Relationship between Financial Development and Economic Growth - Coursework Example

Relationship between financial development and economic growth Introduction The relationship between financial development and economic growth is greatly a matter of debate among economic scholars. In essence, a well balanced and efficient financial market can bring growth and security to a country’s economy. In a study conducted on East Asian developing countries, it was concluded that the most significant cause of economic growth is capital accumulation which contributes towards 50 to 80 percent of economic growth. As opposed to this, another study conducted on G-5 countries revealed that technological development is an important contributor towards economic growth by 60 percent (Lau & Park, 2003, p.36). The question thus remains whether financial sector can be considered as a signification source of economic development. In general, financial development has a twofold effect on economic growth. For one, capital accumulation can be increased by the financial sector. Secondly, development of financial institutions leads to enhanced savings which means greater investments resulting in greater capital accumulation. With increasing investments, capital can be used to increase the level of gross production. Also, properly developed financial institutions means increased variety of financial instruments that facilitate lenders and borrowers thus having a positive impact on the overall economy. However, in the long run other factors like human and physical capital need to be considered as other sources of economic growth. This paper will conduct a literature review on the subject of the relationship between financial development and economic growth in the context of the Indian economy. Further, the literature findings will be related with theories from articles based on similar context. Literature review – Theoretical support Although not all views support the role of financial development on economic growth, positive views can be seen in Levine’s (1997) article. According to Levine’s theory, well developed financial institutions helps in reducing costs attached to information and transaction. Such reduced costs encourage increased investments leading to capital accumulation. With greater level of capital, there can be more spending on research sector leading to technological development causing higher efficiency in production process which in turns means increased level of gross production. Moreover, Levine has taken a broader approach in stating that various functions of financial institutions facilitate capital accumulation, rate of savings and trading of goods. Thus, he has concluded that financial structure as a whole, rather than a single financial instrument like money or a single financial institution like banks, contributes towards economic growth. It has been seen that countries with a stronger financial structure grows more steadily than countries with weak financial structure. However, finance is not always an external cause of economic growth. Economic environment and technological innovations like well developed telecommunication and computer system can reinforce the financial structure. There are also other factors like political and legal systems of a country that decide the state of financial development and economic growth. On the other hand, there is Lucas (1988, p.6) who has stated that the influence of financial development on economic growth has been “over-stressed”. He has stated that two kinds of capital like physical capital (machinery, computers etc.) and human capital are the factors that enhance production capacity. Supporting the theory of Levine (1997) that increasing investments cause capital accumulation which in turns enhances production and economic development, Duhan (2014) has asserted that foreign investments as a major source of capital can have a long term impact on the Indian economy. Moreover, with increased capital the Indian domestic market can get the competitive edge in the global market through improved infrastructure, transfer of technology, increased production level and employment opportunities. Over the previous twenty years, India has encouraged foreign investments from various sources like foreign direct investments (FDIs), remittance from non-resident Indians (NRIs), and so on. One major benefit is that such investments can provide the required capital to those industries which are suffering due to lack of capital. With greater inflow of foreign money into the Indian economy, the country has experienced a rapid economic growth in the period between 2001 and 2010. This can be reflected in the 8.5 to 9 percent GDP growth, increasing domestic savings and investment levels. In the year 2009, India was placed in the third place in global FDIs by the United Nations Conference on Trade and Development report (Duhan, 2014, p.291). FDI as an economic development tool is perceived differently by developed and developing economies. The developed countries utilize FDIs to enter into the developing economic market in order to sustain their economic development. On the other hand, the developing countries encourage FDIs to increase domestic savings, compensate technological gaps, and increase foreign currency reserves. In India, FDI exerts positive impact on the economic growth in many ways. First, it bolsters exports as foreign experts provide technological updates to help production of global quality goods. Second, to meet the increasing demand from global market FDI increases employment opportunities. Moreover, with larger FDIs there is also growth in the number of trained personnel, and along with quality goods at competitive price the living standard of people also gets enhanced. Third, FDI is a good source of revenue for the Indian government with more income tax and import tariffs. There are other benefits of FDIs like increased investments in risky projects due to less vulnerability of foreign investors, increased foreign exchange bolsters domestic savings, and greater number of skilled workers can execute those jobs that local workers cannot accomplish (Duhan, 2014, p.295). Similar views on FDI impact on economic growth in India have been shared by Chakraborty and Mukherjee (2012) in their article. The authors have stated that since the economic reforms in India in 1991, there has been greater focus by policy makers on FDIs as contributor towards economic growth. In the last few years, many economic activities have been allowed to function with 100 percent foreign investments. The authors have adopted a “time series analysis” to understand the relation between FDIs, capital accumulation and economic growth in India. It has been found that while larger inflow of FDIs has boosted domestic savings it is because of a stable growth rate of GDP that there has been incessant inflow of FDIs in recent years. According to the authors, FDIs help in economic growth in India in various ways. First, FDI has solved the capital crisis in India, a country which has traditionally been a labor rich country but has lagged behind due to limited availability of capital. Second, FDI has facilitated private sectors to focus on telecommunication services and infrastructure. Between August 1992 and March 2010, 1.84 percent of total FDI was taken up by telecommunication sector while 1.33 percent was used in transport sector. Third, because of a large section of workforce belonging in young age group, speaking English is a strong element. Increased usage of FDI in sectors like “computer software, real estate, construction service, tourism and consultancy service” has boosted the service sector in India (Chakraborty & Mukherjee, 2012, p.311). Demetriades & Luintel (1996) have studied the Indian economy to propose that interest rate restrictions adopted by banks along with other functions of banks have a strong effect on the financial development. During the 1960s, the Indian government introduced various control measures on the financial system in order to facilitate priority sectors like agriculture, exports and small scale industry. It was during the late 1980s that the government loosened its grip on the financial system by abolishing fixed limitations of lending rates. The authors have suggested that control over banking system can have adverse effect on financial development and consequently on economic growth. On the other hand, the authors have also noted that financial deepening was, to a small extent, positively influenced by the establishment of lending rate ceiling. This was also been advocated by World Bank, 1993 which said that minor suppression of lending rates can actually contribute towards economic development (Demetriades & Luintel, 1996, p.360). The authors have assessed the government’s control measures on the banking sector to get a better understanding of the various impacts of financial policies. It was concluded that there is a two way relation between financial deepening and economic growth. For instance, any policies taken in favor of financial deepening can have impact on the economic growth and vice versa. By altering the approach of banking sector in order to garner more deposits, financial policies can affect financial deepening. In the context of the impact of financial development on economic growth, Chakraborty (2008) has pointed out that the assessment needs to be based on two sectors – banking sector and insurance sector. While supporters of bank-based theories state that efficient banking services can augment economic growth, the advocators of insurance-based theories, on the other hand, have proposed that improved insurance services can provide better risk partaking capacities thus inducing greater profit than banks. For instance, according to King & Levine (1993) financial services offered by banks induce capital accumulation which means increased investments leading to enhanced efficiency in the manner in which the capital is used to increase GDP. On the other hand, in another article, Atje & Jovanovic (1993) have argued that unlike banks the insurance companies can provide greater security for potential risks. This induces people to divert their savings towards more productive albeit risky ventures leading to greater production capacities resulting in increased GDP. Chakraborty (2010) in her article has explored the impact of financial sector on the economic growth in India. In this article, the impacts of banking sector and stock market in the post-reform period have been individually studied. It was concluded that rate of output compared to capital investment, and the rate of increase in human capital have a positive effect on the growth of GDP irrespective of stock market development. While market capitalization has a negative impact on economic growth, there has been no significant impact of turnover on economic growth. In the post-reform period in India, the increase in real GDP has been enhanced by the banking system. However, Chakraborty has noted one interesting fact which is that “net inflows of capital as a ratio of GDP has a negative effect on economic growth, which is perhaps due to the speculative nature of portfolio capital flows in India in the later half of 1990s” (Chakraborty, 2010, p.305). Therefore, the author has suggested that there is no significant positive impact of stock market development on economic growth in India. This means in this country, stock market cannot be a substitute of the banking sector unlike other developing economies like Chile and Mexico. However, this view stands contradictory to the conclusion arrived at by Levine & Zervos (1998) in their article where they have stated that stock market and banking sector both can have positive impact on a country’s economic growth caused by capital accumulation and increased GDP, and such impact is correlated. The authors have further considered other economic contributory elements like political and economic factors. However, they have stated that since the financial services provided by stock market and banking sectors are different therefore in order to more clearly understand their individual roles in long-term economic growth it is needed to study the simultaneous development of each sector in spite of different financial services. Levine & Zevros have also added that they have observed that the trend of stock market and banking sector is not just a reflection of robust economic growth, and that development of each or both sectors certainly have long-term impact on economic growth. Arestic et al. (2001) have taken a more prudent approach towards the role of stock markets on economic growth. Since most of the studies conducted on this subject have been based on “cross-country growth regressions” therefore the impact of stock markets on economy can differ considerably from one country to the other depending on their country based structure and environment. They have illustrated by stating that stock market impact has been negative in developed countries like Japan, UK and France, while the impact has been insignificant in Germany (Arestic et al., 2001, p.37). Vadlamannati (2008) has explored the impact of insurance sector in India on its economic growth. The significance of insurance companies cannot be undermined since they provide finances for long term investments, and reduces the potential impacts of risks. Vadlamannati has stated that both life and non-life insurances have a great positive impact on the economic growth in India. While the impact of life insurance can be felt on immediate basis, the impact of non-life insurance can be felt only after a year. Another important point that has been noted by the author is that the positive economic impact of the insurance sectors has been greatest “during the post-reforms period and post-insurance sector reforms period” (Vadlamannati, 2008, p.74). This has proved that any reforms made in the insurance sector have been a positive element for economic growth in India. Therefore, the author has suggested that any policies in the context of insurance reforms need to be made keeping in mind the impact of the insurance sector on the economic development. Thus, the results obtained in this article have confirmed the theories postulated by Arena (2008) and Ward & Zurbruegg (2000) in their respective articles. Arena has stated that both kinds of insurance like life and non-life insurance have a major impact on economic growth. While the former type of insurance is more significantly effective in developed economies, the latter, i.e. non-life insurance has more apparent economic effect in developing economies. Ward & Zurbruegg, at the same time, have supported this theory by further elaborating that the impact of insurance reforms on economic growth is dependent on the sociocultural environment of a country. This is because risk taking capacity and risk management techniques are dependent on a country’s culture. In the context of significant positive impact of financial development on economic growth in India, Sawant (2003) in his article has explored the effects of technological developments on the Indian banking sector. Apparently, it may seem off topic since this paper is mainly focused on exploring the impact of financial development on economic growth. However, it has been established that information technology like mobile networks and internet can play a significant role in enhancing the services offered by financial institutions like banks and insurance companies. With mobile services, bank customers can avail of banking services through mobile phone devices that include fund transfers and stock market transaction. Then there is internet banking which allows customers to make online payments, stop payments, requests for cheque books, and bill payments among other services (Okiro & Ndungu, 2013, p.148). Sawant (2003), in Indian context, has emphasized that banks need to focus on providing efficient and speedy financial services to customers in cost effective manner to ensure positive impact on overcall economic growth. Today, with technological innovations, the Indian banking sector can provide services at reasonable costs. Moreover, technology has enabled small transactions as feasible. There is MICR (Magnetic Ink Character Recognition) that facilitates clearing of paper-based financial instruments. Then there is NEFT (National Electronic Fund Transfer) that allows easy online transfer of fund between different bank accounts. ATM machines allow customers to withdraw cash and get printout of bank statements. Comparisons All the above articles have opined that there is a positive correlation between financial development and economic growth in India. On the other hand, Lucas (1988), in his article, has expressed that the impact of financial development on economic growth has been “overstressed”. All the articles are divided into two categories – one is based on Indian economy while the other offers linked theories. First, there are Chakraborty & Mukherjee (2012), Duhan (2014), Demetriades & Luintel (1996), Chakraborty (2010), Vadlamannati (2008) who have asserted that financial development in India like development in banking sector, insurance companies has contributed towards economic growth in the country. Then, there are Levine (1997), King & Levine (1993), Atje & Jovonavic (1993), Levine & Zevros (1998), Arestic (2001), Arena (2008), Ward & Zurbruegg (2000) who have agreed that financial development like banking sector, insurance companies can contribute towards capital accumulation leading to greater investments which in turn contributes towards enhanced GDP in a country. Conclusion As final conclusion of this paper, it is now quite clear that majority opinion expresses the positive impact of financial development on economic growth. This is also the case in India where financial institutions like banking sector and insurance companies play an important role in the growth of the economy. Greater inflow of FDI leads to technological updates, increased employment opportunities, larger number of skilled labors, increased domestic savings, and good source of revenue for the Indian government. With development in the financial sector, there is greater accumulation of capital leading to enhanced spending on research projects. This means greater technological development that can increase the efficiency of production process thus ensuring growth of GDP. In India, financial development has a long-term impact on economic growth. References Arena, M. (2008) Does Insurance Market Activity Promote Economic Growth? A Cross-Country Study for Industrialized and Developing Countries. Journal of Risk and Insurance, 75(4), 921-46 Arestis, P., Demetriades, P.O. & Luintel, K.B. (2001) Financial Development and Economic Growth: The Role of Stock Markets. Journal of Money, Credit and Banking, 33(1), 16-41 Atje, R. & Jovanovic, B. (1993) Stock Markets and Development. European Economic Review, 37(2), 632-40 Chakraborty, D. & Mukherjee, J. (2012) Is There Any Relationship Between Foreign Direct Investment, Domestic Investment and Economic Growth in India? A Time Series Analysis. Review of Market Integration, 4(3), 309-37 Chakraborty, I. (2008) Does Financial Development Cause Economic Growth? The Case of India. South Asia Economic Journal, 9(2), 109-39 Chakraborty, I. (2010) Financial Development and Economic Growth in India: An Analysis of the Post-reform Period. South Asia Economic Journal, 11(2), 287-308 Demetriades, P.O. & Luintel, K.B. (1996) Financial development, economic growth and banking sector controls: evidence from India. The Economic Journal, 106(435), 359-74 Duhan, S.K. (2014) Role of foreign direct investment and foreign institutional investment in Indian economy. International Journal of Management, IT and engineering, 4(5), 290-301 King, R.G. & Levine, R. (1993) Finance and growth: Schumpeter might be right. Quarterly Journal of Economics, 108(3), 717-37 Lau, L.J. & Park, J. (2003) The Sources of East Asian Economic Growth Revisited, Conference on International and Development Economics, Stanford Univ. & SUNY, retrieved on August 25, 2014 from: http://web.stanford.edu/~ljlau/RecentWork/ RecentWork/030921.pdf Levine, R. (1997) Financial development and economic growth: views and agenda. Journal of Economic Literature, 35(2), 688-726 Levine, R. & Zevros, S. (1998) Stock markets, banks, and economic growth. American Economic Growth, 88(3), 537-558 Lucas, R. (1988) On the Mechanics of Economic Development. Journal of Monetary Economics, Vol.22, 3-42 Okiro, K. & Ndungu, J. (2013) The impact of mobile and internet banking on performance of financial institutions in Kenya. European Scientific Journal, 9(13), 146-61 Sawant, B.S. (2003) Technological Developments in Indian Banking Sector. Indian Streams Research Journal, 1(9), 1-4 Vadlamannati, K.C. (2008) Do Insurance Sector Growth and Reforms Affect Economic Development? Empirical Evidence from India. Journal of Applied Economic Research, 2(1), 43-86 Ward, D. & Zurbruegg, R. (2000) Does Insurance Promote Economic Growth? Evidence from OECD Countries. Journal of Risk and Insurance, 67(4), 489-506 Read More