Lessons of Financial Liberalization in Asia: A Comparative Study. - book reviews

Business Economics, July, 1991 by Clifford Tan, C.H.

EVEN A CASUAL observer of international finance in the past decade will have realized that rules of the game are changing before his eyes. While events connected with Japan and Europe have grabbed most of the headlines, the financial deregulation steamroller has also affected emerging markets in Asia.

Growth in emerging Asian markets presents a seemingly attractive source of future profits. But because of a history of government intervention and the small number of players, aspiring entrants must tread carefully. There is no substitute for country knowledge and keeping up with regulatory changes, and this book provides some of each.

Changes in Asian financial markets reflect partly policy advice given by the World Bank and other development agencies in the 1980s, which in turn reflect neoclassical thinking and reliance upon markets and competition. Critics paint LDC financial markets as "repressed" arenas where government-dictated low interest rates, coupled with rapid money expansion and high inflation, produce negative real rates of return for those foolhardy enough to stay in the regulated sector. This policy discourages savings, it is claimed, and overall the financial sector shrinks when assets are converted to other forms. Further, artificially low lending rates mean that loanable funds must be rationed - often in ways that reflect more the dictates of politics rather than prudent investment.

The preferred solution is for government to get out of the financial intermediation business, i.e., stop setting interest rates and allocating credit. To varying degrees, this was tried in Indonesia, Korea, Malaysia, the Philippines and Sri Lanka in the past decade. Cho and Khatkhate set out to review what happened and glean lessons.

Ferreting out the impact of liberalization is no easy task. Liberalization progressed under widely differing economic conditions - just think of Korea and the Philippines - differences which obscure the roles reform played. Also, reform in these countries did not mean the type of free competition critics wanted. Even in Korea, this book's leading success story, the government closed out the 1980s with pump-priming measures that included action to "lower" lending rates by a percentage point, hardly the language of free market determination.

Cho and Khatkhate focus on lessons of liberalization in the small - effects on interest rates, banking efficiency, and corporate financing - and in the large - effects on savings (and by implication long-run growth) and stabilization policies. Data limitations excluded an examination of whether liberalization improved the efficiency of investment allocation.

Interest rate effects were surprisingly and, at times, puzzlingly small. Where positive real rates obtained, it was due mainly to slowing inflation, as in Korea, Malaysia and the Philippines, implying that lowering inflation was far more important than reform in achieving positive rates. Some markets showed evidence of closer integration following reform. In Korea, continued growth of nonbank financial intermediaries coupled with reforms brought stronger covariation between interest rates within and outside banking. Indonesia's 1983 reform did the same for interest rates of state and private banks; the subsequent introduction of money market instruments with dictated rates, however, resegmented the market. And interest rates in all countries diverged from international rates, in spite of the authors' contention that several countries maintained open capital accounts.

Banking portfolios deteriorated in several countries, although the direct role of liberalization is unclear. Philippine finances nearly collapsed, for example, in the crisis leading to Marcos' exile. Korea's banking system also floundered in 1980, leading the government to abandon reform temporarily to prop up large banks. Korean bank losses, however, appeared more a result of earlier policy than the effects of liberalization. Although the authors say that banking efficiency improved because of increased competition, they present little statistical evidence for it. The spread between returns and cost of funds, for example, actually widened in Malaysia following reform.

Corporate debt-equity ratios in Korea, which declined following liberalization, returned to its mid-1970s level five years after reform. Economic crises sent debt-equity ratios in the Philippines and Indonesia higher, despite higher real lending rates.

Turning to questions of savings and stabilization policy, Cho and Khatkhate agree with recent evidence that, financial liberationists' claims to the contrary, savings appear unresponsive to changes in the real rate. For example, in Indonesia, the savings rate by 1986 had actually dropped to below prereform levels. This conclusion belies the financial liberalization argument that higher real rates will permanently induce a higher flow of savings. What appears to have happened instead is a onetime stock reallocation of assets following reform. In national income data, this temporarily appears as a higher savings rate.