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Emerging Markets Financial Liberalization Effects On Economic Growth
The purpose of this essay is to examine the effect of financial liberalization on the economic growth in emerging markets. It is found that economic growth responds differently to each financial sector's liberalization. Liberalization in banking sector improves banking system efficiency, and stimulates investment, but also raises the proportion of non-performing loans. Stock market liberalization reduces cost of capital and promotes efficient capital allocation. Nevertheless, informational asymmetry in stock market increases the probability of market failure. Capital account liberalization leads to greater capital accumulation, higher employment and technology transfer, but also causes volatility, current capital account deficits and high inflation. The paper concludes by suggesting a more comprehensive assessment needs further research to capture more institutional and political implications.
Keywords: financial liberalization; economic growth; emerging markets.
Executive Summary 执行摘要
From neoclassical perspective, financial liberalization deepens the development of domestic financial system, improves efficiency, attracts foreign investment and optimizes capital allocation, thus has positive effect on economic growth. However, financial crises in developing economies during late 1990s and recent subprime crisis draw the re-consideration on relationship between financial liberalization and economic growth, particular in the context of emerging markets. This paper reviews the theoretical literatures and empirical studies from 1973 to 2010, in order to provide a panoramic view of academic debate on this topic in an organized way.
The effect of financial liberalization on economic growth depends on the nature as well as the degree (partial or full) of financial sectors liberalization. In banking sector, interest rate and credit deregulation, openness of domestic banking markets, and reduction of financial restriction, together increase efficiency of banking system, which in turn, stimulate investment and economic growth. However, banking system liberalization also tends to increase financial risks with high proportion of non-performing loans. In stock market sector, reduced cost of capital, improved corporate governance, and enhanced financial development spur the economic growth. However, distortions like informational asymmetries affect growth adversely. In capital account sector, increased capital inflow, greater foreign firm entry and FDI lead to greater capital accumulation, higher employment, technology transfer and knowledge spillover, thus, facilitate economic growth. However, volatility of capital flow, current capital account deficits, and incurred high inflation imply negative growth effect.
This paper assesses liberalization in each sector through theoretical explanation with empirical evidences support. It is found that economic growth responds differently to each financial sector's liberalization in emerging markets. Financial liberalization's positive impact on growth is dependant on the economic development level, the quality of domestic institutions, macroeconomic policy and so on. Literatures with implication on institutions and policy are in shortage. Therefore, the paper concludes by suggesting a more comprehensive assessment needs further research to capture more institutional and political indicators.
Financial liberalization concept was first raised in 1970s. Mckinnon (1973) and Shaw (1973) claim that domestic financial liberalization (financial deepening) spurs economic growth. Following researches mostly support that financial liberalization has positive effect on economic growth. It is believed that financial liberalization accelerates the process of capital absorption and efficient capital allocation, thus stimulate economic growth. Between the 1960s and mid-1990s, East Asia featured sustained and rapid growth, with impressive structural change in financial sectors (Asian Development Bank, 1997). However, after the emerging market currency crises (Mexico in 1994, Southeast Asia in 1997 and Russia in 1998), researchers have debate on the effect of financial liberalization on economic stability and growth.
Neoclassical school defines financial liberalization as elimination of interest rate control, privatization of nationalized banks and government interference in banking system (Beim and Calomiris, 2001). The other academic strand refers financial liberalization to financial openness, which focuses on capital account and equity market, for example, lowering of foreign investment barriers, facilitation and encouragement of capital flows (Bekaert, 1995), allowing inward and outward foreign equity investment (Bekaert and Harvey, 2000). Henry (2003) argues that strictly speaking, equity market liberalization is a specific type of capital account liberalization, which is the decision to allow capital in all forms to move freely in and out of the domestic market.
Researchers review the effects of financial liberalization (banking system, stock market and capital account) on economic growth continuously. A large line of research work provides evidence that development of a financial system is a key driver of economic growth (Levine, 1991; King and Levine, 1993; Levine and Zervos, 1996, 1998; Levine et al., 2000; Demirguc-Kunt and Maksimovic, 1996; Rajan and Zingales, 2001; Rousseau and Sylla, 1999, 2003; Bekaert et al., 2002, 2003). Although mainstream academic study claims the positive relationship between financial liberalization and economic growth, the growth effect is mainly driven by developed countries (Edwards, 2001; Klein, 2003; Klein and Olivei, 2008). It is still worth to note that economic growth responds differently to each financial sector's liberalization, especially in the context of emerging markets. Edison et al. (2002), Chandra (2003) and Arteta et al. (2003) suggest that the growth effect hypothesis in emerging markets is mixed and fragile.
This paper provides a comprehensive literature review by using the theoretical and empirical work available from 1973 to 2010, in order to examine the effect of financial liberalization on the economic growth in emerging markets. Three financial sectors: banking system, stock market, and capital account would be examined respectively. The structure of this paper is organized as follows: Section 1 examines the liberalization in banking system with relevant theories discussion and empirical evidences support. Section 2 examines the stock market with theory and empirical study. Section 3 includes the theory and empirical work on capital account liberalization. Section 4 concludes and proposes future research direction.
Theoretical explanation 理论解释
From a neoclassical perspective, domestic financial liberalization's effects are expected to facilitate economic growth (Rajan and Zingales, 1998; Love, 2003; Laeven, 2003). The theoretical explanation follows the rationale that reform increases efficiency, efficiency leads to growth. First, investment becomes efficient after liberalization. Elimination of interest rate control and credit deregulation directly remove financing constraints, stimulate bank lending, improve capital allocation, thus increase investment's quantity and efficiency (Beim and Calomiris, 2001). Second, banking system itself becomes efficient. Opening banking markets (i.e. privatization of nationalized bank, introduction of foreign bank competition) improves the functioning of national banking systems and the quality of financial services, which has positive implication for banking customers (Claessens et al., 2001). Leaven (2003) concludes that banking liberalization reduces financial restrictions, increases efficiency, stimulates investment, thus, incurs economic growth.
However, deregulation of domestic banking system also tends to increase financial risks and to worsen the quality of loans. Interest rate and credit deregulation allow banks with hazard moral and not constrained by an effective prudential regulation, to invest in risky assets in order to maintain larger market share (Hellmann et al., 2000). This reduces asset's quality that in turn results in a higher proportion of non-performing loans and provision for doubtful debts. Under such conditions, efficiency and growth are both adversely affected. Moreover, the high cost of acquiring information about local firms may limit foreign banks to 'cream-skimming', where they lend only to the most profitable local firms (Petersen and Rajan, 1995; Dell' Ariccia and Marquez, 2004; Sengupta, 2007) and adversely affect firms that want to get credit from them (Detragiache et al., 2008; Gormley, 2007, 2010).
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