Chapter

Financial Sector Reform and the Real Sector

Author(s):
International Monetary Fund
Published Date:
March 1991
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Author(s)
R. Barry Johnston and Ceyla Pazarbaşioğlu 

The experience of various countries in the aftermath of financial sector reform has been diverse. Many countries have improved economic growth and efficiency, but several others, including both industrial and developing, have faced financial crisis and disruptions in economic growth. Many economists share a concern that financial sector reforms may involve transitional costs stemming from real sector restructuring, which accompanies reform. This chapter examines some of the channels through which financial sector reform can affect real economic growth and the efficiency of capital using panel data (pooled cross-country and time-series data) from a sample of countries that have liberalized their financial system.

A large body of theoretical literature has analyzed the extent of financial intermediation in an economy as an important determinant of its real growth rate, identifying the channels of transmission from financial intermediation to growth. Early examples of this literature include Cameron (1967), Patrick (1966), Goldsmith (1969), McKinnon (1973), and Shaw (1973). These papers emphasized the role of financial intermediaries in the credit supply process, and concluded that there is a strong positive correlation between the extent of financial development and economic growth. McKinnon and Shaw emphasized the role played by financial liberalization in increasing savings and, hence, investment, while Goldsmith focused primarily on the relationship between financial development and the efficiency of investment. A survey article on financial structure and aggregate economic activity by Gertler (1988) describes these and subsequent models.

Some of the more recent studies, such as Greenwood and Jovanovic (1989) and Bencivenga and Smith (1991), argue that to the extent that financial intermediaries tend to alter the composition of savings in a way that is favorable to capital accumulation, they will tend to promote growth. Similarly, Levine (1992) concludes that financial structures enhance growth by promoting the efficient allocation of investment through various channels.

Empirical tests of the impact of financial intermediation on growth conducted in the context of a large sample of countries by Jappelli and Pagano (1992), Roubini and Sala-i-Martin (1992), De Gregorio and Guidotti (1992), and King and Levine (1993a, b), have concluded that financial variables have an important impact on economic growth. Most of these studies use a similar methodology and follow the strategy of adding variables of financial development to Barro’s (1991) basic cross-country regression to analyze their impact on growth. An alternative approach used by Agarwala (1983), Anderson (1987), Khatekhate (1988), Gelb (1989), Gallagher (1991), Odedokun (1992), and Sundararajan (1985 and 1987) is to model the effects of financial variables on economic efficiency. These studies use the real interest rate and various monetary aggregates as a proxy for financial intermediation.

Although these studies allow inferences to be made about the impact of financial reform on economic growth and efficiency, to the best of our knowledge, none of the studies has sought to examine the role of financial reforms directly on economic growth and efficiency. Moreover, the studies have tended to proxy financial sector development by a single financial indicator—the ratio of either money or credit to GDP or the real interest rate. This approach, however, has its limitations given that financial development and reform have many dimensions. The need to examine the relationships between financial sector variables and the real sector at a more complex level becomes especially important in designing financial sector reforms, and in understanding the reasons why some countries have had more successful financial sector reform experiences than others. As noted by Galbis (1994) and Johnston (1997), the transition from repressed to more market-oriented financial systems involves shocks to interest rates, the exchange rate, and financial flows. Naturally, the authorities’ reactions to these shocks can effect economic performance and the transitional costs of financial sector reform.

To help shed some light on these latter issues, this chapter examines the impact of financial sector variables on economic growth and efficiency using panel data for 40 countries. The financial sector is hypothesized to affect economic growth and efficiency through different channels, which are proxied by the real interest rate, the volume of intermediation, and a measure of financial sector efficiency. To separate their effects, proxies for these channels are entered simultaneously into the estimation equations. The impact of financial sector reform is explored by examining prereform, reform, and postreform periods. A sample of countries that faced financial crisis is compared to a sample of countries that did not face a financial crisis.

The results confirm earlier findings on the importance of financial variables in equations for economic growth and efficiency. Average economic growth and output to capital ratios in countries that reformed their financial systems and avoided financial crises improved strongly following the reforms. The results indicate that financial reforms have structural implications for the way financial variables affect the real economy. Moreover, the results demonstrated that it is important to take account of the different dimensions of the financial reform, in terms of their effect on the interest cost of capital and on the volume and efficiency of intermediation, in explaining the impact of financial variables on economic performance. In addition, the conclusions show that financial variables had quite different effects in countries where financial crises were avoided and in those where they were not. The different results can be attributed partly to the failure of crisis countries to adjust real interest rates and to prevent the inflationary credit and monetary expansion that accompanied the financial sector reforms, and partly to the greater inefficiencies in the banking systems in the crisis countries.

Research Methodology and Linkages Between Financial Sector Variables and the Real Sector

Financial sector reforms typically involve the liberalization of interest rates; the liberalization of quantitative restrictions, including credit and exchange controls; and measures to improve the allocative efficiency and soundness of the financial sector, particularly the banking system. The financial system has its effect on the real sector through a number of channels, including: the cost of capital; the volume of savings and investment funds; and the distribution of funds and project selection.

The channels through which the financial sector affects the real sector are not all readily observable, and therefore, it is necessary to rely on a number of observable indicators or proxies of financial development. In this study we focus on the impact of three proxies of financial development: (1) the level of the real interest rate; (2) the volume of intermediation; and (3) a measure of financial sector efficiency. Each of the above mentioned financial sector reform measures is likely to impact all three proxies. For example, the liberalization of interest rates could affect the real interest rate, the volume of intermediation, and banking sector efficiency by permitting greater competition. There is also no necessary strict one-to-one relationship between these proxies and the channels through which the financial system affects the real sector. For example, the level of the real interest rate would have an impact on the interest cost of capital, the volume of savings, and possibly the distribution of funds through adverse selection incentives. By entering all three proxies simultaneously, however, into the equations for economic growth and efficiency, it should be possible to distinguish somewhat better the importance of the different channels. Thus, including the volume of intermediation and a measure of banking efficiency along with the real interest rate in the estimation equations should allow the real interest rate term primarily to proxy the impact of the financial system on the interest cost of capital, while the savings/investment effect would be reflected in the volume of intermediation, and the allocative efficiency effect in the financial sector efficiency proxy.

The impact of financial sector reform would be observed partly through the movements in the proxies. Financial sector reform, however, is also a process encompassing structural and institutional changes spread over time, which are likely to have effects on the transmission of financial sector variables on the real sector. Therefore, the approach followed here is to split the sample into separate periods—prereform, reform, and postreform—with the period of reform embracing the five years following the introduction of certain discrete financial reforms, usually the elimination of interest rate or quantitative controls. This approach allows us to study the impact of the different channels through which the financial sector affects the real sector under conditions of financial repression and during the reform and postreform periods. This approach also allows analysis of the transitional effects of financial sector reforms.

The transitional impact of the financial reforms on economic growth would depend partly on the starting conditions, including how far unproductive sectors had been supported previously, the extent to which subsidization of unproductive sectors continued, and how quickly the financial system could respond to the demands for new credit from viable sectors that previously had limited access to finance. The restructuring of formerly unprofitable sectors may have an initial adverse effect on growth, but this would be offset by the higher productivity of new investments.

As a measure of economic efficiency, two real sector variables are examined: the rate of real GDP growth and the output to capital ratio. There has been some discussion of whether the financial sector impacts mainly on economic efficiency or more directly on growth, and use of these two proxies allows us to study the importance of the different channels. We follow the methodology adopted in previous empirical tests of the impact of financial sector reform on growth and efficiency, by using the approach in the endogenous growth literature. The use of this approach helps to control, among other things, for the importance of commonly used policy indicators and structural determinants of growth that otherwise might explain the observed correlations between the financial variables and growth and efficiency.

As first developed by Barro (1991), the endogenous growth approach examines the determinants of growth by regressing average per capita growth on a set of relevant variables using cross-section data over an extended period of time.1 These variables include proxies for capital accumulation (human and physical), the macroeconomic environment, government spending, degree of openness, and the terms of trade.2 This approach has been helpful in highlighting the factors that affect growth, although the estimation of semi-reduced forms may present problems of an endogenous nature and hamper the interpretation of coefficient estimates.3

Among the earlier studies that have added variables of financial development to Barro’s basic cross-country regressions, Roubini and Sala-i-Martin (1992) include a dummy variable for financial repression.4 They find that this variable has a negative and significant coefficient implying that a higher degree of financial repression leads to lower economic growth. De Gregorio and Guidotti (1992) add the ratio of domestic credit granted to the private sector by the central bank and commercial banks to GDP (CREDIT) as a proxy for the degree of financial intermediation; they find a significantly positive effect of this variable on long-run growth of real per capita GDP.5 However, when De Gregorio and Guidotti use a panel data set for 12 Latin American countries for the period 1950-85, they find a significant negative correlation between CREDIT and economic growth. They interpret this result as evidence that more financial intermediation may be associated with lower efficiency of investment where the financial liberalization was unsustainable due to inadequate regulation.

King and Levine (1993a) conduct both a cross-country analysis using data averaged over the 1960-89 period and a pooled crosscountry time-series study (panel data) using data averaged over the 1960s, 1970s, and 1980s. They use four indicators of the level of financial sector development:

  • the ratio of liquid liabilities of the financial system to GDP;6
  • the ratio of deposit money bank domestic assets to deposit money bank domestic assets plus central bank domestic assets;
  • the ratio of claims on the nonfinancial private sector to total domestic credit; and
  • a variable similar to CREDIT used by De Gregorio and Guidotti.

Including the indicators one at a time in the regressions, they conclude that higher levels of financial development are positively associated with faster rates of economic growth, physical capital accumulation, and economic efficiency improvements.7

Sundararajan (1987) examines the impact of real interest rates on savings, investment, and efficiency of capital, taking into account the effect of interest rates on the share of debt and equity in non-financial firms (and their cost of capital) and finds that the efficiency effects of interest rates depend upon the size of debt equity ratios.

Odedokun (1992) examines the effect of selected policies on economic efficiency measured by the incremental output-capital ratio (the ratio of the change in GDP to investment) in 81 developing countries using panel data over various periods between 1961-90.8 He concludes that the stock of credit to private sector to GDP ratio is a better proxy for financial depth than the stock of liquid liabilities to GDP, and that in general increases in the real interest rate have a positive effect on the efficiency of resource use.

The empirical work reported here differs from earlier work in a number of respects. The earlier studies have tended to proxy financial sector development by a single financial indicator at a time, and have not distinguished between pre- and post-financial reform experience. The approach, however, does not take into consideration the many channels through which the financial sector can affect the real sector. This study examines the simultaneous impact of the three main proxies for the channels of financial sector development on economic growth and efficiency. Another difference between this study and earlier work is the use of the output to capital ratio as the measure of economic efficiency. The output to capital ratio is a better indicator of economic efficiency than the incremental output capital ratio, both qualitatively and quantitatively. Private capital stock data compiled by the World Bank is used in calculating the output to capital ratio. This study also seeks to differentiate the effects of financial variables before, during, and after the reform, and distinguish between the experiences of countries that faced financial crisis following reforms and those that did not face such crises. The study examines panel data from 40 countries that have introduced financial sector reforms.

Relationship Between the Proxies and Economic Growth and Efficiency

The real interest rate

The real rate of interest affects financial sector development through its influence on financial savings and on the cost of capital (see McKinnon, 1973; Shaw, 1973; Fry, 1988; and Leite and Sundararajan, 1990). The real rate of interest is determined by real factors over the longer term. In the short run, however, the real rate of interest is determined by both monetary policy actions, as well as by structural and environmental factors that influence inflation expectations and the pace of adjustment of nominal rates in the market to policy actions. Thus, monetary policy actions can affect real rates and real sector performance in the short run. For example, maintenance of a low or negative real interest rate on monetary financing could result in the support and expansion of unproductive, nonviable projects, and the channeling of funds into consumption rather than investment, which would be detrimental to economic growth and efficiency. Sufficiently positive real rates can improve the efficiency of investment, while very high real rates can affect the soundness of the banking system and adversely affect allocative efficiency.

Under repressed financial systems, the real interest rate may be maintained at a low level through directed credits and central bank refinancing of certain projects at subsidized interest rates. In contrast, the real rate of interest may be extremely high for other projects that do not meet the criteria for central bank refinance, and must rely on the curb markets for their funds.

Financial sector reform would thereby involve an upward adjustment in the real rate of interest on subsidized projects, and a decline for other projects. This might require some restructuring of the capital stock with a retiring of capital from previously subsidized firms that are no longer viable. The reforms, however, would in all likelihood increase the opportunities for new and more productive activities.

In theory, higher equilibrium real interest rates should be associated with more efficient investment and higher rates of return on capital, in addition to higher savings and growth. Unusually high real interest rates, however, may also be associated with adverse selection and the channeling of funds into more high-risk projects. Such high real interest rates may also reflect other factors, such as a lack of credibility, a country risk premium, or fragility of the banking system (see Calvo, 1988; Calvo and Guidotti, 1991; and Persson and Tabellini, 1990).

The calculation of the real interest rate is problematic since it depends on inflation expectations and can vary depending on the agents involved and the tax system. At this point, we substitute the average deposit rate less the concurrent annual rate of change of consumer prices for the real interest rate (RIR). Except for the caveats mentioned above, we would expect a positive relationship between RIR and economic growth and efficiency.

The volume of intermediation

McKinnon (1973) and Shaw (1973), among others, have emphasized the role played by financial intermediaries in increasing savings and hence investment. Liberalization of interest rates and the introduction of new financial instruments as part of financial sector reform encourage the holdings of financial assets and financial deepening. Various monetary indicators of financial development (deposit/currency and broad money/GDP ratios) generally improve with financial sector reforms.

Two main factors, however, are likely to determine whether the observed increase in intermediation will improve economic growth: the sources and uses of credit expansion. First, to result in higher growth, the increase in financial intermediation should involve a savings rather than a purely inflation component. Inflationary increases in money and credit would at most have a temporary effect in increasing economic growth, and subsequently higher inflation would have detrimental longer-term effects.

Based on various country experiences, financial sector reforms may involve shocks to the volume of intermediation. Rapid credit expansions most often follow the liberalization of controls on the banking system.9 Domestic liberalization can also lead to a reflow of capital flight and improvements in capital accounts, especially if accompanied by external sector liberalization (see Calvo, Leiderman, and Reinhart, 1993; Johnston and Ryan, 1994; and Schadler and others, 1993). Nonsterilized foreign exchange inflows would add to the supply of free reserves in the banking system and fuel the credit boom.

Financial sector reforms will also have structural effects. Liberalization of the financial system resulting in higher financial savings may mean that the authorities will be able to tolerate a somewhat more rapid growth of money and credit in the postreform period without increasing inflationary pressures. A higher foreign demand for the country’s financial assets following external liberalization could take a considerable time to work through and may allow the country to sustain a somewhat large current account deficit in the balance of payments and, therefore, to accept some loss of competitiveness and real exchange rate appreciation. Hence, the authorities may be able to accommodate some of the initial credit and external shocks without affecting long-term growth prospects. Beyond allowance for these structural shifts, however, the resulting monetary and credit expansion will be inflationary and will, therefore, need to be offset by the central bank if the credit expansion is not to have an adverse effect on economic performance.

How the increase in credit is used will also determine whether a rise in intermediation will stimulate economic growth and efficiency. As already noted, this increase may be channeled to consumption rather than investment or into unproductive activities. The level of the real interest rate and the proxy for the efficiency of the financial system should control for these factors. Hence, we anticipate that the volume of intermediation variable will mainly play the role in the financial system of promoting savings and hence positively contribute to growth and efficiency. Insofar as the volume of intermediation rises due to inflationary growth in money and credit, the impact on growth and efficiency would be negative.

We use two alternative proxies for the volume of financial intermediation through the banking system: the share of credit to the private sector by banks in GDP (denoted as CRED), and the share of M2 in GDP (denoted as M2GDP). These variables represent the two main functions of financial markets: the credit allocation role and the deposit mobilization role. CRED is a more appropriate indicator of the volume of intermediation through the banking system than the CREDIT variable used by De Gregorio and Guidotti (1992) and King Levine (1993 a,b) because it excludes the credit granted to the private sector by the central bank, which is often high during financial repression.

Efficiency of intermediation

The channeling of finance through organized financial intermediaries can improve investment and growth for a number of well-known reasons, including the benefits of economies of scale in savings mobilization and allocation and the role of intermediaries in project selection. It also must be recognized, however, that efficiency in intermediation is not something that is necessarily automatic, particularly after prolonged periods of financial repression, and that it has to be promoted as part of the process of financial sector reform.

Appropriate management of banking soundness and efficiency is an important issue in the course of financial sector reforms (see Leite and Sundararajan, 1990). Insolvent banks have incentives to allocate credit to high risk/high return projects without due regard to the prospects for loan recovery. At the same time, the ability of sound banks to compete with insolvent banks is constrained. In some financial reform occurrences ownership interrelationships have resulted in the concentration of lending to connected enterprises, thereby magnifying risk exposures and reducing the supply of credit to new borrowers. Large and inefficient financial institutions may seek to exploit their monopoly power following financial liberalization. Weaknesses in financial intermediation may also be created by poorly designed legislative frameworks that are not attuned to enforce financial contracts and financial discipline among borrowers. These systems are often beset by inadequate accounting and information systems that delay recognition of unsoundness, and inadequate institutional capabilities, knowledge, and skills that perpetuate risk taking. Rapid credit expansion in the wake of financial liberalization can also strain credit approval procedures and result in increased lending to risky projects. Thus, efficiency in credit allocation following financial liberalization requires appropriate policies to foster banking soundness (see Chapter 4).

It is difficult to measure directly the efficiency of the banking system in the allocation of credit. Generally, the efficiency of banks in credit allocation is likely to be reflected in other aspects of their activity. For example, inefficiency in the banking industry may be associated with wide lending margins reflecting, say, lack of competition between banks and attempts by insolvent banks to recoup loan losses. It may also be reflected in the management of bank assets, for example, in the tendency of inefficient banks to hold larger nonremunerated excess reserves, or revealed by the portfolio behavior of nonbanks in their willingness to hold and use bank deposits rather than cash.

Two different variables are used to represent the efficiency of intermediation. One is the gross spread between the average lending and deposit rates (denoted as SPREAD) and the other is the ratio of reserve money to deposits (denoted as RMDEP). The spread variable is calculated as the difference between the average lending and deposit rates. Some caveats, though, are in order. The spread may not be a good measure of efficiency before financial reform when interest controls are in place or after financial reform if the spread reflects different regulations on the banking industry. The spread may also vary with the level of nominal interest rates and inflation, although it will be partly accounted for by the estimates that include a separate inflation term in the regression equations.

Reserve money is defined as the currency in circulation plus the required and excess reserves of the banking system. The variable RMDEP, therefore, includes: the currency to deposit ratio, which is a measure of the efficiency of the banks in mobilizing deposits; the excess reserves, which represent the efficiency of banks in the use of funds; and required reserves, which tend to be higher under financial repression. RMDEP would also reflect the effect of an unsound banking system, if such weakness leads to a run on deposits and shift to cash. A negative relationship is expected between the efficiency proxies and economic growth.

Estimation and Results

Our sample includes 40 industrial and developing countries that undertook financial sector reforms, and is divided according to the stages of the financial reform process: prereform, reform, and postreform. For analytical purposes, the start of reforms is identified with the elimination of credit ceilings and/or elimination of interest rate controls, while the reform period covers the five-year period following the start date of the reforms. The five-year period preceding the start of financial sector reforms is identified as the prereform period, and the fiveyear period following the reform period as the postreform period. The use of five-year data periods is somewhat arbitrary, but country experience also indicates that many countries have implemented financial reform programs over three to five-year periods. The sample was further divided into two subsamples—namely, the noncrisis and crisis countries, based on whether the country experienced a financial crisis. The cases of financial crisis were identified from a review of country case studies.10Appendix I provides a list of the sample countries, the subsamples of crisis and noncrisis countries, and the subperiods for each country in the sample.

The dependent variables are:

RGDPGRthe growth rate of real GDP as a proxy for economic growth,
and
OCRthe output to capital ratio as a proxy for economic efficiency;

whereas the explanatory variables include:

INFthe rate of inflation; or alternatively;
GDPDEFthe GDP deflator;
GEGDPthe ratio of government spending to GDP;
XMGDPthe openness of trade as proxied by the share of total exports plus imports in GDP;
INVGDPthe share of investment in GDP;
DIGPDthe share of foreign direct investment in GDP; as well as the financial reform variables discussed in the previous section.

Because of the endogenous nature of the problem of using the ratio of investment to GDP as an explanatory variable, this variable was instrumented in the regressions.11Appendix II provides a list of the variables and data sources.

The estimation equations are of the following form:

where i denotes a country and t a time period (prereform, reform, and postreform periods), αi is a country specific parameter, y represents RGDPGR or OCR, x is a matrix of explanatory variables as described in the previous paragraph, and β is the vector of regression coefficients.

In estimating equation (1) we use the panel data “random effects” method, which considers each country-specific parameter as a random variable and includes its stochastic component in the error term of the regression (see Hsiao, 1986). Hausman test statistics were used to check for correlated effects. In all cases, the hypothesis that the intercepts are drawn from a common distribution with mean α and variance σα2 was rejected, implying that the use of the random effects model would provide inconsistent estimates and thus the equation has to be estimated by generalized least squares.

Average Performance During Financial Reforms

The mean values for rates of growth, the output to capital ratios, and the financial explanatory variables for the prereform, reform, and postreform periods for the crisis and noncrisis countries are shown in Table 5.1. For the noncrisis countries, the financial reforms are associated with strong improvements in average economic growth rates and output to capital ratios. The crisis countries, however, encountered, on average, a deterioration in economic growth and a decline in output to capital ratios.

Table 5.1.Mean Values for Selected Variables
Noncrisis CountriesCrisis Countries
PrereformReformPostreformPrereformReformPostreform
Dependent variables
RGDPGR2.644.184.364.183.512.16
OCR0.350.360.390.340.330.31
Financial variables
RIR−5.791.432.51−3.20−6.566.14
CRED0.320.420.530.340.480.43
RMDEP0.350.300.260.370.270.39
M2GDP0.480.540.560.390.500.38
SPREAD4.084.614.075.868.2711.05
Notes: The variables are defined as follows: RGDPGR, the growth rate of GDP as a proxy for economic growth; OCR, the output to capital ratio as a proxy for economic efficiency; RIR, real interest rate; CRED, claims on private sector by deposit money banks divided by nominal GDP; RMDEP, reserve money divided by nominal GDP; M2GDP; the sum of money and quasimoney divided by nominal GDP; SPREAD, lending rate minus deposit rate.
Notes: The variables are defined as follows: RGDPGR, the growth rate of GDP as a proxy for economic growth; OCR, the output to capital ratio as a proxy for economic efficiency; RIR, real interest rate; CRED, claims on private sector by deposit money banks divided by nominal GDP; RMDEP, reserve money divided by nominal GDP; M2GDP; the sum of money and quasimoney divided by nominal GDP; SPREAD, lending rate minus deposit rate.

Concerning the behavior of the financial variables, the noncrisis countries dramatically increased the average real interest rate to positive real levels in the reform period. Real interest rates increased further on average in the postreform period, suggesting that while the real interest rate adjustment during the reform was significant, it may have involved some modest undershooting.

The volume of financial intermediation expanded following the reforms, with the ratio of credit to the private sector to GDP increasing on average by a larger amount than the ratio of broad money to GDP. This result is consistent with earlier observations that credit grows more rapidly than money immediately following financial reforms. In the noncrisis countries, it is interesting to note that the credit to the private sector to GDP ratio in the postreform period continued to be much lower than the ratio of M2 to GDP, suggesting that the credit expansion was limited. This constraint may have been because a significant percentage of banking sector assets continued to be subject to portfolio constraints during the reform period, or because the banks were risk averse. Only in the postreform period did the ratio of credit to the private sector to GDP increase to the level of M2 to GDP.

During the reform period, the ratio of reserve money to deposits fell substantially while the average spread between bank loan and deposit rates widened until the postreform period, when it declined. This widening of the spreads has been observed in other studies and attributed to several factors, including the greater freedom to price credit according to risks, to delays in improvements in banking competition, and to a greater reliance on noninterest-bearing reserve requirements during the reform period.12

One can see some important differences in the behavior of the financial variables of the crisis countries compared with the noncrisis countries in the prereform and reform periods. In the crisis countries, the real interest rates, negative to begin with, dropped during the reform period rather than becoming positive; the volume of intermediation expanded much more rapidly with the ratio of credit to the private sector to GDP, reaching a level close to that of M2 to GDP; and the spread between deposit and lending rates widened sharply. While these results are only indicative, they suggest that during the reform period, the crisis countries permitted a much more rapid monetary and credit expansion in the context of a relatively inefficient financial system.13

The mean values for the crisis countries for the postreform period indicate the magnitude of subsequent policy adjustments as real interest rates were raised on average to high positive levels. In addition, the financial crises were associated with a reversal of financial deepening, as measured by the ratio of credit to the private sector and M2 to GDP. The fact that the ratio of credit to GDP exceeded the ratio of M2 to GDP in the postreform period may reflect official support operations in the wake of financial crisis. The indicators of financial intermediation efficiency deteriorated during the postreform period in response to the banking crisis. The crisis countries experienced a sharp reduction in real economic growth in the postreform period.

Estimation Results

In this section we examine the direction of the effect of each explanatory variable. First, we provide a brief discussion of the effects of the macroeconomic variables that are commonly used in the literature, and subsequently we discuss in more detail the effects of the financial reform variables. Appendix II provides the estimation results for the real rate of growth for the crisis and noncrisis countries for the entire period, including the prereform, reform, and postreform periods and for each separate period. Appendix II also provides the results in a similar format for the output to capital ratio.

The effect of the macroeconomic variables are as follows:

The size of the public sector proxied by the share of government expenditure in GDP (GEGDP) has a significantly negative effect on both economic growth and efficiency in the reform and postreform periods and for both noncrisis and crisis countries, indicating that the expansion of the public sector may be detrimental to economic growth and efficiency.

The inflation rate (INF) has a significant and negative effect across all subperiods and in both noncrisis and crisis countries, implying that inflation hampers both growth and efficiency of resource allocation through channels other than the impact of financial variables. (Similar results are obtained when the GDP deflation is used to measure inflation.)

The openness of trade, proxied by the ratio of the sum of exports and imports over GDP (XMGDP), has the expected positive sign during the reform period, implying that trade liberalization is generally beneficial to economic growth and efficiency. However, for the crisis countries the impact of the openness of trade on growth and efficiency becomes negative in the postreform period. This unexpected result may be explained by the greater vulnerability of the more open economies to a loss of international confidence following the onset of a banking crisis, resulting in withdrawals of foreign capital, and possibly in greater recourse in these countries to trade and exchange restrictions in the aftermath of the crisis.

The ratio of investment to GDP (INVGDP) has the anticipated positive effect on growth, whereas the ratio of foreign direct investment to GDP (DIGDP) has a positive effect in the noncrisis countries on growth and on efficiency of resource utilization during the postreform period. For the crisis countries, the variable is negative in the growth equations in the prereform period, which is an unexpected result.

Regarding the impact of financial reform variables in the noncrisis countries, all three financial channel proxies enter with the correct sign in the real growth and efficiency equations for the entire period, and are significant in the growth equations where efficiency is represented by the spread. Hence, the results show the importance of financial variables on the real sector, even after controlling for commonly used policy indicators and structural determinants of growth. They also indicate the importance of taking account of the different dimensions of financial reform in explaining economic growth over a relatively long data period and across countries.

Some important differences in the results, however, occur when comparing the prereform periods with the reform and postreform periods, and between the crisis and noncrisis countries. These are discussed in the following section.

The real interest rate

The real interest rate (RIR) has an insignificant effect on real growth and a significantly negative impact on economic efficiency in the prereform period. This result suggests that the measured real interest rate was not a good indicator of the real cost of capital during this period, perhaps reflecting the impact of credit rationing and the importance of directed finance under financial repression.

Following financial reforms, the impact of the real interest rate on economic growth and efficiency becomes a significant and positive factor. Upward adjustments in real interest rates, which are observed to accompany financial sector reforms, therefore, do not appear to have negative effects on growth. The failure of the crisis countries to raise their real interest rates during the reform process may also partly explain the weaker economic growth and efficiency performances.

In the postreform period, the real interest term becomes highly positive for the crisis countries. The sharp increases in real interest rates, which generally accompany financial crises, therefore, appear to have had quite adverse real sector effects as interest costs rise significantly. These effects may also be magnified given the potential for “adverse selection,” namely the allocation of credit to more high-risk borrowers under conditions of high real interest rates. The real interest rate continues to have a significant positive effect on growth and efficiency in the noncrisis countries in the postreform period.

The volume of intermediation

The volume of financial intermediation (represented by CRED or M2GDP) is not a significant determinant of economic growth and has a significant negative effect on efficiency during the prereform period. This result would be consistent with the weakness of the banking sector in mobilizing savings, with expansions in intermediation involving inflation rather than savings components, and with the allocation of credit into low productivity uses under financial repression.

Following financial reforms, the volume of financial intermediation has a generally positive and significant effect on growth and efficiency for the noncrisis countries. This is the expected effect to the extent that the banking system contributes to enhancing savings mobilization. This positive effect continues in the postreform period. For the crisis countries, the volume of intermediation has a significantly negative effect on growth and efficiency following financial reforms. Hence, under conditions that are conducive to financial crisis—which may involve factors such as banking insolvency, lending to interrelated institutions, and similar issues—expansions of financial intermediation do not appear to improve growth and efficiency. As noted in the discussion of mean values, credit expansion is considerably more rapid in the crisis than noncrisis countries during the reform period. Thus, the negative impact of intermediation on growth and efficiency may reflect the much larger inflationary component in intermediation in the crisis countries compared with the noncrisis countries during financial reforms.

During the postreform period, the size of the financial system continues to be negatively related to growth and efficiency in the crisis countries. The latter result may reflect the burden on growth imposed by financial sector restructuring in the wake of financial crises, and the continuing weak role of the banking systems in savings mobilization (De Gregorio and Guidotti, 1992, provide similar results). It also suggests that countries that downsized their financial systems more rapidly in the wake of a banking crisis may improve growth and efficiency.

Efficiency of intermediation

The proxies of the efficiency of financial intermediation, RMDEP or SPREAD, have the correct sign. The variables are insignificant in the growth equations and significant in the efficiency equations for the noncrisis countries. These results indicate that the efficiency of the financial system mainly affects the efficiency of investment, while the impact on growth is indirect. The results are similar for the crisis countries, but the efficiency proxies are insignificant during the reform period, which may again underline the weakness of the banking systems in these countries and the trouble banks have with the efficient mobilization and allocation of resources.

Conclusions

The results reported in the previous section lead to three broad conclusions. First, financial sector reforms can have important structural implications for the way financial sector variables affect the real economy. In particular, the expected effects of financial variables on economic growth and efficiency based on deductive reasoning become evident only after countries reform their financial systems. Under conditions of financial repression, expansions of financial intermediation can have limited or even perverse effects on economic performance. Also, policies to raise interest rates are likely to be ineffective under financial repression, unless they are accompanied by reforms intended to make the banking systems more responsive to financial variables.

Second, it is important to take into account the different dimensions of financial sector reform in explaining the impact of the reforms on economic performance. Earlier research has tended to represent financial development with a single variable. Our results from the entire sample, as well as the subsamples, though, suggest that separate effects on the interest cost of capital, the volume of intermediation, and the efficiency of intermediation can be identified. It is these effects that are important in understanding how financial reforms influence the real sector. For example, the positive effects on growth and efficiency of interest rate liberalization can be blunted by inefficiencies in the banking system, thus illustrating the importance of having a balanced and comprehensive approach to financial sector reform that includes a range of concomitant reforms to foster sound banking and institution building in support of financial liberalization.

Third, whether countries do or do not face financial crisis is an important determinant of the response of the real sector to financial sector reform and financial variables in general. The noncrisis countries usually experience strong improvements in economic growth and efficiency following the financial reforms. Crisis countries, however, tend to experience expansions in financial intermediation with negative effects on economic growth and efficiency. Moreover, according to our findings the wide fluctuations in real interest rates and the volume of intermediation in these countries harm economic performance. The timing and intensity of the banking crisis and the timing and size of the financial sector reforms differ considerably between the sample of countries. Nevertheless, analysis of the data suggests that the banking crises may in part have been related to the failure of the authorities to respond to the monetary shock, which can accompany financial reform, and the failure to adjust real interest rates during the reforms. In addition, a crisis may also have reflected the greater inefficiency and possibly solvency problems in the banking systems before reform.

These results underscore the importance of managing the monetary shocks that accompany financial sector reforms and that may lead to temporary inflationary financing. They also emphasize the significance of addressing institutional and banking sector weaknesses at a very early stage in financial sector reforms. (Specific issues in addressing banking sector weaknesses in the course of financial sector reforms are discussed in the previous chapter.) In summary, the “quality” of reform matters and the design of reforms is an important determinant of their success and of their impact on economic performance.

Appendix
Appendix I: Financial Sector Reform Dates
Countries1Date of Financial ReformsPrereform PeriodPostreform Period
United Kingdom1971-751966-701976-80
Chile and Uruguay1974-781969-731979-83
Argentina1977-811972-761982-86
Japan1978-821973-771983-87
Australia, Korea, and Philippines1981-851976-801986-90
Indonesia and Italy1983-871978-821988-92
France, Israel, Morocco, New Zealand, Norway, Spain, Sri Lanka, and Turkey1985-891980-841989-93
Brazil, Costa Rica, Finland, Greece, Ireland, Jamaica, Malaysia, Mexico, Portugal, and Thailand1986-901981-851990-93
Guatemala, Mauritius, and Venezuela1989-931984-88
Ghana, Honduras, Kenya, Malawi, Paraguay, Peru, and Tanzania1990-931986-90
El Salvador and Zambia1991-931987-91

Countries that encountered banking crises after the reform process include Argentina, Chile, Finland, Ghana, Israel, Norway, the Philippines, Thailand, Turkey, Uruguay, and Venezuela.

Countries that encountered banking crises after the reform process include Argentina, Chile, Finland, Ghana, Israel, Norway, the Philippines, Thailand, Turkey, Uruguay, and Venezuela.

Appendix II: Description of the Data and Estimation Results
This table provides the description of the annual data used in the empirical analyses.
RGDPGR:First difference of real GDP (line 99b.p of IFS).
OCR:Output-capital ratio, calculated as output at 1987 prices divided by capital stock at 1987 prices (World Bank Database).
GEGDP:Central government expenditure (line 82 of IFS) divided by nominal GDP (line 99b of IFS).
GDPDEF:GDP deflator, calculated as nominal GDP divided by real GDP.
INF:Percentage change in consumer price index (line 64 of IFS).
XMGDP:Sum of exports (line 77aad of IFS) and imports (line 77abd of IFS) divided by nominal GDP.
DIGDP:Foreign direct investment (line 77bad of IFS) times the exchange rate (line rf of IFS) divided by nominal GDP.
EDUCP:Primary school enrollment rate (World Bank Social Indicators Database).
RIR:Real interest rates, calculated as the nominal deposit interest rate (line 60l of IFS) minus the inflation rate.
CRED:Claims on private sector by deposit money banks (line 32d of IFS) divided by nominal GDP.
M2GDP:The sum of money (line 34 of IFS) and quasimoney (line 35 of IFS) divided by nominal GDP.
RMDEP:Reserve money (line 14 of IFS) divided by nominal GDP.
SPREAD:Lending rate (line 60p of IFS) minus deposit rate (line 60l of IFS).
Table 5.2Estimation Results for the Noncrisis Countries: Growth Equations
ConstantGEGDPINFXMGDPINVGDPDIGDPEDUCPRIRCREDM2GDPRMDEPSPREADR2
Entire Period
6.677**−11.638**−0.114**0.4220.132**22.9950.218*0.049*1.024*−0.4070.48
(5.38)(−5.02)(−4.11)(1.37)(11.93)(1.40)(1.72)(1.84)(1.95)(−0.34)
6.996**−11.229**−0.114**0.3600.132**23.5400.220*0.050*1.574*−0.2970.48
(5.41)(−4.84)(−4.09)(0.32)(10.15)(1.44)(1.74)(1.77)(1.83)(−0.45)
7.156**−11.859**−0.106**0.2170.136**23.5400.228*0.044*1.215*−0.060*0.49
(7.70)(−5.30)(−3.80)(0.18)(12.11)(1.35)(1.77)(1.78)(1.94)(−1.80)
7.423**−11.307**−0.105**0.1760.137**22.4970.231*0.045*1.789*−0.062*0.48
(7.73)(−4.97)(−3.78)(0.15)(12.18)(1.38)(1.88)(1.72)(1.80)(−1.74)
Prereform
4.361*−3.995−0.0650.0270.101**6.388*0.007−1.241−0.9240.52
(1.86)(−1.02)(−1.26)(1.013)(3.89)(1.76)(0.12)(−0.55)(−0.31)
3.791−3.777−0.0630.2090.103**6.225*0.008−0.384−0.2820.52
(1.68)(−0.979)(−1.24)(0.107)(4.01)(1.74)(0.14)(−0.19)(−0.09)
3.720*−3.886−0.0730.0620.096**6.887*0.009−0.815−0.0360.53
(2.30)(−1.01)(−1.58)(0.031)(3.53)(1.84)(0.18)(−0.45)(−0.48)
3.504*−3.787−0.0670.2470.098**6.777*0.007−0.254−0.0380.53
(2.16)(−0.99)(−1.53)(0.13)(3.60)(1.83)(0.17)(−0.14)(−0.51)
Reform
5.275**−7.558**−0.115*3.537**0.136**19.2980.041 *0.215*−0.1970.64
(2.93)(−2.99)(−1.72)(3.49)(6.41)(0.94)(1.68)(1.87)(−1.16)
5.601**−7.155**−0.117*3.549**0.136**18.8720.036*0.761*−0.0780.64
(3.46)(−2.71)(−2.04)(3.52)(6.51)(0.93)(1.69)(1.75)(−0.66)
5.412**−7.735**−0.118*3.522**0.136**16.6940.043*0.322*−0.0160.65
(3.28)(−3.18)(−1.69)(3.54)(6.35)(0.79)(1.72)(1.77)(−1.32)
5.720**−7.207**−0.125*3.559**0.136**15.9820.034*0.912*−0.0220.65
(3.83)(−2.78)(−2.13)(3.57)(6.47)(0.77)(1.68)(1.79)(−1.45)
14.613**−19.043**−0.129*2.2270.172**15.2600.070*5.958**−2.1190.78
(3.84)(−4.48)(−1.76)(1.17)(5.81)(0.61)(1.89)(2.82)(−1.10)
8.856**−13.606**−0.065*2.8880.173**10.5790.050**2.981*−0.1440.74
(2.73)(−3.24)(−1.84)(1.18)(5.70)(0.05)(2.60)(2.13)(−0.76)
13.028**−17.555**−0.149*2.3090.166**10.8540.093*5.036**−0.0120.76
(3.84)(−4.21)(−2.03)(0.95)(5.95)(0.41)(1.76)(2.47)(−0.16)
18.818**−13.630**−0.065*14.3730.169**39.5360.068*2.338*−0.0540.73
(2.89)(−3.27)(−1.92)(1.51)(5.97)(0.30)(1.85)(1.86)(−0.69)
Postreform
14.613**−19.043**−0.129*2.2270.172**15.2600.070*5.958**−2.1190.78
(3.84)(−4.48)(−1.76)(1.17)(5.81)(0.61)(1.89)(2.82)(−1.10)
8.856**−13.606**−0.065*2.8880.173**10.5790.050**2.981*−0.1440.74
(2.73)(−3.24)(−1.84)(1.18)(5.70)(0.05)(2.60)(2.13)(−0.76)
13.028**−17.555**−0.149*2.3090.166**10.8540.093*5.036**−0.0120.76
(3.84)(−4.21)(−2.03)(0.95)(5.95)(0.41)(1.76)(2.47)(−0.16)
18.818**−13.630**−0.065*14.3730.169**39.5360.068*2.338*−0.0540.73
(2.89)(−3.27)(−1.92)(1.51)(5.97)(0.30)(1.85)(1.86)(−0.69)
Note: * = significant at 95 percent confidence level.** = significant at 99 percent confidence level.
Note: * = significant at 95 percent confidence level.** = significant at 99 percent confidence level.
Table 5.3Estimation Results for the Crisis Countries: Growth Equations
ConstantGEGDPINFXMGDPINVGDPDIGDPEDUCPRIRCREDM2GDPRMDEPSPREADR2
Entire Period
1.705−3.764−0.502*1.592**0.152**29.7670.597**0.004−2.41*−0.8710.53
(0.54)(−0.83)(−1.82)(3.62)(8.34)(0.97)(1.84)(1.28)(−1.82)(−1.11)
2.236−4.891−0.478*1.691**0.153**40.2790.845**0.004−0.601*−0.9180.53
(0.80)(−1.01)(−1.84)(3.90)(8.28)(1.33)(1.74)(1.29)(1.76)(−1.22)
0.544−3.618−0.434*1.562**0.147**21.7630.3690.004−3.134*−0.0090.52
(0.18)(−0.79)(−1.93)(3.35)(8.16)(0.72)(1.52)(1.28)(−1.89)(−1.97)
1.116−6.172−0.415*1.689**0.149**31.7870.7040.0050.237*0.006*0.53
(0.42)(−1.30)(−1.98)(3.70)(8.08)(1.07)(1.69)(1.29)(1.73)(−1.98)
Prereform
13.175*−1.617−0.018−1.1460.086*−14.914**0.032−3.424−3.4380.51
(2.16)(−0.25)(−1.23)(−1.49)(2.22)(−2.51)(0.74)(−0.53)(−1.30)
16.757*−1.492−0.034−5.5000.108**−14.578**0.052−1.441*−4.131*0.56
(2.87)(1.28)(−1.21)(−0.68)(2.66)(−2.58)(0.81)(−1.72)(−1.85)
12.874*−1.437−0.179*−1.624*0.063*−14.224**0.249*−6.206−0.1850.61
(3.50)(−1.66)(−2.56)(−2.27)(1.73)(−2.76)(2.92)(−1.24)(−1.58)
12.402*−2.420*−0.161*−1.439*0.086*−15.664**0.155**−6.228−0.1580.61
(3.38)(−2.00)(−2.36)(−1.95)(2.33)(−3.11)(1.70)(−0.88)(−1.53)
Reform
5.493−7.168−0.355*3.087**0.172**−50.6300.103*−7.024*−8.1200.78
(0.55)(−0.88)(−1.69)(3.08)(5.10)(−0.94)(2.05)(−1.68)(−1.15)
−12.272−24.691*−0.20316.329*0.168**−48.5350.081**−19.177*−8.2110.80
(−0.95)(−2.06)(−0.87)(2.11)(5.86)(−1.03)(1.76)(−2.25)(−1.25)
12.452−2.732−0.21720.064**0.168**−53.6410.082**−1.830*−0.0520.77
(1.55)(−1.408)(−0.47)(2.82)(5.79)(−1.16)(1.71)(−1.74)(−1.52)
13.486*−0.927−0.04523.897**0.159**−45.4050.068*−6.001*−0.071*0.77
(1.72)(−0.13)(−0.08)(2.86)(5.39)(−0.97)(1.73)(−1.83)(−1.68)
Postreform
−6.297*−4.062*−0.085*−3.508**0.196**−48.090−0.044**−3.581**−0.5330.78
(−3.27)(−4.27)(−2.09)(−3.50)(4.85)(−1.02)(−1.79)(−7.59)(−1.39)
19.066−3.476*−0.599*−3.5660.121*−53.224−0.031*−4.591**−0.4690.72
(0.78)(−2.06)(−1.94)(−1.62)(1.99)(−1.30)(−2.35)(−3.53)(−1.61)
−3.307−2.822*−0.489−2.146*0.129**−48.531−0.115*−3.067**−0.0190.73
(−1.63)(−2.47)(−1.62)(−1.72)(3.48)(−1.45)(−2.51)(−6.71)(−0.20)
5.397−3.704*−0.411*−1.7680.165**−59.874−0.237*−4.265**−0.1580.70
(0.24)(−2.14)(−1.91)(−1.55)(3.25)(−1.07)(3.38)(−3.56)(−0.67)
Note: * = significant at 95 percent confidence level.** = significant at 99 percent confidence level.
Note: * = significant at 95 percent confidence level.** = significant at 99 percent confidence level.
Table 5.4Estimation Results for the Noncrisis Countries: Efficiency Equations
ConstantGEGDPINFXMGDPDIGDPEDUCPRIRCREDM2GDPRMDEPSPREADR2
Entire Period
0.364**−0.288**−0.014*0.0250.693*0.020**0.009*0.091**−0.0300.58
(9.02)(−5.13)(−2.40)(0.80)(1.93)(3.84)(1.74)(4.64)(−1.09)
0.386**−0.265**−0.013*0.0280.784*0.021**0.0100.126**−0.0210.59
(9.26)(−4.73)(−2.33)(0.89)(2.19)(3.94)(1.58)(4.66)(−1.46)
0.387**−0.304**−0.014*0.0340.711*0.020**0.009*0.098**−0.004*0.57
(11.42)(−5.63)(−2.41)(1.09)(1.98)(3.84)(1.75)(5.45)(−1.72)
0.404**−0.274**−0.013*0.0350.805*0.020**0.0100.134**−0.003*0.56
(11.85)(−5.04)(−2.34)(1.11)(2.26)(3.97)(1.68)(5.50)(−1.78)
Prereform
0.320**−0.025−0.002**0.0361.155**−0.002**−0.046*−0.0480.58
(6.87)(−0.43)(−3.21)(1.25)(3.41)(−2.90)(−1.91)(−1.30)
0.302**−0.027−0.002**0.0331.122**−0.002**−0.065−0.0570.49
(6.36)(−0.48)(−3.34)(1.13)(3.46)(−3.00)(−1.56)(−1.56)
0.341**−0.029−0.018**0.0221.121**−0.001**−0.033*−0.002*0.51
(8.54)(−0.50)(−2.89)(0.73)(3.35)(−2.53)(−1.68)(−1.86)
0.332**−0.032−0.017**0.0181.099**−0.001**−0.047−0.002*0.50
(8.25)(−0.56)(−2.91)(0.61)(3.40)(−2.52)(−1.21)(−1.91)
Reform
0.462**−0.217**−0.0060.038*0.2990.003*−0.039−0.147**0.43
(8.22)(−3.98)(−0.94)(1.76)(1.20)(1.73)(−1.17)(−3.87)
0.506**−0.203**−0.0040.029*0.2820.004*0.096*−0.178**0.46
(8.38)(−3.78)(−0.53)(1.77)(1.14)(1.76)(1.98)(−4.41)
0.359**−0.175**−0.0050.052*0.0230.005*−0.010−0.004*0.53
(6.42)(−3.22)(−1.66)(1.70)(1.11)(1.73)(−0.917)(−1.79)
0.358**−0.173**−0.0040.051*0.0220.006*0.065*−0.004*0.55
(6.21)(−3.16)(−0.61)(1.78)(0.86)(1.80)(1.94)(−1.74)
Postreform
0.011−0.062*−0.021**0.147**0.211*0.006*0.036*−0.067*0.65
(0.11)(−1.75)(−3.29)(3.70)(1.94)(1.75)(1.76)(−2.06)
0.009−0.012*−0.023**0.159**0.260*0.006*0.027*−0.046*0.64
(0.09)(−1.81)(−3.21)(3.68)(1.83)(1.84)(1.77)(−1.95)
0.072−0.061*−0.022**0.170**0.1440.0040.028*−0.001 *0.67
(0.57)(−1.92)(−3.02)(4.03)(1.57)(1.63)(1.91)(−1.71)
0.087−0.024*−0.024**0.176**0.201*0.004**0.034*−0.002*0.65
(0.68)(−1.88)(−2.94)(3.91)(1.77)(2.58)(1.75)(−1.732)
Note: * = significant at 95 percent confidence level.** = significant at 99 percent confidence level.
Note: * = significant at 95 percent confidence level.** = significant at 99 percent confidence level.
Table 5.5Estimation Results for the Crisis Countries: Efficiency Equations
ConstantGEGDPINFXMGDPDIGDPEDUCPRIRCREDM2GDPRMDEPSPREADR2
Entire Period
0.791**−0.118*−0.010*0.226**0.554*0.093**−0.005*0.049*−0.0010.43
(12.23)(−1.72)(−1.62)(4.23)(1.61)(6.92)(−1.73)(1.77)(−1.11)
0.755**−0.075−0.009*0.206**0.4290.083**0.006−0.015−0.0050.45
(10.99)(−1.04)(−1.85)(3.87)(1.25)(5.71)(1.58)(−1.33)(−1.58)
0.790**−0.109*−0.023*0.219**0.570*0.093**−0.006*−0.049*−0.001*0.44
(12.46)(−1.70)(−1.91)(4.03)(1.67)(6.98)(−1.75)(−1.83)(−1.70)
0.756**−0.064*−0.0230.199**0.4670.082**−0.005*−0.013−0.001 *0.42
(11.35)(−1.89)(−1.59)(3.67)(1.36)(5.82)(−1.67)(−1.29)(−1.73)
Prereform
0.715**−0.009*−0.033*−0.0980.339−0.009*−0.046*−0.0250.53
(4.81)(−2.09)(−2.08)(−1.24)(0.63)(−2.09)(−1.61)(−1.45)
0.719**−0.048*−0.027*−0.0750.410−0.006*−0.087−0.0280.57
(4.99)(−2.38)(−1.65)(−0.91)(0.82)(−2.16)(−1.11)(−1.52)
0.683**−0.296*−0.025**−0.0430.531−0.005**−0.070*−0.002**0.62
(6.66)(−2.07)(−2.48)(−0.67)(0.51)(−3.70)(−2.13)(−2.84)
0.695**−0.274*−0.022*−0.0310.232−0.004**−0.066−0.002**0.61
(7.24)(−2.01)(−2.32)(−0.48)(0.58)(−2.92)(−1.05)(−2.64)
Reform
0.864**−0.042−0.011*0.238**−0.4170.008*−0.159**−0.0700.69
(5.60)(−0.45)(−2.05)(3.63)(−0.96)(1.85)(−3.63)(−0.92)
0.884**−0.086−0.020*0.237**−0.2570.005*−0.042*−0.0380.58
(5.27)(−0.71)(−1.74)(3.05)(−0.54)(1.98)(−1.73)(−0.38)
0.917**−0.059−0.047*0.203**−0.4680.004*−0.135**−0.0020.68
(9.15)(−0.73)(−1.82)(3.07)(−1.10)(1.75)(−3.29)(−1.64)
0.811**−0.022−0.038*0.169**0.2550.005*−0.054*−0.001 *0.67
(8.84)(−0.38)(−1.75)(2.29)(1.32)(2.26)(−1.76)(−2.17)
Postreform
0.868**0.386**−0.066*−0.116*0.363−0.002**−0.060*−0.058**0.64
(5.12)(2.61)(−1.70)(−1.71)(1.57)(−3.47)(−2.30)(−3.38)
1.024**0.607**−0.095**−0.104*0.478−0.001**−0.312**−0.036**0.66
(9.92)(5.45)(−2.72)(−1.78)(1.46)(−4.13)(−4.30)(−2.55)
0.827**0.485**−0.054*−0.126*0.874*−0.001*−0.144**−0.002*0.62
(3.58)(2.63)(−1.81)(−1.93)(1.68)(−2.01)(−2.71)(−1.78)
1.030**0.590**−0.098*−0.134*0.801*−0.001 *−0.296**−0.003*0.69
(13.22)(10.58)(−1.94)(−1.67)(1.78)(−1.88)(−7.61)(−2.14)
Note: * = significant at 95 percent confidence level.** = significant at 99 percent confidence level.
Note: * = significant at 95 percent confidence level.** = significant at 99 percent confidence level.
Note: The chapter was first issued in 1995 as “Linkages Between Financial Variables, Financial Sector Reform, and Economic Growth and Efficiency,” IMF Working Paper 95/103. The authors are grateful to Dawit Makonnen and Kiran Sastry for research assistance.
1The basic growth equations estimated by Barro include a cross-section study of about 100 countries during the 1960-85 period.
2The average growth in per capita income is regressed on the following explanatory variables: the initial value of GDP, the initial amount of human capital as proxied by initial values of primary and secondary school enrollment rates, the rate of physical capital accumulation, the ratio of government spending to GDP, the openness of trade policies, the rate of inflation, the rate of foreign direct investment, and an index for political tensions.
3See Levine and Renelt (1992) for a detailed study of the sensitivity of cross-country regressions of growth.
4The variable takes the value 1 when real interest rates are positive; 2 when real interest rates are negative but above -5 percent; and 3 when real interest rates are below -5 percent. As an alternative approach, they use the reserve requirement ratio as a proxy for financial repression and conclude that high required reserves lead to a lowering of economic growth.
5The effect is particularly strong in low- and middle-income countries, and stronger in the 1960s than in the 1970s and 1980s.
6Liquid liabilities are currency held outside the banking system plus demand and interest-bearing liabilities of banks and nonbank financial intermediaries (a measure of M3).
7The dependent variables used are the real per capita GDP growth rate, average growth rate of the real per capita capital stock, the ratio of investment to GDP, and the residual of real per capita GDP growth after accounting for the rate of physical capital accumulation (a proxy for economic efficiency).
8Odedokun emphasizes that ideally the actual output to capital ratio (as opposed to the incremental ratio) should be used as the appropriate index. However, due to lack of data on capital stock for developing countries he uses the IFS data on investment. The variables included in the regression are export orientation, size of the public sector, inflation rate, real exchange rate distortion; and the financial variables examined are the real interest rate, directed credit program through development bank lendings, and financial depth (measured as the ratio of the stock of liquid liabilities of the banking system to GDP).
11The current level of investment was regressed on its own lagged values, and the fitted values were included in the regression.
13See also Drees and Pazarbaşioğlu (1995) for a discussion of the expansionary impact of financial deregulation and subsequent financial crises in the case of Nordic countries.

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