Finance, economic growth, and development


The debate on the role of finance in economic growth and development can be traced as far back as the 1800s (see Bagehot, 1873). At the commencement of the 20th century, Schumpeter (1912) highlighted the central role the banking system played in allocating savings to their most productive uses, hence improving productivity and ultimately economic growth. Over time, other authors, such as Gurley and Shaw (1955), Gerschenkron (1962), and Goldsmith (1969), have emphasized the importance of financial intermediation and resource accumulation in the economic growth process. More recently, with the advent of the endogenous growth models, the majority of the theoretical and empirical literature1 has revived the debate and continued to stress the important role of the financial sector in economic growth.

This chapter generally provides a discussion on the theoretical and empirical issues underlying finance, economic growth, and development phenomena. We start by overviewing some concepts and definitions on the topic. We then discuss financial repression, liberalization, and growth. Next, we discuss the finance-growth nexus, highlighting the various hypotheses underpinning the relationship. What follows is a discussion on the role of the financial system, accentuating how the various functions of the financial system spur economic growth and conclude the chapter with a discussion on financial intermediation and growth, emphasizing the role of deposittaking financial institutions and capital markets in the economic growth process.


The financial sector refers to the set of institutions, markets, instruments, and regulator)^ setup under which financial transactions are carried out in the financial system. Key players in the financial sector include banks, microfinance institutions (MFIs), insurance companies, investment bankers, mortgage companies, and stock exchanges, who provide financial services in the sector. Financial services encompass the assorted economic services provided by the financial institutions in the financial system. These comprise intermediation and advisory services, investment services, foreign exchange services, payment services, asset management services, risk management services, and debt resolution sendees, among others. The financial system refers to the framework within which all the aforementioned services are organized and offered. Accordingly, a better financial system will allow for an efficient allocation of resources in the economy. Financial systems function at firm-specific, national, and global levels.

Generally, financial development suggests advancement in the financial sector in terms of institutions, markets, and instruments/products. Empirically, financial sector development has been measured in various ways because of its complex nature and the dimensions it covers. Several indicators are used as proxies of financial sector development, depending on the issue under investigation. Typical financial development indicators (from the banking sector perspective) include total credit granted by financial intermediaries (banks and nonbank financial intermediaries), the private sector, gross domestic product (GDP), the liquid liabilities of the financial system (i.e. currency plus demand deposits and interest-bearing liabilities of banks and nonbank financial intermediaries) relative to GDP, and the ratio of commercial bank assets relative to commercial bank and central bank assets. Common stock market indicators of financial development are stock market capitalization (divided by GDP), stock market turnover, and stock market value traded. On the one hand, stock market capitalization measures the depth or relative size of the stock market. Stock market turnover (total value of domestic shares traded divided by market capitalization) and stock market value traded measure the liquidity of stock markets. These variables aid comparisons of financial development across countries.

Financial development is measured2 in terms of depth, access, efficiency, and stability. Financial depth refers to the extent of advancement and penetration of financial sendees provision to all levels of society in an economy. A relatively wider set of financial services gives people of various socioeconomic groups more options to choose from. Financial depth also connotes the size of the financial market and financial institutions relative to the size of the overall economy. Financial access describes the ability of individuals and businesses to obtain useful and affordable financial products and services that serve their interest in an economy. Hence, higher access to financial products and services implies a high-level financial inclusion. The opposite is also true: the inability of such groups to obtain financial services implies that they are financially excluded. Financial access facilitates the daily transactions of individuals and enterprises and aids in decision-making and planning over the longer term, such as access to short- and long-term financing and risk management instruments such as credit, insurance, and savings.

Financial efficiency refers to the scenario where market distortions are eliminated, where there is active competition in the market with information available to all stakeholders in the financial system such that the highest quality of financial sendees are provided at the lowest cost possible. Financial stability describes the state in which the financial system is resilient to economic shocks and is well capable of smoothly accomplishing its basic functions. It therefore implies the ability of the financial sector to consistently facilitate and boost economic processes, manage risks, and absorb shocks. The incidence of various financial crises, including the global financial crisis of 2007/2008 and the eurozone crisis of 2009, has reaffirmed the importance of maintaining financial stability. Further, depending on the aspect of the financial sector in question, different variables may be employed as indicators or proxies of financial development.

There are clear differences between the financial sectors of developed and developing economies. On the one hand, the financial sectors of most developing countries are typically small, underdeveloped, and bank based. Some of the factors contributing to this include political instability, lack of the appropriate technological infrastructure, lack of trust and confidence in financial institutions, inefficient legal systems, financial illiteracy, and the overregulation of government, inter alia. On the other hand, the financial sectors of most developed countries are far advanced in terms of depth, access, efficiency, and stability and combine a good balance of intermediation that uses banks and capital markets.

The composition of the financial sector, the financial structure, also differs across developed economies and developing economies. There are bank-based systems and market-based systems. In bank-based financial systems, banks play a prominent role in executing functions such as savings mobilization, capital allocation, diversification, and managing risks. In a market-based financial system, economic agents rely more on capital markets for their savings and borrowing. In that system, firms and governments raise funds from savers by issuing financial securities in the form of stocks and bonds. A financial system is described as bank based if the relative share (size or activities) of banks is bigger than that of the capital market. In the case of a market-based system, securities markets collaborate with banks in performing these functions, even though the capital market play the more active role, because they have a bigger market share. Examples of African countries with a bank-based financial system are Ghana, Nigeria, and Morocco. Other countries that have bank-based financial systems include Germany and Japan. Market-based financial systems, on the other hand, focus on the importance of the capital market. They are those in which the stock and bond markets play a critical role in the economy, by helping to raise long-term capital, influencing corporate control, and providing opportunities for risk management. South Africa is an example of an African country with a market-based financial system. The US and the UK are also considered countries with market-based financial systems.

There are differences in how banks and markets channel savings into investments. Typically, banks perform their intermediation function by mobilizing savings (predominantly deposits) for onward lending. By maintaining a close relationship between the two parties through information gathering, they are able to mitigate possible information asymmetry problems and adverse selection. Furthermore, banks provide the means for risk-averse savers to hold bank deposits instead of unproductive liquid assets. Banks are able to lend these deposits for use in productive investments that stimulate economic activity. On the other hand, markets provide a platform where debt and equity securities are issued and traded. Markets overcome information asymmetry problems through contract covenants and through the court system. Since the work of Gerschenkron (1962) and Goldsmith (1969), which expounded on the growth-enhancing role of financial structure, there has been burgeoning empirical debate3 on which financial structure is more efficient and growth enhancing. That is, whether bank- based financial systems or market-based financial systems spur growth faster. The bank-based view postulates that banks (or intermediaries) are better than markets at efficiently allocating resources and hence propelling economic growth. For example, banks play the important role of providing finance to small and medium-size enterprises (SMEs), which usually have limited or no access to capital markets. The market-based view argues that capital markets ensure good corporate governance and hence the optimal allocation of resources to expedite economic growth. The underlying argument is that large, liquid, and well-functioning markets help to ameliorate risk management through diversification and risk sharing. Capital markets are better able to fund new projects, research and development, and venture capital, which are crucial for increasing productivity in the economy.4

Notwithstanding the debate on the bank-based systems and market- based systems, there is still a related strand of literature5 popularly referred to as the financial services view, which posits that bank-based systems and market-based systems are important together for economic growth because of the provision of complementary financial services.

< Prev   CONTENTS   Source   Next >