Does Financial Liberalization Take Ethiopia to the Promised Land?

The Need to Take Necessary Precautions to Avoid Regret. (Part II)

In the first part of this article, I illustrated some of the national economic and political hardship that can follow financial sector liberalization with empirical evidence from Argentina and Turkey. In this and final part, I shall present two success stories related to financial liberalization: Ghana and China. I will also suggest what Ethiopia should do to minimize the costs and maximize the benefits of its seemingly inevitable liberalization of finance.

First let’s see the Ghanaian experience. Ghana has often been cited as an example of a stable democracy in Africa. It had taken financial liberalization measures in the 1980s. A look at the Ghanaian financial sector before and after liberalization offers interesting insights. During the pre–liberalization era, Ghana’s banking sector, like that of Ethiopia, was dominated by state-owned banks which were mainly used as vehicles to satisfy the government’s development agenda. To that end, the government highly controlled interest rates, set high reserve requirements on banks, directed credit programs, and put several other restrictions. Interest rates, in particular, were set at artificially low levels, which helped to direct cheap credit towards the public sector at the expense of more productive and efficient private investments (i.e. crowding out private investment). As real interest rates became negative, people refused to deposit their money in banks. Later on, the domestic financial system found itself in tatters.

It was this domestic financial crisis that forced the Ghanaian government to set a new agenda and implement a financial sector reform program. The new reforms looked to develop an efficient and competitive financial system and bring about stability in the banking system. So, Ghana’s government first improved the legal system, strengthened accounting standards, developed managerial and supervisory infrastructure, and implemented appropriate macroeconomic policy, institutional, and structural reforms. The reforms also covered restructuring of insolvent banks and liberalization of credit allocation. In 1982, the government revised the banking legislation and continually amended it. In 1988, interest rates were liberalized with a view to restructuring financially distressed banks, improving capital markets, undertaking efficient resource mobilization, and allocating credit better.

Following these reforms, an increasing number of foreign banks were allowed to enter the market. In 1990, the government further allowed the prices of deposits and loans to be determined by the market. All these changes brought the financial sector some success. For instance, the sector’s contribution to economic growth grew; financial deepening (measured by broad money to GDP ratio) increased; and the foreign banks introduced longer working hours, reduced long queues in the banking halls, and provided personalized services. Foreign banks also introduced electronic payments technologies such as credit and debit cards and ATMs (automated teller machines). Moreover, they contributed to a declining concentration of deposits and market shares, indicating improved competitiveness in the banking industry during the post-liberalization period. Return on equity, return on assets, and profit before tax in the banking sector also showed declining trends. However, despite the increase in competition, net interest income and net profit of domestic banks increased, suggesting that the banking industry returned to health. The success of Ghana’s financial sector with liberalization can be traced to the groundwork the government laid.

The second successful case of financial liberalization comes from China. The Chinese government initiated a sequence of reforms in its financial sector independently of external pressure. In terms of sequencing reforms, China allowed a gradual opening up of its financial sector to domestic and foreign competition, and only at the final stage did it liberalize capital accounts. The relatively slower financial liberalization process can be split into two time periods: before and after joining of the World Trade Organization (WTO).

During pre-WTO reforms, China had restructured its domestic financial system. Reforms of the banking sector went through four stages. First, between 1979 and 1986, the mono-bank system was abolished and the government established various state banks with different specializations. Second, from 1987 to 1991, the government allowed limited domestic competition to help domestic banks acquire experience and improve their managerial skills. Third, during 1992-1996, the authorities permitted diversified financial activities and established two stock exchanges and inter-bank markets. Foreign firms were also given license to provide banking services and to sell life and non-life insurance products. Fourth, from 1997 to 2001, the country started preparations to join the WTO. In this period, government policy measures focused on addressing portfolio problems in commercial banks, strengthening state banks in terms of recapitalization, and establishing asset management companies (AMCs).

Once China signed up to be governed by WTO rules in December 2001, it was expected to undertake further structural reforms in the domestic financial sector. Indeed, immediately after entry into the organization, the government passed a new law to strengthen the supervision and regulation of the banking sector, and the China Securities Regulatory Commission (CSRC) issued regulations for foreign investors to participate in the open stock market. In 2002, the People’s Bank of China (PBC) published an information disclosure system for financial institutions. The government also introduced a preliminary regulation that gave a framework for mergers and acquisitions, allowing some foreign banks to negotiate with Chinese banks. Eligible foreign investors were allowed to invest in Class A shares, which had previously been owned by domestic investors. Foreign equity stakes in local banks were allowed to increase from 15Pct to 20Pct for a single shareholder and 25Pct overall. The government then published additional rules which govern foreign financial intermediaries. The PBC also announced that both foreign and domestic banks would be subject to the same interest rate regulations and that the foreign banks could extend their foreign exchange services to domestic companies and individuals.

In 2003, China outlined plans for upcoming banking sector reforms, which enabled banks to raise new capital and implement better corporate governance, and fostered competition with the entry of more foreign banks. At this time, the government encouraged foreign investors while restructuring many state banks. In addition, it opened the insurance market to global competition in line with WTO commitments. Then in April 2003, the China Bank Regulation Commission (CBRC) was established. In 2004, capital injections into two state banks, the Bank of China and China Construction Bank (CCB), were eliminated. Instead, these state banks were restructured with USD45 billion to make them among the strongest in Asia and competitive domestically alongside foreign banks. Domestic banks were not that much hurt by the entry of foreign banks because of the various measures taken ahead of time.

To sum up what I have tried to show in this two-part article about financial liberalization: Financial liberalization cannot be considered in a vacuum, but rather with other aspects of the economy that it is supposed to improve. It is particularly important to get the timing and sequence of reforms right and to adopt a proactive approach to problems. Full opening up of the financial sector at once or amid severe macroeconomic, political, and structural problems, as Argentina and Turkey found, could result in major crises in the financial sector itself with spillovers to the rest of the economy. By contrast, developing appropriate regulatory and supervisory frameworks, institutions, and competitiveness of domestic financial intermediaries before embarking on liberalization is likely to lead to a better outcome, as exemplified by Ghana and China.

Ethiopia should thus focus, first, on addressing its macroeconomic, institutional, and structural problems. It also appears helpful to enhance competition within the domestic banking system—by, among other things, addressing the Commercial Bank of Ethiopia’s dominant position—before allowing in foreign banks. Improving the capacity and independence of the National Bank of Ethiopia (NBE) is another necessary condition. Finally, and perhaps more importantly, Ethiopia should carefully weigh the benefits of liberalizing finance against its overall development goals.

What good does it do for a country to liberalize its financial sector if it does not help it transform the economy and move up the development ladder? In spite of the International Monetary Fund’s (IMF) and the World Bank’s badgering to open its door to global financial service providers, Ethiopia should only do it if and when it is convinced and feels ready.

9th Year • September 2021 • No. 100

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