Financial Liberalisation (I)

inSight

26 Aug 2004

Financial Liberalisation (I)

This first of two articles analyses the benefits and risks of liberalisation of a financial system.

When a particular jurisdiction decides to open up its financial system and its financial markets to the outside world, it does so for a variety of very good reasons. But it has always to be alert to the risks that are associated with financial liberalisation.

As has often been pointed out, the presence of foreign financial intermediaries with international repute and experience - banks, including investment banks, and stock-brokers of various descriptions - increases the efficiency of financial intermediation and therefore promotes economic growth and development. Indeed, this has been the experience of many "emerging" markets. The presence of foreign banks tends to increase competition, which, in turn, sharpens the competitive edge of domestic banks. The increased efficiency will be translated eventually into higher returns for domestic savings and cheaper cost of funds for borrowers. There will also be greater efficiency in the pricing of credit and other risks, and therefore in the allocation of credit generally. Equally convincing arguments apply to the equity and debt channels of financial intermediation. Foreign experience and expertise in the organisation of initial public offerings, supported by liquidity and an efficient price discovery mechanism in the secondary market, increase the quantity as well as the quality of the flow of domestic savings into domestic investments. The development of the domestic debt market to increase the diversity of funding and therefore improve the overall stability and resilience of the process of financial intermediation can also benefit from foreign experience and expertise.

There is not much debate, up to this point, other than perhaps the degree and pace with which this openness in the financial system should be pursued. There may be legitimate concerns over the chances of survival of domestic financial institutions when they are exposed to intense foreign competition, with consequences for general confidence in the financial system and financial stability. There may also be concerns, more so at the political rather than the professional level, about the behaviour of foreign financial institutions, as against that of indigenous ones, at times of financial stress, when inevitably the long-term public interests may need to prevail over the short-term private ones, and there is a need, however undesirable it may seem, for political pressure to be brought to bear. Consequently, experience and expertise, it may be argued, should, as much as possible, be acquired through other, less risky means, for example, by training abroad or by importing experts rather than institutions. But this is very much a matter of degree. In any case, realistically emerging markets do not usually have the luxury of choice. Reputable foreign financial institutions have to be encouraged to establish a presence, principally by the substantial profit motive, rather than keep knocking at the door of any emerging market.

Furthermore, for foreign financial institutions, the opportunity for profit is often more prominent in developing economies opening up their financial markets to the outside world, thus enabling cross-border financial intermediation, than in the case of just opening up domestic financial systems so that they can participate in domestic financial intermediation. It is probably the business, or the potential for the business, arising from mobilising foreign savings into emerging markets or domestic savings of emerging economies into foreign investments that is relatively more attractive, from a profitability point of view. In practice, therefore, the opening up of emerging markets invariably involves the liberalisation of capital account, eventually or perhaps even up-front, to give foreign savings access to domestic financial markets and, possibly, also domestic savings access to foreign financial markets. Indeed, it is not difficult to see the benefits in the free mobility of capital globally. It promises more efficient allocation of scarce funding on a global basis, as capital is allowed to look for the highest risk-adjusted return in financial instruments, whether in the form of deposits, debt or equity. This is as far as the theory goes. In practice, however, global finance is a lot more complicated than that: next week I shall examine the risks of financial liberalisation and how they can be addressed.

 

Joseph Yam

26 August 2004

 

 

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