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Does financial liberalization really improve private investment in developing countries?

  • Morisset, Jacques

Assuming that liquidity constraints exist in most developing countries, the majority of analysts believe that increasing real interest rates will raise the volume of lending and hence private investment. The author, focusing on the demand for capital goods, argues that the positive effect on the domestic credit market may be offset by the negative effect of a portfolio shift from capital goods and public bonds into monetary assets. The author also demonstrates that a policy of financial liberalization could increase the public sector's demand for domestic credit, thus limiting the funds available to the private sector. This crowdingout does not result from a change in the government's behavior but from a shift in the portfolio of private agents. Higher demand for bank deposits reduces the private sector's willingness to hold government bonds, so the public sector must finance a given budget deficit with more domestic credit. Simulations for Argentina for 1961 - 1982 suggest that the low response of private investors to changes in interest rate policy in those 20 years was attributable not to the low values of interest elasticities but to the interaction of the mechanisms allowed for in the model, which tends to neutralize the impact of such policies. The author concludes that the effect of changes in interest rate policy on the demand for capital goods is weak in Argentina and might affect the quality of private investment more than its quantity.

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Paper provided by The World Bank in its series Policy Research Working Paper Series with number 717.

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Date of creation: 31 Jul 1991
Date of revision:
Handle: RePEc:wbk:wbrwps:717
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