Ebook The Economy-wide Impact of Financial Liberalization in China and India: A Computable General Equilibrium Simulation
The world economy is undergoing a period of extraordinary trade, productive and financial integration within the context of rapid policy reform and liberalization, both within countries as well as within global and regional associations. Within this rapidly changing environment, how a country manages the timing and scope of domestic policy reforms and international negotiations will have profound implications for its position in the emerging new world economic order. Yet in many cases, sector specific reforms or multilateral negotiations are evaluated from the perspective of the political economy of that specific sector, instead of the national economy-wide and long-term global competitive implications that this sector specific agenda many have.
This paper examines the case of two of the most important emerging countries in the world economy and the choices they will face in the context of post-GATT policy reforms and negotiations. The potential impacts of financial sector liberalization for these countries is of particular interest since reform of this sector is emerging as one of the most important issues for negotiations within the new World Trade Organization (WTO) framework. It is also a case where the political economy of specific concerns within national financial sectors may be at odds with the broader economy wide implications and opportunities of financial sector reforms. In other words, reform measures targeting financial sectors are likely to decrease the profitability of local financial firms, at least in the short run, while reducing costs and improving efficiency in the other productive and service sectors. This paper seeks to make available more comprehensive methodologies for evaluating the economy-wide impacts of specific financial sectors liberalizations which might be able to better inform the choices available to policy makers and other economic actors.
Financial liberalization, as part of a broader program of economic reforms, may contribute to economic growth in three key ways. First, interest rate decontrol will lead to higher real returns for savers and, in most cases, an increase in resources in the financial system which can be loaned for investment projects. To the extent that preliberalization savings rates were voluntary, we would expect national rates of savings and investment to rise, boosting economic growth in the medium to long term. We posit that, in the context of relative macroeconomic stability, increased competition among banks, non-bank financial institutions, and foreign financial institutions will prevent a sharp rise in the lending rate that might otherwise reduce investment levels.
Secondly financial liberalization will mean an end to the practice of allocating cheap credit to preferred sectors. This will improve the allocation of resources in the economy, as capital is allocated to sectors in which it is most profitable. Over a transition period of 5 to 10 years, depending on the extent of the pre-liberalization distortions, economic growth will be higher.
Finally, our definition of financial liberalization implies greater access to international capital, facilitated in part through an expanded role for foreign banks and non-bank financial institutions, could be a third benefit of financial liberalization. This definition of financial liberalization goes beyond mere domestic financial reform. This access to international markets carries risks and responsibilities as well, since macroeconomic mismanagement may now lead to capital outflows in search of “safe haven” investments. But as long as inflation is low and predictable, openness to participation by foreign banks, direct and portfolio investment, and foreign currency loans to national corporations should increase the supply of foreign savings and thus the level of investment and growth rate of real output. These three impacts will be the key elements of our empirical estimates presented in this paper.
The remainder of the paper is organized as follows. Section II will review the theoretical considerations on the impact of financial liberalization in developing countries, including the problems of “Financial Repression” and potential benefits and pitfalls of financial liberalization. Section III will review the cases of China and India, including the most obvious parallels between the two countries with respect to size and relative poverty, but also the fact that, in contrast to the vast majority of low income developing countries, their domestic savings rates are relatively high. Past liberalization episodes and current liberalization efforts are discussed, and some of the remaining financial sector distortions are surveyed.
In Section IV, a computable general equilibrium (CGE) model designed for China and India is introduced and the results of various scenarios and sensitivity analyses are discussed. The model focuses on the real side impacts of financial liberalization. Within the broad CGE context, in which all changes have impacts that spread throughout the economy, three primary avenues of effect from financial liberalization to savings, investment and production decisions are introduced. Section V presents our conclusions and some policy recommendations. A brief description of the workings of the base model is given in Appendix 1.
contents
Executive Summary
I. Introduction
II. Theoretical Considerations on the Impact of Financial Liberalization in Developing Countries
III. Background of Financial Sectors and Proposed Liberalizations in China and India
IV. Model and Modeling Results of Financial Liberalization in China and India
V. Conclusions
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