threat for welfare and peace, an exit from financial repression is often necessary when the costs outweigh the benefits.

# 1.4. Blueprint for exit from financial repression

Much debate surrounds the issue of the timing, sequencing, scope, and pace of financial liberalization, especially in relation to developing countries’ development strategies.<sup>14</sup> The McKinnon‐Shaw hypothesis assumes that as controls on the economy are lifted through liberalization, its association with higher real interest rates would stimulate savings, which encompasses an underlying assumption that savings is responsive to interest rates and more broadly that savings is a key determinant of growth. With the real interest rate adjusting to the equilibrium level, low‐yielding investment projects would be eliminated, enhancing the overall efficiency of investment projects. These savings rates would then finance a higher level of investment and thus, higher growth.<sup>15</sup> Economic liberalization would have the additional benefit of promoting transparency and accountability, thereby reducing adverse selection and moral hazard while alleviating liquidity problems in the market.<sup>16</sup> However, despite the prevailing theories, many have noted that, contrary to the experience of developed countries, developing countries that have undertaken the process of financial liberalization over the past 50 years have had mixed experiences.<sup>17</sup> Financial liberalization has not always led to higher growth, in part because of the weak link between real interest rates and savings, in turn due to the poor quality of institutions and inappropriate sequencing of liberalization and institutional reforms in many developing countries.<sup>18</sup> The exit from financial repression in developing countries requires the appropriate sequencing of institutional build‐up and reconstitution of market forces.<sup>19</sup> Because of the use of financial institutions as captive investors in public debt, many developing countries have not developed the legal environment and the dedicated national debt offices at the ministry of finance and central bank, staffed with skilled 14 This literature review draws on Miho, Antonela (2015). Do free markets imprison? The effects of economic liberalization and financial deregulation in developing countries during external economic booms and crises. ‐ <u>http://economics files.pomona.edu/GarySmith/Econ190/Econ190%202015/Antonella%20Miho.pdf</u> 15 McKinnon, Ronald I. (1973). Money and Capital in Economic Development, Washington, DC: Brookings Institute. Shaw, Edward S. (1973). Financial Deepening in Economic Development. New York: Oxford University Press. 16 Stulz, René M. (1999). Globalization of Capital Markets and the Cost of Capital. Journal of Applied Corporate Finance Vol. 12(3), pp. 8‐25. Mishkin, Frederic S. (2001). Financial Policies and the Prevention of Financial Crises in Emerging Market Countries. NBER working paper No. 8087.

17 Giovannini, Alberto, (1985)."Saving and the Rate of Interest in LDCs," Journal of Development Economics, Vol. 18, pp. 197‐217. Ostry, Jonathan D., and Carmen M. Reinhart, 1992."Private Saving and Terms of Trade Shocks: Evidence from Developing Countries," Staff Papers, International Monetary Fund, Vol. 39, pp. 495‐517. Reinhart, Carmen M. and Carlos A. Végh, 1995. "Intertemporal Consumption Substitution and Inflation Stabilization: An Empirical Investigation," University of Maryland Working Papers in International Economics No. 3. Bandiera, G. Caprio, P. Honohan, and Schiantarelli (2000). “Does Financial Reform Raise or Reduce Saving?, Review of Economics and Statistics, May, 82(2): 239‐263. ; Loayza N., K. Schmidt‐Hebbel, and L. Serven (2000). “What Drives Private Saving Across the World? Review of Economics and Statistics, May 2000, 82(2) :165‐181.

18 Graciela Laura Kaminsky and Sergio L. Schmukler, 2008. "Short‐Run Pain, Long‐Run Gain: Financial Liberalization and Stock Market Cycles," Review of Finance, Oxford University Press for European Finance Association, vol. 12(2), pages 253‐292.

19 McKinnon, Ronald I. (1993). The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy. Baltimore: The Johns Hopkins University Press.

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