II. Financial Liberalization
- Robert Corker, and Wanda Tseng
- Published Date:
- March 1991
During the past decade, nearly all Asian countries liberalized their financial systems. In many countries, this was accompanied by a relaxation of capital controls and a shift toward more flexible exchange rate arrangements. The resulting changes in the financial structures have had widespread implications for money demand and the conduct of monetary policy. To provide a background for the discussions that follow, this section reviews the financial liberalization and the changes in financial structures in the Asian countries during the 1980s. First, it provides an overview of the financial systems in the countries prior to liberalization. Then it examines the impetus for changes that surfaced during the period and the liberalization measures that were implemented. In this review, the emphasis is on the common elements and the broad thrust of reforms, rather than on providing a complete listing of all the liberalization measures; a summary of the financial liberalization undertaken by each country is presented in Appendix I.
Preliberalization Financial Systems
The Asian countries differed widely in their levels of overall economic development, economic structures, and degrees of financial market sophistication. Despite the diversity of circumstances, their financial systems prior to liberalization shared many similar characteristics. These included interest rate restrictions, domestic credit controls, high reserve requirements, segmented financial markets, underdeveloped money and capital markets, and controls on international capital flows.
Interest rate restrictions were pervasive in most of these countries prior to the 1980s. These restrictions typically took the form of ceilings on deposit and loan rates of commercial banks; nonbank financial institutions were usually subjected to fewer restrictions. The imposition of controls on interest rates was motivated by a desire to provide low-cost funds to encourage investment, particularly for priority sectors, and to guard against increases in interest rates that were viewed as socially or politically unacceptable. However, these restrictions led to financial disintermediation as savers and investors sought alternative outlets outside the formal financial system. Over time, the acceleration of financial disintermediation resulted in the growth of unregulated financial markets and nonbank institutions, reducing the effectiveness of monetary controls. Also, banks often attempted to maintain profits by imposing compensating balances and/or various fees and charges that were not subjected to controls, leading to distortions in the provision of financial services. Consequently, financial deepening was hindered and financial resources were not directed into productive activities.
Direct controls to regulate both the aggregate supply and sectoral allocation of credit were used in many Asian countries. These typically involved ceilings on the level or growth of bank credit and directed credit schemes. Credit ceilings were widely used as an instrument of monetary policy, particularly because of the lack of markets and instruments to support indirect means to influence bank reserves such as open market operations. While credit ceilings proved effective in controlling domestic credit, their use over time often had deleterious effects on financial sector development. In setting credit ceilings, the monetary authorities usually allocated the scope for future lending largely on the basis of banks’ past share in total lending. The imposition of the status quo on the market structure inhibited growth and competition, which in turn, contributed to disintermediation. The effectiveness of monetary control was, therefore, weakened because of the growth and expansion of markets outside the controlled (usually the banking) sector.
Sectoral credit allocation schemes included direct central bank lending to priority sectors, preferential central bank refinancing facilities, and lending targets for commercial banks. These schemes often proved costly in terms of allocative efficiency and the effectiveness of monetary policy. Directed credit programs in many countries resulted in investments with low rates of return, which subsequently burdened banks with large nonperforming loans. This, in turn, limited the scope for monetary policy because of pressures to continue to provide credit to priority sectors. The effectiveness of directed credit programs in supplying adequate credit to priority sectors was also questionable because it was difficult to ensure that credit was actually used for the intended sectors.
High reserve requirements were a feature of the monetary control procedures in some Asian countries. High reserve requirements, with no interest paid on reserves, served as an implicit tax on commercial banks that often increased the cost of financial intermediation to such an extent that the financial system was bypassed altogether. This eroded the effectiveness of monetary control and required that the monetary authorities further tighten controls on the formal financial sector to achieve policy results, thereby creating a vicious circle of intensifying controls that became increasingly less effective.
The financial systems of many Asian countries were characterized by a high degree of segmentation. Each type of financial institution was restricted to conduct business within its explicitly prescribed sphere. Entry of new institutions into particular segments was extensively regulated or even prohibited. Activities of foreign banks, where allowed, were restricted. These restrictions reflected the desire to protect depositors and to maintain confidence in the stability of the financial system; the restrictions were also justified on the basis of market imperfections and the need to provide credit to priority sectors and to promote the development of domestic financial institutions. However, the restrictions limited competition in the financial system, inhibiting improvements in financial intermediation and the development of new services and instruments.
Money and capital markets in these countries were generally underdeveloped prior to the 1980s and played a minor role in intermediating funds between borrowers and savers. While interbank markets existed in some countries to allow banks to manage their short-term liquidity needs, such markets were generally not available to the nonbank sector. Capital markets, where they existed, were of marginal importance. Firms often found that their long-term financing needs were not met either because credit was not available or because they had to turn to informal financial markets where the cost of funds was high. In some countries, the authorities responded to this shortcoming by setting up special development banks. The lack of established financial markets also had major implications for the conduct of monetary policy because it precluded open market operations and indirect controls on interest rates. As a result, the monetary authorities were limited to using direct controls and changes in reserve requirements and refinancing facilities to achieve their policy objectives.
For the most part, international capital flows were strictly controlled. The controls were generally imposed to insulate domestic interest rates and monetary conditions from influences from abroad, as well as to support fixed exchange rate arrangements.
Financial Liberalization During the 1980s
The move toward financial liberalization reflected, in part, the shift in the philosophical underpinnings of economic policies that occurred in the 1980s. Excessive controls and regulations were increasingly viewed as inappropriate for efficient resource allocation and for the attainment of rapid economic growth. As discussed above, overly regulated financial systems discouraged financial savings, created distortions in investment decisions, and generally failed to intermediate effectively between savers and investors. In many Asian countries, rigidities in the financial systems prevented them from meeting the needs of increasingly complex and sophisticated economies.
The reforms were also motivated by the need for more flexible and effective policy responses to the severe external shocks experienced by these countries during the past decade. The slowing of market growth in industrial countries, worsening terms of trade, rising international interest rates, and proliferating protectionist pressures required comprehensive adjustment policies to sustain noninflationary growth and balance of payments viability. The traditional instruments of monetary policy—administered interest rates and direct credit controls—proved to be inadequate to meet this challenge. The effectiveness of traditional instruments had eroded over time reflecting, among other things, the development of new financial instruments and markets to circumvent traditional controls.
In general, the objectives of financial liberalization undertaken by these countries were to enhance efficiency through a greater reliance on market forces as well as to improve the effectiveness of monetary policy. The key reforms were aimed at liberalizing interest rates, reducing controls on credit, enhancing competition and efficiency in the financial system, strengthening the supervisory framework, and promoting the growth and deepening of financial markets. The liberalization of the domestic financial system was accompanied by the relaxation of restrictions on international capital flows and a shift toward more flexible exchange rate arrangements.
The implementation of financial liberalization varied widely across the countries in terms of both the pace and scope of reforms. Singapore largely liberalized its financial sector and abolished capital controls in the mid-1970s. Consequently, Singapore already had a relatively well-developed financial sector that was closely integrated with international financial markets, and financial reforms during the 1980s focused on improving existing institutions and markets.
The other countries had more restrictive financial systems and, therefore, greater scope for reforms. Sri Lanka embarked on financial reforms in the context of its overall economic liberalization program of the late 1970s. Significant reforms were undertaken in Indonesia, Malaysia, and the Philippines in the early 1980s. More gradual steps toward liberalization, which were intensified in the latter half of the 1980s, occurred in Korea and Thailand. Nepal began to implement a financial liberalization program in the second half of the 1980s. Myanmar, however, maintained a highly restrictive financial system during most of the 1980s. Overall, financial liberalization in the Asian countries has been a gradual, phased, and continuing process rather than being concentrated in discrete episodes of comprehensive liberalizations.
Liberalization of Interest Rates
The objectives of interest rate liberalization are to promote savings and efficient investment and to deepen financial markets. Saving is affected by many factors and while the empirical evidence on the effect of interest rates on saving is ambiguous, their effect on the form of saving is clear.2 Positive real interest rates favor financial over nonfinancial savings, leading to the deepening of financial markets. In turn, greater financial intermediation tends to ensure that the more productive investments are financed. Positive real interest rates, therefore, contribute to economic growth by promoting financial deepening and improving the productivity of investment.
The liberalization of interest rates was a prominent feature of the financial reforms implemented by nearly all these countries. Interest rates were fully deregulated in Indonesia, the Philippines, and Sri Lanka in the early 1980s; Nepal freed most key interest rates in 1986; and Korea, Malaysia, and Thailand relaxed controls by more frequent adjustments in rates, wider bands for regulated rates, and the removal of some interest rate ceilings. In contrast, interest rates played virtually no role in allocating resources in Myanmar, and remained unchanged from 1977 until late 1989.
The liberalization of interest rates, together with the substantial progress achieved in reducing inflation, resulted in positive real interest rates in most Asian countries during the 1980s (Chart 1).3 By contrast, during the period prior to liberalization (in the 1970s), real interest rates had tended to be negative. The immediate impact of liberalization on interest rates in all these countries was to move rates upward. The increases in nominal rates were sufficiently large to establish positive real interest rates in Indonesia and Malaysia; in other countries (Korea, Nepal, the Philippines, Sri Lanka, and Thailand), positive real interest rates were achieved subsequently as inflation subsided. In Singapore, after the interest rate liberalization in the mid-1970s, nominal interest rates have closely followed international interest rates and real interest rates have remained consistently positive. Only Myanmar experienced negative real interest rates throughout the 1980s.
Chart 1.Asian Countries: Interest and Inflation Rates, 1974–891
Source: Incemicional Monetary Fund, international Financial Statistics.
1 Deposit and lending rates are taken from lines 601 and 60p, respectively, of International Financial Statistics. Inflation rices are the quarterly percent changes in consumer prices (line 64) from the corresponding period in the previous year.
Positive interest rates contributed to financial deepening in most of these countries. Financial depth, as measured by the ratio of M2 to gross domestic product (GDP), rose in most of these countries during the 1980s; growth was particularly rapid in Malaysia, Singapore, and Thailand where the ratio reached 60–90 percent in 1989 (see Chart 2). In Korea, the ratio of M3 (including nonbank financial assets, particularly corporate bonds and commercial paper) to GDP rose sharply after 1981 and faster than the ratio of M2 to GDP. This reflected the more relaxed regulatory environment of the nonbank financial institutions and their ability to offer higher yields on financial instruments than banks. In Indonesia, the ratio of M2 to GDP rose from about 20 percent in 1983 to about 35 percent in 1989. In both the Philippines and Sri Lanka, the financial sector expanded in the immediate period following the reforms (1980–83 for the Philippines and 1979–80 for Sri Lanka); however, the expansion was not sustained. Financial sector development in Myanmar has been set back by two major demonetizations—in November 1985 and September 1987—in which notes of higher denomination were declared illegal tender.4
Chart 2.Asian Countries: Broad and Narrow Monetary Aggregates, 1970–89
Sources: International Monetary Fund. International Financial Statistics; and Fund staff estimates.
1 In percent of GNP.
Reductions in Credit Controls
Nearly all Asian countries reduced or eliminated overall direct credit controls on bank lending (Indonesia, Korea, Malaysia, Nepal, the Philippines, Sri Lanka, and Thailand), However, some controls were reintroduced in a few countries to address particularly severe monetary disturbances and/or adverse macroeconomic developments. Korea, for example, intermittently resorted to informal direct controls toward the end of the 1980s to help offset the monetary impact of the large balance of payments surpluses. Sri Lanka also imposed selective credit controls in 1989 when confronted with a severe deterioration in its balance of payments and a large liquidity overhang.
Sectoral credit allocation requirements were also largely discontinued in Indonesia, Korea, and the Philippines. However, in Indonesia, while selective credit ceilings were abandoned in 1983, preferential central bank rediscounting, in the form of liquidity credits to banks that lend to priority sectors, was continued albeit with modifications;5 the share of liquidity credits in total bank credit declined during the 1980s.6 Sectoral credit allocation requirements remained in Malaysia, Myanmar, Nepal, Sri Lanka, and Thailand.
Financial System Reforms
Efforts were made to enhance banks’ efficiency by increasing competition and by improving management. Most Asian countries (Indonesia, Korea, Malaysia, Nepal, the Philippines, Sri Lanka, and Thailand) undertook measures to reduce obstacles to competition and market segmentation by allowing greater freedom of entry, expanding the scope of permissible business activities for different types of financial institutions, and relaxing restrictions on the activities of foreign banks. Better management often meant that banks needed to be given greater autonomy and more responsibilities for their operational performance; such autonomy was facilitated, in some countries, by the privatization of government-owned banks. Improved management also necessitated new lending policies, better loan recovery procedures, more sophisticated information systems, and better trained staff.
Deregulation of the financial system was accompanied by measures to strengthen the supervisory framework. These measures were prompted, in part, by the financial crises of different magnitudes that were experienced by nearly all of these countries during the 1980s. Unfavorable macro-economic trends, greater competition, the failure to adapt to the liberalized environment, larger interest rate fluctuations, and the absence of adequate prudential regulations and bank supervision all contributed to the failure of financial institutions. Also, excessive regulations of the banking system during the 1970s (both in terms of interest rate and credit controls) had important deleterious effects: banks’ lending portfolios had been weakened in some countries, and nonbank financial institutions, that were in some cases not subject to adequate supervision, had grown rapidly. Nearly all of these countries (Indonesia, Korea, Malaysia, Nepal, the Philippines, Singapore, Sri Lanka, and Thailand) implemented measures to restructure failing financial institutions and to strengthen the supervision of other financial institutions. These measures included centralizing supervisory responsibilities, developing and unifying the regulatory framework, providing for depositors’ insurance, and extending supervision to nonbank financial institutions. In general, the emphasis of supervision shifted from monitoring routine operations to monitoring procedures of credit analysis, bank portfolios, and the enforcement of prudential ratios.
Most Asian countries undertook measures to encourage the creation and development of money and capital markets. The Philippines and Singapore already had active organized money markets prior to the mid-1970s. By the beginning of the 1980s, money markets became increasingly important in Indonesia, Korea, Malaysia, and Thailand, and by the late 1980s, money markets were being developed in Sri Lanka and Nepal. The markets in many of these countries, however, remain thin and volatile. In general, the development of money markets was fostered by the development of new financial instruments, including central bank and government securities, certificates of deposit, various commercial papers, and repurchase agreements. Interest rates on these instruments were typically subjected to fewer restrictions than those on more traditional instruments. Developing money markets not only increased competition in the financial system but also provided a flexible means for managing liquidity through open market operations.
Alongside the traditional banking system, institutions providing longer-term finance, particularly development finance institutions, finance companies, insurance companies, and pension funds, also became increasingly important. The rapid growth of nonbank financial institutions reflected both the efforts to circumvent extensive controls in the banking sector as well as policy measures to provide a more relaxed regulatory framework than that applied to the banking sector and to develop new financial instruments. By the late 1980s, nonbank financial institutions accounted for 20–50 percent of the total assets of the financial sectors in Korea, Malaysia, and Thailand. Capital markets, especially stock markets, have also expanded rapidly in a number of these countries, particularly in Indonesia, Korea, Malaysia, Singapore, and Thailand.
Singapore advanced most rapidly in terms of financial sector development and became an important international financial center during the 1980s. The potential for the domestic financial sector to become a growth sector, serving the needs not only of the domestic economy but also the regional and international economy, was recognized in the late 1960s. A strategy, encompassing legislative, fiscal, and administrative measures, was formulated to develop Singapore into a major offshore banking center. These efforts contributed to the rapid growth of Singapore’s financial sector, which became the second largest contributor to GDP and employment growth in the economy during 1978–88. In addition, the internationalization of the financial sector provided an environment for evolving new financial activities and reinforcing and improving existing ones.
Reductions in Capital Controls and More Flexible Exchange Arrangements
Together with the liberalization of domestic financial markets, most Asian countries relaxed international capital controls. By the early 1980s, restrictions on capital flows were virtually eliminated in Indonesia and Singapore. Malaysia imposed almost no restrictions on international capital flows that are not financed by local borrowing. Thailand retained controls on outward capital movements but inward movements were largely unregulated. Controls on capital flows remained in Korea, although some liberalization measures, particularly those involving foreign direct investment and overseas investment by residents, were implemented in the latter part of the 1980s.
During the 1980s, there was a movement toward more flexible exchange rate arrangements. In contrast to the late 1970s when a number of these countries maintained fixed exchange rate arrangements—usually pegged to the U.S. dollar (Indonesia, Korea, Nepal, Singapore, and Thailand)—by 1989, the exchange rate arrangements were more flexible and included pegs to composite baskets (Malaysia, Myanmar, Nepal, and Thailand) or managed floating regimes (Indonesia, Korea, the Philippines, Singapore, and Sri Lanka).7