Journal Issue

Economic Forum Financial sector liberalization promises benefits, but appropriate sequencing of reforms is crucial

International Monetary Fund. External Relations Dept.
Published Date:
January 1999
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Financial sector liberalization can spur economic growth and development. But liberalization can also entail risks if reforms are not appropriately designed and implemented. Participants in a recent IMF Economic Forum, “Getting It Right: Sequencing Financial Sector Reforms,” examined this issue from several angles, including the optimal speed of liberalization, the appropriate timing and sequencing of reforms, and the lessons learned from past attempts to defend the financial sector against external threats. V. Sundararajan, Deputy Director of the IMF’s Monetary and Exchange Affairs Department, was the moderator. Participants included Gerard Caprio, Director of the World Bank’s Financial Policy and Strategy Group and Head of Financial Sector Research; R. Barry Johnston, Division Chief in the IMF’s Monetary and Exchange Affairs Department; Nicolas Eyzaguirre, IMF Executive Director; and Anders Åslund, Senior Associate at the Carnegie Endowment for International Peace.

Case for “right regulation”

Properly balanced and sequenced liberalization, Gerard Caprio said, is the only way to ensure maximum protection from financial crisis. The dangers and inherent risks of unbalanced liberalization are well known. Moving from rationing credit by quantity to rationing by price could impose substantial losses on those who have privileged access to funds, including governments. It is also likely that interest rates and asset prices, tightly controlled in repressive regimes, will become volatile once the restraints are removed, thereby increasing risk.

The dangers inherent in liberalization were magnified, Caprio said, by the way governments approached the process. In many cases, governments favored reforms that were cheap, easy, and quickly implemented—such as deregulation of interest rates, formal reductions in directed credit programs, and capital account liberalization. Wholly neglected in these efforts were more difficult, long-term, and expensive reforms—especially institution building.

Proper regulation—and, by extension, the government’s role in the economy—can provide a framework for building a sound financial sector, Caprio said. The pervasiveness of the information problem in financial activities suggests that the larger the number of highly motivated monitors, the better the chance of guaranteeing the safety and soundness of the banking sector. The first line of defense in this “multiple eyes” approach should be the bank owners and managers. The greater the safety and soundness of their banks, the less likely owners will be to take excessive risks. Thus, governments need to find ways to increase that stake by assuring banks they can earn good profits from respectable banking rather than by gambling or by increasing the liability of bank owners and managers for imprudent actions.

The second line of defense should be the markets or bank creditors. Strong disclosure laws will provide information once accounting and auditing procedures have been developed to ensure that the information exists and is reliable. Forcing banks to issue uninsured subordinated debt is another attractive way to create a class of large bank creditors that will have an incentive to monitor the risk that the banks are taking, Caprio noted.

Supervisors would provide the last line of defense. They have an important role in ensuring safety and soundness in the banking sector, Caprio said. But effective supervision is not possible unless bankers oversee their own institutions and markets monitor developments, because supervisors might not find out about problems until too late.

Poor financial reform will surely generate back-lash—possibly against all kinds of reform—so getting financial liberalization right is indeed critical, Caprio concluded. But establishing effectively working institutional structures in the financial sector is a long-term affair, and the effort needs to begin right away.

Sequencing and orderly liberalization

The recent currency crises in Asia, Russia, and Latin America have demonstrated the urgency of finding ways to achieve orderly liberalization, R. Barry Johnston said. Countries have turned to liberalization because of the benefits it provides—in particular, enabling them to achieve higher and more sustainable rates of growth. The trend toward more liberal capital accounts also reflects global developments—technical and financial market innovation, and the liberalization of current payments and transfers—that have generally lessened the effectiveness of capital controls. Countries may have to deal with large capital movements whether or not they have liberalized their own financial systems, Johnston said.

Capital account liberalization is an element of a broader program of financial sector reform that develops systems, institutions, and markets designed to operate in a world where financial resources are allocated by market processes. In the absence of these reforms, any liberalization attempt is likely to founder, Johnston noted. In particular, capital account liberalization will require broader financial sector reform, consistent monetary and exchange rate policy mix to avoid creating incentives for more volatile capital flows, and development of procedures and policies dealing with risk.

Turning to actual experiences, Johnston said there could be no unique approach to sequencing financial sector reform. What matters, rather, is the reform package, the supporting policies—that is, the “synergies within the reform mix.” The speed with which the reform takes place, Johnston noted, has not proved to be a critical element in its success or failure, but the comprehensive policy package is crucial.

How does capital account liberalization fit into this process, particularly when a country has a weak financial market? Capital account liberalization is not an all or nothing affair, Johnston noted. Elements within the capital account can be liberalized at different points as a country opens its financial system. The key issue is to identify those liberalizations with the objectives of building and establishing efficient financial markets and instruments so that the financial system is equipped to withstand shocks.

Discussing the liberalization of short-term capital flows, Johnston noted that such flows have often become problematic when there was a regulatory bias toward them, the country provided implicit or explicit exchange rate guarantees, and inadequate attention was paid to the risks of such flows.

Creating a “critical mass” of reforms

The choice between a big-bang liberalization or a gradual approach is really a “false problem,” according to Nicolas Eyzaguirre. The transition from a closed economy with a repressed financial system to a market-based, financially open system is a difficult process. Because the amount of required institution building is enormous, big-bang attempts will almost unavoidably end in a crisis and a subsequent reversal. But the gradual approach is also unworkable; it is impossible to break down the liberalization process into finite building blocks, because of the strong interlinkages between the various components—for example, fiscal, monetary, domestic financial, and capital account issues. A more practicable approach, he said, is to aim for a “critical mass” of reforms that would include measures in all areas. These measures would be divided into core areas where reforms should be implemented early and into subsidiary areas where reforms can be postponed.

Among the core conditions, Eyzaguirre said, fiscal soundness is a prerequisite. Beginning the process of financial system reform with a weak and vulnerable fiscal position would invite domestic shocks that the newborn financial system might not be able to handle. More important, Eyzaguirre observed, a sound fiscal position is key for financing corrections to, and recovering early from, any financial crisis that may come down the pike.

Monetary stability is also of primary importance because, among other things, it imparts credibility to the central bank. A credible central bank, in turn, offers some defense against an attack on the domestic currency.

Because financial sector reform is extremely important for growth, Eyzaguirre advised careful in the pursuit of fiscal and monetary stability. A cautious liberalization of the interest rate would, he noted, avoid initial overshooting and excessive credit expansion. Also, direct monetary control instruments could be removed gradually to allow the development of mechanisms for open market operations and more sophisticated market-based instruments.

Macroeconomic balancing and domestic financial sector regulation should precede capital account deregulation, Eyzaguirre said. Without such regulation, foreign investors would take advantage of perceived soft budget constraints or willingly lend to distressed banks in the expectation of a government bailout.

As for sequencing capital account deregulation, Eyzaguirre said he favored initially liberalizing foreign direct investment, some long-term government borrowing, and portfolio flows, even if that involved retaining controls on other flows. He was aware that some observers had argued that considerable institutional capability was needed to differentiate and enforce controls, but, he contended, the institutional capability needed in a system without controls was also high.

Is “tough medicine” the only cure?

Departing from the tack taken by previous speakers, Anders Åslund said he would concentrate not on what should be done in financial sector reform but on what can be done, given the actual situation of a country—in this instance, Russia and Ukraine. Both countries have suffered recent financial crashes and are structurally weak. The choices open to them, Åslund said, are much more limited and much less attractive than some observers would like to admit.

The causes of the severe financial crises that struck Russia and Ukraine last year were similar and straightforward: large budget deficits and the inability to finance them; overvalued pegged exchange rates; and problems servicing short-term debts because of limited international and domestic reserves rather than because of large overall government debt.

The preventive actions that should have been taken were as obvious as the symptoms, Åslund said: reduce budget deficits, devalue the exchange rate earlier and faster; and restrict the government’s own borrowing, at least of short-term international capital. The relevant question, Åslund said, is why these actions were not taken.

Initially, the effect of the crash on the Russian economy was much more severe than that on the Ukrainian economy, Åslund said: industrial output in Russia fell by 15 percent in September 1998, and GDP fell by 4.6 percent, whereas in Ukraine, GDP fell by barely 2 percent. Both countries devalued, but the Russian devaluation was fourfold, the Ukrainian, twofold. Similarly, inflation in Russia soared to 200 percent from June 1998 to June 1999, while in Ukraine, it doubled to 20 percent in the same period. In addition, Russia defaulted on its treasury bills, and half of its banks collapsed. The financial crisis in Russia was, in social terms, more costly than the entire transition period up to that point.

Åslund said a year later the situation looks quite different. Both countries have been forced to make radical cuts in public expenditures, so the budget deficits are now very small; both have lingered on the verge of external default but have essentially avoided it through restructuring; and both are getting IMF funding—although with some delay.

In short, both countries are managing to do a lot of things they could not do before, because the financial crash in Russia and its repercussions in Ukraine made the hard budget constraint credible for the first time. What the precrisis reformers never managed, Åslund said, the financial crash—an exogenous force—made possible.

In Russia, the salutary effects of the crash are even more apparent than in Ukraine. The country has been forced to undertake a substantial restructuring of the banking sector, with the result that a lot of bad banks have been closed. As a result of the hard budget constraints, arrears are falling and monetization is rising dramatically. Income differentials have fallen sharply, largely because of the hit the upper middle class took from the financial crash.

Unlike Ukraine, Russia is already experiencing a resurgence of portfolio investment; the Russian stock index has risen almost fourfold since October 1998, and Eurobonds have risen almost threefold. Most important, Åslund observed, industrial growth in the first half of 1999 has risen to 3 percent and is clearly headed for double that amount for the year. Ukrainian output, however, remains stagnant.

The fundamental problem in both Ukraine and Russia, Åslund said, is that they were dominated by rent seekers from the old communist elite who hoped to make money on government subsidies and regulations. In Russia, at the heart of this rent seeking were the banks, which were in reality not banks at all, but powerful general companies that were wholly resistant to regulation or reform.

Nothing could dislodge these nonbanks or break their power, Åslund noted, short of attrition or exogenous shock. Similarly, the budget deficit could not be brought under control as long as the elite thought they could get more subsidies from the government. And, structurally, since the Russian banks were not really banks, they blocked the development of a banking sector. The crash, Åslund said, took out the nonbanks and left the real banks standing.

Several conclusions may be drawn from the Russian and Ukrainian experiences, Åslund noted:

• The main task of the initial transformation is to impose hard budget constraints. To do so, the old power structure needs to be disarmed. A financial crash may be the only way to break up the power of these structures.

• An early and radical liberalization can weaken the oligarchy—either immediately if the liberalization is successful, or later because the effort facilitates a crash.

• In Russia, the political strength of the banks was solidly entrenched even before the transition process began; there was no chance that they would submit to regulation.

These observations, Åslund said, suggest that in countries like Russia and Ukraine, where the governments could do little to resist vested interests, there was scant choice about sequencing of reform, and orderly liberalization was out of the question from the outset. For countries in similar circumstances, he said, the only choice may lie between petrification and stagnation and doing as much as they can whenever they can.

The full transcript of this Economic Forum, “Getting It Right: Sequencing Financial Sector Reforms,” is available on the IMF’s website (

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