Article

Financial Reform and Capital Flows in a Developing Economy

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1979
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Authorities in a developing country face difficult policy choices when simultaneously confronted with slow growth, rapid inflation, and external balance problems. Restrictive monetary and fiscal policies usually result in improvements in the rate of inflation and the balance of payments at the expense of even slower growth. Thus, it is not surprising that in the past decade there have been several attempts to improve on the tradeoff between growth and inflation by combining traditional stabilization policies with trade and financial market reforms. It has been argued that these reforms will raise the rate of growth by stimulating exports, investment, and savings and lower inflation by increasing the supplies of foreign and domestic goods. While these programs have encompassed many structural and institutional changes, the most common themes have been the elimination of trade restrictions (e.g., quotas), a substantial depreciation of any overvalued exchange rate, and the relaxation or elimination of ceilings on nominal interest rates.

This mix of reform and stabilization policy has generally proved successful over the medium term, but one unanticipated side effect often has been a substantial capital inflow which has made it difficult for the authorities to control monetary growth; this has occurred despite the fact that capital controls and weak domestic capital markets have traditionally allowed developing countries to operate in a world of capital immobility. These experiences raise the question of what steps the authorities can take to retain control over domestic monetary aggregates. It has been suggested that these inflows be managed by either capital controls, taxes on capital account transactions, or a move to a flexible exchange rate. The objective of this paper is to show that if capital inflows are properly anticipated they can be made a beneficial part of stabilization and reform programs. In fact, it will be argued that stabilization programs which incorporate capital inflows not only will generate a less disruptive financial reform program but also will yield a more rapid reduction in inflation and a higher rate of growth than programs which attempt to eliminate these inflows. Capital inflows will have this beneficial effect, however, only if exchange rate policy and interest rate decontrol are carefully coordinated.

This paper is divided into five sections. The first section presents a simple macroeconomic model of a developing economy which focuses on the linkages between capital flows, exchange rate movements, financial reform, growth, and inflation. The model is used in the second and third sections to analyze the problems of integrating trade and financial reform with stabilization policy to minimize the departures of the rate of inflation and rate of growth from their target values. In the fourth section, these results are used as general criteria for analyzing the experience of Korea with financial reform and capital flows. A summary of conclusions is presented in the fifth section.

I. Basic Model

Since one cannot hope to encompass all the complexities of a developing economy in a simple model, the analysis here focuses on identifying how financial markets, exchange rate policy, and monetary policy interact to determine the rate of inflation, the rate of growth, and the balance of payments.

OUTPUT AND PRICES

A labor-surplus economy which produces a set of consumption and investment goods via fixed coefficient technologies using physical capital, labor, and real working capital is considered.1 Employers face an unlimited supply of labor at an institutionally determined real wage that is a markup over the average product of labor in the subsistence sector. With fixed coefficient technologies and an unlimited supply of labor, total production is constrained by the stocks of physical and real working capital. Let K be the sum of the stocks of physical capital services (F) and real working capital. The ratio of physical to total capital (F/K = λ) will be taken as fixed by technical factors.2 If the flow of capital services is taken as proportionate to the stock, then output (Y) can be written as

where σ = output/capital ratio.

In an open economy, a distinction must be made between the prices of imported goods and the prices of domestic (or exported) goods. Since the assumption is that an imported good has a fixed world price, its domestic price equals the world price times the exchange rate {XPF), where X equals the exchange rate and PF the world price of the import good. If domestic nationals view the import as an imperfect substitute for the domestic good, then domestic as well as foreign demand and supply considerations determine the absolute and relative prices of the domestic good. In this situation, the percentage rate of increase in the prices of domestic goods (P/P = Π) will depend positively on the excess demand for domestic goods.3

where Q = demand for domestic goods

  • Y = supply of domestic goods

  • In = natural logarithm

Since the demand for domestic goods will reflect both foreign and domestic demands, Q will be a negative function of the prices of domestic goods relative to foreign goods and a positive function of real income, foreign real income (YF), and the expected rate of increase in the prices of domestic goods.4

where τ1, τ2, τ3, τ4 > 05

This means that equation (2) can be rewritten as

With both foreign and domestic goods, the general price level (PG) is a weighted average of the prices of domestic (P) and foreign (XPF) goods. It is assumed that the general price level is as follows:6

financial markets and capital formation

For simplicity, the economy’s financial structure consists only of a banking system. In this analysis, the importance of these financial institutions in the growth process will be discussed in terms of the percentage of all additions to physical and real working capital holdings financed by borrowing from the banking system (θ).7 Within this framework, the real demand for loans (l) is

where L = nominal stock of loans.

This financing decision is one aspect of the overall decision that capitalists must make regarding additions to their physical and real working capital holdings. While many hypotheses have been advanced to explain such behavior, the assumption here is that additions to the physical stock of capital are determined by income and the physical savings ratio. Given that firms finance θ of capital stock additions through bank borrowing, the physical savings ratio (S) will be sensitive to changes in the return on capital (rK)8 and the real loan rate (rLΠGe), where ΠGe is the expected rate of inflation. Thus, Ḟ = S(rK – rL + ΠGe) Y + θḞ, where θḞ represents the proportion of new capital financed by bank borrowing. Since physical and real working capital are utilized in fixed proportions, the physical savings relationship implies that additions to the sum of physical and real working capital stocks (K˙) will be as follows:9

Note that equation (6) determines the growth of the total capital stock and the demand for new loans.

Credit market equilibrium requires that the demand for loans equal the supply of loans. The supply of bank loans will depend on bank portfolio behavior, the structure of banking regulations, and the demand for bank deposits. Monetary authorities in developing countries have usually imposed restrictions which not only limit entry into the financial system but also strongly influence its portfolio choices. These regulations often have resulted in an oligopolistic financial system with little price competition and an excess demand for real credit. To capture the influence of some of these restrictions, the banking system in this model will face a required reserve ratio of k per cent on deposits, a ceiling nominal loan rate of rL1, and a ceiling nominal deposit rate of rD1 Under the assumption that banks do not hold excess reserves, the nominal supply of bank loans will equal (l–k)D (where D is the nominal stock of deposits). While a high k will limit the proportion of deposits that can be transformed into loans, the ceiling interest rates will be the primary factors leading to an excess demand for credit. To understand why this is true, the demand for deposits must be considered.

The household sector’s desired holdings of bank deposits will in general depend on income and the expected real yields on assets (including demand deposits) that make up its portfolio. Since the concern here is with international capital movements, domestic portfolios will contain foreign assets as well as domestic deposits.10 In this situation the ratio of deposits to income will be taken as a positive function of the expected real yield on domestic deposits and a negative function of the expected real yield on foreign assets. The real yield on domestic deposits will equal the nominal deposit rate less the expected rate of inflation (rDΠGe, where rD equals the deposit rate and ΠGe is the expected rate of change in the price level). In contrast, the real yield on foreign assets will equal the nominal foreign interest rate (rF), plus the anticipated capital gain generated by a depreciation of the exchange rate (xe), and less the expected rate of inflation (rF + xeΠGe). An increase in the relative yield on domestic deposits will thus generate a capital inflow that represents the redistribution of portfolio holdings from foreign assets to domestic deposits. Thus,

where rD = domestic deposit rate

  • rF = foreign interest rate

  • re = expected rate of depreciation of the exchange rate

  • ΠGe = expected rate of inflation of the general price level

This formulation of the deposit/income ratio allows for varying degrees of capital mobility. If capital is completely immobile internationally, then the real return on foreign assets will not affect deposit holdings (f2 = 0). Alternatively, if capital is perfectly mobile, then the real return on domestic deposits will be identical (apart from a risk premium) with that on foreign assets (rDΠGerF + xeΠGe). Since the degree of capital mobility lies between these two extremes for most developing countries, we will focus on the intermediate case where the deposit/income ratio is sensitive to the yields on both assets.11

Given this portfolio structure, the combination of rapid inflation, periodic exchange rate depreciations, and ceiling nominal lending and deposit rates will result in an excess demand for real credit. With a high expected rate of inflation and a fixed nominal loan rate, firms will see a negative real loan rate which will generate a large demand for real bank credit. In contrast, a high expected rate of depreciation of the exchange rate and a fixed nominal deposit rate will increase the expected yield on foreign assets relative to that on domestic deposits. The resulting portfolio adjustments will reduce real deposit holdings and limit the banks’ ability to supply real credit. This shortage of real working capital will contribute to the slowing of the rate of growth.12

To increase the real size of the financial system and raise the growth rate, the authorities must undertake financial reforms that include the elimination of nominal interest rate ceilings and the easing of restrictions on entry into the banking system. Ultimately, this will result in a competitive financial system that yields market-clearing interest rates. To institute this policy, the authorities must decide on how rapidly to eliminate the existing financial restrictions and on how to coordinate this reform program with stabilization policy. Whatever coordination takes place, however, the authorities’ first objective must be to establish lending and deposit rates that eliminate the initial excess demand for real credit. This will require that

MONEY MARKET

For simplicity, assume that all money is held as deposits in the banking system. Currency holdings could be added simply if the currency/deposit ratio is fixed. While the demand for money is given by equation (7), the supply of money will be determined by the stock of high-powered (or base) money. In the absence of currency holdings, the stock of base money will equal the reserves of the banking system (i.e., H = kD, where H is the nominal stock of base money). Whether the authorities can fix base money will depend on their exchange rate policy. Since there are both domestic (domestic credit) and foreign (foreign exchange reserves) sources of base money,

where DC = stock of domestic credit

  • R = foreign exchange reserves measured in terms of foreign prices

  • X = exchange rate

If there is a floating exchange rate, then the government can control base money since foreign exchange reserves will remain fixed. Under a system of either fixed or managed exchange rates, however, base money becomes endogenous. In this situation, the rates of growth of base money and the money supply (μ=1dHHdt=1dDDdt if k is constant) are determined by private sector portfolio decisions. Portfolio adjustments will generate a balance of payments deficit (surplus) whenever domestic credit is growing more (less) rapidly than the demand for nominal money.13 The authorities therefore can use domestic credit to influence the balance of payments even though they cannot control the rate of monetary growth.

The authorities thus have the choice of either setting the domestic level of foreign prices by controlling the exchange rate or of controlling the growth of the nominal money supply. Since most developing countries seem to prefer exchange rate policies, the exchange rate is considered the primary policy instrument.

EXPECTATIONS

The expected rate of inflation and the expected rate of depreciation of the exchange rate play crucial roles in determining the real returns on deposits, loans, and foreign assets. Since the world price of the foreign good is fixed, the expected rate of increase of the overall price level (ΠGe) will equal a weighted sum of the expected rate of increase in the prices of domestic goods (Πe) and the expected rate of depreciation of the exchange rate (xe). Thus, ΠGe = αΠe + (1–α) xe.

There are a number of hypotheses about how the private sector formulates its expectations. For example, the adaptive expectations hypothesis assumes that market participants change their expectations about a price only on the basis of their observations on that variable. Unfortunately, this assumes that individuals ignore the fact that current changes in monetary and fiscal policy influence future price movements. An alternative hypothesis is that the public forms its best estimate of the impact of policy actions on prices and output. This rational expectations structure seems appropriate for economies that have a history of rapid inflation. In this situation, expectations are less sticky because the cost of ignoring the future effects of current policy actions can be quite high. Under this rational expectations hypothesis, the expected rate of inflation will equal the actual rate of inflation; and the expected rate of depreciation of the exchange rate will equal the actual rate of depreciation.14 Thus, Πe = Π, xe = x, and ΠGe = αΠ + (1 - α)x.

INITIAL CONDITIONS AND AUTHORITIES’ OBJECTIVES

Initially, it is assumed that the authorities face rapid inflation, a low or zero rate of growth, and a balance of payments deficit. While the inflation and balance of payments deficit will reflect past monetary growth and inappropriate exchange rate policies, the economy’s slow rate of growth will reflect the shrinking real size of the financial system. The shortage of real bank credit will depress output in the short run (by reducing the availability of working capital) and in the long run (by reducing capital formation).

The authorities’ response to this situation will be determined by their long-run policy objectives, their willingness to trade off between these objectives, and their impatience regarding the attainment of these objectives. It is assumed that the authorities ultimately want to achieve the maximum sustainable growth rate, a stable price level, and balance of payments equilibrium.15 To simplify, the importance the authorities attach to the attainment of the first two of these objectives will be summarized in an objective function which expresses the disutility the authorities receive whenever the actual and target rate of inflation and rate of growth differ. The authorities will thus seek to maximize

where ρ = authorities’ internal discount rate

  • δi = relative importance attached to the inflation (δ1 and growth δ2) objectives

  • ΠG = overall rate of inflation

  • n = real rate of growth

The willingness to trade off between the growth and inflation objectives is given by the δi. If δ1 > δ2, then departures from the inflation objective receives more emphasis than departures from the growth objective. The authorities will be impatient (patient) about achieving their objectives if ρ has a high (low) value.

The authorities will select the paths for their policy instruments that maximize equation (10). In this analysis, there are four instruments: the ceiling loan rate, the ceiling deposit rate, the stock of domestic credit, and the exchange rate. We have seen, however, that there cannot be independent monetary and exchange rate policies. When the authorities focus on attaining the appropriate path for the exchange rate, domestic credit can only be used to ensure balance of payments equilibrium.

FINANCIAL REFORM AND FOUR CONSTRAINTS ON INTEREST RATE POLICY

In order to have a successful financial reform in most developing countries, there are certain general constraints which must be placed on the interest rate policy that the authorities can select. If the authorities view the domestic financial system as highly competitive, then the financial reform program can consist solely of the removal of the interest rate ceiling. Competitive forces will then generate a level of interest rates that will establish and maintain (1) money market equilibrium, (2) credit market equilibrium, and (3) a normal level of profits for the firms in the financial system. Since most developing countries limit entry into their financial systems, a monopoly or oligopoly element is likely. In this situation, competitive market results can be obtained only if the authorities set the ceiling lending and deposit rates not only to maintain continuous money and credit market equilibrium but also to limit the differential between lending and deposit rates. The following will show that there are four constraints that must be placed on interest rate movements if the authorities are to duplicate the interest rate behavior of a competitive financial system.

To eliminate an excess demand for credit, both the ceiling deposit and lending rates must be increased. Credit market equilibrium requires that the demand for loans (L) equal the supply of loans ((1–k)D). If we let l = L/PG and d=D/PG, this condition for credit market equilibrium becomes l = (l–k)d. Since firms finance θ of all additions to the capital stock through bank borrowing, l = θK. The demand for real deposits is d = f · Y = fσK (see equation (7)). This means that l = (l–k)d is equivalent to θK = (l–k) fσK or f = θ/α(1–k). Thus, the initial increase in the deposit rate will establish credit market equilibrium if it generates a deposit/income ratio (f) equal to θ/σ(1–k). This is the first constraint that must be placed on the path the authorities can select for rD.

The loan rate must generally also initially be increased to ensure a reasonable level of profits in the financial system. 16 If interest rates are decontrolled in a competitive financial system, then the loan rate will rise until consistent with zero excess real profits for each firm in the financial system. In the less competitive environment typically found in developing countries, the authorities must either increase the degree of competition or limit the increase in the loan rate to avoid the emergence of monopoly profits. Real profits (Pr) equal earnings on loans (rLl) less deposit costs (rDd) less any fixed and variable factor costs (fvc). Since l = (l–k)d, Pr = [rL(1–k) – rD]d–fvc. Zero excess real profits therefore requires 0 = [rL(l–k)–rD]–fvc/d.17 If factor costs in the banking system are proportionate to real deposits, then zero excess profits requires that the loan rate exceed the deposit rate (divided by l–k) by a fixed amount. Thus,

where fvc′ = fvc/d (a constant). This is a second constraint that must be placed on the path the authorities can select for rD and also for rL.

Once the appropriate initial interest rate changes have occurred, there will be both money and credit equilibrium and a normal level of profits for banks. There are, however, only certain paths for rL and rD that will maintain financial market equilibrium through time. Money market equilibrium will be maintained if the private sector continuously holds its desired level of deposits. This requires that D/PG = d = f(rD–αΠ–(1–α)x, rF + x – αΠ–(1–α)x)·Y (see equation (7)). If we define μ=1DdDdt,n=1YdYdt=1KdKdt (by equation (1)), x=1xdXdt,andΠ=1PdPdt, then this condition for continuous money market equilibrium can be rewritten as

Thus, money market equilibrium will be maintained if the nominal supply of money grows at a rate equal to the sum of the rise in the price level, the real rate of growth, and the change in the velocity of money produced by movements in the real deposit rate and the real yield on foreign assets.

In contrast, credit market equilibrium requires that (l–k)D = L= θKPG or, upon taking the time derivative,

Continuous credit market equilibrium will therefore occur if the increase in nominal credit equals the rate of growth plus the increase in the price level.

When the conditions for continuous money and credit market equilibrium are combined, then the private sector will simultaneously hold its desired stocks of loans and money if

where η=f2f1<0

This third constraint on the path the authorities can select for rD means that once the appropriate initial change in rD has occurred then continuous money and credit market equilibrium can be maintained if the nominal deposit rate moves in line with the rate of increase in the prices of domestic goods and the rate of depreciation of the exchange rate. In general, it is not clear whether rD must rise or fall with an increase in Π or x.18 It can be shown, however, that rD must rise (fall) whenever x and Π increase (decrease), as long as the deposit/income ratio is more sensitive to changes in the real deposit rate than in the yield on foreign assets (1 + η > 0).

The final constraint, on the path that the authorities can select for the loan rate, is that rL must move in line with the deposit rate in order to avoid creating monopoly profits in the financial system. This is required as long as factor costs in the banking system are proportionate to real deposits (see equation 11) and the reserve ratio is constant.

II. Optimal Stabilization Policy, Exchange Rate Movements, and Financial Reform

Subject to the above constraints on interest rate movements, the authorities can use the ceiling loan and deposit rates, the exchange rate, and domestic credit to minimize departures of the rate of inflation and rate of growth from their target levels. It must be stressed that the analysis of the optimal mix of financial reform and stabilization policy is not designed to provide a description of the best program for all countries. The optimal program for each country must necessarily allow for differences not only in the economic and financial structures of various economies but also in the initial conditions faced by each economy. The objective here is to examine this optimal program to see which of its general characteristics are likely to be common to all stabilization programs. It is, therefore, useful to begin the specification of the optimal program by examining the general effects of the policy instruments on ΠG and n.

Given the fixed world price of the import good, the rate of inflation (ΠG) equals the weighted sum of the rate of increase of domestic prices (αΠ) and the rate of depreciation of the exchange rate ((1–α)x). Thus, exchange rate policy has a direct impact on the overall rate of inflation. In contrast, interest rate deregulation can reduce inflation by eliminating the shortage of real working capital and allowing output to expand.

Once the initial credit market disequilibrium is eliminated, the real rate of growth will be determined by the investment activities of firms. Since firms add to their stock of capital according to K˙ = s(rK – rL + ΠGe · Y (equation (6)), then

The real rate of growth thus depends on the marginal product of capital (rK), the loan rate (rL), the rate of increase of the price of domestic goods (Π), and the rate of depreciation of the exchange rate (x). Both exchange rate and interest rate policy, therefore, have a direct impact on the rate of growth.

When the authorities’ objective function is combined with the relationships describing Π and n and the constraints on the paths that can be selected for the interest rates, there is a set of nonlinear differential equations (containing n, rL, rD, P, and X as unknowns) that will describe the economy’s behavior over time. In general, this nonlinear system will be difficult to solve for the optimal paths for rD, rL, and x (the policy instruments) except by analytical methods. There is a fairly simple solution, however, if we focus on a linear approximation to this system around its steady-state equilibrium. 19 The four key relationships (apart from the authorities’ objective function) will then be given by the following: 20

While the first equation describes the determinants of the growth rate, the second relationship represents the combinations of r1 and rD that will avoid excess profits in the financial system. The third equation describes the movement in rD that will ensure money and credit market equilibrium, and the final relationship illustrates the response of the prices of domestic goods to the excess demand for these goods. The above relationships reveal two important facts. First, in terms of specifying the optimal paths for rL, rD, and x, we have a recursive system. A normal level of profits (the second equation) can be maintained in the banking system if the loan rate changes in line with the deposit rate. And continuous money and credit market equilibrium requires that the deposit rate increase whenever either the rate of increase of the prices of domestic goods (Π) or the rate of depreciation of the exchange rate (x) rises. Thus, we can first specify exchange rate policy and then imply the appropriate interest rate policy. This indicates the interdependence between interest rate and exchange rate policy. The second important fact is that, given the recursive nature of interest rate policy, the above relationship can be reduced to one linear equation for n and one differential equation for Π of the form

equation (16) represents the reduced form expression for the rate of growth once the lending and deposit rates have been expressed as functions of Π and x. Given that η < 0, s’ > 0 and, in general, 1–τ3ψ > 0,21 it is clear that ∂n/∂x < 0; but the sign of ∂n/∂Π is ambiguous. 22 It can be shown, however, that a sufficient condition for ∂n/∂Π > 0 is |η| > k.

Finally, when equation (16) is used to eliminate the n – n term in (17), we obtain a reduced form differential equation for Π of the form

If k < |η|, then equation (17’) implies that an increase in Π will lower Π, which will contribute to a stable adjustment path. 23 In contrast, a higher rate of depreciation of the exchange rate will lead to a more rapid increase in the prices of domestic goods.

When equations (16) and (17’) are combined with the authorities’ objective function given in equation (10), we have three equations that can be solved for the paths for Π, n, and x that will maximize the authorities’ objective function. Given the solutions for x and Π, then equations (11) and (14) can be solved for the paths for rL and rD that yield money and credit market equilibrium. 24

III. Optimal Stabilization Policy and Financial Reform

To be successful, the optimal mix of stabilization policy and financial reform must simultaneously lower the rate of inflation, raise the rate of growth, and eliminate any balance of payments deficit. Unfortunately, policy measures which lower inflation generally slow the growth rate. Thus, while it is not surprising that the characteristics of the authorities’ objective function will affect the timing and size of the policy actions, the model suggests that these characteristics will also determine the stability of the adjustment process. The basic problem is that certain policy preference structures may not lead to a stable adjustment process. For example, if the authorities follow a patient, anti-inflation program, the model can be used to show that the optimal mix of financial reform and stabilization policy will always yield a stable adjustment process. In contrast, an impatient, growth-oriented program may or may not yield a stable adjustment process. To illustrate the nature of this instability problem, we will first consider the optimal mix of financial reform and stabilization policy under a patient, anti-inflation program (see Figure 1 for an illustration of the paths followed by the policy instruments and endogenous variables under a patient, anti-inflation policy).

Figure 1.Patient, Anti-Inflation Policy

PATIENT, ANTI-INFLATION POLICY

In the model, the optimal mix of stabilization policy and financial reform will involve discrete and gradual changes in the policy instruments. During the first phase of the optimal program, the exchange rate, the ceiling loan rate, the ceiling deposit rate, and the rate of domestic credit expansion will undergo discrete changes. In contrast, the second phase will see only gradual movements of the policy instruments.

Initial phase of patient, anti-inflation policy

The discrete changes in the policy instruments are designed to (1) stimulate growth by eliminating the initial shortage of real working capital, (2) correct the balance of payments deficit, and (3) lead to a rapid decline in the rate of inflation. The initial phase of the stabilization program will consist of an overdepreciation of the exchange rate, discrete increases in the loan and deposit rates, and a decline in the rate of growth of the domestic component of base money. This policy mix will restore money and credit market equilibrium, increase the rate of growth and the rate of inflation, and improve the balance of payments. It can be explained why these are the best initial policy steps by first considering what actions are required to restore money and credit market equilibrium.

To remove the initial shortage of real working capital, the nominal deposit rate must be increased so that the deposit/income ratio rises to equal θ/σ (l–k). Since the deposit/income ratio is sensitive to the expected real yields on both domestic deposits and foreign assets, the authorities must coordinate the initial changes in interest rates and the exchange rate because of the impact of the exchange rate depreciation on expected foreign asset yields.

The interdependence between interest rate and exchange rate policies is illustrated in Figure 2. The f curve represents the values of the deposit/income ratio generated by different nominal deposit rates given the expected rate of inflation of the prices of domestic goods (Π), the expected rate of depreciation of the exchange rate (x), and the foreign nominal interest rate (rF). If there is initially a ceiling nominal deposit rate of rD1, then the deposit/income ratio would equal (θ/σ (l–k))1, and the initial excess demand for real credit would be θ/σ (l–k) minus (σ/σ(1–k))1.

Figure 2.Initial Excess Demand for Real Credit

To eliminate this excess demand for real credit, the nominal deposit rate must rise to increase the relative yield on domestic deposits. It would not be appropriate, however, to increase rD from rD1 to rD0 because the f curve is drawn under the assumption of a large expected exchange rate depreciation. Since the exchange rate will be depreciated during the initial stage of the stabilization program, this will lower the expected rate of depreciation in the near future and thereby reduce the yield on foreign assets. In Figure 2, this change in expectations shifts the f curve down to the right. The increase in the nominal deposit rate required to establish credit market equilibrium will be smaller than the movement implied by the increase in rD from rD1 to rD0.

Given this interdependence, the optimal initial combination of interest rate and exchange rate policies will involve a relatively moderate increase in the nominal deposit rate and an overdepreciation of the exchange rate. The overdepreciation of the exchange rate will improve the trade balance (by increasing the relative price of the foreign good) and raise the deposit/income ratio and stimulate a moderate capital inflow (by creating the expectation of a future appreciation of the exchange rate).

The impact of these changes in rD and x on the credit market is illustrated in Figure 3. Since an overdepreciation of the exchange rate raises the relative yield on domestic assets, the deposit/income curve will fall in comparison to what it was in Figure 2 (curve f2 versus curve f1). Thus, a moderate increase in the nominal deposit rate (from rD1 to rD2) will establish a money/income ratio equal to θ/σ (l–k). 25

Figure 3.Initial Change inrD

In general, this increase in rD will establish a nominal deposit rate above its long-run value but a real deposit rate below its steady-state value. In the long run, the authorities must establish the nominal deposit rate (rD) that yields a deposit/income ratio equal to θ/σ (l–k) when there is a stable price level and a stable exchange rate. This deposit rate is illustrated in Figure 4 where the f curve is drawn under the assumption of a stable price level and exchange rate. In a highly inflationary economy, the f2 curve will be above the f curve. 26 Thus, domestic wealth holders will hold the appropriate levels of deposits only if rD is above its long-run value (such as rD2).

Figure 4.Short-Run Versus Long-Run Changes inrD

While the nominal deposit rate will be above its steady-state value, the real deposit rate will be below its long-run value. The real deposit rate can be kept below its long-run value because foreign rather than domestic savings will supply much of the initial increase in the deposit/income ratio. The real deposit rate can be kept below its long-run value as long as private portfolios are being redistributed from foreign to domestic assets. The initial increase in rD under any degree of capital mobility must therefore be smaller than the increase under capital immobility.

Since financial market equilibrium requires that banks earn a normal level of profits, the nominal loan rate must increase in line with the nominal deposit rate.

These interest rate and exchange rate adjustments will have a sharp impact on output and prices. As the shortage of credit is eliminated, the rate of growth will rise above its steady-state level as long as the real loan rate stays below its long-run value.

It may seem surprising that an inflation-oriented policy involves an initial overdepreciation of the exchange rate. This overdepreciation, however, will result in relatively low real deposit and loan rates, which imply a higher rate of growth. The resulting increase in the supply of goods will set the stage for a rapid reduction in the rate of inflation during the second phase of the stabilization program.

Since the authorities are following an exchange rate policy, they can use the domestic component of base money to influence the balance of payments. Since the initial balance of payments surplus will increase the money supply, an initial discrete increase (decrease) in the domestic component of base money will be required if the increase in the demand for nominal money exceeds (falls short of) the increase in the supply of nominal money generated via the balance of payments. Whatever initial policy change takes place, the rate of growth of this domestic component must decline if the improvement in the balance of payments is to be sustained.

Second phase of patient, anti-inflation policy

The second phase of the stabilization program involves a gradual appreciation of the exchange rate, gradual reductions in the nominal loan and deposit rates, and a gradual increase in the rate of growth of the domestic component of base money (see Figure 1). These actions will result in a reduction in the rate of inflation, a return to balance of payments equilibrium, and a decline in the rate of growth to its long-run value.

Expanding output and an appreciating exchange rate will generate supply and demand effects that will slow the rate of increase of the prices of domestic goods. The rate of inflation will thus fall as a result of a declining price for foreign goods and a slowing of the rate of increase of the prices of domestic goods.

While the nominal loan and deposit rates must be reduced roughly in line with the expected rate of inflation, real interest rates will actually increase. We have seen that as long as the redistribution of private sector portfolios from foreign to domestic assets continues, the real deposit and loan rates can remain below their long-run values. Once portfolio equilibrium is attained, however, the capital inflow will cease; and the real deposit and loan rates must attain their long-run values to maintain the appropriate deposit/income ratio.

Finally, as the undervalued exchange rate is eliminated, the rate of growth of the domestic component of base money can be increased to ensure that the nominal money supply grows in line with the demand for nominal money and balance of payments equilibrium is achieved.

It is important to note that a patient policy differs from what is referred to as a gradualist policy. In the gradualist program, the policy instruments are moved slowly toward values consistent with the authorities’ long-run objectives. While a patient policy involves a phase of gradual changes in policy instruments, it also involves an initial phase of discrete (and potentially large) changes in the policy instruments. These discrete changes are a vital part of the adjustment program because they create inflation and exchange rate expectations consistent with the authorities’ stabilization program.

IMPATIENT, GROWTH-ORIENTED STABILIZATION POLICY

In the context of the model, an impatient, growth-oriented policy will yield either an unstable adjustment process or a growth rate that is inferior to that under a patient, anti-inflation program. While it is assumed the authorities derive equal disutility from rates of growth above or below the target growth rate (see equation (10)), most governments would clearly prefer a transitory growth rate above the target level. 27 In part, the attractiveness of a patient, anti-inflation policy stems from the fact that it involves an adjustment process with a rate of growth that lies above its steady-state value. An impatient, growth-oriented policy that minimizes the time period during which the actual (n) and target (n) rates of growth differ will leave n below n during the adjustment process. 28

Under an impatient, growth-oriented policy, the initial phase of the optimal program must minimize the gap between n and n; and the second phase must rapidly bring n into equality with n. The initial phase will therefore involve an underdepreciation of the exchange rate and larger increases in interest rates than under a patient, anti-inflation program. Since this will yield high domestic interest rates, the rate of growth will recover only to a level close to the long-run target rate of growth (see Figure 5 for a description of the paths followed by the policy instruments and endogenous variables under an impatient, growth-oriented policy).

Figure 5.Impatient, Growth-Oriented Policy

In order to quickly eliminate the remaining gap between n and n during the second phase, an impatient policy must rapidly reduce the real loan rate to its long-run value; this requires declines in the nominal loan rate and the expected rate of inflation. The rate of inflation will decline as the rate of depreciation of the exchange rate slows and increased output reduces the rate of increase in the prices of domestic goods. Since the rate of inflation will be slowing, the lower real loan rate will require relatively rapid reductions in nominal interest rates.

The potential instability of the adjustment process under an impatient policy arises if the authorities push too rapidly to achieve their long-run exchange rate, inflation, and rate of growth objectives. With an impatient policy, there is the possibility that, when the rate of inflation (ΠG) declines owing to a reduction in the rate of increase in the prices of domestic goods (Π), the authorities will feel that they can raise the rate of depreciation of the exchange rate (x) to allow the exchange rate to achieve its long-run value more rapidly. When Π increases too rapidly, however, then both ΠG and Π will rise because of relative price effects. If Π increases, then the authorities will have to decrease x to start ΠG down again. Constant switching of x from positive to negative values could lead to an unstable adjustment process.

CONTRAST BETWEEN PATIENT, ANTI-INFLATION POLICY AND IMPATIENT, GROWTH-ORIENTED POLICY

It should be clear that in the model the optimal mix of financial reform and stabilization policy under a patient, anti-inflation program is superior to that under an impatient, growth-oriented program. A patient program yields not only a more rapid reduction in inflation but also a transitional rate of growth that is above rather than below the target growth rate. In terms of the actual policy steps taken, the differences between an impatient and a patient program are quantitative rather than qualitative. Table 1 summarizes the policy actions under each program.

Table 1.Summary of Optimal Policies
optimal policy mix under
Patient, anti-inflation programImpatient, growth-oriented program
initial phase
Discrete overdepreciation of the exchange rateDiscrete underdepreciation of the exchange rate
Moderate increases in nominal loan and deposit ratesLarge increases in nominal loan and deposit rates
Decline in rate of growth of domestic component of base money.Decline in rate of growth of domestic component of base money
second phase
Gradual exchange rate appreciationGradual exchange rate depreciation
Gradual decline in nominal interest ratesGradual decline in nominal interest rates
Gradual increase in rate of growth of domestic component of base moneyGradual increase in rate of growth of domestic component of base money

Since the model is based on a number of simplifying assumptions, it is important to consider which of the conclusions are model specific and which have more general applicability. There are three general conclusions. First, the optimal program must always involve coordinating the initial increases in the exchange rate and nominal interest rates. The larger the initial exchange rate adjustment, the smaller must be the initial interest rate increases. Second, the initial discrete changes in policy instruments will play a vital role in affecting private sector expectations. Regardless of whether private sector expectations are rational or adjust with a lag, discrete adjustments in the policy instruments will help to quickly bring private sector expectations in line with the authorities’ inflation and exchange rate objectives. Third, the rate of growth of the domestic component of base money must decline sharply if the initial improvement in the balance of payments is to be sustained through time.

Despite the model’s relatively simple structure, it illustrates the vital role that authorities’ preferences play in determining not only the paths that will be selected for the policy instruments but also the stability of the adjustment process. The stability of the adjustment process is influenced by interaction between ρ, which measures the authorities’ impatience, and the relative importance attached to the growth and inflation targets. As a general rule, impatient policies (a high ρ) are much more likely to be unstable than patient policies (a low p). This does not mean, however, that a patient policy will necessarily involve only gradual changes in the policy instruments. For example, the initial exchange rate movement under a patient, anti-inflation program is larger than that under an impatient, growth-oriented policy, although just the reverse is true for the initial interest rate changes. In both cases, these discrete movements in the policy instruments play an important role in bringing private sector expectations into line with the authorities’ objectives.

The basic difference between patient, anti-inflation and impatient, growth-oriented policies lies in the real interest rates that the authorities will attempt to establish. With an impatient, growth-oriented policy, the authorities will attempt to rapidly generate the level of real interest rates consistent with the maximum sustainable real rate of growth (n). To minimize the time period during which n differs from n, the real deposit and lending rates must be quickly established at their long-run values. Given the high initial rate of inflation, this will require relatively high nominal interest rates. To avoid large capital inflows, however, these high domestic nominal interest rates can be maintained in the face of relatively low international interest rates only if a further exchange rate depreciation is expected (thus the initial underdepreciation of its exchange rate). In contrast, with a patient, anti-inflation program the authorities are willing to wait to achieve their inflation objective; and, as a result, they can obtain a transitional rate of growth that is above the long-run, sustainable rate of growth. For this to occur, however, domestic economic units must see lower real interest rates than under an impatient, growth-oriented policy. Given the structure of international interest rates, the required relatively low domestic nominal interest rates can be established only if an exchange rate appreciation is expected (thus the initial overdepreciation of the exchange rate).

IV. Korean Financial Reform29

The objective in this section is to use the foregoing theoretical analysis to explain why Korea experienced large-scale capital inflows following its 1965 financial reform. In the mid-1960s, the Korean authorities undertook a series of economic reforms designed to slow the rate of inflation, stimulate growth, raise the level of domestic savings, and improve the balance of payments. While these reforms had very favorable medium-term effects on the economy, they were accompanied by a sustained capital inflow which created short-run difficulties for controlling domestic monetary aggregates. To understand why these inflows took place and to examine what policy steps could have been taken to control these inflows, we must first consider the nature of the reform program.

REFORM PROGRAM

The 1964-65 Korean stabilization program contained fiscal, trade, and financial reform elements. 30 The fiscal reforms focused on reducing the government deficit by making tax collections responsive to economic growth and price changes, increasing the revenues from government enterprises, and limiting the growth of government expenditures. The new trade policy included fewer restrictions on imports and capital flows and the establishment of a single exchange rate which involved a substantial depreciation from the average rate under the old multiple exchange rate system. The financial reform involved increases in nominal interest rates (see Table 2), but the interest rates on special preference loans by the Bank of Korea to finance such activities as exports and fertilizer purchases remained fixed.

Table 2.Korea: Selected Interest Rates of Bank of Korea and Commercial Banks, 1965–70(In per cent per annum)
Bank of KoreaCommercial Banks
Date of ChangeExport

and UN

supply

loans
Rice lien

loans
Commercial

bills
Other

bills
Purchase

of aid

goods
Export

bills
Import

bills
Commercial

bills
Other

bills
Over

draft
Over

due

loans
Lending rates
Prior to September 30, 19653.54.011.513.59.56.514.016.018.020.0
September 30, 19656.524.026.026.036.5
November 6, 19653.54.021.023.023.0
December 1, 19653.54.028.028.026.0
February 1, 19666.56.0124.026.028.036.5
June 29, 19676.06.0124.026.028.036.5
March 1, 19683.54.021.028.026.0
October 1, 19683.54.023.028.025.26.06.0126.025.228.036.5
June 1, 196922.026.024.06.06.0124.624.026.036.5
April 1, 197021.024.0
December 3, 197019.023.0
Sources: Bank of Korea, Monthly Economic Statistics (various issues).
Date of ChangeTime DepositsSavingsShort-Term Savings
3 months6 months12 monthsOver 18

months
National Savings

Association
InstallmentNoticeSavings2
Deposit rates
Prior to September 30, 19659.012.015.015.016.810.03.73.6
September 30, 196518.024.026.430.030.030.05.07.2
April 1, 196815.620.426.427.628.028.05.0
October 1, 196814.419.225.2325.225.05.0
June 1, 196912.016.822.822.823.05.0
Sources: Bank of Korea, Monthly Economic Statistics (various issues).

These reform programs significantly improved economic performance. The rate of inflation dropped from almost 35 per cent in 1964 to 9 per cent in 1966, and the rate of growth rose from 6 per cent in 1965 to 12 per cent in 1966. And while the economy’s overall savings ratio (as a proportion of gross national product) increased from 14.6 per cent in 1964 to 21.6 per cent in 1966, the Government’s savings ratio rose even more sharply from 0.5 per cent in 1964 to 2.8 per cent in 1966. The higher savings ratio was accompanied by an increase in the ratio of M2 (coins and currency in circulation plus demand deposits plus savings accounts) to gross domestic product (GDP) from 0.091 in 1964 to 0.154 in 1966. In addition, the balance of payments changed from a US$5 million deficit in 1964 to a surplus of US$15 million in 1965 and US$90 million in 1966. As shown in Table 3, this improvement in the balance of payments was the result of a capital account surplus that more than offset a growing balance of trade deficit. Table 4 illustrates that during 1966-70 both private and official capital inflows were important. While official grants remained relatively constant over this period, private credits (which primarily reflected project loans) proved much more volatile.

Table 3.Korea: Aggregate Data, 1963–701
Growth of

Real GDP

(Per Cent

Per Annum)
Rate of

Increase in

Wholesale

Price Index
M1/GDPM2/GDP
19638.820.40.0860.114
19648.634.40.0700.091
19656.09.90.0820.122
196612.09.00.0840.154
19677.36.40.0940.203
196812.88.10.1130.277
196915.26.60.1230.343
19708.69.40.1190.348
Balance of Payments
(In millions of U. S. dollars)
Goods and

Services

Balance
Long-Term

Capital

Account
Short-Term

Capital

Account
Overall

Balance
1963–14377–18
1964–2613–5
1965519–315
1966–103177790
1967–1922334564
1968–44038313132
1969–54937256122
1970–62329212255
Sources: International Monetary Fund, International Financial Statistics (various issues); Bank of Korea, Monthly Economic Review and Monthly Economic Statistics (various issues).
Table 4.Korea: Inflows of Foreign Capital and Official Grants, 1966–70(In millions of U. S. dollars)
19661967196819691970
Foreign capital1197.3296.0562.1697.4709.8
Three years and longer197.3239.3355.5640.3653.7
Government and multilateral loans72.8105.670.2220.9217.0
Private loans110.2124.0268.4403.5371.5
Equity14.39.716.915.965.2
One to three years56.7206.657.156.1
Trade credits54.7166.627.131.1
Bank loans40.030.025.0
Cash loans2.0
Official Grants164.9157.4150.7178.7121.2
AID assistance61.647.143.428.617.0
PL 48068.356.763.8100.755.6
Japan P. A. C.229.337.430.032.128.2
Technical assistance3.75.57.53.93.9
Other2.010.86.013.416.5
Total362.2453.4712.8876.1831.0

A major problem for the authorities after the financial reform, however, was the rapid growth of domestic monetary aggregates which made it difficult to bring down the rate of inflation below the 6-7 per cent level. This rapid monetary growth primarily reflected growing central bank holdings of net foreign assets generated by the balance of payments surplus, which, as we have seen, resulted from a rising capital account surplus that more than offset a growing current account deficit. This capital inflow reflected the fact that Korean enterprises faced a substantial interest incentive to borrow abroad. 31

While long-term government bond rates during 1965-67 averaged 5 per cent in the United States and 7 per cent in Japan, the return on Korean commercial bills averaged roughly 24 per cent. The cost of commercial bank loans in the United States or Japan naturally exceeded the interest rate on long-term government bonds, but Korean firms nonetheless saw an uncovered interest rate differential of 10 to 15 per cent on foreign loans. This differential would not have induced a capital inflow, however, if foreign banks or domestic nationals had been concerned with default risk or the expected losses from future depreciations of the Korean won. During this period, two factors reduced default risk and expected exchange losses: The Government provided guarantees of repayment on approved loans; 32 and, since there was a substantial initial exchange rate depreciation, this reduced the likelihood of an additional major depreciation in the near future. The development of the balance of payments surplus also made it less likely that the exchange rate would depreciate substantially in the longer term.

In terms of the analysis in Section II, this lack of monetary control was the result of the interaction between exchange rate and interest rate policy. While the exchange rate had been depreciated to a level sufficient to generate a balance of payments surplus, and is thus similar to the type of exchange rate policy that would be followed under the optimal patient, anti-inflation program, nominal interest rates were set at levels designed to ensure rather high, positive real deposit rates. As Brown (1973) has argued, these high nominal interest rates thus had two offsetting effects on the rate of inflation:

Higher domestic bank interest rates served to create inflationary pressures by encouraging foreign borrowing and adding to monetary reserves on the one hand and, on the other generated a rise in time and savings deposits that made it possible to partly offset the effect of higher exchange reserves on the money supply.33

Brown’s argument can be restated in terms of the effects of high interest rates on the flow markets for credit and money. The new interest rate and exchange rate structure generated a capital inflow designed to satisfy the excess flow demand for credit. Given the relatively fixed nature of the exchange rate, however, this capital inflow also produced growth in domestic monetary aggregates that was in excess of the growth in the flow demand for money. This was true despite the fact that the demand for money was rising quite sharply owing to the higher real return on money holdings.

Further evidence that the level of interest rates was initially set at too high a level can be found in McKinnon’s (1976) data, which indicates that Korean real interest rates during the initial stage of their financial reform were considerably higher than those in China during the beginning of its financial reform. Table 5 reproduces McKinnon’s calculations concerning the real returns on time deposits in Korea and China during the 1960s.

Table 5.Korea and China: Real Return on One-Year Time Deposits, 1960–69(In per cent per annum)
YearKoreaChina
1960–0.73.1
1961–1.210.0
19625.310.0
1963–4.65.7
1964–14.68.1
19658.116.2
196619.48.4
196722.17.1
196818.17.6
196916.210.0
Source: McKinnon (1976), p. 84.

In the period 1960-69, China had an average real deposit rate of 8.46 per cent versus the Korean average of 7.34 per cent. Only in 1965 (a year of a relatively large decline in China’s wholesale price index), however, did the real deposit rate in China exceed the real deposit rates paid in Korea during the 1966-69 period. While both economies experienced rapid growth in real money holdings, this difference in the level of real deposit rates (and correspondingly real loan rates) appears to explain why Korea had much greater problems than China with capital inflows, excess monetary growth, and inflation.34

EFFORTS TO REGAIN MONETARY CONTROL

Since the Korean authorities wanted to maintain high nominal interest rates to encourage domestic savings, there were three policies that could have been used to break the linkage between capital flows, the balance of payments, and base money, First, a flexible exchange rate would have eliminated the balance of payments surplus and prevented the capital inflow from expanding base money. Second, the banks’ ability to expand credit and other monetary aggregates could have been limited. Third, capital controls could have been tightened. During 1966-69, the authorities decided not to allow the exchange rate to float freely. Instead, they first attempted to limit monetary growth by restricting commercial bank lending, but were finally forced to resort to tighter capital controls.

The analysis in Section II suggests that one way that the Korean authorities could have regained control over the growth of domestic monetary aggregates and hence the rate of inflation would have been to combine a gradual appreciation of the Korean won with a gradual reduction in nominal interest rates. While the stabilization program would still have been constrained to maintain positive real interest rates, this mix of exchange rate and interest rate policies could have been used to reduce the incentive to borrow abroad and the size of the overall balance of payments surplus. Instead of adopting this approach, however, the Korean authorities decided that they wanted to maintain not only high nominal interest rates in order to encourage domestic savings but also a relatively fixed exchange rate. Since they nonetheless wanted to curb inflation, they first attempted to limit monetary growth by restricting commercial bank lending; but they were finally forced to resort to tighter capital controls. 35

To limit the growth of total credit, the authorities first used required reserve ratios and special bonds and deposits. In December 1965, average reserve requirements of demand deposits rose from 16 per cent to 20 per cent; and, on February 1, 1966, the reserve ratios increased to 35 per cent on demand deposits, 20 per cent on short-term savings deposits, and 15 per cent against time deposits. Then, in March 1966, the Bank of Korea was allowed to issue stabilization bonds with a maturity of 91 days and an effective yield of 5.08 per cent a year. By July 1966, W 3.0 billion of these bonds were outstanding. In October 1966, the central bank supplemented these measures by establishing marginal reserve ratios of 50 per cent and 45 per cent, respectively, against demand deposits and savings deposits.

By March 1967, however, the high marginal reserve ratios were squeezing bank earnings, and the central bank’s stabilization bonds were near statutory ceiling. It therefore eliminated the marginal reserve requirements on April 1, 1967, but then created stabilization accounts (carrying roughly a 10 per cent yield) which more than absorbed the released liquidity.

Despite these measures, the authorities failed to curb the growth of total credit, the money supply, or the capital inflow. Bank loans grew from W 72 billion at the end of 1965, to W 103 billion in 1966, and to W 177 billion in 1967. The capital inflow also grew from US$197 million in 1966 to US$296 million in 1967 (see Table 4).

The authorities next tightened capital controls. On November 30, 1967, the Economic Ministerial Council announced the “Overall Guidelines for the Rationalization of Foreign Capital Inducement” to indicate its intention to discourage short-term borrowing. In early 1969, for example, it was required that foreign cash loans for generating won funds have a maturity of at least three years. Then, in September 1969, this type of loan was forbidden.

These actions reduced private foreign borrowing during 1969-70 (see Table 4). Total credit nonetheless continued to grow rapidly, reflecting the fact that preferential credits began to replace capital inflows as a major source of credit and base money growth. 36 Preferential credits were loans from official banks for items such as export credits, rice imports, and fertilizer purchases. As mentioned earlier, the interest charges on these loans were not increased during the financial reform of September 1965 (see Table 2). Firms turned to preferential loans as a source of credit once foreign loans became more difficult to obtain. This development was reflected in the proportions of base money accounted for by preferential loans and the foreign sector (see Table 6). 37 Thus, even though the authorities limited capital inflows, they did not regain complete control over total credit or reserve money.

Table 6.Korea: Central Bank Credits and Reserve Money, 1965–701(In per cent)
196519661967196819691970
Government sector34.3629.6628.7112.8013.7713.93
Fertilizer sector12.3018.5020.1027.9032.0030.00
Foreign sector17.2649.4765.91102.01138.20157.69
Bank sector (Private)6.936.1311.9318.8835.1689.75
Preferential financing other than fertilizer credits2.883.727.8513.9231.9948.33
Other22.5013.588.15–4.05–3.32–13.17
Total reserve money48.3590.18118.55165.64222.45304.54
Reserve money Foreign sector0.360.550.560.620.620.52
Preferential loans0.060.040.070.080.140.16
Source: Bank of Korea, Monthly Economic Statistics (December 1971).

There are four specific conclusions that emerge from the analysis of the Korean experience. First, when compared with the initial policy changes that would occur under a patient, anti-inflation program, the initial Korean exchange rate depreciation was of roughly the appropriate magnitude; but, the interest rates on most loans and deposits were increased too sharply. The exception to this conclusion is that the interest rates on special preference loans were not increased enough. Second, since this new exchange rate and interest rate structure was kept relatively fixed throughout the 1965-70 period, there was a substantial incentive for Korean firms and state enterprises to borrow abroad; and this led to the development of a large balance of payments surplus. Third, while this inflow of foreign loans helped to satisfy the excess demand for credit, it produced growth in the monetary aggregates that was in excess of the growth in the demand for money and was therefore not consistent with a stable price level. Finally, the appropriate policy mix for restoring monetary control without having to rely on capital controls would have involved combining a gradual exchange rate appreciation with reductions in most nominal interest rates. 38

V. Conclusion

The analysis presented in this paper indicates that financial reform must be carefully coordinated with exchange rate policy if large-scale capital inflows are to be avoided. The experience of Korea indicates that substantial capital inflows will develop whenever a large exchange rate depreciation is combined with too sharp an increase in domestic interest rates. Since the theoretical analysis is based on a restrictive set of assumptions, we cannot hope to define the appropriate mix of financial reform and stabilization policy that will always ensure that these problems with large-scale capital inflows will be avoided. There are, however, certain general restrictions on the types of policies enacted that will help to minimize these problems. First, the initial nominal interest rate changes during any financial reform must be such that they create positive real yields on financial assets. The establishment of real interest rates will be consistent not only with the long-run financial reform objective of generating market-clearing interest rates but also with the short-run objective of eliminating the initial shortage of real credit. The requirement that there be positive real interest does not necessarily mean that there be high, positive real interest rates. The optimal initial level of real interest rates must be decided upon on a country-by-country basis and will depend on, among other factors, the size of the initial excess demand for credit and the sensitivity of capital flows to interest rate differentials. The presence of internationally mobile capital also means that the initial interest rate increases must be carefully coordinated with the initial exchange rate depreciation in order to avoid creating too large an incentive for capital inflows. The larger is the initial exchange rate depreciation, the smaller must be the initial increases in nominal interest rates. Finally, the rate of growth of the domestic component of base money must be reduced quickly at the beginning of the program. Without this reduction, it will be difficult to retain the benefits of the initial exchange rate and interest rate adjustments.

In addition to these specific policy actions, there is the general fact that patient programs oriented toward inflation objectives are more likely to be stable than impatient programs oriented toward a growth objective. The greater instability under impatient programs reflects the fact that rapid policy instrument movements can create overshooting effects that can only be offset by even more rapid future policy instrument changes. This instrument-instability problem can destabilize the entire adjustment process. Patient programs are also more likely to lead to an adjustment process with a substantially higher rate of growth than under impatient programs. It must be stressed, however, that a patient program should not be confused with what is generally known as a gradualist policy. Under the typical gradualist policy, the policy instruments are moved slowly and without any discrete jumps toward values consistent with the authorities’ long-run objectives. In contrast, a patient program usually will involve an initial phase of discrete, and potentially large, changes in the policy instruments, followed by a second phase of gradual movements. These discrete changes play a vital role in bringing private sector expectations in line with the authorities’ objectives, and they will be required regardless of whether private sector expectations are adaptive or rational.

APPENDIX

Notation

K = total stock of capital (physical plus real working)

F = physical capital stock

λ = ratio of physical to total capital

Y = domestic output

σ = output/capital ratio (= rK = marginal product of capital)

P = vector of prices of domestic goods

α = importance of domestic goods in general price index

Π = P˙/P

Q = demand for domestic goods

X = exchange rate

x = X˙/X

PF = world price

PG = general price level

ΠG = P˙G/PG=αΠ+(1α)x

L = nominal stock of loans

l = L/PG

ΠGe = expected rate of inflation

Πe = expected rate of increase in prices of domestic goods

xe = expected rate of depreciation of the exchange rate

rL = nominal loan rate

rD = nominal domestic deposit rate

rF = foreign nominal interest rate

D = nominal stock of deposits

d = D/PG

k = required reserve ratio in banking system

H = stock of high-powered money

DC = stock of domestic credit

R = foreign exchange reserves

μ = 1HdHdt=1DdDdt

δi = relative importance the authorities attach to their inflation (i = 1) and growth (i = 2) objectives

ρ = authorities’ internal discount rate

θ = percentage of capital stock financed by borrowing from banking system

f = D/PGY

η = f/(rF+xαΠ(1α)x)f/(rDαΠ(1α)x)

n = real rate of growth = K˙/K

YF = foreign real income

BIBLIOGRAPHY

    Arrow, Kenneth J., Applications of Control Theory to Economic Growth,” in Lectures in Applied Mathematics, Vol. 12, American Mathematical Society (Providence, Rhode Island, 1968), pp. 85119.

    Brown, Gilbert T., Korean Pricing Policies and Economic Development in the 1960s (The Johns Hopkins Press, 1973).

    Chandavarkar, Anand G., Some Aspects of Interest Rate Policies in Less Developed Economies: The Experience of Selected Asian Countries,” Staff Papers, Vol. 18 (March1971), pp. 48112.

    Frank, Charles R., Jr., Kwang Suk Kim, and LarryWestphal, Foreign Trade Regimes and Economic Development: South Korea (Columbia University Press, 1975).

    Gurley, John G., Hugh T.Patrick, andEdward S.Shaw, The Financial Structure of Korea,” United States Operations Mission to Korea (July1965).

    Kamien, M.I., and E.Muller, Optimal Control With Integral State Equations,” Review of Economic Studies (October1966), pp. 46973.

    Kanesa-Thasan, S., Stabilizing an Economy—A Study of the Republic of Korea,” Staff Papers, Vol. 16 (March1969), pp. 126.

    Kapur, Basant K., Two Approaches to Ending Inflation,” in Money and Finance in Economic Growth and Development: Essays in Honor ofEdward S.Shaw, ed. by Ronald I.McKinnon (New York, 1976), pp. 199221.

    Mathieson, Donald J., Optimal Stabilization Policies in a Developing Economy” (unpublished, International Monetary Fund, 1977).

    Mathieson, Donald J., Financial Reform and Stabilization Policy in a Developing Economy” (unpublished, International Monetary Fund, 1978).

    McKinnon, Ronald I., Money and Capital in Economic Development (The Brookings Institution, 1973).

    McKinnon, Ronald I., Savings Propensities and the Korean Monetary Reform in Retrospect,” in Money and Finance in Economic Growth and Development: Essays in Honor ofEdward S.Shaw, ed. by Ronald I.McKinnon (New York, 1976), pp. 7591.

    Morley, Samuel A., Inflation and Stagnation in Brazil,” Economic Development and Cultural Change, Vol. 19 (January1971), pp. 184203.

    Shaw, Edward S., Financial Deepening in Economic Development (Oxford University Press, New York, 1973).

Mr. Mathieson, economist in the Financial Studies Division of the Research Department, holds degrees from the University of Illinois and Stanford University. He has taught at Columbia University.

An earlier version of this paper was presented at the Fifteenth Meeting of Central Bank Technicians of the American Continent, Port of Spain, Trinidad, November 19-24, 1978.

The model in this section is an open-economy version of that used in Mathieson (1978). See the Appendix for a summary of notation.

These assumptions rule out any change in the relative returns to capital and labor.

P represents a price index for domestic goods. For simplicity, the relative prices of all domestic goods are fixed.

A dot (•) above a variable denotes the time derivative.

The level of foreign income is fixed.

While τ3 has been assumed to be positive, there is empirical evidence that τ3 could be negative, reflecting the fact that a higher expected rate of inflation is associated with greater uncertainty and thereby greater savings. Since later results depend only on the assumption that 1 – τ3 ψ > 0, it would be quite easy to allow τ3 to be negative.

For simplicity, α is fixed. In a general analysis, would be α function of the proportion of total expenditures on domestic goods.

Real working capital is assumed to consist of inventories of raw materials and goods in process and advances to workers prior to actual sales.

The same constant, θ, applies to borrowing for both physical and real working capital holdings. A more detailed analysis would involve separate 0’s for each type of borrowing and would specify the determinants of using bank borrowing versus retained earnings.

rK will equal the marginal product of capital, which is a constant in the model.

With fixed proportions, F/K = λ. This means that K˙ = Ḟ/λ = S · Y/λ(1 – θ) = s·y. Since θ is fixed, a rise in rt will unambiguously reduce the rate of capital formation (∂K˙/∂rL = ∂S/∂rL ·Y/λ(1 – θ)) < 0): If θ was a negative function of rt, then this negative effect would only be further amplified (K˙/∂rL = (S • Y/(λ (1 – θ))((∂S/∂rL)/S +(∂θ/∂rL) / (1 – θ)) < 0).

The analysis would not be greatly altered if it was assumed that capital flows were undertaken by foreign rather than domestic nationals. The presence of capital mobility, rather than who undertakes the capital transfers, is the important issue.

If one assumed that foreign as well as domestic nationals undertook capital flows, the f function given in equation (7) would be composed of a weighted sum of the f functions for domestic nationals (fd) and for foreign nationals (ff), with the weights being the proportion of deposits held by each type of investor. In this situation, even if foreigners held only a small proportion of domestic deposits, the overall f function might still be quite sensitive to changes in the yield on foreign assets if ff were highly sensitive to this yield.

For a discussion of the importance of this shortage of real working capital in developing countries, see McKinnon (1973) and Morley (1971). For simplicity, the effects of the substitution out of financial assets into real capital are ignored on the grounds that this substitution effect would be swamped by the financial repression effects on the general availability of real credit.

The path for R will thus be determined by the growth in the demand for base money and the path the authorities select for DC.

This reflects the fact that, although rational forecasts could differ from actual price movements in stochastic models, rational expectations are equivalent to perfect foresight in deterministic models.

A discussion of the conditions under which these targets will be consistent is available upon request from the author, whose address is Research Department, International Monetary Fund, Washington, D.C. 20431.

It is assumed that the banking system is privately owned or, if state owned, that the authorities wish to earn at least a normal level of profits on resources devoted to the financial system. This analysis ignores the effect of this interest rate behavior on the distribution of income or the role of financial system profits as a source of government revenues.

A normal level of profits is implicit in the fixed and variable cost term.

This ambiguity arises for two reasons. First, the deposit/income ratio is a positive (negative) function of the expected real yield on domestic (foreign) assets. Second, we know that the deposit/income ratio must be equal to θ/σ (1 – k) if credit market equilibrium is to be maintained. These two factors imply that rD must be increased (decreased) whenever a higher Π or x reduces (increases) the demand for money relative to income, but it is unclear whether an increase in Π or x will raise or lower the deposit/income ratio. If the deposit/income ratio is most sensitive to changes in the domestic asset yield (1 + η > 0), then a higher Π or x will lower the deposit/income ratio, and the nominal deposit rate will have to increase to maintain money and credit market equilibrium.

Just how good an approximation this solution will be to the true paths for r1, rD, and x will depend on how far the economy is from its steady-state growth path.

A bar (–) above a variable denotes the steady-state value.

For stability, 1 – τ3ψ must be greater than zero; otherwise, an initial excess demand for goods would lead to an explosive rise in the price level.

The ambiguity of ∂n/∂Π reflects the fact that a higher θ may either raise or lower the real loan rate (rL ΠG) and thereby reduce or increase the real rate of growth. An increase in Π will work to raise both the expected overall rate of inflation (ΠG) and the nominal loan rate.

In an earlier version of this paper, which is available upon request from the author (see n. 15), it is shown that if k <|η|, then ∂n/∂Π > 0.

This provides a further justification for assuming that k < | η |.

The derivation of these optimal paths is available upon request from the author (see n. 15).

The increase in rD will still establish a positive real deposit rate.

Whether the f2 curve lies above or below the f curve depends upon (1) how sensitive the deposit/income ratio is to the relative yields on foreign and domestic assets and (2) on how sensitive relative yields are to the expected appreciation of the exchange rate and the expected increase in the prices of domestic goods. In a highly inflationary economy, the initial expected rate of inflation will be far in excess of the expected rate of appreciation of the exchange rate; and this will make it most likely that the f2 curve will lie above the f curve.

It must be emphasized that reference is to only a temporary rise in n above n during the transition to long-run equilibrium; n has been defined as the maximum sustainable growth rate in the long run.

If the objective function included a positive weight for the rate of growth as well as for the departure of n from n, then the patient, anti-inflation policy would become the optimal program.

A discussion of the mathematics of this case is available upon request from the author (see n. 15).

A more detailed discussion of the Korean experience and that of Argentina is available upon request from the author (see n. 15).

For a comprehensive discussion of these reforms, see Brown (1973) and Kanesa-Thasan (1969).

On this point, Brown (1973) concluded that “After the interest rate reform made foreign credits much less expensive than domestic bank credits, Korean businessmen always sought foreign credits if these were a possible alternative to commercial bank loans or other more expensive domestic credits. The interest-rate-stimulated ‘demand-pull’ for foreign credits coincided with government desires dating from at least 1962 to obtain such credits in order to speed investment and growth” (p. 218).

This system was replaced by commercial bank guarantees in December 1965.

Brown (1973), pp. 207-208.

For a further discussion of the China experience, see Mathieson (1978).

Brown (1973) argued that the appropriate way for the authorities to curb the capital inflow would be a devaluation of the won in line with the rate of inflation: “Of the policies other than the interest rate reform which led to such a large inflow of foreign credit, perhaps the most important was the failure (until 1971) to allow the exchange rate to decline nearly as rapidly as the rise in domestic inflation. If the exchange rate had been changed to reduce the value of the won more nearly in step with the rate of inflation, the estimated cost of foreign borrowing would have been higher and the desire to borrow abroad reduced” (p. 219). There are two problems with this argument. First, it assumes that interest rates were at the appropriate level. Second, it is essentially arguing that the way to eliminate a balance of payments surplus is to devalue the domestic currency!

McKinnon (1976) was among the first to discuss this shift.

As shown by McKinnon (1976), this proportion increased even further during the early 1970s.

The exception to this policy mix would have been to sharply increase the interest rates on special preference loans.

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