25 to a less repressed system enabled us to identify changes in the domestic financial market. Finally, the reliable and adequate data needed to perform econometric tests on the hypothese! suggested by the analytical framework was available.

# The Empirical Evidence

Empirical analysis of trade liberalization and financial market reform yielded a number of interesting results.

First, as described above, trade liberalization is facilitated when financial intermediation becomes more extensive. More institutional credit becomes available to finance the desired fxpansion of the tradable sector. In Sri Lanka, the M3/GDP ratio rose from 29% in the 1970-77 period to 34Z in the 1980-87 period. The Ml/GDP ratio declined after 1977, indicating a shift from cash to savings and time deposits in household asset portfolios. Econometric tests (using an OLS regression model) confirm a positive relationship between time and savings deposits and the interest rates paid on such deposits. Similarly, a negative relationship was found between interest rates and real cash holdings. For example, a one percent increase in savings and time deposits was associated with an 8% decline in real cash holdings and a 4.2Z increase in the real interest rates paid on the deposits. The regressions also indicated a wealth effect. A one percent increase in real GDP was associated with a 1.5% increase in savings and time deposits. As hypothesized, a nonrepressed financial system led to a higher rate of domestic asset accumulation. That helped the trade liberalization by increasing the availability of institutional credit.

Second, there was also ample evidence to show that private savings responded positively to the increased real interest rates. There was an impressive improvement in the ratio of private savings to private income, from 14.4Z in the 1970-76 period to 20.2Z in the 1977-84 period. This increase in private savings can be interpreted as the response to a change in permanent income and the real interest rate. Econometric estimates suggest an interest elasticity of 0.98% and an income elasticity of 1.22% for private savings. These results stand in contrast to the earlier work of others, which found no relationship between total domestic savings and interest rates. This is not surprising, since public sector savings are seldom correlated with interest rate changes. Besides, the large inflows of foreign capital to the public sector following the 1977 reforms implied negative public savings. Thus, to the extent that savings responded to interest rates, more noninflationary finance was available for investment.

Third, a relationship exists between the trade reform and the domestic financial market through the real exchans£e rate. To the extent that households increased their demancd for dnmesti' financial assets *ather than nontradables because of the increase in income from trade liberalization. appreciation of the real exchange rate was retarded. Thus, in the ahsence of attractive domestic financial asspts and reqtrictions on holding foreign assets, the exchange rate would appreciat9 more. Evidence from the Consumer Finance and Socioee onomif SurveV in Sti Lanka indicates that household portfolios did shitt towaLd h,ank depits, the most attractive financial asset at the time, the shari **otf** Ianl: leposits in household asset portfolios rising from a historical ratio of **1s17** to 3.° in 1981-82.