Macroeconomic convergence, financial development and economic growth - Dissertation Example

?Macroeconomic convergence, economic growth and financial development Table of Contents Macroeconomic convergence, economic growth and financial development 1 Table of Contents 2 Introduction 3 Macroeconomic convergence and economic growth 4 Convergence and growth for EU countries 6 Economic growth and financial development 8 Financial development and economic growth in Turkey 12 Conclusion 13 References 14 Introduction Convergence is a process in which the per capita incomes of the poorer economies tend to grow as fast as that of the richer economies. The process results in the all the economies per capita incomes to converge eventually. The potential of the developing countries to grow faster is more than that of the developed countries as the developing countries have diminishing returns to factors. Convergence can be of two types, the process of poorer economies catching up with the richer economies is referred as alpha convergence whereas beta convergence is the process in which a country converges to its own steady state rate of growth (Alfaro et al.2005). As pointed out by professor Jeffrey Sachs ,many countries due to its closed economic policies cannot converge, this could however be overcome if the free trade policies are included which will lead to openness of the economy. Between the years 1970-1989, 111 countries have been studied on the basis of their rate of convergence. It was found by Andrew Warner and Sachs that the countries following closed economic policies had a growth rate of 2% whereas the countries following open economic policies have a growth rate of 4.5 % (Alfaro et al.2005) There are many countries that have converged with the developed countries such as the Asian tigers, HongKong, Singapore, Taiwan, and South Korea. As sited by many economists the endogenous rather than the exogenous factors triggers the growth of an economy (Alfaro et al.2005). Convergence depends on various factors such the speed of capital formation, population growth and the presence of efficient economic policies as well as appropriate financial institutions. The rate of convergence highly depends on the initial condition of the economy as well the growth potential of the economy. Along with this the accumulation of human and physical capital are important as it significantly influences the savings and rate of investment (Halmai & Vasary.2009.p.3).Technological spread, change in growth rate and total productivity of the factors are the major players in enhancing the rate of convergence. Macroeconomic convergence and economic growth Integration of the national and regional economies with the global economy is one of the salient features over the history. Two models of economic integration which relates to income convergence are firstly growth models and secondly trade models (Kim.1997.p.4). According to the neoclassical Solow model of growth, the regional level of income varies due to the different capital labour ratios. Whereas the Hecksher Ohlin trade model says that the income varies across the regions due to the difference in the factor prices and factor endowments (Kim.1997.p.5). Income convergence occurs due to trades in goods and economic integration via equalisation in prices. Factor endowments vary across the regions and therefore various regions specialise in different industries. Thus if the regional variation in the factor endowments increases then there arises divergence in the income levels as the structure of industries diversifies. Conversely as there exits similarity in the factor endowments then the income level also converges in the due course. Economic integration also gives rise to income divergence (Kim.1997.p.5) The growth models put forward by Romer and Lucas, which are based on increasing returns on physical capital, states the chances of such income divergence. Even the trade models by Krugman states that income divergence may arise due to the differences in the industrial structures. If the industries equipped with high technology and high wages are subjected to external economy then the trade transactions will cause all high wage and high technology industries to concentrate in specified regions. Such a concentration will then lead to income differences as the left over industries will be equipped with low technology and low wages (Kim.1997.p.5) .Between the periods of 19th century and the 20th century the US emerged into an integrated economy from pool of regional economies. Economic integration also provided an impetus to the industrial development in the US regions (Kim.1840-1987.p.6). In a paper presented by Harold Codrington, it’s been stated that the Caribbean economies in order to fasten their pace of economic growth have been in the process of integrating their economies. The criteria of a single market and currency union were announced to enhance the process of convergence. Although the establishment of a single market has been successful but the currency union is still elusive (Cordrington.2008.p.1). For the Caribbean economies the differences in the economic performance helped in pushing the speed of economic convergence. Thus in 1991 the Caribbean countries moved for convergence in the exchange rate, holdings of foreign exchange and external debt services. These economies had also agreed upon on certain targets for convergence which included firstly Exchange rate criteria secondly Import covers criteria, thirdly Fiscal criteria, fourthly Inflation criteria and finally Debt service criteria (Cordringinton.2008.p.3) After the establishment of the monetary union in 1992 the pace of economic convergence has been disappointing for the Caribbean economies for a variety of reasons. As coefficient of variation has been used as a proxy for the countries convergence performance, it shows that convergence occurred in relation to each variable but at different time points. This measure that has been used does not say much about the countries convergence. So re-examining the convergence criteria is required for the Caribbean economies (Cordrington.2008.p.15). Convergence and growth for EU countries After the inclusion of ten States in the European Union in 2004, the nominal GDP increased by 5% and GDP measured at PPP increased by 9%.Although this figure is less than the EU -15 countries as compared o the EU- 10 countries. Although in the beginning of the transformation process the growth rates of the EU-10 countries were slow but soon they have been catching up with the EU-15 countries. However the rates of convergence in the Baltic States, Solvenia and Hungary have been more dynamic. According to the theory of convergence the GDP convergence occurs faster for the countries having initial low level of income. Over the years the new included states have shown a growth rate of 3.5% in contrast to the growth rate of older nations growth rates which is just 1%.Increase in the factor productivity and capital formation have been assigned to be the driving force for the economic growth in the EU-10 countries (Halmai.2009.p.1-2). This dynamic growth rate is consistent with the theory of convergence and in the future it is expected to grow even more. In the EU-10 countries the labour market is characterised by a high rate of structural unemployment and a low rate of unemployment. Despite these irregularities in the labour market the growth rate in the EU-10 countries did not fall due to the positive effect of the capital formation. Based on 2001-2005 figures, the growth potential of the EU-10 countries is more than that of the EU-15 countries except for Malta. It is thus estimated that if the rate of growth of the EU-10 countries increases at such a pace then the real GDP of the EU-10 nations will catch up with that of EU-15 countries in duration of 35 years (Halmai.2009.p.5). However it is seen that growth potential of the EU-15 countries have been declining and this questions the fundamentals of real convergence. One major reason for such a downfall in the rate of growth is the very little opportunity for employment. Secondly the growth rate of labour productivity has also fallen in contrast to US while it has risen in contrast to the region’s main competitors. Thirdly with respect to capital deepening too EU-15 is lagging behind. Lastly the fall in the labour productivity was accompanied by a fall in the total factor productivity. This fall in the total factor productivity leads to a fall in the investment and thus technological progress. Therefore changes in the total factor productivity are important for convergence and economic growth. Since 1990 the increase in the total factor productivity has only increased by 0.8% yearly for the EU-15 countries. Thus based on these criteria it can be said that the growth prospects for the EU countries are not forthcoming. (Halmai.2009.p.6-7) With an increasing market integration the inter regional differences disappear .This is nearly a universal proposition. Although for the developed economies there are many evidences that support this but for the developing countries the scenario is relatively inconclusive. Boumal found no evidence for a productivity convergence on taking a sample of developing countries for the years 1870-1986.These results are also consistent with the latest findings on the convergence for the developing nations. Developing countries often follow the Lewis model type development process .This process often leads to a short run fluctuation in the investments between commercialised capitalist sector and the traditional agricultural sector. It is attributed to the co existence of the non market and market institutions (Anderson & Edgerton.2011.p.3). Paper presented by Stephen Dobson, John Goddard and Carlyn Ramlogan, sheds light on the process of convergence for the developing nations. It used the unit root tests to evaluate the process of convergence for a huge sample of developing nations. The per capita real GDP has been used for the purpose of study covering the period’s 1960-1995.On the basis of this study Africa showed the slowest growth and lowest per capita GDP in contrast to Asia/Pacific which showed the highest growth (Dobson et.al.2003.p.23). The literature on productivity and income convergences suggest that the developing countries have benefitted less due to being backward. In the last 40 years very few developing nations could join the so called converging club. This failure of the poor nations to catch up with the wealthier nations has recently gained the attention of many economists. As a result many growth models have been developed by various economists that could explain such a result (Lipsey & Zejan.1992.p.3). Economic growth and financial development There have been many literatures in the recent times which showed the importance of having sound financial system leads to economic growth. For those countries that are associated with financial deepening, an integration of financial system with that of the world economy may turn beneficial. Most of the studies have been done from the perspective of an open economy. Here it is important to know that having a well developed financial market helps in building an integrated international financial market. At the same time financial reforms that take place in the developing countries helps them to create a capital account which would lead the domestic financial markets to be more competitive as well as integrated with world (Gregorio.1999.p.3). Economic growth basically occurs from two processes either increases in the amount of factors of production or an increase in the level of efficiency in the manner in which they are used. An increase in the investment and its efficiency induces growth. For a closed economy savings equals the investment and due to this savings is regarded to trigger the pace of growth. Investment efficiency not only includes the growth in overall factor productivity but also includes other factors apart from human capital that fosters the pace of growth. Financial developments have twin effects on the rate of economic growth (Gregorio.1999.p.3). Firstly the improvement of domestic financial market enhances the efficiency for capital accumulation and on the other hand investment and savings rate increases through financial intermediation. Goldsmith was the person who first analysed the importance of the development of a domestic financial market in increasing the efficiency of capital accumulation. He also posited the positive relation between per capita real GNP and financial development. He further argued that the growth process has a link with the financial market through incentive effects which leads to further financial development. McKinnon and Shaw had extended the previous argument of Goldsmith and stated that financial deepening not only implies higher capital productivity but also leads to high rate of savings and investment. Unlike Goldsmith, the focus of McKinnon and Shaw was on the effects of the public policies on investment and savings (Gregorio.1999.p.3).They argued that the policies which lead to financial repression, reduces the incentive to save. Lower savings rate results in a lower rate of investment and hence low level of growth. However the empirical validation of the research made by McKinnon and Shaw has been questioned by many economists. Diaz Alejandro argued that the experiences by the Latin American countries showed that savings rate did not increase due to financial deepening. So he concluded that rise in the marginal capital productivity is the driving force for which growth occurs for financial deepening. In a model presented by Greenwood and Jovanovie, both growth and financial intermediation have been considered endogenous. They showed that there is a two way relationship between growth as well as financial development. On one side growth increases the participation in the financial markets and thus facilitates the expansion and creation of financial institutions (Gregorio.1999.p.4). On other side as the financial institutions collect and analyse various information from different potential investors, helps them to undertake investment projects more efficiently which further results in investment and hence growth. In the framework presented by Bencivenga and Smith, financial integration leads to growth via channelling the savings into the activity which has higher productivity. At the same time the individuals are allowed to reduce their risk which is associated with the liquidity needs. One interesting result posited by Bencivenga and Smith, is that the growth increased even when the savings rate reduced due to the financial development (Gregorio.1999.p.4).The reason for such an interesting result is the dominance of the financial development on the investment efficiency. Levine (1992) in his model stressed on the fact that financial institutions raises total savings that is devoted to investment and thus avoids premature capital liquidation. Banks, mutual funds, investment banks and stock markets increases growth by promoting efficient allocation of investment through several channels (Gregorio.1999.p.5). On the other hand Roubini and Salai Martin emphasised the role of government policies in analysing the relation between growth as well as financial integration. In a model developed by them, they used financial repression as a tool by the government to broaden the base for inflation tax. They showed that in order to retrieve high revenue from inflation tax, policymakers repress the financial system via imposing high income tax. Thus growth is hampered as the financial repression reduces capital productivity and lowers savings rate (Gregorio.1999.p.5). As per Demetriades and Hussein there exists a direct causation running from economic growth and leading to financial development. This is however due to taking the ratios of banks deposit liabilities to the nominal GDP and ratio of banks claim on private sector to the nominal GDP.Darrat also suggested that there exists a positive relation between economic growth and financial development by using currency ratio, ratio of currency to M1 and ratio of M2 to the GNP, as the indicators for financial development (Ince.2011.p.8). Jappelli and Pagalo analysed the effectiveness of the developments of financial markets on the rate of savings. Their study was concentrated on the impact of borrowing constraint. Here there has been a shift on the focus of effectiveness of financial market on production side to that on the household. A conclusion that is drawn from this study is that the partial or full inability of the individual to borrow against future income causes them to increase savings. Therefore the study reveals that financial deepening on the consumer credit side will not increase savings. The result is also consistent with the observation sited in Latin America where financial liberalisation did not lead to increased rate of savings. On the other hand De Gregorio showed that relaxing the borrowing constraint increases the incentive for human capital accumulations. This will increase the marginal productivity of capital and cause higher rate of growth despite low savings (Gregorio.1999.p.5) In a paper presented by Michael Graff, he posed the question that whether financial development leads to economic growth. Causal relation between economic growth and financial development is still not well understood. There are many literatures that deal with this question and are grouped into four categories (Graff.2001.p.3) Firstly it is seen that economic growth and financial activity are not causally related. In this respect what is observed is that the relation between the two is spurious. The economy grows and so does the financial sector but according to its own logic. Secondly it is stated that economic growth leads to financial development, thus financial development is demand driven. Thirdly financial development is viewed to be the factor causing economic growth. In the recent models that were developed emphasise on the fact that a well developed banking system, a properly functioning monetary system and capital markets is important for economic growth. Fourthly, according to some scholars, financial activity is occasionally viewed as an instrument for economic growth. Here financial system is viewed to be inherently unstable (Graff.2011.p.4) However there is no simple procedure that would determine the empirical validation of the above mentioned views since the instruments that lead to economic growth include many other instruments apart from financial development. In the empirical test conducted by Graff it was found that financial development indeed lead to economic growth in the 1980’s, but the causation mainly ran from financial development to real development with very little evidence on mutual causation and no evidence for the reverse causation. Even after dividing the countries into developed as well as less developed it was sited that the relation between financial development and economic growth is unstable. Although the relation between financial development and output increase is stable for the economies that have experienced a long period of boom, the scenario is different for not for the less developed economies (Graff.2001.p.16). Financial development and economic growth in Turkey Turkey being one of the developing countries has been facing financial liberalisation in order to achieve economic growth. In order to pursue growth the economy has to be stable which is impossible in the light of financial crisis in Turkey due to capital immobility. Therefore the researches showed that the causation between economic growth and financial development is difficult. Despite been stricken by crisis twice, Turkey has applied a series of policies and programmes to restructure its financial system. These reforms had a positive impact on its economic growth. However after the empirical analysis done by using the VAR technique it was found that in the short run development in the financial sector leads to economic growth but it is not a long run phenomenon. The reason for such a result is the heavy inflation rate and the unstable policies prevailing there. So it is required that the private as well the commercial banks be revaluated in Turkey (Ince.2011.p.17). Conclusion So it can be said that although there is a relation between macroeconomic convergence, economic growth and financial development, but it varies considerably between the cross section of countries. The potential of the developing countries to grow faster is more than that of the developed countries as the developing countries have diminishing returns to factors. Various economists have put forward various models and theories to explain the causation between economic growth, convergence and financial development. Although there is a difference in the approaches followed by the economists but each one tied the three parameters i.e. convergence, growth and financial development to reach to the conclusion that financial institutions, economic policies and initial conditions of an economy plays an important role in the development of a country. References Kim, S. 1997. “Economic integration and convergence: US regions, 1840-1987” [Pdf]. 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National bureau of economic research, working paper series 4132.Available at: http://www.nber.org/papers/w4132.pdf?new_window=1 [Accessed: August 25, 2011] Gregorio, J.1999. “Financial integration, financial development and economic growth” [Pdf]. Available at: http://www.econ.uchile.cl/uploads/publicacion/c6b5fc4b-498f-462e-9453-2ae0325e0b2f.pdf [Accessed: August 25, 2011] Graff, M & Karmann, A.2001. “Does financial activity cause economic growth?”[Pdf]. Available at: http://econstor.eu/bitstream/10419/48121/1/328043052.pdf [Accessed: August 26, 2011] Ince, M.2011. “Financial liberalisation, financial development and economic growth: An empirical analysis for Turkey” [Pdf]. Available at: http://mpra.ub.uni-muenchen.de/31978/1/MPRA_paper_31978.pdf [Accessed: August 26, 2011] Halmai, P & Vasary, V.2009. “Economic growth and convergence in the European union” [Pdf]. Available at: http://www.utgjiu.ro/revista/ec/pdf/2009-01/12_HALMAI_PETER.pdf [Accessed: August 25, 2011]. Alfaro, L et al.2005. “Why doesn’t capital flow from rich to poor countries? An empirical investigation” [Pdf]. Available at: http://www.people.hbs.edu/lalfaro/lucas.pdf [Accessed: August 25, 2011] Read More