Financial liberalization in the Philippines : retrospect and prospect

Abstract

That the financial system plays a crucial role in the development process can no longer be disputed. When it is functioning effectively and efficiently, it promotes and enhances the growth process; when it is not, it becomes a drag on the entire economy. The rationale behind the various financial sector reforms that were implemented in the Philippines was precisely to improve the workings of the financial system. In particular, a move away from interventionist and repressionist policies towards freeing up the system from various restrictions was seen as growth promoting. This thesis examines the Philippines' financial liberalization experience from the early 1980s to the 1990s. Policies to reform the financial sector evolved gradually over time, with reforms building up on previous reforms. The process was far from smooth and was fraught with difficulties. Apart from the political and economic crisis, initial attempts to liberalize the financial system in the early 1980s failed because of the simultaneous implementation of inappropriate macroeconomic policies, particularly imprudent fiscal policy and inconsistent monetary policy. Other reasons for the failure were the incomplete nature of the reform itself and institutional weaknesses. Further reforms were then implemented in the late 1980s and 1990s particularly to strengthen financial institutions, including the Philippine central bank. Financial liberalization led to the rapid expansion and growth, especially of the Philippine banking system. However, overall, the expected efficiency gains were not fully realized. This was due to policy inconsistencies, both in the financial and real sectors. Competitive pressure was not enhanced by the liberalization of interest rates because there was no corresponding change in the rules on new bank entry and bank branching. The various distortions in credit allocation were also not corrected. Finally, the over valuation of the domestic currency induced the flow of scarce loanable funds to the nontradable sectors such as real estate. The thesis also assesses the macroeconomic and microeconomic effects of financial liberalization in the Philippines. On the macroeconomic level, the thesis focuses on the impact of the reforms on the conduct of monetary and exchange rate policies. The analysis shows how macroeconomic policies that were inconsistent with the financial sector reforms, as well as the reforms themselves, significantly complicated the conduct of monetary policy. In particular, the vector autoregression (VAR) results indicate that the efficacy of monetary aggregate targeting in the light of a liberalized domestic financial system and deregulated capital account has been diminished. Thus, the conduct of monetary policy needs to be more eclectic and flexible, but with a well defined objective. On the microeconomic level, the thesis examines the characteristics of, and institutional arrangements in, the financial sector that were inconsistent or interfered with financial liberalization, and how they continue to limit financial policy. In particular, when financial liberalization is undertaken in the presence of severe asymmetric information problems and an inefficient market structure, in the context of a highly unstable macroeconomy, it could lead to a financial crisis rather than financial deepening. This is what happened to the Philippines in the 1980s. While an inefficient market structure still exists in the 1990s, the relatively stronger macroeconomy and financial sector should help to avert a crisis similar to Thailand and Indonesia. However, there may be long term consequences if the problem persists, as shown in the cases of Japan and South Korea. Thus, even if an economy has been growing quite fast for an extended period of time, as long as scarce financial resources are not being channeled by the financial system to their most efficient uses, that rate of economic growth will not be sustained.