Journal Issue

Crisis prevention Appropriate sequencing of financial sector reform can play key role in successful liberalization

International Monetary Fund. External Relations Dept.
Published Date:
January 1999
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A country with a tightly controlled financial sector embarks on a series of ambitious reforms. It introduces market-based procedures for monetary control, promotes competition in the financial sector, and relaxes restrictions on capital flows. The moves stimulate the financial sector and spur growth.

At the same time, a second country begins to dismantle its repressed financial system, embracing similar reforms and pursuing many of the same policies. But instead of providing a boost, the reforms spark a full-fledged financial crisis that plunges the country into a recession.

Why was the loosening of financial sector controls associated with a boom in one country and a crisis in another? The connection between financial sector liberalization and financial crisis is complex, and a broad range of interrelated economic forces can influence events. The implications of these developments are analyzed in a new book, Sequencing Financial Sector Reforms: Country Experiences and Issues, edited by R. Barry Johnston and V. Sundararajan. The book looks at the practical experiences of Argentina, Chile, Indonesia, and other IMF member countries with financial sector reforms since the late 1970s and concludes that these point to a critical piece of the puzzle: the sequencing of reform.

An orderly and well-supported financial sector liberalization can mean the difference between stabilization and collapse. Countries pursue liberalization hoping that it will lead to higher and more sustainable rates of growth. Some fear that a failure to loosen controls in the financial sector will shut them off from global capital markets and make them unattractive to potential investors.

But these financial reforms can lead to trouble if they are sequenced inappropriately or are insufficiently supported. Academic literature has tended to place financial sector reform relatively late in the overall sequence of economic reform and to favor a gradual approach.

Still, the potential role of financial systems in improving economic performance argues for examining ways of accelerating the financial sector reforms while seeking to reduce the chances of an economic downturn due to poorly sequenced or poorly managed reforms. Maintaining controls on the financial sector is costly—in terms of low savings mobilization, capital flight, lack of monetary control, and an inefficient allocation of resources. The challenge of financial sector reform is to evolve strategies that can improve financial sector efficiency while achieving or maintaining financial stability.

Financial sector reform

Financial sector liberalization can be viewed as a set of reforms and policy measures designed to deregulate and transform the financial system and its structure. Throughout the world, financial sector reforms have led to greater flexibility in interest rates; an enhanced role for markets in credit and foreign exchange allocation; increased autonomy for commercial banks; greater depth for money, securities, and foreign exchange markets; and significant increases in cross-border flows of capital.

Such reforms have usually involved

  • increasing autonomy for central banks in monetary management;

  • developing market-based monetary control procedures and money and interbank markets to bolster interest rate regimes;

  • reforming prudential regulations and the banking supervision system;

  • recapitalizing and restructuring weak financial institutions, supported by enterprise restructuring policies;

  • reforming selective credit regulations and reducing the scope of directed credit and interest subsidies;

  • fostering autonomy and competition in the financial system and promoting institutional development of both banks and nonbank financial intermediaries;

  • developing long-term capital markets, including domestic public debt management and government securities markets;

  • reforming clearing and settlement systems for payments;

  • developing foreign exchange markets supported by appropriate prudential regulations on foreign exchange exposure; and

  • eliminating restrictions on payments and transfers for current international transactions and liberalizing controls on capital movements.

Country experiences

A number of IMF member countries have pursued financial sector liberalization since the 1970s, the study notes, and their experiences reveal close structural linkages among specific components of financial sector reforms. These linkages have implications for the appropriate sequencing of reform. Examinations of data from 40 countries, and of selected individual country experiences, such as Argentina, Chile, Indonesia, Korea, and the Philippines, yield lessons in a number of areas, including monetary reform, banking crises and prudential supervision, real sector effects, and capital account liberalization.

Monetary reform. Two types of monetary and portfolio shocks are evident from the experiences of various countries. First, in nearly all countries, financial liberalization has been followed by a period in which credit growth exceeded the growth of deposits, and in several countries, the gap between the growth of credit and the growth of deposits widened following the reforms. Second, eliminating controls on capital inflows has, at least initially, resulted in stronger capital inflows.

To cope effectively with these monetary and credit shocks and the potential foreign capital inflow, the study suggests, policymakers need to develop indirect instruments of monetary control. Countries that implemented successful reforms have tended to liberalize monetary controls in stages, ensuring that necessary concomitant reforms are implemented in a timely manner. They have also relied on a range of monetary instruments during the initial stages of reform. Countries have generally found it necessary to speed up the introduction of and reliance on indirect monetary controls to help manage the effects of foreign inflows of capital.

Banking crises and prudential supervision. The failure to strengthen bank supervision appears to have been a critical weakness in a number of financial sector reforms, in the view of the study. Reforms in several countries—for example, Argentina, Chile, and the Philippines—were undermined by financial crises that stemmed from banking sector weakness. These crises disrupted the entire financial sector and were accompanied by a sharp contraction in GDP. Also, banking sector problems and weaknesses in Asia contributed to the inefficient use of capital inflows and were an important ingredient in the currency crises that enveloped the region in 1997. These episodes indicate the significant two-way correlation between banking soundness and macrostability and point to the importance of implementing financial sector reforms with due regard to the soundness of financial institutions.

Early and timely attention to developing vigilant bank supervision and well-designed prudential regulations could have helped detect and contain the buildup of financial fragility, the study finds. In some countries, financial reform was accompanied by strengthened prudential regulations, but implementation of the regulations was weak. This underscores the importance of having not only adequate regulations but also the capacity to implement them.

Real sector effects. The transition from repressed to more market-oriented financial systems involves shocks to interest rates, the exchange rate, and financial flows, and policy-makers reactions to these shocks can affect economic performance, the authors report. Many countries have improved economic growth and efficiency through financial sector reforms, but several other countries, industrial and developing, have experienced financial crises and disruptions to economic growth.

When properly managed, financial reforms can contribute to strong improvements in economic growth and efficiency. Key elements of successful reforms included increases in real interest rates; management of credit growth following the reforms; and improvements in banking efficiency in the postreform period.

Capital account liberalization. Removing restrictions on the movement of capital into and out of a country can boost growth. But a poorly timed or badly managed liberalization of the capital account can expose a country to dramatic reversals in short-term capital flows and to other external shocks. The speed at which a country abandons controls on its capital account came under intense scrutiny in the wake of the Asian currency crisis of 1997, with some observers pointing to the opening of the capital account as a critical force in the crisis.

Sequencing Financial Sector Reforms: Country Experiences and Issues examines how financial sector reforms proceeded in a number of Asian and Latin American countries. The table below illustrates how Chile structured its financial reforms.

Chile: sequence of financial reforms
Deregulation of the financial sector
Short-term money market rates freed
Most commercial banks privatized
Barriers to entry lowered
Subsidized and selective credits reduced
Quantitative credit controls removed
Interest rates liberalized
Saving and dollar deposit rates indexed
Only real interest received is taxable
Restrictions on scope of activities eased
Commercial banks free to borrow abroad
Strengthening of supervisory, regulatory,
and legal systems
Disclosure requirements enforced
Capital requirements raised and indexed
Limits on concentration of
bank ownership introduced*
Supervisory jurisdiction widened
Limits on credit to a bank customer rationalized
Maximum firm shares doubled for banks
Reform of monetary control instruments
Foreign exchange rate primary monetary target
Interest paid on reserve requirements
Reserve requirements lowered and unified
Interest payments on reserve requirements
phased out
Auctions of central bank credit and
treasury bills introduced

Measure rescinded.

Data: IMF, Sequencing Financial Sector Reforms: Country Experiences and Issues

Measure rescinded.

Data: IMF, Sequencing Financial Sector Reforms: Country Experiences and Issues

The experiences of the Asian countries confirm that it is necessary to approach capital account liberalization as an integral part of a comprehensive program of economic reform, coordinated with appropriate macroeconomic and exchange rate policies. The question was not so much one of capital account liberalization having been too fast, since some of the countries in Asia followed a gradualist approach. Rather, successful opening of the capital account appears to call for coordinated and concurrent reforms irrespective of the pace of reforms.


Financial sector reforms require mutually supporting reforms in a number of areas, the study concludes. Reforms to certain sectors, such as monetary and exchange systems, can enhance economic performance, but without simultaneous moves to strengthen financial institutions, they can also contribute to banking crises and other economic problems.

Financial reforms involve monetary and portfolio shocks. To prevent such shocks from leading to financial crises, policymakers should introduce indirect instruments of monetary control early, strengthen financial institutions, and implement prudential regulation and supervision, according to the study. A mix of these instruments can help ensure adequate monetary control and support financial market development.

The study recommends that capital account liberalization be approached as an integrated part of comprehensive reform strategy and should be paced with the implementation of appropriate prudential measures and macroeconomic exchange rate policies.

Countries that implemented successful financial sector reforms and avoided financial crises significantly boosted their economic performance. Those that experienced financial crises, however, suffered a decline in performance. The study’s finding argues forcefully for ensuring that financial reforms, when undertaken, be properly managed and implemented with requisite attention to both stabilization and financial system soundness.

Copies of Sequencing Financial Sector Reforms: Country Experiences and Issues, edited by R. Barry Johnston and V. Sundararajan, are available for $27.50 each from IMF Publication Services. See page 284 for ordering details.

Photo Credits: EPA-Hurriyet for AFP page 273; Denio Zara and Padraic Hughes for the IMF, pages 274, 280, and 288; and Ralph Orlowski for Reuters, page 282.

Artwork: Massoud Etemadi page 286.

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