Effects Of Financial Repression On Growth Rate Economics Essay

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The concept by which government restrictions and policies, regulations and other non market boundaries avoid and stop the financial intermediates of an economy to function at their full capability known as Financial Repression. Mckinnon(1973) describes financial repression as government policies that puts ceiling on the exchange rate and leads to heavy reserve requirement on deposits in banks that leads to ongoing price inflation and have eventual effects on the growth of an economy. The financial instrument by which a government sterilize its currency by buying foreign bonds also falls under the definition of financial repression. The level and degree of this mechanism is depends on the kindness of the country's political economy. There are a lot of policies that can be a cause of financial repression some of them includes limitation on interest rate, liquidity ratio requirements, high bank reserve requirements, command on capital, constraining the markets going to financial sectors ceiling on credit and government possession and authority on banks. Many economists believe that financial repression can hold down the interest rates and it can manipulate the value of the currency. The effect of financial repression is evident from the previous studies by different economist. These studies and effects of financial repression on the growth of a country will be discussed late in that paper. They believe that financial repression it prevents and avoid the organised allocation of money that results in the negative impact on the growth of a country.

The study from (Roubini and Sala-i-Martin, 1992) argues that financial repression results in the inefficient and unorganised distribution of the wealth. They believe that financial repression leads to more benefits for the financial intermediates and lower rate returns to investors and savers. The leads financial repression in inhibits the growth of a country. Due to the possible negative effects of financial repression on the growth of the country, does not mean that a country should adopt a laissez-faire stance on its financial development and remove all the regulations that causes thar repression. In the past it can be observed that many countries specially developing countries experience financial crisis due to the external shocks that caused by the financial liberalization. It can be argued that financial liberalization is more important for long-term benefits as compared to the short term gains. (Kaminsky and Schmukler, 2002) argue that in the short run financial liberalization creates volatility but in long terms it can leads to gains. On the other hand, removing all the public financial constraints may be yield an favourable environment for the development. Creating a set of policies and regulation alternative to the financial repressive management can be a better solution to make sure the competition in market that contributes a lot to the growth of an economy.

There are a lot of studies has done that studies the relationship the financial growth and development in a country as McKinnon (1973) and Shaw (1973). The positivity of this relationship is evident from the past studies. Moreover, studies from King and Levine (1993), Levine (1997), and Levine and Zervos (1998) argue that financial development bears a positive relationship with the economic growth of a country. McKinnon (1973) and Shaw (1973) created different formulation that shows that financial repression has a negative influence on the economic development of a country that eventually leads lowering the growth rate of a country.

Kang and Sawada (2000) deem that the financial intermediates can affect the economy in many ways. First of all the non-market credit rationing can create and unorganised allocation of capital that lowers downs the total investments under financial repression. Banks cannot share many investments that results into lower yields. Secondly, it has also proven that the monetary intermediation prevent the well-organized use of information. Thirdly, the capital cost can ne increase due to the increase in transaction cost cause by financial intermediation. Lastly, the firms normally improves the self-finance ratio that leads to the decrease in average scale of investments, which causes the lost of productivity loss on economies of scale.


Kang and Sawada (2000) - Determination of human capital

As it has discussed above, the McKinnon and Shaw model believes that there is financial development ad economic growth bears positive relationship by bearing in mind that how savings are owed capably to investment.

However, financial developments untie borrowing constraints by expanding the financial services to control the decision of human capital to invest. It may decrease the monetary cost of investment. It can be shown in the given figure that house hold determines most favourable investment in human wealth. This is done because the marginal benefit (MB) and marginal cost (MC). As the MC curve going downwards and the MB curve going upwards. As it is clearly shown in the diagram that financial development results in the downward shift of MC curve, it depicts that resulting in household raise in its optimum quantity of human capital investment (figure 1 Kang and Sawada 2000). De Gregorio (1996) explains in his empirical research that tight borrowing constrains lead to lower economic growth and have negative impact on the employment ratio. Moreover, to the financial development, opening the economy to the international markets can affect the human wealth growth that can be a reason due to trade commodities and spillover effects. As in Grossman and Helpman (1991), Edwards (1992), and Sachs and Warner (1995) explains that opening the country to the global economy benefits the country by the spillovers such as technological advancement and development. This leads to the efficient human capital that is shown in the diagram that portrays the upwards shift in the MB curve.

Kang and Sawada (2000) belives that financial repression results in decrease in human capital investment, thus in the long terms it bears the negative influence on the economic growth rate in a country due to the net insignificant cost of investment . Moreover, the increase in amount of the money supply growth leads to high inflation rates. Furthermore, the low interst rate and low economic growth rate can overlap, as it can seen in 1980s in the Latin American Countries.

Taking the discussion further Burkett and Vogel's (1992) elaborated the McKinnon's hypothesis and explains impacts of financial repression on the rate of inflation. The empirical result after studying the Brazilian Firms leads to decrease in liquidity of assets, increase in the cost of equipments, decrease in the capital strength of production and increase in overall scale of operation in a firm. Natka (2008) argues that there is a positive relationship between the scale of operation and debt, in most of the production units, as the size of operation expands the debt increase. Small domestic firm faces much stronger positive relationship between the scale of operations and debt. That eventually results in the lower growth and production rates.

Demetriades and Luintel (1997) studies the impacts of financial repression in India, they argues that financial repression bears the negative relationship with the growth rates in India. It has been believed that success of economic policies normally depends on the institution that carry out the implementation of these policies so the results can be different in other countries. Demetriades and Luintel (1997) deems that may be for other countries the results would be different but there case study for India proves that due to financial repression the growth rate in India fell down. Moreover there results evaluated the theoretical viewpoint to madel the financial repression in a framework where banks are more active as compared to the previous models of financial repression. Additionally the game-theoretic technique can also adopted and it can serve an important tool that leads to positive results in improvement of tactical feature of financial repression.

Coming back to Mckinnon(1973) and Shaw(1973), they agree that financial repression has a very strong relationship distorting the interest rates and foreign exchange rates. This reduces the real size and real growth rate of an economy. In all cases this policy stopped or slow down the development process in a country. In the Mckinnon-Shaw model the banks under financial repression assign credit not according to the likely output of the investment but they issue credit in the bases of transaction cost and apparent risks of default. In addition to the flaws of banking system in financial repression Fry (1997) deems that political pressure involves in issuing the loans. Loans are issued on the secret benefits to the loan officers and loans issued on the names of the investers. As the loan rate ceiling is lesser the average effectiveness of the investment is reduced, that results in the profitability on the investments with lower returns. Small businessmen who were refused to get loans previously started entering the markets now. As the interest rates are low it result in the unpleasant assortment from the potential of the social welfare. That eventually produces disequilibrium that effects the growth of the economy (Fry 1997).

Summing up the discussion in the light of above mentioned evidences it has been agreed that financial repression reduces economic growth. But dumping financial repression as a device to reduce cost for the government deficit may result in immense high real interest rate that leads to the sever damage in the economy. Studies evaluate that for a successful economy financial liberalization must be go together with by the fiscal improvement to make sure that government debt will not blow up. Moreover the organised management and regulation of the banking system also improves the conditions (Fry1997). In experience financial repression appears to have capitulated government returns in the order of 2% of GDP on average in model of developing countries (Giovannini and de Melo, 1993; Fry et al. 1996, p. 36). Financial repression can be named as two sided sword. 'Goodbye financial repression, hello financial crash' is the finding

of Diaz-Alejandro {1985) on the Latin American research with financial liberalisation since 1970s. However, (Fry 1997) concludes that if governments spending cannot be reduced than discarding financial repression may result in increase of government debt, instability in economy and lower growth rate. In experience financial repression emerges to yield government revenue, as there is no question that it holds back growth, there is other solution and debate should move from the condition of financial repression to the state of financial liberalization. So far the researches are failed to give sufficient plans for this change.