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

Finally, liberalize capital account involving the elimination of restrictions on inflows and outflows of foreign direct investment as well as portfolio investment and the use of long and

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

NGUYEN HUU DUNG

Real Estate and Natural Resources Economics, National Economics University –

nguyenhuudungforest@gmail.com

DANG HOANG HA

International School, Thai Nguyen University – danghoanghavn@gmail.com

Abstract

How to restructure the economy is an important question for many developing countries in order to minimise the reform cost and adverse effects to the economy This paper provides insight into the order of economic restructure in the perspectives of policy reform, particularly

in timing and sequencing of liberalization It argues that, stabilizing macroeconomic such as fiscal consolidation and low inflation should be achieved first Next, remove distortions in domestic goods, capital, and financial sector Removing distortion means deregulate domestic interest rate, remove distortion in prices and free up wages in labour market Third, liberalise international trade, which removing quotas, tariffs and other direct administrative controls, and reducing tariffs across the board Finally, liberalize capital account involving the elimination of restrictions on inflows and outflows of foreign direct investment as well as portfolio investment and the use of long and short term financial instruments

Keywords: policy reform; liberalization; interest rate; capital account

1 Introduction

Since the 1970s many countries have adopted economic reform and liberalised economies, particularly favouring free trade, privatization, fiscal consolidation, financial deregulation and liberalisation with the main objective to promote growth of their economies The initial achievements with massive capital inflows and increase in consumption of some economies in the late 1970s and early 1980s such as Chile and Britain have triggered for many other countries’ economic liberalization programs Most of Eastern Europe and East Asia countries in the later time began adopting

transformation of their economies from central planed which are highly repressed and distorted by governments mandated control on output and prices into some form of economic liberalisation (Yung and Hugh, 2013) Liberalization has been considered as

a miracle for attracting foreign investment and economic development

However, after some initial success period, the pictures of liberalizing countries become various In the late of the 1980s and early 1990s some of countries such as Chile and Britain continue having remarkable achievements while others experienced recession or even finance crisis and economic instability fail such as Argentina, Brazil, Peru and especially former Soviet Union (Pradeep et.al., 1995) These problems again cause economists debate over the question how to approach economic liberalisation McKinnon in 1982 (and then in 1991) initially proposed a gradual approach economic liberalization He argued that the appropriate policies, and in particularly timing and sequencing of liberalization were the main issue There is, an optimal order

of economic liberalization that a country should follow to minimise the reform cost and adverse effects to the economy Although that sequencing is still an area of debate,

it has been generally received consensus during the recent time

For better understanding the sequencing proposed by McKinnon (1982), this paper discusses how an economy can approach liberalization safely and in the right pace The focus of the paper will be on liberalisation of tightly-controlled capital account which is

in highly repressed economy Some country experiences will be taken for discussion The paper is arranged as follows The first section of the paper is the introduction; second section discusses the optimum order of economic liberalisation; Section third discusses some critiques over the sequence Section fourth concludes

2 Sequencing of economic restructuring of a repressed economy

During the recent time, although there are few other critics such as Little, Scott, and Michael argue for different sequencing, the order proposed by McKinnon (1982) has been generally received consensus McKinnon (1982) suggest the optimal orders of economic liberalisation; that is, stabilize macroeconomic first, remove distortions in domestic goods, capital and labour markets second, liberalize international trade third, and open capital account at the last stage

i Macroeconomic stabilization is necessary condition before embarking on

economic liberalisation Macroeconomic stabilisation refers to fiscal control and price stability in which fiscal consolidation is suggested to be taken in the first place (McKinnon, 1982) It would be difficult for government to conduct monetary policies during the transition period with out fiscal consolidation and inflation under control because of the potential lost of macroeconomic control when monetary policies are dependent to government budget deficit

Argentina can be seen as an example of this Argentina’s fiscal situation was not bad prior to the limitary government in 1977 However, the government was not effective

in fixing fiscal situation by revamping tax system and make its budget continue to deficit through out late 1970s Because of large budget deficit, its monetization of budget deficit rampant in inflation makes inflation shot to over 500 per cent This leads to the fall in international competitiveness Exporters had to struggle in exporting with other prevailing countries causing a fail in liberalising trade Argentina eventually had to reintroduce direct administrative control Stable macroeconomic environment such as fiscal consolidation and low inflation have been proved that it must be achieved first in order to provide a prudential base for other reforms

To reduce budget deficit, McKinnon (1982) suggested that direct government spending should share a very small proportion with GDP Lost from the central bank should also be reduced Since central bank in highly repressed economy usually has to subsidy for public sectors and households, the lost occurs This lost contributes considerably to the budget deficit By phase out or fold in off-budget government subsidy, the central bank can avoid potential lost from subsidy for domestic deposit or credit in public sectors and households and hence be able to avoid over-printing money which cause harmful inflation

Inflation which is related to keep stable price is another important issue needed to

be under control The tax system should be strengthening to help repressing inflation

As the economy liberalisation is in progress, government usually have to privatize and give up its ownership of enterprises which are means of productions Leaving its own means of production makes much threat of inadequate revenue (Yung and Hugh, 2013) It is necessary to develop tax system for retrieving the revenue lost from giving

up those enterprises (Cashin et al., 1998) Let s take Chile as a successful case when its government get the right liberalisation approach Besides eliminating subsidy, Chile

government had introduced new tax system imposing value added tax at a uniform rate of 20 per cent (McKinnon, 1982) which provided stable revenues to the budget GDP of Chile as a result increased from negative13.5 per cent in 1973 to positive 3.7 per cent in 1976 and maintained surplus through out 1977-1980 (McKinnon, 1982) In general, if the tax system is not good enough to ensure the government revenue, there

is possibility that the government will fall in heavy debts or printing money to finance budget deficit This causes inflation and distorts prices which could arise and defeat the purpose of reform since the trade reform will be taking under the wrong market signals

However, the pace of privatisation should not too fast so that it will not put too high pressure on the fiscal system In fact, privatisation should be in parallel with the development of tax system to ensure enough collection of government revenue Some

of industrial and natural assets can remain under the government ownership initially and then be broadened as the tax system becomes adequate

ii Removing distortions in domestic goods, capital, and financial sector is the

next step after stable macroeconomic environment such as fiscal consolidation and low inflation is achieved Removing distortion means deregulate domestic interest rate, remove distortion in prices and free up wages in labour market

It is necessary to remove distortions in banking systems so that banks free from setting “standard” interest rate Relaxing of interest rates ceiling allows to have positive interest rates and thus increases financial depth as well as raises the level of savings and improves the quality of investment (Hallwood and MacDonald, 1994) Elimination of credit and interest rate controls follow by the macroeconomic stabilisation has potentially important effects on monetary and credit aggregates (Gertler and Kiyotaki, 2010) In addition, banking system should be free form reserves requirements and official guidance in setting standard interest rate after tight fiscal controls in place so that government does not have to rely on inflation tax to generate revenue (Mckinnon, 1982)

However, the pace of deregulation of banking systems should be in relation to the achievement of macroeconomic stability Macroeconomic stability provides prudential base for price level stability If price level stability is not good enough, interest rates become unpredictable volatility This makes unrestricted domestic borrowing and lending by deposit taking banks Deposit taking banks have incentive to take short

term deposit and lend in the long term hence duration mismatch occurs The ultimately can be the panics or collapse of the banking system Make sure the safety payment mechanism exist is essential

Poor regulatory and supervisory structures contributed significantly to the failure of the whole process of liberalisation (Villanueva and Mirakhor, 1990) The presence of moral hazard problem in the financial system of most high repressed economies dues

to explicit or implicit deposit guarantee schemes or many forms of government support Moral hazard makes banks behave as risk takers and set the interest rates at higher and riskier levels as they would be, and tend to lend aggressively thus provide wrong signals to the non-banking sector about the future returns Over borrowing and potential increase of non performing loans will occur If the economy was not opened

up towards the international capital markets, then the domestic problems would be absorbed locally and not severe suffer the economy However, if the capital account has been already liberalised by that time, over borrowing would take place and result in serious problems (McKinnon and Pill, 1997) Adequate supervision and regulation is necessary

Financial crisis in Mexico in 1994-1995 is the evidence for the importance of supervision and regulation Mexico started to deregulate its financial sector in the 1980s With its privatisation and deregulation, bank credit to private non financial sector grew rapidly from 10 per cent of GDP in 1988 to over 40 per cent of GDP in

1994 (Mishkin, 1996) The currency denominated liabilities of banks shot form 116, 4 billion Peso in 1993 to over 213 billion in 1994 (Minskin, 1996) The lending boom in the absence of adequate supervision and regulation environment makes non-banking financial institutions expanded their loan activities and took excessive risks Since Mexico had high inflation, and debt structure was mostly short term duration with the same due of maturity and denominated in foreign currency, the banking system became fragile and vulnerable when interest rates in US in 1994 put upward pressure

on interest rates in Mexico Under pegged exchange rate, Mexico‘s central bank have to increase interest rates to keep the value of Peso Interest rates increased leads to increase in asymmetric information and adverse selection problem in the financial markets This intervention exhausts Mexico’s international reserves and ultimately the government had to devalue Peso in 1994 Lending fell sharply at the same time with the increase in withdraw funds of investors makes Mexico fell in a deep recession in

1994 Mexico clearly did not have macroeconomic stability before opening financial sector hence fails to liberalise the economy

Highly repressed economies in initial stage of development are much segmented domestic labour, goods and financial markets Regarding to labour market, the urban segmented labour market is relatively organised and industrial labour force coexist with a large primarily informal rural work force The financial markets are also segmented and made up of a number of sub-markets (Huu-Dung and Yeo-Chang 2012) Due to the lack of financial instruments available to other money markets and capital market and commercial banks still maintain a fairly high excess reserves ratio; the volume of trade in the financial markets is low This is closely associated with the less developed payment system of the central bank As the interest rates of excess reserves are high, commercial banks lack of motive to reduce them This has driven down the demand for interbank borrowing The development of financial markets therefore depends on the further reform of the reserve system and the efficiency of the central banks payment and financial market as a whole

iii Liberalising international trade needs to remove quotas, tariffs and other

direct administrative controls, and reduce tariffs across the board since a high repressed economy is usually under massive quantitative protected restrictions These protections are administrative controls through either indirectly or directly The administrative controls can be many sets of tariffs or subsidy These tariffs or subsidy, however, highly distort prices either directly or indirectly rather than do “equivalent” tariffs This provides market the wrong signals, causing the economy away from the optimal equilibrium It is necessary to replace these quantitative quota and administrative controls by appropriate tariffs

McKinnon (1982, 1991) suggested that liberalisation of international trade should be undertaken gradually and in parallel with decontrol prices in the domestic trade of goods and services The implicit structure tariffs should be carefully approach because

it can causes collapse of domestic manufacturing Subsidy for producers, for example,

is in order to keep effective domestic prices of primary input below some countries which are prevailing in the world Removing it can make the domestic producers lost the target markets and end up with bankruptcy Recently, when analysing the liberalisation process of the former socialist economies, McKinnon (1991) suggested that optimum order of liberalizing foreign trade for highly-protected economies may

begin by converting their implicit quota restriction into explicit tariffs such as preannounce the adjustment or establish special international economic zone for international operation then expand rights to other places This had been successful archived some countries such as Chile’s liberalisation

Chile has been a remarkable reform During 5 years time, most of quantitative restrictions on foreign trade were eliminated and tariffs were reduced form an average rate of 94 per cent to a uniform rate of 10 per cent By the end of 1976 the Government successfully accomplished the unification of the exchange rate and eliminate all restrictions on payments for current transactions The reform was preannounce and carried out according to schedule, which contribute to the success (McKinnon, 1982) However, free international trade needs not means extending full foreign exchange convertibility to capital account transactions Let strong foreign currency to circulate in parallel with relatively week domestic currency may cause destabilise Moreover, as long as domestic banks still remain restricted, there is no point or even destructive to allow foreign banks to operate freely in domestic markets

After current account liberalization, opening of capital account can be implemented Opening capital account at the earlier stages of the reform may result in large inflows

of foreign capital due to substantial interest differentials Under both the fixed and floating exchange rates these inflows will result in a real appreciation of the domestic currency Since financial markets adjust faster that goods markets, this real appreciation may be destructive for the economy (Edwards 1984)

iv Liberalisation of capital account involves the elimination of restrictions on

inflows and outflows of foreign direct investment as well as portfolio investment and the use of long and short term financial instruments This allows domestic residents to borrow freely from or deposit in international markets Foreign exchange is freely convertible on capital account

Liberalisation capital account will help economy gain lots of benefits Liberalisation capital account brings about freedom of choice for investors and borrowers in choosing and exchange assets The diversifications of assets offer to investors the risk diversification for avoiding unexpected lost The more integrated economy creates more channels for evasion Free flow of capital can improve welfare if the domestic financial markets are efficient, and foreign funds are used to support the development

process Foreign capital can reduce the cost of capital and help make financial intermediation more efficient Most empirical studies found that capital account liberalisation have positive effects on domestic investment, and technology (Mehran and Seyed, 2017) In addition, resource allocation is also more efficient through increasing completion for financial resources It is no point to restrict capital transaction since it creates lost in effectiveness, incurs high administrative cost, distorts the economy, and raises corruption and rent seeking behaviour

However, there are some criticisms of capital liberalisation When liberalise capital account, the ability to carry monetary policy autonomy and exchange rate stability will

be reduce simultaneously (Gertler and Karadi, 2011) Macroeconomic management for excessive capital inflows may be more difficult as well Excessive capital inflows may

go beyond absorptive capacity of the banking system create inappropriate lending decisions lends to financial fragility Over borrowing syndrome may also occur However, these disadvantages can be avoided if capital account liberalisation approached in sequencing

It is widely accepted that capital account liberalisation should be the last step in the economic liberalisation procedure Because the success in the trade and financial reform leads to capital inflow, the domestic currency will has a real appreciation which leads to reduce competitiveness However, the successful liberalisation of trade requires a real depreciation in order to support exporters (Edwards, 1984) The appreciation generated by the opening of the capital account will tend to reduce the profitability in the tradable goods sector at a moment when this sector is going through a costly readjustment process Consequently, capital and current accounts should not be opened simultaneously, and that capital inflow should be tightly controlled during the trade reform and then will be opened last

There have been some economists such as Little, Scitovshy, and Scott have opposite argument and think that capital account should be opened first or at the same time as the current account The main argument was to use foreign funds available due to opening of capital account to smooth the adjustment process and to provide assistance

to industries that are negatively affected by the trade reform When the trade barriers are reduced, domestic relative prices will be changed and resources will be reallocated across the sectors Any process of economic liberalisation will require a costly adjustment period (Yung and Hugh, 2013) To enhance the success of trade reform,

there authors argued that adjustment costs such as unemployment associated with the reduction of tariffs should be kept as low as possible To accomplish this, they recommended that liberalisation of trade should be implemented slowly and that assistance, which is usually in the form of foreign funds, to finance a smoother adjustment by the import-competing industries These arguments, however, are not persuasive In fact, trade liberalisation should not be undertaken based on short-term capital inflows or on credits from foreign countries or international agencies releasing from capital account liberalisation (McKinnon, 1982) Such capital inflows are simply not sustainable in the long run, and during the liberalisation process they will throw out incorrect market signals (McKinnon, 1982) which are harmful for the economic liberalisation process as a whole Moreover, the McKinnon’s arguments for liberalising capital account last are also strongly strengthen by the theoretical approach known as

an over borrowing syndrome

A country fall in “over borrowing syndrome” when it undertakes successful “real side” economic reforms and removes distortions in liberalising international trade, it tends to borrow too much from financial institutions to finance investment and then faces problem of repayment for the loans The main root of over borrowing syndrome

is moral hazard spreading in the banking sector The sources of moral hazard in the financial system that generate the market failure which leads to over borrowing are likely to include the explicit or implicit insurance, government guarantee, and fixed exchange rate policy The moral hazard will induce the banks, which subject to both credit risk and currency risk, borrowing unhedged excessively to finance domestic investment During the economic downturn, when the bank borrowers fail to repay the loans, the banking sector can systematically goes to bankruptcy Then it leads to the lost of foreign investors confidence which eventually results in financial crisis

In the over borrowing syndrome model, all financial flows are intermediated through domestic banks because banks have special characteristics First, banks have certain informational advantage on the lending side Second, bank liabilities are central

to the domestic payment system, a vital component of a modern economy, which make them enjoy explicit or implicit government guarantee (McKinnon, 1998) A credit channel from bank lending to real activity, therefore, is important for the liberalising economy

However, in assessing investment risks in the reforming economy, banks may suffer from moral hazard by ignoring the probability of the bad outcome to occur that leads them to behave too optimistically regarding the pay-off from new investment (McKinnon 1999) When economy is liberalised domestically (see Figure 1) the non-baking sector starts to borrow from domestic capital markets Some firms invest into new technology some into old technology and put savings into banks

Figure 1: Rational – Beliefs Equilibrium in the DLE

Source: McKinnon and Pill (1997)

Assuming that investment returns in Period 2 are known with certainty than the market works efficiently The problem occurs when banks exploit moral hazard, which exists in domestic capital market due to the implicit and explicit government guarantee

of bank deposits When prudential supervision is insufficient, banks start to lend aggressively and send a wrong signals to the non bank sector about futures on investment are represented by function α’ g(.) When investment turns out to yield less than anticipated, borrowers can not repay the loans and ultimately end up with bankruptcies Because the economy is not opened to the international markets yet, this problem can be solved with not too much cost Although firms and households see their future income to be high, the sharp increase in the domestic interest rate

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