Whither Financial Liberalization
Keynote Address delivered at the Second Annual Indian Derivatives Conference Mumbai, India
© Peterson Institute for International Economics
This speech was given while Mr. Williamson was the Chief Economist for the South Asia Region at the World Bank.
India has been fairly typical of developing countries in liberalizing its financial sector during the 1990s. I imagine that most of those present believed, as did most economists, that this was a wise move that brought significant benefits to India. Yet in recent months the global economic crisis has led to a widespread questioning of the benefits of a liberalized financial system. We need to re-examine the merits of financial liberalization in the light of recent events and ask how much farther, and how fast, we expect liberalization to go.
A Short History of Financial Liberalization
The modern economic analysis of financial policy in developing countries started with the seminal works of McKinnon (1973) and Shaw (1973). Both authors drew attention to the widespread "financial repression" (as they termed it) in developing countries. Such repression occurred in six dimensions:
- The government, not the market, determined who received credit.
- The government, not the market, determined interest rates.
- The government determined whether new institutions would be allowed to enter the financial sector.
- The government laid down details of banks' operations such as who they hired and what salaries were paid.
- The government owned financial institutions.
- The government decided who would be allowed to borrow and lend abroad and on what terms.
McKinnon and Shaw argued that this financial repression was imposing major costs on the countries that practiced it. For one thing, sub-market real interest rates would tend to repress the level of saving, and thereby investment. In addition, the failure to ration credit by price would result in an inefficient allocation of what savings there were. Growth would suffer on both counts: too little would be saved, and what savings there were would not be allocated to those uses promising the best return, and thus would not contribute as much as potentially possible to the rate of growth. Critics challenged the likelihood of these benefits and contended that financial liberalization would have two negative effects: it might lead to a loss of monetary control, and it might nurture financial crises.
Since then there has been a very widespread move to liberalize financial systems. This move is documented in Williamson and Mahar (1998), a paper written in response to a request voiced at a previous meeting with members of the financial community in this city. Not only were domestic financial systems liberalized, but an increasing number of countries eliminated controls on international capital movements. Following the report of the Tarapore Committee (1997), India last year appeared to have set itself the objective of establishing capital account convertibility within three years.
Sufficient experience has now accumulated to permit reasonably confident verdicts about the consequences of financial liberalization. So far as domestic liberalization is concerned, it seems that one of the beneficial effects of liberalization anticipated by McKinnon and Shaw is typically realized but that the other is not. The one that is realized is a better allocation of investment. It is true that the simple model of credit being rationed by price to those who bid the highest is inappropriate in the case of the financial sector: those who are prepared to bid the highest are typically those with the riskiest projects, and a prudent banker has to search for the borrower that offers the best risk-return combination rather than the one who offers to pay the highest interest rate. But liberalization of lending rates nonetheless permits bankers to search for the borrowers who offer them the best combination of risk and return, rather than giving them an incentive to lend to the safest borrowers almost regardless of the expected rate of return, and the evidence is that this does lead to a better pattern of investment. The anticipated benefit that seems to be absent is the impact on savings, at least once the real interest rate is positive. (But there is one margin on which the real interest rate does have an impact: not the savings decision, but the choice between placing assets at home versus abroad. Without reasonably competitive interest rates, a country has to expect capital flight.)
I might note that, in addition to gathering savings and directing them to potential investors, and providing the payments mechanism, modern analysis has pointed to other key functions of the financial system (Stiglitz 1993). Banks and/or the capital market not only allocate capital among borrowers, they also monitor whether it is being used properly by the borrowers. Financial markets, most particularly the derivatives markets that are the focus of this conference, also redistribute risk. I know of no empirical study that has yet evaluated how well they perform this task, or whether microeconomic benefits of shifting risks to those most able to bear them may be countered by macroeconomic costs of some sort, such as the apparent propensity of hedge funds like LTCM to increase total risk by engaging in destabilizing speculation.
So far as the feared costs are concerned, it again seems that one of these effects occurs as expected, but the other does not. The one that is not in practice a problem is the loss of monetary control; on the contrary, the indirect methods of monetary control that go with financial liberalization appear to be more effective than direct credit controls, at least after a short period of time. Unfortunately the evidence on the other issue is much less comforting: it seems that liberalized systems are indeed more prone to banking crises (Reinhart and Kaminsky 1996, Demirguc-Kunt and Detriarche 1997, Williamson and Mahar 1998). Reassuringly, however, there is some recent evidence that suggests that this effect is much less pronounced in the presence of a strong institutional environment, meaning that the rule of law prevails, corruption is largely absent, contracts are efficiently and impartially enforced, and both the bureaucracy and the judiciary are respected as efficient and fair (Demirguc-Kunt 1998). The moral is that liberalization needs to be complemented by institution building (as was nicely illustrated by the discussion of the design of a market for index futures this afternoon).
But it is not just banking crises that constitute a problem. Indeed, it is perhaps the suspicion that liberalization generates balance of payments crises that is nurturing the backlash against liberalization.
The Generation of Balance of Payments Crises
Recent years have seen a succession of booms and busts in international lending. The first great boom came in the wake of the first oil crisis. It involved principally sovereign lending by banks and was mainly focused on Latin America, and ended with the debt crisis of the 1980s. It is normal to ascribe that crisis to macro imprudence, meaning fiscal deficits, unrealistically low interest rates, and the defence of fixed exchange rates, and I see no reason to challenge that diagnosis for most of the affected countries. (Indeed, it is easy to think of other countries where a similar diagnosis would seem called for, including India in 1966 and 1991 or my own country, Britain, in 1967 and 1976.) But there were two countries in Latin America that could not be accused of fiscal imprudence in the early 1980s: Chile, which had made its capital account convertible, and Colombia, which had not, and which alone managed to defy the regional trend to the extent of avoiding involuntary rescheduling (and was rewarded by the fastest growth rate in the region during that decade).
At the same time that Latin America was suffering its "lost decade" of growth, East Asia was experiencing a boom (the famous miracle), which brought a gradual increase in capital inflows. Early in the 1990s this boom in lending generalized to most developing countries outside Africa, supported by widespread capital account liberalization. This time around the form of the capital inflows was more diversified, with FDI playing a much more important role, portfolio equity investment emerging as a major factor, bonds becoming more prominent, and banks lending to the private sector as well as sovereigns. But this diversification did not prevent the short sharp Mexican crisis in 1994-95 or the East Asian meltdown of 1997 that has now spread to most developing regions except South Asia.
The Mexican crisis was in my judgment quite clearly a consequence of currency overvaluation. The Thai crisis that started the East Asian meltdown can also be explained easily enough in those terms. What I cannot understand is how anyone can contend that the other East Asian victims of the crisis were guilty of macroeconomic mismanagement; on the contrary, in terms of the standard macro variables, both Korea and Indonesia had exemplary performance (and Korea had been praised by the IMF only months before the crisis broke). I think most people would agree that the reason these countries suffered contagion was the structure of their financial liabilities: too much debt and too little equity, too much short-term debt and too little long-term debt, too much foreign currency debt and too little domestic currency debt. This financial structure left them extremely vulnerable to adverse shocks, such as the questioning of whether they might succumb to a crisis that was naturally prompted by events in Thailand, which made investors want to get out as a precautionary move while the going was good, and in that way precipitated the very crisis that was feared.
How did countries build up that vulnerability? We have learned since the crisis broke, but many of us did not realize before, that the financial sectors were poorly regulated. This meant that there were no constraints on lending to already over-leveraged corporates (indeed, in some cases there was government pressure to lend more to them). Transparency was poor, which meant that foreign investors did not get the information that might have restrained them from over-lending. The problem with these explanations is that they do not distinguish those countries that succumbed to the Asian flu from those that proved immune to it, such as India, Bangladesh, China, Sri Lanka, and Taiwan. Supervision and transparency may well have improved in some of these countries in recent years, but one can surely not claim that it is better than in Hong Kong, Indonesia, Korea, Malaysia, and the Philippines. Nor are these two groups of countries distinguishable by their exchange rate policies, or by their record of macro management. The one dimension in which there is a systematic difference between the two groups is with respect to whether or not they had liberalized their capital accounts (i.e., made their currencies convertible on capital account). Note that this is the same difference that distinguished crisis-afflicted Chile from crisis-resisting Colombia in the 1980s.
It is not difficult to see how capital account convertibility made countries vulnerable to crisis, for it allowed companies and banks to borrow abroad in the way that the lenders preferred, in short-term, foreign currency denominated debt. Each of the lenders seems to have believed that these terms would allow them to get out before the crisis struck if conditions deteriorated. Each of the borrowers seems to have failed to see the danger to which it was exposing itself. And as long as the boom lasted, they were all happy to lend and borrow respectively more and more money on those terms, terms that left the countries increasingly vulnerable to any adverse shock. Thailand provided the shock.
Appraising Capital Account Convertibility
If capital account liberalization is as dangerous as it appears to be, one needs to ask whether it brings great benefits that need to be traded off against the risks. Until recently we were content to identify the benefits that can in theory flow from a liberalized capital account: the ability to divorce the level of domestic investment from the level of domestic savings, by importing capital where domestic investment opportunities that are worthwhile at the world interest rate exceed domestic saving; the risk diversification that can be achieved by holding an internationally diversified portfolio; the intangible capital that can be acquired as a byproduct of FDI; and the increased competition in the financial sector as a result of the entry of foreign banks. But Jagdish Bhagwati has recently pointed to the need for empirical investigation of whether these benefits amount to enough to have an econometrically detectable impact on the growth rate, and the first attempt to search for such effects, by his former colleague Dani Rodrik (1998), has failed to identify any. In understanding this result, it is important to note that most of the potential benefits of capital mobility can be realized without going all the way to capital account convertibility: it is just not true that the only alternatives are a completely closed and a completely open capital account.
If capital account convertibility makes countries vulnerable to crisis and brings with it no measurable benefit, why not delay it for 20 or 30 years, like Western European countries did after World War Two? I posed this question to two reporters of The Economic Times a week ago and was taken to task by an editorial on Monday. This claimed that the potential gains of capital account convertibility are now greater than they were earlier in the postwar period, which is another of those empirically unsubstantiated assertions of which Jagdish Bhagwati complained. The editorial went on to concede that the risks are also greater, and also pointed out that the risks would be minimized by the reforms (fiscal discipline and a sound financial system) that had been set down as preconditions for capital account convertibility by the Tarrapore Committee. Those reforms, it asserted, were desirable in themselves, an assessment which I enthusiastically endorse. It argued that an elastic timetable for capital account convertibility should not become an excuse for easing up on those reforms, which seems to me something of a non-sequitur if one accepts that the reforms are desirable in themselves. Then, it claimed, if we have those reforms, we might as well have capital account convertibility.
The last claim would follow only if the Tarapore Committee had correctly identified all the necessary preconditions for capital account convertibility. It is here that I have a serious doubt.2 When I first analyzed this issue, in Chile in 1992, I argued that it would be potentially dangerous to dismantle all capital controls until a country could be confident that in the event of a shock (for example, in Chile's case, a fall in the copper price) it would be able to borrow more rather than see its sources of foreign capital dry up or, worse still, see foreign or domestic capital flee, which has been the typical pattern in developing countries. A friendly critic characterized my argument as "first join the OECD, then liberalize the capital account". Since then we have seen two countries (Mexico and Korea) join the OECD and shortly thereafter suffer severe crises prompted by capital flight, which strongly suggests that membership of the OECD is an insufficient institutional precondition for the sort of acceptance by the international financial community that I was seeking to describe. Let me stress that this does not just require a country to be determined to avoid default: the inability of several East Asian countries to service foreign debt in the past year was not due to any lack of will on their part, it was a case of force majeure. My argument is that capital account convertibility is dangerous until one can be confident that such instances will not arise. I should not be dogmatic in saying that this will be a matter of decades rather than years, but that would be my best guess. At the moment, I doubt if any developing countries other than Singapore and perhaps Hong Kong have the degree of acceptance needed to justify capital account convertibility.
The Future of Financial Liberalization
Does that imply that I wish to see an end to the process of financial liberalization? Not at all. At the beginning of this speech I identified six dimensions of financial liberalization. In terms of credit allocation, India still has priority sectors and high statutory liquidity requirements. In terms of the setting of interest rates, India is still some way from a fully market-determined system with a well-defined yield curve.3 Entry to the financial sector is still not free. Commercial banks still do not enjoy autonomy from the Banking Division of the Ministry of Finance. Most of the commercial banks, not to mention much of the rest of the financial sector, are still wholly or predominantly publicly owned, a situation that surely has something to do with the damaging risk aversion being exhibited by Indian banks these days. So even without capital account convertibility, there is plenty of scope, as well as a genuine need, for liberalization. Liberalization certainly needs to be complemented by institutional development, e.g. to develop the corporate and government debt markets.
India proved immune to financial contagion from East Asia, but contagion is not the only risk that the East Asian crisis poses. An obvious second source of risk is that the severe regional recession and the increased competitiveness with which the victims will emerge will lead to an export slowdown that will intensify the industrial recession that India is already experiencing. This risk is real, but it threatens only a slowdown, not the sort of collapse that East Asia has experienced, so long at least as India does not abandon the prudent macro policies that it has pursued in recent years. The third source of risk lies in the realm of ideas. There is a danger that people will draw the wrong lessons from the crisis, and will blame liberalization in general. The view that I have expressed this evening is that the best way to parry this threat is to admit the germ of truth that it contains. It would be a real tragedy if domestic liberalization were to be jeopardized because of a refusal to concede that premature capital account liberalization poses big risks.
Demirguc-Kunt. Asi, and Enrica Detriarche (1997), "Banking Crises Around the World: Are There Any Common Threads?", World Bank, Washington.
Demirguc-Kunt, Asli (1998), "Financial Liberation and Financial Frasility", Annual Bank Conference on Development Economics, World Bank, Washington.
Friedman, Milton (1953), "The Case for Floating Exchange Rates", in M. Friedman, Essays in Positive Economics, University of Chicago Press, Chicago.
McKinnon, Ronald I. (1973), Money and Finance in Economic Development, Brookings Institution, Washington.
Reinhart, Carmen, and Graciela Kaminsky (1996), "The Twin Crises: The Causes of Banking and Balance of Payments Problems", IMF Seminar series no. 96/12.
Rodrik, Dani (1998), "Who Needs Capital Account Convertibility?", at http://www.ksg.harvard.edu/rodrik/papers.html.
Shaw, Edward S. (1973), Financial Deepening in Economic Development, Oxford University Press, New York.
Stiglitz, Joseph E. (1993), "The Role of the State in Financial Markets", Annual Bank Conference on Development Economics, World Bank, Washington.
Tarapore Committee (1997), Report of the Committee on Capital Account Convertibility, Reserve Bank of India, Mumbai.
Williamson, John (1996), The Crawling Band as an Exchange Rate Regime: Lessons from Chile, Colombia, and Israel, Institute for International Economics, Washington.
Williamson, John, and Molly Mahar (1998), A Review of Financial Liberalization, World Bank, Washington.
2. I am not sure that I have explained this doubt well in the past, or even in my oral exposition of this paper. I hope that the formulation offered here will avoid the misunderstanding that reports of my speech engendered in some quarters.
3. Joseph Stiglitz (1993) has argued in favour of keeping a ceiling on the deposit interest rate equal to the Treasury bill rate for any deposits with an explicit or implicit government guarantee. I sympathize with the logic of his argument, which is that the government should not guarantee a return higher than it pays on its own debts, but I see no reason to suppose that action is needed to impose such a regulation on Indian banks, since they show no sign of acting in the imprudent way the regulation is intended to curb. Indian mutual funds are another matter, where regulation of the character Stiglitz envisaged does indeed seem called for.