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The story really began in 1960s, characterized with an optimistic view that developing countries were economically young and full of potential for growth. Markets in developing countries however were considered very weak, shallow and prone to failure. In financial markets, a primary weakness of capital shortage was seen as an important reason for underdevelopment. Hence, in order to speed up the contribution of the financial system to economic development, government intervention was strongly encouraged. Intervention took the form of interest rate ceilings and direct controls on credit allocation, which forced the financial system to fund government fiscal imbalances as well as to subsidise priority sectors. The control of the government over the financial system led to very low and often negative interest rates on both deposits and loans. Unfortunately, many financial market distortions resulted from the strong interventions of government. The situation of "financial repression", i.e., excess of government intervention in the financial market, was announced by the influential works of McKinnon and Shaw (1973). They point out that financial repression limits economic growth in developing countries and that the ill- functioning of the financial market has become a source of macroeconomic instability. The removal of government controls over the financial market (financial liberalization) - they argued, was the solution to financial repression since it would stimulate savings, investment and economic growth. In the last three decades, many developing countries have been
carrying out interest rate liberalization In Vietnam, the government heavily intervened in the financial sector during the centrally planned period. Such interventions included restrictions on banking entry, capital movements, money reserves, interest rates and credits. This strong financial repression, combined with other factors caused high inflation, and low levels of savings, investment and economic growth during 1986-1988. Economic reform was then strengthened in 1989, which touched all aspects of economic sectors. In the financial sector, interest rate liberalization was considered as the central piece of reform. Interest rates were gradually adjusted towards free-market levels. The rise in the real interest rate has contributed to economic growth through curbing inflation, and raising the level of savings and investment (both in quantity and quality). In line with the process of liberalizing interest rates, the regulatory and supervisory framework governing the financial sector has been improved but still remains weak (WB 1998). The financial market is characterized by a high banking concentration and especially interlocking relations among “State owned enterprises (SOEs)- State owned commercial banks (SOCBs)- Government”. Such a situation has contributed to moral hazard problems. Moreover, economic integration into the world economy has more or less caused Vietnam to fall into the trilemma of exchange rate stability, full financial integration and monetary independence. The small crisis involving short-term capital flows with the default on a number of deferred letters of credit in 1997 raises a question on the policy consistency during the interest rate liberalization process, especially in relation to domestic interest rates, foreign interest rates and exchange rates. All these issues, more than ever, require an appropriate strategy for interest rate liberalization in Vietnam. To date, there has been many works more or less considering the impact of financial reforms generally and interest rate liberalization particularly on the Vietnamese economy, including WB (1990, 1994, 1995, 1996); OECF (1996); McCarty (1994); Tue (1996); Van (1996); Ngan (1996); Ha (1996); Thanh (1997) and Quang (1998). However, it is observed that no systematic study on interest rate liberalization has been undertaken by analyzing lessons from experiences of other developing countries for the purpose of policy implications for Vietnam, given the current economic context. Therefore, the study on “Interest rate liberalization in developing countries: Lessons and policy implications for Vietnam” is an effort to fill these gaps.
The focus and scope of the thesis are as follows: - Issues of interest rate liberalization in developing countries: effects of interest rate liberalization on savings, investment, credit availability and economic growth; factors hampering the success of interest rate liberalization in developing countries, including structural factors and the sequencing of the financial liberalization. - Financial instability experiences involve interest rate liberalization in developing countries in Latin America (Chile, Uruguay, Argentina) and Asia (Malaysia, Thailand, Indonesia, South Korea, the Philippines, Turkey) are considered. These countries are chosen because: (i) they represent different levels of success in interest rate liberalization; (ii) most of their interest rate liberalization experiences involved financial instability; and (iii) information and data on these countries are available. - Interest rate liberalization in Vietnam: effects of financial conditions on savings, financial deepening, investments and economic growth; factors that can hamper the success of interest rate liberalization in Vietnam, including structural factors and sequencing of financial liberalization. - Time frame for Vietnam study: 1986-1999 because the year 1986 marked a turning point in economic reforms in Vietnam, with the “doi moi” policy.
The thesis seeks answers to the following research questions: 1. Why can interest rate liberalization bring beneficial effects to the developing countries involved? 2. What are the experiences of interest rate liberalization in developing countries? Sub- questions: - What are effects of interest rate liberalization on savings, investment, credit availability and economic growth? - What causes the failure of interest rate liberalization in developing countries? 3. What are the policy implications for Vietnam in term of interest rate liberalization, given the current economic context? Sub-questions: -
What are the
effects of financial conditions on savings, financial deepening, investments, and economic growth in Vietnam? -
What
are the major factors that may hamper the success of interest rate liberalization in Vietnam?
Secondary and tertiary data collected from various sources are used in the study, including policy statements, official and unofficial reports, various comments and figures from published studies in the field, newspapers, and conferences. The research methods in the study combine descriptive analysis, historical trends, statistical analysis, and comparative method. Econometric techniques are also used.
The thesis is divided into 4 chapters. Chapter I presents theories and critiques of interest rate liberalization. The major difficulties which hamper the success of financial liberalization in general and interest rate liberalization in particular are also discussed in the chapter. Chapter II documents the interest rate liberalization in developing countries as well as its effects on some main macroeconomic variables. The chapter also analyses major issues in interest rate liberalization in developing countries, focusing on factors hampering the success of the implementation of interest rate liberalization with reference to Latin American and Asian developing countries. Lessons from experiences are then provided in the chapter. Chapter III focuses on interest rate liberalization in Vietnam, analysing effects of interest rate liberalization on savings, financial deepening, investments, and economic growth. The chapter also considers the major factors that may hamper the success of interest rate liberalization in the country. Chapter IV provides main conclusions and policy implications for Vietnam. The chapter seeks answers to the following 2 questions: 1. What are the theories advocating interest rate liberalization? 2. What are the difficulties of the implementation of financial liberalization in general and interest rate liberalization in particular?
Financial repression is observed when the government distorts the
domestic capital markets. As argued by McKinnon (1973), government intervention including
restrictions on interest rate, heavy reserve
requirements on bank deposits, and compulsory credit allocations, interacts
with ongoing price inflation to reduce the attractiveness of holding claims on
the domestic banking system. In such a repressed financial system, real deposit
interest rates on monetary assets are often negative. It therefore causes a
reduction in the demand for domestic money, then a fall in investment and
economic growth.
The distortions and erosions of the financial system resulting from financial repression in developing countries have called for financial liberalization initially developed by McKinnon and Shaw (1973). The primary policy advice of economists advocating financial liberalization is the general freeing and increasing institutional interest rates and/or a reduction in the rate of inflation. This section surveys the McKinnon-Shaw school of thought and criticisms.
The section mentions different models/ approaches to interest rate liberalization, including those of McKinnon (1973), Shaw (1973), Kapur (1976), Galbis (1977), Mathieson (1979), and Fry (1988). A common feature of all the models surveyed in this section, called McKinnon-Shaw school is that the growth-maximising deposit rate of interest is the competitive free-market equilibrium rate. An increase in the deposit interest rate induces a rise in the real supply of credit and hence the rate of economic growth. The policy implication of these models is that economic growth can be achieved through interest rate liberalization- the core policy in financial liberalization policy packages.
The McKinnon-Shaw doctrine of interest rate liberalization has been challenged from various approaches. However, there have been three most influential critics of interest rate liberalization so far. The first group representing the post-Keynesian views (Burkett, Dutt) analyses the outcome of interest rate liberalization based on effective demand of the economy. The second group with new-structuralist views, represented by Buffie (1984), van Wijnbergen (1982), Taylor (1983), emphasises the role of an unofficial market and a working-capital cost-push effect in consideration of interest rate liberalization policies. The third group, typically Wade (1988), Lee (1992) and Stiglitz (1994), maintains its favor of financially repressed systems in facilitating rapid economic growth. The thesis indicates that though the critics of financial liberalization are interesting and suggestive, the ideas seem unable to dilute the benign nature of interest rate liberalization, i.e., the positive effects of interest rates on savings, investment and economic growth, due to the lack of authority.
The McKinnon-Shaw school recognizes that interest rate liberalization difficulties still remain in the presence of adverse factors which supervene in the process but not the logic of the reform /or liberalization. Despite a little debate among the McKinnon-Shaw school about the strategy of interest rate liberalization, the response to the difficulties of interest rate liberalization is their most common. The major constraints to the success of interest rate liberalization, as indicated in the thesis, are imperfect information, macroeconomic (price) instability, inadequate regulation and supervision, and dis-sequencing of financial liberalization. The chapter address the following three questions: 1. What are the effects of interest rate liberalization on developing countries involved in interest rate liberalization? 2. What causes the failure of interest rate liberalization in developing countries? 3. What lessons can be drawn from experiences of interest rate liberalization in developing countries?
The role of government interventions
in economy growth was strongly favoured during the decades of 1950s and 1960s.
However, strong intervention of the government in the economy created heavy
economic repression that progressively distorted economic performance of many
developing countries in 1970s. Macroeconomic performance was poor with large
public sector deficit, high inflation, overvalued exchange rates, low interest
rates and excessive foreign borrowings. In response to these problems,
developing countries then carried out a series of economic restructuring
programs, including financial reform. The implementation of economic
restructuring programs in developing countries was also pushed by WB and IMF. Interest rate
liberalization as one of stabilization and restructuring policies was
implemented to correct the misallocation of resources as well as to cure developing
economies from serious crisis that resulted from repressed economic mechanizm
during 1970s-1980s. The wave of interest rate liberalization brought about an
upward trend in real interest rate in developing countries.
A number of empirical findings shows that the relation
between interest rate and savings is not very clear-cut (Mikesell and Jinser
1973, Modigliani 1986, Olson and Martin 1981). Fry (1995) explains that such a
situation comes from different measures of saving and real interest rates,
different theoretical models, different econometric techniques, different
samples of developing countries as well as different time periods. Fry builds
up a model to test the effects of real deposit interest rates on gross national
savings rather than other saving measures. His empirical work shows significant
positive interest rate effects on the savings ratio in a sample of 14 Asian
developing countries and Turkey. On average, he concludes that each percentage
point increase in the real deposit interest rate makes the national saving
ratio rise about 0.1 percentage point in the long run. Rossi (1988:125) also estimates positive short run real
interest elasticities of saving in developing countries: Sub-Saharan
Africa (0.25); Middle East and North Africa (1.04); East and South Asia and the
Pacific (0.18); Southern Europe (0.18); Central America and the Caribbean
(0.37); and South America (0.01). The effect of real deposit interest rate on saving ratio is
relative small. Fry (1995) states that, as a device for increasing saving, the
real deposit interest rate is subject to an upper bound at its competitive
free-market equilibrium level normally lying in the range of 0- 5 percent.
Therefore, only in countries where a considerable negative real deposit
interest rate is observed can there be many opportunities for increasing saving
directly through raising the deposit rate.
The effect of real interest rates on the quantity of investment is not so clear since different empirical
studies on different sample countries, in different
time periods make different results. Such empirical studies includes Voridis
(1993), Dailami (et al., 1991), Haque (et al., 1990), Edwards (1988), Greene
and Villanueve (1991), Fry (1995). Taking the issue of
regime changes before and after liberalization in the case- study of Turkey,
Rittenberg (1991) shows that when the real deposit interest
rate is negative, investment is constrained by savings and the interest rate
coefficient in the investment function is positive for negative real rate. When
real deposit rates are positive, surprisingly, investment is reduced by higher
interest rates, and the interest rate coefficient is negative for positive real
rates.
While the empirical
effects of real deposit interest rates on the
quantity of investment conflict, their positive
effects on the average efficiency of investment are experienced in many
developing countries in the ways McKinnon (1973), Shaw (1973) and Galbis
(1977) all strongly theoretically suggest. If average investment
efficiency is monotonically related to the incremental output/capital ratio
(IOCR), then a positive association between IOCR and dis-equilibrium real
deposit interest rate will support the idea that
increasing real deposit interest rates toward
their competitive free-market equilibrium raises the quality of investment. The empirical tests of Fry and Asian
Development Bank find such association in a sample of 11 Asian developing
countries and Turkey (Fry 1988). Geld (1989)
shows a significant coefficient of 0.989 using period-average data for 1965-73
and 1974-85 for 34 developing countries. Additionally, Morisset (1993)
A large number of empirical tests find a positive
relationship between the investment ratio and the availability of domestic
credit [3].
Therefore, if interest rate liberalization leads to an increase in the
availability of credit, then the positive effects of availability of credit on
investment ratio may produce an indirect mechanism through which interest rate
liberalization speeds up economic growth. Lanyi and Saracoglu (1983), by analyzing the effect of
interest rate on financial deepening (as measured by the rate of growth in the
real M2) in 21 developing countries, discovers that a country with positive
real interest rate leads to an increase in the growth rate of real M2 of about
5.6 percentage point. They also make a conclusion that positive interest rate
speeds up economic growth, which mainly results from the intermediation of
financial asset accumulations. With the view that the rate of change in the real stock of
financial assets is determined almost on the demand side, Fry (1988) estimates
the relation between demand for financial assets and real deposit interest
rates for the sample of 14 Asian developing countries in the period 1961-83. On
average, a 1 percentage point change in the real deposit interest rate in the
14 sample countries changes the demand for the financial assets by 0.8 percent
in the short run and 1.4 percent in the long run. Additionally, Chamley and
Hussain (1988) also discover long run deposit rate coefficient of 0.8 for
Thailand (1974-86); 1.2 for Indonesia (1972-85); and 1.9 for the Philippines
(1972-87). The empirical findings presented above are interesting
though they contradict with the low sensitivity of saving behavior to the
changes in the real deposit interest rates. These findings suggest that changes
in real interest rates cause a considerable reallocation in the household
portfolio but only cause small changes in the total size of those portfolios.
More importantly, a rise in real deposit interest rate raises the proportion of
saving poured into investment through the financial intermediation channel.
A study on the effect of real interest rates on economic
growth for the sample of 21 developing countries implemented by Lanyi and
Saracoglu (1983) shows that a positive real interest rate policy brings about a
2.4 percentage point increase in real GDP Roubini and Martino (1992) tested very large sample size
with 53 countries over the period 1960-85, indicating that countries with real
interest rates of less than –5 percent in 1970s caused their economic growth
rate which averaged 1.4 percentage point less than the growth rate in countries
with positive interest rates. Fry (1988) himself has also carried out a number
of empirical tests of real interest rate effect on growth for different country
sample size as well as different time period. His results suggest that on
average a 1 percentage point increase in the real deposit interest rate towards
its competitive free-market equilibrium level causes a rise in economic growth
of about ½ percentage point in Asia. The hypothesis of an inverted U-curve relationship between
real interest rates and economic growth holds up well by the work of De
Gregorio and Pablo (1993). Very low real interest rates reduce economic growth
as implied by McKinnon-Shaw hypothesis while very high real interest rates are
likely to cause lower level of investment, then retard economic growth. The
finding of Fry (1995) for 16 developing countries also supports this point by
implying that economic growth maximizes at some positive real interest rate (Figure
1).
The thesis shows that interest rate liberalization as one major economic reform measure implemented against an unstable macroeconomic background, may make that instability worse. Macroeconomic instability characterized by high and unstable inflation, balance of payment deficit, external debts, expectations of devaluation of the currency and capital flight makes high volatility of interest rates from freeing interest rate. In many cases, it leads to a high increase in real interest rates. Thus, it spurs not only poor macroeconomic performance but also the problems of moral hazard and adverse selection in credit markets. The rapid implementation of interest rate reform in several Latin American Southern Cone developing countries under severe macroeconomic imbalances in 1970s caused heavy failures of the reforms. In Argentina, major financial reform measures including the elimination of interest rate ceilings were implemented during 1977-1981, but were not able to attain macroeconomic stability, especially price. Argentinean interest rate liberalization under poor macroeconomic performance exacerbated macroeconomic instability. Such situation also occurred in Chile during its reform (Corbo 1985). Hyperinflation in Chile after complete interest rate liberalization in 1975 made an extreme increase in real lending interest rates. Meanwhile, unstable hyperinflation in Uruguay during 1973-1983 caused very unsustainable and variable real lending interest rates. Macroeconomic instability affected the performance of investment projects, increasing the risk of default on bank loans. Moral hazard and adverse selection problems occurred. The poor macroeconomic situation really raised distress borrowing at higher interest rates from firms which needed to roll over maturing debt and were nearing bankruptcy. The roll over of bad loans and capitalization of interest arrears were estimated to be about 72% of outstanding peso loans in Chile in 1982 (Velasco 1991). Much the same situations was also experienced in Argentina, Uruguay and the Philippines following their interest rate liberalization (Vos 1993). The strong
interaction between macroeconomic instability and moral hazard occurred in
Turkey also. The quality of bank portfolio in these countries deteriorated due
to the high levels of real interest rates in relation to the marginal
productivity of capital, plus relatively high gearing ratios of the corporate
sector. Interest rate liberalization in Turkey was carried out during the period
of fragile financial positions of business sector. Thus, the profitability of
the private sector and the banking system was further hurt (Atiyas 1989). Additionally, interest rate liberalization and
macroeconomic instability in the country caused lower household savings and
higher financial savings. Chile, Argentina and the Philippines also faced the
same outcomes (Vos 1993). In Indonesia,
despite the failure to achieve macroeconomic stability, the government still
liberalized interest rates completely. Therefore, inflationary pressure and
destabilizing capital flows in combination with the expectation of currency
devaluation caused high and volatile domestic interest rates that often
exceeded the rates of return to domestic fixed investments. This was also
observed in Turkey, the Philippines, and Latin American countries (Villanueva, Mirakhor 1990).
Most banking
and financial crises that occurred after the introduction of interest rate
reforms in developing countries, were to a great extent attributed to the lack
of adequate regulation and supervision. The rapid liberalization strategy in
Latin American countries involved a complete and abrupt elimination of interest
rate ceilings and credit controls and a relaxing of strict government
supervision over the banking system. This plus virtually free deposit insurance
(explicit or implicit), distorted the financial behavior of banks and firms (Le Fort 1989). Loosing banking supervision and an unstable
macroeconomic climate intensified moral hazard in the banking system. Banks
raised lending interest rates to higher and riskier levels with the expectation
that deposit insurance would (and in fact really did) cover any unusual losses. Corbo and de Melo
(1985) show that in Argentina, the provision of full and free deposit insurance
plus the lack of supervision on loan quality generated incentives for
destabilizing behavior. Nonperforming loans in Argentina stood at 25.2% of
total loans during 1983-1987, on annual average, which forced many firms into
bankruptcy. In Chile, the number of bankruptcies increased from two corporate
enterprises in 1978 to 75 in 1982 and from 75 general establishments in 1974 up
to 810 by 1982. Loans in Chile to financial and manufacturing conglomerates,
called ‘grupos’, represented
approximately 1/5 of the banking system’s portfolio. This clearly provides the
evidence of the dominance of these groups and the lack of sound supervision of
bank lending activities (Velasco 1988). Bankruptcies often involved these ‘grupos’
Note: (1) Includes past due loans as recorded
in accounts of financial institutions plus risky loans sold to the Central
Bank. Source: Vos (1993) p.35 Lack of
adequate regulation and supervision is also one of the main factors that leads
to the banking fragility in Indonesia, South Korea- the countries characterised
by gradual interest rate liberalization (Villanuava,
Mirakhor 1990). The weakness of the legal framework in Indonesia makes
one surprised since banks can be easily established without cautious criteria.
Additionally, strong legal measures seem just good on paper since something is
lost in execution (Visser and van Herp 1996). Moral
hazard occurred, contributing to the nonperforming loans of 13% of total
lending in 1996 (Corsetti et al. 1998). In Korea,
interest rate liberalization and inadequate regulation shifted funds to
high-risk assets. The failure to establish an adequate supervision and
monitoring program of non-bank financial institutions, the short-term
securities market and banks’ trust accounts economic performance by the authorities
and the reckless over expansion by corporate firms, especially ‘chaebols’,
rapidly deteriorated the corporate financial structure and made the firms
susceptible to external shocks (Cho 1999:13-16). In Turkey, the inadequate regulatory framework was catalysis for the appearance of moral hazard during interest rate reform since it allowed insolvent banks to avoid bankruptcy by offering high rates to depositors, and using mobilized funds to refinance nonperforming loans. Moreover, at the same time, firms that made losses increased their leverage, though the cost of borrowing had raised.
Successful
interest rate liberalization is not fully secured where financial markets tend
to be highly concentrated, since such a situation intensifies the risks of
moral hazard. Unfortunately, high bank concentration is observed in many
developing countries and in particular, usually remained considerable in
countries undergoing interest rate reforms (Table
2). The
prevalence of interlocking ownership in developing countries has a poor effect
on the allocative efficiency of credit supplies, hence reduces the positive
effects of interest rate liberalization by spurring moral hazard problems.
Obviously, financial intermediaries that operate within an economic group often
tend to favor interests of the group rather than those of creditor and
depositors. Therefore, it is easy for firms of such “family” groups to have
strong access to bank’s credit, even without normal risk considerations. As a
result, such so-called “in-house” lending exacerbates the problems of
nonperforming loans in many developing countries (Table
1).
In South
Korea, just 30 largest ‘chaebols’ control about 85% of the industry, operating
like nebulous conglomerates. Cross-subsidies within conglomerates are
detrimental to the economy. Weaker members of conglomerates often receive
guarantees from other firms in the group (Delhaise
1998:102-103). Therefore, they can borrow from outside. Such
movements plus lack of strong supervision worsens the moral hazard problems
since excessive risk taking is stimulated. In Latin
American countries, Turkey and the Philippines, serious moral hazard problems
occurred in the existence of interlocking firms in which banks had close
interest (Villanueva and Mirakhor 1990, Vos 1993,
Atiyas 1989).
It is
generally accepted that any premature opening of the capital account in the
balance of payments during economic reform may result in macroeconomic
instability and destabilize capital flows. A considerable destabilizing capital
outflow may be a consequence of any early opening of the capital account in an
economic context of domestic financial repression and low-level interest rate
ceilings (McKinnon 1991, Fry 1995). Hanson and de Melo (1985) indicate
that interest rate liberalization and the opening of the capital account in Uruguay caused a rapid
increase in private sector liquidity. It thus contributed to the increased
indebtedness in Uruguay which, after generating two asset bubbles Interest rate liberalization in Chile created increases in domestic interest rates. With insufficient restrictions on capital inflows and under a pegged exchange rate regime, capital inflows that followed came up to a level of no less than 25 percent of GDP in the first half of 1981. It then resulted in an inflated non-tradable sector and a rapidly increasing excess demand in the tradable sector, making a large trade deficit (Corbo 1985). Such situations were also observed in Argentina (Fanelli and Medhora 1998), where expansion in absorption and the external deficit were primarily financed by massive capital inflows which were channelled through domestic credit and capital markets. Thus, it contributed to a fast increase in private and public indebtedness. In Turkey, Balkan and Yeldan (1998) Most recently, the
Asian crisis in 1997 provides the clearest evidence of how crises occur as the
governments had liberalized the domestic financial sector and the capital
account without a well-designed sequence. The very large capital inflows
resulted from strong macroeconomic fundamentals, the interest rate differentials
(because of substantial deregulation of domestic financial sector) and a belief
that the fixed exchange rate regime would be more or less sustainable. In
Thailand, for instance, net capital inflows between 1990-1996 on average were
10 percent of GDP each year (Vichyanond 2000). The capital surge made the real
exchange rate appreciated in a number of countries, especially Thailand and
Malaysia (Leung 1996:8). Moreover, the financial institutions in most
crisis-attacked countries The opening of the capital account without strengthening the domestic financial system contributed to the Asian crisis. Vichyanond (2000) indicates that the Thai crisis is attributed to three policy errors (policy inconsistency) which are most common in all Asian crisis-attacked countries: (i) liberalization of foreign capital flows while keeping exchange rate rigid, (ii) premature liberalization of financial institutions and (iii) lack of prudent supervision of financial institutions.
Source: World Bank data in Corsetti Gaincarlo (et al.)
(1998), p. 45
Whatever reasons for the different liberalization strategies, a number of countries, which were characterized by both rapid and gradual strategies, have involved financial instability and crises to date. The failures of rapid-strategy countries (involving premature liberalization policies) in Latin America clearly indicate that it seems impossible to carry out successful interest rate liberalization in a short period, given structural constraints including macroeconomic imbalances and very inadequate supervisory and regulatory frameworks that are often characteristic of developing countries. Furthermore, the recent Asian crisis in the 1990s, which also involved countries with a gradual strategy (Korea, Indonesia) indicate that policy consistence is required for successful interest rate liberalization. A proper sequence of reform is needed, thus it really takes time to carry out full interest rate liberalization without financial instability. The idea is that a gradual approach to interest rate reform is better than a rapid one, and is more likely to be successful.
It is now clear that interest rate liberalization is hazardous under conditions of great macroeconomic imbalance. Under macroeconomic instability, higher real interest rates may have little effect on the savings behaviour of private individuals. These effects may become worse and negative in the case where increases in real interest rates create a considerable redistribution of income from debtors to creditors. High and volatile inflation leads to unstable interest rates, which in turn stimulates moral hazard and adverse selection on credit markets. Such problems may be compounded in the case where the macroeconomic design requires a restrictive monetary policy (in order to fight inflation), reflected in the sharp increase in the cost of funds. In this sense, excessive levels of real rates are as deleterious as repressed ones. Moreover, the emergence of bad loan problems plus possible saving availability under macroeconomic imbalance may put financial markets under stress and push up real interest rates. Therefore, financial instability involves, continuing to distort macroeconomic performance. Stability in the macroeconomic environment is no doubt required before full interest rate liberalization.
Strict supervision and adequate regulation on operations of the banking system and credit markets are required and strengthened in order to minimize moral hazard problems. A strong banking regulatory and supervisory framework is important not only because it ensures the viability and health of the banking industry which is the traditional microeconomic justification but also because interest rate liberalization would be ineffectual without it. Lack of adequate regulations and their enforcement provides a catalyst for excessive risk taking during the interest rate reform (the main cause of bad debt problems), and then financial instability.
Strong concentration in the banking sector and interlocking ownership patterns in the developing world are causes of inefficiencies in productive finance. Experience finds that many bad loan problems in developing countries have resulted from unsound bank behaviour related to interests of proper bank management and easy loan provision to allied firms, plus ineffective bank supervision. Yet, these institutional problems themselves do not fully explain bad loan problems. Rather, it is their existence in combination with macroeconomic imbalance and ill-conceived liberalization policies. McKinnon (1973, 1991) suggests that interest rate liberalization be better warranted under a competitive banking environment. The suggestion is true in liberalization practices in Latin American and Asian countries.
It is clear that freeing interest rates and liberalising the capital account are part of economic reform policy packages. However, an appropriate order of liberalization is required to ensure the success of the reform. Free capital flows may break down the macroeconomic balance through unstable interest rates, exchange rates, capital account and the balance of payments. The outcome of macroeconomic instability may discourage interest rate liberalization. Additionally, with an environment of bank-based capital markets (which are often observed in developing countries), surges in capital inflows may create “bubble” economies and distort the prices of capital as experienced in Asian and Latin American countries. The probability of failure of reform generally and interest rate liberalization particularly increases. The optimum order of economic
liberalization
of McKinnon (1993), plus the experiences of the reform process in developing
countries shows the common view that capital account should be opened only
after both liberalizing the domestic financial sector and opening the current
account in the balance of payments. It means capital account liberalization
should be the “last step” in the liberalization process, after the domestic
financial system is strengthened.
The evidence of many developing countries shows that credit rationing, in a number of cases, creates rent-seeking costs. Rationing credit opens doors for political patronage in access to loans. This, in turn feeds bad lending, corruption and wastage of resources go into the evasion process as difference in the controlled and liberalised sectors of the economy is strongly arbitraged. Lack of transparency is also helped and caused by this rent-seeking process, and those involved resist efforts to liberalise the economy and make the economy more transparent. Stiglitz and Weiss (1981) show that with expectation and moral hazard problems, banks still put a limit on loan rates in order to maximize their expected profits. It means that “too- high” interest rates can create credit rationing under competitive market equilibrium. Vos (1993) suggests that underdeveloped financial markets in combination with credit market segmentation, also leads to credit rationing. Therefore, certain borrowers are excluded from credit market access. In many developing countries, it is observed that a large number of small-scale farms as well as small and medium-scale industries, find it difficult to access credits. Government-owned financial institutions have usually been established to fill this gap but subsidised loans and poor management often generate a high cost burden to taxpayers. However, in case markets fail to assess risk due to asymmetric information, dropping out a number of productive borrowers, the establishment of some special financial institutions with government stimulus is justified. The chapter focuses on answers to the three following questions: 1. What are the effects of financial repression on the Vietnamese economy? 2. What are the effects of liberalization of interest rates on Vietnamese economy? 3. What factors may hamper the successful implementation of interest rate liberalization in Vietnam?
In the section, the thesis briefly addresses financial repression in Vietnam before 1989 and its impacts on the Vietnamese economy. The thesis shows that financial repression heavily characterised by negative real interest rates was one important factor that distorted economic relations and activities in Vietnam prior to 1989. To some extent, it not only caused low levels of domestic savings, investment (both in quantity and quality) but also stimulated speculative behaviour, distorted credit flows in the economy and contributed greatly to hyperinflation during 1986-1988. Though the operational mechanizm of the centrally planned economy was an important catalyst that exacerbated the adverse effects of financial repression on the economy, what McKinnon and Shaw (1973) criticize the problems of financial repression in developing countries, no doubt, still hold for Vietnam in the period prior to 1989.
The thesis indicates that interest rate policy
has experienced many positive changes during the ten years of reforming the financial sector (1989-1999), directed towards market-determined
interest rate policy. The main changes are: (i) the implementation of a
positive real interest rate policy; (ii) the carrying out of long and medium-term
interest rates which are higher than short-term rates; and (iii) the removal of
the regulated spread between lending and mobilising (deposit) rates, the
gradual elimination of ceiling levels on interest rates as well as spread
between mobilising and lending rates.
The thesis indicates that interest rate reform
has made interest rates positive in real terms, which provides savers an
incentive to save. Such movement was strongly observed during 1992-1999 because
low and stable inflation protected the real return on savings. Running the regression model developed by Fry (1980): DS = m1 + m2*R + m3*G + m4*Y + m5*FS + m6* DS(-1) (where, DS is the domestic saving/GDP ratio; R is annual real deposit interest rate; G is the growth rate of GDP; Y is the growth rate of per capita GDP; FS is the foreign saving rate as a proportion of GDP and DS(-1) is the lagged saving ratio), the thesis finds that (other thing being equal): (i) in the short-run: an one percentage point increase in the real deposit interest rate leads to a 0.026 percentage point increase in the domestic saving rate; and (ii) in the long run: an one percentage point increase in the real deposit interest rate leads to a 0.133 percentage point increase in the domestic saving rate.
The thesis finds a relation between real interest rates and financial deepening of the economy, indicating that even if a higher real interest rate does not lead to higher real savings sometime, households are still expected to change the form in which they hold their savings from real to financial assets, given the right incentive. Testing the association of the real deposit interest rate and financial deepening by using model developed by Khan (1999), the result shows that one percentage point increase in the real deposit interest rate would lead to about a 0.059 percentage point increase in financial deepening (other things being equal).
The thesis indicates that the nature of interest rate liberalization theories hold firmly in Vietnam since the ripple effects of ‘higher real interest rate è higher savings è higher funds available for investment è higher actual volume of investment’ was observed. More interestingly, the thesis also tests the relation between real interest rates and quality of investments with proxies of ICOR and IOCR. The findings are (other things being equal): (i) an one percentage point increase in the real deposit interest rate leads to a 0.11 percentage point decline in the incremental capital-output ratio ICOR; (ii) an one percentage point increase in the real deposit interest rate causes a 0.0023 percentage point increase in the incremental output- capital ratio IOCR.
The analysis in the section shows that interest rate reform really helped increase in economic growth through increases in savings and investment (both in quantity and quality). Using the model developed by Fry (1980) to test the association of economic growth rates and real deposit interest rates, the thesis finds that an one percentage point increase in the real deposit interest rate causes a 0.028 percentage point increase in the economic growth rate (other things being equal).
The section identifies the main factors that could hamper the success of interest rate liberalization in Vietnam, including macroeconomic performance, prudential regulation and supervision, banking concentration and the sequencing of the capital account liberalization. Analyses indicate that the main difficulties remaining for interest rate liberalization are weak banking regulation and supervision and low competition in the financial system. Though control over capital account to some extent has been effective, which limits the probability of financial instability caused by liberalization process, the past experience suggests that policy consistence is of great importance during liberalization and integration. Macroeconomic performance and liberalization of the capital account that is not premature are now seen to be consistent with interest rate liberalization. I. ConclusionsAs suggested by McKinnon-Shaw school, interest rate liberalization (freeing interest rate) is a good solution for financially repressed economies in which domestic capital markets are distorted by government interventions. Higher interest rates resulting from liberalization causes higher levels of savings, higher funds available for investment and then higher economic growth. However, interest rate liberalization may fail if it is implemented under an environment in which some factors are observed, including asymmetric information, macroeconomic instability, weak regulation and supervision and inappropriate sequencing of financial liberalization, especially of the capital account. Experiences of interest rate liberalization in developing countries confirm the hypothesis of the McKinnon-Shaw school. Strong positive effects of real deposit interest rates are observed on the efficiency of investment, the availability of credit and economic growth rates. Though the direct effects of real deposit interest rates on saving and the quantity of investment are not clear-cut, significant indirect effects of real deposit rates on investments result from the change in allocation of household portfolios towards financial assets, which increase the availability of credit. The indirect positive effects of real deposit rates on savings may result from increases in economic growth rates. Experiences from the failures of interest rate liberalization in Latin American and Asian developing countries clearly indicate that macroeconomic instability (especially inflation volatility) and dis-sequencing of capital account liberalization are the main reasons. Additionally, other structural factors are attributed to be obstacles of interest rate reforms including weak regulatory and supervisory framework, lack of competition on financial markets, heavy bad debt problems and structural weaknesses in saving and investment performance. All these factor intensify moral hazard and adverse selection (directly or indirectly), thus worsening financial instability. Lessons from the experiences of interest rate liberalization in developing countries are then clear for Vietnam: - No doubt, interest rate liberalization can brings about beneficial effects to the developing countries involved which are financially repressed. Economic growth can be observed through increases in savings and investment that result from freeing interest rates. - A strategy of gradualism of interest rate liberalization is better than a rapid strategy. - Interest rate liberalization may lead to financial instability and even crisis if the country does not pay attention to “pre-conditions” and the so-called “the sequencing of the capital account liberalization”, i.e., policy consistency during liberalization and integration. Such pre-conditions include macroeconomic balance, prudential regulatory and supervisory framework and competitive banking environment. Additionally, in case markets fail to assess risk due to asymmetric information, dropping out a number of productive borrowers, then the establishment of some special financial institutions with support of the government may be necessary. The study of Vietnam shows that the hypothesis of McKinnon-Shaw school holds strongly. Interest rate reform/liberalization (among others) has helped the country overcome financial instability in the late 1980s. The findings show that the real deposit rates can contribute to economic growth through its positive (although still modest) effects on savings, financial deepening, quantity and quality of investment. While the macroeconomic stability (especially stable and low inflation) and un-premature liberalization of capital account supplement the continuation of interest rate liberalization in Vietnam, some difficulties are still heavily remaining in weak banking regulation and supervision and low competition in the financial system since such difficulties exacerbate rent seeking, moral hazard and adverse selection problems. II. Policy implicationsIt is now clear that the continuation of interest rate liberalization with a gradualizm strategy should be carried out in Vietnam for four reasons: - Theories of interest rate liberalization developed by the McKinnon-Shaw school suggest that interest rate liberalization can benefit the countries involved. - Experiences from developing countries support the hypothesis of the McKinnon-Shaw school that freeing interest rates can benefit the economy. Experiences also suggest that a gradual approach to interest rate liberalisation is more likely to be successful than a rapid one (other things being equal). - The experience of Vietnam during 1986-1999 also support that interest rate liberalization improves the performance of the economy. - Macroeconomic stability, especially stable and low inflation as the most important pre-condition holds in Vietnam. Moreover, effective controls over capital flows, i.e., not premature liberalization of capital account, also limit the external risks that may be exacerbated during liberalization. Some policy implications for Vietnam are as follows: - Inflation rate should be kept at a low and stable level. Consistency of monetary policy and fiscal policy is required to target inflation stability and macroeconomic balance. - The prudential regulatory and supervisory framework should be strengthened. Unless better regulations are issued, supervision and accounting system improved and inspection of banks is strengthened, there will be insufficient incentives for banks to behave prudently and a room for rent seeking activities. Moreover, stronger enforcement is also required. - Competition among banks is necessary to improve banking services as well as to mobilize more deposits. Banking monopoly and oligopoly should be reduced. Changes in policies with respects to bank entry and exist and levelling the playing field for all banks, including foreign banks, should be more relevant for better services and enhanced competition, then reducing moral hazard, adverse selection and rent seeking in banking activities, especially in the relation between SOEs and SOCBs. - The approach of gradualism to economic liberalisation should be applied in Vietnam. Given the context that Vietnamese macro-economy, especially inflation is now stable, the domestic trade and finance should be opened and liberalised in parallel with the improvement of transparency of the economic environment. After the successful internal liberalisation of domestic trade and finance, the appropriate pace is to liberalise the foreign exchanges. The transaction on current account in the balance of international payment should be liberalised much faster than international capital flows. Full capital account liberalization should be left until very last during the economic liberalization process, after the domestic financial sector is strengthened. Policy consistency is required to solve the problem of “trilemma”: exchange rate stability, full financial integration and monetary independence. - Though full interest rate liberalization is the ultimate target, the poor banking capacity, weak banking institution and inefficient regulations, supervision and inspection do not allow full interest rate liberalization right now. However, it is suggested that gradually freeing interest rates towards full interest rate liberalization is good for the economy. The policy sequencing toward full interest rate liberalisation should include two steps, given the current Vietnamese context. Step one is to maintain economic stability and boost transparency and supervision; and while enhance transparency and supervision, temporarily regulate interest rates. Step two is to fully liberalise interest rates. Experiences of developing countries indicate that it generally takes no less than three years to fulfil successful gradual liberalisation of interest rates (Villanueva et al. 1990). Vietnam should implement full interest rate liberalisation within the duration of three or four years, given the pressure and its commitment of economic integration (ASEAN, Vietnam- United State Bilateral Trade Agreement). At present, there is only one ceiling on lending interest rate for all maturity which applied for all credit institutions in urban and rural areas (0.85 percent per month from 10/1999) (Hung 2000). Under the circumstance of weak regulation and supervision, ceilings on lending rate limits “too-high” risk taking as well as moral hazard in the financial system. However, the interest rate should be adjusted in the manner of more flexible management on the basis of supply and demand with the aim at eliminating interest rate ceilings and getting prepared for full interest rate liberalization whenever possible. For example, a more flexible interest rate policy should be carried out by allowing an appropriate “fluctuation band” around the ceiling on interest rates. It means that credit institutions can freely determine their interest rates under ceilings which are then more flexible. The determination of the band should be regularly adjusted whenever necessary in order to keep pace with changes in inflation rates or in international interest rates. The idea is that the band therefore should be large enough to allow competition in the market, for instance, a 5 or 10 % band. The determination of lending interest rate ceilings should based on several factors: (i) annual economic growth rate expected, (ii) expected inflation, (iii) objectives of monetary policy (strict or loose monetary policy), (iv) the supply and demand for capital in the market, and (v) the relation between interest rate and exchange rates. [1] The term “interest rate liberalization” used in the thesis should be understood as a process of deregulation of interest rates. [2] In Fry (1995) [3] Here, availability of domestic credit is measured by the ratio of total or private sector credit to GNP or the changes in the total or private sector credit divided by real GNP. [4] Ibid. [5] The same happens to ‘Chaebols’ in South Korea, considered later. [6] Agricultural land and real estate- Hanson and de Melo (1985), p.922. [7] Documented in Fanelli Jose M and Medhora Rohinton (1998), pp.129-155. [8] The major countries hurt by Asian crisis include Thailand, Indonesia, Malaysia, the Philippines, and South Korea. | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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