Financial Liberalization – ‘The Correct Sequence’: A Sri Lankan Experience

Abstract

Financial repression that existed for a period of two decades prior to the 1977 economic reforms led to a reduction of the economic growth to the lowest possible level that Sri Lanka has ever experienced. This dismal performance of the economy, which could be witnessed by 1977, paved the way for introducing a set of far reaching economic reforms including financial reforms (financial liberalization). The financial liberalization that was followed starting from 1977, were mainly based on the McKinnon-Show hypothesis, calling for more liberal financial sector reforms which should precede economic development. Empirical Studies done in the late 1980s and 1990s with financial liberalization experience in the world as well as in Sri Lanka lent support to the McKinnon-Shaw hypothesis. But, the later evidence shows no clear relationship between financial liberalization and the achievement of desired outcomes in recent years, thus the current literature is more to identifying and explaining the reasons for non-achievement of the objectives of financial liberalization. The main factor that has been identified by majority of recent research for eroding the outcomes of financial liberalization is the incorrect policies being followed in implementing financial liberalization (sequential problem). Therefore this study attempts to empirically test whether financial liberalization undertaken in Sri Lanka has followed the correct sequence of policies for financial liberalization or not. The hypothesis is tested, by constructing three financial liberalization indices for the three sequences (viz., real sector liberalization should precede domestic financial sector liberalization and that domestic sector financial liberalization should precede the external sector liberalization.) identified as most desirable to make financial liberalization a success. Finally it was found that, last sequence has been implemented at a fast pace than that of its desired sequential predecessors during the initial years of financial liberalization in Sri Lanka. Even after the initial period the real sector liberalization, which is seen as the stabilizing force under financial liberalization process has not been reformed adequately.The Kelaniya Journal of Management, Vol. 3(2); 2014: 1-27