Economic restructuring in a highly repressed economy perspectives on the order of policy reform

Keywords:policyreform;liberalization;interestrate;capitalaccount... Overborrowingandpotentialincreaseofnonperformingloanswilloccu r.Iftheeconomywasnotopenedu p towardstheinternationalcap

NguyenHuuDung&DangHoang Ha|1

Economicrestructuringinahighlyrepress edeconomy:Perspectivesontheorderofp

olicyreform

NGUYENHUUDUNG

RealEstateandNaturalResourcesEconomics,NationalEconomicsUniversity–

nguyenhuudungforest@gmail.com

DANGHOANGHA

InternationalSchool,ThaiNguyenUniversity–

danghoanghavn@gmail.com

Abstract

Howtorestructuretheeconomyisanimportantquestionformanydevelopi ngcountriesinordertominimisethereformcost andadverseeffects tot heeconomy.Thispaperprovidesinsightintotheorderofeconomicrestructur ein

theperspectivesofpolicyreform,particularlyi n timingandsequencingofli beralization.Itarguesthat,stabilizingmacroeconomicsuchasfiscalconsolid ationandlowi n fl a t i o n shouldbeachievedfirst.Next,r e m o v e distortionsi

n domesticgoods,capital,andfinancialsector.Removingdistortionmeans deregulatedomestici n t e r e s t rate,removedistortioninpricesandfreeu pwagesinlabourmarket.Third,liberaliseinternationaltrade,whichremovin gquotas,tariffs andotherdirectadministrativecontrols,andr e d u c i n g t a r

i ff s acrosst h e board.Finally,l i b e r a l i z e capitalaccounti n v o l v i n g t h e e l

i m i n a t i o n o f r e s t r i c t i o n s oninflowsa n d outflowso f f o r e i g n directi nvestmentaswellasportfolioinvestmentandtheuseoflongandshorttermfin ancialinstruments.

Keywords:policyreform;liberalization;interestrate;capitalaccount.

1 Introduction

Sincet h e 1970sm a n y c o u n t r i e s haveadoptede c o n o m i c r

e f o r m andliberalisede c o no m i e s , particularlyf a v o u r i n g freetr ade,privatization,fi s c a l consolidation,fi n a n c i a l deregulation andliberalisationwiththemainobjectivetopromotegrowthoft h e i r e conomies.Theinitialachievementswithmassivecapitalinflowsandin creaseinconsumptionofsomeeconomiesinthelate1970sandearl y1980ssuchasChileandB r i t a i n havet r i g g e r e d f o r m a n y othe

rc o u n t r i e s ’ e c o n o m i c liberalizationprograms.M os t o f Eastern EuropeandEastAsiac o u n t r i e s int h e latertimebeganadopting

theireconomiesfromcentralplanedwhicharehighlyrepressedanddis tortedbygovernmentsmandatedcontrolonoutputandpricesintoso meform ofe c o n o m i c liberalisation(YungandHugh,2013).Liberal izationhasbeenconsideredasa miracleforattractingforeigninvestme ntandeconomicdevelopment

However,a f t e r somei n i t i a l successperiod,t h e pictureso f liber alizingc o u n t r i e s becomevarious.Inthe lateof the1980sandea rly 1990ss o m e ofcountriessuchasChileandBritaincontinuehavingrem arkableachievementswhileothersexperiencedr e c e s s i o n orev enfinancecrisisandeconomicinstabilityfailsuchasArgentina,Brazil,

P e r u andespeciallyformerSovietUnion(Pradeepet.al.,1995).The seproblemsagaincauseeconomistsdebateoverthequestionhowtoap proacheconomicliberalisation

McKinnonin1982(andthenin1991)initiallyproposedagraduala pproacheconomicliberalization.H e arguedthatt h e appropriatepoli cies,andi n particularlyt i m i n g andsequencingofliberalizationwere themainissue.Thereis,anoptimalordero f ec onom ic liberalizationt

ha ta countryshouldfollowt o minimisethe re form c os t andadverse effectstotheeconomy.Althoughthatsequencingisstillanareaofdebat e,i t hasbeengenerallyreceivedconsensusduringtherecenttime ForbetterunderstandingthesequencingproposedbyMcKinnon(19

economycanapproachliberalizationsafelyandinthe right pace.Thef o c u s o f thepaper will beonliberalisationoftightly-controlledcapital

accountwhichisi n highlyrepressedeconomy.Somecountryexp erienceswillbetakenfordiscussion.Thepaperi s arrangedasfoll ows Thefi r s t sectiono ft he paperi s t he in tr od uc t i on ; secondsection discussestheoptimumorderofeconomicliberalisation;Sectionthir ddiscussessomecritiquesoverthesequence.Sectionfourthconcludes

2 Sequencingofeconomicrestructuringofarepressedecon omy

Duringtherecenttime,althoughtherearefewothercriticssuchasLitt le,Scott,andM i c h a e l arguefordifferentsequencing,theorderprop osedbyMcKinnon(1982)hasbeengenerallyr e c e i v e d c o n s e n s u

s McKinnon(1982)suggestt h e o p t i m a l orderso f e c o n o m i c liber alisation;thati s , stabilizem a c r oe c o no m i c fi r s t , r e m o v e distorti onsi n domesticgoods,capitalandlabourmarketssecond,liberalizeint ernationaltradethird,andopencapitalaccountatthelaststage

i Macroeconomicstabilizationisnecessaryconditionbeforee

mbarkingone c o n o m i c liberalisation.Macroeconomicstabilisatio nreferstofiscal controlandpricestabilityinwhichfiscalconsolidationi ssuggestedtobetakeninthefirstplace(McKinnon,1982).Itwouldbe difficultforgovernmenttoconductmonetarypoliciesduringthetra nsitionperiodwithoutfiscal consolidationandinflation undercontr olbecauseo f thepotentiallosto f macroeconomiccontrolwhenm o n e

t a r y policiesaredependenttogovernmentbudgetdeficit

notbadpriortothelimitarygovernmentin1977.However,thegovern mentwasnoteffectivei n fi x i n g fi s c a l situationbyr e v a m p i n g t a x systemandm a k e i t s budgetcontinuet o deficitthrougho u t late197 0s.Becauseo f largebudgetdeficit,i t s monetizationo f budgetdeficitr

a m p a n t i n i n fl a t i o n makesinflationshottoo v e r 5 0 0 percent.Thi sleadstothefallininternational competitiveness.Exporters ha dtostruggleine x p o r t i n g withotherprevailingcountriescausingafai linliberalisingtrade.Argentinaeventuallyhadt o reintroducedirectad ministrativecontrol.Stablemacroeconomicenvironmentsuchasfiscal consolidationandlowinflationhavebeenprovedtha t itm u s t beachi evedfirstinordertoprovideaprudentialbaseforotherreforms

Toreducebudgetdeficit,McKinnon(1982)suggestedthatdirectg overnmentspendingshouldshareaverysmallproportionwithGDP.Lo stfromthecentralbankshouldalsobereduced.Sincecentralbankin highlyrepressedeconomyusuallyhastosubsidyforpublicsectorsand households,thelostoccurs.Thislostcontributesconsiderablyt o t h e budgetdeficit.B y phaseo u t o r f o l d i n

off-budgetgovernmentsubsidy,thecentralbankcanavoidpotentiallostfr omsubsidyfordomesticdepositorc r e d i t i n publicsectorsandhouse holdsandhencebeablet o

avoidover-printingm o n e y whichcauseharmfulinflation

Inflationwhichisrelatedtokeepstablepriceisanotherimportantis sueneededtobeundercontrol.Thetaxsystemshouldbestrengthenin gtohelprepressinginflation.Astheeconomyliberalisationisinprogre ss,governmentusuallyhavetoprivatizeandgiveupitsownershipofen terpriseswhicharemeansofproductions.Leavingitsownmeanso f pr oductionm a k e s m u c h t h r e a t o f i n a d e q u a t e r e v e n u e (Yun gandHugh,2013).Itisnecessarytodeveloptaxsystemforretrievingt herevenuelostfromgivingu p thoseenterprises(Cashinet.al.,1998) LetstakeChileasasuccessfulcasewhenitsgovernmentgett h e rightlib eralisationapproach.Besideseliminatingsubsidy,Chile

governmenthadintroducednewtaxsystemimposingvalueaddedta xatauniform r a t e of20percent(McKinnon,1982)whichprovided stablerevenuestothebudget.GDPofChileasaresultincreasedfromn egative13.5percentin1973to

positive3.7perc e n t i n 1 9 7 6 andmaintainedsurplust h r o u g h out

1977-1980(McKinnon,1 9 8 2 ) I n general,ifthetaxsystemisnotgoodenou ghtoensurethegovernmentrevenue,therei s possibilitythatthegove rnmentwillfallinheavydebtsorprintingmoneytofinancebudgetdefic it.Thiscausesinflationanddistortspriceswhichcouldariseanddefeatth epurposeo f reformsincet h e trader e f o r m willbet a k i n g u n d e r t

h e wrongm a r k e t signals

However,thepaceofprivatisationshouldnottoofastsothatitwillnot puttoohighpressureo n t h e fi s c a l system.I n f a c t , privatisations houldbei n parallelwitht h e developmentoftaxsystemtoensureeno ughcollectionofgovernmentrevenue.Someo f industrialandnatur alassetscanremainunderthegovernmentownershipinitiallyandthe nbebroadenedasthetaxsystembecomesadequate

ii.Removingdistortionsindomesticgoods,capital,andfinan cialsectoristhen e x t stepafterstable

macroeconomicenvironmentsuch

asfiscalconsolidationandlowi n fl a t i o n i s achieved.R e m o v i n g distortionmeansderegulatedomesticinterestr a t e , r e m o v e distor tioninpricesandfreeupwagesinlabourmarket

Itisnecessarytore move distortionsinbanking systemssothat b anksfre efrom s e t t i n g “standard”i n t e r est rate.R e l a x i n g

o f interestr a t e s ceilingallowstohavepositiveinterestratesandthu sincreasesfinancial depthaswellasraisesthelevelofsavingsandimp rovest h e qualityo f investment(HallwoodandMacDonald,1 9 9 4 ) E liminationo f c r e d i t andi n t e r e s t r a t e controlsf o l l o w byt h e m a

c r o e c o n o m i c stabilisationhaspotentiallyimportanteffectsonmon etaryandcreditaggregates(GertlerandKiyotaki,2010).Inaddition,b ankingsystemshouldbefreeformreservesrequirementsandofficialg uidanceinsettingstandardi n t e r e s t r a t e aftertight fiscalcontrolsin placesothatgovernmentdoesnothavetorelyoninflationtaxtogener aterevenue(Mckinnon,1982)

However,thepaceofderegulationofbankingsystemsshouldbeinr elationtotheachievementofmacroeconomicstability.Macroecon omicstabilityprovidesprudentialbaseforpricelevelstability.Ifpricel evelstabilityisnotgoodenough,interestratesbecomeunpredictablev olatility.Thismakesunrestricteddomesticborrowingandlendingbyde posittakingbanks.Depositt a k i n g bankshaveincentivet o takeshort

termdepositandlendinthelongtermhencedurationmismatchocc urs.Theu l t i m a t e l y canbethepanicsorcollapseofthebankingsyst em.Makesurethesafetypaymentmechanismexistisessential

Poorregulatoryandsupervisorystructurescontributedsignificantly tothefailureoft h e wholeprocessofliberalisation(VillanuevaandMir akhor,1990).Thepresenceofm o r a l hazardprobleminthefinancial systemofmosthighrepressedeconomiesduest o explicitorimplicitd epositguaranteeschemesormanyformsofgovernmentsupport.Mor alhazardmakesbanksbehaveasrisktakersandsettheinterestrates athigherandriskierlevelsastheywouldbe,andtendtolendaggressiv elythusprovidewrongsignalstothenon-bankingsector

aboutthefuturereturns

Overborrowingandpotentialincreaseofnonperformingloanswilloccu r.Iftheeconomywasnotopenedu p towardstheinternationalcapital markets,thenthedomesticproblemswould beabsorbedlocallyan dnotseveresuffertheeconomy.However,ifthecapitalaccounthasbee nalreadyliberalisedbythattime,overborrowingwouldtakeplacean dresultinseriousproblems(McKinnonandPill, 1997).Adequatesuper visionandregulationis necessary

FinancialcrisisinMexicoin1994-1995istheevidencefortheimportanceofsupervisionandregulation Mexicostartedt o deregulatei t s fi n a n c i a l sectori n t h e 1 9 8 0 s

W i t h i t s privatisationandderegulation,b a n k c r e d i t t o privaten o

n fi n a n c i a l sectorgrewrapidlyfrom10 percentofGDPin1988to over40percentofGDPin1 9 9 4 (Mishkin,1996).Thecurrencydeno minatedliabilitiesofbanksshotform116,4billionPesoin1993toover 213billionin1994(Minskin,1996).Thelendingboomint h e absenceo

fadequatesupervisionandregulationenvironmentmakesnon-bankingfi n a n c i a l i n s t i t u t i o n s expandedt h e i r loanactivitie sandt o o k e x c e s s i v e r i s k s S i n c e Mexicohadhighinflation,a nddebtstructurewasmostlyshorttermdurationwiththesamedueofm aturityanddenominatedinforeigncurrency,

thebankingsystembecamefragileandvulnerablewheninterestrates inUSin1994putupwardpressureo n interestrates

inMexico.Underpegged exchange rate,Mexico‘scentralbankhave toi n c r e a s e interestr a t e s t o k e e p t h e valueo f Peso.Interestr a

t e s increasedleadstoi n c r e a s e i n asymmetricinformationandadv erseselectionproblemi n t h e fi n a n c i a l m a r k e t s Thisinterventi onexhaustsMexico’sinternationalreservesandultimatelythegovern menthadtodevaluePesoin1994.Lendingfellsharplyatthesametim ewitht h e increaseinwithdrawfundsofinvestorsmakesMexicofel linadeeprecessionin

1994.Mexicoc l e a r l y didn o t havemacroeconomicstabilitybeforeo p

e n i n g fi n a n c i a l sectorhencefailstoliberalisetheeconomy

Highlyre press ed e c onom ie s in in it ia l stageofdevelopmentar

em u c h segmenteddomesticlabour,goodsandfinancialmarkets.R egardingtolabourmarket,theurbansegmentedlabourmarketi s rela tivelyorganisedandi n d u s t r i a l labourforcec o e x i s t witha largepri marilyinformalruralworkforce.Thefi n a n c i a l marketsarealsosegm enteda n d m a d e u p o f a n u m b e r o f s u b - m a r k e t s

(Huu-

DungandYeo-Chang2012).Duetothelackoffinancialinstruments availabletooth ermoneymarketsandcapitalmarketandcommercialbanksstillmai ntainafairlyhighexcessreservesratio;t h e volumeoftradeinthefin ancialmarketsislow.Thisiscloselyassociatedwiththelessdevelope dpaymentsystemo f t h e c e n t r a l bank.Ast h e interestr a t e s o f e x

c e s s r e s e r v e s arehigh,commercialbankslackofmotivetoredu cethem.Thishasdrivendownt h e d e m a n d f o r interbankborrowing Thedevelopmento f fi n a n c i a l m a r k e t s t h e r e f o r e dependsont hefurtherreformofthereservesystemandtheefficiencyofthec e n t r a l bankspaymentandfinancialmarketasawhole

iii.Liberalisinginternationaltradeneedst o removequotas,t a

r i ff s andotherdirectadministrativecontrols,andreducetariffs acro sstheboardsinceahighr e p r e s s e d economyisusuallyundermassi vequantitativeprotectedrestrictions.Theseprotectionsareadminist rativecontrolsthrougheitherindirectlyordirectly.Theadministrativ econtrolscanbemanysetsoftariffsorsubsidy.Thesetariffsorsubsidy, however,highlydistortpriceseitherdirectlyorindirectlyrathertha ndo“equivalent”tariffs Thisprovidesmarketthewrongsignals,c ausingtheeconomyawayfromtheoptimalequilibrium.Itisnecess arytoreplacethesequantitativequotaandadministrativecontrolsbya ppropriatetariffs

McKinnon(1982,1991)suggestedthatliberalisationofinternational tradeshouldbeu n d e r t a k e n graduallyandi n parallelwithdecontro lpricesi n t h e domestictradeo f goodsandservices.Theimplicitstructu retariffsshouldbecarefullyapproachbecausei t cancausescollaps eofdomesticmanufacturing.Subsidyforproducers,forexample,i s in ordertoke e p effectivedomesticpricesof primaryinput belowsomec ountrieswhichareprevailingintheworld.Removingitcanmakethed omesticproducerslostt h e targetmarketsandendupwithbankrup tcy.Recently,whenanalysingtheliberalisationprocesso f thef o r m

e r socialisteconomies,McKinnon(1991)suggestedt h a t optimumor derofliberalizingforeigntradeforhighly-protectedeconomiesmay

beginbyconvertingtheirimplicitquotarestrictionintoexplicittariffs suchaspreannouncetheadjustmentorestablishspecialinternational economiczoneforinternationaloperationthenexpandrightstoothe rplaces.ThishadbeensuccessfularchivedsomecountriessuchasChile

’sliberalisation

Chilehasbeena remarkabler e f o r m During5 yearstime,m o s t o f quantitativer e s t r i c t i o n s onforeigntradewereeliminatedandtariff

auniformrateof10percent.Bytheendof

1976theGovernmentsuccessfullyaccomplishedtheunification ofth eexchangerateandeliminateallr e s t r i c t i o n s onpaymentsforcu rrenttransactions.Thereformwaspreannounceandcarriedoutacc ordingtoschedule,whichcontributetothesuccess(McKinnon,1982) However,freeinternationaltradeneedsnotmeansextendingfullfo reignexchangeconvertibilitytocapitalaccounttransactions.Letstron gforeigncurrencytocirculateinparallelwithr e l a t i v e l y w e e k domest icc u r r e n c y m a y causedestabilise.M o r e o v e r , aslongasdomestic banksstillremainrestricted,thereisnopointorevendestructivetoallo wforeignbankstooperatefreelyindomesticmarkets

Aftercurrentaccount

liberalization,openingofcapitalaccountcanbeimplemented.Opening capitalaccountattheearlierstagesofthereformmayresultinlargeinfl owso f f o r e i g n capitalduet o substantialinterestdifferentials.U n d e

r botht h e fi x e d andfloatingexchangeratestheseinflowswillresulti narealappreciationofthedomesticcurrency.Sincefinancialm a r k e

t s adjustfastert h a t goodsm a r k e t s , t h i s r e a l appreciationmay bedestructivefortheeconomy(Edwards1984)

iv.Liberalisationofcapitalaccounti n v o l v e s t h e eliminatio

no f restrictionso n i n fl o w s andoutflowsof foreigndirectinvestm

o f longandshorttermfinancialinstruments

Thisallowsdomesticresidentstoborrowfreelyf r o m o r depositi n inte rnationalm a r k e t s Foreigne x c h a n g e i s freelyconvertibleoncapi talaccount

Liberalisationcapitalaccountwillhelpeconomygainlotsofbenefits Liberalisationcapitalaccountbringsaboutfreedomofchoiceforinvest orsandborrowersinchoosingande x c h a n g e assets.Thediversificati onso f assetsoffert o i n v e s t o r s t h e r i s k diversificationf o r avoidin

gu n e x p e c t e d lost.Them o r e i n t e g r a t e d economyc r e a t e s

m o r e channelsforevasion.Fre eflowofcapitalcanimprovewelf areifthedomesticfi n a n c i a l marketsareefficient,andforeignfund sareusedtosupportthedevelopment

process.Foreigncapitalcanreducethecostofcapitalandhelpmake financial i n t e r m e d i a t i o n moreefficient.Mostempiricalstudiesfo undthatcapitalaccountliberalisationhavepositiveeffectso n domesti cinvestment,andte c h no lo gy (MehranandSeyed,2017).Inaddition, resourceallocationisalsomoreefficientthroughi n c r e a s i n g co mpletionf o r financialresources.I t i s n o pointtorestrictcapitaltransa ctionsinceitcreateslostineffectiveness,incurshighadministrativec ost,distortstheeconomy,andraisescorruptionandrentseekingbehavi our

However,therearesomecriticismsofcapitalliberalisation.Whenli beralisecapitalaccount,theabilitytocarrymonetarypolicyautonomy andexchangeratestabilitywillbereducesimultaneously(Gertlerand Karadi,2011).Macroeconomicmanagementfore x c e s s i v e capitali nflows maybemoredifficultaswell.Excessivecapitalinflows may gobeyondabsorptivecapacityo f t h e bankingsystemc r e a t e i n a p

p r o p r i a t e lendingdecisionslendstofinancial fragility.Overborrow ingsyndromemayalsooccur.H o w e v e r , t h e s e disadvantagesc

a n beavoidedi f capitalaccountliberalisationapproachedinsequenci ng

Itiswidelyacceptedthatcapitalaccountliberalisationshouldbethel aststepinthee c o n o m i c liberalisationprocedure.Becausethesucc essinthetradeandfinancialr e f o r m leadstocapitalinflow,thedomes

appreciationwhichleadstoreduce competitiveness.Howe ve r, the successfulliberalisationoftrader e q u i r e s arealdepreciationinord ertosupportexporters(Edwards,1984).Theappreciationgeneratedb ytheopeningofthecapitalaccountwilltendtoreducetheprofitabi lityi n thetradablegoodssectoratamomentwhenthissectorisgoingt h

r o u g h a costlyreadjustmentprocess.Consequently,capitalandc u r

r e n t accountsshouldnotbeopenedsimultaneously,andthatcapitali nflow shouldbetightlycontrolledduringthetradereformandthenwillb eopenedlast

Therehavebeensomeeconomistssuch

asLittle,Scitovshy,andScotthaveoppositeargumentandthinkthatca pitalaccountshouldbeopenedfirstoratthesametimeast h e currenta ccount.Them a i n argumentwastou s e foreignfundsavailableduetoo peningofcapitalaccounttosmooththeadjustmentprocessandtoprovi deassistancet o industriesthatarenegativelyaffectedbythetraderef orm.Whenthetradebarriersarereduced,domesticrelativepriceswil lbechangedandresourceswillbereallocatedacrossthesectors.Any processofeconomic liberalisationwillrequireacostlyadjustment period(YungandHugh,2013).Toenhancethesuccessoftraderefor m,

thereauthorsarguedthatadjustmentcostssuchasunemploymentass ociatedwithther e d u c t i o n oftariffsshouldbekeptaslowaspossibl e.Toaccomplishthis,theyrecommendedt h a t liberalisationoft r a d

e shouldbeimplementedslowlyandthatassistance,whichisusuallyint heformofforeignfunds,tofinanceasmootheradjustmentbytheimpor

t-competingindustries Thesearguments,however,arenotpersuasi ve.Infact,tradeliberalisationshouldnotbeundertakenbasedonshor

t-termcapitalinflowsoroncreditsfromforeigncountriesorinternationa lagenciesreleasingf r o m capitalaccountliberalisation(McKinnon,1 982).Suchcapitalinflows aresimplyn o t sustainableinthelongrun, andduringtheliberalisationprocesstheywillthrowoutincorrect marketsignals(McKinnon,1982) whichareharmfulfor theecono mic liberalisationprocessasawhole.Moreover,theMcKinnon’sargu mentsforliberalisingcapitalaccountlastarealsostronglystrengthenb ythetheoreticalapproachknownasanoverborrowingsyndrome Acountryfallin“over borro wing syndrome”whe nit unde rtak

es successful“re a l s i d e ” economicreformsandremovesdistort ionsinliberalisinginternationaltrade,itt e n d s toborrowtoomuchfr omfinancial institutionstofinance investmentandthenf a c e s pro blemofrepaymentfortheloans.Themainrootofoverborrowingsyndro mei s moralhazardspreadinginthebankingsector.Thesourcesofm oralhazardinthefinancia l systemthatgeneratethemarketfailure whichleadstooverborrowingarelikelytoi nc lu de the e x p l i c i t or i mpliciti ns ur a n c e , governmentguarantee,andfi xe d exchangera tepolicy.Themoralhazardwillinducethebanks,whichsubjecttobot

hc re di t r i s k andc u r r e n c y r i s k , borrowingunhedgedexcessively

t o financedomesticinvestment.Duringtheeconomicdownturn,whe nthebankborrowersfailtorepayt h e loans,thebankingsectorcans ystematicallygoestobankruptcy.Thenitleadstot h e lostofforeignin vestorsconfidencewhicheventuallyresultsinfinancialcrisis

Intheoverborrowingsyndromemodel,allfinancialflowsareinterm ediatedt h r o u g h domesticbanksbecausebankshavespecialcharac teristics.First,bankshavec e r t a i n informationaladvantageonthel endingside.Second,bankliabilitiesarecentralt o thedomesticpaymen tsystem,avitalcomponentofamoderneconomy,whichmaket h e m e

n j o y explicito r implicitgovernmentguarantee(McKinnon,1998).A c

r e d i t c h a n n e l frombanklendingtorealactivity,therefore,isim portantfortheliberalisinge c o n o m y

ICUEH2017

C 2 X 2

α' g(.)

U e

α g(.)

f(.)

C 1 X 1

However,i n assessinginvestmentr i s k s i n t h e reforminge c o n

o m y , banksm a y sufferfrommoralhazardbyignoringtheprobabilit yofthebadoutcometooccurthatleadst h e m t o behavet o o optimisti callyr e g a r d i n g t h e p a y

-o ff f r -o m n e w investment(McKinn-on1999) Whenec-on-omy islib eraliseddomestically(seeFigure1)

thenon-b a k i n g sectorstartstothenon-borrowfromdomesticcapitalmarkets.Som efirmsinvestintonew technologysomeintooldtechnologyandputsa vingsintobanks

Figure1:Rational–BeliefsEquilibriumintheDLE

Source:McKinnon andPill (1997)

AssumingthatinvestmentreturnsinPeriod2areknownwithcert aintythanthem a r k e t worksefficiently.Theproblemoccurswhen banks

exploitmoralhazard,whiche x i s t s indomesticcapitalmarketdueto theimplicitandexplicitgovernmentguaranteeo f bankdeposits.W h e

n prudentialsupervisionisinsufficient,banksstarttolendaggressively andsendawrongsignalstothenonbanksectoraboutfuturesoninvest

Wheninvestmentturnsouttoyieldlesst h a n anticipated,borrowersc annotrepayt h e loansandultimatelyendu p withbankruptcies.Beca usetheeconomyisnotopenedto

theinternationalmarketsyet,thisproblemc a n besolvedw i t h n o t too

m u c h c o s t Althoughfirmsandhouseholdsseet h e i r futureincomet obehigh,thesharpincreaseinthedomesticinterestrate