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This paper was prepared during a summer internship at the Fund. A discussion with Abbas Mirakhor in the early stages of this paper was helpful. I am indebted to Ishan Kapur, Joaquin Pujol, Reinold van Til, Michael Hadjimichael, Paul Hilbers, and Thomas Rumbaugh for very helpful comments. I thank Ronald Hicks, Menachem Katz, and Philip Young for locating information as well as for making numerous useful comments, and Janet Bungay for editorial advice. All remaining errors are mine.
Giovannini and de Melo (1991) picked up this line of thought and analyzed financial repression from this public finance perspective. They calculated the revenue from this financial-repression tax in a set of 24 developing countries and found that it can be quite substantial. They concluded that, from this perspective, financial repression can be an efficient way for the government to raise revenue if there are constraints on other types of taxation. They also argued that a financial liberalization program might require a concurrent fiscal reform to make up for the lost revenue from financial liberalization.
Besides its effect on interest rates, Cho (1986) stresses that not only the structure of the banking sector, but also the structure of the financial market as a whole is important to the efficiency of a financial liberalization program. He emphasizes that, with imperfect information, “a substantial liberalization of the equity market is a necessary condition for complete financial liberalization.” He constructs a model in which banks group the borrowers in classes depending on the average return on their projects. However, they cannot observe the riskiness of the different borrowers within the different classes. After showing that the variance of the projects enters the profit function of the banks, he demonstrates that this might lead to situations where banks refuse to lend to a certain class of borrowers that has a higher average return than another. If the equity market is little or not developed, government intervention through selective credit policies might improve the allocation of capital in the economy. This conclusion only holds under rather stringent conditions, such as the government having the same information on borrowers that the banks have.
A depreciating exchange rate also affects the effectiveness of credit ceilings whenever the latter are formulated as percentage of deposits. A depreciating exchange rate increases the domestic currency value of deposits denominated in foreign currency, which gives the banks more room to extend credit. Concerned about high inflation, the Nigerian authorities forbade banks to extend credit based on these foreign-denominated assets in April 1989.
Indexed loans can be absent for very good reasons. As Mirakhor & Villanueva (1990) point out the fates of the financial institutions and borrowers are intertwined. Indexed loans put the entire burden of inflation on the firms. If they cannot carry this burden, the financial intermediaries are threatened too.
Greene (1989) notes a. potentially favorable effect of high inflation on the balance sheets of commercial banks when part of the assets are nonperforming. High inflation enables the banks to “inflate away” the impact of these nonperforming assets on their profitability. While this is undoubtedly true, high inflation can induce more defaults on new loans and also works on the liability side of the balance sheet. If depositors demand positive real interest rates or if high inflation leads to disintermediation, the banks can face a double profit squeeze.
For the sequencing of financial liberalization in countries with different initial conditions, see Mirakhor and Villanueva (1990).
“Distress borrowing” occurs when firms borrow to pay off previous loans, regardless of how high the interest rate may be.
Velasco (1985) stresses the importance of inflationary expectations. In the case of Chile, the government was not able to reduce these expectations, which made it more difficult to implement the liberalization program. He also shows how the liberalization program contributed to the breakdown of the financial system in 1981-83 and how this in turn aggravated the macroeconomic imbalances in Chile in the early 1980s.
The lack of precise information on the profitability of banks prevents a careful analysis of their cost structure before the liberalization of interest rates. If the spread between lending and deposit rates was implicitly suppressed through sectoral credit allocations and interest rate ceilings, an increase in the spread after the interest rate liberalization might reflect an attempt by the banks to revert to a pattern of operating losses.
In June 1991, the nonbank financial institutions were brought under the direct supervisory control of the central bank. This will ultimately result in a more uniform regulatory structure.
In the countries in this sample, there exists an informal financial sector, interacting with the formal financial system. Limited availability of information on the relative importance of informal financial markets prevents a closer look at this subject.
The absence of well-developed bond markets makes the government highly dependent on the banking sector to finance its budget deficit. This can create serious moral hazard problems since the banks know that the government will bail them out in case of financial distress. It also gives the government incentives to use moral suasion on the banks not to raise lending rates too much despite the official policy of interest rate liberalization. At the same time, banks do not have to fear the competition of the government when attracting deposits from the public.