metadata: authors: 0: author: Athukorala, Premachandra
1: author: Rajapatirana, Sarath
count: Sri Lanka
docna: 0: docna: The domestic financial market and the trade
            liberalization outcome : the evidence from Sri Lanka
docty: Policy Research Working Paper
subtopic: Banks & Banking Reform,Trade Policy,International Trade and Trade Rules,Rules of Origin,Financial Sector Policy,Trade and Multilateral Issues
teratopic: Finance and Financial Sector Development
abstracts: cdata!: The authors developed a framework for
            analyzing the relationship between domestic financial
            markets and the effects of trade liberalization and applied
            it to Sri Lanka's experience between 1977 and 1987.
            They found that the domestic financial market significantly
            affects the outcome of trade liberalization.  Because Sri
            Lanka deregulated its interest rates when it undertook the
            trade liberalization, this allowed those earning more from
            trade liberalization to hold financial assets rather than
            nontradables.  The availability of savings and time deposits
            at attractive interest rates prevented the premature
            appreciation of the exchange rate, thus helping to maintain
            the competitiveness stimulated by trade liberalization.  By
            reforming interest rates, removing credit ceilings, and
            increasing competition among banks, Sri Lanka helped
            increase private sector savings - which could be reallocated
            to the tradable sector.  Unlike earlier studies on financial
            reform in Sri Lanka, this one finds that financial reforms
            have increased private savings in financial institutions,
            raised economywide financial intermediation ratios, and
            expanded credit to the private sector.  More important, the
            authors find a statistically significant relationship
            between the financial intermediation ratio and the real
            exchange rate.
geo_reg_key: 517198,517212,517191
repnme: repnme: The domestic financial market and the trade
            liberalization outcome : the evidence from Sri Lanka
display_title: The domestic financial market and
            the trade liberalization outcome : the evidence from Sri Lanka
listing_relative_url: /research/1991/02/700068/domestic-financial-market-trade-liberalization-outcome-evidence-sri-lanka
topicv3: Commercial Banking m1326069 1236,Trade m1326924 698,Trade Policy and Integration m1327407 775,Trade Policy m1327640 776,Financial Sector Development m1327681 1920
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Policy, Research & Ect Affairs
no_of_pages: 60
model_extractions: **Poy, R_Enwkmxftml Afa**

**Trade, Finance, and Industry**

WPS 590 This paper-aproductof theTrade, Finance, and Industry Division,Teclnical Department, Latin America and the Caribbean Regional **Office -** was undertaken as part of **the** World Bank's comparative study, Macroeconomic Policies: **Crisis** and Growth in the Long Run. Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Margaret Kienzle, room 14-058, extension 30733 (55 pages).

Athukorala and Rajapatirana developed a framework for analyzing the relationship between domestic financial markets and the effects of trade liberalization and applied it to Sri Lanka's experience between 1977 and 1987. They found that the domestic financial market siirniricantly affects the outcome of trade liberalization.

Because Sri Lanka deregulated its interest rates when it undertook the trade liberalization, this allowed those eaming more from trade liberalization to hold financial assets rather than nontradables. The availability of savings and time deposits at attractive interest rates prevented the premature appreciation of the exchange rate, thus helping to maintain the competitiveness stimulated by trade liberalization. By reforming interest rates, removing credit ceilings, and increasing competition among banks, Sri Lanka helped increase private sector savings - which could be reallocated to the tradable sector.

have increased private savings in financial institutions, raised economywide financial intermediation ratios, and expanded credit to the private sector.

More important, Athukorala and Rajapatirana find a statistically significant relationship between the financial intermediation ratio and the real exchange rate.

Credit to the private sector had increased after reform of the financial sector, but its reallocation was inhibited by large fiscal deficits, inconsistent monetary policies, and increased intervention in the financial market. Through their negative effect on the real exchange rate, these interventions offset some of the gains in competitiveness achieved through trade liberalization.

Athukorala and Rajapatirana find no evidence of financial crowding out in Sri Lanka.

Unlike earlier studies on financial reform in Sri Lanka, this one finds that financial reforms The PRE Working Paper Series disseminates the findings of work under way in the Bank's Policy, Rcsearch, and Extemal AffairsComplex. An objective of theseries is to getthese findings out quickly, even if presentations arc less than fully polished. Thc findings, nterpretations, and conclusions in these papers do not necessarily represent official Bank policy.

Produced by PRE Editorial Services
# Table of Contents

|1.0 Introduction**..................................................... 1 **|
|---|
|2.0 Central Relationships**............................................ 2**|
|2.1 Demand Side Complementarity ....................................... 3|
|2.2 Supply Side Complementarity ....................................... 4|
|2.3 Some Qualifications**............................................... 5**|
|3.0 The Sri Lankan Setting**............................................ 7**|
|3.1 Key Elements of the 1977 Policy Reform ............................<br>8|
|4.0 Empirical Analysis ............................................... 12|
|4.1 Financial Deepening and Savings Mobilization ..................... 12|
|4.2 Financial Liberalization and the Real Exchange Rate .............. 14|
|4.3 Volume of Credit and Private Investment .......................... 16|
|4.4 Efficiency of Credit Allocation .................................. 19|
|4.5 Financial Liberalization and the Informal Credit Market .......... 21|
|5.0 Summary and Conclusions .......................................... 23|
|References .......................................................<br>27|
|Data Appendix ....................................................<br>33|

*The research done for this paper was undertakeni as part of the Wotld Banl. comparative study, "Macroeconomic Poli(:i-S. CLisis and Growth in tlw Long Run," RPO 673-99. The authors would lilk'tthank vittorio Corb' and W. M1. Tilakaratna for their very helptui. rmm-nts (') a draft proposal for thiz research. We would also like to thank LPena l;hatkh-te for his comments **(oi** an earlier vprsiion **of** the pap)eL and Phillip Sawicki **fot** -litorial ascictan **p.**
1

# 1. Introduction

A sizable body of literature on the relationship between trade and development has appeared over the past two decades and has demonstrated that establishing a liberal trade regime is superior to a restrictive trade regime in achieving development objectives. This has led to a second wave of literature on trade liberalization--that is, on the issues involved in a shift away from a controlled (and hence, distorted) trade regime toward a more liberal one.

One such issue is the complementarity between trade reform and the operations of domestic financial markets. "Financial repression," meaning policy distortions that interfere with efficient domestic financial markets, is just as common in developing countries as policy distortions of the foreign traie regime. For many of these countries, "the liberalization of the foreign trade and financial sectors can be considered as two aspects of the same problem" (McKinnon 1981:366). An unawareness of this complementarity may be one reason why many countries have opted for trade liberalization while continuing to intervene in the operations of their domestic financial markets.

The present study has two objectives. First, it presents a framework for analyzing the impact of the domestic financial environment on trade reform. Second, using this analytical framework, it examines the role of the domestic financial market in determining the fate of trade policy reforms initiated in Sri Lanka in 1977. Although generalizing from a single case has its pitfalls, the insight gained from the study may be useful to policymakers in other countries in identifying critical issues that may crop up in the process of designing and implementing similar policy reforms.

Sri Lanka was chosen to explore the hypothesized relationships because of both the nature of the reforms carried out there and the controversy surrounding the extent to which financial market reform contribute to the sustainability of trade reform. Some authors argue that the half-hearted nature of financial reform in Sri Lanka, combined with macroeconomic instability, was a major factor in reversing the 1977 policy of trade liberalization. (Lal and Rajapatirana, 1989; Hiemenz and Langhammer, 1989). Other authors (e.g., Jayawardena et al., 1987; Roe, 1982) have pointed to the Sri Lankan experience as an illustration of the harmful long-run consequences of setting interest rates "too high." In light of what happened during the first two post-reform years, for instance. Roe (1982, p. 218) argued that the high interest rate provides a useful antiinflationary check in the short run and helps to moderate the speculative influences which could otherwise have been stimulated by Sri Lanka's trade liberalization. However, it is not a policy that should be looked to for significant long-term benefits. There is little evidence that the high interest rates are contributing to an improved allocation of capital funds.
2 Coats and Khatkhate (1984) and Khatkhate (1988) consider Roe's analysis to be a 'quite convincing" demonstration that freeing interest rates without regard for Lhe real rate of return on investment may jeopardize the complementary relationship between financial asset accumulation and capital formation.

This study confines itself to the relationship between the domestic financial market and trade reform. In other words, it does not deal with the relationship between the capital account in the balance of payments and the trade liberalization. This latter iss-te has been extensively studied in recent years, and a consensus seems to have emerged that liberalization of the current account in the balance of payn,ents should precede liberalization of the capital account in mos# circumstances (e.g., Corbo, 1987; Edwards and Edwards, 1987; Frenkel, 1982; McKinnon, 1982).

Following established practice, the term 'trade liberalization" as used here means "the process of removing, or reducing, the implicit premiums associated with quantitative restrictions (including rationing in the case of price controls) that prevent individuals from carrying out the transactions they wish to undertake at prevailing (world market) prices" (Krueger, 1985; see also Michaely et al., forthcoming; Choksi and Papageorgiou 1985). The term "financial liberalization" refers to any action to remove or reduce "financial repression" or "financial restriction." Financial repression occurs when the government orders interest rates to be set at rates well below those needed to balance the supply of financial savings with investment demand. Financial restriction occurs when explicit or implicit taxes (e.g., high reserve requirements, compulsory purchases of government securities, deposit taxes, prohibitions on lending to certain types of businesses, forced lending to bad risks) force banks to maintain a wide wedge between lending and borrowing, even if they are allowed to charge market rates (McKinnon, 1973; Shaw, 1973; Fry, 1988).

The rest of this paper is structured in the following manner. Section 2 surveys existing theory on how domestic financial market conditions affect the outcome of trade liberalization and delineates testable hypotheses. Section 3 outlines economic performance and financial development in the pre-reform Sri Lankan economy and describes the key elements of the 1977 trade policy reform. Section 4 attempts to sort out the ways in which financial market conditions affected Sri Lanka's economic adjustment following the trade liberalization. The implications of various policy initiatives in the financial arena as well as distortions which were left untouched in the process are analyzed in light of the earlier theoretical postulates. The final section gives a summary and the conclusions of the study.

# 2. Central Relationships

The object of trade liberalization is to realize gains that can be made from a better allocation of domestic resources. In particular, the restructuring of incentives under trade liberalization is done in the belief that total factor productivity will be improved by eliminating discrimination against exports and efficient import substituting activities, reducing the variance in production incentives across
3 industries, and encouraging a better allocation of resources to tradables. In coordination with trade liberalization, reform of domestic financial markets can play a crucial role on both the demand and supply sides. The demand side complementarity of the financial market involves appropriate adjustment of the real exchange rate (the relative price of traded to nontraded goods) following a trade liberalization. On the supply side,<sup>the</sup> domestic finance market influences factor mobility through its impact on both the volume and allocation of credit.

# 2.1 Demand Side Complementarity

The relative price adjustments which occur in an economy following trade liberalization can be expected to bring about a dep-:eciation in the real exchange rate, thus encouraging a shift of resources to the production of tradables. Sustaining (and improving upon) this greater price competitiveness is necessary if the gains from liberalizat.on are to be permanent.

Liberalization, however, usually will have favorable output and employment effects which may cause the real exchange rate to appreciate, thus counteracting the main goal of liberalization. That is, favorable expectations about income growth may be translated into greater perceived wealth, and greater perceived wealth may in turn be reflected in increased consumption if households change their savings levels with a view to achieving desired wealth targets in Metzlerian fashion. The level of investment may also increase, since liberalization generally raises the real return on investment. In the typical situation, this increase in aggregate demand will cause a deterioratiorn of the current account and an appreciation in the real exchange rate.<sup>1</sup> A rise in domestic int.rest rates towa.d market clearing levels, when it is one part of a financial reform package, may be an effective means of preventing premature appreciation of the exchange rate (McKinnon, 1973; Kapur, 1986).2 An increase in interest rates raises the demand for interest-bearing bank deposits and reduces domestic nontradable prices for a given rate of money expansion ano inherited set of inflationary expectations. A rise in domestic interest rates has the added advantage that it will produce an immediate increase in the volume of bank credit and thus may facilitate supply side adjustments. The use of contractionary monetaty policy as an alternative strategy for preventing a premature appreciation of the exchange rate may produce contractionary supply side

1. Under the usual assumption that tradables and nontradables are both normal goods, a rise in aggregate demand raises the demand for both types of goods. Since the economy is a pricetaker in the world market. the increase in demand for tradables is simplv reflected as a trade deficit without generating any price rise. By contrast. increased demand for nontradables push ul) their prices as the supply is not perfectly elastic.

2. Here we of course assume that cortrcls or the capital account are not relaxed.
4

-ffects, given that business firms depend heavily on bank credit for working capital.

Interest rate reform may also have a favorable impact on the real exchange rate through its impact on the composition of asset portfolios. In most developing countries, the typical saver's (investor's) portfolio is composed mainly of direct financial claims (cash and bank deposits) and physical assets (mostly real estate and related nontradables, and consumer durables). The market for indirect financial claims (such as bonds, common stocks, mortgages, commercial bills) is insignificant in most small country economies. Thus, if the financial regime remains repressed, the impact of an increase in income generated by trade liberalization will lead to stronger demand for physical assets, part4cularly nontradables. Real estate is a typ.lcal nontradable asset. Since property is in fixed supply, total holdings of financial assets and property are not altered by purchases of nontradables. The enhanced demand for physical assets will only stop when the price of property rises high enough to deter further purchases (Bevan et al., 1987). The outcome of this proc ss will be an appreciation in the real exchange rate which reduce the incentive to increase production of tradables.

# 2.2 Supply Side Complementarity

The typical pre-liberalization economy is one in which a variety of domestic markets, as well as the foreign trade regime, are subject to controls. As well as incurring significant econ'mic costs individually, these controls interact with one another in a synergistic fashion to magnify their total cost to the economy (Krueger, 1984). In such a context, the manner in which the economy reacts to trade liberalization depends on what happens in related markets. Government control of these markets may severely constrain factor mobility, both by limiting the volume of credit and preventing its efficient allocation, thus reducing the intended benefits of trade liberalization.

A well-known feature of a repressed financial regime is the maintenance of real incerest rates which are much less than the sum of the real rate of return on capital and the real resource costs of financial intermediation. Consequently, financial deepening is reduced, leading to a shrinking in the volume (f institutional credit. This problem may be compounded if the government siphons away an increased proportion of institutional credit to finance its own investments. If that happens, the quality of the nation's investment portfolio and the capacity of the economy to generate surpluses may be compromised. The value of financial liberalization is that it augments the availability of investable funds, particularly for the private sector, and thereby facilitates investment in the tradable sectors foll.,wing trade liberalization.<sup>3</sup> In a reoresqed financial regime. and owing to the resulting excess demand for institutional credit. credit is usuallv rationEd on the basis of criteria unrelated to economic feasiibilitv. r,reJit rationing usually means making room in credit queues for projects that would automatically be disqualified if an equilibrium 3. It is generally the case that tradable sectors in most developing (ountries are dominated by the private sector.
5 interest rate prevaileci. The invariable outcome is the allocation of some of the available credit f)r suboptimal projects while a larger number of high-return projects are denied credit.

There is another relationship between trade liberalization and the financial, markets that should be noted. One of the purposes of trade liberalization is to raise the return on investments in the tradable sector. However, the sectors or firms to which the government channels credit are not necessarily associated with trade strategy priorities. Moreover, the cost of borrowing in a financially repressed economy can differ from sector to sector and may do so in a way that reduces the efficiency of resource allocation. Consequently, if the financial market is repressed, the anticipated reallocation of resources that should follow trade liberalization may not take place or may take place in a less effective way.

There are two ways in which a controlled financial reg.me can thwart the employment and income distribution effects of trade liP eralization. Credit rationing at artificially low interest rates, together with real exchange rate overvaluation and the preferential treatment accorded to capital goods imports in a controlled trade regime, encourages capitalintensive activities at the expense of labor-intensive activities (Krueger 1983). Furthermore, credit rationing may squeeze out small borrowers who cannot pay the high costs of obtaining information, who lack adequate collateral, or who are not likely to achieve economies scale. Small borrowers may also be denied credit because of the natural inclination of commercial private banks to favor only the largest and safest borrowers. (Gonzalez-Vega, 1984 and 1985). Reducing or eliminating credit rationing can therefore be expected to improve employment prospects and income distribution, since labor-intensive activity wiil benefit and a larger number of borrowers will have access to formal cr

# 2.3 Some Qualifications

The hypotheses above focus only on the operations of che organized (formal) money market (OMM). In most developing countries, however, there is also an active but unorganized money market (UMM) often referred to as the "curb market" or "informal market." The volume of the lending transacted on this market may be at least as great as, and perhaps many times greater than, that of the OMM.4 Because of this, it has been argued that "financial liberalization is an exceedinglv chancy proposition" in terms of whether it will produce financ:al deepening (Buffie. 1984:318, see also van Wijnbergen, 1982 and 1983: Buf'ie. 1984: Taylor. 1983: andl Edwards, 1988). Claims in the informal market may be an important alternative to holding transaction balances '-ashi and time deposits with commercial banks. These claims are me-t l; in ehp form of dire-t borrnwinp by households and thus can be termed "1Q0 percent intermediation.' By contrast. reserve requirements constituta a leakage in the financial intermediation done through fommercial banks. ecB(-ause of offi-ial roservP 4. Ghate (1988) provides a comprehensive suiv-., f the literature on thiphenomenon.
6 requirements, bank lending based on household deposits implies a "(l-a) 100 percent intermediation" where "a" is the reserve deposit ratio.) Given this difference, so the argument goes, financial liberalization **may** reduce the overall degree of financial intermediation of the economy, provided bank deposits are better substitutes for UMM claims than for cash. Van Wijnbergen (1982) and Edwards (1988) have provided empirical support for this hypothesis (now popularly known as the "financial crowding-out hypothesis"), using data from South Korea (henceforth, Korea).

The analytical value of this hypothesis for developing countries **as a** whole is yet to be established, however. The evidence of other authors (Little et al., 1987; Ghate, 1988; Fernando, 1988), in fact, suggests that any generalizations based on the Korean experience may be misleading. In Korea, "the UMM is largely an urban phenomenon" (van Wijnbergen 1982:124) and is "intertwined closely with the banking system, as funds raised by dealers in that market often pass through the banking system" (Kim 1986:151). It is therefore not unrealistic to treat UMM claims and commercial bank deposits as close substitutes. In other developing countries (except perhaps in Taiwan (Koshaka, 1984)), there is no such thing as "the informal credit market." Rather, there are many informal credit markets (distinguished by such factors as geographic location, type of lerder, and industry or service being financed) which operate independently of each other and with no links to the banking system. A significant portion of iaiformal lending takes the form of noninterestbearing loans made on the basis of kinship, friendship, or patron/client relationships. And, given the high risk involved in the informal markets, most interest-bearing loans are made at rates that may be 5 to 10 times higher than market rates. Moreover, surveys suggest that resorting to the informal markets for investment and working capital is not typical of entrepreneurs in most countries, however common it may be in Korea (Little et al., 1987). It therefore seems reasonable to conclude that financial market reform is not likely to trigger a significant shift of funds from the informal to the formal market.

Another objection to the crowding out argument is that it assumes that a choicc is made by borrowers on the basis of monetary assets (cash, bank deposits, informal market claims) alone. Thus, the possibility of substitution of physical assets for financial assets, strongly emphasized by certain investigators (McKinnon, 1973: Galbis, 1977) is ignored. Given the nature of household asset holding behavior in develoning countries, this substitution process may be of crucial importance in determining the outcome of financial market reform.

An increase in the volume of OMM transactions, even if it involves considerable crowding out of UTMI activities. may be desirable on efficiency grounds. That is, a given quantitv nf savings mobilized via the formal financial sector may be more productive than the same quantity of savings mobilized through informal channels. Eeeause the supply of credit in curb markets is limited. money lenders itn these mart ts operate on a small scale and charge high interest rates. Cuonequentlv. borrowers use these funds mostly for short-term projects and for a':tiviti-s where the potential
7 competition for funding is low,<sup>as in the nontradable sector.5</sup> Given the high degree of variability<sup>of intzrest rates across informal markets and</sup> among different types of lending,<sup>"the main burden of ensur"ng that there</sup> is uniformity in borrowing rates<sup>and that competition is brLadly based</sup> rests with direct bank lending"<sup>(Shaw 1973:85).</sup>

# **3.** The Sri Lankan Setting

After becoming an independent<sup>member ot the British Commonwealth in</sup> 1948, Ceylon (as it was then<sup>commonly called) maintained an open trade</sup> reginte and a generally free domestic economy,<sup>but subsequent government</sup> decisions had practically closed<sup>the economy to the free flow of imports by</sup> the mid-1960s. By then, the Bank of Ceylon had<sup>been nationalized for</sup> five years and a state-owned commercial<sup>bank (The People's Bank) had been</sup> established to meet the financial<sup>needs of Ceylon's rurel areas. Aided by</sup> prohibitions on the opening<sup>of new branch offices by foreign banks, and the</sup> opening of new accounts in foreign<sup>banks by Ceylon's inhabitants,</sup> the two state-controlled banks had grown rapidly. The<sup>financial sector was</sup> extremely repressed, and there was<sup>little room for independent and</sup> efficient financial intermediation<sup>(Khatkhate,</sup> 1982). The insurance industry had been nationalized<sup>in 1963, and large and growing percentages</sup> of the industrial, trade, and<sup>agricultural sectors were owned by</sup> inefficient state enterprises.<sup>The currency was highly overvalued, and</sup> most prices were stringently<sup>controlled.</sup> Despite the steep rise in government<sup>intervention in the economy during</sup> the 1960s, Ceylon's economic<sup>growth was fairly respectable. The average</sup> annual rate of GDP growth<sup>during the decade was 4.5 percent, while average</sup> annual growth in per canita<sup>income was 2.1 percent.</sup> The period from 1970 to 1977 was<sup>marked by further government</sup> intervention in the economy<sup>and declining growth rates. In 1972 (the same</sup> year in which Ceylon was<sup>formally renamed Sri Lanka), the government</sup> consolidated its control over<sup>the mobilization of household savings by</sup> setting up a National Savings Bank.<sup>By the mid-1970s, almost C0 percent of</sup> the total credit extended<sup>by al' financial market institutions was directly</sup> absorbed for budgetary purposes<sup>(Lee, 1987), and the balance was rationed</sup> in favor of preferred institutions<sup>(mostly public corporations). With the</sup> enlarged conscription of funds<sup>from the banking system to finance public</sup> sector activities, the government<sup>succumbed to the temptation to set</sup> interest rates at low levels.<sup>Given continuing inflation (which had begun</sup> in the late 1960s), this<sup>produced negative real interest rates (Table 4).</sup> The stock market stayed in<sup>the dolcdrums during the first half of the</sup> 1970s, with total share turnover<sup>declininr to 2.5 million Rs. in 1975,</sup> compared with 19.8 million in<sup>195'</sup> fV arinatilakp 1986). Constraints<sup>on</sup> foreign exchange remittances<sup>JiscUadeid f'reign-ownec</sup> 4 companies from **buving** 5. One way of saving this is that the a tivlties of the informal sector are less contestable as it isz **ihroft** A f're ipn competition, 6. For details on Sri Lanka's trade and i'evelApment policy since independence see Rajapatirana f19988 and th *1.'rks cited theiein.
8 or selling the **shares** they owned, while threats of **nationalization** prevented the incorporation of new companies. Meanwhile, about one in every five Sri Lankan workers was unemployed.

Pervasive restrictions on the financial system had produced **a** process of financial disintermediation. The degree of financial intermediation, **as** measured by the M2/GNP ratio, declined or re..-.ned stagnant in most years. In 1977, this ratio was well below the level recorded in the early 1960s (Khatkhate, 1982). In short, the financial sector was moriburd, and the two major state-owned banks held 82 percent :in value) of all deposits in the banking system. Average annual growth in GDP between 1970 and 1977 slumped to 3 percent (1.2 percent in per capita term^.). By 1974, the share of GDP produced by the public sector had risen to x_.2 percent (from 5.7 percent in 1961), **and** nationalization of the tea, ruI-ber, and coconut plantations had raised this above 20 percent by 1977. The country's legendary ability<sup>**t**</sup> **o** give its people a higher standard of living was rapidly disappearing.

# 3.1 Key Elements of the 1977 Policv Reform<sup>7</sup>

Consternation over economic stagnation Eet the stage for marketoriented policy reform in 1977: trade liber.alization, a significant exchange rate realignnment, new incentives for foreign investors, overhaul of financial markets, limits on public sector participation in the economy, and the removal of price controls and government monopolies in domestic trade. Half-heartedness and inconsistencies characterized the implementation of the new policies, but their mere existence marked a clear departure from the conventional wisdom of the closed eccnomy era.

## Trade Policy Reform

Trade policy reform was the key element in 1977. Sri Lanka's quantitative restrictions on imports were supplanted by **a** revised system of tariffs, and this far-reaching change was accompanied by the removal of most of the price controls on domestic trade. While many of the tariff changes involved a gazetted increase in the rate, the degree of protection provided reviously by way of licensing was significantly reduced. Some 280 items remained under license, but for the most part licenses were issued freely. Subsequent measures in this area were of a corrective kind. A few items whose free importation had "damaging" impact on public enterprises were returned to the licensing list, and certain tariff rates were increased from time to time to increase revenues. The average effective rate of protection for the manufacturing sector increased 7. Elements of the 1977 policy reform package and its implementation, particularly the trade reform and its consequences. have been examined in detail elsewhere (Lal and RaJapatirana 1989: Cuthbertson and Athukorala 1990).

8. These items together accounted fll- al-ut 9 percent of import value in 1980 (a normal' year followitng liileiaiizatiinr) (Cuthbertson and Athukorala. 1990).
9 marginally (by 3 percent) between 1978 and 1984, but at the same time the average degree of dispersion of sectoral protection declined by about 6 percent.

The opening up of the economy was limited to current account transactions. While restrictions on remitting investment income or the proceeds of sales of assets by foreign firms were removed, the prohibition on overseas capital transactions by Sri Lankan citizens remained intact.

To supplement import liberalization, the dual exchange rate system introduced in 1968 was abolished, and the new unified rate was placed under a manag-d float. This resulted in an initial devaluation of almost 100 percent. The cumulative effect of trade and exchange rate reform was quickly reflected in a significant improvement in the overall profitability of tradable production (Table 3).

# Financial Market Reforms

The major emphasis in financial market reform involved interest rate policy. The bank rate was raised from 8.5 percent to 10 percent, and this was followed by a sbhrp increase !n int rest rates on deposits at the government-owned National Saving Bank (NSB). Commercial banks followed suit (Table 4). By 1980, due to rising inflation, real interest rates again became negative.

The govern.nent responded by increasing NSB rates once more, thus triggering a second round of increases by the commercial banks. Interest rates on deposits have been freely determined since then, with the Treasury bill rate serving as the lower limit and the deposit rates of the National Development Bank the upper limit.<sup>9</sup> There is no direct interference by authorities in the determination of lending rates, however.

In the area of institutional reform, the prohibition on new foreign bank branch offices, which had been in place since 1961 was relaxed in 1979. By mid-1980, 14 foreign banks had opened branches in Colombo, bringing the total number of foreign banks operating in the country to 21 (Table 1). Another institutional measure authorized all commercial banks to operate Foreign Currency Banking Units (FCBUs). An FCBU is permitted to undertake offshore banking services (accepting deposits and ,-r?nting loans in designated foreign currencies) to nonresidents, commercial banks, free trade zone enterprises, and other residents approved by the Central Bank.

These developments in banking, and rapid expansion by finance cor.panies, set the stage for some competition in deposit mobilization and interest rates. An active interbank market also emerged. However, these 9. The rates paid by major commercial banks have continued to be lower than NDB rates. Some of the newly opened foreign banks and almost all finance companies (privatelv owned deposit-taking institutions involved mainly in hire- purchase and leasing financing), however, pay rates higher than these rates. Major commercial banks are able to pay lower rates because they provide additional services to customers.
10 developments reduced the preeminence of the two state-owned banks only marginally (Tables 1 and 2).

The most important policy initiative in the sphere of credit allocation was the termination of the Comprehensive Rural Credit Scheme, under which the Central Bank offered an interest rate subsidy and a 75 percent defaultage guarantee to commercial banks (mostly to the two state-owned banks) on cheap loans provided to the agricultural sector. It was expected chat ending tne programn would encourage commercial banks to become active in grantirng agricultural credit (Sanderatne, 1989).10 These actions notwithstanding. initiatives on the credit supply side generally meant an intensification of government intervention rather than liberalization. Following the interest rate reform, for example, the Central lank intensified its intervention in credit allocation. The Medium and Long Term Credit Fund, a little-used 1963 scheme to refinance loans maturing in 3 to 15 years by commercial banks and development finance institutions (DFIs), was revised in 1979 with a view to directing resources into priority areas. Prior to this, the program had only two categories: development of agriculture, and "other." Under the revision, agricultural development was divided into four subcategories, and export-oriented proiects were accorded priority. More elaborate operational procedures were set up, while final approval of each individual project was retained by the Central Bank. Refinancing allowed the lending bank a final margin of . percent, a lending rate below the market interest rate for similar loans.

Then, a National Development Bank was established by the government to provide project finance, equity funding, and refinancing to public and private enterprises in priority areas. The Central Bank plays a supportive role in the operation of the NDB by guaranteeing repayment of loans provided by N1DB under a Small and Medium Industry loan scheme (SMI).

In 1985, the Central Bank launched a scheme to establish Regional Rural Development Banks (RRDBs) (which essentially took the form of regional outlets providing cheap credit). The goal was "to build a sound rural credit structure because the existing commercial banks i- the country were not granting an appropriate amount of credit to the rural sector" (Central Bank, 1985).

A National Credit Plan had been introdu_ed in 1981 as a way to monitor the expansion of credit to the private sector and to direct credit to priority areas.<sup>11</sup> Under this plan. the Central Bank allocated credit 12. Credit provided undJpr thi; ; hema -'inte,' for about 7 percent of total bank credit to' the private seo-tor hy the mid-1970s. The default rate haJ -limbed close to 80 per-.ent.

11. There 5eems to have be-r a sit.nifi ant external" influence behind these poliov initiative? of th- C-ntiRl Fan1-. The RRDB scheme was modeled after a similar s':hem- in Inlia. 'uiner the advice of an expert from the Reserve Bank of India 'Malhetra. 198 and 1982 (published in 1989)). The external influence an also, be identified in the designing Int in.iel on next page
11 among the banks by negotiation. There were no penalties<sup>for noncompliance,</sup> but the Central Bank tried to bring banks into<sup>line through "moral</sup> persuasion." No attempt was made, however, to reduce the government's<sup>absorption of</sup> financial savings mobilized through the "captive"<sup>financial institutions.</sup> About 90 percent of the NDB's loan portfolio continued<sup>to take the form of</sup> investment in government securities,<sup>12</sup> and a similar pattern wan observable in the operations of the government-managed<sup>provident fund (EPF)</sup> and insurance corporations.

# Accompanying Policies

A major setback to the impl-mentation of policy<sup>reform occurred in the</sup> areas of exchange rate management, export promotion,<sup>and public sector</sup> enterprises. After about 1981, the Central Bank<sup>gradually intensified its</sup> intervention in the foreign exchange market to support<sup>the exchange rate of</sup> the rupee. The rupee then gradually appreciated<sup>in real terms, with</sup> adverse implications for tradable production (Table<sup>3). The newly</sup> established Export Development Board then had<sup>little success in restoring</sup> incentive levels, since the financial incentives<sup>it could provide to</sup> exporters were miniscule compared with the massive<sup>disincentive of currency</sup> appreciation.

While a few loss-making public enterprises were<sup>either shifted to the</sup> private sector or closed down, many others continued<sup>to operate despite</sup> dismal performance and ongoing dependence on budgetary<sup>transfers. Further,</sup> a number of ccrporations continued to receive<sup>preferential treatment,</sup> including high tariffs and quota protection<sup>(Cuthbertson and Athukorala,</sup> 1990). During the period 1977-85, almost Z5<sup>percent of total annual</sup> budgetary expenditures took the form of transfers<sup>to public enterprises.</sup> The comparable figure for the period 1970-76 was<sup>only 10 percent.</sup> The chief constraint to the realization of gains<sup>from economic</sup> liberalization, however, was the macroeconomic<sup>instability generated by a</sup> massive public investment program that included<sup>a billion-dollar</sup> multipurpose irrigation project (the Mahaweli<sup>Development Program, or MDP),</sup> a large public housing program,and an urban development<sup>program.</sup> Between 1978 and 1982, these three projects absorbed<sup>about 75 percent</sup> of public investment, the Mahaweli project alone accounting<sup>for 45 percent.</sup> The imports needed for the projects were largely<sup>financed by aid donors,</sup> but the pressure on the Sovernment budget to<sup>provide counterpart funds was</sup> substantial. Thus, the projects put pressure on the<sup>government's ability</sup> (continued from previous page) of the Export Credit Insurance Corporation and various<sup>export-credit</sup> schemes of the Central Bank.

12. Investment in government securities<sup>carried an interest rate</sup><sup>**of**about</sup> 10 percent as compared with the NSE, deposit rates of<sup>11 to 18 percent.</sup> The loss to the NSB resulted from this difference<sup>was covered bv a</sup> subsidy from the treasury.
12 to mainitain macioeconomic sta1ility. Thes direct **expenditure effects of the** Vr CO .c ou`T1d w;ith inflationarv pressure that originated in deficit _tinan ing,_ c'nt L ibuted to an apprec ia ion of the **real** exchange rate with ad3verse implications for the tradable goods sector. Macroeconomic instalility thenl compelled the government to take some policy steps which Lan ounter to the l17- reforms. For instance, import duties were incr-easedl trorn time _to_ time for revenue purposes. with adverse protective effects. Cr.edit ceilings, and higher reserve requirement ratios on comm,1ercial btank deposits, produced a credit crurnch which negated the anti ipat ed tavoiab)le supply side effects of financial reform. Finally, intlattionar:v prs sures gen9rated bV the public investment program shriveled etoded real initerest rates, with adverse implications for savings molilization.

# **Empirical Analysis**

To set the stage in applying the above framework, it is necessary to assess the impact of reform on financial **deepening. Then, an attempt is** made to trace the connection between the new financial regime and the outcome of trade liberalization. This is followed **by** an examination of the impa t of financial policies on the availability and distribution of loanabie funds, with emphasis on the implications for private-sector investmernt. In particular. changes in the interest rate structure and sectoral allocation of credit are examined with a view to identifying the irpli:at ions of the financial regime on expected efficiency gains from trade liberalization. Finallv, the findings of the previous sections are re:-onsideied in light of the nec-structuralist emphasis on the crowding out ette **o** f finan, ial retor-m on the cuLb market.

## .l Financial Deepening and Savings Molilization

Fasic in_iivators of the financial depthi of the economy are presented in Ta!ble K It is evidenit. that interest rate reform in 1977 was followed by a remarkabile improvement in financial intermediation. **The** M3/GDP ratio **rose** from an average level of 2, percent in the 1970-77 period to 34 percent in - al.! stalilize. at arounld 4O percent in the 1980-87 period. While Ml -n, irn1e o increase in Lrel terms. its ratio to GDP declined. This 'R A r S t-S a shift **in** household aszet portfolios from cash holdings to savinv **and** time deposits (STPsl in response to favorable interest tates. -o examine the role of interest rate changes in determining the pattern of tirnan al inteLmediationl, we estimated demand functions for Ml and STD. The explanatoiv variables use.1 in each eauation -.ere real CDF 'toe represent **'-** vR-alth tfe.t'. thp ;icht;.-av;race 4av:ncR and time depj,,ie rate RFSTP , represent owin ra- **i' - iznn** 'TD1 sr the opportunitv cost of '1.8!'sr.= !!ing F1* . 1 L?F; ... > .. a tr4 ? 'n "' v' ' 'n-p'~r L i .-J lag. FE -mlinus thie :ea' rate . retun .n Iash **ala-** -; a _t'ons_ were estimated usinc *!1 st za: -9 _vsr-'s_ n-l.' .!. vib *.l: 'amiab>les expressed in _-*'.w: artK-'.-; "_ -a _- i ' .l_m'_ .-.ai _` 3_ I an intercept dummv and -:r-.' _eX-'.t_ :r _ia'- '_ re included to tect ths - t pre- and post-r t-rm i.Tl .: r .'.R1i'.'-m-al- _!: 1'b*!_ tinal regressiot'. nrl . m **..** ! .M-inl th a*F_ ' '-?.a a - t F-test' for variable !-:- **p-.** T-'; : 's!- ; ar r Ip.'t@ K TR`W77h- two regreLDssions pas s 'vea F 1 initi :all an e a.: i! F.a-m<ev - F.ESET test for
13 appropriateness of functional form. (The basic assumptions relating to the OLS error process were amply supported by various test statistics.) The result for the RSTD variable in both equations suggests that individual financial asset-holding behavior strongly depends on the rate of return on bank deposits. For the post- reform period (1978-87), a one percent increase in RSTD seems to have been associated with a 0.8 percent decline in real cash holdings and a 4.2 percent increase in real RSTD. The equation for STD showed a significant wealth effect operating upon financial savings behavior: a one-percent change in GDP was associated with a 1.5 percent change in STD. This effect on demand for Ml was also statistically significant. but much smaller (0.5 percent). In sum, portfolio shifts (both from cash balances and other assets) triggered by interest rate policy were behind the surge in bank deposits (and hence the degree of financial intermediation), while the weaith effect generated by liberalization-led income growth seems to have played an important but secondary role.

Was the growth of financial savings reflected in an increase in the level of total domestic savings? According to the McKinnon-Shaw thesis, a positive link between interest rates and financial savings also implies a positive link between the former and total domestic savings (investment), for at least two reasons. First, according to McKinnon's "complementarity hypothesis" in a developing country context, a decision to accumulate financial savings is coterminous with a decision to acquire physical capital. Second, given limited portfolio choices, the savings process in these countries tends to be highly "money intensive" (McKinnon, 1976). A contrary view is expressed by the neo-structuralists, who argue that while raising the rate of return on bank deposits is likely to induce a portfolio shift in favor of that asset, such a response need not reflect more savings but simply a decline in other assets (Taylor, 1988).

Jayawardena et al. (1987) interpret the Sri Lankan experience as supportive of the neo-structuralist position. Despite the impressive growth of bank deposits, there was "little evidence of any-significant mobilization of domestic savings" (p. 27). But the data reported in Table 8 suggest that this observation, based on an analysis of data on total domestic savings, is misleading. During this period, public sector savings performance did not show any improvement, indicating the country's heavy dependence on foreign aid. t)onetheless, the behavior of private savings was an impressive improvement over the pre-reform period. For- instance. the average propensity to save (the private savings to private ineome ratio, or PRS/YPR) increased from 14.4 ptr-ent in the 197Q-76 p-jri'd t( 20.2 percent in the 1977-84 period. Ec('nmetri.w -rk (Athukorala and Jayasuriya, 1989) lends supj'('tt **t'** the - j- **ti4'f** intPrest rat'j r;t''rm wa-y laid behind this improvement. The-timato- -ugaest an inteleZt. late elasticitv ''f .98 per_ent and an in Wla i ity omf ('t 1.22 per ent. **t'L** private savings. In sum. whpn the analv-in i- appropriately f'uqewl on private savings behaviol. **thi-** SL i LasnkIan -xl i. i "nf e pr''vides ampl Quplfor the McKinnon-Shaw vipw point ] 13. The evidence on interest elast i i,v f 'an in 1XveP1o!inV 'nt I i@, which come from numerous multi'untrv - studies, i- tar (continued on next page)
14

# 4.2 Financial Liberalization and the Real<sup>Exchange Rate</sup>

In section 2, we presented the theoretical<sup>case for</sup><sup>**expecting**</sup> complementarity, operating via the real exchange rate,<sup>between financial</sup> liberalization and the outcome of trade liberalization.<sup>In particular, it</sup> was postulated that financial deepening would<sup>help sustain depreciation in</sup> the real exchange rate by containing<sup>aggregate demand pressure and by</sup> tilting household asset demand away from<sup>nontradable assets and towards</sup> interest-bearing bank deposits.

The empirical evidence presented in the<sup>previou3 section showed that</sup> both financial savings and total private<sup>savings responded favorably to</sup> interest rate reform. This evidence,<sup>in turn, supports the view that</sup> interest rate reform was instrumental in<sup>dampening the impact on nontraded</sup> goods prices of the surge in private income<sup>(expenditure) triggered by</sup> trade reform. In the absence of high interest<sup>rates, the expansion of</sup> domestic demand would have been stronger, and<sup>thus would have created</sup> greater pressure to push the real exchange rate<sup>upward.</sup> Any attempt to make a detailed analysis<sup>of the impact of interest rate</sup> policy on household asset-holding behavior<sup>was hampered by an absence of</sup> time series data. Nevertheless, data from<sup>the Consumer Finances Survey of</sup> the Central Bank provide some support for<sup>our hypothesis (Table 9). Bank</sup> deposits as a share of household asset portfolios<sup>reached 33 percent in</sup> 1981-82, as compared with a historical figure<sup>of less than 10 percent.1 4</sup> (continued from previous page) from clear. (see Fry, 1989, Gonzales-Arrieta, 1988<sup>for surveys of this</sup> literature). While some studies come down<sup>against any interest rate</sup> effect on savings, the others find a positive<sup>but rather small interest</sup> elasticity (around 0.1 percentage point) which<sup>is "not large enough to</sup> warrant great policy significance" (Fry,<sup>1989, p.20).</sup> The appropriateness of the multi-country cross-section<sup>approach (which</sup> implicitly assume that the observations<sup>are drawn from a "homogenous</sup> universe") to measure the average saving<sup>propensity for a diverse group</sup> of countries is, however. highly queltionable. The few available country studiec (eg. anis and Riedel 1QPQ.<sup>Y-usuf and Kyle-Feters, 1984</sup> have, in fact, produced int-r-t- ola<sup>iit</sup> Pstimates which ars qimilai in magnitude to our estimate for Sri Lanka.

**14.** The, mild decline in this -hare in l 37-7 as reflected in the survey data iq come-w'hat puz7linc. Thp '7ontL1l Pank ascribes this decline to "oneun)lts' ruTh to iati-v thloii 1-n-up domarnd ( accumulated<sup>Ovftr</sup> a

_lonw period_ of import iestrictionq, fi JouLalle consumer goods. following the trade liberalizati.n (C.-nttal Bank. Consumet Finances Survey 19?e,'79. Part 1, p. 171.
15 To ascertain the cumulative impact of financial deepening on the real exchange rate, we developed the following model and then used annual data for the period 1970-87:

- RER = f(FIR, NFC, GEXP, BMP, TOT) fl>l; f2 ,f3,f4 ,f5 <0

Where,

- RER = the real exchange rate, defined as the relative price of traded goods to nontraded goods,

- FIR = the financial/intermediation ratio (M3/GDP),

- NFC = net foreign capital as a ratio of GDP,

- GEXP = government expenditures measured as a proportion of GDP,

- BMP = the black market premium on the official exchange rate measured as (BER-ER)/ER where BER and ER represent the black market and the official exchange rates, defined as rupees per US dollar, and

- TOT = terms of trade (1980 = 1.0).

Because of the difficulties involved in directly measuring the prices of traded and nontraded goods, the real exchange rate is usually proxied by the nominal exchange rate, adjusted for change in the weighted average of the wholesale price indexes of trading partners relative to the domestic consumer price index (e.g., Edwards. 1988: Favaro and Spiller. 1989: Cottani and Garcia, 1989). This proxy measure is based on the (rather restrictive] "law of one price" assumption (Warr, 1986). In this study we measured the RER using implicit deflators derived directly from the national income accounts for tradable and nontradable production.

The degree of financial intermediation (the key regressor in the model) was represented by the M3/GDP ratio. The black market premium was included to capture the impact of government intervention on the real exchange rate. The expected effect of an overvalued exchange rate, of course, is that it tends to suppress the prices of tradables. Thus, we would expect a negative sign for the coefficient of this variable. The use of the other three variables is now standard procedure in determining the real exchange rate.

The model was estimated using the ordinary least squares method. As in the case of estimating money demand functions (Table 7), a dummy variable technique was employed to detect anv structural break ir the hvpothesized relationships that might have followed the 1977 reforms. Onlv the slope dummy for FIR was found to be imilortant. Thor; was high collinearity between TOT, and NFC and CE.XF. and ex( luqir 'i the former impr':ed the statistical significance of the- *'ettii iTltz +'t 'h'. latter tW' 'VaLial'l-'. The results are reported iTn TaIl'l 1.. The coptfitient ot FIR wac nlt icti'allv signiticant for thi. peri(1970-77. Eut it was highl; -icnitiant !jith thW expe'ted sign ttr tlh poqstreform period (1978-? . -ip'r tillLc '11 hV: Phecic that V.eal, 'L finiancial intermediation (a hIiev.!! t jant nh''Ic ial retorm Tit Lil'ut d t improvement in the competitiveneqq ,t tira alVl 'rod'iUt ion. We us.sper t thtla the failure of our model to Jete(t a icoitic ant relationshij between REF
16 and FIR during the pre-reform period was due to purely statistical reasons. First, our RER series might not have been a satisfactory indicator of real exchange rate behavior in an economy characterized by quantitative restrictions (QRs). In the presence of QRs, the distinction between traded and nontraded goods becomes blurred; commodities subject to QRs are usually priced not on the basis of the prices of competitive imports but on the basis of domestic demand and supply (as in the case of nontradables) (Corden, 1987). Second, the degree of year-to-year variability of both data series was rather small. Given this "insufficient" variability, our regLession exercise may have failed to distinguish the effect of the FIR on the RER from other random effects on the latter. As we expected, both net foreign capital inflow (NFC) and government expenditures (GEXP) seem to have exerted significant downward pressure on the real exchange rate. By contrast, the coefficient of BMP was not statistically different from zero. This result supports the view that the real exchange rate is determined by real variables, and that therefore the nominal exchange rate has little influence upon it (Brock and Tower, 1986).

To sum up, our regression exercise provided a useful framework for understanding the behavior of the real exchange rate in Sri Lanka following the 1977 reforms. While interest rate reform had a notably salutary effect on the real exchange rate, this effect was crowded out by the much stronger combined negative effect of massive capital inflows and uncontrolled public expenditures. Consequently, the significant improvement in the country's international competitiveness achieved through trade liberalization was short-lived (Table 3). Had it not been for the favorable impact of increased financial deepening, the squeeze on the profitability of tradable producticni during the ensuing period would have been much sharper.

# 4.3 Volume of Credit and Private Investment

The increase in financial intermediation after reform (section 4.1) was reflected in a massive increase in the volume of institutional lending. Total real credit recorded a three-fold increase from Rs. 15,361 million in 1977 to Rs. 47,798 million in 1985 (Table 11). There was also a major shift in the allocation of credit in favor of the private sector. That sector's share increased from 28 percent in 1977 to 60 percent in 1985, at the expense of the combined share of the government and public sector corporations. As noted above (section 3.2), financial reform did not include any measure to allow greater freedom for the portfolio decisions of government-owned nonbank financial institutions. Instead, these institutions continued to function as captive sources' of budgetarv finance. The increase in private sector credit therefore came predominantly from commercial banks. Refle:tinz the government's emphasis on guided credit to prioritv sectr-<. i-'Jit -xtended by the development finance institutions (PFIss di.l in(r-asz (TaIle 13), but their share of total i7stitutional .-redit allocated t- the private sector increased to only 7 per.ent by 1985. In that vear. ommercial banks accounted for 85
17 percent of such credit, with the balance coming mostly from finance companies.15 Expansion of institutional credit was undoubtedly a factor in the expansion of private sector investment in the postreform economy. Private fixed investment as a share of GDP increased from an average level of 8.5 percent in the early 1970s to 18 percent in 1978-82 (Table 15). Between these two periods, the share of fixed investment in private-sector income rose from 10 percent to 18 percent.

To delineate the link between institutional credit and private fixed investment (PRW), an investment function was estimated using annual data for the period 1960-82.16 The explanatory variables were total real (1980) institutional credit to the private sector (ICP), the real GDP growth rate estimated in terms of logarithmic differences (YR), real<sup>public</sup> sector fixed investment (PBIV), an index of rental cost of capital (RC),<sup>1 7</sup> and PRIV with a one-year lag (PRIV(-1)). The inclusion of YR as an explanatory variable implied an accelerator-type relationship between the level of domestic economic activity and capital formation. PBIV was<sup>chosen</sup> as an explanatory variable in light of the debate on the crowding out effect (Blejer and Khan, 1984). PRIV(-l) was included as a regressor on grounds that the adjustment of actual investment to the desired level is not completed within a single period.

The estimated investment function is, ln PRIV = - 0.33 + 0.63 ln ICP - 0.34 ln PBIV(-l) (0.25) (3.52)* (2.26)** + 0.05 ln (1+YR) - 0.07 ln RC + 0.71 ln PRIV (-1) (3.14)* (1.17) (4.73)* R<sup>2</sup> = 0.92 F = 49.3 LM = 0.02 RESET2 = 0.03 JB = 0.96 WH = 0.85 15. Estimated using figures obtained from, Central Bank, Review of the Economy. Figures used in the remainder of this paper, unless otherwise stated, come from this source.

16. The Central Bank has stopped publishing a qeparate private investment series since 1983.

17. This index is constructed as RC = [PIH (1 * NLR)/PJ 100 where PIM = [price of investment goods proxied by the import price index of investment goods (1080 = 10'" (adjusted for the dual exchange rate (FEEC) premium for the perio"d l9I53-, ILR = nominal one-vear (maximum) lending rate of commer. ial I(ank's and F = implicit GDP deflator (1980=100) for non-service a tivities.
18 Notes

- (1) t-ratios are given in parentheses, with level of significance denoted as * = 1Z and ** = 52.

- (2) For definitions of test statistics, see note 1 to Table 7.

According to the regression results, the short-run (one-year) elasticity of real private investment with respect to loanable funds was 0.63. This figure, when combined with the coefficient of the lagged dependent variable, yields a long-run elasticity estimate of 2.17. Thus, the hypothesis that private investment depends crucially on the availability of credit is supported overwhelmingly. The results also support the hypotheses on the positive impact of income growth and the negative impact (the crowding out effect) of public sector investment on private investment. But these influences seem much less important in magnitude as compared with the impact of credit availability. The coefficient of RC is not statistically different from zero. From the use of the available data, there is no statistical support for the statement that "higher interest rates and the high cost of investment appear to have inhibited private investment activity" (Jayawardena et al., 1987:29; see also Roe, 1982). Ideally, one would have compared the rate of interest and the marginal efficiency of capital to test whether high interest rates inhibited investment. But in the absence of estimates for the marginal efficiency of capital it was necessary to estimate the specific investment function.

Commenting on the Sri Lankan finance market liberalization from a neostructuralist perspective, Roe (1982:248) noted that deposit interest rates were much higher "than the underlying productivity of the economy's capital will allow." But the regression results reported above do not accord with that view, which can also be disputed on other grounds. First, the empirical basis for Roe's view came fLom estimates of return on capital (which vary from 5 to 10 percent) for public sector corporations. Our estimates of profitability for a sample of p.lic limited liability companies in the private sector, however, present an entirely different picture (Table 16). Second, it is inappropriate in any case to make a judgment about the desirable interest rate on the basis of a profitability estimate coming from the previous controlled trade regime, since the for-es set in motion by liberalization would be expected to improve the profitability of investment. According to both macro-level and firm-level data (Tables 3 and 16), the profitability of private sector production improved remarkably following the trade reforms. As has been discussed in detail elsewhere (Cuthbertson and Athukorala. 1990). it was inconsistencies in the overall policy package which caused the improvement in profitability (particularly that of traded Roods) t.' deterioiate afterwards. Third. as the experience of the ensuing years clearlv indicates. the increase in the cost of credit cannot be ascribed entirely to higher eeposit rates. The interest rate spread tended to widen in the early 1980s (Table 4), reflecting the impact of other factors. including the increased
19 restrictiveness in monetary policy,<sup>18</sup> high inflation, a new business turnover tax on interbank transactions, and the mounting operational costs of government-owned baniks (see Lindrer. et al., 1986, and Datta, 1983, for details). Finally, as noted above, even though total credit to the private sector increased considerably, the government continued to utilize well over a third of total institutional savings through its authority over nonbank financial institutions. The interest rate outcome would have been different if measures had been taken to redress this compartmentalization in the financial markets.

# 4.4 Efficiency of Credit Allocation

The analysis in the previous section provides empirical support for the view that financial reform, by augmenting the volume of institutional credit, played an important role in facilitating supply-side adjustment in the economy. This section extends that analysis by focusing on the pattern of credit allocation. In light of the theoretical discussion in section 2, we focus on two aspects of the credit allocation process, namely, borrowers' access to institutional credit and the degree of dispersion in the cost of credit for various types of borrowing.

There are no time series data on the distribution of institutional credit at the firm level. The available survey-based evidence, however, points to an increase in the number of recipients of credit from the banking system. For instance, in a comparison of the financial structure of small-scale enterprises in 1977 and 1986, Islam and Romijn (1988) found that the percentage of firms which had obtained financial support during the period fror the banking system increased from 13 percent to 24 percent. The findings of the Consumer Finances Survey of the Central Bank relating to the distribution of household borrowing by source are consistent with this pattern (Table 17). According to this source, the institutional share in total household borrowing increased from 20.2 percent in 1973 to 25.3 percent in 1978-79 and 40.1 percent in 1981-2. This overall increase occurred despite the shrinking of subsidized institutional lending to the agricultural sector following the termination of the comprehensive credit scheme.<sup>19</sup> At the disaggregated level, the sharpest increase occurred in borrowing for industrial activities. There does not seem to have been a rapid increase, as is popularly alleged, in borrowing for consumption. As theory predicts, various elements of financial reform, such as the greater availability of loanable funds, removal of credit rationing, and a more flexible interest rate structure might have contributed to the increased availability of institutional credit. Whatever the underlying reason may 18. The level of statutory reserve requirement on commercial bank deposit was increased in mid-1981 and again in November 1983, in response to aggravating macroeconomic imbalance in the economy.. As a result, the weighted average of reserve requiremenit on all deposits increased from 7.4: to 8.1F in 1981 and 10.5' in 1094.

19. Following this step the share (if avri:ultuLal credit in total hank credit to private sector declined from 15. percent in 1977 to 8.2 in 1982.
20 be, the broadening of the credit base may have been instrumental in improving employment prospects and income distribution.

Did financial reform, by reducing the degree of dispersion in the cost of credit, contribute to greater neutrality in the incentive structure of the economy? An in-depth analysis of this question is not possible, given the nature of the data base. There are no time-series data on lending rates or cost of credit on a sectoral basis. The only available data are those relating to the lowest and the highest lending rates of commercial banks and DFIs (Table 18). These data show that disparities in borrowing Lates increased substantially (or else, the credit allocation in the economy became less efficient) after 1977. But it could also be that interest rate deregulation made it easier for less desirable borrowers to get institutional credit.

The lower rate for commercial bank lending, as well **as** all rates of **the** DEF and NDB, were usually those applicable to loans to sectors accorded priority under the "directed" credit policy. Given an annual inflation rate of 5 to 12 percent during this period, these rates implied a negative real cost of capital to preferred borrowers. By contrast, the upper (market-determined) rates remained highly positive. The structure of lending rates therefore introduced credit market distortions and ran counter to the primary objective of trade liberalization--realizing gains from better allocation of resou:ces.

A major explanation for the wide gap between lending at favored or nonfavored rates seems to lie in the nature of the banking system itself. ihe opening of the banking system to foreign competition had only a marginal impact on the dominance of the two state-owned banks, in terms of both volume of transactions and extent of lending activities (Tables 1 and 2). The "old" foreign banks and the locally-owned private banks showed little interest in extending their operations beyond their traditional domain of trade financing, while the "new" foreign banks, were not eager to do business with purely domestic clients. The provision of long and medium-term finance ffr industry and agriculture continued to be the role of the state-owned banks. Given the compartmentalized nature of lending, there was little competition in loan rates. Added to this, the state-owned banks continued to be under pressure to set lending priorities and interest lending rates with the government's policy priorities. Since these banks were also expected to be profit-making institutions, relatively low (and at times negative) interest rates for priority clients usually implied excessively high rates for on non-priority borrowers.

Administered prioritv lending was based on the premise that "high" market-determined rates might deter long-term investment in the tradable sector and thus jeopardize the sustainabilitv of trade liberalization.<sup>2 0</sup> In lLactice, however. apart from introducing a significant element of distortion into the economv. this guided credit policy achieved little. By 1983. Lefinanced credit accounted for less than 5 percent of the total domn-stic loans ()f tommercial banks. and ab')ut two-thirds of this lending . This has been a recirrent theme in the annual financial-sector review in the Review i'f the Econona of the Central Bank.
21 represented pre-export credit extended at a rate below the Treasury bill rate.

Despite policy rhetoric, the share of commercial bank credit allotted to the tradable sector relative to credit for the nontradable sector declined from about 1978 (Table 12). Accompanying this was a gradual decline in the combined share of medium and long-term credit in total bank lending.

The operation of DFIs was lackluster. An inspection of their lending records shows that they were not successful in allocating resources to priority sectors, particularly export-oriented industries. Their lending continued to be limited mainly to meeting the credit needs of a handful of established business groups with diversified interests. 2 1 This suggests that a large part of the credit subsidy was diverted into nonpriority sectors.

The failure of Sri Lanka's directed credit policy in the context of trade liberalization is a subject which needs further study. 2 2 However, the evidence considered so far supports tbe view that a directed credit policy is unlikely to be successful when the overall climate of incentives is moving in a different direction.

# 4.5 Financial Liberalization and the Informal Credit Market: Some Observations

So far, we have examined the implications of financial reform with respect to the formal money market (OMlM). In this section we briefly consider whether our basic conclusions neea to be qualified in light of the neo-structuralist crowding-out argument against financial liberalization (Section 2.3). A formal test of the crowding-out hypothesis is precluded by the absence of required time-series data. However, there is a 21. In a comparison of lists of client companies of NDB and DFC for 1984 we were able to detect 30 instances of the same client appearing in both lists. Most of these are well established import-substituting manufacturing firms with a long history of operation. Moreover, the DFC's sublist of large-scale clients for 1984 is not much different from a similar list for the mid-1970s. On the basis of a li';t of exporters (for 1984) prepared hy the Exprrt Development BoaFld, we werP able to identify only about 1r)-15 per-'ent **cof** the client companies of DFC and NDB as exporters.

22. This issue is of particular interest eiven the recent concern about ths need, in the context of the typical Jeve loping economy where there is nlo well developed equitv market. foat hi-'.ing a prr:nec halan-e 1-twepn the confli-ting o1bje( ti;'-s of maintAinilnw makL-ket el.aring intertL-t rates that would ensure effi i-t-t a1.1a **IT IIn If** rPsui es and p,i,-i Tinc a "growth-promoting" credit 1 **v** -h-. I **K** ' (ohaia. 1984: NIEKinnon. 1988; Collier and Mayer, 1989).
22 substantial body of survey-based evidence on informal credit markets in Sri Lanka<sup>23</sup> which permits us to draw some inferences.

In Sri Lanka, as in many other developing countries (Ghate, 1988). the informal money market has continued to play a more important role than th, formal market in the provision of credit.<sup>24</sup> In 1981-82, for instance, almost 60 percent of the household borrowing in Sri Lanka rwhich includes borrowing by informal businesses and cottage inoustries) was provided by the UMM (Table 17). According to a mid-1970s survey of the informal sector in Colombo, over 75 percent of the credit granted to informal businesses came from informal sources (Marga Institute, 1978 and 1981). Informal sources of credit are by no means confined to households and small businesses. The Pettah Money Market (the informal money market in Colombo) is believed to handle vcry large volumes of fun.s (Sanderatne, 1989; Datta, 1983). However, the mere existence of a sizable UMM does not necessarily imply significant crowding-out following reforms in the OMM. This will occur only if the UMM is "competitive and agile" (Taylor, 1983), and if it is closely linked with the OMM so that bank deposits are a better substitute for UMM claims than cash or other assets. As argued in Section 2.3, such a characterization may be incorrect in the typical developing country. In fact, the competition and agility is restricted to limited areas and groups. The evidence from Sri Lanka further illustrates this point.

One of the important facts shown by this evidence is that "informal lending consists of a wide range of sources and arrangements, in contrast to the general tendency to think of informal credit as synonymous with pure money lending" (Sanderatne, 1989:22). The share of pure morney lenders in the total informal borrowing of households seems to be only about 24 percent (Table 17). A larger share (31 percer') comes from friends and relatives in the form of reciprocal transactions. The rest (55 percent) is mostly a part of land tenure relations and the systems of produce marketing and consumer credit. Under these credit arrangements, the lender usually has a vested interest in the borrower's economic activity which extends beyond interest income.

The view that the informal financial market is segmented, noncompetitive, and not well integrated with the formal market, is further supported by data on the interest rate structure of informal credit (Table 19). According to the data, nearly 50 percent of such credit is granted either free of interest or at interest rates which are much lower than those of institutional credit. Given the absence of directly observable interest rates in kinship and patron-client relationships, it is difficult to compare the terms of credit in the inthrmal market with those of institutional credit. Howevet . the l-ull 'v-i ?5 percent) of the credit supplied by moneylenders is -xtendIed at -i v Iiight interest rates. It therefore se~Pms utl ikPl: that even a dAraQt iK iLange in institutional 23. Fernando (1988S and S3ntldeLatn.o (198P and IO9R) provide useful svntheses of this literature.

- . The relative importance ot U1UI _haC 'f_ derlined ]'m! as institutional l-nding increased (Table 17!.
23 interest rates has an impact on the volume of informal credit. This is perhaps because the financial technologies to scrve different clients also vary very much.

In the informal financial system, moneylenders rarely act as intermediaries between savers and investors (Sanderatne, 1989; Bouman, 1984). Moneylending has been characterized as unsocial and exploitative in Sri Lanka. Hence, the activity of moneylenders is often clandestine and restricted to known persons. Moneylenders usually operate with their own funds, and the average saver rarely considers them an alternative source of saving.

Data relating to the purpose-wise distribution of informal lending also indicate that it is predominantly obtained for so-called nonproductive purposes, such as family ceremonies and emergencies. Formal sector financial institutions seldom are willing to make loans for these purposes. on the other hand, the bulk of the credit used for agricultural, industrial, and other productive activities does come from formal sources. For instance, according to a Central Bank survey of planned investment in the corporate sector, 'other sources" (which includes informal borrowing) contributed less than 5 percent of the total financial needs of the corporate sector in 1983/85 (Central Bank, 1986). The Marga Institute survey cited above found that moneylenders provided only 1.3 percent of the total borrowings of informal sector businesses in Colombo.

In summary, Sri Lanka offers no evidence that funds flow freely and swiftly between formal and informal markets in response to interest rate differentials. It is therefore unlikely that the substitution from UMM would have been of significant magnitude to counterbalance the significant increase in institutional savings/lending that resulted from the substitution of bank deposits for currency holdings and real assets supplemented with the wealth effect on demand for financial assets following the 1977 reforms.
24

# **5. Summary and Conclusions**

# The analytical framework

An analytical framework to assess the role of the domestic financial market in the outcome of trade liberalization outcome was developed and then applied to Sri Lanka's 1977 trade reform. At that time the domestic financial market was also reformed, reducing financial repression. The main finding of the study is that the domestic financial market plays a very significant role in the success of a trade liberalization.

In Sri Lanka's case, financial sector reform helped to some extent to sustain the greater competitiveness of the tradable sector achieved through the trade liberalization. Financial reform, however, did not go far enough, and its implementation remained somewhat ambiguous. The emergence of large fiscal imbalances after 1982 ther. weakened the impetus for trade liberalization.

On the demand side, the domestic financial market made its impact on trade liberalization by way of the real exchange rate. A domestic financial market that offers financial assets with attractive rates of retuLn affords an alternative to the spending of increased income from trade liberalization on nontradables. Premature appreciation of the exchange rate is thus averted. But high rates of return on financial assets can only be found in a nonrepressed domestic financial market. Moreover, market determined interest rates will influence overall savings/investment decisions and restrain aggregate demand. This too will prevent premature appreciation of the .xchange rate by channeling increased real savings into investment and thus avoid the need to provide investment funds through money creation.

On the supply side, a nonrepressed domestic financial market can complement trade liberalization by facilitating increased investment in the tradable sector. Such a market will also lead to better channeling of credit for the increased production of tradables induced by a trade libeLalization.

# The Sri Lanka Case

There were several reasons why the application of our theoretical fr-amewioLk to Sri Lanka made good sense. First, the 1977 trade lilberalization replaced nearlv all the quantitative restrictions on imports with tariffwhich reduced thl It-:-'l -f -nli t!b variance in prctrt tion. and waq a-compani-d bv a Stronp leva lbation - nl. there was a sharlp c('ntLa~t, in t effe'tient' t t i- tLa'.lY L-rime between the I>L-r-fornm peri:l 1>'--- and tho p\'1ct-L-t(-rm Tperil 1?7S-87). This helped us to idntitiv k-; hanzes in the trade rDPimThird. the tact that thD capital ar cunt in 'he bal1.nc, -f paavmentz r-main-el irtuallv closed to private **Lanqa ttj** - **n-** all) ei uc .j' 'r3 **th- r1ol** _1f_ thdomestic financial market in L-lation t(' trade libeLalizati-n-. F" t -rale lileralization occurrod at he came t ime that the Sri Lank.an vrnmlm 3erep-ulat-d lr the interest cv *@'-. t I'i. ld diLre-ted "1dit , al',, 1".@d :il: 1ankS to enter the domestit +''S, '9. .; Thu,; tbl- ;hif! tlvmm r a 1uhlv reprssed financial regime
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.
26 Econometric tests were performed to investigate the cumulative effect of financial deepening on the real exchange rate. A regression model was estimated with the real exchange rate as the dependent variable: the model used the financial intermediation ratio and a number of other explanatory variables. The results indicate that the financial intermediation ratio was a highlv significant deterrninant of the real exchange rate and showed the expected sign for the postreform period. The tests, however, failed to show such a relationship during the pre-reform period. This is perhaps to be expected, given that the real exchange rate could have been contaminated by the presence of import quotas. Moreover, the financial intermediation ratio remained low and constant over a long period up to 1977, reflecting a high degree of financial repression.

The other variables used in the regression model, such as the exchange rate premium, government expenditures and terms of trade variations seem to have controlled the real exchange rate in the prereform period. Thus, the evidence confirmed the hypothesis that in the absence of financial reform, the 1977 trade liberalization would have been thwarted by an earlier and larger appreciation of the exchange rate. Financial reform helped to maintain the competitiveness gained from trade liberalization by providing attractive financial assets as an alternative to the purchase of nontradables.

Fourth, following the financial reform and the resulting rise in the financial intermediation ratio, real credit to the private sector increased threefold during the 1977-85 period. Given that the private sector produces and consumes relatively more tradables than the public sector, this may also have helped to delay appreciation of the exchange rate. This is because increased expenditure on tradables has no impact on the real exchange rate. Moreover, with the increase in real credit, private fixed investment rose from 8.5Z of GDP in the early 19<sup>7</sup> 0s to 182 in 1978-82. Regression results showed the elasticity of private direct investment with respect to real loanable funds to be 0.63% in the short term and 2.17Z in the long run. Private investment in thie tradable sectors became more profitable after the trade liberalization, and this investment in turn was facilitated by the financial sector reforms that increased the availability of real loanable funds.

Finally, as indicated in the theoretical framework, an interest determined credit allocation enhances the shift of resources to the tradable sector following a trade liberalization and improve resource allocation. Conversely, the presence of directed credit in a repressed financial system stands in the way of credit flows to finance the expansion of the tradable sector. To the extent that directed credit would have favored large firms producinR for the domestic market under a repressed financial Fvstem, increases in the alloeation of credit to small-scale enterprises would provide some support for the view that credit allocation improved following the reforms. Following the financial reforms, the amount of credit flowing to sml31 enterprises in Sri Lanka doubled between 1977 and 1986. However. evidence for impro)ved credit allocation because of the dispersion of interest, rates remains amliguous. The dispersion of intpr-t rates increased( following thttadle and financial sector reforms. ?ntraiv to what is predict- ly thI' r-. But -- me factors could help to expl.ir, the increased dispersion. The financial market reform may have
27 given risky borrowers a better opportunity to obtain credit. On the other hand, the Central Bank continued to maintain differential discount rates and to subsidize credit for some purposes. This in turn tended to impede the competitiveness of the tradable sector gained through the 1977 trade liberalization.