Economic and Financial Growth - Literature review Example

Finance and Accounting Introduction The relation between economic and financial growth is very controversial (Cavenaile, Gengenbachy and Palmz, ; for understanding this relation the government policies should facilitate economic development. It is observed that there are many theoretical debates, which have tried to figure out the effect of banks and stock markets on growth of economy (Mauro, 1995). The following essay is prepared to establish the relation by highlighting the opinion of different authors. In this context the economic growth of different countries are compared. In the past, the economists focused on role of banks towards the development of economy. Schumpeter (1912 cited in Levine and Zervos (1996) and Bagehot (1873 cited in Cavenaile, Gengenbachy and Palmz, 2011) had stated that banking system was capable of spurring innovation and future growth by funding and identifying productive investments. However economist such as Lucas (1988) was of the opinion that the banks had responded passively for the economic growth. Levine (1991) had identified that level of financial innovation was a perfect predictor for long-run rates of the growth of economy, improvement of productivity and accumulation of capital. Apart from the contrasting opinion of different authors on the role of banking system, there is also an extensive study related to establishment of the relation between long run growth and stock market. Bencivenga et al (1993) had derived different models for examining the liquidity of the stock market. They had stated that stock markets are less expensive for trading equities when the liquidity is high. It reduces disincentives for investing in the long run projects as the investors are able to sell off their stake in projects even before its completion (Holmstrom and Tirole, 1993). Hence, it can be stated that the enhanced liquidity has the capability to facilitate investment in the long run in case of higher valued projects. Therefore, the essay at examining whether stock market and banking system indicators are correlated with future economic growth rates. However, findings had suggested that they bear independent empirical relation with long run growth economic growth rate (Holmstrom and Tirole, 1993). Theoretical evidence and literature Banking industry plays a significant role in Australian economy by providing a wide range of financial instruments and services to the general public at a global level (Harper, 2011). It is the main contributor for improving the Gross Domestic Product (GDP) of a country. As for example, the insurance and finance industry contributes to the Australian industry to a great extent. The industry have accounted for 11.1% of the total economic activity of the country during 2010 (Harper, 2011). As banking industry is the largest contributor in the economy, it provides the Australian government with high tax revenue (Harper, 2011). In Australia, the banks also contribute to the economic development by investing in Information Technology (IT). It also helps in increasing employment level in the country; during 2010, about 216000 employees were recruited in the banking industry, which accounts for about 2% of the total labour force in the country. With the rise in employment level, the spending power of the individual has increased; these have resulted in improvement in the standard of living (Levine, Loayza and Thorsten, 2000). During the 19th century, the economists had identified that the banks had played an excellent role in mobilizing the savings of the individuals. Moreover, with the increase in demand for financial products also lead to the development of financial sector to a great extent (Bencivenga and Smith, 1991). With the increase in demand for the products the government is forced to allow the banks to innovate more and meet the requirements of the market. This also results in adaptation of advanced technology, which will increase the productivity of bank employees. Moreover, economic growth has increased investor confidence as they have the scope of earning higher profit on their investments. It also provides opportunity for increasing environmental sustainability and efficiency (Bencivenga and Smith, 1991). McKinnon (1973 cited in Ekmekçioğlu, 2012) had stated that liberalization of the financial markets have allowed introduction of the financial products and service in the rural areas of the world. People living in rural areas are devoid of benefits that are present in the social cycle. Hence, if they are provided with financial tools, which have the ability to raise their standard of living, it is regarded as a major step towards the development of the economy (Ekmekçioğlu, 2012). The development in the financial services has lead to the improvement of the life style of the individuals. It has also assisted in diversifying the risks of investing in any risky financial instrument. This also encourages the producers and consumers to invest in the financial products and services so as to achieve higher returns (Ekmekçioğlu, 2012). The financial performance index of the following countries can be compared in order to portray their differences in economic growth. Figure 1: Financial Performance Index (Source: Ekmekçioğlu, 2012) The table provided above highlights that the performance of Brazil is stable because of its currency system. In Brazil, the non-banking financial services have remained robust for many years. However, it is observed that the financial sector in Brazil experiences low liberalization and the financial access is one of the most important advantages of the economy (Ekmekçioğlu, 2012). The economic performance of China is strong, which is encouraged by its financial condition. Comparatively, the economic performance of India is dependent on the non-financial services. It is well known that the financial access in this country is weak but the strong financial intermediation have generated robust outcomes and its growth is stimulated by foreign exchange (Ekmekçioğlu, 2012). On the contrary, stock markets also play controversial role in development of an economy. It is often regarded as casinos in the developing countries and thus it has negligible positive impact on the economic growth (Bencivenga and Smith, 1991). Nevertheless, recent researches have provided evidence regarding the fact that stock market has the ability to boost economic development. The global stock market is booming as the investors are venturing into the new world of investment where they can era considerable amount of return. The extraordinary growth is observed in the stock market developing countries but whether the economy is benefitted from the market is a big question (Bencivenga and Smith, 1991). The stock markets are affected by economic activities through development of liquidity. Evidences have proved that greater liquidity in the stock market boosts the economic growth. Smith (1994 cited in Obstfeld, 1994) had explained that international risk sharing in the integrated stock market helps in inducing shift in the portfolio from a low return safe investment to risk high return investments. The risk and liquidity models have affected the saving rates in the international capital markets. Higher return and improved risk sharing force the savings rate to fall in such a manner that the growth is slowed down by increasing liquidity and integrate the international financial markets (Obstfeld, 1994). Four ways for financial development are described henceforth, which helps in economic growth. According to Boyd and Prescott (1986) had exclaimed that the financial intermediaries have the ability to lower cost the expense attached with processing and collecting information; hence it helps in improving the allocation of financial resources. This information boosts the economic growth to a great extent. Moreover, the banks have the capability to stimulate technological innovation through selection of appropriate entrepreneurs, who have the chance to launch a successful business (King and Levine, 1993). According to Bencivenga and Smith (1993), the banks have the desire to improve the corporate governance status by decreasing the monitoring cost; it helped them to reduce credit rationing that stimulates growth. Similarly, both banks and stock markets provide a good platform for pooling, trading and diversifying risks. Hence, the financial system, which permits the agents to own diversified portfolio comprising of risky projects, will stimulate the society to earn higher returns; this have positive influence on the economic growth of the country (Gurley, and Shaw, 1955; King and Levine, 1993). The main differences between the role played by banks and stock market in improving the economic condition are discussed with the help of theoretical debates. The debates takes into account cross-country research that are executed by renowned researchers on the growth and extension of the analysis made by King and Levine (1993), on banking system and stock markets. The authors had stated that liquidity in the stock market is measured by the volume of stock trading to the size of market and value of the trading comparative to its size of economy (Devereux and Smith, 1994; King and Levine, 1993). It is observed that both are significantly and positively correlated with future and current economic growth rate, growth in productivity and accumulation of capital. Liquidity in stock market is a good indicator of per capita growth in GDP, initial investment, fiscal policy, political stability and the movement in stock prices (Asli and Levine, 1996). On the other hand, the development in banking system is measured with the help of bank loans that are provided to the private financial institutions divided by the gross domestic product. There is an insignificant correlation between volatility and growth; however, the size of the stock market is not related with the capital accumulation and improvement in productivity (Stanley, 1993). There is positive and strong relation between liquidity of stock market and economic growth rate. According to Bencivenga et al. (1993) the integrated capital markets possess influence on the savings and growth rate of the economy negatively; higher liquidity often retards the growth in productivity. According to Stanley (1993), the returns in the stock market do not hinder resource allocation and investment by the investors. He also depicted the fact that banks offer many services as compared to the stock markets. Hence, the banking industry in a country helps in promoting growth as compared to the stock market, where the entire activity is dependent on the share price movement (Asli and Levine, 1996; Devereux and Smith, 1994; King and Levine, 1993). Levine and Renelt (1992) had identified that the previous researches had failed to establish any significant relation between macroeconomic indicator and growth, which are influenced by small changes. According to Devereux and Smith (1994) had identified that the efficient banking system and stock market around the world grows faster when the individual companies performs well. In countries, where the operation of companies is dependent on debt and borrowing from banks, the economy experience developed banking system. This companies helps in bringing revenue to the economy as a result the banks promotes economic development. Hence, the banking system helps in generating finance for new ventures and existing businesses. On the other hand, the stock markets can affect the investors negatively. If a particular company does not perform well, the returns on stock investments are affected negatively; hence the stock market performance declines. This incident has severe influence on the economic growth as the investors and the government loses significant amount of money (Demirguc-Kunt and Maksimovic, 1996; Levine and Renelt, 1992; Devereux and Smith, 1994; King and Levine, 1993). Levine and Zeros (1996) has examined that there is strong association between economic growth and the stock market. In order to prove the relation, Demirguc-Kunt and Maksimovic (1996), employed conglomerate measures like integrated world market, size of the stock market and liquidity. In the research, GDP growth rate was regressed by different variables, which aims at controlling the political stability, economic and macroeconomic condition. The result indicated that there is a strong correlation between the overall performances of the stock market with that of economic growth (Asli and Levine, 1996). However, countries, which have well structured and operated banks tends to grow faster than the underdeveloped banks. In order to examine the relation between stock market, banks and economic growth, 38 samples were chosen by Demirguc-Kunt and Maksimovic (1996) and divided in different groups. The groups are as follows: 1) Group 1: Greater liquidity in stock market, which is gauged with the help of value-traded-to-GDP 2) Group 2: Liquid stock markets and less developed banking system 3) Group 3: Less developed stock market but developed banking system 4) Group 4: Illiquid stock market and less developed banking system (Demirguc-Kunt and Maksimovic, 1996). The result highlighted the fact that the countries, which have liquid stock market and developed banking system grew faster as compared to the countries that had underdeveloped banks and illiquid stock markets. Moreover, higher liquidity in stock market is linked with faster economic growth irrespective of the banking development. On the contrary, well developed banking system depicts higher growth irrespective of progress in stock market. Hence, both are seen to contribute towards the development of the economy independently (Holmstrom and Tirole, 1993). Despite a proper discussion regarding the relation between the three factors such as economic growth, banks and stock markets, the main reason for independent affected has remained unknown. The stock markets aim at offering opportunities for trading the risk that are associated with each investments made by the investors (Holmstrom and Tirole, 1993). Conversely, the banks concentrate on achieving long run relationships with the companies as they try to gather information regarding the different projects and their managers, thereby increasing greater corporate control. Nevertheless, there are few overlaps such as both of them helps in diversifying risk and gather information of the investors (Bencivenga and Smith, 1993). The investors are very interested in gathering information regarding the financial performance of companies as they want to earn profit by investing in high valued stocks. The stock markets also targets to improve the corporate governance of the companies through simplification of takeovers; this provides incentives for improving the managerial competence (Demirguc-Kunt and Maksimovic, 1996). According to Holmstrom and Tirole (1993) liquid equity markets renders higher investments. Apart from equity shares, the retained earnings are also viewed as an efficient source of finance for the investment purpose. However, the liquid stock markets in the developing markets are connected with the rise in capital, which is acquired with the help of bank loan and bonds. This increases the debt-equity ratio of the stock market (Arestis, Demetriades and Luintel, 2001). Apart from the above mentioned debates, the relation between the three factors can be discussed with the help of further statistical analysis. The evidences provide that the relation suffers from the econometric weakness. Arestis, Demetriades and Luintel, (2001) had employed quarterly data of five different countries’ economic growth and then time series is applied in order to establish a particular relation. The result indicated the fact that both the stock market and banking sector had contributed towards economic growth; but the influence of banking sector is more effective than the stock market (Boyd and Prescott, 1986; Arestis, Demetriades and Luintel, 2001). Few examples are cited in depicting the relation between stock market, banks and economic growth. In Nigeria, the stock market has shown illiquidity due to low average turnover ratio of shares that are trade; nevertheless the illiquid stock market has failed to hinder the growth of the economy. In Nigeria, the banking sector has provided strong support to the economy along with other sectors. The stock market of Nigeria is ruled by few companies; therefore its contribution towards the development of the economy is smaller as compared to the banking sector (Arestis, Demetriades and Luintel, 2001; Bencivenga and Smith, 1991). It can be stated that banking sectors have contributed more than the stock markets to an economy. The main reason behind this view is that the stock markets are affected by the macroeconomic factors which have the ability to decrease the returns on the stocks. Moreover, the company stocks are also influenced by the financial performance of the same. The financial performance is associated with the revenue of the company that is generated from the sale of products or services. Conclusion The essay clearly depicted that there is a significant impact of stock market and banks on economic growth of a country. Both have independent relation with economic growth rate; however, it is observed that the banking sector has greater influence on the economic growth rate as compared to stock markets. This is due to the fact that the stock markets are subject to fluctuations, which rise from the different macroeconomic factors. These factors have the ability to decrease the returns of the stocks thus affecting the interest of the investors to a great extent. Hence, it can be concluded that though both of them influence the economic growth to a large extent, however, the banking sectors have succeeded in playing the most important role. Reference List Arestis, P., Demetriades, P. and Luintel, K., 2001. Financial Development and Economic Growth: The Role of Stock Markets. Journal of Money, Credit, and Banking, 33, pp. 16-41. Asli, D. and Levine, R., 1996. Stock Market, Corporate Finance and Economic Growth: An Overview. The World Bank Review, 10(2), pp. 223-239. Bencivenga, V. and Smith, B., 1991. 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