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COPYRIGHT 2000 MIT Press Journals
I. Introduction
A WAVE OF liberalization of financial markets has swept over much of the developing world, especially since the mid-1980s. This liberalization has been characterized by greater scope being granted to market forces in determining interest rates and in allocating credit (Caprio, Atiyas, and Hanson (1994)). Although this has occurred under the pressure of increased globalization of financial markets and following the example of many industrial countries, there has been an expectation that financial liberalization would help economic development. In particular, the early literature on financial repression, following McKinnon (1973) and Shaw (1973), stressed the potential role of higher interest rates in mobilizing savings that could be put to productive use.
But it is far from clear that financial liberalization actually does increase private saving. One obvious and important consideration is that the effect of interest rates on saving is itself ambiguous, as the income effect might offset substitution effects. In addition, one must recognize that financial liberalization involves more than just a change in interest rates. Other dimensions of financial liberalization, such as increased household access to consumer credit or housing finance, might also work to reduce private saving (Muellbauer and Murphy (1990), Jappelli and Pagano (1994)).(1) Furthermore, the long-term effect of liberalization on saving may differ substantially from the impact effect. Lastly, financial liberalization is a process rather than a one-shot event.
The purpose of this paper is to provide an empirical examination of the total effect of the financial reform on aggregate private saving based on eight case studies: Chile, Ghana, Indonesia, Korea, Malaysia, Mexico, Turkey, and Zimbabwe. These countries have all significantly liberalized their financial sector policies, but they differ in the nature and phasing of financial liberalization, in other aspects of their policy reform program, and in the macroeconomic context in which liberalization took place. This variety allows us to explore the degree to which the saving response differs from country to country, as well as to test whether the response is a common one.
Financial reform typically comprises several key phases that are often separated by several years. Reform measures are introduced in a number of different dimensions: interest rates, credit allocation, bank ownership, prudential regulation, security markets, and openness of the capital account. The best sequencing of these various elements is frequently debated. In practice, reform has not been a monotonic process: In some cases, setbacks have involved temporary policy reversals.
A thorough quantitative assessment of the impact of such a process must take account of its gradual and reversible nature. Based on an analysis of the historical evolution in each case, we have identified the timing of major moves on eight different dimensions towards a more liberalized system. Using the principal components of the resulting matrices of 0-1 variables (1's correspond to the years after a particular reform is introduced), we obtain a single continuous financial liberalization index for each of our countries. As an alternative, we also construct for each country a pair of subindices that capture different aspects of the liberalization process. Our data extends over a quarter of a century--a period long enough to allow us to model the response to liberalization in each country separately--but in addition to the country-by-country results, we also present panel data evidence.
Visual inspection of the time series of the main relevant variables--the financial liberalization index, the real interest rate, monetary depth (either M2 or total credit to the private sector expressed as a percentage of GNDI), and the private saving ratio--reveals little evidence of a clear-cut relationship between saving and liberalization.
We estimate an econometric relationship expressing the private saving ratio as a function of the real interest rate and of the index of financial liberalization (or its subcomponents), along with income, inflation, and government saving. In addition to directly measuring the contribution of liberalization to the volume of aggregate saving, our procedure improves on earlier estimates of the saving-interest relation, which omitted any role for financial-sector liberalization other than the real interest rate channel.
Although they cannot be solved-out for a net effect on the level of saving, Euler equations can be helpful in detecting the extent of credit rationing. In this spirit, we also assess the impact of financial reform on the extent of liquidity constraints by estimating an augmented Euler equation for consumption, in which it is assumed (in an extension of the model of Campbell and Mankiw (1989, 1991)) that the fraction of the consumers are liquidity constrained varies with the degree of financial liberalization.
The structure of the paper is as follows. Section II describes the main channels through which financial liberalization may affect saving and briefly reviews the relevant empirical literature. Section III describes the financial reform process as it occurred in each of the eight countries being studied here. This section also explains and graphs our index of financial liberalization and examines the prima facie evidence about its effects. Sections IV and V present the econometric results based on the saving function and on the augmented Euler equation for consumption, respectively. Section VI concludes.
II. Financial Liberalization and Saving: Theoretical Background and Review of the Empirical Evidence
Although financial liberalization can enhance the efficiency with which saved resources are channeled into productive use, the effect on the quantity of saving is theoretically ambiguous.(2)
The mechanisms at work here include both long-term and short-term effects. Once it has settled down, a competitive, liberalized financial system will typically be characterized by improved saving opportunities, including higher deposit interest rates, a wider range of savings media with improved risk-return characteristics, and, in many cases, more banks and bank branches, as well as other financial intermediaries. Bank lending rates will typically be higher for those borrowers who had privileged access in the restricted regime, but access to borrowing should be wider. These long-term effects of liberalization on aggregate private saving will be felt through changes in rates of return and in the degree of credit restrictions. Moreover, if financial liberalization also has a favorable effect on the allocation of resources, this will generate increases in income that will in turn increase saving.(3)
The process of financial liberalization also unleashes a series of short-run effects. Not only can the process of domestic portfolio adjustment lead to transitory changes in the volume of domestic saving, but (especially when combined with liberalization of the foreign exchange market) it may also induce large capital inflows, largely but not exclusively attributable to a return flow of past flight capital. If not sterilized, such inflows can result in a credit boom leading to real income surges, which in turn have a direct, but transitory, effect on the volume of saving. Modeling of the effect of financial liberalization on saving needs to take account of these short-run effects, as well as the long-run effect. It is also important to recognize that some of the overall effects can come through the effect of income on saving.
A. Steady-State Effects
If financial liberalization improves the rate of return for savers, then knowledge of the interest elasticity of saving can help predict the long-term impact of liberalization on saving. However, because of the wealth and current income effects that will generally be present, there is no presumption as to the direction of the aggregate saving response to an exogenous interest rate change. Despite many studies, this remains an empirically controversial area, partly because of a surprising shortage of reliable and comparable cross-country data on retail interest rates. Recent reviews by Balassa (1990), Srinivasan (1993), and Fry (1995) conclude that more studies have found a positive interest elasticity of saving than a negative one, but the coefficients have generally been small and often insignificant.(4) Furthermore, the theoretical impact on saving of the improved opportunities for hedging and risk reduction that can also become available as a result of financial liberalization is equally ambiguous.
Possibly of greater importance for aggregate saving than deposit interest rates may be the availability of a variety of alternative, nonfinancial assets, the return on which may not be captured by deposit interest rates. While the use of real interest rates implicitly acknowledges that goods inventories are an alternative to financial assets, it would be very useful in principle to take explicit account of alternative investment opportunities, notably the rate of return on owner-occupied housing and other real-estate investment. Many developing countries have experienced property booms, and household saving may have been very sensitive to the after-tax rate of return on investment in real estate. (See, for example, Koskela and Viren (1994).) Unfortunately, in most cases, data on such rates of return are not available for developing countries.
Measured interest rates may not reflect capital market realities if households and small enterprises are constrained from borrowing what they would wish because of financial repression or for other reasons. To the extent that liberalization reduces these borrowing constraints, saving ratios could be lowered (Jappelli and Pagano (1989, 1994)). Two mechanisms are at work here. First, when the borrowing constraint binds, it induces the individual to consume less. Second, even when the constraints are not binding in the current period, the expectation that they may bind in the future reduces today's consumption.
A very large literature, in response to Hall's (1978) original contribution, has attempted to gauge the importance of borrowing constraints by inferring that any dependence of the change in consumption on income might reflect the inability of households to smooth the intertemporal pattern of their consumption through borrowing. (See, for instance, Campbell and Mankiw (1989, 1991) and Zeldes (1989).)(5) The developing-country literature here generally confirms the importance of such dependence, with some indication that it has been higher for developing countries. (See, for instance, Rossi (1988), Haque and Montiel (1989), and Corbo and Schmidt-Hebbel (1991).)
B. Transitional Effects of Liberalization
The impact effect of financial liberalization on saving could be larger than the sustained long-term effect. This is because households will be able to revise target precautionary balances, allowing, for example, some middle-aged households that had hitherto been constrained from lifecycle borrowing to consume at a higher rate than they would have over a full lifetime of unconstrained access to borrowing. These transitional effects suggest that aggregate household saving could dip below its steady-state level, and that a surge in consumption may be observed (Muellbauer (1994)). Moreover, as noted above, financial liberalization has been accompanied by real-estate booms in some countries; the resulting increase in real wealth also may have a temporarily negative impact on saving.(6)
The large capital inflows that have been associated with recent liberalizations have also had complex, short-term, macroeconomic consequences. Liberalization of the domestic financial system has typically been only one element of a package of reforms that have been associated with these inflows, and the inflows have proved to be easily reversible. The impact on saving comes through the associated changes in availability and cost of credit, revised expectations of income growth, and increases in financial wealth, especially due to upward movements in property prices. All this may lead to consumption booms and to a fall in the saving rate.
C. Quantifying the Effects of Financial Liberalization on Saving
Most empirical examinations of the effects of financial liberalization or, more generally, of financial development on saving have involved adding one or more variables to established econometric specifications either of saving or of the rate of change in consumption. The simplest specifications identify pre- and post-liberalization periods with a dummy variable (an early example is de Melo and Tybout (1986) for Uruguay); an alternative is to specify a linear trend reflecting gradual liberalization (Muellbauer and Murphy (1993) for the UK).
Others have employed such proxy variables as the volume of consumer credit (such as Jappelli and Pagano (1989, 1994)). Ostry and Levy (1995) used this variable both on its own and in interaction with an interest rate, and concluded that liberalization had not only lowered saving in France but had transformed a negative association between saving and interest rates into a positive one (cf. Bayoumi (1993) for the UK). An easing of credit market conditions facing households was also detected for the 1980s in Scandinavian countries by Koskela, Loikkanen, and Viren (1992), and Lehmussaari (1990). Here the effect on saving came indirectly through the impact of increased housing finance on house prices.
In their thirty-country study, Jappelli and Pagano (1994) also found another type of credit availability variable to be highly significant, namely the normal loan-to-value ratio obtainable from mortgage finance institutions: an increase of fifteen percentage points in the loan-to-value ratio reducing the national saving rate by 2.6 percentage points. This substantial effect may not be entirely housing related, as the variable may be capturing movements in wider credit availability.
Other proxy measures of the prevalence of credit constraints that have been used include the percentage of homeowners in certain age groups, the interest rate wedge on consumer and mortgage loans (Jappelli and Pagano (1989)), and the rate of consumer credit delinquencies (Carroll (1992)). Confirming the evidence for industrial countries, Vaidyanathan (1993) shows that international variations in the sensitivity of consumption to income are positively related to financial depth (measured by the ratio of M2 to GDP), suggesting again the importance of liquidity constraints.
More directly, Miles (1992) estimated that 80% of the total amount of home equity withdrawn by U.K. households each year in the 1980s was consumed (rather than involving just a portfolio shift), accounting for essentially all of the collapse in the U.K. personal saving ratio from 12% to less than 5%.
The existence of well-functioning stock markets could also be a factor influencing saving by offering an improved risk-return frontier while retaining liquidity. Again, as mentioned, the predicted impact on aggregate saving is theoretically ambiguous, and recent empirical evidence suggests that funds attracted to liquid stock markets in developing countries come mainly as a switch from other assets.(7)
III. Financial Reform: Measurement and Effects
A. Financial Repression and the Process of Reform
The multifaceted nature of financial reform--involving deregulation, liberalization, globalization, and privatization--complicates the measurement of its effects. In addition, the reforms undertaken in each country have reflected the perceived problems of the pre-reform environment. Prior to reform, most countries experienced a period of mild or severe financial repression: intervention by governments in allocating and pricing credit, controlling what banks and other intermediaries could do, using intermediaries as tax-collection devices, and often limiting competition, in particular from foreign institutions. These interventions varied by country, and in some countries included government ownership of banks as a very direct way of influencing how they did business.(8)
In developing countries, intervention in the financial sector went considerably further than the regulation of interest rates and of credit expansion that characterized industrial-country policy. In some countries, banks were required to hold as much as one-half or more of their liabilities in the form of reserve or liquid assets (often deposits at...
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