0115 966 7955 Today's Opening Times 10:30 - 17:00 (BST)

Direct Effects of Financial Repression in India

Published: Last Edited:

Disclaimer: This essay has been submitted by a student. This is not an example of the work written by our professional essay writers. You can view samples of our professional work here.

Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

FINANCIAL REPRESSION (PAPER 7)

Financial repression refers to the notion that a set of government regulations, laws, and other non-market restrictions prevent the financial intermediaries of an economy from functioning at their full capacity (McKinnon (1973) and Shaw (1973)...PAPER 1).

Generally, financial repression consists of three elements. First, the banking system is forced to hold government bonds and money through the imposition of high reserve and liquidity ratio requirements. This allows the government to finance budget deficits at a low or zero cost. Second, given that government revenue cannot be extracted that easily from private securities, the development of private bond and equity markets is discouraged. Finally, the banking system is characterized by interest rate ceilings to prevent competition with public sector fund raising from the private sector and to encourage low-cost investment (PAPER 1).

The policies that cause financial repression include interest rate ceilings, liquidity ratio requirements, high bank reserve requirements, capital controls and restrictions on market entry into the financial sector, credit ceilings or restrictions on directions of credit allocation, and government ownership or domination of banks (PAPER 7).

Economists have commonly argued that financial repression prevents the efficient allocation of capital and thereby impairs economic growth. While theoretically an economy with an efficient financial system can achieve growth and development through efficient capital allocation, McKinnon and Shaw argue that historically, many countries, including developed ones but especially developing ones, have restricted competition in the financial sector with government interventions and regulations. According to their argument, a repressed financial sector discourages both saving and investment because the rates of return are lower than what could be obtained in a competitive market. In such a system, financial intermediaries do not function at their full capacity and fail to channel saving into investment efficiently, thereby impeding the development of the overall economic system (PAPER 7).

This paper aims to analyse the concept of financial repression and reasons why it is seen and detrimental to economic growth......explain sections below.

Rationale for and types of financial repression

The key reason for the government to implement financially repressive policies is to control fiscal resources. By having a direct control over the financial system, the government can funnel funds to itself without going through legislative procedures and more cheaply than it could when it resorts to market financing. More specifically, by restricting the behaviour of existing and potential participants of the financial markets, the government can create monopoly or captivate rents for the existing banks and also tax some of these rents so as to finance its overall budget. Existing banks may try to collude with each other and to interrupt possible liberalization policies as long as they are guaranteed their collective monopoly position in the domestic market.

In some countries, governments require banks to meet high rates of the reserve ratios, and use the reserves as a method to generate revenues. Since reserves earn no interest, they function as an implicit tax on banks and restrict banks from allocating a certain portion of their portfolios to productive investments and loans. If high reserve requirements are combined with interest ceilings and protective government directives for certain borrowers, savers who are usually unaware of the requirement policy become the main taxpayers because they face reduced rates of interest on their savings. Inflation can aggravate the reserve tax because it reduces the real rates of interest.

Thus, high reserves requirements make the best use of the government's monopolistic power to generate seigniorage revenue as well as to regulate reserve requirements. A variant of this policy includes required liquidity ratios; that is when banks are required to allocate a certain fraction of their deposits to holding government securities that usually yield a return lower than could be obtained in the market.

Governments often impose a ceiling on the interest rate banks can offer to depositors.

Interest ceilings function in the same way as price controls, and thereby provide banks with economic rents. Like high required reserve ratios, those rents benefit incumbent banks and provide tax sources for the government, paid for by savers and by borrowers or would-be-borrowers. The rents borne by the interest ceiling reduce the number of loans available in the market thereby discouraging both saving and investment. In return for allowing incumbent banks to reap rents, the government often require banks to make subsidized loans to certain borrowers for the purpose of implementing industrial policy (or simply achieving political goals).

Interest ceilings in high inflation countries can victimize savers because high inflation can make the real interest rates of return negative. Financial repression also takes the form of government directives for banks to allocate credit at subsidized rates to specific firms and industries to implement industrial policy. Forcing banks to allocate credit to industries that are perceived to be strategically important for industrial policy ensures stable provision of capital rather than leaving it to decisions of disinterested banks or to efficient securities markets. It is also more cost effective than going through the public sector's budgetary process.

Government directives and guidance sometimes include detailed orders and instructions on managerial issues of financial institutions to ensure that their behaviour and business is in line with industrial policy or other government policies. The Japanese Ministry of Finance (MOF) is a typical example of government's micromanagement of financial industry.

Capital controls are restrictions on the inflows and outflows of capital and are also financially repressive policies. Despite their virtues, the use of capital controls can involve costs. Because of their uncompetitive nature, capital controls increases the cost of capital by creating financial autarky; limits both domestic and foreign investors' ability to diversify portfolios; and helps inefficient financial institutions survive.

Impacts of Financial Repression

Because financial repression leads to inefficient allocation of capital, high costs of financial intermediation, and lower rates of return to savers, it is theoretically clear that financial repression inhibits growth (Roubini and Sala-i-Martin, 1992). The empirical findings on the effect of removing financial repression, i.e., financial liberalization on growth supports this view, but various channels through which liberalization spurs growth have been evidenced.

The possible negative effect of financial repression on economic growth does not automatically mean that countries should adopt a laissez-faire stance on financial development and remove all regulations and controls that create financial repression. Many developing countries that liberalized their financial markets experienced crises partly because of the external shocks that financial liberalization introduces or amplifies.

Financial liberalization can create short-term volatility despite its long-term gains (Kaminsky and Schmukler, 2002). Also, because of market imperfections and information asymmetries, removing all public financial regulations may not yield an optimal environment for financial development. An alternative to a financially repressive administration would be a new set of regulations to ensure market competition as well as prudential regulation and supervision.

ECONOMIC THOUGHTS

The literature on finance and development postulates a symbiotic relationship between the evolution of the financial system and the development of the real economy. This prediction is common to both the McKinnon-Shaw approach and the endogenous growth literature. However, while in the former financial development determines the level of steady-state output, in the latter it is a determinant of the equilibrium rate of economic growth.

In the McKinnon-Shaw literature the basis for the relationship between financial and economic development is Gurley and Shaw's (1955) debt-intermediation hypothesis. In this framework an increase in financial saving relative to the level of real economic activity increases the extent of financial intermediation and raises productive investment which, in turn, raises per-capita income. In these models nominal interest rate controls inhibit capital accumulation because they reduce the real rate of return on bank deposits, thereby discouraging financial saving. Moreover, higher reserve requirements also exert a negative influence on financial intermediation by increasing the wedge between lending and deposit rates. Under a competitive banking system this wedge is an increasing function of the rate of inflation. Thus higher real interest rates encourage capital accumulation and real economic activity, largely through an increase in the extent of financial intermediation.

The competitive model of the banking industry are theoretically inadequate because First, in many less developed countries the banking industry is typically dominated by a small number of banks and collusive behaviour is not uncommon. Second, asymmetric information in loan markets is sufficient to generate a considerable degree of market power for lenders.

Theoretical inadequacy relates to the implication of the assumptions of perfect competition, which leave little room for analyzing the behaviour of banks and their reactions to government interventions. Departure of the benchmark model from perfect competition has important implications for the way in which repressionist policies affect financial development. These effects may differ depending on the source of the departure from perfectly competitive behaviour. In the case where the departure is due to collusive behaviour, banking controls may induce banks to use non-interest-rate methods to influence the volume of bank deposits.

Whenever the departure from perfect competition is due to imperfect information, the possibility of government corrective actions must be acknowledged. According to Stiglitz (1993), interest rate restrictions may be able to address moral hazard in the form of excessive risk taking by banks. Thus if one is prepared to assume that depositors perceive such restrictions as enhancing the stability of the banking system, their imposition may increase depositors' willingness to hold their savings in the form of bank deposits. However, this crucially depends on how government policies are perceived by the public, which in turn relates to the existence or otherwise of good governance.

Ill perceived and/or executed policies may have the opposite effect than that predicted by the market failure paradigm. Thus the success or failure of certain policies may largely depend on the effectiveness of the institutions that implement them (World Bank (1993). The endogenous growth literature offers additional channels through which financial sector policies may affect financial development, independently of the real rate of interest. In contrast to the Courakis-Stiglitz analysis, where repressionist policies may have positive effects, this literature typically predicts negative effects.

The above analyses serve to suggest that the effects of certain types of interventionist policies as well as the channel through which they work may be different than has so far been recognized by much of the empirical literature. In particular, these policies may have direct effects on financial depth by: (1) changing the willingness of banks to raise deposits by non-interest-rate methods, and (2) changing the willingness of savers to supply their savings to the banking system. Thus these policies can have effects over and above-and sometimes conflicting with-those that are widely recognized in the literature.

DATA ANALYSIS

We focus on the economy of India for a variety of reasons. Besides the obvious reason that India is one of the most important developing economies in the world, it also has a rich history of varying types of repressionist policies which aids the statistical investigation. In the late 1950s the financial system of India was fairly liberal with no ceilings on interest rates and low reserve requirements. In the early 1960st he government tightened its control over the financial system by introducing lending rate controls, higher liquidity requirements, and by establishing state development banks for industry and agriculture. This process culminated in the nationalization of the 14 largest commercial banks in 1969. Further nationalizations took place in 1980. Interest rate controls were rigidly applied from the 1970s to the late 1980s to all types of loans and deposits. The term structure of interest rates was largely dictated by the Reserve Bank. Credit planning, a formal system of directed credit introduced in 1970, increasingly covered a very large percentage of total lending. Moreover, concessionary lending rates were offered to priority sectors. The late 1980s were, however, marked by the beginning of a process of gradual liberalization of the financial system. Ceilings on lending rates began to be lifted in 1988 and were completely abolished in 1989. Finally, further relaxations on directed credit and concessionary lending rates took place in 1990 and 1992.

Interestingly, the index appears to reflect quite well many of the policy shifts that occurred during the sample period. According to this index, the early 1960s appear to be characterized with gradual increases in the level of financial repression. There was some stability in the mid-1960s followed by a big jump in 1969. This behaviour coincides with developments in the 1960s which culminated with the nationalization of the largest eleven banks in 1969, which allowed the Reserve Bank of India to intensify its directed credit program and to impose controls on deposit rates. The 1970s were characterized with the gradual imposition of more controls, i .e. a lending rate floor operated during 1973 and 1974, a lending rate ceiling was imposed in 1975 and remained in operation for 13 years, and reserve requirements (PAPER 3) were raised in 1976. The early 1980s saw even more controls imposed and an intensification of the directed credit program. Once again the gradual increase in the index follows these developments quite well. The index drops significantly in 1985, which coincides with a partial deregulation of deposit rate controls. It then rises again, reflecting the reintroduction of deposit rate controls in 1988 and a 4% increase of reserve requirements in 1989, but drops again in 1990 when the directed credit program is relaxed. Finally, there is a small drop of the index in 1991, which coincides with further deregulations of deposit rates. (PAPER 3)

RECOMMENDATION (financial liberalisation)

Since the break-up of the colonial empires, many developing countries suffered from stagnant economic growth, high and persistent inflation, and external imbalances under a financially repressed regime. To cope with these difficulties economic experts had advocated what they called “Financial liberalization" mainly a high interest rate policy to accelerate capital accumulation, hence growth with lower rates of inflation (McKinnon (1973), Shaw (1973), Kapur (1976) and Matheison (1980)). Their argument that relaxation of the institutionally determined interest rate ceilings on bank deposit rates would lead to price stabilization and long-run growth through capital accumulation is based on the following chronology of events: (a) the higher deposit rates would cause the households to substitute away from unproductive assets (foreign currency, cash, land, commodity stocks, an so on) in favour of bank deposits; (b) this in turn would raise the availability of deposits into the banking system, and would enhance the supply of bank credit to finance firms' capital requirements, and ; (c) this upsurge in investment would cause a strong supply side effect leading to higher output and lower inflation.(paper 1)

CONCLUSION

The main finding of this paper is that the direct effects of financial repression in India were negative and quite substantial. We would, however, advise caution in generalizing from these results to other countries. It is well known that the success of economic policies largely depends on the effectiveness of the institutions that implement them, and this clearly varies from country to country (e.g., World Bank (1993)). Thus we would not be surprised if future research showed- that the direct effects of financial repression in other countries (e.g., South Korea) were positive and significant.19 In fact, according to our theoretical analysis, the possibility of positive effects cannot be ruled out. Our conjecture is that "repressionist" policies may have positive effects whenever they are able to successfully address market failure. How-ever, market failure should encompass not only information-related imperfections but also those pertaining to the structure of the banking industry, as the latter may be equally important. Our results highlight a number of potentially fruitful avenues for further research. From a theoretical view point much work needs to be done to model financial repression in a framework where banks are more active than has so far been customarily assumed. Models where banks are able to influence the volume of their loanable funds may also be in the spirit of the modem banking literature, which emphasises the importance of active liability management. In such a framework it would be interesting to explore the role of market structure. A game-theoretic approach may also be taken, which could yield rich insights about the strategic aspects of financial repression. From an empirical point of view, the examination of the direct effects of financial repression in other countries is likely to be of considerable value. Furthermore, comparisons of these effects across different economies are likely to shed light on the relative effectiveness of repressionist policies, thereby providing indirect evidence on relative levels of good governance. Finally, our results suggest that there is also considerable scope for empirical studies of bank behaviour under conditions of financial repression. (PAPER 3)


To export a reference to this article please select a referencing stye below:

Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.

Request Removal

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal:


More from UK Essays

We can help with your essay
Find out more