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Essence of financial liberalization[1]

Essence of financial liberalization[1]

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Published by: damsana3 on Aug 26, 2008
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I.Essence of financial liberalization1.What is financial liberalization?
Financial liberalization can be defined as a set of reforms and policy measuresdesigned to deregulate and transform the financial system and its structure with aview to achieving a liberalised market-oriented system within an appropriateregulatory framework.Specifically, the objective of financial liberalization is to promote the role of themarket and to minimize the role of the state in determining who gets and gives creditand at what price, or as stated by McKinnon (1973), the primary objective of financialliberalization is to eliminate financial sectors from “financial repression.”The success of financial sector reform throughout the world has seen the introductionof market-based procedures for monetary control, the promotion of competition in thefinancial sector, and the relaxation of restrictions on capital flows. Specifically, themove away from a tightly controlled financial sector to a deregulated one results ingreater flexibility in interest rates, enhancement of the role of markets in credit andforeign exchange allocation, increased autonomy for commercial banks, greater depth of money, securities, and foreign exchange markets, and a significant increasein cross-border capital flows.
In details, the key components of financial liberalization are the following: (a)deregulation of interest rates; (b) removal of credit control; (c) privatisation of government banks and financial institutions; (d) liberalization of restrictions on theentry of private sector and/or foreign banks and financial institution into domesticfinancial markets; (e) introduction of market based instruments of monetary control;and (f) capital account liberalization (Singh, 2000).Based on the above six components, the scope of financial liberalization can be seeneasily. Operationally financial liberalization does not only consist of the tightbudgetary policy and the removal of subsidies but also includes the privatisation of state owned enterprices. For example, the removal of credit control has a direct
relationship with the removal of subsidy from statepowned enterprises credit. Theprivatisation of state-owned banks and financial institutions has also a direct link withthe privatisation of state owned enterprises. While the removal of restrictions for foreign banks to enter domestic financial markets, indirectly relates to tradeliberalisation.
2.Benefits of financial liberalization
When a particular jurisdiction decides to open up its financial system and its financialmarkets to the outside world, it does so for a variety of very good reasons.A common view is that capital account liberalization leads to the development of financialmarkets that channel funds to borrowers with the most productive investmentopportunities.3Theory suggests several mechanisms for this occurrence. First, financialliberalization maymitigate financial repression in protected financial markets, allowing the real interestrate to rise toits competitive market equilibrium (McKinnon, 1973; Shaw, 1973). Second, theremoval of capitalcontrols allows domestic and foreign investors to engage in more portfoliodiversification, therebyreducing the cost of capital, and increasing the availability of funds. Third, and notleast, theliberalization process usually increases the efficiency of the financial system byweeding outinefficient financial institutions and creating greater pressure for a reform of thefinancialinfrastructure, alleviating information asymmetry issues such as adverse selectionand moral
As has often been pointed out, the presence of foreign financial intermediaries withinternational repute and experience - banks, including investment banks, and stock-brokers of various descriptions - increases the efficiency of financial intermediationand therefore promotes economic growth and development. Indeed, this has beenthe experience of many "emerging" markets. The presence of foreign banks tends toincrease competition, which, in turn, sharpens the competitive edge of domesticbanks. The increased efficiency will be translated eventually into higher returns for domestic savings and cheaper cost of funds for borrowers. There will also be greater efficiency in the pricing of credit and other risks, and therefore in the allocation of credit generally. Equally convincing arguments apply to the equity and debt channelsof financial intermediation. Foreign experience and expertise in the organisation of initial public offerings, supported by liquidity and an efficient price discoverymechanism in the secondary market, increase the quantity as well as the quality of the flow of domestic savings into domestic investments. The development of thedomestic debt market to increase the diversity of funding and therefore improve theoverall stability and resilience of the process of financial intermediation can alsobenefit from foreign experience and expertise.
3.Risks of financial liberalization
But it has always to be alert to the risks that are associated with financialliberalisation.There may be legitimate concerns over the chances of survival of domestic financialinstitutions when they are exposed to intense foreign competition, with consequencesfor general confidence in the financial system and financial stability. There may alsobe concerns, more so at the political rather than the professional level, about thebehaviour of foreign financial institutions, as against that of indigenous ones, at times

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