Financial Policies and Capital Markets in Arab Countries

Saíd El-Naggar

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1994
• ISBN:
  9781557754189

NONE

I The Role of Financial Sector Reform in Macroeconomic and Structural Adjustment

MANUEL GUlTIÁN*

Introduction

The last decade can be called a period of financial liberalization in both developed and developing countries. Financial markets in many of the more advanced economies have seen the virtual completion of the deregulatory process, and developing countries have also launched financial sector reforms or have accelerated the process of their liberalization. Currently, dramatic financial liberalization is under way in Central and Eastern Europe as well as in the states of the former Soviet Union. Despite wide country-specific differences, these universal financial reforms have responded to a common aim: the achievement of better economic performance through a sound and efficient financial system. While few economists would argue against this broad statement, there are aspects of the reform process—for example, the urgency of financial reforms and the relative importance of real versus financial sector liberalization—on which views vary.

The purpose of this paper is to examine the essential role that financial sector reform can play in macroeconomic and structural adjustment. The analysis will discuss the sequencing of economic reform—namely, the importance of simultaneous action in financial and real sector reform, as well as in domestic and external sector reform.

Definition, Concepts, and Forms of Financial Reform

Financial liberalization may be narrowly defined as policies that reduce the restrictiveness of controls on the workings of financial markets. A broader concept would encompass measures to enhance the efficiency and soundness of the financial system. Under this general definition, actions such as the development of money markets, the adoption of an indirect monetary control system, or the establishment of a strong supervisory framework can be labeled “financial liberalization.” In this paper, I have adopted this general concept of liberalization.

There is also a need to clarify some of the related concepts used in the analysis. In particular, the term “structural adjustment” means actions aimed at the attainment or restoration of rapid economic growth through the elimination of internal and external economic distortions or imbalances. As such, structural adjustment policies will have a macroeconomic or a microeconomic dimension, depending on the nature of the economic imbalance or distortion they are addressing.

Macroeconomic adjustment policies aim to keep or bring domestic expenditure in line with resource availability, an aim that typically requires a combination of fiscal, monetary, exchange rate, and trade policies to ensure that the level and composition of aggregate demand conform with the pattern of supply. For macroeconomic balance to be sustained, an appropriate incentive structure will be required among sectors in the economy, including in particular those for traded and nontraded goods and services.¹ This aspect of macroeconomic management reaches out toward the area of microeconomic adjustment policies, which are typically aimed at improving efficiency in resource use by removing price distortions, strengthening competition, and dismantling administrative control.

Economic distortions and imbalances interact, a characteristic that must be taken into account in the design of adjustment efforts. For example, an unrealistic exchange rate, which may reflect a macroeconomic imbalance, can produce microeconomic distortions by favoring certain sectors of the economy over others. Similarly, microeconomic distortions can result from pricing policies of public enterprises that do not reflect input costs appropriately; in addition, institutional distortions can arise from the resulting improper incentives for efficient enterprise management. Public enterprise pricing policy often leads to macroeconomic distortions in the form of large public sector deficits. This “interrelatedness” is the main reason why any approach must be simultaneous and comprehensive in the design of policies that aim to achieve overall balance in the economy.

The modalities of financial liberalization differ across countries and depend on specific policy objectives. Typically, financial liberalization initiatives can be grouped into five categories:²

• Measures to deregulate the financial sector, which include interest rate decontrol, deregulation of fees and commissions, increased autonomy of financial institutions, and elimination of bank-specific administrative norms, such as credit ceilings;
• Measures to improve the monetary policy framework, which involve the development of indirect monetary policy instruments, the reduction of preferential credits in priority sectors, and the lifting of direct credit controls;
• Measures to promote competition in the financial sector, which encompass easing of entry and exit barriers, enlarging the scope of business boundaries of financial institutions, improving the ownership structure of financial companies, and restructuring and privatization of state-run banks. Also in this group are measures to improve infrastructure and deepen financial markets, such as establishing a broker/dealer network in the money market and developing new capital market instruments.
• Measures for international financial liberalization, which entail actions to open the capital account and liberalize trade in financial services.³ These include the lifting of controls on inbound and outbound direct investment, allowing private holdings of foreign currency and other financial assets, moving toward a market-determined exchange rate system, and providing market access to foreign financial institutions on a nondiscriminatory basis; and
• Measures to strengthen prudential regulation and the supervision framework, which include recapitalization of banks, enhanced transparency, and improved protection for depositors or investors.

In some countries, financial reform measures have focused only on some of these areas, thereby overlooking other related measures and complementary actions. A theme of this paper is that structural efficiency and the establishment of a competitive environment in the financial sector and in the economy at large, as well as better macroeconomic balance, will be attained more effectively through simultaneous and comprehensive reforms.

Optimal Design and Implementation of Financial Reform

In designing a financial reform strategy, some contend that real sector adjustment should be nearly complete before embarking on reforms of the financial sector; some argue that financial reform is best undertaken gradually. This paper will examine the merits of the “real sector first” strategy and the “gradualist” approach. These arguments will be viewed in light of the diversified experiences of selected reforming countries and will identify pivotal roles for financial sector reform to play in general economic reform. Against this background, I will argue for a simultaneous and rapid approach to financial reform.

Real Versus Financial Sector Reform

A relatively large segment of the literature on the sequencing of economic reforms advocates a slower pace for reform of the financial sector than for the real sector of the economy. One line of argument asserts that capital account restrictions should be lifted only after trade and other industrial sector distortions have been dismantled. Reasons include the differential speed of adjustment in the markets for goods and capital, which may result in harmful overadjustment of prices (“overshooting”) in financial markets, or the possibility of real exchange rate appreciation that may result from large capital inflows.⁴ Another line of argument is that the enterprise sector should be restructured before undertaking key reforms of financial liberalization, such as interest rate deregulation, the main reason being that the net worth of enterprises will likely be adversely affected by the generally upward movement of interest rates.⁵ This in turn can feed back into the banking system in the form of bad loans and tends to defeat the purpose of financial reform by weakening the banks’ ability to intermediate new funds.

More recently, actual experience with structural and macroeconomic reform has led to a recognition that programs that do not incorporate financial sector reform measures early on either encounter reversals, achieve their intended results very slowly, or often fail. Indeed, a strategy that delays financial reform ultimately will limit real sector development (Korea) and, by injecting new distortions into the economy, may actually be counterproductive. Delaying reform of the financial sector is also likely to exacerbate the macroeconomic stabilization problem and limit the ability of the authorities to respond to unexpected new shocks.

The case for an early focus on financial sector reform, ideally concurrent with other reform measures, has both an efficiency (microeconomic) and a stabilization (macroeconomic) dimension.

As to the efficiency dimension, it is increasingly recognized that wide-ranging structural reform policies—price reform, fiscal reform, exchange and trade system reform, and industrial restructuring—imply a fundamental reallocation of capital resources and a redirection of new savings and investment flows. Thus, financial institutions and markets are intimately involved, and must be permitted to play their intended role. Financial sector reform, including widened access to foreign capital, can help to ensure that sound, economically viable firms have access to the credit flows necessary to permit restructuring.⁶ In addition, well-functioning credit markets can provide the required “information system” for lenders to assess risk and creditworthiness of borrowers, and allocate and price credit according to risk, thus facilitating the separation of efficient from inefficient enterprises.

Some proponents of the simultaneous approach refer to the growing empirical evidence that countries with a more liberal financial system have benefited from increased savings, better and more efficient investment performance, and faster rates of economic growth.⁷ It is increasingly recognized that the liberalization of interest rates and other financial reforms in many Asian countries have contributed significantly to the mobilization of financial savings as well as to the increased efficiency of investment (Malaysia, Thailand).⁸ Moreover, if reform extends to the privatization of inefficient, state-run commercial banks, it can be expected that lower intermediation spreads will result and, ceteris paribus, the cost of capital to the industry sector will be reduced.

Another aspect of the efficiency argument is that concurrent financial sector reform can reinforce other structural policies, and sometimes be a precondition for their effective implementation. As an example of the mutually reinforcing role that financial sector and reforms in other areas can play, it is sufficient to point to the importance of exchange liberalization and an early opening of the capital account in promoting a more outward orientation of the economy and economic behavior. Another example that may be particularly relevant for Arab countries concerns the pivotal role financial markets can play in the privatization of public enterprises; namely, facilitating proper equity valuation and offering a channel for widespread distribution and subsequent trading of claims. Financial sector reform also has a role to play when state-run enterprises are restructured, if not actually privatized. In these cases, by eliminating preferential access to credit and subsidized exchange rates, public enterprises can be encouraged to become, over the medium term, more competitive and autonomous.

Relevant though efficiency is, it should not conceal the other critical improvements in the process of macroeconomic stabilization that can be gained from early and concurrent financial sector reform. In many instances, it would appear that structural flaws in the financial system “cause” high inflation by impeding and raising the costs of combatting it, to the point where the authorities become reluctant to pursue an effective monetary policy. If so, stabilization efforts are unlikely to be successful without appropriate accompanying financial sector reform measures.⁹

Sometimes, therefore, it can be useful to think of financial sector reform as a structural reform designed to enhance the capacity of the monetary authorities to meet their macroeconomic stabilization objectives.¹⁰ Typical measures will include shifting the focus of the central bank away from financial intermediation (particularly the financing of the government deficit), the introduction of new techniques and instruments of monetary management (substituting market-oriented indirect techniques for direct controls, enhancing monetary programming skills within the central bank), and “unclogging” the channels through which the effects of monetary policy are transmitted to the real sector (strengthening financial institutions, introducing an element of competition, and encouraging the market determination of interest rates and credit flows).

There are at least two other ways in which a concurrent focus on financial sector reform can aid in the macroeconomic stabilization and structural transformation of the economy. First, when reforms generate positive real rates of interest and a more diverse choice of assets for the placement of investible funds, financial liberalization can make an important contribution to staunching capital flight. Second, it can provide the authorities with greater flexibility and additional tools to deal with the destabilizing effects of unexpected macroeconomic shocks. Such room to maneuver may well prove crucial in maintaining the momentum of the overall structural reform program, which might otherwise be threatened should a major shock occur while reform was...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Foreword
• Preface
• Opening Statement
• 1. The Role of Financial Sector Reform in Macroeconomic and Structural Adjustment
• 2. The Role of Financial Institutions in Facilitating Investment and Capital Flows
• 3. The Emerging Arab Capital Markets: Status, Role, and Development Prospects
• Footnotes