abhishreshthaa
Abhijeet S
In short, the purpose of financial sector reforms is to make the financial sector an aliquot part of globalised finance.
An economy that has undertaken financial liberalization also becomes vulnerable to crisis. When short term funds flow in they tend to cause an appreciation of the exchange rate, the consequence of which is to make imports cheaper relative to home production and hence need to deindustrialization.
But if this is avoided through the central bank intervention that supports the exchange rate by holding foreign exchange reserves, then that in turn enlarges liquidity in the economy which is typically used either for an expansion of luxury consumption or for an expansion of investment in the domestic non-tradable sector such as real estate, or for financing speculative booms in asset markets especially the stock market.
When short funds begin to flow out, there is both a downward pressure on the exchange rate and a collapse of asset prices, which reinforce one another and cause an avalance of outflow. Efforts by the central bank to manage the forex market by raising the interest rate to induce short term funds to say or to come back, have very little effect or even have the opposite effect of further enhancing outflows by aggrevating the asset market to collapse.
On the other hand,interest rate increases which leads to a contraction of the real economy. Thus, while the inflow of short term funds, generally, has little impact by way of increasing the growth rate of the real economy, the withdrawal of short term funds does affect the real economy adversely.
An economy that has undertaken financial liberalization also becomes vulnerable to crisis. When short term funds flow in they tend to cause an appreciation of the exchange rate, the consequence of which is to make imports cheaper relative to home production and hence need to deindustrialization.
But if this is avoided through the central bank intervention that supports the exchange rate by holding foreign exchange reserves, then that in turn enlarges liquidity in the economy which is typically used either for an expansion of luxury consumption or for an expansion of investment in the domestic non-tradable sector such as real estate, or for financing speculative booms in asset markets especially the stock market.
When short funds begin to flow out, there is both a downward pressure on the exchange rate and a collapse of asset prices, which reinforce one another and cause an avalance of outflow. Efforts by the central bank to manage the forex market by raising the interest rate to induce short term funds to say or to come back, have very little effect or even have the opposite effect of further enhancing outflows by aggrevating the asset market to collapse.
On the other hand,interest rate increases which leads to a contraction of the real economy. Thus, while the inflow of short term funds, generally, has little impact by way of increasing the growth rate of the real economy, the withdrawal of short term funds does affect the real economy adversely.