Financial repression as many studies advocate seem to be an obstacle for the emerging market development. This paper will try to tour some of the many empirical studies to examine on how this phenomenon hindered the economy of a now emerging market. This paper also will examine the impact of financial liberalization of the emerging economy affected by the financial repression, using financial liberalization as a measure for financial repression. Several empirical papers presented by many researchers will be used in over viewing the importance of financial liberation in the emerging economy. The paper also will examine the negative side of the financial liberation in the emerging market and determine how much is too much liberation and to what extent it impact the world economy during a period 1981 to 2002.
INTRODUCTION
Financial sector is the backbone of any economy, whether it is the developed economy like US, and Western Europe countries, or emerging economy like Russia, Ukraine, China, Brazil and South Africa and/or developing economy like African countries and some Asian countries and Far East. Financial sector through financial markets facilitate a movement of capital (funds) in the economy by mobilizing funds from savers and bring to borrower. Due to its nature, the government sees this sector as an easy source of funds to finance her projects and therefore tend to put it in her hand. Many scholars termed this as financial depression.
The concept of the financial depression was introduced in 1973 by Stanford economists Edward S. Shaw and Ronald I. McKinnon. Financial repression occurs when governments implement policies to channel funds to itself so that in a deregulated market environment would go elsewhere. It refers as a notion that a set of government regulations, laws, and other non-market restrictions prevent the financial intermediaries of an economy from functioning at their full capacity. These includes interest rate ceilings, liquidity ratio requirements, high bank reserve requirements, capital controls, restrictions on market entry into the financial sector, credit ceilings or restrictions on directions of credit allocation, and government ownership or domination of banks.
Generally, financial liberalization is the process of breaking away from financial depression by allows the financial market to smoothly operate under the force of the market and its product being derived by demand and supply. Financial liberalization is generally believed to improve financial sector development, which, in turn, will enhance economic growth. However, some authors argue that liberalization induces risk-taking behavior and may cause financial crises (Demirgüç-Kunt and Detragiache, 1998, 2000; Mehrez and Kaufmann, 2000).
The empirical study by Shehzada and De Haan 2008, suggest that financial liberalization reduces the likelihood of systemic crises. In various sensitivity tests, these results turn out to be very robust, though there is some evidence that the likelihood of non-systemic crisis increases after financial liberalization.
DEFINITIONS
FINANCIAL REPRESSION
Financial repression is the measures that governments employ to channel funds to liquidity herself for the funds a cheap way than could have been in a deregulated market. Financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation. (Carmen M. Reinhart, et al 2011)
Financial repression is a term that describes measures by which governments channel funds to themselves as a form of debt reduction. This concept was introduced in 1973 by Stanford economists Edward S. Shaw and Ronald I. McKinnon. Financial repression can include such measures as directed lending to the government, caps on interest rates, regulation of capital movement between countries and a tighter association between government and banks. The term was initially used in response to the emerging market financial systems during the 1960s, '70s and '80s. (Investopedia 2013)
FINANCIAL LIBERALIZATION:
Economic liberalization is a very broad term that usually refers to fewer government regulations and restrictions in the economy in exchange for greater participation of private entities; the doctrine is associated with classical liberalism. The arguments for economic liberalization include greater efficiency and effectiveness that would translate to a "bigger pie" for everybody. Thus, liberalization in short refers to "the removal of controls", to encourage economic development. (Choudhary 2008)
Most first world countries, in order to remain globally competitive, have pursued the path of economic liberalization: partial or full privatization of government institutions and assets, greater labour-market flexibility, lower tax rates for businesses, less restriction on both domestic and foreign capital, open markets, etc. British Prime Minister Tony Blair wrote that: "Success will go to those companies and countries which are swift to adapt, slow to complain, open and willing to change. The task of modern governments is to ensure that our countries can rise to this challenge. (Wikipedia 2013)
Developing countries refer economic liberalization as the attraction of more foreign capitals and investment in their economies. Brazil, Russia, India, and China
In developing countries, economic liberalization refers more to liberalization or further "opening up" of their respective economies to foreign capital and investments. Three of the fastest growing developing economies today; Brazil, China and India, have achieved rapid economic growth in the past several years or decades after they have "liberalized" their economies to foreign capital.[3]
Many countries nowadays, particularly those in the third world, arguably have no choice but to also "liberalize" their economies in order to remain competitive in attracting and retaining both their domestic and foreign investments. This is called TINOA factor (i.e. there is no alternative). For example, In 1991, India had no choice but to implement economic reforms.[4] Similarly, in the Philippines, the contentious proposals for Charter Change include amending the economically restrictive provisions of their 1987 constitution.[5]
The total opposite of a liberalized economy would be North Korea's economy with their closed and "self-sufficient" economic system. North Korea receives hundreds of millions of dollars worth of aid from other countries in exchange for peace and restrictions in their nuclear programme. Another example would be oil rich countries such as Saudi Arabia and United Arab Emirates, which see no need to further open up their economies to foreign capital and investments since their oil reserves already provide them with huge export earnings.
Thus, it is clear that adoption of economic reforms in the first place and then its reversal or sustenance is a function of certain factors, presence or absence of which will determine the outcome. Sharma (2011) explains all such factors. The author's theory is fairly generalizable and is applicable to the developing countries which have implemented economic reforms in the 1990s.[6]
Financial Liberalization refers to reduction of any sort of regulations on the financial industry of a given country. One of example of the economy liberalization is Chinese. The Chinese economy, was the government controlled and restricted from its ability of anyone to invest in from outside, except for Direct Investment which is physical investments, and not financial. The Chinese economy system now reduced some of its restrictions, and this is what termed to be, the system is going through liberalization.
HOW FINANCIAL REPRESSION HINDERED ECONOMIC DEVELOPMENT IN COUNTRIES THAT ARE NOW CONSIDERED EMERGING MARKERT.
In a 2011 The National Bureau of Economic Research (NBER) working paper, by Carmen Reinhart and Belen Sbrancia characterize financial repression as consisting of the following key elements:
Explicit or indirect capping of, or control over, interest rates, such as on government debt and deposit rates
Government ownership or control of domestic banks and financial institutions with simultaneous placing of barriers before other institutions seeking to enter the market.
Creation or maintenance of a captive domestic market for government debt, achieved by requiring domestic banks to hold government debt via reserve requirements, or by prohibiting or disincentivising alternative options that institutions might otherwise prefer.
Government restrictions on the transfer of assets abroad through the imposition of capital controls.
There reason that pushes the government to implement this policy includes control fiscal resources that it can channel funds to itself without going through legislative procedures in a more cheaper way than it could when it resort to market financing.
More specifically, by restricting the behavior of existing and potential participants of the financial markets, the government can create monopoly or captive rents for the existing banks and also tax some of these rents so as to finance its overall budget. Since the domestic banks were guaranteed the collective monopoly they may try to collude with each other and to interrupt possible liberalization policies.
Another financial depression policy motivate the government to use for its fiscal needs is fixing the high reserve requirements. The government requires banks and financial institutions to keep high rate of the reserves so that it can later use as a mean of generate revenues. Reserves earn no interest, and therefore it functions as an implicit tax on banks and also restricts banks from allocating a certain portion of their portfolios to productive investments and loans. The high reserve ratio is a requirement causes the lending and borrowing rate spread must widen to incorporate the amount of no-interest reserves. This tends to reduce the amount of funds available in the financial market.
The combination of the high reserve requirements, interest ceilings and protective government directives for certain borrowers and savers who are usually unaware of the requirement policy become the main taxpayers because they face reduced rates of interest on their savings.
Inflation can aggravate the reserve tax because it reduces the real rates of interest. Thus, high reserves requirements make the best use of the government's monopolistic power to generate seigniorage revenue as well as to regulate reserve requirements.
The policy also includes banks requirement to allocate certain fractions of their deposit to hold government securities that that usually yield a return lower than could be obtained in the market.
The Governments as party of the strategies to control financial sector and make it as source of revenues is to imposes a ceiling on the interest rate banks offer to depositors which provides bank with economic rents, like high required reserve ratios, those rents benefit incumbent banks and provide tax sources for the government. These rent tax paid for by savers and by borrowers or would-be-borrowers. The rents borne by the interest ceiling reduce the number of loans available in the market because of the higher real interest rates on loans and lower real interest rate on depositors, thereby discouraging both saving and investment.
In return for the allowing incumbent banks to reap rents, the government often requires banks to make subsidized loans to certain borrowers for the purpose of implementing industrial policy (or simply achieving some political goals). Interest ceilings in high inflation countries can victimize savers because high inflation can make the real interest rates of return negative.
Financial repression also takes the form of government directives for banks to allocate credit at subsidized rates to specific firms and industries to implement industrial policy. Forcing banks to allocate credit to industries that are perceived to be strategically important for industrial policy ensures stable provision of capital rather than leaving it to decisions of disinterested banks or to efficient securities markets.
It is also more cost effective than going through the public sector's budgetary process. Government directives and guidance sometimes include detailed orders and instructions on managerial issues of financial institutions to ensure that their behavior and business is in line with industrial policy or other government policies. The extreme example of direct state control of banks is nationalization of banks as was observed in Mexico in the 1980s, when the government nationalized all the banks to secure public savings.
Capital controls are restrictions on the inflows and outflows of capital and are also financially repressive policy. The capital control have a behavior of uncompetitive in nature which lead to increases in the cost of capital by creating financial autarky; limits both domestic and foreign investors' ability to diversify portfolios; and helps inefficient financial institutions survive.
Impacts of Financial Repression
The policies that emanating the financial repression leads to inefficient allocation of capital, high costs of financial intermediation, and lower rates of return to savers. These hinder and inhibit the economy as suggested by Roubini and Sala-i-Martin, (1992). The empirical findings on the effect of removing financial repression, i.e., financial liberalization on growth supports this view, but various channels through which liberalization spurs growth have been evidenced.
The possible negative effect of financial repression on economic growth does not automatically mean that countries should adopt a laissez-faire stance on financial development and remove all regulations and controls that create financial repression. Many developing countries that liberalized their financial markets experienced crises partly because of the external shocks that financial liberalization introduces or amplifies.
Financial liberalization can create short-term volatility despite its long-term gains (Kaminsky and Schmukler, 2002). Also, because of market imperfections and information asymmetries, removing all public financial regulations may not yield an optimal environment for financial development (see Asymmetric information).
An alternative to a financially repressive administration would be a new set of regulations to ensure market competition as well as prudential regulation and supervision See also: Asymmetric information. Banking crisis, Capital controls, Capital management techniques, Convertibility, Financial liberalization, International regulatory cods and standards, Money supply, Seigniorage.
FINANCIAL LIBERALIZATION AS A MORE APPROPRIATE STRATEGY FOR PURSUING GROWTH IN THE EMERGING ECONOY.
The financial liberalization is a notion that includes freeing of the economy drivers from the government policy of repression and enable market force to operate the economy. It involves interest rate liberalization, elimination of directed credits, remove restrictions on high reserve requirements, easing of portfolio restrictions on banks, changes in the ownership of banks, enhanced competition among banks, integration of domestic entities to international markets, as well as changes in the monetary policy environment.
Financial liberalization as one of external sector reforms goes hand in hand with financial sector reforms of removing restrictions on exchange and payments system by establishing a freely functioning foreign exchange market that will remove the distortions that limit portfolio behavior.
Financial liberalization as a reforms involve two phases: removal of all restrictions on current payments and transfers, and capital account liberalization; Liberalization of the capital account will enhancing country's integration with the rest of the world, imposes perhaps the strictest limits on financial repression (Turkey is a good example for the latter).
The reform of the institutional context of monetary policy implementation primarily involves increased independence for the central bank and a switch from direct instruments of monetary control like interest rate controls, bank-by-bank credit ceilings, statutory liquidity ratios, directed credits, bank-by-bank rediscount quotas to indirect instruments like reserve requirements, rediscount and Lombard window, public sector deposits, credit auctions, primary and secondary market sales of bills, foreign exchange swaps and outright sales and purchases.
The main purpose of the financial reform is release the central banks from direct control and remain with a main task of stimulate the growth of money markets and instruments with a view to enhancing market-orientedness of its policy environment.
Several authors of empirical studies have advocated that, financial liberalization is a main cure of the financial repression. However other argued that liberalization includes risk - taking behavior that may cause bank crises.
(Demirgüç-Kunt and Detragiache, 1998, 2000; Mehrez and Kaufmann, 2000) advocated that financial liberalization is associated with risk that may cause financial risk and hence bank crises sight example of Russia banks crisis in 1990s.
Data from Honahan and Laeven (2005) on bank crises used by C.T.Shehzad (2008) to analyze systematic and non-systematic banking crises during the period 1981 to 2002 focusing on whether financial liberalization affect the likelihood of banking crisis and if so, are there difference among the various dimensions of financial liberalization that we distinguish and whether the system and non-systematic crises affected in the same way by financial liberalization?
The result of this study suggests that liberalization reduce the likelihood of systemic crises. In contrast, there is some that the likelihood of non-systemic crisis increases after financial liberalization.
Another study by E. Murat Ucer indicated that Financial liberalization resulted into bank crisis taking example of the Latin America experience in 100s and early 1980 (e.g Argentina, Chile and Uruguay). These countries faced a serious high inflation. As an effort to end this hiked inflation, they deregulated and privatized their banking system. Interest rates on both bank deposits and loans were completely freed, with the latter often increasing to unexpectedly high level in real terms. These attempted financial liberalization generally ended in failure with an undue build up of foreign indebtedness and government intervention to prop up failing domestic banks and industrial enterprises.
(Demirguc-Kunt and Detragiache, 1998 and Fischer and Chenard, 1997) support the above evidence in their study of the empirical relationship between financial liberalization and financial crises. The study was carried in a panel of 53 countries for the period 1980-95 in a multivariate logit model. The following set of variables were accepted as standard predictors of banking crises used; economic growth, terms of trade changes, real interest rates, inflation, M2 as percent of international reserves, private sector credit to GDP, ratio of bank liquid reserves to GDP, rate of growth of private sector credit, real GDP per capita, the control for a host of institutional factors including respect for the rule of law, a low level of corruption, and good contract enforcement as the relevant institutional characteristics.
The find of the above study indicated that, banking crises are more likely to occur in liberalized financial systems, even if institutional factors reduce the likelihood of banking.
CONCLUSION
Financial repression is the main obstacles of the economy development as suggested by many empirical studies. Studies by Patrick Conway 2008, David MKemme (2001) advocated that, financial repressions brought about economy disaster in many emerging market sighting example of former planed economy like Eastern Europe countries includes; Czech Republic, Hungary, Poland and Slovenia (CHPS) which experienced a substantial down fall with a hike inflation rate. Example East German consumer price inflation was at 1000% consecutively in 19922 and 1923, and former Soviet States suffer an inflation of over 1000 percent f)or a three consecutive years (1992 to 1994.
Financial repression includes the government intervention of the economy to control fiscal policy. The financial repression includes interest rate ceilings, liquidity ratio requirements, high bank reserve requirements, capital controls, and restrictions on market entry into the financial sector, credit ceilings or restrictions on directions of credit allocation, and government ownership or domination of banks. Fiscal and monetary irresponsibility interacted with excessive control over the interest rates offered by deposit-taking financial intermediaries to discourage saving. Low rates of saving perpetuated the slow growth equilibria.
However, liberalization of states owned economy was argued by empirical studies that it reduce the likelihood of systemic crises caused by financial repression. The liberalization stand in a context of financial sector reform which involves free interest rates rapidly, reduce reserve requirements, and eliminate directed credit schemes, while stabilizing the price level, say in the context of a strong disinflation program. Taking an example of Chinese economy were in the past it was 100% state owned and now started to release some of the economy activities to be run by private sector. The reform was also affected some Planned economy like Soviet State, Ukraine, Latin Amrica state example Chile, Argintina, and Mexico.
Though it is argued that liberalization brought about efficiency in the market but it has brought some negative effect to those emerging market which were not prepared to receive a rapid effect of the financial liberalization. One example is Russia economy which moved from a somewhat optimistic macroeconomic environment in 1997 and the first quarter of 1998, before collapse by the end of 1998.4 By mid-1999 the economy had stabilized and policy makers were taking measures to bolster the fiscal system.
