3—
Consequences of Monetary Reform and Financial Liberalization
3.1—
Monetary Reform
McKinnon (1973) and Shaw (1973) were the two most influential economists in advancing the cause of financial liberalization in the early 1970s. They provided a theoretical basis for, as well as empirical evidence of, the benefits from a liberal financial regime in developing countries. Combining a number of national experiences, including those of Brazil, Korea, and Taiwan, McKinnon (1973) develops a framework in which a monetary reform—an exogeneous increase in bank deposit and lending rates close to an equilibrium level—is shown to be conducive to a high rate of capital accumulation and economic growth through financial deepening.[6]
In most developing countries the insignificance of institutionalized markets for primary securities implies that the financial instruments for saving in these countries are limited to currency, demand, and time and savings deposits, the sum of which is often defined as broad money or M2 . According to McKinnon (1973), an increase in the nominal interest rate on time and savings deposits controlled by the monetary authorities would induce savers to increase their rates of saving, because the increase means a higher rate of return on savings adjusted for the risk, convenience, and liquidity of savings instruments.
After interest-rate reform, more investment resources will be allocated through the banking system than before. This is because in response to the higher rate of return to savings, owners of wealth are likely to save more in terms of M2 (a flow effect) and also move out of inventories, precious metals, foreign currencies, and lending to informal credit markets; the liquidity thus generated will flow into bank savings deposits, which become more attractive saving instruments than before (a portfolio shift effect). Assuming that banks have scale economies in collecting and processing information, they will be more efficient in seeking out borrowers with investment projects yielding high real returns. Since investment opportunities with high yields abound in developing countries, the high real cost of financing would not discourage, but
[6] Shaw is equally convinced about the positive effects of financial liberalization. According to him, financial liberalization (which he does not define explicitly) could raise ratios of private domestic savings to income, open the way to superior allocations by widening and diversifying the financial markets on which investment opportunities compete for savings flow, and even tend to equalize the distribution of income (1973, 9–12).
rather stimulate, investment through a greater availability of credit. Interest-rate reform thus has the effect of enhancing growth both by increasing the savings ratio and by reducing the capital-output ratio (Long 1983).
The effect of an exogenous increase in the real interest rate on savings, which can be either positive or negative in theory, is essentially an empirical issue.[7] The economics literature abounds with empirical studies examining the relationship between saving and a variety of measures of the real rate of interest. Fry (1978, 1980) shows empirically that for a sample of developing countries, saving is positively affected by real deposit rates of interest, as is real M2 demand. However, many other empirical studies find that the impact of real interest rates on saving is negligible, though all of these studies are subject to theoretical and estimation problems of one kind or another (Mikesell and Zinser 1972; Giovannini 1983).[8]
While the interest sensitivity of saving remains a controversial empirical question, others have emphasized the efficiency gains from the high interest rate policy (Patrick 1966; Galbis 1977). Improvements in the process of financial intermediation, such as those brought about by higher real interest rates, could result in a high rate of economic growth because they help shift resources from low-yielding investments to investments in the modern technological sectors. This efficiency improvement is claimed to be sizable in developing countries where disparities in the rates of return to capital are wide and indivisibilities of physical capital are substantial.
The validity of this argument rests, of course, on the assumption that banks have a comparative advantage in gathering and analyzing information on alternative investment projects. This may not always be true, however. As McKinnon himself points out, banks may have little
[7] McKinnon argues that in an earlier stage of development in developing countries, money (M) and physical capital are likely to be complements rather than substitutes in savers' asset portfolios. If this hypothesis is valid, then an increase in the real interest rate on time and savings deposits will lead to an increase in the real demand for M, and a corresponding increase in real savings (1973, chap. 6). Fry (1978) shows in an empirical study that the hypothesis did not hold in a number of Asian developing countries he examined.
[8] McKinnon cites the Korean monetary reform in 1964–66, in which real deposit and lending rates were raised in a remarkable policy shift that had I he effect of sharply increasing saving, had a buoyant impact on investment and output, and altered the future course of the economy (1973, 105–11). Cole and Park argue that the effect of the financial reform was ambiguous because it was only one of many changes that contributed to an upward shift in the savings function (1983, 204–11).
experience in identifying borrowers who can pay high real interest rates on their loans (1981, 383).
There are also more serious problems than the lack of experience in credit allocation among bank officers. In the absence of asset portfolio regulations, banks could utilize the increased availability of credit to finance consumption rather than investment spending.[9]
In countries where informal credit markets are extensive and efficient, high deposit rates could result in an overall credit contraction. This is because high deposit rates induce a shift of resources out of informal financial markets with no lending restrictions and into the organized banking sector where reserve requirements and credit ceilings are strictly enforced (Taylor 1983, 197). Improvement in efficiency hinges critically on who controls the banking system. In many developing countries financial markets are dominated by a few oligopolistic commercial banks, which are often connected with large industrial groups through ownership or management. These commercial banks often channel a large share of their resources to the firms with which they are affiliated (Long 1983). Given these market distortions, high interest rate policies may not result in any improvement in the allocation of credit, because the banks could simply supply more credit, after a monetary reform, to large industrial groups that are favored clients at the banks but not necessarily efficient.
A monetary reform can invite greater direct government involvement in credit allocation, as it did in Korea, unless it is accompanied by a relaxation of other regulations governing bank-asset management. Insofar as the government has a strong inclination to intervene in resource allocation, the increased availability of credit, which means an allocation of more resources through the banking system than before, will persuade policymakers of a greater need to tighten their grip on the banking industry. The effects of a monetary reform on the autonomy of the financial system could be more negative than positive.
3.2—
Financial Liberalization
According to Shaw (1973) and McKinnon (1973), monetary reform is a step toward a fully liberated financial sector and should be distinguished from full financial liberalization. No country, developed or developing, has ever attempted to establish laissez-faire finance. Beginning in the mid 1970s, however, the Southern Cone countries of Latin America
[9] Patrick 1966 is concerned with this consequence of financial decontrol.
(Argentina, Chile, and Uruguay) embarked on a course of extensive and radical economic liberalization. The important element was financial deregulation in which state-owned financial intermediaries were privatized, interest rates were freed to be determined in financial markets, controls over banks' asset management were lifted, and foreign banks were allowed to operate in domestic financial markets.
As noted in the preceding section, a variety of monetary reforms are claimed to have succeeded in a number of developing countries in the 1960s. McKinnon and Shaw suggest that if a monetary reform (a partial liberalization) can mobilize domestic savings and allocate them to efficient uses, as has been claimed, full financial liberalization may produce the optimal result of maximizing investment and further raising the average efficiency of capital investment.[10] Contrary to this expectation, the financial liberalization efforts of the Southern Cone countries ended in renationalization of banks, reimposition of banking regulations, and chaotic financial markets. Because of their radical nature and traumatic results, the liberalization experiences of the Southern Cone countries have generated a great deal of research interest and subsequently produced a voluminous literature (which is still growing) on just what went wrong in these countries.[11] In this section an attempt will be made to identify some of the characteristics of, and institutional arrangements in, the financial sector that doomed the liberalization efforts. It will also be argued that the success of monetary reform does not necessarily imply a similar success of full-scale financial liberalization.
The economic liberalization in the three Southern Cone countries was undertaken from an exceedingly difficult situation, characterized by serious inflation, unemployment, and current account problems. Not surprisingly, economic liberalization was pursued simultaneously with a stabilization program. Consequently, it is difficult to determine the extent to which liberalization efforts should be held responsible for the failure. Sjaastad (1983) and Edwards (1985) argue that the economic crises all three countries encountered in the early 1980s did not arise from trade and financial liberalization, but from the implementation of stabilization programs. They are in a distinct minority. Most other observers claim that economic liberalization—in particular, misguided financial
[10] McKinnon points out that the best policy, as against various second-best policies designed to eliminate financial repression, would be to move to a completely open capital market where borrowing and lending take place at high-equilibrium rates of interest (1982, 382).
[11] For a listing of these studies, see Edwards 1985 and Corbo and de Melo 1985a.
deregulation in an undisciplined manner—played a major role in determining the magnitude of the crises in all three countries.
A careful reading of the available studies on the Southern Cone experiences of economic liberalization in the 1970s suggests that financial deregulation:
(1) complicated macroeconomic management, inasmuch as it created incentives for destabilizing behavior on the part of banking firms;
(2) did not help mobilize domestic savings despite a marked increase in real interest rates to over 3 percent per month and diversification of financial instruments;
(3) did not help establish competitive market structure in the financial sector, but instead resulted in the domination of financial intermediaries by large nonfinancial economic groups;
(4) did not produce efficiency gains, partly because of distortions in credit allocation associated with (3); and
(5) dried up long-term finance.
One lesson to be drawn from the Southern Cone experience is that banks and financieras (expanded finance companies) do not always intermediate between savers and investors as is widely perceived in the financial literature, but sometimes transfer net savings of one group to finance consumption of other groups. During the deregulation period, Chilean banks and financieras actively competed with retailers and department stores for customers seeking consumer loans. In Uruguay the increased availability of credit from financial intermediaries went to finance consumer credit, with the consequence that consumer credit as a percentage of commercial bank credit rose from 4 percent two years earlier to 12 percent in 1981 (Hanson and de Melo 1985).
In all three countries, it appears, the financial intermediaries were active in financing the purchases of imported consumer durables by making credit available for such purposes. Unregulated, financial intermediaries—knowingly or unknowingly—can easily be drawn into speculation in real estate, commodities, and stock. The subsequent increase in asset prices stimulated consumption spending in Chile, as it implied an increase in private wealth (Harberger 1984).
Financial deregulation produced an undesirable effect in that it dried up long-term finance in the three countries. Even at the height of the financial boom, maturities of both deposits and loans at the banks were less than six months (Diaz-Alejandro 1985). In the meantime, savers became increasingly sensitive to changes in interest rates, and more receptive to new kinds of instruments yielding higher rates of return than the
existing ones. On the other hand, private firms were hardly in a position to finance their fixed investment at a real interest cost of over 3 percent per month. Simply to avoid bankruptcy and ride out the rough period in the hope that interest rates would eventually come down, they continued to borrow at the short end of the market and had their short-term loans rolled over. Given the high variable real interest rates, banks, in order to avoid the default and interest rate risk, did not want to make any long-term loans. Banks had the incentives to match the maturities of their assets and liabilities. In the process, they became less like financial intermediaries and more like finance companies and securities brokers.
While these undesirable consequences of financial deregulation were serious enough, most analysts of the Southern Cone experience point out that the undisciplined behavior of financial intermediaries was critical in bringing down the entire liberalization program (Diaz-Alejandro 1985; Harberger 1984; Corbo and de Melo 1985).
At the center of the controversy lie the moral-hazard consequences of financial deregulation, a universal problem inflicting the financial system with a deposit-insurance system. When deregulated, financial intermediaries did not behave in the prudent manner expected of them either in Argentina, which had a deposit-insurance system, or in Chile, which did not. The harshest indictment of the financial deregulation comes from Harberger (1984): "Chile could well have avoided the problem that started in mid-1981 had the banks been better regulated" (249). "I think that the biggest mistake of the policymakers ultimately lay in overlooking the need to keep the banking system under a strict discipline" (248).
During the liberalization period financial intermediaries in both Chile and Argentina took excessive risks and extended too many bad loans, and the insurance system, as the argument goes, was the major cause of their irresponsible behavior. Over time, these institutions accumulated a large stock of nonperforming loans. Instead of writing off these loans as bad debts, they rolled them over and let interest rates accumulate along the way, thereby increasing their bankruptcy probabilities (Harberger 1984).
With the rapid accumulation of nonperforming loans and the subsequent profit squeeze, some of the intermediaries experiencing financial difficulties began to offer higher interest rates to compete for new deposits, which were needed to make up the shortfall on interest payments to depositors. They were able to attract new deposits, because
depositors were hardly concerned about the insolvency possibility of these institutions because payment of their deposits was guaranteed by the government (Fernandez 1985; Corbo 1985). The competition among intermediaries for deposits was in part responsible for a high real interest rate in excess of 3 percent per month during the latter part of the 1970s in Chile.[12]
Early in the deregulation process, some banks in Argentina and Chile ran into trouble and had to be liquidated. Practically all depositors were rescued in Argentina, and even though there was no institutionalized insurance system in Chile, the government was forced to bail out the insolvent banks by taking over their bad debts. The bailout sent out a clear signal to domestic residents as well as foreign banks that the government would in the end assume the nonperforming loans of financial intermediaries. With this implicit guarantee, foreign banks became more aggressive and at the same time less stringent in extending loans to these countries (Harberger 1984). Domestic firms took the government's bailout operation as a sign that the government would in the end socialize their debts and began distress borrowing (Fernandez 1985).
A disturbing question, then, is why the banking institutions did not write off the bad loans instead of accumulating them. The moral hazard is one reason, but there are other explanations. One, pertaining to the Chilean case, points out that writing off the loans would have meant a loss in banks' competitiveness. The reduction in capital and surplus that is inevitable with writing off bad loans automatically reduced the legal limits on lending, deposits, and borrowing from abroad, which were expressed as multiples of capital and competitiveness. These legal limits made banks extremely reluctant to dispose of their bad loans (Harberger 1984).
Another explanation finds fault with the pace of financial deregulation, which in all three countries, may have been too rapid and abrupt for banking institutions to adjust to new market arrangements. Bank managers and officers under government ownership and control had seldom been guided by profit motive in their management, had had little
[12] The high interest rate, combined with an exchange rate that was "preannounced" (pegged to the U.S. dollar) in an effort to stabilize domestic prices, brought about a huge inflow of foreign capital, which led to a sharp real exchange-rate appreciation and a subsequent current account deterioration. When the authorities could no longer manage the burgeoning current account deficit and consequently were forced to devalue, domestic firms heavily in dollar debt could not make the loan payments. Capital flight ensued, the availability of foreign loans dried up rather quickly, and banks became insolvent and had to be rescued by the government. See Dornbusch 1984 and Corbo 1985.
experience in, or for that matter reason to, seek out creditworthy borrowers, and had not established any efficient procedure for evaluating loan applications and supervising credit use. When they plunged into free competition, it was not altogether clear whether the officers of the newly liberated financial intermediaries were prepared or trained to withstand the rigors of the competitive market.
A third explanation focuses on the large share of nonperforming loans in the asset portfolios of many of the denationalized or decontrolled banks in both Chile and Argentina even before the liberalization began.[13] As Harberger (1984) notes, hundreds of Chilean corporations that had been in the hands of the government were generating substantial losses and were on the verge of technical bankruptcy around the mid 1970s when they were denationalized. At that point, the Chilean banks began to pile up a stock of bad loans. With this past legacy, Chilean banks were in a disadvantageous position to compete for deposits with the newly established intermediaries, such as financieras after the relaxation of the entry barriers. These old banks were paying very high market rates on all deposits while incurring large losses on nonperforming loans. For the survival of these institutions, the government should have taken measures to relieve the banks of this bad debt burden before proceeding to a rapid liberalization.
Many corporations in government hands in both Argentina and Chile before the economic liberalization was set in motion were in a very weak financial position, and a reasonable assumption would be that the banks under government control were directed to support these unhealthy firms by making generous amounts of credit available at a subsidized interest rate. A large part of the loans extended to the troubled firms eventually became nonperforming. Consequently the governments in both countries bore some responsibility for the accumulation of bad debts. Financial deregulation did not absolve the economic authorities from their past mistakes.
Furthermore, it was not clear who should be held accountable if and when those loans made by the government became nonperforming. As long as this ambiguity remained, it appears, banking institutions were less inclined to dispose of the bad loans, since they could always blame the government for their problems with bad debts and ask for assistance. Thus the past legacy of government intervention in credit allocation
[13] A large increase in the nonperforming loans of commercial banks in the late 1970s has been one of the major causes delaying financial deregulation in Korea (Park 1985).
was an important source of, and at least aggravated, the nonperforming loan problem that eventually led to banks' bankruptcy.[14]
A fourth explanation, which is the most important one from the perspective of this chapter, blames the close association of financial intermediaries with nonfinancial firms. In my view, the control of banks and financieras by a few industrial conglomerates was primarily responsible for the lack of discipline in the banking industry in the Southern Cone countries. To further substantiate this point, a typical case of the interpenetration of economic and financial power in developing countries, and how this acts as a constraint on financial liberalization, will be sketched.
The real sector of many developing economies is often dominated by a limited number of industrial groups and large public enterprises. Since they account for a large share of total output, a large part of bank credit is then allocated to these groups and enterprises. Because of the limited availability of equity financing and subsidized low interest rates, large corporations rely heavily on bank credit financing, and hence are highly leveraged.
As noted before, economic liberalization is usually undertaken in a crisis atmosphere, when the rate of inflation often exceeds several hundred percent a year, and industrial capacities are underutilized and layoffs are widespread. This means that the large industrial groups and public enterprises are also experiencing financial difficulties, so that the banks that extended credit to these corporations will also find themselves in a weak financial position. Most likely, the banks will start accumulating bad loans.
Suppose financial deregulation is undertaken under these difficult circumstances. As part of the deregulation, the ownership or management control of the banks is turned over to the private sector. An important question in this regard, then, is who, in the end, will control these banking firms? Private investors will find that bank shares are not a very attractive instrument for their savings because of the poor financial condition of the banks. On the other hand, large industrial groups and corporations will be very anxious to acquire a controlling interest of at least one bank, because they know that those who control the banks will also control themselves.
[14] In view of the Latin American experience, it may be better for the government to take over outstanding bad loans and put them in a separate government fund for liquidation. This way the legacy from the past would not poison the future. The author owes this point to Larry Krause.
In denationalizing, governments in developing countries lay down a number of restrictions designed to prevent industrial groups from gaining control of the banks by limiting bank stock ownership. Despite all sorts of stringent ownership regulations, the large conglomerates find ways, mostly through cross ownership arrangements, in which they can control the management of the banks.[15] Once they take over the institutions, they start using the banks as a private means for mobilizing resources. It is therefore not surprising that as long as these groups are borrowing just to remain in business, the banks will be forced to support them at any cost.
The moral hazard associated with deposit insurance and bailout was certainly a factor contributing to the imprudent bank behavior during the deregulation transition period in Argentina and Chile. However, it is debatable whether better regulation of bank activities would have mitigated the problem as long as the banks were controlled by a few industrial groups and conglomerates, in particular when these groups believed that the government could not afford to let them go bankrupt.
Freer entry into financial industries is not necessarily a solution to the concentration problem. As noted in the preceding section, completely free entry may be undesirable for the stability and soundness of the financial system. Even when new banks and other intermediaries are chartered to promote competition in financial markets, the government must establish and enforce certain ownership regulations to ensure a wide dispersion of the stocks of the new institutions. Otherwise, it is likely that these new institutions will also be taken over by the industrial conglomerates that control the other banks and intermediaries.
An interesting question arises at this stage of discussion. Why did major financial liberalization efforts meet with failure, whereas partial deregulation—monetary reform—has succeeded, or at least has not resulted in a breakdown of the financial system?
In developing countries, money is the most attractive instrument of private wealth accumulation because, as McKinnon points out, it is a means of payment sanctioned by the state. McKinnon is also right in saying that financial instruments other than money cannot be easily
[15] Although the Chilean authorities took a number of legal and regulatory precautions in denationalizing the banks so as not to allow industrial groups or conglomerates to take control of these institutions, in the end the large business groups found ways in which they could dominate the intermediation industry. Diaz-Alejandro (1985) argues that the close association of financial intermediaries with nonfinancial corporations led to the heavy use of debt by private firms, concentration of loans in banks' affiliates, and distortions in credit allocation.
marketed, because lenders know little or nothing about either the honesty or the repayment capability of potential borrowers in developing economies—a case of market failure owing to informational asymmetries (1973, 38). Money is a riskless asset because economic agents believe that their deposits are insured regardless of whether there is a formal insurance system or not, and that the government will bail out banks when they are in trouble. Perhaps, as Diaz-Alejandro (1985) notes, they may know that domestic political and judicial systems are not compatible with laissez-faire finance. More important, however, is the fact that government intervention in credit allocation carries with it an implicit promise that the government will protect depositors from the risk of bank default.
A liberal reform will not make marketing of nonmonetary financial assets any easier than before (remember that the problem is informational asymmetries and uncertainty), but it could impair the viability of the payments system and will reduce the value of deposits as an attractive financial instrument. That is, the efficiency gains from liberalization may be partially or fully offset by the loss of the value of deposits as an instrument of capital accumulation. If the government authorities retain the deposit-insurance system and lender-of-last-resort function, a full-scale financial liberalization will most likely produce serious moral hazards and other problems. This seemingly unavoidable trade-off between efficiency gains (if they could be realized, that is) and safety of the payments system associated with financial deregulation may explain why the success of monetary reforms does not ensure a similar success of full-scale liberalization efforts.