strategies and deal with the associated fiscal and debt challenges.<sup>6</sup> However, given the mixed results of these policies (including the Latin American and African debt crises of the 1980s and 1990s and the economic collapse of the socialist economies in Central and Eastern Europe and the former Soviet Union in the early 1990s), and in light of the successful experience of Japan and some small tiger states that have experimented with economic and financial liberalization in the 1960s and 1970s, many developing countries began to liberalize their economic and financial systems in the 1990s and 2000s.

# 1.3. Cost and benefits of repressed financial systems

The main benefits of financial repression are to capture savings and keep nominal interest rates lower than would otherwise prevail. By having direct control over the financial system, the government (and the public sector at large) can capture private funds without going through legislative procedures and more cheaply than it could when it resorts to market financing. It could then directly allocate domestic savings to public uses or private firms or sectors that are considered strategic or to be prioritized, such as exporters or manufacturers. Below‐market interest rates have the effect, other things equal, to reduce the public sector’s interest expenses for a given stock of debt and contribute to deficit reduction. Indeed, teamed with a steady dose of inflation, financial repression cuts domestic debt burdens from two directions: via low nominal interest rates and reduced debt servicing costs; and via a tax on savers (negative real interest rates) to erode the debt‐to‐GDP ratio.<sup>7</sup> The evidence indicates that the revenue from financial repression can be quite substantial but varies significantly across countries.<sup>8</sup> Financial repression can be optimal when governments need to issue unusually large amounts of debt, such as during wartime.<sup>9</sup> An argument has also been made that financial repression policies may have positive effects whenever they are able to successfully address market failures. In a context of imperfect information, for instance, interest rate restrictions may be able to address moral hazard in the form of excessive risk taking by banks; thereby enhancing the stability of the banking system and increasing the willingness of depositors to hold their savings in the form of bank deposits.<sup>10</sup> When restrictions on market entry and exchange and capital controls are in place, financial repression has also the effect of protecting the domestic banking system from the contagion of international financial crises.

The main costs of financial repression are to gradually distort resource allocation, reduce economic efficiency, and inhibit financial deepening. Because excessive financial repression leads to inefficient

> 6 Giovannini, A. and M. de Melo (1993). Government Revenue from Financial Repression, The American Economic Review 83, 4, 953–963.

> 7 Reinhart, Carmen and Jacob Kirkegaard (2012). Financial repression: Then and now. VoxEU CEPR Policy Portal. <u>https://voxeu.org/article/financial‐repression‐then‐and‐now</u>

> 8 Giovannini, Alberto and Martha de Melo (1993). Government Revenue from Financial Repression. American Economic Review, Vol. 83, No. 4 (Sep 1993), pp. 953‐963. In this study of 24 developing countries in the 1980s, the authors found that revenue from financial repression reached up to 5 percent of GDP in Mexico and Zimbabwe and 20 percent or more of total government revenue (excluding the revenue from financial repression) in India, Mexico, Pakistan and Sri Lanka. The same orders of magnitude were found in Reinhart, Carmen M. and M. Belen Sbrancia (2011). The Liquidation of Government Debt. NBER Working Paper No. 16893.

9 Chari, V., Alessandro Dovis, and Patrick J. Kehoe (2018). On the Optimality of Financial Repression. Federal Reserve Bank of Minneapolis, Research Department Staff Report 1000.

10 Stiglitz, Joseph E. (1993). The Role of the State in Financial Markets, in proceedings of the World Bank Annual Conference on Development Economic, 19‐52, Washington DC.

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