Financial Liberalization

Contents of the Presentation

1. Introduction
2. From Financial Repression to Financial Liberalization
3. Factors behind Financial Liberalization
4. The Evolution of Financial Liberalization
5. Arguments in favor of financial liberalization
6. The negative effects of financial liberalization
7. Internal Liberalization
8. External liberalization
9. Financial liberalization elements
10. Levels of Financial Liberalization
11. Financial liberalization in Pakistan
12. Future of Financial Liberalization
13. ARTICLE: Financial liberalization and stock market volatility in
selected developing countries
ARTICLE: Financial liberalization and stock market volatility
in selected developing countries
By: Konstantinos Kassimatis
Applied Financial Economic s, 2002, 12, 389 ± 394

1. THEORY OF FINANCIAL LIBERALIZATION

2. PURPOSE OF THE STUDY
3. DATA FOR THE STUDY
4. METHODOLOGY
5. RESULTS (FIGURES ONLY)
6. RESULTS AND FINDINGS
7. CONCLUSION
8. FUTURE RESEARCH
 Introduction
 In the late 1970s and early 1980s, most developing
countries were in economic crisis
 Due to adverse circumstances and the

deteriorating economic and financial conditions

 Financial aid from the World Bank and International

Monetary Fund
 Many developing countries in Asia, Europe, Latin

America and Africa have undertaken economic

reforms to create
◦ Suitable investment environment
◦ Develop the private sector through economic system
◦ Improve market mechanisms.
 Intro……
 The result of these reforms was to
◦ transform developing economies
◦ underpinned by strong private sector growth
◦ rapid maturation of capital markets.
From Financial Repression to
Financial Liberalization
 Financial Repression
Financial Repression
 The financial repression that prevailed in developing

and transition countries in the 1970s and 1980s

reflected a mix of state-led development, nationalism,
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
◦ state-guaranteed external borrowing to ensure supplies of
credit for themselves and public sector firms
◦ directed part of the resources that were left to sectors they
favored
 Financial Repression
◦ State banks were considered necessary to carry out the
directed credit allocations, as well as to reduce dependence
on foreigners.
◦ Bank supervisors focused on complying with the often
complicated requirements of directed credit rather than with
prudential regulations.
◦ Interest rates to depositors were kept low to keep the costs of
loans low.
◦ Low deposit and loan rates were measures intended to
improve income distribution.
 Financial repression has been most commonly
associated with government fixing of interest rates
and intervening in the financial system of the country.
 Financial Liberalization
 Financial liberalization refers to when, restrictions on financial
institutions and financial markets are eliminated.
 Financial liberalization is an important component for building
the sustainable financial systems.
 Financial liberalization is the process of breaking away from a
state of financial repression.
 The reforms of financial liberalization means
 to give central banks more authority to conduct monetary policy
 to privatize and restructure the banking sector
 to liberalize interest rates
 to waive the direct loans
 to develop and promote the role of financial markets in financing
the economy.
 The main objective is to enable emerging economies to emerge
from recession, and later to develop rapidly.
 Factors behind Financial
Liberalization
 Three general factors provided inputs for the
financial liberalization
◦ poor results
◦ high costs
◦ pressures from globalization
 Poor results
 the limited mobilization and inefficient
allocation of financial resources slowed
economic growth.
 Low interest rates discouraged the mobilization
of finance.
 Factors behind Financial
Liberalization
 Allocation of scarce domestic credits and
external loans to government deficits and
unproductive private activities yielded low
returns.
 Worsened income distribution.

 Subsidies on directed credits were often large,

particularly in periods of high inflation, and

actual allocations often went to large borrowers.
 The low interest rates led to corruption and to

the diversion of credits to powerful parties.

 Factors behind Financial
Liberalization
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
 Loan collection efforts were insufficient, borrowers

tended to treat loans from the state banks simply as

transfers.
 Factors behind Financial
Liberalization
Pressures from Globalization
 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.
 The Evolution of Financial
Liberalization
 The shift in policies differed in timing,
content, and speed from country to country
and included many reversals.
 African countries turned to financial

liberalization in the 1990s,

 In East Asian countries liberalized in the

1980s.
 In the 1990s,substantial financial

liberalization occurred, although the degree

and timing varied across countries.
 The Evolution of Financial
Liberalization
 In South Asia, financial repression began in the
1970s with the nationalization of banks in India
(1969) and Pakistan (1974).
 Interest rates and directed credit controls were
subsequently imposed and tightened, but for
much of the 1970s and 1980s real interest rates
remained reasonable.
 Liberalization started in the early 1990s with a
gradual freeing of interest rates.
 a reduction in reserve, liquidity, and credit
requirements, and liberalization of equity markets.
 Arguments in favor of financial
liberalization
 Underlying most of the arguments for financial liberalization
measures are some basic monetarist postulates, namely:
 Real economic growth
◦ Which is determined by the available supply of factors of production
such as capital and labor and the rate of productivity growth, and
changes in money supply do not have any impact on real economic
activity and the growth of output;
 Money supply can be controlled by the monetary
authorities, who can successfully pursue well-defined
targets for monetary growth
 Inflation is attributable to an excessive growth of money
supply relative to “real rate of growth of output” and can be
moderated by reducing the rate of growth of money supply.
 The negative effects of financial
liberalization
 There are some significant negative economic and social
effects of financial liberalization which are often so large
that they significantly outweigh any benefits in terms of
access to more capital inflows.
 These relate both to financial markets and to the real
economy.
 Essentially, financial liberalization creates exposure to the
following kinds of risk:
◦ High propensity to financial crises
◦ a deflationary impact on real economic activity and reduced access
to funds for small-scale producers, both urban and rural.
◦ This in turn has major social effects in terms of loss of employment
and more volatile material conditions for most citizens.
Internal versus external liberalization
 Internal financial liberalization typically includes
some or all of the following measures, to varying
degrees:
◦ The reduction or removal of controls on the interest rates
or rates of return charged by financial agents.
◦ The central bank influence as administer the rate through
structure adjustments of its discount rate and through its
own open market operations.
◦ Deregulation typically removes interest rate ceilings and
encourages competition.
◦ As a result, price competition squeezes spreads and
forces financial firms (including banks) to depend on
volumes to ensure returns;
Internal financial liberalization
 The withdrawal of the state from the activity of
financial intermediation
 the privatization of the publicly owned banking
system, on the grounds that their presence is not
conducive to the dominance of market signals in the
allocation of capital.
 This is usually accompanied by the decline of
directed credit and the removal of requirements for
special credit allocations to priority sectors
 Whether they be government, small-scale producers,
agriculture or other sectors seen as priorities for
strategic or developmental reasons;
Internal financial liberalization
 The easing of conditions for the participation
of both firms and investors in the stock
market by diluting or doing away with listing
conditions
 By providing freedom in pricing of new

issues, by permitting greater freedoms to

intermediaries, such as brokers, and by
relaxing conditions with regard to borrowing
against shares and investing borrowed funds
in the market;
Internal financial liberalization
 The 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 offshore secondary market products
 Such as ADRs (American Depository Receipts—
the floating of primary issues in the United
States market by firms not based in the United
States) or GDRs (Global Depository Receipts);
Internal financial liberalization
 The 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’s being the principal intermediary
bearing risks in the system.
 External financial liberalization typically
involves changes in the exchange control
 Measures that allow foreign residents to hold
domestic financial assets, either in the form of
debt or equity. This can be associated with
greater freedom for domestic firms to
undertake external commercial borrowing,
often without government guarantee or even
supervision.
 It can also involve the dilution or removal of
controls on the entry of new financial firms,
subject to their meeting pre-specified norms
with regard to capital investments.
Financial liberalization elements

 Capital account liberalization

 Banking sector liberalization
 Stock market liberalization
 Levels of Financial Liberalization
 Full Liberalization

 Partial Liberalization

 Non Liberalization
Full Liberalization
Partial Liberalization
Non Liberalization
 FINANCIAL LIBERALIZATION IN
PAKISTAN
 Pakistan started the process of financial
liberalization in late 1980s.
 liberalization was the major component of
financial reforms.
 The objectives of the liberalization were to
◦ improve the efficiency of financial markets
◦ formulate the market based and relatively more efficient
monetary and credit policies
◦ to strengthen the capital and market based financial
institutions.
◦ financial market strengthening
◦ institutional development and macroeconomic stability
 In 1991, permission was granted to open the private
domestic banks and licenses were granted to 3 foreign
banks to operate in Pakistan. In later three years further
8 domestic and 3 foreign banks were established.
 The stock market of a country plays vital role in the
economy by channeling resources to productive
investment.
 The stock market reforms were started in 1991.
 First, the Karachi Stock Exchange (KSE) 100 index came
into being and Corporate Law Authority was suspended
and the Securities and Exchange Commission of
Pakistan was established in 1991.
 In 1997 the Central Depository Company of Pakistan
(CDC) was established. The trading in futures contracts
was started in 2003.
 The system of credit ceilings was replaced
with credit deposit ratio (CDR) in 1992. After
three years the system of CDR was stopped
and replaced by a market based mechanism.
 The system of prudential regulation was

introduced in 1994.
 State Bank of Pakistan was granted autonomy

in 1994, issuance of three more ordinances in

1997 further strengthen the autonomy.
 To exercise an effective indirect money

policy, Open Market Operation were

introduced in 1995 and now it is a major
instrument of monetary policy.
 Banks were instructed to apply the system of risk-
weighted capital
 From December 31, 1997, all banks were required
to maintain capital and unencumbered general
resources of not less than 8 percent of their risk
weighted assets.
 The interest rate deregulation was started in
1995, and completely liberalized in 1997.
 Caps on minimum lending rates of banks and
NBFIs for trade and project related modes of
financing were removed in 1997.
 All NBFIs were required to have themselves credit
rated by State Bank of Pakistan’s approved rating
agency. The same become applicable for all
commercial banks from June 2000.
 Lending rates on special financing schemes
including locally manufactured machinery and
export finance scheme were gradually raised
(during 1990-2000) to eliminate the element
of subsidy.
 In order to enhance the efficiency of banking

sector, the privatization of banking sector

was started in 1991.
 The Muslim Commercial Bank (MCB), Allied

Bank Limited (ABL) and Habib Credit &

Exchange Bank were privatized. The 23.2
percent share of the National Bank of
Pakistan (NBP) was off-loaded in 2004-05.
 To enhance competition in the banking
sector, the entry barriers in financial sector
were removed in 1993.
 The banking courts were established in 1997,

to provide the legal framework of loan

recoveries.
 The market based exchange rate system was

introduced in 2000.
Financial Liberalization Index
A comparative picture of financial systems (%
of GDP)
 Future of Financial Liberalization
 To evolve a low denomination strategy that
meets the average consumer’s needs.
 Then it is possible to tap the huge potential
numbers that make low margin-high volume
a viable business model in Pakistan.
 In order to do so, systemic features that
discourage small investors have to be changed
 Investor confidence should be built up
 Positive incentives must be offered.
 Possible measures
 Education of investors, increasing financial
literacy
 Making information and suitable services

available
 Reducing transaction costs in using

technology for ease of entry and exit

 Registering and rating of agents
 Promoting simple transparent low cost

instruments in Money and Capital markets

 Infrastructure financing
 Poor Pakistani infrastructure is a bottleneck
and an opportunity. Spending on
infrastructure is currently low.
 Long-term finance is required, and to

develop bond markets has some urgency

in this context.
 Risk: Derivative markets
 Laying-off risk requires not only development
of instruments and markets but also random
movements in asset prices so that agents
are not able to speculate on expected
one-way movements.
 In markets, regulators sometimes have to

create such movements, even while

restraining excess volatility.
 Equity
 Trading in Pakistani markets is dominated by
a few stocks, products, cities, and is largely
short term and cash settled. Only 1%
percent of the population invest in
markets
 Only few large cap stocks are liquid, 90

percent trading volume in top 10-20

companies.
 Banks
 Pakistani credit deposit ratios remains lowest
among developing economies. There is
considerable scope for expansion.
 Interest rate futures
 Globally, exchange traded derivatives, have
81 percent share, and interest rate futures
(IRFs) dominate in these.
 But in Pakistan markets the share was only 1

percent in 2009. Attempts were made in

2003 and in 2009 to start but they did not
succeed.
 FOREX markets
 As elsewhere over the counter (OTC) trade
conducted by banks dominates, with swaps being
most widely used.
 Exchange traded futures were permitted in 2009

and saw rapid growth.

 But limitations continue such as they cannot be

settled in hard currency.

 Day traders dominate and open interest is low.

The low contract size of USD 1000, and absence

of customization in futures, makes OTC the
preferred option for large corporate deals.
Thank You !