Sequencing of Financial Liberalization

1
Financial Liberalization
2
Financial liberalization

• Financial liberalization has been defined as
  the process by which a particular country moves
  away from a state of financial repression.

3
Motivation for financial repression

• Inability to raise taxes either due to
  administrative inefficiencies or political
  constraints
• Government manipulates the financial system to
  promote its development goals through financial
  repression

4

• Financial repression yield substantial revenue to
  the government.
• First source implicit tax on financial
  intermediation by high revenue requirement rates.
• Second source implicit subsidy government
  benefit by obtaining access to central bank
  financial at below-market interest rate

5
Financial repression and Financial liberalization1

• Interest rate ceiling
• - Used to keep borrowing costs low
• - Used to ensure bank profitability
• - Over borrowing Syndrome
• - Reduced saving
• Interest rate deregulation
• - Attract saving
• - Increase efficiency of aggregate investment

6
Financial repression and Financial liberalization2

• Government directed credit
• - Needed to direct funds to important
• sectors of the economy
• - Increase political power
• - the flow of loanable funds reduced
• Eliminate of credit controls
• - more efficient allocation of credit banks

7
Financial repression and Financial liberalization3

• High required reserve ratio
• - Insures liquidity in the banking system
• - Prevents bank runs and panics
• - A tax that is unseen by depositors
• Reduction of reserve requirement

8
Financial repression and financial liberalization4

• State ownership of commercial banks.
• - Domestic banks can not complete with
• large, rich, foreign banks
• - Fear of lack of local lending
• - Short run benefits, long term disasters
• Private ownership of banks
• - Allowing domestic economic agents freedom

9
Financial repression and financial liberalization5

• Government restrictions on foreign bank ownership
  and/or non-bank competition.
• - Fear of foreigners controlling financial
• markets
• - Foreign owned banks may not be willing
• to lend to key domestic industries
• Free entry into the banking sector
• Bank autonomy
• - increase the availability of resource to
  support
• - Improve resource allocation

10
Financial repression and financial liberalization6

• Restrictions on capital flows.
• - Global hot money cause asset bubbles
• - Foreign exchange rate fluctuation
• Liberalization of international capital flows
• - Capital inflows
• - Lending boom

11
Sequencing of Financial Liberalization

• Domestic financial liberalization
• interest rate liberalization
• elimination of credit controls
• develop indirect instruments of monetary control
  (markets for government bonds)
• Capital account
• long term flows (FDI, portfolio)
• short-term flows

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Capital and Current Account Liberalization1

• Opening the current account first is desirable,
  followed by gradual opening of the capital
  account.
• Reason if trade and capital account reforms
  are implemented simultaneously, net outcome can
  be an appreciation of real exchange rate due to
• ?slow response of real sector to changes in
  relative prices in the short run
• ? relatively faster response of capital flows

13
Capital and Current Account Liberalization2

• If the domestic financial system is liberalized
  prior to the removal of capital controls,
  massive capital inflows occur
• Successful liberalization of the trade account
  requires real depreciation of the domestic
  currency
• On the contrary, real appreciation associated
  with removal of capital controls

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Assumptions and Omissions

• The traditional liberalization thesis is based on
  
• the following implicit assumptions / omissions
• Perfect information
• Perfect competition
• Institutions-free analysis
• No role for stock markets
• Ignores destabilizing effects of capital flows

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• Combination of
• imperfect information, imperfect competition,
  poor quality of institutions, inefficient stock
  markets, destabilizing influence of short-term
  capital flows
• could mean that financial liberalization may lead
  to
• too high real interest rates
• macroeconomic instability
• asset price bubbles
• deterioration of asset quality in bank balance
  sheets
• financial fragility and crisis

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FINANCIAL INTEGRATION
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1970 WERNER REPORT

• The Snake in the Tunnel
• European common margine arrangement
• Very short term financing (VSTF) Facility
• European Monetary Cooperation Fund
• EMCF

19
1978 European Monetary System EMS

• Exchange rate Mechanism (ERM)
• European Currency Unit (ECU)
• European Monetary Fund (EMF)

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1990 Maastricht Treaty

• Economics and Monetary Union EMC
• STATE I
• - Make the Maastricht Treaty (1993)
• - Single market (1995)
• - Exchange rate mechanism ERM
• Financial Integration

21

• STATE II
• - Convergence Criteria
• - EMI
• - ECB
• - ESCB
• - Executive Board and Council of the European
  Central Bank (1998)

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STAGE III - EURO currency (1998 2002)

• Phase I
• Periods 1 JAN 1999 (initial period)
• Actions - Irrevocable fixed conversion rate
• - Dual pricing
• Results - ECU basket currencies ECUS
  rescission
• - Non-cash operation

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• Phase II
• Periods 1 JAN 1999 31 DEC 2001
  (transitional period)
• Actions - Monetary Policy
• - Foreign exchange administrative
• Results - Financial switch over
• - Public debts securities

24

• Phase III
• Periods 1 JAN 2002 1 JUL 2002
• (Final Period)
• Actions - EURO Banknotes Coins
• - Single System Currency
• - Complete in Euro Zone
• Results Local currency repeal Euro
  currency is adopted among member countries.

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????????(Common Market) ? ????????????????????????
??(Free Movement of Capital) ? ????????????(Single
Market) ? ???????????????????????????????(Converg
ence in Economies) ? ???????????????????????(Econo
mic and Monetary Union)
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Convergence Criteria

• - The Commission
• - European Monetary Institution EMI
• 1. Price stability
• 2. Marginal Propensity of interest rate
• - Nominal long term interest rate
• 3. Fiscal policy deregulation
• 4. Exchange rate stabilization

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?????????????????????????????????????

• ??????????? (Money market)
• -?????????????????????????????????????????????
  ?????????????????????????? ???????????????????????
  ??????????????????????????
• -????????????????????????????????????????????????
  ??????????????????????????????????????????????????
  ???????????????????????????????? (Interbank Rate)
  ??????????????????????????????????????????????????
  ??????????????????????? 1 ??????????????
  ??????????????????????????????????????????????????
  ?????????? ???????????????????????????????????????
  ???????????????????????????????

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• -???????????? ??????????????????????????????????
  ????????????????????????????????????
  ????????????????????????????????????
  ?????????????????????????????????????? (EURIBOR)
  ??????????????????????????????????????????????????
  ?? ?????????????????????????????????????? ???Euro
  LIBOR ????????????????????????????????????????????
  ??????
• -???????????????????????????????????????????????
  ????????????????????????????? ????????????????????
  ??????????????????????????????????????????????????
  ????????????????????????????????????????????
  ??????????????????????????????????????????????????
  ??????????????????????????????????????????????????
  ???????????????????????????? ????????????????????
  ??????????????????????????? ??????????????????????
  ??????????????????????????????????????????????????
  ??????????????????????????

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• ???????????? (Bond Market)
• ?????????????????????????????????????????????????
  ? 2 ???????
• 1.??????????????????????????????????????????????
  ??????????????????? (Harmonization of Market
  Convention) ??????????????????????????????????????
  ??????????????????????????????????????????????????
  ?????????????????????????????????????????????
  ??????????????????????????????????????????????????
  ??????????
• 2.?????????????????????????????????????
  (Redenomination) ?????????????????????????????????
  ??????????????????????????????????????????????????
  ??????????????????????????????????????????????????
  ?????? ??????????????????????????? ??????? 1
  ?????? 1999 ?????????????????????????

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• ????????????????????????????????????????????????
  ???????????????????????????????????????????
  ??????????????????????????????????????????????????
  ???????????????????? 31 ??????? 2001
• ???????????? ???????????????????????????????????
  ??????????????????????? ??????????????????????????
  ??????????????????????????? ??????????????????????
  ??????????????????????????????????????????????????
  ?????????

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• ?????????????? (Equity Market)
• ????????????????????????????????????????????????
  ???????????????????????????????????????? (Equity
  market environment) ?????????????????????????????
  
• 1.??????????????????????????????????????????????
  ???? (improve the risk reward opportunities)
• 2.????????????????????????????????
  ?????????????????????????????????????????
  ???????????????????????????????????
• 3.??????????????????????????????????????????????
  ??????? ???????????????????? ?????????????????????
  ????????????? ????????????????????????????????????
  ??????????????????????????????????????????????????
  ???????????

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• 4.??????????????????????????????????????????????
  ?????????????????????????????????
  ??????????????????????????????????????????????????
  ??????????????????????????????????????????????????
  ???????????????????????????????????????
  (Diversification of Portfolio Investment)
• ??????????????????????????????????????????????
  ??????????????????????????????????????????
  ???????????????????????? ?????????????????????????
  ??????????????????????????????????????????????????
  ?????????????????????????????? ???????????????????
  ??????????????????????????????????????????????????
  ???????????????????????????????????????

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