IX Experience with Rapid Liberalization
- Akira Ariyoshi, Andrei Kirilenko, Inci Ötker, Bernard Laurens, Jorge Canales Kriljenko, and Karl Habermeier
- Published Date:
- May 2000
Following bouts of hyperinflation in the 1970s and 1980s, Argentina experienced an almost complete loss of monetary policy credibility and a collapse in demand for domestic money and banking services. Stability was reestablished in 1991 with the adoption of the Convertibility Plan, which created a currency board; this ruled out monetization of the fiscal deficit and completed the process of eliminating restrictions on international current and capital payments and transfers that began in late 1989. This monetary and exchange rate regime has been in place ever since, with only minor changes. The adoption of the new regime was accompanied by wide-ranging trade liberalization, deregulation, privatization of public enterprises, fiscal consolidation, and a first round of measures to strengthen prudential regulation and supervision of the financial system.
The adoption of the currency board was followed by a marked increase in capital inflows in 1991–94, reflecting the removal of legal restrictions, the privatization program, the regularization of relations with external creditors through the Paris Club and Brady operations, and the general renewal of access of developing countries to international capital markets. Foreign direct investment and portfolio inflows reached 11 percent of GDP in 1993, compared with less than 1 percent in 1990. Under the currency board and in the absence of capital controls, the scope for countervailing policy action was limited; in any event, the authorities saw no pressing need for such action. There was an impressive recovery in economic activity, with the increase in real GDP averaging more than 7 percent a year in 1991–94, following the virtual stagnation of the 1980s. At the same time, consumer price inflation declined markedly, from over 80 percent in 1991 to about 4 percent in 1994, and a substantial remonetization of the economy began.
This liberalized and stability-oriented framework for policymaking faced its first serious test during the Mexican crisis of 1994–95. Argentina’s access to international capital markets was substantially curtailed in early 1995and there was a large outflow of short-term capital. Under a currency board, outflows of foreign exchange are broadly matched by a contraction in the domestic monetary base, with concomitant effects on wider monetary aggregates, the domestic banking system, and economic activity. During the first half of 1995, the central bank lost about one-third of its international reserves; bank deposits declined by about 20 percent; and interest rates on both domestic currency and U.S. dollar deposits increased by more than 12 percentage points. Many smaller and provincial banks suffered deposit losses of up to 50 percent, nonperforming loans rose sharply, and regulators were forced to suspend and liquidate some institutions.
The policy response to these developments did not include a reimposition of capital controls. Instead, the authorities adjusted macroeconomic policies (including a marked tightening of fiscal policy under an IMF program adopted in March) and initiated a second generation of reforms to further strengthen the banking system to make it more resilient to future shocks. These reforms included heightening capital adequacy requirements beyond the minimums established by the Basel Committee, improving risk classification, substantially increasing the liquidity of the system, fostering transparency and market-based restructuring, and increasing foreign participation. During the Mexican crisis, the authorities also temporarily provided additional liquidity to the domestic financial system within the narrow confines of the currency board arrangement.60 A concerted effort was also made to improve public debt management, by lengthening the maturity of the public debt,61 avoiding floating rate instruments, and pre-borrowing in good market conditions to create a cushion.
Although real GDP declined by nearly 3 percent in 1995, inflation remained broadly stable, owing to the currency board arrangement. Confidence was rapidly reestablished. By the end of August, more than half of the deposit outflow had been reversed; and by December, deposits had reached their precrisis levels. The recession also bottomed out by the end of the year and real GDP grew by an average of about 7 percent during 1996–97. Partly reflecting a large-scale drive for structural reforms and delays in addressing some labor market rigidities, the unemployment rate showed considerable persistence and did not return to its precrisis level until end–1998. Efficiency gains, on the other hand, helped to contain unit labor costs and maintain external competitiveness.
The principal lesson of the Argentine experience with capital account liberalization is that sound macroeconomic policies, combined with ongoing efforts to create a sound and well-capitalized banking system, and steps to lengthen the maturity of external debt, have allowed the economy to withstand even severe external shocks and the associated temporary loss of confidence and large-scale capital outflows.
Following a collapse of tea and coffee prices in 1987, Kenya was left with a budget deficit of 6.4 percent of GDP, a rapidly deteriorating current account position, and a severe shortage of foreign exchange. Real GDP growth slowed from 7.1 percent in 1986 to about 6 percent annually in both 1987 and 1988. Inflation increased from 4.8 percent in 1986 to 8.3 percent in 1987 and 13 percent in 1988, despite extensive price controls. By 1989, it became evident that without foreign financing and structural reforms, Kenya would experience a severe economic downturn.
The Kenyan economy, however, was characterized by a highly regulated financial sector and exchange and trade system in the late 1980s. The central bank relied on differentiated credit ceilings and interest rate controls to manage liquidity in the financial system. The imbalances in the financial sector were further accentuated by ineffective banking supervision and political pressures to grant credit to connected financial institutions.
To avoid a severe recession, the government embarked on a wide-ranging liberalization program aimed at attracting foreign savings. The program intended to remove rigidities in the real and financial sectors by freeing prices, liberalizing foreign trade and foreign currency transactions, and relaxing and then dismantling credit ceilings and interest rate controls. Liberalization of the financial sector began in 1989 with measures intended to harmonize interest rate regulations for banks and nonbank financial institutions (NBFIs). Interest rate ceilings were raised for both the banks and the NBFIs and most of the disparity between them was eliminated. Interest rate liberalization was completed in 1991, following the liberalization of the treasury bill market.
A significant step toward liberalization of current and capital account transactions was made in 1991 with the introduction of foreign exchange bearer certificates of deposit (FEBCs), which were available to residents and nonresidents alike, traded in the secondary market with no need for license or registration, redeemed at the central bank at face value at a prevailing official exchange rate, and used for any current and capital account international transactions without restriction.62 At the same time, some enterprises were permitted to hold foreign currency–denominated accounts abroad or with authorized banks domestically. Consequently, banks were allowed to conduct business directly in foreign currency, buy and sell foreign currency from their clients, and offer forward foreign exchange contracts at market-determined rates without any restriction on the amount or the period covered.
In 1994 the Kenyan shilling became fully convertible and Kenya accepted the obligations of Article VIII. Finally, in 1995 all remaining foreign exchange controls were eliminated and the powers to license and regulate foreign exchange transactions were transferred to the central bank. In the course of 1995, restrictions on investment by foreigners in shares and government securities were eliminated. All remaining restrictions on capital account transactions were removed with a few exceptions: a ceiling on purchases of equity by nonresidents (40 percent on aggregate, 5 percent for an individual investor); approval from the Capital Markets Authority prior to the issuance of securities locally by nonresidents or abroad by residents as well as derivative securities; and government prior approval for the purchase of real estate.
Despite the introduction of these liberalization measures, the economy experienced a sharp economic downturn from late 1991 onward. Economic growth decelerated from 4.7 percent in 1990 to –0.8 percent in 1992, while inflation increased from 21.8 percent to 53.5 percent during the same period. Inconsistent economic policies in the run-up to the first democratic elections in December 1992, including the misappropriation of public funds, led to a further deterioration of economic conditions, and by early 1993 the economy was in crisis. The money supply continued to increase throughout the period, inflation accelerated further, and external payments arrears emerged for the first time in late 1992. Furthermore, unsound practices in the financial system contributed to economic instability. Several commercial banks were allowed to maintain overdrafts with the central bank, obtain export preshipment financing facilities, draw checks against insufficient funds, abuse the clearing system, and delay payment. Prudential supervision and enforcement were weak. A number of banks persistently violated the statutory cash and average reserve ratios. Following their liberalization, interest rates increased and became positive in real terms. Finally, the shilling depreciated rapidly.
The authorities responded to the emerging pressures by tightening monetary and fiscal policies, closing down four banks while replacing management in two other banks, and reintroducing an export retention mechanism. The macroeconomic stabilization measures were supported by an Enhanced Structural Adjustment Facility (ESAF) arrangement, approved in April 1996. The first and only disbursement under the arrangement was made in 1996, after which the arrangement expired without completion of the review in mid-1997 because of the failure to tackle outstanding governance issues.
The main lesson from Kenya’s experience seems to be that rapid and wide-ranging liberalization in the context of continued major macroeconomic imbalances may have increased the country’s vulnerability to capital flows by providing legal channels for capital flight (the latter reflecting both a deterioration in private sector confidence and corruption). Therefore, rapid and wide-ranging liberalization of the financial system and capital account is a necessary, but not sufficient, condition for economic recovery and growth. Only consistent macroeconomic and structural policies are able to eliminate existing economic imbalances. It is difficult to determine whether in the absence of capital account liberalization, the recession would have been even more severe, or whether capital account liberalization contributed to instability given the inadequacy of supporting reforms, especially in the financial sector.
From the early 1970s to the mid-1980s, Peru experienced recurring balance of payments crises accompanied by increasingly sluggish growth, accelerating inflation, large fiscal imbalances, and rapidly accumulating debt. Adjustment programs in 1984 and early 1985 reduced the fiscal deficit, but economic activity remained subdued and inflation accelerated further. Following a temporary boom in 1986–87 with higher wages, easier credit, lower taxes, and price and interest rate controls, real GDP fell by a cumulative 20 percent in 1988–89, investment collapsed, inflation rose to over 1,700 percent in 1988 and nearly 2,800 percent in 1989, and the stock of international reserves was virtually depleted. Upon taking office in 1990, the new Peruvian administration implemented a wide-ranging program aimed at liberalizing most sectors of the economy, reducing inflation, and creating conditions for sustained growth. The program included liberalization of the financial sector and the capital account; the elimination of price controls followed by large increases in fuel, water, and electricity prices; greater restraint in public sector wage increases; improvements in tax administration; and a comprehensive privatization program.
In the financial sector, the reform package of 1990–93 abolished interest rate controls on domestic currency loans and deposits and government intervention in credit allocation. The interest rate ceilings on foreign currency loans were raised to nonbinding levels, subsidized lending through the Agricultural Bank was eliminated, and all development banks were closed. The supervisory and regulatory framework was extended to include nonbank financial intermediaries, and a system of deposit insurance was initiated. A tight monetary policy was followed to curb inflation, while the domestic financing requirement of the public sector was eliminated. In the real sector, all remaining price controls were abolished in 1990, while wages in the private sector were permitted to be determined freely. To increase labor market flexibility, procedures to ease the dismissal of workers were approved, and the scope for retroactive wage increases was limited. On the external front, the multiple exchange rate that had been put in place in the mid-1980s to protect the balance of payments was unified in 1990. The exchange rate was allowed to float, quantitative import restrictions were lifted, the previously complex tariff system was consolidated, and export subsidies were eliminated.
The official objective of the liberalization was to promote the mobilization and efficient allocation of resources, including foreign capital through various incentives. New legislation on foreign investment was subsequently introduced in August and November 1991 as part of the liberalization program. These changes were made part of the new constitution enacted in January 1994. The constitution subjected national and foreign investors to the same terms, although foreign investment was required to be registered with the National Commission on Foreign Investment and Technology. Foreign investors were allowed to freely remit profits or dividends (the previous system established a ceiling on remittance of profits equal to 20 percent of the investment, with exceptions granted to some sectors); freely reexport capital; access domestic credit; acquire shares owned by nationals; and contract insurance for their investment abroad. Exporters and importers were permitted to undertake foreign exchange transactions in the market without intermediation by the central bank, and full convertibility of the currency (the “sol”) was guaranteed by the constitution. Residents and nonresidents were permitted to open foreign currency–denominated accounts in any financial institution offering such accounts, although differentiated (higher) reserve requirements on foreign currency deposits have been maintained throughout. In subsequent years, foreign investment increased substantially, with a stock of foreign direct investment rising from US$1.3 billion in 1990 to US$6.0 billion in 1995.
Capital account liberalization in Peru was undertaken when U.S. interest rates were declining and domestic interest rates were high, reflecting an anti-inflationary monetary policy. These circumstances, together with a significant improvement in fundamentals resulted in sustained capital inflows and, with the adoption of the floating exchange regime, in a sharp appreciation of the currency: between 1990 and 1995 the real effective exchange rate appreciated by 25 percent. The current account deficit increased significantly from 3.8 percent of GDP in 1990 to 7.3 percent in 1995, before declining somewhat thereafter (between 5 and 6 percent of GDP during the period 1996–98). Even so, strong private capital inflows helped to largely finance this deficit.63 Moreover, fiscal restraint and the imposition of high reserve requirements on dollar deposits allowed for a substantial increase in net international reserves. Concerns about the current account deterioration led some academics to criticize the timing and sequencing of capital account liberalization in Peru, arguing that the real appreciation of the currency had exacerbated the contractionary effects of strict monetary and fiscal policies in an economy where export-oriented industries were key to growth. In their view, it would have been preferable either to retain some control over the exchange rate, or else to have maintained some controls to restrain capital inflows. (For more details, see Sheahan, 1994.). Others have held a more sanguine view, noting that the current account was primarily driven by the demand for imports of capital goods and inputs for the mining sector and in the newly privatized sectors of the economy, and was largely financed by the strong foreign investments.
Following the liberalization of the capital account and subsequent improvements in market sentiment, financial institutions regained access to foreign lines of credit, starting with short-term credit, making them potentially vulnerable to sudden reversals of flows. Some small and medium-sized institutions experienced difficulties in 1998 following the turmoil in international financial markets, and the authorities stepped up liquidity support to the banking system. This episode notwithstanding, tighter prudential regulation and enforcement coupled with increased foreign participation have increased the banking system’s resilience. Moreover, the overall vulnerability of the economy has been limited, as a large increase in reserves more than offset the increase in short-term debt, with the coverage of net international reserves to short-term debt (due in 12 months and less) currently exceeding 100 percent.
Capital account liberalization has contributed to higher foreign direct investment, increased competition, and more favorable relations with the international community. Some progress has also been made in developing the financial markets following the liberalization of the capital account: the assets managed by the new private pension funds system increased from US$29 million in 1993 to US$1.5 billion in 1997, while the stock of mutual funds rose from US$3 million to US$736 million over the same period. Foreign funds accounted for two-thirds of all equities trading in 1994, compared with virtually none five years earlier. Growth picked up substantially, from 2.9 percent in 1991 (– 5.2 percent in 1988–91) to an average of 6 percent a year in 1992–98, and inflation continued to fall, from above 100 percent in 1991 to 6 percent in 1998. Peru also weathered the international financial turmoil of 1995 and 1997–98 without significant damage to its economy. Overall, therefore, Peru’s experience with a fast and wide– ranging capital account liberalization, accompanied by prudent fiscal and monetary policies, a flexible exchange rate system, and strengthening of the financial system, seems to have been beneficial.