Academic journal article Contemporary Economic Policy

Are Financial Sector Policies Effective in Deepening the Malaysian Financial System?

Academic journal article Contemporary Economic Policy

Are Financial Sector Policies Effective in Deepening the Malaysian Financial System?

Article excerpt

I. INTRODUCTION

Since the emergence of the new theories of endogenous economic growth in the past two decades, financial development has been the subject of considerable research interest (e.g., Bencivenga and Smith, 1991, 1993; King and Levine, 1993b; Pagano, 1993). Motivated by the seminal work of King and Levine (1993a), a number of empirical papers have tried to examine the role of financial development in the process of economic development (see, e.g., Beck and Levine, 2004; Levine, 1998; Levine and Zervos, 1998, among others). With few exceptions, these studies have consistently demonstrated that financial development has a beneficial impact on economic growth. Another group of authors, typified by the work of Demetriades and Hussein (1996) and Arestis and Demetriades (1997), have attempted to examine the causality between financial development and economic growth.

However, their results do not yield conclusive findings on the direction of causality.

Although the positive association between financial development and economic growth is already a stylized fact as verified by many empirical studies, an important and yet somewhat underresearched issue is what determines financial development? Motivated by the earlier work of Demetriades and Luintel (1997, 2001), who have found that financial liberalization, real interest rates, and economic development are important determinants of financial development for India, there is a growing literature that attempts to examine the determinants of financial development using a cross-country framework. For instance, Chinn and Ito (2006) demonstrate that capital account openness and institutional environment have significant effects on equity market development for a panel of 108 countries. Similarly, Baltagi, Demetriades, and Law (2007) show that financial development is shaped by trade openness and economic institutions.

The present study addresses the question of how government intervention in the financial systems (including statutory reserve requirements, directed credit programs, capital liquidity requirements, and interest rate controls) affects development of the financial sector. We build upon the work of the authors cited above and, in particular, generalize the work of Ang and McKibbin (2007) by extending the analysis to explore how each type of financial sector policies affects development of the financial system in Malaysia. Our work is similar in some respects to the above studies, but the focus of this paper is on financial sector policies. Understanding how each type of financial sector policies affects financial development has important policy implications. In particular, the role of central bank in stabilizing the financial systems has recently been of considerable interest to academic researchers and policy makers in the aftermath of the recent episodes of financial turbulence in several Asian economies (Caprio, Honohan, and Vittas, 2002; Honohan and Laeven, 2005). While this paper does not directly address the implications of financial crisis, the analysis does provide policy makers with some direction in formulating financial sector policies.

On the theoretical front, the financial liberalization thesis of McKinnon (1973) and Shaw (1973) proposes that government restrictions on the operation of the financial systems, such as interest rate ceilings, directed credit programs, and reserve and liquidity requirements, may inversely affect the quality and quantity of investment and thus hinder financial development. Therefore, they called for the removal of these financial repressionist policies in order to foster financial development. However, there are contrary arguments as well. For instance, Kim and Santomero (1988), Gennotte and Pyle (1991), Stiglitz (1994), and Hellmann, Murdock, and Stiglitz (1996) put forward that financial liberalization may also retard financial development. Hence, the above discussions seem to suggest that how each type of financial sector policies impacts on financial development is theoretically ambiguous, and therefore, it is ultimately an empirical issue. …

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