ARE FINANCIAL SECTOR POLICIES EFFECTIVE IN DEEPENING THE MALAYSIAN FINANCIAL SYSTEM? JAMES B. ANG* This paper provides an empirical assessment of the effects of financial sector pol- icies on development of the financial system in Malaysia over the period 1959–2005. The technique of principal component analysis is used to construct a summary mea- sure of interest rate policies in order to account for the joint influence of various inter- est rate controls imposed on the Malaysian financial system. The results show that economic development, interest rate controls, and capital liquidity requirements posi- tively affect the level of financial development. However, greater trade openness, higher statutory reserve requirements, and the presence of directed credit programs appear to be harmful for development of the Malaysian financial system. The results provide some support to the argument that some form of financial restraints may help promote financial development. (JEL E44, E58, O16, O53) I. INTRODUCTION Since the emergence of the new theories of endogenous economic growth in the past two decades, financial development has been the subject of considerable research interest (e.g., Bencivenga and Smith, 1991, 1993; King and Levine, 1993b; Pagano, 1993). Motivated by the seminal work of King and Levine (1993a), a number of empirical papers have tried to examine the role of financial develop- ment in the process of economic development (see, e.g., Beck and Levine, 2004; Levine, 1998; Levine and Zervos, 1998, among others). With few exceptions, these studies have consistently demonstrated that financial development has a beneficial impact on economic growth. Another group of authors, typified by the work of Demetriades and Hussein (1996) and Arestis and Demetriades (1997), have attempted to examine the causality between financial development and economic growth. However, their results do not yield conclusive findings on the direction of causality. Although the positive association between financial development and economic growth is already a stylized fact as verified by many empirical studies, an important and yet some- what underresearched issue is what determines financial development? Motivated by the ear- lier work of Demetriades and Luintel (1997, 2001), who have found that financial liberaliza- tion, real interest rates, and economic develop- ment are important determinants of financial development for India, there is a growing literature that attempts to examine the determi- nants of financial development using a cross- country framework. For instance, Chinn and Ito (2006) demonstrate that capital account openness and institutional environment have significant effects on equity market develop- ment for a panel of 108 countries. Similarly, Baltagi, Demetriades, and Law (2007) show *The author would like to thank Jakob Madsen, Russell Smyth and Martin Paldam for sharing their in- sights. Helpful comments and suggestions received from two anonymous referees of this journal, conference partic- ipants at the 2007 Singapore Economic Review Confer- ence, 36th Australian Conference of Economists, Dynamics, Economic Growth, and International Trade (DEGIT) XII Conference, and seminar participants of the Department of Economics at Monash University are gratefully acknowledged. Ang: Lecturer, Department of Economics, Monash Uni- versity, 900 Dandenong Road, Caulfield East, Victoria 3145, Australia. Phone +61-3-99034516, Fax +61-3- 99031128, E-mail james.ang@buseco.monash.edu.au ABBREVIATIONS ADF: Augmented Dickey-Fuller BLR: Base Lending Rate BNM: Bank Negara Malaysia DOLS: Dynamic Ordinary Least Squares GDP: Gross Domestic Product IV: Instrumental Variable NEP: New Economic Policy PP: Phillips-Perron UECM: Unrestricted Error Correction Model VAR: Vector Autoregression VECM: Vector Error Correction Model Contemporary Economic Policy (ISSN 1074-3529) Vol. 26, No. 4, October 2008, 623–635 doi:10.1111/j.1465-7287.2008.00110.x Online Early publication July 9, 2008 Ó 2008 Western Economic Association International 623