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Financial Liberalization and Financial Fragility

In the last three decades several developed and developing countries have moved towards liberalization of their financial system. Countries eased or lifted bank interest rate ceilings, lowered compulsory reserve requirements and entry barriers, reduced government interference in credit allocation decisions, and privatized many banks and insurance companies. Also, some countries actively promoted the development of local stock markets, and encouraged entry of foreign financial intermediaries.

Generally, the trend towards financial liberalization is part of a broader trend towards reduced direct intervention of the state in the economy. In a number of developing countries, however, financial liberalization is also a deliberate attempt to move away from “financial repression” as a policy to fund government fiscal imbalances and subsidize priority sectors, a move strongly advocated by the influential work of McKinnon (1973) and Shaw (1973).

According to McKinnon and Shaw, financial repression, by forcing financial institutions to pay low and often negative real interest rates, reduces private financial savings, thereby decreasing the resources available to finance capital accumulation. From this perspective, through financial liberalization developing countries can stimulate domestic savings and growth, and reduce excessive dependence on foreign capital flows.

The work of McKinnon and Shaw also stimulated a fast-growing strand of research that analyzes how financial development can stimulate economic growth by accelerating productivity growth rather than through saving mobilization (see Levine, 1997, for a survey). This research includes a number of empirical studies on the relationship between financial development and growth; most studies find various measures of financial development to be positively correlated with both contemporaneous and future growth rates of GDP, suggesting that financial liberalization, by fostering financial development, can increase the long-run growth rate of the economy (King and Levine, 1993).

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Financial Liberalization and Financial Fragility