Study On The Concept Of Financial Repression

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02 Nov 2017

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Financial repression refers to the notion that a set of government regulations, laws, and other non-market restrictions prevent the financial intermediaries of an economy from functioning at their full capacity (Mckinnon&Shaw,1973).

Financial repression consists of three elements. First, is that the banking system is compelled to hold government bonds and money by imposing high reserve and liquidity ratio requirements. According to Gupta(2005), this allows the government to finance budget deficits at a low or zero cost. Secondly, knowing that government revenue cannot be extracted easily from private securities, the development of private bond and equity market is discouraged. And thirdly, the banking system is characterised by interest rate ceilings to prevent competition with public sector fund raising from the private sector and to encourage low-cost investment.

Certain policies aid financial repression and they include interest rate ceilings, high bank reserve requirements, liquidity ratio requirements, capital controls and restrictions on market entry into the financial sector, credit ceilings or restrictions on directions of credit allocation, and government ownership or domination of banks (Martin&Roubini,1991).

Economists have frequently debated that financial repression prevents the efficient allocation of capital and thereby weakens economic growth. Theoretically, an economy with a proficient financial system can attain growth and development through efficient capital allocation. McKinnon &Shaw(1973) argue that previously, with government regulations many developing countries have limited competition in the financial sector. Implying that a repressed financial sector discourages savings and investment since the rates of return is lower than the opportunity-cost in a competitive market. In a repressed system, financial intermediaries do not perform at their full capacity and fail to channel savings into investment efficiently, thereby inhibiting economic growth.

This essay aims to analyse the concept of financial repression and reasons why it maybe detrimental to economic growth. The first section analyses forms of financial repression and their economic impact, the second part highlights various economic views on the impact of financial repression on economic growth. While a recommendation is prescribed, the last section is a conclusion.

FORMS AND IMPACT OF FINANCIAL REPRESSION

Major reason why governments implement financially repressive policies is to control fiscal resources. A direct control of the financial system will help the government channel funds to itself without going through legislative procedures and less costly than if it resorts to market financing. In particular, by limiting existing and potential participants of the financial markets, the government can form a monopoly to captivate rents for the existing banks and also tax some of these rents to finance its overall budget. Banks may also attempt to collude to interrupt possible liberalisation policies if they are guaranteed their collective monopoly position in the financial market.

In certain countries, governments oblige banks to attain high rates of reserve-ratios, and use the reserves to generate revenues. High reserve requirements and interest ceilings will protect government directives for certain borrowers, making naive savers the main taxpayers because of reduced rates of interest on their savings. In high inflation countries, interest ceilings can disfavour savers since high inflation can result in negative real interest rates. Thus, high reserve requirements use government’s monopolistic power to generate seigniorage revenue. An alternative to this policy is the required liquidity ratios; compelling banks to hold government securities that typically yield lower return than could be obtained in the market.

Governments usually enforce a ceiling on the interest rate banks can offer depositors, thereby providing banks with economic rents. Like required reserve ratios, those rents benefit banks and afford tax sources for the government, paid for by savers and borrowers. These rents reduce the amount of loans available to the market and discourages saving and investment. With Financial repression, in return for permitting incumbent banks to earn rents, governments require banks to give subsidised loans to certain borrowers for the purpose of implementing industrial policy or simply achieving political goals.

Government directives consist of instructions on managerial issues for financial institutions to guarantee their behaviour and business are in line with industrial policy or other government policies. The Japanese Ministry of Finance- (MOF) is a typical example of government’s micromanagement of financial industry.

Capital controls restrict inflows and outflows of capital, are also financially repressive policies. Despite the merits, the use of capital controls involves costs. Due to its uncompetitive nature, capital controls increase the cost of capital by creating financial autarky, limiting both domestic and foreign investors’ ability to diversify portfolios and helps inefficient financial institutions survive.

ECONOMIC EVIDENCE OF THE EFFECT OF FINANCIAL REPRESSION

The-literature on-finance-and-development-suggests-a-mutual-relationship-between-the-evolution-of-the-financial-system-and-the-development-of-the-real-economy. Several-economists-have-also-analysed-this-relationship-of-financial-repression-leading-to-low-economic-growth. This-prediction-is-common-to-both-the-McKinnon-Shaw-approach-and-the-endogenous-growth-literature. However,-with the-former-financial-development-determines-the-level-of-steady-state output, in-the-latter-it is-a-determinant-of-the equilibrium-rate-of-economic-growth- (Roubini &Sala-i-Martin,1991).

In-McKinnon-Shaw-literature, the-basis-for-the-relationship-between-financial-and economic-development-is-Gurley-and-Shaw's- (1955) -debt-intermediation hypothesis. In-this-case, increase-in-financial-saving-relative-to-level-of-real-economic-activity will-increase-financial-intermediation-and-raise-productive-investment. This-in-turn, increases-per-capita-income. In-these-models-control-of-nominal-interest-rate hinders-capital-accumulation; they-decrease-the-real-rate-of-return-on-bank deposits, -thereby-daunting-financial-saving.

Higher-reserve-requirements-also-exercise-a-negative-influence-on-financial intermediation-by-raising-the-link-between-lending-and-deposit-rates. Within-a competitive-banking-system-this-link-is-a function-of-inflation-rate. Therefore, -higher real-interest-rates-promote-capital-accumulation-and-economic-activities, -largely through-the-increase-in-financial-intermediation.

The-competitive-model-of-the-banking-industry-may-be-theoretically-inadequate because-first, in-many-less-developed-countries-the-banking-industry-is-typically dominated-by-a-small-number-of-banks-and-collusive-behaviour-is not-uncommon. Second, -asymmetric-information-in-loan-markets-is-sufficient-to-produce-a considerable-degree-of market-power-for-lenders- (Roubini &Sala-i-Martin,1991). According-to-Stiglitz- (1993), interest-rate-restrictions-may-correct-moral-hazard-in-the-form-of-extreme-risk-taking-by-banks. Thus-the-success-or-failure-of-certain-policies-mainly-depends-on-the-effectiveness-of-the-institutions-that-implement-them- (World-Bank- (1993). The-endogenous-growth-literature offers additional channels-through-which-financial-sector-policies-may-affect-financial-development, independently-of-the real-rate-of-interest.

King-and-Levine- (1993) present-a-model-in-which-financial-sector-taxes-which-may-include-interest-rate-ceilings-or-high-reserve-requirements-have-a-negative-effect on financial intermediation and, subsequently, on innovative activity and economic growth. likewise, Bencivenga-and-Smith- (1992), using a three-period overlapping generations model with financial intermediation, show that higher reserve requirements reduce the steady-state values of the capital stock, output, and bank deposits.

The above analysis suggests that the effects of some types of interventionist policies as well as the channel through which they are implemented may be different. Also these policies may have direct impact on financial depth by: (1) changing the willingness of banks to raise deposits by non-interest-rate methods, and (2) changing the willingness of savers to supply their savings to the banking system (Roubini-and-Sala-i-Martin,1991).

EVIDENCE FROM INDIA

The focus is on the economy of India for many reasons. Apart from the obvious reason that India is one of the most important developing economies in the world, it also has a wealthy history of different types of repressionist policies which helps the statistical investigation. The financial system of India in the late 1950s was liberal with no ceilings on interest rates and low reserve requirements. The early 1960s government stiffened its control over the financial system by pioneering higher liquidity requirements, lending rate controls and by starting state development banks for industry and agriculture. The process terminated the nationalisation of the 14 largest commercial banks in 1969.

More nationalisations took place in 1980. Interest rate controls were strictly applied from the 1970s to the late 1980s to all types of loans and deposits. The structure of interest rates was largely determined by the Reserve Bank. Credit planning, a formal system of directed credit began in 1970, gradually covering a large percentage of total lending. Likewise, concessionary lending rates were offered to priority sectors (Demetriades-and-Luintel,1997). The late 1980s were, nevertheless, marked by the establishment of a process of gradual liberalisation of the financial system. Ceilings on lending rates began to dissolve in 1988 and totally abolished in 1989. Finally, more relaxations on directed credit and concessionary lending rates took place in 1990 and 1992.

Below is a graph depicting the index of financial repression in India as explained above- (Demetriades-and-Luintel,1997):

The index appears to replicate quite well many of the policy shifts that occurred during the sample period. According to the index, the early 1960s seem to be characterised by steady increases in the level of financial repression. Stability occurred in the mid-1960s followed by a huge jump in 1969. This performance correspond to developments in the 1960s which concluded with the nationalisation of the largest eleven banks in 1969, which permitted the Reserve Bank of India to deepen its direct credit program and to enforce controls on deposit rates. The 1970s were identified with the gradual imposition of more controls, implying that a lending rate floor operated during 1973 and 1974, a lending rate ceiling was enforced in 1975 and remained in operation for 13 years, and reserve requirements were raised in 1976 (Demetriades &Luintel,1997). In early 1980s more controls were enforced and intensification of the directed credit program. Also a gradual increase in the index pursued these developments. The index drops significantly in 1985, which corresponds with a partial deregulation of deposit rate controls. It rose again, showing the reintroduction of deposit rate controls in 1988 and a 4% increase of reserve requirements in 1989, but drops again in 1990 when the directed credit program was relaxed. Finally, there was a small drop of the index in 1991, which coincides with further deregulations of deposit rates.

RECOMMENDATION: Financial Liberalisation

Since the break-up of colonial empires, many developing countries experienced stagnant economic growth, high inflation, and external imbalances under a financially repressed regime. To survive the difficulties, economic experts had campaigned what they called "Financial liberalization" mainly a high interest rate policy to accelerate capital accumulation, hence growth with lower rates of inflation (McKinnon &Shaw(1973), Kapur(1976) and Matheison(1980). The argument that relaxation of the institutionally determined interest rate ceilings on bank deposit rates would lead to price stabilisation and long-run growth through capital accumulation is based on the following chronology of events: (1) the higher deposit rates would cause the households to substitute away from unproductive assets (foreign currency, cash, land, commodity stocks, an so on) in favour of bank deposits; (2) this in turn would raise the availability of deposits into the banking system, and would enhance the supply of bank credit to finance firms' capital requirements, and ; (3) this upsurge in investment would cause a strong supply side effect leading to higher output and lower inflation (Gupta, 2005)

Identifying that financial repression leads to inefficient allocation of capital, high costs of financial intermediation, and lower rates of return to savers, it is theoretically clear that financial repression hinder growth (Roubini &Sala-i-Martin,1992). The empirical finding on the effect of removing financial repression, i.e., financial liberalisation on growth supports this view, but various channels through which liberalisation stimulate growth have been evidenced.

The likely negative effect of financial repression on economic growth does not automatically mean that countries should adopt a laissez-faire attitude towards financial development and remove all regulations and controls that create financial repression. Many developing countries that liberalised their financial markets experienced crises partially due to the external shocks that financial liberalisation introduces or amplify.

Financial liberalisation may create short-term volatility despite its long-term gains (Kaminsky&Schmukler,2002). Also, due to market imperfections and information asymmetries, eliminating all public financial regulations may not produce an optimal environment for financial development. However, an alternative to a financially repressive administration would be a new set of regulations to ensure market competition as well as prudential regulation and supervision.

CONCLUSION

The success of economic policies largely depends on the efficiency of the implementing institution, and this clearly differs from country to country (World Bank,1993). Thus future research may show that direct effects of financial repression in other countries (e.g., South Korea) were positive and significant. In fact, based on various theoretical analyses, the possibility of positive effects cannot be ruled out. The speculation is that "repressionist" policies may have positive effects when they successfully address market failure. However, market failure should encompass not only information-related imperfections but also those pertaining to the structure of the banking industry. In theory, financial repression framework needs to be better defined where banks are more active, able to influence the volume of their loanable funds banking literature and emphasises the importance of active liability management. From an empirical point of view, the examination of the direct effects of financial repression in other countries is likely to be of considerable value. Furthermore, comparisons of these effects across different economies are likely to shed light on the relative effectiveness of repressionist policies, thereby providing indirect evidence on relative levels of good governance.



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