For more than a decade, financial liberalisation as been cited as a necessary and significant part of an economic policy package promoted by what used to be called the “Washington Consensus.” Typically, financial sector liberalisation in developing countries has been associated with measures that are designed to make the central bank more independent, relieve “financial repression” by freeing interest rates and allowing financial innovation, and reduce directed and subsidized credit, as well as allow greater freedom in terms of external flows of capital in various forms. Increasingly, these policies are not imposed from outside, whether through the conditionality of multilateral lending institutions or bilateral pressure. Rather, policy makers, and especially those in finance ministries across the developing world, appear to have absorbed and internalized the idea that such measures are necessary to improve the functioning of the financial sector generally, in terms of profitability, competitiveness and intermediation, as well as to attract international capital to increase resources available for domestic investment.
Yet, the arguments in favour of financial liberalisation – both theoretical and empirical – are relatively flimsy, and there are many grounds for scepticism regarding the claims made by the votaries of such measures. Indeed, there are good reasons for questioning both the extent and the pattern of the kind of financial liberalisation that is promoted. In many cases, the social and economic effects have been especially adverse for the poor and for farmers and workers, who have not only suffered more precarious conditions even during a so-called “financial boom”, but two have typically also been the worst affected during a financial crisis or the subsequent adjustment. It is also worth noting that the extreme forms of liberalisation are neither effective nor necessary, and that a large variety of alternative measures, as well as varying degrees of liberalisation, is not only possible but can also be observed in several more ‘successful’ developing countries. Financial liberalisation refers to measures directed at diluting or dismantling regulatory control over the institutional structures, instruments and activities of agents in different segments of the financial sector. These measures can relate to internal or external regulations (Chandrashekhar, 2002).
Underlying most of the arguments for financial liberalisation measures are some basic monetarist hypothesises, namely: (i) that real economic growth is determined by the available supply of factors of production such as capital and labour and the rate of productivity growth, and changes in money supply do not have any impact on real economic activity and the growth of output; (ii) that money supply is exogenous rather than endogenous to the system and can be controlled by the monetary authorities, who can successfully pursue well-defined targets for monetary growth, and (iii) that inflation is attributable to an excessive growth of money supply relative to an exogenously given “real rate of growth of output” and can be moderated by reducing the rate of growth of money supply. These postulates can then lead to arguments for an “independent” central bank whose essential job would be to control inflation by using money market levers to control money supply and therefore the price line. The basic difficulty with these arguments is now rather well known. There is no clearly discernible relationship between the rates of growth of money supply and of inflation on the one hand and real output growth on the other. The monetarist argument is based on the twin assumptions of full employment (or exogenously given aggregate supply conditions) and aggregate money supply determined exogenously by macro-policy. Neither of these assumptions is valid; on the contrary, there is a strong case for arguing that, in a world of financial innovation where quasi-moneys can be created, the overall liquidity in the system cannot be rigidly controlled by the monetary authorities.
Rather, the actual liquidity in the system is endogenously determined. Therefore, the real money available in the hands of the government is the interest rate, and thus, attempts to control money supply typically end up as forms of interest rate policy instead. The process of development involves the large- scale transformation in the pattern and composition of economic activity and the achievement of a substantial rise in productivity in the domestic economy through the absorption and movement of underutilized labour and capital. This structural transformation has been ‘associated with a shift of the population from rural to urban areas and a constant reallocation of labour within the urban economy to higher-productivity activities’ (UNCTAD 2011, p. 6.). An extensive economic transformation is necessary to obtain higher standards of living and involves a permanent change in a nation’s role in the global economy. In this formulation, the reduction of poverty or the achievement of higher standards of living is a consequence of the transformation of economic activities. Development is not just “human development” meaning higher levels of income, nutrition, education, and health outcomes but instead human development entails higher levels of productivity and capabilities achieved by societies and the individuals that comprise them (Sen, 1985). This differentiation of development as being more than higher incomes, nutrition, education, and health outcomes is not an idle one. Development requires the introduction of new and more productive jobs for people. Thus, significant investment in new activities and products, not just anti-poverty programs, is indispensable.
The flow of funds can tell how the financial system in general, including both the parallel or curb markets and the organised banking system allocates funds in the presence of rationing and other direct controls. Dr. Amartya Sen, studies the impact of monetary policy in India where, until the liberalisation of 1990s, the Reserve Bank relied heavily on reserve ratios and credit controls as its main policy instruments (Sen, 1996). If markets are liberalised, flow of funds analysis permits an understanding of the liberalisation (Moore, 2001). When we look at the Korean financial crisis, Chang et al (1998) argue that the three most contentious issues regarding the origins of the Korean Crisis were namely financial liberalisation, industrial policy, and corporate governance. The authors argue that it was the dismantling of the traditional mechanisms of industrial policy and financial regulation, rather than the perpetuation of the traditional regime, that generated the crisis. They also point out that the allegedly pathological corporate governance system was neither a main cause of the crisis on its own, nor something that needs radical restructuring in the Anglo-American direction before the country could resume its growth.
Before the propagation of the Washington Consensus in the 1980s, mainstream explanations of the development process and evaluative judgements of the goals of development were both conducted within a national frame of reference. First, economic and social trends within countries were explained, in the mainstream, on the basis of conditions within the countries themselves, i.e. as a result of national factors. Particular external relations might be necessary to start the process, or to close “gaps” which threatened its breakdown. But the key ingredients of a successful development process were usually identified through analyses of sequences of change within already industrialised countries, which were then applied in less developed countries without any reference to their different external situation. Second, development policies were geared toward the achievement of national objectives. This orientation was often simply taken for granted in development policy analysis. But it was also influenced, more or less strongly, by political and economic nationalism. Liberalisation of financial flows does not necessarily promote economic development through international trade. The myth that greater international trade exposure and trade dependence necessarily require greater financial integration and both internal and external financial liberalisation. In fact, the most successful trading economies of the recent past have been those which have relatively more controlled financial systems. China is, of course, the best example, where a major export boom and rapid trade dependence have been associated with a financial system which allows the government not only to systematically channel credit in desired areas, but also to use this as a major macroeconomic instrument for demand management and smoothing business cycles. The rapid expansion of Chinese enterprise does not appear to have been inhibited by such controlled credit, even in the period when mainland Chinese entrepreneurs could not directly access bank credit; neither has the growing integration of China with the world economy been hampered by the absence of any capital market worth the name. Other countries, with a more liberalised financial market, have not seen the levels of economic development that China has been able to hit, thus I conclude by saying that liberalised financial flows are in fact an obstacle to economic development.