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
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
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.
The result of these reforms was to
◦ transform developing economies
◦ support by strong private sector growth
◦ rapid maturation of capital markets.
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
◦ 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 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 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.
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.
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.
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.
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 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.
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.
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.
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 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;
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;
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;
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);
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.
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.
Capital account liberalization
Banking sector liberalization
Stock market liberalization
Full Liberalization
Partial Liberalization
Non Liberalization
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.
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.
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
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.
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.
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.
Pakistani credit deposit ratios remains lowest
among developing economies. There is
considerable scope for expansion.
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.
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.
