Financial development and economic growth

The relationship between finance and economic growth has been the subject of
increasing attention over recent years. Financial development often affects the
economic growth of a country. There have been numerous explanations
regarding differences in the growth for different countries. Here financial
development can be regarded as establishment and expansion of institutions,
instruments and market. As explained by FitzGerald (2006) “Financial
intermediation supports this investment process by mobilizing household and
foreign savings for investment by firms; ensuring that these funds are allocated to
the most productive use”. This explains that financial development is a key factor
for economic growth.

The theoretical relationship between financial development and economic

growth can be traced in the work of McKinnon (1973) where he talked about the
efficient flow of resources by using financial intermediation. King and Levine
(1993) talked about positive linking between financial development and
economic growth. FitzGerald (2006) also discussed some relevant issues related
to it. These are amongst many others who have written on this particular topic.
This paper will provide a selective overview of literature on financial
development and economic growth, with an aim of understanding difference in
viewpoint.

As explained by Gupta (1984) different economic schools have divided people

with different theoretical approaches on this particular topic into three different
sections. These different sections are the structuralists, the repressionist and
endogenous growth supporters. First of all talking about financial structuralists
viewpoint according to which wide spread network of financial institutions with
a range of financial instruments will have positive impact on the saving and
investment process, which in turn leads to economic growth. In other words
building up of financial institutions and their wide range of services happens in
advance and demand for these services follows. Demand for these institutions
and services can be created by entrepreneurs or in growing sectors. This group
can include the study of Patrick (1966) and Berthelemy & Varoudakis, (1998).

Secondly, talking about the financial repressionist which was mainly lead by
‘McKinnon-Shaw” (1973); “says that financial liberalization in the form of an
appropriate rate of return on real cash balances is a vehicle of promoting
economic growth”. In other words they also explains that if there is lower rate of
return will depress savings. This will lead to less availability of funds, which in
turn can lower the economic growth rate. Their proposition to this that interest
rate ceiling and direct credit programs create depressing effect on economic
growth.

Thirdly, endogenous growth supporters which includes ideas of king (1993) and
Levine (1997) expresses that financial development have a positive relation with
economic growth. They have stated that financial development has a prediction
power for future growth. This was found in the cross-country study done by
them, which included four measures of financial development. One of the
measures is that liabilities of bank and non-bank institutions are a share of GDP.
“The second is the ratio of bank credit to the sum of bank and central bank credit,
which measures the degree to which banks versus the central bank allocate
credit” (Khan and Senhadji, 2000). The third is ratio between domestic credit
and private credit. The last is ratio of GDP as private credit.

Some studies have taken a narrow approach while explaining relationship

between financial development and economic growth. This can be seen in the
work of Rajan and Zingales (1996), which concentrate on industry-level growth
performance across countries and financial development. Another example of
this can be observed in Jayaratne and strahan (1996) were they showed the
when “in the U.S. individual state relax interstate branching restrictions, bank
lending quality increased significantly leading to higher growth”. (Khan and
Senhadji, 2000: 6)
In a recent empirical study by Saci et al (2009) in which data was taken for 30
developing countries for the period of 1988-2001 regarding the GDP and credit
by banks. The study found that variable domestic credit by all the financial
institution as part of GDP had a negative coefficient with stock market value. In
this case it can be said that stock market have a positive relation.

Another study which was done by FitzGerald (2006) showed a different picture.
Table 1 below precisely summarizes the focal point of the argument presented
here. The basic conclusion, which can be taken from this table, is that the higher
the level of financial depth (that is, ratios of total financial assets to GDP) is
linked with greater levels of productivity.

Table 1: “Financial Development by Income group, Worldwide, 1990s” (asset

capitalization as percent of GDP)

FitzGerald (2006) concluded in his study on the said topic by giving four major
points. First of all he concluded that financial development has a significant on
economic growth, but it all depends on the fitting institutional structure. In other
words one can say that existence of positive relationship between development
and growth but there is high amount of dependence on the kind of structure of
financial market.

Secondly FitzGerald (2006) also said that financial liberalization leads to more
efficient and liquid financial intermediation, but it may not increase the rates of
domestic savings or investment as a whole. Moreover, he focused that “the
effective gains from the standard model of financial liberalization in terms of
investment allocation and corporate governance can be outweighed by new of
instability from short-term foreign capital flows.” FitzGerald (2006: 26). In other
words it can be said that short-term foreign capital can affect the standard model
of liberalization. Lastly he made a point that not always standard measures of
financial development and growth are not linked with higher rates of economic
growth.

Now let us focus on the empirical evidence of financial development and

economic growth. King and Levine (1993) retreat in 1960-1989 in orders to
avoid endogeneity of contemporary variable for some certain reasons. It can also
be seen that when modern correlation of financial depth and growth is
accounted for future predictive power the model fails completely. (Arestis and
panicos, 1997).

In the figures below King and Levine (1993) measures financial development in
the U.K and Mexico over the long period of time.

Table 2: King & Levine measure of financial depth applied to the UK over the long
run.
Table 3: King & Levine measure of financial depth applied to Mexico over the
long run.

This can be a perfect example for understanding the topic because U.K being a
developed country in opposition to Mexico. King and Levine (1993) say’s that
there was a definite increase in 1980’s, which signifies high amount of financial
development. Now they make a question that was UK really becoming less
developed between 1950 and 1980. Now comparing this with Mexico where it
shows relatively less difference over the long run despite huge changes in
Mexico’s financial system; while the short-run shifts are clearly related to shifts
in monetary view related to different shocks. Therefore, it can be said that cross-
section studies including Mexico can be confusing, as the certain choice of base
year will clearly affect the results considerably. Indeed, if we take this measure
literally, Mexico had the same financial depth.

It can be observed that starting from early 1970s, the relationship between
financial development and economic growth has been widely studied in two
stages. Before 1990s, a number of researchers such as McKinnon (1973)
Goldsmith (1969), and Shaw (1973), among many others, produced considerable
evidence that financial development correlates with growth. However, it can be
found that their work can be treated as found to lack critical support. After this
exploration was started on the base of endogenous growth model (Ren, 2006).

There are several growth models, which take into account financial market and
financial functions. Some of these functions often reduce frictions within the
market, which in turn affects growth. A perfect example of this can be the work
of Aghion and Howitt (1992) where they created a developed a model in which
growth is affected by financial system by changing the rate of technological
innovation.

One more concept related to this topic is supply driven economic growth. In this
type of growth financial development happens when there is a supply. In
different words one can say that at times financial structure has to be made in
advance to the demand of it. This is required to support new emerging
entrepreneurs and growing sectors. This what is called as supply driven financial
development that leads to economic growth.

To conclude, this paper analyzed the selective literature available on the said
topic, which is financial development and economic growth. The aim of this
selective literature review was to understand the difference in viewpoint. This
paper also presented some empirical evidence.

Recently, studies have shown a trend to follow endogenous growth theory to

show the relationship between financial development and growth. The main
idea, which comes out to, is that financial development improves the working of
capital distribution, which in terms of endogenous model leads to higher
sustainable growth.

There are still certain points that are being discussed in relation to this topic.
One of the issues is; how to measure the financial depth. The second point that is
being discussed is causality between financial development and economic
growth. Lastly as said by Khan and senhadji (2000) the point of discussion is
which system is better for growth is it financial based or market-based.

The result of this paper accepts the fact that there is a highly strong and positive
relation between financial development and economic growth in the cross-
section analysis. Looking at the theories, which have been done earlier one, can
say that the effect is significantly powerful, but the nature of the effect
differentiates from different financial indicators. Now an important question
arise that time variation can actually justify and give reasoning for differences in
growth rate. At last this paper aggress with the point made by Levine (2005)
made that “Theory and empirical evidence make it difficult to conclude that the
financial system merely- and automatically- responds to economic activity, or that
financial development is an inconsequential addendum to the process of economic
growth”. A great amount study has been done on the said topic but there is still
lot more to explore.
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