Notes on Financial Liberalization 1

Notes on Financial Liberalization 1 E. Murat Ucer Financial liberalization has come to be most commonly associated with interest rate liberalization, although it comprises a much broader set of measures including those pertaining to the banking s

Notes on Financial Liberalization 1

E Murat Ucer 2

Financial liberalization has come to be most commonly associated with interest rate

liberalization, although it comprises a much broader set of measures including those

pertaining to the banking sector, the external sector, and the institutional framework of

monetary policy The purpose of this note is to provide a background on issues surrounding financial liberalization and guide the reader through this very broad topic The note comprises five sections The first section provides a conceptual background to the early themes as well

as the scope of financial liberalization The second section reviews the record with financial liberalization Early record has been disappointing in terms of its strong association with very high real interest rates and banking crises However, the econometric evidence on the link between finance and growth is favorable, suggesting that financial development, as has been originally advocated, indeed helps growth The conciliatory view, which is discussed in the third section, is that while financial liberalization does benefit countries, countries need to be careful with a number of “initial conditions” as well as “sequencing issues” prior to full liberalization The fourth section is devoted to some specific aspects of the experience of Turkey with financial reform A final section offers some concluding remarks

I On the Concepts: Financial Liberalization, Repression, Deepening, Reform, etc.

Financial liberalization is the process of breaking away from a state of financial repression.

As financial repression has been most commonly associated with government fixing of interest rates and its adverse consequences on the financial sector as well as on the economy, financial liberalization, in turn, has come to be most commonly associated with freeing of

interest rates This is pretty much the old view We now understand financial liberalization as

a process involving a much broader set of measures geared toward the elimination of various restrictions on the financial sector, such as the removal of portfolio restrictions on the banking sector, the reform of the external sector, as well as changes in the institutional framework of monetary policy This section develops these issues

Financial repression, by-now a classic phrase, originated in the works of Ronald I.

McKinnon and Edward S Shaw in the early 1970s, to describe a developing country

environment whereby “the financial system…is repressed (kept small) by a series of

government interventions that have the effect of keeping very low (and often at negative levels) interest rates that domestic banks can offer to savers” (p.152, Agenor and Montiel,

1996); the most common forms that these interventions would take were interest rate

regulations, directed credit schemes, and high reserve ratios

The main motive behind financial repression is fiscal The government wishes to promote development, but lacks the resources to do so Through imposition of large liquidity and reserve requirements, it creates a captive demand for its own interest bearing or non-interest

bearing instruments, respectively, and uses it to finance its own priority spending (p.152,

Agenor and Montiel, 1996) It puts a cap on rates, which creates excess credit demand, and directs credit to its own priority sectors An additional means for financial repression involves limiting the menu of instruments that the public can hold (e.g., foreign exchange deposits) in order to ensure greater “seigniorage” revenue.3

1

Background notes prepared for an EDI seminar on “Macroeconomic Management: New Methods and Current Policy Issues” held in Nairobi, Kenya and Ankara, Turkey

2

Murat Ucer was Adjunct Faculty, Center for Economics and Econometrics, and Economics

Department, Bogazici University and Advisor, Yapi Kredi Bank, Istanbul, Turkey when these notes were prepared He is now an economist with Credit Suisse First Boston, Istanbul Office

3

Seigniorage is government revenue arising from the issuing of paper money

Financial repression is a problem because, as McKinnon-Shaw hypothesized, repressing the

monetary system fragments the domestic capital market with highly adverse consequences for the quality and quantity of real capital accumulation (McKinnon, 1988, McKinnon, 1993).

This would happen primarily through four channels:

(a) the flow of loanable funds through the organized banking system is reduced, forcing potential investors to rely more on self-finance;

(b) interest rates on the truncated flow of bank lending vary from one class of

favored or disfavored borrower to another;

(c) the process of self finance is itself impaired; if the real yield on deposit is

negative, firms cannot easily accumulate liquid assets in preparation for making discrete investments and socially costly inflation hedges look more attracive as a means of internal finance; and

(d) significant financial deepening outside of the repressed banking system becomes impossible when firms are dangerously illiquid and/or inflation is high and unstable; robust open markets in stocks and bonds, or intermediation by trust or insurance companies, require monetary stability

The fix pretty much follows from the diagnosis detailed above: free interest rates rapidly, reduce reserve requirements, and eliminate directed credit schemes, while stabilizing the price level, say in the context of a strong disinflation program This would help countries

grow faster, because, following financial liberalization, investment and growth would pick up either because of a “complementarity effect”, i.e the need to accumulate funds to undertake lumpy investments would make money and capital complementary (rather than substitutes) or because of a “credit availability effect”, i.e increased savings into the banking system would

increase investment through enhanced credit availability (p.474, Agenor and Montiel, 1996).

In essence, to achieve all this, real interest rates must be kept positive by way of the freeing of rates while stabilizing the price level Positive real interest rates resulting from financial liberalization is supposed to lead to financial deepening (or a higher level of intermediation),

as demand for money, defined as savings and term deposits as well as checking accounts and currency increases as a proportion to national income, which in turn, is supposed to promote economic growth Given the important role played by interest rates in all this, removal of controls over interest rates has become the centerpiece of the liberalization process

What we understand from financial liberalization today is different Other than interest rate liberalization and elimination of directed credits and high reserve requirements, it involves a wide set of additional measures including the easing of portfolio restrictions on banks,

changes in the ownership of banks, enhanced competition among banks, integration of

domestic entities to international markets, as well as changes in the monetary policy

environment.4 Of these, external sector reforms go hand in hand with financial sector reforms

because removing restrictions on exchange and payments system and establishing a freely functioning foreign exchange market are central to removing distortions that limit portfolio

behavior Broadly, reforms involve two phases: removal of all restrictions on current

payments and transfers, and capital account liberalization; the latter, by enhancing country’s integration with the rest of the world, imposes perhaps the strictest limits on financial

repression (Turkey is a good example for the latter, covered in Section III below)

The reform of the institutional context of monetary policy implementation primarily involves

increased independence for the central bank and a switch from direct instruments of monetary

4

Agenor and Montiel (1996), following Park (1991), prefers to draw a distinction between monetary

reform, defined as an increase in controlled interest rates to near-equilibrium levels, and financial liberalization, a much more ambitious set of reforms, directed at removing at least some of the

restrictions on bank behavior (p.473)

control (e.g., interest rate controls, bank-by-bank credit ceilings, statutory liquidity ratios, directed credits, bank-by-bank rediscount quotas) to indirect instruments (e.g reserve

requirements, rediscount and Lombard window, public sector deposits, credit auctions, primary and secondary market sales of bills, foreign exchange swaps and outright sales and

purchases) The main idea here is for central banks to stimulate the growth of money markets and instruments with a view to enhancing market-orientedness of its policy environment In

general terms, this would imply for the central bank to cease direct control over bank behavior

in its conduct of monetary policy (e.g credit controls with a view to controlling the path of a broad monetary aggregate) and move toward indirect means such as controlling aggregates from its own balance sheet through market-oriented instruments, most notably open market operations No doubt, this alters monetary policy implementation substantially, i.e the

behavior of money demand, money supply processes, as well as the link between the targets and instruments.5 While these changes create problems for the policy-maker in policy

management, as will be noted in Section III below the real difficulty is posed by ongoing uncertainties in the macroeconomic environment

Overall then, while the early literature concentrates mainly on interest rate liberalization, the scope of financial liberalization extends into a number of more modern themes, most notably banking crises and the liberalization of the capital account

II On the Record: Has Financial Liberalization Worked?

An assessment of the record with financial liberalization is difficult for at least two reasons First, the experiences are relatively recent, whereas it takes several business cycles to assess whether efforts have been successful or not (Atiyas, Caprio, and Hansen, 1994) And second, measurement is a problem; on the one hand, it is difficult to determine exactly when

liberalization efforts might have started and ended, on the other, it is difficult to come up with single empirical measures of financial liberalization and performance under financial

liberalization that would help assess the link These difficulties notwithstanding, what we

seem to have learned thus far is that the record with financial liberalization, in the sense of freeing of interest rates, is quite poor, in that it appears to have been heavily associated with banking crises However, financial liberalization, to the extent that it leads to financial deepening and development, appears to promote growth When assessing the record, these

tend to be the main issues covered by analysts This section develops these points before moving on to the discussion of the reasons as to why financial liberalization might have led to banking crises.6

It is known that the early record of financial liberalization, taken as an abrupt freeing of interest rates, is not that bright, as high interest rates, distressed borrowing, and numerous episodes of banking crises followed, most well-known examples being the early Latin

American experiences of the late 1970s and early 1980s (e.g., Argentina, Chile, Uruguay) These countries made serious efforts to end high inflation and to deregulate and privatize their

5

The implications of financial reform on monetary policy implementation is covered in Khan and Sundarajan (1991)

6

As to other issues covered in the preceding section, directed credits are the first to be removed and experience suggests is the least problematic of all, while reserve requirements and liquidity ratios are usually kept even through the most advanced stages of reforms and continue to be employed as

monetary policy instruments In the external sector, as noted above, two critical areas are the

unification of foreign exchange market and the opening of the capital account Agenor and Ucer (1994) provide us a conceptual framework to think about unification of foreign exchange markets and argue that its adverse consequences have been limited As to capital account liberalization, while views differ

on whether capital account controls should be imposed or not, we are at the very early stages of the debate, recently rekindled by the Southeast Asian crises In Section III below, our review of the experience of Turkey provides some insights

banking systems Interest rates on both bank deposits and loans were completely freed, with the latter often increasing to unexpectedly high levels in real terms.7 These attempted

financial liberalizations generally ended in failure with an undue build up of foreign

indebtedness and government intervention to prop up failing domestic banks and industrial enterprises.

This episodic evidence has been recently supported by more systematic work that looks into the relation between financial liberalization and financial fragility (Demirguc-Kunt and Detragiache, 1998; Fischer and Chenard, 1997).8 To develop a basic feel for this type of research, let us describe the gist of what Demirguc-Kunt and Detragiache (1998) do They study the empirical relationship between banking crises and financial liberalization in a panel

of 53 countries for the period 1980-95 in a multivariate logit model In addition to a set of variables which are accepted as standard predictors of banking crises (economic growth, terms of trade changes, real interest rates, inflation, M2 as percent of international reserves, private sector credit to GDP, ratio of bank liquid reserves to GDP, rate of growth of private

sector credit, real GDP per capita), they control for a host of institutional factors including

respect for the rule of law, a low level of corruption, and good contract enforcement as the

relevant institutional characteristics They find that banking crises are more likely to occur in liberalized financial systems, even if institutional factors reduce the likelihood of banking crises.

They construct both the banking crisis variable and the financial liberalization variable as dummy variables whereby they experiment with the exact specification of dummies over time They do not use the real interest rate as an indicator on the grounds that real interest rates especially when measured ex-post are likely to be affected by a variety of factors that

have little to do with the regulatory framework of financial markets and can be misleading.

For instance, as they argue, a positive correlation between real interest rates and the

probability of a banking crisis may simply reflect the fact that both variables tend to be high during economic downturns, while financial liberalization plays no role Some of their key results are summarized in Tables 2 and 4 in the paper (see Demirguc-Kunt and Detragiache

(1998) on www.imf.org).

Doubts about the performance of liberalization in terms of, allegedly, causing serious banking

crises, while well taken, do not mean that liberalization should not go ahead That is, the right question to ask would be, in the overall, whether financial liberalization has led to higher long-term growth, which was the original McKinnon-Shaw hypothesis anyway Broadly, there are two sets of studies here: those that look at the link between real (deposit) interest rates and growth, and those that look at the link between financial development and growth

It appears that most studies that focused on real deposit rates as an indicator of financial liberalization, found encouraging results The classic works by Lanyi and Saracoglu (1983) and Gelb (1989), both covered in Agenor and Montiel (1996) are in this category The former found that the real deposit interest rate had a positive and a significant coefficient in a

regression of the growth rate on the deposit rate The latter concluded that the efficiency effect on investment, and not the overall volume of investment, accounted for the positive relationship between real interest rates and growth Unfortunately, interpretation of this coefficient is a bit tricky It was argued that it might be indicating uncertainties arising from high and variable inflation and the inefficiencies that it causes, rather than an efficiency or

7

Paranthetically, we should note that high real interests should not automatically be a cause for

concern High returns in the order of 10-20 percent may be easily justifiable for countries at the initial stages of development, given that the banking system is broadly sound, a good regulatory farmework is

in place, and the country is macroeconomically stable See Galbis (1993) for more on this

8

Also Goldstein and Turner (1996), in a survey of banking crises in emerging economies, include inadequate preparation for financial liberalization, among the key factors that lead to banking crises

better resource allocation effect (p.476, Agenor and Montiel, 1996) Furthermore, as just

noted above, a strong correlation may simply reflect the fact that both variables tend to be high during economic downturns, while financial liberalization plays no role

Looking at the evidence on the link between financial development and growth is in a way

more direct way of exploring the link between financial liberalization and growth Evidence

in this area seems to be somewhat more conclusive and indicate strong links between the two King and Levine (1993) appear to be a good example of relatively recent research in this area;9 it may be worthwhile to go through the basics of what they do

Using a cross-section data set, they explore the link between various measures of the level of financial development and indicators of economic performance, and they find strong

association between the two, both contemporaneously and between current values of financial development indicators and the future values of economic performance indicators; the latter, they interpret as providing evidence that financial development leads economic development They tackle two issues particularly carefully, robustness across various measures and

econometric specification The first issue is how best to define financial development and growth They end up using four indicators for both For financial liberalization, they take the ratio of the size of the formal financial intermediary sector to GDP, the importance of banks relative to the central bank, the percentage of credit allocated to private firms, and the ratio of credit issued to private firms to GDP For growth, they take real per capita GDP growth, the rate of physical capital accumulation, the ratio of domestic investment to GDP, and a residual measure of improvements in the efficiency of physical capital accumulation It turns out that the results are robust to all indicators, in standard growth regression framework (see Table 7

of the paper) Their results pass a number of sensitivity checks, including altering the

condition set of information, using sub-samples of countries and time periods, and examining the statistical properties of the error terms.10

For the sake of completeness, we should note that the analysts looked into a number of related themes when studying the impact of financial liberalization on growth, including the links between financial liberalization on the one hand, and saving and investment on the other, as well as specific effects that were noted above, i.e complementarity and credit availability effects Evidence in these area seems much less conclusive It appears, however, that three near-consensus results may be distilled from a review of the literature First, the channel of influence that financial development stimulates growth seems to be more by accelerating productivity growth rather than through saving mobilization What this means in practice is that, in standard growth regressions, the coefficient of the financial liberalization indicator does not seem to change much between regressions with and without the investment rate

9

Fischer and Chenard (1997) are more skeptical of these results, and suggest a research program that focuses more on time series techniques than cross-section analysis However, the former is not devoid

of problems either; for one thing, long time series would be necessary for meaningful references, whereas exeriences are relatively recent It should be noted, however, that Demirguc-Kunt and

Detragiache (1998) also find strong correlations between financial development and financial

liberalization, but weak correlations between financial development and growth in their panel data and

take this to indicate that choosing financial liberalization at the cost of experiencing a banking crisis does not necessarily pay off in terms of higher growth, at least in a medium term time frame However, others find more encouraging results For instance, Easterly and Levine (1997) find that financial underdevelopment is among the main factors that explain Africa’s low growth performance De Gregorio and Guidotti (1995) show that the empirical relationship between financial development and

growth is positive in general, but negative in Latin America.

10

Robustness and sensitivity checks are very important because results from these studies tend to be

notoriously non-robust and change quite a bit with respect to the sample, variables included in the regressions, as well as the econometric technique employed We lived through these problems in a study we undertook on the determinats of growth, saving, and investment in sub-saharan Africa See Hadjimichael et al (1995).

Second, interest rate liberalization tends to positively affect financial savings or lead to

“financial deepening”, but not necessarily domestic savings Third, there is little evidence in favor of the complementarity effect, while the credit availability effect is reasonably strong

It seems then that, financial liberalization causes banking fragility, but through financial development, it tends to promote growth How to reconcile these two conflicting arguments?

Well, the conciliatory view seems to be that financial liberalization did not work because countries did not get the “initial conditions” nor the “sequencing of policies” right

Let us now explore these issues

III On Initial Conditions and Sequencing

Research that tried to identify what went wrong with initial episodes focused on the peculiar characteristics of the financial markets In hindsight, they argued, the key to the failures was ignoring a host of asymmetric information problems, of Stiglitz-Weiss variety, i.e the so-called “adverse selection” problem, aggravated by “moral hazard” as well as the weaknesses

in the regulatory environment of banking systems in developing countries.11

One of the key issues to recognize is that under asymmetric information, the market clearing rate is neither optimal nor efficient for the bank, because at this rate, the bank’s expected profit is less than at the credit-rationing level, and borrowers with high payment probability tend to drop out and are replaced by those with high default risks This is because, in the market for bank credit, the interest charged on the loan differs from the expected return to the bank, which is equal to the product of the interest rate and the repayment probability of borrowers As this probability is always less than one, because borrowers have greater

information about their own default risks than banks, market clearing rate in the loanable funds market tends to be higher than expected profit maximizing return As the probability of repayment is negatively related to the interest charged, at some point, interest rate increase is

by more than offset by the sharp decline in profits, hence reducing overall profits (Villanueva and Mirakhor, 1990) In this scenario, the crowding out of the good borrowers has been named the “adverse selection” problem, while the tendency of “good guys” to take on more risky projects, as the “adverse incentive” problem The end result to all this is that, a clever, profit maximizing bank would hold back credit, compared to the level implied by the market clearing interest rate, where bank profits are at a maximum level and risky borrowers are rationed out

Why then, did we observe real rates on the order of 20 percent or higher, following financial liberalization, which are likely to have attracted bad borrowers? Simply because credit-rationing by a clever bank scenario may not work out as smoothly, if there is some sort of a

“moral hazard” problem at play, and if the banking sector environment regulation,

supervision, skill levels, etc is weak First, with inadequately priced deposit insurance, implicit or explicit, depositors tend to be indifferent between aggressive risk-taking (low capital) and less aggressive high capital banks (moral hazard), hence the former which can offer higher interest rates, will tend to attract the depositors and fund high-risk projects, because they in effect, face a one-way bet If the projects pay off, bank owners reap the profits, whereas if they do not, the government foots the bill to pay off the depositors, with

bank owners risking only their limited capital (p.478; Agenor and Montiel, 1996).12 Second, banking sectors in developing countries tend not to be well regulated and lack the right infrastructure to physically perform the required functions, such as various risk management techniques

11

For an excellent review of these issues, see Mishkin (1996)

12

This story is strikingly similar to some aspects of what seems to be happening recently in SouthEast Asia (Krugman, 1998)

Then the lessons to be drawn seem fairly simple: monitor the banking system very carefully,

in terms of capital and their risk-taking activities, and make sure economic stability and improved bank supervision precedes complete removal of interest rate controls In developing

countries, however, this is easier said than done, owing to, inter alia, political strengths of the banking sector as well as lack of capacity in banking supervision and various banking skills noted above As a matter of fact, Atiyas, et al (1994), in their in-depth look at various

liberalization episodes (Turkey, New Zealand, Korea, Malaysia, and Indonesia) arrive at similar, although somewhat broader, “initial conditions” Their list of “what to avoid” before deregulation suggests that the following criteria must be met before complete deregulation: (a) macroeconomic conditions are reasonably stable; (b) the financial conditions of banks and their borrowers is sound; (c) at least a minimal base of financial skills is maintained; and (d) some checks are in place to limit collusive behavior among banks in the determination of interest rates.13

There are at least two reasons why we need macroeconomic stability prior to interest rate deregulation First, when inflation is high and variable, the adverse selection problem

becomes more acute In contracting at any nominal interest rate substantially above the normal levels, the borrower must bet on what the future inflation will be and also determine the riskiness of his own project He will then accept a riskier project in the hopes of a

favorable high yield in case inflation does not bail him out and he has to default anyway (McKinnon, 1988; Villanueva and Mirakhor, 1990) Second, ongoing macroeconomic

instability or a disinflationary process reduces “borrowers’ net worth” which, in turn,

increases defaults as well as aggressive high-risk borrowing; this important link between financial and real sectors must be taken into account (Atiyas, Caprio, Hanson, 1994)

Macroeconomic stability would have given the corporate sector (the borrowers) the chance to restore its balance sheet

These initial conditions give us a sense of what to do or what to avoid prior to undertaking financial reform In addition, three sequencing issues must be highlighted, two of which are

covered in Agenor and Montiel (1996, p.500) The first issue is that, the domestic financial

system must be liberalized by freeing up domestic interest rates, increasing reliance on

indirect instruments for the purposes of monetary control, and strengthening domestic

financial institutions and markets, along the lines discussed above, before opening the capital account of the balance of payments The main issue here is that capital outflows can easily occur, if interest rates cannot be flexibly used The second issue is that liberalization of the capital account before the current account, most notably, trade, is not a desirable reform strategy There seem to be three main reasons First, there seems to be an agreement that trade liberalization requires depreciation, while sudden capital inflows that tend to go along with liberalization cause appreciation pressures The latter may derail the trade liberalization process Second, recession may follow if the capital account is opened during trade

liberalization, as economic units switch spending from the present to the future, with the expectation that tradable prices will decline in the future Third, it may create an undesirable consumption boom, if there are doubts about the viability of trade reforms

We could perhaps stress a very important third sequencing issue here, which will be noted in more detail in Section III Strong fiscal adjustment and some visible progress on structural reforms must precede financial liberalization, most notably capital account liberalization The most important issue here is related to credibility and sustainability of reforms For one thing, inadequate adjustment on these fronts restricts the active use of interest rate policy during stabilization, owing to concerns over the budget as well as financial sector soundness We know that one of the key issues with trade reform, has been the fiscal dimension that is making allowance for the loss of international taxes In a way, financial liberalization also has

13

Similar points are reproduced in, inter alia, Galbis (1995) and Fry (1997)

a similar strong fiscal dimension that needs advance preparation At a minimum, financial liberalization leads to higher interest rates, and this should be accounted for in the budget

On balance then, it seems that, from a policy angle, interest rate management is not a bad idea For one thing, until we make sure that all the above-mentioned preconditions are in

place, we are vulnerable The second issue is related to correct macroeconomic signaling If any individual sees very high nominal interest rates above recorded inflation, he or she could interpret this as a signal that most other people in the economy expect inflation to continue and the stabilization program to fail (McKinnon 1988)

As to the role of the international institutions in all this, it would not be unfair to say that, despite quite extensive studies done at the IMF, banking sector soundness issues have not been receiving much attention during its usual surveillance or even program practices Now that the recent crises are private sector/banking sector driven in nature, the IMF seems to be preparing to integrate a regular “bank soundness check list” into its regular surveillance activities, as noted by Stanley Fischer, the first deputy managing director of the IMF, in a Financial Times article:

“The IMF has been working…to develop and disseminate a set of best practices in the

banking area These standards are codified in the Basle Committee on Banking Supervision’s

25 core principles, introduced last year This standard-setting effort is extremely important But ensuring compliance is just as important, and politically more difficult IMF surveillance will play an important role here” (Personal View, Financial Times, March 30, 1998)

IV On the Experience of Turkey: Some Observations

Turkish economy has undertaken important reforms in the 1980s, and successfully

transformed into an open and export-oriented economy Financial liberalization has played an important role in this However, macroeconomic stability in the sense of low inflation, has never been achieved, because of growing fiscal imbalances While a comprehensive look at the Turkish experience with financial liberalization goes beyond the purpose of this note, a broad-brush review might offer some interesting lessons to the policy-maker. 14 It may be useful to look at this experience in two distinct, easily observable phases: interest rate

liberalization (early 1980s) and a full liberalization of the capital account (August 1989) Interest rates were liberalized in the early 1980s, in the context of a stabilization program It was followed by a minor episode of “goodbye-financial-repression-hello- financial-crash” Somewhat ironically, the Turkish crisis was essentially a “bankers’” crisis, whose ponzi-game went on unnoticed or uninterrupted by the supervisory authorities Ironically, as noted in Atiyas and Ersel (1994), confidence in the banks increased after the crisis.15 Nevertheless, a couple of small banks went bust as well, and restrictions were reimposed on deposit and lending rates and remained in place till 1988, but under a policy aimed at maintaining mildly positive real interest rates Beginning in the mid-1980s, the Central Bank began to stimulate the growth of money markets and instruments Following the freeing of rates, the capital account was fully opened in late 1989

As to sequencing, interest rates as well as the current account were liberalized, and a free, reasonably well functioning foreign exchange market was established, prior to the opening of the capital account Prior to the opening of the capital account, the central banks took

important steps to stimulate the development of money markets and instruments, and largely

14

See, for instance, Atiyas and Ersel (1994)

15

Still, though, Atiyas and Ersel (1994) take this episode as a systemic crisis and argue that one main source of the crisis was the sharp decline in the borrowers’ net worth, due to distress emerged in the

corporate sector during disinflation.

shifted from an environment of direct monetary controls to indirect controls The key problem was that, despite the achievements in terms of reducing inflation, macroeconomic stability was tenuous owing to lagging fiscal and structural reforms

This has resulted, in an open economy context, in interesting macroeconomic relations On the one hand, the government continued to dominate the domestic markets because of its heavy borrowing requirement At the same time though, the banks as well as the public began

to ask higher and higher real interest rates and the use of new instruments such as foreign exchange deposits or high yielding “repos” reduced the inflation tax substantially As a matter

of fact, very illustrative of course, seigniorage, as defined by the ratio of change in reserve money to GNP, started declining after 1988 It is also notable that in 1994, when inflation jumped significantly due to a financial market crisis, seigniorage did not increase (see the attached charts, taken from Alper and Ucer, 1998) The most popular game in town has become, and increasingly so, the financing by the private sector of growing fiscal balances exploiting the reasonably high interest differential Given the ongoing uncertainties in the economy, non-TL aggregates or risky means of financial innovation (e.g., foreign exchange deposits, overnight repos with customers) have become the means to maintain financial

deepening In this kind of environment, the Government learned not to tinker with rates the hard way, unfortunately, because a crisis blew up in early 1994, when the government tried to maintain interest rates artificially low in a potentially explosive high inflation environment.16

In some ways, the interest rate liberalization phase was more manageable There was a

“banking crisis”, but whether this was a full-fledged “systemic” crises or not is debatable.17 They were quite serious, but did not seem to be the direct result of liberalization, i.e a quick-fix early on to stop the bankers’ ponzi game, would do, as the Turkish crisis did not seem to have many characteristics of the Latin American crises (i.e excessive borrowing, coupled with enhanced external exposure) The real problems in macroeconomic management or the implications of perhaps what one could call “untimely” liberalization of the financial sector were begun to be felt more deeply, when the capital account was fully liberalized

The capital account was opened in a bit of a “big bang” manner In principle, basic

sequencing was in place: current account transactions were liberalized, Turkey was close to accepting the obligations arising from the IMF’s Article VIII clause, interest rates had been freed, and monetary policy implementation had largely shifted toward indirect monetary policy instruments However, at the time of the liberalization, macroeconomic stability and commitment to structural reforms, as noted above, continued to be slim This did not stop capital account liberalization; on the contrary, it speeded up the process to signal commitment

to reform or perhaps more to alleviate the costs of delays in fiscal adjustment As a result, against the backdrop of declining TL-denominated aggregates, the system expanded and growth continued by way of money created through a balance of payments surplus Since Turkey was a current account deficit country, this had to come through a capital account surplus

V Concluding Remarks

A rocky road perhaps, but it seems that in the overall, financial liberalization is a good thing because it seems to stimulate growth It entails risks though, if we do not take note of initial conditions or get the sequencing right; unless these conditions are met, a financially repressed

16

These issues are elaborated in Agenor, McDermott, and Ucer (1996) and Alper and Ucer(1998)

17

A couple of banks going bust is an important problem, but it does not of course imply a systemic

crisis The problem is whether these problems lead to a bank run Fractional reserve banking is fragile

business by definition, and the intuition suggests that banking sector would be partciularly susceptible

to self-fulfilling attacks

economy may turn into a financially restrained one, and crises may follow Until these pre-conditions are in place, interest rate management seems to be a good idea

Of course, to the policy-maker, there is a bit of a problem with this “initial conditions” talk, as initial conditions tend to be so demanding that they may indeed be achievable only at the end

of the very reform process he (or she) seeks to initiate If one loses hope that the political system will ever achieve the initial conditions or the right sequencing, it may be risky, but somewhat defensible to move ahead to reverse the order and seek to impose discipline on the economy, by being open, and hence change the behavior of politicians However, experience suggests that it is usually costly to get that discipline this way and that at the end, the poor suffer

When fiscal policy is not an instrument one can effectively use, the scope for active macro policy narrows and policy making can be quite an agonizing experience The experience of Turkey attests to this point Recall what Brazil did some months ago to fend off the contagion effect arising from the Southeast Asian crisis They pushed through additional fiscal

adjustment and immediately ran it through Parliament Brazil faced serious external pressures, but this carries lessons for all, in illustrating the kind of flexibility we need to have, in the new international environment Unless fiscal and structural reforms are being carried out, interest rates tend to be high, because of too much reliance on bond-finance tight money loose fiscal story as well as the existence of a “risk premium”, capturing all that you can imagine,

a depreciation risk, a default risk, as well as a delayed reform penalty This creates a vicious circle, hard to break, because high interest rates are seen as a problem because they hinder growth, cause problems in public debt management, and lead to banking and corporate sector fragilities Tinkering with interest rates when the debt stock is high, reserves are not so strong, lead to crises

Interestingly, IMF never knew a lot about the health of the banking sector during regular consultations, nor to my knowledge, did the health of the banking sector take a central role in the Turkish missions until recently in the wake of the Southeast Asia crisis The missions made broad statements but did not seem to have a “bank soundness check-list”, which is only now being put together as suggested by the S Fischer quote

A philosophical ending In some ways, the debate on the benefits and costs of liberalization (an also on capital account liberalization) seems to miss the point Liberalization means, by definition, more freedom No doubt, to enjoy freedom, a country needs to build adequate capacity, transparency, and accountability