ABSTRACT

The Mckinnon-Shaw Hypothesis: Thirty Years on: A Review of Recent Developments in Financial Liberalization Theory by Dr Firdu Gemech and Professor John Struthers University of Paisley The Mckinnon-Shaw Hypothesis, in its various forms, is now thirty years old. Over that period literally hundreds of empirical studies have been completed examining the hypothesis in many different contexts. Initially, the hypothesis focused on the effects of so-called Financial Repression (low or negative real interest rates) on savings and investment levels in developing countries. In more recent times, researchers have extended the debate to consider other effects of financial repression on: economic growth; financial crises and poverty (for example the effects of overvalued exchange rates). Currently, significant research is being conducted on the potentially destabilizing effects of financial liberalization (the converse of financial repression) on global financial markets. This paper attempts to survey the literature on the Mckinnon-Shaw Hypothesis and tries to draw out some of the recurrent themes of this literature. The paper also highlights the continuing relevance of the original hypothesis to on-going debates concerned with the effects of financial liberalization.
CONTACT

Dr Firdu Gemech 00 44 141 848 3393;firdu.gemech@paisley.ac.uk Professor John Struthers 00 44 141 848 3364; john.struthers@paisley.ac.uk Division of Economics and Enterprise Paisley Business School University of Paisley Paisley PA1 2 BE Scotland

* Paper presented at Development Studies Association (DSA) Annual Conference on Globalisation and Development, Glasgow, Scotland, September 2003

An Overview of Recent Developments in Financial Liberalization Theory The literature on Financial Liberalization policies in developing countries has a long pedigree. This literature commenced with the seminal work of Mckinnon and Shaw in 1973 which focused on Financial Repression (see below) and the need for developing economies to allow real interests rates (along with other financial indicators) to be determined by market forces. Though originally focusing on interest rates, the Financial Repression approach also incorporated the adverse affects of high reserve ratios and government directed credit programmes, which together contributed to low savings, credit rationing and low investment. In later years, the literature can be classified into: First Generation approaches (represented by the work of Krugman (1979); Second Generation approaches (Obstfeld, 1996) ; and Third Generation approaches again represented by the work of Krugman (1998;1999) In this evolving literature, it is possible to detect a clear lineage stemming from the original Mckinnon-Shaw contribution, albeit one which represents an increasingly sophisticated theoretical and empirical development of the original hypothesis. This paper will trace the development of this body of thought as well as highlight possible further theoretical developments. It will also highlight some of the future directions that this research might take and the potential policy implications therein. I. Theoretical Underpinnings 1. Liberalization as a catalyst for higher saving, (McKinnon-Shaw) McKinnon (1973) and Shaw (1973), analysed the benefits of (if not eliminating) Financial Repression, at least reducing its impact on the domestic financial system within developing countries. Their analyses- (sometimes referred to as the Complementarity Hypothesis)- concluded that alleviating financial restrictions in such countries (mainly by allowing market forces to determine real interest rates) can exert a positive effect on growth rates as interest rates rise toward their competitive market equilibrium. According to this tradition, artificial ceilings on interest rates reduce savings, capital accumulation, and discourage the efficient allocation of resources. Additionally, McKinnon pointed out that Financial Repression can lead to dualism in which firms that have access to subsidized funding will tend to choose relatively capital-intensive technologies; whereas those not favored by policy will only be able to implement high-yield projects with short maturity. Another effect of Financial Repression, to which the original hypothesis made only scant reference, stemmed from the implicit credit rationing effect which results from the Feast and Famine consequences of excessive government intervention in money and credit markets in developing countries. Given that real interest rates are prevented from adjusting to clear the market, other non-market forms of clearing have to take their place. These can include various forms of queuing arrangements to ration the available credit such as auctions, quantitative restrictions (for example quotas), as well as

different types of bidding systems which themselves may be open to nepotism or even outright corrupt practices. In essence, these manifestations of Financial Repression mean that not only is the quantity of savings (and investment) low, or at the very least irregular; it also means that the level of activity which does occur is of poor quality. This is really what the term Financial Repression entails. If the real interest rate is not allowed to clear the money and credit markets, both the overall level as well as the quality of savings and investment will be repressed. The quantity and the quality effects compound each other. In a Feast and Famine environment, the typical borrower may borrow too much (too little) and this very tendency will reinforce the Feast and Famine problem itself. The early hypotheses of McKinnon and Shaw assumed that liberalization, which would be associated with higher real interest rates--as controls on these are lifted--would stimulate saving. The underlying assumption is, of course, that saving is responsive to interest rates. The higher saving rates would finance a higher level of investment, leading to higher growth. Therefore, according to this view, we should expect to see higher saving rates (as well as higher levels of investment and growth) following financial liberalization. (see Appendix for the relevant equations of the McKinnon-Shaw model) 2. Liquidity constraints, credit channels, and financial liberalization ( Campbell Mankiw) As a further development of the Financial Repression literature Campbell and Mankiw (1990) concluded that it is reasonable to assume that not all households have access to credit markets, and hence, some households have no ability to smooth consumption over time. Thus, for such liquidity-constrained households, consumption decisions are entirely determined by current income. On theoretical grounds, it has been shown that a relaxation of liquidity constraints will be associated with a consumption boom and a decline in aggregate saving. More specifically, Campbell and Mankiw postulated that there are two types of households in the economy: One type of household, , is liquidity constrained and their consumption is entirely determined by the evolution of current income, while the remaining type (1 ) , has free access to capital markets and can smooth their consumption intertemporarily. Such a theoretical development led these authors to challenge the implicit Mckinnon-Shaw assumptions that were based on a homogenous household set in which it was assumed that all relevant households had free access to capital markets within the domestic economy. 3. The role of subsistence consumption (Ostry and Reinhart) This development was based on the Stone-Geary utility function where the intertemporal elasticity of substitution (which determines the sensitivity of consumption to real interest rates) is determined by permanent income and subsistence consumption. According to this view, increases in real interest rates will affect consumption/saving decisions in varying degrees. In countries where the representative household is close to subsistence consumption, consumption(and saving) will not be sensitive to changes in the real rate of interest. Only in wealthier countries would consumption decline (and saving increase)

following an increase in real interest rates. Hence, in this analysis the magnitude of the increase in saving following the higher real interest rates associated with financial liberalization will depend on the level of income (which was used as a proxy for how close are actual consumption levels to subsistence levels). II. The Empirical Literature The broad empirical literature varies greatly in terms of both empirical approach and country coverage. The McKinnon-Shaw hypothesis literally spawned hundreds of such empirical studies across many different contexts, countries and time periods. The empirical literature, in general, suggests that the relationship between saving rates and real interest rates is at best ambiguous. Yet surprisingly, and somewhat perversely, financial liberalization also has a mixed track record regarding saving rates. Indeed, in the studies reviewed here, in most of the cases liberalization appears to lead to a decline in the saving rate. a) Saving and real interest rates There is little consensus in the empirical literature on the interaction between saving and the real rate of interest. Some researchers have been unable to detect much of an effect of changes in real interest rates on domestic saving in developing countries. For example, Giovannini (1985), who examined this issue for eighteen developing countries, concludes that for the majority of cases, the response of consumption growth to changes in the real rate of interest is insignificantly different from zero and that one should therefore expect negligible responses of aggregate saving to the real rate of interest. In a model with a single consumption good, Ostry and Reinhart (1992) confirm these findings. Only when a disaggregated commodity structure that allows for traded and nontraded goods is assumed, do these authors find higher and statistically significant estimates of the sensitivity of consumption to interest rates. In a similar vein, Ogaki, Ostry, and Reinhart (1996), present evidence that consumption in developing countries may be more related to subsistence considerations -particularly in the case of extremely low-income countries - than to intertemporal consumption smoothing. The rationale here is that if households must first achieve a subsistence consumption level-allowing intertemporal considerations to guide their decisions only for that portion of their budget left after subsistence has been satisfied - then the intertemporal elasticity of substitution and the interest-rate sensitivity of private saving will be close to zero for countries at or near subsistence consumption levels, but will rise thereafter. b) Liberalization and saving 1. Bandiera, Caprio, Honohan, and Schiantarelli (2000), construct an index of financial liberalization on the basis of eight different components: interest rates; reserve requirements; directed credit; bank ownership; prudential regulation; securities markets deregulation; and capital account liberalization. Their data spans from 1970-94 for Chile, Ghana, Indonesia, Korea, Malaysia, Mexico, Turkey and Zimbabwe. Among the key findings of the estimation of their benchmark model is that, there is no evidence of any

positive effect of the real interest rate on saving. Indeed in most cases the relationship is negative, and significantly so in the cases of Ghana and Indonesia. Furthermore, the effects of the financial liberalization index on saving are mixed: negative and significant in Korea and Mexico, positive and significant in Turkey and Ghana. The long run impact of liberalization is, however, sizeable. Corresponding to the realized change in the index, the estimated model indicates a permanent decline in the saving rate of 12% and 6% in Korea and Mexico, and a rise of 13% and 6% in Turkey and Ghana. Based on an estimate of augmented Euler equations (a la Campbell-Mankiw) , Bandiera et al present some evidence of the presence of liquidity constraints. It was not possible, however, to confirm whether financial liberalization removes these constraints. The Euler equation results may suggest, at best, that financial liberalization has had little impact on the amount of credit available to consumers through the formal financial sector. The general conclusion that emerges from this study is that there is no systematic and reliable real interest rate effect on saving; whilst the effects of liberalization have a mixed record. 2. Bayoumi (1993), examined the effects of financial deregulation on personal saving. Within an overlapping generations framework, the author argues that deregulation produces an exogenous short-run fall in saving, some of which is recouped over time. Also, deregulation increases the sensitivity of saving to wealth, current income, real interest rates and demographic factors. Using data on the eleven standard regions of the United Kingdom, the author finds that household saving showed an exogenous decline associated with financial innovation saving also became more sensitive to wealth, real interest rates and current income; though the results imply that much of the decline in savings in the 1980's was caused by the rise in wealth. Financial deregulation also played a significant direct role. In particular, the author concludes that an autonomous fall of 2.25% in the personal saving rate may be attributed to deregulation alone. 3. Jappelli and Pagano (1994), investigate the role of capital market imperfections on aggregate saving and growth. The analytical framework of their paper is a simple overlapping generations model, within the context of which it is shown that liquidity constraints on households (but not on firms) can raise the saving rate; strengthen the effect of growth and may increase welfare. Using a panel of OECD countries for the 1960 to 1987 period, the authors conclude that financial deregulation in the 1980's has contributed to the decline in national saving and growth rates in the OECD countries and expressed concern regarding the welfare implications of further liberalization within the European Union. 4. Koskela, Loikkanen and Viren (1992), describe the institutional aspects of housing markets and analyze the evolution of prices of owner-occupied housing and their interaction with the household saving ratio in Finland in the 1970's and 1980's. The volatility of house prices in relation to income can be traced to a large extent to major changes in financial market conditions. The evidence they present suggests that financial market conditions - as measured by the households indebtedness rate, the after tax rate of return on housing, and the thinness of rental markets - have all had a positive effect on housing prices. Yet, household saving was affected negatively by the rate of change of

real house prices, and positively by the after tax nominal interest rate. Taken together, their findings imply that financial conditions, and the liberalization of the mid-1980's in particular, contributed to the decline in the household saving ratio in these countries. 5. Loayza, Schmidt-Hebbel, and Servens (2000), produced results, which suggest that the direct effects of financial liberalization are detrimental to private saving rates. The real interest rate has a negative impact on the private saving rate. Its income effect probably outweighs the sum of its substitution and human wealth effects. A 1% increase in the real interest rate reduces the private saving rate by 0.25% in the short run. The indicator of financial depth (M2/GNP) has a small and statistically insignificant impact on the private saving rate. The flow of private domestic credit relative to income has a negative and significant coefficient; relaxing credit constraints reduces the private saving rate. When the flow of private credit rises by 1%, the private saving rate declines by 0.32% on impact. The authors suggest that though they do not find direct positive effects of financial liberalization on the saving rate, if financial reform has a positive impact on growth, it has a potentially important indirect positive effect on the saving rate. 6. Reinhart and Tokatlidis (2001), in a study of 50 countries (14 developed and 36 developing) report that financial liberalization appears to deliver: higher real interest rates (reflecting the allocation of capital toward more productive, higher return projects.); lower investment, but not lower growth (possibly owing to a shift to more productive uses of financial resources); a higher level of foreign direct investment; and high gross capital flows. Liberalization appears to deliver financial deepening, as measured by the credit and monetary aggregates--but, again, low income countries do not appear to show clear signs of such a benefit. As regards saving, the picture is very mixed. In some regions, saving increased following financial sector reforms; but in the majority of cases saving declined following the reforms. Indeed, it would appear that what financial liberalization delivers is greater access to international capital markets, although this appears to be uneven across regions and income groups. III. First Generation Models: The Financial Crises Literature Financial crises are attributed to rapid reversals in international capital flows prompted chiefly by changes in international investment conditions. Flow reversals are likely to trigger sudden current account adjustments, and subsequently currency and banking crises. A second generation of currency crises models (Krugman, 1979) explained the collapse of exchange rate regimes on the grounds that weak fundamentals lead foreign investors to pull resources out of the country, and as a consequence the depletion of foreign reserves (see Appendix for a summary of the key equations of the Krugman model). A Second Genration of models (Obstfeld, 1996) suggests that currency crises may also occur despite sound fundamentals, as a result of self-fulfilling expectations, speculative attacks and changes in market sentiments. More recently, there have been important developments in this area of research, most of them using the event analysis

methodology. A summary of two studies is presented below (see Appendix for relevant equations). The Third Generation Models (Krugman, 1998, 1999) attempt to stylize the causal mechanics underpinning the 1997 Asian currency crisis as the First and Second Generation models did not fully explain these phenomena. One version of the ThirdGeneration model attributes the crisis to implicit guarantees offered by domestic banks in developing countries leading to a massive influx of short-term capital which turns out to be unsustainable. This invariably results in an asset price bubble that is destined to burst and reverse the capital inflows. Another version identifies the existence of Fragile Financial Institutions as the cause of the build up of unhedged short-term borrowing denominated in foreign currency. A sudden change in market sentiment causes panic and investor responses which bring about a reversal in these capital flows. This transforms an illiquid asset into insolvency and ultimately a currency peg collapse (See Appendix for relevant equations) In a key empirical study Kaminsky and Schmukler (2001) examined the short-run and long-run effects of financial liberalization on capital markets by constructing a comprehensive chronology of financial liberalization in 28 developed and emerging economies since 1973. They used three measures of financial liberalization: (a) capital account liberalization (capital mobility); (b) domestic financial system liberalization (regulations on deposit interest rates, lending interest rates, allocation of credit, and foreign currency deposits) and, (c) stock markets liberalization (evolution of regulations on the acquisition of shares in the domestic stock market by foreigners, repatriation of capital, and repatriation of interest and dividends etc). The authors arrived at the following broad conclusions: 1. While liberalization has been an uninterrupted process in most developed markets, it has been characterized by reversals in emerging markets, in which capital controls and restrictions are at times reintroduced. They also found that the pattern of liberalization varies across regions, with developed countries liberalizing first their stock markets and developing economies opening first their domestic financial sector. 2. Although liberalization leads to excessive financial booms and busts in the shortrun, these booms and busts have not intensified in the long run. In fact, despite the claim that financial integration leads to volatile capital markets around the world, stock market cycles become less pronounced after liberalization. The short-run effects of liberalization vary across developed and emerging markets. The evidence from emerging markets reveals larger booms and crashes in the immediate aftermath of liberalization. In contrast, the evidence from developed markets, with larger bull markets but less pronounced bear markets in the aftermath of deregulation, supports the view that liberalization is beneficial even in the short run.

3. To explain the contrasting short and long-run effects of financial liberalization, the authors collected information on the quality of institutions as well as data on the laws governing the functioning of the financial system. The evidence suggests that as the quality of institutions improves, financial cycles become less pronounced. Perhaps due to lack of correct incentives, countries do not tend to improve their financial systems before liberalization, disregarding the typical policy prescriptions. Baldicci, de Mello and Inchauste (2002) in a new approach considered the impact of financial crises (defined as large scale nominal currency depreciation and successful speculative attack) on the incidence of poverty and on the distribution of income in Mexico. The authors identified the following channels through which financial crises affect poverty and income distribution: A slowdown in economic activity following a crisis leading to a fall in earnings of both the formal and informal-sector workers. Reduced working hours and real wage cuts adversely affect the earnings of the poor. Relative prices change after a currency depreciation leading to an increase in the price of imported food (and domestic food prices). This in turn adversely affects poor individuals and households that are net consumers of food. Spending cuts (fiscal retrenchment) affect the volume of publicly provided crucial social services and limits the access of the poor to these services at a time when their incomes are declining. Changes in asset prices (wealth effects) following changes in interest rates and real estate prices affect the wealth of the better off.

IV. Arguments for and against financial liberalisation policies (a) For In what appears to be a parallel world, many authors still praise the advantages of liberalization. It is claimed that financial liberalization helps to improve the functioning of financial systems, increasing the availability of funds and allowing cross-country risk diversification. Obstfeld (1998) argues that international capital markets can channel world savings to their most productive uses irrespective of location. Stulz (1999) and Mishkin (2001) claim that financial liberalization promotes transparency and accountability, reducing adverse selection and moral hazard while alleviating liquidity problems in financial markets. These authors argue that

international capital markets help to discipline policy makers, who might be tempted to exploit an otherwise captive domestic capital market. The benefits of financial liberalization can therefore be grouped into increased access to domestic and international capital markets, and increased efficiency of capital allocation. (b) Against Critics of financial liberalization policies have argued that the efficient markets paradigm is fundamentally misleading when applied to capital flows. In the theory of the second best, removing one distortion need not be welfare enhancing when other distortions are present. If the capital account is liberalized while import competing industries are still protected, for example, or if there is a downwardly inflexible real wage, capital may flow into sectors in which the country has a comparative disadvantage, implying a reduction in welfare. If information asymmetries are endemic to financial markets and transactions, in particular in countries with poor corporate governance and low legal protections, there is no reason to think that financial liberalization, either domestic or international, will be welfare improving (Stiglitz (2000)). Moreover, in countries where the capacity to honor contracts and to assemble information relevant to financial transactions is least advanced, there can be no presumption that capital will flow into uses where its marginal product exceeds its opportunity cost. Stiglitz (1994) argues in favor of certain forms of financial repression. He claims that repression can have several positive effects such as: improving the average quality of the pool of loan applicants by lowering interest rates; increasing firm equity by lowering the price of capital; and accelerating the rate of growth if credit is targeted towards profitable sectors such as exporters or sectors with high technological spillovers. However, these claims can be doubtful given that they increase the power of bureaucrats, who can be less capable than imperfect markets, to allocate financial resources. Focusing on the development of the domestic financial sector, capital account liberalization that allows firms to list abroad has been identified as a factor leading to market fragmentation, and can tend to reduce liquidity in the domestic market thereby inhibiting its development. Finally, liberalization has also been linked to macroeconomic instability. The financial reforms carried out in several Latin American countries during the 1970s, aimed at ending financial repression, often led to financial crises characterized by widespread bankruptcies, massive government interventions, nationalization of private institutions and low domestic saving (Diaz-Alejandro (1985). Demirguc-Kunt and Detriagiache (1998), however have shown that the likelihood of a crisis following liberalization decreases with the level of

institutional development in the country. In this sense, the arguments that Stiglitz (1994) makes in favor of government intervention in financial markets in the form of prudential regulation and supervision are convincing. The main argument is that the government is, de facto, the insurer of the financial systems, and hence a financial collapse can have significant fiscal repercussions. V. Measurement problems (a) Proxies for repression (and liberalization) Several empirical studies have tried to address the extent to which financial liberalization affects growth. Researchers have followed two distinct empirical approaches. One approach is to proxy financial liberalization with outcome variables; the other approach focuses on explicit policy measures. Regarding outcome variables, several measures have been suggested to proxy financial repression. Early empirical literature focused on the value of real interest rates as an indicator of repression. The presumption was that countries with negative real interest rates were financially repressed, while those with positive ones were liberalized. In short, it was found that countries with negative real interest rates exhibit lower growth rates compared with those with positive real interest rates. However, De Gregorio and Guidotti (1993) claim that real interest rates are not a good indicator of financial repression, and that a better indicator of repression, or lack thereof, is the ratio of credit to the private sector to GDP or a similar measure of financial development (actually financial widening rather than financial deepening). Similar concerns were expressed regarding the measurement of financial deepening. Prior to international financial liberalization, broad money offers a good indication of the banking systems scope for credit expansion, since domestic bank deposits are the main source of finance for bank lending. When capital controls are abolished, however, capital inflows in the form of deposits made by foreign residents in domestic banks add to the funds banks have available for credit expansion but do not increase broad money (since they are excluded from it by definition). Money based measures of financial deepening may therefore be misleading when capital inflows are important. Capital flows are not the only reason why money and credit-based measures of financial deepening may diverge. In general, government borrowing from the banking system will, for a given level of broad money, reduce the amount of credit available to the domestic private sector. If private sector activity is more productive than government expenditure, then this crowding out of private borrowing may have strong negative repercussions for economic performance that would not, however, be reflected in the conventional measure of financial deepening.

10

(b) Outcomes (Results) There is consensus that financial development has had a significant positive impact on the growth rates of countries. The extent to which these results can be interpreted as being influenced by financial liberalizations is, however, dubious. As noted by Rajan and Zingales (1998), it is unlikely that such empirical approaches are truly identifying the impact of financial development on growth, due to the fact that financial development occurs at the same time that economies go through significant structural transformations. In the case of financial development, Rajan and Zingales (ibid) note, financial development may simply be a leading indicator rather than a causal factor (p. 560) Laeven (2000) constructs liberalization indexes for 13 developing countries since the late 1980s and finds that the liberalization process in general has eased financial constraints faced by large firms in these countries. Galindo et al. (2001) use Laevens data and find that financial liberalization increases the allocative efficiency of investment. However, these findings are subject to the identification critique. According to Fry (1995, p. 179), the simultaneity of reforms appears binding for researchers: in practice, however, most clear cut cases of financial liberalization were accompanied by other economic reforms (such as fiscal, international trade, and foreign exchange reforms). In such cases it is virtually impossible to isolate the effects of financial components of the reform package

VII. Concluding remarks To date, the empirical literature on Financial Repression as originally postulated by Mckinnon and Shaw in 1973 has failed to settle conflicting debates on the effects of financial liberalisation. Several factors-both theoretical and institutional- may have contributed to the inability to resolve this debate. It is important to recognise that the success of financial reforms is contingent on the financial system being well behaved throughout the liberalization process. There is convincing evidence from a number of empirical studies referred to in this article that the process of financial liberalization is far from being a smooth or continuous one. In many developing countries financial liberalization reversals take place due to exogenous shocks. This makes assessment of the costs and benefits of financial liberalization difficult to undertake. Moreover, the coexistence of formal alongside informal credit markets in developing countriesfinancial dualism is a phenomena which has rarely been incorporated adequately within empirical studies. Stiglitz and others have highlighted the important role that institutional factors play in reaping the benefits of the financial liberalization process. This is a key aspect on which much of the current debate (especially within IMF deliberations)focuses. Indeed, it is fair to argue that over the last 30 years, since the original formulation of the McKinnon-Shaw hypothesis, the emphasis of the debate has moved from a purely narrow economic or

11

technical one of measuring the effects of raising real interest rates on saving; to explicit considerations of such aspects as moral hazard, adverse selection and corporate governance within developing countries. Where significant market failures exist, or government intervention in the financial system continues, the freedom that liberalization offers financial institutions may be exploited in ways that harm the overall development strategy. This is certainly the case in many African (and some Asian) countries where banks are publicly owned and, therefore, remain susceptible to government interference even after controls on credit pricing and allocation have been formally abolished. Liberalization will do little to improve credit allocation or spur financial deepening in such circumstances, since the banks remain wholly dependent on the government, and their lending decisions are subject to its discretion. Similarly, if competition among banks in the newly deregulated financial sector is weak, liberalization may result in lower real deposit rates rather than the anticipated movement towards modestly positive, equilibrium levels. That said, however, financial liberalization may deliver other types of benefits that are associated with the process of financial deepening, even when the obvious positive results for saving and growth are absent. As the liberalization process matures, it may have a stabilizing influence on financial assets by dampening the boombust cycles in equity markets as well as the traditional feast and famine problem in credit markets.

REFERENCES Baldicci, de Mello & Inchauste (2002), Financial Crises, Poverty and Income Distribution, IMF Working Paper WP/02/04. Bandiera, G. Caprio, P. Honohan, and Schiantarelli (2000). Does Financial Reform Raise or Reduce Saving?, Review of Economics and Statistics, May, 82(2): 239-263 Bayoumi, Tamim, "Financial Deregulation and Household Saving, 1993." Economic Journal, Vol. 103, pp. 1432-43. Bayoumi, T. (1993). Financial Deregulation and Household Saving, Economic Journal, 103,November 1432-1443. Brecher, R. A. and Diaz-Alejandro, C., (1977). "Tariffs, Foreign Capital, and Immiserizing Growth," Journal of International Economics, Vol.7, pp. 317-322. Campbell, John Y. and N. Gregory Mankiw (1990), Permanent Income, Current Income and Consumption, Journal of Business and Economic Statistics, 8(3), 265-79.

12

Deaton, Angus, 1989."Saving in Developing Countries: Theory and Review," in Proceedings of the World Bank Annual Conference on Development Economics, (Washington: World Bank). De Gregorio, J. and P. Guidotti. (1993). Financial Development and Economic Growth. Washington DC. International Monetary Fund, July. Demirguc-Kunt, A. and E. Detriagiache. (1998) "Financial Liberalization and Financial Fragility". World Bank Working Paper. De Melo, Jaime, and James Tybout, (1986). The Effects of Financial Liberalization on Savings and Investment in Uruguay, Economic Development and Cultural Change, 56187. Easterly, William, 1994."Economic Stagnation, Fixed Factors, and Policy Thresholds," Journal of Monetary Economics, Vol. 33, pp. 525-57. Frankel, J.A., and Rose, A.K., 1996. Currency Crises in Emerging Markets: Empirical Indicators, CEPR Discussion Paper No.1349 (London: Center for Economic Policy Research). Frenkel, Jacob A. and Assaf Razin, 1992. Fiscal Policies and the World Economy: An Intertemporal Approach, Second Edition, MIT Press. Fry, Maxwell J.(1995). Money, Interest, and Banking in Economic Development. The Johns Hopkins University Press, Baltimore. Galindo, A., F. Schiantarelli and A. Weiss. (2001) "Does Financial Liberalization Improve the Allocation of Investment? Micro Evidence from Developing Countries" Mimeo. IDB. Galbis, V. (1993). "High Real Interest Rates Under Financial Liberalization: Is There A Problem?" IMF Working Paper WP/93/7. Ghosh, Atish R., and Jonathan D. Ostry, 1994. "Export Instability and the External Balance in Developing Countries," Staff Papers, International Monetary Fund, Vol. 41, pp. 214-35. Giovannini, Alberto, (1985)."Saving and the Rate of Interest in LDCs," Journal of Development Economics, Vol. 18, pp. 197-217. Gupta, Kanhaya L., "Aggregate Savings, Financial Intermediation, and Interest Rate, Review of Economics and Statistics, (1987), pp. 303-11.

13

Haque, Nadeem U., and Peter. J. Montiel, 1989."Consumption in Developing Countries: Tests for Liquidity Constraints and Finite Horizons," Review of Economics and Statistics, Vol. 71, pp. 408-15. Jappelli and Pagano (1994). Saving, Growth and Liquidity Constraints, Quarterly Journal of Economics, 109, 83-109. Kaminsky, Graciela and Sergio Schmukler (2001) .On Booms and Crashes: Financial Liberalization and Stock Market Cycles, World Bank WP. Krugman, Paul (1979). A model of Balance-of Payments Crises, Journal of Money, Credit, and Banking, Vol. 11, pp. 311-25 Krugman, Paul (1998), What happened to Asia? January 1998, Available At: http://web.mit.edu/krugman/www/DISINTER.html. Krugman, P (1999), Balance Sheet, the Transfer Problem and Financial Crisis. Available At: http://web.mit.edu/krugman/www/#other Koskela, Loikkanen, and Viren (1992). House Prices, Household Saving and Financial Market Liberalization in Finland, European Economic Review, 36, 549-558. Laeven, L. (2000), Does Financial liberalization Reduce Financial Constraints?, Mimeo, The World Bank. Lehmussaari. O.P., (1990). Deregulation and Consumption: Saving Dynamics in the Nordic Countries, IMF Staff Papers, March, 37, 1, 71-93 Loayza N., K. Schmidt-Hebbel, and L. Serven (2000). What Drives Private Saving Across the World? Review of Economics and Statistics, May 2000, 82(2) :165-181 McKinnon, Ronald I., (1973). Money and Capital in Economic Development, (Washington: The Brookings Institution). Miles, D, (1992). Housing Markets, Consumption and Financial Liberalization in the Major Economies, European Economic Review, 36, 1093-1136 Mishkin, F. 2001. Financial Policies and the Prevention of Financial Crises in Emerging Market Countries. NBER working paper No. 8087. Obstfeld, M., 1996. Models of Currency Crises with Self-Fulfilling Features, European Economic Review, Vol,40, pp.103-47 Obstfeld, O. 1998. The Global Capital Market: Benefactor or Menace? Journal of Economic Perspectives Vol. 12(4), pp. 9-30.

14

Ostry, Jonathan D., and Joaquim Levy, "Household Saving in France: Stochastic Income and Financial Deregulation," Staff Papers, International Monetary Fund, Vol. 42, (1995), 375-397. Ostry, Jonathan D., and Carmen M. Reinhart, 1992."Private Saving and Terms of Trade Shocks: Evidence from Developing Countries," Staff Papers, International Monetary Fund, Vol. 39, pp. 495-517. Ostry, Jonathan D., and Andrew K. Rose, 1992. "An Empirical Evaluation of the Macroeconomic Effects of Tariffs," Journal of International Money and Finance, Vol. 11, pp. 63-79. Rajan, Raghuram and Luigi Zingales (1998). Financial Dependence and Growth, American Economic Review, 88, 559-586. Razin, Assaf, and Lars Svensson, 1983. "Trade Taxes and the Current Account," Economics Letters, Vol. 13, pp. 55-57. Reinhart, Carmen M. and Carlos A. Vgh, 1995. "Intertemporal Consumption Substitution and Inflation Stabilization: An Empirical Investigation," University of Maryland Working Papers in International Economics No. 3. Rossi, Nicola, 1988. "Government Spending, the Real Interest Rate and the Behavior of Liquidity Constrained Consumers in Developing Countries," Staff Papers, International Monetary Fund, Vol. 35, pp. 104-40. Shaw, Edward, (1973). Financial Deepening in Economic Development, (New York: Oxford University Press). Schmidt-Hebbel, Klaus, Steven B. Webb, and Giancarlo Corsetti, 1992. "Household Saving in Developing Countries: First Cross-Country Evidence," The World Bank Economic Review, Vol. 6, pp. 529-47. Stiglitz, J., (1994). Economic Growth Revisited, Industrial and Corporate Change, 3(1), pp. 65-110. Stiglitz, J., (2000). Liberalization, Moral Hazard in Banking and Prudential Regulation: Are Capital Requirements Enough? American Economic Review, 90(1), March 2000, pp. 147-165. Stulz, R. 1999. Globalization of Capital Markets and the Cost of Capital. Journal of Applied Corporate Finance Vol. 12(3), pp. 8-25. Vaidyanathan, G. (1993). "Consumption, Liquidity Constraints and Economic Development," Journal of Macroeconomics, Vol. 15, 591-610. Wijnbergen, Sweder, 1983. "Interest Rate Management in LDCs," Journal of Monetary 15

Economics, Vol. 12, pp. 433-52.

16

APPENDIX (A) The Complementarity Hypothesis (McKinnon, 1973, Shaw, 1973)

This hypothesis implies that the demand for real money balances (M/P) depends on real income, Y, the ratio of gross investment to GNP, I/Y, and the real deposits rate of interest, d-e, (where d is the nominal deposit rate and e is the expected rate of inflation). The demand for real money balance is expressed in the following function:

(1)

M/P = L(Y, I/Y, d-e)

The investment ratio, I/Y, must be positively related to the real rate of return on money balances. This is because a rise in the real return on bank deposits, d-e, if it raises the demand for money and real money balances is complementary to investment. It must also lead to a rise in the investment ratio. Hence, McKinnons complementarity hypothesis gives a demand for investment function as: (2) I/Y = F(R, d-e)

Where R is the average return on physical capital. The complementarity hypothesis states that the partial derivatives in equation (1) and (2) should meet the requirements: LI/Y > 0; Fd-e > 0

(B) (B1)

Currency Crises Models First-Generation Models (Krugman, 1979)

Second generation models attribute currency crises to economic fundamentals which evolve inconsistently with the commitment of a fixed exchange rate. More specifically, excessive monetary expansion will lead to a breakdown of the fixed parity. In this type of model, the only analytically interesting question when the attack will happen.

Assume a highly simplified demand for money equation (all variables in natural logarithms) given by:

(1)

mt pt = -i t + y t

17

Where m is the domestic money supply (high-powered money), p is the domestic price level, y is real income and i is the domestic interest rate. The coefficients - and represent constant interest rate

elasticity and income elasticity of the demand for money. Equilibrium in the money market requires money demand equals money supply, md = ms.

Purchasing power parity (PPP) is assumed to determine the exchange rate

(2)

pt = p t * + s t

Where p* is the foreign price level and s is the exchange rate (domestic currency/foreign currency).

The interest rate is governed by uncovered interest parity assuming a high degree of capital mobility.

(3)

i t+1 = i t+1 * + [E t +1 (s t+1) - s t ]

Where i* is the foreign interest rate, [ E t +1 (s t+1) - s t ] is the expected depreciation (appreciation) of the exchange rate. Assuming that p* and i* are constant, during the pre-crisis fixed-rate period (when [E t +1 (s t+1) st ]= 0), p and i are externally determined via (2) and (3)

Fundamental macroeconomic variables (real money balance, interest rate and real income determine the actual exchange rate, which can be derived from equations (1), (2) and (3). (4) s t = 1/ [(m t -p t + i t+1 * - y t) E(s t+1)]

In the central banks balance sheet, high-powered money is backed by domestic credit (d) and international reserves (r): (5) mt = dt + rt

18

Speculative attack in Krugmans models is determined by establishing the shadow exchange rate - the rate that equilibrates the money market after international reserves are exhausted by the attack (r t = 0) When that happens, equation (5) can be written as: mt = dt + 0 OR (6) mt = dt

The assumed source of disequlibrium in the second generation models comes from a budget deficit that grows at the rate of and is monetised through the growth of domestic credit. Therefore, denotes the growth rate of domestic credit or the domestic components of the money base and the shadow exchange rate (e) can be specified as: (7) e = d t +

Since there are no reserves left, is also the depreciation rate of the shadow exchange rate. A speculative attack occurs when the shadow exchange rate is equal to the pegged rate, as losses and profits from international arbitrage are equal. At that time, high-powered money drops by the amount of the attack and the interest rate jumps upward. Subsequently, the exchange rate will depreciate at the same rate as the expansion of domestic credit. If the actual fixed rate is above the shadow rate, an attack will not occur because that would lead to the appreciation of the domestic currency imposing losses on speculators.

(B2)

Second Generation Models (Obstfeld, 1986)

This class of models examines the governments motivation to change its exchange rate policy. The government pursues its exchange rate policy by minimising the loss function given by:

(1)

L = ( /2) + [{ E() u k}/2] 2

19

Where L is a social loss function, is the rate of (shadow) exchange rate depreciation, E() is the expected rate of currency depreciation, u is a disturbance term, k is a measure of distortion and is the relative (inflation) weight. Two models of policymaking a rule or discretion are available. The rule requires the government to set policy regardless of the current shock (u); while discretion allows the government to respond to the shock (u) and E(). This presents the problem of time inconsistent policy making.

For the government to stick to the rule, the following must apply.

(2)

LR < LD + C

Where the loss from sticking to the rule LR must be smaller than the sum of losses when pursuing discretionary policy LD and the cost of policy C (loss of credibility).

A speculative attack occurs for the value of u, when the following happens.

(9)

LR(u) = LD(u) + C

That is, the loss arising from maintaining the regime just equals the sum of losses incurred due to discretionary policy and credibility loss. According to these models, a currency crises occurs due to coherent self-fulfilling expectations, herd behaviour and contagion.

(B3) Third Generation Models (Krugman, 1998b)

The model encompasses two periods. In period one, companies purchase capital which they use for production in period two. The model can be characterized by the following (quadratic) production function,

20

(1)

Q = (a + u)K bK2

where u represents a random variable, introducing some uncertainty into investment decision, K is the capital account and, a and b are coefficients. The model applies to a small open economy that can borrow at a fixed international rate equal to 1 , whereas for the purpose of simplicity, the real domestic interest rate is assumed to be zero. The return on capital is expected to be its marginal product and the compensation for the borrowed capital (r) will equal the marginal product (dQ/dK):

(2)

r = (a + u) 2bK

If there are no shocks to the economy, capital will be invested up to the point where the expected return on capital equals the borrowing cost (r =1). The amount of capital in the absence of a shock is given by:

(3)

K = (a + Eu)/2b

where E is the expectation operator. When equation (3) holds, financial intermediaries borrow from the global market and lend to domestic firms for the purchase of capital equipment. Any domestic return higher than the international safe return represents a profit under any realization of u in which r > 1. There are two possible outcomes of this: (a) competition among financial intermediaries will lead to equilibrium ( r = 1) , and (b) financial intermediaries with guarantees will buy out all available capital (K) when r > 1.

Outcome (a) is favorable for the domestic economy while outcome (b) has adverse effects. The reason for this is that the financial intermediaries with implicit or explicit guarantees bid up the price of capital until it reaches the profitability margin for the position taken (guaranteed loss). When the maximum quantity of guaranteed loss has been reached, new losses are no longer guaranteed. Thus, banks (foreign and domestic)

21

advance loans to domestic firms up to the maximum guaranteed losses. Any unfavorable shock can cause an excess loss beyond the maximum guarantee. At that point, the price of capital falls since the foreign banks that invested in the domestic economy become aware of domestic banks exposure to losses. They withdraw their funds from the domestic economy (country), triggering a currency crisis.

22

TABLE 1:

SUMMARY: EMPIRICAL STUDIES OF FINANCIAL REPRESSION/FINANCIAL LIBERALIZATION

STUDY
Giovannini (1985) Ostry & Reinhart (1992) Ogaki et al (1996) Bandiera et al (1996)

SCOPE
18 Developing Countries -

EMPIRICAL TESTS
Response of Consumption to Real Interest Rates

FINDINGS
Negligible or Negative Negligible or Negative (except for distinction between traded and nontraded good) Negligible (except for LDC households above subsistence levels) Short-run effect, Negative (though some positive cases); However Negligible Long-Run effects sizeable, some Positive (e.g. Turkey and Ghana); others Negative (Korea and Mexico) Various impacts of financial innovation, wealth effects, and real interest rates on savings. Difficult to isolate real interest factor Liquidity constraint on households has positive effect on savings, growth and welfare Household Saving Ratio Negatively Correlated with House Price (Real) Changes; Positively Correlated with after Tax nominal Interest Rate Overall negative effects though possible positive indirect effects through impact of financial depth (M2/GNP) Positive effects in terms of FDI and Capital Flows; mixed picture for Savings Effects Very Low Income LDCs see little benefit i. Liberalization is not continuous process in emerging economies; ii. Liberalization

1970-94 (8 Developing Countries)

8 Indicators (e.g. reserve requirements; interest rates; de-regulation etc)

Bayoumi (1993)

11 British Regions

Effects of Deregulation on Short-Run Savings

Jappelli and Pagano (1994) Koskela et al (1992)

OECD Countries (1960-1987) 1970s and 1980s Finland

Role of Capital Market Imperfections and Subsequent Deregulation Various Financial Indicators (e.g. House Prices, Indebtedness, After Tax Rates of Return etc) Income and Subsistence Effects of Real Interest Rates on Savings Effects of Financial Liberalization on Foreign Direct Investment; Saving; Capital Flows 3 Measures of Financial Liberalization (Capital Account Domestic Liberalization on Interest Rates, Credit, Reserves and

Loayza et al (2000)

Reinhart and Tokatlidis (2001) Kaminsky and Schmukler (2001)

50 Countries (14 DEV; 36 LDCs)

1973 on; 28 Developed and Emerging Economies

23

STUDY

SCOPE

EMPIRICAL TESTS
Stock market Liberalizations)

FINDINGS
leads to booms and busts in emerging economies especially in short run iii. Quality of institutional governance is crucial to process i. Formal and informal sector effects; ii. Relative price changes after crises raises price of imported food iii. Fiscal retrenchment affects public services iv. Better off affected by wealth consequences of real interest rates and real estate prices Leads to financial crises; low domestic savings; large government bail-outs Crises less likely if liberalization accompanied by institutional reform Process has eased financial constraints faced by large firms in LDCs Process eases allocative efficiency of investment

Baldicci et al (2002)

Impact of Financial Crises (Large Scale Nominal Currency Depreciation) on Poverty and Income Distribution

Diaz Alejandro (1985) DemirgusKunt and Detriagiache (1988) Laeven (2000) Galindo et al (2001)

Latin American Economies in 1970s -

Financial Reforms Financial Liberalization

13 LDCs (1980s) -

Financial Liberalization

24

25