metadata: authors: 0: author: Chamley, Christophe
1: author: Husain, Qaizar
count: Indonesia,Philippines,Thailand
docna: 0: docna: The effects of financial liberalization on
            Thailand, Indonesia, and the Philippines : a quantitative analysis
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Taxation & Subsidies,Economic Adjustment and Lending,Public Sector Economics,Legal Institutions of the Market Economy,Banks & Banking Reform,Capital Markets and Capital Flows,Capital Flows,Inflation,Public Finance Decentralization and
            Poverty Reduction
teratopic: Macroeconomics and Economic Growth,Finance and Financial Sector Development,Environment
abstracts: cdata!: In the early 1980s, interest rate
            ceilings and other regulations affecting financial assets
            were lifted in Thailand, Indonesia, and the Philippines. The
            paper finds that liberalization of interest rates
            significantly increased the real return on financial assets
            in Thailand and Indonesia, because all interest and credit
            constraints were removed. Similar reforms failed in the
            Philippines, where taxes on the financial sector interacted
            with high rates of inflation. The paper is organized as
            follows. Each of the first three sections in devoted to one
            of the countries with a specific emphasis on the main policy
            issues. The last section turns to a more general analysis of
            the intratemporal efficiency costs of the taxation of
            financial assets which draws on the empirical evidence of
            the previous sections.
geo_reg_key: 517198,517191
repnme: repnme: The effects of financial liberalization on
            Thailand, Indonesia, and the Philippines : a quantitative analysis
display_title: The effects of financial
            liberalization on Thailand, Indonesia, and the Philippines :
            a quantitative analysis
listing_relative_url: /research/1988/10/700619/effects-financial-liberalization-thailand-indonesia-philippines-quantitative-analysis
topicv3: Commercial Banking m1326069 1236,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Capital Markets m1326967 332,Taxation m1327615 1121,Financial Institutions m1505015 3797
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Finance and Financial Sector Development,Environment
origu: Policy Plan & Prog Review Dept (PPR)
no_of_pages: 53
model_extractions: <!-- Start of picture text --> Plc,Planning, and Reaearch<br>Pubic¢ 'aconomlc*<br><!-- End of picture text --> In the early 1980s, interest rate ceilirngs and other regulations affecting financial assets were lifted in Thailand, Indonesia, and the Philippines.

Did financial liberalization work equaly well in all thiee countries? The topic is important because the heavy burden many countries put on tinancial institutions falls mainly on the holders of financial assets.

removed. Similar reform failed in the Philippines, where taxes on the financial sector interacted with high rates of inflation.

As the quantitative evaluation in this paper shows, the efficiency gains in Thailand and Indonesia were small compared with GDP but large compared with the levels of transfers (explicit or implicit) induced by policies of regulation.

The answer is that liberalization of interest rates significantly increased the real return on financial assets in Thailand and Indonesia, because all interest and credit constraints were The chief lesson to be drawn from these - experiences particularly in the Philippinesis that reallocating resources by manipulating the financial system may be less efficient than other fiscal policies.

This paper is a product of the Public Economics Division, Country Economics Department. Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contactAnn Bhalla, room N10-077, extension 60359.

The PPR Working Paper Series disseminatis the findings of work under way in the Bank's Policy, Planning, and Research Complex. An objective of the series is to get these findings out quickly, even if presentations are less than fully polished. The ftmnings, interpretations, and conclusions in these papers do not necessarily represent official policy of the Bank.
# Table of Contents

# THE REMOVAL OF INTEREST CEILINGS AND OTHER REGULATIONS ON FINANCIAL ASSETS IN THAILAND. INDONESIA AND THE PHILIPPINES: A QUANTITATIVE EVALUATION

|I.|INTRODUCTION<br>AND SUMMARY<br>......................................|...<br>1|
|---|---|---|
||Summary..........|3|
|II.|THAILAND..........|5|
||A.<br>Interest<br>RatesPolicy<br>before<br>1980.|6|
||B.<br>The Openness of the Financial<br>System.|8|
||C.<br>The Interest<br>Rate Liberalization<br>of 1980 .13||
||D.<br>The Impact of the Reform .13||
|III.|INDONESIA<br>..|17|
||A.<br>The Regime Before June 1983 .18||
||The Policy Context .18||
||Financial Institutions<br>and Policy ...........................<br>|....<br>18|
||Interest Rates:ATwo-Sector Banking System .20||
||<br>Rediscounting by the Central Bank ...................|21|
||B. The Open Economy .22||
||C. The 1983 Reform .22||
||The Context: Pressures of the International<br>Markets .22||
||Policy Measures ............................|27|
||D. The Impact of the Reform ............................|27|
|IV.|PHILIPPINES<br>.....................<br>,<br>.<br>..........|**30**.,<br>.|
||A.<br>The Openness of Capital<br>Markets...<br>,,.,,,,,.31||
||B. Explicit and Implicit Taxes on Banks .....................|.. 36|
||Explicit Taxes ...........................**.**<br>,, ,,,,,,,,.|36|
||Implicit Taxes ........................<br>,,,.,,,.,.,,...........|36|
||The Interaction<br>of Inflation and Taxes on Financial<br>Institutions ..... ,,,,,,,,,.,............|37|
||C. The Impact of Interest Rates on Deposits<br>...|39|
|V.|THE EFFICIENCY GAINS OF INTEREST LIBERALIZATION<br>...<br>,,.|39|
|VI.|CONCLUSIONS ................................................|......<br>47|
|REFE|RENCES .............................................<br>,,,,.,.......|48|

We are grateful to Javad Khalilzadeh-Shirazi for discussions and support and to Ajay Chhibber for particularly useful comments.
# I. INTRODUCTION AND SUMNARY

The taxation of financial assets is determined by a numoer of policy instruments which can be divided into two groups that belong to the tax code and to other financial policies, respectively.

This paper will deal mostly with the second set of policies. The list of these instruments includes reserve requirements, rules for the investments of financial institutions, ceilings on borrowing and lending rates, and credit ceilings. They have been used either when the tax administration or standard taxes have been inadequate for raising the desired revenue (an example is seignorage), or when policymakers have preferred to affect the allocation of resources through nontax instruments (such as interest ceilings or credit targets). It is noteworthy that nontax financial policies may have an impact on the real rate of return of financial assets tha;. dwarfs that of the standard tax instruments. For example, a direct tax on interest income has an effective rate smaller than one hundred percent in an economy with no inflation. But the combination of an inflation policy with ceilings on interest rates can easily lower the net raal rate to negative values.

In developing economies, the bulk of financial assets consists of bank deposits. This institutional setting is explained by the embryonic nature of the capital markets and other financial institutions. Indeed, the role of banks ir. the mobilization of resources has been emphasized by several authors in the seventies (Shaw [197J], McKinnon [1973]), and has been mentioned previously for other countries such as Germany in the nineteenth century. These authors have stressed that the removal of taxation of financial assets would generate a large expansion of the
- 2 -

financial sector, a higher rate of saving and of output growth. The removal of the so-called "financial repression" has even been called the 'linchpin" theory of economic development.

One of the most commonly observed forms of implicit taxes that falls on financial assets is the implementation of interest ceilings for loans made by financial institutions. The purpose of this tax is to lower the borrowing cost for borrowers (private or public). In most cases it has a direct impact on the real rate of return of financial assets. Indeed some financial institutions may be able to circumvent the ceilings or loans with fees and compensating balances. But in doing so they merely appropriate some of the rents generated by the rationing of funds. They are rarely in a position to pass on this rent to the depositors who have to be content with the regulated loan rate minus a "fair" margin for banking costs. This paper will concentrate mainly on the removal of interest ceilings (and some other regulations) that occurred in the early eighties, in a group of three countries in South East Asia, Thailand, Indonesia and the Philippines. It has two motivations. First, the liberalization of interest rates has led to significant increases of the real return of financial assets and may provide interesting policy lessons. Second, the topic is important because a number of countries are maintaining a heavy tax burden on financial institutions that falls to a large extent on the holders of financial assets.

We have chosen three countries in Southeast Asia because their similarities enable an observer to make meaningful comparisons and their differences provide some variety in the policy experiments. These countries belong to a common area, they are fairly open to the same foreign capital markets, they may even share some cultural features, and they have introduced reforms at about the same time, in the early eighties. They
- 3 -

also offer a variety of institutional settings, natural resources and macro-economic policies.

The liberalization of the financial sector in these countries has already been described in other studies (Ilang-Sheng Chen, ed., [1984]). However, a new evaluation is useful at this stage because there has been more time to acquire a better perspective and more information. Furthermore, this paper will put a special emphasis on a comparative approach for the three countries.

-Summarv

The main lessons for policy are the following:

1. Because of the openness of all the three economies, the domestic interest rates are affected by foreign rates. The rise of the international rates in the early eighties was a decisive factor in the breakdown of long standing interest ceilings in all three countries.

2. The removal of interest ceilings and other regulations on credit has led to a spectacular growth of deposits in Thailand and Indonesia. In the Philippines a significant relation between the real rate of deposit and the M2 to GDP ratios was found. However, the positive effect of intsrest liberalization was offset by the interaction of inflation and taxes on financial institutions and the N2 to GDP ratio did not change after the liberalization of interest rates.

3. The growth of M2 was much higher than that of income in Thailand and Indonesia, but it did not result in higher inflation. The large response of financial assets to the net real rate available to depositors shows a high
- 4 -

degree of substitutability with other assets. These other assets are presumably traded in informal or foreign markets. The lack of available data on informal markets has precluded an examination of the effect of interest liberalization in this market. Its importance is nevertheless well established (the Bank of Thailand estimates its size to be of the same order of magnitude as that of the formal market). The high substitutability with foreign markets is documented here t&rough a comparison of the domestic and foreign rates of return.

4.

The large response of deposits to the net real rate of return shows that the intra-temporal efficiency cost of the taxation of financial assets is large in economies that have opportunities for substitution with foreign or informal capital markets. We found that this cost is low as a fraction of GDP but high in terms of revenues (explicit or implicit). It was probably greater tharn 40 and 100 percent of revenues in Thailand and Indonesia, respectively. These numbers are much larger than the commonly accepted values of the efficiency cost of the labor tax.

~.5. The high degree of substitutability between financial assets and other assets implies that the increase of deposit real rates had a minimal impact on the overall rate of return of savings. This eviderce is therefore in agreement with the results of other studies that found no relation between the rates of return on deposits and the saving rate (Giovanini, [1983],
- 5 -

empirical work that was done as a background to the present paper. They were omitted because a complete analysis that takes into account country specific factors would require another study.

6. The large financi' deepening (as measured by the increase of the M2 of GDP ratio), occurred in a period of lower growth for Thailand and Indonesia. A proper test of the "linchpin" theory of development is beyond the scope of the paper, but the current evident does not support this theory.

The paper is organized as follows. Each of the next three sections is devoted to one of the three countries with a special emphasis on the main policy issues. In the last section we turn to a more general analysis of the intratemporal efficiency cost of the taxation of financial assets which draws on the empirical evidence of the previous sections.

# 11. THAIILAND

Before 1980, the government of Thailand had conducted an active policy on interest rates and credit targets that had a significant impact on the implicit taxation of the system and that induced a substitution of financial assets towards the informal and foreign markets. This policy was motivated by a long tradition of low interest rates and usury laws rather than by the need to lower the cost of domestic public borrowing Two lessons can be drawn from the experience of Thailand: (i) The competition of foreign markets severely restricts the capacity of the government to regulate interest rates (and indirectly tax the domestic system of financial intermediation), and
- 6 -

(ii) The raising of interest ceilings has a powerful effect on the expansion of the financial system.

The arguments are developed in this section in the following sequence. First, we describe briefly the policy before 1980. Second, we provide empirical evidence of the linkage between domestic and foreign capital markets. Third, we show how the raising of international rates led to the removal of interest ceilings. Fourth, we analyze quantitatively the impact of interest rates on the level of bank deposits which represent the bulk of financial assets in the domestic formal sector.

# A. Interest Rates PolicE before 1980

Ceilings on interest rates came from a long tradition in Thailand. Since the government did not use inflationary finance, prices have been by and large stable and real rates have been positive. The ceilings on interest rates have at times contributed to a lower cost of the public debt, but the amount of this subsidy has remained relatively modest. Table 1 presents the ratios between net government borrowings from commercial banks and GDP, the nominal interest rates on deposits and the real rate. The system of rigid rates experienced its first jolt in 1973-1974 with the inflationary shock that was due to the first oil crisis. Real interest rates became negative and the money (M2) to GDP ratio began to decline. This period did not last long, and real interest rates regained a positive level after prices were stabilized in 1975.

The second oil shock and the U.S. policy of high interest rates brought the system to an end. The ceilings on interest rates were not compatible with a regime of open capital markets, stable exchange rates in an environment which provided ample opportunities for substitution with markets in neighbor countries (Singapore, Hong Kong, which are linked to other markets). We now turn to a quantitative analysis of the competition of foreign markets.
Table 1. Thailand

||(1)<br>NETCOGGD|(2)<br>LEPR|(3)|(4)<br>RDEPR<br>(2-3)|
|---|---|---|---|---|
|1972|6.86|5.0|4.85|0.15|
|1973|5.54|5.0|15.50|-10.50|
|1974|4.60|6.0|24.32|-18.32|
|1975|4.83|6.0|5.33|0.67|
|1976|4.83|6.0|4.15|1.85|
|1977|4.45|8.0|7.60|0.40|
|1978|4.01|8.0|7.92|0.08|
|1979|3.34|8.3|9.89|-1.65|
|1980|3.12|12.0|19.70|-7.70|
|1981|3.42|12.5|12.66|-0.16|
|1982|4.97|13.0|5.26|7.74|
|1983|4.04|13.0|3.73|9.27|
|1984|6.62|13.0|0.86|12.14|
|1985|5.72|13.0|2.43|10.57|
|1986|7.63|9.8|1.84|7.91|
|1987|7.59|9.5|2.47|7.03|

Note: NETCOGGD COG - GD - DEPR - i - RDEPR (COG-GD)/GDP where Commercial banks' claims on government and Government deposits at commercial banks Deposit Rate Inflation Rate Using the CPI Real Deposit Rate (DEPR-ir) Source: IFS.
-8-

# B. The Openneas of the Financial System

The formal financial system faces two competitors. The first is the domestic informal market that is well developed. Its size is notoriously difficult to estimate, but some authors think that it almost matches the size of bank deposits (Vorgpradhip, [1986]). The interest rates observed in this market are higher than in the formal market. This differential was probably due both to the higher risks and to the rationing in the formal market.

> The other competitor for banks is the foreign market. . . the sixties, the exchange policy of Thailand has been a stable exchange rate and an open capital account. This regime and the proximity of active financial centers such as Singapore or Hong Kong, which act also as intermediaries with world capital markets, generates an environment that is suitable for a high degree of substitutability between domestic fin&ncial assets and foreign assets. In order to test the hypothesis that the domestic rates are influenced by foreign rates, Thailand's quarterly money market rate was regressed on Singapore's money market rate and other independent variables. The time period used is 1974-1987 and the equation is of the form:

rTHA - CONST + _plTSGP_ + 2[GDPI + P3 ' + P4 (rTHA)_1<sup>9</sup>

- where rTHA is the money market rate for Thailand, rSGp is the money market rate for Singapore,

- GDP is the ratio of nominal GDP to Ml in logarithms, M

r is the inflation rate for Thailand,

- and (rTHA)-1 is the lag of the money market rate for Thailand.
- 9 -

Since there is no quarterly data for GDP at market prices, quarterly series were formed from annual series through interpolation. The results of the regression are presented in Table 2a.

As expected, the foreign interest rates do have a high correlation with the domestic rates with a t-statistic of 4.0. The coefficient of

[GDP) representing the degree of tightness of the monetary policy, has a very low number (.003), with a t-statistic of 0.3. and is insignificant. The inflation rate (Xt) is also insignificant. When M2 is replaced by the monetary base, the results are almost identical, and therefore omitted from the table.

Table 2a: Determinants of the Interest Rate for Thailand

|Variable<br>Parameter Estimate<br>T-Statistic|
|---|
|1974-87) Quarterly Using Money Supply (M2)<br>ariable-<br>rTHA<br>CONST<br>0.009<br>0.8|
|rSGP<br>0.484<br>4.0|
|GDP/M2<br>0.003<br>0.3|
|iX<br>-0.079<br>0.6|
|rFTHA_1<br>0.627<br>7.0|

I. Thailand (1974-87) Quarterly Using Money Supply (M2) DeR Variable - rTHA R-Square - 0.838 Durbin-Watson D - 1.81 Source: IFS.
- 10 -

The estimation equation does not include the rate<sup>of change of the</sup> exchange rate because the exchange rate was<sup>stable except for in two</sup> devaluations that occurred (by 11.5 percent) in<sup>1981 and (by 18.0 percent)</sup> in 1984. The determination of a proxy for the expected rate of devaluation when devaluations are discrete, is a delicate issue. We have preferred<sup>to</sup> assume that this expectation is represented by<sup>a Poisson process and that</sup> it is contained in the constant term of the equation.<sup>This procedure is</sup> not very satisfactory and may be improved in subsequent work.

The equation was reestimated without the significant variables and under the form: rTHA - CONST + xl rSGp + (1 - xl + P)(rTHA)_ The results (line I of Table 2b) show that the<sup>coefficient6is not</sup> significantly different from zero and that an increase<sup>of the Singapore</sup> rate by one point implies an equal increase of<sup>the Thai rate, in the</sup> long-run.

Since a visual comparison of the rates in Thailand<sup>and in the</sup> euro-dollar markets may indicate a exchange of regime<sup>after 1980 (see also</sup> Figure 1), the equation was estimated separately<sup>for the two subperiods</sup> (74-80) and (81-87). The results in line II and<sup>ITI of Table 2b show that</sup> there is no econometric evidence for such<sup>a shift. A Chow test did not</sup> infirm the stability of the estimated coefficients.

Another indication of the close relation between<sup>domestic and</sup> foreign rates of interest is given by<sup>the Figure 1 which represents the</sup> money market rates in Thailand and Singapore.<sup>From the previous regression</sup> we expect to observe a close relation<sup>between the two rates, but the</sup> diagram shows also that the domestic rate is never smaller<sup>than the foreign</sup> rates. At times the difference is large (this<sup>difference is probably due</sup>
- 11 -

Table 2b: Determinants of the Interest Rate for Thailand Variable Parameter Estimate T-Statistic Thailand (1974-87) Quarterly DEP Variable - T THA CONST 0.011 1.5 (TSGP - TTHA-1 ) 0.460 4.4 TTHA-1 1.096 15.1 R-Square - 0.836 Durbin-Watson D - 1.81 I. Thailand (1974-87) Quarterly II. Thailand (1974-80) Quarterly Using Money Supply (M2) DeR Variable - TTHA CONST 0.072 1.6 TSGP 0.332 2.7 GDP/M2 -0.052 -1.2 0.016 0.1 0.675 4.9 R-Square - 0.857 Durbin-Watson D 1.84 III. Thailand (1981-87) Quarterly Using Money Supply (M2) DeR Variable - rTHAL CONST 0.008 0.4 7SGP 0.686 2.3 GDP/M2 0.008 0.02 X -0.204 -0.6 TTHA-1 0.552 3.4 R-Square - 0.825 Durbin-Watson D 1.79
- 12 -

# Figure **1.** Money Market Rates<sup>and Three-Month</sup> Euro-Dollar Rates

|12.:|If<br>iS.0~~~~~~~~~~~~~~~~~~.<br>Ia<br>.'<br>;NZ (z~<br>M<br>m<br>rte|II|:|
|---|---|---|---|
||ER = Eurodollc9<br>1r80 1981 1982 198a i<br>MR"<br>Monev muarket<br>race<br>ER Eurodolla**r**ate|18e||
- 13 -

to speculative attacks on the baht). Foreign rates provide a floor on domestic rates: if the domestic rate is lower than foreign rates, then capital moves abroad.

# C. The Interest Rate Liberalization of 19 ')

The liberalization of interest rates in Thailand was forced by the increase of international rates in 1980 and the policy of open capital markets with a stable currency. The sequence of events is illustrated in Figure 2. Until 1979, the lending and the deposit rates (represented by the schedules LRATE and DEPR in the figure) were constant. The money market rate in Thailand (MHR) evolved in the interval between these two rates. It increased gradually in the late seventies under the pressure of the international rates (represented by the money market rate in Singapore, MMRSGP). In 1980, the continuation of fixed rates for loans and deposits became infeasible and the values of the ceilings were raised.

# D. The Impact of the Reform

The impact of the interest liberalization was impressive, as can be seen in Figure 3. The quantity of money M2 increased at the average annual rate of 18 percent between 1980 and 1986. This large increase occurred with no effect on the price level; during the same period the average inflation rate was equal to 4 percent.

The response of deposits to the rate of return is supported by estimations of the demand for money (M2). Various specifications are presented in Table 3. All the coefficients have the right sign and the opportunity cost of money is significant and negative. The sum of the coefficients of the deposit rate, the inflation rate, and the money market rate is zero, which is as it should be: the demand for money depends on the differences between the return of money and the returns of other assets.
- 14 -

<!-- Start of picture text --> Figure 2. Interest Rate in Thailand Around<br>the Time of the Reform<br><!-- End of picture text --> <!-- Start of picture text --> 20-<br>12 i_ DEP<br>I8<br>4<br>2-<br>'M Moncy0Market mmt<br>LRATE Lending rate<br>;-RSGP Singapore Money Marcet rate<br><!-- End of picture text -->

# EFS Data
# Figure 3. The Expansion of Bank Deposits in Thailand

<!-- Start of picture text --> 0.7 .<br>0.6 -<br>0.5<br>[ j<br>0.4 Z-_- 0 o K-MIZ<br>0. 3 VW* M2Z<br>1 *- ~~~~~~~~~~~~~~~~~~~~~~INF<br>0.2<br><!-- End of picture text --> <!-- Start of picture text -->
*o.1 9-0-t  -2-3-4-5-B-7-6-9-0-1-2-3-4-5-6-7<br><!-- End of picture text -->

MIZ %II/GDP .M'2Z M2GD; INF lnflaton rate (CPl) Source [FS
- 16 -

Table 3. Results of Money Demand Equations for Thailand

|I.<br>Dependent<br>Variable|Constant<br>LM2Z(-l)|MMR|DEPR|irDEF|
|---|---|---|---|---|
|DIFLM2Z<br>(1974-86)|-0.05<br>-0.131<br> <br>(2.8)<br>(3.8)|-0.338<br>(3.4)|0.799<br>(6.1)|-0.413<br>(10.8)<br>R2<br>0.945<br>DW-<br>2.48|
|II.<br>Dependent<br>Variable|Constant<br>LMlZ(-l)|DEPR|wDEF||
|DIFLM1Z<br>(1972-87)|-0.30<br>-0.312<br>(2.7)<br>(2.9)|-0.730<br>(3.2)|-0.108<br>(1.3)||
|||||R-- 0.710<br>DW-<br>1.35|
|Note: LM2Z<br>-<br>log (<br>DEPR<br>-<br>Depos<br>LMIZ<br>-<br>log (<br>MMR<br>-<br>Money<br>iwDEF<br>-<br>Infla<br>DIFLM2Z-<br>(LM2Z<br>DIFLMlZ-<br>(LMlZ<br>Source: IFS.|M2/GDP)<br>it Rate<br>Ml/GDP)<br>Market Rate<br>tP,n Rate using the GDP<br> -<br>(LM2Z (-1))<br> -<br>(IMIZ (-1))|Deflator|||
- 17 -

Figure 3 shows that MI has been less responsive than M2 to changes of the rate of return. This is confirmed by the estimates of demand for MI (second equation in Table 3). The rate of return on deposits has a significant value with a negative sign. As expected the response of Ml to rates of return are weaker than for M2.

# III. INDONESIA

Before 1983, the financial system was constrained by ceilings on interest rates and on the expansion of credit. This policy generated a low rate of return for financial savings. As a consequence, the degree of monetization was low; the M2 to GDP ratio was stationary during the seventies at a level of 18 percent, and time deposits represented about 20 percent of M2. As in Thailand, the openness of the economy to foreign markets and the increase of world interest rates imposed the liberalization of the interest rates.

This liberalization occurred in June 1983, therefore a little later than in Thailand, and the delay may be explained by the second oil boom that lasted until 1982. Its lessons are similar to those of the Thailand experience.

(i) The removal of the ceilings on the rates and the volume of credit was followed by a expansion of the financial sector that was large, but smaller than in Thailand. The M2 to GDP ratio grew from 22 percent to 30 percent between 1982 and 1986.

(ii) The expansion of financial assets came from a substitution with foreign assets and the informal market. The rapid growth of financial assets after 1983 shows that the taxation of financial assets implies significant efficiency costs.
- 18 -

The purpose of this section is to provide a quantitative evaluation of the interest liberalization in Indonesia, which can be compared with the similar experiences in Thailand and the Philippines. The description of the experience will be kept short since an excellent account of the financial policy has been given by Balifto et al. (1985, 1987).

A. **The** Resime Before June 1983

# The Policy Context

The context .'or the policy on financial assets before and after the reform has the following elements:

- The government is prevented from borrowing domestically by a balanced budget law (which does not apply to foreign borrowing).

- Oil is an important resource for the government which has produced well known windfall gains in 73-74 and again in 79-80.

- The economy is open: there is no restriction on foreign trade or capital transactions. The exchange rate is managed with periodically large devaluations by 50.6 percent in 1978, 43.5 percent in 1983 and 45.9 percent in 1986.

- Interest rates and credit have been regulated until 1983.

# Financial Institutions and Policy

- The main financial institutions are:

- The Central Bank (43 percent of assets in 1982) that plays an important role in financial markets through its large rediscounts of banks' loans to the preferred sectors (at preferential rates).
- 19 -

- The state commercial banks (79.6 percent of assets in 1982) that were constrained by ceilings on deposit rates, loan rates and level of credit.

- 1v private banks (16.8 percent of assets in 1982) that consist of sixty nine national banks (with 9.9 percent of total assets in 1982), and eleven foreign banks which were not subject to ceilings on interest rates credit levels but faced other constraints on their activities (such as lending) to to enterprises basad in the Jakarta area).

The two main elements of the financial policy were therefore the ceilings on interest rates and credit, and the rediscounts of the Central Bank. Two preliminary two remarks can be made about these policies.

- The interest rates ceilings were not motivated by a need for cheap public borrowing since a balanced budget law prevented the government from borrowing domestically, and the debt of public enterprises was relatively low; less than 2 percent of GDP. The ceilings applied to state banks, which dominate the financial sector institutions.

- The rediscountings by the Central Bank at low rates reached a level that was almost half of the banks' credit to the private sector. Resources were available for these loans. They were financed by seignorage. Resources were available to BI because the government did not borrow from the Central Bank.
- 20 -

# Interest Rates: A Two-Sector Banking System

The difference between the deposit ratas in the state and the private banks is evident in the data of Table 4. Given this d'fference, it is surprising that state banks were able to collect deposits. Some have argued that the deposits at state banks were insured by the government, but the failure of the foreign banks was unlikely and this argument is not convincing. A better explanation is that the government required public enterprises to keep deposits with the state banks. In July 1984, deposits of state enterprises, government agencies, and financial institutions were equal to about 46 percent of state bank time deposits and 71 percent of their demand deposits, (Balifio and Sundararajan, 1985.) Another explanation is that borrowers who benefited from the preferential loans (granted only by the state banks) were forced to keep balances with the state banks.

Table 4. Interest Rates in Indonesia

|Year|(1)<br>State<br>banks<br>6 month<br>deposit<br>end of<br>period|(2)<br>Private<br>banks<br>6month<br>deposit<br>end of<br>period|(3)<br>Singapore<br>MMR|(4)<br>State<br>Banks<br>Lending Rate|(5)<br>UsingCPI|(6)<br>If<br>X<br> GDP Deflator|(7)<br>Real Deposit<br>Rate<br>(1-5)|
|---|---|---|---|---|---|---|---|
|1972|15.0||3.57||6.42|13.59|8.58|
|1973|12.0||11.69||31.03|32.94|-19.03|
|1974|12.0||8.90||40.63|47.31|-28.63|
|1975|12.0||4.39||19.07|12.47|-7.07|
|1976|12.0||4.15||19.84|14.46|-7.84|
|1977|9.0||4.76|9.0|11.02|12.87|-2.02|
|1978|6.0||5.93|9.0|8.11|11.08|-2.11|
|1979|6.0|16.75|7.76|9.0|20.59|32.51|-14.59|
|1980|6.0|18.45|10.98|9.0|18.53|29.15|-12.53|
|1981|6.0|18.05|11.54|9.0|12.24|18.50|-6.24|
|1982|6.0|18.35|7.92|9.0|9.48|5.13|-3.48|
|1983|6.0|18.63|7.11|9.0|11.79|13.20|-5.79|
|1984|16.0||7.67|12.0|10.46|11.27|5.54|
|1985|18.0||5.38|12.0|4.73|6.49|13.27|
|1986|16.0||4.27||5.83|||
|1987|||3.89||9.28|||

Source: IFS.
- 21 -

Rediscounting by the Central Bank Loans by the Central Bank are either direct loans or rediscounts of loans made by the commercial banks. The direct loans have bqen made essentially to the public sector (mainly to PERTAMINA). BI's rediscounts, called liquidity credits, were made for preferential sectors. In most cases, the lending rate charged by the commercial banks was fixed at 12 percent, and BI rediscounted between 70 and 100 percent of the loan at the rate of 3 percent. The commercial bank's share in a loan was therefore at most 30 percent.

These rediscounts required large resources of the Central Bank that come essentially from seignorage and the net deposits of the government in equal parts. Since these resourc.es are fungible, a direct relation between seignorage or government deposits and BI rediscounts cannot be established. Nevertheless, the Central Bank has maintained an approximate balance between the levels of liquidity credits and that of the monetary base or the government net deposits. Whether this policy was deliberate is not clear at this point.

The liquidity credits were very important resources for the DMBs, (with a level equal to about half of that of deposits). Their share of the loans (at most 30 percent) to the preferential sector was financed by deposits that paid a low interest rate because of BI regulation. The rediscounting mechanism was therefore fairly profitable to state banks. Furthermore, the state banks could benefit from the requirement that public enterprises kept deposits with the state banks. This policy was similar to an official requirement that borrowers (or potential borrowers) should keep compensating balances with the banks. It may have increased the effective margin between the loan and the rediscount rates that was already high.
- 22 -

# B. The Open Economy

As in Thailand, the mobility of capital between Indonesia and foreign markets presented a constraint on the interest policy that ultimately led to the removal of interest ceilings. Since this market structure plays an important role in the political economy of financial reforms and is a factor that contributes to the large expansion of domestic financial assets after the reform, it is interesting to examine the empirical evidence.

We have therefore investigated the determinants of the domestic money market interest rate by the same method as for Thailand. The results are presented in Table 5. Two measures of the foreign rate are used; the first is the Singapore money market rate; the second uses the same rate corrected by the actual variation of the exchange rate. We can observe that the second measure performs poorly, for the same reasons as in Thailand. Periods of a crawling exchange rate were interrupted by maxidevaluations in 1979 and 1983. In this context the proxy for the expected value of the depreciation of the exchange rate can be taken as a constant which implies a premium of the domestic rate over the foreign rate.

The results support the hypothesis of a link between the foreign and *:he domestic rate. There is also some evidence that the domestic mon6rary policy in Indonesia may have affected the domestic money market rate.

# C. The 1983 Reform

# The Context: Pressures of the International Markets

The financial policy of interest and credit ceilings became unsustainable in the early eighties when foreign interest rates rose. The level of net foreign assets of banks, as a fraction of deposits, had been rising since 1973 (Table 6). In 1979 it became positive. In order to stem
23 Table 5. Determinants of the Interest Rate for Indonesia

|Variable|Parameter Estimate|T-Statistic|
|---|---|---|
|I. Indonesia (1978-87) Quart|erly Using Monetary Base|(MB)|
|DEP Variable-<br>rIDN|||
|CONST|0.639|1.9|
|rISp|0.654|2.1|
|GDP/MB|0.255|2.0|
|7r|0.458|1.2|
|7IDN.1|0.130|0.6|
|||R-Square-<br>0.395<br>Durbin-Watson<br>-<br>2.0|

II. Indonesia (1978-87) Quarterly Using Monetary Base (MB)

|DEP Variable: rIDN||
|---|---|
|CONST|-0.472<br>1.3|
|fSGP+e|-0.078<br>0.8|
|GDP/MB|0.210<br>1.5|
|ir|0.544<br>1.3|
|nIDN-1|0.253<br>1.2|
||R-Square-<br>0.308<br>Durbin-Watson-<br>2.0|

Note: e is the change of the exchange rate between the home country's currency and the Singapore Pound.

Source: IFS.
- 24

Table 6. Financial Ratios of the Deposit Money Bank in Indonesia

||RES|NFA|TRES|CPS|NETCG|K|OT|LIABIL|CCB|
|---|---|---|---|---|---|---|---|---|---|
|1972|0.286|-0.225|0.061|1.191|-0.055|0.148|0.275|1.423|0.479|
|1973|0.281|-0.451|-0.17|1.433|0.12|0.178|0.656<br>|1.834|0.393|
|1974|0.42|-0.444|-0.02|1.328|0.192|0.174|0.766|1.94|0.373|
|1975<br>|0.38<br>|-0.221<br>|-0.159<br>|0.477<br>|0.227|0.211|-0.127|1.084|0.461|
|1976|0.36|-0.145|0.215|0.458|0.252|0.188|-0.118|1.07|0.397|
|1977<br>|0.36<br>|-0.126<br>|0.234<br>|1.093<br>|0.228<br>|0.216<br>|0.464<br>|1.68<br>|0.333<br>|
|1978<br>|0.274<br>|-0.087<br>|0.187<br>|0.584<br>|0.205<br>|0.229<br>|-0.166<br>|1.064<br>|0.383<br>|
|1979|0.313|0.001|0.314|0.604|0.189|0.178|-0.071|1.106|0.409|
|1980|-0.295|0.19|0.486|0.612|0.152|0.188|-0.128|1.06|0.383|
|1981|0.243|0.24|0.483|0.569|0.161|0.172|-0.199|0.973|0.442|
|1982|0.3|0.034|0.334|0.636|0.283|0.191|0.028|1.219|0.587|
|1983|0.205|0.115|0.32|0.702|0.26|0.184|-0.017|1.166|0.481|
|1984|0.203|0.106|0.308|0.628|0.318|0.197|-0.049|1.149|0.629|
|1985<br>|0.194<br>|0.132<br>|0.326<br>|0.675<br>|0.239<br>|0.168<br>|-0.059<br>|1.108<br>|0.464<br>|
|1986|0.168|0.153|0.321|0.802|0.234|0.175|0.029|1.204|0.444|
|1987|0.149|0.085|0.235|0.866'|0.178|0.159|0.035|1.194|0.352|

# Variables

All variables are expressed as a fraction of total deposits (demand and time).

RES -serves NFA Ne6 foreign assets TRES Sum of RES and NFA cPS Net banks' credit to the private sector (the difference between the banks' credit to the private sector and the BI rediscounting).

NETCG Sum of credit to the government and to public enterprises minus the government's deposits. K Banks' capital OT Net other liabilities minus loans to other financial institutions LIABIL Total liabilities (equal to total assets) CCG BI loans to DNBs (rediscounting) The variable NETCG does not represent the net liability of the public sector since it does not include the deposits of the public enterprises. (The net position of the government with DMBs has been always positive).

The level of total liabilities (of assets) exceed that of deposits. Therefore the value of LIABIL is greater than one.
- 25 -

this growth BI started to pay interest on excess-reserves in 1978. The liquidity ratio of banks (the sum of net foreign assets and reserves divided by total deposits), continued to increase after 1978 (Figure 4). This growth of the liquidity ratio had two causes. Banks were facing a constraint on the expansion of credit and domestic lending rates were low with respect to foreign rates. Both of these factors contributed to the high liquidity ratios. One could argue that since the credit constraint was binding it may have been the sole explanation of the high liquidity. eilings on loan rates, the enforcement of the credit constraint might have proven to be impossible, and that therefore both factors had an effect. In other terms, it seems doubtful that a relaxation of the credit constraint would have led to a significant expansion of the banks' credit to the private sector and interest ceilings may have been the main constraint on the expansion of domestic financial assets. (Such a hypothesis is difficult to test, however).

The differential between domestic and foreign rates induced an outflow of capital. The second oil boom of 1979-1981 provided a temporary counterweight to this outflow. But, in 1982, the net foreign assets of the financial system began to fall. Furthermore, the real exchange rate had decreased during the boom period because of domestic inflation. The nominal exchange rate was allowed to depreciate at the cumulative rate of 12 percent between 1980 and the March of 1983, when a maxi-devaluation of 39 percent was effected. The new exchange rate created an environment where the financial markets could be liberalized without a severe disruption due to speculation against the rupiah.
- 26 -

Figure 4. Liquidity Ratio of the DMBs (Reserves Plus Net Foreign Assets)/ Total Deposits TRESRAT <!-- Start of picture text --> 0.45<br>0.4 /<br>0.35 -<br>0.3i<br>0.25<br>0.2__<br>0.1s ,__<br>0..05 _<br>76 77 78 79 so 8 82 83 84 as 86 87<br><!-- End of picture text --> <!-- Start of picture text --> Source: IFS.<br><!-- End of picture text -->
- 27 -

# Policy Measures

The main effect of the reform was to eliminate in June 1983 the

- bank credit ceilings

- state banks' interest rates on deposits and loans (except for the remaining priority loans)

Simultaneously with this change of regime, a process to reform of the credit policy of the Central Bank towards commercial banks was initiated with the

- Phased removal of a wide range of loan categories from access to the Central Bank liquidity credits

- Introduction of rediscount facilities and the BI certificate (SBI) as new tools of monetary control (February 1984)

- Introduction of new money market instruments (February 1985).

- D. The Im2act of the Reform

The main impact of the reform has been the large increase of bank deposits. As can be expected, the growth of interest bearing time deposits has been the dominant component of this growth (Figure 5). The response of the demanu for money to the interest rate is apparent in the estimates of the demand for money that are presented in Table 7. The deposit rate was also found to be significant for the sub-period 1972-1982 during which public enterprises were required to hold deposits at the state banks.

Both the nominal rate and the inflation rate are significant variables, but they can be replaced by their difference, i.e., the real deposit rate, without loss of explanatory power. In order to determine the long-run response of the demand for money, we have estimated the equation
- 28 -

Figure 5. Financial Deepening and the Real Interest Rate in Indonesia <!-- Start of picture text -->
-<br>0.4;<br>0 ~  ~5  °_0_r°\°-  76  °7a=0o-°  08  8  .7 .87  48  68 M2Z<br>° ' *1- =~~~~~~~~~~~~~~~~C- RRAT<br>73 74  75  76  77  78  79  80  81  82  83  84  83  86  87<br>MIZ  Ml/GDP~~~~~~~~~~~~~I<br>Daw: I_  dS<br>',IZ  -MI/GDP<br>IN5F  Inflation rate (CPI)<br>RRATE  Oppomtuniy  cost  of money- INF - Deposit rate<br><!-- End of picture text -->

Data:[FS
- 29 -

Table i. Results of Money Demand Equations for Indonesia (Annual Data)

|I.|Dependent<br>Variable|Constant|LM2Z(-l|)<br>DEPR|irDEF|
|---|---|---|---|---|---|
||LM2Z<br>(1972-85)|-0.172<br> <br>(1.6)|0.747<br>(5.7)|<br>0.297<br> <br>(2.0)|-0.244<br>(4.9)|
||||||R2- 0.939<br>DW-<br>1.86|
|II.|Dependent<br>Variable|Constant|LM2Z(-l|)<br>RDEPRDE|F|
||DIFLN2Z<br>(1972-85)|-0.13<br> <br>(1.9)|-0.206<br>(2.4)|<br>0.240<br> <br>(6.2)||
||||||RZ-<br>0.778<br>DW-<br>1.66|
|Note:|LM2Z<br>-<br>DEPR<br>-<br>DIFLM2Z<br>-<br>wDEF<br>-<br>RDEPRDEF<br>-|Log(M2/GDP)<br>Deposit rate<br>_:4M2Z_- LU2Z(-l))<br>Inflation rate using<br>Real deposit rate or|the GDP<br>(DEPR-|deflator<br> xDEF)||

Source: IFS.
- 30 -

The coefficients in the equation imply that an increase of the real rate by 20 percentage points (which is the variation between 1980 and 1986) generates an increase of the money to GDP ratio of 23 percent. This value is obviously very sensitive to the estimated coefficient of lagged money, which is subject to a significant uncertainty. The range within two standard deviations is between 5 and 40 percent. Note that the actual increase of the M2 to GDP ratio was about 50 percent between 1982 and 1987, which is beyond the range within two standard deviations. Some exogenous financial deepening cannot be ruled out.

This higher than predicted growth must be due to either a change of the demand for money (that may have been involved by the switch of regime) or to exogenous factors. The reliance share of these factors cannot be determined in the framework of this study.

# IV. PHILIPPINES

Before 1980, nominal interest rates were constrained by ceilings as in Thailand and Indonesia. This policy depressed the level of financial deepening; the M2 to GDP ratio stayed at a stable level in the seventies, below 22 percent. As in Thailand and Indonesia, the rise of the differential between domestic and foreign rates stimulated a gradual and eventually complete liberalization of domestic interest rates which was implemented between 1981 and 1983. However, in contrast to the results in Thailand and Indonesia, the interest liberalization failed completely to
- 31 -

generate an increase of the bank deposits. In 1987, the M2 to GDP ratio was the same as in 1981.

During the eighties, there were two important differences between the financial policies in the Philippines and those of Thailand and Indonesia. The first was a high inflation rate, which was the consequence of macroeconomic policies. The effect of inflation on deposits was amplified by the taxation of financial institutions through reserve requirements and a loan tax. These policies had a powerful impact on the financial system because they had conjugated effects.

As the inflation rate increased during the second oil shock, the level of the real deposit rate declined (Table 8). In the years 1980 to 1982, the various restrictions on rates were lifted gradually, and interest rates were completely free by the end of 1982. Nevertheless, real rates were negative again during the inflationary episode of 1984-1985. The fall of the real rates induced a decrease of the money to GDP ratio. The question here is why was the real deposit rate negative after the liberalization?

# A. The Openness of Cagital Markets

Before 1983, the regulations on capital movements with the foreign markets could be circumvented by well-known methods. Since the complete interest rate liberalization of 1983, there are no restrictions on the holdings of foreign exchange.

The representative interest rate for the money market in the Philippines is the Treasury bill rate. The T-bill market plays a vital role in the finance sector in Philippines by its sheer size. A large fraction of bills are held outside of banks; these holdings reached P85
- 32 -

# Table 8. Interest Rates in Philippines

||(1)<br>Deposit<br>Rate|(2)<br>T-Bill<br>Rate|(3)<br>Lending<br>Rate|(4)<br>Singapore<br>MMR|(5)<br>rUsing<br>CPI|(6)<br>wUsing<br>GDP<br>Deflator|(7)<br>(Deposit<br>Rate-w)<br> <br>(1-5)|
|---|---|---|---|---|---|---|---|
|1972|8.0|||3.57|8.20|6.79|-0.20|
|1973|8.0|||11.69|16.58|18.08|-8.58|
|1974|9.25|||8.90|34.16|31.02|-24.91|
|1975|11.0|||4.39|6.76|8.33|4.24|
|1976|12.0|10.19|12,0|4.15|9.20|9.19|2.80|
|1977|12.66|10.89|12.0|4.76|9.90|7.41|2.76|
|1978|10.77|10.88|12.0|5.93|7.33|9.19|3.44|
|1979|12.72|12.26|14.0|7.76|17.53|15.24|-4.81|
|1980|13.2|12.14|14.0|10.98|18.20|15.60|-5.0|
|1981|15.51|12.55|15.34|11.54|13.08|10.98|2.43|
|1982|15.5|13.78|18.12|7.92|10.22|8.43|5.28|
|1983|15.68|14.23|19.24|7.11|10.03|11.73|5.65|
|1984|24.7|28.53|28.20|7.67|50.34|49.69|-25.64|
|1985|21.8|26.72|28.61|5.38|23.10|7.66|-1.30|
|1986|13.0|16.08|17.53|4.27|0.75|11.80|12.25|
|1987|8.0|11.51|13.34|3.89|3.79|7.07|4.21|

Source: IFS.
- 33 -

billion in June 1987 (Honohan, 1988). Because the authorities can withdraw bills from the auction if the price is too low (and the rate too high), some have speculated that the T-bill rate may be regulated. This is of course not a proof that the authorities can control the T-bill rate over an extended period, given the constraints of government borrowing and of the foreign market.

The relation between offshore and markets and the domestic Treasury bills market is tested in Table 9. Two values for the foreign interest have been considered. The first is the money market rate in Singapore. The second is the MMR in Singapore corrected for the depreciation of the peso with respect to the Singapore dollar. Note that the second variable is significant. For Thailand and Indonesia, only the first index of foreign rates was significant. This difference is easily explained: the currencies of Thailand and Indonesia were allowed to crawl in a narrow band between maxi-devaluations. But in the Philippines, the variations of the domestic price level and of the e. change rate were more frequent and of greater magnitude. The actual variation of the exchange rate was therefore anticipated to some extent. The results of the table show that the domestic interest rate was influenced by the foreign rate as in the two other countries of our study.

The level of Treasury bill rate has always been greater than the time deposit rate. This difference is due to the combination of burden of taxation on the intermediation margin and the access of non bank agents to the market for T-bills. The taxation of the financial institutions raise two issues here. First, the burden was significant in the years with "normal" inflation because the interest rates on reserve and loan requirement were below the level of nominal market rates in those years.
- 34 -

Iable 9. Determinants of the T-Bill Rate in Philippines

# Variable Parameter Estimate T-Statistic

I. Philippines (1976-87) Quarterly Using Monetary Base (MB) DEP Variable r 'PHL*

|CONST|0.027|0.3|
|---|---|---|
|TSGP+|0.205|2.3|
|GDP/MB|-0.014|0.4|
|ff|0.421|2.8|
|'PHL-1|0.860|13.6|
|||R-Square-<br>0.846<br>Durbin-Watson-<br>2.1|

II. Philippines (1976-87) Quarterly Using Money Supply (M2)

|DEP Variable-<br>TPHL|||
|---|---|---|
|_%,>I ai.|.,-U.J|1.4|
|TSGP+|0.252|2.7|
|GDP/M2|0.091|1.3|
|**_if_**|0.428|2.9|
|TPHL-1|0.857|13.8|
|||R-Square-<br>0.851<br>Durbin-Watson-<br>2.1|
> - 35 -

Table 9: (Cont'd.) Determinants of the T-Bill Rates in the Philippines Variable Parameter Estimate T-Statistic III. Philippines (1976-87) Quarterly Using Monetary Base (M2)

# **DEP** Vaxiable - rPHL

|CONST<br>T|-0.063<br>|0.5<br>|
|---|---|---|
|SGP|0.137|0.6|
|e|0.004|1.3|
|GDP/M2|0.032<br>|0.4<br>|
|-n|0.573|3.9|
|TPHL-1|0.766|9.0|
|||R-Square-<br>0.833<br>|
|||Durbin Watson-<br>2.2|

*Note<sup>T</sup> PHL here is the Treasury Bill Rate as opposed to rTHA and rIDN which are the Money Market Rates.

Also note that e is the exchange rate between the home country's currency and the Singapore Pound.

Source: IFS.
- 36 -

Second, the values of the regulated rates were not adjusted during the years of high inflation, thus widening the gap between lending and deposit rates. The wedge between the lending and the deposit rates is explained by the explicit and implicit taxes on banks which are now discussed in greater detail.

# B. Explicit and Impllcit Taxes on Banks

# Explicit Taxes

In contrast to Thailand and Indonesia, where there are no special types of taxes, the Philippines have two types of taxes on the banking industry.

- (a) The Gross Receigt Tax (GRT) is levied on all bank receipts (including both interest and capital gains). GRT is imposed on a sliding scale, with a lower rate applied to income from instruments of longer-term maturity (with a maximum rate being 5 percent). During 1983-86, the GRT added between 73 and 99 basis points to the average intermediation cost.

- (b) Withholding Tax **of** 20 **Percent** is levied on all but overnight deposits (Financial Sector Study, p. v). This tax is a tax on savers which does not result in double taxation and is not very important for our study since it is not a direct tax on financial institutions.

# Implicit Taxes

The instruments of implicit taxation are the requirements for reserves and for specialized loans at low interest rates. Reserves paid only an interest rate of 4 percent and represented an average of 18 percent of deposits, (21 percent of demand and 5 percent of time deposits).
- 37 -

> d The requirements of special loans are that banks have to allocate 25 percent of net loanable funds for agricultural credit with 15 percer. for general agriculture and 10 percent for beneficiaries of the agrarian Deform program (they have been practically abolished now). Banks have also the option to purchase specified securities at 9.0 percent coupon rate instead of providing "riskier" loans to agriculture to comply with the regulations. This program has not been as successful as intended since most banks, which are based in urban areas, have little expertise in agricultural lending. Urban-based banks perceive the loans to agriculture as being quite "risky". In the past the yield on these agri-agra securities has been lower than the yield on secured loans. As a consequence, the agri-agra requirements imposed on all commercial banks have further contributed to the increase in intermediation costs. This higher cost is passed on to the depositors through higher spreads.

The Interaction of Inflation and Taxes on Financial Institutions The difference between the lending and the deposit rates increased sharply in 1984 and 1985. The values of the time deposit rate and of the lending rate are presented in Figure 6. One can observe that after the complete liberalization of interest rates in 1982, the values of the two rates move on a line. The slope of this line is about 0.7. When the loan rate increases by one point, the deposit rate can increase only by (l-k)(l-a)(l-t) point, where k, a and t represent the rates of the reserve requirement, of the requirement for agri/agra loans and of the GRT. When inflation increased in 1984-1985, the nominal lending rate increased (albeit by an amount smaller t;an the inflation rate increase). The
Deposit Kte Figure 6. Deposit Rate and Lending Rate in the Philippines (1980-87) <!-- Start of picture text --> 20~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~<br>1.1<br>.s<br>O.1<br>so0 Il loO/3SOI 6 f?o A . t2<br>II} so. A<br>8.L Sore<br>/Fs Lenin<br>a-I~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~~~~~~~~~~~~~Rt<br><!-- End of picture text --> Source: IFS.

Rlate8
- 39 -

deposit rate increased only by about 70 percent of the same amount. The effective tax rate increased by .3 points for every point increase of the nominal lending rate.

C. The Imr.act of Interest Rates on Deposits The impact of the high level of taxation on financial institutions can be observed in Figure 7. The M2 to GDP ratio increased after the liberalization of interest rates, but fell in the inflation years of 1984 and 1985.

Th_ response of the demand for money to the opportunity cost is measured in the estimations that are presented in Table 10. The coefficients of the explanatory variab'.es are significant and have the right sign.

These equations imply that the long-run response of the level of deposits to the real rate of return is at least as high as in Indonesia. The degree of financial deepening is now at about the same stage as in Indonesia before the interest liberalization. One can therefore expect that the efficiency of removing taxes on the financial intermediation in the Philippines will be of the same order of magnitude as they have been in Indonesia over the last four years. We now turn to the analysis of the efficiency gains of the successful reforms in Thailand and Indonesia.

# V. THE EFFICIENCY GAINS OF INTEREST LIBERALIZATION

The results of the previous sections show that the taxation of financial assets involves an important reallocation of the stock of savings be away from the financial sector. This reallocation is represented in
- 40 -

Figure 7. Financial Deepening and the Real Rate in the Philippines <!-- Start of picture text --> 0.6*.<br>0.5 , a<br>0.4<br>0.3 -- 2<br>0.21 \<br>0.1<br>1g6197¶97197197197197¶97197197197¶gSlgSl9819lgeglgelgs¶98<br>9 0 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7<br><!-- End of picture text --> Source: IFS.
- 41 -

Table 10. Results of Money Demand Equations for Philippines

|I.|Dependent<br>Variable|Constant|<br>L12Z(-1)|DEPR<br>w|
|---|---|---|---|---|
||LM2Z<br>(1972-87)|0.370<br>(1.2)|0.837<br>(6.2)|0.349<br>-0.294<br>(2.5)<br>(5.2)<br>R2- 0.879<br>DW-<br>1.87|
|II.|Dependent<br>Variable|Constant|<br>LM2Z(-1)|RDEPR|
||LM2Z<br>(1972-87)|0.350<br>(1.2)|0.849<br>(6.6)|0.288<br>(6.4)<br>-R- 0.879<br>DW-<br>1.85|
|III.|Dependent<br>Variable|Constant|LM2Z(-l)<br>DEPR|TBRATE<br>7rDEF|
||LM2Z<br>(1976-87)|0.848<br>(1.2)|0.643<br>0.235<br>(2.1)<br>(0.6)|<br>-0.218<br>-0.179<br>(0.8)<br>(1.8)<br>R'<br>0.508<br>DW-<br>1.59|

Note: LM2Z - Log(M2/GDP) DEPR - Deposit rate i - Inflation rate using the CPI RDEPR - Real deposit rate or (DEPR-w) TBRATE - Treasury Bill Rate ffDEF - Inflation Rate using the GDP deflator Source: IFS.
- 42 -

Figure 8. The schedule (S) is the supply of deposits at banks by the private sector. It represents the private opportunity cost of funds whizh is equal to the net rate of return on deposits. The schedule (D) represents the demand for loans from banks by the private sector, which depends on the lending rate. For simplicity, the banks's intermediation costs can be assumed to be equal to zero. The equilibrium with no taxation is represented by the point E.

In the analysis of the efficiency cost of financial taxation we have to ignore the cross effects in other markets. These effects depend on the values of the tax rates for other goods and on the impacts of financial taxation on the levels of tcansactions in these goods. Unfortunately, we do not have any evidence eixher on the values of the tax rates or on the magnitude of these cross-effects, and we have to restrict ourselves to the partial analysis of the Figure 8.

The wedge of deposits is represented by the segment AB. This wedge may be created by an explicit tax (on loans, or reserves) such as in the Philippines after 1980, or by a ceiling on the deposit rate that is fixed at iD, as in the case of Thailand, Indonesia, or the Philippines before 1980. In the latter case, the loans are rationed and the tax wedge AB is implicit: borrowers who are lucky to get a loan pay the same rate iD since the bank cost is netted out), and the total rent of borrowers is equal to the implicit tax revenues, which is measured by the area ABCD.

There are several problems that arise in the analysis of the efficiency cost of interest ceilings.

- (i) The social opportunity cost that is represented by the schedule (S) depends on the alternate use of funds (in foreign markets or informal markets).
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FiRure 8. The Efficiency<sup>Cost of Taxation</sup> <!-- Start of picture text --> i<br>i C B /(S)<br>X. .<br>(D)<br>D 77 A<br>0 MA ME M<br><!-- End of picture text -->
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- (ii) The demand (D) for bank funds is affected by the supply (S) of the depositors who shift their assets between the formal and informal markets and borrowers rely on the formal and informal credit markets.

- (iii) When the tax is explicit, a possible measure of the efficiency cost is equal to the area of the triangle AEB.

- (iv) When there is an interest rate ceiling with rationing, this afficiency cost should include also the amount of resources used by borrowers to capture at least some of the rent. The maximum amount of the resources devoted to rent seeking is equal to to the area ABCD.

The efficiency cost depends on the slopes of the two schedules (S) and (D). The slope of the supply (S) can be computed from the empirical data of the previous sections. Unfortunately there is no evidence on t*e slope of the demand schedule (D). Its value depends on the possibiliti,es of substitution for borrowing by the private sector and on the production technology.

In this paper we measure only the area AHE. A detailed analyswis of the efficiency cost that takes into account all the aspects listed above ((i) to (iv)) would provide a value that is greater than the area AHE which is therefore a lower bound estimate of the true value. This area is equal to: This formula is very simple, but there are measurement problems for each of the terms in the formula. Both problems arise because the interest liberalization takes time to have an effect. The empirical evidence shows that the time lag may be about four or five years. During
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this interval of time, the market rate iE may change and this variation affects the measurement of the interest change iE-iA.

The measurement of the increase of money is affected by a similar problem, since some growth of the money to GDP ratio may be due to exogenous factors. However, the case of the Philippines serves as a reminder that the expansion of the financial system is not an inevitable fact and may be completely stalled by policy.

Table 11 presents estimates of the changes. of interest and bank deposits (in terms of GDP) for Thailand and Indonesia that conducted a successful interest liberalization. The values of the efficiency gains are about 3 percent and 1 percent of GDP for Thailand and Indonesia, respectively.

We have seen that these values may underestimate the efficiency kain. An important source of bias may come from the omitted area of the producer surplus ABE. In order to assess its magnitude one can also ask what would have been the market lending rate iB in these two countries; if a tax on financial institutions had introduced a wedge AB. This is in fact the present situation in the Philippines. It seems that the difference between the lending rate and no tax on financial institutions iE, is not very large, i.e., much smaller than the difference of between the deposit wates iE - iA. This would indicate that the downward ,Aas of the estimates in Table 11 is fairly small.

The efficiency gain of the interest liberalization are small in terms of GDP, but they are large in terms of tax revenues (explicit or implicit). In the framework of the Figure 8, the tax revenues are measured by the area ABCD. The measurement problems are the same as for the excessburden. Using the same arguments we approximate them by the area AHKD
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Table 11. The Efficiency Gain of reform

||Increase<br>of the<br>Rate of Return<br>(1)|Initial<br>Level<br>of Deposit<br>(2)|Increase<br>of<br>Deposit<br>(3)|Efficiency<br>Gain<br>In Terms of GDP<br>(4)|Efficiency<br>Gains in<br>Terms of<br>Revenue<br>(5)|
|---|---|---|---|---|---|
|Thailand|.05|.( 26|.3|0.075|0.58|
|Indonesia|<br>.13 b/|0.04 c/|0.12 d/|0.062|1.19|

Notes:

- a/ This value is equal to the difference between the average real rates before and after the reform.

- _/ The increase is equal to the difference between the rates of unrestricted banks just before the reform (see Table _)._

- c/ This value is smaller than the ratio between all time deposits and GDP because only a fraction of these deposits was taxed (see Section II).

- A/ This is a fraotion that represents the total increase of money end quasi-money. This fraction is equal to ,8 to be compatible with the estimated demand for money.

From the empirical evidence of the previous sections, we have assumed that most of the increase of deposits came from assets that were outside the financial sector (in informal or foreign markets). The levels of time and saving deposits at the time of the reform are reported in column (2) of the table. The tax revenues are therefore equal to the products of the numbers in the first two columns. The efficiency cost computed as a fraction of tax revenues in column 5. We now observe that it is very high. In Indonesia the efficiency cost of the interest ceiling was more than 150 percent of the amount of implicit revenues.
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# VI. CONCLUSIONS

This study has shown that the removal of constraints (interest rate ceilings, credit targets) has a very powerful impact on the level of financial assets in the domestic sector. The reforms were successful in Thailand and Indonesia because all interest and credit constraints were removed. A similar reform failed in the Philippines because taxes were monitored on the financial sector and interacted with the inflation rates.

The efficiency gains of the successful reforms were small when compared to GDP, but very large when compared to the levels of transfers (explicit or implicit) that were induced by the policies of regulation. The lesson of the experience is that a reallocation of resources through the manipulation of the financial system may be very inefficient relative to other fiscal policies. This hypothesis that was verified for Thailand and Indonesia, most certainly applies to the Philippines, and remains to be tested in further work that will concentrate on other countries.