Inefficiencies from Financial Liberalization in the Absence of Well-Functioning Equity Markets

Abstract

SINCE THE SEMINAL WORKS BY MCKINNON (1973) AND SHAW (1973), there has been active research into the working of financially repressed economies and the beneficial effects of Elnancial liberalization (see Fry 1982 for a survey of literature). They claim that liberalization of the Elnancial sector from interest rate ceilings and other restrictions facilitates economic development and growth because higher interest rates lead to both increased savings and greater efficiency of capital allocation. Today, the idea that financial activity should not be repressed has become the new orthodoxy in academia as well as in the major international institutions that provide policy guidelines for developing countries. The Elnancial liberalization argument, however, is incomplete. The literature on Emancial liberalization has emphasized eliminating interest-rate ceilings and fostering free competition among banks. It has largely overlooked the possibility that endogenous constraints in the credit market, such as imperfect information, could be signiElcant barriers to efElcient credit allocation even when banks are freed from interest rate ceilings. Nor has the literature dealt with market structure, e.g., the oligopolistic and cartelized banking systems found in most LOCs. The literature has emphasized the role of the banking sector, which is correctly perceived as the only organized capital market in most developing countries. It has neglected the potential