Response to Shocks: Shocks are one-time events that trigger an almost immediate realignment of decision-making forces - for example, a new government coming to power, changes in the global economy, and conditions imposed by international financial institutions such as the World Bank and the IMF on countries seeking to borrow.
According to the so-called "honeymoon hypothesis" advanced in earlier studies, policy reforms can be expected at the beginning of an electoral cycle, right after a new government has come to office, rather than later, when an incumbent government is seeking reelection - particularly if the benefits of reform will be realised over the long term and the costs felt in the short term.
The evidence on this is mixed, however. It is true that the tendency toward maintaining the status quo weakens significantly during a chief executive's first year in office, as shown by the drop of status quo observations in those periods from 78 percent to 70 percent (Table 1), and the likelihood of large-scale reform increases markedly.
But a change of government may also lead to a reversal of liberalisation - for example, during 1973-96, new democratic leaders in Argentina, Bolivia, and Brazil pursued expansionist policies after they took office, delaying needed reform.
In contrast, financial reform is not likely during periods of drastic political change, such as coups d'état and the imposition or lifting of martial law. In fact, our index showed that there was a slight increase in the relative frequency of status quo observations during such periods.
TABLE 1. THE EFFECT OF POLICIES AND POLITICAL CONDITIONS ON FINANCIAL REFORM.
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(In percent)
Drastic
First Year Political
in Office? Change?
No Yes No Yes
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Large reform 3.9 9.8 Large reform 5.2 3.9
Reform 15.4 15.3 Reform 15.4 15.4
Status quo 77.7 69.9 Status quo 76.0 78.9
Reversal 3.0 3.7 Reversal 3.2 1.9
Large reversal 0.0 1.2 Large reversal 0.3 0.0
Total 100.0 100.0 Total 100.0 100.0
Pearson Chi-sq: 12.52 Pearson Chi-sq: 0.04 -
Prob: 0.01 Prob: 1.00 -
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The impact of balance of payments crises and banking crises, recessions (defined simply as negative economic growth), and high inflation (defined as an annual inflation rate of over 50 percent) is shown in Table 2 (page 8). During periods marked by any one of these four adverse economic events, the relative frequency of status quo observations falls.
However, the extent, and even the direction, of the policy change varies with the nature of the adversity. In response to a balance of payments crisis, the likelihood of a large reform increases from 3.1 percent to 9.7 percent. In contrast, when a country is in a banking crisis, the likelihood of a large reform falls from 5.5 percent to 2.6 percent, and the incidence of reversals (big or small) increases from 2.3 percent to 9.5 percent. Recessions and high inflation increase the likelihood of both reforms and reversals.
Besides crises, external influences such as changes in the global economy - such as increases or declines in global interest rates - can influence the balance of decision-making power and upset the status quo. When global interest rates are low, for example, access to cheap international capital provides a strong incentive, strengthening reformers and increasing the likelihood of liberalising reforms.
In contrast, when rates are high, the incentive to reform declines, except in countries eager to signal their commitment to liberalisation (in the hope of attracting future investment) by maintaining their openness even in the face of high world interest rates.
TABLE 2. REFORM UNDER CRISIS CONDITIONS:
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(In percent)
Balance of
Payments Banking
Crisis? Crisis?
No Yes No Yes
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Large reform 3.1 9.7 Large reform 5.5 2.6
Reform 15.2 15.8 Reform 15.8 13.0
Status quo 78.7 70.5 Status quo 76.4 74.8
Reversal 3.1 3.2 Reversal 2.3 7.8
Large reversal 0.0 0.8 Large reversal 0.0 1.7
Total 100.0 100.0 Total 100.0 100.0
Pearson Chi-sq: 16.95 Pearson Chi-sq. 15.40 -
Prob: 0.00 Prob: 0.00 -
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High
(>50%)
Recession? Inflation?
No Yes No Yes
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Large reform 5.1 4.9 Large reform 4.8 7.6
Reform 14.9 18.6 Reform 15.6 14.1
Status quo 77.1 69.6 Status quo 76.9 70.7
Reversal 2.8 4.9 Reversal 2.8 5.4
Large reversal 0.0 2.0 Large reversal 0.0 2.2
Total 100.0 100.0 Total 100.0 100.0
Pearson Chi-sq: 8.79 Pearson Chi-sq. 10.22 -
Prob: 0.07 Prob: 0.04 -
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International financial institutions such as the IMF may also be able to induce reform (see Table 3). Their actions can strengthen the hand of domestic "outsiders" - that is, those who do not have much of a voice in the political process - who support reform. Such outsiders include groups without access to credit and savers who receive low returns on their financial assets. To their benefit, an external impetus to reforms may originate as a condition imposed by an international financial institution on its loans or may come from external advisors from multilateral institutions, universities, and think tanks, as well as nationals previously associated with such organizations. These outside forces played a significant role in several reform episodes in our sample.
TABLE 3. THE EFFECT OF IMF-SUPPORTED PROGRAMS ON REFORM:
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IMF-Supported Program?
No Yes
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Large reform 4.6 6.6
Reform 14.4 18.3
Status quo 77.2 73.2
Reversal 3.6 1.9
Large reversal 0.3 0.0
Total 100.0 100.0
Pearson Chi-sq: 3.42 -
Prob: 0.49
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THE DYNAMICS OF LEARNING: Political economy theory highlights the importance of the uncertainty faced by individuals regarding the outcome of reform. If individuals or interest groups do not know who among them will benefit, they may oppose change even if it is socially optimal and a majority stands to gain. Even if some of the existing financial institutions may prosper after liberalisation, uncertainty regarding the identities of the winners and losers may cause the financial sector as a whole to oppose reform.
But what are the mechanisms for discovery, and why is the status quo eventually abandoned and reforms undertaken? Here, learning made possible by the accumulation of new information is particularly relevant. If reform is a multistage process, then early reform may help interest groups assess whether they will benefit or lose. Early opponents of reforms thus sometimes become the strongest advocates for further reforms.
Following an initially successful program, strong political opposition to reform is often neutralised. If additional policy measures (and good luck) then provide additional economic gains, support for the reforms may strengthen and opposition weaken. New interests emerge favouring the altered economic policies.
Learning may also occur - and reforms may cascade - when technical or managerial expertise in undertaking reforms is lacking initially but gradually builds. Under these conditions, implementation of multistage reform programs may need to be protracted. As expertise is gained from initial reforms, further reforms are easier to carry out.
Recent investigations of the political economy of reform - and of the spread of democracy - have noted a clustering of reforms in certain regions during the same period, which suggests that countries may learn from their "peers" - neighbouring nations with similar economic, social, and political structures and shared experiences. There is also considerable evidence that countries within a region compete for the same international pool of risk capital, which may provide an impetus for reform.
We assessed the relevance of the learning process by determining if the distribution of policy changes varied with the level of financial liberalisation in a country. One might surmise a negative relationship, since countries with highly repressed financial sectors have the most potential for liberalising, while liberalised economies have less to do, but this is not the case. Rather, countries with highly repressed financial systems tend to stay that way, as evidenced by a much higher proportion of status quo observations.
But if these countries liberalise somewhat, the likelihood of further reforms increases substantially. Reforms are much more probable in countries whose financial sectors are in an intermediate range of liberalisation - either partially repressed or largely liberalised. Of course, countries with highly liberalised financial sectors are less likely to undertake further reforms. It is interesting to note, however, that none of the countries that are fully liberalised reverse their reforms.
The relationship between the level of financial liberalisation and the incidence of reform supports the idea that learning creates a self-sustaining dynamic in the reform process. Reforms do not have to be undertaken all at once - even small reforms are a victory, as they carry the seeds of future reforms.
IDEOLOGY, INSTITUTIONS, AND STRUCTURE: Finally, some economists believe that reforms can be conditioned by a government's ideology, institutions, or economic and political structure. This category of trigger includes the political orientation of ruling parties, forms of government (presidential versus parliamentary, for example), electoral rules, legal systems, and a country's openness to international capital and trade.
With respect to ideology, the conventional view is that right-wing governments are more receptive to market-oriented reforms such as financial liberalisation. However, we found the opposite to be true - left-wing governments liberalised more frequently than right-wing governments. One possible explanation is that party ideology and credibility interact in interesting ways.
If the electorate cannot tell whether a government's policies are being motivated by social concerns or simply by the politicians' ideological preferences, then policy reforms become more credible when undertaken by political parties normally associated with ideologies opposed to those reforms. For example, a reform-minded Labour Party government coming to power in New Zealand during a currency crisis in 1984 was able to undertake a program of rapid economic liberalisation.
Some economists have argued that presidential forms of government can overcome the logjam arising from conflicting interests and push through reforms more easily than parliamentary governments. Others have emphasised the importance of legal systems, while yet others have suggested that, in economies that are more open to international investment and trade, insider opposition to liberalisation is weaker, since there is more to gain from new opportunities.
While ideology and structure can have a long-term influence on the direction of reform, the question remains whether these overarching forces changed the observed dynamics of financial sector reform in the last quarter of the twentieth century. Was the period long enough? Or was there a common ideology behind the apparent differences that, together with the forces of globalisation, pushed policymakers to undertake reforms?
We found that no one form of government was likelier than any other to initiate reform. Nor did we find a significant relationship between legal systems and financial reform. Looking at the sample as a whole, we did not find a significant relationship between liberalisation and openness to trade and foreign investment, but, breaking the sample down, we found that openness was strongly associated with liberalisation in highly repressed countries but less so in more liberalised countries. Trade openness was also associated with a greater tendency to privatise banks.
THE LESSONS OF LIBERALISATION: Liberalization thus occurred as a combination of discrete changes and gradual learning. Since shocks resulted in setbacks to liberalisation almost as often as they resulted in reform measures, learning - whether from successful reforms on the domestic front or from observation of neighbouring countries - was essential to the dynamic that sustained widespread reform.
FIVE CONCLUSIONS ABOUT THE DYNAMIC OF REFORM EMERGED FROM OUR STATISTICAL ANALYSIS:
1. The countries with the most repressed financial sectors were the most likely to stay that way. However, countries whose financial sector became even slightly less restrictive after some initial reforms were far likelier to undertake further reforms.
The self-sustaining nature of reforms can be explained in several ways. Initial reforms tended to strengthen those who benefited from (and lobbied for) them relative to those who opposed them. Initial reforms may also have caused changes that necessitated further reforms. An interesting example is Japan, which received its initial reform impetus in the 1970s from the need to finance large fiscal deficits.
This led to the development of the government bond market, which, in turn, created demand for a more open corporate bond market. As the corporate bond market grew, commercial banks prevented from participating in it experienced substantial revenue loss. Ultimately, the government had to liberalise the scope of banks' activities-an example of reforms in one area triggering further reforms in other areas.
2. Regional influences were important. Countries in a given region faced greater pressure to liberalise their systems the more repressive their own financial systems were relative to the region's leader. In part, this was because countries in the same region possessed similar characteristics and were likely to be motivated by similar objectives and to be competing for the same pool of international capital. The effect of competition sharpened over time as the level of liberalisation increased.
3. Crises that posed a serious challenge to the status quo triggered action. Pressure to do something built rapidly when things went wrong. However, different types of crises had strikingly different effects. Balance of payments crises, for example, increased the likelihood of reform, while banking crises discouraged-or even reversed-it.
The nationalisation of banks during or following a banking crisis often dealt a setback to reform. In addition, since banking crises made the fragility of the banking sector evident, it was hardly surprising that governments did not push hard for reforms that could have further undermined banks' franchise values in the short run. Instead, governments attempting to resolve banking crises by encouraging strong banks to take over weak banks were apt to offer incentives such as temporary monopoly power.
4. Reforms seemed to follow certain kinds of events. For example, a new government was most likely to undertake reforms in the first year after it assumed power, and this effect was strongest in countries with repressed financial sectors. Reforms also accelerated following a decline in US interest rates, while a rise in rates set them back.
And the conditions associated with IMF-financed structural adjustment programs appear to have had a strong influence initially in countries with relatively repressed financial systems, but this influence decreased over time.
5. Among factors such as a country's political ideology and economic structure, only openness to international investment and trade affected the pace of reform, stimulating reform in countries with relatively repressive financial systems. Right-wing governments were no more reform-oriented than left-wing governments. If anything, left-wing governments were a bit more likely to introduce reforms, although the difference was not significant. Static factors such as the type of government or legal system were also not influential.
(Concluded)
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