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Programme: BA (Hons) in Economics, Politics and Law in Dublin City University

Module: Global Economic Issues

Assignment Title: What is the relationship between financial liberalisation and economic growth

Word Count: 2732

Author: Ed Cuddy

Introduction

The aim of this essay is to explore the relationship between financial liberalisation and

economic growth. Financial liberalisation importance for growth in developing

economies is widely accepted. The IMF and the World Bank encourage financial

liberalisation policies in developing countries as part of free market reforms or

stabilisation programmes. However, this Neoclassical financial liberalisation thesis is

encountering increasing skepticism. Stiglitz (1998) suggests that financial liberalisation

is "based on an ideological commitment to an idealised conception of markets that is

grounded neither in fact nor in economic theory" (p. 20). This essay will critically

reviews the empirical evidence between financial liberalisation and growth in low and

middle income economies. The essay will be structured as follows: first it will analyses

the theoretical underpinning on the role of finance on growth. It will examine the

benefits and the downsides in the theory of financial liberalisation. Furthermore, this

essay will explore the concept of finance and instability. Second, this essay will analyse

the empirical evidence on the finance and growth nexus and also on finance and

instability.

Theoretical underpinnings of Financial liberalisation

The theoretical underpinning of neoclassical economics generally supports the positive

relationship between financial liberalisation of both the banking sector and the equity

markets with economic growth (Baumann et al 2013). In the context of the Solow-Swan

model, financial liberalisation is the removal restrictions that allow capital to flow to

those economies where returns on capital are higher. This flow of capital augments the

productive capacity of such countries and promotes growth in the long run. This is

because resources flow from developed countries, which are in essence capital abundant,

to developing countries where capital is scarce and its return high. These flows then

reduce the latter’s cost of capital and conduce to economic growth (Henry 2007).

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What is the relationship between financial liberalisation and economic growth

In this essay we are focusing on financial liberalisation on the banking sector rather than

on the equity markets. As Keynes (1930) stated on the Treatise on Money, a bank loan

"is the pavement along which production travels, and the bankers if they knew their

duty, would provide the transport facilities to just the extent that is required in order

that the productive powers of the community can be employed at their full capacity".

Keynesian economists therefore understand there is a role for the banking sector in financing growth, while being skeptical of the role of monetary policy in economic growth.

Benefits in the theory of financial liberalisation

This removal of restriction brings along what is known as financial deepening, which is

the increase of financial assets relative to the GDP of a country. Shaw (1973) argued that

more competition in the banking sector is beneficial to growth as these institutions

improve the efficient allocation of capital into productive assets. This is because in the

process of transforming savings into investment, financial intermediaries absorb

resources as a reward for the services offered. Hence, a more competitive financial sector

reduces higher margins and promotes growth by more efficiently funneling savings to

firms (Pagano 1993). In addition, Shaw (1973) believed that the deregulation of interest

rates act as an attraction force within the banking system, which increase the availability

of credit, therefore increasing investment.

Another role for financial intermediaries is to allocate funds in projects where the

marginal product of capital is highest (Pagano 1993). In this way, financial

intermediation increases the productivity of capital and promotes growth in two ways.

First, financial intermediaries collect information to judge the best alternatives in

investment projects. Greenwood and Jovanovic (1990) link the informational role of

financial intermediation and productivity growth in the following way. In their model

investors can choose a safe but low-yield technology or a high-yield and risky one.

Banks scan their large portfolios better than individual investors can, hence choosing the

technology which will lead to a positive shock in productivity and conducive to higher

growth.

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Secondly, risk sharing provided by financial intermediaries induces individuals to invest

in technologies that are riskier but more productive. Banks, by investing in more illiquid

but productive project, effectively pool the liquidity risk of depositors who, as individual

investors, would prefer a less efficient option of a more liquid asset (Pagano 1993).

Bencivenga and Smith (1991) argue that banks increase return on investment in two

ways. First, they direct funds to illiquid but more productive technology. Secondly,

banks avoid more instances of premature liquidation than individual investors, hence

improving productivity of capital assets and hence increasing growth (Pagano 1993).

Downsides in the theory of financial liberalisation

Financial liberalisation on its own is not a ‘silver bullet’ for growth, but should be

accompanied with other institutional preconditions required for a healthy economy. Lee

(2003) argues that a successful financial liberalisation story is only possible in such

economies with an existent stock of human capital. This is because bankers that make

correct loan decisions are those that have skill in risk assessment. Similarly, the initial

stock of information capital such as audited financial statements and mature equity

markets would determine the success of the financial liberalisation agenda. In addition,

Lee (2003) highlights the importance of a developed system of rules and procedures in

the banking sector, which fall within the wider category of the institutional fabric of a

country (North 1990).

Cho (1986) warns that even within the context of financial deepening, growth may be

hindered if it is not accompanied with a well-functioning equity market. This is mainly

due to credit rationing by banks, which is the inefficient allocation of loans at interest

rates below equilibrium. Stiglitz and Weiss (1981) argue that this may occur due to

information asymmetries which lead bankers to loan funds to safer borrowers rather than

to those who are ready to pay the highest interest rate available. This may inhibit growth

by excluding projects with higher risk but with higher returns (Lee 2003).

Another line of thought warns against the dangers of indiscriminate financial

liberalisation. Minsky (1986) developed his financial instability hypothesis to explain

what he considered an unstable endogenous dynamic inherent in modern economies. For

him, periods of financial robustness lead to others of financial fragility by linking

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investors to the Keynesian concept of “animal spirits”. In other words, investors rush to

acquire debt that looks profitable in boom times but eventually create an environment of

debt deflation and contraction.

In summary, under the context of the Solow-Swan model, the overall benefit in theory

of financial liberalisation allows for the removal on restrictions on capital flows to

economies, which allows for higher returns. This flow sees an increase the availability of

credit, therefore increasing investment; this has a knock on effect the productive capacity

of a country and promotes growth. This increase of market forces within a domestic

financial sector is said to improve the effective allocation of resources. However, the

theoretical work by Hyman Minsky has highlighted this liberalisation of finance can be

determined as a source of instability within an economy.

Empirical evidence

Overall, there is an academic consensus regarding the beneficial effects of financial

liberalisation. Authors such as Demirgüç-Kunt and Levine (2008) argue that countries

that show higher level of financial development brought by financial liberalisation at the

same time show stronger growth than less liberalised economies.

The meta-analysis performed by Bumann et al (2013) was based on 60 empirical studies

on the nexus between financial liberalisation and growth. The authors found an overall

positive but weak relationship, concluding that financial liberalisation is not a ‘silver

bullet’ for achieving strong growth. With respect to developing countries, the authors

found mixed results with countries not showing positive coefficients between

liberalisation and growth except in those cases where the focus of the study was banking.

In addition, they found that countries with less developed financial systems that

liberalise their economies could stimulate growth.

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Interest rates liberalisation

Regarding interest rates liberalisation, which in theory should serve as a surge in

domestic savings, Bandiera et al (2000) concluded that there is a weak relationship

between such lifting of restrictions and growth. Similarly, Achy (2003) found a negative

and insignificant relationship on financial depth indicators and growth when examining

MENA countries. For this author, other importance variables such as trade openness,

inflation rate or the burden of external debt are more important in determining growth.

On the other hand, Agenor and Montiel (2008) suggest studies that measure financial

depth by an increased level of savings neglect to recognise the key role of markets as

allocators of information.

Capital Account liberalisation

In relation to capital account liberalisation and growth, Grilli and Milesi-Ferresti (1995)

did not find a strong correlation between capital controls and economic growth.

Similarly, Baillu (2000) analysed data for 40 developing countries between 1975 and

1995 and concluded that a liberalised capital account and its correspondent inflows are

conducive of economic growth. However, this author adds a caveat to his findings with

respect to the level of development of the banking sector. For those economies with a

low level of banking development, capital inflows negatively affect the growth rate as

distortions imposed by governments in the financial sector channel funds into

speculative investments that lead to financial crises. Rodrik (1998) study includes 100

countries over the period 1975 and 1989 and concludes that those economies without

capital controls have not experienced more growth than their more liberalised

counterparts.

This is particularly evident in emerging economies. Klein and Olivei (2008) conclude

that the positive relationship between capital account liberalisation and growth is only

present in developed countries, arguing that developing economies must first improve �6

their institutional fabric if they want to reap the benefits of this type of financial

liberalisation. In addition, Gamra (2009) finds that a blanket capital account

liberalisation hindered growth in the East Asian economies. This is in line with the

account by Lee (2003) regarding poor institutions in these countries when they

experience the financial crisis during the 1990s.

On the other hand, Quinn (1997) found a positive relation in the nexus of capital account

liberalisation and growth. The same can be said for Klein and Olivei (1999), although

they find that capital account liberalisation does not provide equal benefits to all. These

authors concluded that the strong positive relationship shown in industrial economies is

not exactly replicated in developing ones, suggesting that policy reforms in the latter

countries should be rightly timed to wait for the development sound macroeconomic

indicators and appropriate institutions. Quinn and Toyoda (2003) found that the

relationship between openness and growth is positive and linear, hence not contingent on

the presence of other pre conditions such as healthy institutions or human capital.

However these study includes both developed and developing countries. More recently

Saidi (2014) found there was an institutional quality relationship between capital account

liberalization and economic growth. This study found that emerging economies seeking

economic growth are required to have “highly developed institutional, legal and judicial

framework” to promote and benefit from capital account liberalisation .

Authors such as Chandra (2005) and Arteta (2003) find that the effect of capital account

liberalisation on the growth rate is mixed without any clear indication of net benefits or

net losses. Klein (2003) found that capital account liberalisations are of an inverted U-

shaped form, with the majority of the gains obtained by middle-income countries and

less so in the poorest or richest ones (Bekaert 2005). Within the “inconclusive” empirical

data picture, Gamra (2009) suggests the effect of financial liberalisation on economic

growth depends not only on the nature but as well as the intensity of the policy reform.

For this author, there is a significant positive effect on domestic financial liberalisation, a

weak relationship with regards to equity openness and a quite strong negative effect

associated with capital account liberalisation. In the same vein, partial liberalisation is

seen as beneficiary to growth prospects and full liberalisation is associated with financial

crises and less economic growth (Gamra 2009)

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Another line of thought espouses that the financial liberalisation and growth nexus is

non-linear (Shen and Lee 2006). This means that the financial sector promotes growth

when it is not too large. If the size of the financial sector increases disproportionally, it

can hinder growth by suffering episodes of financial crises.

In Summary, The empirical evidence on the finance-growth nexus is mixed. While

some research has found a positive relationship, others do not. The extensive study by

Bumann et al (2013) found a positive, but weak relationship on the effect of financial

liberalisation and growth. Interest rates liberalisation showed a weak relationship with

growth. In relation to research capital account liberalisation the growth nexus was mixed

with the positive finding having some caveats relating to pre-existing healthy institutions

and the studies including developed as well and emerging economies.

Financialisation and Instability

As described in the theory section, Minsky’s financial instability hypothesis predicts that

crises are recurrent phenomena in modern capitalist societies. Kroszner et al (2006)

examined crisis periods to find that these episodes have a disproportionately negative

impact on sectors relying on external creditors in countries with high levels of financial

depth. Similarly, Kose et al (2003) study of external shocks in emerging economies

during the 1990s concluded that consumption volatility increased due to financial

instabilities.

On the other hand, Bekaert et al (2005) meta-analysis study concluded that financial

liberalisation soften the extent of the business cycle by reducing consumption volatility.

However, they found this phenomenon is less prominent in developing economies.

Similarly, Bonfiglioli and Mendocino (2004) recognise that banking crises are harmful

for growth but that extent of the damage can be controlled by liberalising financial

restrictions and by fostering sound institutions. In a similar vein, Calderon et al (2005)

study on financial exposure due to openness found that contrary to common wisdom

international integration does not increase external vulnerability by hindering growth or

increasing volatility.

However, Caprio et. al. (1994) argue that financial instability can be reduced by carefully

managing the liberalisation reform process rather than adopting a blanket approach of �8

laissez-faire measures. This is mainly due to the importance of a stable sequence of

macroeconomic indicators in the moment prior to the implementation of reforms.

Jokipii and Monnin (2013) explore the relationship between financial stability and

economic growth. In the countries studied, banking sector stability appears to be an

important driver of growth. Consequently, this emphaises the need for governments’

economic policy to pay greater attention to banking sector stability.

Conclusion

In Conclusion, there is widespread acceptance that the Neoclassical ideal of financial

liberalisation can have a positive effect on growth. Consequently, this essay has analysed

a number of key theoretical propositions of the financial liberalisation thesis. Firstly,

under the Solow-Swan model, financial liberalisation the overall benefit in theory of

financial liberalisation is that capital can find bigger returns when the financial restraints

those low and middle-income economies endure are lifted. This sees an increase the

availability of credit, therefore increasing investment. However, the drawback to the

theory is Minsky's Financial Instability Hypothesis, which highlights how this financial

liberalisation can show to be a source of instability within an economy.

Secondly this this essay investigated the impact of financial liberalisation policies on

finance growth relationship. The analysis of found that empirical evidence on the

finance-growth nexus is mixed. While some studies found a positive relationship, others

were less conclusive. An extensive study by Bumann et al (2013) found a positive, albeit

weak relationship on the effect of financial liberalisation and growth, indicating it may

not be the ‘silver bullet’ for achieving strong economic growth. Empirical research into

interest rates liberalisation found a weak relationship with growth. Furthermore, mixed

growth was found in relation capital account liberalisation. However, even with the

positive growth finds, there were caveats relating to pre-existing healthy institutions and

the research including not just developing but emerging economies also. This leads to

weak and inconclusive empirical support of the financial liberalisation thesis. In

emerging economies the nexus between institutional quality and capital account

liberalization leads to growth economic growth. However, the lack of such institutional

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frameworks has been blamed for risky global bank flows, credit booms, and banking

crises in emerging economies.

Ultimately, this lends some credence to Stiglitz (1998) suggestion that the Neoliberal

thesis for financial liberalisation is an idealised conception of markets that is grounded

neither in economic theory or factual evidence (p. 20). Keynesian economic thought

recognises the need for regulation and government intervention in the banking sector, to

minimise market imperfections caused by the laissez-faire operation of the market,

idealed by Neoclassical thought.

.

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