78. From Financial Repression to Financial Liberalization
For a long period, developing countries used to intervene in the financial
sector by imposing quantitative or qualitative restrictions on the activities
of financial institutions and markets such as interest rate control and
directed allocation of credit. This practice is called financial repression.
Based on theoretical and empirical analyses, some economists have
concluded that financial repression leads to a low level of financial
development. Strict control over interest rates coupled with inflation often
result in negative deposit rates, decreasing the size of loanable funds. As
loans are less available from the formal financial system, investors have to
I rely more on self-finance. At the same time, directed credit schemes
accompanied by preferential interest rates often give rise to widespread
misallocation of investment funds land low productivity of capital.
The solution to the above problems, as often suggested, is financial
liberalization. As interest rate ceiling is removed, savings will increase and
the efficiency of investment allocation in the financial market will also
improve.
However, market failures occur in finance. An increase in real interest
rate brought about by financial liberalization can produce the undesirable
effects of adverse selection and moral hazard. First, the higher the level of
interest rate, the higher the proportion of risky borrowers applying for
loans. Second, any borrower will try to change the nature of their project to
make it more risky. Thus, many governments pursuing hasty quick and
complete liberalization have been met with waves of severe financial
crises.
Economists have now tend to content that financial liberalization has to
occur in sequences in tandem with reforms in other sectors, and more
importantly critical soft infrastructures such as regulatory institutions have
