The impact of financial development on economic growth in Japan

1969 words (8 pages) Essay in Economics

5/12/16 Economics Reference this

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The fundamental question in economic growth that has preoccupies researchers is why do countries grow at different rates. The empirical growth literature has come up with numerous explanations of cross-country difference in growth, including factor accumulation, resource endowments, and the degree of macroeconomic stability, educational attainment, institutional development, legal system effectiveness, international trade, and ethnic and religious diversity. The list of possible factors continues to expand, actually without limit.

One critical factor that has begun to receive considerable attention more recently is the role of financial development in the growth process. The important link between financial development and economic growth has been the subject of numerous studies, for many years. More specifically, these researches have highlighted, at the theoretical as well as empirical level, the significance of having a developed financial system to support economic growth. Additionally, recent studies have also addressed this topic from an open economy perspective, and found that financial integration with the global economy like financial deepening can bring about economic benefits. Studying the relationship between financial development and economic growth is a vital one, considering the continuing progress in its financial sector. The focus of study provides support for research work, which have included in its cross country evidence.

The positive link between financial depth, defined broadly as the level of development of financial market, and economic growth is in one sense fairly obvious. That is, more developed countries without exception, have more developed financial markets. Therefore, it would seem that policies to develop the financial sector would be expected to raise economic growth. Indeed, the role of financial development is considered by many to be the key to economic development and growth (Demirguc- Kunt and Levine 1996a).

The general consensus of an ever-increasing number of empirical and theoretical works on economic growth is that a well-developed financial system plays an essential role in fostering a country’s economic growth. We used to see that the development of different aspects of the financial development has different impacts on economic growth. In this study, we focus on Japan. Japan is a good indicator of financial market development in analyzing the relationship with economic growth. Hence, well-developed financial systems could channel financial resources to the most productive use (Goldsmith, 1969).

The notable early works on finance and development along the Schumpeterian lines included Gurley and Shaw (1955), Goldsmith (1969), and Hicks (1969).They argued that the development of a financial system is crucially important in stimulating economic growth. Under-developed financial systems slow down economic growth. The policy implication of this viewpoint is that it is important to formulate policies aimed at expanding the financial system in order to foster growth.

Financial development in developing countries and emerging markets is part of the private sector development strategy to encourage economic growth. A solid and well-functioning financial sector is a powerful engine behind economic growth. It generates local savings, which in turn lead to productive investments in local business. Furthermore, effective banks can channel international streams of private remittances. The financial sector therefore provides the rudiments for income-growth and job creation (Sinha and Macri, 2001).

Financial development has classified as two either of the bank-based type or stock market-based type. It is a crucial policy question on which type of financial development should the government actively promotes to foster the economic growth (Chakraborty, 2008). There are three basic characteristics of financial system that are now regarded as capturing the impact of these five functions on economic growth: i) the level of financial intermediation; ii) the efficiency of financial intermediation; and iii) the composition of financial intermediation. Historically, the role of banks and non-bank financial intermediaries ranging from pension funds to stock market, has been to translate household savings into enterprise investment, monitor investment and allocate funds, and to price and spread risk. Yet, financial intermediation has strong externalities in this context, which are generally positive such as information and liquidity provision but can also be negative in the systemic financial crisis which are endemic to market systems (FitzGerald, 2006).

The Financial sector is all of the wholesale, retail, formal and informal institutions in an economy offering financial services to consumers, businesses and other financial institutions. It consists of financial intermediaries such as (banks, insurance companies, finance companies, and credit unions) and financial markets such as (money markets, stock exchanges, and foreign exchange markets). It can also include money lenders and microfinance institutions. Financial sector development occurs when financial instruments, markets and intermediaries reduce the costs of information gathering, enforcement and transactions in an economy, thereby improving the provision of the five functions. The financial sector can play an important role in reducing risk and vulnerability for private sector firms, individuals and households. It can increase the ability of individuals and households to access basic services like health and education (Odedokun, 1996).


Japan is the second largest industrial economy in the world. It is the market for about one-sixth of the exports of ASEAN-4 (Indonesia, Malaysia, Philippines and Thailand) and South Korea. Their growth in general and their export growth in particular have to be supported by growth in domestic demand in Japan. Since the bursting of the asset price bubble in 1990, however, the Japanese economy has been in a morbid state.

Figure 1.1: Yearly Growth of Japan Gross Domestic Product (GDP)

Source: Department of Statistic Japan

Since 1990, however, the Japanese economy suddenly has been in recession with GDP growth at an average of 1.7%. As the bubble’s collapsed in 1990, the Japanese economy slumped into the long stagnation in the 1990. To solve this stagnation, the government began to encourage financial reform. In 1992, the financial reform law was approved and financial institutions were allowed to enter into other kinds of financial business by establishing subsidiaries. For example, banks were allowed to engage in securities business through their subsidiaries.

From 1993, the GDP of Japanese economy achieved a high rate of economic growth. The following years, GDP growth quite stable until rapidly drop to 1.8% in 1997 because of financial crises that gripped the region during 1997 and 1998.

Table 1: The financial development index 2008 ranking




United states



United kingdom


















Hong Kong
























United Arab Emirates






Source: World Economic Forum (2008)

Table 1 shows the financial development index ranking among countries. According to several authors, they stated that more developed countries have more or better financial development. This is can be proved by United states, United Kingdom, Germany, Japan, Canada, France and most of the developed countries list in a top position The United Stated and United Kingdom takes first and second place in the financial development index (FDI), driven by its strong showing across all different aspects of financial intermediation.

Japan emerged as the highest ranked Asian country (4th) by delivering well-rounded performance in financial development. it is strongest scores are seen with respect to financial intermediation and in particular its highly efficient banks, IPO and M&A activities, insurance, foreign exchange and derivatives markets. But Japan’s institutional and business environments appear less successful. Corporate governance is a weak point characterized by a need for greater incentive-based compensation of management and better audition and accounting standard. Japan’s large public debt, fueled in part by massive spending on public works projects, goes beyond levels that may be considered healthy for the financial system. But the difficulty of access to private credit, loans, and venture capital places Japan in the bottom half of these measures of capital access.


The financial development (financial market and institutions) perform an important role in promoting a good economic growth, particularly through their role in allocating finance for productive activities. Every an economy requires to have an efficient financial system to perform a better economic development. A more efficient financial system will provides better financial services and this enable an economy to increase its GDP growth rate (Levine, 1997). Otherwise, a non-efficient financial system will worst the economy growth of a country. Establishing well-functioning financial markets and financial institutions, which attract savings and channel them to productive investment projects, should therefore be a policy priority for governments. The important role of financial intermediaries and financial markets therefore merits more attention from researchers and policy makers. It is a crucial policy question which type of financial development (bank-based or stock-market based type) should the government actively promote. The relative importance of these two types of financial structures in economic growth has been debated for over a century (Allen and Gale 1999; Stiglitz 1985). The policy implication of this view of points is the importance of formulating policies aimed at expanding the financial system in order to encourage growth. On the other hand, an interesting question remains why, if financial system are very excellent for growth, but still have so many countries remained financially or even economically under-developed?


What is the link between financial development and economic growth?

What are the financial development variables that contribute to the economic growth in Japan?

Which type of financial development (bank-based or stock market-based) should government actively promote?


The general objective of this research is to examine the impact of financial development on economic growth in Japan.

Based on the general objective, the study intends to address the following specific objectives:

To observe whether bank-based or stock market- based type is important to determine the economic growth.

To investigate whether there is any causality between financial development and economic growth.


The proposed outcome of this research is the provision of practical advice on financial sector policies and performs relevant to the needs of policymakers in the low income economies. This research will provide policy advice on such issues as: strengthening the efficiency and regulation of the domestic financial sector; boosting domestic savings; to increase the public and private investment, improve the import and export to increase the real gross domestic product (GDP) of economic growth (Goldsmith,1969).

This study covers greatly into the increase understanding of the crucial relationship between the parallel strategies of financial development and economic growth indicators that will be the main sources for the purpose of data collection in this study. It is clear that if causality can be establishing from financial development to economic growth then these studies have direct policy implication and improve the effectiveness of policy design and implementation in future.

Additionally, this study provides knowledge to investors who are considering investing in Japan and Thailand. By knowing the relationship between the financial development and economic growth, it can help investors to hedge some risk. This study also helps us to promote an understanding on this topic and gives an opportunity to contribute to the literature review on financial development and economic growth to further researchers. It will be important research material on financial development and economic growth.

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