FINANCIAL REPRESSION

 The term 'financial repression', coined by McKinnon, refers to 'the phenomenon where bank credit remains
an appendage of certain enclaves, where ordinary government deficit on current account frequently pre-
empts the limited lending resources of the deposit bank, and financing of the rest of the economy must be
met from the meagre resources of money lenders, pawn brokers, and cooperatives' (McKinnon, 1973:69).
Thus, in financial repression, governments tax and distort the operations of financial markets.
 Furthermore, “Financial repression” refers to a wide array of policies that allow a government to place its
debt with financial institutions at relatively low interest rates.
 In financially repressed systems capital is underpriced by banks. The returns on deposits are low (could be
negative if inflation is significant) as banks do not charge a high enough interest rate to reflect equilibrium
conditions. Potential savers under these circumstances will reduce their holdings on money or near money
and save in tangible assets. This point represents one element of financial repression. Montiel (1995) lists
other elements of financial repression. They include: 
 • Restriction of entry into banking, often combined with public ownership of major banks;
 • High reserve ratio;
 • Legal ceiling on bank lending and deposit rates;
 • Quantitative restrictions on the allocation of credit; and
 • Restriction on capital transactions with foreigners.
Causes and consequences of financial
repression
 Economists have commonly argued that financial repression prevents the efficient allocation of capital and
thereby impairs economic growth. McKinnon, (1973), and Shaw, (1973), were the first to illuminate the notion of
financial repression. While theoretically an economy with an efficient financial system can achieve growth and
development through efficient capital allocation, McKinnon and Shaw argue that historically, many countries,
including developed ones but especially developing ones, have restricted competition in the financial sector
with government interventions and regulations. According to their argument, a repressed financial sector
discourages both saving and investment because the rates of return are lower than what could be obtained in a
competitive market. In such a system, financial intermediaries do not function at their full capacity and fail to
channel saving into investment efficiently, thereby impeding the development of the overall economic system.
 According to Roubini & Sala-i-Martin,(1991) governments repress financial development by not allowing the
financial sector to operate at its full potential by introducing all kinds of restrictions, laws and non-market
restrictions to the behaviour of banks and other financial intermediaries.
 Financial repression also takes the form of government directives for banks to allocate credit at subsidized rates
to specific firms and industries to implement industrial policy. Forcing banks to allocate credit to industries
that are perceived to be strategically important for industrial policy ensures stable provision of capital rather
than leaving it to decisions of disinterested banks or to efficient securities markets. It is also more cost effective
than going through the public sector‟s budgetary process Kirkegaard & Carmen, (2012). Government directives
and guidance sometimes include detailed orders and instructions on managerial issues of financial institutions
to ensure that their behavior and business is in line with industrial policy or other government policies. The
Japanese Ministry of Finance (MOF) is a typical example of government‟s micromanagement of financial
industry.
Causes and consequences of financial
repression cont
The extreme example of direct state control of banks is
nationalization of banks as was observed in Mexico in the
1980s, when the government nationalized all the banks to
secure public savings. According to Magud, et al (2011), in
support of financial repression noted that throughout history,
debt/GDP ratios have been reduced by (i) economic growth;(ii)
a substantive fiscal adjustment/austerity plans; (iii) explicit
default or restructuring of private and/or public debt; (iv) a
sudden surprise burst in inflation; and (v) a steady dosage of
financial repression that is accompanied by an equally steady
dosage of inflation. The author found that financial repression
in combination with inflation played an important role in
reducing debts.
How liberalization helped correct this phenomenon.

 The financial repression of the 1970s and 1980s reflected a mix of state- led development,
nationalism, populism, politics, and corruption.
 The financial system was treated as an instrument of the treasury: governments allocated
credit at below- market interest rates, used monetary policy instruments and state-
guaranteed external borrowing to assure supplies of credit for themselves and public
sector firms, and directed part of the resources that were left to sectors they favored.
 State banks were considered necessary to carry out the directed credit allocations, as well
as to reduce dependence on foreigners. Bank supervisors focused on compliance with the
often-intricate requirements of directed credit rather than with prudential regulations.
Interest rates to depositors were kept low to keep the costs of loans low.
 Governments had to allocate credit because they set interest rates that generated excess
demand for credits. Capital controls were needed not (as often argued) to protect
national saving, but to limit capital outflows fleeing low interest rates and
macroeconomic instability, and to increase the returns from the inflation tax. 3 In effect,
capital controls were a tax on those unwilling or unable to avoid them and they
encouraged corruption (Hanson 1994).
Factors behind financial liberalization

 Three general factors provided an impetus for the

move to financial liberalization:

Poor results
High costs
Pressures from globalization
Evolution of Financial liberalisation
The shift in policies differed in timing, content, and speed from country to country and included many
reversals. Broadly:
African countries turned to financial liberalization in the 1990s, often in the context of stabilization and
reform programs supported by the International Monetary Fund and World Bank, as the costs of
financial repression became clear.
In East Asia, the major countries liberalized in the 1980s, though at different times and to different
degrees. For example, Indonesia, which had liberalized capital flows in 1970, liberalized interest rates in
1984, but Korea did not liberalize interest rates formally until 1992. Low inflation generally kept East
Asian interest rates reasonable in real terms, however. In most countries, connected lending within
industrial- financial conglomerates and government pressures on credit allocation remained important.
In South Asia, financial repression began in the 1970s with the nationalization of banks in India (1969)
and Pakistan (1974). Interest rates and directed credit controls were subsequently imposed and
tightened, but for much of the 1970s and 1980s real interest rates remained reasonable. Liberalization
started in the early 1990s with a gradual freeing of interest rates, a reduction in reserve, liquidity, and
directed credit requirements, and liberalization of equity markets.
In Latin America, some episodes of financial liberalization occurred in the 1970s but financial
repression returned, continued, or even increased in the 1980s, with debt crises, high inflation,
government deficits, and the growth of populism (Dornbusch and Edwards 1991). In the 1990s,
substantial financial liberalization occurred, although the degree and timing varied across countries.
Evolution continues…….
At very different speeds in different countries, interest rate liberalization came to be
supplemented by other changes:
Central banks were made more independent. They abandoned their earlier
developmental role to focus on limiting inflation, often in the context of stabilization
programs.
Reserve requirements and directed credit were eased.
Capital accounts were liberalized, even in countries where domestic foreign currency
instruments remained banned. Foreigners were allowed to participate in capital
markets9 and private corporations were allowed to raise funds offshore.
 Markets were set up for central bank debt and government debt. Equity markets
were set up in the transition countries and liberalized where they already existed.
In some countries, pension systems added defined contribution/defined benefits
elements, often operated by private intermediaries.
Gradually, state banks were privatized. Banking competition increased, as a result of
the entry of new domestic and foreign banks and, in some cases, non-bank
intermediaries.
Outcomes in financial sectors due to financial liberalization

 Deposit growth
 Bank deposits grew as a share of GDP in the 1990s, unlike the 1980s as purported by
Hanson 2003b). And in India and some East Asian and Latin American countries, non-
bank deposits supplemented the rapid growth in bank deposits. Thus, a major objective
of financial liberalization was successfully achieved in most major countries and most
regions. Box 7.1 discusses the resumption of deposit growth in India as it gradually
liberalized, as well as the growth of its capital market.
 Financial liberalization increased financial resources
 A financially liberalized economy tends to generate more financial resources than a
repressed economy—an old lesson (McKinnon 1973; Shaw 1973) that was forgotten. In the
1990s, the growth in bank deposits (relative to GDP) speeded up in many countries, after
slowing during the financially repressed 1980s. The speed-up reflected lower inflation,
more realistic interest rates, and a wider menu of financial instruments, including foreign
exchange denominated instruments. In addition, domestic capital markets were started
and developed and private firms increased their external borrowing and external equity
issues.
Outcomes continue……
 Deposits and domestic capital markets performed best where growth was already rapid, where
there was a history of high deposit mobilization, and where investors were willing to take risks
to get equity shares in rapidly growing corporations—East Asia and India. Elsewhere, deposit
growth was less and capital market performance was less good. Deposit growth picked up
much less in Latin America, reflecting its history of inflation and government intervention.
Also, much of the growth was in foreign currency deposits that complicated policymaking. The
decline in listings in equity markets in Latin American and transition economies suggests that
access to finance through equity issues did not widen much.
 Led to Macroeconomic stability
 Another old lesson is that successful financial liberalization and successful finance depend on
macroeconomic stability (World Bank 1989). If anything, open capital accounts and volatile
international capital flows place a larger premium on sound macroeconomic management.
However, financial reforms, or at least more market-based interest rates, were often put in
place in the 1990s in the midst of macroeconomic imbalances, complicating what was already a
technically difficult problem. For example, countries with unsustainable fiscal policies often
used financial liberalization to continue their debt build-up and delay adjustment. Even when
fiscal deficits were smaller than in the 1980s, the countries that liberalized finance often had
large external and internal debt overhangs that contributed to volatility.
Part B) Based on evidence, do interest rate increases following financial
liberalisation promote investment and growth as argued by Shaw and McKinnon
or cause stagflation(as argued by neo structuralists)?

 The essential message of the McKinnon-Shaw hypothesis is that a low or negative real
interest rate discourages savings; and hence, it reduces the availability of loanable funds.
McKinnon’s explanation of how interest rates impact on savings, investment, and growth,
is based on three assumptions.
 The first is that economic agents are confined to self-financing when undertaking
investment. The second assumption is that investment expenditures are indivisible and
lumpier than consumption expenditures.
 Thirdly, it is assumed that the formal financial sector concentrates mainly on providing
credit to urban, modern, and export industries, since these are the priority sectors of the
economy
 The essential message here is that at low real interest rates, people would not want to
hold much money, because low interest rates produce a bias in favour of current
consumption. It is also worth noting that, according to McKinnon’s hypothesis, low
interest rates in developing countries only increase the desire to invest, but not the
realised investment (or actual investment) – because loanable funds are assumed to be
scarce in developing countries (Odhiambo, 2004c).
Shaw and McKinnon hypothesis
 McKinnon argues that the financial markets in less developed countries are fragmented. The
repressed capital markets that typify these countries therefore retard the efficient allocation of
resources. This is what forces these countries to rely heavily on internal sources of finance. And
this leads to low-quality investment and the retention of traditional technology. According to
McKinnon, a policy of high interest rates helps to mobilize savings and to channel them into more
productive investment opportunities. Hence, complementarity exists between money and
physical capital in the production process of less developed countries (Odhiambo, 2004c).

 According to the McKinnon-Shaw hypothesis (hereinafter referred to as M-S hypothesis),

deregulating the financial system raises interest rates, which then encourages more people to
demand financial savings. These in turn lead to increase in the quantity and the quality of
domestic investments. The first theoretical pillar to the independent works of McKinnon (1973)
and Shaw (1973) is on the premise that interest rates have a positive relationship with economic
growth via investment and that financial repression, far from being regarded as growth
promoting, is deleterious to investment and economic growth. However, the transmission
mechanism or the ‘channel of influence’ of how interest rates affect investment differs according
to the viewpoints of these two economists. McKinnon (1973) posits that potential investors must
accumulate money balances prior to investment.
Shaw and McKinnon hypothesis
continues…..
 He argues that money holding and capital accumulation are complementary in the developing process, which
is in contrast to the neoclassical monetary growth theory. He contends that because of the lumpiness of
investment expenditure and the reliance on self-finance, agents need to accumulate money balances before
investment takes place. Positive (and high) real interest rates are necessary to encourage agents to accumulate
money balances, and complementarities with capital accumulation will exist as long as the real interest rate
does not exceed the real rate of return on investment. A higher real deposit rate of interest provides an impetus
for firms purporting to finance investment projects. Shaw (1973), on the other hand, emphasizes the
importance of financial liberalization for financial deepening, and the effect of high interest rates on the
incentive to save and disincentive to invest in low-yielding projects. The increased liabilities of the banking
system, resulting from higher real interest rates, enable the banking system to lend more resources for
productive investment in a more efficient way.
 According to him, measures to raise real rates of return on financial assets, to reduce the variance of returns,
and to improve financial technology, along with measures in non-financial areas, extend savers’ horizons over
both space and time. Shaw, therefore, included debt intermediation in his model of financial repression,
reflecting what investors could borrow. He also included opportunity costs (in real terms) of holding money,
such as non-monetary financial assets and inflation hedges. However, the point of convergence with McKinnon
is that he also places premium on the role of deposits as a source of funds for financial intermediaries. As he
explains, the expanded financial intermediation between savers and investors as a result of higher real interest
rates increase incentives to save by means of deposits. This then stimulates investment due to an increased
supply of credit, and raises the average efficiency of investment. In sum, the important policy conclusion
emanating from the M-S hypothesis is that financial liberalization policies that lead to a deregulated interest
rate result in an increase in the nominal deposit rate which undoubtedly stimulates savings and investments.
Neo-Structuralists argument
 The main critics of the McKinnon (1974) and Shaw (1974) hypothesis are the neo-structuralists.
Highlighting the difference between the formal and informal financial sector, they criticise the
financial liberalisation hypothesis from a macroeconomic perspective. The ideas of Taylor
(1983) and Van Wijnbergen (1983) are eminent in this school of thought.
 Van Wijnbergen (1983), in his critique of the McKinnon (1973) and Shaw (1973) framework,
formulates a short run model in order to explain the relationship between time deposit rates,
bank lending rates and the level of economic activity. His model provides a realistic description
of the portfolio allocation problem faced by wealth holders and applies financial markets in a
typical developing country. He assumes that wealth holders hold their assets either as currency,
direct loans to curb markets (also referred to as the unorganised money market or informal
financial sector) or as time deposits. The decision on which type of asset to hold is described by
a Tobin-style portfolio model and depends on the real rate of return on the three assets, real
income and real wealth. He further assumes that private time deposits are the only source of
funds for the banks, out of which they are obliged to hold reserves. Banks then apportion their
remaining financial assets between free reserves and loans, depending on the rate of inflation
and the bank lending rate. Ideally, firms are required to take advantage of every loan that the
banks are willing to offer, especially as the loans are offered below the market rates of interest.
According to him, any surplus credit needs is satisfied by the curb markets which always clear
through changes in the curb market rate of interest.
Neo Stracturalists continues……
 Van Wijnbergen (1983) also analyses the substitution effects generated by changes in the time deposit rate
and the effects of these changes on the level of economic activity and growth. Assuming on one hand that
the time deposit rate is increased as part of the liberalisation policy, he claims that this change does not
directly impact on the market for goods however, it alters the asset portfolio that economic agents are
willing to hold as they will prefer to hold time deposits rather than currency. The implication of this
portfolio shift according to Van Wijnbergen (1983) is that credit availability will increase and banks can
grant more loans to firms for investment purposes. On the other hand, if the rise in time deposits induces
economic agents to deviate from holding curb market loans to time deposits instead, credit availability will
decline because funds are moved away from the curb markets which are unregulated and not subject to
reserve requirements to the banks which are highly regulated and subject to reserve requirements. The
magnitude of the latter impact, he claims, is reliant on the reserve requirement level in the formal sector
and the relative size of the curb markets. The implication of this change, according to Van Wijnbergen
(1983) is that funds available to firms for investment purposes will decrease, leading to a decline in the level
of economic activities and consequently growth.
 The neo-structuralists generally anticipate that the second impact prevails, meaning that as the time
deposit rate increases, funds will be shifted away from the curb markets, leading to a decline in the
supply of credit. Higher interest rates lead to an increase in working capital costs for investors, thus
leading to a decline in supply. On the assumption that this supply side effect exceeds the demand
effect, the rate of inflation will rise. Thus, Van Wijnbergen (1983) asserts that the effect of interest
rate liberalisation on the economy is far from beneficial due to the fact that it leads to a fall in output
and investment and a rise in inflation.
Neo-structuralists continues……
Taylor (1983) also disagrees with McKinnon (1973) and Shaw (1973) claim of the
positive effect of interest rate liberalisation on economic growth for two reasons.
Taylor (1983) maintains that a rise in the willingness to save (as a result of an
increase in real interest rates due to interest rate liberalisation) leads to a reduction
in aggregate demand and may cause economic contraction rather than economic
growth. This argument is in line with the Keynesian critique of the liberalisation
hypothesis as illustrated by Burkett and Dutt (1991). Furthermore, he argues that the
impact of a rise in the real deposit rate and consequently bank deposits depends to a
large extent on the origin of the deposits. Taylor (1983) advocates that deposits could
come from unproductive assets such as gold or from deposits in the informal
financial sector, also referred to as the curb markets. If the deposits originate from
the assets which were formally unproductive such as gold, then there is likely to be a
positive impact on the availability of credit and capital formation. On the contrary,
if bank deposits originate from the curb markets, the entire the entire credit supply
in the economy could decline easily. This effect occurs because the curb markets are
not subject to reserve requirements whereas banks are.
Savings patterns in Africa
Conclusion
Part C) Discuss why the effects of financial deregulation would
be weaker in lower income countries
 The search for ways of improving the living standard of citizens through enhanced sustainable development
has created a new corridor for the deregulation of financial sector. This sustainable development entails
development which meets the needs of the present without compromising the ability of future generations
to meet their own needs (Onwumere, Onudugo & Ibe, 2013). Jalloh (2011) contended that a well-designed
financial system provides incentives for investment that fosters trade and business linkages thereby
facilitating improved resource and technological innovation. Given the benefits associated with having
well-functioning financial systems, a number of low income countries, have attempted to put in place
various measures to develop their financial sector with a view to enhancing economic growth. Financial
deregulations have therefore been widely used as a policy measure to encourage the development of
domestic financial systems as well as the dismantling of barriers to international capital flows
(Omankhanlen, 2012).
 Most of less developed countries are highly regulated leading to financial disintermediation which
had retarded the growth of the economy (Orji, Anthony-Orji & Mba, 2015). Most third world
countries had in the past used governmental interventions as a tool in allocation of resources. These
interventions have been described as not only repressive but a major factor retarding the process of
the growth of the economy. Hicks (1969) noted that the financial system plays a crucial role in the
mobilization of capital for industrialization while Robinson (1952) argued that economic
development creates demand for certain financial instrument, Honohan (2000) contended that
deregulation and its overall effects are to induce competition within the financial services industry.
Despite all these positive views, most of Low income countires financial sector has not achieved the
expected objective.
Financial Sector Deregulation and
Economic Growth
 The financial sector of any economy in the world plays a vital role in the development and growth of the economy.
The development of this sector determines the ability of a nation to effectively and efficiently discharge its major
role of mobilizing fund from the surplus sector to the deficit sector of the economy. This sector has helped in
facilitating the business transactions and economic development. If a financial sector is well developed, it will
enhance investment by identifying and funding good business opportunities, mobilize savings, enable trading,
hedge and diversify risk and facilitate the exchange of goods and services. All these result in a more efficient
allocation of resources, rapid accumulation of physical and human capital, and faster technological progress,
which in turn results in economic growth (Orji, Anthony-Orji & Mba, 2015). Economic growth is a gradual and
steady change in the long-run which comes about by a general increase in the rate of savings (Jhingan, 2005). An
economy is said to be growing when it increases its productive capacity which later yields in production of more
goods and services. It is the yardstick for raising the standard of living of the people. This is made possible
through a well developed financial sector (Jhingan, 2003; Akingunola, Adekunle & Badejo, 2013).
 Financial sector deregulation encompasses an act by which the government regulation of a particular industry is
reduced or eliminated in order to create and foster a more efficient market place. Deregulation of the financial
sector aims at stabilizing and fundamentally restructuring the economy and places it on a durable and suitable
growth path (Ifeanyi & Chukwu, 2014; James, Richard & Victor, 2013; Ahmed, 1993; Jalloh, 2011). Those in favour of
deregulation argue that financial institutions, as intermediaries, affect the level of savings and the distribution of
investment funds positively, thereby encouraging economic growth. The premise upon which this conclusion is
based is competition. Increased competition between financial institutions leads to an increase in interest rates
on investment, which reduces the spread between rates on investment and lending. This ensures optimal credit
allocation by channeling funds to the most feasible investment projects. The overall impact on economic
development and welfare is positive (Mc Grath, 2005; Akingunola, Adekunle & Badejo, 2013).
Financial Sector Deregulation and
Economic Growth Cont…….
Financial sector deregulation in low income countries haven’t yielded much as the
performance of their economies has remained relatively low in spite of the various
reforms and institutional changes put in place by the monetary authorities. It has
been noted that most of this countries, for instance Nigeria experience a low level of
monetization of the economy and the level of private sector credits have negatively
affected the level of financial deepening on economic growth. This implies that
financial sector deregulation has not really increased the depth of the financial
system which would consequently impact positively on the economy.
It is therefore recommended that an enhancement of private sector investment
through financial sector credits and through a combination of macroeconomic
stabilization which would surely enhance the performance of economic growth. Also,
in order to consolidate the gains from financial sector deregulation, government
should avoid drastic policy reversal but rather, concentrate efforts in fine-tuning the
existing policy measures which will not only compel prudence on the part of major
operators in the financial market but also stimulate saving behaviour of all economic
agents. This will go a long way at enhancing mobilization of funds in the country.