Question

Questions and suggested answers:

1. What did the McKinnon and Shaw predict about the movements of interest rates once financial markets are no longer repressed? Explain why. [6 marks]

2. Briefly discuss three (3) things that went wrong with financial repression. [9 marks]

3. Based on the above reading by Greenidge and Belford (2001), how was financial liberalization supposed to affect economic growth? [9 marks]

4. During what period did some CARICOM countries begin to liberalize and what were the economic circumstances they were in at that time? [6 marks]

5. According to Greenidge and Belford (2001), what was the overall impact of financial liberalization in Jamaica, Guyana and Trinidad and Tobago as compared to what were the expected results? [10 marks]

Answer 1

#ANSWER 1

FINANCIAL REPRESSION

Financial repression is a term that describes measures by which governments channel funds from the private sector to themselves as a form of debt reduction. The overall policy actions result in the government being able to borrow at extremely low interest rates, obtaining low-cost funding for government expenditures.

It comprises "policies that result in savers earning returns below the rate of inflation" in order to allow banks to "provide cheap loans to companies and governments, reducing the burden of repayments". It can be particularly effective at liquidating government debt denominated in domestic currency. It can also lead to a large expansions in debt "to levels evoking comparisons with the excesses that generated Japan’s lost decade and the 1997 Asian financial crisis".

The term was introduced in 1973 by Stanford economists Edward S. Shaw and Ronald I. McKinnon in order to "disparage growth-inhibiting policies in emerging markets".

Financial repression consists of the following:

1. Explicit or indirect capping of interest rates, such as on government debt and deposit rates (e.g., Regulation Q).
2. Government ownership or control of domestic banks and financial institutions with barriers that limit other institutions from entering the market.
3. High reserve requirements.
4. Creation or maintenance of a captive domestic market for government debt, achieved by requiring banks to hold government debt via capital requirements, or by prohibiting or disinsentivising alternatives.
5. Government restrictions on the transfer of assets abroad through the imposition of capital controls.

These measures allow governments to issue debt at lower interest rates. A low nominal interest rate can reduce debt servicing costs, while negative real interest rates erodes the real value of government debt.Thus, financial repression is most successful in liquidating debts when accompanied by inflation and can be considered a form of taxation,or alternatively a form of debasement.The size of the financial repression tax was computed for 24 emerging markets from 1974 to 1987. The results showed that financial repression exceeded 2% of GDP for seven countries, and greater than 3% for five countries. For five countries (India, Mexico, Pakistan, Sri Lanka, and Zimbabwe) it represented approximately 20% of tax revenue. In the case of Mexico financial repression was 6% of GDP, or 40% of tax revenue.

MCKINNON AND SHAW PRECIDTS ABOUT THIS

“Financial repression” is self-evidently a metaphor. Someone or something is being kept down by the repressor, evoking mental images such as tanks crushing peaceful demonstrations, or robber barons “capturing” or “stealing” your money.

The term was first coined in 1973 by two Stanford University economists Ronald McKinnon and Edward Shaw, who worked in the field of LDCs (“less developed countries”). That year, McKinnon’s book Money and Capital in Economic Development was published, as was Shaw’s Financial Deepening in Economic Development.

McKinnon’s thesis begins as follows:

Most of the population, and most actual and potential entrepreneurs, in LDCs (especially in rural areas) are not served by the banking system. They are forced into the hands of local moneylenders and pawnbrokers at very high rates of interest. They are thus financially repressed.

Here at the outset, it is poor people who are the victims of financial repression. In this context the metaphor seems to makes sense. McKinnon’s remedy is to remove maximum rates on interest rates (usury ceilings), and thus to encourage the banking system to increase and broaden lending, at very high real rates of interest – of around 15-25%.

However McKinnon is not consistent in his assessment of who is being repressed. At another point he writes:

Unfortunately, the more usual method in LDCs is to maintain a small and repressed monetary system and then to rely on a battery of fiscal and other interventions in commodity and factor markets as a substitute for bank intermediation.

A repressed monetary system? He has shifted the metaphor from the “repressed rural masses” to the “repressed monetary system”. And both he and Shaw go on to use it generally in this sense.

Recently, he has disclosed that he coined the term “financial repression” to make a political point. In his paper “Hot Money Flows, Commodity Price Cycles, and Financial Repression in the US and the People’s Republic of China” (January 2013) co-authored with Zhao Liu, he explains its origin:

In the 1970s, the term financial repression originated with McKinnon and Shaw when inflation was a problem in a number of less developed countries (LDCs). In the 1960s and 1970s, governments in many LDCs intervened to put ceilings on nominal interest rates and impose high reserve requirements on their banks, along with other techniques to direct the flow of credit in the economy… Wanting to find a pejorative term—akin to political repression — to describe this syndrome, McKinnon and Shaw first used the term financial repression in 1973.

#ANSWER 2

At the time of financial repression gone with some advantages and disadvantages.Its hard to apply financial repression in market that time and there are many things which gone wrong and here they are:

• Caps or ceilings on interest rates
• Government ownership or control of domestic banks and financial institutions
• Creation or maintenance of a captive domestic market for government debt
• Restrictions on entry to the financial industry.
• Directing credit to certain favored industries.

Why Interest Rates Are Not To Be Meddled With

Keynesian theory posits that governments should attempt to manage the business cycle by lowering rates during recession and raising them should the economy "overheat." (Counter-cyclical policy) Some suggest they should even actively pop asset bubbles.

In a free market, low interest rates signify to the markets that savers are willing to postpone consumption and allow entrepreneurs to invest their savings in future consumption.

Artificially lowering interest rates during a recession has the following consequences:

1) Mal-investment.

Entrepreneurs are led to believe that the conditions are ripe for risky ventures; it's much easier for a business to survive when paying 1.5% than 6% on its debt. When these unsustainably low rates change, businesses fail.

2) Consumer credit explosion.

Since the 1970s, real wages have been stagnant. In order to accommodate a steadily rising standard of living consumers bought on credit.Credit has a positive GDP multiplier when channeled into production; debt results in a temporary boost in consumption followed by a drag on overall economic activity later (its severity is determined by the average interest rate over that period. With some consumers paying 20% on their credit cards.

3) Increased risk / overvaluation.

Investors and financial institutions are incentivized to invest in riskier assets. We are seeing this right now with dividend-paying equities and risky debt securities like municipal bonds and junk debt.Classically, money flows from fixed income will find their way into other assets: equities, commodities, derivatives, etc… The tendency is an overvaluation of non-debt securities alongside the artificially high prices in government bonds and other debt securities.

4) Suffocation.

Some types of investors depend on interest from fixed income. These include pensioners, retired people, university endowments, sovereign wealth funds, insurance companies, and anyone that has a need for low volatility, liquid assets and/or considerable cash on hand. Some funds, realizing the negative real yields of treasuries, gilts, bunds, etc., have been diversifying into land, dividend-paying equities, and commodities.

This is impossibly risky in a global financial system that is perpetually inches away from the precipice of catastrophic failure, and the solvency of these big, slow moving capital pools is integral to the stability of the real economy.

5) Ultra-low rates punish savers.

This one is straightforward: if someone saves a dollar today that will be worthless tomorrow when they want to invest it, the aggregate potential of future investment drops. Cash savings (how most people save) are destroyed. If too much savings disappears into the black hole of inflation designed to finance government ponzi spending, the capital formation process will falter.

#ANSWER 3

From Financial Repression to Financial Liberalization
The financial repression that prevailed in developing and transition countries in 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 ensure 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,1 as well as to reduce dependence on foreigners. Bank supervisors focused on complying 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. In some cases, low deposit and loan rates were also populist measures intended to improve income distribution.2 Repressed finance was thus an implicit tax and subsidy system through which governments transferred resources from depositors receiving low interest rates (and from those borrowers not receiving directed credits) to borrowers paying low rates in the public sector and to favored parts of the private sector. 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).

EFFECTS ON ECONOMIC GROWTH

Poor Results

Together, the limited mobilization and inefficient allocation of financial resources slowed economic growth (McKinnon 1973;Shaw 1973).Low interest rates discouraged the mobilization of finance, and bank deposit growth slowed in the 1980s in the major countries (figure 7.1).Capital flight occurred despite capital controls (Dooley et al.1986).Allocation of scarce domestic credits and external loans to government deficits, public sector “white elephants,”and unproductive private activities yielded low returns, crowded out more efficient potential users,and encouraged wasteful use of capital.

High Costs

The repressed systems were costly.Banks,particularly state banks and development banks, periodically required recapitalization and the takeover of their external debts by governments.Political pressures and corruption were widespread.Loan repayments were weak because loans financed inefficient activities,because loan collection efforts were insufficient, and because borrowers tended to treat loans from the state banks simply as transfers.

Pressures from Globalization

Perhaps most important,financial repression came under increasing pressure from the growth of trade, travel,and migration as well as the improvement of communications.The increased access to international financial markets broke down the controls on capital outflows on which the supply of low-cost deposits had depended. Capital controls may be effective temporarily, but over time mechanisms (such as overinvoicing imports and underinvoicing exports) develop to subvert them.These mechanisms became more accessible as goods and people became more internationally mobile.

Some more Effects On Economic Growth

1.Reduction or removal of controls on the interest rates or rates of return charged by financial agents. Of course, the central bank continues to influence or administer that rate structure through adjustments of its discount rate and through its own open market operations. But deregulation typically removes interest rate ceilings and encourages competition between similarly placed financial firms aimed at attracting depositors on the one hand and enticing potential borrowers to take on debt on the other. As a result, price competition squeezes spreads and forces financial firms (including banks) to depend on volumes to ensure returns.

2. Dilution or removal of controls on the entry of new financial firms, subject to their meeting pre-specified norms with regard to capital investments. This does not necessarily increase competition, because it is usually associated with the freedom to acquire financial firms for domestic and foreign players and extends to permissions provided to foreign institutional investors, pension funds and hedge funds to invest in equity and debt markets, which often triggers a process of consolidation.

3. Reduction in controls over the investments that can be undertaken by financial agents, and specifically, breaking down the “Chinese wall” between banking and non-banking activities. Most regulated financial systems sought to keep separate the different segments of the financial sector such as banking, merchant banking, the mutual fund business and insurance. Agents in one segment were not permitted to invest in another for fear of conflicts of interest that could affect business practices adversely. Bringing down these regulatory walls separating these sectors leads to the emergence of “universal banks” or financial supermarkets. This increases the interlinkages between and pyramiding of financial structures.

4. Expansion of the sources from and instruments through which firms or financial agents can access funds. This leads to the proliferation of instruments such as commercial paper and certificates of deposit issued in the domestic market, and allows for off-shore secondary market products such as ADRs or GDRs.

5. Liberalization of the rules governing the kinds of financial instruments that can be issued and acquired in the system. This transforms the traditional role of the banking system of being the principal intermediary bearing risks in the system. Conventionally, banks accepted relatively small individual liabilities of short maturities that were highly liquid and involved lower income and capital risk and made large, relatively illiquid and risky investments of longer maturities. The protection afforded to the banking system and strong regulatory constraints on it were meant to protect its viability given the role it played. With liberalization, the focus shifts to that of generating financial assets that transfer risks to the portfolio of institutions willing to hold them.

6. Changes in the exchange control regime, with full convertibility for current account transactions accompanying trade liberalization being complemented with varying degrees of convertibility on the capital account. The capital account liberalization measures broadly cover those which allow foreign residents to hold domestic financial assets, those which allow domestic residents to hold foreign financial assets and those which allow foreign currency assets to be freely held and traded within the domestic economy (“dollarization” of accounts).

#ANSWER 4

The CARICOM Single Market and Economy, also known as the Caribbean Single Market and Economy (CSME), is an integrated development strategy envisioned at the 10th Meeting of the Conference of Heads of Government of the Caribbean Community (CARICOM) which took place in July 1989 in Grand Anse, Grenada. The Grand Anse Declaration had three key Features:

1. Deepening economic integration by advancing beyond a common market towards a Single Market and Economy.
2. Widening the membership and thereby expanding the economic mass of the Caribbean Community (e.g. Suriname and Haiti were admitted as full members in 1995 and 2002 respectively).
3. Progressive insertion of the region into the global trading and economic system by strengthening trading links with non-traditional partners.

A precursor to CARICOM and its CSME was the Caribbean Free Trade Agreement, formed in 1965 and dissolved in 1973.

There is free movement of capital involves the elimination of the various restrictions such as foreign exchange controls and allowing for the convertibility of currencies (already in effect) or a single currency and capital market integration via a regional stock exchange. The member states have also signed and ratified an Intra-Regional Double Taxation Agreement.

The Global Environment

In many ways the global outlook for 2004-05 is now more favorable than at any time since the 1990s. Robust growth in the United States—especially important to the Caribbean—is still the main driving force, but all the major regions of the world are showing a welcome pickup in activity. Looking ahead, overall financial conditions and productivity growth in the United States should provide continued impetus to activity. Indeed, most signs point to a very strong first half of this year and, while activity would be expected to moderate by the end of 2004, we still expect GDP growth to exceed 4½ percent this year and to remain around 4 percent in 2005. These are exceptionally favorable external conditions that should continue to provide near-term support to the recovery in this region.

Of course, there are risks. There has been considerable attention by markets to the rise in oil prices and the outlook for monetary policy in the United States. On both these fronts, the risks should be manageable. Oil prices in real terms are still below previous peaks and are expected to ease in the coming months. Moreover, the likelihood is of a gradual—rather than abrupt—withdrawal in monetary stimulus in the United States, and financial markets appear to be well prepared for this.

Growth is firming, significantly in some countries in the region, current account imbalances have eased, and many countries are securing welcome improvements in their primary fiscal positions. Of course, vulnerabilities remain and the remainder of my remarks will be on this subject, especially in the context of this region's continuing integration with a globalized world.

Condition

The Caribbean region can be proud of its integration with the world community. In many respects, the region has been among the pioneers of globalization, with an intermingling of peoples from different parts of the world that began many centuries ago. The Caribbean today has its own unique culture that is much-admired world-wide. I need hardly mention the significant contribution of the peoples of the Caribbean in the fields of literature, the arts, and sport. And, in the field closest to us economists and policymakers, St. Lucia's Sir Arthur Lewis, the Nobel Laureate in Economics, indelibly shaped our thinking on economic development.

Globalization is, of course, a two-way process. The benefits of globalization can be seen in many walks of life in the Caribbean. Aided by technological advances in transportation, tourism has flourished, enabling countries to reduce their dependence on single commodities such as cocoa, cotton, sugar, and bananas. There are many professional schools in the region that attract foreign students from the U.S. and other industrial countries. The region exports labor, including highly skilled labor to industrial countries, and there are large Caribbean communities outside the region whose remittances have helped raise living standards of those at home. Rapid growth in telecommunications, telemarketing, and in the computer and software industry has broken the physical barrier among distant nations. Caribbean countries with relatively cheap labor costs are tapping the outsourcing markets.

Yet, despite this openness to globalization, strongly democratic political systems, the high quality of human capital, and natural resources, the region's per capita GDP has increased by less than two percent per annum in the past 25 years. This is lower than the average of other developing countries in the world. I am sure that it is also less than your own aspirations, certainly less than is needed to reduce poverty and unemployment.

Of course, the region has suffered disproportionately from adverse shocks and natural disasters. The dismantling of preferential trade arrangements has triggered a decline in the agricultural sector and disrupted traditional lifestyles and cultures. The events of September 11, 2001 sharply curtailed tourism travel in 2001-02. Many islands are in the hurricane zone and have been repeatedly devastated by their destructive force. Recent floods in the Dominican Republic and Haiti have created serious new difficulties, particularly on the poorer sections of society.

The region's integration with international capital markets opened the door to enormous opportunities but also amplified exposed vulnerabilities—reminding us again that capital market opening places a high premium on strong macroeconomic and financial policies. Access to foreign capital has helped finance development projects and smooth over adverse shocks but, in the circumstances of the region's development over the past decade, it has been associated with rising fiscal deficits and debt burdens. This means, of course, that the returns to investment generally did not keep pace with the costs. As a result, the Caribbean nations are today among the most indebted emerging market countries. As many of you will be the first to testify, this reality places enormous burdens on other elements of the macroeconomic framework. What can be done to entrench a policy framework that will be more supportive of growth and consistent with the region's openness to globalization?

Looking Forward—Benefiting from Globalization

The experience of small open economies world-wide demonstrates that globalization offers tremendous benefits in terms of new jobs, technology transfer, and higher incomes. The Caribbean nations have the potential, and indeed the right, to aspire to more of these benefits. The government's role—and I include the international official community in this challenge—is to make sure that we are doing all that we can to harvest these benefits and make sure that the gains are evenly distributed.

The agenda for the region needs, in my view, to encompass at least three core elements. First, to develop a more supportive macroeconomic policy framework with declining public debt burdens and strengthened financial systems. Second, to make economies more flexible, especially in the labor market. And, third, to strengthen domestic institutions in areas critical to entrenching growth and macroeconomic stability

It would also serve to make the region more resistant to adverse shocks and macroeconomic volatility. Of course, policies in these areas need to be phased in with full ownership; there are some clear near-term priorities, while others would naturally need a somewhat longer time frame to be developed and implemented. Let me make brief remarks in each of these areas.

Macroeconomic policy framework. Ensuring debt sustainability and maintaining financial sector soundness are among the priorities here. These would open the door to reduced pro-cyclicality of economic policies, higher fiscal reserves, and greater room for private sector credit for growth. While the region's tax effort is generally relatively high in proportion to GDP, there is still much room to reduce tax concessions and exemptions, and reorient spending away from subsidies and wages and toward greater infrastructure support. In addition, many of you here have emphasized to me the importance we all need to give to strengthening financial supervision, especially in the context of open capital accounts, offshore banks, and significant nonbank financial institutions. The Caribbean region is certainly not alone in tackling these challenges and we have learned from other countries how financial sector weaknesses and public debt vulnerabilities can interact to the detriment of macroeconomic stability and growth.

15. Increasing flexibility. In today's globalized world, there is even more importance to ensuring that economies remain flexible. Globalization entails structural shifts within domestic economies, and emerging evidence strongly suggests that the beneficiaries will be those with the most flexible economic structures—especially labor markets—to facilitate the associated shifts in resources. This is a lesson of particular relevance for this region that is already faced with periodic shocks, and where there are rigidities in elements of the policy framework and generally high unemployment. For example, in many countries, wages have tended to rise well ahead of productivity, especially in the public sectors. Enhancing flexibility will require increased training and improved safety nets, especially in the context of declining traditional agricultural sectors and the need to provide fresh opportunities for displaced workers.

#ANSWER 5

These countries were similar in that they all had open economies, produced a relatively narrow range of products, and were members of a regional customs union, the Caribbean Community (CARICOM). But there were also important differences among them—including the types of products they specialized in, the extent of state involvement in productive activity, and the size of their outstanding debts—which determined their policy options.

These all four countries adopted market-oriented strategies to reduce state economic activity and stimulate the private sector. This was a major change for Guyana, and encouraging foreign investment became a pillar of its comprehensive economic recovery program. Guyana's debt overhang was so overwhelming that it also sought external debt relief. With a fixed exchange rate, Barbados concentrated on spending cuts, economy-wide income restraints, and diversification into offshore financial services. Trinidad and Tobago combined income restraint with expenditure-switching measures, using devaluations to compensate manufacturers for exposing them to import competition. Jamaica concentrated first on rapid trade and financial liberalization and then on lowering inflation through tight monetary management. All of the programs were supported by IMF arrangements.

Fiscal policy, It is a main component of the programs, was initially contractionary, as policymakers sought to reduce overall spending and foreign exchange needs. Subsequently, the countries undertook tax reforms designed to fortify government revenue while stimulating private sector activity by reducing the income tax burden.

Monetary policy: It was not central to the adjustment programs (except in Jamaica in the late 1990s), and it was focused on limiting central bank credit to the public sector. Nonetheless, monetary control did contribute in all countries to reducing inflation—in Guyana and Jamaica, from triple and double digits, respectively, to single digits (see chart). Central banks stopped micromanaging the distribution of credit within the private sector, and the four countries moved toward market-oriented instruments of monetary policy while maintaining reserve requirements. Only Barbados retained controls on interest rates.

Financial reforms: Financial sector problems eventually emerged in all of the countries—the worst were in Jamaica— prompting varying degrees of public sector support for restructuring.

In Trinidad and Tobago, the oil boom sparked tremendous growth of unregulated nonbank deposit takers. Although new legislation was enacted to cover non bank institutions and deposit insurance was introduced in the 1980s, the economy remained weak, and several institutions had to be restructured after receiving liquidity support from the government. Higher prudential standards were finally adopted in 1993.

In Jamaica, financial and capital account liberalization, high inflation, and the availability of government instruments at attractive interest rates contributed to the surge of new financial entities in the early 1990s. Some packaged themselves to take advantage of differential reserve and other requirements (such as lower reserve requirements for nonbanks than for banks). A number of financial conglomerates were set up, linking insurance companies, commercial banks, merchant banks, and building societies, and related-party lending became pervasive. As tight monetary policy led to a dramatic decline in inflation and an increase in real interest rates, loan portfolios weakened. A large part of the financial system was in deep trouble by 1996-97. The government responded by guaranteeing all deposits and life insurance policies and setting up a resolution company that eventually took over most domestic financial institutions, several of which the state had divested less than a decade earlier. Legislation was amended in 1997 to improve financial sector supervision and restrict credit to related parties; Jamaica introduced deposit insurance the following year.

Exchange rates:The four countries adopted different exchange rate policies. Barbados's steadfast adherence to a fixed exchange rate was given formal expression in successive "protocols" among the government, business, and labor leaders that laid the basis for economy-wide wage restraint. Jamaica and Guyana moved from fixed to floating exchange rates through a variety of arrangements; Jamaica held regular foreign exchange auctions, while Guyana adopted a "cambio" market arrangement by merging official market transactions with a large parallel market. The result was a substantial depreciation of the countries' currencies. Trinidad and Tobago switched abruptly from a fixed to a flexible exchange rate in 1993.

The lessons learned from these experiences can be valuable for future stabilization efforts:

• Fiscal measures need to be at the core of a prudent macroeconomic policy framework and must be maintained if growth is to be sustained. Stabilization programs may provide the opportunity for deeper fiscal reform by streamlining tax regimes (thereby creating incentives for private sector activity). Over time, public investment that may have been cut in the short term can be restored to stimulate growth.
• Economy-wide consensus on the role of wage restraint in successful adjustment is desirable, particularly in safeguarding competitiveness.
• Monetary policy should be supported by fiscal policy; it should not be overburdened, because high interest rates may inhibit investment and growth, weaken the fiscal position, and undermine the financial sector's health.
• Exchange rate policy should be clearly defined and supported by other policies to build the adjustment program's credibility. The choice between fixed and floating regimes is less important.
• Public debt is a major constraint on adjustment, because it severely limits the fiscal authorities' room for maneuver. It should therefore be reduced to the extent possible.
• A narrow output base makes countries vulnerable to external shocks. Consequently, policies that diversify a country's exports may help reduce vulnerabilities.