WHAT IS FINANCIAL LIBERALISATION?

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CHAPTER 3 THE THEORY OF FINANCIAL LIBERALISATION

INTRODUCTION

McKinnon (1973: 9) and Shaw (1973: 9) have documented the importance of financial liberalisation in relation to economic growth. Ever since then, numerous studies have attempted to document the effects of financial liberalisation on, inter alia, economic growth, financing constraints, market integration, capital flows and capital structure. All these economic fundamentals are crucial in influencing firm financing behaviour. As a result, there is a need to synthesise the literature on financial liberalisation and its effects, to unfold the picture that is emerging out of previous studies. This analysis will provide a sound basis for formulating testable hypotheses.

Goal of this chapter

The main goal of this chapter is to discuss the literature on the theory and implications of financial liberalisation. It begins by highlighting the case for financial liberalisation and provides contrasting empirical evidence on the effects of financial liberalisation. Next, the process of financial liberalisation is discussed together with its effects on capital flows, financing constraints and capital structure.

 Layout of this chapter

The rest of this chapter is organised as follows: Section 3.2 defines the concept of financial liberalisation. Section 3.3 presents arguments for and against financial liberalisation. Section 3.4 articulates the process of financial liberalisation by highlighting the multifaceted nature of financial reforms. Section 3.5 deals with the effects of financial liberalisation on capital flows, credit constraints and capital structure of firms. Section 3.6 provides an analysis of the dating of financial liberalisation. Section 3.7 concludes the chapter.
3.2 WHAT IS FINANCIAL LIBERALISATION?
Auerbach and Siddiki (2004: 231) define financial liberalisation as the elimination of a series of impediments in the financial sector in order to bring it in line with that of the developed economies. There are principally three types of financial liberalisation. Firstly, this term may be used to describe domestic financial sector reforms such as privatisation and increases in credit extension to the private sector. For example, Gelos and Werner (2002: 1) examine how domestic manufacturing firms in Mexico have responded to these types of reforms.
Secondly, financial liberalisation may be used to refer to stock market liberalisation. In this case, stock market liberalisation occurs when a country opens up its stock markets to foreign investors, at the same time allowing domestic firms‟ access to international financial markets (Bekaert and Harvey, 2003: 5).
Finally, financial liberalisation may refer to the liberalisation of the capital account. This is a situation where special exchange rates for capital account transactions are relaxed (Loots, 2003: 237), where domestic firms are permitted to borrow funds from abroad (Schmukler and Vesperoni, 2006: 183), and where reserve requirements are lowered (Kaminsky and Schmukler, 2008: 259).

DOES FINANCIAL LIBERALISATION MATTER?

The concept of financial liberalisation stems back from McKinnon (1973: 9) and Shaw,(1973:  9),  who  attribute  economic  development  in  developing  countries  to  financia liberalisation. McKinnon (1973: 9) argues that financial liberalisation is a necessary ingredient in the generation of high saving rates and investment. Shaw (1973: 9) further argues that the subsequent real growth in the financial institutions provides domestic investors with the incentive to borrow and save, thus enabling them to accumulate more equity thereby lowering the cost of borrowing. The same view is echoed by Gibson and Tsakalos (1994: 578) who argue that financial liberalisation is necessary for financial markets to operate efficiently and to provide new opportunities for financing in the existing economy.
Eichengreen (2001: 342) observes that restrictions on capital mobility shelter the financial institutions from foreign competition and that these capital controls “…vest additional power with bureaucrats who may be even less capable than markets at delivering an efficient allocation of resources …” However, Gibson and Tsakalos (1994: 579) do not regard all forms of government intervention as financial repression needing to be liberalised. They suggest a better understanding of how financial markets in the developing countries operate, and which aspects of the financial markets are pertinent.
There have been some concerns that have been raised by researchers about the effects of financial liberalisation. For example, Eichengreen and Leblang (2003: 205) utilise data set for 21 countries ranging from 1887 to 1997, and they find weak evidence that financial liberalisation leads to growth. Nyawata and Bird (2004: 289) warn that the liberalisation of domestic interest rates could lead to excessive borrowing, which may jeopardise profitable investment opportunities. Recognising that financial liberalisation has its own limitations, McKinnon (1989: 53) believes that it is still “… the only game in town …” in the view of achieving economic development.
Lee and Shin (2008: 106) dissect the effects of financial liberalisation into direct and indirect effects. The direct effects are clearly the benefits that arise in terms of the removal of frictions in the markets, thus leading to lower borrowing costs. The indirect effects are the negative impacts leading to crises. Although they find that the probability of crises occurring is two percentage points, the net effect, which combines the direct and indirect effects, leads to positive economic growth.
Given the slower pace of economic transitions, Henry (2007: 891) argues, firstly, that cross-sectional regressions applied by many studies fail to capture the true impact of financial liberalisation on growth. Secondly, in the case of instantaneous integration of markets, cross-sectional regressions designed to test long run growth may not be suited for measuring the short-run changes in market convergence.
Fry (1997: 759) identifies some of the key prerequisites for successful financial liberalisation; these are effective supervision of commercial banks, price stability, fiscal discipline enhanced by sustainable domestic borrowing by governments, adequate competition by commercial banks in a profit-maximising environment and a non-discriminatory tax system on financial intermediaries.
The evidence reviewed thus far suggests that the McKinnon (1973: 9) and Shaw (1973: 9) propositions have been met with mixed empirical evidence. The impact of financial liberalisation on economic growth is mainly conditional. Table 3.1 sums up some of the conditions found in recent studies on the effects of financial liberalisation on economic growth. The next section articulates on the process of financial liberalisation.

THE PROCESS OF FINANCIAL LIBERALISATION

The multifaceted nature of financial liberalisation

The process of financial liberalisation is a complex one (Demirguc-Kunt & Levine (1996: 292), Bekaert, Harvey & Lumsdaine (2002a: 204) and Bekaert & Harvey,(2003: 5)). This is because financial liberalisation generally occurs in line with other macroeconomic reforms aimed at developing the domestic financial market. Bandiera, Caprio, Honohan and Schiantarelli (2000: 239) acknowledge the multifaceted nature of reforms that occur in line with financial liberalisation. They also point out that, in some cases, the process of financial liberalisation involves reversals in capital inflows.
Henry (2000a: 532) approaches the study of the impact of stock market liberalisation on emerging-market equity prices with caution. Owing to its complexity, he controls for reforms such as trade liberalisation, exchange control relaxation and privatisation. In the South African context, the liberalisation of the financial markets was accompanied by various political and economic developments. Makina and Negash (2005a: 149) note that the negotiations that led to the unbanning of the ANC in February 1990, also led to the first democratic elections in April 1994. They argue that these developments brought anticipation for the full opening of the JSE in March 1995.
According to Kaminsky and Schmukler (2008: 259), complete liberalisation is accomplished when at least two sectors in the domestic economy are fully liberalised, and one sector is partially liberalised. Partial liberalisation occurs when at least two sectors are partly liberalised.

Financial liberalisation and market integration

Bekaert and Harvey (2003: 4) observe that financial liberalisation leads to market integration with the global equity markets. Therefore, assets in the integrated markets should exhibit similar expected returns. However, in practice, markets may not be fully integrated. For example, French and Poterba (1991: 222) and Tesar and Werner (1995: 467) find that the benefits of risk sharing across integrated markets have not been fully exploited, thus leading to a home bias inherent in national investment portfolios. In fact, Bekaert and Harvey (2003: 4) argue that the home asset preference phenomenon has led many economists to believe that even well-developed capital markets are still not fully integrated. The next section discusses the effects of financial liberalisation on capital flows, financial constraints and capital structure.

THE EFFECTS OF FINANCIAL LIBERALISATION

This section analyses the literature on the various effects of financial liberalisation. Firstly, the effect of financial liberalisation on the evolution of capital flows is reviewed. Secondly, the issue of whether financing constraints are eased by financial liberalisation is documented. Finally, the literature on the effects of financial liberalisation on capital structure is analysed.

Financial liberalisation and capital flows

The removal of restrictions on cross country capital mobility results in increases in capital inflows. Bekaert, Harvey and Lumsdaine (2002b: 297) find that, as investors rebalance their portfolios, net capital inflows increase sharply in the first three years following financial liberalisation. However, they note that these capital inflows level off thereafter. Fernandez-Arias (1996: 414) cites low international interest rates as one of the reasons for the observed sharp increases in capital flows.

CHAPTER 1: BACKGROUND AND INTRODUCTION
1.1 INTRODUCTION
1.1.1 Goal of this chapter.
1.1.2 Layout of this chapter
1.2 THE FINANCIAL SECTOR IN SOUTH AFRICA
1.2.1 The evolution of the banking sector in South Africa
1.2.2 The evolution of the JSE.
1.2.3 Financial liberalisation in South Africa.
1.3 MOTIVATION FOR THIS STUDY
1.3.1 The economic and political imperative
1.3.2 The cost of equity capital imperative
1.3.3 The capital inflow imperative
1.4.4 The financial constraints imperative.
1.5.5 Other imperatives
1.6.6 Why South Africa?
1.4 THE RESEARCH PROBLEM.
1.4.1 The implications of stock market liberalisation
1.4.3 The implications of domestic financial sector liberalisation.
1.4.4 The implications of capital account liberalisation.
1.4.5 The implications of market segmentation.
1.4.6 The implications of transaction costs.
1.4.7 Other unresolved issues..
1.5 RESEARCH OBJECTIVES
1.6 DEFINITION OF KEY TERMS
1.7 STRUCTURE OF THE THESIS
1.8 CHAPTER SUMMARY
CHAPTER 2: THE THEORY OF CAPITAL STRUCTURE
2.1 INTRODUCTION
2.1.1 Goal of this chapter.
2.1.2 Layout of this chapter.
2.2 DOES CAPITAL STRUCTURE MATTER?
2.3 THEORETICAL DETERMINANTS OF CAPITAL STRUCTRE
2.3.1 The trade-off theory
2.3.2 The agency theory.
2.3.3 Information costs theories
2.3.4 Contracting cost theories.
2.3.5 The difficulties in testing the theories of capital structure
2.3.6 Summary of the origins and evidence of the main theories of capital Structure
2.4 EMPIRICAL EVIDENCE ON FACTORS AFFECTING CAPITAL STRUCTURE
2.4.1 Institutional, legal and financial factors.
2.4.2 Size.
2.4.3 Profitability
2.4.4 Asset tangibility
2.4.5 Age.
2.4.6 Growth prospects
2.4.7 Corporate taxes.
2.4.8 Non-debt tax shields
2.4.9 Dividend policies
2.4.10 Similarities in capital structure determinants
2.5 CORPORATE CAPITAL STRUCTURES AROUND THE WORLD
2.5.1 Corporate capital structures in the developed economies
2.5.2 Corporate capital structures in the developing economies.
2.6 CHAPTER SUMMARY.
CHAPTER 3: THE THEORY OF FINANCIAL LIBERALISATION
3.1 INTRODUCTION
3.2 WHAT IS FINANCIAL LIBERALISATION?
3.3 DOES FINANCIAL LIBERALISATION MATTER?
3.4 THE PROCESS OF FINANCIAL LIBERALISATION.
3.5 THE EFFECTS OF FINANCIAL LIBERALISATION
3.6 THE DATING OF FINANCIAL LIBERALISATION
3.7 CHAPTER SUMMARY
CHAPTER 4: HYPOTHESIS DEVELOPMENT
4.1 INTRODUCTION
4.2 HYPOTHESES DEVELOPMENT
4.3 CHAPTER SUMMARY
CHAPTER 5: METHODOLOGICAL ISSUES
5.1 INTRODUCTION
5.2 THE DATING PROBLEM
5.3 THE LEVERAGE MEASUREMENT PROBLEM
5.4 VARIABLE DEFINITION
5.5 CHAPTER SUMMARY
CHAPTER 6: RESEARCH DESIGN AND ECONOMETRIC APPROACH.
6.1 INTRODUCTION.
6.3 DATA ANALYSIS
6.4 MODEL SPECIFICATION TECHNIQUES
6.5 TESTING FOR STRUCTURAL SHIFTS IN PARAMETER ESTIMATES
6.7 FORMAL TESTS OF SPECIFICATION IN PANEL DATA
6.8 CHAPTER SUMMAR
CHAPTER 7: EMPIRICAL RESULTS.
7.1 INTRODUCTION
7.2 BASIC TESTS AND SUMMARY STATISTICS
7.3 THE CONTRASTING EFFECTS OF FINANCIAL LIBERALISATION ON CAPITAL STRUCTURE
7.4 REGRESSION OUTPUTS
7.5 RESULTS AND PRESENTATION OF HYPOTHESES
7.6 FIRM SPECIFIC DETERMINANTS OF LEVERAGE
7.7 THE LONG RUN TARGET ADJUSTMENT MODEL AND TRANSACTION COSTS
7.8 CHAPTER SUMMARY
CHAPTER 8: CONCLUSIONS AND IMPLICATIONS FOR FURTHER RESEARCH
8.1 INTRODUCTION
8.2 THE THEORETICAL CONCLUSIONS OF THE STUDY
8.3 THE EMPIRICAL FINDINGS OF THE STUDY
8.4 THE CONTRIBUTIONS OF THE STUDY
8.5 SHORTCOMINGS AND SUGGESTIONS FOR FURTHER RESEACRH
LIST OF REFERENCES
APPENDIX
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