Financial systems and development

Box 9.1
Financial liberalization in New Zealand
i New Zealand is an example of a developed country rate, introduced market-based tenders for sales of govthat
has made the transition from a heavily regulated ernment securities, and established a new system of
financial system to one more reliant on market forces. monetary control. To promote competition among fi-
By 1984 government intervention in finance had be- nancial institutions, the government encouraged the
come widespread. Most intermediaries were subject to entry of new banks irrespective of domicile and exinterest
rate controls, credit was directed toward pre- tended the right to deal in foreign exchange to institu-
* ferred sectors such as housing and farming, and inter- tions outside the banking sector. External capital conmediaries
were obliged to buy government securities at trols were removed to deepen the foreign exchange
below-market interest rates. Although these policies market. Liberalization was accompanied by strengthstimulated
investment in housing and agriculture and ened supervisory capabilities. Prudential regulation
provided the government with a cheap source of deficit emphasized the prevention of system-wide failure
financing, they contributed to slow growth by reducing rather than failures of individual institutions, and the
the credit available for other, potentially more profit- government chose not to introduce a deposit insurance
able activities. They also undermined financial stability scheme.
and the effectiveness of monetary policy as financial It is too early to make definitive judgments on the
intermediation shifted to firms less amenable to regula- success of the financial reforms, but the evidence thus
tion and to institutions less constrained by prudential far is reassuring. The removal of capital controls did
standards. not lead to capital flight-an outcome attributed to the
Following the 1984 election the government intro- credibility and the comprehensive nature of New
duced a new market-oriented strategy. The compre- Zealand's program of reform. The number of banks
hensive package of structural reforms sought to spur operating in New Zealand has risen from four to fifgrowth
and to redress external imbalance by increasing teen. Financial activity appears to have gravitated back
the role of market forces in the economy. Included toward the banking sector, and the narrowing of some
were trade liberalization, labor market reforms, mea- banking margins, especially on foreign exchange transsures
to restore fiscal discipline, and reform of state- actions and consumer loans, indicates that competition
owned enterprises (including privatization). In the fi- has increased. New Zealand's apparent success sugl
nancial sector the government abolished all interest gests the importance of incorporating financial reforms
rate controls and credit directives, floated the exchange into a broader program of structural reform.
lems. The government merged five insolvent on the services that could be offered by different
banks with bigger ones, imposed ceilings on de- institutions were also reduced or eliminated. Fiposit
interest rates, and increased its monitoring. nancial systems in these countries were already
In the meantime several brokerage houses, includ- market-oriented, and the reforms were designed
ing some of the largest, went bankrupt. to stimulate further competition and efficiency.
While Turkey reregulated interest rates, the With modestly rising inflation in the 1970s and
Philippines-after substantially restructuring its fi- early 1980s, interest rate controls on deposits prenancial
intermediaries-continued its liberal pol- vented institutions from competing effectively
icy. The financial problems of both countries re- with unregulated suppliers in the securities marflected
past economic policies and bad bank kets and Euromarkets. Although the reforms genmanagement.
External shocks, structural adjust- erally improved the efficiency of financial systems,
ment, and abnormally high interest rates turned they caused stress for certain institutions such as
these problems into a financial crisis. The liberali- the savings and loan system in the United States
zation of interest rates left the corporate sector vul- and finance companies in Malaysia. Interest rates
nerable to macroeconomic shocks. In both coun- in general were affected more by macroeconomic
tries weak prudential regulation and supervision developments than by the financial reforms. Bank
allowed the capitalization of interest and a rapid deposit and loan rates rose modestly in real terms.
deterioration of bank portfolios.
Financial depth increased substantially. Interest
rate spreads and the dispersion of rates in different
Reforms in other couintries market segments narrowed-all signs of greater
competition and efficiencv.
Australia, Japan, Malaysia, New Zealand (see Box Other countries that had more repressed sys-
9.1), and the United States have all liberalized their tems have also undertaken financial reforms. The
interest rates during the past decade. Restrictions scope and pace of reforms, however, have been
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