This chapter will review the literature based on theoretical and empirical review which has been made on the impact of the financial sector development on economic growth. First, the review will be made on economic growth and then it will be followed by the …….
Economic growth is the long-term expansion of an economy's productive potential. It refers to the rise in the ability of an economy to produce goods and services, that is, a rise in its productive capacity, recorded as a percentage on a period to period basis (Kuznets 1968). It should be noted that economic growth does not only include the aforementioned but also takes into account the improvement in the quality of life, level of literacy of the population and the technological advancement of that particular economy, thus leading to a better social welfare, which is a one of the main aims of government (Clayton and Radcliffe 1996).
Economic growth is usually measured taking the increase/decrease in the real Gross domestic product (GDP) between 2 consecutive years. The real GDP is taken because it accounts for the inflation prevailing in the economy at that time. However, it is better to use real GDP per head, also known as per capita GDP of the economy as the latter is not only inflation adjusted but it also reflects the population differences between economies.
It has been a matter of concern for many economists to identify the different factors which cause different countries to evolve differently in relation to economic growth. It is mainly seen that most East Asian countries have achieved very rapid rates of economic growth joining the rich countries whereas in the Sub Saharan Africa, a relatively low percentage of growth is usually recorded.
Cherery (1986) states that despite the fact that neoclassical economic theory plays a major role in economic analysis, economists with another school of thought, namely, the development economists are denying its approval for the purpose of developing countries as the latter is believed to predict stable growth irrespective of the policy decisions. Recently, though, there has been the development of new economic growth models which deals with issues such as trade policy, the operation of financial markets, taxation and government expenditure, namely the Neoclassical Growth Model, also known as, Solow-Swan growth model. This has been developed following the Harrod-Domar growth model, where there was the presence of steady-state growth. It is only after the above that Robert M. Solow (1956), Nobel prize winner in economics and Trevor Swan (1956) rejected Harrod-Domar growth model's deduction. According to them, the capital-output ratio was a variable which should not be treated as exogenous but rather should be used as an adjusting variable to lead an economy back to its steady-state growth path. According to their model, capital stock (quantity of machine and equipment), total employment (in terms of hours or number of employees) and technology (which is assumed to be free) were included to analyse the long run economic growth.
Taking a look now at the determinants of economic growth, it has been shown that apart from labour force growth, in order to record an economic growth, the presence of low inflation, open trade policies, research and development spillovers, economies of scale, together with both physical and human capital is necessary. On top of that, it is also imperative to adapt to the technological changes which have the role of increasing efficiency (see http://www.reservebank.gov.fj/docs/wp2001-04.pdf, pg 3).
It was also found in African countries that compared to capital accumulation which amounted to approximately 64.5% of growth, productivity approximately did only 4.5% (Montiel 1999) and this was supported by Jorgensen (2005) who, while doing his research concluded that physical capital accumulation did not account for long run economic growth.
There are many other factors which affect economic growth which can be broken down to culture, government power to intervene, the extent of competition, geographical position of the economy and other macroeconomic factors. Brenner (1998) worked on the question of whether changes in corporate strategies, government policies or financial innovation can be used as the ladder to reach economic growth. This paper will take into consideration the role that the financial sector has in boosting the level of economic growth.
FINANCIAL SECTOR DEVELOPMENT
Having seen the literatures on Economic growth, now, before having a look at the finance-growth nexus, the financial sector will be reviewed. It will consist of the main functions of the financial sector and how the latter's development benefits the society.
A financial sector is one which provides services which includes a vast range of money managing organisations to retail and commercial customers. These organisations include credit unions, banking institutions, credit card companies, insurance companies, consumer finance companies, stock brokerages, investment funds and some government sponsored enterprises, money markets, real estate, commodity and stock market exchanges.
The financial sector is the interaction of markets within a regulatory framework. It is a relationship which consists of lending and borrowing. It is the financial intermediaries which take the responsibility of achieving these functions. The 'lenders' will consist of categories of individuals such as households, firms, governments and savers while that of 'borrowers' will consist of again households, firms, governments, mortgagers, and so on.
In order for an economy to be financially smooth and proper, it is good for the latter to be having the following features:
A functioning banking system with an effective central bank
Efficient public finance and public debt management
Stable money through low inflation and stable exchange rates
Securities markets improving access of finance capital to governments and firms
Organisations which issue securities (stocks, bonds, etc.) to pool capital
Creane et al. (2003) further stated that a modern and efficient financial system involves improvements in mobilising savings, in promoting investment by screening business to end up financing only businesses with good future prospects, in monitoring firm by looking at managers' performance, in enabling hedging, trading and risk diversification and in easing the exchange of the commodities. These aforementioned will be further discussed later in this paper.
According to modern growth theory, there are two ways that have been identified related to the question of 'how the financial sector might affect the long run growth of an economy'. Firstly, it is through the impact of the financial sector on both human and physical capital accumulation. And secondly, it is through its impact on the rate of technological improvement in the economy.
Levine (1997) has found out five functions of financial intermediaries which give rise to the effects mentioned above, namely savings mobilization, risk management, acquiring information about investment opportunities, monitoring borrowers and exerting corporate control and facilitating the exchange of goods and services.
The Policy Division of the Department for International Development described its approach to stimulate growth in one of its article published on the … (http://www.ruralfinance.org/fileadmin/templates/rflc/documents/1143190906272_DFID_finsecworkingpaper.pdf) as having the following framework.
To build up strong investment incentives which will have the effect of increasing productivity
To encourage trade and business amalgamations to facilitate the transfer of technology and to improve the resources available that are being used.
To give access to the population to assets and markets to reduce poverty and also to increase the returns on those assets.
To reduce the risk element and allowing the poor also to participate in the evolvement of the financial sector to promote growth.
The financial sector helps to achieve the above as follows:
1. By mobilising savings for productive investment, and by facilitating capital inflows and remittances from abroad, the financial sector has a crucial role to play in stimulating investment in both physical and human capital, and hence increasing productivity.
2. By reducing transactions costs, facilitating inward investment, and making capital available for investment in better technologies, the financial sector can promote technological progress, thus increasing productivity, and improving resource use.
3. By enabling the poor to draw down accumulated savings and / or borrow to invest in income-enhancing assets (including human assets e.g. through health and education) and start micro-enterprises, wider access to financial services generates employment, increases incomes and reduces poverty.
4. By enabling the poor to save in a secure place, the provision of bank accounts (or other savings facilities) and insurance allows the poor to establish a buffer against shocks, thus reducing vulnerability and minimising the need for other coping strategies such as asset sales that may damage long-term income prospects.
It should be noted that the development of the financial sector may be reached in different ways, namely:
When the efficiency and competitiveness of the sector improves
When the range of financial services that are available increases
When the diversity of institutions which operate in the financial sector increases;
When the amount of money that passes through the financial sector increases
When the regulation and stability of the financial sector improves
When more of the population may gain access to financial services
These functions and ways of encountering economic growth by an economy will be used for further analysis in this paper.
GETTING INFORMATION ABOUT INVESTMENT AND ALLOCATION OF CAPITAL
CONTROLLING FIRMS AND ENSURING CORPORATE CONTROL
MANAGEMENT OF RISK AND DEVERSIFICATION
MOBILISING SAVINGS
Savings mobilization is also a very significant function of the financial sector. This facility allows households to store their money benefiting from the security element that these institutions provide. Not only household benefit from the pooling of savings, firms who need capital may then borrow this money to use it in a more productive manner. It is the costly process that involves taking money from individual savers, pooling them together and finally distributing them to lenders. During that process, the parties involved must make sure that they are overcoming the transaction costs of collecting savings from so many individuals and also that they are overcoming the information asymmetries related to inducing savers to part with their money (to become less liquid). This is mainly done by banks and other financial institutions and therefore leads to capital accumulation investment by the process of credit creation.
It is the faith that people have in the financial system that induces them to save their money into the financial sector. If the latter was not reliable, fair or secure, people would prefer to save in terms of physical assets such as jewelry or plot of lands or even store their money at home itself, and this would negatively affect economic growth. It should also be noted that the returns on investors may be a side-benefit to the savers in terms of higher return that they in turn will expect to get.
McKinnon (1973) explained through his studies that, by mobilising savings which in turn increases the level of credit available to lend, the acquiring and even the development of better technologies may be undertaken by borrowers. This process facilitates investment in an economy and thus contributes positively towards the overall productivity of the country.
It was further stated by De Gregorio (1996) that the credit available may be used to finance the investment in health or education which, here, improves the accumulation of human capital.
Jalilian & Kirkpatrick (2001) propounded that allowing the access of the financial services to the poor, through savings facilities, will further increase the country's growth as it reduces risks of the poor, thus implying that poverty reduction will have a direct positive effect on the economic growth of a country.
Levine (2005) found that the management of risks, the acquiring of information and the monitoring borrowers also adds to the mobilisation of savings as they make the risks attached with savings fade and on top of that, they also allow for an increase in the expected return of savings. These will be discussed further later in this paper.
To summarise, the pooling of savings will have an important effect on the economic growth of a country in terms of increased investment, increased productivity and increased human capital that the latter will be producing.
FACILITATE EXCHANGE OF GOODS AND SERVICES
FINANCE-GROWTH NEXUS
STRUCTURE OF FINANCIAL SECTOR AND GROWTH
LEGAL FACTORS
POLITICAL FACTORS
INFLATION
TRADE
