The papers in this volume illustrate the structural linkages among different components of financial sector reforms and the impact of these reforms on macroeconomic performance, based on country experiences. An underlying theme throughout the volume is that specific financial sector reforms should be properly sequenced and coordinated in order to complement and support macrostabilization objectives, and to reflect the technical linkages among various components of financial sector reform. An appropriate sequencing of financial sector reforms that supports stabilization can help to derive the full benefits of these reforms in terms of efficiency and growth. The book is therefore concerned with the elements that contribute to orderly liberalizations of financial systems, and with avoiding the pitfalls from inappropriately sequenced or insufficiently supported financial reforms.

The papers in this volume illustrate the structural linkages among different components of financial sector reforms and the impact of these reforms on macroeconomic performance, based on country experiences. An underlying theme throughout the volume is that specific financial sector reforms should be properly sequenced and coordinated in order to complement and support macrostabilization objectives, and to reflect the technical linkages among various components of financial sector reform. An appropriate sequencing of financial sector reforms that supports stabilization can help to derive the full benefits of these reforms in terms of efficiency and growth. The book is therefore concerned with the elements that contribute to orderly liberalizations of financial systems, and with avoiding the pitfalls from inappropriately sequenced or insufficiently supported financial reforms.

The objective of developing the monetary and exchange system, and more broadly the financial system, derives from the simple proposition that the more efficient and more stable such systems are, the better a country’s economic performance will be. Stable and efficient financial systems will provide the foundation for implementing effective stabilization policies and successfully mobilizing capital and putting it to efficient use, and, therefore, achieving higher rates of economic growth. This proposition will be valid not only in the mobilization and use of national savings but also in harnessing foreign savings. In a world of increasing capital mobility, capital will move not only as a response to competing monetary policies but also to competing financial systems. Inefficient and unstable monetary and exchange systems are likely to be increasingly penalized, placing a premium on developing financial sector institutions and sound macroeconomic policies.

The efficiency of financial systems is governed by the range of intermediaries and the role of markets in mobilizing and allocating financial resources; in providing liquidity and payment services, including through the convertibility of currencies; and in gathering information on which to base investment and savings decisions and influence corporate governance. Stability is concerned with safeguarding the value of liabilities of financial institutions that serve as stores of value and wealth, and media of domestic and international exchange. It is also concerned with the interrelationship between financial systems and macroeconomic management. This aspect involves questions of monetary control, prudential supervision and financial regulation, and broader questions of good governance.

Figure 1.1 illustrates the types of trade-offs that might be thought to exist between stability and efficiency depending on the nature of market arrangements and type of governance. Market-based systems with strong internal governance (upper right quadrant) are likely to have better economic performance than those in the lower left quadrant. Nonmarket-based systems that rely on direct controls may or may not involve instability, depending upon the quality of governance, but invariably involve inefficiency compared with market-based arrangements. Maintenance of direct controls for prolonged periods is more likely to be associated with instability given the scope for avoidance of direct controls. Seriously repressed financial systems are more likely to be associated with instability and inefficiency and lower economic growth. Success in moving toward higher rates of growth will depend on the sequencing of reforms. An inept approach to sequencing reforms may result in instability and weaker improvements in efficiency than better sequenced reforms. A banking crisis, associated with poorly managed reforms, would damage economic performance. The “quality” of financial reform matters.

Figure 1.1.
Figure 1.1.

Factors Influencing Financial Sector Efficiency and Stability

Against this background, financial sector liberalization can be viewed as a set of operational reforms and policy measures designed to deregulate and transform the financial system and its structure with the view to achieving a liberalized market-oriented system within an appropriate regulatory framework. Such worldwide financial sector reforms have led to greater flexibility in interest rates, an enhanced role for markets in credit and foreign exchange allocation, increased autonomy to commercial banks, a greater depth for the money, securities, and foreign exchange markets, and significant increases in cross-border flows of capital. In parallel, the framework for monetary and exchange policy has undergone major changes. Bank-specific credit ceilings and selective credit allocations have been replaced by market-based instruments to implement monetary policy. Prudential supervision systems have been put in place to foster sound credit decisions and effective management of market risks. A regime of strong exchange and trade restrictions and limited foreign exchange markets has given way to a multilateral international exchange and payment system with significant progress toward currency convertibility and active interbank foreign exchange markets.

In support of such a transition, financial sector reforms have, in varying degrees, involved:

  • Increasing autonomy to central banks in monetary management.

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

  • Reforming prudential regulations and the banking supervision system.

  • Recapitalizing and restructuring weak financial institutions, supported by enterprise restructuring policies.

  • Reforming selective credit regulations and reducing the scope of directed credit and interest subsidies.

  • Fostering autonomy and competition in the financial system, and promoting institutional development of both banks and nonbank financial intermediaries (NBFIs).

  • Developing long-term capital markets, including domestic public debt management and government securities markets.

  • Reforming clearing and settlement system for payments.

  • Developing foreign exchange markets supported by appropriate prudential regulations on foreign exchange exposure.

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

The relative importance of these components and the specific measures within each component have varied from country to country, depending upon, among other things, the prevailing initial conditions, the commitment to reform on the part of the authorities, and the speed of reform process. Examination of country experiences shows that there are close structural linkages among specific components of financial sector reforms, and these linkages have implications for the appropriate sequencing of reforms. Smooth implementation of financial sector reforms would typically also require a wide range of legislative measures and organizational changes. In particular, the organization and functioning of the central bank would need significant strengthening to facilitate implementation of financial sector reforms.

In all cases, however, these reforms have been motivated by the need to pursue stabilization and broader structural reforms in an efficient and effective manner, and thereby step up savings mobilization, improve the efficiency of investment allocation, and achieve sustainable growth. These broader issues are reviewed briefly in the next section, before outlining the structure of the book and the main themes.

The Link Between Stabilization and Financial Sector Reforms

The resurgence in academic interest in the role of financial systems in economic development dates to the early work of Gurley and Shaw (1960) on the interaction between financial structure and economic activity, and especially on the role of intermediaries in the credit supply process. Many authors have argued that credit market conditions and balance sheet developments such as debt-equity ratios, ratio of net worth to liabilities, and other similar ratios can have important effects on output and investment (see, for example, Gertler, 1988; and Sundararajan, 1987). In addition, the information asymmetries and the resulting market failures, such as equilibrium credit rationing, credit market collapse, bank runs, and weak secondary markets, suggest that governments can, through appropriate regulations, improve on the types of contractual arrangements that would arise in an unfettered private economy.1 Empirical literature has also increasingly emphasized the importance of financial sector variables in economic cycles.2 Recently, several studies have reported positive correlations between levels of financial development and economic growth (e.g., King and Levine, 1993a; and Japelli and Pagano, 1992).

It is widely recognized that certain structural adjustments are necessary to support the effectiveness of stabilization, and at the same time, the successful pursuit of stabilization policies is necessary for the effectiveness of broader structural reforms—price reforms, exchange and trade reforms, industrial restructuring and enterprise reforms (see Barth, Roe, and Wong, 1994). Both stabilization and general structural reform policies, however, need to be supported by complementary financial sector reforms. As discussed later in this volume, wide-ranging structural changes in the financial sector are often needed for the effective and efficient conduct of monetary and exchange policies, without which sustained progress toward macroeconomic and financial stability would be difficult to achieve.

The policy implications of this work are that important gains for economic performance are to be had from financial sector reforms, and therefore these reforms should be accelerated. Countries wishing to attract or retain private savings so as to achieve adequate rates of economic growth have little option but to reform their financial systems and to follow policies that will maintain financial stability. Often, rapid financial liberalization can overcome inertia and be a catalyst for broader economic reforms. Moreover, rapid reforms can add credibility to the government’s commitment to carry out reforms and help the mobilization of external resources. This realization comes in the form of both tangible evidence that the authorities are moving ahead with reforms and the evidence of increased willingness of the government to subject itself to discipline from markets.

Nevertheless, financial reforms carry risks if they are sequenced inappropriately or insufficiently supported, and the academic literature has tended to place financial sector reform relatively late in the overall sequence of reform and to favor a gradual approach.3 The literature suggests broad propositions on the optimal sequencing of economic reforms, including that: (1) macroeconomic stabilization is a prerequisite to successful structural adjustments; (2) the liberalization of domestic financial markets should precede the removal of controls on international capital flows; and (3) trade liberalization and real sector adjustments should precede capital account liberalization. Nevertheless, the potential role of financial systems in improving economic performance argues for examining ways of accelerating the financial sector reforms while seeking to reduce the possible adverse consequences for macroeconomic control and resource allocation of poorly sequenced or managed reforms. Acceleration of reforms is especially important where restrictive financial systems have failed to deliver adequate economic performance; people appear to be circumventing existing controls; and countries are confronting critical macroeconomic and structural problems that make it difficult to delay reform.

The challenge of financial sector reform is to evolve strategies that can improve financial sector efficiency while achieving or maintaining financial stability—or at least to identify the risks and tradeoffs between the efficiency and stability of different strategies. The first task often is to understand the costs of maintaining a high degree of financial repression and the benefits of proceeding with financial sector reform. The second task is to design reforms that can help minimize the costs and risks and, thus, promote more successful transitions to market-oriented financial systems and better economic performance. The development of such strategies requires taking into account the interrelationships among different structural components of financial systems, and between the microeconomic and structural features of financial markets and institutions on the one hand and macroeconomic policy on the other. In particular, conditions in the financial sector could influence the instrument mix and effectiveness of macro policies, while macroeconomic developments could, in turn, affect financial sector soundness and efficiency. These interrelations are complex, however, and the dependence of outcomes on specific institutional structures and policy mixes so far has not been amenable to theoretical analysis. Nevertheless, the experience of different countries with financial reform is rich in information and lessons about the feasibility and risks of different strategies.

Sequencing of Reforms: Country Experiences

This book brings together a number of research papers that address the issue of pace and sequencing of financial sector reforms based on country experiences. Discussions focus on what is feasible in terms of financial sector reform to support stabilization and avoid major risks, and on the practical approaches that can be followed for this purpose. The chapters take a pragmatic and empirical approach aimed at understanding the operational experiences and institutional reforms that shape the financial liberalization process. More specifically, the papers address issues of monetary control and money market development, sequencing of financial sector reforms, sequencing of prudential supervision and bank and enterprise restructuring policies, exchange market and capital account liberalization, and real sector consequences of financial sector reform. Collectively, these papers are the result of work over nearly a 10-year period (1988-97), building on years of advisory work provided by IMF staff.4

Chapter 2 examines the development of monetary control procedures and the supporting institutional reforms. It reviews the experiences of nine developing countries that have introduced such instruments, and provides quantitative estimates of their importance in monetary management. It also discusses the implications of increased capital flows for the design of monetary policy frameworks and the effectiveness of monetary policy instruments.

Chapter 3 reviews the historical experiences of five developing countries—Argentina, Chile, Indonesia, Korea, and the Philippines—regarding the sequencing of financial sector reforms. Each country’s approach varied considerably, but their results showed a great deal of commonality. Three of these five countries experienced a banking crisis following the reforms, and this chapter examines the background leading up to the crises, and the lessons learned concerning the design of monetary and prudential regulatory policy and the avoidance of financial crisis.

Chapter 4 considers issues in the sequencing of prudential supervision and financial restructuring of banks in the course of financial liberalization. The recognition of major two-way linkages between banking soundness and macroeconomic policy calls for appropriate strategies to foster banking soundness in the course of transition to market-based monetary and exchange systems.

To understand the benefits and potential risks of financial sector reforms more fully, Chapter 5 examines the links between financial sector reform and economic growth and efficiency. The research reported is based on an examination of panel data from 40 countries that reformed their financial systems. This chapter also analyzes prefinancial reform, reform, and postreform data for countries that had successful financial liberalizations, as well as countries that faced a financial crisis following the reforms.

Finally, Chapter 6 evaluates the sequencing of capital account liberalization, drawing lessons from four emerging market economies that have experienced large capital inflows—those of Chile, Indonesia, Korea, and Thailand. The impact of capital account liberalization on economic performance varied, and three of the countries experienced a currency crisis. This survey leads to broad conclusions about the conceptual framework for an orderly liberalization of the capital account. This survey also reviews the role of capital account liberalization in the currency crisis in Asia, and draws lessons for the sequencing of liberalizations.

Main Themes and Findings

The major themes and findings are summarized below, as they refer to the sequencing of monetary reforms and managing the shocks associated with liberalizations; the sequencing of banking restructuring and strengthening prudential regulation; the impact of financial sector reform on the real sector; and the sequencing of capital account liberalization.

Monetary Reforms

Many countries with repressed financial systems face problems of monetary control associated with the ineffectiveness of direct credit and interest rate controls. Administered interest rates and credit allocation have tended to be eroded over time, and are inflexible in the face of substantial international capital flows. Moreover, they are associated with inefficiency in resource allocation. The modification of monetary policy instruments in order to achieve more effective monetary control is an important motivation of financial sector reform, and the freeing of direct controls on interest rates and credit is central to most financial sector reforms.

More indirect, market-based approaches have increased the scope for macroeconomic control while allowing for a deregulation of interest rates and the allocation of credit, which can improve resource allocation efficiency. The experience of countries with reforming monetary controls indicates that the introduction of indirect approaches has often been accompanied by an initial active use of reserve requirements and refinance facilities, and for a time, guidance on interest rates and bank credit were continued because of concern over the weak institutional capacity of financial markets (Chapter 2). The introduction of indirect instruments by itself stimulated money and interbank markets, but the successful adoption of indirect instruments required parallel reforms to strengthen money market structures and trading arrangements, and the supporting clearing and settlement system for interbank payments. Where a deregulation of interest rates and credit controls occurred abruptly after a long period of control, countries have experienced significant financial deepening but also some problems of a loss of monetary control. Other countries that liberalized administered controls over bank credit more gradually did not experience the same loss of control (Chapter 3), but the pace of development of financial markets was correspondingly slow.

Two types of monetary and portfolio shocks are evident from the experience of various countries. The first relates to the credit creation process, with rapid credit expansions tending to follow the liberalization of controls on the banking system (Chapter 3). The second relates to external sector liberalizations, with evidence that external liberalization can lead to a reflow of capital flight, improvements in countries’ capital accounts, and additional constraints on monetary and exchange rate policies (Chapter 6).

First, in nearly all countries, financial liberalization has been followed by a period in which credit growth exceeded the growth of deposits, and in several countries, the gap between the growth of credit and the growth of deposits widened following the reforms. The initial tendency for credit to grow more rapidly than deposits is perhaps not surprising where credit growth was previously constrained by direct controls with an excess demand for credit. Once the direct controls are removed, the tendency is for financial institutions to respond by running down holdings of excess reserves built up under credit controls, with credit expanding rapidly thereafter. In the prereform period, deposits were not limited by direct controls, and so a similar excess demand did not exist. Deposit growth, however, responds to the adjustments in interest rates.

The adjustment of interest rates to positive real levels and the adoption of interest rate flexibility to contain inflationary pressures appear to be critical policy actions in the reform period to deal with the credit and monetary effects of reform. When the authorities maintain positive real interest rates, the experiences of various countries suggest that the tendency for credit to grow more rapidly than deposits will be temporary. Following the initial stock adjustment, credit growth slows down, while deposit growth continues in response to the ongoing financial deepening. After an adjustment period, the growth of deposits and credit converge, allowing for balanced growth with a higher level of overall resource mobilization (Chapter 3). Thus, over time liberalization of the financial system results in increased financial savings, and the economy can tolerate a somewhat more rapid growth of money and credit without increasing inflationary pressures. In those countries that did not increase their real interest rates, however, financial reforms often impeded economic growth and efficiency. In these cases, the credit expansion resulted in inflation, unproductive investment, and weak bank credit portfolios (Chapters 3 and 5).

Second, eliminating controls on capital inflows has generally, at least initially, resulted in stronger capital inflows as international investors (and local residents with capital abroad) react to the improved investment environment. Such inflows can help support the balance of payments, reduce costs of borrowing, and, therefore, support more rapid economic growth.5 Increased freedom of capital movements also reduces the capacity to conduct independent monetary and exchange rate policies. High capital mobility also alters the effectiveness of different monetary instruments in achieving the objectives of monetary policy. Instruments that impose a high cost or administrative constraint on the banks—for example, credit or interest rate ceilings or high unremunerated reserve requirements—may be circumvented more easily by disintermediation through the capital account, and therefore become less effective (Chapter 2).

To manage the monetary and credit shocks and the potential foreign capital inflow effectively, the authorities would need to develop indirect instruments of monetary control; the development of such instruments has generally occurred very early in the reform process (Chapters 3 and 6). Because of the close technical and operational linkages between the design of monetary policy instruments and operations, and the structure and depth of money markets, including the supporting payment systems, reforms of monetary control procedures are accompanied by parallel measures to strengthen money and interbank markets, and payment systems (Chapter 2).

Countries with successful financial reforms have tended to liberalize monetary controls in stages, ensuring that necessary concomitant reforms are implemented in a timely manner, and relying on a range of monetary control instruments during the initial stages of reform (Chapters 2 and 3). For example, it may be necessary to phase in the post-liberalization credit expansion because of its potentially destabilizing effects on both the macroeconomic variables and the balance sheets of commercial banks. An attempt to constrain credit demand solely through interest rates could result in high real interest rates, thereby encouraging substantial foreign capital inflows, while weakening a bank’s loan portfolio. Countries have generally found it necessary to speed up the introduction of and reliance on indirect monetary controls to help manage the effects of foreign inflows of capital (Chapters 2 and 6).

Monetary and credit aggregates have usually become less stable in the aftermath of financial sector reforms (Chapter 2). Therefore, the authorities have to use a broader range of monetary and macroeconomic indicators to guide monetary and exchange policy and to coordinate monetary, public debt, and exchange market operations.6 Some of the aggregates at the level of the central banks’ balance sheet may be more reliable guides to the stance of monetary policy than broader monetary and credit aggregates during the reforms. With increased capital mobility, the external counterpart of money supply may become more volatile, and the demand for domestically defined monetary aggregates may become more sensitive to international interest rate differentials, thus making it more difficult to identify a stable domestic monetary aggregate. Capital account liberalization, therefore, reinforces the trend toward the adoption of a more eclectic monetary framework, and toward giving more weight to exchange rates in monetary assessments (Chapter 6).

Banking Crises and Prudential Supervision

Experiences with financial sector reforms highlight the critical importance of addressing early in the reform process problems in financial system soundness, particularly in the banking industry. Serious banking sector problems are often the legacy of prolonged financial repression. A failure to address these problems weakens the effectiveness of reforms in improving resource allocation, and risks a banking crisis that could seriously disrupt stability and economic growth. The evidence from cross-country experiences indicates that only those countries that avoided financial crisis were able to benefit significantly in the short run from financial sector reform (Chapter 5). Financial sector problems were also a significant component of the currency crises in countries that liberalized their capital accounts (Chapter 6).

Several countries—for example, Argentina, Chile, and the Philippines—experienced financial crises following financial sector reforms (Chapter 3). These crises disrupted the financial sector and were accompanied by a sharp contraction in gross domestic product (GDP) and a reversal of the financial deepening that initially followed the financial reforms. Banking sector problems and weaknesses contributed to an inefficient use of capital inflows and were an important element of the currency crises in Asia (Chapter 6). These episodes indicated the significant two-way correlation between banking soundness and macrostability, and the importance of implementing financial sector reforms with due regard to stability.

The major common elements of these financial crises were the unsound asset structures of banks (reflecting, for example, subsidized credit and insider loans); changes in relative prices, including interest rates and exchange rates, that influenced the viability of borrowers; and weaknesses in the institutional structure of banking, including weak prudential regulation and banking supervision, that facilitated risk taking. Certain characteristics of the reform may have contributed to the crises. First, the very rapid growth of bank credit following the domestic liberalizations and strong capital inflows may have strained the credit approval process and resulted in an increase in lending to more high-risk projects. This was a particular problem because of extensive lending to interrelated entities and the lack of regulation of loan classification, provisioning, and interest capitalization. Second, in some cases the abruptness of the financial liberalization did not give the private financial institutions time to develop the necessary internal monitoring, credit appraisal, and risk-management procedures, nor did it give the public sector banks time to create a more commercial approach. Third, information systems—accounting, financial disclosure rules, company analysis, credit-rating systems, etc.—that are necessary for an efficient allocation of resources were not developed. At the same time, while prudential supervision was not well formed, market discipline remained weak because of explicit or implicit government guarantees, with depositors and creditors being largely indifferent to bank credit risks. Insolvent banks were able to attract deposits and to disguise their true financial positions by continuing to pay interest and dividends out of deposit receipts.

Early and timely attention to developing vigilant bank supervision and well-designed prudential regulations could have helped detect and contain the buildup of financial fragility. In some countries, financial reform was accompanied by a strengthening in prudential regulations; however, implementation of the regulations was weak and some critical regulations—for example, restrictions on lending to interrelated entities, on loan classification and provisions, and on accounting rules on interest accruals—did not exist and others were rescinded because of an inability to implement them. This underlines the importance of having not only adequate regulations but also the capacity to implement them. Such a capacity is in part technical, but also requires the absence of political interference. The achievement of such a capacity takes time and often involves the strengthening of key public institutions, particularly the central bank, as part of the process of financial reform.

In practice, policies to restructure banks (and enterprises) and strengthen prudential supervision can be phased in to support the interest rate and capital account liberalization process, and thereby avoid either undue delays in liberalization or its abrupt interruptions due to financial crisis. Appropriate sequencing of banking restructuring and supervision policies can help to set up initially a critical mass of reforms in prudential supervision and bank balance sheets, and these can be progressively refined and adjusted in line with the evolution of financial markets and internal governance in commercial banks.

Nevertheless, the speed and nature of interest rate and capital account liberalization also has to take into account the financial structure of nonfinancial firms, and the pace with which problem banks and their assets can be restructured. If nonfinancial firms are highly leveraged, any sharp increase in real interest rates could further weaken the repayment capacity of these firms and the condition of banks. Allowing weak banks to expand their balance sheets through domestic or foreign sources is likely to risk a banking crisis. The preferable option would be to recapitalize the banks and restructure their asset portfolios. This may require corporate restructuring and budgetary transfers and, therefore, a larger fiscal adjustment in support of the financial reforms. Where banking sector reforms are delayed it may then be desirable to liberalize bank interest rates and banks’ capacity to borrow abroad only gradually, while pushing ahead with industrial sector restructuring and the recapitalization of banks.

Where banking sector weaknesses are not well perceived by financial markets, or where banks are considered to be explicitly or implicitly guaranteed, so that the markets exercise only weak discipline on the borrower, there would be a case for more direct measures to limit bank balance sheet growth, including controls on the banks’ capacity to borrow internationally. In such circumstances, it would be risky to liberalize banks’ access to foreign finance until the government addresses banking weaknesses and concerns about moral hazard and implements appropriate supervisory standards.7 Similar concerns may also arise when providing corporate borrowers access to overseas finance, if the financial sector guarantees are perceived as extending to the corporate sector.

Nevertheless, policies to restructure banking systems have often proved quite difficult to implement. This can create an important dilemma for the pace and sequencing of financial sector reforms. Should the authorities move forward with reforms in other areas—such as interest rate liberalization—in the expectation that these will be a catalyst to broader financial sector reforms? The country experiences reviewed illustrate the risks of proceeding with partial reforms and the need for supporting measures in a broad range of areas. Partial liberalizations of the financial system without supporting banking sector reforms have frequently led to banking crises. The very large loan losses that have become evident in the episodes of financial crisis in the 1990s, including the recent experience in Asia, have again highlighted the critical importance of phasing in bank supervision and restructuring policies to support domestic and external liberalization. These experiences also highlight that a comprehensive and well-sequenced approach is needed to prevent crisis or to minimize public costs of restructuring during crisis. Such an approach should coordinate the strategies to strengthen prudential supervision with those to restructure banks and banking systems, and to foster efficient institutional arrangements for loan recovery and enterprise restructuring and adopt prudential supervision to meet the emerging circumstances of the market (Chapter 4).

Financial reforms have tended to broaden initially banks’ gross lending margins, reflecting, among other things, the removal of interest rate controls, which allowed banks to price credits and risks more appropriately, and increased use of non-interest-bearing reserve requirements. Margins have tended to decline subsequently as more reliance has been placed on indirect monetary controls, and financial sector competition gradually increases. Portfolio weaknesses in banking, however, can result in a widening of lending margins for a prolonged period of time. Not only is this detrimental to economic performance but it can also encourage unsustainable foreign inflows, and thus requires that domestic financial sector restructuring be sequenced appropriately with the opening of the capital account.

Capital market development has tended to lag reforms in the banking systems, although capital markets could play an important role in enhancing competition and intermediating domestic and foreign investment funds, and promoting longer-term capital flows. Although the papers do not provide direct evidence on the importance of capital markets for financial sector reform, they do indicate the importance of following a balanced approach to financial sector development that would involve the simultaneous development of the capital market and the liberalization of the banking system. This is a conclusion that is reinforced by the experiences with capital account liberalizations in Asian economies, where an over-reliance on the intermediation of capital flows through banks rather than capital markets contributed to the short-term composition of capital inflows, and increased the vulnerability to reversals of capital flows (Chapter 6).

Failure to strengthen bank supervision appears to have been a critical weakness in a number of financial sector reforms. In some countries, evident market failures resulted from institutional weaknesses and inappropriate incentives. The critical need to address these difficulties through effective prudential supervision and adequate internal governance was identified only late in the reform process, as was the need to reform deposit insurance as a means of increasing market discipline on financial institutions. In some other countries, such as Argentina, Chile, Indonesia, and Thailand, new prudential regulations were introduced in the initial stage of the reforms, but they were ineffective. The latter underlines the importance of the implementation of the standards as well as the adequacy of the standards themselves.

Real Sector Effects of Financial Reform

A large body of theoretical literature analyzes the extent of financial intermediation in an economy as an important determinant of its real growth rate.8 Empirical tests using a large sample of countries have also concluded that financial variables have an important impact on economic growth.9 But, as already noted, the transition from repressed to more market-oriented financial systems involves shocks to interest rates, the exchange rate, and financial flows, and the authorities’ reactions to these shocks can affect economic performance and the transitional costs of financial sector reform. Many countries have had successful financial sector reforms accompanied by improvements in economic growth and efficiency, but several other countries, industrial and developing, have faced financial crisis and disruptions to economic growth.

The results of the research reported in Chapter 5 indicate that financial sector reforms can have important structural effects on the transmission of financial variables to the real economy. Where financial reforms are properly managed, they can contribute to strong improvements in economic growth and efficiency. Key elements of successful reforms included increases in real interest rates; management of the credit growth following the reforms, which often allowed for a more gradual increase in credit to the private sector; and improvements in banking efficiency in the postreform period. However, poorly managed reforms that are manifest in financial crisis can damage both economic growth and efficiency. Moreover, expanding the financial sector under conditions of financial repression or poorly managed reforms increases the chances that intermediation will be channeled into unproductive projects, thereby hampering economic efficiency and growth.

Those countries that reformed their financial systems and confronted a financial crisis often encountered a deterioration in economic growth and some decline in output to capital ratios. In these countries, real interest rates declined and credit expansion tended to be more rapid, suggesting that the banking crises may have been partly related to the failure of the authorities to respond to the monetary shocks that accompanied the reforms. The crisis countries also appear to have faced greater problems of banking inefficiency and insolvency. Post-crisis adjustments also imposed heavy real sector costs. In summary, the “quality” of financial reform matters, and the design of reforms is an important determinant of the success of financial reform and of economic performance.

Liberalization of the Capital Account

The issues raised in liberalizing the capital account (Chapter 6) are to a large extent the same as those that confront a country liberalizing its domestic financial system—how to strengthen financial institutions so that they can operate in a market-based system, and how to achieve monetary objectives and maintain macroeconomic stability in such an environment. The liberalization of capital flows can thus be viewed as one aspect of a broader program of financial sector liberalization.

Capital account liberalization also introduces an additional external dimension and urgency to financial sector reforms. Capital inflows will either be channeled through domestic intermediaries or compete with them. In both cases, the intermediaries will need to be strengthened, either to help ensure the efficient use of the capital inflows, or to help domestic financial institutions cope with increased competitive pressure and the need to restructure. Capital account liberalization can also open the way for domestic banks and corporations to take on greater foreign exchange risks than domestic financial liberalizations. Capital account liberalization will also bring more sharply into focus inconsistencies in monetary and exchange rate policies and the weaknesses of direct monetary instruments.

There are a number of reasons for adopting a coordinated and comprehensive approach to financial sector reforms and capital account liberalization. First, from a macroeconomic and balance-of-payments perspective, the stage of development and the stability of domestic financial systems have key influences on the growth and composition of capital movements and on the capacity of the authorities to manage capital flows. Countries with developed financial markets and institutions have been better able to attract portfolio capital flows than countries where such markets are just emerging. Countries with sounder banking systems also have been better able to handle reversals in capital inflows, since under a strong financial system, banking weaknesses do not act as constraints to interest rate and exchange rate policies. The efficiency of the use of capital flows and thus the extent to which such flows contribute to sustained improvements in economic performance will also depend on the stage of development and efficiency of the domestic financial system. This factor in turn may depend on the existence of a well-regulated and supervised financial system, and the elimination of various sources of market failures that may be the legacy of previous financial repression.10 With greater freedom of capital movements, short-term interest rates will increasingly be determined by the covered interest rate parity condition, which is the consequence of arbitrage between short-term domestic and foreign interest rates and the discount on the currency in the forward exchange market. As a consequence, the capacity to assign monetary and exchange policies to achieve different macroeconomic targets will be increasingly constrained (see Chapters 2 and 6).

Second, the opening of the capital account can have important implications for financial markets and institutions. In many cases, the implications are positive in that the liberalizations help to develop deeper, more competitive, and more diversified financial markets. However, some countries have been confronted with banking crises when faced with sudden inflows and subsequent sharp reversals in capital flows.

Third, the opening of the capital account may involve risks different from those encountered in purely domestic transactions. Such risks include those associated with cross-border lending (including transfer, sovereign, and country risk), the cross-border listing of securities, and the increased exposure to foreign exchange risks (see Johnston, 1998). The Asian currency crises have highlighted the risks associated with the reversibility of short-term capital flows and the importance of having in place appropriate safeguards to prevent large foreign currency open positions, short-term foreign currency maturity mismatches, and excessive reliance on short-term foreign borrowing. As well as prudential measures, such safeguards encompass the regulatory regimes for cross-border capital transactions, and the monetary and exchange rate policy mix (see Chapter 6). The prudent management of short-term capital flows is of critical importance in view of the central role of such flows in international trade finance, the efficient functioning of money and foreign exchange markets, and the international monetary system more generally.

Chapter 6 concludes that capital account liberalization should be integrated with the design of structural and macroeconomic policies. Maximizing the benefits from capital account liberalization while minimizing the risks requires a comprehensive approach to reforms. Although in general it would be advisable to have well-planned and sequenced reforms, this does not necessarily imply a gradualist approach. Rather it calls for coordinated and concurrent reforms irrespective of the pace of the reforms. Faster liberalization of the capital account would require equally rapid progress in the necessary concurrent reforms to domestic financial markets and institutions and in adapting the macroeconomic policy framework. Accelerating these reforms is desirable in any event in view of the limited extent to which countries can insulate themselves from the market.

The experiences of the Asian countries (reviewed in Chapter 6) confirm that it is necessary to approach capital account liberalization as an integral part of a comprehensive program of economic reform, coordinated with appropriate macroeconomic and exchange rate policies—including policies to strengthen financial markets and institutions. The question is not so much one of the capital liberalization having been too fast, since some of the countries in Asia followed a very gradualist approach. Rather, it has more to do with the appropriate sequencing of the reforms and, more specifically, what supporting measures need to be taken.


The literature on sequencing has tended to place financial sector reforms relatively late in the overall order of reforms, favoring a gradualist approach. But if one takes into account the costs of maintaining the controls on the financial sector—in terms of low savings mobilization, capital flight, lack of monetary control, and an inefficient allocation of resources—together with the benefits for stabilization, economic growth, and efficiency of successful reforms, then a strategy of more rapid financial sector reform could be desirable in terms of achieving better economic performance. Such a strategy should anticipate and avoid the risks that poorly sequenced financial sector reforms can pose for macroeconomic stability and the adverse consequences of macroeconomic instability for banking soundness. This two-way interaction between financial sector reforms and macroeconomic control poses special challenges for the orderly sequencing of financial sector reforms.

The experiences with financial sector reforms provide a number of important lessons. First, financial sector reforms require that mutually supporting reforms be undertaken in a number of areas—monetary and exchange, prudential, and structural. Reforms to certain sectors, such as monetary and exchange systems, can perform a critical catalytic function and help to provide momentum to the reform process. However, these reforms need to be concomitant with the strengthening of institutional structure to ensure that the liberalizations induce the appropriate responses in terms of resource mobilization and allocation and help to avoid banking crises. Prolonged periods of financial repression are usually associated with banking sector weakness and private market failures that need to be addressed at an early stage in the reforms through, among other things, implementation of a critical mass of accounting rules, prudential norms, supervisory procedures, and bank restructuring. The parallel development of critical money, exchange, and capital market institutional instruments should facilitate money and exchange system reforms. These institution-building reforms can thus promote more efficient credit and foreign exchange allocation and support macroeconomic adjustment by safeguarding against a financial crisis, and by allowing for a more rapid introduction of indirect and more efficient monetary instruments, as well as external liberalization.

Second, financial sector reforms involve monetary and portfolio shocks. Liberalization of the bank credit market can result in inflationary credit expansions. Similarly, external liberalizations may promote potentially inflationary foreign inflows. The authorities’ reaction to these shocks can be critical in the success of financial sector reforms. In particular, real interest rates may need to be increased during the reform period, both to reduce the inflationary impact of the reforms and to help ensure that credit is channeled to more productive uses. The post-liberalization expansion of bank credit may also need to be implemented in phases. Exchange rates may have to be allowed to become more flexible as part of a strategy for addressing increased capital flows. Failure to manage the monetary shocks can contribute to financial crises and result in inflationary finance, which is detrimental to economic growth and efficiency. To facilitate a flexible response to monetary shocks and to the increase in capital flows, indirect instruments of monetary control should be introduced early, and phased in using a mix of instruments that can help ensure adequate monetary control and support financial market development.

Third, the liberalization of the capital account should be approached as an integrated part of comprehensive reform strategies and paced with the implementation of appropriate prudential measures and macroeconomic and exchange rate policies. The management of capital flows depends on the overall incentive structure for such flows, with the configuration of interest rates and exchange rates, as well as the stage of development of the domestic financial system, appearing particularly critical.

Fourth, countries that implemented successful financial sector reforms and avoided financial crisis experienced substantial improvements in economic performance. Real growth rates and the output to capital ratio increased strongly in this group of countries following financial reforms. In countries that faced a financial crisis, however, there has been a deterioration in economic performance. This finding argues forcefully for ensuring that financial reforms, when undertaken, are properly managed and implemented with requisite attention to both stabilization and financial system soundness.


For example, Cho (1986) shows that the development of equity markets should accompany the liberalization process in order to overcome credit rationing of productive projects due to information frictions. Also, recent literature on banking crisis (Sundararajan and Balino, 1990) shows that structural measures to strengthen prudential regulations and correct portfolio weaknesses in the financial sector are important for the effectiveness of stabilization policies, in particular monetary policies.


For example, Mishkin (1978) and Bernanke (1983) analyzed data from the Great Depression and concluded that financial sector variables had a significant impact on economic activity. See Gertler (1988) for a recent survey.


The literature on interaction between financial reforms (both domestic markets and external capital accounts) and stabilization programs is quite extensive. On the Southern Cone, see Corbo and De Melo (1985); Connolly and Gonzalez-Vega (1987); Calvo (1983); and Corbo, De Melo, and Tybout (1986). For the Pacific Basin countries, see Cheng (1986). See also Diaz-Alejandro (1985) for a more general discussion. The “conventional” approach suggests that fiscal adjustment should occur before financial sector liberalization and the elimination of controls on capital movements should occur after the domestic financial system is liberalized. See, for example, McKinnon (1991).


These papers were prepared in the IMF’s Central Bank Department, and subsequently in the expanded and renamed Monetary and Exchange Affairs Department, drawing on the technical assistance experience of the department.


Capital inflows in the form of foreign direct investment can also support growth through transfers of technology and management skills, while portfolio capital flows can help to diversify and deepen financial markets.


This often requires central banks to strengthen their monetary analysis and research functions to develop short-term information systems and liquidity forecasting.


Regulation and supervision must be adequate and effective, yet it should also be designed in ways that will let private markets function efficiently. Over-regulation stifles the efficient functioning of markets and can lead to moral hazard problems since private financial institutions do not take adequate responsibility for their actions.


Early examples of this literature include Cameron (1967), Patrick (1966), Goldsmith (1969), McKinnon (1973), and Shaw (1973).


For a discussion of the sources of such market failures and the need for supporting reforms, see Johnston (1997).