Is Financial Liberalization Impeding Industrial Sector Growth in Pakistan?

Article : Financial Reforms and Industrial Sector Growth:

Bound Testing Analysis for Pakistan

Authors:

Dr Shahida Wizarat, Head, Economics Department, College of Business Management (CBM), IOBM, Karachi, Pakistan Qazi Muhammad Adnan Hye, Independent Researcher
Presenter : Muhammad Waqas Babar

Abstract

The paper focuses on the relationship between financial liberalization and services sector growth in Pakistan, capturing the impact of financial liberalization using the Financial Liberalization Index (FLI) first developed by Hye and Wizarat (2010). The results suggest that in the short run both FLI and the real interest rate (RIR) positively impact the services sector growth, but in the long run, FLI and RIR are negatively related to services sector growth.

Introduction

Services sector in Pakistan includes transportation, storage, communication, wholesale and retail trade, finance and insurance, ownership of dwellings, public administration and defense, community services, etc Due to the growing volume of services sector in the economic growth of Pakistan, several changes have been made to enhance its role in overall growth. The liberalization of financial services, mainly insurance, banking and market securities in the 1990s, is among the many steps taken by Pakistan for the development of this sector.

Introduction

The services sector is believed to be the most affected by the financial liberalization process, because it has long been dominated by the industrial and agriculture sectors in Pakistan. The recent reforms in this sector include privatization of state-owned banks and insurance companies, opening up of the stock market to foreign investors under the Private Investment Act, 1976, prudential regulations and interest rate deregulation.

Theoretical Framework

In the theoretical literature on financial liberalization and growth three types of views are available: First, a positive link between financial development and economic activity has been stated by Joseph Schumpeter (1911), Goldsmith (1969) and Hicks (1969), McKinnon and Shaw (1973) Romer, (1986); Barro, (1991); Japelli and Pagano, (1994). The second, view states that finance is relatively less important for economic growth [see, Robinson (1952), Lewis (1955) and Lucas (1988)]. The third view departs yet further and argues that financial development could have a potential negative impact on growth [ see, Van Wijnbergen (1982) and Buffie (1984)]

Liberalization of Financial Sector in late 1980s

Pakistan started to liberalize the financial sector in the late 1980s on the advise of WB and IMF. The main aim of these reforms was to increase economic growth through increase in capital productivity, lowering the cost of intermediation through competition, increase efficiency and the saving.

Impact of Financial Liberalization

The impact of Financial Liberalization on Industrial Sector growth was explored by computing a financial liberalization index (FLI) for the first time for Pakistan by using eleven policy measures: Islamization Interest Rate Deregulation Credit Controls Stock Market Reforms Prudential Regulations Privatization of Financial Institutions Removal of Entry Barriers Non Performing Loans External Account Liberalization Debt Management Reforms Open Market Operations

Impact of Financial Liberalization

FLI Shows that 1990 - 1996 was the time period when most liberalization measures were undertaken by Pakistani Policy makers. Diagnostic tests were applied which confirm that there is: No serial correlation No hetroscedasticity Normality of Data Stability of functional form

Conclusion and Policy Recommendation

Empirical results indicate that the financial liberalization index (FLI) and the real interest rate (RIR) are negatively (statistically significant) associated with industrial growth, while labor and capital are positively associated with economic growth in accordance with the postulates of growth theory. In the short run the financial liberalization index and the real interest rate both show a robustly positive (statistically significant) relationship with economic growth lending support to McKinnon and Shaw, etc. Financial liberalization impedes economic growth in the long run confirming the post Keynesian and Structuralist views. The study recommends further research on developing a financial liberalization model that is consistent with growth and stability.