Economic restructuring in a highly repressed economy perspectives on the order of policy reform

Nguyen Huu Dung & Dang Hoang Ha | 1

Economic restructuring in a highly repressed economy:
Perspectives on the order of policy reform
NGUYEN HUU DUNG
Real Estate and Natural Resources Economics, National Economics University –


DANG HOANG HA
International School, Thai Nguyen University –

Abstract
How to restructure the economy is an important question for many developing countries in
order to minimise the reform cost and adverse effects to the economy. This paper provides
insight into the order of economic restructure in the perspectives of policy reform, particularly
in timing and sequencing of liberalization. It argues that, stabilizing macroeconomic such as
fiscal consolidation and low inflation should be achieved first. Next, remove distortions in
domestic goods, capital, and financial sector. Removing distortion means deregulate domestic
interest rate, remove distortion in prices and free up wages in labour market. Third, liberalise
international trade, which removing quotas, tariffs and other direct administrative controls,
and reducing tariffs across the board. Finally, liberalize capital account involving the
elimination of restrictions on inflows and outflows of foreign direct investment as well as
portfolio investment and the use of long and short term financial instruments.
Keywords: policy reform; liberalization; interest rate; capital account.

1. Introduction
Since the 1970s many countries have adopted economic reform and liberalised
economies, particularly favouring free trade, privatization, fiscal consolidation,
financial deregulation and liberalisation with the main objective to promote growth of
their economies. The initial achievements with massive capital inflows and increase in
consumption of some economies in the late 1970s and early 1980s such as Chile and

Britain have triggered for many other countries’ economic liberalization programs.
Most of Eastern Europe and East Asia countries in the later time began adopting


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transformation of their economies from central planed which are highly repressed and
distorted by governments mandated control on output and prices into some form of
economic liberalisation (Yung and Hugh, 2013). Liberalization has been considered as
a miracle for attracting foreign investment and economic development.
However, after some initial success period, the pictures of liberalizing countries
become various. In the late of the 1980s and early 1990s some of countries such as
Chile and Britain continue having remarkable achievements while others experienced
recession or even finance crisis and economic instability fail such as Argentina, Brazil,
Peru and especially former Soviet Union (Pradeep et.al., 1995). These problems again
cause economists debate over the question how to approach economic liberalisation.
McKinnon in 1982 (and then in 1991) initially proposed a gradual approach
economic liberalization. He argued that the appropriate policies, and in particularly
timing and sequencing of liberalization were the main issue. There is, an optimal order
of economic liberalization that a country should follow to minimise the reform cost
and adverse effects to the economy. Although that sequencing is still an area of debate,
it has been generally received consensus during the recent time.
For better understanding the sequencing proposed by McKinnon (1982), this paper
discusses how an economy can approach liberalization safely and in the right pace. The
focus of the paper will be on liberalisation of tightly-controlled capital account which is
in highly repressed economy. Some country experiences will be taken for discussion.
The paper is arranged as follows. The first section of the paper is the introduction;
second section discusses the optimum order of economic liberalisation; Section third
discusses some critiques over the sequence. Section fourth concludes.
2. Sequencing of economic restructuring of a repressed economy

During the recent time, although there are few other critics such as Little, Scott, and
Michael argue for different sequencing, the order proposed by McKinnon (1982) has
been generally received consensus. McKinnon (1982) suggest the optimal orders of
economic liberalisation; that is, stabilize macroeconomic first, remove distortions in
domestic goods, capital and labour markets second, liberalize international trade third,
and open capital account at the last stage.


Nguyen Huu Dung & Dang Hoang Ha | 3

i. Macroeconomic stabilization is necessary condition before embarking on
economic liberalisation. Macroeconomic stabilisation refers to fiscal control and price
stability in which fiscal consolidation is suggested to be taken in the first place
(McKinnon, 1982). It would be difficult for government to conduct monetary policies
during the transition period with out fiscal consolidation and inflation under control
because of the potential lost of macroeconomic control when monetary policies are
dependent to government budget deficit.
Argentina can be seen as an example of this. Argentina’s fiscal situation was not bad
prior to the limitary government in 1977. However, the government was not effective
in fixing fiscal situation by revamping tax system and make its budget continue to
deficit through out late 1970s. Because of large budget deficit, its monetization of
budget deficit rampant in inflation makes inflation shot to over 500 per cent. This
leads to the fall in international competitiveness. Exporters had to struggle in
exporting with other prevailing countries causing a fail in liberalising trade. Argentina
eventually had to reintroduce direct administrative control. Stable macroeconomic
environment such as fiscal consolidation and low inflation have been proved that it
must be achieved first in order to provide a prudential base for other reforms.
To reduce budget deficit, McKinnon (1982) suggested that direct government
spending should share a very small proportion with GDP. Lost from the central bank
should also be reduced. Since central bank in highly repressed economy usually has to

subsidy for public sectors and households, the lost occurs. This lost contributes
considerably to the budget deficit. By phase out or fold in off-budget government
subsidy, the central bank can avoid potential lost from subsidy for domestic deposit or
credit in public sectors and households and hence be able to avoid over-printing
money which cause harmful inflation.
Inflation which is related to keep stable price is another important issue needed to
be under control. The tax system should be strengthening to help repressing inflation.
As the economy liberalisation is in progress, government usually have to privatize and
give up its ownership of enterprises which are means of productions. Leaving its own
means of production makes much threat of inadequate revenue (Yung and Hugh,
2013). It is necessary to develop tax system for retrieving the revenue lost from giving
up those enterprises (Cashin et. al., 1998). Let s take Chile as a successful case when its
government get the right liberalisation approach. Besides eliminating subsidy, Chile


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government had introduced new tax system imposing value added tax at a uniform
rate of 20 per cent (McKinnon, 1982) which provided stable revenues to the budget.
GDP of Chile as a result increased from negative13.5 per cent in 1973 to positive 3.7 per
cent in 1976 and maintained surplus through out 1977-1980 (McKinnon, 1982). In
general, if the tax system is not good enough to ensure the government revenue, there
is possibility that the government will fall in heavy debts or printing money to finance
budget deficit. This causes inflation and distorts prices which could arise and defeat the
purpose of reform since the trade reform will be taking under the wrong market
signals.
However, the pace of privatisation should not too fast so that it will not put too high
pressure on the fiscal system. In fact, privatisation should be in parallel with the
development of tax system to ensure enough collection of government revenue. Some
of industrial and natural assets can remain under the government ownership initially

and then be broadened as the tax system becomes adequate.
ii. Removing distortions in domestic goods, capital, and financial sector is the
next step after stable macroeconomic environment such as fiscal consolidation and low
inflation is achieved. Removing distortion means deregulate domestic interest rate,
remove distortion in prices and free up wages in labour market.
It is necessary to remove distortions in banking systems so that banks free from
setting “standard” interest rate. Relaxing of interest rates ceiling allows to have
positive interest rates and thus increases financial depth as well as raises the level of
savings and improves the quality of investment (Hallwood and MacDonald, 1994).
Elimination of credit and interest rate controls follow by the macroeconomic
stabilisation has potentially important effects on monetary and credit aggregates
(Gertler and Kiyotaki, 2010). In addition, banking system should be free form reserves
requirements and official guidance in setting standard interest rate after tight fiscal
controls in place so that government does not have to rely on inflation tax to generate
revenue (Mckinnon, 1982).
However, the pace of deregulation of banking systems should be in relation to the
achievement of macroeconomic stability. Macroeconomic stability provides prudential
base for price level stability. If price level stability is not good enough, interest rates
become unpredictable volatility. This makes unrestricted domestic borrowing and
lending by deposit taking banks. Deposit taking banks have incentive to take short


Nguyen Huu Dung & Dang Hoang Ha | 5

term deposit and lend in the long term hence duration mismatch occurs. The
ultimately can be the panics or collapse of the banking system. Make sure the safety
payment mechanism exist is essential.
Poor regulatory and supervisory structures contributed significantly to the failure of
the whole process of liberalisation (Villanueva and Mirakhor, 1990). The presence of
moral hazard problem in the financial system of most high repressed economies dues

to explicit or implicit deposit guarantee schemes or many forms of government
support. Moral hazard makes banks behave as risk takers and set the interest rates at
higher and riskier levels as they would be, and tend to lend aggressively thus provide
wrong signals to the non-banking sector about the future returns. Over borrowing and
potential increase of non performing loans will occur. If the economy was not opened
up towards the international capital markets, then the domestic problems would be
absorbed locally and not severe suffer the economy. However, if the capital account has
been already liberalised by that time, over borrowing would take place and result in
serious problems (McKinnon and Pill, 1997). Adequate supervision and regulation is
necessary.
Financial crisis in Mexico in 1994-1995 is the evidence for the importance of
supervision and regulation. Mexico started to deregulate its financial sector in the
1980s. With its privatisation and deregulation, bank credit to private non financial
sector grew rapidly from 10 per cent of GDP in 1988 to over 40 per cent of GDP in
1994 (Mishkin, 1996). The currency denominated liabilities of banks shot form 116, 4
billion Peso in 1993 to over 213 billion in 1994 (Minskin, 1996). The lending boom in
the absence of adequate supervision and regulation environment makes non-banking
financial institutions expanded their loan activities and took excessive risks. Since
Mexico had high inflation, and debt structure was mostly short term duration with the
same due of maturity and denominated in foreign currency, the banking system
became fragile and vulnerable when interest rates in US in 1994 put upward pressure
on interest rates in Mexico. Under pegged exchange rate, Mexico‘s central bank have to
increase interest rates to keep the value of Peso. Interest rates increased leads to
increase in asymmetric information and adverse selection problem in the financial
markets. This intervention exhausts Mexico’s international reserves and ultimately the
government had to devalue Peso in 1994. Lending fell sharply at the same time with
the increase in withdraw funds of investors makes Mexico fell in a deep recession in


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1994. Mexico clearly did not have macroeconomic stability before opening financial
sector hence fails to liberalise the economy.
Highly repressed economies in initial stage of development are much segmented
domestic labour, goods and financial markets. Regarding to labour market, the urban
segmented labour market is relatively organised and industrial labour force coexist
with a large primarily informal rural work force. The financial markets are also
segmented and made up of a number of sub-markets (Huu-Dung and Yeo-Chang
2012). Due to the lack of financial instruments available to other money markets and
capital market and commercial banks still maintain a fairly high excess reserves ratio;
the volume of trade in the financial markets is low. This is closely associated with the
less developed payment system of the central bank. As the interest rates of excess
reserves are high, commercial banks lack of motive to reduce them. This has driven
down the demand for interbank borrowing. The development of financial markets
therefore depends on the further reform of the reserve system and the efficiency of the
central banks payment and financial market as a whole
iii. Liberalising international trade needs to remove quotas, tariffs and other
direct administrative controls, and reduce tariffs across the board since a high
repressed economy is usually under massive quantitative protected restrictions. These
protections are administrative controls through either indirectly or directly. The
administrative controls can be many sets of tariffs or subsidy. These tariffs or subsidy,
however, highly distort prices either directly or indirectly rather than do “equivalent”
tariffs. This provides market the wrong signals, causing the economy away from the
optimal equilibrium. It is necessary to replace these quantitative quota and
administrative controls by appropriate tariffs.
McKinnon (1982, 1991) suggested that liberalisation of international trade should be
undertaken gradually and in parallel with decontrol prices in the domestic trade of
goods and services. The implicit structure tariffs should be carefully approach because
it can causes collapse of domestic manufacturing. Subsidy for producers, for example,
is in order to keep effective domestic prices of primary input below some countries

which are prevailing in the world. Removing it can make the domestic producers lost
the target markets and end up with bankruptcy. Recently, when analysing the
liberalisation process of the former socialist economies, McKinnon (1991) suggested
that optimum order of liberalizing foreign trade for highly-protected economies may


Nguyen Huu Dung & Dang Hoang Ha | 7

begin by converting their implicit quota restriction into explicit tariffs such as
preannounce the adjustment or establish special international economic zone for
international operation then expand rights to other places. This had been successful
archived some countries such as Chile’s liberalisation.
Chile has been a remarkable reform. During 5 years time, most of quantitative
restrictions on foreign trade were eliminated and tariffs were reduced form an average
rate of 94 per cent to a uniform rate of 10 per cent. By the end of 1976 the Government
successfully accomplished the unification of the exchange rate and eliminate all
restrictions on payments for current transactions. The reform was preannounce and
carried out according to schedule, which contribute to the success (McKinnon, 1982).
However, free international trade needs not means extending full foreign exchange
convertibility to capital account transactions. Let strong foreign currency to circulate in
parallel with relatively week domestic currency may cause destabilise. Moreover, as
long as domestic banks still remain restricted, there is no point or even destructive to
allow foreign banks to operate freely in domestic markets.
After current account liberalization, opening of capital account can be implemented.
Opening capital account at the earlier stages of the reform may result in large inflows
of foreign capital due to substantial interest differentials. Under both the fixed and
floating exchange rates these inflows will result in a real appreciation of the domestic
currency. Since financial markets adjust faster that goods markets, this real
appreciation may be destructive for the economy (Edwards 1984).
iv. Liberalisation of capital account involves the elimination of restrictions on

inflows and outflows of foreign direct investment as well as portfolio investment and
the use of long and short term financial instruments. This allows domestic residents to
borrow freely from or deposit in international markets. Foreign exchange is freely
convertible on capital account.
Liberalisation capital account will help economy gain lots of benefits. Liberalisation
capital account brings about freedom of choice for investors and borrowers in choosing
and exchange assets. The diversifications of assets offer to investors the risk
diversification for avoiding unexpected lost. The more integrated economy creates
more channels for evasion. Free flow of capital can improve welfare if the domestic
financial markets are efficient, and foreign funds are used to support the development


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process. Foreign capital can reduce the cost of capital and help make financial
intermediation more efficient. Most empirical studies found that capital account
liberalisation have positive effects on domestic investment, and technology (Mehran
and Seyed, 2017). In addition, resource allocation is also more efficient through
increasing completion for financial resources. It is no point to restrict capital
transaction since it creates lost in effectiveness, incurs high administrative cost,
distorts the economy, and raises corruption and rent seeking behaviour.
However, there are some criticisms of capital liberalisation. When liberalise capital
account, the ability to carry monetary policy autonomy and exchange rate stability will
be reduce simultaneously (Gertler and Karadi, 2011). Macroeconomic management for
excessive capital inflows may be more difficult as well. Excessive capital inflows may
go beyond absorptive capacity of the banking system create inappropriate lending
decisions lends to financial fragility. Over borrowing syndrome may also occur.
However, these disadvantages can be avoided if capital account liberalisation
approached in sequencing.
It is widely accepted that capital account liberalisation should be the last step in the

economic liberalisation procedure. Because the success in the trade and financial
reform leads to capital inflow, the domestic currency will has a real appreciation which
leads to reduce competitiveness. However, the successful liberalisation of trade
requires a real depreciation in order to support exporters (Edwards, 1984). The
appreciation generated by the opening of the capital account will tend to reduce the
profitability in the tradable goods sector at a moment when this sector is going
through a costly readjustment process. Consequently, capital and current accounts
should not be opened simultaneously, and that capital inflow should be tightly
controlled during the trade reform and then will be opened last.
There have been some economists such as Little, Scitovshy, and Scott have opposite
argument and think that capital account should be opened first or at the same time as
the current account. The main argument was to use foreign funds available due to
opening of capital account to smooth the adjustment process and to provide assistance
to industries that are negatively affected by the trade reform. When the trade barriers
are reduced, domestic relative prices will be changed and resources will be reallocated
across the sectors. Any process of economic liberalisation will require a costly
adjustment period (Yung and Hugh, 2013). To enhance the success of trade reform,


Nguyen Huu Dung & Dang Hoang Ha | 9

there authors argued that adjustment costs such as unemployment associated with the
reduction of tariffs should be kept as low as possible. To accomplish this, they
recommended that liberalisation of trade should be implemented slowly and that
assistance, which is usually in the form of foreign funds, to finance a smoother
adjustment by the import-competing industries. These arguments, however, are not
persuasive. In fact, trade liberalisation should not be undertaken based on short-term
capital inflows or on credits from foreign countries or international agencies releasing
from capital account liberalisation (McKinnon, 1982). Such capital inflows are simply
not sustainable in the long run, and during the liberalisation process they will throw

out incorrect market signals (McKinnon, 1982) which are harmful for the economic
liberalisation process as a whole. Moreover, the McKinnon’s arguments for liberalising
capital account last are also strongly strengthen by the theoretical approach known as
an over borrowing syndrome.
A country fall in “over borrowing syndrome” when it undertakes successful “real
side” economic reforms and removes distortions in liberalising international trade, it
tends to borrow too much from financial institutions to finance investment and then
faces problem of repayment for the loans. The main root of over borrowing syndrome
is moral hazard spreading in the banking sector. The sources of moral hazard in the
financial system that generate the market failure which leads to over borrowing are
likely to include the explicit or implicit insurance, government guarantee, and fixed
exchange rate policy. The moral hazard will induce the banks, which subject to both
credit risk and currency risk, borrowing unhedged excessively to finance domestic
investment. During the economic downturn, when the bank borrowers fail to repay
the loans, the banking sector can systematically goes to bankruptcy. Then it leads to
the lost of foreign investors confidence which eventually results in financial crisis.
In the over borrowing syndrome model, all financial flows are intermediated
through domestic banks because banks have special characteristics. First, banks have
certain informational advantage on the lending side. Second, bank liabilities are central
to the domestic payment system, a vital component of a modern economy, which make
them enjoy explicit or implicit government guarantee (McKinnon, 1998). A credit
channel from bank lending to real activity, therefore, is important for the liberalising
economy.


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However, in assessing investment risks in the reforming economy, banks may
suffer from moral hazard by ignoring the probability of the bad outcome to occur that
leads them to behave too optimistically regarding the pay-off from new investment

(McKinnon 1999). When economy is liberalised domestically (see Figure 1) the nonbaking sector starts to borrow from domestic capital markets. Some firms invest into
new technology some into old technology and put savings into banks.
C2X2
α' g(.)
Ue

α g(.)

f(.)

XM IRB

CDLE IRB

C 1 X1

Figure 1: Rational – Beliefs Equilibrium in the DLE
Source: McKinnon and Pill (1997)

Assuming that investment returns in Period 2 are known with certainty than the
market works efficiently. The problem occurs when banks exploit moral hazard, which
exists in domestic capital market due to the implicit and explicit government guarantee
of bank deposits. When prudential supervision is insufficient, banks start to lend
aggressively and send a wrong signals to the non bank sector about futures on
investment are represented by function α’ g(.). When investment turns out to yield less
than anticipated, borrowers can not repay the loans and ultimately end up with
bankruptcies. Because the economy is not opened to the international markets yet, this
problem can be solved with not too much cost. Although firms and households see
their future income to be high, the sharp increase in the domestic interest rate

Nguyen Huu Dung & Dang Hoang Ha | 11

restrains consumption and investments. Thus it does not lead the economy into
serious over investment and over consumption (McKinnon, 1997)
When the domestic economy open to the international market, all firms and
households become net borrowers in Period 1. Firms tend to borrow money form
abroad too much and channel them to the domestic lenders. Due to moral hazard
problem, they expect national government or international organizations such as IMF
or World Bank bail them out if crisis happens. Unless tightly regulated, domestic banks
will borrow excessively from both domestic and international capital market and lend
the proceeds to speculative domestic investment and consumption (McKinnon, 1999).
This leads to an excessive expansion of credit and ultimately leads to overinvestment
and over consumption.
C2X2

α' g(.)

Ue

α g(.)

f(.)
V
XM IRB

W
CILE IRB

Figure 2: Rational – Beliefs Equilibrium in the ILE

Source: McKinnon and Pill (1997)

Again the function α’ g(.) represents wrong anticipated pay-off on investment. As a
result, consumption and investment levels increase. Over consumption and over
investment occur as a result of banks lending aggressively and sending wrong
optimistic signals to non-banking sectors. Over consumption and over investment are
represented by W and V respectively.
If prudential supervision is inefficient, risk – neutral banks will shorten the true
probability distribution of futures by overly discounting the possibility of bad


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outcomes. Thus, risk-neutral banks could run their loan programs over optimistically.
Unaware of the inadequacy of bank supervision, firms and households take this overly
optimistic signal at face value and bid eagerly for funds to exploit the fake higher
returns. This corresponds to what Kurz (1994) called rational beliefs equilibrium.
Under deposit insurance loosely supervised banks prefer to gamble with government
money.
When banking supervision is effective, regulator will ensure that banks do not
exploit the potential for moral hazard, and credit conditions will accurately reflect the
privileged information about macroeconomic development enjoyed by the banking
sector. However, when regulators are unable to control the moral hazard problem, the
signal being implicitly in credit conditions will be distorted in a direction that may
head to over borrowing and increase financial and macroeconomic instability. As
banks signal higher payoffs for investments than the reforms warrant, increase
consumption and investment make saving decline and the current account deficit.
Unless the economy experiences a lucky payoff in the future, this situation is
unsustainable. Firms will have wide spread loan default and cause domestic banking
system to seize up and could require a bail out from foreign indebtedness (McKinnon,

1997)
The cause of over borrowing syndrome can also be the unhedged currency risk.
Usually the interest rates in the international market are lower than interest rates in
the countries that have a reform program. The domestic banks will borrow abroad in
foreign currency at the low interest rates and lend to domestic resident at higher
interest rate in domestic currency. Due to problem of moral hazard spreading in the
banking sector, the domestic banks will borrow unhedged in foreign currency because
they are implicitly or explicitly protected by deposit insurance and other government
guarantees. Moreover, usually in developing countries adopting the fixed or pegged
exchange rate policy, banks will take unhedged foreign exchange positions when they
borrow money in foreign currency because they are implicitly guaranteed by the fixed
exchange rate policy that the exchange rate will not fluctuate much. However, if there
is a sudden economic downturn and domestic currency depreciated, the loan from
abroad in foreign currency will increase abruptly in term of domestic currency. In
countries where the governments provide implicit and explicit deposit insurance and
adopt the fixed exchange rate policy, banks are able to offer credit to private sector at


Nguyen Huu Dung & Dang Hoang Ha | 13

artificially low interest rates and will have tendency to implicitly transfer most of the
currency risk incurred on to the government by borrow unhedged.
If the domestic regulators allow banks and financial institutions to assume both
credit and foreign exchange risks simultaneously, the regime is unlikely to survive. In
many emerging markets, failures by banks borrowers appear to trigger currency
devaluation that imposes enormous capital losses on banks. The consequence is
bankruptcies that are likely to trigger the collapse of foreign investors’ confidence and
eventually leads to currency crisis of many countries such as Mexico.
Mexico fell in crisis in 1994-1995 after starting to embark economic reforms in the
mid 1980s. Starting to move toward free trade, Mexico had undertaken an intensive

structural reform focusing on privatization, deregulation of domestic industry, and
fiscal consolidation (Martinez, 1998). Banking sector was privatized and reserve
requirements had been reduced quickly and banks credit controls were lifted (GriffthJones, 1996) It had also undertaken financial reforms, renegotiated its external debts,
and made great efforts to open up trade. The reforms favouring free trade attracted
large capital inflows particularly after 1988. The major capita inflows were foreign
portfolio investment that more volatile feature than other forms of investment. This
implies the country’s vulnerability to capital flight during the economic downturn.
However, the foreign direct investment kept rising at a moderate rate while the
portfolio investment rose considerable (Figure 1). These large capital inflows were also
consistent with interest rate differential that the domestic rate was higher than the
foreign rate. These capital inflows were one of the main causes of external current
account deficit (Martinez, 1998). These phenomenons reflect high risk of over
borrowing occur.
Over borrowing and over consumption arise when banks exploit moral hazard
implied by the government guarantee (McKinnon and Pill, 1997). As the capital
account of Mexico open, commercial banks borrowed internationally at a low interest
rate. With out adequate and effective regulations, banks ten to over borrow and over
lend. Bank’s over lending sends wrong signal to non-baking sector and households
hence they increased their consumption and investment with expectation of higher
future payoffs. As the result, saving declined and current account deficits. Private
saving in GDP of Mexico fell by half between 1984-1990 and 1991-1993. Import grew at
nearly 50 per cent per year in seven years from beginning of reform to the crisis. At


14 | ICUEH2017

the mean time, the rapid growth of domestic credit reflecting easier access to credit
following the financial deregulation and privatization of commercial banks.
Specifically, in 1994, commercial bank credit grew by over 100 per cent in real terms,
credit for housing increased by 1000 per cent and credit for consumption rise by over

45 per cent. Both banks and non-banking sector expanded their loans by taking on
excessive risks (Minskin, 1996). As the result, many loans are bad. These significantly
contribute to a worsen balance of payment in Mexico in 1994.
In addition, the pegged exchange rate policy of Mexico has implicitly guaranteed
that there will be no changes in the value of Peso. This encourages banks tend to over
borrowing unhedged leading to excessive exchange risk (Martinez, 1998). Before the
crisis in 1994, there were very large share of banks’ total outstanding credit
denominated in foreign currencies, mainly US dollar (OECD, 1995) The appreciation of
real exchange rate, growing short term external debt, large current account deficit,
Mexico finally have to float its exchange rate in 1994.
Mexico had undertaken reform with out order. In other worlds, it had taken capital
account liberalisation simultaneously with privatisation of banks with out sufficient
attention on improving supervision and regulation (Griffth, 1996). Moral hazard led to
over borrowing and over lending which eventually caused currency crisis and financial
crisis in Mexico in 1994.
In recent years, the financial crisis in East Asian economies again confirmed the
necessary of the order of economic liberalisation. Even though these East Asian
economies have sustained macroeconomic stability through fiscal discipline and
moderated rates of inflation, which contributed to their rapid economic growth for
many years, the weaknesses of their financial systems were revealed by the events of
1997 (Copper, 1999). All countries such as Thailand, Malaysia and Indonesia had a
large external debt and mainly short term maturity (Mehran and Seyed, 2017). Most of
these debts were denominated in US dollar and Yen. They also have pegged exchange
rate regime and consistently continue this policy until international reserves were
almost exhausted just before the crisis happened. Poor banking regulation and
supervision also contribute greatly to the collapse of financial system of East Asian
economies in 1997 (Mehran and Seyed, 2017).


Nguyen Huu Dung & Dang Hoang Ha | 15

3. Conclusion
How to restructure the economy is an important question for many developing
countries. This paper argues that the first step is that macroeconomic environments
such as fiscal consolidation and low inflation should be achieved to provide a
prudential base for other reforms. With out macroeconomic stabilisation, problems
such as inflation and budget deficit could be arise and defeat the purpose of reform.
The next step is removing distortions in domestic goods, labour, and capital markets,
which are very high in the highly repressed economies, in order to improve capability
of collecting non-inflation tax to generate revenue for the government. International
trade liberalisation helps to remove quota, tariffs and other administrative controls
and reduce tariffs across the board. The final step is liberalising capital account.

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