The need to take necessary precautions to avoid regret.
Since the unveiling of the administration’s Homegrown Economic Reform Plan and restart of the accession process with the World Trade Organization (WTO), talks of economic liberalization have been heating up in Ethiopia. Indeed, the liberalization process of the telecom sector is well underway and Prime Minister Abiy Ahmed (PhD) himself has indicated that the hitherto closed financial sector will be next in line. Speeding up of WTO accession is one of the plans in the plan. The government’s aspirations of reforming the economy and WTO accession may imply that the government will inevitably open up the financial sector in the near future, with the ongoing deregulations set as good launching pads. Many economists and people in domestic financial circles received the news with shock, predicting disaster for local financial players and the overall economy, while multilateral institutions such as the IMF, who have long demanded Ethiopia liberalize its finance sector, gave it a warm welcome. Questions are there. Is it too soon to open up the financial services sector? Should the financial sector remain closed forever?
My intention in this two-part article is to shed some light on the opportunities and challenges of the imminent opening-up of the financial sector, drawing on the experiences of other countries. In this first part, I begin by discussing the challenges Ethiopia can face during and after financial liberalization, illustrated with the experiences of two countries. In the second part, I will turn to the opportunities and review some success stories.
The process of financial sector liberalization is a broad concept that could feature complete freedom of finance to move within, into, and out of the economy; fully convertible currencies; market-determined interest rates; removal of restrictions on credit and ownership of financial institutions like banks, insurance companies, brokerage and investment companies, and savings and loan associations (including allowing foreign nationals full freedom to participate in the financial system of the hosting country); and privatization of parastatal financial institutions. It also gives the central bank real autonomy from the government to act just in response to economic and market conditions.
But in the real world, it is not a new thing to liberalize the financial sector and find oneself in real trouble. In this regard, I will present the examples of Argentina and Turkey, beginning with the former. Most notably in the 1980s and 1990s, many countries in Latin America went through financial sector liberalization. Argentina was a member of the General Agreement on Trade in Services (GATS), a precursor of the WTO. Its financial liberalization was applied by its own consent to fulfill GATS requirements and other targets.
Argentina undertook several reforms towards liberalizing finance: deregulation of the banking sector in 1976; the lifting of interest rate controls in 1977; and the replacement of publicly funded deposit insurance by a bank-funded partial coverage plan in 1979. However, these considerable reforms were followed by a banking crisis in 1980. Between 1980 and 1982, as most financial companies faced severe problems, studies confirmed that the financial liberalization induced banks’ risk-taking behavior that led to a banking crisis. Another factor was liberalization through poor or non-transparent policy. The existing banks had huge debt which liberalization worsened as real interest rates grew during a lower inflation rate period.
In addition, the reform allowed deposits to increase as well as a massive inflow of capital, which provided the banking system with more supply to again loan further and resulted in the rocketing of non-performing loans. The building of strong institutions, legal frameworks, and reforms were taking place in a rush because of the high expectation that external financing would alleviate the scarcity of saving and thereby increase investment and growth.
Finally, the Argentina bank regulators intervened and the state-owned financial institutions re-entered the market as credit providers. The government had initially intended to defuse the crisis and hoped for a brief stay in the market, but its role grew and it even reintroduced interest rate controls in late 1982. Although these measures helped mitigate the effects of the crisis, the overall economy did not fully recover. Thus, the government took the additional measure of vacillating exchange rate regimes to combat inflationary surges and to be on a sustainable growth path.
Argentina then liberalized its equity market in 1989. It also adopted a currency board and implemented a foreign exchange convertibility plan in 1991. The latter measure initially resulted in stable inflation and currency by fixing the Argentine peso with the U.S. dollar, together with strong international reserves and opening up of the capital account. In addition, some state-owned banks downsized and some of them were privatized. Following this, the country’s real GDP grew strongly between 1991 and 1995. The observed improvement was not without blemish, however, due to delays in reforming other aspects of the public sector and the country run significant fiscal deficit in 1994.
Although financial openness (involving the transfer of many local banks to foreign ownership) provided Argentina with large foreign capital and investment, it also made the country vulnerable to external shocks. For example, the Mexican peso crisis in 1994, the Russian and Asian economic crises in 1997, and the Brazilian devaluation in early 1999 had caused the Argentine economy to be affected by appreciating domestic currency, poor competitiveness, fiscal imbalance and overall recessions. The policy measures taken by the government, including devaluation of the peso, fiscal stimuli, and export promotion failed to initiate sustainable growth. So Argentina faced another massive economic downfall in 2001, resulting in civil unrest, fall of government, a major banking crisis, and default on government debt repayment. Finally, the currency board collapsed in 2002 and the result was a full-blown financial crisis.
The second real-world example that one can cite for Ethiopia to draw valuable lessons from is the experience of Turkey. In 1980, the Turkish government believed that the entry of foreign banks could enhance efficiency and competition in the domestic financial system. Thus, the government fully liberalized the financial sector by eliminating interest rate controls and reducing indirect credit programs. As expected, these measures enhanced competition in the domestic financial market and reduced market concentration. Further, the Istanbul stock exchange reopened in 1986 and, finally, the capital account was liberalized in 1989. These steps initially improved efficiency in the domestic banking business.
However, it did not take long for the economy to fall ill with the usual symptoms—chronic inflation, persistent fiscal imbalance, balance of payment crisis, and very high domestic interest rates, to go with political instability. Very high domestic interest rates in particular induced domestic banks to seek funding from foreign sources. This, together with a flexible exchange rate, resulted in large amounts of foreign capital inflows into the country, which, combined with high inflation rate, caused the real exchange rate to appreciate between 1990 and 1993. In 1993, the country’s fiscal balance also highly deteriorated. But this was not the end of the story and a major financial crisis after liberalization occurred in 1994. The rapid deprecation of the Turkish lira led to depositors’ loss of confidence and to a massive withdrawal of deposits. As a result three small banks went into liquidation.
To prevent further bank failure, the government announced 100Pct insurance (Could Ethiopia afford such a scenario?). During the financial sector crisis, three small banks failed. In order to prevent further panic, 100Pct deposit insurance was introduced. In response to the crisis, the Turkish central bank had also taken measures aimed at the real exchange rate, which again depreciated further. The amount of foreign borrowing grew huge, which made the country highly exposed to external shocks. These problems, plus unfair competition between state and private banks, riskier investment made by private banks due to capital inadequacy, and government’s reluctance to deal with problematic banks in time, caused the second major financial crisis in the year 2000. This crisis got even worse in 2001 when one large bank failed due to chronic liquidity problems and some other failing banks were moved to the Saving Deposit Insurance Fund (SDIF) to be recapitalized.
In the aftermath of the second financial crisis, the Turkish government focused on restructuring the state and SDIF banks, strengthening private banking, and improving the legislative and regulatory environment. Indeed, these measures improved banks’ nonperforming loans, profitability, and capital adequacy. However, until 2004, the banking sector remained vulnerable because they were quite concentrated and the state banks continued to finance the then non-viable favored sectors. In sum, the major reason for the banking crises in the Turkish economy was the full opening up of the financial sector amid high macroeconomic and political instability and serious structural problems in the banking sector.
So, for those who think Ethiopia should sprint towards financial liberalization, the examples of Argentina and Turkey discussed above should make them stop and think twice. The road to liberalization could indeed be bumpy, and the destination not the desired one. But, aren’t there countries which benefited from financial liberalization without so much of the associated economic and political turmoil? And under what conditions could financial liberalization be a force for good? I will take up these questions in the next part of the article.
Deciding financial liberalization as good or bad based on few countries’ cases is misleading. Financial liberalization needs enough time to think about how and when. I prefer to wind up with the grand summary at the end of the second edition on the basis of both the challenge and success stories of the practice of financial liberalization. I will forward my recommendations after analyzing cases of successful countries, in the next edition. The aim of this first part is not implying or predicting that Ethiopia will also fail, like Argentina and Turkey, but to give insight into financial liberalization, which requires a careful move because it has not only stipulated benefits but also repercussions when we assess other countries’ experience.
9th Year • Jun 16 – July 15 2021 • No. 99