A stable, effective and efficient financial system is very crucial and plays a great role on a country’s economic growth. Governments must always ensure that their financial sector is well and functioning properly in order to enjoy and maintain economic prosperity. The sector interacts dynamically with other key sectors in the economy that are key drivers of economic growth. Many governments keen to ensure that the financial sector achieves its role have always intervened with a number of measures. One such a measure has been the financial liberalization.
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From financial repression to financial liberalisation
For many years, governments intervened in the financial sector to ensure that everything was regulated and that it was shielded from external pressures for stability. A protective policy of financial repression that saw everything from interest’s rates to the flow of credit fixed and regulated by the government was adopted in many economies. Although the move was aimed at addressing the economic challenges faced by the world economies by the time, the policy did not bring the desired benefits. On the contrary, it did not take very long before the distortions brought by the defective policy became evident. The move hindered development of the financial systems and with it bringing more problems and challenges. The government fixed interest rates mainly below the nominal rates discouraged savings. Investments were not at their best mainly due to the ineffective and inefficient lending practises. As a result, there were poor economic performances due to the allocation inefficiencies and players in the financial sectors sunk into survival problems.
Due to the challenges that the financial repression had brought, there arose growing concerns against the policy. Calls for financial liberalisation mostly advocated by the world financial institutions were everywhere leading to the abandonment of the protective policy. Many governments loosened their grip on the financial system and agreed to open up. At first, it seemed as if the financial liberalisation was taking economies in the right direction but not until the late 1990’s East Asia financial crisis threatened this smooth transition. In combination with other fiscal and monetary policies the crisis was effectively managed. Financial liberalisation has been praised to have brought a lot of benefits more so in the emerging economies. However, the recent recession and yet another crisis arising from the financial system has yet again raised doubts on the effectiveness and sustainability of the policy in driving economic growth. Although financial liberalisation has brought in a lot of benefits, it has definitely not led to the most effective and efficient financial system. But what’s its overall relationship with economic growth; is it positive, negative or no relationship at all?
Financial liberalisation and macro-economic performance
Many scholars have sought to explain the relationship between financial liberalisation with macro-economic performance. Divergent views however arise in the way economists view economic liberalisation to impact on economic growth. A review of literature by Bonfiglioli (2005) finds some ambiguous theoretical predictions in the works of different scholars. On one hand, financial liberalisation positively promotes economic growth by increasing specialization and efficiency in capital allocation and growth (Acemoglu & Zilibotti, 1997 and Obstfeld, 1994) (as cited by Bonfiglioli, 2005). Additionally, better financial systems shaped by the international competition have beneficial effects on savings and resource allocation in an economy’s investments (Klein & Olivei, 1999 and Levine, 2001) (cited by Bonfiglioli, 2005). On the other hand, financial liberation may be yield a negative impact on economic growth yet on others its effect is neutral. Negative economic growth is especially imminent where there exists other distortion and may result to financial instability and misallocation of capital (Bonfiglioli, 2005).
Views supporting financial liberation to stimulate growth
According to a study by Bekaert & Harvey (2001), financial liberation alone leads to increased average annual per capita GDP growth rate of 1.3 to 2.3 percent per year. Taken together with other macro-economic growth variables, its impact to boost economic performance remains significantly strong as between 0.7 to 1.4 percent annually. Growth is derived from increased domestic consumption and investments. Financial liberation is also seen to attract capital investments as evidenced by increased imports and exports. Tswamumo, Pardee & Wunnava (2007) found that, financial markets liberalization leads to increased stock turnover and foreign investments. Attracting foreign capital especially by the developing countries is a major boost to economic growth. The impact caused by liberalizing financial market in developing countries is likened to the impact created by an IPO in boosting access to capital for business and investments. Small businesses are poised to benefit as the cost of capital gets cheaper with increased foreign capital inflow. Some studies also show that liberalization increases stock market liquidity boosting investment confidence among investors (Tswamumo, Pardee & Wunnava, 2007).
Another source of GDP growth emanates from the additional financial development which is the immediate product of financial liberalization. In accordance with endogenous growth theories, financial development leads to economic growth (Bekaert & Harvey, 2001). Financial development leads to increased access to financial services and capital for businesses. According to LEE and Shin (2007), financial liberation leads to increase interest rates and furthers financial deepening which is crucial for economic growth. The grip lost by the government to control and fix interest rate ceilings results in higher interest rates. When interest’s rates are high, they stimulate households to save and invest. The ratio of consumption to GDP however according to Bekaert and Harvey (2001) remains unchanged with economic growth. This is seen to affirm that neither savings nor investment is done at the expense of current consumption. According to this studies therefore, financial liberation brings about welfare effects by improving households standard of living.
Views against financial liberation
Not all economists who have studied the effects of economic liberation on economic growth agree on its positive contribution on the economy. Proponents to this view prefer economic repression as opposed to liberalization. The argument presented here is that, liberalization opens the economy to the risk of speculative attacks and thus exposes an economy to international shocks and capital flight (Tswamumo, Pardee & Wunnava, 2007). Speculation and lobbying over the credit market by international investors may generate financial fragility. As a result, financial liberation is a major cause of banking crises especially in countries where there are credit market imperfections (Tswamumo, Pardee & Wunnava, 2007). As to increasing capital inflow, financial liberalisation can on the contrary result to capital flight in economies where there exist other distortions.
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The removal of interest ceilings and hence higher interest rates and the inducement they cause on savings and investments depends on whether it’s the income or substitution effect that prevails (Abiad, Oomes & Ueda, 2004). A study done following liberalization of South Africa’s stock market concluded that financial market liberalization resulted to negative economic growth. This was despite it having resulted to massive increase in stock market turnover and attracting foreign investments (Tswamumo, Pardee & Wunnava, 2007). In economies where household consumption is constrained by liquidity problems, liberalization may in deed result in a fall ion savings. Thus financial liberalisation can lead to better functioning financial systems without necessarily resulting to increased savings and investments (Abiad, Oomes & Ueda, 2004).
As a result of the shortcomings observed with financial liberation, proponents of this view advocate are now calling for financial repression. They argue that this can create better control over interest rates and interest rates and hence induce higher investments. More so, there exist a lot of distortions and imperfections difficult to be eliminated through financial liberation. Distortions and imperfections are the main cause of financial crises such as the East Asian late 1990’s crisis and the currently being experienced economic crisis. They argue that, government and not the market have better knowledge and may be able to eliminate such imperfections if financial repression was adopted (Ozdemir & Erbil, 2008).
Abiad, A., Oomes, N. and Ueda, K. (2004). The Quality Effect: Does Financial Liberalization Improve the Allocation of Capital? IMF Working Paper.
Bekaert, G. & Harvey, C. R. (2001). Economic Growth and Financial Liberalization. NBER Reporter. Web.
Bonfiglioli, A. (2005). How Does Financial Liberalization affect Economic Growth? Institute for International Economic Studies. Web.
Lee, I. and Shin, J. (2007). Financial Liberalization, Crises, and Economic Growth. KIEP Working Paper.
Ozdemir, D. & Erbil, C. (2008). Does Financial Liberalization Trigger Long-run Economic Growth? Evidence from Turkey and Other Recent EU Members. Web.
Tswamuno,D. T., Pardee, S. and Wunnava, P. V. (2007). Financial Liberalization and Economic Growth: Lessons from the South African Experience. Journal of Applied Economics, 4(2), 75-89