Financial liberalisation in India and a new test of the complementarity hypothesis

Abstract

This paper reappraises the financial repression hypothesis for India in the light of the partial liberalisation of the financial sector in the early 1990s, using for the first time, state-of-art multivariate cointegration and vector error correction models (VECM). From this robust test we find that for the Indian economy over the sample period 1951-1999 money and capital are complementary, suggesting that higher real interest rates will raise the demand for money and lead to higher levels of investment. Furthermore, testing for a structural break in the early 1990s – to coincide with the liberalisation of the financial sector in India – suggests that these reforms have not significantly changed the complementary relationship between money and capital. The policy implication is that further financial liberalisation is required in India, to enhance investment and economic growth.