P2: DF201 Exam|Question 1

4. Interest Rates, Resource Allocation and Investment

...Ronald McKinnon, regard increase money balances, rather than increased credit availability, as the crucial constraint on investment. This is because McKinnon pictures most investors in physical capital in developing countries as engaging in self-finance. He also argues that a certain build-up of money balances necessarily precedes investment because investment is so typically 'lumpy'.

Even if the quantity of saving and investment has not clearly been shown to increase with financial liberalization, it might still be possible to argue that beneficial effects result through the improved quality of investment undertaken.
1. Has the efficiency of investment increased...
2. Has the efficiency of credit allocation increased...

comparing the period before and after liberalization?

4.1 The Efficiency of Investment

...the efficiency of investment through examination of the amount of extra investment necessary to produce a unit increase in output, and the way this ratio changes over time. This ratio is known as ICOR or 'incremental capital: output ratio', where 'incremental capital' is an alternative term for physical investment. ...the Harrod-Domar growth model assumed this ratio to be fixed, for the purposes of an aggregate growth model.

When ICOR gets smaller this implies an increasing efficiency of investment. Estimates for ICOR from Turkey by Ercan Uygur (1993, "Liberalization and Economic Performance in Turkey", UNCTAD Discussion Paper No. 65, Geneva) is with mixed results. But ultimately ICOR can change for a whole host of reasons and thus is not helpful.

4.2 The Efficiency of Credit Allocation
Yoon Je Cho (1988) The Effect of Financial Liberalisation on the Efficiency of Credit Allocation Journal of Development Economics 29.

...a difference in the marginal returns obtained from credit implies that credit is being allocated inefficiently, Measuring the extent to which marginal returns to credit vary would then give us a measure of efficiency of that credit allocation.
...
...the variance of the cost of credit could also be taken as a more indirect measure of the efficiency of credit allocation (Cho). The reason is the simple one that the cost of credit is fairly easy to measure, while the returns to credit are not.

For each sector:
(total interest and discount payments)/(total debt)

Cho concludes that the McKinnon-Shaw financial liberalisation (financial repression model) was beneficial in decreasing variance of credit costs during the 1980s/70s.

But...Amsden, Alice and Yoon-Dae Euh (1993) "South Korea's 1980s Financial Reforms: Goodbye Financial Repression (Maybe) Hello New Institutional Restraints", World Development Vol 21 No 3

...as industrialisation proceeds, the number of new industries requiring special assistance falls. Therefore, as the number of industrial enterprises grows, the variance in heir borrowing costs will fall. This the see as a result of industrialisation rather than a cause of industrialisation.

Jaramillo, Fidel "The Effects of Financial Liberalistion on the allocation of credit, Panel Data Evidence for Ecuador" Country Economics Department, The World Bank, WPS1092 PDF

...the larger and older firms which had benefited from the reallocation of financial resources following liberalisation. (Study book)

Of course asymmetry of information is a higher hurdle for the smaller firms which leads to smaller firms having less access to short-term credit.

Summary: The authors discuss two effects of financial liberalization, using panel data for Ecuadorian firms. After describing the main thrust of the reforms and the general macroeconomic developments, they document the changes that occurred in the firms' financial structure and in the allocation of credit. Descriptive evidence suggests that there has been a reallocation of resources towards older, larger firms after liberalization. The authors also investigate econometrically whether financial reform has helped direct credit to more efficient firms. The results, based on measures of technical efficiency obtained from estimating stochastic production frontiers, show that this has indeed been the case in Ecuador. (Above link)

Summary:

The authors discuss two effects of financial liberalization, using panel data for Ecuadorian firms. After describing the main thrust of the reforms and the general macroeconomic developments, they document the changes that occurred in the firms' financial structure and in the allocation of credit. Descriptive evidence suggests that there has been a reallocation of resources towards older, larger firms after liberalization. The authors also investigate econometrically whether financial reform has helped direct credit to more efficient firms. The results, based on measures of technical efficiency obtained from estimating stochastic production frontiers, show that this has indeed been the case in Ecuador.

The Quality Effect: Does Financial Liberalization Improve the Allocation of Capital?

This study documents evidence of a "quality effect" of financial liberalization on allocative efficiency, as measured by dispersion in Tobin's Q across firms. Based on a simple model, we predict that financial liberalization, by equalizing access to credit, reduces the variation in expected marginal returns. We test this prediction using a new financial liberalization index and firm-level data for five emerging markets: India, Jordan, Korea, Malaysia, and Thailand. We find strong evidence that financial liberalization, rather than financial deepening,
improves allocative efficiency.

So the answer at least in this study was yes financial liberalization is good for the economy. Abiad, Oomes, Ueda-Jacques Polak Annual Research Conference.2005