Impact of financial liberalization on private savings rate a panel data analysis

Beginning with McKinnon 1973 and Shaw 1973 theory, they suggest that financial liberalization will break the government intervention on interest rates, pulling interest rate up to the na

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM – NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

IMPACT OF FINANCIAL LIBERALIZATION ON

PRIVATE SAVINGS RATE:

A PANEL DATA ANALYSIS

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

BY

Mr LE THANH THANH

Academic Supervisor:

Dr NGUYEN HOANG BAO

Ho Chi Minh City, April 2016

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM – NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

IMPACT OF FINANCIAL LIBERALIZATION ON

PRIVATE SAVINGS RATE:

A PANEL DATA ANALYSIS

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

BY

Mr LE THANH THANH

Academic Supervisor:

Dr NGUYEN HOANG BAO

Ho Chi Minh City, April 2016

ABSTRACT

This paper investigates the impact of financial liberalization on private savings rate The study covers the data of 58 countries from 1980 to 2005 The Abiad et al (2008) database was used to measure the financial liberalization indices Three-Stage Least Squares (3SLS) was chosen as the main estimator of this study The finding results show that financial liberalization has both direct and indirect effect on private savings rate The direct effect, through state ownership in the banking sector, credit controls and excessively high reserve requirements, entry barriers, prudential regulations and supervision of the banking sector, capital account restrictions, interest rate controls, reduces private savings rate while indirect effect, through entry barriers and capital account restrictions, are increasing Besides that, the findings also show an ambiguous correlation between economic growth and the private saving rate However, using de jure indicators to measure financial liberalization makes the study can only identify the existence and direction of the impact of financial liberalization on the private savings rate The intensity of this impact can not yet be measured In addition, the observed data only updated to 2005 and not focus

on any special group of countries So, it is not appropriate to recommend a particular policy based on the results of this study

Keywords: financial liberalization, private savings, panel data

ACKNOWLEDGEMENT

Foremost, I would like to sincerely and gratefully thank Dr Nguyen Hoang Bao,

my supervisor, for his great support, crucial advice, and precious during my thesis finish Without his guidance, I am unable to finish this thesis

Besides, I special thanks to the Vietnam – Netherlands Programme, especially professors and staffs for their help during my thesis process

I would like to thank all my friends who always beside me to encourage, help me when I got stuck in doing the thesis and want to give up Without them, I cannot finish this thesis

Last but not least, I would like to thank my family for their sacrifices for supporting

me not only in doing thesis but also in my life

CONTENTS

ACKNOWLEDGEMENT 5

CONTENTS 6

LIST OF TABLES 8

LIST OF FIGURES 9

CHAPTER ONE: INTRODUCTION 10

1.1 Problem statement 10

1.2 Research objectives and research questions 12

1.3 The structure of research 13

CHAPTER TWO: LITERATURE REVIEW 14

2.1 Theoretical literature 14

2.1.1 Private savings 14

2.1.1.1 Definition 14

2.1.1.2 Theoretical models of saving function 15

 Keynesian savings function 16

 Life cycle theory 18

 The Mckinnon - Shaw Hypothesis 20

2.1.2 Financial liberalization 24

2.1.2.1 Definition 24

2.1.2.2 Financial liberalization indices 27

2.1.2.3 Process of financial liberalization 28

2.1.2.4 Criticism of financial liberalization 31

2.1.3 Economic growth 32

2.1.3.1 Definition 32

2.1.3.2 Theoretical models of economic growth 33

 Classical growth theory 33

 Dual-sector model 33

 Keynesian growth theory 34

 Harrod–Domar model 35

 Solow model 35

 P.A Samuelson theory 36

2.1.4 The relationship between private savings, economic growth and financial liberalization 37

43

2.2.1 General saving function 43

2.2.2 Financial liberalization and private saving rate 45

CHAPTER THREE: RESEARCH METHODOLOGY 47

3.1 Model descriptions 47

3.1.1 Model specification 47

3.1.2 Method specification 52

3.2 Variable measurements 55

3.2.1 Measurement of private savings rate 55

3.2.2 Measurement of financial liberalization 56

3.3 Summarize of variables description and data sources 59

CHAPTER FOUR: RESULTS 62

4.1 Description statistics 62

4.2 Estimation results 71

CHAPTER FIVE: CONCLUSIONS 76

5.1 Major findings and policy implication 76

5.2 Limitations 77

REFERENCES 79

APPENDIX 89

A Financial liberalization measures 89

B Coding rule of Abiad et al financial liberalization indices 95

C List of countries 102

D Detailed econometrics estimating and testing results 103

LIST OF TABLES

Table 2.1 Determinants of the Ratio of Private Saving to Income in Panel Studies 43

Table 3.1 Description and expected sign of variables 52

Table 3.2 The direction of combined effect 54

Table 3.3 Summary Statistics for Financial Liberalization Components and Index (Abiad et al, 2008) 58

Table 3.4 Variable description and data source 59

Table 4.1: Descriptive statistics 62

Table 4.2: Correlations among financial liberalization indices 63

Table 4.3 The effect of seven financial liberalization indicators on private savings rate 70

LIST OF FIGURES

Figure 2.1: Life cycle theory 18

Figure 2.2: The effect of interest ceiling rate on saving and investment 21

Figure 2.3: The Mckinnon and Show hypothesis 22

Figure 2.4: Financial liberalization process 29

Figure 3.1: The interaction between Financial liberalization, Private savings and Economic growth 47

Figure 4.1 The average private saving rate, economic growth and financial liberalization (1980 - 2005) 64

Figure 4.2 Private saving rate (PSR), GNDI per capita growth rate (GY) and Financial liberalization indices (1980 - 2005) 66

Figure 4.3: Scatter plot between Private saving rate (PSR) and Financial liberalization indices (1980 - 2005) 68

CHAPTER ONE: INTRODUCTION

1.1 Problem statement

From the mid-1980s, many developing countries undertook to liberalize its financial markets This process is considered to be one of the important factors in promoting national economic development as well as promoting economic integration in the world economy Studying about the impact of financial liberalization on the country’s economy, therefore,

is a very interesting topic

Although there have been many studies on this subject, however, there are a lot of issues have not yet been settle and must be discussed further One of them is the impact of financial liberalization on savings Beginning with McKinnon (1973) and Shaw (1973) theory, they suggest that financial liberalization will break the government intervention on interest rates, pulling interest rate up to the natural equilibrium of the market, thus increasing the savings rate Many subsequent studies have tried to find a deeper understanding as well as testing this hypothesis (Giovannini, 1985; Campbell and Mankiw, 1990; Ostry and Reinhart, 1992; Koskela, Loikkanen and Viren, 1992; Bayoumi, 1993; Jappelli and Pagano, 1994; Ogaki, Ostry and Reinhart, 1996; Bandiera et al, 1999; Loayza

et al, 2000; Chowdhury, 2001; Hebbel and Serven, 2002; Reinhart and Tokatlidis, 2003; Baliamoune and Chowdhury, 2003; Nair, 2006; Ahmed and Islam, 2010; Ang and Sen, 2011) However, the results are still ambiguous Some studies show the positive impact of financial liberalization on savings (Bandiera et al, 1999; Baliamoune and Chowdhury, 2003; Ahmed and Islam, 2010), while others indicate that financial liberalization is the cause that reduce savings rate (Koskela, Loikkanen and Viren, 1992; Jappelli and Pagano, 1994; Loayza et al, 2000; Ang và Nair, 2006; Sen, 2009; Ang, 2011) Besides, there are other studies resulting an unclear relationship between these two factors (Bayoumi, 1993; Hebbel and Serven, 2002; Reinhart and Tokatlidis, 2003)

One of the limitations of previous studies is the difficulty to measure accurately

First, many studies measure financial liberalization very rudimentary They used a dummy variable with value 0 and 1 to measure financial liberalization (Harris, et al., 1994; Haramillo, et al., 1996; Hermes and Lensink, 1998; and Bekaert, et al., 2005).With 0 for year financial repression and 1 from the year starting financial liberalization In fact, it is clearly that financial liberalization is a process, not simply as an event The financial markets have gone through many stages to reach a certain degree of liberalization, it can not be changed in a short time

Second, some studies focus only on one or several aspects of financial liberalization

as opening up banking and stock Domestic Markets to Foreigners (Levine, 2001), capital account liberalization (Eichengreen and Leblang, 2003) and stock market liberalization (Bekaert, et al., 2005) Financial liberalization, in fact, is a process that includes a lot of stages and different aspects The review merely on one or a few aspects can not bring the expected results

Another thing should also mention when referring to aspects of financial liberalization is: most previous studies have focused on building a general index reflecting the financial liberalization of the country The general index is constructed primarily by summing the possible aspects of financial liberalization can be measured Principal component analysis (PCA) is a method often used This inadvertently leads to two following consequences:

- This index may consist of two parts: policies have an effect on private saving and policies have not (or insignificant) effect The combined all of those effects could not provide a specific and detailed view of the impact of financial liberalization

General financial liberalization index

Factors have significant effect

Factors have insignificant effect

- The factors that affect private savings may include two smaller groups One group has a positive impact when the other has a negative impact The combination of all these factors that could make them eliminate or weaken each other, leading to undesirable results in the research process

The last issue is the surprisingly lacking cross countries analysis Most previous studies have only focused on one country or a small group country On average, the study

of each country or each group of countries often give a different result The research on a broad perspective with a larger data sets will bring more general accurate judgments on this issue

This study uses a new data set in which financial liberalization is divided into multiple fragments in order to approach and examine the impact of financial liberalization

on saving more specific and detailed Besides, as mentioned above, the limited studies within the country or a small group of neighboring countries often lead to different results This study uses large data sets with more than 50 countries in many regions around the world which differ the level of socio-economic development in hopes of eliminating or limiting the effects of the exogenous variation distort the impact of financial liberalization

on private savings, and shows the pure and raw effects of the relationship between these two factors

1.2 Research objectives and research questions

To resolve the problem the first two issues, this study use Abiat et al (2008) data set

to measure financial liberalization This database divides financial liberalization into seven

General financial

liberalizaation index

Factors have significant effect

Positive effect

Negative effectFactors have

insignificant effect

small indices represents for seven different aspects, including interest rate controls, credit

controls and reserve requirements, state ownership, entry barriers, policies on securities

markets, restrictions on the capital account, and banking regulations This study expects to

find more specific results about the impact of financial liberalization on private savings

rate

To resolve the third issue, this study used a large data set for 58 countries around

the world in hopes of providing a most general theoretical view about that relationship

With those main purposes, this study will answer two following questions:

- Does financial liberalization effect on private saving rate?

- How does each channel of financial liberalization, including interest rate controls,

credit controls and reserve requirements, state ownership, entry barriers, policies on

securities markets, restrictions on the capital account, and banking regulations,

effect on private saving rate?

1.3 The structure of research

This study is organized into five sections Chapter one presents an overview of the

main objectives of this study Chapter two overviews of theoretical background as well as

present and comment on the previous empirical studies The analytical framework of the

study is also presented in this chapter Measurement and analysis of the data analysis are

discussed in chapter three Chapter four covers research methodology, empirical model and

the results of the regression model The final chapter, chapter five summarizes the research

results that have been achieved, some limitations in the study and ideas for further research

CHAPTER TWO: LITERATURE REVIEW

The theoretical literature section introduces a general overview about private savings, financial liberalization, and economic growth The definition, theoretical models, criticism as well as the relationship between them are mentioned This section aim to point out the analytical framework of this study Afterward, the empirical literature section synthesizes numerous studies on general savings function and the relationship between financial liberalization and private savings rate

2.1 Theoretical literature

2.1.1 Private savings

2.1.1.1 Definition

Savings, in general, is considered as a part of the income that is not used or the rest

of income after consuming Along with the globalization of the economy, saving is defined into two different types: domestic savings and national savings

Domestic savings are the savings from the internal economy, is composed of two parts public savings (savings from governments sector) and private savings

In a closed economy, total national income Y is divided into three parts: consumption (C), investment (I) and the shopping area of government (G):

With an open economy, the identity (2.1) is rewritten as follows:

2.1.1.2 Theoretical models of saving function

In Dictionnaire d'analyse économique (3rd edition, 2002), Bernard Guerrien has commented that the classical economists and Marx consider saving as a behavior of rich persons, it is almost merged to the surplus that social generated and accumulating for the purpose of expanding production

For the Neo-classical economics, saving primarily the result of an individual It comes from the choice between current consumption and future consumption The Neo-classical economics said that the future is known with certainty (or with the risks have a clearly limit) This makes each individual can make intertemporal choices most accurate Saving behavior, therefore, depends entirely on the interests and decisions of each individual (life-cycle hypothesis), besides that, it also depends on the interest rate (the model of financial liberalization by Mc Kinnon and Shaw, 1973)

However, Keynes argue that the future is uncertain, do not have any model or equation can help people to make intertemporal choices correctly He considered saving as

a remainder, the rest after consuming Thus saving is the result of a behavior that is described through consumption function

In this section, the study will review saving models mentioned above (life-cycle hypothesis, the model of financial liberalization by Mc Kinnon and Shaw, and the saving function of Keynes)

 Keynesian savings function

John Maynard Keynes, in his famous work - The General Theory of Employment, Interest, and Money, mentioned consumption with some following ideas:

First, he said the basic psychological law of the consumer is that when incomes rise, consumers will decide to increase consumption but with a less increasing level than income growth Marginal propensity to consume (MPC): 0 < MPC < 1

𝑀𝑃𝐶 = ∆𝐶

∆𝑌𝑑Second, average propensity to consume (APC) tends to decrease as income increases

𝐴𝑃𝐶 = 𝐶

𝑌𝑑

Third, disposable income is the most important factor in deciding consumer behavior and household savings As disposable income increases, the consumption and saving of households increases and vice versa

From there he gave a consumption function as follow:

C = Co + MPC.Yd

In which Co is autonomous consumption (Co > 0), the minimum consumption, does not depend on disposable income Although income is zero, a household must spend a minimum amount of Co for their basic needs MPC is marginal propensity to consume, showing the change of consumption as incomes changes one unit

Disposable income Yd is used for two main purposes: consumption (C) and saving (S), therefore, Keynesian saving function is derived from consumption function:

If C = Yd => S = 0: household do not save nor borrow

If C > Yd => S < 0: household is spending more than their income

The two key parameters that characterize the saving function are slope and intercept The slope is MPS (Marginal Propensity to Save), reflecting the change of savings when Yd change one unit

𝑀𝑃𝑆 = ∆𝑆

∆𝑌𝑑MPS is assumed to be greater than zero but less than 1 (0 < MPS < 1)

Intercept So is autonomous saving, measuring the amount of saving undertaken if income is zero

Keynesian models still have some certain restrictions, especially in Keynes’s conjecture about APC But this is also the driving force for economists to continue further research on consumption and saving behavior I.Fisher (1930) realized that consumption and saving of households not only depend on current income but also depend on the income

expected in the future Then this idea continues to be studied and clarified, especially in the life-cycle theory of Franco Modigliani income the permanent income hypothesis of Milton Friedman

 Life cycle theory

In the early 1950s, Franco Modigliani and his student, Richard Brumberg, developed a theory to analyze the behavior of the individual consumption, this theory is called the life-cycle theory Life-cycle theory determination an important role of the rate

of the population outside working age and income per capita in saving functions cycle theory was built on the micro perspective, with two basic assumptions:

Life The income of each individual will be low in the beginning and end of the lifecycle (stages not within the working age)

- Each individual has the desire to maintain a stable level of consumption throughout their lifecycle

Figure 2.1: Life cycle theory

Assume that there is a consumer who expects that he will live for T years and has wealth W He will work for R year and earning income Y each year In this case, the

Lifetime

lifetime resources of consumer includes both original resources endowment, W, and lifetime earnings, RY (the interest rate is assumed to be zero)

To to maintain a stable level of consumption, he distributes his lifetime resources for T years The consumption for each year in his lifetime, therefor, equal to:

His consumption function can be written as

Thus, the income each year Y throughout in R years is not used all for consumption The income spend for consumption in each of Y year is 𝑅

in working age increased more slowly than in the age group of adolescents Conversely, if the population grew slowly (older population structure), savings will increase due to the population outside the working age increase more slowly than the population in working age Although the population of retirement age has increased but the decreasing savings rate in this region is not much because of demand of consumption tends to decrease with reducing income and the entering to final stages of the life-cycle

In addition, other factors that affect directly or indirectly to the increased income (economic growth, labor productivity growth) will be affected increase savings

Saving function, in this case, can be modeled as follows:

S = f(D, Y, G,…)

Where:

S: saving rate/GDP

D: population outside the working age rate

Y: per capita income

G: economic growth rate

However, the weakness of this theory is assuming no bequest, no social security, and no uncertainty Many economists found out a problem in the life-cycle model: old people do not dissave as quickly as has been assumed in the model There are two explanations for this fact:

First, there is an uncertainty in the future, therefore, retired individuals are usually cautious about unpredictable expenses The additional savings arising from this behavior called precautionary savings Precautionary savings may stem from living longer than expected of an individual and, therefore, need to provide an extra living expenses for that extra period of time In addition, the cost for health care in old age are often quite large This makes the elderly saving more

The second explanation is that the elderly may save more for their children This will reduce the saving rate

 The Mckinnon - Shaw Hypothesis

In another aspect, McKinnon and Shaw (1973) studied the savings under the impact

of financial liberalization, specifically the interest rate The basic content of this theory said that deposit rates have a positive impact on savings Financial liberalization will remove constraints on interest rate cap, push up interest rates, thereby increasing savings

With the aim of promoting economic and create jobs, governments often intervene

in financial markets by keeping interest rate low However, Kinnon and Shaw criticized this action They said that low-interest rate is the cause of poor saving situation Investment,

therefore, is restricted and low investment efficiency Kinnon and Shaw suggest that financial liberalization will push interest rate up to the equilibrium level of the free market

in order to remedy that situation

Three basic assumptions that Kinnon and Shaw given in their model are:

- All the savings in the economy have been concentrated on the banking system in the form of savings deposit

- The supply for the entire capital investment demand in the market come fully from savings deposit

- Saving and investing are purely a function of interest rate Saving is a positive function of interest rate while investment is a negative function

Figure 2.2: The effect of interest ceiling rate on saving and investment

The level of savings S0 corresponding economic growth g0 is a function of the real interest rate In a certain economic growth rate, the higher real interest rates the higher savings FF line represents financial repression policy Nominal interest ceiling rate applicable and makes real interest rate is limited below the equilibrium level The amount

of actual investment is equal to the amount of savings I0 in real interest rates r0 Controlling interest rate makes the amount of investment I0 clearly lower than the balance at the point

E Besides the impact of reducing investment, interest ceilings rate reduces the efficiency

of investment because of the projects have lower returns now can be made

In short, according to Kinnon and Shaw, financial liberalization will create the following sequential processes:

- Increase in real interest rates increases real savings in the economy

- Increase in real savings will increase real investment

- Increase in real interest rates increases investment efficiency

The result will be improved economic growth

Figure 2.3: The Mckinnon and Show hypothesis

In figure 2.3, suppose that the interest rate ceiling is increased from FF to FF' Real deposit rates are now limited to r1 and make investments increased The increase in interest

rates at the same time make the project has a low rate of return can not be done The average rate of return (or effectiveness) of loan projects thus increased These effects make the economic growth rate increased from g0 to g1 Saving curve shift to the right from S0(corresponding to the economic growth g0) to S1 (corresponding to the economic growth

g1) Investments increased to I1

If financial liberalization is strongly promoted with the completely removing controls on interest rates, savings, investment and economic growth has been promoted Saving curve moves to position S2 corresponding to economic growth rate g2 Equilibrium now is E2 The real interest rate is r2 and the amount of investment is I2

According to this model, the real interest rate (the rate of return as that savers are entitled) is the key to increased investment Moreover, the impact of the increase in volume and efficiency of investment interaction with each other and jointly promote economic growth

In turn, economic growth will stimulate saving in any public interest rate, and a new cycle of influence begin Kinnon and Shaw’s ideas have shown that financial liberalization, the specifically rising real interest rate will affect saving through both two channels: direct channel and indirect channel Direct effects: rising real interest rate directly impact on the income of savers, the increasing in returns will encourage saving behavior Indirect effects: increasing interest rate would improve the investment, leading to economic growth, people have more asset will save more Kinnon and Shaw's model took real interest rate as the focus However, besides that, this model also took into account the effects of economic growth, savings of the previous year as well as the factors that directly influence the growth The savings of the previous year appear in this model because it represents for wealth (or previous nonconsumption) which supposedly affect the current consumer behavior through economic growth and wealth effect Saving function in the model of financial liberalization of Kinnon and Shaw can be written as follows:

S = f(G, Y, R, S(-1), )

Where:

S: saving rate/GDP

G: economic growth rate

Y: income per capita

R: real interest rate

S(-1): saving rate /GDP previous year

The biggest criticisms against Mckinnon and Shaw’s financial liberalization theory

is that they did not take into account the effects of market failure

One important function of financial markets is to collect, process and convey information about the mobilization of savings, allocate capital and monitor the use of capital If it costs a lot of resources to get the information, then the market may fail So, building this theory base on the idea of the perfect market is not realistic

The real interest rate increases by financial liberalization can bring unwanted effects

of adverse selection and moral hazard First, when the interest rate increase, there is a greater proportion of reckless investors apply for credit, but the prudent borrower will be forced to leave the market as the expected profit on a loan contract of the prudent investor might not be high enough to pay the loan interest rates(adverse selection) Second, the borrower usually motivated to find ways to change the nature of their project to make it become more risk (moral hazard)

2.1.2 Financial liberalization

2.1.2.1 Definition

At first, financial liberalization focuses on easing or elimination of government control on the interest rate Liberalizing interest rate is set at the center of financial liberalization (Kinnon and Shaw, 1973)

However, at present, financial liberalization is not an end in the reduction of government intervention on interest rates anymore Terminology “financial liberalization”

is now much broader definition

Basically, financial liberalization is easing restrictions on capital account (mainly capital flows) and the financial transactions of individuals and businesses to promote an easier implementation of these transactions, thereby making the allocation of financial resources more effectively Kaminsky and Schmukler (2003), Arestis and Caner (2004) define financial liberalization as the elimination of controls on three components: the capital account, the domestic financial sector, and the stock market

On the other hand, financial liberalization is also determined by the reduction or elimination of specific indicators of financial repression It can also be seen as a process of policy reform through which a country setting themselves an openness and more freely financial markets in a suitable legal framework The market forces will determine their decisions themselves, without (or with a very little) intervention from the state (Williamson and Mahar, 1998) Williamson and Mahar (1998) argues that financial liberalization has six factors: interest rates deregulation, free participation in the banking sector, private ownership of banks, bank autonomy, the removal of credit controls and liberalization of international capital flows

Baliamoune and Chowdhury (2003) suggest that financial liberalization including the removal of controls on credit and interest rates, easier to participate in financial services market, capital market development, strengthening prudential regulation and supervision, and the international capital markets liberalization

Abiad et al (2008) supposed that financial liberalization has seven main sectors, including interest rate controls, credit controls and excessively high reserve requirements, the elimination of entry barriers, privatization of state-owned banks, securities market policies, prudential regulations and bank supervision, and capital account restrictions

An important issue when referring to the financial liberalization is that whether it is necessary to distinguish clearly between financial liberalization and financial development

or not

At the beginning, the economists talk about financial liberalization such as the reduction of state intervention in the domestic economy But with the development of the world economy and the process of globalization, the concept of financial liberalization is increasingly expanding It is difficult to give an accurate general concept of financial liberalization Nowaday, the concept of financial liberalization are not confined to the national framework but extends further into the international financial integration While financial development is generally defined as a process to improve the quantity, quality, and efficiency of financial markets Both financial liberalization and financial development have certain impacts to economic growth However, the clear distinction these two definitions are quite difficult In terms of nature, financial liberalization often refers to the government as a barrier hindering financial market development Purest idea of financial liberalization is directed to a financial market as free as possible, the regulatory role of the government as little as possible, the invisible hand is enough to drive the operation of markets In the concept of financial development, the role of the state seems to be more emphasis The state is one of the components has the most significant role in the development of the financial markets of a country In addition, financial liberalization often leads to financial development, and vice versa, financial development often requires financial liberalization accompanied The ambiguity between these two concepts makes studying sometimes unclear, especially in developing appropriate measurable indicators as well as the exact role of each process in the process of economic development Financial development often vast and broader financial liberalization, however, financial liberalization has the certain specific characteristic

In this study, financial liberalization is considered in a broad sense, mainly based

on the opinion of Abiad et al (2008)

2.1.2.2 Financial liberalization indices

Economists have learned a lot of different ways to measure financial liberalization

So far, there are two most commonly groups represent two ways of measuring financial liberalization are de jure and de facto

De facto often use the volume of real financial and investment flows between a domestic financial market and the rest of the world to represent financial liberalization Some indicators are commonly used in this group may be mentioned as stock, flow ratios

of assets, liabilities, FDI, portfolio investments in percentage to GDP (Gehringer, 2014) This group index shows the actual flow of financial capital across countries However, it

is not dependent on the financial laws or regulations

Besides the indicators mentioned above, the economists also use other indicators as

a proxy variable for financial liberalization Two prominent indices are broad monetary aggregates (M2 or M3) measured in percentage of GDP and bank credit to the private sector (as a proportion of GDP) It seems there is an analogy between financial liberalization and financial development Indicators like these are often used to measure the size and depth

of financial markets The objective of financial liberalization is financial development But use common indicators that measure financial development to measure financial liberalization seems unreasonable Back to the definition of financial liberalization has been discussed in the previous section of this study, financial liberalization is the elimination or reducing government intervention on financial markets, besides, building an efficient legal system framework for market operations Therefore, financial liberalization should be considered under the term of policy and laws more than the real financial statistics indicators Another argument about the limitations of these indicators is these indices may sometimes increase while financial markets tend to be repressed or controlled more closely In other words, financial liberalization is not always the only one cause leading to financial development

De jure measure financial liberalization in a different way This group index is often based on policy, regulatory and financial law to evaluate the level of financial liberalization

of the country De jure covers various aspects of the financial markets It often focuses on the changes in the regulations of the government on interest rates, directed credit, reserve requirements, reducing state ownership in banking sector, the securities markets liberalization, prudential regulation, and international financial liberalization For each component, the researchers will collect relevant policies and regulations, assigning the score depend on their financial liberalization scale level Component analysis (PCA) is often chosen to synthesize the components on into an overall index measuring the degree

of financial liberalization of the country This measure is often encountered difficulties in collecting data on policies and regulations Many economists have built up many de jure indices of financial liberalization, Greenidge and Milner (2007) has listed over 10 different indices (See Appendix) Therefore, studies using this measure is often limited research in one or a small group of countries However, the advantage of this method is that it considered the financial markets of countries in many different aspects and overcome the limitations of de facto indicators mentioned above

2.1.2.3 Process of financial liberalization

Eliminating or reducing government intervention on financial markets as well, but complete suddenly eliminate all of it is not recommended, even that can lead to serious consequences McKinnon (1982) argues that financial liberalization must be conducted step by step

However, there is not any generic process that can be applied to all economies Depending on the economic situation, economic characteristics, as well as the objectives, set out, each nation often building a concrete roadmap for the liberalization of their country Sequence of financial liberalization that some economists concur are as follow:

Figure 2.4: Financial liberalization process (Source: Author’s adaptation from various sources)

Reducing the budget deficit is the first necessary step Financial repression was launched to raise funds for the government in order to provide capital for development projects or offset the budget deficit Financial liberalization via the elimination of controls

on interest rates and lowering the required reserve rate has removed a tool of government

to offset the budget deficit If the government can not afford to borrow in the domestic market and do not want to increase tax rate, the capital account must be eased to use foreign savings to offset budget deficits

The elimination of controls on interest rates and then increase in domestic interest rates are factors that attract foreign capital inflows into the domestic capital market Real exchange rates will be pushed up In fact, the exchange rate may appreciate excessively then decrease due to the diminishing over time of capital inflows as the amount of foreign debt approached the level that the domestic economy requires

Instability in macroeconomic arise Initially, profits in non-foreign trade region increase lead to an increasing investment in this area, especially in real estate investment Land prices increase and inflation occurs The appreciation of the real exchange rate depresses export sector The deficit of current account increase, and is offset by the amount

of foreign capital flowing When the exchange rate is too high and unsustainable, withdrawal situation will occur Finally, the exchange rate will be forced to devalue, profits

in the non-foreign trade region drop and created a further round of economic adjustment

To escape this situation, the current account deficit must be reduced and foreign debt should stabilize But if the government budget remained in deficit and unable to borrow more from abroad any more, financial repression is re-used

Thus, if budget deficit is not reduced, financial liberalization will lead to instability and ultimately will be reversed

Financial liberalization could boost economic growth by increasing the volume and efficiency of investment capital However, the increasing capital must be allocated appropriately Therefore, trade reforms must be carried out in parallel to minimize the distortions in prices due to trade barriers caused

Reasons for trade reform must be done before the relaxation of exchange controls and capital account reforms are capital account liberalization often leads to capital inflows, and dramatically increase the exchange rate This creates price signals that conflict with trade reforms: exchange rate appreciation undermine the export sector while trade reform

is to strengthen this area

Managing the exchange rate is very important during liberalization Choosing the exchange rate mechanism (floating, fixed, pulsation changes) depending on the economic situation as well as concrete steps are carried out in the reform process

2.1.2.4 Criticism of financial liberalization

Since it was formed in the 1970s, financial liberalization has received quite a lot of criticism from different economic schools Until today, there are at least five critics of financial liberalization, especially in the relationship with economic growth

The first argues that the savings are not necessarily dependent on the interest rate or even increasing rate can be the cause of reduced saving Bandiera et al (1999), Warman and Thirlwall (1994), Cho and Khatkhate (1989), Arrieta (1988) and Giovannini (1983) have argued that raising interest rates will lead to several adverse effects on savings rate

If interest rate increase, holding cash and/or spend become less attractive, people tend to save more This is the substitution effect – with higher interest rates, consumers substitute spending for savings However, the saver can reduce their saving but still maintain the income from saving (income effect) In addition, they can receive more income from their saving payments and feeling that they become richer (wealth effect) These will encourage more spending When these two effects (income effect and wealth effect) crowding out substitution effect, an increasing in interest rate cause decline in the savings rate Gupta (1984) and Mahambare and Balasubramanyam (2000) suggest that raising interest rates will only change the distribution of the available savings resources rather than increase the total volume of savings

The second debate stems from the opinion of the economists of neo-structuralist school Their ideas focused on the existence of the informal financial market They said that when interest rates rise, the capital will move from informal market to formal market, however, this time, banks face barriers of required reserves, thus available lending funds will be reduced (Gibson and Tsakalotos 1994; Fry 1997)

The third argument comes from the difference between the impact of interest rates

to economic growth between Keynesian and Mckinnon and Show's theory Keynesian school claim that raising interest rates will reduce investment thereby reducing economic growth while relying on the idea of financial liberalization, raising interest rates would increase savings, and thereby increase the investment in the future (Khatkhate 1988, 1972)

The fourth argument comes from the criticism of Stiglitz and Weiss Stiglitz and Weiss (1981) and Stiglitz (1994) suggest that financial liberalization in reality often encounter the failures of the market The increasing in deposit interest rate leads to an increase in lending rates The increase in lending rates pushed prudent investor out of the market, only investments with high-risk are enough profitable to pay the cost of borrowing This fact will make the banks face higher risks in granting credit, thus providing credits will be rein back

The fifth argument suggests that the theory of financial liberalization of McKinnon and Shaw focuses on banks as an only financial intermediaries and credit distributor channel on the market Levine and Zervos (1998) said that stock market is also playing a role very important in mobilizing and allocating financial resources Well-developed securities markets can bring another capital supply channels contribution to promoting investment

- “Gross national product (GNP): The total income of all residents of a nation, including the income from factors of production used abroad; the total expenditure

on the nation’s output of goods and services” (Mankiw, 7th, 678)

- GDP per capita is gross domestic product divided by midyear population

- Per Capita Income is Gross National Income (GNI) divided by total population

Economic growth is the increase of the size of an economy In other words, it is the increase of GDP, GNP or per capita income in a given period These indicators are also indices that commonly used to measure economic growth

Economic growth is the topic of economics has always been interested in researching To explain the origins of economic growth, the economists have used a lot of theories and different economic models These will be discussed in the next section

2.1.3.2 Theoretical models of economic growth

 Classical growth theory

Conceived by Adam Smith and Ricardo, this model has some following basic contents:

Fundamentals of economic growth are land, labor and capital Among them, land is the most important factor But land is limited, thus to produce more, the producer must produce on less fertile land Landowner profits declining lead to an increase in cost and price of food, nominal wage increases and profitability of industrial capitalists decrease But profit is the accumulation to expand investment and economic growth So, the limitation of agricultural land lead to a reduction in the profitability of both agricultural production and industrial and affect economic growth

However the actually increasing economic growth rate suggests the unsuitable of this model, it can not explain the source of growth

 Dual-sector model

In this model, economic growth is based on the growth in the two sectors: agriculture and industry The key factors of this model are the labour transition between the capitalist sector and the subsistence sector The capitalist sector is the sector which uses reproducible capital and pays capitalists thereof while the subsistence sector is the sector which is not using reproducible capital

The model assumes that the surplus labor in agriculture will be attracted and transferred to the industrial sector, where wages are higher The economy moved from a traditional to an industrialized will operate better and have more capital accumulation Thus promoting economic growth more effectively

This model also concluded that, where there is surplus labor and the possibility of increasing food production are limited, population growth could be a disaster However, most of the economies does not have surplus labor, therefore, the industrial development occurs along with a decline in agricultural production, and population growth does not necessarily have a negative impact on economic growth

Typical representatives of dual-sector models are the Lewis model and Harry T Oshima

 Keynesian growth theory

In the 30s of the 20th century, the economic crisis and unemployment were quite serious The world economic crisis 1929-1933 proved that the "invisible hand" or “self-regulation" theory of classical and neoclassical economics lacks accuracy This situation forced economists to come up with new theories to adapt to the new situation In this context, the theory of economic regulation of J.M Keynes was born

This is considered as a major breakthrough in the history of economics It is also a prerequisite for the development of modern economic growth theory

According to Keynes, the economy can reach and maintain the balance in a certain production level, which is normally well below the potential output with a certain level of unemployment Keynes's theory asserts that: demand (investment and consumption), not supply, is an important factor deciding the output, therefore deciding economic growth

After analyzing the trends of consumption, savings, investment, and their effect on total demand, Keynes emphasized the role of aggregate demand in determining the output

of the economy He also highlighted the role of government in regulating the economy

through economic policies, especially policies to increase aggregate demand That was the first time the role of the public sector in the economy is valued

 Harrod–Domar model

Based on the ideas of Keynes, in the 1940s, Roy Harrod and Domar Evsay gave a model to explain the growth of the economy Harrod-Domar has shown the role of saving and investing for growth, in which, investment is the most basic motivation

This model assumes a production function with constant coefficients This simplifies the model but offer a rigid association between capital and labor In this model, growth has a direct relationship with the savings through Incremental Capital Output Ratio (ICOR)

Harrod-Domar excessive emphasis on the role of savings by implying that saving (and investment) is a sufficient condition for sustainable growth while actually it is not enough The model also does not directly mention the change in productivity In reality, economic growth can still occur in the absence of increased investment Even in cases of investment is effective, increase investment or savings can only help the economy to reach the increasing growth rate in the short term, but can not be achieved in the long term

Besides, the assumption of fixed ICOR makes models become less accurate over time as the evolution production structure and the marginal productivity of capital changes This model, therefore, has more implications for growth in the short and medium term than

in the long term

 Solow model

Based on the disadvantages of the Harrod-Domar model and the ideas of neoclassical theory, in 1924, Solow has built a new model of economic growth

If Harrod-Domar model only considers the role of productive capital (through saving and investment) on growth, Solow model has added labor and technology factors into the growth equation He also confirmed that technical progress is the decisive factor

in the growth, both short and long term It became the main model used in growth economics in the 1950s

This model assumes that there are diminishing returns to capital and labor (because

of depreciation and population growth) Therefore, in the case of absent technological improvements, the economy will reach steady state, where capital per worker remains unchanged and the economy remained stable, no longer growing This is also the best breakthrough point of Solow model compared with the Harrod-Domar model

This model also shows that technological improvements will help the economy overcome the steady state and continue growth However, this model does not explain the sources of technological change Besides, it does not explain the underlying cause of the accumulation of factors of production and productivity growth, and as a regional model, it does not explain the allocation of resources between economic areas

Solow model has several important implications, including:

- The potential of poor countries grows relatively fast

- The rate of growth tends to slow down when incomes Rise

- Between the countries that have important common features, the income of poor countries has the potential to converge with the income of rich countries

- Absorb new technologies is the key to accelerating and sustain economic growth

 P.A Samuelson theory

Based on the theories of Keynes, governments have used economic policies to curb inflation and unemployment, increase the level of potential output But after a long time to apply this theory, governments tend to over-emphasize the role of economic policies, thus limiting the extent of market self-regulation, thus creating obstacles to the growth process

In this situation, a new school of economics was born This school of economics favor the

development of a mixed economy The market will directly determine the relationship of supply and demand and other basic relations of the economy, government intervene in the economy at a certain level in order to limit the negative aspects of the market

The most typical representatives for this school is PA Samuelson with "Economics" (1948)

Like Keynesian model, the concept of economic balance determined at the intersection of AS (aggregate supply) and AD (aggregate demand) Equilibria is not necessarily in the potential output level, it is often well below that output While economies operate normally, unemployment and inflation may exist The task of the state is to identify and control them at an acceptable level

Consistent with neoclassical models, the total supply of the economy is determined

by the inputs of the production process, that is, resources, labor, capital, science and technology This theory also agrees with the idea of Cobb-Douglass production function in term of analyzing the impact of these factors on economic growth

The economists of this school also agreed with the Harrod-Domar model on the role

of savings and investment in economic growth

Therefore, this theory can be considered as the rapprochement of neoclassical economic theory and Keynesian theory

Thus, economic growth is influenced by many different factors, including at least four important factors: labor, capital, natural resources and technology However, to match the objectives of this study, the factors that measure the degree of financial liberalization will also be included in the model of economic growth along with the factors mentioned above

2.1.4 The relationship between private savings, economic growth and financial

liberalization

In terms of theory, the impact of financial liberalization on private savings rate usually includes the impact in both short-run and long-run

The impact in the short run is often directly affected through interest rates and the availability of credit Financial liberalization remove interest rates constraint, real interest rates will be pushed up, thereby increasing the savings rate However, this effect is usually quite small and diminishing in the following years (Fry, 1978) Financial liberalization has increased the supply of credit in the market, especially objects difficult to access credit markets in financial repression ago Agents can now easier access to credit This often leads

to a decline in savings and temporary consumption boom in the short term (Muellbauer, 1994)

In the long term, the impact of financial liberalization on private savings rate is often indirect effects, through economic growth Financial liberalization is an important factor

in reducing the cost of capital and reallocate financial resources The loosening and developing domestic financial markets increase the mobility of capital, the collection and redistribution of available capital in the market becomes more simple and effective Besides that, the availability of capital from foreign markets making capital becomes cheaper, the ability to access capital becomes easier Investments therefore increase Financial liberalization also reduced government intervention on the market, especially the capital market by reducing the directed credits This makes efficient use of capital higher than the period of financial repression Thus, financial liberalization is expected to boost economic growth, and then increasing the future incomes, leading to an increase in savings

However, there is still a lot of controversies revolves around the impact of financial liberalization on economic growth which has pretty much opinion that financial liberalization increases the instability of the domestic economy When integrating with the world economy, the domestic economic environment becomes more sensitive to changes

in the global economic environment, especially when the economic crisis occurred The spreading effect and the interdependence of the economy is a major cause leading to a domino effect in economic: a national economic crisis could be the detonator sparked a global economic crisis In which, the financial market is the fastest and most powerful transmission channel

Anyway, the impact of financial liberalization on the private saving rate and economic growth is still unclear This effect depends on the net impact of the intermediate channel In addition, financial liberalization is a process often consists of many different stages and aspects So, evaluating the impact of financial liberalization on savings rates require to distinguish this effect in both short-term (direct effect) and long-term (indirect effect) as well as analyze the impact through various channels This will help bring an in-depth and comprehensive results

There are some intermediate channels which financial liberalization effects on the saving rate They are the interest rate, credit constraints, raising saving opportunities, portfolio diversification, international credit flows, higher growth, and higher income and wealth

 Interest rate McKinnon (1973) and Shaw (1973) suggests that in a financial repression, interest rates will be lower than the market equilibrium Therefore, financial liberalization, especially removing the control and regulation on interest rates (both deposit rates and lending rates) will push interest rates to rise Deposit interest rate rise will increase the benefits to depositors, which will encourage increased savings However, deposit rates increase means that lending rates will rise too The interest rate is the price of the currency Therefore when lending interest rate rises, the credit will tend to decrease The decline in credit demand will pull interest rates (both lending and deposit interest rates) to a new level lower than the initial balance This will reduce the interest of some people to save money due to the decrease in expected income Besides, the illusion of increasing the value of savings assets (wealth effect) due to the rising interest rates will make individuals feel richer, resulting in more spending and the decline in the savings rate It usually depends on the net effect of the substitution effect, income effect and wealth effects

The relationship between interest rates and savings rates are still ambiguous An overall review of the Balassa (1990) showed a positive interaction between interest rates

and savings found more than a negative correlation, but the coefficients are relatively small and less significant

 Credit constraint:

Credit constraint is one of the factors that influence the saving behavior of each individual It tends to increase the rate of savings in two ways First, difficulties in the current credit often make agents who are facing difficulties to save more This often happens to those who are young and have no steady income Second, the concerns of facing credit constraint in the future will lead agents to cut their current consumption to increase precautionary savings (Hebbel and Servén 2002)

 Raising saving opportunities:

Financial liberalization promotes financial market development The financial instruments on the market become more abundant and diverse Providing alternative saving instruments that suit every personal taste and characteristics make saving easier In addition, an extensive network of banks and credit institutions will make mobilizing the surplus financial resources in the economy more favorable Thus saving behavior are also encouraged

 Portfolio diversification:

The increase in the financial instruments not only increases instruments for saving purpose but also increase the financial instruments for investment This will help the investor to not only diversify their portfolio but also have the suitable instruments for risk hedging Thus, the risk aversion agents would not worry about the uncertainties that damage to their property and income So, they will reduce their precautionary savings (Skinner, 1988 and Zeldes, 1989)

 International credit flows:

Financial liberalization also connects local financial markets with foreign markets This leads to the capital flows in and out These capital inflows into the domestic market

will increase the availability of credit, facilitating access to credit becomes easier with lower costs Moreover, when those capital flows to domestic, it will encourage investment, the expectation of increasing future incomes, therefore, will appear All of this will lead to

a boom in consumption and declining savings rate

 Higher growth:

Financial development, which begins as financial liberalization, is one of the important factors for economic growth This effect may be through two main channels First, financial liberalization increases the flow of investment capital, while reducing the cost of this capital flow Then increase the domestic investment Second, the abolition of bias credit distribution regulations will increase efficiency in the use of scarce financial resources These will promote economic growth and often lead to increasing savings in long-term Many studies have confirmed this reality (King and Levine, 1993; Levine, Loayza and Beck, 2000)

 Higher income and wealth:

Economic growth often leads to growth in income and wealth Therefore, as mentioned above, it often leads to an increase in long-term savings However, in the short term, the expectation of the increase in income and wealth often leads to a decline in temporary savings and increased spending in the short term instead Especially the real estate spending boom in the developing countries (Bandiera et al, 1999)

Theoretical framework: