10 sample vietnam ir liberalization

8/2/2019 10 Sample Vietnam Ir Liberalization

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Introduction

I Background and relevance of the thesis

The story really began in 1960s, characterized with an optimistic view that developing countrieswere economically young and full of potential for growth. Markets in developing countries

however were considered very weak, shallow and prone to failure. In financial markets, a primary

weakness of capital shortage was seen as an important reason for underdevelopment. Hence, inorder to speed up the contribution of the financial system to economic development, government

intervention was strongly encouraged. Intervention took the form of interest rate ceilings and direct

controls on credit allocation, which forced the financial system to fund government fiscalimbalances as well as to subsidise priority sectors. The control of the government over the

financial system led to very low and often negative interest rates on both deposits and loans.

Unfortunately, many financial market distortions resulted from the strong interventions of

government. The situation of "financial repression", i.e., excess of government intervention in the

financial market, was announced by the influential works of McKinnon and Shaw (1973). They

point out that financial repression limits economic growth in developing countries and that the ill-

functioning of the financial market has become a source of macroeconomic instability. The

removal of government controls over the financial market (financial liberalization) - they argued,

was the solution to financial repression since it would stimulate savings, investment and economic

growth.

In the last three decades, many developing countries have been carrying out interest rate

liberalization. Though interest rate liberalization brings beneficial effects to the developing

countries involved, it also often leads to financial instability if the so-called order of financial

liberalization and appropriate economic conditions are not warranted. This is evident in the

financial crashes observed in Latin America and Asian countries in the early 1980s and 1990s.

In Vietnam, the government heavily intervened in the financial sector during the centrally

planned period. Such interventions included restrictions on banking entry, capital movements,

money reserves, interest rates and credits. This strong financial repression, combined with other

factors caused high inflation, and low levels of savings, investment and economic growth during

1986-1988. Economic reform was then strengthened in 1989, which touched all aspects of

economic sectors. In the financial sector, interest rate liberalization was considered as the central

piece of reform. Interest rates were gradually adjusted towards free-market levels. The rise in the


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real interest rate has contributed to economic growth through curbing inflation, and raising the

level of savings and investment (both in quantity and quality).

In line with the process of liberalizing interest rates, the regulatory and supervisory

framework governing the financial sector has been improved but still remains weak (WB 1998).

The financial market is characterized by a high banking concentration and especially interlocking

relations among State owned enterprises (SOEs)- State owned commercial banks (SOCBs)-

Government. Such a situation has contributed to moral hazard problems. Moreover, economic

integration into the world economy has more or less caused Vietnam to fall into the trilemma of

exchange rate stability, full financial integration and monetary independence. The small crisis

involving short-term capital flows with the default on a number of deferred letters of credit in 1997

raises a question on the policy consistency during the interest rate liberalization process, especially

in relation to domestic interest rates, foreign interest rates and exchange rates. All these issues,

more than ever, require an appropriate strategy for interest rate liberalization in Vietnam.

To date, there has been many works more or less considering the impact of financial

reforms generally and interest rate liberalization particularly on the Vietnamese economy,

including WB (1990, 1994, 1995, 1996); OECF (1996); McCarty (1994); Tue (1996); Van (1996);

Ngan (1996); Ha (1996); Thanh (1997) and Quang (1998). However, it is observed that no

systematic study on interest rate liberalization has been undertaken by analyzing lessons from

experiences of other developing countries for the purpose of policy implications for Vietnam,

given the current economic context. Therefore, the study on Interest rate liberalization in

developing countries: Lessons and policy implications for Vietnam is an effort to fill these

gaps.

II Focus and scope of the thesis

The focus and scope of the thesis are as follows:

- Issues of interest rate liberalization in developing countries: effects of interest rateliberalization on savings, investment, credit availability and economic growth; factors

hampering the success of interest rate liberalization in developing countries, including

structural factors and the sequencing of the financial liberalization.


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- Financial instability experiences involve interest rate liberalization in developingcountries in Latin America (Chile, Uruguay, Argentina) and Asia (Malaysia, Thailand,

Indonesia, South Korea, the Philippines, Turkey) are considered. These countries are

chosen because: (i) they represent different levels of success in interest rate liberalization;

(ii) most of their interest rate liberalization experiences involved financial instability; and

(iii) information and data on these countries are available.

- Interest rate liberalization in Vietnam: effects of financial conditions on savings, financialdeepening, investments and economic growth; factors that can hamper the success of

interest rate liberalization in Vietnam, including structural factors and sequencing of

financial liberalization.

- Time frame for Vietnam study: 1986-1999 because the year 1986 marked a turning pointin economic reforms in Vietnam, with the doi moi policy.

III Research questions

The thesis seeks answers to the following research questions:

1. Why can interest rate liberalization bring beneficial effects to the developing countriesinvolved?

2. What are the experiences of interest rate liberalization in developing countries?Sub- questions:

- What are effects of interest rate liberalization on savings, investment, creditavailability and economic growth?

- What causes the failure of interest rate liberalization in developing countries?

3. What are the policy implications for Vietnam in term of interest rate liberalization, giventhe current economic context?

Sub-questions:

- What are the effects of financial conditions on savings, financial deepening,investments, and economic growth in Vietnam?

- What are the major factors that may hamper the success of interest rate liberalizationin Vietnam?


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IV Sources of information and research

method

Secondary and tertiary data collected from various sources are used in the study, includingpolicy statements, official and unofficial reports, various comments and figures from published

studies in the field, newspapers, and conferences.

The research methods in the study combine descriptive analysis, historical trends, statistical

analysis, and comparative method. Econometric techniques are also used.

V Structure of the thesis

The thesis is divided into 4 chapters. Chapter I presents theories and critiques of interest

rate liberalization. The major difficulties which hamper the success of financial liberalization in

general and interest rate liberalization in particular are also discussed in the chapter. Chapter II

documents the interest rate liberalization in developing countries as well as its effects on some

main macroeconomic variables. The chapter also analyses major issues in interest rate

liberalization in developing countries, focusing on factors hampering the success of the

implementation of interest rate liberalization with reference to Latin American and Asian

developing countries. Lessons from experiences are then provided in the chapter. Chapter IIIfocuses on interest rate liberalization in Vietnam, analysing effects of interest rate liberalization on

savings, financial deepening, investments, and economic growth. The chapter also considers the

major factors that may hamper the success of interest rate liberalization in the country. Chapter IV

provides main conclusions and policy implications for Vietnam.

chapter I: Theoretical framework

The chapter seeks answers to the following 2 questions:

1. What are the theories advocating interest rate liberalization?

2. What are the difficulties of the implementation of financial liberalization in generaland interest rate liberalization in particular?


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I. Financial repression

Financial repression is observed when the government distorts the domestic capital

markets. As argued by McKinnon (1973), government intervention including restrictions on

interest rate, heavy reserve requirements on bank deposits, and compulsory credit allocations,

interacts with ongoing price inflation to reduce the attractiveness of holding claims on the domestic

banking system. In such a repressed financial system, real deposit interest rates on monetary assets

are often negative. It therefore causes a reduction in the demand for domestic money, then a fall in

investment and economic growth.

II. Interest rate liberalization theories

The distortions and erosions of the financial system resulting from financial repression in

developing countries have called for financial liberalization initially developed by McKinnon and

Shaw (1973). The primary policy advice of economists advocating financial liberalization is the

general freeing and increasing institutional interest rates and/or a reduction in the rate of inflation.

This section surveys the McKinnon-Shaw school of thought and criticisms.

II.1 The McKinnon-Shaw school

The section mentions different models/ approaches to interest rate liberalization, including

those of McKinnon (1973), Shaw (1973), Kapur (1976), Galbis (1977), Mathieson (1979), and Fry

(1988). A common feature of all the models surveyed in this section, called McKinnon-Shaw

school is that the growth-maximising deposit rate of interest is the competitive free-market

equilibrium rate. An increase in the deposit interest rate induces a rise in the real supply of credit

and hence the rate of economic growth. The policy implication of these models is that economic

growth can be achieved through interest rate liberalization- the core policy in financial

liberalization policy packages.

II.2 Critics of McKinnon-Shaw school

The McKinnon-Shaw doctrine of interest rate liberalization has been challenged from

various approaches. However, there have been three most influential critics of interest rate


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liberalization so far. The first group representing the post-Keynesian views (Burkett, Dutt)

analyses the outcome of interest rate liberalization based on effective demand of the economy. The

second group with new-structuralist views, represented by Buffie (1984), van Wijnbergen (1982),

Taylor (1983), emphasises the role of an unofficial market and a working-capital cost-push effect

in consideration of interest rate liberalization policies. The third group, typically Wade (1988), Lee

(1992) and Stiglitz (1994), maintains its favor of financially repressed systems in facilitating rapid

economic growth. The thesis indicates that though the critics of financial liberalization are

interesting and suggestive, the ideas seem unable to dilute the benign nature of interest rate

liberalization, i.e., the positive effects of interest rates on savings, investment and economic

growth, due to the lack of authority.

III. McKinnon-Shaw school response to thedifficulties of interest rate liberalization

The McKinnon-Shaw school recognizes that interest rate liberalization difficulties still

remain in the presence of adverse factors which supervene in the process but not the logic of the

reform /or liberalization. Despite a little debate among the McKinnon-Shaw school about the

strategy of interest rate liberalization, the response to the difficulties of interest rate liberalization is

their most common. The major constraints to the success of interest rate liberalization, as indicatedin the thesis, are imperfect information, macroeconomic (price) instability, inadequate regulation

and supervision, and dis-sequencing of financial liberalization.

Chapter II: Major issues of Interest rate liberalization in developing countries

The chapter address the following three questions:

1. What are the effects of interest rate liberalization on developing countries involved ininterest rate liberalization?

2. What causes the failure of interest rate liberalization in developing countries?

3. What lessons can be drawn from experiences of interest rate liberalization indeveloping countries?


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I. Interest rate liberalization in

developing countries

I.1 An overviewThe role of government interventions in economy growth was strongly favoured during the

decades of 1950s and 1960s. However, strong intervention of the government in the economy

created heavy economic repression that progressively distorted economic performance of many

developing countries in 1970s. Macroeconomic performance was poor with large public sector

deficit, high inflation, overvalued exchange rates, low interest rates and excessive foreign

borrowings. In response to these problems, developing countries then carried out a series of

economic restructuring programs, including financial reform. The implementation of economic

restructuring programs in developing countries was also pushed by WB and IMF.

Interest rate liberalization as one of stabilization and restructuring policies was

implemented to correct the misallocation of resources as well as to cure developing economies

from serious crisis that resulted from repressed economic mechanizm during 1970s-1980s. The

wave of interest rate liberalization brought about an upward trend in real interest rate in developing

countries.

I.2 The effects of interest rate liberalization on savings,investment, credit availability and economic growth: A

survey

I.2.1 Saving ratio

A number of empirical findings shows that the relation between interest rate and savings is

not very clear-cut (Mikesell and Jinser 1973, Modigliani 1986, Olson and Martin 1981). Fry

(1995) explains that such a situation comes from different measures of saving and real interest

rates, different theoretical models, different econometric techniques, different samples of

developing countries as well as different time periods. Fry builds up a model to test the effects of

real deposit interest rates on gross national savings rather than other saving measures. His

empirical work shows significant positive interest rate effects on the savings ratio in a sample of 14


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Asian developing countries and Turkey. On average, he concludes that each percentage point

increase in the real deposit interest rate makes the national saving ratio rise about 0.1 percentage

point in the long run.

Rossi (1988:125) also estimates positive short run real interest elasticities of saving in

developing countries: Sub-Saharan Africa (0.25); Middle East and North Africa (1.04); East and

South Asia and the Pacific (0.18); Southern Europe (0.18); Central America and the Caribbean

(0.37); and South America (0.01).

The effect of real deposit interest rate on saving ratio is relative small. Fry (1995) states

that, as a device for increasing saving, the real deposit interest rate is subject to an upper bound at

its competitive free-market equilibrium level normally lying in the range of 0- 5 percent.

Therefore, only in countries where a considerable negative real deposit interest rate is observed can

there be many opportunities for increasing saving directly through raising the deposit rate.

I.2.2 Investment ratio

The effect of real interest rates on the quantity of investment is not so clear since different

empirical studies on different sample countries, in different time periods make different results.

Such empirical studies includes Voridis (1993), Dailami (et al., 1991), Haque (et al., 1990),

Edwards (1988), Greene and Villanueve (1991), Fry (1995).

Taking the issue of regime changes before and after liberalization in the case- study of

Turkey, Rittenberg (1991) shows that when the real deposit interest rate is negative, investment is

constrained by savings and the interest rate coefficient in the investment function is positive for

negative real rate. When real deposit rates are positive, surprisingly, investment is reduced by

higher interest rates, and the interest rate coefficient is negative for positive real rates.

I.2.3 Investment efficiency

While the empirical effects of real deposit interest rates on the quantity of investment

conflict, their positive effects on the average efficiency of investment are experienced in many

developing countries in the ways McKinnon (1973), Shaw (1973) and Galbis (1977) all strongly

theoretically suggest. If average investment efficiency is monotonically related to the incremental

output/capital ratio (IOCR), then a positive association between IOCR and dis-equilibrium real

deposit interest rate will support the idea that increasing real deposit interest rates toward their


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competitive free-market equilibrium raises the quality of investment. The empirical tests of Fry

and Asian Development Bank find such association in a sample of 11 Asian developing countries

and Turkey (Fry 1988). Geld (1989) shows a significant coefficient of 0.989 using period-average

data for 1965-73 and 1974-85 for 34 developing countries. Additionally, Morisset (1993) also

discovers a coefficient of 1.206 for Argentina during 1961-82.

I.2.4 Availability of credit

A large number of empirical tests find a positive relationship between the investment ratio

and the availability of domestic credit . Therefore, if interest rate liberalization leads to an increase

in the availability of credit, then the positive effects of availability of credit on investment ratio

may produce an indirect mechanism through which interest rate liberalization speeds up economic

growth.

Lanyi and Saracoglu (1983), by analyzing the effect of interest rate on financial deepening

(as measured by the rate of growth in the real M2) in 21 developing countries, discovers that a

country with positive real interest rate leads to an increase in the growth rate of real M2 of about

5.6 percentage point. They also make a conclusion that positive interest rate speeds up economic

growth, which mainly results from the intermediation of financial asset accumulations.

With the view that the rate of change in the real stock of financial assets is determined

almost on the demand side, Fry (1988) estimates the relation between demand for financial assets

and real deposit interest rates for the sample of 14 Asian developing countries in the period 1961-

83. On average, a 1 percentage point change in the real deposit interest rate in the 14 sample

countries changes the demand for the financial assets by 0.8 percent in the short run and 1.4

percent in the long run. Additionally, Chamley and Hussain (1988) also discover long run deposit

rate coefficient of 0.8 for Thailand (1974-86); 1.2 for Indonesia (1972-85); and 1.9 for the

Philippines (1972-87).

The empirical findings presented above are interesting though they contradict with the low

sensitivity of saving behavior to the changes in the real deposit interest rates. These findings

suggest that changes in real interest rates cause a considerable reallocation in the household

portfolio but only cause small changes in the total size of those portfolios. More importantly, a rise

in real deposit interest rate raises the proportion of saving poured into investment through the

financial intermediation channel.


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I.2.5 Economic growth

A study on the effect of real interest rates on economic growth for the sample of 21

developing countries implemented by Lanyi and Saracoglu (1983) shows that a positive real

interest rate policy brings about a 2.4 percentage point increase in real GDP . The World Bank

(1989) reproduces the same method of Lanyi and Saracoglu for 34 developing countries, finding

that the GDP growth rate in developing countries with strongly negative real interest rates is much

lower than that in countries with positive real interest rates.

Roubini and Martino (1992) tested very large sample size with 53 countries over the period

1960-85, indicating that countries with real interest rates of less than 5 percent in 1970s caused

their economic growth rate which averaged 1.4 percentage point less than the growth rate in

countries with positive interest rates. Fry (1988) himself has also carried out a number of empirical

tests of real interest rate effect on growth for different country sample size as well as different time

period. His results suggest that on average a 1 percentage point increase in the real deposit interest

rate towards its competitive free-market equilibrium level causes a rise in economic growth of

about percentage point in Asia.

The hypothesis of an inverted U-curve relationship between real interest rates and

economic growth holds up well by the work of De Gregorio and Pablo (1993). Very low real

interest rates reduce economic growth as implied by McKinnon-Shaw hypothesis while very highreal interest rates are likely to cause lower level of investment, then retard economic growth. The

finding of Fry (1995) for 16 developing countries also supports this point by implying that

economic growth maximizes at some positive real interest rate (Figure 1).


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II. Factors hampering the success of

interest rate liberalization in developing

countries

II.1 Macroeconomic instability

The thesis shows that interest rate liberalization as one major economic reform measure

implemented against an unstable macroeconomic background, may make that instability worse.

Macroeconomic instability characterized by high and unstable inflation, balance of paymentdeficit, external debts, expectations of devaluation of the currency and capital flight makes high

volatility of interest rates from freeing interest rate. In many cases, it leads to a high increase in

real interest rates. Thus, it spurs not only poor macroeconomic performance but also the problemsof moral hazard and adverse selection in credit markets.

The rapid implementation of interest rate reform in several Latin American Southern Cone

developing countries under severe macroeconomic imbalances in 1970s caused heavy failures of

the reforms. In Argentina, major financial reform measures including the elimination of interestrate ceilings were implemented during 1977-1981, but were not able to attain macroeconomic

stability, especially price. Argentinean interest rate liberalization under poor macroeconomic

performance exacerbated macroeconomic instability. Such situation also occurred in Chile duringits reform (Corbo 1985).

Hyperinflation in Chile after complete interest rate liberalization in 1975 made an extreme

increase in real lending interest rates. Meanwhile, unstable hyperinflation in Uruguay during 1973-

1983 caused very unsustainable and variable real lending interest rates. Macroeconomic instability


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affected the performance of investment projects, increasing the risk of default on bank loans.

Moral hazard and adverse selection problems occurred. The poor macroeconomic situation really

raised distress borrowing at higher interest rates from firms which needed to roll over maturing

debt and were nearing bankruptcy. The roll over of bad loans and capitalization of interest arrears

were estimated to be about 72% of outstanding peso loans in Chile in 1982 (Velasco 1991). Much

the same situations was also experienced in Argentina, Uruguay and the Philippines following their

interest rate liberalization (Vos 1993).

The strong interaction between macroeconomic instability and moral hazard occurred in

Turkey also. The quality of bank portfolio in these countries deteriorated due to the high levels of

real interest rates in relation to the marginal productivity of capital, plus relatively high gearing

ratios of the corporate sector. Interest rate liberalization in Turkey was carried out during the

period of fragile financial positions of business sector. Thus, the profitability of the private sector

and the banking system was further hurt (Atiyas 1989). Additionally, interest rate liberalization

and macroeconomic instability in the country caused lower household savings and higher financial

savings. Chile, Argentina and the Philippines also faced the same outcomes (Vos 1993).

In Indonesia, despite the failure to achieve macroeconomic stability, the government still

liberalized interest rates completely. Therefore, inflationary pressure and destabilizing capital

flows in combination with the expectation of currency devaluation caused high and volatile

domestic interest rates that often exceeded the rates of return to domestic fixed investments. This

was also observed in Turkey, the Philippines, and Latin American countries (Villanueva, Mirakhor

1990).

II.2 Inadequate supervisory and regulatory framework

Most banking and financial crises that occurred after the introduction of interest rate

reforms in developing countries, were to a great extent attributed to the lack of adequate regulation

and supervision. The rapid liberalization strategy in Latin American countries involved a complete

and abrupt elimination of interest rate ceilings and credit controls and a relaxing of strict

government supervision over the banking system. This plus virtually free deposit insurance

(explicit or implicit), distorted the financial behavior of banks and firms (Le Fort 1989). Loosing

banking supervision and an unstable macroeconomic climate intensified moral hazard in the


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banking system. Banks raised lending interest rates to higher and riskier levels with the expectation

that deposit insurance would (and in fact really did) cover any unusual losses.

Corbo and de Melo (1985) show that in Argentina, the provision of full and free deposit

insurance plus the lack of supervision on loan quality generated incentives for destabilizing

behavior. Nonperforming loans in Argentina stood at 25.2% of total loans during 1983-1987, on

annual average, which forced many firms into bankruptcy. In Chile, the number of bankruptcies

increased from two corporate enterprises in 1978 to 75 in 1982 and from 75 general establishments

in 1974 up to 810 by 1982. Loans in Chile to financial and manufacturing conglomerates, called

grupos, represented approximately 1/5 of the banking systems portfolio. This clearly provides

the evidence of the dominance of these groups and the lack of sound supervision of bank lending

activities (Velasco 1988). Bankruptcies often involved these grupos . Nonperforming and bad

loans to the total loans in Chile reached more than 35% in 1986 compared to just 2% in 1981).

Such movements were similar to Uruguay and the Philippines (Cho and Khakhate 1989).

Table 1: Quality of bank assets in selected developing countries (nonperforming loans tototal loans: percent)

Country 1980 1981 1982 1983 1984 1985 1986 1987

Argentina - - - 16.9 29.1 30.3 24.6 25.1

Chile 1 1.2 2.3 8.2 18.4 19.6 30.0 35.4 33.3Colombia 1.4 3.0 5.1 5.7 8.5 18.5 5.4 11.3

Ecuador 9.9 13.5 16.2 17.4 13.9 11.9 10.8 -

Mexico 1.5 1.5 2.4 2.9 1.8 1.6 1.0 0.6Uruguay 8.9 14.6 30.4 24.7 22.3 36.2 45.9 25.2

Philippines 11.5 13.2 13.0 8.9 12.7 16.7 19.3 -

Note: (1) Includes past due loans as recorded in accounts of financial institutions plus risky loans sold to the

Central Bank.

Source: Vos (1993) p.35

Lack of adequate regulation and supervision is also one of the main factors that leads to the

banking fragility in Indonesia, South Korea- the countries characterised by gradual interest rate

liberalization (Villanuava, Mirakhor 1990). The weakness of the legal framework in Indonesia

makes one surprised since banks can be easily established without cautious criteria. Additionally,

strong legal measures seem just good on paper since something is lost in execution (Visser and van


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Herp 1996). Moral hazard occurred, contributing to the nonperforming loans of 13% of total

lending in 1996 (Corsetti et al. 1998).

In Korea, interest rate liberalization and inadequate regulation shifted funds to high-risk

assets. The failure to establish an adequate supervision and monitoring program of non-bank

financial institutions, the short-term securities market and banks trust accounts economic

performance by the authorities and the reckless over expansion by corporate firms, especially

chaebols, rapidly deteriorated the corporate financial structure and made the firms susceptible to

external shocks (Cho 1999:13-16).

In Turkey, the inadequate regulatory framework was catalysis for the appearance of moral

hazard during interest rate reform since it allowed insolvent banks to avoid bankruptcy by offering

high rates to depositors, and using mobilized funds to refinance nonperforming loans. Moreover, at

the same time, firms that made losses increased their leverage, though the cost of borrowing had

raised.

II.3 Bank concentration and interlocking ownership

Successful interest rate liberalization is not fully secured where financial markets tend to be

highly concentrated, since such a situation intensifies the risks of moral hazard. Unfortunately,

high bank concentration is observed in many developing countries and in particular, usually

remained considerable in countries undergoing interest rate reforms (Error: Reference source not

found).

The prevalence of interlocking ownership in developing countries has a poor effect on the

allocative efficiency of credit supplies, hence reduces the positive effects of interest rate

liberalization by spurring moral hazard problems. Obviously, financial intermediaries that operate

within an economic group often tend to favor interests of the group rather than those of creditor

and depositors. Therefore, it is easy for firms of such family groups to have strong access to

banks credit, even without normal risk considerations. As a result, such so-called in-house

lending exacerbates the problems of nonperforming loans in many developing countries (Error:

Reference source not found).

Table 2: Bank concentration ratios for selected developing countries


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Country Year Bank concentration ratios 1

Argentina 1987 82 2

Chile 1988 54 2

Philippines 1990 47 3

Thailand 1988 69 3

Malaysia 1988 543

Indonesia 1986 81 3

Taiwan 1987 63 3

South Korea 1987 63 3

Notes: 1 Percentage shares of assets of the largest banks in total assets of the banking system

2 Four largest banks

3 Five largest banks

Source: Vos (1993), p.34

In South Korea, just 30 largest chaebols control about 85% of the industry, operating like

nebulous conglomerates. Cross-subsidies within conglomerates are detrimental to the economy.

Weaker members of conglomerates often receive guarantees from other firms in the group

(Delhaise 1998:102-103). Therefore, they can borrow from outside. Such movements plus lack of

strong supervision worsens the moral hazard problems since excessive risk taking is stimulated.

In Latin American countries, Turkey and the Philippines, serious moral hazard problems

occurred in the existence of interlocking firms in which banks had close interest (Villanueva and

Mirakhor 1990, Vos 1993, Atiyas 1989).

II.4 The sequencing of financial liberalization

It is generally accepted that any premature opening of the capital account in the balance of

payments during economic reform may result in macroeconomic instability and destabilize capital

flows. A considerable destabilizing capital outflow may be a consequence of any early opening of

the capital account in an economic context of domestic financial repression and low-level interest

rate ceilings (McKinnon 1991, Fry 1995).

Hanson and de Melo (1985) indicate that interest rate liberalization and the opening of the

capital account in Uruguay caused a rapid increase in private sector liquidity. It thus contributed to

the increased indebtedness in Uruguay which, after generating two asset bubbles , created


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widespread defaults when the real rate rose. The manufacturing sector debt rose from 52% of value

added in 1979 to 118% in 1983 (Hanson and de Melo 1985:923).

Interest rate liberalization in Chile created increases in domestic interest rates. With

insufficient restrictions on capital inflows and under a pegged exchange rate regime, capital

inflows that followed came up to a level of no less than 25 percent of GDP in the first half of 1981.

It then resulted in an inflated non-tradable sector and a rapidly increasing excess demand in the

tradable sector, making a large trade deficit (Corbo 1985).

Such situations were also observed in Argentina (Fanelli and Medhora 1998), where

expansion in absorption and the external deficit were primarily financed by massive capital inflows

which were channelled through domestic credit and capital markets. Thus, it contributed to a fast

increase in private and public indebtedness.

In Turkey, Balkan and Yeldan (1998) finds that the short-term capital inflows during

macroeconomic instability and interest rate liberalization created bubbles in the stock exchange

market.

Most recently, the Asian crisis in 1997 provides the clearest evidence of how crises occur

as the governments had liberalized the domestic financial sector and the capital account without a

well-designed sequence. The very large capital inflows resulted from strong macroeconomic

fundamentals, the interest rate differentials (because of substantial deregulation of domestic

financial sector) and a belief that the fixed exchange rate regime would be more or less sustainable.

In Thailand, for instance, net capital inflows between 1990-1996 on average were 10 percent of

GDP each year (Vichyanond 2000). The capital surge made the real exchange rate appreciated in a

number of countries, especially Thailand and Malaysia (Leung 1996:8). Moreover, the financial

institutions in most crisis-attacked countries were allowed to set their interest rates on a market

basis and were given strong access to foreign financing without developed risk management

systems as well as sound regulation and supervision. Such weak financial systems were worsened

much further due to poor corporate governance of financial and non-financial firms, non-financial

firms heavy reliance on direct finance and especially the interlocking relation among financial

institutions, firms and governments (Shirai 2000). Such circumstances created massive capital

inflows which were much more than the amount needed for financing current account deficits.

Excessive financial institutions credit expansion and excessive firms borrowing were therefore

intensified. The boom-burst business cycle and heavy vulnerability of financial institutions were


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observed. Moral hazard and adverse selection problems also exacerbated these bubble

economies as well as deteriorated asset quality. Lenders often ignored the fact that lending in

foreign exchange involved substantial credit risks. In Thailand and Indonesia, over-borrowing and

over-lending occurred in such a case that short-term borrowings were used to finance long-term

investment, especially real estate with very low liquidity, while in Korea very excessive loans were

poured into large traded-sector conglomerates without careful consideration and supervision

(Corsetti et al. 1998). That many domestic banks also faced short-term foreign-currency liabilities

heavily contributed to an increased foreign debt burden, especially short-term debts (Table 3).

Banks balance sheets, strongly characterised by maturity mismatches, were then heavily

vulnerable to various shocks. In mid-1997, investor confidence was critically shaken in Thailand.

Massive capital outflows, as a result of fears of an upcoming devaluation plus widespread

bankruptcies caused the floating of the Baht in the middle of 1997, which created a series of

financial crises region-wide.

The opening of the capital account without strengthening the domestic financial system

contributed to the Asian crisis. Vichyanond (2000) indicates that the Thai crisis is attributed to

three policy errors (policy inconsistency) which are most common in all Asian crisis-attacked

countries: (i) liberalization of foreign capital flows while keeping exchange rate rigid, (ii)

premature liberalization of financial institutions and (iii) lack of prudent supervision of financial

institutions.

Table 3: Debt service plus short-term debt in selected Asian countries (% of foreignreserves)

Country 1990 1991 1992 1993 1994 1995 1996

Korea 127.43 125.90 110.35 105.66 84.9 204.93 243.31

Indonesia 282.92 278.75 292.03 284.79 277.95 309.18 294.17

Malaysia 63.96 45.87 45.55 42.37 48.73 55.92 69.33Philippines 867.64 256.99 217.08 212.6 171.98 166.6 137.08

Thailand 102.35 99.34 101.34 120.28 126.54 138.13 122.62

Source: World Bank data in Corsetti Gaincarlo (et al.) (1998), p. 45

III. Lessons from experiences of interest

rate liberalization in developing countries


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III.1 Gradual versus rapid interest rate liberalizationstrategy

Whatever reasons for the different liberalization strategies, a number of countries, which

were characterized by both rapid and gradual strategies, have involved financial instability and

crises to date. The failures of rapid-strategy countries (involving premature liberalization policies)

in Latin America clearly indicate that it seems impossible to carry out successful interest rate

liberalization in a short period, given structural constraints including macroeconomic imbalances

and very inadequate supervisory and regulatory frameworks that are often characteristic of

developing countries. Furthermore, the recent Asian crisis in the 1990s, which also involved

countries with a gradual strategy (Korea, Indonesia) indicate that policy consistence is required for

successful interest rate liberalization. A proper sequence of reform is needed, thus it really takestime to carry out full interest rate liberalization without financial instability. The idea is that a

gradual approach to interest rate reform is better than a rapid one, and is more likely to be

successful.

III.2 Macroeconomic balance

It is now clear that interest rate liberalization is hazardous under conditions of great

macroeconomic imbalance. Under macroeconomic instability, higher real interest rates may havelittle effect on the savings behaviour of private individuals. These effects may become worse and

negative in the case where increases in real interest rates create a considerable redistribution of

income from debtors to creditors. High and volatile inflation leads to unstable interest rates, which

in turn stimulates moral hazard and adverse selection on credit markets. Such problems may be

compounded in the case where the macroeconomic design requires a restrictive monetary policy

(in order to fight inflation), reflected in the sharp increase in the cost of funds. In this sense,

excessive levels of real rates are as deleterious as repressed ones. Moreover, the emergence of bad

loan problems plus possible saving availability under macroeconomic imbalance may put financial

markets under stress and push up real interest rates. Therefore, financial instability involves,

continuing to distort macroeconomic performance.

Stability in the macroeconomic environment is no doubt required before full interest rate

liberalization.


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III.3 Prudential regulatory and supervisory framework

Strict supervision and adequate regulation on operations of the banking system and credit

markets are required and strengthened in order to minimize moral hazard problems. A strong

banking regulatory and supervisory framework is important not only because it ensures the

viability and health of the banking industry which is the traditional microeconomic justification but

also because interest rate liberalization would be ineffectual without it. Lack of adequate

regulations and their enforcement provides a catalyst for excessive risk taking during the interest

rate reform (the main cause of bad debt problems), and then financial instability.

III.4 Competitive banking environment

Strong concentration in the banking sector and interlocking ownership patterns in the

developing world are causes of inefficiencies in productive finance. Experience finds that many

bad loan problems in developing countries have resulted from unsound bank behaviour related to

interests of proper bank management and easy loan provision to allied firms, plus ineffective bank

supervision. Yet, these institutional problems themselves do not fully explain bad loan problems.

Rather, it is their existence in combination with macroeconomic imbalance and ill-conceived

liberalization policies. McKinnon (1973, 1991) suggests that interest rate liberalization be better

warranted under a competitive banking environment. The suggestion is true in liberalizationpractices in Latin American and Asian countries.

III.5 Sequencing of the capital account liberalization

It is clear that freeing interest rates and liberalising the capital account are part of economic

reform policy packages. However, an appropriate order of liberalization is required to ensure the

success of the reform. Free capital flows may break down the macroeconomic balance through

unstable interest rates, exchange rates, capital account and the balance of payments. The outcome

of macroeconomic instability may discourage interest rate liberalization. Additionally, with an

environment of bank-based capital markets (which are often observed in developing countries),

surges in capital inflows may create bubble economies and distort the prices of capital as

experienced in Asian and Latin American countries. The probability of failure of reform generally

and interest rate liberalization particularly increases.


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The optimum order of economic liberalization of McKinnon (1993), plus the experiences

of the reform process in developing countries shows the common view that capital account should

be opened only after both liberalizing the domestic financial sector and opening the current

account in the balance of payments. It means capital account liberalization should be the last step

in the liberalization process, after the domestic financial system is strengthened.

III.6 Issues of credit rationing

The evidence of many developing countries shows that credit rationing, in a number of

cases, creates rent-seeking costs. Rationing credit opens doors for political patronage in access to

loans. This, in turn feeds bad lending, corruption and wastage of resources go into the evasion

process as difference in the controlled and liberalised sectors of the economy is strongly arbitraged.

Lack of transparency is also helped and caused by this rent-seeking process, and those involved

resist efforts to liberalise the economy and make the economy more transparent.

Stiglitz and Weiss (1981) show that with expectation and moral hazard problems, banks

still put a limit on loan rates in order to maximize their expected profits. It means that too- high

interest rates can create credit rationing under competitive market equilibrium. Vos (1993)

suggests that underdeveloped financial markets in combination with credit market segmentation,

also leads to credit rationing. Therefore, certain borrowers are excluded from credit market access.

In many developing countries, it is observed that a large number of small-scale farms as well as

small and medium-scale industries, find it difficult to access credits. Government-owned financial

institutions have usually been established to fill this gap but subsidised loans and poor

management often generate a high cost burden to taxpayers. However, in case markets fail to

assess risk due to asymmetric information, dropping out a number of productive borrowers, the

establishment of some special financial institutions with government stimulus is justified.

Chapter III: The process of interest rate liberalization in Vietnam

The chapter focuses on answers to the three following questions:

1. What are the effects of financial repression on the Vietnamese economy?

2. What are the effects of liberalization of interest rates on Vietnamese economy?


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3. What factors may hamper the successful implementation of interest rate liberalizationin Vietnam?

I.

financial repression and its impacts oneconomy

In the section, the thesis briefly addresses financial repression in Vietnam before 1989 and

its impacts on the Vietnamese economy. The thesis shows that financial repression heavily

characterised by negative real interest rates was one important factor that distorted economic

relations and activities in Vietnam prior to 1989. To some extent, it not only caused low levels of

domestic savings, investment (both in quantity and quality) but also stimulated speculative

behaviour, distorted credit flows in the economy and contributed greatly to hyperinflation during

1986-1988. Though the operational mechanizm of the centrally planned economy was an important

catalyst that exacerbated the adverse effects of financial repression on the economy, what

McKinnon and Shaw (1973) criticize the problems of financial repression in developing countries,

no doubt, still hold for Vietnam in the period prior to 1989.

II. Interest rate liberalization process in

Vietnam: 1989-1999

II.1 An overview of interest rate liberalization in Vietnamduring 1989-1999

The thesis indicates that interest rate policy has experienced many positive changes during

the ten years of reforming the financial sector (1989-1999), directed towards market-determined

interest rate policy. The main changes are: (i) the implementation of a positive real interest rate

policy; (ii) the carrying out of long and medium-term interest rates which are higher than short-

term rates; and (iii) the removal of the regulated spread between lending and mobilising (deposit)

rates, the gradual elimination of ceiling levels on interest rates as well as spread between

mobilising and lending rates.


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II.2 Impacts of financial conditions on savings, financialdeepening, investments and economic growth

II.2.1 Savings

The thesis indicates that interest rate reform has made interest rates positive in real terms,

which provides savers an incentive to save. Such movement was strongly observed during 1992-

1999 because low and stable inflation protected the real return on savings.

Running the regression model developed by Fry (1980): DS = m1 + m2*R + m3*G +

m4*Y + m5*FS + m6* DS(-1) (where, DS is the domestic saving/GDP ratio; R is annual real

deposit interest rate; G is the growth rate of GDP; Y is the growth rate of per capita GDP; FS is the

foreign saving rate as a proportion of GDP and DS(-1) is the lagged saving ratio), the thesis findsthat (other thing being equal): (i) in the short-run: an one percentage point increase in the real

deposit interest rate leads to a 0.026 percentage point increase in the domestic saving rate; and (ii)

in the long run: an one percentage point increase in the real deposit interest rate leads to a 0.133

percentage point increase in the domestic saving rate.

II.2.2 Financial deepening

The thesis finds a relation between real interest rates and financial deepening of the

economy, indicating that even if a higher real interest rate does not lead to higher real savings

sometime, households are still expected to change the form in which they hold their savings from

real to financial assets, given the right incentive.

Testing the association of the real deposit interest rate and financial deepening by using

model developed by Khan (1999), the result shows that one percentage point increase in the real

deposit interest rate would lead to about a 0.059 percentage point increase in financial deepening

(other things being equal).

II.2.3 Investment

The thesis indicates that the nature of interest rate liberalization theories hold firmly in

Vietnam since the ripple effects of higher real interest rate higher savings higher funds

available for investment higher actual volume of investment was observed. More interestingly,


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the thesis also tests the relation between real interest rates and quality of investments with proxies

of ICOR and IOCR. The findings are (other things being equal): (i) an one percentage point

increase in the real deposit interest rate leads to a 0.11 percentage point decline in the incremental

capital-output ratio ICOR; (ii) an one percentage point increase in the real deposit interest rate

causes a 0.0023 percentage point increase in the incremental output- capital ratio IOCR.

II.2.4 Economic growth

The analysis in the section shows that interest rate reform really helped increase in economic

growth through increases in savings and investment (both in quantity and quality).

Using the model developed by Fry (1980) to test the association of economic growth rates

and real deposit interest rates, the thesis finds that an one percentage point increase in the real

deposit interest rate causes a 0.028 percentage point increase in the economic growth rate (other

things being equal).

III. Major issues of interest rate

liberalization in Vietnam

The section identifies the main factors that could hamper the success of interest rate

liberalization in Vietnam, including macroeconomic performance, prudential regulation and

supervision, banking concentration and the sequencing of the capital account liberalization.

Analyses indicate that the main difficulties remaining for interest rate liberalization are weak

banking regulation and supervision and low competition in the financial system. Though control

over capital account to some extent has been effective, which limits the probability of financial

instability caused by liberalization process, the past experience suggests that policy consistence is

of great importance during liberalization and integration. Macroeconomic performance and

liberalization of the capital account that is not premature are now seen to be consistent with interest

rate liberalization.

Chapter IV: Conclusions and policy implications

I. Conclusions


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As suggested by McKinnon-Shaw school, interest rate liberalization (freeing interest rate)

is a good solution for financially repressed economies in which domestic capital markets are

distorted by government interventions. Higher interest rates resulting from liberalization causes

higher levels of savings, higher funds available for investment and then higher economic growth.

However, interest rate liberalization may fail if it is implemented under an environment in which

some factors are observed, including asymmetric information, macroeconomic instability, weak

regulation and supervision and inappropriate sequencing of financial liberalization, especially of

the capital account.

Experiences of interest rate liberalization in developing countries confirm the hypothesis of

the McKinnon-Shaw school. Strong positive effects of real deposit interest rates are observed on

the efficiency of investment, the availability of credit and economic growth rates. Though the

direct effects of real deposit interest rates on saving and the quantity of investment are not clear-

cut, significant indirect effects of real deposit rates on investments result from the change in

allocation of household portfolios towards financial assets, which increase the availability of

credit. The indirect positive effects of real deposit rates on savings may result from increases in

economic growth rates.

Experiences from the failures of interest rate liberalization in Latin American and Asian

developing countries clearly indicate that macroeconomic instability (especially inflation volatility)

and dis-sequencing of capital account liberalization are the main reasons. Additionally, other

structural factors are attributed to be obstacles of interest rate reforms including weak regulatory

and supervisory framework, lack of competition on financial markets, heavy bad debt problems

and structural weaknesses in saving and investment performance. All these factor intensify moral

hazard and adverse selection (directly or indirectly), thus worsening financial instability.

Lessons from the experiences of interest rate liberalization in developing countries are then

clear for Vietnam:

- No doubt, interest rate liberalization can brings about beneficial effects to thedeveloping countries involved which are financially repressed. Economic growth can

be observed through increases in savings and investment that result from freeing

interest rates.

- A strategy of gradualism of interest rate liberalization is better than a rapid strategy.


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- Interest rate liberalization may lead to financial instability and even crisis if thecountry does not pay attention to pre-conditions and the so-called the sequencing of

the capital account liberalization, i.e., policy consistency during liberalization and

integration. Such pre-conditions include macroeconomic balance, prudential regulatory

and supervisory framework and competitive banking environment. Additionally, in

case markets fail to assess risk due to asymmetric information, dropping out a number

of productive borrowers, then the establishment of some special financial institutions

with support of the government may be necessary.

The study of Vietnam shows that the hypothesis of McKinnon-Shaw school holds strongly.

Interest rate reform/liberalization (among others) has helped the country overcome financial

instability in the late 1980s. The findings show that the real deposit rates can contribute to

economic growth through its positive (although still modest) effects on savings, financial

deepening, quantity and quality of investment. While the macroeconomic stability (especially

stable and low inflation) and un-premature liberalization of capital account supplement the

continuation of interest rate liberalization in Vietnam, some difficulties are still heavily remaining

in weak banking regulation and supervision and low competition in the financial system since such

difficulties exacerbate rent seeking, moral hazard and adverse selection problems.

II. Policy implicationsIt is now clear that the continuation of interest rate liberalization with a gradualizm strategy

should be carried out in Vietnam for four reasons:

- Theories of interest rate liberalization developed by the McKinnon-Shaw schoolsuggest that interest rate liberalization can benefit the countries involved.

- Experiences from developing countries support the hypothesis of the McKinnon-Shawschool that freeing interest rates can benefit the economy. Experiences also suggest that

a gradual approach to interest rate liberalisation is more likely to be successful than a

rapid one (other things being equal).

- The experience of Vietnam during 1986-1999 also support that interest rateliberalization improves the performance of the economy.


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- Macroeconomic stability, especially stable and low inflation as the most importantpre-condition holds in Vietnam. Moreover, effective controls over capital flows, i.e.,

not premature liberalization of capital account, also limit the external risks that may be

exacerbated during liberalization.

Some policy implications for Vietnam are as follows:

- Inflation rate should be kept at a low and stable level. Consistency of monetary policyand fiscal policy is required to target inflation stability and macroeconomic balance.

- The prudential regulatory and supervisory framework should be strengthened. Unlessbetter regulations are issued, supervision and accounting system improved and

inspection of banks is strengthened, there will be insufficient incentives for banks to

behave prudently and a room for rent seeking activities. Moreover, stronger

enforcement is also required.

- Competition among banks is necessary to improve banking services as well as tomobilize more deposits. Banking monopoly and oligopoly should be reduced. Changes

in policies with respects to bank entry and exist and levelling the playing field for all

banks, including foreign banks, should be more relevant for better services and

enhanced competition, then reducing moral hazard, adverse selection and rent seeking

in banking activities, especially in the relation between SOEs and SOCBs.

- The approach of gradualism to economic liberalisation should be applied in Vietnam.Given the context that Vietnamese macro-economy, especially inflation is now stable,

the domestic trade and finance should be opened and liberalised in parallel with the

improvement of transparency of the economic environment. After the successful

internal liberalisation of domestic trade and finance, the appropriate pace is to liberalise

the foreign exchanges. The transaction on current account in the balance of

international payment should be liberalised much faster than international capital flows.

Full capital account liberalization should be left until very last during the economic

liberalization process, after the domestic financial sector is strengthened. Policy

consistency is required to solve the problem of trilemma: exchange rate stability, full

financial integration and monetary independence.


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- Though full interest rate liberalization is the ultimate target, the poor bankingcapacity, weak banking institution and inefficient regulations, supervision and

inspection do not allow full interest rate liberalization right now. However, it is

suggested that gradually freeing interest rates towards full interest rate liberalization is

good for the economy. The policy sequencing toward full interest rate liberalisation

should include two steps, given the current Vietnamese context. Step one is to maintain

economic stability and boost transparency and supervision; and while enhance

transparency and supervision, temporarily regulate interest rates. Step two is to fully

liberalise interest rates.

Experiences of developing countries indicate that it generally takes no less than three

years to fulfil successful gradual liberalisation of interest rates (Villanueva et al. 1990).

Vietnam should implement full interest rate liberalisation within the duration of three

or four years, given the pressure and its commitment of economic integration (ASEAN,

Vietnam- United State Bilateral Trade Agreement).

At present, there is only one ceiling on lending interest rate for all maturity which

applied for all credit institutions in urban and rural areas (0.85 percent per month from

10/1999) (Hung 2000). Under the circumstance of weak regulation and supervision,

ceilings on lending rate limits too-high risk taking as well as moral hazard in the

financial system. However, the interest rate should be adjusted in the manner of more

flexible management on the basis of supply and demand with the aim at eliminating

interest rate ceilings and getting prepared for full interest rate liberalization whenever

possible. For example, a more flexible interest rate policy should be carried out by

allowing an appropriate fluctuation band around the ceiling on interest rates. It means

that credit institutions can freely determine their interest rates under ceilings which are

then more flexible. The determination of the band should be regularly adjusted

whenever necessary in order to keep pace with changes in inflation rates or in

international interest rates. The idea is that the band therefore should be large enough to

allow competition in the market, for instance, a 5 or 10 % band.

The determination of lending interest rate ceilings should based on several factors: (i)

annual economic growth rate expected, (ii) expected inflation, (iii) objectives of


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monetary policy (strict or loose monetary policy), (iv) the supply and demand for

capital in the market, and (v) the relation between interest rate and exchange rates.

The term interest rate liberalization used in the thesis should be understood as a process of

deregulation of interest rates.

In Fry (1995)

Here, availability of domestic credit is measured by the ratio of total or private sector credit to

GNP or the changes in the total or private sector credit divided by real GNP.

Ibid.

The same happens to Chaebols in South Korea, considered later.

Agricultural land and real estate- Hanson and de Melo (1985), p.922.

Documented in Fanelli Jose M and Medhora Rohinton (1998), pp.129-155.

The major countries hurt by Asian crisis include Thailand, Indonesia, Malaysia, the Philippines,

and South Korea.

10 sample vietnam ir liberalization

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