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ABSTRACT

The Mckinnon-Shaw Hypothesis: Thirty Years on:

A Review of Recent Developments in Financial Liberalization Theory

by

Dr Firdu Gemech and Professor John Struthers
University of Paisley The Mckinnon-Shaw Hypothesis, in its’ various forms, is now thirty years old. Over that
period literally hundreds of empirical studies have been completed examining the
hypothesis in many different contexts. Initially, the hypothesis focused on the effects of
so-called “Financial Repression” (low or negative real interest rates) on savings and
investment levels in developing countries. In more recent times, researchers have
extended the debate to consider other effects of financial repression on: economic
growth; financial crises and poverty (for example the effects of overvalued exchange
rates). Currently, significant research is being conducted on the potentially destabilizing
effects of financial liberalization (the converse of financial repression) on global
financial markets.

This paper attempts to survey the literature on the Mckinnon-Shaw Hypothesis and tries
to draw out some of the recurrent themes of this literature. The paper also highlights the
continuing relevance of the original hypothesis to on-going debates concerned with the
effects of financial liberalization.
credit rationing and low investment. In later years, the literature can be classified into:
First Generation approaches (represented by the work of Krugman (1979); Second
Generation approaches (Obstfeld, 1996) ; and Third Generation approaches again
represented by the work of Krugman (1998;1999) In this evolving literature, it is
possible to detect a clear lineage stemming from the original Mckinnon-Shaw
contribution, albeit one which represents an increasingly sophisticated theoretical and
empirical development of the original hypothesis. This paper will trace the development
of this body of thought as well as highlight possible further theoretical developments. It
will also highlight some of the future directions that this research might take and the
potential policy implications therein. I. Theoretical Underpinnings

1. Liberalization as a catalyst for higher saving, (McKinnon-Shaw)

McKinnon (1973) and Shaw (1973), analysed the benefits of (if not eliminating)
Financial Repression, at least reducing its impact on the domestic financial system within
developing countries. Their analyses- (sometimes referred to as the Complementarity
Hypothesis)- concluded that alleviating financial restrictions in such countries (mainly by
allowing market forces to determine real interest rates) can exert a positive effect on
growth rates as interest rates rise toward their competitive market equilibrium. According
to this tradition, artificial ceilings on interest rates reduce savings, capital accumulation,
and discourage the efficient allocation of resources. Additionally, McKinnon pointed out
that Financial Repression can lead to dualism in which firms that have access to
subsidized funding will tend to choose relatively capital-intensive technologies; whereas
those not favored by policy will only be able to implement high-yield projects with short
maturity.

Another effect of Financial Repression, to which the original hypothesis made only scant

As a further development of the Financial Repression literature Campbell and Mankiw
(1990) concluded that it is reasonable to assume that not all households have access to
credit markets, and hence, some households have no ability to smooth consumption over
time. Thus, for such liquidity-constrained households, consumption decisions are entirely
determined by current income. On theoretical grounds, it has been shown that a
relaxation of liquidity constraints will be associated with a consumption boom and a
decline in aggregate saving. More specifically, Campbell and Mankiw postulated that
there are two types of households in the economy: One type of household, λ , is liquidity
constrained and their consumption is entirely determined by the evolution of current
income, while the remaining type (1 − λ) , has free access to capital markets and can
smooth their consumption intertemporarily. Such a theoretical development led these
authors to challenge the implicit Mckinnon-Shaw assumptions that were based on a
homogenous household set in which it was assumed that all relevant households had free
access to capital markets within the domestic economy.

3. The role of subsistence consumption (Ostry and Reinhart)

This development was based on the Stone-Geary utility function where the intertemporal
elasticity of substitution (which determines the sensitivity of consumption to real interest
rates) is determined by permanent income and subsistence consumption. According to
this view, increases in real interest rates will affect consumption/saving decisions in
varying degrees. In countries where the representative household is close to subsistence
consumption, consumption(and saving) will not be sensitive to changes in the real rate of
interest. Only in wealthier countries would consumption decline (and saving increase)

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following an increase in real interest rates. Hence, in this analysis the magnitude of the
increase in saving following the higher real interest rates associated with financial
liberalization will depend on the level of income (which was used as a proxy for how
close are actual consumption levels to subsistence levels).

satisfied - then the intertemporal elasticity of substitution and the interest-rate sensitivity
of private saving will be close to zero for countries at or near subsistence consumption
levels, but will rise thereafter.

b) Liberalization and saving

1. Bandiera, Caprio, Honohan, and Schiantarelli (2000), construct an index of financial
liberalization on the basis of eight different components: interest rates; reserve
requirements; directed credit; bank ownership; prudential regulation; securities markets
deregulation; and capital account liberalization. Their data spans from 1970-94 for Chile,
Ghana, Indonesia, Korea, Malaysia, Mexico, Turkey and Zimbabwe. Among the key
findings of the estimation of their benchmark model is that, there is no evidence of any

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positive effect of the real interest rate on saving. Indeed in most cases the relationship is
negative, and significantly so in the cases of Ghana and Indonesia. Furthermore, the
effects of the financial liberalization index on saving are mixed: negative and significant
in Korea and Mexico, positive and significant in Turkey and Ghana. The long run impact
of liberalization is, however, sizeable. Corresponding to the realized change in the index,
the estimated model indicates a permanent decline in the saving rate of 12% and 6% in
Korea and Mexico, and a rise of 13% and 6% in Turkey and Ghana.

Based on an estimate of augmented Euler equations (a la Campbell-Mankiw) , Bandiera
et al present some evidence of the presence of liquidity constraints. It was not possible,
however, to confirm whether financial liberalization removes these constraints. The Euler
equation results may suggest, at best, that financial liberalization has had little impact on
the amount of credit available to consumers through the formal financial sector. The
general conclusion that emerges from this study is that there is no systematic and reliable
real interest rate effect on saving; whilst the effects of liberalization have a mixed record.



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real house prices, and positively by the after tax nominal interest rate. Taken together,
their findings imply that financial conditions, and the liberalization of the mid-1980's in
particular, contributed to the decline in the household saving ratio in these countries.

5. Loayza, Schmidt-Hebbel, and Serven’s (2000), produced results, which suggest that
the direct effects of financial liberalization are detrimental to private saving rates. The
real interest rate has a negative impact on the private saving rate. Its income effect
probably outweighs the sum of its substitution and human wealth effects. A 1% increase
in the real interest rate reduces the private saving rate by 0.25% in the short run.

The indicator of financial depth (M2/GNP) has a small and statistically insignificant
impact on the private saving rate. The flow of private domestic credit relative to income
has a negative and significant coefficient; relaxing credit constraints reduces the private
saving rate. When the flow of private credit rises by 1%, the private saving rate declines
by 0.32% on impact. The authors suggest that though they do not find direct positive
effects of financial liberalization on the saving rate, if financial reform has a positive
impact on growth, it has a potentially important indirect positive effect on the saving rate.

6. Reinhart and Tokatlidis (2001), in a study of 50 countries (14 developed and 36
developing) report that financial liberalization appears to deliver: higher real interest rates
(reflecting the allocation of capital toward more productive, higher return projects.);
lower investment, but not lower growth (possibly owing to a shift to more productive
uses of financial resources); a higher level of foreign direct investment; and high gross
capital flows. Liberalization appears to deliver financial deepening, as measured by the
credit and monetary aggregates--but, again, low income countries do not appear to show
clear signs of such a benefit. As regards saving, the picture is very mixed. In some
regions, saving increased following financial sector reforms; but in the majority of cases
saving declined following the reforms. Indeed, it would appear that what financial

Financial Institutions’ as the cause of the build up of unhedged short-term borrowing
denominated in foreign currency. A sudden change in market sentiment causes panic and
investor responses which bring about a reversal in these capital flows. This transforms an
illiquid asset into insolvency and ultimately a currency peg collapse (See Appendix for
relevant equations)

In a key empirical study Kaminsky and Schmukler (2001) examined the short-run and
long-run effects of financial liberalization on capital markets by constructing a
comprehensive chronology of financial liberalization in 28 developed and emerging
economies since 1973. They used three measures of financial liberalization: (a) capital
account liberalization (capital mobility); (b) domestic financial system liberalization
(regulations on deposit interest rates, lending interest rates, allocation of credit, and
foreign currency deposits) and, (c) stock markets liberalization (evolution of regulations
on the acquisition of shares in the domestic stock market by foreigners, repatriation of
capital, and repatriation of interest and dividends etc). The authors arrived at the
following broad conclusions: 1. While liberalization has been an uninterrupted process in most developed
markets, it has been characterized by reversals in emerging markets, in which
capital controls and restrictions are at times reintroduced. They also found that the
pattern of liberalization varies across regions, with developed countries
liberalizing first their stock markets and developing economies opening first their
domestic financial sector.

2. Although liberalization leads to excessive financial booms and busts in the short-
run, these booms and busts have not intensified in the long run. In fact, despite the
claim that financial integration leads to volatile capital markets around the world,
stock market cycles become less pronounced after liberalization. The short-run
effects of liberalization vary across developed and emerging markets. The


• Spending cuts (fiscal retrenchment) affect the volume of publicly provided
crucial social services and limits the access of the poor to these services at a
time when their incomes are declining.

• Changes in asset prices (wealth effects) following changes in interest rates and
real estate prices affect the wealth of the better off. IV. Arguments for and against financial liberalisation policies

(a) For

In what appears to be a parallel world, many authors still praise the advantages of
liberalization. It is claimed that financial liberalization helps to improve the functioning
of financial systems, increasing the availability of funds and allowing cross-country risk
diversification.

• Obstfeld (1998) argues that international capital markets can channel world
savings to their most productive uses irrespective of location.

• Stulz (1999) and Mishkin (2001) claim that financial liberalization promotes
transparency and accountability, reducing adverse selection and moral hazard
while alleviating liquidity problems in financial markets. These authors argue that

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international capital markets help to discipline policy makers, who might be
tempted to exploit an otherwise captive domestic capital market.
• Focusing on the development of the domestic financial sector, capital account
liberalization that allows firms to list abroad has been identified as a factor
leading to market fragmentation, and can tend to reduce liquidity in the domestic
market thereby inhibiting its development.

• Finally, liberalization has also been linked to macroeconomic instability. The
financial reforms carried out in several Latin American countries during the
1970s, aimed at ending financial repression, often led to financial crises
characterized by widespread bankruptcies, massive government interventions,
nationalization of private institutions and low domestic saving (Diaz-Alejandro
(1985). Demirguc-Kunt and Detriagiache (1998), however have shown that the
likelihood of a crisis following liberalization decreases with the level of

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institutional development in the country. In this sense, the arguments that Stiglitz
(1994) makes in favor of government intervention in financial markets in the
form of prudential regulation and supervision are convincing. The main argument
is that the government is, de facto, the insurer of the financial systems, and hence
a financial collapse can have significant fiscal repercussions.

V. Measurement problems

(a) Proxies for repression (and liberalization)

• Several empirical studies have tried to address the extent to which financial
liberalization affects growth. Researchers have followed two distinct empirical
approaches. One approach is to proxy financial liberalization with outcome
variables; the other approach focuses on explicit policy measures. Regarding
outcome variables, several measures have been suggested to proxy financial
repression. Early empirical literature focused on the value of real interest rates as