Reprint Series 1, December 2012

Financial Liberalization: The Key Issues.

In recent years financial policies in both industrial and developing countries have put increased emphasis on the market mechanism. Liberalization was partly a response to developments in the financial markets themselves: as these markets innovated to get round the restrictions placed on them, governments chose to throw in the towel. More important, however, governments embraced liberalization as a doctrine.

In developing countries, the main impulse behind liberalization has been the belief, based on the notion that interventionist financial policies were one of the main causes of the crisis of the 1980s, that liberalization would help to restore growth and stability by raising savings and improving overall economic efficiency; greater reliance on domestic savings was necessary in view of increased external financial stringency. However, these expectations have not generally been realized. In many developing countries, instead of lifting the level of domestic savings and investment, financial liberalization has, rather, increased financial instability. Financial activity has increased and financial deepening occurred, but without benefiting industry and commerce.

In many industrial countries the financial excesses of the 1980s account for much of the sharp slowdown of economic activity in the 1990s. Financial deregulation eased access to finance and allowed financial institutions to take greater risks. The private sector accumulated large amounts of debt at very high interest rates on the expectation that economic expansion would continue to raise debt servicing capacity while asset price inflation would compensate for high interest rates. Thus, when the cyclical downturn came, borrowers and lenders found themselves overcommitted: debtors tried to sell assets and cut down activity in order to retire debt, and banks cut lending to restore balance sheets. Thus, the asset price inflation was replaced by debt deflation and credit crunch.

The recent experience with financial liberalization in both industrial and developing countries holds a number of useful lessons. This paper draws on this experience to discuss some crucial issues in financial reform in developing countries. The focus is on how to improve the contribution of finance to growth and industrialization; developing the financial sector and promoting financial activity is not synonymous with economic development.

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