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Financial Development and Economic Growth The proposition that financial sector development supports economic growth is fairly

well established in the literature. Almost a century ago, Schumpeter (1911) argued that financial intermediation through the banking system played a key role in economic growth by improving productivity and technical change. The specific channels through which financial development can help economic growth include: (i) raising and pooling funds (allowing riskier investments to be undertaken); (ii) allocating resources to their most productive use; (iii) allowing effective monitoring of the use of funds; (iv) providing instruments for risk mitigation; (v) supporting firms growth opportunities, especially for small and medium enterprises; and (vi) reducing inequality. Turning to the empirical evidence, Jalilian and Kirkpatrick (2005) and Levine (2005) review the current state of play. Recent cross-country econometric analysis provides evidence that financial development is robustly related to economic growth (King and Levine, 1993; Arestis and Demetriades, 1997; Levine, 1997; Rajan and Zingales, 1998; Caprio and Honohan, 2001). The link seems to work mainly through greater accumulation of physical capital and improvements in economic efficiency under well-developed financial systems. Recent econometric techniques that use the pooling of cross-country and time-series data make it possible to test the direction of causality between financial development and growth. Studies that employ these techniques including those of Levine, Loayza, and Beck (2000) and Beck, Levine, and Loayza (2000) also find a positive link between financial development and growth. The causal factors include the contribution of financial development to private savings, capital accumulation, and productivity, with the latter playing the most important role. In terms of the magnitude of this impact, Caprio and Honohan (2001) has found that a doubling of private sector credit as a share of GDP a common measure of financial depth is associated with a 2 percentage point increase in the rate of GDP growth. 1 But the literature also finds substantial cross-country heterogeneity in the relationship between financial development and economic growth unsurprising, given structural, institutional, and policy differences in the economies included in the sample (Jalilian and Kirkpatrick, 2005). That topic is covered later in the chapter. The development of a financial system will necessarily be affected by endogenous and exogenous factors, and by the sociopolitical development of individual countries. Endogenous factors refer to indicators of the soundness of individual financial institutions. C ommonly used to assess that soundness is the so-called CAMELS framework. The acronym stands for capital
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Debate persists. Aghion, Howitt, and Mayer-Foulkes (2005) raise serious questions about whether financial development affects steady-state growth or instead influences the rate of convergence with higher-income countries. Either way, however, financial development is positive for economic growth.

adequacy, asset quality, management soundness, earnings and profitability, liquidity, and sensitivity to market risk. Exogenous factors refer to macroeconomic developments that can affect financial system depth. Imbalances in economic growth rates may have a negative impact on the financial system of a country in at least two respects. First, low or declining aggregate growth rates often weaken the debt-servicing capacity of domestic borrowers and raise credit risk. Second, if an economy is overly dependent on one or two sectors for its economic growth, and if financial institutions are overly exposed in those sectors, an adverse real sector shock may have an immediate impact on the financial system. The system is even more vulnerable if those sectors are subject to exogenous forces, such as climatic conditions. The pattern and trend of inflation has a direct bearing on the stability and health of the financial system. High and volatile inflation complicates the task of accurately assessing credit and market risk in a financial institutions portfolio and its ability to manage and plan for the future. The relationship between financial system development an d a countrys external position, exchange rates, and international interest rates is complex (table 6.1). Table 6.1 Possible effects of various policies on the financial system
Indicator Current-account deficit as share of GDP External capital inflows Ratio of international reserves to short-term liabilities Terms of trade Composition, maturity of capital flows Exchange rate and interest rates Exchange rate Exchange-rate guarantees Interest rates Interest rates Source: Authors. Pattern/movement Increasing Increasing Low Comment May signal vulnerability to currency crisis if foreign investors judge the deficit as unsustainable, causing them to withdraw their investments, with negative implications for the liquidity of the financial system. May lead to asset price and credit booms. Seen by investors as a major indicator of vulnerability. Poor terms of trade or a sharp decline in a small country with high export concentrations may precipitate a banking crisis. Terms that are too high or that increase sharply may lead to inflation and asset price bubbles. Current-account deficits and low investment ratios may signal potential vulnerability of the financial system. The higher the volatility, the higher the foreign-exchange and interest risks for financial institutions, especially if the external debt burden is high or if foreign portfolio investments represent a high share of total foreign investment. Currency mismatches between bank assets and liabilities Considered major contributors to volatility in capital flows and excessive foreign currency exposures. Capital outflows. Adverse impact on emerging market borrowers. May promote capital inflows that could lead to risky lending.

Fluctuating

Low investment ratios

Volatile pattern Volatile n.a. Increasing international rates Declining

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