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The Impact of Premature Financial Liberalisation on Macroeconomic and Financial Stability Essay

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Updated: Jun 28th, 2019

Introduction

Currently, liberalisation has emerged as a current trend occurring in both developed and developing countries. A country may institute financial liberalisation among its financial institutions due to various reasons. For instance, these countries aim at accelerating the growth and development of domestic financial markets and institutions to achieve efficiency in the allocation of domestic capital and ensuring equitable sharing of individual risks.

In addition, while allowing financial liberalisation, most developing countries aimed at attracting developed countries and investors to pump capital into their economy; hence, financing higher growth coupled with investment (Bodie, Kane & Marcus 2005). Insurance against aggregate shocks and reduction of consumption volatility was also another conventional view that led to countries adopting the concept of financial liberalisation.

However, researchers and scholars have proved the aspects and conventional views on financial liberalisation as inappropriate elements. The latest financial and economic crisis that rocked the world in 2008 called for re-examination of the need to implement financial liberalisation.

However, this aspect does not mean that financial liberalisation does not have some benefits attached to it. A number of studies carried out demonstrated that financial liberalisation could initiate growth among financial markets and organisations (Fry 1995). For instance, financial liberalisation may call for a positive effect on growth rates, due to increment in the level of interest rates. Elimination of controls on interest rates and their upwards movement can stimulate a higher level of savings.

At this point, an assumption is made that higher interest rates would increase financial intermediation. In response to financial liberalisation, economic development can be fostered due to changes in quality and the quantity of investment (Nier 2009).The aim of this paper is to discuss the impact of premature financial liberalisation on microeconomics and financial stability of an economy.

Impacts on macroeconomics and financial stability

Effects on rate of savings and investment

One of the roles of liberalisation is to remove rigidity in the control of rates of exchange and rates of interest, compulsory allocation of credits from banks, and quantitative limitations in credit given to the private sector by banking institutions.

These aspects were part of the common practices among developing countries, hence causing inefficiencies that resulted into low direct investment. Current studies and evidence established shows that high rates of interest and financial depths due to financial liberalisation does not exclusively lead to increased savings and investment.

In most developing countries, financial reforms due to liberalisation lead a decrement in savings. Financial reforms adopted thereafter lead to the relation of credit constraints, thus increment in the alternatives available for borrowing, hence decreasing private savings. For instance, it was noted that financial reforms due to liberalisation led to decreased rate of savings in France, though there was a reversal on the negative perception between rates of interest and savings.

This was the same case with the United Kingdom, while further research revealed significant explanations on the evolution of savings. While some countries depicted a negative trend in private savings due to financial liberalisation, Chile was one of the countries where liberalisation had a positive contribution as it led to an increment in the country’s rate of growth.

Inadequate financial stabilisation measures

Countries should be warned against premature implementation of financial reforms due to liberalisation. This assertion means that there should be a careful evaluation of the reform to ascertain its benefits and disadvantages to the economy (Corrado & Jordan 2005). Due to controversies that lie behind financial liberalisation, all countries should scrutinise a reform thoroughly before implementation, as the outcome may not be desirable.

However, economists have asserted that financial liberalisation has risks attached to it, and thus it should be evaluated carefully to enjoy its benefits. For instance, excessive and rapid financial reforms are not desirable for they lead to credits that are difficult to sustain and increment of activities that lead to financial crises in an economy (Fry 1995).

In the absence of relevant and adequate measures or regulations, risks obtained increase significantly, hence affecting both banking institutions and capital markets. Close link between financial institution crisis and liberalisation is another sign of increased fragility nature of financial systems (Corrado & Jordan 2005). From the survey carried out by researchers on the banking crisis that took place from 1980 to 1995, it was evident that a crisis is more likely to occur within a financially liberalised economy.

The study was carried out on 53 developed and developing countries. Findings stated that in the process of initiating financial reforms due to liberalisation, domestic banks are subject or exposed to external shocks especially where the system of banking is not developed sufficiently. However, banking crisis could be due to extremely high growth especially in the countries where there are imperfections in the credit market.

Effects on banks and other financial institutions

In a developing country, financial liberalisation can yield negative results if not evaluated keenly before implementation for the existence of poor supervision of institutions and inefficient sectors accompanied with poor governance create loopholes for arbitrage and other uneconomical practices (Corrado & Jordan 2005).

Following financial liberalisation, there will be the establishment and mushrooming of banks, which tend to purchase foreign currencies at lower rates than the officially stipulated rates (Toporowski 2005).They later resell the foreign currencies to other forex exchange bureaus to make substantial returns.

The short-term arbitrage activities lead to poor closing balances and financial performance, as there are restricted towards lending to the private sector. This scenario leads to the rise of systematic risk in the banking sector with some banks landing into liquidation due to financial distress. Various macroeconomics variables are significantly sensitive to policies and reforms connected to financial liberalisation (Toporowski 2005).

They tend to depict a significant difference in their performance before and after the implementation of financial liberalisation. These variables include the real gross domestic product, foreign direct investment, and national savings. However, there may be insignificant or no effect at all on the rate of inflation and the country’s financial depth.

With disregard to many controversies surrounding financial liberalisation, some researchers affirm that there are advantages behind it; for instance, it has been argued that financial liberalisation and integration helps in improving functionality of various financial systems and institutions. This aspect results into increased funds as well as their availability. In addition, when countries are allowed to trade across borders, there is a tendency to diversify and spread risks over a wide region (Helleiner & Pagliari 2010).

For instance, researchers note that most international capital market can channel their savings to most productive utilisation without restriction on location. Others also argue that due to financial liberalisation, accountability and transparency improve. When investors place their money in foreign companies, they tend to be cautious; therefore, placing extreme emphasis on the accountability of their funds.

Companies are required to submit regular reports on the usage of funds to the investors, which leads to the reduction in the adverse selection of a country and multinationals to invest. In addition, moral hazards will be curtailed since the immoral practices will be defaulted by accountability, hence reducing liquidity problems in the market.

Moreover, the authorities in charge of international capital market help to discipline formulators of economic policies who may have malicious attempts of boycotting and exploiting the domestic capital market. With many studies carried out in relation to impacts of financial liberalisation, a majority of them have not helped in resolving a conflict that exists between those supporting financial liberalisation and those against it as a stimulator of economic growth.

Transparency and accountability

Although financial liberalisation stipulates measures that ensure transparency and accountability of funds in an economy, the measures suffer shortcomings largely (Shelagh 2005). For instance, they are not a true reflection of the extent of openness of capital accounts of various countries, which could be the reason for they are based on various restrictions in relation to exchanges and foreign transactions.

Measures stipulated may not be effective in capturing the required degree of stringent capital controls, hence being subject to change especially where legal restrictions are not changed. Moreover, the regulations fail to show actual integration of a financial status of an economy into the international capital market (Stiglitz & Uy 1996).This move leads to the inability to stop the inflow of speculative capital as experienced by some economies such as that of China.

Impact on capital flows

According to neoclassic economists, capital flows due to liberalisation result to drain of capital from some economies. For instance, rich countries have a notion that they are rich; consequently, they pump most of their capital into poor economies.

They do so for the poor economies return higher capital to the investor as compared to the amount invested initially (Goonatilake & Herath 2007). However, this aspect is a dangerous speculation especially when investing in a developing economy. These economies have poor structures and thus incur huge losses where investments occur blindly.

Capital inflows to poor economies serve as a complement for the limited resources and savings done domestically (Goonatilake & Herath 2007). However, it leads to reduction in the cost of capital, which leads to increased investment. In addition, increased funding leads to acquisition of technology in excess, and thus an improvement of the management coupled with other functions performed by an organisation. This element also results to the flow of advanced expertise from advanced economies (Lewis & Misen 2000).

Sharing of risks is a way though which specialisation propagates within a liberalised economy, which in turn fosters development and growth within a domestic financial sector and the overall economy. This scenario is the case as financial liberalisation imposes different disciplines in relation to policies regarding macroeconomics, hence stable policies.

However, researchers have expressed some challenging issues in defining the relationship between capital flow due to liberalisation and growth depicted. However, without careful scrutiny, this problem can hardly be recognised, especially when one solely relies on data generated through macroeconomics (Mishkin 2001). The reason behind this assertion is that strong statements on financial liberalisation can hardly be made without reliance on micro or macroeconomics data utilised in the study.

Volatility of outputs

Financial liberalisation has various effects on volatility of outputs. Due to financial liberalisation, poor countries are in a position to adopt diversification in various production sectors that mostly rely on agriculture or natural resources. However, diversification tends to reduce macroeconomic volatility ultimately. Countries with such economies tend to be exposed to industry specific shocks due to specialisation gained in the advanced stages of development (Mishkin 2001).

Based on comparative considerations, trade and financial integration can allow enhanced specialisation, thus leading to the problem stated above. The concept of macroeconomic volatility makes such a strong prediction on the relationship between volatility of consumption and financial integration. According to the consumer’s theory, both consumers and the entire economy are risk averse (Dick 2009, 150).

However, the theory recommends that consumers should utilise financial markets in insurance against risks related to incomes to sooth the effects of fluctuations in the growth of incomes. This aspect is vital because ultimately, the rate of consumption is highly dependent on the growth rate of incomes. There exist various benefits in relation to sharing risks on an international platform (Goonatilake & Herath 2007).

For instance, some macroeconomics policies are meant to stabilise or reduce volatility arising from consumption. In addition, they can have significant benefits to the economy, however minimal they could be. Higher volatility depicted by developing countries as opposed to developed ones indicates a potentiality to reap more benefits from international arrangements concerning sharing risks (Stiglitz & Uy 1996). Financial reforms concerning capital play a crucial role in curbing financial crises.

However, premature financial liberalisation can cause various financial crises especially among emerging economies and young markets. While these crises attract significant attention from researchers, there is little literature to support their findings. Both output and consumption volatility have been on the downwards trend recently among developing economies and emerging markets (Toporowski 2010).

Impacts on consumption

In relation to consumption, there exist predictions that financial liberalisation can lead to transnational movement of macroeconomics aggregates. However, the nature of shocks and specialisation determine the effect of financial integration among countries. Theoretically, the integration of a country’s financial system should lead to stronger cross movement of consumption patterns and growth among countries.

However, this element should not denote a correlation between incomes and output (Lewis & Misen 2000). Premature adoption of financial liberalisation can attract various reactions, which depend on whether a country is economically stable or not in terms of capital endowment.

However, countries should be careful since some impacts of financial liberalisation are transitory for they are not flexible, hence not subject to change. Increased accumulation of capital due to financial liberalisation leads to an increment in the rate of consumption at all seasons, which leads to a rise in wages leading to a decrease in the rate of returns on savings. However, the first generation after pioneers do not benefit from high wages, while at the same time experience the bad effects due to a decline in the rate of savings (Fry 1995).

Moreover, the effect is accompanied by an increment in the rate of consumption that can hardly be eliminated. During the first period after implementation of liberalisation, consumption keeps on the rise unless it is curbed through an increment in wage savings. If no measures are put in place to curb this menace, consumption will always remain higher than the period before financial liberalisation.

This point helps to denote a key point as stipulated by the conventional view of implementing financial liberalisation measures. A country can take advantage of development opportunities arising from financial liberalisation. However, this move calls for the presence of efficient and suitable infrastructure to enable right decisions towards remaining steady or moving towards financial liberalisation.

Effects on foreign and domestic debts

Premature financial liberalisation can lead to additional debts, hence instability of the economy. This scenario arises when enforcement of foreign and domestic debts occur concurrently, which means that enforcement of domestic debts leads to enforcement of the foreign ones. This aspect arises from the inability to discriminate; therefore, countries end up exchanging benefits accrued to enforcing domestic debts against the costs associated with acquiring and enforcing foreign debts (Itoh & Lapavitsas 1999).

In case entrepreneurs default on payment, the effect is on domestic debt, while its impact on consumption depends on the interrelation between foreign and domestic bonds in the entrepreneurs’ portfolios. Ultimately, this scenario leads to inequalities in the treatment of the two types of debts in favour of foreign debts (Mishkin 2001).

Conclusion

Impacts of financial liberalisation have remained controversial across the world for some of the issues have attracted considerable attention from many researchers and scholars. This paper has attempted to evaluate the impact of premature financial liberalisation on microeconomics and financial stability of any given economy and based on the discussion held above, premature liberalisation depicts both positive and negative impacts in both developed and developing or emerging economies.

Reference List

Bodie, Z, Kane, A & Marcus, A 2005, Essentials of Investments, 6th edn, McGraw-Hill, New York.

Corrado, C & Jordan, Fundamentals of Investments-Valuation and Management, 3rd edn, McGraw-Hill, New York.

Dick, N 2009, Global Financial Crisis: Foreign and Trade Policy Effects, Diane Publishing, New York.

Fry, M 1995, Money, Interest and Banking in Economic Development, Johns Hopkins Press, Baltimore.

Goonatilake, R & Herath, S 2007, ‘The volatility of the stock Market and News’, International Research Journal of Finance and Economics, vol.11, pp.53-64

Helleiner, E &Pagliari, S 2010, Global Finance in Crisis: The Politics of International Regulatory Change, Taylor & Francis, New York.

Itoh, M & Lapavitsas, C 1999, Political Economy of Money and Finance, Macmillan, London.

Lewis, M & Misen, P 2000, Monetary Economics, Oxford University Press, Oxford.

Mishkin, F 2001, The Economics of Money, Banking, and Financial Markets, 6th edn, Addison Wesley, Boston.

Nier, E 2009, Financial Stability Frameworks and the Role of Central Banks, <>

Shelagh, H 2005, Modern Banking, Wiley, Chichester.

Stiglitz, J & Uy, M 1996, Financial Markets, Public Policy and the East Asian Miracle. Web.

Toporowski, J 2005, Theories of Financial Disturbance, Edward Elgar, Cheltenham.

Toporowski, J 2010, Why the World Economy Needs a Financial Crash’ and Other Critical Essays on Finance and Financial Economics, Anthem Press, New York.

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