• Background of the Study

Financial liberalization can be viewed as a set of operational reforms and policy measures designed to deregulate and transform the financial system and its structure with a view to achieve a liberalized market-oriented system within an appropriate regulatory framework (Johnston and Sundararajan, 1999).  Financial liberalization has been variously characterized in the literature but Niels and Robert (2005) observed that whatever characterization, financial liberalization usually include official government policies that focus on deregulating credit controls, deregulating interest rate controls, removing entry barriers for foreign financial institutions, privatizing financial institutions, and removing restrictions on foreign financial transactions. In other words, financial liberalization has both domestic and foreign dimension.  Moreover, it focuses on introducing or strengthening the price mechanism in the market, as well as improving the conditions for market competition.  As opposed to financial liberalization financial repression (the inverse of financial liberalization) is evidenced by ceilings on interest rates and credit expansion, selective credit policies, high reserve requirements, and restriction on entry into the banking industry (Ikhide and Alawode, 2001).

There has been a renewed interest on the role of financial liberalization in economic growth. This current focus has been heightened by two key factors.  First, the global financial crisis that has ravaged the economies of the world especially the western world and the apparent inability of the classical and neo-classical economic models to adequately address the crisis.  Second, the on-going government interventionists’ activities in the financial systems of various countries of the world have called to question the McKinnon-Shaw hypothesis of financial liberalization as a catalyst for economic growth and the Schumpeterian ‘creative destruction’ logic of free and liberalized economies.

According to Ogbu (2010), the current global financial and economic crises, the huge bailout of the financial and non-financial institutions across the world and the rather uncertain and timid response to these massive government interventions in the functioning of the market are altogether producing four-fold theoretical-conceptual outcomes.  One, the empirical scenario is re-defining or re-evaluating the capitalist market economy.  Two, it is exposing the limits of ‘creative destruction’ logic of Schumpeter (1911).  Three, it calls to question the adequacy of the current economic modeling and analytical tools.  Four, it is leading the way to the emergence of a ‘new market economy’.

Ogbu (2010) argued further “not since the great depression of the 1930s has the world experienced this kind of economic down-turn.  Now, unlike then, the effects have been widespread, global and faster and the amounts involved staggering.  Unfortunately, the lessons of the 1930s could not be relied upon to provide answers for the current economic crisis.  As each country tries on its own to deal with the problems, the governments are getting more involved with market activities outside the previously accepted limits for a functioning market economy especially in the financial system”.

Theoretically, it is widely accepted that liberalizing the financial system could play a vital role in economic development.  Since the original theoretical analysis which provided a rationale for financial sector liberalization as a means to promote economic development was given by McKinnon (1973) and Shaw (1973), a lot of theoretical and empirical research has been carried out examining the concept in different contexts, countries and time periods (see for example, Abel 1980; Romer 1994; Lucas 1982; Bandiera et al. 2000; Khan and Reinhart 1990; and King and Levine 1990, Demir, 2005).

According to Arestis (2005) a number of writers question the wisdom of financial repression, arguing that it has detrimental effects on the real economy. Goldsmith (1969) argued that the main impact of financial repression was the effect on the efficiency of capital. McKinnon (1973) and Shaw (1973) stressed two other channels: first, financial repression affects how efficiently savings are allocated to investment; and second, through its effect on the return to savings, it also affects the equilibrium level of savings and investment. In this framework, therefore, investment suffers not only in quantity but also in quality terms since bankers do not ration the available funds according to the marginal productivity of investment projects but according to their own discretion. Under these conditions the financial sector is likely to stagnate. The low return on bank deposits encourages savers to hold their savings in the form of unproductive assets such as land, rather than the potentially productive bank deposits. Similarly, high reserve requirements restrict the supply of bank loans even further whilst directed credit programmes distort the allocation of credit since political priorities are, in general, not determined by the marginal productivity of different types of capital.

Arestis (2005) remarked further “the policy implications of this analysis are quite straightforward: remove interest rate ceilings, reduce reserve requirements and abolish directed credit programmes”. In other words, liberalize financial markets and let the free market determine the allocation of credit, where it is assumed that there will be a ‘free market’ with just a few banks, thereby ignoring issues of oligopoly and, of course, of credit rationing problems (Stiglitz and Weiss, 1981). With the real rate of interest adjusting to its equilibrium level, at which savings and investment are assumed to be in balance, low yielding investment projects would be eliminated (Schumpeter’s ‘creative destruction’), so that the overall efficiency of investment would be enhanced. Also, as the real rate of interest increases, saving and the total real supply of credit increases, this in turn will induce a higher volume of investment. Economic growth would, therefore, be stimulated not only through the increased investment but also due to an increase in the average productivity of capital. Moreover, the effects of lower reserve requirements reinforce the effects of higher saving on the supply of bank loans, whilst the abolition of directed credit programmes would lead to an even more efficient allocation of credit thereby stimulating further the average productivity of capital.

In recent years, several papers have been published on the relationship between financial liberalization and growth. Some studies focus on the quantity effects of liberalization while others concentrate on the quality effects of liberalization.  These studies use firm-level as well as cross-country data (see Niels and Robert, 2005). Laeven (2003) quoting from Niels and Robert (2005), in a study finds evidence for the hypothesis that financial liberalization reduces financial constraints of firms.  His study was based on information from 13 developing countries.  Similarly, positive effects of liberalization on reducing financial constraints are found, among others, by Koo and Shin (2004) for Korea, Harris, Schiantarelli and Siregar (1994) for Indonesia, Guncavdi, Bleaney and McKay (1998) for Turkey and Gelos and Werner (2002) for Mexico.  At the same time, however, studies by Jaramillo, Schiantarelli and Weiss (1996) on Ecuador and Hermes and Lensink (1998) on Chile find much less supportive evidence for the positive effect of financial liberalization on reducing financial constraints and inducing investment.

Other studies have used cross-country panel data.  Nazmi (2005) uses data for five Latin American countries and finds evidence that deregulation of financial markets increases investment and growth.  Bekaert, Harvey and Lunblad (2005) for a large sample of countries looked at liberalization of the stock market in particular, opening them up to foreign participation and found support for the view that a type of liberalization spurs economic growth through reducing the cost of equity capital and increasing investment.  Other cross-country analyses are less positive about the quantity effect of financial liberalization.  For instance, Bonfiglioli (2005) using information for 93 countries shows that financial liberalization marginally affects capital accumulation and hence investment.    Moreover, Bandiera et al. (2000) reviewed the impact of financial liberalization on saving based on information from eight developing countries over a 25-year period and found that savings rates actually fall, rather than increase, after financial liberalization.

From the foregoing, it could be seen that findings from extant research on the impact of financial liberalization on investment and growth remains inconclusive.  Further studies, perhaps, at micro (firm)-level may shed greater light as observed by Carruth et al. (1998) “the apparent inconsistencies in the results reveal the crucial importance of disaggregation when attempting to identify the impact of financial liberalization on investment and also highlights the need for appropriate econometric techniques that can integrate both time-series and cross-section information.  Moreover, it is apparent that there is a high degree of heterogeneity across industries which may potentially bias the results from any aggregate-level study.  Given these conclusions, it is clear that the use of company-level panel data, with its even higher level of disaggregation coupled with its greater data variability, is likely to be advantageous…”