Effects on Economic Growth by Financial Repression - Essay Example

Effects on Economic Growth by Financial Repression Introduction By its very nature, financial repression must have been fundamentally influenced by Keynesian economics as well as provoked by the instability of the early 20th century events. Like Keynes, who advocated government intermediation in the economy to ensure stability, financial repression is underpinned by the theory that the state should intervene in financial matters to ensure lesser demand for money that should be channeled instead to the capital/labour sector. It was McKinnon and Shaw, however, who called the attention of the world to the negative effects of such practices and who officially gave it its name through a publication of their works in the 1970s. The McKinnon-Shaw hypothesis recommended the liberalisation of the financial sectors from such restrictions to stop economic stagnation and initiate economic growth. This hypothesis, however, is not without its share of critics who pointed out that severe financial repression must be distinguished from mild repression or that the McKinnon-Shaw framework failed to take into certain factors such as inflation or that some of its basic components lacked empirical basis. Moreover, specific studies of countries that adopted this financial repression yielded unequivocal results that could lead one to assert that financial repression leads only to one and only one result - economic stagnation. In connection with this, the cases of India and China, both of which have experienced financial repression, are presented in this paper to shed light to the McKinnon-Shaw claim that financial repression negatively affects economic growth. This is timely considering that both, especially China, are presently considered emerging super economies of the world. The Theory of Financial Repression Financial repression is a term that was first coined in the 1970s by McKinnon and Shaw, but was actually a condition that existed prevalently before that. As a matter of fact, financial repression was the norm and financial liberalisation, its opposing term, the exception prior to the 1980s. Financial repression, thus, refers to government intervention in the financial environment by substituting regular market variables and mechanisms with its own (Spratt 58). The existence of financial repression can be deduced from the presence of the following factors: unsystematic distortions in financial prices such as interest and exchange rates; interest rates with ceiling caps and nominal interest at fixed rates, which lead to low or even negative real interest rates; high reserve ratios; guided credit programmes, and; ineffective credit rationing (Bhole 16). Gupta (2004), however, narrowed down the elements of financial repression into interest rate ceilings, high reserve requirements and compulsory credit allocation. The consequences of these intermediary measures are: the implementation of high reserve and liquidity ratio for the purpose of easing budget deficits forcing banks to hold government bonds and money; private bond and equity markets remain undeveloped because of the difficulty of getting government money from private securities, and; government measures adopted to discourage private financial entities from competing with the public sector and to spur low-cost investment characterise the banking sector with interest rate caps (2). Financial repression is an economic tool usually employed by developing countries and was popular before the last quarter of the 20th century. It was said to be a knee-jerk reaction to the events of the first half of that century. History shows that the first half of the 20th century was blighted by two financial catastrophic events: the Wall Street Crash in 1929, and; the Great Depression, which was instigated by the Crash. These two events were themselves thought to be two of the underpinning reasons for the outbreak of WWII. The lesson that these events brought was that command economies were more stable and that the state can take the reins of the economy to engender more jobs and stabilise the economy in general. Moreover, the centrally-controlled economy of the USSR was, at that time, hinting towards a faster pace than that of the West encouraging the notion that state intervention in the economy would yield positive effects. This development has furthered encourage state intervention in the economy and the implementation of financial repression, although the name was not yet attached to this practice until the 1970s when McKinnon and Shaw decided to turn their attention to this phenomenon (Spratt 58-60). Financial repression is underpinned by the Keynesian liquidity preference theory (Eschenbach 8), where Keynes objected to the notion that interest rates are influenced by savings and investments. Instead, Keynes believed that interest rates are determined by demand and supply for money and that “interest rate is a price that makes the quantity of money the public would like to hold equal to the quantity of money in existence” (Wray & Forstater 245). In the financial repression system, states place a cap on interest rates to prevent income fall on the ground that full-employment of the real interest rate is inclined to be lesser than liquidity preference engendered interest rate. It is believed that financial repression results in lesser demand for money whilst increasing productive capital, ensuring augmenting capital/labour share and ultimately spurs economic growth (Eschenbach 8). Developing countries are not only impelled by the aforesaid Keynesian theory, but also by domestic economic realities. A financial repression measure acts as a means of augmenting tax revenues where the government is unable to collect sufficient taxes. These implicit taxes and government earnings take the form of seignorage and the channeling of savings to the public sector at no cost with the employment of reserve requirements, obligatory holding of government bonds and caps on interest rates (Eschenbach 8). Another reason for the popularity of financial repression in the first half of the 20th century was the emergence of nationalistic movements after WWII. This gave rise to protectionism and resistance to imperialistic and expansionist tendencies of more dominant and powerful states. State enforced financial measures, such as limitation to entry of foreign financial institutions, to protect domestic banks and guided credit programmes, to ensure that national firms were given priority in the grant of loans, were resorted to by protectionist governments (Spratt 59). Other reasons for the adoption of financial repression strategies, according to Gupta (1984) were: it is a means of enforcing anti-usury laws; it gives monetary authorities control over money supply; governments are in a better position than the financial sector to determine the investments most suited to the country, and; interest rates that are below market rates diminish the costs of servicing debts (14). In 1973, McKinnon and Shaw published their works that assailed the practices of developing countries in imposing restrictions on their financial markets and asserted that such restrictions impede economic growth because of its adverse effects on that sector. Labeling this practice as financial repression, McKinnon and Shaw recommended the liberalisation of repressed financial sectors to stop economic stagnation. The McKinnon-Shaw framework is based on the premise that savings determine investments, which clashes with the Keynesian theory of liquidity preference (Li 12-13). One of the manifestations of financial repression is limiting interest rates. McKinnon and Shaw believed that this results in the following ill effects: it discourages savings and may result in a shift to consumption; it could dissuade lenders from making available their funds for high-yielding investments in the form of savings and instead, engage in low-yielding ventures on their own; priority borrowers may tend to over-invest in projects that require high capital; it would draw borrowers with inferior projects resulting in low return of capital; certain borrowers are discouraged from resorting to organised banking sector when different interest rates are imposed for different types of borrowers, and; foreign capital becomes unreachable to domestic borrowers (Roland 86-87). The McKinnon-Shaw framework suggested a liberalisation programme for repressed financial markets that will work for a better intermediation between savers and investors (Serieux 3). The McKinnon-Shaw model provided basis for the development of other models involving financial repression. Table 1 summarises all of these models patterned after the McKinnon-Shaw study on financial repression. These models are: the Resource-Transfer model by Galbis (1977), which looks at the positive side of financial intermediation as ultimately affecting a per capita income increase if interest rates are raised to a level that would attract financial savings; the Investment Efficiency model by Fry (1978), which uses the case of ESCAP countries to illustrate that nonprice rationing equates to economic distortion; the Two-Phase model by Mathieson that acknowledges that complete elimination of government intervention in interest rate control can lead to widespread bankruptcies and instead suggests a kind of interest decontrol programme that allows the government to gradually eradicate economic distortion; the Stimulation model by Newly and Avramides (1977) likewise suggests financial intermediation, but done in three specific stages, which has the ultimate goal of developing financial markets; the Finance and Growth model by Gupta (1984) that simply links economic growth to financial development, and; the Life-Cycle model of Molho (1986), which places emphasis on investment motives as a consideration in any financial intermediation. Table 1 Financial Repression Models based on McKinnon-Shaw Framework (Li 15) Effects of Financial Repression on Economic Growth According to the McKinnon-Shaw framework, the impact of financial repression on a country’s economy is to retard its growth. The dearth in financial savings results in the economic stagnation because of its undesirable effects on the volume and productivity of investments. The channeling of funds to a priority sector and all other measures of restrictions imposed by the government create a shallow condition of finance where distorted financial prices diminish real growth and size of the financial system. Shaw remarked that “Where finance is shallow, in relation to national income or non-financial wealth, one finds that it bears low, often negative real rates of returns, and holders of financial assets including money are not rewarded for real growth in their portfolios” (cited Li 11). Shallow finance, according to the McKinnon-Shaw hypothesis, forces a government to rely on its own resources to finance capital growth (Li 11). The McKinnon-Shaw hypothesis, however, is not without its share of critics nor has unequivocally established its fundamentals beyond contention. For example, it has been pointed out that the framework’s key component of interest rate-savings connection lacks empirical basis. In addition, the hypothesis also did not take into consideration market failure, which is a key element in market analysis (Islam and Chowdhury 79-80). In other studies that attempted to establish a link between real interest rate and economic growth, some elements are evidently missing such as the failure to distinguish between the types of financial repression and the element of inflation. This was evident in the study conducted by Fry and Gelb, whose study did equate real interest rates to economic growth, but admittedly, had such limitations. These shortcomings are significant because in most developing countries, unstable inflation rates may account for poor economic progress and big negative real interests, and not necessarily brought about by the financial restriction policies of the government (Hossain et al 46). A contrary finding of positive effect of financial repression was presented by no less than the World Bank in 1993. However, the financial repression in that study was characterised only as mild as opposed to the large extent of repression usually made subject to studies. This finding came out from the study of high performing Asian economies (HPAEs) such as Korea and Malaysia in the 1980s. In Korea, for example, “almost every financial activity … including access to the banking sector, the determination of interest rates, and the allocation of credit, has been regulated by the government” (Hosain & Chowdhury 47). Financial repression in Korea was engendered by the 1980 international recession that saw the breakdown of high-leveraged Korean business firms and the ensuing economic instability. The Korean government intervened and imposed low deposit and loan rates, which enabled the many Korean banks and businesses to weather the recession. A similar situation took place in Malaysia with the tin market collapse in 1985 to which the government reacted by implementing lowered real interest rate (Hosain & Chowdhury 47). A more detailed look at the effects of financial repression is considered in the following paragraphs with the cases of India and China, two countries that had experienced financial repression in the past and even in the present. A. Case Study: India Beginning the 1960s, the Indian financial sector underwent government intermediation to meet the goal of the government to allocate funds for development programmes. It introduced lending rate controls and required higher reserve funds. It also established state development banks to serve its agriculture and industry sectors, which led to the nationalisation of 14 of its largest commercial banks in 1969. Financial repression took place until the late 1980s when liberalisation slowly took place. Financial repression took the form of interest rate controls over all kinds of loans and deposits, which was dictated by the Reserve Bank of India (RBI), whilst a very big portion of total lending was governed by directed credit (Demetriades and Luintel 311). Similarly, all international outflows and inflows were subjected to restrictions, such as purchase of foreign assets by residents, direct investments by foreign nationals and external borrowings by private entities (Kletzer & Kohli 26). During the years it engaged in financial repression, the Indian government raised revenues from two kinds of reserve requirement imposed on the banking sector: the cash reserve ratio (CRR), and; the statutory liquidity ratio (SLR). Both were below the market rates and the former compelled banks to hold cash assets equivalent to their debts whilst the second required them to hold cash assets, although a bit lower, to their holdings of government interest-bearing obligations (Kletzer & Kohli 19-20). Demetriades and Luintel (1997) measured the impact of financial repression on India, before it undertook liberalisation beginning the late 1980s. The authors attempted to quantify the effects of such policies by building an index that summarises all the government’s repressive policies and assessed the relationship between said policies and financial depth using a co-integration technique. The short-run and long-run multipliers are then calculated and exogeneity tests undertaken. The results showed that financial policies have definite connection with short-run and long-run of financial deepening, a term referring to the climbing proportion of money supply to either the GDP or price index, whilst real interest rates cannot be established as significant determinant of such deepening. Nonetheless, the control of deposit rates was found to have negatively impacted on financial deepening by about 12% as was the control of real rates of interest. Demetriades and Luintel (1997) concluded that indeed repressive policies had negatively impacted on Indian economy in a substantial way and offered a caveat that this finding should not apply to other countries. This is because the success of economic policies is dependent on the entities implementing them. The authors acknowledged that the possibility of economic success borne out of repressive policies cannot be ruled out (311-320). B. Case Study: China Financial repression in China is implemented through “controls on international capital flows and near state monopoly of the banking system” (13). Thus, citizens are not allowed to purchase foreign assets or take assets out of China whilst foreign investors are allowed to take out only legitimate profits. Capital accounts, meanwhile, are strictly controlled whilst current accounts have been liberalised. It is in the domestic banking sector that state intervention is so evident considering that 90% of all outstanding loans are shared by the state and that virtually all savings deposits are made to state banks. This virtual monopoly of the banking system has ensured the effectiveness of the enforcement of all interest rate regulations (Bai et al 13). When China launched economic reforms in the 1980s, part of its financial sector was still governed by repressive policies such as “heavily regulated interest rates, state influenced credit allocation, high official reserve requirement and strict capital account controls” (Huang & Wang 2). Notwithstanding, China achieved a GDP that averaged at 10% during the reform period, an achievement that impacted on the overall global economy accounting for 75% of the world’s total growth from 1980 to the turn of the century. Domestically, this economic rise has impacted on its more than 1.2 billion population (Bai et al 1). The high economic performance of China under financial repression has become a paradox in the light of the McKinnon-Shaw framework that asserts that financial repression in the form of interest rates ceilings, high reserve requirements and directed credit allocation will cause the stagnation of a country’s economy (Huang & Wang 3). Huang and Wang (2010) conducted analyses of the China paradox following three steps: quantitative measurement of financial repression in China using the principal component approach; investigation of the effects of repressive policies on China’s economic growth, and; examination of such effects. The authors concluded after the three-step process that China indeed experienced economic growth during the reform period amidst the presence of repressive policies existing although such financial repression caused a significant negative impact nevertheless. The slowing down of financial development, the dominance of the state over financial resources and the regulation of interest rates all combined to engender a negative impact on China’s economy (1-29). From these findings, it can be said that China’s significant economic growth was not prompted by financial repression, but had been lessened by it. Despite China’s strong economic recovery that catapulted it as a fast emerging world economy, Nicholas Lardy (2008) pointed out the need for the state to continue further economic reforms, particularly in its financial sector and exchange rate system. Lardy identified several negative effects that financial repression can exact on China’s economy. First, Lardy suggested that China’s undervalued exchange rate caused financial repression considering that the former had the potential to induce runaway inflation in the light of a rapidly increasing external surplus, unless the government imposes a ceiling on interest rates. Another effect of financial repression on Chinese economy is that it renders bank performance assessment difficult. For example, it would be difficult to credit bank profits to a singular basis because of the presence of implicit government subsidies and implicit taxes impose by the government on banks (Lardy 1-6). Moreover, financial repression encourages the development of underground finance. As government imposes restrictions on the banking sector, a sector of borrowers whose needs cannot be met by it turns to underground financing paying at higher interest rates than that imposed by banks. The potential size of the underground financing has the potential of damaging the financial system of China as well as destabilise the country’s monetary policies. In addition, financial repression towards household savings account has resulted in the decreasing contribution of household consumption on the economy making it dependent and vulnerable to changes in external demand. Finally, financial repression is less likely to strengthen China’s capital market considering that the only viable investment in China is bank deposits (Lardy 1-6). Conclusion McKinnon and Shaw, founders of the hypothesis of financial repression asserted that it causes economic stagnation and that countries must therefore liberalise their financial sectors. This assertion is confirmed by other studies and models as well. Nonetheless, a number of cases exists that point to a contrary finding such as the cases of Korea and Malaysia that were both placed under financial repression in the 1980s to avert financial collapse during the 1980s international recession. This paper has presented as well the cases of India and China, both of which are considered emerging global super economies. At first look, the McKinnon-Shaw hypothesis does not seem to be applicable to their cases considering their present economic achievements. The studies conducted by experts, however, confirm that the restrictions imposed on the financial sectors of these two countries have indeed negatively impact on their respective economies giving credence to the McKinnon-Shaw hypothesis. In the India case, however, the experts have warned that the facts resulting from its study should not be used on other countries considering that the success of policies depend on the instrumentality enforcing them. In the China case, it is difficult to accept that financial repression had negatively impact its economy considering its economic status today. In conclusion, it can be said that the effect of financial repression may go either way depending on the government instrumentality enforcing it and taking into consideration a myriad of other factors. Works Cited Bai, Chong-En & Li, David & Qian, Ying Yi & Wang, Yijang. Anonymous Banking and Financial Repression: How Does China’s Reform Limit Government Predation without Reducing its Revenue? 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