Financial Sector Development And Growth Theory Economics Essay

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This section will cover the theories and empirical evidences related to financial sector. Generally speaking, the role of the financial sector in all economies is to channel resources from primary savers to investment projects. The importance of this financial sector role has received much attention in the recent literature on economic growth. Owing to the vital importance of finance numerous studies have been made, from the pioneer Goldsmith (1969) to Bagehot (1873) to Meier and Seers (1984) to Stiglitz (1985) to Robert Lucas (1988) to Schempter (1912) to Mckinnon (1973) to King and Levine (1993) to Levine and Zervos (1996& 1999) to Demetraides and Hussein (1996) to Levine (1997) to Shleifer and Vishny (1997) to Singh( 1997)to Neusser and Kugler (1998) to Demirguc- Kunt and Maksimoric (1998) to Ram (1999) and more recently Levine et al (2000,2003& 2005 ) to Stulz and Williamson(2001) to Dolar and Meh (2002) to Svaleryd and Valschos (2002) to Rajan and Zingales (2000& 2003) to Favara (2003) to Acemoglu and Robinson (2005) to Do Quy-Toan and Levchenko (2006) to Hasan and Mingminy (2006) to Herger, Hodler and Lebsiger (2007) among others.

2.2 Financial Sector

The financial sector plays a vital role in every economy. Financial services are the economic services supplied by the finance industry, which incorporates a broad range of organizations that manage money, including credit unions, banks; onshore and offshore, credit card companies, insurance companies consumer finance companies, stock brokerages, investment funds and some government sponsored enterprises. In a broadest meaning, financial sector includes everything from banks, stock exchanges, insurers, credit union, microfinance institutions and money lenders. The financial sector mobilizes savings and allocates credit across space and time. It provides not only payment services, but more vitally products which enable firms and households to cope with economic uncertainties by hedging, pooling, sharing, and pricing risks. An efficient financial sector reduces the cost and risk of producing and trading goods and services and thus makes an important contribution to raising standards of living.

Banks are essential to economic growth. Their operations consist of accepting deposits and issuing loan to the public. Banks comprises of commercial banks, merchant banks, finance houses, building societies, saving banks and current unions.

The basic purpose of insurance is to protect against loss. Insurance has become an integral part of human life and business. The benefits attached to insurance are:

1. Provide security

2. Spread risk

3. Source of collecting funds

4. Encourage saving

Financial sector plays a role in the growth process since it is essential to the provision of funding for capital accumulation and for the diffusion of new technologies.

The securities markets help to effect the efficient allocation of resources through pricing of equity.

2.3 Financial Sector Development and Growth Theory

Finance is a leading sector for economic development. Bagehot (1873), Schumpeter (1912) and Hicks (1969) are the people who did ground breaking work on the relationship between financial development and economic growth. Bagehot (1873) said that financial development played an important role for channelling the industrialisation process in England. It is claimed that financial development helps to identify better investment opportunities, reduces productive cost, mobilises savings, boosts technological innovation and enhances the risk taking capacity of investors (Levine 1997). Enjoying economic growth implies many benefits associated with it. For instance, if economic growth outstrips population growth, it will lead to higher real income per head. This can further lead to higher levels of consumption of goods and services. Obviously the society gains as human welfare will increase due to rise in consumption level. Also, it avoids macro-economic problems. Mckinnon and Shaw (1973) concluded that government on the banking system, such as interest rate ceiling and direct credits negatively affect the development of the financial sector and harm growth. Jansen (1990) found that financial development contributes to economic growth, if good allocation of financial resources is made for the efficient mobilisation of production factors. Goldsmith studied financial development in 1969 using data on 35 countries from 1860-1963, he found evidence of a relationship between economic and financial development over long periods, and that periods of rapid economic growth have often been accompanied by an above average rate of financial development. Many researchers find evidence of a strong positive relationship between the various financial development indicators and growth.

A seminal study was undertaken by Goldsmith (1969). Using data on 35 countries from 1860 - 1963, he found evidence of a relationship between economic and financial development over long periods, and that periods of rapid economic growth have often been accompanied by an above-average rate of financial development.

2.4 Financial Sector Impact on Savings

Saving is the percentage of disposable income not spent on consumption of consumer goods but accumulated or invested directly in capital equipment or in paying off a home mortgage, or indirectly through purchase of securities. Saving decision is at the heart of both short- and long-run macroeconomic analysis. In the short run, spending dynamics are of central importance for business cycle analysis and the management of monetary policy. And in the long run, aggregate saving determines the size of the aggregate capital stock, with consequences for wages, interest rates, and the standard of living. Shaw (1973), McKinnon (1973), said that in a financially repressed economy, real deposit and lending rates are often negative, with adverse consequences for the development of financial system, and savings .As a remedy, the standard approach suggests establishing positive and real rates of interest on deposits and loans by, among other measures, eliminating interest rate ceilings and direct credit allocations through appropriate macroeconomic and structural policies. One of the most contentious issues in financial policy is the effect of interest rate on savings. There can be little doubt that short term temporary savings and interest rates have little effects on private savings behaviour since that is governed largely by expectations and plans regarding current and future incomes and expenditures. They alter the level of savings primarily by affecting the levels of investments and income. However, when there is a rise in interest rate that is expected to be permanent, the propensity to save will rise, hence removing repression will have a strong positive effect on savings (Shaw, 1973, p.73). Thus it can facilitate development and better technologies. Savings hence, increase the availability of credit, financial facilities investment and ultimately increased productivity and efficiency. Therefore, it can be conclude that saving impact on investment, growth and human capital.

The mobilisation of savings also creates an opportunity for re-lending the collected funds into the community. The availability of credit can strengthen the productive assets of the poor by enabling them to invest in productivity-enhancing new 'technologies' such as new and better tools, equipment, or fertilizers etc., or to invest in education and health, all of which may be difficult to finance out of regular household income, but which could provide for a higher income in future. The availability of credit can also be an important factor in the creation or expansion of small businesses, thus generating self- and wage-employment and increasing incomes.

2.5 Financial Sector Impact on Investment

The central point of the McKinnon-Shaw (1973) hypothesis is that, an increase in the real interest rate may induce the savers to save more, which enables more investment. Financial sector improves liquidity of investment.

2.6 Financial Sector Impact on Macro-economic Indicators

Gross Domestic Product: GDP is most commonly used macroeconomic indicator to measure total economic activity within an economy. The growth rate of GDP reflects the state of the economic cycle and is expected to have an impact on the demand for bank loans. The economic conditions and the specific market environment would affect the bank's mixture of assets and liabilities. Sufian and Habibullah (2010) point out that the GDP is expected to influence numerous factors related to the supply and demand for loans and deposits. Favourable economic conditions will affect the demand and supply of banking services positively. Bank's growth and profitability is limited by the growth rate of the economy. If the economy is growing at a good rate, a soundly managed bank would profit from loans and securities sales. Economic growth can enhance bank's profitability by increasing the demand for financial transactions, that is, the household and business demand for loans. Strong economic conditions also characterized by the high demand for financial services, thereby increasing the bank's cash flows, profits and non interest earnings. Thus there is a positive relationship between the growth rates of Gross domestic product and the profitability of the bank.

Inflation Rate: Inflation can affect in the way of Changes in interest rates and asset prices on the profitability of banks. Bashir (2003) stated that the anticipated Inflation affects positively while unanticipated inflation affects negatively the profitability of the banks. There is a positive association between the anticipated inflation and performance of the bank as it gives banks the opportunity to adjust interest rates accordingly, resulting in revenues that increased faster than costs, thus implying higher profits and reverse with the unanticipated inflation. Bourke (1989) revealed a positive relationship between inflation and bank profitability. Higher inflation rate lead to higher loan rates, and hence higher revenues will be generated by the bank. Inflation has a negative effect on bank profitability if wages and other costs (overhead) are growing faster than the rate of inflation.

2.7 Empirical Review of Literature

Ground-breaking work from King and Levine (1993) examined Finance and Growth: Schumpeter Might Be Right. They present cross-century evidence consistent with Schumpeter's view that the financial system can promote economic growth, using data on 80 countries over the 1960 to 1989 periods. Various measures of the level of financial development are strongly associated with real per capita GDP growth, the rate of physical capital accumulation, and improvements in the efficiency with which economies employ physical capital. Further, the predetermined component of financial development is robustly correlates with future rates of economic growth, physical capital accumulation, and economic efficiency improvements.

Jansen (1990) found that financial development contributes to economic growth, if proper allocation of financial resources is made for the efficient mobilisation of production factors. Patrick and Park (1994) examined the role of financial development for economic growth in three countries; Japan, Korea, and Taiwan. Becsi and Wang (1997) observed that financial intermediation plays an important role in the economy. Ahmed and Ansari (1998) examined the relationship between financial development measures and economic growth for three South Asian countries, India, Pakistan and Sri Lanka, based on the result of correlation analysis, Granger causality and Cobb-Douglas production function type equation for pooling data. The major finding of this study is that the governments in these countries were able to promote economic growth by encouraging financial sector development. Khan (1999) analysed the relationship of financial development and economic growth by developing a theory of financial development based on the cost of the provision of external finance. He concluded that financial development reduces the costs of external finance and accelerates the rate of economic growth; on the other hand he predicts financial development would raise the return on loans and reduce the spread gap between borrowing and lending rates.

Deidda and Fattouh (2002) presented a simple model to establish a non-linear relationship between financial development and economic growth. They suggested that no significant relationship between financial development and economic growth is found in low-income countries. Gregori and Guidotti (1995) examined the empirical relationship between long run growth and financial development for Latin America. They found a positive relationship between the variables across the countries using cross country data and a negative relationship across countries from panel data analysis. Jean and Varoudakis (1996) used a large sample of cross-country data to conclude that the developed financial sectors favour growth by mobilising savings. Demetraides and Hussein (1996) conducted causality tests between financial development and real GDP using time series data. The paper concluded that finance is a leading sector for economic development and there are different causality patterns across countries. In some cases the study found evidence that economic development systematically causes financial development. It shows the bidirectional relationship between financial development and economic growth.

Neusser and Kugler (1998) empirically assessed Manufacturing Growth and Finance Development from OECD countries and find that recent theoretical models conjecture that the development of the financial sector is essential for economic growth. They investigate this hypothesis from a time series perspective and find that financial sector GDP is co integrated for many OECD countries not so much with manufacturing GDP but mostly with manufacturing total factor productivity. Moreover, this relation is in some instances characterized by long-run causality in the sense of Granger and Lin. However, even within this homogeneous group of countries, the variety of results suggests a more complex picture than is apparent from cross-sectional evidence.

Levine and Zervos (1996) studied stock Markets, Banks and Economic Growth. The stock markets and banks differ in the financial services they provide. Using data on 49 countries from 1976 to 1993, the authors investigate whether measures of stock market liquidity, size, volatility, and integration in world capital markets predict future rates of economic growth, capital accumulation, productivity improvement, and private savings. They find that stock market liquidity as measured by stock trading relative to the size of the market end economy is positively significantly correlated with current and future rates of economic growth, capital accumulation, and productivity growth, even after controlling for economic and political factors Stock market size, volatility, and integration are not robustly linked with growth. Nor are financial indicators closely associated with private savings rates. Significantly, banking development as measured by loans to private enterprises divided by GDP when combined with stock market liquidity predicts future rates of growth, capital accumulation, and productivity growth entered together in regressions. The authors determine that these results are consistent with views that; financial markets and institutions provide important services for long-run growth and stock markets and banks provide different financial services.

Sinha and Macri (1999) studied the relationship between financial development and economic growth in eight Asian countries and concluded that a significant positive relationship exists between the income and financial variables for some countries. Kar and Pentecost (2000) examined the causal relationship between financial development and economic growth in Turkey. They developed five alternative proxies for financial development and suggested that the direction of causality between financial development and economic growth in Turkey was sensitive to the choice of proxy used for financial development.

Rioja and Valev (2002) studied the effects of financial development on the sources of growth in different groups of countries with the panel data of 74 countries using GMM (Generalised Method of Moments) dynamic panel techniques. They found strong positive influences of finance on productivity growth mainly in the developed economies, while such growth occurs in less developed economies through capital accumulation. Christopoulos and Tsionas (2004) investigated the long run relationship between financial depth and economic growth combining cross sectional and time series data for developing countries. They found a single equilibrium relationship among financial depth, growth and ancillary variables; and Cointegration relationship indicated unidirectional causality from financial depth to growth. Waqabaca (2004) examined the relationship between financial development and economic growth in the context of Fiji using time series data of 30 years and found a positive relationship between financial development and economic growth, with causation running predominantly from economic growth to financial development.

Das (2002) examined the effects of financial deregulation on risk and productivity change of public sector banks in India for the period 1995-2001. They found evidence that capital; non-performing loans and productivity were entwined, with each reinforcing and to a certain degree complementing the other. They also found that higher capital led to a rise in productivity whilst higher loan growth reduced productivity. Moreover, increased government ownership tended to increase productivity.

Levine (2002) reinforces Goldsmith's (1969) argument when concluding that "financial structure did not matter much since the four countries have very similar long-run growth rates". Levine addresses this problem by using a broad cross-country approach that allows treatment of financial system structure across many countries with different growth rates. The findings of this study support neither the bank-based nor the market-based views; they are, instead, supportive of the financial services view, that better-developed financial system is what matters for economic growth. An earlier study by Demirguc-Kunt and Levine (1996), using data for forty-four industrial and developing countries for the period 1986 to 1993, had concluded that countries with well-developed market-based institutions also have well-developed bank-based institutions; and countries with weak market-based institutions also have weak bank-based institutions. Thereby supporting the view that the distinction between bank-based and market-based financial systems is of no consequence. However, Levine and Zevros (1998), employing cross-country regressions for a number of countries covering the period 1976 to 1993, conclude that market-based systems provide different services from bank-based systems. In particular, market-based systems enhance growth through the provision of liquidity, which enables investment to be less risky, so that companies can have access to capital through liquid equity issues. The World Bank (2001) provides a comprehensive summary of the available evidence, which also reaches similar conclusions. It argues strongly that the evidence should be interpreted as clearly suggesting that "both development of banking and of market finance help economic growth: each can complement the other" (p. 48). In what follows we attempt to tackle the problem alluded to by Goldsmith (1969) and others. We also deal with the concerns surrounding the panel and cross-country regressions referred to by, among others, Levine and Zervos (1996). Our usage of time-series and heterogeneous panel estimators to analyse a number of diverse countries, should go some way in tackling these concerns.