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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’
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