25th April 2015

DOES FINANCIAL
DEVELOPMENT LEAD
TO ECONOMIC
GROWTH?
Table of contents:
1.0 Introduction
2.0 Literature Review

2.1 Financial systems and economic growth

2.2 Impact of financial developments on economic growth in
developed and developing countries
2.3 Factors influencing financial sector development on economic
growth
3.0 Conclusion

Submitted to:
Mr S Hurrymun
Prepared by:
Nadia Nosheen Nunkoo (1420106)
DFA6240 Financial Institutions and Markets
MBA FINANCIAL SERVICES (YR 1 SEM 2)

1.0 INTRODUCTION

Long-term sustainable economic growth depends on the ability to raise the rates of accumulation
of physical and human capital, to use the resulting productive assets more efficiently, and to
ensure the access of the whole population to these assets.

Financial development is usually defined as a process that marks improvement in quantity,

quality, and efficiency of financial intermediary services. This process involves the interaction of
many activities and financial institutions which possibly is associated with economic growth.

Financial development thus involves the establishment and expansion of institutions, instruments
and markets that support this investment and growth process. Historically the role of banks and
non-bank financial intermediaries ranging from pension funds to stock markets, has been to
translate household savings into enterprise investment, monitor investments and allocate funds,
and to price and spread risk. Yet financial intermediation has strong externalities in this context,
which are generally positive but can also be negative in the systemic financial crises which are
endemic to market systems.

The costs of acquiring information and making transactions create incentives for the emergence
of financial markets and institutions.
Research has found that there is an established link between the development of a countrys
financial sector and the level and rate of economic growth. Essentially, it has been discovered
that the functions of the financial sector provide spatial design of economic growth rates (Curley
and Shaw, 1955; Patrick, 1966). For instance, Goldsmiths (1969) study establishes a significant
theoretical framework that indicates average rates of economic growth tend to be accompanied
by faster financial developments.

2.0 LITERATURE REVIEW

According to McKinnon (1973) liberalisation of financial markets allows financial deepening

which reflects an increasing use of financial intermediation by savers and investors and the
monetisation of the economy, and allows efficient flow of resources among people and
institutions over time. This encourages savings and reduces constraint on capital accumulation
and improves allocative efficiency of investment by transferring capital from less productive to
more productive sectors.

The efficiency as well as the level of investment is thus expected to rise with the financial
development that liberalisation promotes. These benefits include a decrease in firms in selfinvestment at low and even negative rates of return, allocation of credit by capital markets rather
than by public authorities and commercial banks, a shift away from capital-intensive investments
due to the higher cost of capital reflecting its scarcity, the lengthening of financial maturities, and
the elimination of fragmented and inefficient curb markets (Balassa, 1993). Development of the
financial system facilitates portfolio diversification for savers reducing risk, and offers more
choices to investors increasing returns. Another important function of financial system is to
collect and process information on investment projects in a cost effective manner, which reduces
cost of investment for individual investors (King & Levine, 1993b). The productive capacity of
the economy is determined by the quality as well as by the quantity of investment and capacity
utilisation is as important as the installed capacity.

2.1. Financial systems and economic growth

In fact, financial systems serve five broad functions:

1. They produce information ex ante about possible investments.
2. They mobilise and pool savings and allocate capital.
3. They monitor investments and exert corporate governance after providing finance.
4. They facilitate the trading, diversification and management of risk.
5. They ease the exchange of goods and services.

While all financial systems provide these financial functions, and each of these functions can be
expected to have an impact on economic growth, there are large differences in how well they are
provided. There are three basic characteristics of financial systems 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.

The level of financial intermediation

The size of a financial system relative to an economy is important for each of the functions listed
above. A larger financial system allows the exploitation of economies of scale, as there are
significant fixed costs in the operation of financial intermediaries. As more individuals join
financial intermediaries, the latter can produce better information with positive implications for
growth, a channel emphasised in some of the earlier theoretical models of the finance growth
literature (e.g. Greenwood & Jovanovic, 1990: Bencivenga & Smith (1991). A larger financial
system can also ease credit constraints: the greater the ability of firms to borrow, the more likely
that profitable investment opportunities will not be by-passed because of credit rationing.

A large financial system should also be more effective at allocating capital and monitoring the
use of funds as there are significant economies of scale in this function. Greater availability of
financing can also increase the resilience of the economy to external shocks, helping to smooth
consumption and investment patterns. More generally, a financial system plays an important
function in transforming and reallocating risk in an economy. Besides cross-sectional risk
diversification, a larger financial system may improve risk sharing (Allen & Gale, 1997). By
expanding a financial system to more individuals there will be a better allocation of risks, which
can in turn boost investment activity in both physical and human capital, leading to higher
growth rates.

The efficiency of financial intermediation

The channels linking the size of the financial system and growth effectively assume a high
quality of financial intermediation. The efficiency of financial systems, however, cannot be taken
for granted, especially as information gathering is one of their key functions. Asymmetric
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information, externalities in financial markets (Stiglitz & Weiss, 1992) and imperfect
competition can lead to sub-optimal levels of financing and investment, an inefficient allocation
of capital, or have other undesirable consequences such as bank runs, fraud or illiquidity which
are detrimental for economic growth. Some of these market imperfections may be best addressed
through appropriate oversight by a public body but the legal and institutional background
(including competition policy) may also foster the efficiency of financial markets and hence
contribute to economic growth.

The composition of financial intermediation

This affects the efficiency with which firms allocate resources is through its impact on corporate
governance. There is however no theoretical models that assess the role of markets as opposed to
banks in boosting steady-state growth through their impact on corporate governance. Indeed,
starting with Berle & Means in 1932 many researchers have observed the limited corporate
governance capability afforded by markets, which leads to managerial discretion or which can
distort corporate decisions (Shleifer & Vishny, 1997).

It is a strong argument that a well-built financial sector exerts a strong impact on economic
growth, and financial sector development accelerates economic growth. Since the financial
sector serves one primary function, to ameliorate transaction and information costs, and to
facilitate the allocation of resources and lower credit constraints, this encourages economic
growth. If, for example, the government in a country arranges and encourages development of
the financial sector this may more easily influence economic growth. The financial sector can
develop by making it easier to establish financial institutions, for example to allow foreign actors
to enter and establish financial institutions. Thus, this will be a form of financial sector reform
which implements the privatisation and restructuring of banks and an increased entrance of new
domestic and foreign participants to the financial sector. There are several advantages and
positive externalities of such a liberalisation of the financial system:
A well-developed financial sector can be seen as well-offered financial services, which
may offer more competition, with all the positive externalities increased competition.
More competition tends to be more efficient and offers advantages such as lower prices,
higher quality services and higher productivity (Eschenbach and Francois, 2002). When

foreign banks are permitted in the domestic market, interest rates and bank taxes can be
lowered and credit constraints decreased, which opens the market for several actors.
An increased financial services sector can result in higher employment, and thereby have
a positive growth influence. As well as more openness and predictability, it offers higher
stability, and it is easier to forecast and plan the future.

In fact, financial development affects economic growth through two main channels namely:
Capital accumulation
On capital accumulation, one class of growth models uses either capital externalities or
capital goods produced using constant returns to scale but without the use of nonreproducible factors to generate steady-state per capita growth (Paul Romer 1986; Lucas
1988; Sergio Rebelo 1991). In these models, the functions performed by the financial
system affect steady-state growth by influencing the rate of capital formation. The
financial system affects capital accumulation either by altering the savings rate or by
reallocating savings among different capital producing technologies.
Technological innovation
On technological innovation, a second class of growth models focuses on the invention of
new production processes and goods (Romer 1990; Gene Grossman and Elhanan
Helpman 1991; and Philippe, Aghion and Peter Howitt 1992). In these models, the
functions performed by the financial system affect steady-state growth by altering the rate
of technological innovation.

2.2 Impact of financial developments on economic growth in developed and developing

countries

Following the work of Fisher (1933) and Gurley and Shaw (1955) continued the study of the
relationship between financial markets and rates of economic growth. They tend to show that the
difference between developed and developing countries is that the financial sector is accorded
greater status in developed countries than is the case in developing countries. Gurley and Shaw
found that financial markets contribute to economic development by enhancing physical capital
accumulation. The findings were also supported by the research of Friedman and Schwartz
(1969). Prior to the 1970s research into the relationship between financial markets and real
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growth rates suffered due to the lack of evidential studies. This remained the case until
Goldsmith (1969), McKinnon (1973) and Shaw (1973) found that the development of financial
markets have been significantly correlated with the rate of economic growth. Goldsmith (1969)
argued that as real income and wealth increase, then this, in turn, will lead to the size of financial
markets growing as well.

Theoretical models have identified a number of channels through which financial integration can
promote economic growth, especially in developing countries. A large part of the theoretical
literature shows that financial intermediaries can reduce the costs of requiring information about
firms and managers, and lower the costs of conducting transactions (see Levine, 1997).
Greenwood and Jovanovic (1990) and Levine (1991) have constructed models where efficient
financial markets improve the quality of investments to increase the average return and thus
accelerate economic growth. Greenwood and Jovanovic have developed a model in which
financial intermediation allows agents to diversify risk across a spectrum of risky capital
investment. By providing more accurate information about production technologies and exerting
corporate control, better financial intermediaries can enhance resource allocation and accelerate
growth. The financial intermediaries prime task is therefore to channel funds to the most
profitable investments with the help of collected and analyzed information.

Meier (1991) suggests that regardless of the developing level of an economy, there will be a need
for financial institutions, allowing savings to be invested conveniently and safely, and ensuring
that the savings are channeled into the most useful purposes. The poorer a country is, the greater
the need is for agencies to collect and invest the savings of the broad mass of people and
institutions within its borders. Such agencies will permit small amounts of savings to be handled
and invested efficiently, as well as allowing the owners of savings to retain liquidity individually,
while long-term investment is financed collectively.

2.3 Factors influencing financial sector development on economic growth

There are other variables that are likely to influence the effects of financial sector development
on economic growth:

 Secondary school enrolment

This is a measure of human capital investment. Secondary education completes the
provision of basic education that began at primary level. Growth theory suggests a
positive relationship between education and economic growth (Barro, 1991). Human
capital investment is the framework for lifelong learning and human development, by
offering more subject or skill oriented instruction, using more specialized teachers. A
more skilled population can make a foundation for economic growth, since higher
educational standards can promote technological innovation. Nelson and Phelps (1966)
argue that education increases the ability of individuals to deal with rapid changes in
knowledge, and the improvement in technology is a channel to growth. Secondary school
enrolment can therefore be used as a control variable for economic growth. A growth in
the financial sector raises demands for skilled labour. Thus growth may be delayed by a
low educational level.
Inflation rate
Earlier research has found the inflation rate can be detrimental to long run economic
growth. Even though there is no consistent relationship between the level of output and
inflation, there are indications of a connection between high inflation rates and low
economic growth rates. High inflation is associated with uncertainty and thereby low
investment, low savings and thus low GDP per capita growth. It is useful to include the
inflation rate as a control variable, as the financial coefficient might have a lower
influence on economic growth if the inflation effect is not separately measured in the
regressions.
High government consumption
This can reduce and increase economic growth in various ways, as it includes expenditure
for the purchase of goods and services. It may crowd out private investment and
inflationary pressures due to monetary financing of fiscal deficits. However, we assume
the effect of government consumption to be positive since it can increase domestic
demand and improve investments. Thus, without separately including government
consumption, financial indicators may incorporate this effect and exert a higher influence
on economic growth.
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3.0 CONCLUSION
The above study investigates empirically the relationship of independent correlation between
financial market development and economic growth. In respect of the empirical work, this paper
addresses the gap in this field by providing an empirical analysis of the effect of financial market
development on economic growth rate in emerging markets by proposing a endogenous growth
model that suggests that financial market development may influence economic growth rate vis a
vis improving capital accumulation, increasing productivity of capital investment and facilitation
of capital mobilisation. From the data and analysis available, we can therefore conclude that a
relationship exists between financial development and economic growth.

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5. McKinnon, R.I. (1973), Money and Capital in Economic Development, Washington DC: The
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6. Meier, G. M. (1991), Leading Issues in Economic Development, 4th edition, Oxford: Oxford
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