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Literature Review on Interest Rate Liberalisation, Capital Formation and Economic Growth

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2.1. Introduction


The abolishment of interest rate controls was the earliest policy measure indicating a country’s move towards financial liberalisation. In most cases, during the 1950s and 1960s, the government of developing countries controlled interest rates in order to generate financial resources required to finance government budget deficits and for stabilisation purposes (World Bank, 2005). However, by the early 1970s, these so-called government interventions were largely criticised by proponents of the financial liberalisation hypothesis (McKinnon (1979), Shaw (1979)) who maintained that developing countries should move away from financial repression towards financial liberalisation in order to boost their levels of economic activity and growth.

A substantial part of the literature has focused on the link between financial liberalisation, capital formation and economic growth since the seminal contribution of McKinnon (1973) and Shaw (1973). The conventional prediction emanating from the literature is that financial liberalisation could influence economic growth via two different mechanisms. Firstly, domestic financial liberalisation, which involves removing controls on interest rates; reducing reserve requirements; and reducing government involvement in credit control and allocation will lead to greater efficiency in resource allocation and encourage productive investments thereby accelerating economic growth. Secondly, international financial liberalisation, also referred to as capital market liberalisation which involves opening up a country’s capital market to foreign participation will encourage capital formation which will be used to boost domestic investments and consequently improve economic growth levels (Fry, 1997).

This chapter is the first of two chapters which survey the theoretical and empirical literature on the effect of two main financial liberalisation policies on capital formation and economic growth. Chapter two is divided into six sections including the introduction. Section two examines the financial liberalisation hypothesis postulated by McKinnon (1973) and Shaw (1973) while Section three presents the theoretical linkage between interest rate liberalisation, capital formation and economic growth. Section four reviews the theoretical literature on interest rate liberalisation, capital formation and economic growth and Section five reviews the empirical literature on interest rate liberalisation, capital formation and economic growth. A brief summary of the chapter is presented in Section six.

2.2. An Overview of the Financial Liberalisation Hypothesis


For over a century, there has been an ongoing debate on the role of a country’s financial sector in promoting economic growth. Schumpeter (1911) emphasized the role of financial intermediation in economic development and growth in his book entitled “The Theory of Economic Development”, stating that financial intermediaries such as banks do not only transport money across sectors but also engage in activities such as providing credit facilities. Ever since Schumpeter’s publication, a substantial amount of both theoretical and empirical studies have been developed. At first, the literature centered on the causal relationship between financial sector development and economic growth i.e. whether financial development led to economic growth or whether economic growth induced financial development.

The idea that financial sector development occurs as a result of globalisation and economic growth was pioneered by Robinson (1952) and her opinion was predominant in the financial development literature until mid-1960s when Patrick (1966) and Goldsmith (1969) emphasized the crucial role that the financial sector plays in promoting economic development and growth. During the 1970s, the debate focused on financial repression, a policy practiced by majority of the governments of developing countries to enable them generate revenue especially to finance their deficits by keeping interest rates low and conducting inflationary monetary policies. These financial repressive policies were built on Keynes (1936) liquidity preference theory and Tobin’s (1965) theory of monetary growth.

In his book entitled “The General Theory of Employment, Interest and Money”, Keynes (1936) developed the liquidity preference theory to analyse interest rate determination through the demand and supply of currency holdings. In his theory, Keynes identified interest rates as the reward for giving up liquidity and not necessarily as a reward for savings. He maintained that there are three motives behind economic agents’ desire to hold money in liquid form. The first motive was that economic agents tend to prefer liquid holdings or readily available cash for transaction purposes, i.e., in order to satisfy their everyday needs. Individuals for instance need some level of liquidity for frequent transactions while businesses require some level of liquidity in order to meet their immediate running costs such as workers’ salaries. Keynes stated that the second motive for liquidity preference was in order to take care of unanticipated costs, generally referred to as the precautionary motive. Individuals require readily available funds in case of sudden illness or loss of employment while businesses require some level of liquidity when business conditions become unfavorable. Furthermore, economic agents’ desire to hold some amount of their resources in liquid form in order to take advantage of future interest rates. Keynes (1936) referred to this as the speculative motive and he maintained that the speculative demand for money may fall as interest rates increased.

Tobin’s (1965) publication titled ‘Money and Economic Growth’ was a major influence on growth economics and the focus of his paper was on long run economic growth and capital formation in a monetary economy. He maintained that money and capital are substitutes from the wealth holder’s viewpoint, and that a higher rate of monetary expansion and hence of inflation raises the opportunity cost of holding real money balances and so leads to portfolio balance with a lower real rate of return on capital and a greater capital intensity. The message of Tobin’s publication is summarized below:

“In classical theory, the interest rate and the capital intensity of the economy are determined by ‘productivity and thrift’, that is, by the interaction of technological and savings propensities. This is true both in the short run when capital is being accumulated at a rate different from the growth of the labour force, and in the long run stationary or ‘moving stationary’ equilibrium, when capital intensity is constant. Keynes gave reasons why in the short run, monetary factors and portfolio decisions modify, and in some circumstances dominate the determination of the interest rate and the process of capital accumulation…………..a similar proposition is true for the long run. The equilibrium interest rate and degree of capital intensity are in general affected by monetary supplies and portfolio behavior as well as by technology and thrift” (Tobin, 1965. pp 684).

McKinnon (1973) and Shaw (1973) were the earliest economists to independently propose theoretical arguments challenging financial repression. Challenging the views of Keynes (1936) and Tobin (1965), they both advocated the call for interest rate liberalisation and the elimination of other financially repressive policies practiced by governments such as discriminatory credit controls which slowed down the level of economic activity and growth. The conventional wisdom emanating from the McKinnon (1973) and Shaw (1973) theory of financial liberalisation is that financial liberalisation is beneficial to developing countries on the grounds that removing restrictions on interest rates will encourage financial savings which would lead to an increase in the quantity and quality of investment thus enhancing economic growth (Fry, 1997; Ghosh, 2005).

In McKinnon’s 1973 complementarity hypothesis, he assumes that all investors are exclusively self-financed and that money balances and physical capital are complementary. He asserts that an investor needs prior accumulation of money deposits or alternative financial resources before any investments could be undertaken hence, there exists an “intertemporal complementarity” of financial deposits and the stock of capital. McKinnon maintains that a positive relationship exists between money balances and interest rates, meaning that a higher deposit rate through interest rate liberalisation will encourage financial savings which will be available to finance investments.

In the debt intermediation hypothesis, Shaw (1973) emphasises the important role of financial intermediaries and asserts that complementarity is non-essential. He points out several benefits of financial intermediaries which channel savings for investment purposes. First of all, financial intermediaries help to reduce information and transaction costs associated with bringing potential savers in contact with potential borrowers. Secondly, financial intermediaries generate liquidity by borrowing funds short term and lending to investors long term. Usually, majority of savers (especially households) tend to hold a portion of their wealth in liquid form for consumption and other unforeseen expenses and sometimes due to uncertainties in the financial system. Financial intermediaries provide liquidity by making depositors funds readily available whenever the need arises while the investors need not repay their loans immediately. A third benefit as pointed out by Shaw (1975) is that financial intermediaries reduce credit risks relating to investment funding because they have the competence to regulate how much they should lend to investors and what projects or sectors they should fund..

Although, McKinnon (1973) and Shaw (1973) employed entirely different theoretical models, they arrived essentially at the same conclusion- that financial savings are instrumental to the process of capital formation and economic growth through financial liberalisation. The authors maintain that a repressed financial system will deter savings, hinder efficient resource allocation, lead to financial disintermediation and encourage the segmentation of financial markets and institutions. Since the financial liberalisation hypothesis, numerous studies such as Kapur (1976) and Galbis (1977) have extended the original McKinnon and Shaw hypothesis while others such as Jao (1985) have supported their seminal work. These models are discussed in more detail in section 2.3.

Numerous economic observers acknowledge that financial liberalisation as a good thing as it affects nearly all sectors of an economy. Financial liberalisation benefits the labour market in the sense that a rise in interest rates will increase the amount of savings relevant for capital formation and investment purposes hence, production will expand, leading to the creation of more jobs for the labour force. Also, an increase in the volume of financial savings due to higher interest rates may reduce the need for the government’s enormous taxation policies which may be detrimental to businesses and hence, growth. From the welfare perspective, financial liberalisation brings about more equitable distribution of income, bridging the gap between the rich and poor. International institutions such as the International Monetary Fund (IMF) and the World Bank have adopted the McKinnon (1973) and Shaw (1973) financial liberalisation hypothesis as a benchmark model while providing advisory and lending services to developing countries (Odhiambo, 2011).

Among the Sub-Saharan countries considered in this research, South Africa was the first to officially liberalise its financial system beginning from 1980. Majority of other Sub-Sahara African countries have since moved on to implement financial liberalisation policies, persuaded by both the experience of other successfully liberalised countries and the rapid pace of globalisation. However, while some countries have experienced a remarkable increase in their growth rates, others have experienced a fall in economic activity levels and growth rates due to very high and unstable real rates of interest and stagflation (Grabel, 1995; Fowowe, 2013).

2.3. The Theoretical Linkage between Interest Rate Liberalisation, Capital Formation and Economic Growth.


The theoretical analysis of McKinnon (1973) and Shaw (1973) supports the proposition that interest rate liberalisation aids financial sector development as well as capital formation and acts as a positive stimulus to economic growth and is illustrated in Gibson and Tsakalotos (1993). The interest rate liberalisation theory focuses on financial repression which is defined as a situation whereby governments distort financial sector activities, especially in relation to controls on interest rates and directed credit allocation programmes (McKinnon, 1989). McKinnon (1973) and Shaw (1973) maintain that real interest rates affect economic growth through their influence on savings and capital formation or investment. Hence, capital formation, I is a negative function of the real interest rate, r. Thus,

I = I (r);      Ir < 0                                      (1)

The level of aggregate savings, Sis influenced by real interest rates and the national income growth rate, g. Hence,

S = S (rg);    Sr>0; Sg >0                     (2)

Figure 2.1 below illustrates the effect of interest rate controls on savings and capital formation. The vertical axis measures the real interest rate while the horizontal axis measures the level of savings and capital formation. g1g2 and g3 are different rates of economic growth where g1<g2<g3. McKinnon (1973) and Shaw (1973) assert that if interest rates were not regulated and the market was allowed to operate freely, equilibrium in the loanable funds market would be at point E with interest rate at r* and savings equal capital formation or investment at I*.


Fig 2.1: The McKinnon and Shaw Financial Liberalisation Hypothesis (Gibson and Tsakalotos, 1994)



Assuming initially that government sets a ceiling (Ceiling 1) on the nominal deposit rate (at Ceiling 1, real deposit interest rate is below the equilibrium point, r*). In addition, it is assumed that the growth rate of the economy is at g1. At this point, the real deposit rate is at r1 and I1 savings are anticipated. As the ceiling is set only on the nominal deposit rate, banks can charge any interest rate they so desire on loans. In this scenario, the interest rate charged is r3, with I1level of investment attempted. According to McKinnon (1973) and Shaw (1973), the profits which the banks make from their lending activities (r3 – r1) could be used for non-price competition such as expansion of branch networks.

However, since the intention of government regulations is to stimulate capital formation or investment activities by reducing borrowing costs, it is expected that interest rate restrictions will apply to both deposit and loan rates. In this case, I1 savings are anticipated, and I1investment will be financed so, investment demand given by AB is unsatisfied. Setting a ceiling on both deposit and loan rates will lead to a situation whereby credit is rationed and some firms with potentially lucrative investment projects will not have access to loanable funds. Besides, investment projects which are eventually financed tend to have interest rates which are only slightly higher than the interest rate ceiling (Ceiling 1). Gibson and Tsakalotos (1994) argue that when credit is rationed, financial intermediaries would rather fund less risky projects. Hence, in this case, potentially profitable projects are likely to fall into the unsatisfied investment category (AB) due to their high risk.

The significance of interest rate liberalisation can be examined by looking at the effects of an increase in the interest rate. Assuming that the government increases the interest rate to Ceiling 2 (note however, that ceiling 2 is still below the equilibrium interest rate). An increase in the interest rate will boost capital formation or investment efficiency since investors usually undertake investment projects which are more profitable. The economic growth rate shifts upwards from S(g1) to S(g2) and the savings function shifts right, increasing to I2. Credit rationing is still highly likely in this condition, but has decreased to CD. McKinnon (1973) and Shaw (1973) argue that before credit rationing can be completely eliminated from financial intermediaries, governments have to fully liberalise interest rates. In this case, economic growth rate increases to S(g3) while savings and capital formation or investment shift to the equilibrium point, E. Hence, McKinnon (1973) and Shaw (1973) in their examination of financially repressed economies advocate that ceilings on interest rates restrain savings by encouraging consumption in the current period and reducing capital formation below optimum level, as well as reducing the quality of investments by encouraging financial intermediaries to finance investment projects with low returns.

2.4. Theoretical Literature Review on Interest Rate Liberalisation, Capital Formation and Economic Growth.

This section is further divided into two sub-sections. Sub-Section 2.4.1 presents the theoretical arguments supporting the interest rate liberalisation hypothesis while sub-section 2.4.2 presents the theoretical arguments against interest rate liberalisation.

2.4.1. Theoretical Arguments in Support of Interest Rate Liberalisation

Since the McKinnon (1973) and Shaw (1973) argument that financial liberalisation, through its impact on savings and capital formation will improve economic growth, a number of studies which support the financial liberalisation hypothesis have emerged. These include the works of Kapur (1976) who focuses on the impact of interest rate liberalisation on the quantity of investment and Galbis (1977) who focusses on the impact of interest rate liberalisation on the quality of investment.

Kapur (1976) analyses how interest liberalisation impacts on a developing country in which fixed capital is under-utilised and there is surplus labour. Given the Harrod-Domar production function below:

Y = σK                                (1)

Where Y represents final output in real terms; K represents total amount of capital utilised; and σrepresents capital productivity.

The nominal money stock (M) is made up of two components:

M = C + L                          (2)

Where C denotes high-powered money issued by the government, part of which is circulated and part of which is held as deposits with the banks. L denotes the total amount of loans granted by the banks. Kapur (1976) assumes for simplicity that there is no depreciation of fixed capital assets; that investments in working capital is financed by bank borrowing; and that bank credit is utilized solely to finance working capital holdings. He further assumes that a fixed proportion θ of the total usage of working capital is replaced through finance from the bank and that (1-θ) of the total usage of working capital is replaced through internal (self) finance. Usually, investors are obliged to pay up their loans to the banks first in order for them to purchase the fraction θ of the working capital they have previously utilised. These repayments made to the banks by investors become available for further lending by banks hence, the extra funds available for bank lending in order to maintain the working capital stock is equal to  ΔPθ(1 – α)K in real terms. Assuming that π = ΔP/P represents the inflation rate, the rate of capital accumulation in Kapur’s model is given by the below functional form:

ΔK =

1(1- α) ΔL- ΔPθ 1-αKP



11- α  ΔLP- πθ1-αK

The numerator of the expression in bracket in the first line of equation (3) above represents the excess of the increase in nominal bank lending over the increase in the nominal cost of replacing the bank- financed component of working capital. The excess is available to finance investments in working capital and this net increase is then multiplied by

11- αto obtain the net increase in the flow of the utilised fixed and working capital.

Substituting qM = L (where q = L/M) and μ = ΔM/M, we can rewrite equation (3) as

ΔK =

1(1- α) μqMP-πθ1-αK                                                          (4)

Assuming that ϒ = ΔY/Y represents the growth rate of the economy and dividing equation (4) by K (recall from equation (1) that σ =Y/K hence, ΔK/K = ΔY/Y = ϒ), we arrive at:

ϒ = μ

σq(1-α) MPY– πθ                                      (5)

Equation (5) shows that the economy’s growth rate is positively influenced by the rate of monetary growth (μ), the productivity of capital (σ), the ratio of loans to currency (q) and the ratio of utilised fixed capital to total utilised capital (α).

In his model, Kapur (1976) asserts that real credit supply impacts on capital formation through its function as the main determinant of finance for working capital. The real supply of credit is conditional on the demand for broad money which is a function of the real deposit interest rate and inflation. Interest rate liberalisation brings about a rise in the real deposit interest rates (due to the removal of interest rate controls) and the reduction or removal of reserve requirements. Kapur (1976) maintains that these two policy measures will encourage a rise in capital formation and economic growth. A rise in the deposit interest rate he claims, has a more indirect impact on the supply of credit. In this case, there is an increase in broad money demand and financial intermediaries (the banks) will have the capacity to supply more loanable funds for investment purposes due to the expansion of the financial sector. On the other hand, when reserve requirements are reduced, credit supply increases, given the initial level of deposits. An increase in credit supply will encourage firms to increase their investments in working capital which will lead to an increase in output and economic growth, given the existence of labour and spare capacity. In sum, Kapur (1976) advocates that the  increase in financial savings as a result of a rise in deposit rates leads to an improvement in capital formation which will consequently boost economic growth.

Another supporter of the McKinnon (1973) and Shaw (1973) financial liberalisation hypothesis is Galbis (1977). He models how financial intermediation affects capital formation and economic growth by analysing a scenario whereby an economy is made up of two sectors. Sector 1 is a less efficient ‘traditional’ sector in which investments are self-financed and rate of return is low while sector 2 is a more efficient ‘modern’ sector in which investments are financed through the banking sector and the rate of return is higher. Both sectors have distinct financial constraints and different levels of technical progress, but produce the same amount of output which are sold for the same price.

     In Galbis (1977) model, both sectors are characterised by the different production functions:

Y1 = F1 (K1, L1)                                                (1)

Y2 = F2 (K2, L2)                                                (2)

Where equation (1) represents the production function for Sector 1 and Equation (2) represents the production function for Sector 2. F1 and F2 incorporate technical factors such as the different production methods, level of human capital and economies of scale.

For simplicity, Galbis (1977) assumes that in each sector, competitive conditions exist and factors of production are paid for in accordance with their marginal productivities which consequently influence the returns on capital. Thus,

                                                                ∂Y1/∂K1 = r1

                                                                ∂Y2/∂K2 = r2

Given the conditions above, the assumption that Sector 2 is more efficient and offers a higher rate of return on investment compared to Sector 1 means that:

r2 > r1                                                             (3)

Equation (3) represents the empirical prediction regarding the broad differences in technological efficiencies in developing economies which can be easily linked to an assumption relating to growth. Assuming that factors of production are wholly utilised and that they are paid their marginal productivities, the income determination equation is given by the below functional form:

Y = Y1 + Y2 = r1K1 + w1L1 + r2K2 + w2L2           (4)

Where w1 and w2 are the returns to labour in Sectors 1 and 2 respectively; Y represents aggregate output; andL represent capital and labour, the factors of production.

Equation (4) could be used to explain the outcome of capital redistribution from Sector 1 to Sector 2. Under the assumption that capital is fully utilised and is given, K = K1 + K2. A rise in K2 to the detriment of K1 leaving K fixed, would indicate an increase in Y, since this change in the capital structure would be in favour of the higher capital returns associated with K2. This result gives a hint to understanding the efficiency aspects of an improvement in the allocative mechanisms of savings and capital formation or investments. Galbis (1977) further assumes that there is no depreciation and asserts that the growth rate of capital inputs is related to investment in capital goods. Thus,

1 = I1                                                                   (5)

2 = I2                                                                  (6)


Galbis expresses the basic aggregate expenditure identity as follows:

Y= C + I = C1 + C2 + I1 + I2                                   (7)

Where C = C1 + C2 and I = I1 + I2

Assuming that consumption is a linear function of income, the determinants of expenditures by sector 1 is given by:

C1 = c1Y1            0<c1<1                                       (8)

The level of savings is simply the difference between income and consumption:

                                                                   S1 = Y1 – C1 = (1 – c1)Y1 = s1Y1

Investment decisions by economic agents in Sector 1 depends on the real rate of return on available alternative financial assets. It is assumed for simplicity that bank deposits are the only available alternative financial assets. The investment function is given by

I1 = H1(r1, d –

*/P)Y1                                          (9)

Where d represents the interest rate on bank deposits and

*/P is the anticipated inflation rate. Assuming that economic agents in Sector 1 are exclusively self-financed and do not have access to bank loans, it implies that

Y1 > C1 + I1. That is, I1 < S1, since economic agents in the sector can save in the form of bank deposits. Hence, ex-post savings and capital formation or investment are related by the following functional form:

S1 = I1 + d (M1/P)/dt                                      (10)

Where d(M1/P)/dt represents the aggregate financial savings in sector 1. Equation (10) represents Sector 1’s budget constraint. It implies that the aggregation of financial savings by Sector 1 is interrelated with the level of consumption and investment within the sector. The consumption behavior of economic agents in Sector 2 is similar to Sector 1:

C2 = c2Y2 ;         0<c2<1                                   (11)


                                                       S2 = Y2 – C2 = (1 – c2)Y2 = s2Y2

There are two sources of investable physical resources which may contribute to an increase in Sector 2’s capital stock. First, there exists Sector 2’s non-consumed output, S2. Secondly, there is the real physical counterpart of the increase in financial claims by units in Sector 1, i.e. d(M1/P)/dt, the difference between output in Sector 1 and its own total absorption of physical resources for consumption and self-financed investment.

Summing up, the supply of investable financial resources in Sector 2 is given by

IS2 = S2 + d (M1/P)/dt                                      (12)

Where S2 represents the non-consumed output from sector 2 and d (M1/P)/dt is the real value of output produced but not consumed in Sector 1.

Investment decisions by economic agents in Sector 2 just like Sector 1 depends on the relative rate of return:

ID2 = H2 (r2, b –

*/P)Y2                                 (13)

Where b –

*/P represents the real interest rate on bank loans. An important difference between Sector 2 and 1 is that r2 is relatively larger than r1, so that the benefit from investing in Sector 2 is greater. Another critical difference as regards the level of investment demand in Sector 2 compared to Sector 1 is that its validation is dependent on the availability of credit.

Galbis (1977) claims that where financial repression prevails, the deposit rate is below its equilibrium level (too low in most cases) and the supply of bank deposits from Sector 1 will be relatively low because firms will prefer to invest any surplus funds back into their business rather than saving the surplus funds in banks with low rates of return. Thus, credit will not flow to the more efficient sector. He argues that financial repression causes investment to take place in the less efficient sector. On the contrary, with interest rate liberalisation, the deposit interest rate will rise and this will cause a fall in Sector 1 investments, because firms will find it more profitable to deposit any surplus funds from profits in banks rather than investing in their own firms. Galbis (1977) further maintains that increases in the deposit interest rate as a result of interest rate liberalisation, will lead to a rise the supply of deposits from the less efficient sector to the banking sector and therefore the banks will have more funds available to lend to firms in the more efficient sector. Due to the fact that the more efficient sector has a higher rate of return on investment, the investment quality increases and this leads to an increase in economic growth.

The significance of financial development through financial liberalisation on economic growth has also been emphasised in endogenous growth models which emerged in the early 1990s (see for instance, Greenwood and Jovanovic, 1990; Bencivenga and Smith, 1991; Pagano, 1993; King and Levine, 1993; and Levine, 1997). These endogenous growth models highlight the importance of financial intermediaries in the economic growth process by showing how well-functioning financial intermediaries and liberalised financial markets could lead to self-sustained long run economic growth. Pagano’s (1993) endogenous growth model is quite straightforward and could be used to show how financial development, through financial liberalisation improves economic growth. He makes use of the ‘AK’ model in which aggregate output is linearly related to the aggregate stock of capital.

Yt = AKt                                                       (1)

Pagano (1993) assumes that the population of the economy is stationary, and that the economy produces only one output which can be consumed or invested, depreciating at rate δ per period if invested. He further assumes that a share (1 – φ) of the savings flow is forfeited during financial intermediation. Given these assumptions, gross investment (I) could be expressed as a function of the below form:

It = Kt+1– (1 – δKt                                         (2)

The equilibrium condition is given by:

ϕSt = It                                                                                              (3)

Equation (3) is derived from integrating Pagano’s third assumption (that a proportion (1 – φ) of the savings flow is forfeited during financial intermediation) with the equilibrium condition (that savings = investment) which prevails in a closed economy without government intervention.

From equation (1), the growth rate at time t+1 will be expressed as

gt+1 = Yt+1/Yt – 1 = Kt+1/Kt1                            (4)

Using equation (2) and getting rid of the time indices, the steady state growth rate could be expressed as:


IY– δ = Aϕs – δ                                           (5)

Where s represents the gross savings rate, (



From equation (5), Pagano asserts that financial development may influence economic growth in three ways:

  • By increasing the social marginal productivity of capital (A), financial intermediaries enhance capital formation and allocation. This could be achieved by encouraging firms to invest in riskier but more productive projects while providing opportunities for risk sharing and by gathering information and ensuring that investments which are more productive are financed.
  • By increasing the proportion of savings (ϕ) used for investment purposes, financial intermediaries can raise the growth rate, g.
  • By increasing the private savings rate (s), financial intermediaries improve the financial resources available for capital accumulation and for the reason that returns to capital are non-decreasing, a rise in the savings rate will lead to a permanent increase in the output per capita growth rate.

Furthermore, Pagano (1993) suggested that any distortions existent in the financial system must be dealt with before financial liberalisation can have a positive impact on savings.

In the context of endogenous growth models, Levine (1997) developed the functional approach to understanding the link between a country’s financial sector and economic growth. He asserted that financial intermediaries and other financial institutions emanate due to transaction and information costs. He further claims that the financial system, in reducing transaction costs, performs five significant functions which comprise the allocation of financial resources; elimination of risks; mobilisation of savings for capital formation; exchange promotion and the exertion of corporate control. Levine (1997) stated that if financial systems were to adequately perform these five core functions, savings and capital formation will improve, consequently leading to long run economic growth (Fowowe, 2013).

2.4.2. Theoretical Arguments in opposition to Interest Rate Liberalisation


Ever since the McKinnon (1973) and Shaw (1973) hypothesis which postulates that financial liberalisation is essential to savings, capital formation and economic growth, different lines of reasoning have emerged which argue against the efficacy of financial liberalisation. These criticisms have developed from various lines of reasoning. For instance, the Post-Keynesians such as Burkett and Dutt (1991) maintain that although, an increase in deposit interest rates as a result of liberalisation may boost the supply of financial savings and loans, it may also lead to a fall in aggregate demand which is detrimental to economic growth while neo-structuralists such as Taylor (1983) and Van Wijnbergen (1983) highlight the role of the informal financial sector especially in developing countries. Also, Diaz-Alejandro (1985) and Demirguc-Kunt and Detragaiche (1999) claim that financial liberalisation may cause financial fragility while Stiglitz and Weiss (1981) assert that the presence of asymmetric information in financial markets may lead to market failures in the financial system. Up till now, there exists no less than five theoretical arguments against the McKinnon (1973) and Shaw (1973) financial liberalisation hypothesis. These criticisms are discussed below. The Neo-structuralists

The main critics of the McKinnon (1974) and Shaw (1974) hypothesis are the neo-structuralists. Highlighting the difference between the formal and informal financial sector, they criticise the financial liberalisation hypothesis from a macroeconomic perspective. The ideas of Taylor (1983) and Van Wijnbergen (1983) are eminent in this school of thought.

Van Wijnbergen (1983), in his critique of the McKinnon (1973) and Shaw (1973) framework, formulates a short run model in order to explain the relationship between time deposit rates, bank lending rates and the level of economic activity. His model provides a realistic description of the portfolio allocation problem faced by wealth holders and applies financial markets in a typical developing country. He assumes that wealth holders hold their assets either as currency, direct loans to curb markets (also referred to as the unorganised money market or informal financial sector) or as time deposits. The decision on which type of asset to hold is described by a Tobin-style portfolio model and depends on the real rate of return on the three assets, real income and real wealth. He further assumes that private time deposits are the only source of funds for the banks, out of which they are obliged to hold reserves. Banks then apportion their remaining financial assets between free reserves and loans, depending on the rate of inflation and the bank lending rate. Ideally, firms are required to take advantage of every loan that the banks are willing to offer, especially as the loans are offered below the market rates of interest. According to him, any surplus credit needs is satisfied by the curb markets which always clear through changes in the curb market rate of interest.

Van Wijnbergen (1983) also analyses the substitution effects generated by changes in the time deposit rate and the effects of these changes on the level of economic activity and growth. Assuming on one hand that the time deposit rate is increased as part of the liberalisation policy, he claims that this change does not directly impact on the market for goods however, it alters the asset portfolio that economic agents are willing to hold as they will prefer to hold time deposits rather than currency. The implication of this portfolio shift according to Van Wijnbergen (1983) is that credit availability will increase and banks can grant more loans to firms for investment purposes. On the other hand, if the rise in time deposits induces economic agents to deviate from holding curb market loans to time deposits instead, credit availability will decline because funds are moved away from the curb markets which are unregulated and not subject to reserve requirements to the banks which are highly regulated and subject to reserve requirements. The magnitude of the latter impact, he claims, is reliant on the reserve requirement level in the formal sector and the relative size of the curb markets. The implication of this change, according to Van Wijnbergen (1983) is that funds available to firms for investment purposes will decrease, leading to a decline in the level of economic activities and consequently growth.

The neo-structuralists generally anticipate that the second impact prevails, meaning that as the time deposit rate increases, funds will be shifted away from the curb markets, leading to a decline in the supply of credit. Higher interest rates lead to an increase in working capital costs for investors, thus leading to a decline in supply. On the assumption that this supply side effect exceeds the demand effect, the rate of inflation will rise. Thus, Van Wijnbergen (1983) asserts that the effect of interest rate liberalisation on the economy is far from beneficial due to the fact that it leads to a fall in output and investment and a rise in inflation.

Taylor (1983) also disagrees with McKinnon (1973) and Shaw (1973) claim of the positive effect of interest rate liberalisation on economic growth for two reasons. Taylor (1983) maintains that a rise in the willingness to save (as a result of an increase in real interest rates due to interest rate liberalisation) leads to a reduction in aggregate demand and may cause economic contraction rather than economic growth. This argument is in line with the Keynesian critique of the liberalisation hypothesis as illustrated by Burkett and Dutt (1991). Furthermore, he argues that the impact of a rise in the real deposit rate and consequently bank deposits depends to a large extent on the origin of the deposits. Taylor (1983) advocates that deposits could come from unproductive assets such as gold or from deposits in the informal financial sector, also referred to as the curb markets. If the deposits originate from the assets which were formally unproductive such as gold, then there is likely to be a positive impact on the availability of credit and capital formation. On the contrary, if bank deposits originate from the curb markets, the entire the entire credit supply in the economy could decline easily. This effect occurs because the curb markets are not subject to reserve requirements whereas banks are. The New-Keynesians (Market Imperfection, Asymmetric Information and Credit Rationing)

Another influential criticism of the financial liberalisation hypothesis, based on microeconomic foundations emanates from Stiglitz and Weiss (1981) who assert that the relationship existing between financial liberalisation and economic growth is not as precise as McKinnon (1973) and Shaw (1973) propose because imperfections exist in financial markets due to asymmetric information which consequently lead to the problems of moral hazard and adverse selection. It is widely accepted in the financial liberalisation literature that removing controls on interest rates will eliminate the problem of credit rationing. Nevertheless, market imperfections in general and asymmetric information in particular do have adverse effects on financial markets. When information asymmetries exist in loan markets, credit rationing problems may arise because the quality of loans offered by banks will be adversely affected if they alter the interest rates. Hence, Stiglitz and Weiss (1981) advocate some form of government intervention in the financial sector so that interest rates will be kept below equilibrium, and suggest that this action will improve financial market performance, capital formation and economic growth.

Assuming that there exists numerous banks and potential borrowers, and that banks seek to maximise profits through the interest rates charged on loans while borrowers seek to maximise profits through their investment choice, Stiglitz and Weiss (1981) examine how loan market equilibrium is characterised by credit rationing. When banks grant loans, they are mainly interested in the returns they receive on the loans and how risky the loans are. However, raising the rate of interest charged on loans by the bank has two effects on the riskiness of the loan.  First, the incentive effect will encourage firms to undertake riskier investments because with higher interest rates, the return on investment declines and less risky projects become less profitable. Hence, banks portfolio of investment projects become riskier. Secondly, a rise in interest rates brings about the adverse selection effect. Information asymmetry is a characteristic of credit markets because economic are likely to be more informed about their prospective investments than the banks who provide loanable funds. The banks on the other hand are aware that the probability of loan repayment varies among the firms so, the banks would want to screen potential borrowers. If the banks screen borrowers by using the rate of interest, they are likely to attract bad borrowers because borrowers who are ready to borrow funds at higher rates of interest may worry less about the likelihood of non-repayment. However, due to imperfect information and transaction costs, the authors assert that a rational and profit maximising bank will ration available credit. Stiglitz and Weiss (1981) also show that in circumstances where banks can differentiate between groups of borrowers for instance, according to the size of the firm or sector, some borrowers may be excluded completely even if their anticipated investments could generate higher returns.  This means that in as much as credit rationing is a probable detrimental effect of financial repression, it is also an issue in liberalised financial markets.

Another very interesting type of market failure is addressed by Mankiw (1986). In the context of interest rate liberalisation, he proposes a theoretical model similar to Stiglitz and Weiss (1981), analysing credit allocation in a market characterised by asymmetric information. He justifies his investigation of bank loans to students on grounds that there are very limited number of financial instruments available to students and that the market for student loans has induced considerable intervention by government. Although the banks who grant loans treat all students as identical, the students differ by the expected rate of return on the knowledge gained from education, R, and by their probability, P of paying back the loans. Mankiw (1986) assumes for simplicity that both parties, i.e., the students and the banks are risk neutral. Although, each student is aware of his values of R and P, the banks are unaware of these attributes.

Assuming that P, the probability of repayment and R, rate of return on investing in education are given, it is possible to formulate an exhaustive model in which the students inability to repay the loan is endogenous. The students could be modelled as having different degrees of sincerity. The probability of default varies among students and a dishonest student is more likely to avoid paying back the loan. Alternatively, all students could be modelled as sincere. In this case, a student may default if his return leaves him unable pay back the loan ex-post; the likelihood of this event occurring is private information. Banks could resolve to invest in treasury bills which are regarded as safe assets and receive a guaranteed future payment ρ, or alternatively grant loans to one of the group of students. Assuming that the banks charge an interest rate, r, on loans to students, since the banks see all students are identical, they will charge all students the same r.

Assuming that a student is unable to repay his loans, the banks will receive no payment. However, it is possible to include a default payment of Δ such as collateral. In this case, the student could beconsidered as taking a loan of Δ/ρ that is paid back with certainty and a loan of 1 – Δ/ρ that is repaid with probability P and a defaulted loan with probability 1 – P. Let  be the average repayment probability. The anticipated repayment to the bank on the student loan is пr. For the bank to grant loans to students, the expected payment пr must be equivalent to ρ. Therefore, the first condition for equilibrium is given by:

Пr = ρ                                      (1)

Equation (1) describes the locus of market loan rates and repayment probabilities that provide the lenders the required rate of return.

Every student must make a decision whether to accept the bank loan at the rate of interest r in order to invest in education. If the student decides to take the loan, the expected borrowing cost is Pr while the expected return on his investment in education is R. hence, the student will take out the loan from the bank if R > Pr, that is, if his expected return exceeds the cost of the loan. Applying equation (1), the condition for investment is R > (P/п)ρ. If there is perfect information regarding the probability of default, then P = ᴨ and the student will invest in education if R > ρ, that is, if socially profitable. Thus, in this case, even though R is not publicly observable, the market for loans is fully efficient. The probability of repayment п as seen by banks is the average of P for the students who invest, thus, the function relating r to  is

ᴨ(r) = E[P ǀ R > Pr]                            (2)


Equations (1) and (2) are the equilibrium conditions. Together, they determine the market loan rate r from which the students’ decision and the average probability of repayment ᴨ can be ascertained. Mankiw (1986) also shows that if there is perfect information regarding P, the loan market will attain its first best allocation. However, in practice, this is not the case as markets are inefficient and the author claims that government intervention may enhance efficiency. He further examines the case whereby the expected return, R is constant across students and claims that free market equilibrium may leave profitable investment opportunities unrealised. The Post-Keynesian Critique


The Post-Keynesians have also criticised interest rate liberalisation, stressing the role of effective demand. The Keynesians disagree with McKinnon (1973) and Shaw (1973) neo-classical approach, specifying different savings and investment functions which incorporate typical Keynesian features. The Keynesians maintain that liberalising may cause a decline in output and economic growth and lead to financial instability or crisis. The works of Asimakopoulos (1986); Davidson (1986); and Burkett and Dutt (1991) represent the Keynesian view. Burkett and Dutt (1991) investigate the effects of interest rate liberalisation in a closed economy characterised by excess capacity. According to the authors, an increase in the deposit interest rate as a result of interest rate liberalisation brings about two effects. On one hand, it leads to a rise in deposits and consequently loans. This means that the equilibrium rate of interest falls and investment and output increases. In addition, an increase in the deposit interest rate may lead to an increase in the marginal propensity to save. Burkett and Dutt (1991) assert that in most cases especially in developing countries, it is highly likely that the economy’s aggregate demand may decline and if this is the case, they maintain that the rate of return on investment would decline due to a fall in aggregate demand. Furthermore, the authors argue that if a decline in the prevailing rate of return on investments discourages investors about the future rates of return, there may be a substantial decline in investments, thus bringing about a strong negative effect of interest rate liberalisation on capital formation and consequently economic growth.

Comparing the work of Burkett and Dutt (1991) to the McKinnon (1973) and Shaw (1973) neo-classical view, recall from Figure 2.1 that the effect of interest rate liberalisation was reflected in a rise in savings and capital formation or investments. An increase in the deposit rate due to liberalisation induced an upward shift along the savings function S(g1) and as the level of investment increased, the growth rate also increased and the savings function shifted right to point S(g2). Note also that from Figure 2.1, the investment function remained unchanged following liberalisation. Burkett and Dutt (1991) present a rather different explanation in their model as shown in Figure 2.2 below. As in Figure 2.1, the vertical axis represents the real interest rate while the horizontal axis measures the level of savings and capital formation or investments. The authors challenge the neo-classical view that the investment function remains unchanged after interest rate liberalisation.



Figure 2.2. Loanable Funds and Interest Rate Policy (Burkett and Dutt, 1991)


Burkett and Dutt (1991) maintain that when effective demand falls, the rate of return on investment declines as well and higher deposit rates may consequently reduce the level of savings, investment and output enough to offset the positive effects of the reduced loan rate, as depicted by the S and I schedules in Figure 2.2. Similar to the Neo-classical school, the authors assume that higher deposit rates lead to equilibrium in the loan market with deposit and loan rates both equal to r0. In this case however, the level of savings and investment schedule shift backwards to   S2 = I2, despite the decline in the effective loan rate from r1to r0. The implication is that interest rate liberalisation could cause the level of investment to be lower than it was when financial repression prevailed in the economy. The Post-Keynesians also claim that higher interest rates due to interest rate liberalisation may lead to stagflation because if there is excess capacity in the economy, higher interest rates may worsen income distribution, increase inflation and lead to a decline in the growth rate of the economy. The Role of Stock Markets

Supposedly, the stock market plays a very crucial role in financial liberalisation especially in developing countries but the McKinnon and Shaw model fails to incorporate this importance in their model. Another criticism of the financial liberalisation hypothesis rests on the assertion that the McKinnon (1973) and Shaw (1973) hypothesis pays no attention to the relevance of stock markets in the process of economic development and growth. Although, their study is empirical, Levine and Zervos (1997) assert that stock market development affects economic growth and development in several ways. For instance, by improving the level of liquidity and capital formation, stock markets may affect the level of economic activity. Usually, majority of high yielding projects require long term commitment of capital. Investors however, are generally unwilling to give up control of their savings for long periods. Without liquid markets or alternative financial sources that may improve the level of liquidity, less investments may occur in high yielding projects. Specifically, liquid stock markets reduce the downside risk and costs of investing in projects that do not payoff for a long time but when the stock market is highly liquid, initial investors do not lose access to their savings for the duration of the investment project because they can confidently and easily sell off their stake in the company.

Thus, more liquid stock markets ease investment in the long run by encouraging more profitable projects, thereby improving the allocation of capital and enhancing prospects for long run growth. Secondly, stock market may impact on economic growth through risk diversification. Since projects which generate higher returns are supposedly riskier, enhanced risk diversification through well-developed stock markets will encourage investment in higher return projects. Stock market development may also, according to Levine and Zervos (1997), influence corporate control. The authors claim that well-functioning stock markets help to mitigate the principal-agent problem (because management compensation could be directly linked to stock performance), promote efficient allocation of financial resources as well as improve the rate of economic growth. However, Stiglitz (1985) argues that the existence of asymmetric information in financial system would not make these benefits possible.

Singh (1997) specifically examines the role of developed stock markets through financial liberalisation by investigating the effect on economic growth. He asserts that in principle, a well-functioning stock market should impact on economic growth through channels similar to those by which the equilibrium interest rate is expected to influence it in the McKinnon (1973) and Shaw (1973) hypothesis, that is, through raising the level of financial savings, improving capital formation and consequently growth. Financial Liberalisation and Financial Fragility

There is a growing body of literature which suggests that financial liberalisation induces financial sector instability and fragility, leading to frequent financial crises (Diaz-Alejandro, 1985; Demirguc-Kunt and Detragaiche, 2000; Kaminsky and Schmukler, 2002; Loayza and Ranciere, 2004). These authors maintain that liberalising the financial system reduces bank regulation and supervision and this can cause banks to undertake imprudent practices. The creation of a deposit insurance scheme, primarily created to correct the negative externalities running from financial activities to their customers, could cause yet another type of market failure if it encourages risk taking by the banking sector- the moral hazard problem (Gennotte and Pyle, 1991). Diaz-Alejandro (1985) specifically focuses on Latin America, especially countries in the Southern Cone such as Chile during the 1970s and he disagrees with the liassez-faire or free market economy policy proposed by McKinnon (1973) and Shaw (1973). He also argues that due to the existence of market failures, banks and other financial institutions should not be seen or treated as an ordinary business and hence, suggests that the suitability of the free market policy as advocated by McKinnon (1973) and Shaw (1973) school should be questioned. Diaz-Alejandro (1985) proposes that there should be some level of government intervention in a country’s financial sector.

Wynne (2002) in line with the financial fragility argument, argues that the fundamental problem underlying financial fragility does not reside in banks’ incentives to screen and monitor potential borrowers; rather, the problem is that it takes time and effort for firms to build financial reputation and public knowledge about the quality of their investment projects. This is important because of the intrinsic asymmetry of information between potential borrowers and lenders. Firms create “information” capital only gradually through a higher survival rate and wealth accumulation. When financial liberalisation occurs and a large number of new firms enter the market (as more credit is available for investment funding due to a rise in interest rates which encourages savings), the absence of information capital leads to high interest rates, risky banks’ loans portfolios, cycles of credit fluctuations and low output growth, particularly if the economy is hit by large shocks.

These numerous criticisms of the financial liberalisation hypothesis do not necessarily challenge each other. Instead, they highlight distinct aspects of the financial liberalisation process. They suggest that the various liberalisation programs advocated by the proponents of the financial liberalisation hypothesis are not suitable for developing countries which should rather strive to promote a plan of action which combines financial liberalisation with the development of suitable institutions to facilitate the development of long term positive relationships among economic agents. Gibson and Tsakalotos (1993) suggest that when this is achieved, developing countries will be able to compete with the world at large. Overall, it is worth mentioning that whilst there is a sufficient body of literature in support of the McKinnon (1973) and Shaw (1973) financial liberalisation hypothesis, the theoretical arguments against interest rate liberalisation are steadily growing in number and substance and whether interest rate liberalisation indeed contributes to capital formation and/or economic growth remains an empirical issue. Moreover, given that different countries have different financial structures such an outcome may differ from country to country and over time.

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