IN FAVOUR OF FINANCIAL LIBERALISATION*

Abstract

In practice, many developing country governments find it virtually impossible to satisfy their inter‐temporal budget constraint with conventional tax revenue. Hence, they rely on revenue from the inflation tax and they reduce their interest costs through financial repression (Brock, 1989, p. 116; Giovannini and de Melo, 1993; Agénor and Montiel, 1996, p. 156; Fry, 1997). This paper suggests that financial repression is a particularly damaging quasi‐tax from the perspective of economic growth. A key stylised fact about financial systems in developing countries is that they are dominated by commercial banks (Fry, 1995, pp. 4–5; Rojas‐Suárez and Weisbrod, 1995, pp. 4–11). Assets of insurance and pension companies are minuscule in most developing countries. Development financial institutions such as agricultural and development banks are also small compared with the commercial banks. Commercial bond markets are typically thin and government bond markets are often used only by captive buyers obliged to hold such bonds to satisfy liquidity ratio requirements or to bid for government contracts. Although equity markets are sizeable in several developing countries, their role in the process of financial intermediation between the household and business sectors remains small. Indeed, the relatively large Taiwanese equity market produces a transfer of resources from the business sector to the household sector in the form of dividends that exceeds the transfer from the household sector to the business sector in the form of new issue purchases. The net flow through stock exchanges is also relatively small in most Latin American countries (Rojas‐Suárez and Weisbrod, 1995, p. 6). At best stock markets play a minor role; more often they resemble gambling casinos and may actually impede growth in developing countries (Singh, 1997). Hence, this paper focuses quite deliberately on commercial banks as the key institutions involved in the process of saving‐investment intermediation that are affected by financial liberalisation.