FINANCIAL LIBERALIZATION AND MONETARY POLICY

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FINANCIAL LIBERALIZATION AND MONETARY POLICY

• Financial reforms have major implications for the
  conduct of monetary policy
• Several countries have suffered from loss of
  monetary control after financial liberalization
• Financial reform involves the introduction of
  indirect approaches of monetary control
• This process implies a gradual shift from direct
  interest and credit controls towards market-based
  procedures

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• Market-based procedures involve
• -- central bank lending facilities
• -- open-market operations and repurchase
  operations
• -- reserve requirements

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• In many countries, reform of monetary policy
  involved
• -- initial active use of reserve requirements
  and refinance facilities
• -- guidance on interest rates and bank credit

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• In many countries, monetary policy continued to
  rely on reserve requirements
• Also, interest rate controls were not fully
  eliminated out of concern about the
  competitiveness of the banking system
• In almost all cases, regular auctions of central
  bank offers or govt securities were introduced

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• A common way of day-to-day monetary operations
  has been repurchase and reverse repurchase
  agreements using govt securities
• Introduction of market-based operations was
  accompanied by measures to strengthen money and
  interbank markets
• To this extent, secondary markets for govt
  securities play a central role

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• Financial liberalizations are usually followed by
  rapid credit creation
• When controls are eliminated, financial
  institutions tend to run down excess reserves
• In many cases, the growth of credit is
  significantly higher than the growth of deposits

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• After some time, and especially in cases when
  authorities maintain positive real interest
  rates, credit and deposit growth converge
• In these cases, financial reforms tend to
  increase savings
• But, there is also evidence from countries where
  financial liberalization was followed by a
  consumption boom

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• In most cases, financial liberalization results
  in more financial deepening
• In many countries, the ratio M2/GDP increased
  significantly

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HOW FINANCIAL LIBERALIZATION AFFECTS FINANCIAL
INSTITUTIONS

• In many countries, financial liberalization was
  followed by a banking crisis
• Only countries that avoided these crises were
  able to benefit from reforms in the short run
• Weaknesses in the institutional environment
  played a major role
• But, financial reforms may have contributed to
  problems in four ways

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• -- High rates of credit growth and strong
  capital inflows increased lending to high-risk
  borrowers
• -- Sudden financial reforms did not allow banks
  time to strengthen their credit evaluation and
  risk-management systems
• -- State-owned banks did not have time to adopt
  private-based management

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• -- Information systems in the banking sector
  were underdeveloped
• A sequence of bank supervision policies in line
  with the development of institutions helps
  safeguard reforms
• If authorities allow weak banks to expand their
  operations during a period of financial reforms,
  then there is a higher chance of a crisis

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• Initially after reforms are introduced, banks
  tend to increase their interest margins
• Interest margins tend to come down unless banks
  suffer from portfolio weaknesses
• In many countries, capital market reforms have
  lagged behind reforms in the banking sector

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FINANCIAL LIBERALIZATION AND THE REAL SECTOR

• Financial reforms could affect the real sector
  through the following three channels
• -- Level of real interest rates
• -- Volume of financial intermediation (credit)
• -- Efficiency of financial sector
• The above channels are used as proxies of how
  well the reforms improve credit allocation

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REAL INTEREST RATES

• Monetary policy determines real interest rates in
  the short term
• Negative real interest rates will result in
  resources allocated to unproductive activities
  and increase consumption
• In financially repressed systems, real interest
  rates are very high for unsubsidized projects

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• Financial reform results in higher real rates for
  subsidized borrowers and lower real rates for
  unsubsidized borrowers
• These changes result in a capital reallocation in
  the economy
• Reforms are expected to increase opportunities
  for more productive projects

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VOLUME OF CREDIT

• Financial liberalization leads to higher rates of
  credit expansion
• Impact of more available credit on economic
  growth depends on two factors
• -- sources of credit expansion
• -- uses of credit expansion

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• Increases in available credit will result in
  higher growth rates in they come from increased
  savings
• If more credit is available simply due to
  increases in money supply from the central bank,
  then the effect will be higher inflation
• Financial liberalization may also increase
  foreign demand for domestic financial assets

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• This will lead to capital inflows, which will
  support growth while covering for a CA deficit
• Equally important is the use of increased credit
• If increased credit is directed towards
  consumption or unproductive activities, economic
  growth will not be stimulated

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EFFICIENCY OF FINANCIAL SECTOR

• Financial condition and efficiency of banks will
  affect the channeling of credit to the real
  sector
• Insolvent banks have incentives to allocate
  credit to high-risk projects
• Also, solvent banks will find it more difficult
  to compete with insolvent banks for deposits

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• Ownership interrelationships and connected
  lending may be exploited during periods of
  financial liberalization
• Rapid credit expansion may put a strain on credit
  evaluation departments and result in increased
  lending to risky borrowers
• Misallocation of credit after financial
  liberalization will have a negative effect on an
  economys growth and public finances