Financial repression may be defined as direct government intervention that alters the equilibrium in the financial sector. It is usually aimed at providing cheap loans to business firms and governments by reducing their burden of repayments through lowering returns to savers below the rate that would normally prevail. Its typologies include ceilings and floors on interest rates for loans and deposits, directing credits to certain industries and businesses, and imposing constraints on the composition of bank portfolios. It is typically accompanied by additional restrictions on financial activities, such as imposing extra controls on international capital movements thereby squeezing alternative investment opportunities for savers.
Financial repression was largely abandoned during the liberalisation wave that swept the globe in the 1990s, despite being widely applied in the past. At that juncture, erstwhile support for interventionist policies succumbed to a renewed faith in the government's role as an impartial referee. But it made a comeback following the Global Financial Crisis of 2008-09 with a few countries reintroducing administered ceilings on interest rates. However, a recent working paper published by the International Monetary Fund (Jafarov, Maino & Pani, September 2019, ) titled 'Financial Repression is Knocking at the Door, Again' has found that financial repression causes significant drag on growth prospects, which could range between 0.4 and 0.7 per cent of gross domestic product (GDP). The study estimated the impact of financial repression on growth by applying an updated index of interest controls covering 90 countries over a time-span of 45 years (1973-2017). The findings reinforced the view that financial repression distorted market incentives and signals by inducing losses emanating from inefficiency and rent-seeking.
The economists' logic for financial repression was founded on the Keynesian approach that dominated during the 1960s. Keynes (1936) and Tobin (1965) prescribed an active and interventionist role by the government in the economic sphere, which included the financial market. Based on this view, many governments maintained controls on interest rates, credit supply and its composition, and other financial variables, for boosting investment and growth through artificial lowering of interest rates. According to Keynes, efficient markets were not necessarily effective. He called for a distinction between the capital invested for productive purposes and those used for speculation. The supporters of this view referred to the Great Depression of the 1930s, when speculative investment was excessive and productive investment insufficient.
The Keynesian view became quite dominant during the post-Second World War era, especially among the policy makers. The attention shifted more specifically to growth during the 1960s. Two distinct patterns namely 'demand following' and 'supply leading' were then identified. The former was considered to be occurring when economic development generated a demand for financial services that was met passively by a burgeoning financial sector. The latter was believed to be dominant during the earlier stages of development when the financial sector played the leading role in extending capital to entrepreneurs for developing the modern industrial sectors. These phenomena implied that initially the causality ran from finance to growth, but later it ran from growth to finance. It was then argued by Cameron (1967) that a financial system could be both growth-inducing and growth-induced, and therefore efficiency of financial intermediation played a critical role in promoting growth by channelling funds from risk-averse savers to risk-prone entrepreneurs.
The theories that supported financial repression were criticised by the 'McKinnon-Shaw School' during the 1970s, with McKinnon mainly focusing on the developing countries and Shaw on the advanced economies possessing sophisticated financial systems. They defined financial repression as a combination of indiscriminate nominal interest rate ceilings and accelerated high inflation, and opined that it was damaging for long-term economic growth owing to reduction in volume of investment funds. They recommended allowing real interest rates to reach the market clearing level, as higher savings and investment rates could be achieved by removing interest rate ceilings.
Mathieson (1980) and Fry (1980) supported the views of McKinnon and Shaw and showed that real money demand declined thereby lowering credit availability and real GDP growth when the authorities kept the deposit rate below market clearing value. Galbis' two-sector model (1977) showed that if deposit rates were compressed through financial repression, investments were mainly directed to the traditional (self-financed) sector, as banks were unable to collect enough deposits for funding large investments in the modern sector. On the other hand, allowing deposit rates to rise encouraged the use of savings to fund investments in the modern sector through bank intermediation.
Critics of financial liberalisation policies during the 1980s including Stiglitz and Weiss (1981) claimed that disequilibria in the credit market might happen even in the absence of government intervention. They opined that credit was prone to the risk of adverse selection, as high market clearing interest rates could attract riskier investments while discouraging less profitable but safer investments. Lending became riskier when interest rates rose, as borrowers with limited liabilities like shareholders of joint-stock companies were willing to take increased risk when interest rates were high. This might result in credit rationing and a preference for large loans. Mankiw (1986) showed that when the pool of loan applicants became too risky, banks were unable to achieve a minimum rate of return and the entire credit market could even collapse.
The new theory of endogenous growth focusing on productivity as the key factor driving long-run growth inspired research on the inter-relationship between financial development and economic growth during the 1990s. It argued that financial intermediation enabled innovative entrepreneurs to enhance productivity by introducing innovations. Further, a sound financial system increased the probability of successful innovation by screening borrowers, assessing potential profitability, pooling financial resources and diversifying risks. The financial sector channelled savings to more productive uses through collection and analysis of information about investment opportunities and promoted growth by facilitating the accumulation of knowledge.
However, the global financial crisis of 2008-09 gave rise to new questions about the impact of financial liberalisation and the government's role in the functioning and stability of financial sector. Researchers like Yulek (2017) claimed without providing empirical evidence that financial repression could be beneficial if it enabled governments to make the private sector internalise the positive productivity externalities of investment in the modern sector. Several studies, however, emphasised that liberalisation could lead to or increase instability if not accompanied by appropriate prudential safeguards.
Based on the above-mentioned review of relevant literature, a conclusion can be drawn that growth cannot be enhanced by keeping interest rates artificially low with the objective of encouraging investment. Rather, the financial market should be allowed to reach its equilibrium, thereby encouraging savings and achieving an efficient allocation for investments. Financial liberalisation would also improve the short-term contraction effects of monetary stabilisation programmes. Therefore, an agreement appears to have been reached by many on abolishing interest-rate ceilings and directed credit, reducing reserve requirements, and promoting financial sector competition for its holistic and healthy growth. The central bankers and financial authorities of Bangladesh would be wiser if they paid heed to these conclusions and shunned the path of needless financial repression in an already fragile and corruption-prone sector.
Dr. Helal Uddin Ahmed is a retired Additional Secretary of GoB and former Editor of Bangladesh Quarterly.
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