Financial liberalization, institutional factors and economic development

This study probes the linkages between the institutional framework of an economy and the outcome of financial liberalization. It argues that institutions and institutional quality are crucial to avoiding the crises often precipitated by financial liberalization. This issue is examined in detail at two levels, first by building a theoretical model that extends existing theory regarding the role of institutions in financial liberalization. This is followed by an empirical analysis of the experiences of five developing economies, Korea, Thailand, Indonesia, Mexico and India that liberalized their financial sector in the 1980s and 1990s.; The theoretical model captures the process of financial liberalization by explaining how given initial institutional conditions, policy changes determine the adjustment path of the economy and the final outcome. It reveals how a policy response that does not take into account weak institutions leads to negative outcomes. A model for a closed economy and an extension for an open economy that captures the impact of international capital flows are presented. The institutional setup under two alternate economic scenarios is considered. One in which the production sector is dominated by firms operating in ‘priority sectors’ and having preferential access to credit. Another in which these conditions do not apply to firms operating in the economy.; The empirical model examines how critical institutions are to financial liberalization outcomes, financial sector growth and the ability to withstand crises. Four indices of institutional quality (based on ICRG, BERI, WCR, and IQI) have been constructed and tested for their significance in financial sector development, and economic growth. The regression results indicate that all the four indices measuring institutions are significantly correlated to the financial sector development and economic growth. While financial liberalization helped the sample countries to achieve faster economic growth through financial deepening, in the absence of strong institutions it resulted in increased volatility. The results under logistic regression indicate that where institutions remained weak, the growth resulting from liberalization was unsustainable in the long run and increased the financial fragility of countries. Overall we found that countries benefited from financial liberalization, and long-term sustainability of reforms is correlated to developing strong institutions.