Financial sector reforms in Bangladesh and Sri Lanka

Abstract

In the context of Structural Adjustment which involved changing the relative wrights of public and private sectors in the economic matters. Financial Sector Reforms assume added significance as financial institutions have been used extensively to achieve development goals, in many of the third world countries, which became independent after 1945 (post World War-2 period). The impact of such use is varied. The successful cases of intervention in financial sector are Korea, Taiwan and Japan. In the case of many other countries (many countries in south Asia fall in this category) the control of financial systems by governments has yielded less than satisfactory results in terms of promoting growth and equity. In many developing countries the health of the financial sectors deteriorated over the years. This is mainly because of the poor performance of the banks, because of low quality asset portfolios. This has resulted in threats to the existence of banks and other financial institutions because of erosion of capital, caused by losses. These losses are the result of inadequate accounting and income recognition standards followed by these institutions in the past. In many of the third world countries the governments have access to cheap funds, obtained by imposing high reserve requirements on banks and restrictions on the portfolios of other financial institutions like insurance companies and pension funds, Another important feature of the financial systems in developing countries is the domination of financial sector by banks as the other institutions (pension funds, insurance funds and capital markets are not significant in size) are in early stages of development and not well developed. In 80’s number of third world countries began reforms in their financial sectors, usually under a broader agenda of giving ‘active’ role to ‘the market’. The main thrust of financial sector reforms is allowing market forces a greater role in allocating credit. It means limiting and reducing the ‘directed’ credit programs and fostering greater competition in the financial sector by easing various restrictions(in many developing countries the financial systems are dominated by government owned banks). New institutions like – capital/securities/foreign exchange markets and money markets are set up as part of financial reforms. Interest rate controls are also sought to be eased as a part of financial reform. The reform process attempts to control the cheap access of bank funds to Governments by reducing reserve requirements and by increasing the interest paid to banks on reserves. Tightening the accounting and income recognition norms of financial institutions is another important component of financial reforms. Our study is an attempt at understanding the reform process and the impact of such reform efforts on the savings and investment performance of two South Asian developing countries; Bangladesh and Sri Lanka. In our study the focus is on the sequencing of reforms 9how financial sector reforms are organized with respect to ‘internal sequencing’ and ‘external sequencing’) and the influence of interest rates on savings and investments measured as percentage of GDP. The case study methodology is followed in examining the sequencing of reforms. Ordinary Lease Square(OLS) estimates are used to test the influence of real interest rates on Savings (domestic, national and financial) and Investments(gross investment and private investment) The findings of the study are: In both Bangladesh and Sri Lanka monetary sectors(central bank and commercial banks continue to dominate the financial sector, through this domination is decreasing slowly. Banking and insurance sectors were opened to private sector in both the countries. Real interest rates turned and stayed positive in the post-reform period. Financial deepening (MS/GDP) increased rapidly in the early post-reform period, and fluctuated around 30-33% in late 1980s and early 1990s. Domestic investment/GDP increased ‘significantly’ in Sri Lanka in the post-reform period. National savings/GDP increased ‘significantly’ in both the countries. Proper sequencing of Financial Reforms, “internal” sequencing and ‘external’ sequencing(with respect to real sector reforms), which are essential for successful financial reform, are not addressed adequately in these countries. In Bangladesh, lack of public enterprise reform is holding back effective financial reform. Public sector enterprises’ performance showed increasing losses in the post-reform period. This is one of the major handicaps for effective financial reforms, because state owned banks that lend to these enterprises constitute the most important segment of financial sector in Bangladesh. Accounting practices and regulatory mechanisms remained weak into 1990s. This is one of the reasons for the poor performance of the commercial banks. The “privatization” undertaken in 1980s was not successful, because of problems in the valuation of assets at the time of privatization in 1983-84. In Sri Lanka, regulatory practices and accounting standards, governing banks, remained weak into 1990s, though reforms bagman as early as 1977. In late 1980’s banks and other financial institutions in Sri Lanka faced problems with bad and doubtful debts. Recapitalization of the state-owned banks was carried out 1993, 16 years the reforms began, though this falls in the 1st stage of financial reform. Budget deficits remained high(over10% of GDP) through out 1980s and early 90s, which makes easing of ‘Portfolio restrictions” difficult. One of the indicators of real sector reforms, the maximum import duty rate was high at 50% in Sri Lanka in 1992, indicating rather slow pace of real sector reforms. The regression results show significant positive effect of real deposit rate on domestic and national savings(measured as percentage of GDP) in the pre-reform period, in both the countries, indicating financial repression in that period. Real deposit rate shown a significant positive effect on financial savings (time and savings deposits/GDP) in case of Sri Lanka. The effects of real lending rates on gross and private investments(as percentage of GDP) are insignificant in Bangladesh. In Sri lanka, both these measures of investments are significantly influenced (positive coefficients) by real lending rate. The magnitude of the effects shows a decline in the post-reform period, which shows the decreasing marginal effect of real lending rate on investments in Sri Lanka.