Macroeconomic Convergence, Financial Development and Economic Growth - Coursework Example

Macroeconomic convergence, financial development and economic growth Literature Review Convergence theory in the economic growth model can be described as the process whereby different nations with varied growth rate converge to similar level of economic development and growth. The rationale of convergence in growth was developed by Solow. The theory of Solow growth model states that all the economies in the world eventually reach a steady state of equilibrium. The statement implies that the poorer counties match up to the per capital income of the richer ones as they normally displays fast growth rate. There are primarily two types of convergence such as the absolute and conditional convergence. The theory of absolute convergence states that the growth level of countries initially varies due to difference in their levels of capital. The second theory of conditional convergence states that each country has a steady state and they converge to their own level of steady state. The paper focuses on the effect of convergence on China and the resultant financial development and economic growth in this country. Deep-down analysis of the fact that poor countries can catch up to the rich countries through the increase in the average rates of growth has been carried on for proper understanding of this topic. The investigation of the way in which the financial development and economic growth of China helped it to reach the position equivalent to a developed country is considered for the purpose of review. The Solow swan model and laws of diminishing marginal utility are used to help in the process of interpretation of the topic in a simple and easy manner. The empirical evidences are laid down in the paper along with charts to facilitate the process of understanding. Meaning of Convergence: The idea of catch-up-effect or convergence in economics is based on the hypothesis that the per capita income of the poorer economies will tend to grow at much faster rate than the richer ones. The resultant factor is the convergence of the both the economies in terms of the per capita income. The financial functions control the investment and saving decisions, technological innovations and therefore economic growth (Shahbaz, Khan and Tahir, 2013). Theories and models: Classical theories: The Ricardian theory of production and growth are related to the law of variable proportion. The law states that if any factor of production is increased while keeping the other same with no technological changes, there can be an increase in the output but in diminishing rate. This increased output eventually approaches towards zero (Warr and Ayres, 2012). Neo-Classical growth model: This is the first attempt made to model the long term growth analytically. The assumptions of the Solow swans model can be explained as follows (Ding and Knight, 2011): 1. The Solow swan growth model has the notion that growth is a result of increased stock of capital goods. Therefore, it states that increasing capital relative to the labour leads to the economic growth as it adds to the productivity of the people. 2. It also states that poor countries, with less amount of capital in the hands of each people, have increased growth rate as each investment of capital leads to a higher return, as compared to the richer ones. 3. This theory also makes the prediction that going by the law of diminishing returns; an economy no longer experiences economic growth with the increase in capital. Therefore any increase in capital no longer causes an increase in the economic growth eventually as per the theory of diminishing returns. These are the primary theories stated in the neo-classical model. Endogenous growth theory: This model successfully incorporated the conception of human capital, knowledge and skills that has the capability to increase the productivity of the workers. This model assumed that human capital can make more returns than the physical capital. The financial and economic development of China Initial phase of China China had a low phase during the period of 1949 (Warr and Ayres, 2012). The economic development of the country was at a standstill. As a result of that the overall growth of the country was on hold and that led to several issues and problems within the country. The civil war was responsible for the low economic phase of China. The gross domestic output of the country suffered a huge downfall because of the ongoing turbulence in the country. There were high rates of inflation, urban unemployment. The standard of living of the people dropped drastically as there were lack of funds in the hands of people, problems related to the shortage of food and their high prices. The new leaders faced complications to solve the economic problems facing China. It was quite tough for them to bring in the required stability in the market. The leaders of the country quickly tried to restructure the social relationships with the agriculturists and motivated those to produce more for the development of the economy. As China had an agricultural economy it was important to motivate the farmers, so that with the development of the agricultural sector, the industrial sector also gets the required momentum (Cai, Ye and Gu, 2014). The industrial development of China started soon after this initiative. The leaders started utilising the labourers and capital of the country efficiently. China had least amount of capital during the low growth phase which helped it to have more return. Therefore, this phase of China can be related to the Solow-swan model which states that poor countries, with less amount of capital in the hands of each people, have increased growth rate as each investment of capital leads to a higher return, as compared to the richer ones. The assumption was justifiable and can be related to the introduction stage of China. Beginning of the growth phase of China China experienced a swift economic growth and rapid financial development during the last few years. The Chinese economy has rightfully maintained a 10% growth rate in real terms. On the other hand the total amount of loan that is outstanding has a drastic increase from 51% to 107% (Guariglia and Poncet, 2008). It is the largest emerging market and has an uninterrupted growth since the last three years. The industrial development of China is responsible for the financial development and in turn the economic development of the country. The economic growth of a country does not always depend upon the capital accumulation but also on the social and technological changes. The economic growth of China was a result of a number of technological and social changes. The developing nation, China was quite backward till 1949 (Guariglia and Poncet, 2008). It has merged to be one of the world’s most prominently economic powers and has the greatest potential. The overall standard of living in China has also experienced up-liftmen. After the reform and industrialisation in 1979, the economy of China has developed at a rapid rate. The momentum is successfully kept steady in the 21st century as well (Hermes and Lensink, 2013). The government of China improved and strengthened the macroeconomic control which resulted in the experience of the most prominent period of development in the recent years. The GDP for the year 2004 was 13687.59 billion Yuan which in higher than 2003 (Fabião, Teixeira and Borges, 2014). Therefore industrialisations of the country lead to the financial development and in turn the economic development. This was quite relevant to the Solow-swan model which stated that the use of the capital can lead to the economic growth of a country. China took the necessary steps that lead to the financial development and economic growth. The major decision taken by the nation was to adapt a five year plan strategy for improving the economic condition (Jun, Z., Guiying and Jipeng, 2004). The ninth five year plan was a success which motivated the formulation of the tenth five year plan. The main aim of the plan that can be laid down as follows: 1. Sustaining and improving the benefit and quality of economic growth, strategic restructuring was all intended in the plan so as to double the GDP by the year 2010 as compared to the year 2009 (Allen, Qian and Qian, 2005). It also aimed at substantial perfection of socialist economy and bringing changes in the state owned enterprises by providing them a modern organisational footing. The basic motive for such changes was to participate more in international competition and cooperation. 2. The GDP was also aimed at 12500 billion Yuan and the per capita GDP at 9400 Yuan for the year 2005(Xu and Gui, 2013). This displayed the aim to bring in marked up-liftmen in the standard of living. It helped to retain a growth rate of 5 percent of the disposable income of the people residing in the urban areas and net income of the rural residents (Xu and Gui, 2013). The aim was also to stabilise the rate of unemployment of the registered urban to 5 percent. The maintenance of stable rates of expenditure and revenue was the primary motive of this plan (Naudé, 2010). 3. The industrial structure was also an area which was aimed to be upgraded and optimised for sharpening the competitive edge of China. The different levels of industry were targeted to have a growth rate of 13%, 51% and 36%.The labour force that was needed to be employed for the same was 44%, 23% and 33% respectively (Lee, Peng and He, 2012). Further it was intended to improve the infrastructure, increase the urbanisation of the country. 4. Optimisation and up gradation of the industrial structure was also targeted, to sharpen the competitive edge of China. The added value of all industries ranging from primary, secondary and tertiary was intended to have a GDP of 13%, 51% and 36%. The employment of the labour force was targeted at 43%, 23% and 33% (Knox, Agnew and McCarthy, 2014). Furthermore there were also intentions to improve the widening disparity between the developed regions. China successfully carried out all the targets of the tenth five year plan to contribute in the financial development and economic growth of the country (Lee, et al., 2012). Therefore, the overall plan to bring in the required improvement in the long term growth by making proper usage of the excess capital was quite comparable to the Solow swan’s growth model (Xu and Gui, 2013). The right usage of the capital helped it to regain its status and have a high rate of the financial development and economic growth. The Solow swans growth model thus duly mentioned that the usage of the capital in the right amount can bring in the required growth to a country (Warr and Ayres, 2012). Detailed analysis of the empirical evidence: Convergence is rightly the reason for the economic development of China. China turned from a poor economy to a wealthier one in terms of per capita income over the years (Knox, Agnew and McCarthy, 2014). China had a closed economy initially. There was not much industrial growth in this country. With the opening up of the industrial sector the country benefited immeasurably (Xu and Gui, 2013).It started to trade with all the other countries in the world. Soon, China turned out to be the second largest country in terms of the service sector and industrial development. Globalisation helped in the process of increased amount of foreign investment in this country (Naudé, 2010). Countries like United States, Europe and Japan started extending their business in China. The low cost of labour is a primary reason for the foreign investments in this country (Ferrara, 2011). Top countries started to outsource their employees and labourers from China to take the advantage of their low cost (Xu and Gui, 2013).China prospered due to the investment of the countries with more currency power. The development in the service and industrial sector of the country is responsible for the rapid increase in its GDP. The GDP as well as per capita income of China is growing at a fast pace and can soon reach the margins of US. US is the leader of the arms and ammunitions industry. China is also developing as one of the top industry for arms and ammunitions. Besides that, the technological industry of China is equally developing over the years. China is the top technological hub of the world. The country exports huge amount of technological goods to US. Therefore, China is rapidly transforming from a low income to a high income country (Jun, Guiying and Jipeng, 2004). It is eventually catching up to the wealthier countries like US in terms of per capita income. The trend analysis of China and US till the year 2039 indicates that indicates that the standard of living in China will surpass that of the US (Shahbaz, Khan and Tahir, 2013). The following graph can explain the same in a more detailed manner. Figure 1: Graphical Representation of Per Capita GDP of China and USA (Source: ppt) The stock market of China is developing rapidly along with the market economy of the country. This has contributed to the national economic development of the country. Yet the system of the establishment of the stock market is relatively weaker and caused a continuous fall in the share index in the last few years (Fabião, Teixeira and Borges, 2014). With the advancement of the economy, the stock market flourishes and with the shrink in the economy the stock market turns bearish. Although, the stock market of China continues to be sluggish even after the rapid economic development of the country. Certain statistical data showed that in the year 2003, the GDP of China was 13.65 Yuan (US$ 1.65 trillion) which indicated a rise of 9.5% from the previous year (Ding and Knight, 2011). In the same year, the index of Shanghai stock exchange dropped by 15.15% (Abreu, 2014). The primary reason for this issue is the split share structure of China which needs to be resolved. China has taken several steps to increase the rate of stock market development. The financial development and economic growth of the developing country, China rightly shows that the low income countries tend to have higher average rates of returns than the high income countries like United States (US) (Warr and Ayres, 2012). China was initially a poor country but the rapid development of the country helped it to have increased average rates of growth (Ferrara, Guerrini and Mavilia, 2013). It is in the growth stage of economic development and currently trending towards the maturity level. The effective usage of the capital and labour has lead to the increase in the productivity of the country but excessive use of the same might lead to the diminishing marginal utility (Guariglia and Poncet, 2008).Therefore, it is important for China to maintain balance between the capital and labour. As the capital stock increases given a fixed level of employment the productivity of capital declines. China should ensure that the amount of capital should not increase more than that of labour. The usage of capital should thus be controlled by China to ensure maximum productivity and profitability. Summary about the financial and economic development of China The term convergence rightfully suited the gradual economic and financial development of China. China is a developing country which is gradually catching up to the wealthier countries like US, Europe and Japan in terms of the per capita income (Wong and Zhou, 2014). The economic development has helped the process of transformation of China. The industrial and service sector development is leading to the gradual economic growth of China (Hermes and Lensink, 2013). The increase in the number of foreign investments in this country has lead to the financial development. The major decision of globalisation has proved to be fruitful for this country. China is in the growth stage of economic development and heading towards the maturity stage. The stock market development of the country is not directly linked to the economic development and needs to be taken care of. China should utilise the capital in a right manner for further economic growth and financial development of the country. Therefore, the empirical evidences of China can rightly be cited as an example for explaining the process of convergence and its effect on the financial growth and economic development of China. References Abreu, M., 2014. Neoclassical Regional Growth Models. In Handbook of Regional Science. New York City: Springer Publishers. Allen, F., Qian, J. and Qian, M., 2005. Law, finance, and economic growth in China. Journal of financial economics, 77(1), pp. 57-116. Cai, D., Ye, H. and Gu, L., 2014. A Generalized Solow-Swan Model. In Abstract and Applied Analysis. 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