Friday, April 3, 2009

Financial Repression or Financial Crash?

Financial repression, notably interest rate ceilings and foreign exchange rate controls, reduces economic growth. But it also reduces the cost of the government deficit and abandoning its use may result in extraordinarily high real interest rates, which can be just as damaging. Ronald McKinnon was among the first to analyze financial repression as a substantial barrier to successful economic development. McKinnon argued that developing countries had to open their capital account as a way to broaden their financial markets. His view on capital account liberalization influenced the IMF set of prescriptions for Latin America to achieve price and macroeconomic stabilization.

Goodbye financial repression, hello financial crash’ was the verdict of Carlos Diaz-Alejandro on the Latin American experiments with financial liberalisation from the mid-1970s. If government expenditure cannot be reduced or traditional tax revenue increased, abandoning financial repression as a means of financing and reducing the government deficit may result in extraordinarily high real interest rates that can be just as damaging, leading to an explosion in government debt, economic instability and even lower economic growth.

It is very interesting to notice how contemporary these papers are. The idea that the whole world should have open capital accounts made the current financial crisis not restricted to the US but something that is spreadout around the world.

What about Latin America? Different from Europe, and to some extent Asia, Latin banking and financial system are not exposed to CDS and CDOs to the same extent that Asia, Europe and the US are. Does this mean that Latin countries have a more ‘responsible’/solid financial system? Or does it suggest that the Latin financial system is not as developed as those in the developed countries? In our view, Latin countries have solid banking systems. However, these banks have still an incipient basis and have yet to develop products with the complexity of the US. In brief, Latin financial system do not possess a developed financial system. This fact, however, came as a blessing in disguise especially considering that we are now starting to question the meaning of ‘developed financial system’.

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