended by the IMF, which were aimed at stabilising exchange rates, were destabilising • Difficult issue to address empirically, because interest rates and exchange rates are simultaneously determined • Caporale, Cipolini and Demetriades (2002), using advanced identification methods, find that while tight monetary policy helped during normal periods, it had the opposite effect during the Asian crisis

16. International financial architecture The Asian crisis revealed wider weaknesses in international financial arrangements • With free capital mobility, and the tendency of banks to borrow short and lend long, there is a need for an effective international lender of last resort (ILLR) • The role of the IMF as ILLR is limited, as its resources are limited (cannot print unlimited amounts of the international currency!) and cannot intervene effectively into the supervision and regulation of domestic financial intermediaries

17. Financial Liberalisation and Equity Markets • Bekaert and Harvey (2000, 2003) propagate the benefits of capital account liberalisation, by focusing on its effects on stock returns and the cost of equity capital. They find that • dividend yield decline by less than 1% following fin lib • Fin lib has no significant impact on volatility • Durham (2000) challenges the results found by this literature, suggesting that they are highly sensitive to • alternative fin lib dates • conditioning on other determinants of stock market anomalies

18. Direct effects of financial repression Financial repression may have large direct effects on financial development, over and above the effects of real interest rates • However, these effects are not always negative • In South Korea the effects have been found to be positive (Demetriades and Luintel, 2001), while in India they were found to be negative (Demetriades and Luintel, 1997) • The effects vary depending on market structure (imposing a lending rate ceiling on a bank cartel will increase financial development, even if deposit rates are regulated) and government efficiency

19. Financial liberalisation: conclusions • The case for financial liberalisation is far from proven • More often than not fin lib has been associated with financial and economic instability • This association is not coincidental proven empirically and thee are sound theoretical reasons to expect it, emanating from financial market imperfections • Financial market imperfections can, however, be contained by a sound institutional infrastructure: • An effective system of financial regulation • Contract enforcement and rule of law (protection of investors’ property rights)

20. State Banks & Financial Development • Recent work by La Porta et al JF 2002 suggests government ownership of banks is a deterrent to financial development and growth • Cross country regressions show that government ownership of banking is negatively correlated with economic growth (political view of state banks) and banking crises • Implication: privatisation of state banks leads to higher growth A 10% reduction in the share of state banks results in an increase in growth by 0.25%

21. Is Privatisation the Answer? Again, causality is critical: Andrianova et al. (2002) examine the factors that explain government ownership of banks • Weak institutions may allow opportunistic behaviour in private banking (common in transition economies) • Banking crises result in confidence problems (state banks may offer safe haven for depositors) • At low levels of institutional development, state banks may be the only way to mobilise savings • Empirical evidence suggests that institutions (financial regulation, disclosure rules, rule of law) are much more strongly and robustly correlated with the share of state banks

22. Legal Factors La Porta et al (1998), examine legal rules covering the protection of shareholders. They find that • Common law based legal systems protect shareholders and creditors better than civil-law based systems • Within civil law tradition, the French civil law group does worse than the German and Scandinavian one • GDP per capita has a positive effect on legal enforcement, so that richer countries in the French group can (in principle) offer better law enforcement than poor common law countries

23. Law and Finance • La Porta et al (1997), examine the influence of legal origins on financial development. They find that • French civil law countries have the least and common law countries have the most developed capital markets • However, their results show that legal origins make little difference to banking sector development • Rajan and Zingales (JFE,2003) find that French civil code countries were no less financially developed in 1913 and 1929 than common law countries and only started to lag behind after WWII • Zingales (2003) suggests that legal origins are correlated with many other institutional quality indicators

24. Political Economy Factors • Rajan and Zingales (JFE, 2003) emphasise the lack of political will and capture of politicians by interest groups as an important obstacle to financial development • Openness to international trade and capital flows breeds competition and threatens the rents of incumbents • When financial markets are under-developed, established industrial firms enjoy rents because new firms are unable to obtain financing • ‘Financial incumbents’ enjoy rents because they develop relation-based financing, and become monopolists in providing loans to firms

25. Political Economy Factorscontinued.. • Rajan and Zingales argue that the best way to remove opposition to financial development is to simultaneously open product and capital markets • Liberalising trade without opening the capital account could make things worse, e.g. industrial incumbents could obtain financial protection to (unfairly) fight new entrants • Protected product markets with free capital flows can create stronger resistance from incumbent financiers, who now face competition in financing the same clients

26. Conclusions • Institutions have a first-order effect on financial development and growth • Strength of institutions can determine the success or failure of policies, such as bank privatization and financial liberalization • Financial regulation and rule of law hold the key role for both financial development and growth • We need to improve our understanding of the obstacles to the development of the institutions that underpin the functioning of the financial system