Critically Examine Why Financial Liberalisation Brought Financial Crisis in Most of the Asian Countries but Did Not Bring a Crisis in Either China or India.

The government have been using the policy of financial repression now for many years. Financial repression consisted of fixing interest rates below market levels and controlling the allocation of credit. Under developed financial systems, inefficient lending patterns, and failure of distributional goals, all existed. Low savings where noticeable due to negative real interest rates. Macro economic performance fell within this policy, also those countries whom had large negative real interest rates suffered from growth rates. Most economical factors where state owned under financial repression. Within state owned banks existed problems of poor lending decisions and low repayment rates, this in return led to bank insolvency.

The logic of financial repression was to make the financial sector assist the needs of development.

This is where financial liberalisation comes in; the purpose of this is to reverse all the negative facts of repression.

There are 3 crucial aspects of financial liberalisation, these are consisted of:

1. To allow the free flow of international finance to a country

2. To remove controls and restrictions on the functioning of domestic banks, to allow them to be integrated in the world financial markets.

3. To provide autonomy from the government to the central bank so that it’s supervisory and regulatory role vis-а-vis the banking sector is dissociated from the political process of the country, and hence from any accountability to the people.

Financial liberalisation also lifts the ceiling on interest rates. By doing this it relaxes foreign currency flow.

McKinnon and Shaw (1973) stated that financial liberalisation in those countries that are financially repressed would bring about higher savings, credit supply will be increased; stimulate investment and therefore increasing growth.

From this the theory of financial liberalisation was formed, whereby the links between higher interest rates and savings where focused on as well as investment and economic growth. This was the main principle in using this policy to help develop countries in Asia, Eastern Europe and Latin America.

The basic assumption is that savings are a function of interest rates. (Basu, Financial Liberalization and intervention, Chp4 Pg66). However this is not generally the case. It can be said that savings are derived from income and not interest rates.

Banks play an important role in the financial sector. It is said that banks may operate on the presence of uncertainty. (Basu; Financial Liberalization and intervention). Meaning that they can’t calculate the returning on loans. Banks use credit standard as one way of recouping loans, these offer some form of security and are a backup if there are uncertain outcomes. The other factor is credit risk; this is the risk when loans are not fully secured by the credit standard. Credit standards are set in accordance to the interest rates.

The more banks the greater competition between them, hence creating more attention for depositors and borrowers. There are various types of borrowers in the market, so banks have to offer all borrowers some access to loans. Banks tend to lower their credit standard to attract a large number of borrowers in high competition times; during low competition banks do not do this.

A bank uncertainty arises from the fact of giving the loan to receiving the repayments. Borrowers are expected to pay back the loan on top the interest that is added. If a promise has been made to pay back the interest than this does not amount to repaying the whole loan back. Those lending the money have to ensure that if a borrower’s project fails than this does not affect the loan capital. They have to ensure they have continuous repayments. Measures have to be taking into consideration that credit standards are met. Large borrowers are given larger loans, and this group offers a higher expected rate of return. This creates a higher demand as interest rates are specifically given, borrowers will find funds, either by borrowing from banks, or via the stock market. Banks must offer incentives to this group. However this all leads to a higher credit risk which was not a problem before liberalisation.

There may be a link between financial development and the growth rate. In the early stages of development, finances from banks were vital, as development carried on the banks were becoming less important, due to the result of growth on the stock market (Goldsmith 1969). Banks play an important role in aiding development, as they allow individuals to place their savings as deposits, which helps the economy to increase