Since World War II, most developed countries have reformed their financial sectors and deepened financial liberalization. Advanced developing countries have followed in their footsteps, particularly since the 1970s, and have further deepened ever since. Countries such as Malaysia, Singapore, and South Korea have cautiously and gradually introduced financial liberalization. They did so after they had successfully industrialized their economies, fostered vibrant and dynamic institutions, promoted investments and export competitiveness, and substantially boosted the living standards of their citizens.
Before liberalization, they had also put in place sound policies and robust intervention strategies including “infant industry protection”. For instance, credit underwriting and targeted incentives to the domestic private sector as well as “policy-based financing” have been widely practiced in these countries. These measures greatly assisted in sustaining growth and deepening structural economic transformation while containing the adverse impacts of financial liberalization.
In Latin America, empirical evidence suggests that premature financial liberalization triggered episodes of the banking crisis particularly in Argentina (in the 1990s, 2000s, and recently in 2023), Brazil (1998), and Mexico (1994), disrupting or halting industrialization and structural transformation.
RELATED POSTS
In SSA, financial liberalization was undertaken as part of the Structural Adjustment Programmes (SAPs) of the 1980s prescribed to the countries of the sub-region. Cameroun, Cote d’Ivoire, Ghana, Kenya, Nigeria, South Africa, Zambia, and several others have undertaken partial or full financial liberalization since the 1980s. The recommended packages included removing barriers and restrictions, policy distortions, and regulatory controls over financial institutions and the movement of capital.
More specifically, they included rationalizing credit allocation, liberalizing interest rates and exchange rate regimes, opening the financial sector to foreign banks, easing restrictive monetary policies, and revamping the banking sector. The objective was to ensure that monetary tools and instruments, such as interest rates, credit distribution, exchange rates, etc are determined by market forces (demand and supply). Liberalization and deregulation also diminished the role of governments, compromising the monetary autonomy of the state and state institutions.
However, the history and experiences of present-day developed economies tell us that socioeconomic progress, industrialization, and technological advances are the results of the interplay of supportive government policies and entrepreneurial capabilities. Their industrialization and overall economic development are much less the outcome of unfettered openness and liberalization of the financial sector.
Following financial liberalization, SSA’s average saving rates have moderately improved from historically low and negative levels, and capital flows and economic growth improved. However, the improvements were short-lived, sluggish, and inadequate to address savings-investment gaps, unemployment, and generalized poverty. Most countries of SSA continued being locked in low-income and generalized poverty traps. Their respective manufacturing value-added continued to decline from the already low levels, commodity dependency increased and over-dependence on external aid continued to rise even after the episodes of financial liberalization.
Moreover, they could not address systemic weakness and vulnerability in the banking sector such as volatile exchange rates, and the widening gap between lending and deposit interest rates. What is more unsettling is the weak productive capacities of SSA particularly in areas such as energy (electricity), ICTs, private sector, institutions, and economic complexity.
Within SSA, except for Mauritius, South Africa, and to some extent Botswana, the productive capacities on the multidimensional Productive Capacities Index (PCI) remained the weakest and the lowest of the developing regions of the world. Therefore, financial liberalization in SSA can be regarded as “premature” and mistimed. It also undermined the roles and responsibilities of governments to actively pursue industrialization and overall economic development.
Some countries, such as Ethiopia, are latecomers to financial liberalization and SAPs, having escaped the earlier episodes of adjustment programs. In this respect, Ethiopia has a latecomer advantage to learn from the experiences of other countries to avoid the pitfalls and mistakes observed in frontrunners. Countries’ Experiences can provide useful policy insights and lessons in addressing structural challenges and fostering institutional, legal, regulatory, and structural capabilities needed to turn financial liberalization into a powerful tool for macroeconomic stability, industrialization, and economic development.
Identifying the foundational preconditions necessary to ensure that financial liberalization results in macroeconomic stability and economic development Is crucial. The right timing and appropriate sequencing of financial liberalization is key to maximizing development outcomes while minimizing adverse consequences. It is important to ensure that the liberalization measures are supportive of the development priorities of countries of SSA. Otherwise, badly sequenced, mistimed, and “premature financial liberalization” could turn the macroeconomic environment from bad to worse. Alternative approaches to financial liberalization which can serve as lessons for policymakers in Ethiopia and other latecomers should also be considered.
Objectives & underlying assumptions
The overall objectives of financial liberalization in SSA were to improve savings and investment rates to revive the sub-region’s sluggish socioeconomic performance of the preceding decades. The premise of the policy move was the neoliberal conviction that financial liberalization enhances industrialization, generates economic growth, and improves macroeconomic stability.
The policy was also intended to deepen financial services (widening actors, choices, and services); foster efficiency and competitiveness; and modernize the economy. Further proclaimed objectives include enhancing global integration, boosting foreign direct investment (FDI) flows, and facilitating technological advancement.
Behind these objectives of financial liberalization are underlying assumptions, which include: the existence of egregious policy distortions and operational inefficiency in the economy in general and the financial sector in particular; the inability of governments and state institutions to ensure flexibility and effective policy responses to structural challenges and systemic vulnerability of economies to exogenous shocks; market forces are agile and flexible to correct structural imbalances and policy distortions in the economy.
Furthermore, protectionist policies are disastrous to the economy and are key in worsening terms of trade, rising interest rates and increasing external indebtedness in poor economies; and age-old government-driven monetary policies are unable or inadequate to manage interest rates, ensure a balanced distribution of credits or better allocation of scarce resources in the economy and modernize the economy, particularly the financial sector.
The problem for SSA is not financial liberalization per se. Rather it is the lack of serious thoughts about pre-existing socioeconomic conditions (macroeconomic imbalances), erroneous policy sequencing, and the lack of strong and dynamic institutions that are capable of enforcing policies, regulations, and supervision mechanisms in the financial systems.
The concern is whether market forces by themselves can address underlying structural challenges, systemic underdevelopment, and persistent vulnerability of these economies to endogenous and exogenous shocks.
For Ethiopia and other SSA economies, the objective of financial liberalization should be to maximize development gains with macroeconomic stability. To achieve this, in the face of increased negative externalities and binding constraints to development, the following issues demand serious policy considerations.
Key issues and options for policy consideration in SSA before undertaking financial liberalization
Addressing pre-existing macroeconomic imbalances: historically, success in financial liberalization has depended on addressing macroeconomic imbalances and structural constraints to development before adopting such policies. For example, the root causes of Ethiopia’s macroeconomic imbalances are related to poor export performance due largely to limited development of productive capacities, inability to generate adequate foreign exchange, and persistent current account deficits.
Inflationary pressures, external indebtedness, unemployment, widespread poverty situations, and protracted conflicts are the causes and effects of structural imbalances.
The key policy lesson is that financial openness and the deepening of financial liberalization should be undertaken only once such structural imbalances are corrected or effectively addressed. If not, financial liberalization will intensify rather than solve the existing socioeconomic problems.
Fostering institutional and regulatory capabilities: In SSA, institutions are too weak to manage the volatility and instability entrained by financial liberalization. Central banks are not independent or free from political interference. Likewise, existing regulatory frameworks and enforcing mechanisms are unable to undo or reduce dominant positions in the financial and banking sectors that emerge out of financial liberalization.
Financial liberalization can increase freedom for banks (domestic and foreign) to engage in financial activities that are unrelated to the immediate development priorities.
For instance, while the economy needs investment in production, banks may favor distribution, other services, or consumption. In many countries of SSA, such as Ghana, Kenya, Nigeria, and Zambia, financial liberalization has not channeled resources to productive sectors. Instead, it encouraged the reallocation of investment from production to distribution and consumption, leading to massive “servicification” of the respective economies.
Moreover, the openness of the financial sector may facilitate an increase in domestic interest rates which can shift foreign currency holding to domestic real assets and repatriation of capital. SSA’s governments must ask themselves how to best organize their domestic financial institutions and regulatory regimes before assuming obligations under financial liberalization.
Each country should also ask whether it has a strong and competitive domestic banking sector that withstands fierce competition from foreign banks. Are there sound competition policies and requisite human resources with the right mix of skills, knowledge, and expertise? Are domestic institutions capable of enforcing competition rules and regulations to mediate cases of abusive dominant positions and restrictive business practices in financial markets? Such questions are critically important given robust experience, the highest technological disposition, and the superior expertise of newly entering foreign banks.
Restructuring real economic sectors: Policy sequencing and timing are key in making any reform process successful. If financial liberalization and deepening financial services go faster than reforms in the industrial, trade, investment, and other services sectors, it can lead to crises and instabilities as was observed during major episodes of financial and banking crises. These were observed in the above-mentioned economies of Latin America, Russia (1998), Thailand (2008), Turkey (2018), the Asian financial crisis (1997), and the global financial crises (2008-2009).
In other words, developing countries must first prioritize liberalizing their current accounts before liberalizing their capital accounts. Financial liberalization must follow the restructuring of the real economy, including removing egregious distortions in trade, industrial, and investment policies. This is because the key role of the financial sector, beyond the deepening of financial services, is to facilitate industrialization, accelerate structural transformation, and foster export competitiveness.
Financial liberalization will likely miss its intended objectives without addressing sectoral rigidities in the economy. Therefore, it is vital to foster industrialization with a focus on increasing manufacturing value-added in the economy. It is equally important to modernize trade and investment regimes as well as trade logistics so that financial liberalization contributes to the overall development objectives of countries.
Historical and empirical evidence suggests that without industrialization and structural economic transformation, financial liberalization cannot raise economic efficiency and productivity. Nor can it contribute to economic growth, job creation, poverty reduction, and overall development. This is because, in structurally weak economies, market-based financial liberalization does not guarantee the reflection of fundamentals in its valuation and in improving productivity, and efficiency as well as facilitating production transformation. This means that latecomers such as Ethiopia should ensure financial liberalization accelerates industrialization and fosters export competitiveness.
Otherwise, unfettered, mistimed, and premature financial liberalization can lead to increased volatility, risks, and uncertainties in the economy, worsening existing socioeconomic woes.
Protecting monetary policy autonomy at all costs: The issue of policy space and policy autonomy has not been given adequate attention in economic literature and development policy discourses. By and large, policies are prescribed or imposed from outside, despite some countries’ intention to formulate home-grown economic policies. In so doing, there was no serious consideration given to domestic or country-specific circumstances.
Poor economies were ill-advised to remove subsidies to their strategic sectors such as agriculture or industry with disastrous consequences for their socioeconomic transformation and development. This has also undermined the capacity of nations to design home-grown policies and finance their development priorities. When policies are designed domestically, the combination of weak institutions, a lack of human capabilities, and a financing gap complicates their implementation.
The dilemma faced by countries in SSA is how best to protect their policy space and macroeconomic policy autonomy under severe constraints facing them in the areas of institutions, human resources, and paucity of financial resources. None of the recently implemented financial liberalization policies in SSA are either home-grown or supported through domestically mobilized resources, which is essential for maintaining policy space and autonomy.
The assumptions that market forces are agile and flexible to correct structural imbalances and that protectionist policies are disastrous to the economy are myths propagated by market fundamentalism under neoliberal orthodoxy. Particularly, in weaker economies of SSA, financial liberalization and openness to foreign banks rarely mediate savings-investment rates. They are also incapable of addressing systemic risks and uncertainties (such as bubble-bust cycles, over-indebtedness, and payment crises) that can arise due to huge capital inflows, with devastating impacts on job creation and poverty reduction.
Policymakers in poor economies should also ask themselves whether financial liberalization is driven by their development priorities (endogenous factors) or if it is externally imposed.
Investing in productive capacities: The root causes of macroeconomic problems in weaker economies are “structural” in nature. They are related to their underdeveloped productive capacities needed to produce a diverse range of goods and services for domestic consumption, exports, and accumulation of surplus. Financial liberalization before addressing such structural constraints is akin to putting the cart before the horse.
Instead of deepening industrial development, improving productivity and the macroeconomic situation, mistimed and badly sequenced financial liberalization, can reallocate resources to non-productive sectors. This in turn exposes the economy to an import-intensive development process.
Financial liberalization is also known for causing volatility in interest rates, equity prices, and exchange rates by shifting finance to real estate, precious stones, and collectible assets.
In short, financial liberalization will have a more positive impact only after countries have developed productive capacities, and fostered dynamic entrepreneurship, and innovative enterprises in parallel with functioning institutions. Macroeconomic stability and proactive states are more important in driving the development processes than financial liberalization.
Experiences of successful developing countries show that direct and preferential credit to the private sector and “infant industry protection” are foundational for the development of a vibrant, dynamic, and innovation-driven domestic private sector which is an important pillar of productive capacities.
Imperfect or incomplete market information: In countries where institutions are weak, distortions in markets are rampant. The assumption that markets and governments operate in opposite directions is not substantiated by empirical evidence.
Markets function best where state institutions are dynamic and vibrant to correct information asymmetries. The known distortions of the markets, particularly in SSA, are due largely to asymmetries and imperfection of information and other externalities. This is simply because market forces could not allocate scarce resources under well-known information asymmetry and negative externalities existing in the economies of SSA.
Understanding the role of risks: Learning from the experiences of early liberalization episodes, policy distortions, risks, and uncertainties play vital roles in determining the cost of finance (interest rates), and the level of borrowing and lending, as well as effects of financial liberalization.
Investment decisions and returns on investment are largely determined by the level of risks and uncertainties in an economy than financial liberalization. Lenders factor in potential risks and uncertainties that arise due to unforeseen circumstances in the determination of interest rates on loans.
Investors’ decisions are influenced by market size, locational advantages, political stability, production costs, skill levels, institutional strengths, and stability of regulatory regimes rather than financial liberalization. Therefore, policymakers in SSA should not ignore risks, pitfalls, and uncertainties in their economies. Instead, they must carefully assess these and develop contingency planning to address them to the extent possible.
Better coordination of policy formulation and implementation, timely sharing of relevant information, ensuring political and policy stability, improving knowledge and skill mixes of their labor force, and incentivizing firms can assist in mitigating some of the potential or perceived risks.
Conclusion
Latecomers such as Ethiopia have distinct advantages of not repeating the mistakes of developing countries that are frontrunners in deepening financial liberalization.
Undertaking financial liberalization without a broader assessment of risks and uncertainties can lead to socioeconomic disasters. It compounds structural challenges and imbalances, further entrenching vulnerability to shocks of weaker economies. It is vital to understand the hazards that may face Ethiopia and other latecomers in the context of financial liberalization and increasingly sophisticated banking and financial markets.
Moreover, policy sequencing and timing of financial liberalization must be given the utmost attention. Domestic financial markets and current accounts should be liberalized before capital accounts. Domestic banks should be strengthened and made vibrant, dynamic, and competitive. Similarly, fiscal balances and monetary policy stability should be attained before financial liberalization and the opening of the banking sector for foreign banks.
In principle, financial liberalization and unfettered openness of the sector allow residents to acquire assets and liabilities denominated in foreign currencies. Liberalization can also undermine the role of governments in monetary decision-making and allow non-residents to operate and freely invest in national financial markets. Liberalization also allows residents to transfer capital and hold financial assets abroad while encouraging non-residents to issue liabilities and borrow from domestic markets, facilitating capital flights in the former case and crowding out domestic operators and investments in the latter case.
In conclusion, there are several lessons to be drawn from experiences of successful developing countries in financial liberalization that can serve as policy guides for latecomers. Strong institutions and a dynamic and value-creating private sector are vital to ensure the successful outcome of policies; Policy sequencing and timing are equally important to make financial liberalization successful and development-friendly.
For policymakers in countries such as Ethiopia, the priorities should be controlling inflationary pressure, ensuring macroeconomic stability, limiting excessive credits, and fostering an overall enabling environment. And, macroeconomic and political stability are more beneficial for fostering productive capacities, industrialization, structural economic transformation, and facilitating trade and investment flows than financial liberalization.
This article was prepared in full consideration of ST/AI/2000/13 section 2. The opinions expressed in this article are the author’s own and do not reflect the official views of UNCTAD or the Magazine. The author can be reached at [email protected]
