Importance of the Financial Sector - Research Paper Example

Main contributions which financial institutions can make to the achievement of economic growth and poverty reduction in developing countries Table of Contents Introduction: Importance of the financial sector 1 Role of financial institutions in stimulating economic growth 2 Conclusion 8 Reference 9 Atkin, M. (1989) Agricultural commodity markets: a guide to futures trading. London: Routledge. 9 Cottrell, P. L. (1980) Industrial finance, 1830-1914: the finance and organization of English. London: Methuen & Co. 9 Ghosh, B. N. (2001) Global financial crises and reforms: cases and caveats. London: Routledge. 9 Kayizzi-Mugerwa, S (1999). The African economy: policy, institutions and the future. London: Routledge. 9 Robinson, M. S. (2002) The microfinance revolution: Lessons from Indonesia (Vol. 2). Washington D. C.: World Bank Publications. 9 Skartlos, K. (2004) ‘Microfinance and Women’s Economic Empowerment: Bridging the Gap, Redesigning the Future’, WISCONSIN Coordinating Council of Nicaragua, Working Paper No. 1. Available at http://www.unity.edu/facultypages/aphillippi/Nicaragua/EconomicEmpowerment.pdf (Accessed: January 8, 2010) 9 Bibliography 10 Atkinson, A.B. (ed) (2004). New Sources of Development Finance. Oxford: Oxford University Press 10 Thirlwall, A. P. (2006). Growth and Development (8th ed). Basingstoke: Palgrave Macmillan. 10 Todaro, M.P. & Smith, S.C. (2008). Economic Development (10th ed). Harlow: Addison Wesley Pearson 10 Introduction: Importance of the financial sector Financial sector comprises of the most vital segment among all contributors in an economy’s future growth mechanism. In fact, the domestic financial sector is one of the most suitable of all mediums that the national government utilises to implement its growth stimulating policies. This is mainly because the financial institutions deal with money matters which forms the main ground of distinction between the low and the high income earning nations. Instances from reality would also reveal the truth about the active role of financial institutions in eradicating the curse of poverty and eventually triggering economic growth into many less developed nations. Bangladesh could be cited as a commendable example where microfinance operations initiated by the domestic financial institutions under the patronage of Nobel laureate Muhammad Yunus, facilitated the advancement of loans at subsidised rates in the rural economy. Microfinance activities gained a high popularity among the Asian economies and the concept was readily adopted by many neighbouring nations to deal with poverty. Moreover, the financial institutions can also regulate the characteristics of savings in a nation so as to promote future investment activities, as well as attract international investors through adopting unique monetary policies (Cottrell, 1980). The present paper deals with the ways through which the local financial institutions can contribute in abolishing poverty and stimulating economic growth into the nations. The study involves illustrations from real life so that the reader can figure out the paper’s reliability. Role of financial institutions in stimulating economic growth There had been many intensive studies and researches conducted to invent the diversified roles of the financial institutions in tackling with the problem poverty in less developed nations. After the potentials of the financial institutions have been discovered, they had been assigned responsible roles in promoting growth triggering measures and have been found to be quite successful in the field. Some of the ways through which the vices of developing nations could be dealt with have been discussed as follows. 1. Inviting Foreign Direct Investment Observations by eminent economists have revealed the fact that policy measures adopted by the local financial institutions can significantly help in promoting the entry of foreign direct investment into the nation. FDI implies the foreign exchange resources entering the national boundaries from outside to assist productive activities. Unless the local financial institutions are robust enough, the foreign entrepreneurs decline from investing in a particular nation, since the financial stability of the host nation is by large ensured by the sturdiness of the domestic financial sector which again assures the future of a foreign company in domestic soil. There are many instances of such developmental activities elicited by a stable financial sector in a number of developing economies, especially those belonging to Asia and Latin America. Growth of the textile export industries in Bangladesh were prompted by investment activities of Daewoo, a South-Korean conglomerate, in 1979. However, this joint collaboration between Daewoo and Bangladeshi garment factories would not have been a success had it not been for the ease in acquiring loans to set up factories, from the indigenous financial institutions. Today, the textile exports contribute a huge proportion to the current account position of the nation and this development shows from a consistent increase in the export figures of the nation – the nation had recorded a 96.4% rise in its textile garment export figures from 2005 to 2006. The huge exports that resulted due to significant contributions by the national financial companies had a considerable backward linkage, since their establishment were followed by the entry of a large number of other multinational groups into the nation and gradually helped the nation to overcome its destitution. The Bangladeshi example was repeated in the cases of Latin American nations of Costa Rica and India as well. Similar to the proceedings in Bangladesh, Suzuki entered into a joint venture with the government of India and assisted in the production of small sized cars in the nation. The good side of this transformation was noticed within a decade of this change as large numbers of firms were found to enter into the scene as subsidiary industries of Suzuki. This change however was possible only due to assistance forwarded by the Indian financial houses. On the other hand, the production of local software was triggered in Costa Rica following the entry of ‘Intel Associates’ into the local market in 1996. All the above three cases focus upon the fact that even though the entry of FDI on a large-scale basis was followed by the investment of one big conglomerate in the host nation, the latter would not have invested in the first place had the host nation not possessed a sturdy financial sector (Alfaro, Chanda, Kalemli-Ozcan & Sayek, 2003). The graph below shows the contribution of the financial sector in promoting real estate activities in the nations of USA and UK. It is found that higher the financial intermediation activities went in these nations, the higher went the activities in the real estate sector in the nation, implying a growth in economic activities in the economies.1 Figure 1: Association between financial intermediation and real estate activities (representative of economic activities) in USA and UK. Source: USA: Department of Commerce, Bureau of Economic Analysis; UK: Office of National Statistics, National Statistics Online 2. Resource Mobilisation Financial sector of any nation plays a vital role in mobilising the domestic resources from one segment to another one. For instance, unless there are considerable efforts from the indigenous financial institutions, the appropriate movement of funds cannot be assured and this is a very important aspect to ensure economic growth in developing economies; in fact, the domestic government often pins upon the efforts of the national financial sector to pass on its aid to various needy segments of the society. When the nationals deposit their money with the commercial banks of a nation, it always forms the responsibility of an ideal financial institution to forward them to facilitate investment activities in the nation, instead of keeping them idle in the individual accounts. This is the reason why in macroeconomics it is often said that the higher that the savings propensity in a nation is, the greater will be the future investment potentials of the economy. In fact, in Japan, high savings propensities among the nationals had proved as a contributing factor behind the fast economic growth of the nation. A similar measure is being adopted in a large portion of the rural economy in Africa too (Kayizzi-Mugerwa, 1999). Sometimes, in developing nations it is often noticed that the government chooses the domestic financial sector to regulate the flow of resources to the weaker sectors of the economy and thus promote their developmental process. In India, for instance, the Reserve Bank of India had consistently adopted monetary policies throughout the economy’s planning period, in compliance with the government’s efforts to eradicate poverty and inequality from the rural belt of the nation. The financial sector has assisted in providing agricultural loans at subsidised rates so as to promote irrigation facilities and Green Revolution in the agrarian economy. These financial contributions by the national banks of the nation has helped in improving the nation’s agricultural position and reduced its dependability on other economies for the provision of necessary commodities such as food items. In other words, a persistent effort on part of the financial sector of the nation has helped in making the economy self-sufficient by a large extent. In addition to the contributions to the lagging agrarian society, the financial institutions in a number of developing nations helped to support the small-scale enterprises which contribute considerably in creating employment opportunities in the developing nations and thus eradicating the problem of poverty from such societies. 3. Stimulate Economic Activities The financial sectors in almost all nations around the world are responsible for the adoption of certain monetary policies that help in triggering financial activities of the respective nation and thus help to bounce the nation back into a path of financial stability, thus assisting in economic growth. For instance, it is the duty of the financial sector of a nation to enable price discovery, especially in the context of developing nations or for the weaker segments of the economy. Consider the case of Ghana, the world’s largest producer and exporter of cocoa and which also happens to be one of the largest contributors in the national income. If in a particular year, there is very low demand coming from USA, the largest importer of cocoa in the world, then the farmers of Ghana would have to sell off their products at very poor prices and thus will have marginal surpluses, not enough to prop the next crop. In such situations, it is the financial institutions that come up to their rescue. If the farmers had already hedged themselves against such potential risks, then they will relatively be at a stable position, since they can easily claim the money that they had decided to accept against their yield. This step can be adopted even when there is a probability of crop failure. However, the pessimistic side of the situation is that, if the yield is found to contradict the previous views of the farmers, they would be at a position to lose their money, previously paid as a premium. In developing nations, however, where the farmers and agricultural labours find it very difficult to make both ends meet, it takes quite an effort to convince them to adopt such a step in the first place (Atkin, 1989). 4. Microfinance Revolution Microfinance operations are one of the most essential of all activities popularised recently in 1990s, which is why the topic has been dealt with in a separate section, despite the fact that it is more in line with resource mobilisation activities. Microfinance is a modern concept where the rural economy is allowed to take loans at subsidised rate jointly. The origin of the concept could be traced back to the Indonesian government’s efforts to facilitate the uplift of the nationals belonging to the low income group (Robinson, 2002). Next the example was followed in Bangladesh for the empowerment of the rural women population. In Bangladesh, the women were not allowed to take loans unless they were supported by their husbands, which the latter rarely did given the conservative views of the Islamic patriarchal society. This discrimination resulted to discouraging entrepreneurial activities of the women and thus formed as a barrier in their liberalisation. It was then that the financial institutions of the nation came forward to their help and granted them loans not only at subsidised rates but also did not require the consent of their husbands. Thus this measure proved to be a step towards eradicating poverty and thus, promoting economic activities, with all the credit assigned to the local financial institutions. A similar example was cited in case of Nicaragua where the microfinance institution is widespread throughout the economy. It was mainly promoted by the Sandinsta government that took over the administration in 1979, and aimed at eradicating the curse of poverty from the rural sector of the economy. A preliminary step towards achieving this target was to nationalise all the private financial institutions and holdings, so that they could be regulated as per the motives of the government. This proves the important role that the national financial institutions can play in ensuring economic growth within the national sphere, which is why the government thought it necessary to tackle the activities of the domestic financial institutions as a preliminary step (Skartlos, 2004). 5. Dealing with financial crisis Despite the fact that corrective steps of financial crisis are not directly involved with the eradication of poverty in a nation, it is however linked with shoving back the nation in the path of economic growth. During financially critical phases, it is the domestic financial institutions which are entrusted with the responsibility to implement and impose certain regulations on the financial activities of the economy through monetary policy measures. In the recent global financial crisis period, it was only due to the activities of the financial institutions of the affected nations, that they were found to bounce back into expansionary economic activities. The extent of monetary policies can range from regulating the market interest rate to that of open market operations of the banks. The main idea is to restrict the financial activities of the nationals and regulate them so as to correct the crisis. The global meltdown was a consequence of unpredictable changes in the market rate of interest that led to a severe global recession. However, this recession was again managed through lowering the rate of interest in the nation and thus, the financial activities of the afflicted regions were revived. A similar corrective measure was followed when the Asian financial crisis took over the region and gradually spread to the rest of the world. Hence, from time to time it is found that the national financial institutions play a vital role in correcting financially critical phases globally (Ghosh, 2001). Conclusion The domestic financial institutions form an integral part of an economy. Their role is especially noticeable in cases of developing nations, where the institutions play the role of not only regulating the financial activities in the nation like in the high-income nations, but are also involved in a large amount of developmental activities. Some of the noteworthy operations that the institutions perform have been discussed in the previous section. However, there is no reason to assume that the discussion is purely theoretical in nature, since there are good examples where it is found that the national financial institutions have promoted growth activities in their respective economies. Especially mentionable are examples from Asia, where the role of the domestic financial institutions is perhaps the highest contributing factor behind the fast development that the region has attained within a short span of time. Reference Alfaro, L., Chanda, A., Kalemli-Ozcan, S. & Sayek, S. (February, 2003) ‘FDI and Economic Growth: The Role of Local Financial Markets’. Available at http://www.people.hbs.edu/lalfaro/JIEfinal1.pdf (Accessed: January 8, 2010) Atkin, M. (1989) Agricultural commodity markets: a guide to futures trading. London: Routledge. Cottrell, P. L. (1980) Industrial finance, 1830-1914: the finance and organization of English. London: Methuen & Co. Ghosh, B. N. (2001) Global financial crises and reforms: cases and caveats. London: Routledge. Kayizzi-Mugerwa, S (1999). The African economy: policy, institutions and the future. London: Routledge. Robinson, M. S. (2002) The microfinance revolution: Lessons from Indonesia (Vol. 2). Washington D. C.: World Bank Publications. Skartlos, K. (2004) ‘Microfinance and Women’s Economic Empowerment: Bridging the Gap, Redesigning the Future’, WISCONSIN Coordinating Council of Nicaragua, Working Paper No. 1. Available at http://www.unity.edu/facultypages/aphillippi/Nicaragua/EconomicEmpowerment.pdf (Accessed: January 8, 2010) Bibliography Atkinson, A.B. (ed) (2004). New Sources of Development Finance. Oxford: Oxford University Press Thirlwall, A. P. (2006). Growth and Development (8th ed). Basingstoke: Palgrave Macmillan. Todaro, M.P. & Smith, S.C. (2008). Economic Development (10th ed). Harlow: Addison Wesley Pearson Read More