Analyze the correlation between growth and financial institutions

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Main Research Question (Abstract)

The main question under consideration is dedicated to the issue of the Georgian banking system and growth of economy. The urgency of this problem consists in the question whether already quite developed banking system is able to act such actor providing helpful hand to the economic growth of Georgia. To circumvent this question the importance of banks' intermediation in the regions of one economy: Georgia will be examined.

The aim of this paper is to observe - how economic structure and financial institutions are developing after its independence in Georgia; whether these two sectors are significantly interconnected and in what way do financial institutions influence the pace of economic growth. Does the mixture of financial institutions functioning in an economy influence economic development?

Literature Review

This section shall provide the reader with the underlying theories and the necessary background information that the thesis will be based upon, enabling one to fully understand the following parts.

2.1. Theoretical Considerations of Financial Development and Growth

The development of financial institutions is often considered as the precondition of a higher level of capital productivity and economic growth. Recent research has made substantial progress in expanding the analysis of the connection between financial development and economic growth. Particularly, researchers have provided additional information on the finance-growth connection and the results are following: firm-level, industry-level and cross-country studies all suggest that the level of financial development influences a large positive impact on economic growth.

The early studies of economists such as Goldsmith (1969), McKinnon (1973) and Shaw (1973) defined the role played by financial institutions mainly in increasing savings and consequently, investment. After these studies it is obvious that the direction of causation goes from financial institutions to economic development. The endogenous growth theory also proves that financial intermediaries improve the effectiveness of investmentX. Nowadays, it is more widely accepted that the development in the financial sector should have a positive influence on the economic growth.

XSee Bencivenga and Smith (1991), also King and Levine (1993)

Goldsmith (1969) quite successfully explained the evolution of national financial systems, particularly the evolution of financial intermediaries. He showed that banks tend to become larger relative to national output as countries develop. Goldsmith met with more limited success in evaluating the connections between the financial development and economic growth. He clearly demonstrated a positive correlation between the level of financial development as well as the level of economic activity in thirty-five countries using data prior to 1964. However, later some assumptions were made that Goldsmith's work was not sufficient to be completely effective. The reasons would be the following: It doesn't regularly control for the other factors influencing economic growth; doesn't examine whether financial development is linked with productivity growth and capital accumulation; the close relationship between the size of the financial system and economic growth doesn't identify the direction of causalityM.

Since the early 1990s, King and Levine (1993) with their empirical literature have also showed that financial development leads to economic growth. They study 80 countries over the period 1960-1989 regularly controlling for other factors in long-run growth, examine the capital accumulation and productivity growth channels as well as with additional measures analyze whether the level of financial development predicts capital accumulation and long-run economic and productivity growth.

Among many other types of financial system, the banking system was more effectively promoting economic growth through a larger share of bank deposits, bank assets or bank credits to the private sector, after controlling for endogeneity. Using deregulation of banking sector in different places of United States over the period 1972-1991 as a proxy for a quantum jump in financial development, Jayaratne and Strahan (1996) found out that annual growth rates in a state increased by 0.51 to 1.19 percentage points a year after deregulation.

Banks set-up best means to mobilize capital, monitor managers, manage risk as well as identify good projects (Levine 1997) and stimulate individual investors to acquire information since they form long-run co-operations with different firms (Boot et al. 1993) since information is not made public as in other financial institutions.

In the initial stage of development, when income per capita is relatively low, financial intermediation is absent or almost minor. As soon as capital is accumulated and income per capita increases, financial markets become more developed after the emergence of financial institutions and of new and more complex forms of financial instrumentsG. During these early stages of development bank intermediation is the prevalent means of by which savings are directed to investment as stock markets are relatively insignificant.

The importance of financial markets in the process of economic development was also recognized by the famous economist Joseph Schumpeter (1934) who identified the role played by financial institutions in channeling resources towards more productive investments. According to him, the development of financial markets and institutions was a nesseccary condition of the industrial revolution, expending the opportunities for borrowing and lending that allowed firms to take over new technologies and to take on riskier but potentially higher-return investments.

MGoldsmith (1969) recognized these weaknesses

GSee Goldsmith, 1969; also De Gregorio and Guidotti, 1995

Country Case Studies

In the theoretical considerations we already mentioned that cross-country studies - as well as firm-level and industry level studies, which suggest that the financial development influences a large positive impact on economic growth. For example: Rondo Cameron et al. (1967) analyzed the historical relationships between banking development and the beginning of industrialization for the countries such as England (1750-1844), Scotland (1750-1845), France (1800-1870), Belgium (1800-1875), Germany (1815-1870), Russia (1860-1914) and Japan (1868-1914). In these country-case studies the researchers carefully examined financial, economic and legal conections between banks and industry during their industrialization. While emphasizing the analytical limitations of those country-case studies, Cameron (1967) concludes that in almost every country the banking system played a positive, growth-persuading role.

The relationship between financial and economic development has been examined for many other countries. Stephen Haber (1991, 1996) made a comparative study of industrial and capital market development in Brazil, Mexico and United States between 1830 and 1930, after which he concluded that capital market development had a significant influence on industrial and economic performance. Haber shows that when Brazil formed first republic in 1889 after overthrowing its monarchy, it dramatically liberalized restrictions on its financial markets, which gave more firms an easier access to external finance. Mexico also liberalized its financial markets, but in the period of hard dictatorship (1877-1911) the changes were very minor, which was the result of the financial and political support of a small group of powerful financial capitalists (p. 561). Thus the increase in economic growth was much stronger in Brazil then in Mexico. Through this evidence Haber concludes that "differences in capital market development had a significant impact on the rate of growth of industry within an economy"Z.

Finally, McKinnon's (1973) well known book "Money and Capital in Economic Development" studies the relationship between the financial system and economic development in many countries such as: Argentina, Brazil, Chile, Germany, Korea, Indonesia, and Taiwan in the post War II period. From these country-case studies he strongly suggests that better working financial systems support economic growth, as we already mentioned in the theoretical part, although disagreement exists over many of these individual cases. Therefore it is extremely difficult to isolate a single factor in the economic growth process. Any statements about causality are largely impressionistic and specific to particular countries and specific periods. Thus, the proposal of the country-studies is that, while the financial system responds to demands from the nonfinancial sector, well-functioning financial systems are greatly encouraged by economic growth in some cases during some periods of time.

Z Interestingly, these political and legal obstacles to financial development are apparently difficult to change.

Banking Sector and Finance

Challenges and Future of Banking Sector

Since Goldsmith (1969) published the relationship between financial and economic development 30 years ago, the issue had made important progress. Theoretical work carefully enlightens many channels through which the emergence of financial markets and institutions takes place, and are affected by economic development. A growing number of empirical analyses, including firm-level studies, industry-level studies and broad cross-country comparisons, show a strong positive correlation between the functioning of the financial system and long-term economic growth.

3. Overview of Georgian Economy

Georgia has experienced many important developments during the latest years since 2004. There have been many successes, as well as failures. For years, there was made strong progressed and developed the economy, despite economic blockades and cuts to the energy supply.

The difficulties of 2009 were caused by three different but equally devastating problems: First it was Russian invasion and military occupation with the permanent threats which posed a serious problem to the country and hit the investment driven economy hard; then followed world's economic crises, which caused a painful economic shock in Georgia as well as other countries in the world. And the final cause was the domestic political tension with different nature from the war and the world crisis. Hence, the country's economic indicators fell to their lowest levels.

2.3. Financial Crises and the Challenges of the Banking Sector in Georgia

The financial crisis, together with the war with Russia stuck a terrible blow to Georgia's young and developing economy and destroyed the foundations of its earlier development. Many companies faced bankruptcy and some even disappeared. Tens of thousands of citizens faced crippling debts, as the procedures of taking credit were very simplified at that time.


Georgian economy contracted by 5.5 percent in the first three quarters of last year. And in the fourth quarter it started to emerge from recession and the first signs of positive growth started to appear.


The objective of this paper was to analyze the finance and growth in a bank-based economy in the case of Georgia. To establish the influence of the Georgian banking system on the significant growth of economy.

The decline has stopped, in every sphere of the economy there are strong signs of recovery; the key economic indicators have stabilized.