- Ashoka Mody, and Abdul Abiad
- Published Date:
- July 2005
The IMF launched the Economic Issues series in 1996 to make the IMF staff’s research findings accessible to the public. Economic Issues are short, nontechnical monographs on topical issues written for the nonspecialist reader. They are published in six languages—English, Arabic, Chinese, French, Russian, and Spanish. Economic Issue No. 35, like the others in the series, reflects the opinions of its authors, which are not necessarily those of the IMF.
©2005 International Monetary Fund
IMF External Relations Department
Published June 2005
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As used in this Economic Issue, the term “country” does not in all cases refer to a territorial entity that is a state as understood by international law and practice. As used here, the term also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis.
In an unliberalized financial system, the government plays a large role in determining who gives and receives credit and at what price. Governments may offer various rationales for maintaining such a system, including, for example, preserving financial stability or channeling resources to support government industrial policy, give priority sectors access to low-cost credit, or finance a budget deficit.
Proponents of liberalization point out that financial development is strongly associated with economic growth. They argue that the allocation of capital is more efficient in a competitive financial system and that higher real interest rates stimulate saving, thereby increasing the funds available to finance investment. Moreover, government-allocated credit tends to be characterized by poor lending decisions, weak repayment discipline, and government corruption, since those granted access to capital (usually at low rates) may buy influence to protect their favored positions.
While liberalization is not without its critics—who question the link between liberalization and higher saving rates and suggest that it may make some countries more vulnerable to crisis—financial sector reform was high on the agenda of policymakers during the last quarter of the twentieth century. Countries around the world, developed and developing alike, liberalized their financial systems—allowing markets to set interest rates, eliminating controls so that capital could flow freely across borders, and opening their doors to foreign financial firms.
But there were significant differences in the pace and scale of reform. Reforms were swift in some countries, sluggish in others; some countries merely tweaked their financial sectors, while others overhauled them. A large and technically sophisticated literature has examined the consequences of financial sector liberalization, but the factors triggering reform have received less attention. Although there have been case studies supporting various economic and political theories about the forces driving reform, little statistical testing has been done.
To overcome this gap, we compiled a cross-country database—the first large cross-country database focused specifically on financial liberalization—that allowed us to compare the experiences of different countries and analyze our findings objectively, in the hope of uncovering the factors that triggered reform and influenced its timing and extent—why, when, and how much.
This economic issue, which was prepared by Charles Gardner, is based on our study “Financial Reform: What Shakes It? What Shapes It?” (American Economic Review, March 2005). The working paper version (IMF Working Paper No. 03/70, April 2003), which presents our methodology and findings in greater detail, is available free of charge at www.imf.org/pubs.