Liberalization, Financial Instability and Economic Development: 1 - Brossura

Akyz, Yilmaz

Brossura

ISBN 10: 1783082623 ISBN 13: 9781783082629

Casa editrice: Anthem Pr, 2014

Riassunto

Weighing up the costs and benefits of economic interdependence in a finance-driven world, this book argues that globalization, understood and promoted as absolute freedom for all forms of capital, has been oversold to the Global South, and that the South should be as selective about globalization as the North. ‘Liberalization, Financial Instability and Economic Development’ challenges the orthodoxy on the link between financial deepening and economic growth, as well as that between the efficiency of financial markets and the benefits of liberalization. Ultimately, the author urges developing countries to control capital flows and asset bubbles, preventing financial fragility and crises, and recommends regional policy options for managing capital flows and exchange rates.

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Informazioni sugli autori

Yilmaz Akyüz is chief economist at the South Centre, an intergovernmental think tank for developing countries based in Geneva, Switzerland.

Yilmaz Akyüz is chief economist at the South Centre, an intergovernmental think tank for developing countries based in Geneva, Switzerland. 

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Liberalization, Financial Instability and Economic Development

By Yilmaz Akyüz

Wimbledon Publishing Company

Copyright © 2014 South Centre
All rights reserved.

ISBN: 978-1-78308-262-9

Contents

Introduction, 1, 
Part One Liberalization, Stability and Growth, 
Chapter I Financial Liberalization: The Key Issues, 
Chapter II Managing Financial Instability in Emerging Markets: A Keynesian Perspective, 
Chapter III From Liberalization to Investment and Jobs: Lost in Translation, 
Chapter IV Exchange Rate Management, Growth and Stability: National and Regional Policy Options in Asia, 
Chapter V Reforming the IMF: Back to the Drawing Board, 
Part Two The Global Economic Crisis and Developi ng Countries, 
Chapter VI The Current Global Financial Turmoil and Asian Developing Countries, 
Chapter VII The Global Economic Crisis and Asian Developing Countries: Impact, Policy Response and Medium-Term Prospects, 
Chapter VIII The Staggering Rise of the South?, 

CHAPTER 1

FINANCIAL LIBERALIZATION: THE KEY ISSUES1

A. Introduction

In recent years financial policies in both industrial and developing countries have put increased emphasis on the market mechanism. Liberalization was partly a response to developments in the financial markets themselves: as these markets innovated to get round the restrictions placed on them, governments chose to throw in the towel. More importantly, however, governments embraced liberalization as a doctrine.

In developing countries, the main impulse behind liberalization has been the belief, based on the notion that interventionist financial policies were one of the main causes of the crisis of the 1980s, that liberalization would help to restore growth and stability by raising savings and improving overall economic efficiency; greater reliance on domestic savings was necessary in view of increased external financial stringency. However, these expectations have not generally been realized. In many developing countries, instead of lifting the level of domestic savings and investment, financial liberalization has, rather, increased financial instability. Financial activity has increased and financial deepening occurred, but without benefiting industry and commerce.

In many industrial countries the financial excesses of the 1980s account for much of the sharp slowdown of economic activity in the 1990s. Financial deregulation eased access to finance and allowed financial institutions to take greater risks. The private sector accumulated large amounts of debt at very high interest rates in the expectation that economic expansion would continue to raise debt servicing capacity while asset price inflation would compensate for high interest rates. Thus, when the cyclical downturn came, borrowers and lenders found themselves overcommitted: debtors tried to sell assets and cut down activity in order to retire debt, and banks cut lending to restore balance sheets. Thus, the asset price inflation was replaced by debt deflation and credit crunch.

The recent experience with financial liberalization in both industrial and developing countries holds a number of useful lessons. This chapter draws on this experience to discuss some crucial issues in financial reform in developing countries. The focus is on how to improve the contribution of finance to growth and industrialization; developing the financial sector and promoting financial activity is not synonymous with economic development.

B. Interest rates and Savings

One of the most contentious issues in financial policy is the effect of interest rates on savings. There can be little doubt that short-term, temporary swings in interest rates have little effect on private savings behavior since that is largely governed by expectations and plans regarding current and future incomes and expenditures: they alter the level of savings primarily by affecting the levels of investment and income. However, when there is a rise in interest rates that is expected to be permanent (for instance, because it is the result of a change in the underlying philosophy in the determination of interest rates), will consumer behavior remain the same, or will the propensity to save rise? The orthodox theory expects the latter to occur, and thus argues that removing "financial repression" will have a strong, positive effect on savings (Shaw 1973, 73).

Empirical studies of savings behavior typically do not distinguish permanent from temporary changes in interest rates. Recent evidence on savings behavior in a number of developing countries that changed their interest rate policy regimes shows no simple relation between interest rates and private savings. This is true for a wide range of countries in Asia and the Middle East (Indonesia, Malaysia, Philippines, Sri Lanka, Republic of Korea and Turkey: Cho and Khatkhate 1989; Amsden and Euh 1990; Lim 1991; Akyüz 1990), Africa (Ghana, Kenya, Malawi, Tanzania and Zambia: Nissanke 1990), and Latin America (Massad and Eyzaguirre 1990) that undertook financial liberalization, albeit to different degrees and under different circumstances.

But this should come as no surprise:

• Even according to the conventional theory, the personal propensity to save from current income depends on the relative strength of two forces pulling in opposite directions, namely the income and substitution effects. Moreover, if current income falls relative to expected future income, a rise in interest rates can be associated with a fall in savings. This often happens when interest rate deregulation occurs during rapid inflation and is accompanied by a macroeconomic tightening that results in a sharp decline in employment and income.

• A large swing in interest rates can lead to consumption of wealth, especially when noninterest income is declining. This is true especially for small savers who can react to increases in interest rates by liquidating real assets and foreign exchange holdings in order to invest in bank deposits in an effort to maintain their standard of living, consuming not only the real component of interest income but also part of its nominal component corresponding to inflation. This tendency is often reinforced by "money illusion" or the inability to distinguish between nominal and real interest incomes, something that tends to be pervasive in the early stages of deregulation. Thus, the initial outcome of deregulation can be to lower household savings, particularly if it is introduced at a time of rapid inflation. For instance in Turkey high deposit rates in the early 1980s allowed a large number of small wealth-holders to dissave.

• The behavior of households may be quite different from that assumed in conventional theory. For instance, they may be targeting a certain level of future income or wealth. Higher interest rates may then lower household savings by making it possible to attain the target with fewer current savings. For instance, in the Republic of Korea and Japan low interest rates combined with high real estate prices have tended to raise household savings (Amsden and Euh 1990).

• Financial liberalization can lower household savings by allowing easier access to credit and relaxing the income constraint on consumption spending. In many countries financial liberalization has, indeed, given rise to a massive growth in consumer loans (such as instalment credits for cars and other durables, credit card lending, etc.). This appears to have been one reason why the household savings rate declined and the debt/income ratio rose in the 1980s in the United States – something which is at the heart of the current debt deflation process (UNCTAD TDR 1991, part 2, chaps 1–2; 1992, part 2, chap. 2). An inverse correlation between household borrowing and savings ratios has also been observed in most other OECD countries since the early and mid-1980s (Blundell-Wignall and Browne 1991).

• Even if financial liberalization and higher interest rates do not lower personal savings, they can reduce total private savings and aggregate domestic savings by redistributing income away from debtors – a category which typically includes corporations and the government. In many developing countries undistributed corporate profits are an important part of private savings and the most important source of business investment. Generally, the savings rate is higher than for households: corporate retentions are high, ranging between 60 to 80 percent of after-tax profits, because ownership is usually concentrated in the hands of families and there is no outside pressure to pay out dividends (Honohan and Atiyas 1989; Akyüz 1991). The redistribution of income from corporations to households through higher interest rates can thus reduce total private savings even if it raises household savings. In developing countries this effect can be particularly strong because firms operate with high leverage, loan maturities are short and corporate debt usually carries variable rates. Thus, a rise in interest rates not only raises the cost of new borrowing but also the cost of servicing existing debt. Evidence from the studies already mentioned suggests that in a number of countries (e.g., Philippines, Turkey, Yugoslavia), sharp increases in interest rates were a major factor in the collapse of corporate profits and savings that took place particularly in the early phases of financial liberalization.

Such adverse effects are especially marked when interest rates are freed under rapid inflation. There is a widespread agreement that financial liberalization undertaken in an unstable environment may make things worse, and that such reforms should be undertaken only after macroeconomic balances are attained (World Bank 1989; Edwards 1989). Nevertheless, many countries have resorted to liberalization as part of shock therapy against stagflation.

Thus, interest rate increases are not a reliable instrument for raising domestic savings, but can damage macroeconomic stability and investment. The crucial question is how to design interest rate policies compatible with sustained stability and growth.

The historical experience of major industrial countries holds some useful lessons. Until the 1980s real short-term interest rates in these countries were slightly negative and real long-term bond rates slightly positive; i.e., about 1 to 2 percent below and above inflation respectively. Until the oil shocks of the 1970s, there was sustained growth and price stability. But since the beginning of the 1980s (for reasons to be discussed later) real interest rates have been, on average, more than twice their historical levels. Nevertheless, these countries enjoyed one of the longest periods of economic expansion in the postwar period with low inflation. This generated a widespread perception that high real interest rates do not impede investment and growth, but help price stability. However, the subsequent debt-deflation-cum-recession has clearly shown that economic expansion attained at very high real interest rates eventually depresses income, investment and growth.

C. Financial Liberalization and deepening

It is generally agreed that financial liberalization raises financial activity relative to the production of goods and nonfinancial services. However, there is much less consensus on the causes and effects of this "financial deepening." According to the financial repression theory (McKinnon 1973; Shaw 1973) financial deepening represents increased intermediation between savers and investment because higher interest rates raise savings and shift them from unproductive assets toward financial assets, thereby raising the volume of productive investment.

While it is true that financial liberalization can shift existing savings toward financial assets, reallocation is not the only and even the most important reason for financial deepening. Financial liberalization can also lead to deepening by redistributing savings and investment among various sectors, and by creating greater opportunities for speculation. Since these can worsen the use of savings, financial deepening is not necessarily a positive development.

The prime role of the financial system in the savings/investment process is to intermediate between deficit and surplus sectors rather than to transfer aggregate savings into aggregate investment. Deficit sectors (typically the corporate sector and the government) save as well as invest, while surplus sectors (households) invest as well as save. Thus, redistribution of savings and investment among sectors can, by changing sectoral surpluses and deficits, result in financial deepening without any change in aggregate savings and investment – for instance, as already noted, when higher interest rates redistribute income and savings from debtors to creditors. Even when this does not alter the volume of aggregate savings (i.e., lower savings of debtors are compensated by higher savings of creditors), it increases deficits and surpluses and, hence, the amount of financial intermediation. Indeed, financial intermediation can increase while aggregate savings and investment fall (Akyüz 1991). This can happen even under the orthodox assumptions that saving rates are positively related to the interest rate and that savings determine investment and growth (Molho 1986, 112).

In such cases financial deepening is a symptom of a deterioration of the finances of the corporate and public sectors, reflecting an accumulation of debt in order to finance the increased interest bill rather than new investment. Financial deepening driven by such Ponzi financing has been observed in a number of countries (e.g., Turkey, Yugoslavia and New Zealand) where financial liberalization redistributed income in favor of creditors and encouraged distress borrowing.

Similarly financial deepening can be the result of a redistribution of a given volume of aggregate investment, when, for instance, higher interest rates induce households to reduce investment in housing and shift to bank deposits. Then, the increase in the household surplus and in the volume of deposits represents a decline in household investment, not a rise in savings.

Financial liberalization often raises holdings of both financial assets and liabilities by firms and individuals at any given level of income, investment and savings. This tendency to borrow in order to purchase assets is driven by the increased scope for capital gains generated by financial liberalization. Liberalization increases the instability of interest rates and asset prices, thereby raising prospects for quick profits through speculation on changes in the market valuation of financial assets. It also allows greater freedom for banks and other financial institutions to lend to finance activities unrelated to production and investment, and to firms and individuals to issue debt in order to finance speculation. These can generate considerable financial activity unrelated to the real economy, and lead to financial deepening – as in the United States in recent years through leverage takeovers, mergers, acquisitions and so on (UNCTAD TDR 1992, part 2, chap. 2).

Deepening can also result from the impact of changes in interest rates on the form in which savings are held. Indeed, one of the main reasons why savings do not in practice strongly respond to increases in real interest rates is the existence of a range of assets with different degrees of protection against inflation; for, returns on such assets also influence savings decisions. The greater the influence of interest rates on the allocation of savings among alternative assets, the smaller the influence on the volume of savings.

Whether shifts of savings into financial assets improve the use of resources depends on where they come from and how efficiently the financial system is operating. Clearly, a switch from commodity holdings can improve the use to which savings are put. But, contrary to widespread perception, there is very little evidence of extensive commodity holding in developing countries as a form of savings. Such holdings entail substantial storage and transaction costs, making their own real rate of return typically negative. Moreover, there is considerable uncertainty regarding the movement of prices of individual commodities even when the general price level is rising rapidly. These factors, together with the existence of more liquid, less costly inflation hedges (such as foreign currency or gold) reduce the demand for commodities as a store of value. The large commodity holdings that exist in African countries typically reflect the nature of production and nonmonetization of the rural economy. Consequently, increases in deposit rates are often unable to induce liquidation of commodity stocks (Aryeetey et al. 1990; Mwega 1990; Nissanke 1990).

An increase in domestic interest rates can induce a shift from foreign currency holdings to domestic assets, and repatriation of flight capital. Many governments, however, have found it necessary to legalize foreign currency holdings and introduce foreign currency deposits for residents and to offer very high interest rates in order to attract foreign currency holdings to the banking system. Certainly, in both cases the portfolio shifts can increase the resources available for investment and deepen finance. However, as discussed in Section H, capital flows and dollarization resulting from such policies often prove troublesome for macroeconomic stability, investment and competitiveness.

(Continues...)

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Dettagli dell'edizione

• Editore: Anthem Pr
• Data di pubblicazione: 2014
• Lingua: Inglese
• ISBN 10: 1783082623
• ISBN 13: 9781783082629
• Rilegatura: Copertina flessibile
• Numero di pagine: 327
• Contatto del produttore: non disponibile
• Persona responsabile: non disponibile