Ebook Financial Market Development: Does financial liberalization induce regulatory governance reform?
Financial liberalization allows market forces to determine the allocation of capital. Models of perfect markets suggest that domestic financial liberalization and international financial liberalization have welfare and efficiency enhancing effects. Thus, prior to the East Asian financial crisis, economists broadly concurred that financial liberalization is desirable. However, the collapse of the “miracle” economies in Thailand, Indonesia and South Korea during the 1997 East Asian financial crisis motivated policymakers and academic scholars to question the indiscriminate advocacy of financial liberalization. During the 1997 crisis, the liberalized economies in Thailand, Indonesia and South Korea experienced sharp recessions and sudden withdrawals of international capital flows, while both China and India, with protected financial economies, emerged unscathed. The crisis raised somber questions on the benefits of financial liberalization and compelled economists to be more circumspect and modify their stance.
Some now argue that a significant cause of financial crises such as the East Asian crisis is the unprecedented emergence of financial liberalization among many developing countries since the 1980s (Tornell, Westermann, Martinez, 2004). Financial liberalization creates scope for innovation and enhances the mobility of risk, but the increasing complexity of financial instruments and risk transfers have also made it more challenging for market participants, supervisors and policy makers to track the development of risks within the financial system and over time. In addition, capital account liberalization may be welfare-enhancing only when there are no serious imperfections in the information and contracting environment (Eichengreen, 2001). As a consequence, some prominent economists such as Rodrik (1998), Krugman (1999) and Stiglitz (2003) have advocated limits on capital flows to moderate irrationally exuberant investors and the erratic boom-bust patterns in financial markets. Yet, while economists continue to caution against rash, premature financial liberalization, they maintain that financial liberalization is advantageous for long term economic growth. However, they recommend that countries develop a sound regulatory structure, legal system and social safety net, prior to financial liberalization.
While sequencing regulatory governance reform before financial liberalization is a prudent policy prescription, it may be a ponderous task to carry out because regulatory governance reform faces severe obstacles in many countries. Thus, it is worth considering a different perspective. This paper explores whether financial liberalization itself may induce regulatory governance reform and proposes that the sequencing of regulatory governance reform and financial liberalization is the reverse of the above prescription. Using an ordered probit model and data from 17 emerging financial economies between 1973 and 2004, the results show that the probability of regulatory governance reform increases after partial and full financial liberalization. In the case of no financial liberalization, there is significantly higher institutional inertia. On a micro-scale, using a probit model, there is evidence supporting the hypothesis that liberalization of the domestic financial sector spurs banking reforms. Overall, the paper finds that the dynamics between financial liberalization and regulatory governance reform are richer than commonly thought.
Section II is a review of the relevant crisis and growth literature. Section III describes the theoretical perspectives underpinning the empirical work and postulates possible causal mechanisms for financial liberalization to spur institutional reforms. Section IV details the data that are used in the model and compares it to existing alternative measurements, highlighting its strengths and weaknesses. It also includes some preliminary statistical analysis. Section V explains the model specification for testing whether financial liberalization spurs regulatory governance reforms and reports the findings from the study. Section VI summarizes the findings and explains the policy implications of the study.
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