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See discussions, stats, and author profiles for this publication at: https://www.researchgate.net/publication/228289397 Financial Reform - Literature Review on Theory and the Experiences of Developing Countries:The Case of Egypt Article in SSRN Electronic Journal · June 2010 DOI: 10.2139/ssrn.1976676 CITATIONS 0 READS 82 1 author: Ahmed RostomGeorge Washington University 13 PUBLICATIONS 23 CITATIONS SEE PROFILE All content following this page was uploaded by Ahmed Rostom on 04 December 2016. The user has requested enhancement of the downloaded file. All in-text references underlined in blue are added to the srcinal documentand are linked to publications on ResearchGate, letting you access and read them immediately. Electronic copy available at: http://ssrn.com/abstract=1976676 Financial Reform Literature Review on Theory and the experiences of Developing Countries: The case of Egypt Ahmed Rostom 1 (
[email protected]) This Version: June 30 th , 2010 Abstract: Keynes (1937), Tobin (1965) and their followers believe that financial repression reflects on higher savings, investment and economic growth through monetary expansion and by lowering interest rates. Financial liberalization theorists (such as McKinnon and Shaw 1973) contested this position, emphasising the need for a determined interest rate, in order to ensure better intermediation and a more effective allocation of financial resources, especially in developing countries. The experience of Egypt — which has followed a financial reform program as part of its economic reform since the 1990‘s supports the view that financial development contributes to the momentum of economic growth. JEL Classification Numbers: E44, G0, G18, O11, O16 1 This is based on the author ‘ s earlier dissertation submitted in partial fulfilment of the academic requirements for the award of the degree of Master of Science in Economics and Social Policy Analysis (ESPA) at the University of York – UK in May 2007. This paper can be also found on the World Bank ‘ s website at http://lnweb90.worldbank.org/exteu/SharePapers.nsf/($all)/274442C3C7E50EBB852573A700322670/$File/AHMED+ROSTOM+SUBMITTED+YORK+DISSERTATION.PDFhttp://lnweb90.worldbank.org/exteu/SharePapers.nsf/($all)/274442C3C7E50EBB852573A700322670/$File/AHMED+ROSTOM+SUBMITTED+YORK+DISSERTATION.PDF Electronic copy available at: http://ssrn.com/abstract=1976676 ii Keywords: Financial reform, repression, financial liberalization, McKinnon-Shaw hypothesis, Egyptian financial reform program. Table of Contents Page I. Introduction 1 II. Theoretical Developments 4 i. Financial Repression and Government intervention in financial markets 4 a. Keynesian liquidity trap 4 b. Tobin‘s portfolio and inflation tax 5 ii. McKinnon and Show Hypothesis for financial liberalization 7 iii. Some similarities and differences between the approaches of “repressionists” and “liberalizers” 11 iv. Further theoretical developments 12 a. First Generation Models 12 b. Second Generation Models 16 v. Criticism of financial liberalization 19 a. Informal credit markets 19 b. Effective demand and the demand for bank credit 19 c. Information asymmetries and adverse selection in financial markets 20 III. Developing countries‘ experience in financial reform – the case of Egypt 21 i. Economic Policies and the development of the Egyptian financial sector – a historical review 21 ii. Pre- and Post-reform macroeconomic performance 25 iii. Review of empirical contributions on the Egyptian financial liberalization experience. 31 IV. Conclusion and Policy implications 36 V. References 37 VI. Appendices 40 1 I. Introduction The main tasks of finance are to mobilize resources and allocate them efficiently. This is carried out through an intermediation mechanism that allows for the diversification and hedging of various risks, thereby permitting economic agents to concentrate on other productive activities and to utilize financial resources efficiently. (Caprio, Atfyas and Hanson, 1993) The precise objectives of financial intermediation vary across the literature on the subject. Nonetheless Levine (2004) summarized five of the main functions of financial systems. These are: • To produce information ex ante about possible investments and capital allocation; • To monitor investments and exert corporate governance • To facilitate the trading, diversification, and management of risk • To mobilize and pool savings • To ease the exchange of goods and services It can therefore be seen that the objectives of financial intermediation are constrained by regulations and the availability of capital. They are also focused on corporate governance monitoring and saving mobilization as basic functions. While all financial systems provide these financial functions, there are large differences in how well financial systems do so. Historically, and prior to the 1970's, financial restrictions were often imposed specifically in capital-scarce countries. Government intervention was a binding factor in financial policies — on the grounds that usury could be better prevented, money supply better controlled, and higher investment-savings targets met than if financial markets were liberalized. (Denizer, Desai and Gueorguiev, 1998) However, d uring the 1950s and ‗60 s, distortions evolved in developing countries. Ceilings on nominal deposit and loan rates were in general lower than the actual or expected inflation rates. This was followed by limited growth in the financial sector, which was severely affected by a combination of repressive financial policies and inflationary explosion. Such repressive policies depressed savings and distorted the 2 allocation of resources. Moreover, they were further intensified by inefficient investment through the low borrowing cost of already scarce capital. (Fry, 1997). Therefore, it appears that repressive financial policies have caused the misallocation of financial resources, resulting in economic depression and unsustained growth. This has caused a growing belief that the objective of financial repression adopted in developing countries is to obtain resources to finance governments‘ deficits. In the 1970s, the governments of developing countries governments realised that strict regulations and extensive intervention into financial markets could distort their financial structures. In particular, negative interest rates eroded both real value of savings and the potential purchasing power of financial assets. This is in addition to reduced investment efficiency, and contracted economic capacity. The result of which was expectations of devaluation and deteriorating macroeconomic performance, and loss of confidence in the domestic currency. This situation was compounded by the impact of highly volatile interest rates, flexible exchange rates and competitive with deregulated and innovative financial markets. The global trend for financial reform 2 policies started in the 1980s when governments, central banks and other market participants realized that market rigidities and inefficiencies increased social and financial costs. Reform policies set out to: Abolish interest rate ceilings Ease the entry of new financial institutions into the market Lift restrictions on foreign currency payment Open domestic financial systems to competitive market conditions. The reforms taken by governments and monetary authorities aimed at increasing the role of market forces in determining interest and exchange rates allocating credit and structuring financial intermediation. The financial reform process generally involves eliminating the financial market distortions created by extensive government intervention. 2 ―The term financial reform is used inter changeably with [the] terms financial liberalization, financial deregulation and financial deepening.‖ (Bascom, 1994 p.1)
