I The Role of Financial Sector Reform in Macroeconomic and Structural Adjustment
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund


The last decade can be called a period of financial liberalization in both developed and developing countries. Financial markets in many of the more advanced economies have seen the virtual completion of the deregulatory process, and developing countries have also launched financial sector reforms or have accelerated the process of their liberalization. Currently, dramatic financial liberalization is under way in Central and Eastern Europe as well as in the states of the former Soviet Union. Despite wide country-specific differences, these universal financial reforms have responded to a common aim: the achievement of better economic performance through a sound and efficient financial system. While few economists would argue against this broad statement, there are aspects of the reform process—for example, the urgency of financial reforms and the relative importance of real versus financial sector liberalization—on which views vary.


The last decade can be called a period of financial liberalization in both developed and developing countries. Financial markets in many of the more advanced economies have seen the virtual completion of the deregulatory process, and developing countries have also launched financial sector reforms or have accelerated the process of their liberalization. Currently, dramatic financial liberalization is under way in Central and Eastern Europe as well as in the states of the former Soviet Union. Despite wide country-specific differences, these universal financial reforms have responded to a common aim: the achievement of better economic performance through a sound and efficient financial system. While few economists would argue against this broad statement, there are aspects of the reform process—for example, the urgency of financial reforms and the relative importance of real versus financial sector liberalization—on which views vary.

The purpose of this paper is to examine the essential role that financial sector reform can play in macroeconomic and structural adjustment. The analysis will discuss the sequencing of economic reform—namely, the importance of simultaneous action in financial and real sector reform, as well as in domestic and external sector reform.

Definition, Concepts, and Forms of Financial Reform

Financial liberalization may be narrowly defined as policies that reduce the restrictiveness of controls on the workings of financial markets. A broader concept would encompass measures to enhance the efficiency and soundness of the financial system. Under this general definition, actions such as the development of money markets, the adoption of an indirect monetary control system, or the establishment of a strong supervisory framework can be labeled “financial liberalization.” In this paper, I have adopted this general concept of liberalization.

There is also a need to clarify some of the related concepts used in the analysis. In particular, the term “structural adjustment” means actions aimed at the attainment or restoration of rapid economic growth through the elimination of internal and external economic distortions or imbalances. As such, structural adjustment policies will have a macroeconomic or a microeconomic dimension, depending on the nature of the economic imbalance or distortion they are addressing.

Macroeconomic adjustment policies aim to keep or bring domestic expenditure in line with resource availability, an aim that typically requires a combination of fiscal, monetary, exchange rate, and trade policies to ensure that the level and composition of aggregate demand conform with the pattern of supply. For macroeconomic balance to be sustained, an appropriate incentive structure will be required among sectors in the economy, including in particular those for traded and nontraded goods and services.1 This aspect of macroeconomic management reaches out toward the area of microeconomic adjustment policies, which are typically aimed at improving efficiency in resource use by removing price distortions, strengthening competition, and dismantling administrative control.

Economic distortions and imbalances interact, a characteristic that must be taken into account in the design of adjustment efforts. For example, an unrealistic exchange rate, which may reflect a macroeconomic imbalance, can produce microeconomic distortions by favoring certain sectors of the economy over others. Similarly, microeconomic distortions can result from pricing policies of public enterprises that do not reflect input costs appropriately; in addition, institutional distortions can arise from the resulting improper incentives for efficient enterprise management. Public enterprise pricing policy often leads to macroeconomic distortions in the form of large public sector deficits. This “interrelatedness” is the main reason why any approach must be simultaneous and comprehensive in the design of policies that aim to achieve overall balance in the economy.

The modalities of financial liberalization differ across countries and depend on specific policy objectives. Typically, financial liberalization initiatives can be grouped into five categories:2

  • Measures to deregulate the financial sector, which include interest rate decontrol, deregulation of fees and commissions, increased autonomy of financial institutions, and elimination of bank-specific administrative norms, such as credit ceilings;

  • Measures to improve the monetary policy framework, which involve the development of indirect monetary policy instruments, the reduction of preferential credits in priority sectors, and the lifting of direct credit controls;

  • Measures to promote competition in the financial sector, which encompass easing of entry and exit barriers, enlarging the scope of business boundaries of financial institutions, improving the ownership structure of financial companies, and restructuring and privatization of state-run banks. Also in this group are measures to improve infrastructure and deepen financial markets, such as establishing a broker/dealer network in the money market and developing new capital market instruments.

  • Measures for international financial liberalization, which entail actions to open the capital account and liberalize trade in financial services.3 These include the lifting of controls on inbound and outbound direct investment, allowing private holdings of foreign currency and other financial assets, moving toward a market-determined exchange rate system, and providing market access to foreign financial institutions on a nondiscriminatory basis; and

  • Measures to strengthen prudential regulation and the supervision framework, which include recapitalization of banks, enhanced transparency, and improved protection for depositors or investors.

In some countries, financial reform measures have focused only on some of these areas, thereby overlooking other related measures and complementary actions. A theme of this paper is that structural efficiency and the establishment of a competitive environment in the financial sector and in the economy at large, as well as better macroeconomic balance, will be attained more effectively through simultaneous and comprehensive reforms.

Optimal Design and Implementation of Financial Reform

In designing a financial reform strategy, some contend that real sector adjustment should be nearly complete before embarking on reforms of the financial sector; some argue that financial reform is best undertaken gradually. This paper will examine the merits of the “real sector first” strategy and the “gradualist” approach. These arguments will be viewed in light of the diversified experiences of selected reforming countries and will identify pivotal roles for financial sector reform to play in general economic reform. Against this background, I will argue for a simultaneous and rapid approach to financial reform.

Real Versus Financial Sector Reform

A relatively large segment of the literature on the sequencing of economic reforms advocates a slower pace for reform of the financial sector than for the real sector of the economy. One line of argument asserts that capital account restrictions should be lifted only after trade and other industrial sector distortions have been dismantled. Reasons include the differential speed of adjustment in the markets for goods and capital, which may result in harmful overadjustment of prices (“overshooting”) in financial markets, or the possibility of real exchange rate appreciation that may result from large capital inflows.4 Another line of argument is that the enterprise sector should be restructured before undertaking key reforms of financial liberalization, such as interest rate deregulation, the main reason being that the net worth of enterprises will likely be adversely affected by the generally upward movement of interest rates.5 This in turn can feed back into the banking system in the form of bad loans and tends to defeat the purpose of financial reform by weakening the banks’ ability to intermediate new funds.

More recently, actual experience with structural and macroeconomic reform has led to a recognition that programs that do not incorporate financial sector reform measures early on either encounter reversals, achieve their intended results very slowly, or often fail. Indeed, a strategy that delays financial reform ultimately will limit real sector development (Korea) and, by injecting new distortions into the economy, may actually be counterproductive. Delaying reform of the financial sector is also likely to exacerbate the macroeconomic stabilization problem and limit the ability of the authorities to respond to unexpected new shocks.

The case for an early focus on financial sector reform, ideally concurrent with other reform measures, has both an efficiency (microeconomic) and a stabilization (macroeconomic) dimension.

As to the efficiency dimension, it is increasingly recognized that wide-ranging structural reform policies—price reform, fiscal reform, exchange and trade system reform, and industrial restructuring—imply a fundamental reallocation of capital resources and a redirection of new savings and investment flows. Thus, financial institutions and markets are intimately involved, and must be permitted to play their intended role. Financial sector reform, including widened access to foreign capital, can help to ensure that sound, economically viable firms have access to the credit flows necessary to permit restructuring.6 In addition, well-functioning credit markets can provide the required “information system” for lenders to assess risk and creditworthiness of borrowers, and allocate and price credit according to risk, thus facilitating the separation of efficient from inefficient enterprises.

Some proponents of the simultaneous approach refer to the growing empirical evidence that countries with a more liberal financial system have benefited from increased savings, better and more efficient investment performance, and faster rates of economic growth.7 It is increasingly recognized that the liberalization of interest rates and other financial reforms in many Asian countries have contributed significantly to the mobilization of financial savings as well as to the increased efficiency of investment (Malaysia, Thailand).8 Moreover, if reform extends to the privatization of inefficient, state-run commercial banks, it can be expected that lower intermediation spreads will result and, ceteris paribus, the cost of capital to the industry sector will be reduced.

Another aspect of the efficiency argument is that concurrent financial sector reform can reinforce other structural policies, and sometimes be a precondition for their effective implementation. As an example of the mutually reinforcing role that financial sector and reforms in other areas can play, it is sufficient to point to the importance of exchange liberalization and an early opening of the capital account in promoting a more outward orientation of the economy and economic behavior. Another example that may be particularly relevant for Arab countries concerns the pivotal role financial markets can play in the privatization of public enterprises; namely, facilitating proper equity valuation and offering a channel for widespread distribution and subsequent trading of claims. Financial sector reform also has a role to play when state-run enterprises are restructured, if not actually privatized. In these cases, by eliminating preferential access to credit and subsidized exchange rates, public enterprises can be encouraged to become, over the medium term, more competitive and autonomous.

Relevant though efficiency is, it should not conceal the other critical improvements in the process of macroeconomic stabilization that can be gained from early and concurrent financial sector reform. In many instances, it would appear that structural flaws in the financial system “cause” high inflation by impeding and raising the costs of combatting it, to the point where the authorities become reluctant to pursue an effective monetary policy. If so, stabilization efforts are unlikely to be successful without appropriate accompanying financial sector reform measures.9

Sometimes, therefore, it can be useful to think of financial sector reform as a structural reform designed to enhance the capacity of the monetary authorities to meet their macroeconomic stabilization objectives.10 Typical measures will include shifting the focus of the central bank away from financial intermediation (particularly the financing of the government deficit), the introduction of new techniques and instruments of monetary management (substituting market-oriented indirect techniques for direct controls, enhancing monetary programming skills within the central bank), and “unclogging” the channels through which the effects of monetary policy are transmitted to the real sector (strengthening financial institutions, introducing an element of competition, and encouraging the market determination of interest rates and credit flows).

There are at least two other ways in which a concurrent focus on financial sector reform can aid in the macroeconomic stabilization and structural transformation of the economy. First, when reforms generate positive real rates of interest and a more diverse choice of assets for the placement of investible funds, financial liberalization can make an important contribution to staunching capital flight. Second, it can provide the authorities with greater flexibility and additional tools to deal with the destabilizing effects of unexpected macroeconomic shocks. Such room to maneuver may well prove crucial in maintaining the momentum of the overall structural reform program, which might otherwise be threatened should a major shock occur while reform was under way.

Domestic Versus External Reform

Another aspect of the debate on sequencing concerns whether structural reform of the external sector (especially, exchange and trade liberalization measures) should be undertaken before or after domestic macroeconomic stability is attained.

Exchange and Trade Liberalization. Those who favor the “stabilization first” strategy base their views either on the distortionary effects of high inflation, or on the difficulty of avoiding overvaluation of currencies in countries with high fiscal deficits or high domestic inflation.11 The experiences of countries in the Southern Cone of Latin America are often cited in this context. In those countries, financial liberalization was accompanied by massive capital inflows, which either complicated inflation control or resulted in a real exchange rate appreciation, or both, thus making a full-scale trade liberalization program unsustainable.

However, as supporters of the “liberalization first” strategy maintain, the connection between the determinants of inflation and of the orientation of trade or exchange regime can only be tenuous.12 In their view, it is possible to both disinflate and liberalize at the same time, provided that appropriately comprehensive policy programs are formulated and fully implemented. More important, the costs of trade or exchange restrictions in terms of efficiency losses may be too high to justify the postponement of liberalization until the macroeconomy has regained equilibrium. In a setting of highly distorted price structures and monopolistic industrial patterns, for example, exchange and trade liberalization may be the only way of rapidly injecting competition and bringing the domestic price structure into line with international prices. Without such liberalization, the allocation of resources will not only remain inefficient, but may actually worsen.13

It is equally important not to overlook the stabilizing aspects of liberalizing the exchange rate regime and opening the capital account. Insofar as the exchange rate and the traded goods sector can be an important channel for the transmission of the effects of monetary policy, early attention to them can contribute to improving the overall effectiveness of monetary policy.

External Financial Liberalization. The preceding discussion on the urgency of external reform can be equally applied to the financial services industry. As elsewhere, rent-seeking activities in this industry can continue in the absence of external competition. Notwithstanding the well-known benefits from free trade, the authorities often impede international transactions in financial services, either by refusing to provide effective market access and uniform national treatment to foreign financial institutions, or by otherwise restricting capital movements that arise from the underlying transactions in financial services.

Some argue that progress on internal financial liberalization, such as eliminating restrictions on entry into the domestic banking system, is necessary before international financial flows can be freed. The concern here is that under monopolistic conditions, the domestic banking sector, by charging more to borrowers unable to obtain cheaper foreign credit, would appropriate part of the welfare gains deriving from the availability of cheap sources of funds from abroad.

However, allowing freer entry of local participants alone may not be sufficient to change a highly concentrated market structure and monopolistic practices. The new banks may collude with existing banks, or they may simply be squeezed out of the market by natural monopoly. In such cases, foreign banks allowed to enter the market will strengthen competitive forces in the sector. With superior technology and relatively lower costs of operation, the entry of foreign banks will tend to eliminate existing monopolies. External financial liberalization, therefore, can be a powerful means toward achieving a higher level of competition within the domestic banking sector.14 From this standpoint, then, such liberalization does not destabilize but rather becomes a useful complement to the process of internal financial liberalization.

The Need for Comprehensive Design

While the design of the financial reform program has to be consistent with overall macroeconomic strategy, it must also provide internal consistency among its own various components. An unbalanced program of financial sector reform, with key elements left untreated or even with the various elements proceeding in an unsynchronized way, has been identified as one of the main factors causing problems during the course of financial sector reform, thereby causing delays in its full implementation.15

One problem frequently encountered is financial distress in the banking sector, which can occur when progress in liberalizing financial markets runs ahead of improvement in the bank management and of the supervisory framework. In this case, the antidote is to implement simultaneously needed microeconomic reform measures, such as modernization of bank accounting and the introduction of interest rate risk-management techniques, and to strengthen prudential standards and supervisory practices to secure the safety and soundness of the financial system. Another interesting example of coordination failure is provided by a relatively rapid interest rate liberalization in a tight credit situation without the proper lifting of capital controls. The detrimental effect of a sharp rise in domestic interest rates on real investment, and thus on economic growth, may make it extremely difficult to sustain financial liberalization policies.16

In addition to internal consistency, it is essential for the reform plan to recognize the tight linkages with the other elements of the overall program of structural reform, and vice versa.17 These interdependencies can be pervasive, as the following list (which is not intended to be exhaustive) clearly demonstrates:

  • Measures such as indirect taxation and the elimination of government subsidies can put upward pressure on prices and thereby alter the monetary needs of the economy.

  • Introduction of indirect methods of monetary control may provide a basis for offsetting such inflationary pressures and so facilitate a more rapid pace of reform than would otherwise be possible.

  • Certain export promotion policies may require that the exchange rate be managed in a way that is contrary to domestic inflation objectives.

  • The desire to strengthen capital investment in certain sectors of the economy, by providing privileged access to credit and keeping interest rates low, may conflict with the need to vary monetary conditions sufficiently to contain inflation.

  • Liberalizing interest rates and restricting government access to central bank financing will put upward pressure on the fiscal deficit.

The existence of such linkages underscores the importance of undertaking a comprehensive program of concurrent financial and real sector reforms. Moreover, in the absence of joint action, these interdependencies can pose difficult choices for the authorities. Unless they are fully recognized, they can severely complicate the objectives of structural and macroeconomic adjustment. At the same time, however, they can be managed and often used in a mutually reinforcing way, both to minimize the adverse consequences of other reform measures and to create the preconditions for other reforms.

The Need for Rapid Implementation18

Besides the need for consistency in the design of financial sector reforms, there is the question of the pace of implementation to ensure that reforms take hold.19

Sometimes, the economy is so distorted and the financial sector is so repressed that a country has no practical alternative to rapid and comprehensive structural reform (Central and Eastern European countries as well as those in the former Soviet Union). More likely, however, the typical situation will be one in which the country has some discretion over the pace of reform, which in principle can be determined on the basis of a cost/benefit analysis. Then, the result frequently has been the selection of a cautious, gradual pace of reform, on the grounds that total adjustment costs are likely to be lower when they are stretched out over time, while overall benefits are likely to be unaffected.

Such a view recognizes that financial system reform can involve difficult cultural and attitudinal changes, not to mention significant capital expenditure and costly and time-consuming training,20 and will likely result in substantial adjustment costs, defined in terms of temporary losses in output and unemployment.21 Spreading the costs over as long a period as possible has clear political appeal, and may help to sustain the reform effort. Moreover, some countries have favored the gradual approach as a means of reducing the magnitude of the destabilizing macroeconomic developments that sometimes accompany financial sector reform, such as large international capital movements or even temporary loss of monetary control.22 Indeed, at least one country (Korea) formulated a contingent phased plan that made the implementation of particular reform measures dependent on meeting certain macroeconomic preconditions.23

There are a number of compelling reasons, however, for adopting a relatively rapid pace of reform. First, the focus should be placed on net benefits, not exclusively on costs, and it can be presumed that visible, offsetting benefits will accrue more rapidly, the more rapid the pace of reform (New Zealand). This is particularly true of those reforms that are likely to take a long time to yield results as, for example, in the development of a viable long-term bond market or the privatization of large-scale enterprises. In addition, it is not clear that costs are minimized by stretching them out; when reforms are undertaken relatively slowly, they tend to produce significant disruptions over an extended period of time.

Second, if the pace of reform is too gradual, necessary behavioral response may be put off, further extending the ultimate period of disruption and raising the overall costs of adjustment. While the intent of a gradual pace of reform is to give economic agents enough time to brace for change, it can also dull the incentives to implement change, such as enhanced external competition. There is therefore a serious risk that gradualism will merely facilitate the continuation of inefficient economic activity, and thus end up hindering structural adjustment rather than enhancing it. In contrast, speedy implementation may well increase the overall effectiveness of a comprehensive structural reform process, by rapidly putting in place the right price signals or rational institutions for the efficient working of the economy.

Third, and perhaps most important, gradual (and partial) reforms are frequently delayed or subject to reversal (Sri Lanka, Chile). In part, a gradual pace of reform risks sustaining vested interests (e.g., those with privileged access to credit at submarket rates of interest) who, by resisting reform measures, could make the process of opening up the economy politically more difficult.24 In part, too, the longer the period of adjustment, the greater the probability that macroeconomic shocks will impinge, thereby complicating, and possibly even derailing, the reform effort.

Finally, there is a growing realization that gradual reforms often lack credibility and therefore fail to motivate the necessary supporting investment and cultural and attitudinal changes. Financial sector reforms can entail substantial private as well as social costs. If reform is to be effective, the government needs to signal its steadfast commitment to it (Korea) so that agents will begin to undertake necessary and costly adjustment. A clear plan with a definite, public timetable not subject to contingent adjustment is well suited to this need.25

Practical Problems in the Implementation of Financial Reform Measures

The preceding sections have argued for the rapid and concurrent implementation of financial sector reform measures in the context of a comprehensive structural adjustment package; as a practical matter, however, few countries possess either sufficient administrative capacity or foresight to design and implement the ideal reform package at one stroke. In addition, some reforms simply may take longer to implement and take effect than initially planned, and unexpected shocks may intervene. As a result, few reforms go entirely according to plan. The authorities therefore must be prepared to deal with short-term problems and temporary macroeconomic instabilities that may arise to challenge the effectiveness and success of the overall reform program.

While certain problems will be unique to the country undertaking the reform, others can recur. First, financial liberalization is often followed by a period in which domestic credit growth exceeds the growth of bank deposits (Argentina, Chile, Indonesia, Philippines).26

The initial tendency for rapid growth of domestic credit generally comes from the removal of controls that previously constrained credit demand and may have contributed to disintermediation of the banking system. Moreover, financial intermediaries may find it profitable to lend for activities that were previously restricted, such as financing pent-up consumption demand (e.g., durable or luxury goods) or speculative activities (e.g., real estate, stock markets). Sometimes, credit liberalization can create opportunities for large enterprises to consolidate monopolistic power by acquiring existing and related enterprises (Colombia).27 These increased demands for credit are often supported by the enhanced ability of the banking sector to mobilize domestic savings, due in part to reintermediation, and in part to their new ability and willingness to compete for funds by offering competitive interest rates.

Second, financial sector reform and capital account liberalization may expose countries to sudden large capital flows (Egypt, Indonesia, Korea, Mexico, Spain, and Thailand).28 To some extent, inflows are the natural consequences of allowing banks and nonfinancial enterprises greater access to international financial markets. In addition, inflows reflect enhanced confidence in the post-reform economies and thus increased willingness on the part of international investors or lending institutions. In contrast, some countries may experience the opposite problem of a speculative capital outflow (Argentina in 1981, Indonesia in 1984). Often, the causes include an initial surge in private sector credit expansion following financial liberalization, or continued exchange rate overvaluation in the presence of high inflation. Capital flight also may take place, in particular, when capital controls are liberalized while domestic interest rates remain fixed at arbitrarily low or negative real levels. Sometimes, the running down of international reserves following a deterioration in the external current account can aggravate the situation and prompt speculative attacks on the currency.29

Third, financial liberalization may jeopardize the safety and soundness of the banking system, because financial reform that enhances competition in the financial service industry usually puts pressure on weaker financial institutions. These undercapitalized institutions tend to engage in excessive risk-taking activities which, in turn, raise the prospect of bank failure. The safety of the banking system may also be challenged by rapid and uneven credit growth in the initial stages before banks are well equipped to assess and appropriately price differential credit risk, and to some extent, by excessive fluctuations in interest rates and exchange rates, especially before individual banks’ ability to manage market risk or the authorities’ means to contain systemic risk are fully developed.

Containing these adverse developments requires not only wellconceived supplemental measures at the outset of the reform, but also a swift policy response at the first sign of pitfalls. In addition, it requires a strategy which provides the greatest possible degree of flexibility to the authorities. In order to provide as much flexibility as possible, policymakers should emphasize strengthening the prudential framework and developing indirect methods of monetary control in the earliest stages of reform. The following sections suggest various practical ways of dealing with problems commonly encountered during financial sector reform.

Excessive Growth of Domestic Credit

The most practical means of dealing with rapid credit growth and temporary instability in the monetary aggregates is to strengthen the central bank and the monetary policy framework in the earliest stages of the reform process. This can be done by liberalizing interest rates, developing effective interbank and short-term money markets, and introducing indirect methods of monetary control. Such measures provide the authorities with the means to tightly control the supply of reserve money relative to demand by using monetary programming techniques. Recognizing that an effective system of indirect monetary control cannot be implemented overnight, and that a learning period is needed for both the authorities and financial institutions to adapt to the changed environment, many countries have opted to continue using some direct credit controls as a temporary, transitional policy option (Indonesia).

Increased demand for credit following financial sector liberalization can also originate with the central government and public sector enterprises, which together may find that their fiscal position has weakened as the result of their sudden need to begin paying a market-related rate of interest on new and (in some cases) outstanding borrowings (Egypt, Pakistan). Rather than offsetting these pressures through fiscal consolidation or finding new sources of revenue, some countries initially have tried to finance the expanded deficit through increased borrowing from the central bank, which has led to a sizable injection of high-powered money (Pakistan). In these circumstances, there is a clear need for close coordination of financial sector reform measures and fiscal policy. A reduction in government spending can help reduce the demand for credit (reverse crowding-out or crowding-in), while increased taxation and government revenue can reduce the overall resource pressure emanating from the private sector, and thereby curb inflationary pressure.

Finally, to stem excessive credit demand that may arise from large business groups (conglomerates), the bank supervision and prudential regulation framework can be used to prevent undue credit concentration in a few enterprises. The introduction of an effective industrial competition policy may also serve to temper these demands.

Destabilizing Capital Flows

Though potentially beneficial to the countries with external financing constraints, large capital inflows can cause problems, such as the temporary loss of monetary control, excessive real exchange rate appreciation, and a consequent weakening of the current account. Those countries that have not yet developed a liquid, well-functioning market for government paper can be faced by a dilemma—whether to let the exchange rate appreciate and thereby sacrifice the economy’s competitiveness, or to allow the domestic money supply to expand and thereby lose control over inflation.

In these circumstances, policy responses should be tailor-made, as each country needs to consider its own external current account, fiscal balance, and exchange rate regime. It is generally accepted that sterilized intervention is one of the mechanisms that central banks can employ to curb the influence of capital inflows on domestic money supply (Spain, Mexico, and Egypt). However, the authorities’ ability to implement sterilized intervention is often limited by the capacity of private capital markets to absorb the sale of government securities or central bank bills.30 And in any event, sterilization can only provide a temporary solution to the problem.

An alternative or complementary policy (also of a short-term nature) can be the encouragement of outflows, through the early repayment of external debt (Korea, Thailand) or the discouragement of inflows, through the imposition of temporary capital controls, taxes, or other impediments (Egypt, Spain). One country adapted a flexible capital control in the form of a variable deposit requirement scheme (Australia). This can be used intermittently, particularly when the cause of the inflows appears to be primarily short-term speculation. However, such measures can only be temporary expedients, because their effectiveness usually is eroded over time as incentives and loopholes emerge to evade them. Their use in any case represents a regressive step in the overall liberalization process.31

A more enduring means of avoiding a real appreciation is to strengthen the fiscal position. Unlike tighter monetary policy, a tighter fiscal policy can ease the pressure on domestic interest rates. In some countries, a policy of fiscal restraint, matched by increased government deposits at the central bank, has proven the most effective way of sterilizing the monetary impact of foreign exchange inflows (Indonesia, Thailand). Domestic cost and price flexibility in the economy will still be required to keep a balanced structure of relative prices in the presence of external shocks.

In other countries, the authorities need to be prepared to deal with large capital outflows. As discussed earlier, the improvement in the monetary policy framework can help to contain the initial overexpansion of credit, which otherwise may finance capital flight. More permanent shifts in money and credit behavior during the financial liberalization can be accommodated through a change in the focus of monetary policy. For example, the monetary policy target could be shifted from a monetary aggregate to the exchange rate anchor (Indonesia). More typically, capital outflows require the authorities to respond quickly by raising interest rates and adjusting the exchange rate.

Weak Financial Institutions

As pointed out earlier, the safety and soundness of the banking system can be endangered by the side effects of financial liberalization, such as rapid credit growth, heightened competition among financial institutions, and a bias toward taking excessive risks by weaker institutions. In these cases, preventive measures are needed, such as setting minimum capital requirements (capital asset ratio), setting a limit on loans to any single borrower (risk dispersion ratio), and strengthening banks’ disclosure and reporting requirements. In addition, the establishment of deposit insurance schemes in banking, and the strengthening of “insider trading rules” in securities markets, can be used to maintain confidence by providing depositors or consumers of financial services with a degree of protection against unusual losses or fraud. A worrying feature of these schemes, however, is the potential risk of moral hazard that they entail. Unless the schemes are carefully designed and implemented, insured depositors may lack an incentive to deal only with sound banks; banks may have an incentive to make new loans to existing customers with weakened financial positions (distress borrowing) to avoid recognizing insolvency and triggering bad loans; and the authorities may wish to avoid declaring banks insolvent in order to avoid making large insurance payouts. Finally, to prevent loss of confidence in the banking system as a whole, ultimate support for the banking system should come from the central bank as “lender of last resort.”

Some Implications for Arab Countries

The discussion in the preceding sections of the paper has been of a general nature. It may now be useful to conclude by drawing some general implications that take into account the special circumstances of Arab countries and point to the particular role financial reform can play in dealing with them.

Many Arab countries already have embarked on ambitious programs of comprehensive structural and financial sector reform (e.g., Egypt, Morocco, Tunisia), while others (particularly Gulf Cooperation Council (GCC) countries) have maintained a tradition of relatively open financial markets. Thus, presenting this paper can be likened in part to an exercise in “preaching to the converted.” There can still be merit, however, in taking stock and reaffirming our understanding of basic principles, particularly for those who have begun the difficult and arduous process of reform, and may now be experiencing implementation difficulties and delays. The basis for a rich discussion already exists within the region, and we should encourage its development. The experiences of some Arab countries can provide the means for other countries to assess the benefits, as well as the risks and tribulations of engaging in comprehensive structural reform.

Not all Arab countries face the same economic challenges. As countries differ in terms of their economic structure, resource endowment, and level of development, so do the main challenges and the resulting pressure for structural adjustment. For some countries—particularly the oil exporting countries of the GCC—the main challenge lies in maintaining cautious macroeconomic management strategies in the face of the uncertainties prevailing in world oil markets. The principal benefits of ongoing financial reform and the continued development of financial markets for these countries can therefore be expected to come in the form of enhanced flexibility in the use of monetary policy to deal with unexpected macroeconomic shocks. For many of the non-oil countries, the major challenge lies in attaining sustained rapid economic growth to support a growing population. For these countries, the benefits of financial reform will come also in the form of more efficient resource use.

For those countries where the payoff will be primarily in terms of more effective and flexible macroeconomic control, the principal task will be to continue to refine the tools of indirect monetary policy and to develop the market infrastructure that will permit their use in a relatively unfettered way. An important and ongoing challenge will be the development of liquid interbank and short-term money markets that can be used by the central bank for open market operations. Along these lines, some countries have already introduced a treasury bill auction at market-determined interest rates (Egypt) that is quickly becoming the key determinant of domestic monetary conditions. Others have taken steps to increase their reliance on reserve requirements (Morocco) and to develop the interbank market (Tunisia). Yet, further benefits will flow from sustained efforts to promote a further deepening of the money and capital markets, for example through measures to promote competition among banks and other financial institutions, and by progressively widening access to the markets. The need will become increasingly acute as countries move towards full current and capital account convertibility (Morocco, Tunisia).

For those countries where the primary objective is to promote economic development and efficient resource use, the focus should perhaps be placed on the mutually reinforcing nature of financial sector and other structural reforms. For many of these countries, a central problem appears to lie in the predominance of the public sector in economic activity, due in part to past policies aimed at securing control over strategic natural resources or establishing essential industries such as steel or chemicals. Not only have these developments led in many cases to large fiscal deficits and a burgeoning public debt but—given government control on pricing and investment decisions in many of these enterprises and the lack of pressure to meet the test of a competitive market for their products—there has been a tendency for many of these enterprises to become inefficient and financially weak. There is an evident need in many cases for restructuring or even privatization.

Liberalization of the financial sector can make a major contribution to meeting these needs. Economic reforms that seek to promote efficient resource allocation can be supported by financial sector measures to eliminate preferential access to credit at below market rates of interest and induce enterprises (including parastatals) to raise capital on the open market. When privatization is the preferred longer-term solution, supportive financial reforms, such as the development or revitalization of local equity markets, are essential to provide a vehicle for asset sales to the private sector and to facilitate proper valuation of those assets. Efforts to develop domestic capital markets can be further buttressed by measures aimed directly at attracting foreign capital, such as the removal of various investment restrictions and exchange controls.

A further distinguishing feature of the economic challenges faced by the Arab countries is the extent to which some of them are faced by a severe external debt problem and debt-servicing difficulties, while others are capital-surplus countries numbering among the largest investors or donor countries. Clearly, those capital-deficit countries with serious external financing gaps need to take short-term corrective actions to contain and reduce the debt-service burden to sustainable levels. Seeking greater official assistance, either from Arab donor countries or other international organizations, is another possibility. If it is to be truly helpful, however, the assistance will have to be provided on appropriate terms (maturity and interest rate), and recipients will have to ensure that the funds are employed in projects that yield a meaningful rate of return. Considering the great potential for intra-Arab private capital movements, financial liberalization policies could be aimed at fostering and facilitating the freer movement of capital among Arab countries. Clearly, a stable macroeconomic foundation and policy predictability must be key ingredients in any plan to promote private investment and spur the inflow of foreign capital.32 But the development of more diversified financial instruments, along with the abolition of legal restrictions on foreigners’ access to domestic capital markets, may expedite the further integration of Arab financial markets.

Finally, as in all countries (whether industrial or developing, and whatever the state of the financial markets) the further strengthening of prudential supervision and regulatory standards must be a continuing process.


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* The views expressed in the paper are mine and they should not be attributed to the International Monetary Fund. I would like to thank, without implicating, my colleagues William Alexander and Jang-Yung Lee for their assistance in the preparation of this paper.


See, for further elaboration, Guitián (1987).


The classification, though useful for expository purposes, conceals the existence of areas of overlap among the various groups.


I have discussed the issue of capital account liberalization elsewhere; see Guitian (1992a).


Frenkel (1983) has argued that while asset markets clear almost instantaneously, the attainment of equilibrium in the goods markets usually takes time. Edwards (1989b) has contended that while a reduction in tariffs can, in general, result in either an equilibrium real exchange rate depreciation or appreciation, capital account liberalization will unambiguously result in a real appreciation. On the other hand, Dornbusch (1983) has pointed out that if the domestic capital market is still repressed and interest rates are fixed at artificially low levels, massive capital outflows will take place when the capital account is opened. Some of these arguments are based on empirical findings on the behavior of exchange rates. Edwards (1989a), for example, using data for 12 developing countries, found that higher tariffs resulted in real exchange rate appreciation, as did an increase in capital inflows. However, even this empirical finding seems to support the strategy of a simultaneous opening up of trade and capital account since lower tariffs can be used to mitigate the adverse impact on the real exchange rate coming from the capital inflows during the reform.


The net worth of the bank borrower is regarded as a highly important factor for the sound functioning of financial markets. See Gertler and Rose (1991).


See Khan and Sundararajan (1991) for detailed arguments.


See De Gregorio (1992) for empirical findings that emphasize the role of financial intermediation in improving the efficiency of investment.


See El-Erian and Tareq (1993) for detailed arguments.


This point was argued by Krueger (1981).


Allocative efficiency may worsen, because enterprises with greater autonomy could make inconsistent production and input use decisions according to the signals given by relative prices and costs, which do not fully reflect distortion-free world prices. The traditional coordination mechanism in the prereform economy, on the other hand, could provide a measure of internal consistency through strict enforcement of delivery quotas from enterprises. See Murphy, Shleifer, and Vishny (1992).


One notable case is provided by Korean experience during 1988-89, when the authorities decided to accelerate interest rate deregulation by abolishing the practice of window guidance on most of the bank lending rates. At first, this experiment appeared to be working well. The performance of financial intermediaries and borrowing firms fared well without government intervention, and local interest rates remained stable. Toward the end of 1989, however, market interest rates rose very sharply against the background of a rapidly deteriorating macroeconomic situation (e.g., a dramatic turnaround of the current account balance turned a surplus to a deficit) and a consequent liquidity squeeze. This negative development elicited a strong lobby against the reform, and forced the government to temporarily withdraw its commitment to the interest rate deregulation.


The following follows closely the discussion contained in Atkinson and Alexander (1990).


The need for rapid implementation also was stressed in a recent speech by the Deputy Managing Director of the IMF. See Erb (1993) for details.


Here, I refer to the general strategic question of the appropriate overall pace of the financial reform. This should not be taken to imply that all the elements of the reform will necessarily proceed at the same pace. The latter can be regarded as more of a tactical issue, to be decided on the basis of particular institutional and structural characteristics of the economy and its financial system. For example, the speed of interest rate liberalization can be made more gradual than that of bank restructuring. If the financial structure of borrower firms is initially weak the quality of banks’ loan portfolios is problematic. Also, within the interest rate liberalization plan, there may be circumstances in which it is desirable to decontrol bank lending rates before deposit rates.


The difficulties of introducing a market economy in the states of the former Soviet Union and in Central and Eastern Europe provide a case in point.


See Bruno (1992) for details.


This subject will be taken up in the next section of the paper.


This strategy was included in the initial draft of Korea’s Phase Three Financial Liberalization Plan, which identified three key macroeconomic preconditions—balance of payments equilibrium, domestic price stability, and a narrowing of the gap between domestic and foreign interest rates.


Aggressive sterilization through open market operations may also put upward pressure on domestic interest rates, and thus intensify the initial conditions that attracted large inflows. Fiscal losses, as the interest paid on domestic paper may exceed that received on foreign assets, are another potential consequence of sterilization. See International Monetary Fund (1993b).


Moreover, the reliance on direct administered controls will make the longrun transition to a market-determined exchange rate system more difficult because of the dislocation effect arising from the distortions in the relative prices of financial assets.


See Abisourour (1993) for details.