The financial sector is central to economic development as it serves the role of intermediary by mobilising savings and subsequently allocating credit for productive activities. However, in many developing countries including Pakistan, administered interest rate, domestic credit controls, high reserve requirements, use of captive banking system to finance large budgetary requirements of the government and controls on international capital inflows have remained the main features of the monetary policy. These repressive policies had their repercussions in the form of excess liquidity with the banking system, disintermediation of cash flows, segmentation of financial markets, underdeveloped money and capital markets, etc. [McKinnon (1973) and Shaw (1973)], therefore, argued that low interest rate ceilings unduly restrict the real flow of loanable funds, thus depressing the quantity of productive investment. Financial liberalisation, on the other hand, is defined as policy measures designed to deregulate certain operations of the financial system and transform its structure with a view to achieving a liberalised market oriented system with an appropriate regulatory framework. The financial sector reforms would lead to increase in loanable funds by attracting more household savings to bank deposits due to higher interest rates. This, in turn, would result in greater investment and faster economic growth.

Ashfaque H. Khan

M. Aynul Hasan

S. Sajid Ali

English

Research Papers in Economics

The Pakistan Development Review 
35 : 4 Part II (Winter 1996) pp. 885—895 
 
 
 
Financial Sector Reform and Its Impact on Investment 
and Economic Growth:  An Econometric Approach 
 
M. AYNUL HASAN, ASHFAQUE H. KHAN and S. SAJID ALI 
 
INTRODUCTION 
The financial sector is central to economic development as it serves the role of 
intermediary by mobilising savings and subsequently allocating credit for productive 
activities. However, in many developing countries including Pakistan, administered 
interest rate, domestic credit controls, high reserve requirements, use of captive 
banking system to finance large budgetary requirements of the government and 
controls on international capital inflows have remained the main features of the 
monetary policy. These repressive policies had their repercussions in the form of 
excess liquidity with the banking system, disintermediation of cash flows, 
segmentation of financial markets, underdeveloped money and capital markets, etc. 
[McKinnon (1973) and Shaw (1973)], therefore, argued that low interest rate 
ceilings unduly restrict the real flow of loanable funds, thus depressing the quantity 
of productive investment. 
Financial liberalisation, on the other hand, is defined as policy measures 
designed to deregulate certain operations of the financial system and transform its 
structure with a view to achieving a  liberalised market oriented system with an 
appropriate regulatory framework. The financial sector reforms would lead to 
increase in loanable funds by attracting more household savings to bank deposits due 
to higher interest rates. This, in turn, would result in greater investment and faster 
economic growth. 
In Pakistan, various measures have been undertaken in the early 1990s to 
liberalise the financial sector as part of the overall structural adjustment programme 
(SAP) with the objective to improve the effectiveness of monetary policy. These 
policies were implemented by making a shift from direct to indirect monetary 
control and greater reliance on market forces. The main financial liberalisation 
policies were aimed at liberalising interest rates, reducing controls on credit, 
enhancing competition and efficiency in the financial system, strengthening the 
M. Aynul Hasan is Professor of Economics at Acadia University, Canada. Ashfaque H. Khan is 
Joint Director at the Pakistan Institute of Development Economics, Islamabad. S. Sajid Ali is Economist at 
the State Bank of Pakistan, Karachi. Hasan, Khan and Ali  886 
supervisory framework, promoting growth and deepening of the financial markets. 
In this context, the following measures have already been implemented to date as 
part of the broader financial sector reforms: 
  • Efforts have been made to enhance the health of and competition within the 
banking sector by privatising two nationalised banks, as well as allowing 11 
new scheduled commercial banks to be set up in the private sector. 
  •  Debt management reforms were introduced to promote primary and 
secondary securities markets. The prudential supervisory framework has 
been established to foster sound credit decisions. 
  • Interest rate rationalisation was introduced by paring down concessional and 
direct credit schemes. 
  • The exchange and payment reforms have also been undertaken in the areas 
of foreign investment and foreign trade. 
The adoption of these measures would give way to greater flexibility in the 
interest rate movements, an enhanced role for the market forces in credit allocation, 
gradual deepening of the money and securities markets, and enhancing competition 
and efficiency in the financial system. Against this background, the paper develops 
and estimates a medium-sized 24-equation macroeconometric model for the financial 
sector of Pakistan. The model provides a detailed consistent treatment of financial 
variables by disaggregating the financial assets held by the households, private 
business and enterprises. The behaviour of demand for these assets is then linked 
with the overall national saving and, subsequently, with investment and gross 
domestic product (GDP). This model will be useful device in not only generating ex-
ante forecasts but, more importantly, it will provide answers to numerous interesting 
and critical counterfactual policy questions in the context of Pakistan’s financial 
sector reforms. For example, if the reforms had to take place in the early eighties 
rather than the nineties, the model will quantitatively estimate the counterfactual loss 
foregone in terms of lower GDP, savings and investments in Pakistan. It is expected 
that these counterfactual policy simulation results may be useful to the policy-
makers in designing more accurate and practical future monetary policies in 
Pakistan. 
 
II.  A MODEL FOR FINANCIAL SECTOR 
While the financial sector reform is initiated by bringing about changes within 
the monetary sector only, the impact of such a reform, however, is expected to be 
multifacit and wide-ranging influencing many other sectors of the economy. A single 
equation approach, in this context, to evaluate the implication of this reform may not 
only be inadequate but, at the same time, it could even be misleading. This is due to 
the fact that, with a single equation approach, an increase in the interest rate for Financial Sector Reform  887 
deposit, for instance, may show a greater demand for time deposits. But in terms of 
total financial assets, the impact of such a change on it may be ambiguous because of 
the possibilities of substitution among other financial assets (e.g., currency, 
unfunded debt, floating debt and permanent debt). 
Thus, in order to examine the intra as well as inter sectoral impact of financial 
sector reforms, we have constructed a medium-sized 24-equation macroeconometric 
model for Pakistan. The model is not only dynamic and rich in specifications but, 
more significantly, it is based on a pragmatic approach, which takes into account 
some of the specific institutional arrangements present in the financial sector of 
Pakistan. Broadly, the model has been divided into five blocks, namely monetary, 
savings, government revenue, macroeconomic and definitional blocks. In the 
following, we present the model without discussion so as to conserve the space.
1 
 
A.  Monetary Block 
 
1.  Net Financial Assets 
  NFA = CC + TD + UFDBT +  FDEBT PDEBT +  – L 
 
2.  Currency in Circulation 
CC/NFA= f (Y/NFA,  RD RU RF P g
e
,,,
•
) 
 
3.  Total Deposit  
TD/NFA = f (Y/NFA,  RD RU RF P g
e
,,,
•
) 
 
4.  Unfunded Debt 
UFDBT/NFA = f (Y/NFA,  RD RU RF P g
e
,,,
•
) 
 
5.  Demand for Loan 
L = f ( CP,  R A ) 
 
6.  Price Level 
  Pg = f (TD/Y, ITR/Y, Pm) 
 
7.  Net Interest Bearing Financial Assets 
TIBFA = NFA – CC 
 
1Detailed discussion can be found in Hasan et al. (1996) Hasan, Khan and Ali  888 
B.   Savings Block 
 
8.  Savings in Real Assets 
RSA = f [(YR – DTR/ Pg ), (RD – P g
•
), TD/Y,  Rm ]  
 
9.  Real Financial Assets 
RFS = ∆TIBFA/Pg 
 
10.  Real National Savings 
RNS = RSA + RFS 
 
C. Government Revenue Block 
 
11.  Direct Taxes 
DTR = f (Y) 
 
12.  Indirect Taxes 
ITR = f ( Y, M ) 
 
13.  Total Tax Revenue 
GTR = DTR + ITR 
 
14.  Total Revenue 
GR = GTR + GNTR SUR +  
 
D.  Macroeconomic Block 
 
15.  Private Investment 
Ip  = f ( RA , TD/Y, Pm/Pg, IINFSI) 
 
16.  Private Consumption 
CP =  f [ (YR – DTR/Pg),  RR D m, ]  
 
17.  Public Investment 
Ig = f (GR/Pg,  RFA ) 
 
18.  Public Consumption 
Cg = f (GR/Pg ) 
 Financial Sector Reform  889 
19.  Import 
MR = f (YR, Pm/Pg) 
 
20.  National Income 
YR = CP + IP + Cg + Ig + ∆ST X +  – MR 
 
21.  Public Infrastructure 
IINF = Ig – Igo 
 
22.  Index of Public Infrastructure 
IINFST = [( IINFS  (–1) + IINF)/  IINFS0 ] 
 
23.  National Income at Current Prices 
Y = YR × Pg/100 
 
24.  Imports at Current Prices 
  M = MR × Pm/100 
 
List of Variables 
 
  CC = Currency  in  Circulation 
  Cg = Public  Consumption  Expenditure 
  Cp = Private  Consumption  Expenditure 
  DTR = Direct  Taxes 
FDEBT =  Floating Debt 
 GNTR = Non-tax  Revenue 
  GTR = Total  Tax  Revenue 
  Ig = Public  Investment 
IINESI  =  Index of Economic Infrastructure Investment 
  IINF = Public  Infrastructure 
IINFSO =  Initial Stock of Real Public Infrastructure Investment 
  IP = Private  Investment 
  ITR = Indirect  Taxes 
  L = Loan 
  M  =  Imports at Current Price 
  MR = Real  Imports 
  NFA = Net  Financial  Assets 
PDEBT= Permanent  Debt 
  P g
e •
  =  Expected Rate of Inflation 
  Hasan, Khan and Ali  890 
  Pg = General  Price  Level 
  Pm = Import  Price  Index 
  RA  =  Interest Rate on Advances 
  RD  =  Rate of Return on Time Deposit   
  RF  =  Rate of Return on Floating Debt 
  RFA = Foreign  Aid 
  RFS = Real  Financial  Assets 
  Rm = Remittances 
  RNS = Real  National  Savings 
  RSA  =  Savings in Real Assets 
  RU  =  Rate of Return on Unfunded Debt 
  ∆ST = Changes  in  Stock 
  SUR = Surcharges 
  TD = Total  Deposits 
TIBFA  =  Net Total Interest Bearing Financial Assets 
UFDBT= Unfunded  Debt 
  X  =  Total Exports of Goods and Services 
  Y = Nominal  GDP 
  YR = Real  GDP. 
 
III.  RESULTS 
The results are discussed in the following paragraphs. Given the existence of 
long-run relationship, based on PP cointegration test, we used a simple OLS 
technique to estimate the behavioural equations of the model.
2 By and large, all the 
estimated regression equations have high adjusted R
2 and significant t-values with 
correct signs implying that the individual equations not only explain the postulated 
behaviour well in the model but, at the same time, individual stipulated parameters 
can be meaningfully interpreted. Based on other estimated statistical tests (e.g., LM, 
ARCH, and CUSUM), we can safely argue that the estimated regression equations 
are free from the statistical problems of serial correlation, heteroscedasticity and 
instability of the parameters. 
Based on the estimated equations of the model the policy simulation exercise 
undertaken in this paper is essentially counterfactual in character. The key objective 
in carrying out this type of exercise is to investigate and unfold the conundrum as to 
what would have happened in Pakistan, in terms of the impact (measured by key 
economic variables) and the ensuing monetary cost (or loss of revenue in the form of 
investment and output), had this country introduced the reforms earlier in the  
2The estimated regression coefficients of the model and various test statistics are available on 
request from the authors. Financial Sector Reform  891 
 
eighties rather than later as done so in the nineties. In order to cover the broader aspects 
of the financial reform and, at the same time, keeping the discussion more manageable, 
we report results of the impact of three categories of policy simulation on key selected 
macroeconomic variables. Furthermore, for each type of policy simulation, we also 
calculate the corresponding expected loss of revenue (in rupees) due to late 
implementation of the reforms. The three broad categories of reform considered are: 
  1. Interest Rate Liberalisation; 
  2. Spread Reducing Reform; and 
 3.  Financial  Deepening. 
In the following, we discuss the results of these policy simulations. 
 
1.  Interest Rate Liberalisation 
As a result of repressive monetary policies pursued in Pakistan, the real deposit 
rates remained negative most of the time during the decade of the 1980s. This type of 
policy is expected to make non-bank assets relatively more attractive than the bank 
deposits thus creating financial disintermediation. In order to test the sensitivity of the 
above policy reforms, we conduct two types of simulation. Firstly, we keep the 
nominal deposit rates at least as high as 14 years (1981–94) of average inflation rate. 
This implies that, on average, the real rate of deposits during this period should be non-
zero thus enabling the real return on financial assets to be non-negative. The second 
type of policy simulation in this regard entails the nominal deposit rates to be at least 
two percentage point above the 14 years (1981–94) average inflation rate making the 
real rate positive by two percentage point. The cost of late implementation of the 
reform is evaluated in terms of loss in real private investment and real GDP. The cost 
of late implementation in rupee term is reported in Tables 1 and 2. 
In the first case when real return on financial assets are assumed non-negative 
Pakistan’s economy could have avoided a loss of almost Rs 12 billion in real GDP 
on cumulative basis since 1980-81 as shown in Table 1. In fact, if the rate of return 
on deposits were allowed to be 2 percentage point above the 14 years average 
inflation rate (implying 2 percent positive real return on deposit), the economy could 
have saved a loss of Rs 78 billion in real GDP on cumulative basis or Rs 6 billion on 
average each year since 1980-81 as shown in Table 2. 
 
2.  Spread-reducing Reform 
Another key impediment to the financial sector reform was the government 
policy of maintaining a large spread between the deposits and the lending rates of 
the banking system. Under the spread-reducing financial policy simulation, we have  Hasan, Khan and Ali  892 
Table 1 
Simulation Results of Interest Rate Liberalisation 
(Real Return on Deposit in Non-negative) 
(Rs in Million) 
 
  Year 
Real Private Investment 
(Cumulative) 
Real GDP 
(Cumulative) 
1980-81 223  2748 
1981-82 418  4937 
1982-83 368  4171 
1983-84 560  6878 
1984-85 492  5742 
1985-86 417  4592 
1986-87 363  3773 
1987-88 640  8457 
1988-89 867  12869 
1989-90 742  9936 
1990-91 1076  15534 
1991-92 1060  15066 
1992-93 941  13152 
1993-94 840  11749 
Cumulative Average  106  1341 
Note:  Cumulative values are simply the sum of successive marginal values of each year. 
 
Table 2 
Simulation Results of interest Rate Liberalisation 
(Real Return on Deposit is 2 Percent) 
(Rs in Million) 
 
  Year 
Real Private Investment 
(Cumulative) 
Real GDP 
(Cumulative) 
1980-81 709  8215 
1981-82 1339  14951 
1982-83 1642  18303 
1983-84 2232  26038 
1984-85 2467  28835 
1985-86 2703  32076 
1986-87 2910  35058 
1987-88 3434  43364 
1988-89 3886  51826 
1989-90 3923  52039 
1990-91 4617  63100 
1991-92 5044  68446 
1992-93 5406  73345 
1993-94 5746  77743 
Cumulative Average  483  5960 
Note:  Cumulative values are simply the sum of successive marginal values of each year. Financial Sector Reform  893 
analysed the impact of keeping the differences between the deposit and lending rates 
at 2 percent on private investment and real GDP. The results, as reported in Table 3, 
suggest that Pakistan could have saved Rs 22.7 billion in term of loss in real GDP on 
cumulative basis or Rs 1.65 billion per year since 1980-81. 
 
Table 3 
Simulation Results of Spread Reducing Reforms 
(Difference between the Average Lending and Deposit Rate is 2 Percent) 
(Rs in Million) 
 
  Year 
Real Private Investment 
(Cumulative) 
Real GDP 
(Cumulative) 
1980-81 238  1849 
1981-82 496  3784 
1982-83 727  5395 
1983-84 953  7165 
1984-85 1178  8843 
1985-86 1381  10333 
1986-87 1541  11179 
1987-88 1719  12465 
1988-89 1860  13209 
1989-90 2010  14156 
1990-91 2237  16306 
1991-92 2466  18074 
1992-93 2723  20358 
1993-94 2992  22697 
Cumulative Average  222  1645 
Note:  Cumulative values are simply the sum of successive marginal values of each year. 
 
3.  Financial Deepening 
Another interesting policy simulation conducted in this study pertains to the 
impact of financial deepening on the economy. Financial deepening in this context 
implies a broadening of the monetary base in relation to the real sector of the 
economy. The basic premise underlying such a reform is that making the financial 
sector wider and covering larger sectors of the economy will facilitate economic 
activity and may improve physical investments as well as total output of the 
economy. This simulation was implemented by increasing the financial deepening 
variable (TD/Y) by 25 percent as compared to its actual value. Promoting financial 
deepening policies in the early eighties rather than in the nineties could have saved 
Pakistan’s economy up to about Rs 260 billion in terms of loss in real GDP on 
cumulative basis or Rs 16.6 billion per year on average basis since 1980-81 (see 
Table 4). Hasan, Khan and Ali  894 
Table 4 
Simulation Results of Financial Deepening 
(Financial Deepening Variable Increased by 25 Percent) 
(Rs in Million) 
 
  Year 
Real Private Investment 
(Cumulative) 
Real GDP 
(Cumulative) 
1980-81 1652  17482 
1981-82 3153  32283 
1982-83 4237  43720 
1983-84 5795  62451 
1984-85 6867  74999 
1985-86 8081  90955 
1986-87 9256  106965 
1987-88 10848  129702 
1988-89 12306  154636 
1989-90 13156  169028 
1990-91 15092  196951 
1991-92 16830  217529 
1992-93 18553  239716 
1993-94 20262  260489 
Cumulative Average  1416  16616 
Note:  Cumulative values are simply the sum of successive marginal values of each year. 
 
IV.  CONCLUDING REMARKS 
While the significance of financial reforms in Pakistan introduced in the early 
1990s cannot be undermined in that it has brought about some real changes in terms 
of freeing interest rates, reducing the spread rates between the deposit and lending 
rates, privatisation of nationalised banks, and many more, what is, however, 
important from the public policy point of view in this context is to know how much 
Pakistan’s economy could have saved or gained had the reform been introduced 
earlier in the 1980s. Analysis of this nature which is also known as counterfactual 
exercise is useful not only in terms of getting an estimate of foregone benefits of 
delaying reforms in the past but, more importantly, it provides the policy-makers 
with a better insight into successfully implementing the reform in the future. 
With this perspective in mind, this study develops and estimates a 24-equation 
medium-sized macroeconometric model for Pakistan with a specific focus on the 
financial sector. Although the model constructed does not explicitly deal with 
specific  institutional arrangements (privatisation, NBFI, etc.) and management side 
(prudential regulations, competitions, etc.), of financial reforms, analysis of this 
paper, nevertheless, quantifies some of the important implications of the reform  Financial Sector Reform  895 
within the context of policy simulation exercise. Three important areas of financial 
reform where this study has made some modest contribution are the ones that relate 
to identifying the impact of more flexible market determined interest rates; reducing 
the spread between the deposit and lending rates; and finally, promoting policies to 
improve financial deepening in the economy.  
In general, our findings suggest that the impact of all three financial sector 
reform policies not only reduce financial disintermediation (McKinnon-Shaw 
Hypothesis) but the positive influence also permeate into the real sector. In fact, the 
key finding of this study is that had Pakistan introduced the financial sector reforms 
in the eighties rather than in the nineties, the economy could have enhanced its 
output in real terms by over Rs 16.5 billion every year. This figure is by no means a 
trivial amount given the size of the average annual real output of Rs 344 billion 
during this period (1981–94). 
 
REFERENCES 
Hasan, M. Aynul, Ashfaque H. Khan and S. Sajid Ali (1996) Financial Sector 
Reform and its Impact on Investment and Economic Growth: An Econometric 
Approach. The Pakistan Development Review 35:4. 
McKinnon, R. I. (1973) Money and Capital in Economic Development. New York:  
Oxford University Press. 
Shaw, E. S. (1973) Financial Deepening in Economic Development. New York: 
Oxford University Press. 
 
 
 

Financial Deepening in Economic Development.

Financial Sector Reform and its Impact on Investment and Economic Growth: An Econometric Approach. The Pakistan Development Review 35:4.

Money and Capital in Economic Development.

Financial Sector Reform and Its Impact on Investment and Economic Growth: An Econometric Approach

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Financial Sector Reform and Its Impact on Investment and Economic Growth: An Econometric Approach

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