Financial Development and Industrial Growth in China - Literature review Example

?Financial Development and Industrial Growth: an empirical investigation of the manufacturing sector in China Table of contents Financial Developmentand Industrial Growth: an empirical investigation of the manufacturing sector in China 1 Introduction 3 Role played by manufacturing industry for economic growth of a nation 3 How has manufacturing sector played an important role in growth and development of an emerging nation 5 Industrial development and economic growth: Case of China 10 Conclusion 11 References 13 Bibliography 14 Introduction Over a period of time, economists have claimed that financial institutions have an important role to play in the industrial development of a country. The development process enhances due to the allocation of resources that speed up the productive process. In such a scenario, the well developed financial institutions become crucial for the efficient resource allocation, as against the shocks in the growth opportunities .Walter Bagehot and John Hicks had argued that the financial development in England had played a critical role in its industrialisation process by facilitating capital mobilisation. On the other hand, John Robinson states that finance flows automatically where finance leads. This view emphasises on the fact that demand for financial arrangements arises in accordance to the economic development of a country. However, there are a series of pioneering economists who are sceptical about the importance of financial development in the industrial growth of a country (Livine, 1997). Despite these conflicting views, there exists a striking relation between the financial development and industrial growth, taking into account China’s manufacturing sector. Role played by manufacturing industry for economic growth of a nation The growth rate of manufacturing sectors plays an important role in the economic development of a nation and depicts its economic potential. The manufacturing sector has been the engine of growth since the 18th century. However, recently the service sectors accounts for 70% of GDP in the advanced economies. Particularly in India the ITC services have become an important source of growth. Although the US economy has been badly hit by the recent global meltdown, its manufacturing sector still remains one of the most vital sectors .The manufacturing sectors, helped in creating 14 million jobs in the nation in the year 2007, causing 10.1% of the total employment. Manufacturing sector in US is responsible for generating $1.6 trillion as GDP in the year 2006 .Hence it contributes a major portion of economic production. Manufacturing sector is the dynamic sector of the economy as it is responsible for 60% of spending in research and development in 2003.This strong association between research and development as well as manufacturing, throws light on the fact that the manufacturing sector is vital for maintaining an innovating economy. Manufactured goods are an important source, which creates demand in other sectors, ranging from natural resources to energy and to construction of factories as well as software and engineering firms. Manufacturing sector in Taiwan had experienced a strong growth since the 1950’s; specially the chemical, steel and the shipbuilding industries have helped in raising its GDP growth rate. For the emerging economies, it has been seen that there exists a strong correlation between the income levels and industrialisation. As compared to the agricultural sector, the productivity in the manufacturing sector is more. The shift of resources to the manufacturing industries from the agricultural sectors results in structural shift. From 1950 to 2005, the Asian economies as well as the Latin American economies have seen such a radical shift. Manufacturing industries also provide opportunities for economies of scale as well as technological progress. The spill over effect and the linkage effect is more in the manufacturing industries than in the agricultural sectors. With the rise of income, share of expenditure in the manufacturing sectors increased (Szirmai, 2001). The manufacturing industries, such as the chemical industry, pharmaceutical industry, electronic, biotechnology, energy industry, food and beverages and process engineering, have resulted in the rapid development of an economy and helped in creating jobs that are highly capital intensive. Therefore, the quality of labour is also highly skilled. As a result, the wages are more in the manufacturing sector as compared to the other sectors of the economy. However, the manufacturing sector is important in addressing national challenges, such as reducing the emission of green house gases and maintaining the nation’s resilience on imported energy1. In India, the manufacturing sector is one of the important sectors propelling economic growth. Manufacturing sector in India, grew at the rate of 10.6% in 1994-1998 as compared to the growth rate of 4.9% in 2002-2003.The growth in these periods, were mainly due to growth in both registered as well as unregistered sectors of the industry (Scott, 2001). How has manufacturing sector played an important role in growth and development of an emerging nation The manufacturing sector is fundamentally responsible for the economic growth of a nation. Manufacturing industry consists of activities that are not included in the primary as well as in the service and construction activities. As the manufacturing sector has the unique feature of creating technological capacity, so it is the most investment oriented sector. The foundation for this lays on the fact that there is a causal relation between technology and manufacturing sector. Evidences from countries such as Russia, West and East Asia suggest that output growth of an economy is correlated to the manufacturing sector. Analysing over a long period of time, it has also been proved that the manufacturing sector is the most production intensive sector of an emerging economy. As technology is the fundamental factor triggering growth in the manufacturing sector .So it is evitable, that the sector which is related to the technological up gradation is the most productive sector (Sabbillion, 2008). Over a long period of time, economists have been discussing on the causes behind manufacturing industry and economic growth. However, the interest in the topic revived when Lucas and Romer came up with the “new growth models”. As compared to the neoclassical approach followed by Solow and Swan, the growth models put more stress on the increasing returns to scale. Nicholas Kaldor was the first one who had considered the importance of increasing returns for the economic growth. In Kaldors paper, the case of Latin America had been taken for the purpose of analysis. The paper basically tests Koldar’s first and second growth laws. The first law states, that the manufacturing industry is the key to a nations development whereas the second law states, that there exists a positive relation between the labour productivity and output in the manufacturing sector which is derived from the dynamic and static increasing sale of returns (Fisman & Love, 2001). What has been sited from this paper is that the relation between industrial growth and GDP growth occurs due to the effect of the manufacturing on the various productivity levels of the economy. These effects are because of the labour been transferred from the low to the high productivity industrial sectors and due to the presence of the dynamic and static returns to scale on the economies. So for the Latin American country, the manufacturing industries are indeed the engine that propels growth. The presence of increasing returns to scale in manufacturing sectors, enhance the possibility of growth cycles in the economy, depending on industrial activities (Libanio, 2001).After the structural transformation of the Indian service sector, there has been a tremendous growth which accounts for 50% of the total GDP. Without the support, from the manufacturing sector the knowledge based sector cannot develop. With the abolition of various quantitative restrictions, the competitive edge of the Indian industries has improved. Over 70% of the trade is done with the manufacturing industries. This sector has grown at the rate of 8.9% since 2004-2005 and is therefore regarded as the engine of growth. Despite its high growth rate, the Indian manufacturing industry is not as competitive as compared to the industries in the other nations. This is because of the existence of a large number of unregistered firms across the spectrum. The registered sectors are also tilted towards the low scale industries. This fragmentation has leaded the Indian industrial sectors to be detrimental for growth (Technology status and prospects, 2010) .How financial development contributed towards macroeconomic growth. The degree of openness of an economy and the level of financial development are among the few macro economic variables which result in economic growth. Kletzer and Bardhan cited that countries having a highly developed financial sector are privileged in having industries that are heavily reliable on the external finance. The association between financial development and growth in manufacturing industries is important for various reasons. Most importantly, the level of trade balance is not affected by the financial development .This proves that improvement in the financial sector is necessary for the economic development of a nation (Lipsey & Zijan, 1992).There have been many literatures in the recent times which showed the importance of having sound financial system leads to economic growth. For the countries that are associated with financial deepening, an integration of the financial system with the world economy may turn beneficial. Much study has 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 the world. Economic growth occurs from two processes, either increase in the amount of factors of production or an increase in its level of efficiency. An increase in the investment and its efficiency induce growth. For, a closed economy savings equals the investment. 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). 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. 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. On the other side, as the financial institutions collect and analyse information from different potential investors, it helps them to undertake investment projects more efficiently, which further results in investment and 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, individuals are allowed to reduce risk associated with liquidity needs. One interesting result posited by Bencivenga and Smith, is that, growth increased even when the savings rate reduced due to financial development .The reason for such an interesting result is the dominance of the financial development over the investment efficiency. 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 used 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 a high income tax. Thus, growth is hampered as the financial repression reduces capital productivity and lowers the savings rate .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. 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 & Karmann, 2001). 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 are important for economic growth. Fourthly, according to some scholars, financial activity is occasionally viewed as an instrument for economic growth. Here, financial system is inherently unstable .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 not different for the less developed economies. Turkey being one of the developing countries has been facing financial liberalisation in order to achieve economic growth. In order to pursue growth, an economy has to be stable .This becomes impossible in the light of financial crisis in Turkey due to capital immobility. Despite been stricken by crisis twice, Turkey has applied a series of policies and programmes to restructure its financial system. The 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 presence of heavy inflation rate and an unstable policy. So it is required that the private as well the commercial banks be revaluated in Turkey (Ince, 2001). Industrial development and economic growth: Case of China Industrialisation in a country has the potential to improve the economic performance of a nation through increased savings rate, investment and foreign surplus. United States, Canada and Australia have been successful in increasing its per capita income through the shift of resources from the agricultural sector to the manufacturing sector. Japan too has achieved a growth in its income level from the period 1880-1980 via industrialisation. This was due to an expansion in the manufacturing sectors (Mosk, 2001). Industrialisation through export orientation turned out to be successful in many developing countries of East Asia such as Singapore, Taiwan and Hong Kong and more recently in China. This stresses on the fact that export orientation is the right strategy for economic growth and industrialisation in the developing countries. The East Asian countries, apart from having a manufacturing sector which is highly dependent on export orientation, also have few other common features .These economies are engaged in importing intermediate inputs from the developed countries in order to accelerate the pace of economic growth through industrialisation. Thus, trade induced industrialisation can be well explained by the countries named as East Asian miracle (Park, 2010).China has seen a spectacular economic growth in the last 30 years, owning to increased industrialisation and an increasing importance of entrepreneur skills and change in output composition. The driving force which caused an increment in the productivity is the reallocation of capital and labour in the manufacturing firms. Hsieh and Klenov in a recent paper analysed that reallocation of capital and labour across the manufacturing firms resulted in a 2% increase in the total factor productivity in the period 1998-2005.On the other hand, Yifan Zhang, Johannes Van and Loren Brandt emphasised that almost two third of the growth in the total factor productivity at the manufacturing firms of China, is due to the differences in the productivity in the existing and entering firms for the periods 1998-2005 (Song, 2011). Conclusion The growth rate of manufacturing sectors plays an important role in the economic development of a nation and depicts its economic potential. The manufacturing sector has been the engine of growth since the 18th century. Industrialisation in the country has contributed towards financial and macro economic growth. Various economists have put forward different models to lay emphasis on this fact .For China, the reallocation of capital and labour in the manufacturing sector is the driving force that lead to its economic growth through an increase in the total factor productivity. References Raymond Fisman & Inessa Love, National Bureau of economic research, working paper series 9583, Financial development and the composition of industrial growth,2003,retrieved 7 September 2011, http://www.nber.org/papers/w9583.pdf. LEVINE, R, Financial development and economic growth: views and agenda, Journal of economic literature, (35): June. 1997 Adam Szirmai, Is manufacturing still the main engine of growth in developing countries? 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