Introduction Financial liberalization can be described as the procedure of enabling markets establish who attains and grants credit and at what rate. Extensive financial liberalisation comprises six major aspects: the removal of credit controls, the deregulation of interest rates, free admission into the banking zone, bank independence, personal ownership of banks, and the liberalisation of worldwide fund flows. The major aim of financial liberalisation is to create a more competent, and inherent financial system, able to sustain the development of private sector ventures. Interest cost decontrols lead to extreme real interest rates for savers and a rise in assets in the economic system which can serve as loans for investment ventures.
Financial liberalization brings an end to the custom of giving out low-cost credit to favored sectors. This enhances the allocation of capital in the economy, as resources are allocated to most profitable sectors. Financial liberalization means better access to international resources, made possible by an expanded role for overseas banks and non-bank financial institutions, could be a third benefit of financial liberalization (Stiglitz, 2000). McKinnon and Shaw found that low returns promoted investment, but not savings, generating a gap among preferred investment and domestic savings accessible to finance investment.
This gap influenced a rationing of credits, or dependence on overseas borrowing. They also found out that cheap capital promoted capital-intensive procedures of production. Cheap loan rationed to particular sectors of the economy resulted in an incompetent distribution of loans, instead of a market distribution of loans to greatest return investments. The result of economic liberalization has led to a rise in the private resources flow and changing the way in developing Nations secure foreign capital especially during the 90s.
Foreign financial crises become common during this period, for instance, Mexico in 1995, Asia in 1997 and Argentina in 2001. The discussion on influence of financial liberalization can be summarized into arguments surrounding current accounts and economic account. Opinions regarding current account converge around its positive impacts on development and welfare. In regard of investment account liberalization, effects of economic liberalization are considered under number of variables, for instance, economic development, total factor productivity, distribution of income, domestic investment, and inflation.
There exist four theoretical reasons for economic account liberalization enhancing financial growth: the chances of dividing investment decision, which bring most income prospects, from saving choices ii) increasing interaction with foreign states and advancing knowledge; iii) use of portfolio diversification to lower risk; iv) improving economic markets by increasing competition in the banking industry and higher liquidity in the equity market. The major negative influences of financial liberalization include the problems of susceptibility and contagion. Stiglitz (2000), condemns short-term speculative investment flows and states that liberalization could render these flows more unstable regardless of the form of macroeconomic procedure employed by developing nations.
It could also increase financial problems and make these economies more vulnerable and could result in reduced investments. According to Rodrik (1998), economic liberalization increase the systemic risk since a certain market would be impacted by another’s crisis. Financial globalization as another indirect channel causes economic instability and banking predicaments. Regardless of the method producing banking predicaments, such actions can harm the capability of a financial system to offer the economy with credit.
This results in reduced investments in physical resources and innovation.