Journal Issue

Sequencing the Liberalization of Financial Markets: Open up domestic banking then free capital flows

International Monetary Fund. External Relations Dept.
Published Date:
March 1988
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Mario I. Blejer and Silvia B. Sagari

A key element in the structural adjustment strategy of many developing countries is the adoption of far-reaching trade and financial reforms based on economic liberalization. Such policies include deregulation, the opening up of the domestic economy to external forces, and the adoption of outward-oriented development policies. These measures are designed to eliminate distortions in the allocation of resources, increase competition, and encourage productivity in order to achieve higher and sustainable rates of growth.

A central component of such reforms is the restructuring of the financial sector—to be achieved by relaxing regulations, eliminating interest rate ceilings, and opening up the capital account by reducing the restrictions on international capital mobility. The resulting free flow of funds is expected to increase the availability of financial resources, induce interest rate arbitrage, and reduce the cost of credit to the private sector. However, in several countries that implemented such policies, and most noticeably in some Latin American countries in the late 1970s, these beneficial effects of the reforms did not emerge clearly. Domestic interest rates, for example, failed, or took a long time, to move toward the world rate adjusted for changes in the exchange rate.

This article is based on a more extensive study on this subject published in Economic Reform and Stabilization in Latin America, edited by Michael Connolly and Claudio Gonzalez-Vega (Praeger, New York, 1987).

While several studies have emphasized different reasons for this performance, little attention has been given to the nature of the domestic banking sector at the time the reforms were launched. The competitive structure of the domestic banking market and the level of public sector participation in this market affect interest rate behavior, and, more generally, the outcome of the liberalization policies. As is argued in this article, consideration of these elements may be crucial for the success of any reform.

Internal and external reforms

A central conceptual issue underlying any effort at financial liberalization is the distinction between external and internal financial liberalization. External liberalization generally entails opening up domestic financial markets to international financial flows, removing exchange controls, eliminating barriers to the entry of foreign banks, and so on. Internal financial liberalization refers to the reforms leading to a freer functioning of the domestic financial market, and involves, among other things, the elimination of domestic credit controls relating to credit rationing, interest rate ceilings, and differentiated reserve requirements. Other elements of internal financial liberalization include the elimination of discriminatory practices and capital requirements that drastically curtail the free entry of local participants into the domestic market.

Theoretical analyses of financial liberalization policies have frequently included both internal and external liberalization within a single framework. In practice, too, to a large extent such internal and external reforms have been implemented together in the Latin American Southern Cone countries of Argentina, Chile, and Uruguay. But although external and internal financial reforms clearly interact, they entail different processes, and produce quite different results. Further, it may be that there is an optimal sequence in the implementation of internal and external financial liberalization.

Liberalization and competition

A second conceptual issue in designing a financial liberalization strategy is the distinction between the concept of liberalization and the idea of perfect competition. Clearly the reaction to financial liberalization and deregulation varies according to the competitive structure of banking markets.

The interaction between the domestic banking sector structure and financial liberalization policies can be examined by considering the theoretical case of a small developing economy, with a relatively highly regulated banking sector and a highly concentrated market structure resulting in monopolistic behavior. In this economy no public or foreign institutions participate in financial intermediation, and domestic residents have no access to foreign borrowing or lending.

If liberalization begins with the external sector through the freeing of international financial flows, but foreign banks are not allowed to enter the domestic market at the initial stage, only a few (probably large) local borrowers are likely to gain access to the international loan market, and make transactions at international interest rates. Many other borrowers will still be excluded from the foreign market because of costly or imperfect information, so that monopolistic domestic banks are able to charge more to those borrowers who are unable to obtain cheaper foreign credit. In this situation, the average domestic interest rate may remain higher than the international interest rate. Despite external liberalization, the legal restriction on capital movements has been replaced by a market restriction, and a monopolistic domestic banking sector will appropriate part of the welfare gains deriving from the availability of cheaper sources of funds.

Alternatively, the authorities could begin liberalization from the internal side, by eliminating restrictions on entry into the domestic banking system and by encouraging competition in the financial sector. This step may weaken or even eliminate the monopolistic structure of the domestic banking sector. In this situation, the domestic interest rate will be freely determined by market forces. However, depending on demand preferences and the structure of domestic bank costs and risks, domestic interest rates may be set higher than the international rate. This is particularly likely to happen if monopolistic practices that prevailed before the reforms created inefficiencies that raised the cost of banking services. In such a case, despite the fact that restrictions on external capital flows prevent the economy from benefiting from lower world rates of interest, the economy would still gain from internal liberalization through the elimination of monopolistic distortions.

At this point, once the monopolistic structure of the banking sector has been, at least, weakened, restrictions on foreign borrowing and lending can be eliminated, leading to a convergence of the domestic and the international interest rates. It has been observed in a number of cases, as in Uruguay in the late 1970s, that following the opening of the capital account, the differential between domestic and foreign rates remained until the central bank actively limited the noncompetitive practices of some domestic banks.

Once the restrictions on operations in foreign capital markets have been removed, the volume of loans in the economy could increase, with some lending by local banks and the rest by foreign banks. In this process, local banks could lose part of the local loan market to foreign competition. Total welfare in the economy, however, would increase over and above the welfare increase resulting from internal financial liberalization alone, partly because of the elimination of the social losses from the earlier, inefficient allocation of loans in the domestic market. Foreign competition would not only provide more finance but also at lower interest rates.

Entry of foreign banks

Allowing and encouraging the entry of local competitors into the domestic banking sector may not be enough to weaken the monopolistic structure of the sector if the firms initially present in the market squeeze out the new entrants, or if the new banks tend to collude with existing participants. On the other hand, foreign banks may be considered pure competitors in the international market. It seems reasonable to assume, therefore, that if foreign banks are allowed freely to enter the domestic market, they will bring with them their competitive behavior. The entry of foreign banks would therefore have a greater impact on the level of competition than that resulting from the entry of new domestic banks exclusively.

In small economies where the technology available to the domestic banking sector is less advanced than that in the foreign banking sector, domestic banking services have comparatively higher costs, and conditions may give rise to a natural monopoly. In such an environment, allowing only the free entry of domestic banks will not significantly change the competitive structure of the industry. But if foreign banks are allowed to enter the market, given their superior technology and relatively lower costs of operation, they may eliminate the natural monopoly. Allowing foreign banks entry could, therefore, be thought of as a more powerful means toward achieving higher levels of competition and productivity within the domestic banking sector. The entry of foreign banks may thus be a useful complement to the process of internal liberalization.

Even from this conceptual standpoint, however, it may be better to institute internal before external financial liberalization. When domestic banks have been used to a highly protected and restricted environment, adjustment to a more competitive setting has to be gradual. The speed of adjustment will reflect the costs associated with reorganization, marketing, learning, and, in general, the development of new instruments and practices. During the adjustment period, foreign competitors operating locally may be able to capture a much larger market share than they would if the indigenous banks were more competitive. If the government wishes to establish and maintain a large and profitable domestic banking sector, it should first create the conditions to allow domestic banks to compete with foreign banks. This means that it should deregulate and liberalize the system internally before allowing freedom of entry for foreign banks.

State participation

In many developing countries, notably in Latin America, public sector financial institutions participate greatly in the domestic financial markets. Generally in these countries, financial liberalization can be identified with deregulation but not with a decrease in public sector participation in financial intermediation. In many cases, interest rate ceilings were made more flexible or were altogether eliminated, reserve requirements were reduced, and so on, whereas the role of the government in directing or subsidizing credit to specific sectors and, particularly, the role of public institutions in financial intermediation did not change substantially. In Argentina, for example, even after extensive financial reforms, more than 40 percent of deposits were still held by public institutions in 1982. In Brazil and Uruguay, the large shares of Banco do Brazil and Banco de la Republica, respectively, which are state-owned commercial banks, are also examples of strong government intervention in the financial market. This situation is not confined to Latin America. In Greece, for example, the publicly owned National Bank of Greece accounts for over 50 percent of the banking sector’s assets.

Without entering into the question of the economic and historical roles of public banking, it is clear that in countries where public institutions dominate the financial sector, the consequences of deregulating financial markets should be closely examined. It may be useful to consider the role of the public sector in introducing noncompetitive practices in the banking sector. In order to reduce welfare costs and increase efficiency, these noncompetitive practices should be eliminated, or the scope of public sector financial intermediation cut back, before the external financial sector is liberalized by opening up the capital account.

Regulations versus protection

Given the characteristics of the financial market in developing countries, there is a clear need for some kind of bank regulation and supervision. If each component of the regulatory framework could be distinctly labeled either as essential to the “soundness and safety” of the system or as a purely protectionist measure, a concise definition of internal financial liberalization could be easily proposed. In such a context, internal financial liberalization would be characterized by the elimination of purely protectionist measures. Obviously, reality does not allow for such a sharp distinction, and many measures which hinder free competition may have been designed for the purpose of promoting the banking sector’s safety. In Uruguay, for instance, following the banking crisis of 1965, caused among other reasons by the excessive expansion of the banking system, the banking authorities imposed restrictions on the number of branches that banks could have. This measure, originally designed to promote the safety of the banking system, implied, however, some level of protectionism to the extent that free competition in the sector was constrained.

The fact that financial markets are more sensitive than other markets to uncertainty, imperfect information and crises of confidence and credibility would undoubtedly reinforce the need for efficient prudential supervision. However, in the exercise of such supervision it is important to bear in mind the distinction between internal financial liberalization and surveillance measures which are indeed necessary to maintain the soundness and safety of the banking sector. The Argentine banking crisis of 1980–82, in the midst of a major liberalization attempt, has been attributed, among other reasons, to the inadequate supervision of the financial system. Since it led to some reversed of the liberalization process (through the reintroduction of interest-rate ceilings, for example) that experience stresses the need for coordination between deregulation, on the one hand, and proper supervision on the other.


The main objectives of external and internal financial liberalization are the integration of the domestic financial market with the international market in order to improve the role of the financial markets in the allocation of resources. On the basis of the results of the recent liberalization experiences in developing countries, particularly in Latin America, it is frequently claimed that the financial liberalization measures adopted (e.g., the reduction of regulations on bank entry, the elimination of interest rate ceilings, or the relaxation of exchange controls), failed to attain those main objectives. It is also argued that this failure is reflected in the large spreads between foreign and domestic interest rates after adjusting for changes in exchange rates, and in the emergence of very high real interest rates.

These arguments, however, deserve to be put in context. Large spreads between domestic and international interest rates do not necessarily imply an inefficient financial market. The existence of such spreads may simply reflect the differences between financial instruments. Foreign and domestic financial assets are not perfect substitutes. Further, many domestic financial assets are not tradable. Simple comparisons of interest rates on foreign and domestic assets are thus not very meaningful unless they reflect differences in rates of return on “equivalent” financial assets. Moreover, as emphasized here, such differences may just embody monopolistic profits, particularly if they are accompanied by large spreads between deposit and lending rates. As discussed above, the opening up of the economy to external capital flows does not necessarily imply that all economic agents will have the same direct access to international borrowing. Some borrowers must obtain credit from domestic financial intermediaries that can borrow abroad. If the number of intermediaries with access to foreign markets is limited, the domestic market structure may lead to monopolistic profits which will be reflected in the spread between local and foreign interest rates. Clearly, these aspects of the domestic market—limitations in competitive practices, lack of adequate instruments, and the like— should be the target of an internal financial liberalization program.

Internal and external financial liberalization are, undoubtedly, complementary processes. However, as the preceding analysis indicates, if a banking sector is characterized by very restrictive regulations, significant government participation, and a noncompetitive structure, external financial liberalization should be implemented only after internal financial liberalization is well under way. As a result of this sequencing, the adjustment costs and disruptive effects of opening up the capital account can be considerably reduced, and the benefits to the financial market, and to the economy in general, can be maximized.

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