DOES FINANCIAL REFORM RAISE OR REDUCE SAVING? Oriana Bandiera, Gerard Caprio, Patrick Honohan, and Fabio Schiantarelli* Abstract—The effect of financial liberalization on private saving is may differ substantially from the impact effect. Lastly, theoretically ambiguous, not only because the link between interest rate levels and saving is itself ambiguous, but also because financial liberaliza- financial liberalization is a process rather than a one-shot tion is a multidimensional and phased process, sometimes involving event. reversals. Using principal components, we construct 25-year time-series The purpose of this paper is to provide an empirical indices of financial liberalization for each of eight developing countries: Chile, Ghana, Indonesia, Korea, Malaysia, Mexico, Turkey, and Zim- examination of the total effect of the financial reform on babwe. These are employed in an econometric analysis of private saving in aggregate private saving based on eight case studies: Chile, these countries. Our results cannot offer support for the hypothesis that Ghana, Indonesia, Korea, Malaysia, Mexico, Turkey, and financial liberalization will increase saving. On the contrary, the indica- tions are that liberalization overall—and in particular those elements that Zimbabwe. These countries have all significantly liberalized relax liquidity constraints—may be associated with a fall in saving. their financial sector policies, but they differ in the nature and phasing of financial liberalization, in other aspects of I. Introduction their policy reform program, and in the macroeconomic context in which liberalization took place. This variety WAVE OF liberalization of financial markets has swept allows us to explore the degree to which the saving response over much of the developing world, especially since the A differs from country to country, as well as to test whether the mid-1980s. This liberalization has been characterized by greater scope being granted to market forces in determining response is a common one. interest rates and in allocating credit (Caprio, Atiyas, and Financial reform typically comprises several key phases Hanson (1994)). Although this has occurred under the that are often separated by several years. Reform measures pressure of increased globalization of financial markets and are introduced in a number of different dimensions: interest following the example of many industrial countries, there rates, credit allocation, bank ownership, prudential regula- has been an expectation that financial liberalization would tion, security markets, and openness of the capital account. help economic development. In particular, the early litera- The best sequencing of these various elements is frequently ture on financial repression, following McKinnon (1973) debated. In practice, reform has not been a monotonic and Shaw (1973), stressed the potential role of higher process: In some cases, setbacks have involved temporary interest rates in mobilizing savings that could be put to policy reversals. productive use. A thorough quantitative assessment of the impact of such But it is far from clear that financial liberalization actually a process must take account of its gradual and reversible does increase private saving. One obvious and important nature. Based on an analysis of the historical evolution in consideration is that the effect of interest rates on saving is each case, we have identified the timing of major moves on itself ambiguous, as the income effect might offset substitu- eight different dimensions towards a more liberalized sys- tion effects. In addition, one must recognize that financial tem. Using the principal components of the resulting matri- liberalization involves more than just a change in interest ces of 0–1 variables (1’s correspond to the years after a rates. Other dimensions of financial liberalization, such as particular reform is introduced), we obtain a single continu- increased household access to consumer credit or housing ous financial liberalization index for each of our countries. finance, might also work to reduce private saving (Muell- As an alternative, we also construct for each country a pair bauer and Murphy (1990), Jappelli and Pagano (1994)).1 of subindices that capture different aspects of the liberaliza- Furthermore, the long-term effect of liberalization on saving tion process. Our data extends over a quarter of a century—a period long enough to allow us to model the response to liberalization in each country separately—but in addition to Received for publication February 2, 1999. Revision accepted for the country-by-country results, we also present panel data publication November 29, 1999. evidence. * London School of Economics, World Bank, World Bank and CEPR, Visual inspection of the time series of the main relevant and Boston College, respectively. We would like to thank Pierre-Richard Age´nor, Craig Burnside, Bruce variables—the financial liberalization index, the real interest Hansen, Tullio Jappelli, Peter Pedroni, Deborah Wetzel, Stephen Zeldes, rate, monetary depth (either M2 or total credit to the private participants in seminars at Boston College and the World Bank, and sector expressed as a percentage of GNDI), and the private especially Klaus Schmidt-Hebbel, Luis Serve´n and John Campbell as well as three anonymous referees for useful suggestions. The findings, interpre- saving ratio—reveals little evidence of a clear-cut relation- tations, and conclusions expressed in this paper are entirely those of the ship between saving and liberalization. authors. They do not necessarily represent the views of the World Bank, its We estimate an econometric relationship expressing the executive directors, or the countries they represent. 1 There is also the view, stressed in the neostructuralist contributions of private saving ratio as a function of the real interest rate and Taylor (1983) and Van Wijnbergen (1982) that the effect of reduced of the index of financial liberalization (or its subcompo- taxation on formal financial intermediaries might actually reduce the flow nents), along with income, inflation, and government saving. of credit to the private sector to the extent that reserve requirements captured funds for the government that had been substituted away from the In addition to directly measuring the contribution of liberal- curb market. ization to the volume of aggregate saving, our procedure The Review of Economics and Statistics, May 2000, 82(2): 239–263 ௠ 2000 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology Downloaded from http://www.mitpressjournals.org/doi/pdf/10.1162/003465300558768 by guest on 28 September 2021 240 THE REVIEW OF ECONOMICS AND STATISTICS improves on earlier estimates of the saving-interest relation, The process of financial liberalization also unleashes a which omitted any role for financial-sector liberalization series of short-run effects. Not only can the process of other than the real interest rate channel. domestic portfolio adjustment lead to transitory changes in Although they cannot be solved-out for a net effect on the the volume of domestic saving, but (especially when com- level of saving, Euler equations can be helpful in detecting bined with liberalization of the foreign exchange market) it the extent of credit rationing. In this spirit, we also assess the may also induce large capital inflows, largely but not impact of financial reform on the extent of liquidity con- exclusively attributable to a return flow of past flight capital. straints by estimating an augmented Euler equation for If not sterilized, such inflows can result in a credit boom consumption, in which it is assumed (in an extension of the leading to real income surges, which in turn have a direct, model of Campbell and Mankiw (1989, 1991)) that the but transitory, effect on the volume of saving. Modeling of fraction of the consumers are liquidity constrained varies the effect of financial liberalization on saving needs to take with the degree of financial liberalization. account of these short-run effects, as well as the long-run The structure of the paper is as follows. Section II effect. It is also important to recognize that some of the describes the main channels through which financial liberal- overall effects can come through the effect of income on ization may affect saving and briefly reviews the relevant saving. empirical literature. Section III describes the financial reform process as it occurred in each of the eight countries A. Steady-State Effects being studied here. This section also explains and graphs our index of financial liberalization and examines the prima If financial liberalization improves the rate of return for facie evidence about its effects. Sections IV and V present savers, then knowledge of the interest elasticity of saving the econometric results based on the saving function and on can help predict the long-term impact of liberalization on the augmented Euler equation for consumption, respec- saving. However, because of the wealth and current income tively. Section VI concludes. effects that will generally be present, there is no presumption as to the direction of the aggregate saving response to an II. Financial Liberalization and Saving: Theoretical exogenous interest rate change. Despite many studies, this Background and Review of the Empirical Evidence remains an empirically controversial area, partly because of a surprising shortage of reliable and comparable cross- Although financial liberalization can enhance the effi- country