ABSTRACT
One of the principal concerns in financial policy in developing countries is this: how reliably certain are the putative effects of a financial reform programme? It is generally accepted that financial repression imposes possibly substantial costs on an economy, and that it is desirable to eliminate these (Fry 1997). However, there is considerable uncertainty about the appropriate speed and extent of reform. Asymmetric information and market failure are endemic in credit markets, even in the industrial countries, and there is a risk that liberalisation in developing countries will bring new market failures or exacerbate existing ones, so that many of the gains from reform are reversed or lost altogether (Gibson and Tsakalotos 1994, Stiglitz 1998, Caprio et al. 2000). In general, the risks associated with liberalisation appear to be more serious the less interest-elastic are financial flows in the reforming economy (Ogaki et al. 1996). In this chapter we adopt a novel approach to the analysis of financial reforms
using as exemplar selected aspects of the reform process in India in the late 1980s and early 1990s. Our approach involves two key methodological contributions which, we believe, enhance our analysis and understanding of financial reform. First, we use as framework a disaggregated empirically estimated flow of funds model. This enables us to provide a rigorous account of changes in financial flows and interest rates during a policy reform. In a system-wide flow of funds model, formed by combining the portfolio behaviour of individual sectors, interest rates and financial flows emerge endogenously as a result of the interactions between different sectors and their demands and supplies of assets and liabilities. The flow of funds approach also has the advantage of being relatively eclectic in that it can accommodate a wide range of special cases, and it is particularly useful in the context of a developing economy (Green et al. 2002 and Green and Murinde 2003). Industrial economies benefit from a vast range of deep and liquid markets whose prices provide much of the information upon which policy is based. In developing economies, where markets are more fragmented, and securities markets are often thin and illiquid, prices provide much less useful information. Therefore, information about quantities, such as the flow of funds, takes on a more important role.
