Financial systems and development

In the next stage, financial reform should seek to pending both on economic circumstances and on
promote the development of a greater variety of political possibilities. This section reviews the
markets and institutions and to foster competition. main components of a broadly conceived program
Broader ranges for deposit and lending rates of financial reform.
should be introduced. On the external side, foreign
entry into domestic financial markets should Financing fiscai deficits
be encouraged to increase competition and
efficiency-but perhaps with restrictions, until do- Macroeconomic stability depends on reducing
mestic institutions are able to compete fully. Until public deficits to a level that can be financed by
such reforms are well under way, it will probably means other than inflation or other taxes on the
be necessary to maintain controls on the move- financial sector. Central government deficits have
ment of capital. If, however, a country already has in recent years been equivalent to about one-fifth
an open capital account, the government should of total government spending for a large sample of
give priority to maintaining macroeconomic stabil- developing countries. About half of this total was
ity to avoid destabilizing capital flows. After sub- financed by borrowing from central banks. The restantial
progress has been made toward reform, sulting monetary expansion caused high inflation
the government can move to the final stage: full in many countries. Government borrowing from
liberalization of interest rates, the elimination of the domestic banking system through high reserve
the remaining directed credit programs, the relaxa- and liquidity requirements is less inflationary than
tion of capital controls, and the removal of restric- borrowing from the central bank, but it reduces
tions on foreign institutions. bank profitability, distorts interest rates, and
In sequencing the removal of exchange controls, crowds out private sector borrowers. To the extent
trade transactions should be liberalized first and that a government finances its deficit domestically,
capital movements later. Latin America's experi- borrowing from a securities market is therefore
ence suggests that liberalizing them simultane- preferable to forced borrowing from financial instiously
is undesirable. The speed of adjustment in tutions, which in turn is preferable to borrowing
the capital market is faster than in the goods mar- from the central bank.
ket. An inflow of capital can lead to an appreciation In most countries it is possible to start a market
of the exchange rate, which undermines trade liber- for government bills, provided the government is
alization. In the end, internal and external liberali- willing to pay the market interest rate. Indeed,
zation will be complementary, but external reform several developing countries, including Indonesia,
should wait until internal reform and the recovery the Philippines, and Sri Lanka, have established
of domestic markets are under way. When macro- short-term government securities markets. This is
economic stability has been established and the do- desirable not only because borrowing from such a
mestic financial system has been liberalized and market is less inflationary than borrowing from
deepened, it will be safe to allow greater freedom banks but also because a bills market makes it posfor
foreign institutions and capital flows, to link the sible for the government to engage in open market
domestic and international financial markets.
operations. These can be used to manage the mon-
If the reform process as a whole is too quick, etary and credit aggregates without the distortions
firms that entered into contracts and arrangements entailed by direct controls. A government bills
under the old rules and that would otherwise be market is also a first step toward building a broader
viable may face heavy losses. A gradual liberaliza- market for corporate securities. Once market partion
will also impose losses, but it will allow firms ticipants have become familiar with owning and
time to adjust and financial institutions time to de- trading government instruments and the infravelop
the new skills they will need. Undue delay, structure of brokers and traders is in place, it is
however, carries the cost of perpetuating the ineffi- relatively easy for the private sector to issue its
ciencies of financial repression. The appropriate own securities. And by borrowing from a bills marbalance
must be judged in each case. Here, at any ket instead of from the insurance and pension sysrate,
generalization is not helpful.
tems, governments free long-term funds for investment
in private sector assets.
Components of financial reform
Interest rate policy
Many countries have taken the first steps toward
reforming their financial systems. The elements Studies suggest that rigid ceilings on interest rates
necessary to take the process further will vary, de- have hindered the growth of financial savings and
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