Financial Liberalization Savings Investment and Growth in Mena C

Money and Finance in the Middle East: Missed
Oportunities or Future Prospects?

Financial Liberalization, Savings, Investment, and Growth in MENA Countries
Lahcen Achy
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FINANCIAL LIBERALIZATION,
SAVINGS, INVESTMENT, AND
GROWTH IN MENA COUNTRIES
Lahcen Achy
ABSTRACT
Over the last two decades Middle East and North African (MENA)
countries like much of the developing countries have experienced a wave
of liberalization of their financial sectors. There have been expectations
that financial liberalization would enhance economic growth by stimulat-
ing savings and investment. The purpose of this chapter is three-folds: (1)
to review the literature on the rationale for financial repression; (2) to
examine the theoretical and empirical literature on the links between
financial liberalization, savings, and investment; and (3) to assess em-
pirically the effect of financial reforms on economic performance in the
specific case of MENA countries.
1. INTRODUCTION
Over the last two decades Middle East and North African (MENA) coun-
tries like many of the developing countries have experienced a wave of
liberalization of their financial sectors. For a long time, the primary task of
Money and Finance in the Middle East: Missed Opportunities or Future Prospects?
Research in Middle East Economics, Volume 6, 67–94
Copyright r 2005 by Elsevier Ltd.
All rights of reproduction in any form reserved
ISSN: 1094-5334/doi:10.1016/S1094-5334(05)06004-8
67
68 LAHCEN ACHY
the financial system was to finance the government needs, public enterprises,
and priority sectors through mandatory holding of treasury bills and bonds
issued by development banks.
Interest rates subsidies to priority sectors have been reduced or eliminat-
ed. The monetary authorities started to manage liquidity through a more
active use of reserve requirements and a more market-based allocation of
refinancing. Stock markets legislation has been updated, and their manage-
ment was transferred to the association of brokerage houses. New banking
laws have increased the autonomy of the central bank and introduced pru-
dential regulation in line with international standards. Finally, measures to
increase competition by opening banks’ capital to foreign participation have

been implemented. There have been expectations that financial liberalization
would enhance economic growth by stimulating saving and investment.
The purpose of this chapter is three-fold: (1) to review the literature on the
rationale for financial repression; (2) to examine the theoretical and empir-
ical literature on the links between financial liberalization, savings, and in-
vestment; and (3) to assess empirically the effect of financial reforms on
economic performance in the specific case of MENA countries.
The empirical assessment attempts to capture the effects of both banking
sector and stock market developments. For data availability reasons, our
investigation focuses on a sample of five MENA countries (Egypt, Jordan,
Morocco, Tunisia, and Turkey) over the period 1970–1998.
The rest of the chapter is organized as follows. Section 2 examines why
governments adopt financial repression policies. Section 3 reviews the the-
oretical literature and empirical findings illustrate how financial liberaliza-
tion can affect savings, investment, and growth. Section 4 addresses the
impact of financial liberalization on economic performance in the specific
context of MENA countries, and finally section 5 concludes.
2. WHY DO GOVERNMENTS ADOPT FINANCIAL

REPRESSION POLICIES?
Whether the degree of financial development is crucial or not for economic

growth is a very debatable issue among economists. Lucas (1988) asserts
that economists tend to over-stress the role of financial factors in economic
growth. In contrast, a large literature on economic development states that
the extent of financial intermediation in an economy is crucial for its growth
(Goldsmith, 1969; Shaw, 1973; MacKinnon, 1973; Bencivenga & Smith,
Financial Liberalization, Savings, Investment, and Growth in MENA Countries 69
1991; Levine, 1997). Those who hold the latter view argue that by reallo-
cating capital to the highest-return projects and dealing with moral hazard,
adverse selection and transaction costs problems, financial intermediaries
represent an essential catalyst for economic growth. So, why do govern-
ments adopt financial repression policies?
Financial repression is the result of a nominal interest rate ceiling that is
below the prevailing rate of inflation and currency depreciation. Under fi-
nancial repression regimes, the monetary authorities impose high-reserve
requirements, bank-specific credit ceilings and selective credit allocation,
mandatory holding of treasury bills and bonds issued by the government,
and a non-competitive and segmented financial system.

Theoretically, there are several arguments in favor of financial repression.
First, it allows the authorities to have better control over the money supply.
Second, the government is assumed to know better than the market what
investments are more desirable from a social perspective. Third, the gov-
ernment can protect lenders against usury practices by moderating the free
determination of interest rates. Finally, financial repression is usually ac-
companied by interest rates below market rates, which reduces the costs of
servicing government debts.
Giovannini and De Melo (1993) emphasize the fact that financial repres-
sion is a taxation device used to finance the government needs at artificially
low interest rates. They provide empirical evidence on the interactions be-
tween financial controls and tax policies (budgetary impact of financial re-
pression) by estimating the amount of revenue that governments in
developing countries have obtained from financial repression. Their empir-
ical evidence covers 24 countries over the period 1972–1987. The govern-
ment revenue directly arising from financial repression can be measured as
the difference between foreign and domestic interest rates times the stock of
domestic government liabilities.
The results show that revenue from financial repression as a share of gross
domestic product (GDP) has ranged from 0% in Indonesia, where domestic
government debt is held exclusively by the central bank, to 6% in Mexico
and Zimbabwe. In Algeria it represents 4.3%, in Morocco 2.31%, in Turkey
2.2%, in Tunisia 1.5%, and in Jordan 0.6%. Giovannini and De Melo
(1993) report the two components through which financial repression was
implemented: The interest rate differentials and the changes in exchange
rates. The sum of these two components is equivalent to a tax rate of
financial repression. These components are 8.49 and 1.59% for Algeria, 5.74
and 10.33% for Morocco, 5.98 and 7.22% for Tunisia, 0.85 and 54.64% for
Turkey, and 6.71 and 0.47% for Jordan, respectively. These results suggest
70 LAHCEN ACHY
that in a number of MENA countries financial liberalization will generate a

substantial budgetary problem, unless it is accompanied by appropriate fis-
cal measures to substitute for the revenue losses.
However, there are theoretical as well as empirical arguments which sug-
gest that financial repression may exert adverse effects on economic growth.
Under such circumstances, it is relevant to investigate the government’s
motivations for adopting such policies. According to Roubini and Sala-i-
Martin (1995) the main reason is that the financial sector represents a po-
tential source of ‘‘easy’’ resources for the public budget through the inflation
tax. Financial development, which also means a reduction in the transaction
costs of transforming non-liquid to liquid assets, reduces the need to hold

money. Therefore, financial development decreases the inflation tax-base
and the possibilities to collect seigniorage. Therefore, tax system reforms
aiming at reducing the need for seigniorage revenues have been stressed as a
priority in structural adjustment programs before implementing financial
liberalization reforms.
To the extent that financial liberalization increases the efficiency of al-
locating savings to productive investments, financial repression will also
have negative real effects.
3. FINANCIAL LIBERALIZATION, SAVINGS,

INVESTMENT, AND GROWTH
The financial system affects capital accumulation either by increasing saving

rates (level effect) or by improving the allocation of savings among potential
investors (reallocation effect). The availability of funds may also affect
economic growth by financing technologic innovation.
3.1. Theoretical Review
In an extensive survey, Levine (1997) breaks the primary function of financial

sectors into five basic functions: mobilization of savings; allocation of re-
sources; hedging and pooling risks; easing the exchange of goods and services;
monitoring managers and exerting corporate control. Informational asymme-
tries and transaction costs create incentives for the emergence of financial
markets that supply financial instruments. Banks can offer liquid deposits to
savers and undertake a mixture of liquid low-return investments to satisfy
demand for deposit and illiquid high-return investments. In doing so, banks
provide complete insurance, against liquidity risk, to savers while facilitating
long-run investments. The ability of banks and security markets to pool risk
across individual projects, industries, and regions is also crucial for economic
growth. By facilitating risk diversification, financial markets induce a portfolio
risk toward projects with high-expected returns.
Dornbusch and Reynoso (1989) argue that strong assertions concerning
the positive effects of financial liberalization on economic growth are not
supported by the evidence. To support their claim, they reconsider the con-
ventional theoretical propositions and empirical facts against financial re-
pression. First, the relationship between real deposit rates and the savings
rates: Although there is a strong belief that higher interest rates stimulate
savings, the offsetting income and substitution effects of increased interest
rates mean an ambiguous total effect on saving. In developing countries, the
lack of appropriate data and their poor quality make it harder to provide
any evidence. Second, the relationship between financial depth and growth
is not strong, and varies substantially across countries.
Furthermore, Levine (1991) derives a model where more liquid stock
markets (markets where it is less expensive to trade equities) stimulate long-
run investment projects. This is because investors can easily sell their stake if
they need liquidity before the project matures. He concludes that high-liquid
stock market attracts investment in long-run high-return projects that boost
productivity growth.
Also, Mauro (1995) starts from the documented fact that Japan and
continental Europe have experienced high saving rates and fast growth even
though their stock markets have been relatively underdeveloped, while the
U.S.A. and U.K. have been characterized by low savings and slower growth
even though their stock markets have been well developed. To accommo-
date these facts, he incorporates some results from the precautionary savings
literature into an endogenous growth model in which the young and the old
share the output produced by their ‘‘family business’’. This model suggests
that the existence of a stock market where investors can pool their risks is
expected to reduce precautionary savings and – in a closed economy – in-
vestment and growth. Mauro’s paper shows that if uncertainty is of a mul-
tiplicative nature and utility across states is Constant Relative Risk
Aversion (CRRA), then the mechanism will decrease savings and tend to
lower growth if and only if the elasticity of inter-temporal substitution is
below 1.
However, there is a theoretical debate on whether high stock market
liquidity improves saving rates. In fact, higher returns and better risk
72 LAHCEN ACHY
sharing may reduce saving. Furthermore, since more liquidity makes it eas-
ier to sell shares, it may reduce the incentives of shareholders to monitor
managers (Shleifer & Vishny, 1986). Also, weaker corporate governance
limits the effective resource allocation and affects economic growth.
Regarding the reallocation and productivity effects of financial deepen-
ing, Greenwood and Jovanovic (1990) develop a model where the extent of
financial intermediation and economic growth are endogenously deter-
mined. In their model, financial intermediaries can invest more productively
than individuals because of their better ability to identify investment op-
portunities. They conclude that financial intermediation promotes growth
because it allows a higher rate of return to be earned on capital, and growth

in turn provides the means to implement costly financial structures.
Concerning the role that the stock market plays in allowing investors
to diversify their portfolios to hedge against idiosyncratic risk, Levine
(1991) constructs an endogenous growth model in which the stock mar-
kets emerge to help agents to cope with the liquidity risk and investi-
gates how the stock market affects investment incentives in ways that
change steady-state growth rates. He shows that the existence of a stock
market affects positively economic growth and may stimulate higher returns
and more productive projects rather than safe storage of wealth. His
paper also shows that taxing financial market activities lowers per capita
growth rates.
3.2. Empirical Review
To date the empirical relationship between financial system development

and savings, investment, and economic growth has been difficult to test.
Two streams of research may be distinguished. The first investigates more
generally the relationships between financial development indicators and
economic performance. The second focuses more specifically on the impact
of financial liberalization on economic performance.
King and Levine (1993) examine whether higher levels of financial de-
velopment are positively associated with economic development using data
for over 80 countries from 1969 through 1989. Three indicators have been
constructed in order to measure financial development: (1) the ratio of liquid
liabilities to GDP; (2) the importance of deposit banks relative to the central
bank in allocating credit; and (3) the share of credit issued to non-financial
institutions (in total credit and in GDP). This array of indicators provides a
much better picture of financial depth than using a single indicator. Using
cross-country regressions and after controlling for a set of country and

policy characteristics, they find that higher levels of financial development
are positively associated with faster rates of economic growth and physical
capital accumulation. They also point out that financial development is a
good predictor for long-run economic growth over the next 10–30 years.
Atje and Jovanovic (1993) present a cross-country study of stock markets
and economic growth over the period 1980–1988. They find a significant
correlation between average economic growth and stock market capitaliza-
tion for 40 countries.
Levine and Zervos (1998a) study whether stock markets and banks pro-
mote economic growth. Their chapter extends that of Atje and Jovanovic
(1993) in different dimensions: (1) by enlarging the sample size and the time
coverage; (2) by using different measures of stock market development; and
(3) by controlling for other economic and political factors that may affect
economic growth. Using data on 47 countries from 1976 through 1993, they
find that measures of stock market liquidity are strongly related to growth,
capital accumulation, and productivity. Surprisingly, stock market size does
not seem to be robustly correlated with economic growth. Conversely, bank
lending to the private sector has a strong effect on economic growth. How-
ever, as indicated by Rajan and Zingales (1998), one may be still skeptical
about the causality direction between financial development and economic
growth. Specifically, financial institutions may tend to lend more if they
expect future economic growth and if the stock market capitalizes the
present value of growth opportunities. In this case, financial development
can be viewed as a leading indicator rather than a causal factor. To over-
come these issues, they suggest investigating microeconomic data on firms’
external finance. Using data at the industry level over the period 1980–1990,
their findings indicate that ex-ante development of financial markets facil-
itates the ex-post growth of sectors dependent on external finance.
Harris (1997) re-examines the empirical relationship between stock mar-
kets and economic growth using more appropriate instruments for invest-
ment and applying more advanced econometric techniques. In contrast to
Atje and Jovanovic (1993), he finds no hard evidence that the level of stock
market activity helps to explain growth in per capita output. Splitting the
sample leads to similar results for the sub-sample of less developed coun-
tries. In the sub-sample of developed countries, however, the level of stock
market activity helps to explain per capita growth but by less than half the
value predicted by Atje and Jovanovic for their whole sample.
Bayoumi (1993) investigates the interaction between financial deregula-
tion and household savings behavior using regional data for the U.K. in the
74 LAHCEN ACHY
1980s. He concludes that financial deregulation was responsible for lower-

ing the equilibrium level of savings by roughly 2.25% per year and for
making savings more dependent on changes in wealth, income, and interest
rates.
Henry (2000) examines the relationship between stock market liberaliza-
tion (the decision to allow foreigners to purchase shares in the country’s
stock market) and the growth of real private investment using an event
study approach on a sample of developing countries. His paper covers 10
countries (Argentina, Brazil, Chile, Colombia, India, Korea, Malaysia, The
Philippines, Thailand, and Venezuela). Standard models of international
asset pricing predict that stock market liberalization may reduce the liber-
alizing country’s cost of equity capital. This fall in the cost of equity will
transform some investment project that had a negative net present value
(NPV) before liberalization into positive NPV after liberalization. Data in-
dicate that on average these 10 countries experience large, temporary in-
crease in the growth rate of real private investment on the heels of stock
market liberalization. The relationship between private investment growth
and stock market liberalization persists after controlling for world business
cycle effects, contemporaneous economic reforms, and domestic fundamen-
tals. However, Henry cannot conclude that stock market liberalization
causes investment booms, as the possibility of reverse causality cannot be
ruled out.
The evidence found by Kim and Singal (2000), and Bekaert and Harvey
(2000) supports the fact that stock market liberalization causes a one-time
revaluation of emerging market stock prices and a fall in the cost of capital.
Why a country’s cost of equity falls after financial liberalization? There
are two components in the cost of capital: the equity premium and the risk-
free rate. First, stock market liberalization is expected to increase net capital
inflows and this ‘‘supply effect’’ could reduce the risk-free rate. Second,
more risk sharing between foreign and domestic residents should reduce
equity premium. Increased capital inflows may also increase stock market
liquidity, and increased liquidity reduces the equity premium (Levine &
Zervos, 1998b). But, financial liberalization does not always lead to a fall in
the cost of equity capital. It could increase the risk-free rate. This depends
on whether the liberalization of restrictions on inflows is accompanied by a
liberalization of restrictions on outflows. It also depends on whether the
autarky risk-free rate (before liberalization) was above or below the world
rate. Ultimately, whether a country’s cost of capital rises or falls following
stock market liberalization is an empirical question that must be considered
on a case-by-case basis.
4. EMPIRICAL INVESTIGATION
In this section we investigate the relationship between financial intermedi-

ation and growth. As was already pointed out economic agents rely on
financial intermediaries to reduce information and transactions costs, to
manage liquidity risk, and allocate investments optimally. By doing so, fi-
nancial intermediaries influence savings and investment decisions, and hence
may affect overall economic growth. Our purpose is to assess the existence
of this effect and test the theoretical predictions regarding the relationship
between financial development and economic growth in the particular case
of some selected MENA countries.
4.1. Data Sources and Indicators
4.1.1. How to Capture Financial Liberalization?

Financial liberalization reforms involve usually several key phases that are
implemented in several years. These reforms cover interest rates, reserves
requirements, credit allocation, bank ownership, pro-competition measures,
security markets, prudential regulation, and openness of capital account
(Bandiera et al., 2000).
This process of financial liberalization has generally proceeded in many
stages and the relaxation of different controls has been rarely simultaneous.
As a result, it is difficult to define a single date in which liberalization takes
place. Moreover, official and practical timing of any particular relaxation
often do not coincide. There have also been partial reversals of prior lib-
eralization in some countries. One can try to infer the timing of liberali-
zation from the statistical properties of interest rate data themselves or other
financial indicators (liquid liabilities as a share of GDP, deposit money bank
assets to total financial assets, and credit by deposit money banks to private
sector as a share of total credit or GDP).
Following Bandiera et al. (2000), I construct a financial liberalization
index that captures the exogenous changes in eight items (interest rate reg-
ulation, reserves requirements, credit allocation, bank ownership, pro-com-
petition measures, security markets, prudential regulation, and capital
account liberalization) (Appendices B–C). For each item a dummy variable
that takes on the value 1 for a more liberalized regime and 0 otherwise is
created. Using the principal component analysis, a weighted average of the
more important principal components is computed. This indicator repre-
sents the financial liberalization index that will be used in the regression
76 LAHCEN ACHY
analysis. To this end, International Monetary Fund (IMF) country reports

have been explored in order to construct database records of such policy
changes.
4.1.2. Financial Depth Measures

Assuming that the size of the formal financial intermediary sector relative to
economic activity reveals the extent and the quality of financial services,
many researchers use liquid liabilities over GDP (LL/GDP) as a proxy for
financial development. However, this indicator reflects the overall size of the
financial sector and does not distinguish between the allocation of capital to
the private sectors, and to various governmental and quasi-governmental
agencies. In this respect, it may not inform reliably on the extent to which
financial services such as risk management and information processing are
provided. Data on this indicator are presented in Table 1.
In order to assess more accurately the contribution of commercial banks
in financial intermediation, the ratio of deposit money bank domestic assets
to total financial assets is used, including central bank domestic assets. The
rationale for this measure is that banks are more likely to identify profitable
investment, monitor managers, and mobilize savings than central banks
(Levine, 1997). The weakness of this indicator is that in some countries the
government influences the structure of bank assets and liabilities through
mandatory holdings and controls on credit allocation. Table 2 presents data
on this indicator.
A more accurate indicator of financial development is provided by the
value of credits by financial intermediaries to the private sector (excluding
credit to money banks) divided by total domestic credit. The last indicator is
computed as the ratio of claims on the financial private sector to GDP.
Tables 3 and 4 present, respectively, data on these two last indicators.
Table 1. Liquid Liabilities to GDP.

1970–1979 1980–1985 1986–1991 1992–1997
Egypt 40.0 74.6 80.5 77.4

Jordan 58.6 80.3 115.5 106.1
Morocco 34.5 41.0 45.7 61.7
Tunisia 34.7 40.1 47.5 44.7
Turkey 19.4 19.3 22.0 24.0
Source: IMF, International Financial Statistics.

Table 2. Deposit Money Banks Assets to Total Financial Assets.

1970–1979 1980–1985 1986–1991 1992–1997
Egypt 56.2 50.3 52.9 68.0

Jordan 70.1 78.4 71.8 73.0
Morocco 50.2 48.8 42.8 61.6
Tunisia 80.3 78.5 75.3 79.6
Turkey 60.2 51.4 61.4 74.6

Table 3. Private Credit to Total Domestic Credit.

1970–1979 1980–1985 1986–1991 1992–1997
Egypt 24.8 24.0 26.4 39.2

Jordan 72.4 74.2 61.7 75.2
Morocco 47.1 39.4 44.7 55.1
Tunisia 84.6 87.4 87.2 93.8
Turkey 56.3 45.4 52.8 62.5
Table 4. Private Credit by Deposit Banks to GDP.

1970–1979 1980–1985 1986–1991 1992–1997
Egypt 14.3 22.3 25.6 27.5

Jordan 33.9 47.6 61.2 62.0
Morocco 13.2 16.3 17.2 25.7
Tunisia — — 51.6 50.5
Turkey — — 13.4 13.5
4.2. Econometric Analysis
The econometric analysis is based on three main specifications involving

three dependent variables (private savings, private investment, and real
GDP growth rate). In the first two specifications, the variables are entered in
the logarithmic terms (except for the real interest rate, RR) that contains
negative values. One advantage of the logarithmicic transformation is that
the regression directly yields elasticity coefficients for the private saving
78 LAHCEN ACHY
rates and private investment rates, with respect to the explanatory variables,
making it readily possible to assess the economic relevance of the relation-
ship. The logarithmic transformation also accounts for potential non-lin-
earities in the relationship between the dependent and the explanatory
variables. It is very likely, for example, that the effects of financial depth on
private investment are minimal at low levels of financial depth and increase
as the country’s financial system develops.
The equations are estimated using a panel data approach and allowing
specifically each of the five countries to have its own intercept (fixed-effects
estimation). An F-test rejects significantly the hypothesis of a common in-
tercept and supports the alternative of individual country intercepts.

To test the effects of financial liberalization on private savings, private
investment, and growth, various indicators of the extent of financial reforms
are used alternatively. First, the four classical indicators of financial depth
(total liquid liabilities of financial intermediaries as a percentage of GDP
(LLY), deposit money banks assets as a share of total assets (BANK),
private credit by deposit money banks to GDP (PRIVY), and private credit
by deposit money banks to total domestic credit (PRIV)) are used to proxy
indirectly for the scope of financial liberalization. In a second step, the
financial liberalization index (FINX) constructed on the basis of available
information on the eight main dimensions of financial reforms is used (Ap-
pendices B–C). The results are presented in Table 5 for private saving,
Table 6 for private investment, and Table 7 for real GDP growth rate. To
avoid omitted variables bias, different policy-related variables such as trade
openness, exchange rate overvaluation, inflation rate, and real interest rate
are included in the regressions as well.
Various tests are conducted to examine the ways in which financial depth
affects private saving, private investment, and economic growth and also to
check the robustness of the estimated results.
4.2.1. Financial Liberalization and Private Saving

The estimation results on the impact of financial liberalization on private
savings using each of the five measures of the extent of financial develop-
ment are shown in Table 5. While there are theoretical reasons which sug-
gest that each of the included variables contribute in explaining private
savings, the predicted sign for some variables is ambiguous a priori (Ap-
pendix A).
The coefficients on all five financial indicators are negative although only
two of them are statistically significant at the 95% level of confidence (LLY
and FINX). The results support the hypothesis that an increase in financial
Table 5. The Impact of Financial Liberalization on Private Savinga.

Explanatory Variables LLY BANK PRIVY PRIV FINX
Financial depth 0.37 0.13 0.12 0.13 0.20

(2.12) (1.20) (1.55) (0.91) (3.23)
Real interest rate 0.02 0.02 0.02 0.02 0.003
(1.41) (1.35) (1.34) (1.37) (1.18)
Real GDP growth 0.005 0.01 0.008 0.01 0.01
(1.75) (3.50) (2.31) (3.58) (2.03)
Budget surplus/GDP 0.03 0.04 0.03 0.04 0.02
(1.44) (2.23) (2.13) (2.34) (1.92)
Dependency ratio 0.81 1.26 1.18 1.26 1.89

(1.72) (1.86) (2.06) (2.14) (4.63)
External debt/GDP 0.20 0.35 0.31 0.37 0.18
(0.84) (1.94) (1.74) (1.90) (2.13)
Adjusted R2 0.31 0.28 0.29 0.29 0.35
F-statistic 5.72 5.19 5.31 5.29 7.26
Prob(F-statistic) 0.00 0.00 0.00 0.00 0.00
Observations 114 114 114 114 114
Note: These estimations are obtained using country-fixed-effect estimation over the period
1970–1997. The dependent variable is the private saving rate taking in logarithm. All regression
variables are in logarithm, except for real GDP growth, real interest rate and budget surplus/
GDP. The estimates are corrected for auto-correlation and heteroskedasticity (generalized least
squares, GLS, estimation). The t-statistics are given in parentheses. LLY is the ratio of liquid
liabilities over GDP. BANK is the deposit money banks assets as a share of total assets. PRIVY
is private credit by deposit money banks to GDP. PRIV is private credit by deposit money
banks to total domestic credit. FINX is a financial liberalization index constructed on the basis
of available information on the eight main dimensions of financial reforms implemented in the
countries under study.
Source: Author’s estimates.
a
Data on private saving used are from Loayza et al. (1998).
significant at 10%.
significant at 5%.
depth leads to a lower level of private saving. The coefficients represent the
elasticities of private saving with respect to the financial depth indicators,
since the regression variables are in logarithm. The first column of the table
suggests that a 1% increase in liquid liabilities as a share of GDP leads
roughly to a 0.37% decline in private savings. The elasticities of private
savings with respect to credit issued to the private sector (as a share of
GDP or as a share of total domestic credit) are invariably equal to (0.13).
A similar result is obtained when using deposit money bank assets to
total financial assets as a measure of financial development. Finally, the
elasticity of private savings with respect to the composite index of financial
80 LAHCEN ACHY
Table 6. The Impact of Financial Liberalization on Private Investmenta.

Explanatory Variables LLY 0 PRIVY PRIV FINX
Financial depth 0.58 0.03 0.16 0.19 0.18

(2.62) (0.14) (1.94) (1.24) (1.27)
(3.20) (1.44) (1.32) (0.89) (1.21)
Real GDP growth (t1) 0.01 0.01 0.01 0.02 0.02
(1.86) (2.36) (2.21) (2.46) (2.41)
Trade openness 0.79 0.54 0.57 0.77 0.50
(5.97) (4.16) (6.18) (3.50) (6.06)
Inflation rate 0.13 0.11 0.13 0.10 0.06

(1.82) (1.31) (1.68) (1.19) (1.43)
Exchange rate overvaluation 0.006 0.003 0.002 0.001 0.002
(2.56) (1.53) (1.61) (0.92) (1.10)
Budget surplus/GDP 0.01 0.00 0.005 0.001 0.004
(1.35) (0.02) (0.62) (0.09) (0.50)
Adjusted R2 0.59 0.52 0.54 0.53 0.53
F-statistic 16.59 13.72 14.63 13.95 14.27
Prob(F-statistic) 0.00 0.00 0.00 0.00 0.00
Observations 109 109 109 109 109

For footnote refer to that of Table 5.
a
Data on private investment used are from Pfeffermann et al. (1999).
significant at 10%.
significant at 5%.
liberalization is in the middle range (0.20). The negative impact of finan-

cial development in general and financial liberalization more specifically on
savings suggests that liberalization may have relaxed credit constraints on
households. Jappelli and Pagano (1994) found the same result in a cross-
country study. They argue that easing liquidity constraints on households
by liberalizing consumer and mortgage credits, coupled with financial de-
regulation, lead to a decline in saving and economic growth rates.
As noted earlier, the real interest rate can have a positive or negative
effect on savings, depending on the relative magnitudes of the substitution
and income effects. The evidence is also less clear as shown by the coef-
ficients reported in Table 5. The estimates are positive, which suggest that
higher real interest rates stimulate the saving behavior of private agents, but
they are not statistically significant.
Theoretically, in a closed economy the effect of economic growth on
private saving is positive, but in a small open economy it becomes ambig-
uous; faster growth may reduce the savings rate by stimulating the
Table 7. The Impact of Financial Liberalization on Real GDP Growth.

Explanatory Variables LLY BANK PRIVY PRIV FINX
Financial development 2.03 1.96 2.05 0.91 0.35

(0.93) (0.97) (1.78) (0.68) (0.17)
(2.79) (2.69) (2.80) (2.64) (2.67)
GDP (1) 2.65 2.60 2.79 2.57 2.65
(3.77) (3.73) (3.97) (3.70) (3.27)
Private investment (t+1) 3.48 3.88 3.57 3.86 3.65
(2.75) (3.08) (2.86) (3.07) (2.94)
Human capital 4.31 3.60 3.86 3.11 3.16

(2.48) (2.54) (2.78) (2.24) (2.19)
Trade openness 1.62 1.87 1.69 1.93 2.19
(0.95) (1.13) (1.04) (1.16) (1.34)
Inflation rate 0.88 1.24 0.93 1.21 1.31
(1.16) (1.89) (1.41) (1.84) (1.95)
External debt/GDP 1.80 2.75 2.11 2.46 2.18
(1.47) (2.35) (1.98) (2.30) (2.07)
Term of trade changes 0.62 0.22 1.1 0.72 0.35
(0.38) (0.14) (0.65) (0.42) (0.22)
Exchange rate overvaluation 0.01 0.007 0.006 0.005 0.01
(1.23) (0.71) (0.62) (0.49) (0.82)
Adjusted R2 0.34 0.35 0.36 0.34 0.33
F-statistic 4.95 5.19 5.26 4.83 4.76
Prob(F-statistic) 0.00 0.00 0.00 0.00 0.00
Observations 127 127 127 127 127
Note: These estimations are obtained using country-fixed-effect estimation over the period
1970–1997. The dependent variable is real GDP growth rate. All explanatory variables are in
logarithm, except for real interest rate. The estimates are corrected for auto-correlation and
heteroskedasticity (generalized least squares, GLS, estimation). The t-statistics are given in
parentheses. For expansion of LLY, BANK, PRIVY, PRIV, and FINX, refer to that of Ta-
ble 5.
significant at 10%.
significant at 5%.
consumption of the young (Jappelli & Pagano, 1994). According to our

estimation, the coefficient of economic growth is positive, statistically sig-
nificant and quite robust across the five measures of financial development.
It reveals a positive relationship between economic growth and private
savings. This result tends to corroborate previous finding in the literature. A
potential endogeneity bias may be suspected if growth is itself endogenous
and positively correlated with the error term of the private saving equation.
82 LAHCEN ACHY
To account for this potential bias, the contemporaneous growth rate of

GDP was replaced by the growth rate in the previous period. This spec-
ification yields results similar to those reported in Table 5. As expected, a
higher-dependency ratio (the ratio of (the population under 15 + the pop-
ulation over 60) to the total population) increases family needs and puts
more burdens on workers, thereby reducing savings. This negative coeffi-
cient is consistent with the life-cycle hypothesis. That is, if a high proportion
of the population is not of a working age, then the dissaving patterns of this
segment of the population will outweigh the saving patterns of the working
cohort. The magnitude of the effect, however, does not seem to be statis-
tically robust and vary depending on the financial depth indicator.

The budget deficit as a share of GDP may affect private savings if eco-
nomic agents are Ricardian and use private savings to offset changes in
government savings. The negative and significant coefficient of the govern-
ment budget surplus, in four out of five regressions, is consistent with
Ricardian-like behavior. Finally, the results indicate a positive but insignif-
icant coefficient on external debt as a ratio of GDP.
4.2.2. Financial Liberalization and Private Investment

Theoretically, financial liberalization is associated with better allocation of
capital and more efficient transformation of savings into investment. By
mitigating the liquidity constraints faced by entrepreneurs and reducing
transactions costs of converting illiquid to liquid assets, a more liberalized
financial system should stimulate capital accumulation and have positive
effects on economic growth.
To test the effects of financial development on private investment, the
same methodology applied for private savings is adopted. The results are
reported in Table 6. The results seem to be surprising with regard to the
theoretical expectations. The coefficients on financial development indica-
tors as well as on the financial liberalization index indicate a negative impact
of financial depth on private investment in the five MENA countries in-
vestigated. This finding is inconsistent with the previous literature using
cross-country regressions. Levine (1993), for example, using a cross section
of 77 countries over the period 1960–1989 found a positive effect of financial
development indicator on real per capita capital growth.
One potential explanation of our result can be found in the link between
financial development, and the development of mortgage and consumer
credit markets. By distorting private credit allocation in favor of households
at the extent of lending to firms, financial liberalization not only have re-
duced private savings but also tended to reduce available loans for the
business sector. To assess the validity of this explanation one needs detailed
data on the allocation of private credit between households and firms. A
complete characterization of the allocation of private credit (by sector, by
maturity) is extremely useful to investigate the extent to which financial
liberalization resulted in an effective increase in the flow of funds attributed
to private investment. For data availability reasons, this exercise is left for
future research.
The real interest rate coefficient is positive in three cases out of five,
although only significant when liquid liabilities as a share of GDP is used as
a measure of financial development. In the two other cases, the real interest
rate has a negative but insignificant coefficient. The positive sign on the real
interest rate contradicts the theoretical prediction according to which a
higher cost of capital would discourage private investment. This result may
reflect uncertainty concerning future inflation, since investment decisions are
taken on an ex-ante basis, while the real interest rate used here is the ex-post
measure of the borrowing cost.
The coefficient of economic growth is positive, statistically significant and
quite robust across the five measures of financial development. This result
implies a positive relationship between economic growth and private in-
vestment. To ensure that this result is not biased by the potential positive
correlation of economic growth with the error term of the private invest-
ment equation, the contemporaneous real GDP growth rate is replaced with
the real GDP growth rate in the previous year.
To account for the effect of government policies on private investment,
four variables were included in the private investment equation: the extent
of trade openness, the rate of inflation, the degree of overvaluation of the
real exchange rate, and the extent of the government budget surplus as a
share of GDP. The first variable has the expected positive sign, highly sig-
nificant and statistically robust, implying that trade openness exerts a pos-
itive effect on private investment. The second and third variables have the
predicted negative sign, although only marginally significant. This negative
sign is consistent with the damaging effect of uncertainty in the macroeco-
nomic environment on private investors’ decisions. The fourth variable ex-
hibits insignificant coefficients, although one may expect government
borrowing in order to finance budget deficit to be harmful for private in-
vestment.
4.2.3. Financial Liberalization and Economic Growth

The theoretical underpinning of the relationship between financial develop-
ment and economic growth has recently received considerable attention in
84 LAHCEN ACHY
both theoretical and empirical research. The channels through which finan-
cial development could affect economic growth have already been presented
in our literature review. The purpose here is to assess the relative contri-
bution of financial factors using the framework provided by the recent em-
pirical growth literature.
The estimated growth equation relates real GDP growth to a set of
measures of financial depth, real interest rate, and a set of control variables
consisting of private investment rate, human capital indicator, trade open-
ness, inflation rate, external debt as a share of GDP, annual change of terms
of trade, and real exchange rate overvaluation. The estimation strategy is
the same as before. The results are presented in Table 7.

The first striking feature of our results is the negative and insignificant
coefficients on financial depth indicators (except for private credit as a share
of GDP). This result contradicts those of King and Levine (1993), who
found a positive association between financial system development and
economic growth in a cross-country context. Our results provide evidence
that once fundamental variables such as private investment and human
capital (proxied by the secondary enrollment rate), and policy-related var-
iables such as trade openness, inflation rate, and the burden of external debt
are controlled for, financial depth indicators fail to explain the growth ex-
perience in the five MENA countries under investigation. These findings
indicate the existence of some interactions among variables that cause some
of them to lose significance when they are included simultaneously.
One channel of interaction presented earlier is through the effect of finan-
cial depth on private investment. The second striking feature is the
positive, significant, and robust coefficient of the real interest rate. The
ex-post determination of the real interest rate and the uncertainty sur-
rounding the prediction of inflation rate ex-ante may be an explanation of
this finding.
The remaining results presented in Table 7 show that the coefficient es-
timate on lagged GDP, which stands for the catch-up term, is negative and
significant. The coefficients on private investment and on human capital are
positive and significant which is consistent with our expectations and cor-
roborate the previous literature. The coefficient estimate of external debt as
a share of GDP is negative and statistically robust which indicates that the
burden of external debt has contributed negatively to the observed slow
growth in MENA countries. Debt obligations absorb an important fraction
of resources that could be mobilized for investment purposes. The results on
the other variables need to be interpreted with extreme cautious due to the
potential heterogeneity in growth patterns among the five countries.
5. CONCLUSION
Since the mid-1980s, a gradual liberalization of the financial system has
taken place in MENA countries. Interest rates subsidies to priority sectors
have been reduced or eliminated. The monetary authorities started to man-
age liquidity through a more active use of reserve requirements and a more
market-based allocation of refinancing. New banking laws increased the
autonomy of the central bank and introduced prudential regulation in line
with international standards. Finally, measures to increase competition by
opening banks’ capital to foreign participation were designed. The expec-
tation was that higher financial development would enhance economic

growth through the better mobilization of savings and more efficient allo-
cation of capital.
The aim of this chapter was to assess the impact of financial development
on private savings, on private investment, and on economic growth. While
our results on the effects of financial development on private saving are
consistent with the previous studies, our results on the relationship between
financial development and private investment on the one hand, and financial
development and economic growth on the other are rather disappointing
with regard to our initial expectations.
The coefficients on financial development indicators, as well as on finan-
cial liberalization index, indicate a negative impact of financial depth on
private investment in the five MENA countries investigated. This finding is
inconsistent with the previous literature using cross-country regressions.
One potential explanation of our result can be found in the link between
financial development, and the development of mortgage and consumer
credit markets. By distorting private credit allocation in favor of households
at the expense of lending to firms, financial liberalization may not only have
reduced private savings, but tended also to reduce available loans for the
business sector. To assess the validity of this explanation one needs detailed
data on the allocation of private credit between households and firms. Re-
garding the relationship between financial depth and economic growth, our
results provide evidence that once fundamental variables such as private
investment and human capital (proxied by the secondary enrollment rate),
and policy-related variables such as trade openness, inflation rate, and the
burden of external debt are controlled for, financial depth indicators fail to
explain the growth experience in the five MENA countries under investi-
gation. This is particularly plausible if financial liberalization have led to
further distortion of credit allocation in favor of consumption and at the
expense of productive activities.
86 LAHCEN ACHY
In order to investigate these issues in more depth, it would be worthwhile

to undertake detailed analysis at the country level. Such analysis can take
into account the effect of institutional differences and other country-specific
developments. It can also capture the effect of private credit distribution
between households and firms, among sectors, and between small and large
firms.
NOTES
1. Appendix D describes the list of variables used in the chapter to investigate the
relationship between financial liberalization saving, investment, and growth. It also
presents data sources and the time span covered by available data for each variable.
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APPENDIX A. THE EFFECTS OF FINANCIAL

LIBERALIZATION COMPONENTS ON SAVINGS
Financial Liberalization Direct Effect Effect on Savings

Component
Interest rate liberalization Higher deposit interest

Substitution and income
rates (price effect)effects, total effect on
saving ambiguous
Reduction of reserve More resources available Net effect depends on other
requirements for lending (quantity policy instruments
effect) may also lead (monetary policy: open
to a price effect market operations)
Reduction of directed credit Reallocation within the Ambiguous effect on
to priority sectors business sector (high- corporate saving and
return projects) and reduction of household
more lending to saving
households
88 LAHCEN ACHY
APPENDIX A. (Continued)
Financial Liberalization Direct Effect Effect on Savings

Component
Bank ownership (more May be associated with Reduction of household

privatization) an increase in lending saving
to households
Pro-competition policies More risk taking in Ambiguous effect on saving
lending and reduction
of bank spreads.
Wider range of saving
opportunities
Prudential regulation Offset or moderate risk Ambiguous effect on saving
taking promoted
through competition.
May also reduce
upward pressure on
deposit rates
Development of securities Wider and more flexible Can increase saving, the
markets range of saving effect may take time to be
instruments effective
International financial Flows of foreign funds Ambiguous effect on saving
liberalization and increase in rates because banks can also
of returns as barriers borrow from abroad to
to capital outflow are sustain lending to local
removed firms and households
Source: Bandiera et al. (2000).

Financial Liberalization, Savings, Investment, and Growth in MENA Countries
APPENDIX B. FINANCIAL LIBERALIZATION COMPONENTS AND
FINANCIAL LIBERALIZATION INDEX (1)
Financial Egypt Jordan Morocco Tunisia Turkey

Liberalization
Component
Interest rate 1991: Liberalization Interest rates on deposits Most interest rates 1981: Interest rate
liberalization of interest rates liberalized in 1990 and were liberalized in ceiling abolished
(deposits and 1991 1987, 1994, and 1983: Ceilings
lending) 1996: Controls on lending 1996. But some reintroduced
and deposit rates deposit rates 1988: Ceiling
completely eliminated remain regulated eliminated
except a ban on (interest on sight
remuneration of sight deposits must not
deposits and interest rates exceed a ceiling of
for small saving deposits 2% points)
Reduction of Proxy by total reserves as a share of total deposit money bank assets
reserve
requirements
Reduction of 1994: Credit ceiling From 1991 to 1993, 1991: Mandatory
directed credit for private sector mandatory holding were holding of treasury
to priority abolished reduced. Obligatory debt instruments
sectors 1995: Credit ceiling holding of treasury was relaxed
for public sector papers reduced from 1994: Abolition of the
abolished 35% in 1986 to 10% by obligation for banks
end 1996 to subscribe and
hold treasury bills
89
90
APPENDIX B. (Continued)
Liberalization
Component
1996: Obligatory
sectoral lending
ratios abolished
Bank ownership 1996: Privatization 1989: Barriers to entry 1986: Measures to
(more of public banks reduced by abolishing enlarge the scope of
privatization) ownership in ‘‘Moroccanization’’ activities for foreign
joint venture and decree banks and off-shore
private banks banks
Pro-competition Since mid-1980s: Further 1981: Barriers to
policies competition by breaking entry lowered
down the
compartmentalization of
activities between
development and
commercial banks. 1993:
The new banking law,
full integration of
LAHCEN ACHY
development banks
APPENDIX C. FINANCIAL LIBERALIZATION COMPONENTS AND
FINANCIAL LIBERALIZATION INDEX (2)

Liberalization
Component
Prudential Prudential regulation Prudential Prudential regulation 1991: Adoption of 1986: New banking
regulation applied regulation introduced (to be met by prudential law becomes
progressively since applied since 1996) regulations effective. It
1991 (liquidity 1993 1993: External audits provides
ratios, the capital and off-site supervisory and
adequacy ratio, the reporting prudential
solvency criterion requirements measures
(Basle Accord) 1994: Amendments to
1997: Banks have to the banking law
publish their These requirements
audited financial to be met in 1999
statements in
accordance with
international
standards
Development of 1992: Measures to 1993: Stock market 1994: Stock market 1983: The capital
securities ensure stock capitalization and capitalization and market board is
markets market revival turnover increased turnover increased established to
dramatically dramatically promote and
1997: Electronic quotation 1996: Electronic monitor the
quotations securities markets
1986: Istanbul Stock
Exchange becomes
operative
APPENDIX C. (Continued)

Liberalization
Component
International 1991: Liberalization 1993: Current account 1994: Inter-bank FX 1984: FX

financial of the exchange convertibility. market created deregulation.
liberalization rate. All Liberalization of inward 1997: Forward FX Banks are allowed
transactions in the foreign direct and market established to keep foreign
balance of portfolio investment, 1993: Current currency abroad
payments and external borrowing account 1985: New
including the by residents convertibility. restrictions
capital account 1996: Inter-bank foreign Liberalization of introduced
were fully exchange (FX) market inward foreign 1988: FX liberalized
liberalized (except created direct and portfolio 1989: Capital
investment in real 1996: A Moroccan bank investment, and movements
estate) issued equities in external borrowing liberalized
international capital by residents 1990: Exchange rate
markets and a private 1994: Tunisian liberalized
Moroccan enterprise government issued
issued corporate bonds in long-term bonds
the European markets on the Japanese
capital market
Source: Table constructed by the author.

APPENDIX D. DATA SOURCES AND INDICATORS1
Variable Time Span Description
Liquid liabilities to 1970–1997 LL use IFS line 551 or if not available

GDP (LLY) line 351 which is equal to M2. LL is a
typical measure for financial depth but
does distinguish between the financial
sectors or between the use of liabilities
Deposit money bank 1970–1997 Deposit money bank domestic assets are
assets to total from IFS lines (24 þ 25)

financial assets
(BANK)
Total financial assets ¼ IFS lines
(12 þ 22 þ 42)
Private credit by 1970–1997 Credit issued to the private sector as
deposit money opposed to credit issued to
banks to GDP governments and public enterprises.
(PRIVY) IFS (32D..ZF + 42D..ZF)
Private credit by 1970–1997 Total domestic credit is from IFS
deposit money (32 þ 42)
banks to total
domestic credit
(PRIV)
Reserves to total 1970–1997 Total reserves are from IFS lines
deposits money (20 þ 40)
banks (RES)
Real interest rates 1970–1997 RR is the deposit interest rate (IFS line
(RR) 60L..ZF) less the rate of inflation
measured by GDP deflator (line
99BIPZF) or if not available CPI (line
64). When 60L..ZF is not available,
RR is computed from the lending rate
(60P..ZF) less the spread (from World
saving database) less inflation
Private saving rate 1970–1997 Private saving as a share of gross national
(PSAVY) disposable income (from World saving
database: Loayza et al., 1998)
Private investment 1970–1997 Global Development Finance & World
rate (PINVY) Development Indicators (for gross
domestic investment); Pfeffermann
94 LAHCEN ACHY
APPENDIX D. (Continued)
Variable Time Span Description
et al. ‘‘Trends in Private Investment in

Developing Countries’’ (for public
investment and private investment)
Growth (Grow) 1970–1997 Annual percentage growth rate of GDP
at market prices based on constant
local currency
Exchange rate 1970–1997 Computed from real effective exchange

overvaluation rate index given by Global
(EXOV) Development Finance and World
Development Indicators
Trade openness 1970–1997 Total trade (imports þ exports) as a share
(OPEN) of GDP. Global Development Finance
and World Development Indicators
Inflation rate (P) 1970–1997 Computed from CPI (IFS line 64)
Secondary 1970–1997
enrollment
(SECENR)
Budget surplus as a 1970–1997
share of GDP
(BUDY)
Terms of trade 1970–1997
(TOT)
Share of population 1970–1997
over 60 years
(OLD)
Share of population 1970–1997
under 15 years
(YOUNG)

CPI: consumer price index; IFS: International Financial Statistics; LL: liquid liabilities.
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increase competition by opening banks’ capital to foreign participation have

2. WHY DO GOVERNMENTS ADOPT FINANCIAL

Whether the degree of ﬁnancial development is crucial or not for economic

and a non-competitive and segmented ﬁnancial system.

that in a number of MENA countries ﬁnancial liberalization will generate a

costs of transforming non-liquid to liquid assets, reduces the need to hold

3. FINANCIAL LIBERALIZATION, SAVINGS,

The ﬁnancial system affects capital accumulation either by increasing saving

3.1. Theoretical Review

In an extensive survey, Levine (1997) breaks the primary function of ﬁnancial

because it allows a higher rate of return to be earned on capital, and growth

3.2. Empirical Review

To date the empirical relationship between ﬁnancial system development

cross-country regressions and after controlling for a set of country and

1980s. He concludes that ﬁnancial deregulation was responsible for lower-

In this section we investigate the relationship between ﬁnancial intermedi-

of some selected MENA countries.

4.1. Data Sources and Indicators

4.1.1. How to Capture Financial Liberalization?

analysis. To this end, International Monetary Fund (IMF) country reports

4.1.2. Financial Depth Measures

Table 1. Liquid Liabilities to GDP.

Egypt 40.0 74.6 80.5 77.4

Source: IMF, International Financial Statistics.

Table 2. Deposit Money Banks Assets to Total Financial Assets.

Egypt 56.2 50.3 52.9 68.0

Source: IMF, International Financial Statistics.

Table 3. Private Credit to Total Domestic Credit.

Egypt 24.8 24.0 26.4 39.2

Source: IMF, International Financial Statistics.

Table 4. Private Credit by Deposit Banks to GDP.

Egypt 14.3 22.3 25.6 27.5

Source: IMF, International Financial Statistics.

4.2. Econometric Analysis

The econometric analysis is based on three main speciﬁcations involving

tercept and supports the alternative of individual country intercepts.

4.2.1. Financial Liberalization and Private Saving

Table 5. The Impact of Financial Liberalization on Private Savinga.

Financial depth 0.37 0.13 0.12 0.13 0.20

Dependency ratio 0.81 1.26 1.18 1.26 1.89

Table 6. The Impact of Financial Liberalization on Private Investmenta.

Financial depth 0.58 0.03 0.16 0.19 0.18

Inﬂation rate 0.13 0.11 0.13 0.10 0.06

Source: Author’s estimates.

liberalization is in the middle range (0.20). The negative impact of ﬁnan-

Table 7. The Impact of Financial Liberalization on Real GDP Growth.

Financial development 2.03 1.96 2.05 0.91 0.35

Human capital 4.31 3.60 3.86 3.11 3.16

consumption of the young (Jappelli & Pagano, 1994). According to our

To account for this potential bias, the contemporaneous growth rate of

tically robust and vary depending on the ﬁnancial depth indicator.

4.2.2. Financial Liberalization and Private Investment

4.2.3. Financial Liberalization and Economic Growth

the same as before. The results are presented in Table 7.

tation was that higher ﬁnancial development would enhance economic