The Effect of Financial Liberalization on Economic Development in Ethiopia

Table of Content

Acknowledgment

List of Acronyms

List of Tables

List of Figures Abstract

CHAPTER ONE INTRODUCTION
1.1. Background of the Study
1.2. Statement of the Problem
1.3 Objectives of the Research
1.3.1 General objective:
1.3.2 Specific objectives:
1.4 Research Hypotheses
1.5 Significance of the study
1.6 Scope and limitations of the study
1.6.1 Scope of the Study
1.6.2 Limitation of the study
1.7 Structure of the study

CHAPTER TWO REVIEW OF RELATED LITERATURE
2.1 The Role of Finance on Economic Growth
2.1.1 Supply Leading Hypothesis view
2.1.2 Demand Following Hypothesis view
2.1.3 Bi-directional Causality view
2.1.4 No Causality view
2.2 Financial Repression
2.3 Rationale of Financial Repression
2.4 Types of Financial Repression
2.5 Consequence of Financial Repression
2.6 Financial Liberalization: Views, causes and Approaches
2.7 Liberalization and its Impact on Interest Rates, Savings and Investment
2.8 Effect of Reserve requirement on Credit Availability
2.9 The Role of Securities market on Growth
2.10 Liberalization of the External Account
2.11 The Role of Liberalization in Allocative Efficiency
2.12 Financial Intermediation
2.13 Sequencing of the financial liberalization
2.14 Financial Liberalization and Welfare
2.15 Financial Liberalization and Financial Fragility
2.16 Overview of the Ethiopian economy
2.17. Overview of the Monitory Policy
2.18 Research Gap

CHAPTER THREE RESEARCH DESIGN AND METHODOLOGY
3.1 Research design
3.2 Data and sources
3.3 Econometric Model
3.3.1 Financial Sector Widening
3.3.2 Interest Rate, Saving and investment
3.3.3 Economic Growth and industrialization
3.3.4 Financial Development
3.3.5 Efficiency in Resource Allocation
3.3.6 Employment Opportunities
3.3.7 Poverty Alleviation and Redistribution of Income
3.3.8 Financial Sustainability
3.4 Estimation method

CHAPTER FOUR DATA ANALYSIS AND DISCUSSION
4.1 Construction of the Financial Liberalization Index (FLI)
4.2 The Financial Liberalization Index equation
4.3 Unit Root test
4.4 Model Stability and Diagnostic Test
4.5 Financial sector Widening
4.6 Interest rate saving and investment
4.7 Economic growth and industrial development
4.8 Financial Deepening
4.9 Efficiency of Resource Allocation
4.10 Employment Opportunity
4.11 Poverty Alleviation and Distribution of Income
4.12 Financial Sustainability
4.13 Nexus between finance and economic growth

CHAPTER FIVE CONCLUSION AND FUTURE RESEARCH DIRECTION
5.1. Empirical finding and Policy implications
5.2 Direction for Future Research

References

APPENDIX A

APPENDIX B

Acknowledgment

First and for most, I acknowledge almighty Allah for showering me with grace and mercies in every step of my life. I attribute all my successes to His unwavering presence.

I am grateful to all my lecturers and management of Addis Ababa University, College of Business and Economics for the knowledge and wisdom they have impacted in me since joining the postgraduate program. I am in particular grateful to my advisor, Ababaw Kassie (PhD) for his admirable guidance creative comments and invaluable suggestions which always inspired me to learn more and to strive for high quality work throughout the project. Also I would like to extend my deepest gratitude for Zerayehu Sime Eshete (PhD) of Debremarkos University for spending his valuable time during the model specification stage of the project as well as his assistance during the analysis stage of the project.

I am grateful to the staff of The NBE particularly Mr Tamrat Lembebo for his support in directing me in the right direction during the data gathering process Mr Belete Fola for hisunprecedented support . I would also extend my sincere gratitude for Mr Adnan Abdul-Aziz in MOFEC for his support and help during the data gathering as well as his technical support during the analysis.

Special Thanks are due to Kr. Abdulmuheymin Abdulnasir, for his insight and invaluable support in explaining the socioeconomic dynamism of the country and motivational support.

I also would like to acknowledge my fellow classmates who were my second family; I am especially indebted to Henok Tefera, Asrat Kifle, Solomon Kitata, Miftah Ahmed, Frezewd Birassa.Mikiyas Getachew I have benefited exuberantly from our discussions during the project.

I also wish to thank my colleague and friend Worku Gezahegn and Asmyit Tekeste for their support during my study helping me to better myself.

Finally, I would like to thank my mother and rest of my family for the unconditional emotional support they provided to see me this far and being my sanctuary.

List of Acronyms

Abbildung in dieser Leseprobe nicht enthalten

List of Tables

Table 1 Optimal Sequence of Liberalization

Table 2: Financial Liberalization Trend of Policy Variables in Ethiopia

Table 3: Eigenvalues and Eigenvectors of the Correlation Matrix of Policy Variables

Table 4: Financial Liberalization Index (FLI) for Ethiopia

Table 5: Policy Components and Indicators

Table 6: Unit Root result of the variables

Table 7: ARDL(2, 2, 2, 0, 0) Co-integrating And Long Run Result (Dependent Variable :LVBT)

Table 8: ARDL(2, 2, 2, 0, 0) Co-integrating And Long Run Result (Dependent Variable :LTDR)

Table 9: Pairwise causality test of saving and economic growth

Table 10: ARDL(2, 0, 0, 2, 0) Co-integrating And Long Run Result(Dependent Variable: LBTC)

Table 11: ARDL (1, 0, 0, 1, 0) Co-integrating And Long Run Result (Dependent Variable: LGDPP)

Table 12:ARDL(1, 0, 0, 0, 0) Co-integrating And Long Run Result(Dependent variable: LGDPI)

Table 13: ARDL(1, 1, 2, 1, 0, 2) Co-integrating And Long Run Result(Dependent Variable: LFD)

Table 14: ARDL(1, 1, 2, 1, 0, 2) Co-integrating And Long Run Result(LSNGDP)

Table 15: Percentage Distribution of Urban Employment by Industrial Division

Table 16: ARDL(1, 0, 0, 2, 2) Co-integrating And Long Run Result (LSBCSS)

Table 17: ARDL(1, 0, 0, 0, 2) Co-integrating And Long Run Result (Dependent Variable: LSBCC)

Table 18: ARDL(2, 1, 0, 0, 0, 0) Co-integrating And Long Run Result (Dependent Variable: LCDR)

Table 19: Pairwise Granger Causality Tests

Table 20: Major liberalization measures on interest Rate during the Study Period

Table 21 Express the timing of Liberalization Measures on Banking Entry

Table 22 Alteration of the coding rule of banking entry

Table 23: The criterion for the conversion of the REB value

Table 24 Liberalization Measures Reduction of Reserve Requirement

Table 25 : Shows the Measures on Reduction of Reserve requirement

Table 26: The criterion for the conversion of the RRR value

Table 27: Liberalization Measures on External Account

Table 28: shows the Measures on External Account Liberalization

Table 29: The criterion for the conversion of the EAL value

List of Figures

Figure 1: Sequence of liberalization

Figure 2: Growth rate of Real GDP

Figure 3: Sectorial Contributions to GDP

Figure 4: Monitory expansions. (In thousands)

Figure 5: Monitory Growth (In thousands)

Figure 6: Trends of Import, Export and Trade balance. (In thousands)

Figure 7: Trends of inflation

Figure 8: Financial Liberalization Index (1984-2014)

Abstract

Financial Liberalization emphasizes on the leading role of market forces in the financial sector of the economy and it is one of the debatable issues in the world economy. However, it is far from clear how financial liberalization actually affects the economy in general and the financial system in particular. Thus, this study aims to empirically examine the impact of financial liberalization on economic development in Ethiopia over the period of 1984-2014. In doing so, the ARDL approach to Co-integration and Error Correction Model were employed to investigate the long run and shortrun relationships. Accordingly, the empirical results obtained from the study indicate that financial widening has contributed significantly to the increase in saving and the level of economic growth. Even though, the total deposit happens to generate more investment; there is shortage of supply ofcredit. In addition, the study indicates financial widening and credit to the private sector exhibited a significant positive association with financial development while total banks credit bearing a significant impact on industrial development. However, the overall financial reform showed insignificant association both with economic growth and industrial development. The efficiency in allocating financial resources show significant positive association with share of banks credit to the private sector, however, the overall financial reform has positive insignificant impact on efficiency of resource allocation. The contribution of financial sector after the deregulation has a mixed result on welfare. In terms of catalyzing employment opportunity, financial widening and the overall liberalization policy measure have played a positive role while the financial development has no significant impact on employment creation. Financial widening has significant positive impact on poverty alleviation while the overall policy measure has insignificant impact on the impoverished. Consequently, the result of the study indicate the overall financial liberalization measure actually decrease the likelihood of financial instability and indicates the direction of causality going from economic growth to financial development proving the demand leading hypothesis, which in turn portrays the heavy involvement of government in the financial sector.

Key words: Financial liberalization, Financial liberalization index

CHAPTER ONE INTRODUCTION

This chapter deals with the introductory part of the study. It includes: background information, problem statement, basic research questions, objectives, significance, scope, limitation and organization of the study.

1.1. Background of the Study

The fragile and inefficient state-dominated and repressed financial sector was the main feature of the Ethiopia economy during the military government (1974-1991) which was a major hindrance to economic growth. Since it took power in 1991, the current government has implemented a number of reforms to the financial system.

Such a move of governments are almost in all cases deliberated with in the two schools ofthoughts regarding the possible benefits of financial reform aimed at financial liberalization: Thefirst is the Goldsmith-McKinnon-Shaw school which argues financial liberalization is the onlyeffective means to develop banking intermediation, to start again the capital accumulation and topromote the economic growth in the countries. (McKinnon, 1973) And (Shaw, 1973) come topresent the misdeeds of financial repression and to defend the founded good of financialliberalization. The second is Keynes-Tobin-Stieglitz (also called the Structuralism andNeostructuralists School) propagated in favor of certain sort of financial repression due toeconomic benefits and vulnerability to persistent market failure. (Kahsay, 2014).Using variouseconomic models, each provides background, rationale and intellectual justification for financialliberalization vis a vis financial repression. (Ahmed & Islam, 2010).

Financial liberalization has been proposed as a cure to the ills of repression with a belief that itimproves and enhances the efficiency of investment and eventually economic growth. Overall,financial liberalization has been broken down into three major reforms. This is the liberalizationof the movement of capital, the opening of financial markets to international operators andderegulation in lending and deposit rates to increase interbank competition. The proliferation ofcrises in countries such as Mexico (1995), Asian countries (1997), Brazil (1998), and Turkey (2001) opened the debate on the benefits of deregulation of financial activity. (Farhani,et al.2015)

Government intervention in the financial system, including the setting of interest rates, theimposition of high reserve requirements and quantitative restrictions on credit allocation, wasfairly common practice in the 1960s and 1970s, especially in developing countries. That practicewas challenged initially by (Goldsmith, 1969) and later (McKinnon, 1973) and (Shaw, 1973),who saw it as being responsible for low savings, credit rationing and low investment. Theyreferred it as financial repression. They presented their views criticizing the repressed financialsystem which was assumed to be the reason for low performance of financial sectors of most ofthe developing economies. In their theory of Financial Repression Hypothesis, they assert that,regulated nominal interest rates among other components, undermine not only the efficiency offinancial intermediation but also interfere with allocation of resources and as a result, causefragmented financial markets, dependence syndrome and poor long run growth to mostdeveloping countries. Economies possessing typical characteristics of financial repression showsymptoms of heavily regulated interest rates, state-influenced credit allocation, frequentlyadjusted reserve requirement and tightly controlled capital account. (Wang & Huang, 2011)

As a remedy the (McKinnon, 1973) and (Shaw, 1973) proposed the financial liberalization thesis, which essentially involved freeing financial markets from government intervention and letting the market determine the price and allocation of credit.

Accordingly, the Ethiopian government in line with approaches discussed there off tookmeasures toward the reformation of the financial system. For instance, in 1994, the governmentlegalized domestic private investment in the financial industry. In addition, it restructured thetwo development banks as commercial banks, and introduced a new Banking and MonetaryProclamation that gave more autonomy and further clarified the National Bank of Ethiopia’sactivities as the regulator and supervisor of the banking sector. (Bezabeh & Desta, 2014)

Most previous studies have seen the effect of financial liberalization in fragmented approachfocusing on a specific aspect of growth or financial development or stability, while a fewexamines the welfare aspect they have left out major aspect of economic developmentuncovered. As a result, this study is conducted within the perspective of financial liberalization on growth, welfare and stability to assess the effect of the policy measures in unambiguous and meaningful manner.

Hence considering the above premise the study is organized in five chapters; the first chapter isthe introduction section which includes the statement of the problem, objective of the study,significance of the study, scope and limitation, and organization of the study. The second chapterdeals with review of related literature while the third chapter is dedicated to the research designof the study. The forth chapter presents the analysis and discussion of the results for the study.Finally, the last chapter presents the conclusions and recommendations for the study.

1.2. Statement of the Problem

Financial Liberalization emphasizes on the leading role of market forces in the financial sector ofthe economy and it is one of the debatable issues in the world economy since the introduction of(McKinnon, 1973) and (Shaw, 1973) separate work stressed on the potential role of higherinterest rates in mobilizing savings that could be put to productive use. This liberalization hasbeen characterized by greater scope being granted to market forces in determining interest ratesand in allocating credit (Caprio,et al, 1994). But it is far from clear that financial liberalizationactually does increase private savings. One obvious and important consideration is that the effectof interest rates on savings is itself ambiguous, as the income effect might offset substitutioneffects. In addition, one must recognize that financial liberalization involves more than just achange in interest rates. Other dimensions of financial liberalization, such as increased householdaccess to consumer credit or housing finance, might also work to reduce private savings ratherthan increasing them (Muellbauer & Murphy, 1990) (Jappelli & Pagano, 1994) and (Nair, 2004).(Bandiera, et al,2000) found out that there was no evidence of positive effect of the realinterest rate on saving. In most cases the relationship was negative.

(Bascom, 1994), noted further that real interest rates became positive in the countries where financial reform has initially been unsuccessful. But, the levels of these rates remained too high or were so volatile that they became a disincentive to domestic investment. (Reinhart & Tokatlidis, 2001) Argue that with greater certainty, financial liberalization appears to deliver higher real interest rates, economic growth but lower investment.

(Akyuz, 2014), states there is no simple relationship between interest rate and saving in recentevidence of developing countries who changed their interest rate policy. Investment reallocationis not the only and even the most important reason for financial deepening it is worth to note thatfinancial liberalization can also lead to deepening by redistributing savings and investmentamong various sectors, and by creating greater opportunities for speculation. Since these canworsen the use of savings, financial deepening is not necessarily a positive development.

In terms of growth liberalization was theorize to accelerate economic growth and enhanceefficiency through positive interest rates effect on savings and investment. Various empiricalstudies have been conducted to validate whether financial liberalization has a favorable impact orotherwise. (Akpan, 2004), (Fowowe, 2004) (Abu-Bader & Abu-Qarn, 2005), (Tokat, 2005),(Okpara, 2010) and (Banam, 2010) concluded that financial liberalization positively increasesthe growth of the economy in their investigation. Whereas (Munir,et al, 2010), confirmed thatfinancial liberalization made no significant impact on economic growth. (Achy, 2003), suggestedthat financial liberalization has led to further distortion of credit allocation in favor ofconsumption at the expense of productive activities because the financial depth indicators fail toexplain growth experience. The study shows that financial liberalization is in line with theKeynesian view and inimical to financial development.

The removal of entry barriers is another dimension financial liberalization advocate; it states thatremoval of barrier will lead to an increase in the number of financial institutions in themarket and as a result the financial sector will be widened consecutively causing an increasethe financial depth of the economy by increasing financial resources available to investors.Enhancements of the resource allocation from inferior venture to high yielding ones areexpected to occur. The supporters of Financial Liberalization argue that government restrictionon the banking system obstructs the flow of investments degrading its quality and quantity. Anumber of authors conform that financial liberalization explicitly affects the efficiency of banks.Increased bank efficiency can also manifest in the high competition prevalent in the bankingsector, in the new technology being patronized and in the new features of products intended toreach various kinds of consumers. (Meso & Kaino, 2008) .

Equal distribution of income is one of the vital issues in developing countries. The pattern ofdistribution of income is reflected in employment status and inequality status of an economy.One of the major drawbacks of financial liberalization cited frequently by the critics ofliberalization is that it ignores welfare and leads to unequal distribution of income. Underthe financial liberalization process, market becomes dominant, competition prevails inthe market, and government subsidies are cut, and the deprived sector and the strategicallyimportant sector. (Shaw, 1973) Claims, that the stability of growth in output and employmentare contributions of financial liberalization. A rise in interest rates and foreign-exchange ratesrelative to wage rates may both raise employment and increase the wage share of income.

Despite the efforts made by the government of Ethiopia in liberalizing the financial sector, the overall contributions of financial liberalization to major economic factors as well as the bidirectional effect between the variables remain a mystery. Previous Studies carried out on other hand as discussed in the literature review mostly concentrated on analyzing its effect using its components like interest rates liberalization, loan disbursement and total deposit.

This study seeks to put to light how financial liberalization in its completeness has affected Financial Sector Widening, Savings and Investment, Economic Growth, Industrial Development, Financial Development, Efficiency in Resource Allocation, Employment Opportunities, Poverty Alleviation and Redistribution of Income, and Financial Stability.

A wealth of literature has addressed this issue by either cross-country or time series analysis, asexemplified by, (Achy, 2003); (Akpan, 2004); (Bascom, 1994) and (Fowowe, 2004) thesestudies provide important policy implications especially for developing countries which areunder researched. Notably, Ethiopia has not featured in the cross country studies that haveincluded some of the Sub Saharan African countries. In terms of Single country studies nonehave been carried out in the scope of this particular study on Ethiopia prior studies conducted by(Garedachew, 2011) viewed sequencing of the financial liberalization qualitatively, while(Kahsay, 2014)focused on the banking sector liberalization on economic growth; sequencing andtiming process and assess performance indicators using ADRL co-integration approach. Theprevious researches have viewed financial liberalization in fragmented and using differentvariables from the current study and none have been conducted in a complete set of frame work to explain the impact of the change in Policy variables according to the knowledge of the researcher.

Hence Based on the above context the study tried to assess the following basic researchquestions:

1. Does financial liberalization enhance investment, industrialization and economic growthin Ethiopia?
2. Does the liberalization increase the efficiency of financing and create stability in thefinancial sector?
3. Is the liberalization enhancing the welfare of the Ethiopians?

1.3 Objectives of the Research

The research has the following general and specific objective.

1.3.1 General objective:

The general objective of this study is to analyze the effects of financial liberalization on different measures adopted in the process of financial liberalization in Ethiopia have been assumed brought some changes in different aspects of the financial system and the country’s national economy. In order to ascertain its effectiveness, it is necessary to conduct the impact evaluation of the policy. In this regard, this study intends to examine the impact of liberalization in terms of growth, distribution and stability in Ethiopia.

1.3.2 Specific objectives:

In view of the general objective this paper attempts to achieve the following specific objectives:

The specific objectives of the study are as follows:

1. Establish the Financial Liberalization Index for Ethiopia
2. To evaluate the impact of the liberalization measure on investment
3. To evaluate the impact of the liberalization measure on saving
4. To analyze the impact of liberalization on Economic Growth
5. To analyze the impact of liberalization on Industrial Development
6. To evaluate the impact of liberalization on Efficiency in financial Resource Allocation
7. To assess the impact of liberalization in financial Stability.
8. To examine the impact of liberalization on social welfare of the society

1.4 Research Hypotheses

As mentioned above, the main objective of this study is to examine the impact of financial liberalization in Ethiopia on the national economy in general, and on the financial system in particular. Following the framework presented in the preceding section, the following groups of hypotheses will be tested in this study.

H1: Financial liberalization widened the financial sector in Ethiopia.
H2: Financial liberalization increased domestic savings in Ethiopia.
H3: Financial liberalization increased investment in Ethiopia.
H4: Financial liberalization accelerated economic growth
H5: Financial liberalization enhanced industrial development in Ethiopia
H6: Financial liberalization enhanced financial deepening in Ethiopia.
H7: Financial liberalization improved resource allocation in Ethiopia.
H8: Financial liberalization increased employment opportunities in Ethiopia.
H9: Financial liberalization improved distribution of income in Ethiopia.
H10: Financial liberalization improved financial stability in Ethiopia.

1.5 Significance of the study

Knowledge of the extent to which financial liberalization impacts on a complete set offramework is paramount importance to both the policy makers and to the academicians. Thefindings of this study are believed to provide a useful contribution to the empirical basis neededfor proper understanding of the previous measures as well as management of the futuresequencing of the liberalization process. The study also adds value to the stock of knowledge byusing acceptable approach of financial liberalization index as an indicator of the financial sectorprogress in the Ethiopian economy.

1.6 Scope and limitations of the study

The study has its own scope and limitations as it is presented below.

1.6.1 Scope of the Study

The scope of this study was limited in terms of coverage and method. With regard to coverage, itwas limited to evaluate Ethiopian economy. This is due the absence of studies that featured in thecurrent research scope in neither cross-sectional nor case wise, according to the researcher’sknowledge within the current studies objective in the past. In terms of time, it covers the timeperiod 1984-2014 G.C. this period is selected due to the data availability of major variables usedin this study. The data’s cannot stretch for more than 31 years as some of the variables have notbeen kept as a data by the country.

1.6.2 Limitation of the study

Every study conducted may have certain shortcomings. When conducting Preliminary search for data there occur some constraints that affected the research work. The major constraint of the problem is data about the actual dates of deregulation of some policy variables in the researcher’s preliminary survey was not readily available policy variables such as stock market establishment and privatization of commercial banks are inexistent could not be used in the construction of the financial liberalization index. It is hoped that this did not bias the results since their inexistence can be captured indirectly through absence of the variables.

1.7 Structure of the study

This study is organized in five chapters. The first chapter deals with background of the study, research questions, objectives of the research, Hypothesis, significance of the study, scope and limitation of the study, and finally the Structure of the study. The second chapter discusses concepts and theories related to the area of study. The review of the literature includes the theoretical review in its first section which is followed by the review of the previous studies related to the area and conclusion and knowledge gap finally. Third chapter presents the research design and methodology as well as the model specification. The fourth chapter discusses the presentation, analysis and interpretation of the data collected and the last chapter makes summary of main findings, conclusion and recommendations.

CHAPTER TWO REVIEW OF RELATED LITERATURE

The first chapter introduced the problem to be investigated in this study along with purpose and research hypothesis. In order to put the study within the context of the existing literature, the subsequent section of this chapter present the review of both theoretical and empirical studies related to financial liberalization.

2.1The Role of Finance on Economic Growth

From a theoretical standpoint, different approaches have been applied in investigating the role offinance on economic growth for instance, (Schumpeter, 1911) argued that a well-performingbanking system can contribute to economic growth through the technological innovations thatmay occur as a result of the efficient allocation of funds. In contrast, (Robinson, 1952), arguethat financial development is a result of improvements in economic performance. Accordingly,the first perspective is called the ‘demand following’ hypothesis, while the second is called the‘supply leading’ hypothesis (Patrick, 1966). The fundamental question in relevant empiricalliterature is: What role does financial development play in economic growth of a nation? Toanswer this, it is necessary to investigate the causal relationship between the two variables(Levine R. , 2005); (Ang, 2008); (Demirgüç-Kunt & Levine, 2008); (Shahbaz et al. 2010).Although the direction of causality has received much attention from researchers, the nature ofthis causal relationship remains vague (Calderon & Liu, 2003). As countries’ characteristicsdiffer (such as political history, economic history, culture, institutional arrangements, level offinancial development, role of financial institutions etc.), so too can be causal relationshipbetween financial development and economic growth in these countries. Results from earlierstudies of financial development and economic growth fall into four broad categories:

Economists have employed various proxies to address this practicability problem. Results fromearlier studies of financial development and economic growth fall into four broad categories: 1)the unidirectional causality running from financial development to economic growth; 2) theunidirectional causality running from economic growth to financial development; 3) thebidirectional causality between financial development and economic growth; and 4) no causality between financial development and economic growth i.e. neutral hypothesis.

2.1.1 Supply Leading Hypothesis view

A series of studies have been devoted to analyze the direction of causality between financialdevelopment and economic growth. Most contemporary studies put forward the idea thatfinancial development has a strong causal influence on growth (Gupta K. L., 1984); (King &Levine, 1993a); (Blommestein & Spencer, 1996); (Levine R. , 1997); (Rajan & Zingales,1998); (Levine R. , 1999); Beck, Levine et al. 2000; (Xu, 2000); (Carlin & Mayer, 2003);(Fase & Abma, 2003). This view suggests that the direction of causality runs from thefinancial to real development (Gupta K. L., 1984), attempted to empirically examine whether financial development was the consequence of or the cause of economic growth. He conducted causality test for 14 developing countries using the data from the 1961-1980 period, and employing five different variables as proxies for financial development and industrial production as a proxy for real economic growth. He found that economic growth was the result of financial development. He also reports some evidence of causality from real to financial variables, with even lesser evidence for two-way (simultaneous) causality. This finding mainly suggests that the direction of causality ran from financial development to economic growth (King & Levine, 1993a) , conducted an empirical study using data on 80 countries over the 1960-1989 periods. They employed four indicators of financial development: overall size of the formal financial system; bank deposits; credit allocated to the private enterprises; and, claims on the non-financial private sector. They found that higher levels of financial development are positively associated with faster rates of economic growth, physical capital accumulation, and economic efficiency improvements.

(Beck, et al. 2000) employ data for 63 countries over the period 1960-1995 to examinethe relation between financial intermediary development and sources of growth. Theyuse private credit and liquid liabilities as measures of financial intermediarydevelopment. They find that there is a robust, positive link between financialintermediary development and both real per capita GDP growth and total factor productivity growth.

(Xu, 2000), examines the effects of permanent financial development on domestic investmentand output in 41 countries for the sample period of 1963-1993. He includes real GDP, realdomestic investment, and an index of financial development in his multivariate VectorAuto-Regressive (VAR) framework. The result rejects the hypothesis that financialdevelopment simply follows economic growth and has very little effect on it. Instead,there is strong evidence that financial development is important to growth (Carlin & Mayer, 2003), examine the interrelation between the structure of a country’s financial systems and industrial growth. They use the data from the OECD countries over the period 1970 to 1995, and employ the investment of 27 industries as the proxy for industrial growth. They report a strong relation between the structure of countries’ financial systems and growth of industries in these countries. They found a particularly strong relation between the structures of countries’ financial systems and the growth of industries that are dependent on external equity and skilled labor.

(Fase & Abma, 2003) , conduct the empirical study for nine emerging economies in Asia for asample period of 25 years (1974-1999). They use balance sheet totals of the banking sectoras the measure of financial development. They report that financial development matters foreconomic growth and that causality runs from the level of financial intermediation andsophistication to growth.

(McKinnon, 1973) and (Shaw, 1973), for example, used real interest rate as a measure of thelevel of financial development. Both claim that a low real interest rate below a competitive levelis an index for financial sector repression responsible for economic downturn (Fry M. J., 1993).They used a relatively high positive real interest rate to represent a relatively developed financialsystem and argued that it was a significant positive regressor of economic growth by raisingsaving, financial intermediation and hence the supply of credit for productive use (Abdurohman,2003). However, the contribution of high real interest rate on the broader spectrum of empiricalstudies remains an ambiguous one.

As early as 1911, Joseph Schumpeter claimed that the services provided by financialintermediaries form an element of economic development through channeling the society’sfunds to the most innovative entrepreneurs (Schumpeter, 1934). (Hicks, 1969), argues thatfinancial development played a crucial role in igniting industrialization in England. Theindustrial revolution required funds for long-term capital investment. Emergence offinancial markets that traded a variety of securities encouraged savers to hold such assets,and these availed liquid funds for long-term investment. “The industrial revolution may nothave occurred without this liquidity transformation (Levine R. , 1997).” These argumentshighlight the role of the financial system in economic development.

(Fritz, 1984), used the Philippines to examine the causality using data covering 1969-1981. Hisfindings are in support of Patrick that in the initial stage of the development process, causalityruns from finance to growth (supply leading hypothesis) while in later (affluent) stage ofdevelopment.

The pioneering study by (King & Levine, 1993a) and subsequent work by (Levine & Zervos,1998), (Levine R. , 1999), (Levine, et al, 2000) and (Beck & Levine, 2001) have provided newevidence in an attempt to resolve this debate. They identify three indicators of financial sectordevelopment that are best at explaining differences in economic growth between countries overlong periods: bank credit to the private sector, stock market activity (proxied by the turnover rateor the ratio of traded value to GDP), and features of the legal system such as the extent ofshareholder and creditor protection. Furthermore, (Levine R. , 1999) shows that the impact offinancial development on growth acts mainly through total factor productivity rather thanthrough capital accumulation or savings rates. He concludes, therefore, that ‘may be Schumpeterwas right’.

Growth in Per capita GDP is the most commonly used measure of economic growth. Yet,(Levine R. , 1997) uses three different indicators for growth: 1) the average rate of real per capitaGDP growth; 2) the average rate of growth in the capital stock per person and 3) totalproductivity growth. However, he finds GDP per capita growth to be the most useful forinvestigating economic growth. The measures for financial development differ more from studyto study. Levine introduces four main indicators of financial development. These variables are liquid liabilities, claims on the non-financial sector, claims on the private sector and deposit bankdomestic credit compared to central bank domestic credit. These are supposed to represent thesize and the activity of the financial sector. Levine also runs regressions including otherexplanatory variables like log of initial income, school enrolment rate, inflation, and ratio ofexports and imports to GDP. Levine’s findings indicate a substantial role for the financial sectorin economic growth. His major contribution is the framework of the functions through whichfinancial development can be channeled into economic growth. He states that evidence indirectlysuggests that countries with financial institutions which are effective at relieving informationbarriers will promote faster economic growth through more investment than countries with lesseffective financial systems.

(Atif, et al, 2010) examined the impact of financial development and trade openness on GDP growth in Pakistan using annual data over the period 1980-2009. The study used the ARDL bound test by (Pesaran, et al. 2001).It found evidence of long-run relationship among the variables financial development, trade openness and economic growth. The study also found that FD and trade openness to Granger cause economic growth over the period of study.

(Christopoulos & Tsionas, 2004), using panel data, of 10 developing countries, examined therelationship between financial development and economic growth .Their study used the ratio ofbank deposit liabilities to nominal GDP as a measure of financial debt; it also included inflationrate and the ratio of investment to GDP as control variables. The results provided evidence oflong-run unidirectional causality running from financial development to economic growth.However, the study did not find direction of causality between financial development andeconomic growth in the short-run.

2.1.2 Demand Following Hypothesis view

Some prominent economists view finance as a relatively unimportant factor in economicdevelopment. (Robinson, 1952) Claims, that financial development primarily followseconomic growth. She asserts: “by and large, it seems to be the case that where enterpriseleads finance follows.” Similarly, (Lucas, 1988) states, “the importance of financialmatters is very badly over-stressed.” His model of economic growth encompassesphysical capital, human capital and technological change as the only factors affecting economic growth.

The pioneering empirical work by (Goldsmith, 1969) was successful in documenting the positive relationship between financial development and economic growth. Goldsmith used annual data for a period from 1880 to 1963 from 35 countries and employed a financial interrelations ratio to relate the process of financial development to modern economic growth. He asserts that financial superstructure accelerates economic growth and improves economic performance by facilitating the migration of funds to the place in the economic system where the funds will yield the highest social return.

(Odedokun, 1996), studied 71 developing countries to identify the direction of causation usingdata over 1960s and 1980s. His findings strongly support the supply-leading hypothesis. Heprovided the following conclusions: first, financial intermediation promotes economic growth inroughly 85% of the countries; second, financial intermediation plays an equally important rolein enhancing growth as other factors like export expansion, capital formation ratio and is moreimportant than the labor growth in this context; third, financial intermediation promotes growthprimarily in low income LDCs; and more importantly, he finds that growth-promoting patternsof financial intermediation are practically invariant across various countries and regions.

(Odhiambo N. M., 2008) , using time series of the period 1968-2002 and a dynamic causality model investigated causality between financial development and economic growth in Kenya. The study used broad money (M2), currency ratio (CC/M1) and credit to private sector as proxies of financial development. The results suggested that causality between financial development and economic growth depends on the proxy used for financial development in Kenya, and that causality on the balance runs from economic growth to financial development. This study supports the demand -following hypothesis on average.

(Muhammad & Muhammad, 2010), investigated the direction of causality between financial development and economic growth, and co-integration among the two variables in Pakistan. The results of the study proved the existence of demand following hypothesis Pakistan, implying that economic growth granger causes financial development when broad money (M2) is used as a proxy variable for financial development. The study also found a long-run relationship between financial development and economic growth.

2.1.3 Bi-directional Causality view

Similarly, some studies have also claimed that there exists a bi-directional relationship between financial development and economic growth (Greenwood & Jovanovic, 1990); (Luintel & Khan, 1999).

(Greenwood & Jovanovic, 1990), found growth inextricably linked with financial structure.They claim that growth provides the means to develop financial structure, while financialstructure in turn allows for higher growth since investment can be more efficientlyundertaken. (Luintel & Khan, 1999), empirically examine the long-run causalitybetween financial development and economic growth in a multivariate time seriesframework using data from 10 sample countries. Their finding supports the bi-directionalcausality between financial development and economic growth in all the countriesanalyzed.

(Patrick, 1966), proposes a useful framework for the study of the causal relationships between finance and growth. He highlights the distinction between the ‘supply-leading approach’ and the ‘demand-following approach’ in financial development. According to his views, ‘demand-following’ financial development appears as a consequence of the development of the real sector, whereas ‘supply-leading’ financial development precedes demand for financial services, and can have an autonomously positive impact on growth. This hypothesis suggests the two-way causality that may exist between financial development and economic growth.

(Songul, IIhan, & Ali, 2009), investigated the causality between financial development andeconomic growth in Sub- Saharan Africa for the period 1975-2005. The study used panel co-integration and panel GMM for causality analysis. The results from panel co-integrationsuggested that there is no long-run relationship between financial development and economicgrowth. Results on causality analysis indicated existence of bi-directional causality betweenfinancial development (credit to the private sector was used as proxy for financial development)and real GDP per capita. The study therefore, supports both the supply leading and demandfollowing hypothesis.

(Rachdi & Mbarek, 2011), using panel data co-integration and GMM system approach investigated the direction of relationship between finance and economic growth for 10 countries (6 for OECD and 4 for MENA (Middle East and North Africa countries). Their empirical results showed that there is co-integration between financial development and economic growth for OECD and MENA countries. In addition, the GMM system results confirmed that financial development and real GDP per capita are positively and strongly correlated. Lastly, the study also found that causality is bi-directional in OECD countries while for MENA countries are unidirectional, with economic growth causing financial development.

(Akinlo & Egbetunde, 2010), Investigated co-integration and the direction of causality betweenfinancial development and economic growth of ten sub-Saharan African countries. The studyfound that there is long-run relationship between financial development and economic growth inthe countries selected. The results also showed that financial development granger causeseconomic growth in some countries while in others there was bi-directional causality betweenthe two variables.

2.1.4 No Causality view

Contrary to the above assertions, some studies do not find any strong causal relationshipbetween financial development and economic growth (Demetriades & Hussein, DoesFinancial Development Cause Economic Growth? Time-series Evidence from 16 Countries,1996); (Ram, 1999).

(Demetriades & Hussein, Does Financial Development Cause Economic Growth? Time-seriesEvidence from 16 Countries, 1996) , studied 16 less developed countries using time series data.Their findings provided little support for the finance-leads- to-growth hypothesis; rather therewas more evidence for the opposite direction and for bi-directional causality. For instance, Koreaand Thailand the two countries with successful financial reform provided bi-directionalcausation. They concluded that causality patterns varied across countries and stressed the needfor case studies and careful time-series analysis. Similarly, (Ram, 1999) argues that thepreponderance of empirical evidence does not encourage one to share the view thatfinancial development is observed to have a positive effect on economic growth.

Thus, it is clear from the literature review, regarding the relationship between financialdevelopment and economic growth, that studies produce mixed results. Most of the studies havefound existence of long-run relationship between financial development and economic growth.The empirical results on the direction of causality are more mixed as compared to co-integrationanalysis. Some findings indicate that there is unidirectional causality running from financialdevelopment to economic growth, hence supporting supply leading hypothesis. Another variationin the results of causality is the finding of unidirectional causality running from economic growthto financial development; this supports the demand following hypothesis. And also some studiesargue financial development and economic growth have bidirectional causality and few studieshave no causality between the two.

2.2 Financial Repression

Government intervention in the financial system, including the setting of interest rates, theimposition of high reserve requirements and quantitative restrictions on credit allocation, was afairly common practice in the 1960s and 1970s, especially in developing countries. That practicewas challenged initially by (Goldsmith, 1969) and later by (McKinnon, 1973)and (Shaw, 1973),who saw it as being responsible for low savings, credit rationing and low investment. Theycalled it financial repression. It is the flip-side of financial liberalization or the reverse ofdimensions of financial liberalization. The term ‘financial repression’ was initially coined by(McKinnon, 1973) who defined it as government financial policies strictly regulating interestrates, setting high reserve requirement on bank deposits, and mandatorily allocating resources.Such repressive policies are common in developing countries would impede financial deepeningand hinder efficiency of the financial system consequently; they retard economic growth(McKinnon, 1973); (Shaw, 1973).

Financial repression policies include, but are not limited to, subsidizing loans for specific sectors,heavily regulating the banking sector, and controlling interest rates. The result is an artificiallylow cost of funding, i.e. non market interest rates. Consequently the interest rates do not serve anequilibrating function between the saving and investment decision. (Berthelemy & Varoudakis,1996a) Define all such policies and regulations which prevent financial intermediaries fromoperating in accordance with their full technological potential as forms of financial repressions.

Financial repression is generally equated with controls on interest rates and, in a strict sense, controls which result in negative real interest rates on deposits (Kitchen, 1986).

From a broader perspective as envisioned by (Giovannini & De Melo, 1993), financial repressionalso encompasses restrictions on international capital flows as well as the fiscal dimension thatties financial repression with inflation tax and seigniorage¹. From a more policy oriented view(Serieux, 2008)notes that financial repression is a consequence of misguided fiscal and monetarypolicies, the over regulation of the financial sector, other repressive public sector interventionand excessive borrowing from the local financial system, thus potentially ‘crowding out’investors. From a review of existing literature on the subject, it is interesting to note thatfinancial repression is mainly prevalent in developing countries (Arestis, 2005); (Brock, 1989);(ANG & McKibbin, 2007); (Giovannini & De Melo, 1993) and (Serieux, 2008). Thegovernments must perceive a strong case for financial repression in parts or as a whole. Thefollowing section will explore the rationale employed in the choice of financial repression.

2.3 Rationale of Financial Repression

The main reason why governments resort to financial repression is to control fiscal resources(Giovannini & De Melo, 1993). (Denizer, Desai, et al 1988) and (Roubini & Sala-i-Martin,1992) argue that in most developing countries fiscal deficits are significant and persistent.They do not have efficient taxation systems. Therefore, in order to finance their fiscal deficits,governments may choose to repress the financial sector because it delivers them easyinflationary revenue ‘easy’ revenues or seignorage¹ revenues. As such the finance sector isviewed as a cheap source of financing government deficits (Fry M. J., 1995). (Brock, 1989), offerother frequently sighted reasons for financial repression. These are; restraining the level of domesticdebt, the gain from seignorage, more control of money supply through direct instruments ofmonetary policy, supplying credit to chosen sectors and keeping the cost of credit in the economylow.

The gain from financial repression maybe quite significant in terms of the gains made fromseignorage and inflation tax. Especially in cases where the inflation is high and monetary authorities use direct measures for monetary policy (Giovannini & De Melo, 1993). Similarly, financial repression is associated with interest rates below market rates, which reduces the costs of servicing government debts (Roubini & Sala-i-Martin, 1992).In effect governments are extracting the seignorage from the local financial institutions. The government may achieve their goals by actually enacting laws that dampen the growth of private bond and equity markets, as these may not be easily exploited for seignorage.

Monetary expansion is a much easier method of financing government expenditures. Themoney is simply printed on the backing of government securities. No government taxcollectors are required, and government expenditures appear to be financed at little cost to thepublic. Legislative approval is often not required. Seigniorage extraction is a less problematicmethod of raising revenue. It can be accomplished by imposing large reserve requirementson commercial banks. These reserve requirements force commercial banks to holdgovernment liabilities such as currency or government bonds beyond the point they wouldotherwise consider optimal. Through such large reserve requirements, the monetaryauthority, and eventually the government, avails itself of part of the economy’s savings thatwould otherwise remain with financial intermediaries (Espinosa & Hunter, 1994).

Another frequently cited reason behind financial repression is imposing the anti-usury law tointervene in the free determination of interest rates, in order to protect the public fromexploitation. Financial markets in developing countries are usually relatively small and underdeveloped. Furthermore, they typically have oligopolistic or monopolistic structures. Such non-competitive structures may disturb the proper functioning of interest rates as guides for decisionson savings and investments (Dornbusch & Giovannini, 1990). As such, interest rates may be keptat levels lower than market equilibrium, under the guise that these low interest rates may availfunds to public sectors that will result in wide reaching gains. Furthermore the incumbent bankswould collude so as to gain from their structure and interrupt policies on liberalization that wouldbring financial deepening and competition thereby compromising their profits.

The channeling of credit to certain chosen sectors at subsidized interest rates is referred to as creditrationing (Ghosh et al, 1999). It is the allocation of subsidized credit to the favored sector isanother form of financial repression. Such directed credit programs are carried out due tothe government’s belief that commercial banks allocate credit in a largely speculative and socially undesirable fashion, and that they knew better than markets what the optimal allocation of savings was, or what kind of investments were more or less desirable (Roubini & Sala-i-Martin, 1992) . This claim was frequently supported with evidence from high-growth economies in East Asia, where governments supposedly manipulated financial systems in order to promote targeted industrial expansion (Denizer, Desai, et al. 1988).

In adding to repressive legal statutes the government may also resort to more direct forms of repression i.e. large reserve requirements for banks, compulsory holdings of government stock and foreign exchange controls (Serieux, 2008).

Traditionally there was also support for financial repression given that through legislations andrestrictions on the financial market credit creation ability, it was possible to exert control over thesupply of money. Thus, enabling the monetary authorities to use direct instruments of monetarycontrol in order to manage inflation therefore positively influencing economic growth (Vittas,1992)

2.4 Types of Financial Repression

The types of financial repression emanate from the different forms that financial regulation maytake. Any financial control that is over-exerted or that produces results that adversely affect theeconomy may be considered repressive. In concordance with this notion, (Vittas, 1992), putsforward six types of financial sector controls that may produce distortions and a tax on activitiesof financial intermediation. These include allocative, organizational, macroeconomic, protective,prudential and structural controls. It is noteworthy that the controls are not mutually exclusive asa particular control measure employed may serve the function of one or more of the controls.

In order to maximize profits, banks tend to provide credit to projects which have low risks orhigh risk projects with short payback periods. As opposed to financing projects that have highrisk and long payback periods even if such projects may positively affect the economy. As such agovernment may initiate allocative controls such as compulsory reserve requirements,preferential taxes and credit rationing. Allocative control measures are viewed as compensatingfor the externalities caused by market failure. However, an excess of such actions may prove repressive as private investors are left to compete for scarce credit. In so doing, a number of projects with higher profits and or greater benefit to total productivity are not completed.

(Vittas, 1992), Proposes that structural controls stem from political and economic considerations. Structural controls govern the entry of financial institutions and buttress the fragmentation of the local financial market through the imposition of restrictions on the size of institutions and the range of activities they may undertake.

Prudential, organizational and protective controls are set in place to protect the customer as wellas to fortify the financial system. Prudential controls endeavor to minimize the risk of systemicfailure and they include regulation measures on capitalization, management, risk managementand enforcing accounting policies. Protective controls are measures set in motion to safeguardthe customers of financial services from problems created by information asymmetries, whichaccording to (Vittas, 1992), may include compensation funds and ombudsman offices. On theother hand, organizational controls seek to bridge the gap created by externalities. These arecaused by the existence of markets such as the stock exchange, other trading exchanges, paymentclearing systems and information networks. Thus organizational controls encourage thedisclosure and flow of information in the market with a view to advancing market efficiency.

Given the need to control expansion of credit and price stability, governments often imposecontrols on reserve requirements, interest rate ceilings, selective credit allocation methods (creditrationing), restrictions on foreign investments and importantly interest ceilings which arecollectively referred to macroeconomic controls (Vittas, 1992). Such controls are viewed to betargeted at maintaining internal and external equilibrium and it is also that stringent control in thefinancial system gives monetary authorities increased control over money supply.

2.5 Consequence of Financial Repression

The McKinnon and Shaw school argue that financial repression inhibits growth as it fragmentsthe domestic capital market, adversely affecting the quality and quantity of real capitalaccumulation (McKinnon, 1988; McKinnon, 1993). They stated the following four mainchannels through which financial repression negatively affects capital accumulation and hencegrowth (Ucer, 1997):

- The flow of loanable funds via the organized banking system decreases forcing investors torely more on self-finance;
- Interest rates on the truncated flow of bank lending vary from one class of favored or disfavored borrower to another;
- The process of self-finance itself is impaired. If real deposit interest rate is negative, firms can ’ t easily accumulate liquid assets in preparation for making discrete investments and socially costly inflation hedges look more attractive as a means of internal finance;
- Significant financial deepening outside of the repressed banking system becomes impossible when firms are dangerously illiquid and/or inflation is high and unstable; robust open markets in stocks and bonds, or intermediation by trust or insurance companies, require monetary stability.

The negative impact of financial repression on efficiency and growth is widely accepted and is the theme of a large body of literature. (Pagano, 1993), showed that financial policies such as interest rate controls and reserve requirement lowered financial resources available for financial intermediation. (Roubini & Sala-i-Martin, 1992), Presented theoretical and empirical analyses of the negative relationship between repressive financial policies and long-term growth (King & Levine, 1993a) developed an endogenous growth model to illustrate that financial sector distortions reduced growth by lowering the rate of innovation.

(Haslag & Koo, 2003), assess the empirical link between financial repression, financialdevelopment and growth of data from 119 countries using 1960-1989 years. They used inflationrate and reserve ratio as measures of financial repression concluded that countries with highreserve ratios, on average, grow more slowly than countries with low reserve ratios. Countrieswith high reserve ratios also tend to have less developed financial systems than countries withlow reserve ratios. And, countries with high reserve ratios, on average, have high inflation ratesas well.

Another study conducted by (Roubini & Sala-i-Martin, 1995) study using the data from 98countries for the period of 1960-1985 claim that policies of financial repression have negativeeffects on economic growth. They find a systematic inverse relation between growth and several measures of financial repression, as well as a negative relation between growth and inflation rates. According to them, countries that are financially repressed will have higher inflation rates, lower real interest rates, higher base money per capita and lower per capita growth than countries that are financially developed. This result suggests that financial repression is harmful to economic growth. Further in the literature claim Repressive policies hurt economic growth because financial intermediation is an important component of the aggregate production function. The marginal product of capital of an economy more financially developed is larger than the marginal product of a less financially developed economy.

(Shrestha M. B., 2005), states High inflation is one of the main characteristics of a repressed economy citing (De Gregorio & Guidotti, 1995) which documents the evidence that the level of inflation and its variability, as well as money growth, have negative effects on economic growth.. He claims that if inflation rates had been half of their level in 12 Latin American countries during the 1950-85 periods, per capita GDP growth would have been at least 25 per cent higher. The findings suggest that the main channel through which inflation affects growth is through the reduction of the productivity of capital.

The distortions created in the financial system by the policy of repression crowd out highyielding investment, create a preference for capital-intensive projects, discourage future savings, and thereby reduce both the quality and quantity of investment in an economy (McKinnon, 1973); (Denizer, Desai et al, 1988); (Gupta & Lensink, 1997). Similarly, taxing interest income on government bonds held by the non-bank private sector also has a negative effect on capital formation (Gupta & Lensink, 1997) .

(Denizer, Desai et al, 1988), examine relationships between financial restrictions and some fiscalindicators using annual data for 25 transition economies for the period 1990-1996. They claimthat tax losses are associated with higher real reserve ratios in deposit-taking banks, and thatpositive fiscal balances are associated with higher real discount rates. These findings suggest thatrepressive financial controls may be adopted not to finance deficits more cheaply than would bethe case under financial liberalization, but to maintain the authority and ensure the survival ofthose in power.

(Fry M. J., 1980) Conducts regression analysis using data for 61 developing countries for the 1964-1976 period. He argues that estimates of saving and growth functions lead to the conclusion that the cost of financial repression appears to be around half a percentage point in economic growth foregone for every one percentage point by which the real deposit rate of interest is set below its market equilibrium rate.

(Kang & Sawada, 2000), highlight the status of human capital under financial repression. They argue that a policy of repression tends to result in lower human capital investment, thus lowering the long run economic growth rate According to (Lewis, 1992), in a repressed financial system, the government manipulates thebanking sector for its seigniorage through the control of reserve requirements and regulation ofdeposit rates, which frequently results in a negative real return to saving. In addition, subsidizedborrowing rates are offered to favored sectors or groups in the economy, distorting resourceallocation and forcing those not favored to borrow at high marginal rates from the banking sectoror the informal curb market.

(Fry M. J., 1988), Points toward the effects of financial repression on the country’s balance ofpayments. He argues that repression can exacerbate the growth-inhibiting effects of foreign debtaccumulation in developing countries. Financial repression may cause capital flight throughover-invoicing of imports and under-invoicing of exports. The balance of payments deficit oncurrent account rises when such capital flight increases. Such illegal capital flight can also affectdomestic investment by increasing the domestic real interest rate because the financial capital inthe domestic market becomes scarce.

Proponents of (McKinnon, 1973) and (Shaw, 1973) emphases and argue on the gains from financial deepening others highlighting benefits of financial restraint, which is proposed by (Hellman et al.1997).

(Hellman et al.1997) showed that competition can undermine prudent bank behavior. Capital requirement regulation, for instance, might result in Pareto-inefficient consequences. Better outcomes can be achieved by adding deposit rate controls as a regulatory instrument if they facilitate prudent investment. Under the assumption of incomplete information, financial restraint can be good for efficiency and growth, especially in developing countries.

(Stiglitz, 2000), attributed increasing frequency of financial crises during the past decades tofinancial liberalization in the developing world. It was argued that developing countries might bemore able to manage money supply and financial stability under repressive financial policies(Stiglitz, 1994).

(Li D. , 2001), argued that while financial repression probably supported macroeconomic stability and economic growth during the early years, it increasingly became a burden for economic performance and, more importantly, self-sustaining in recent years in his study of the Chinese experience. He further claim that mild financial repression helped China to maintain financial stability which, in turn, had a favorable effect on growth performance.

(Huang & Wang, 2011) States, repressive financial policies should, in general, reduce economicefficiency; they might enable the authorities to better deal with problems of market failure andfinancial risks. They, further note that the net impact is likely determined by a combination ofthese two possible mechanisms-negative effect suggested by (McKinnon, 1973) and (Shaw,1973) and positive effect highlighted by (Stiglitz, 1994) and (Hellman et al.1997, 2000). Theactual result might be ambiguous, depending on which of these effects dominates.

2.6 Financial Liberalization: Views, causes and Approaches

According to (Ahmed & Islam, 2010), there are two broad groups about the possible benefits ofthis reform process aimed at financial liberalization: The first is the Goldsmith- McKinnon-Shawschool which argue financial liberalization is the only effective means to develop bankingintermediation, to start again the capital accumulation and to promote the economic growth inthe countries. (McKinnon, 1973) And (Shaw, 1973) come to present the misdeeds of financialrepression and to defend the founded good of financial liberalization. The second is Keynes-Tobin-Stiglitz (also called the Structuralist and Neostructuralists School) propagated in favor ofcertain sort of financial repression due to economic benefits and vulnerability to persistentmarket failure. (Kahsay, 2014).Using various economic models, each provides background,rationale and intellectual justification for financial liberalization vis a vis financial repression.(Ahmed & Islam, 2010).

According to (Kaminsky & Schmukler, 2001), financial liberalization would be categorized intothree main categories. There are domestic financial liberalization, capital account and stockmarket. In their analysis of financial liberalization, first, domestic financial liberalizationincludes interest rate liberalization (deposit interest rates, lending interest rate), credit controls(allocation of credit, and elimination of credit control), and development indirect instrument ofmonetary control.

“ Domestic financial market liberalization is the process of designing a regulatory framework for markets that determine who gets and grants credit and at what prices — has swept the world as part of the spread of neo-liberalism over the past three decades ” (Way, 2005) .

In general domestic financial liberalization would be created for increasing and improving thefinancial institution’s operation, in term of interest rate control, credit control and so forth.Second, capital account would be accounted for long term money flow ( more than one yearmoney flow), such as, offshore borrowing by domestic financial institutions, offshore borrowingby nonfinancial corporations, multiple exchange rate markets, and controls on capital outflows.The capital account is implemented to improve and increase the participation of long term moneyflow, both inflow and outflow. Third, stock market liberalization would be tracked by changingin the regulations on three variables; acquisition of shares in the domestic stock market byforeigners(capital inflows), repatriation of capital (capital outflow) and repatriation of interest ofdividends(capital outflow).The stock market liberalization would be set to increasing theparticipation of foreign investors in a country’s stock market. (Kaminsky & Schmukler, 2001),

In addition, (Mahamarn, 2010) notes that stock market liberalization would be included as a part of capital account liberalization which makes it a part of financial liberalization in order to open the market to foreign investors to trading stock in a particular country’s stock market.

There would be several factors that encourage and influence a particular country implementingfinancial liberalization. According to (Mahamarn, 2010) the causes of financial liberalization hasbeen widely investigated and can be explained in two ways; first, financial liberalization is theresult from either economic constraint or further development; second, financial liberalization isthe result from either a domestic aspect; crisis in country, aim to upgrade standards of living and a country’s financial status, and international aspects; the aim to increase the competitive advantage in a global economy.

Generally speaking, the process of financial liberalization mostly starts from the domestic levelthrough deregulation/removal of controls over deposit and lending rates, reducing reserverequirements, reducing entry barriers to the financial services industry, pursing a program tostabilize price levels and generally decrease the state’s involvement in the activity of financialintermediaries, and then followed by trade liberalization before shifting to external capitalaccount liberalization and changes in the institutional framework of fiscal and monetary policies(Ahmed & Islam, 2009). Furthermore, sometimes external liberalizations concern relaxation ofdomestic restrictions, such as buying from abroad and in a broader view, are concerned as theforeign currency trading, also called the capital account. (Mahamarn, 2010)

The second cause for liberalization is International or domestic factors: The increasing of financial liberalization could also be seen as the consequence of either “top-down” mechanisms, also called international factors or “bottom-up” mechanisms, called domestic factors, or both of them that influence the country to reform their financial market. Top-Down mechanisms (international factors) could be implied the increasing of competition in global aspects, the pressure at international level, also called globalization, which country should adapt to the new challenge. Then, Bottom-Up mechanisms (the domestic factor) would refer not only to the economic constraint in the country but also to the reformation of domestic financial markets to improve the living standard of people in the country. (Mahamarn, 2010)

From a theoretical perspective, financial liberalization is said to benefit developing countries in a number of ways. (Levine R. , 1996) and (Claessens & Glaessner, 1998) observe that liberalizing financial markets may generate significant gains through foreign entry which increases competition and so lowers the cost of finance for domestic users, who gain easier access to cheaper funds from external sources. (Ahmed & Islam, 2010)

Additionally, (Sauve, 1999) elaborates that there are at least three main reasons as to whydeveloping countries could benefit from financial liberalization. First, the opening up of financialmarkets provides more opportunities for foreign investors to invest, leading to a spillover intosavings and investment, which contributes to higher growth and development in the long run.

Second, financial globalization potentially brings large benefits related to foreign firmpenetration such as better technique for credit analysis, reduced risk of domestic financialinstability (which in turn enhance economic growth rate and reduce poverty), and improvedquality of financial and management services which can enhance productivity and efficiency.Third, liberalization can promote innovation and modernization of the domestic financial systemthrough transfer of capital, technologies (new foreign innovation) and skilled labor(foreignexpatriates), which results in improved services that lead which results in improved services thatlead to better quality investments.

The above view is opposed by the Keynesian-Tobin-Stiglitz school of thought (Fry M. J., 1995).This group (called neo structuralists) has brought forward a number of economic rationales tojustify some sort of financial repression (such as low interest rate policies, lower inflation anddirected and/or selective credit policies). Through various models (such as the Keynesianliquidity trap and Tobin’s portfolio allocation models), they argue that without carefulmanagement, liberal attitudes to finance and financial market may disrupt economic activityquite seriously. (Fry M. J., 1995).

Each of these groups also nominate various monetary and financial policies in which if pursuedwould promote economic growth and ensure financial stability. From the earlier works of(Goldsmith, 1969); (McKinnon, 1973) and (Shaw, 1973) to recent studies, the benefits offinancial liberalization have been emphasized. All these authors have pointed out that byproviding higher incentives to save and allocating funds to the most productive and profitableproject, financial liberalization improves productivity in the economy as a whole. Put simply, byincreasing saving and enhancing the allocation of capital, financial liberalization stimulates long-run economic development. While there seems to be a general consensus on the importance andthe vital contribution of a financial system to the economy, some initial studies have shown thatreforms towards a more liberal economy have worked differently in Asia, Africa and LatinAmerica (Pill & Pradhan, 1997);( Barajas,et al., 2000). (Stiglitz, 1994), has also argued that,since credit markets are prone to market failures, government intervention in the area ofprudential regulation and supervision is justified, particularly due to the de facto role ofgovernment as an insurer of the financial system (Fry M. J., 1995)

Since the mid1980s, there is policy advice from economic think tanks and world financial institutions in favor of financial liberalization. However, (Ahmed & Islam, 2010) citing (Kose, et al, 2003); (Prasad, et al 2004); (Kose,et al, 2006) point out that financial liberalization can also lead to serious financial crisis and collapse.

2.7 Liberalization and its Impact on Interest Rates, Savings and Investment

Financial liberalization has been equated to a shift towards higher real interest rates. Higherreal interest rates can increase loan able funds by attracting more household savings tobank deposits. This in turn leads to greater investment and faster economic growth (McKinnon,1973); (Shaw, 1973). The two authors emphasized the removal of interest rate ceilings as thekey measure of financial liberalization. They assumed that removal of such ceilings wouldincrease real interest rates, which in turn would stimulate savings. The underlying assumptionis that saving is responsive to interest rates. The higher saving rates would finance a higherlevel of investment. According to this view one should expect to see higher saving rates aswell as higher levels of investment following financial liberalization (Reinhart & Tokatlidis,2001).

(Bascom, 1994), states interest rate can be seen as the price of borrowed money, or asthe opportunity cost of lending money for a specified period of time. During this period,inflation can erode the real value of financial assets and lenders want to be compensated foran expected decrease in the purchasing power of these assets. The real interest rate isthus the rate adjusted with a due compensation for the anticipated inflation. (Shrestha M. B., 2005)

The McKinnon and Shaw school of thought also hypothesizes that higher interest rates willincrease the allocative efficiency of credit by shifting funds from inefficient investments tomore efficient investments through organized sectors. Based on these hypotheses, theMcKinnon-Shaw school argued that financial liberalization would lead to higher economicgrowth (Cho, 1990).

(Giovannini, 1985), studied the effects of savings on interest rates in eighteen developingcountries and concluded that in the bulk of cases, the reaction of consumption growth to changes

in the real interest rate is insignificantly different from zero. It is therefore prudent to expect insignificant responses from total saving to the real interest rate.

(Bandiera et al. 2000) examine the effects of different financial liberalization measures ineight selected countries from 1970-1994. They found that there was no evidence of positiveeffect of the real interest rate on saving. In most cases the relationship was negative.

(Loayza, et al.2000) also document that the direct effects of financial liberalization are detrimental to private saving rates. The real interest rate has a negative impact on the private saving rate. They find that a 1 per cent increase in the real interest rate reduces the private saving rate by 0.25 per cent in the short run.

(Jappelli & Pagano, 1994), investigate the role of capital markets on aggregate saving andgrowth. Using a panel of OECD countries for the 1960 to 1987 period, they find that financialderegulation in the 1980s has contributed to the decline in national saving and growth rates inthe OECD countries.

(Bayoumi, 1993), examines the interaction between financial deregulation and household saving's behavior using eleven standard regional data for UK in the 1980s. He concluded that financial deregulation was responsible for lowering the equilibrium level of saving roughly 2.25 percent per year and making saving more dependent on changes in wealth, income and interest rates.

On the contrary, (Fry M. J., 1988) approximated a pooled time series of savings function for 14Asian developing countries by assuming a similar hypothesis of McKinnon and Shaw frameworkthat savings is a function of income growth. In this study it was established that real interest rateshad a positive and significant effect on national savings. Also, (Schmidt-Hebbel & Serven,2002), use data for 35 countries for the 1973-1995 period to estimate the correlation betweenfinancial liberalization and savings. They find a positive, significant relationship betweenfinancial reform and saving. A higher degree of financial liberalization is observed in countriesthat on average save more, although simple association does not reveal anything about thedirection of causality. Likewise a more recent study by (Serieux, 2008) of 19 African countriesproves that there is a high correlation between savings and interest rates for the sub Saharancountries studied for the period between 1965 and 2003.

A study of Latin American and Asian countries by (Gupta K. , 1987) to address the topical issueof aggregate savings determined by interest rates through financial intermediation. Financialrepressionists of the McKinnon and Shaw framework claim that the positive substitution effectdominates the negative income effect in developing countries. On the other hand, the financialstructuralist’s contend that financial intermediation directly affects savings which is set apartfrom the effect of interest rates. As such Gupta found that there was no overwhelming empiricalsupport for either of the two schools of thought. In Asia, there is some support for both, but forLatin America, neither of the two hypotheses receives any support. However, it is noteworthythat in this study that both groups had a positive sign, which adds weight to the McKinnon andShaw’s framework postulations that increased interest rates, would lead to a rise in the savingsrate.

The relationship between interest rates and savings is not written in stone. As such other researchers have countered this neo-classical economics notion and the McKinnon and Shaw framework of a positive and causal relationship between savings and interest rates. (Mikessell & Zinser, 1973), showed that interest rates did not affect the propensity to save. However, interest rates were important in ascertaining which channels that saving would follow. This notion is also supported by (Serieux, 2008). (Warman & Thirlwall, 1994), in their survey of Mexico for the period stretching from 1960-1990 also found that interest rates had a positive effect on financial savings but a negative outcome on aggregate savings.

McKinnon and Shaw framework postulates that in a financially repressed market, the subequilibrium interest rates result in a shortage of funds in the market. Governments aim to bridge this gap by using credit rationing programs aimed at selectively rationing available credit to projects that are deemed to proffer the highest returns to society. However, some researchers argue that credit rationing will lead to inefficient rationing of credit as the projects that receive finding may not be necessarily the most profitable. (Shrestha M. B., 2005)

(Reinhart & Tokatlidis, 2001), use data from 50 countries consisting of 14 developed and 36developing ones. Their data spans over the 1970-1998 period. Based on their findings, theyargue that with greater certainty, financial liberalization appears to deliver higher real interestrates, lower investment, but not lower growth.

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¹ ‘ Seigniorage ’ is a term derived from the French word ‘ seigneur ’ , which means lord. In medieval times, one of the rights of the feudal lord was to coin money that his subjects had no choice but to accept, no matter how little gold or silver it contained. Seigniorage was the profit the lord made by exercising this right (Espinosa and Hunter 1994, p.4).