Financial

System
Introduction
 The financial system is an
integral component of modern
economies. In most Asian countries,
commercial banks constitute the
primary component of the financial
system. However, informal financial
institutions also play an important
role. Furthermore, in the last decade
or so, other financial institutions,
including insurance companies and
pension funds, as well as stock and
bond markets, have gained greater
importance.
Banking and the Financial System
 The banking and financial
systems in the developing
economies in Asia evolved from
systems that were in place during
the colonial period. In South Asia,
Taiwan, Malaysia, Hong Kong and
Singapore, the British system was
adopted, while in East Asia, the
Japanese model was adopted in
Korea. In cases such as Thailand
and China, which were not
colonized to any significant extent,
the financial system were borrowed
from the industrial countries.
 By the early 1970s, the region as a
whole could be characterized by the
widespread presence of financial
repression. It is a situation, first
described fully by Shaw (1973) and
McKinnon(1973), where government
taxes and subsidies distort the domestic
capital market (compared with a free and
competitive system where private banks
are supervised by a central bank) by
imposing interest rate restrictions and
high reserve requirements. At the same
time there are compulsory credit
allocations to some sectors and the lack
of credit to others. As a result, loans
extended by banks were not thoroughly
analyzed in terms of risk or proper
viability. Competition among banks was
also limited, particularly as foreign banks
were not allowed to enter the market or
where their presence was highly
regulated.

Financial Repression
 “Repressed” financial systems were
characterized by low or negative real
interest rates and a low and sometimes
falling ratio of monetary assets to
GDP/GNP. In a repressed system, the
government usually plays a dominant
role in controlling the banking system by
imposing these kinds of controls, using
banks to serve as the instruments for
allocating credit to key selected sectors.
Often, specialized banks were created to
address the needs of particular sectors.
Rural banks were often created for this
purpose in the early stages of
development and were complemented by
banks focusing on key industries later in
the development process.

Financial Repression
 At the same time, credit to other
potential borrowers was lacking. As a
result, informal or “kerb” markets
developed outside the formal financial
system to mobilize and direct credit to
those sectors not effectively serviced by
the formal financial and banking system.
The overall impact of these
developments was a fragmented banking
system where the organized banking
system serviced only a small part of the
total capital market while informal
finance emerged to serve the needs of
other borrowers.

Financial Liberalization
 Designed to remove all the
restrictions that characterize financial
repression. These include the lowering of
reserve requirements, freeing up interest
rates, and allowing them to respond to
market forces. Managed credit
allocations to key sectors should be
reduced or eliminated, and loan officers
should be required to evaluate potential
borrowers on the merits of the project
and not to give loans indiscriminately
based on other economic criteria.
Competitive forces should be allowed to
operate in the banking system to improve
economic efficiency through the
relaxation of entry requirements, both
domestically and for international banks.
The Financial Crisis of 1997
 The Asian financial crisis of 1997 refers to a
macroeconomic shock experienced by several
Asian economies – including Thailand,
Philippines, Malaysia, South Korea and
Indonesia. Typically countries experienced rapid
devaluation and capital outflows as investor
confidence turned from over-exuberance to
contagious pessimism as the structural
imbalances in the economy became more
apparent.

The crisis of ’97-99 followed several years

of rapid economic growth, capital inflows and
build up of debt, which led to an unbalanced
economy. In the years preceding the crisis,
government borrowing rose, and firms
overstretched themselves in a ‘dash for growth.’
When market sentiment changed foreign
investors sought to reduce their stake in these
Asian economies causing destabilishing capital
outflows, which caused rapid devaluation and
further loss of confidence.
Long-term causes of the Asian
Financial Crisis
 Foreign debt-to-GDP ratios rose from
100% to 167% in the four large ASEAN
economies in 1993-96. Foreign companies were
attracting capital inflows from the developed
world. Investors in the West were seeking better
rates of return, and the “Asian economic
miracle’ seemed to offer better rates of return
than lower growth economies in the West.
 Current account deficits. Countries like
Thailand, Indonesia, South Korea had large
current account deficits; this meant they were
importing more goods and services than they
were exporting – it was a reflection of very high
rates of economic growth and consumption. The
current account deficits were financed by hot
money flows (on capital account). Hot money
flows were accumulated because of higher
interest rates in the East.
Long-term causes of the Asian
Financial Crisis
 Fixed or semi-fixed exchange rates.
This made currencies vulnerable to
speculation. Also, interest rates were
used to maintain the value of a currency.
Causing relatively high-interest rates in
S.E. Asia which caused hot money flows.
 Financial deregulation encouraged
more loans and helped to create asset
bubbles. But, the regulatory framework
and structure of banking and firms meant
loans were often made without sufficient
scrutiny of profitability and rates of
return.
Long-term causes of the Asian
Financial Crisis
 Moral Hazard. With a strong
political desire for rapid economic
growth, governments often gave implicit
guarantees to private sector projects. This
was magnified by the close relationships
between large firms, banks and the
government. This closeness encouraged
private firms to place less emphasis on
the costs of projects and an assumption
expansion plans would be supported by
the government
 Over-exuberance. The booming
economy and booming property markets
encouraged expansive borrowing by
firms. It also encouraged international
investors to move the capital to these
fast-growing economies. There was an
element of irrational exuberance – the
idea that Asian economies were
undergoing an economic miracle where
high returns were guaranteed.
Informal Finance
Informal finance is defined as
contracts or agreements conducted
without reference or recourse to the
legal system to exchange cash in the
present for promises of cash in the
future.
Informal Financial Sector