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Programme: BA (Hons) in Economics, Politics and Law in Dublin City University
Module: Global Economic Issues
Assignment Title: What is the relationship between financial liberalisation and economic growth
Word Count: 2732
Author: Ed Cuddy
Introduction
The aim of this essay is to explore the relationship between financial liberalisation and
economic growth. Financial liberalisation importance for growth in developing
economies is widely accepted. The IMF and the World Bank encourage financial
liberalisation policies in developing countries as part of free market reforms or
stabilisation programmes. However, this Neoclassical financial liberalisation thesis is
encountering increasing skepticism. Stiglitz (1998) suggests that financial liberalisation
is "based on an ideological commitment to an idealised conception of markets that is
grounded neither in fact nor in economic theory" (p. 20). This essay will critically
reviews the empirical evidence between financial liberalisation and growth in low and
middle income economies. The essay will be structured as follows: first it will analyses
the theoretical underpinning on the role of finance on growth. It will examine the
benefits and the downsides in the theory of financial liberalisation. Furthermore, this
essay will explore the concept of finance and instability. Second, this essay will analyse
the empirical evidence on the finance and growth nexus and also on finance and
instability.
Theoretical underpinnings of Financial liberalisation
The theoretical underpinning of neoclassical economics generally supports the positive
relationship between financial liberalisation of both the banking sector and the equity
markets with economic growth (Baumann et al 2013). In the context of the Solow-Swan
model, financial liberalisation is the removal restrictions that allow capital to flow to
those economies where returns on capital are higher. This flow of capital augments the
productive capacity of such countries and promotes growth in the long run. This is
because resources flow from developed countries, which are in essence capital abundant,
to developing countries where capital is scarce and its return high. These flows then
reduce the latter’s cost of capital and conduce to economic growth (Henry 2007).
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What is the relationship between financial liberalisation and economic growth
In this essay we are focusing on financial liberalisation on the banking sector rather than
on the equity markets. As Keynes (1930) stated on the Treatise on Money, a bank loan
"is the pavement along which production travels, and the bankers if they knew their
duty, would provide the transport facilities to just the extent that is required in order
that the productive powers of the community can be employed at their full capacity".
Keynesian economists therefore understand there is a role for the banking sector in financing growth, while being skeptical of the role of monetary policy in economic growth.
Benefits in the theory of financial liberalisation
This removal of restriction brings along what is known as financial deepening, which is
the increase of financial assets relative to the GDP of a country. Shaw (1973) argued that
more competition in the banking sector is beneficial to growth as these institutions
improve the efficient allocation of capital into productive assets. This is because in the
process of transforming savings into investment, financial intermediaries absorb
resources as a reward for the services offered. Hence, a more competitive financial sector
reduces higher margins and promotes growth by more efficiently funneling savings to
firms (Pagano 1993). In addition, Shaw (1973) believed that the deregulation of interest
rates act as an attraction force within the banking system, which increase the availability
of credit, therefore increasing investment.
Another role for financial intermediaries is to allocate funds in projects where the
marginal product of capital is highest (Pagano 1993). In this way, financial
intermediation increases the productivity of capital and promotes growth in two ways.
First, financial intermediaries collect information to judge the best alternatives in
investment projects. Greenwood and Jovanovic (1990) link the informational role of
financial intermediation and productivity growth in the following way. In their model
investors can choose a safe but low-yield technology or a high-yield and risky one.
Banks scan their large portfolios better than individual investors can, hence choosing the
technology which will lead to a positive shock in productivity and conducive to higher
growth.
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Secondly, risk sharing provided by financial intermediaries induces individuals to invest
in technologies that are riskier but more productive. Banks, by investing in more illiquid
but productive project, effectively pool the liquidity risk of depositors who, as individual
investors, would prefer a less efficient option of a more liquid asset (Pagano 1993).
Bencivenga and Smith (1991) argue that banks increase return on investment in two
ways. First, they direct funds to illiquid but more productive technology. Secondly,
banks avoid more instances of premature liquidation than individual investors, hence
improving productivity of capital assets and hence increasing growth (Pagano 1993).
Downsides in the theory of financial liberalisation
Financial liberalisation on its own is not a ‘silver bullet’ for growth, but should be
accompanied with other institutional preconditions required for a healthy economy. Lee
(2003) argues that a successful financial liberalisation story is only possible in such
economies with an existent stock of human capital. This is because bankers that make
correct loan decisions are those that have skill in risk assessment. Similarly, the initial
stock of information capital such as audited financial statements and mature equity
markets would determine the success of the financial liberalisation agenda. In addition,
Lee (2003) highlights the importance of a developed system of rules and procedures in
the banking sector, which fall within the wider category of the institutional fabric of a
country (North 1990).
Cho (1986) warns that even within the context of financial deepening, growth may be
hindered if it is not accompanied with a well-functioning equity market. This is mainly
due to credit rationing by banks, which is the inefficient allocation of loans at interest
rates below equilibrium. Stiglitz and Weiss (1981) argue that this may occur due to
information asymmetries which lead bankers to loan funds to safer borrowers rather than
to those who are ready to pay the highest interest rate available. This may inhibit growth
by excluding projects with higher risk but with higher returns (Lee 2003).
Another line of thought warns against the dangers of indiscriminate financial
liberalisation. Minsky (1986) developed his financial instability hypothesis to explain
what he considered an unstable endogenous dynamic inherent in modern economies. For
him, periods of financial robustness lead to others of financial fragility by linking
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investors to the Keynesian concept of “animal spirits”. In other words, investors rush to
acquire debt that looks profitable in boom times but eventually create an environment of
debt deflation and contraction.
In summary, under the context of the Solow-Swan model, the overall benefit in theory
of financial liberalisation allows for the removal on restrictions on capital flows to
economies, which allows for higher returns. This flow sees an increase the availability of
credit, therefore increasing investment; this has a knock on effect the productive capacity
of a country and promotes growth. This increase of market forces within a domestic
financial sector is said to improve the effective allocation of resources. However, the
theoretical work by Hyman Minsky has highlighted this liberalisation of finance can be
determined as a source of instability within an economy.
Empirical evidence
Overall, there is an academic consensus regarding the beneficial effects of financial
liberalisation. Authors such as Demirgüç-Kunt and Levine (2008) argue that countries
that show higher level of financial development brought by financial liberalisation at the
same time show stronger growth than less liberalised economies.
The meta-analysis performed by Bumann et al (2013) was based on 60 empirical studies
on the nexus between financial liberalisation and growth. The authors found an overall
positive but weak relationship, concluding that financial liberalisation is not a ‘silver
bullet’ for achieving strong growth. With respect to developing countries, the authors
found mixed results with countries not showing positive coefficients between
liberalisation and growth except in those cases where the focus of the study was banking.
In addition, they found that countries with less developed financial systems that
liberalise their economies could stimulate growth.
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Interest rates liberalisation
Regarding interest rates liberalisation, which in theory should serve as a surge in
domestic savings, Bandiera et al (2000) concluded that there is a weak relationship
between such lifting of restrictions and growth. Similarly, Achy (2003) found a negative
and insignificant relationship on financial depth indicators and growth when examining
MENA countries. For this author, other importance variables such as trade openness,
inflation rate or the burden of external debt are more important in determining growth.
On the other hand, Agenor and Montiel (2008) suggest studies that measure financial
depth by an increased level of savings neglect to recognise the key role of markets as
allocators of information.
Capital Account liberalisation
In relation to capital account liberalisation and growth, Grilli and Milesi-Ferresti (1995)
did not find a strong correlation between capital controls and economic growth.
Similarly, Baillu (2000) analysed data for 40 developing countries between 1975 and
1995 and concluded that a liberalised capital account and its correspondent inflows are
conducive of economic growth. However, this author adds a caveat to his findings with
respect to the level of development of the banking sector. For those economies with a
low level of banking development, capital inflows negatively affect the growth rate as
distortions imposed by governments in the financial sector channel funds into
speculative investments that lead to financial crises. Rodrik (1998) study includes 100
countries over the period 1975 and 1989 and concludes that those economies without
capital controls have not experienced more growth than their more liberalised
counterparts.
This is particularly evident in emerging economies. Klein and Olivei (2008) conclude
that the positive relationship between capital account liberalisation and growth is only
present in developed countries, arguing that developing economies must first improve �6
their institutional fabric if they want to reap the benefits of this type of financial
liberalisation. In addition, Gamra (2009) finds that a blanket capital account
liberalisation hindered growth in the East Asian economies. This is in line with the
account by Lee (2003) regarding poor institutions in these countries when they
experience the financial crisis during the 1990s.
On the other hand, Quinn (1997) found a positive relation in the nexus of capital account
liberalisation and growth. The same can be said for Klein and Olivei (1999), although
they find that capital account liberalisation does not provide equal benefits to all. These
authors concluded that the strong positive relationship shown in industrial economies is
not exactly replicated in developing ones, suggesting that policy reforms in the latter
countries should be rightly timed to wait for the development sound macroeconomic
indicators and appropriate institutions. Quinn and Toyoda (2003) found that the
relationship between openness and growth is positive and linear, hence not contingent on
the presence of other pre conditions such as healthy institutions or human capital.
However these study includes both developed and developing countries. More recently
Saidi (2014) found there was an institutional quality relationship between capital account
liberalization and economic growth. This study found that emerging economies seeking
economic growth are required to have “highly developed institutional, legal and judicial
framework” to promote and benefit from capital account liberalisation .
Authors such as Chandra (2005) and Arteta (2003) find that the effect of capital account
liberalisation on the growth rate is mixed without any clear indication of net benefits or
net losses. Klein (2003) found that capital account liberalisations are of an inverted U-
shaped form, with the majority of the gains obtained by middle-income countries and
less so in the poorest or richest ones (Bekaert 2005). Within the “inconclusive” empirical
data picture, Gamra (2009) suggests the effect of financial liberalisation on economic
growth depends not only on the nature but as well as the intensity of the policy reform.
For this author, there is a significant positive effect on domestic financial liberalisation, a
weak relationship with regards to equity openness and a quite strong negative effect
associated with capital account liberalisation. In the same vein, partial liberalisation is
seen as beneficiary to growth prospects and full liberalisation is associated with financial
crises and less economic growth (Gamra 2009)
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Another line of thought espouses that the financial liberalisation and growth nexus is
non-linear (Shen and Lee 2006). This means that the financial sector promotes growth
when it is not too large. If the size of the financial sector increases disproportionally, it
can hinder growth by suffering episodes of financial crises.
In Summary, The empirical evidence on the finance-growth nexus is mixed. While
some research has found a positive relationship, others do not. The extensive study by
Bumann et al (2013) found a positive, but weak relationship on the effect of financial
liberalisation and growth. Interest rates liberalisation showed a weak relationship with
growth. In relation to research capital account liberalisation the growth nexus was mixed
with the positive finding having some caveats relating to pre-existing healthy institutions
and the studies including developed as well and emerging economies.
Financialisation and Instability
As described in the theory section, Minsky’s financial instability hypothesis predicts that
crises are recurrent phenomena in modern capitalist societies. Kroszner et al (2006)
examined crisis periods to find that these episodes have a disproportionately negative
impact on sectors relying on external creditors in countries with high levels of financial
depth. Similarly, Kose et al (2003) study of external shocks in emerging economies
during the 1990s concluded that consumption volatility increased due to financial
instabilities.
On the other hand, Bekaert et al (2005) meta-analysis study concluded that financial
liberalisation soften the extent of the business cycle by reducing consumption volatility.
However, they found this phenomenon is less prominent in developing economies.
Similarly, Bonfiglioli and Mendocino (2004) recognise that banking crises are harmful
for growth but that extent of the damage can be controlled by liberalising financial
restrictions and by fostering sound institutions. In a similar vein, Calderon et al (2005)
study on financial exposure due to openness found that contrary to common wisdom
international integration does not increase external vulnerability by hindering growth or
increasing volatility.
However, Caprio et. al. (1994) argue that financial instability can be reduced by carefully
managing the liberalisation reform process rather than adopting a blanket approach of �8
laissez-faire measures. This is mainly due to the importance of a stable sequence of
macroeconomic indicators in the moment prior to the implementation of reforms.
Jokipii and Monnin (2013) explore the relationship between financial stability and
economic growth. In the countries studied, banking sector stability appears to be an
important driver of growth. Consequently, this emphaises the need for governments’
economic policy to pay greater attention to banking sector stability.
Conclusion
In Conclusion, there is widespread acceptance that the Neoclassical ideal of financial
liberalisation can have a positive effect on growth. Consequently, this essay has analysed
a number of key theoretical propositions of the financial liberalisation thesis. Firstly,
under the Solow-Swan model, financial liberalisation the overall benefit in theory of
financial liberalisation is that capital can find bigger returns when the financial restraints
those low and middle-income economies endure are lifted. This sees an increase the
availability of credit, therefore increasing investment. However, the drawback to the
theory is Minsky's Financial Instability Hypothesis, which highlights how this financial
liberalisation can show to be a source of instability within an economy.
Secondly this this essay investigated the impact of financial liberalisation policies on
finance growth relationship. The analysis of found that empirical evidence on the
finance-growth nexus is mixed. While some studies found a positive relationship, others
were less conclusive. An extensive study by Bumann et al (2013) found a positive, albeit
weak relationship on the effect of financial liberalisation and growth, indicating it may
not be the ‘silver bullet’ for achieving strong economic growth. Empirical research into
interest rates liberalisation found a weak relationship with growth. Furthermore, mixed
growth was found in relation capital account liberalisation. However, even with the
positive growth finds, there were caveats relating to pre-existing healthy institutions and
the research including not just developing but emerging economies also. This leads to
weak and inconclusive empirical support of the financial liberalisation thesis. In
emerging economies the nexus between institutional quality and capital account
liberalization leads to growth economic growth. However, the lack of such institutional
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frameworks has been blamed for risky global bank flows, credit booms, and banking
crises in emerging economies.
Ultimately, this lends some credence to Stiglitz (1998) suggestion that the Neoliberal
thesis for financial liberalisation is an idealised conception of markets that is grounded
neither in economic theory or factual evidence (p. 20). Keynesian economic thought
recognises the need for regulation and government intervention in the banking sector, to
minimise market imperfections caused by the laissez-faire operation of the market,
idealed by Neoclassical thought.
.
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