Financial liberalization in developing countries

In the McKinnon and Shaw analysis, financial liberalization is defined to mean the establishment of higher interest rates that equate the demand for, and the supply of, savings. It expresses the views that higher interest rates will lead to increased savings and financial intermediation as well as to improvements in the efficiency of using savings. Balassa summarizes available empirical evidence, indicating that higher real interest rates increase the extent of financial intermediation while increased financial intermediation raises the rate of economic growth in developing countries. Furthermore, evidence is provided on the effects of interest rates on investment efficiency and on economic growth. The paper notes, however, that excessively high interest rates will have unfavorable economic effects. Such a situation can be avoided if the liberalization of the banking system takes place under appropriate conditions. Domestic financial liberalization may eventually be followed by the liberalization of the capital account. But this would have to be preceded by trade liberalization to avoid unnecessary resource shifts. Finally, it is noted that there is a need in most developing countries for improvements in the functioning of the financial sector.