Financial Liberalization: Does It Pay to Join the Party?

Financial repression leads to segmented domestic financial markets in which some obtained credit (rationing) at very negative real interest rates, while nonfavored borrowers had to obtain funds in expensive and unstable informal credit markets. Public controls over the banking system typically led to negative real interest rates for depositors. Financial repression became an obstacle to domestic savings and their efficient allocation, and financial intermediation languished.

—Carlos Díaz-Alejandro

Financial liberalization is a highly controversial policy. Despite the fact that almost all the regions of the world have undergone liberalization of their financial markets, its effect on the performance of different economic sectors remains a question. In our research, we find that financial liberalization reduces the cost of capital, boosting the relative growth rates of economic sectors that for technological reasons rely heavily on external (to the firm) finance. This result, however, depends on the quality of institutions supporting credit markets. The effects of financial liberalization are more notable in countries that have and enforce regulations to protect property rights. In this sense, the answer to the question in the title of the paper is not clear-cut. The impact of financial liberalization on growth depends on underlying institutional factors.

This paper interprets financial liberalization as the removal of restrictions that impede the free allocation of resources on two fronts: the domestic financial system and the capital account. Liberalization policies affecting the former include the removal of interest rate controls (lending and deposits), directed credit policies, and limitations on foreign currency deposits and foreign ownership. Policies affecting the latter contemplate the removal of restrictions on corporate borrowing abroad and the dismantling of multiple exchange rate mechanisms and capital controls. We use Kaminsky and Schmukler's dataset to quantify the degree to which countries have liberalized their financial markets on these two fronts, and we estimate the resulting effects on growth. ¹

Theory provides no straightforward answers on how liberalization is related to economic performance. Models of perfect markets in the tradition of Goldsmith, McKinnon, and Shaw suggest that removing restrictions on interest rates and credit controls can increase savings, expand the size of credit markets, and improve the efficiency with which funds are intermediated. ² Through these mechanisms, liberalization can promote growth by effectively reducing the cost of funds for firms. ³

Other forms of financial market liberalization can also be beneficial for economic performance. Removing restrictions that limit the use of foreign capital, such as allowing foreign players to invest in the financial system or lifting controls that prevent firms from tapping international capital markets directly, can significantly increase the size and efficiency of markets, while effectively reducing the cost of funds. Here again, such mechanisms promote growth. ⁴ Financial liberalization can also improve corporate governance, because foreign competition pressures local firms to adopt international accounting and regulatory standards. These improvements reduce agency costs that make it harder and more expensive for firms to raise funds in both the banking sector and the securities market. ⁵

At the same time, there are strong arguments against the growth-promoting effects of financial liberalization. Some authors claim that the efficient-markets paradigm, on which most arguments in favor of liberalization are built, is misleading when applied to the financial sector, particularly to capital flows. Removing one distortion may not be welfare-enhancing when other distortions are present. Financial markets are characterized by serious problems of asymmetric information and moral hazard, which may undermine the case for domestic financial liberalization. ⁶ Such considerations lead Stiglitz, for example, to argue in favor of certain forms of financial repression. ⁷ He claims that repression can have several positive effects, such as improving the average quality of the pool of loan applicants by lowering interest rates; increasing firm equity by lowering the price of capital; and accelerating the rate of growth if credit is targeted toward profitable sectors such as...