Financial Liberalization: What Went Right,What Went Wrong?

that took place in the developing countries in the 1980s and 1990s was part of the general move toward giving markets a greater role in development. It was also a reaction to several factors specific to finance: the costs, corruption, and inefficiencies associated with using finance as an instrument of populist, state-led development; a desire for more financial resources; citizens’ demands for better finance and lower implicit taxes and subsidies; and the pressures exerted on repressed financial systems by greater international trade, travel, migration, and better communications. The financial reforms went beyond the interest rate liberalization that had been recommended by the so-called Washington Consensus. To varying degrees, governments also allowed the use of foreign currency instruments and opened up capital accounts. Domestic markets developed in central bank and government debt, and international markets expanded in government and private bonds. Capital markets developed, but less rapidly, and were most successful in the larger,already rapidly growing, East and South Asian countries. State banks continued to have a major role for much of the 1990s; their privatization was gradual and often proved costly. Central banks moved away from trying to finance development; they became more independent and successfully focused on keeping inflation low, but their debt increasingly absorbed bank deposits. Certainly the reforms produced some gains. But the growth benefits of the financial and nonfinancial reforms in the 1990s were less than expected. Financial crises raised questions of whether financial liberalization was the wrong model, what had gone wrong, and the appropriate direction of future financial sector policy. Overall, the 1990s is probably best considered a precursor of better things that will take some time to achieve. Section 1 of this chapter describes why and how financial liberalization occurred. Section 2 discusses the outcomes of financial liberalization during the 1990s, including the crises that occurred and their relation to macroeconomic policies, financial liberalization, and the overhangs of old economic and political systems. Section 3 summarizes the lessons from the experience of the 1990s, and section 4 draws suggestions for future policy. Section 5 concludes the chapter.