Financial liberalization in Africa

World Development, Vol. 21, No. 11, pp. 1867-1881, 1993. 0305-750X/93 $6.00 + 0.00

Primed in Great Britain. 0 1993 Pergamon Press Ltd

Financial Liberalization in Africa

DIERY SECK University of Windsol; Ontario

and

YASIM H. EL NIL* African Centre for Monetary Studies, Dakar

Summary. - Recent evidence has shown that African economies are financially repressed and the underlying motives for perpetuating repressive policies still exist. Increasing real deposit rates, mainly through lower inflation, promotes financial savings, investment and growth. Financial liberalization in Africa has recorded limited success owing to a high and unstable inflation rate, the high cost of financial intermediation, low bank demand for deposits and persistent government interference in credit markets. Chronically high fiscal deficits and their adverse impacts on the balance of payments also constitute hur- dles for financial deepening in Africa.

1. INTRODUCTION

According to the proponents of the financial repression hypothesis, financial liberalization can fos- ter economic growth by freeing developing economies from some of their most severe distortions. Most of those distortions, McKinnon (1973) and Shaw (1973) argue, are the result of government’s attempt to use direct instruments of monetary policy rather than indirect instruments. While the financial liberalization paradigm has gained wide acceptance at the conceptual level, empirical testing of its validity is at best inconclusive.’ The experiences of the Southern Cone countries and econometric tests have shown the limitations of the prescriptions that can be derived from the theory.

ties of various target variables with respect to the policy variables that are prescribed by the financial repression hypothesis. In section 4, a detailed assessment of the reform policy measures implemented by nine African countries over the last decade is presented under the magnifying glass of the financial liberalization framework. Section 5 concludes.

2. FINANCIAL REPRESSION IN AFRICAN ECONOMIES

While the causal relationships implied in the financial liberalization theory have not been found to hold in every country, there is no a priori reason to dispel their applicability in the case of African countries. Furthermore, the Structural Adjustment Programs (henceforth SAPS) that have been implemented by African countries over the last decade incorporate strong elements of financial reform and if only for that reason, the process and results of financial liberalization in an African context deserve close examination.

The extent to which financial repression afflicts African economies is illustrated in Table 1. Of the nine African countries comprised in the sample, only Botswana did not implement a SAP. The starting date of the reform programme is indicated for each country.

The African countries are compared to four high- income developing countries and to the four industrial

The rest of the paper is organized as follows. The next section is a comparative assessment of the extent of financial repression in Africa prior to the com-

*We are indebted to the central bank officials of the following countries for their valuable help during our visits to their respective countries: Botswana, Egypt, The Gambia, Ghana, Kenya, Malawi, Nigeria, Tunisia and Zimbabwe. Our thanks also go to Real Lavergne and Rohinton Medhora for their valuable comments. Remaining errors are, of course, our sole responsibility.

mencement of SAPS. The econometric tests that are’ j This research study has been made possible by financial

performed in section 3 seek to measure the sensitivi- assistance from the International Development Research Centre of Canada. Final revision accepted: May 5, 1993.

1867

1868 WORLD DEVELOPMENT

Table 1. Indicators ofjinancial deepening, fiscal balance and investment for African and non-African countries*

Fiscal Surplus (deficit)/GDP Inflation

Reform Real Rate Real Rate including GNP Start Date M2/GDP Deposit Lending grants Invest-/GDP Deflator

Botswana 33.6 -0.4 1.1 24.9 30.1 17.9 Egypt 5191 85.1 -13.9 -7.9 -11.8 21.3 17.3 Gambia 8/85 38.0 -2.6 5.6 -13.4 19.2 9.0 Ghana 4/83 11.3 -111.8 -103.8 -2.7 3.8 110.6 Kenya l/86 28.2 0.3 3.3 -3.8 25.5 9.3 Malawi 4188 19.5 -18.0 -9.2 -6.0 18.0 25.9 Nigeria 6186 32.3 4.1 9.6 -3.8 10.0 -2.0 Tunisia 12186 46.6 0.9 3.4 6.8 23.6 3.0 Zimbabwe l/91 42.4 -2.5 1.6 -11.0 20.7 10.8 Korea 37.2 7.0 7.0 0.4 28.7 3.7 Portugal 81.5 5.1 9.5 -10.8 24.2 12.2 Singapore 86.9 2.4 5.6 -2.7 35.5 0.5 Turkey 30.9 -3.9 11.1 A.0 25.5 38.1 Germany 60.9 3.0 8.2 -1.1 19.4 2.1 Japan 107.1 1.7 5.1 -3.5 28.4 -3.0 U.K. 81.5 5.2 5.4 -1 .o 17.6 4.4 U.S.A. 62.6 3.2 4.5 -3.3 17.1 3.0

Sources: African countries: Respective Central Banks and IMF, International Financial Statistics, various issues. Other countries: International Financial Statistics Tables, yearbooks. *Figures for African countries apply for years of reform starting date except: Botswana (1985). Egypt (1986) Kenya (1985) and Zimbabwe (1989). For non-African countries, data are for 1987.

countries with the most developed capital markets. The ratio M2/GDP, an indicator of the degree of monetization of the economy, is expected to rise over time as the effects of financial liberalization permeate the African economies. Egypt may be an exception to that trend, given its already high degree of monetization for its level of per capita income.

African real deposit rates of interest are either low or negative and (as shown later in Table 5) highly variable. To illustrate the variability of real interest rates in Africa, consider that over 1983-90, the coeffi- cient of variation of real interest rates is -232.9 for the Gambia, 184.6 for Kenya and -318.2 for Nigeria. High variability of real deposit rates caused by variability of inflation is a very common characteristic of African capital markets. Real lending rates are kept low, often negative, and reflect interest rate ceilings enforced by authorities rather than low level of loan demand or an effort by the banking sector to avoid problems of adverse risk selection associated with high real lending rates of interest.

The spread between lending and deposit rates of African countries is approximately twice that of high- income developing countries and industrial countries and could, to a certain extent, be viewed as an indirect measure of the implicit tax levied through high reserve requirements on the banking sector by monetary authorities. It is also noteworthy that financial liberalization may not help reduce interest spreads in African countries if reduction of reserve requirements

and deregulation of the banking sector are not coupled with increased competition in that sector.

In many African countries, high reserve requirements - averaging 20-25% compared to an average of 557% in industrial countries-may not be not con- straining for the banking sector if the persistent liquidity of banks that takes the form of deposits with the Central Bank over and above the statutory required levels is higher than what the need for high precautionary cash balances would dictate. Notwithstanding the argument for precautionary balances, the fact that credit rationing is pervasive in African countries while the banking sector has high levels of liquidity may be indicative of the seriousness of the potential for adverse risk selection problems, which in turn, reflects the laxity of the legal framework with respect to debt collection.

The figures on fiscal deficit relative to GDP and on inflation illustrate African governments’ incentive to perpetuate the state of financial repression and appropriate segniorage income to finance the fiscal deficit. Except for Botswana that, until recently, enjoyed large fiscal surpluses, African countries have experienced sizable fiscal deficits that are larger than those prevailing in more advanced economies and are in fact understated.* Understatement of the fiscal deficit is prevalent in African countries because of the extent of off-budget transactions and the mandate given to many parastatal entreprises to carry out part of government’s mission through actions such as excessive

FINANCIAL LIBERALIZATION 1869

hiring in a bid to curb unemployment and sale of cheap inputs to subsidize local industries indirectly. The low lending rates imposed by governments on the banking sector for its own benefit and that of priority sectors amount to a tax that, if eliminated, would translate into a higher fiscal deficit.

Much less visible is the extent of directed credit that defeats the allocative efficiency of capital markets but whose adverse impact on the intersectoral mobili- ty of capital is difficult to measure. Prior to implementing SAPS, most African governments were (some still are) engaged in one form or another of directed credit policy often coupled with below-market lending rates. Given that, under directed credit, all production decisions are made taking into account sig- nals that do not convey the scarcity prices of various inputs, African governments have directly distorted economic activity in general and thwarted emergence of new profitable ventures in the process.

3. ECONOMETRIC TESTS OF THE FINANCIAL REPRESSION HYPOTHESIS

The McKinnon-Shaw hypothesis purports that financial liberalization has beneficial effects on the economies of developing countries because as real deposit rates are allowed to be increasingly positive - within the range of the conduit effect - more financial savings are collected, investment is increased, allocative efficiency of capital markets is improved and growth ensues. Dornbusch and Reynoso (1989), Taylor (1986) and Van Wijnbergen (1983) have challenged the basic rationale of the hypothesis while empirical tests conducted by Agarwala (1983), Khatkhate (1988) and Gonzalez Arrieta (1988) have failed to lend support to it. However, Lanyi and Saracoglu (1983a, 1983b), Fry (1988) and Gelb (1989) provide evidence that gives credence to the hypothesis. In the light of this conflict- ing evidence, testing the hypothesis using exclusively African data is a prerequisite to further pursuit of economic policies that are consistent with financial liberalization in the case of African countries.

While several types of methodologies have been used to assess the performance of reform programmes, in the case of African countries, choice of an adequate methodological approach should be guid- ed by the relatively limited data that are available at the country level and the fact that Adjustment Programs are so recent as to preclude ex post assessment of their degree of success.) Consequently, the approach that will be chosen consists in the estimation of the sensititivies of the main target variables identi- fied by the McKinnon-Shaw hypothesis with respect to instruments such as the real interest rate, which can be done with econometric analysis.

In fact, the vector autoregression technique is more appropriate to analyze the causal relationships to be investigated because it allows unambiguous decom- position of the variance of the forecast errors of growth, the key target variable, and gives the dynamic interrelationships between all the target and policy variables. Vector autoregression, however, requires a large number of observations and can be performed for individual countries only. Given the limited amount of data available for the sample countries, a pooling of cross-section and time series will be chosen instead and the results should be seen rather as an illustration of the economic gain that African countries stand to make by liberalizing their economies than as unqualified supporting evidence for the financial repression hypothesis.

(a) The data

The econometric tests have been conducted on two samples comprising African countries only. The first sample includes 2 1 African countries and the second sample is limited to the nine countries whose experiences will be examined in detail in this study.4 Regression results for the sample of 21 countries are presented in the appendix. For each sample, the period under study covers 1974-89 although for some countries the sample period is shorter because of lack of data. A pooling of cross-section and time series is used to offset limited data availability at the country level.5 As a result, the large sample comprising the 21 countries has 266 yearly observations while the small sample has 108 observations. The data sources are World Bank, World Tables (1991), IMF, International Financial Statistics (199 I), and the Central Banks of the nine countries included in the small sample.

The main variables included in the tests are con- structed as follows:

GROWTH: real GDP growth REALDEP: real deposit rate = (1 + R)l( 1 + P*)-1 R = nominal deposit rate, P* = ex post inflation rate INVGDP: Gross investment relative to GDP SAVGDP: Gross savings relative to GDP CAGDP: Current account relative to GDP FINSAV: Growth in M2 relative to GDP DEPRA: Deposit rate INFL: Inflation rate measured with the Consumer Price Index6 PERCAP: GNP per capita.

The nine countries comprised in the small sample are Botswana, Egypt, The Gambia, Ghana, Kenya, Malawi, Nigeria, Tunisia and Zimbabwe. The large sample includes countries in the small sample and Cameroon, Congo, C&e d’Ivoire, Gabon, Lesotho, Mauritius, Morocco, Senegal, Swaziland, Tanzania, Togo and Zambia.


(b) Empirical results for the sample of nine African countries

Aside from the issue of direction of causality posit- ed in the financial repression rationale, which is ques- tioned by opponents of the theory, regression analysis using African data raises two difficulties. The first one relates to consistency of variables definition across countries. The second one, presumably more serious, is that of errors in variables. The inaccuracy of developing countries’ data collection systems gives rise to bias and inconsistency in the estimators and reduces the reliability of the empirical relationships. Since these deficiencies, however, are more likely to imply that regressors are insignificant when they actually are significant, regression analysis can be of some use.

(i) Interest rates and growth McKinnon (I 973) argues that positive real deposit

rates result in further growth. Positive real deposit rates encourage savings in general and financial savings in particular. Higher savings induce more investment which in turn fosters growth. Gelb (1989) uses a simple regression to estimate the relationship between the real interest rate and GDP growth for a cross section of developing countries from various parts of the world. The same relationship is estimated in (1) below for the nine African. Equation (2) is an attempt to capture the hypothesized causal chain suggested by McKinnon.

GROWTH = 5.475 + 0.153 REALDEP (1) (8.34) (2.62)**

Adj. R’ = 0.052 F = 6.89 N = 108

GROWTH = -0.529 + 0.038 REALDEP + 0.085 INVGDP

(-0.30) (0.64) (1.23)

+ 0.169 SAVGDP + 0.370 FINSAV (2) (2.86)** (2.73)**

Adj R2 = 0.204 F = 7.89 N = 108

The numbers in parentheses are the t values. Symbols * and ** denote 95% and 99% confidence levels respectively.

According to equation (1). which depicts the fun- damental relationship hypothesized by McKinnon (1973), the real deposit rate has a significantly positive effect on growth. Equation (2), however, seems to indicate that the effect is mainly indirect, which is consistent with the McKinnon-Shaw hypothesis. The correlation coefficients among regressors in equation (2) range from -0.08 between REALDEP and FIN- SAV to 0.37 between REALDEP and INVGDP. The point can be made that there is reverse causality

between growth and savings and that Patrick’s (1966) dilemma with respect to the actual direction of causality between growth and financial development (FIN- SAV) is not as easily solved as is implied in equation (2). INVGDP is insignificant because some of its major determinants, REALDEP - serving as a proxy for lending rates - and FINSAV are also included in equation (2). It becomes significant, however, in the absence of the other two regressors. Another channel through which positive real interest rates are hypothesized by McKinnon (1973, 1991) and Galbis (1977) to affect economic growth is through improvement in the efficiency of capital, a claim that is not examined in this study.

(ii) Interest rates and investment The following equations have been estimated:

INVGDP = 23.266 + 0.322 REALDEP (3) (26.27) (4.09)**

Adj. R* = 0.128 F = 16.71 N = 108

INVGDP = 26.448 - 0.691 DEPRA - 0. I28 INFL (15.58) (-4.29)** (-3.58)**

- 0.309 CAGDP + 0.395 FINSAV (4) (5.58)** (2.52)*

Adj. R* = 0.468 F = 24.61 N = 108

Foreign savings, measured by CAGDP, and financial savings have strong impacts on the level of investment of the sample countries. It is worth noting that while the level of investment is directly affected by nominal deposit rates-which serve as a proxy for lending rates - in a negative fashion, it is indirectly influenced by it in a positive way through FINSAV.’ Despite the relatively high R* of model (4), caution should be exercised because relevant variables may have been omitted from the specification.

(iii) Interest rates and financial savings Estimation of the determinants of financial savings

has yielded the following results:

FINSAV = 3.057 + 0.129 REALDEP (5) (6.95) (3.29)**

Adj. R* = 0.084 F= 10.83 N= 108

FINSAV = 3.735 - 0.05 1 DEPRA - 0.070 INFL + (2.57) (-0.46) (-3.28)**

0.000 PERCAP (6) (0.32)

Adj. R* = 0.095 F=4.76 N= 108


While the real deposit rate has a positive effect on financial savings, which is consistent with theory, the demand for financial assets is negatively affected by the level of inflation - measured here as the percentage change in the consumer price index. The negative sign of INFL in equation (6) highlights the notion that the household/manager stores wealth in a portfolio comprising money balances and inventories of commodities. An increase in inflation triggers a shift in the composition of the portfolio from money balances in favor of commodities. Equation (6) also shows that reducing inflation is more conducive to higher financial savings than a concomitant increase in nominal interest rates.8 The level of income (PER- CAP) has no significant effect on the amount that is saved in the form of financial assets which implies that, in the African context, financial development does not necessarily result from growth, a result that may be in large part explained by the current state of the banking sector in most African countries, e.g., insolvent banks, absence of deposit insurance, long waiting lines, etc.

Overall, the empirical evidence seems to lend credence to the financial repression hypothesis because real deposit rates have a positive impact on financial savings and investment which, in turn, affect growth positively. The results also show that curbing inflation is more beneficial than increasing nominal deposit rates of interest for the attainment of positive real deposit rates. African countries’ heavy reliance of foreign savings to insure investment has also been established empirically.9

4. ASSESSMENT OF THE REFORM POLICY MEASURES

The nine African countries under study have not only undertaken monetary measures, summarized in Table 2, that were aimed at financial liberalization, but have also put in place accompanying measures with a view to removing most of the distortions afflict- ing their economies.

Bearing in mind that the reform packages that they have implemented were directed at SAPS rather than financial liberalization per se, the foregoing analysis is of relevance to the extent that the objectives that SAPS are supposed to achieve are consistent with those of a true financial liberalization program. The assessment of the African countries’ reform packages will be performed in the dual light of the theoretical literature and the practical experiences of countries in other parts of the world that have also engaged in financial liberalization programs, i.e. the Southern Cone countries and the Asian countries.

(a) Assessment of the monetary reform measures

Reform packages are complex sets of policy measures that always seek to achieve more than one objective. These policy measures are designed to reinforce each other in the pursuit of stated economic objectives and, whenever possible, with the least incidence of

Table 2: Summary ofjinancial reform measures by African countries

Public sector share of domestic credit*

Legal reserve requirements

ratio? Real deposit Interest rate

ratet deregulations

Competitively priced-financial

securitiesp

Before After Before After Before After Deposit Lending Botswana -117.2 -121.5 N/A N/A -1.35 -2.95 F F, P S, BP

Egypt 66.9 71.7 25115 1505 -4.6 -8.95 F F, P S, TB, CD, GB Gambia 60.9 -222.6 15 15 -2.62 1.05 F F TB Ghana 90.6 59.0 25 15 -56.4 -9.05 F F TB, GB Kenya 31.2 31.2 20 24 1.1 0.55 F F S, TB, GB, FXC Malawi 63.2 40.8 10 20 -5.1 -2.95 F F TB, GB, BP Nigeria 51.7 52.0 N/A 30 4.05 -9.4 F, M F, C S, TB, GB Tunisia 13.9 11.9 0 2 -3.25 0.15 F,M F, C, P S, TB, CD, CP Zimbabwe 49.4 41.2 N/A 10 0 N/A R R S, TB, CD

Source: adapted from the country reports in Volume 1 and IMF, International Financial Statistics. *Public sector’s share of domestic credit: before refers to the starting year of the reform program; after refers to end of 1990. Kegal reserve requirements ratio: before refers to the starting year of the reform program; after refers to the situation as of June 199 1. Ratios applicable to commercial banks are considered. *Real deposit rates: before refers to the average of the two years prior to program start; after refers to the average of the two most recent years for which data are available. §Interest rate deregulation: F = fully liberalized, P = directed credit to priority sectors at below-market rates, M = minimum deposit rate enforced by Central Bank, C = maximum lending rate enforced by Central Bank, R = fully or partially regulated. ‘Wompetitively priced financial securities: S = stocks, TB = Treasury Bills, CD = certificates of deposit, GB = Government bonds, FXC = foreign exchange certificates, BP = Central Bank paper, CP = commercial paper.


crossneutralization between measures. While it is often difficult to associate a single policy with a given objective in practical terms, it is often convenient, for expository purposes, to examine each policy separately so as to assess its relevance and degree of appropri- ateness. On the basis of this justification, the packages of monetary measures adopted by African countries will be broken down into three major issues that will be discussed separately: control of domestic credit expansion; legal reserve requirements; and interest rate policies.

(i) Control of domestic credit expansion’0 Domestic credit expansion is a common concern

for most developing countries that face structural imbalances and is one of the key areas targeted for action in reform programs. It is at the heart of demand- side adjustment policies in SAPS and because of its bearing on the level of domestic inflation, it has a major impact on policies aimed at achieving positive real interest rates. Prior to implementing adjustment programs, most African governments, faced with increasingly larger fiscal deficits, either crowded out the private sector or contributed to rapid expansion of domestic credit by way of heavy borrowing from the Central Bank.

As is shown in Table 2, except for Egypt that initi- ated a comprehensive reform package that was supported by the International Monetary Fund (IMF) and the World Bank in May 1991, the public sector (central and local governments and non financial public enterprises) has either maintained its share of domestic credit at its pre-SAP level (Kenya and Nigeria) or has decreased it considerably. As a result, inflationary pressures have subsided in some countries in the after- math of reform measures but not in others.

While relative to 1983, no country has experienced a substantial increase in its rate of inflation by 199@91 - for most countries inflation has remained at the prereform level -no clear pattern emerges as to

the main characteristics of those countries that have recorded sizable reductions in their inflation rates, e.g., Ghana. Meaningful differentiation cannot be made either on the basis of public sector’s share of domestic credit, legal reserve requirements or the level of real deposit rates of interest.

Domestic credit expansion is perceived to be mainly responsible for domestic inflationary pressures but provision must be made for the inflationary impact of the currency devaluations that countries have under- gone in the process of structural adjustment; see Canetti and Greene (1992), Chhibber (1991) Chhibber and Shafik (1991), Greene (1989), Kapur et al. (1991).

(ii) L.egal reserve requirements Aside from being one of the key instruments

through which indirect control can be exerted on domestic credit expansion, legal reserve requirements raise issues of optimality when seen in the light of financial intermediation and deepening. First, legal liquidity reserves constitute a volume of loanable funds that could be used by the banking sector to expand the size of its loan portfolio. So the higher the reserve ratio, the more severe effective financial crowding out of the private sector and the higher the implicit tax rate imposed on the financial system and the slower the economy’s rate of financial development.

Second, an increasing reserve ratio induces a larger wedge between lending and deposit rates of interest which also increases with expected inflation. This effect can be expected to hold even when banks have high levels of liquidity that are motivated by caution. Third, as has been shown by McKinnon (1991), optimal management of the legal reserve ratio is a dynamic process because given an amount of fiscal deficit that is to be financed at least partially by way of reserve requirements, the legal reserve ratio can be

Table 3. Evolution of iqflution in selected African countries (percentage change in CPI)

1982 1983 1984 1985 1986 1987

Botswana 11.1 10.5 8.6 8.1 10.0 9.8 Egypt 14.8 16.1 17.0 12.1 23.9 19.7 Gambia 10.9 10.6 22.1 18.3* 56.6 23.5 Ghana 22.3 123.0* 39.8 10.3 24.6 39.8 Kenya 20.4 11.5 10.2 13.0 3.9* 5.2 Malawi 9.8 13.5 20.0 10.5 14.1 25.2 Nigeria 7.6 23.3 39.6 7.4 5.7* 11.4 Tunisia 13.7 8.9 8.4 8.0 5.8* 7.2 Zimbabwe 10.7 23.1 20.2 8.5 14.3 12.5

Source: IMF, International Financial Statistics, 1992 Yearbook. *Starting year of the reform program for each country.

1988

8.4 17.7 11.7 31.3

8.3 33.9* 54.5

6.4 7.4

11.6 21.3

8.3 25.2

9.8 12.5 50.4

7.4 12.9

1990 1991 Mean Stand. Deviat.

11.4 16.8 12.2 37.2 11.7 11.8 7.4 6.8

17.4

11.8 19.8* 8.6

18.0 14.8 12.6 13.0 8.2

24.3*

10.1 17.9 18.3 37.2 10.9 16.4 22.0

8.1 15.1

1.3 3.2

13.8 30.1

4.5 7.3

18.1 2.1 5.6


either too low or too high and in both cases, higher inflation may ensue.

Table 2 shows that not many African countries have reduced their reserve ratios from their prereform levels. Inspection of the relationship between the public sector’s share of domestic credit and the reserve ratio reveals that countries that have made considerable improvement in the former (the Gambia and Ghana) have relatively low reserve ratios, 15%, compared to countries such as Kenya that have recorded little or no improvement in the public sector’s share of domestic credit.

Another issue of importance faced by African countries is the high spread between lending and deposit rates. Banks are highly liquid and need to operate high spreads to offset the imbalance between deposit and loan volumes. Excess bank liquidity may be explained by banks’ desire to maintain a minimum level of liquid assets that can be withdrawn by depositors at any time given the high variability of the real sector - depositors dissave when their current income decreases - and/or by the limited lending opportunities that the economy offers, given the strong potential for adverse risk selection that they face when lending to marginal borrowers. The higher the interest rate offered by the Central Bank for bank deposits over and above the legal reserve requirements, the stronger the incentive that banks have to divert loanable funds from their loan portfolios and deposit these funds with the Central Bank. Such is the case in the Gambia where the yield on Treasury Bills is higher than the Central Bank rediscount rate and in Botswana where the Central Bank offers a deposit facility to banks and the private sector at attractive rates of interest.

Another explanation of the high lending/deposit spread that is observed in most African countries may lie in part in the simple model proposed by McKinnon (1991, pp. 48-51). A case in point is that of Nigeria where in August 1987, banks were free to set their deposit and lending rates. Nigeria’s inflation rate was 56.6% in 1988 and 27.9% in 1989. Furthermore, overall credit ceilings were not strictly adhered to by the banking sector, which fuelled inflationary expectations. Given a legal reserve ratio of 30%, banks had to operate with large spreads even if the environment was purely competitive.

According to McKinnon’s model, the lending deposit spread for a bank operating under the zero profit condition is:

k r-,--r,= I_k(rd+P*) r, = real lending rate r, = real deposit rate k = reserve ratio P* = expected inflation

(7)

Based on equation (7), a simple simulation has been performed to illustrate the respective and joint impacts of expected inflation and the reserve ratio on the lending/deposit spread for a bank that observes the zero profit condition. For simplicity it is assumed that the nominal deposit rate is equal to expected inflation, i.e. the expected real deposit rate is zero. The simulation is conducted for the hypothetical reserve ratios of 15%, 30% and 40% while expected inflation is assumed to be lo%, 20% and 30%, both sets of numbers being very typical of African economies. The figures in the table represent the lending/deposit spreads that banks would have to operate on if they are to sim- ply break even.

Considering the case of Nigeria in 1991, if expected inflation was 20%, the real deposit rate was set at 0% and banks faced a reserve ratio of 30%, the lending/deposit spread had to be approximately 8.6%, assuming the zero profit condition. This simulation illustrates the need to maintain the reserve ratio at relatively low levels under high inflation expectations so as to limit the cost of banking intermediation and to avoid adverse risk selection in the banking sector.

(iii) Interest rate policies Table 5 depicts the evolution of real deposit rates

of interest in the nine countries under study. Compared to the real interest rates prevailing in 1983, three countries, Kenya, Malawi and Tunisia have shown improvement in their real deposit rates of interest since they implemented their reform programs. Botswana, Zimbabwe and Egypt, three countries that have not formally engaged in SAP during the period under study, have not recorded a major change in the level of their real deposit rates since 1983. Of special interest are the cases of Ghana and Nigeria whose real deposit rates have been very volatile, which is indicative of the variability of the inflation rate in these two countries. As was mentioned by McKinnon (1973) the variability of the real deposit rate has an adverse effect on the proportion of household-managers’ wealth that will be stored in the form of financial assets as opposed to commodities.

In comparison, Table 6 gives the average nominal deposit rates of interest and the average inflation rates (CPI) for five Asian countries that implemented financial liberalization programs for 1980-88.

Table 4. Simulation: break even lending/deposit interest spreads (in percentage)

Reserve requirements ratios

Expected inflation 10% 20% 30%

1.5% 25% 35% 1.8 3.3 5.4 3.5 6.7 10.8 5.3 10.0 16.2


Table 5. Evolufion of real deposit rates of interest in selected African countries (in percentage)

1983 1985 1986 1987 1988 1989 1990 Mean Stand. Deviat.

Botswana 1.4 4x4 -2.3 0.4 -3.8 Egypt -6.0 -2.1 -13.9 -9.7 -7.6 Gambia -2.1 -2.6* -54.2 -6.6 5.8 Ghana -111.s* 8.1 -6.1 -18.3 -12.2 Kenya -2.0 0.3 5.3* 4.4 a.7 Malawi a.7 -0.7 -0.7 -9.6 -18.0* Nigeria -15.8 4.0 4.1* 1.8 N/A Tunisia A.4 -2.6 0.9* 0.0 1.0 Zimbabwe -5.3 -2.2 -2.2 -2.7 2.6

Source: IMF, International Financial Statistics, and Central banks.

-2.1 -5.8 -1.8 2.3 -10.3 4.8 -7.8 3.6

4.9 -2.8 -8.2 19.1 4.0 N/A -20.9 37.9

1.8 0.2 1.3 2.4 -3.0 0.3 4.6 6.2 -9.4 N/A -2.2 7.0 Xl.7 N/A -0.8 1.8 -2.5 -6.2 -2.6 2.6

* Starting year of the reform programme for each country.

Given the rather unimpressive record of African countries with respect to the positivity of real deposit rates, it may be worthwhile examining possible rea- sons as to why banks have not consistently offered positive real deposit rates of interest since the beginning of the reform programs. African governments face large fiscal deficits and have limited access to foreign borrowing to finance these deficits which gives them no other alternative than to resort to seigniorage revenue. The banking sector is often forced to purchase government securities and to lend to priority sectors at below-market interest rates in the presence of high inflation and reserve requirements ratios.

In order to preserve their level of profitability, banks are forced to pass on the implicit tax to nonpri- ority borrowers and to depositors by operating a lending/deposit spread that is a positive function of the inflation tax and of the proportion of their total loan portfolios that is subjected to directed credit. As a result, the nominal deposit rates that they offer incorporate part of the inflation tax and are often lower than inflation. Furthermore, in the absence of a strong reg- ulatory framework, which is currently typical of most banking systems in Africa, and given the lax legal apparatus that is conducive to adverse risk selection problems, banks’s optimal behavior is not to transmit

Table 6. Average nominal deposit rates and inflation rates forjive Asian countries (in percentage)

1980-84 1985-88 Deposit Inflation Deposit Inflation

rate rate

Indonesia 8.0 12.4 17.0 7.0 Korea 12.2 12.6 10.0 3.9 Malaysia 8.6 6.0 6.3 0.6 Singapore 8.1 4.9 3.6 0.3 Thailand 12.7 8.5 10.4 2.7

Source: IMF, International Financial Statistics, 1991 Yearbook.

too sizable a proportion of the inflation tax to borrowers through high lending rates.

(b) Assessment of the accompanying policy measures

In his seminal book McKinnon (1973) under- scored the importance for a country to maintain macroeconomic stability while implementing monetary reform. He argued that the major areas in which stabilization is crucial to the success of financial liberalization are domestic prices (low and stable), fiscal balance (low deficit coupled with a broader tax base), liberalization of the external trade sector and stability of the real exchange rate. Citing the example of Chile and Korea, McKinnon (1989) warned against a pre- mature opening of the capital account of the balance of payments which, he stated, may undermine the liberalization process by giving rise to either inflation or appreciation in the home currency that would be harmful to the export sector.

What particular accompanying policy measures have been implemented by African countries from the point of view of financial liberalization? Table 7 is a summary of the major policy changes recorded in that area. Of the nine countries under study the countries that have experienced a significant increase in their inflation rates are, with the exception of Botswana, those that did not adopt an adjustment program during the 1980s i.e. Egypt and Zimbabwe. Keep in mind that Egypt and Zimbabwe started their formal adjustment program in 1991 and Botswana, whose case is discussed for comparative purposes only, has not implemented one. Has inflation been significantly reduced by the reforming countries? It is worth noting that even after reform measures have been put in place, Ghana still records a higher inflation rate than

those of Botswana, Egypt and Zimbabwe. Two considerations point to the need for further

reduction in inflation. First, compared to the Asian


Table 7. Summary of accompanying policy measures by African countries

Inflation CPI* Fiscal Deficit-F excluding grants

External Trade* Foreign Exchanges

Botswana

Egypt Gambia Ghana Kenya Malawi Nigeria Tunisia Zimbabwe

Before After Before After Tanif Import Producer Rl R2 R3 rate Restriction’fl price

10.6 12.0 18.5 15.4 N/A N/A N/A G M N

14.6 21.1 -20.3 -20.0 D D I T M N

16.4 12.8 -13.4 -6.8 D D M F M N 69.4 24.8 -5.4 0.8 D D I F M N

9.9 12.0 -6.8 -5.9 D D M Cl A N

20.9 14.0 -9.5 -6.0 D D I G A N 22.6 14.0 -7.1 -7.8 D D M T M N

8.2 7.1 -5.0 -3.8 D D M G A N 12.4 23.0 -11.6 -10.4 D D C G A N

Sources: Central banks. *Inflation: Before is average of two years prior to year of reform start except Botswana and Zimbabwe: 1985, 1986, Egypt: 1984, 1985; After is average of 1990, 1991. tFisca1 deficit: Before is year prior to reform start except Egypt, Gambia: 1985, Zimbabwe: 1986; After is 1989. *External trade: Tariff rate the average import duty rate; D = decrease in rate during reform. §Foreign exchange: Rl = foreign exchange regime, G = managed float, F = free float, T = two-tier regime; R2 = foreign exchange allocation system, M = market determined, A = administratively determined (licenses); R3 = controls of foreign capital inflows, N = no significant policy change. ¶Import restrictions: D = decrease in import controls. Producer price: domestic producer price of the main export product, M = market determined, I = administratively controlled but increased during reform, C = market determined but administratively set ceiling.

countries portrayed in Table 6 that have conducted successful financial liberalization programs and to their main trading partners, industrialized countries, the reforming African countries still have considerably higher inflation rates. As a result positive real deposit rates may be difficult to achieve and maintain given the need for the banking sector to operate high lending/deposit spreads under inflationary conditions, high liquidity and high reserve requirements. Second, high inflation usually means highly unstable inflation, a condition that is not conducive to financial savings but rather leads to a commodity-based behavior on the part of savers.

The second accompanying policy area concerns fiscal balance. Columns 3 and 4 of Table 7 report the fiscal deficit (surplus) of the sample countries for the year prior to the start of each country’s reform program and for 1989. Except for Nigeria that experienced a slight increase in its fiscal deficit, the sample countries either recorded a surplus, Botswana and Ghana, or a reduction in their deficits. It is noteworthy that the countries that have the largest reductions in their fiscal deficits, The Gambia, Ghana and Malawi, are also the ones that have the highest reductions in their inflation rates.

The monetary system’s net claims on government relative to GDP was reduced from 15.8% in 1984 to -3% in 1989 for The Gambia, from 15.3% in 1983 to 7.8% in 1989 for Ghana and from 5% in 1987 to 2.7% in 1989 for Malawi. These figures underline the dual cost of uncontrolled fiscal deficits: monetize them and

inflation surges, crowd out the private sector to finance them and investment thus growth is ham- pered; see Greene (1989). At the other extreme, results are mixed because while for Egypt, Kenya, Tunisia and Zimbabwe marginal reductions in the fiscal deficit were coupled with small reductions if not increases in inflation, Nigeria increased its fiscal deficit and still managed to lower its inflation rate. Nigeria, however, also stands out as the country with one of the most unstable inflation rates.

Table 8 provides the fiscal deficits (surpluses) relative to GDP of selected Asian countries that have successfully liberalized their financial systems. Not only have these Asian countries achieved satisfactory levels of fiscal balance by 1988, the ones that had large deficits in 1980, Malaysia and Thailand managed to reduce these deficits considerably during 1986-88. Note that the level of economic development does not seem to be a major factor because Indonesia and Thailand are at economic stages that are

Table 8. Fiscal deficit (surplus) of five Asian countries (expressed as a percentage of GDP)

1980 1983 1986

Indonesia -2.3 -2.4 -3.5 Korea -2.2 -1.0 Xl.1 Malaysia -6.0 -9.7 -9.1 Singapore 2.1 1.8 1.5 Thailand A.8 A.0 -4.4

Source: World Bank, World Tables (1991).

1988

-2.9 1.6

-1.3 7. I I.0


comparable to those of the African countries under study with per capita GNPs of $500 for the former and $1,220 for the latter in 1989.” Joint examination of Tables 6 and 8 reveals that the Asian countries experienced simultaneous reductions in fiscal deficits and inflation rates while their real deposit rates of interest became increasingly positive.

With regard to the relationship between financial deepening and a country’s balance of payments, financial repression is often associated with repressive management of the external trade sector. Excessive absorption and a desire to maintain the value of the home currency, under fixed or managed exchange regimes, usually have adverse effects. Such effects usually are of high import duty rates, extensive import restrictions and quotas, often justified by the need to protect domestic infant industries and repression of the export sector through regulation of domestic prices and an overvalued currency.

Further motives to justify a repressed external trade sector are (i) the need to protect even mature domestic industries from potential erosion of their international competitiveness due to the highly unstable real exchange rate and (ii) the overriding need to increase fiscal revenue given the inefficient tax collection system -ports of entry are a convenient place to collect revenues. It must also be recognized that import restrictions, especially when coupled with a system of administratively allocated foreign exchange tend to maintain the initial uncompetitive structure of the domestic economy and only perpetuate the status quo because domestic producers incorporate them in their investment decisions.

Given these characteristic features of financially repressed economies and the conclusion reached in section 2 that African economies are indeed repressed, it is of interest to examine the process of liberalization of the external trade sector in the sample countries. In that regard, attention will be focused upon three policy issues, namely the evolution of the average import duty rate, of the extent of nontariff import restrictions such as quotas and negative lists and of the degree of implicit taxation of the exporting sector through the regulation of the producer price of the country’s main export product.

The three columns under External Trade of Table 7 give a qualitative description of the records of the countries under survey during the course of economic reform. All the countries have reduced their average import duty rates as part of their reform packages and some of them have phased in a Value-Added Tax which is more trade neutral. The countries under study have equally reduced the number of import goods that are either under a quota system or prohibited. Concerned about the cost of living and the prospects of inflation, however, some countries (Egypt, Ghana, Malawi and Zimbabwe) still maintain pricing regulations on goods that have a large share in the econo-

my’s export revenues. These regulations have an adverse impact on the growth potential of the affected sectors and undermine the countries’ efforts to bridge that trade gap.

At the heart of the external imbalance of repressed economies lies the issue of currency overvaluation and the authorities’ desire to maintain the nominal value of the home currency at unrealistic levels. Whether the regime is fixed or managed, such a policy translates into an overvalued real exchange rate that encourages imports and is detrimental to the country’s export sector. Authorities’ efforts to maintain the nominal exchange rate usually take the form of import restrictions, administrative allocation of foreign exchange, mandatory surrender of foreign exchange earnings by residents and weakly enforced restrictions, if any, of foreign capital inflows that often result in excessive external indebtedness.

The question as to how African countries have sought to remedy their external imbalances through reform of their foreign exchange policies will now be addressed. The last three columns of Table 7 display respectively the current exchange regime of each country, the type of allocation system for foreign exchange and the extent of controls on foreign capital inflows. Of the nine countries under study, two (the Gambia and Ghana), have adopted a free-float regime, five (Botswana, Kenya, Malawi, Tunisia and Zimbabwe) maintain some form of managed float while Egypt and Nigeria combine the two system in two-tier markets.

Five of the nine countries rely on a market-determined system for the allocation of foreign exchange to the private sector. Kenya, Malawi, Tunisia and Zimbabwe still resort to administrative allocation schemes. In Malawi and Kenya, authorities require residents to surrender all foreign exchange earnings to the Central Bank while in Egypt, Ghana and Tunisia residents are allowed to retain part of their export proceeds. None of the sample countries has imposed more severe controls with respect to inflows of foreign capital as part of its reform package.

Given that a stable real foreign exchange rate is key to long-term sustainability of the external balance, the high inflation rates experienced by African countries should have spurred active and continuous policies of adjustment of the nominal exchange rate. If consistently adhered to, such policies have the dual advantage of preempting any speculation against the home currency and maintaining stability of the real foreign exchange rate, which minimizes the need to adopt further distortionary policies such as import restrictions or preferential exchange rates for exporters.

Table 9 displays the evolution of the real bilateral exchange rate indices of the sample countries with respect to the US dollar over 1980-9 1. The evolution


Table 9. Evolution of the real exchange rate indices of selected African countries (bilateral exchange rate with the US Dollar, I980 = 100)

Stand. 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 Deviat.

Botswana 100.0 101.6 118.8 119.3 134.2 189.1 173.3 147.0 152.8 159.1 139.1 140.7 25.9 Egypt 100.0 100.0 92.3 82.2 73.3 67.7 55.7 48.2 42.6 57.9 95.1 137.8* 26.1 Gambia 100.0 120.4 132.5 142.6 165.5 157.4* 182.4 156.2 138.0 151.0 147.4 158.1 20.7 Ghana 100.0 51.0 44.2 65.8* 200.1 284.0 380.9 487.1 507.7 567.1 526.4 524.1 201.8 Kenya 100.0 120.3 127.9 144.5 148.1 154.7 149.7* 149.7 155.1 171.6 180.3 196.5 25.0 Malawi 100.0 108.8 123.8 125.5 131.2 149.5 144.6 142.2 128.1* 128.6 119.9 114.0 14.0 Nigeria 100.0 103.1 110.6 99.8 79.0 88.8 168.0* 358.1 272.4 308.1 330.0 375.4 113.7 Tunisia 100.0 123.5 137.7 150.2 165.3 170.3 156.0* 157.6 159.5 172.3 157.3 159.5 20.0 Zimbabwe 100.0 104.6 110.2 123.4 131.9 163.1 150.1 138.1 145.1 158.0 164.4 193.0* 26.6

Source: Countries’ consumer prices indices and nominal foreign exchange rates are from IMF, International Financial Statistics, Yearbook, 1992. * Starting year of the reform program for each country.

of the real foreign exchange rate is a good measure of the extent of a country’s commitment to a policy of nominal foreign exchange rates that maintain its level of international competitiveness. Such a policy consti- tutes the external sector’s corollary to domestic financial liberalization. According to Table 9, unrealistic foreign exchange policies resulted in the overvaluation of the Egyptian pound during 1983-89, of the Ghanaian cedi during 1981-83 and of the Nigerian naira in 1984-85. In all three cases, corrective measures on the foreign exchange front seem to have sig- nalled the start of the reform program as is indicated by the considerable increase in the real exchange rate index putting an end to the home currency’s overvaluation.

Over the entire period (1980-9 1) two countries, Ghana and Nigeria, stand out for their highly unstable real exchange rate indices while for the other countries, active management of the nominal foreign exchange rate has kept the variability of the real exchange rate index to about 25% of the index’s 1980 value. Malawi, which has not yet fully liberalized its foreign exchange regime, has recorded a standard deviation of 14%, thus maintaining a fairly constant level of international competitiveness relative to the US dollar.‘* Close examination of the figures reveals that most countries that faced an unstable real exchange rate prior to structural adjustment (Gambia, Malawi, Nigeria and Tunisia) improved their stability once economic reform was underway. Further stability of the real exchange rate should ensue as the differ- ential between domestic and foreign inflation rates tends toward zero thus requiring only marginal adjustments of the nominal foreign exchange rate, a prospect that is politically and socially less costly than is currently the case with large devaluations. Such a scenario, however, is possible only if the expected level and variability of inflation are brought under control in African economies.

5. CONCLUSION

Not only is financial repression prevalent in African countries, governments have an incentive to perpetuate it given the incidence of high inflation, large deficits and limited access to foreign capital markets. The empirical evidence seems to illustrate that African countries stand to gain from financial liberalization because real deposit rates have been found to have a positive impact on financial savings which in turn affect the level of investment positively.

African countries’ limited success with financial liberalization can be explained to some extent by the following factors. Real deposit rates have failed to remain consistently positive because (a) inflation is high and unstable which, given the need for banks to operate large interest spreads, tends to keep nominal deposit rates at a low level, (b) banks have a low demand for deposits owing to their credit rationing policy motivated by the potential for adverse risk selection, (c) the implicit tax that government extracts from the banking system through enforcement of below-market lending rates on behalf of priority sectors is passed on by banks to their borrowers and depositors.

African countries’ fiscal deficits are still relatively high and show no sign of declining. A promising avenue for future research that is of relevance to the success of financial liberalization in Africa is the investigation of the strength of the causal link between fiscal balance on the one hand and inflation and the balance of payments on the other hand. Despite marked improvements in external sector policies, distortionary measures such as administrative allocation of foreign exchange, two-tier foreign exchange markets and overly protective trade policies are maintained, probably out of concern for the short term adverse effects of their speedy removal.


NOTES

1. For results of empirical tests of the McKinnon-Shaw hypothesis see Agarwala (1983), Blejer and Khan (1984), Deaton (1990). Fry (1981, 1988), Fry and Mason (1982), Gelb (1989). Giovannini (1983). Gupta (1987), Harris (1979), Lanyi and Saracoglu (1983b) Laumas 1980) and Ram (1982).

2. The case of Botswana is portrayed in this study not because, like other African countries, it faced economic difficulties, but it is an illustration of the potential for stability and growth that liberal policies can bring about, even for a small economy. In this regard, throughout the foregoing policy analysis, Botswanan economic policies, when cited, will be contrasted with those of the other sample African countries that were forced to undergo SAPS.

3. See Khan (1990) for a review of the methodologies used in the assessment of the performance of adjustment programs.

4. Separate testing for the two samples can be justified by the need to examine whether the causal chain between real interest rates and growth suggested in the financial liberalization literature is stronger for countries that have chosen the financial reform path than for African countries in general. Should the regression procedures reveal comparable results for both samples, one would argue that financial liberalization can be prescribed for African countries in general as a theoretically founded remedy for their current economic difficulties.

5. It can be argued that better regression results could be obtained with covariance models or error-components to account for changing intercepts or for disturbances that are correlated across time and countries. For the sake of simpli- fication, however, and to make the present results comparable to those of other studies, it is assumed that the intercept is constant across countries and that regression residuals are well behaved. As a result, ordinary least squares will be used along with the pooling procedure.

6. McKinnon (1973) suggests using the wholesale price index as the measure of price inflation but such an index is unavailable for most African countries.

7. The negative relationship between investment and interest rates portrayed in equation (4) may seem puzzling in light of the conduit effect hypothesized by McKinnon (1973) but can be reconciled with theory as follows. In the absence of highly fluctuating spreads between lending and deposit rates, which is the case for the sample African countries, deposit rates can be considered reasonable prox-

ies for lending rates in a regression analysis. While the conduit effect relates investment to deposit rates of interest in a positive fashion, such a relationship implicity assumes self- finance. In African countries, however, statistics on investment capture mainly activity in the formal sector which resorts to external financing and for which the relationship between interest rates and investment is a negative one.

8. Consider the following arithmetic proof. Country A has 20% inflation, country B has 5% inflation and the real deposit rate is set at 5% in both countries. Assuming a 33% withholding tax on interest income, the real after-tax deposit rate of interest will be -2.8% in country A and 1.6% in country B.

9. The investment-inducing role of foreign savings which is measured by the current account deficit may lead to the wrong impression that there is some benefit in maintaining an overvalued currency. Such a policy, however, would quickly lead to depletion of the country’s foreign assets, dollarization of the economy wherever possible or outright capital flight - foreign assets being cheaper for the country’s residents. Furthermore, the domestic export and import competing sectors would be put at a severe dis- advantage.

10. The debate often arises as to whether credit targets or money supply targets should guide monetary policy in economies that are prone to high inflation. While in the case of African countries both types of targets have merit, the current situation in most countries is one of limited non- bank sources of credit - except for countries such as Kenya and Nigeria - increasingly stronger linkages between domestic and international goods markets, and relatively weak ties between domestic and financial markets. These characteristics favor the choice of domestic credit targets rather than targets related to money supply growth. For a detailed treatment of the theoretical rationale for the choice of monetary policy targets, see Frenkel and Johnson (1976) and IMF (1987).

11. Source: World Bank, World Development Report (1991).

12. It can be argued that the United Kingdom and Malawi’s neighboring countries rather the US economy are the appropriate benchmarks for the assessment of Malawi’s level of international competitiveness. Since the countries in the sample, however, do not have the same trading partners, a single reference point such as the United States provides a convenient basis for comparison.

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APPENDIX; EMPIRICAL RESULTS OF THE SAMPLE OF 21 AFRICAN COUNTRIES

Interest rates and growth

GROWTH = 3.992 + 0.058 REALDEP (A.1) (9.53) (1.34)

Adj. R2 = 0.003 F= 1.8 N = 266 The t statistics are in parentheses.

GROWTH = 0.008 - 0.009 REALDEP + 0.101 INVGDP (0.01) (-0.21) (2.67) (A2)

+ 0.030 SAVGDP + 0.427 FINSAV (1.76) (4.5 1)

Adj. R2 = 0.107 F = 8.94 N = 266

Interest rates und investment

INVGDP = 24.986 + 0.233 REALDEP (37.91) (3.41)

Adj. R2 = 0.039 F = 11.65 N = 266

(A.3)

INVGDP = 23.819 - 0.388 DEPRA -0.125 INFL (16.82) (-2.40) (-3.31)

- 0.416 CAGDP + 0.456 FINSAV (-9.27) (3.43)

ADJ. R* = 0.3 12 F= 31.05 N = 266

Interest rates andjinancial savings

FINSAV = 2.29 I + 0.085 REALDEP (8.78) (3.15)

Adj. R* = 0.036 F = 9.95 N = 266

FINSAV = 2.658 + 0.063 DEPRA 4).065 INFL (3.83) (0.84) (-3.73))

-0.001 PERCAP (-1.33)

Adj. R? = 0.041 F = 4.77 N = 266

(A.4)

(A.5)

(A.6)

Documents

Financial liberalization in Africa