Financial Institutions & Systems and Their Role in the Economic Development and Innovation - Research Paper Example

Financial Institutions & Systems and their role in the economic development and Innovation Table of Contents Financial Institutions & Systems and their role in the economic development and Innovation 1 Table of Contents 1 Introduction 3 Theoretical Framework 5 Role of Financial Institutions behind Economic Growth 5 Role of Financial Institutions behind Innovation 7 Literature Review 9 Role of Financial Institutions behind Economic Growth 9 Role of Financial Institutions behind Innovation 13 Conclusion and Recommendations 13 References 15 Adelman, I. & Moris, C. T. (1973). Economic growth and social equity in developing countries. USA: Stanford University Press. 15 Chowdhury, A. (2010). Financial Sector Regulation in Developing Countries: Reckoning after the crisis. Available at http://www.ideaswebsite.org/featart/feb2010/Anis_Chowdhury.pdf (Accessed: November 25, 2010). 15 Hermes, N. & Lensink, R. (1996). Financial development and economic growth: theory and experiences from developing countries. London, UK: Routledge. 15 Hock, S. & Wong, J. (2009). Regional Economic Development in China. Singapore: ISEAS Publishing. 15 Introduction Financial institutions form a fundamental segment of core capitalist economies. The significance of these bodies lies in the crucial role that they partake towards economic development and innovations. In fact, development of financial sector of any economy is often treated as a reflection of economic growth. Financial institutions are those which provide financial support to their customers; in other words, these institutions are responsible for a proper allocation of resources between entities. An efficiently operating financial body is that which can ideally distinguish between the needy and affluent thus being able to distribute resources in a proper fashion. A continued effort in this direction can abolish many core economic hitches such as poverty, unemployment, unequal distribution of wealth, etc. Moreover, a stable and robust financial system often stands out as an able representative of a sturdy economic structure to foreign investors interested to venture out into a nation. Continued inflow of foreign direct investment is one of the factors which boost up the prospects of a nation through assisting in building up a suitable infrastructure. In addition, increased inflows of FDI from different nations help in the realisation of various technological processes characteristic of the respective projects. Under such a scenario, the host nation can come into contact with various mechanisms of producing a single commodity or accomplishing a single purpose. A nation eager to go ahead in the direction of growth can thus choose the most cost-efficient one that harmonises with one that compromises the least on quality. This is how an economy can innovate out of its association with other nations. However, the sector that commences the entire process comprises of the financial bodies in the nation. Since financial institutions are entrusted with the task of levelling out the monetary issues surmounting an economy, any foreign investor is likely to make a note of the situation underlying the financial sector prior to making an investment move. The present paper is an attempt to illustrate in details the ways through which the financial sector could be regarded as critical to the future of an economy. Basically, two areas have been identified to be influenced by the operations of the financial bodies, namely, the economic growth process and innovative prospects of the nation. Hence, the objective of the paper will be to primarily reflect upon these two areas while evaluating the functions played by financial institutions of a nation. Theoretical Framework Financial institutions, as already mentioned in the introductory part, comprise of those organisations which are responsible for an efficient allocation of resources in an economy. This distribution might be accomplished through an optimal circulation of domestic money in a nation or through the accumulation of foreign reserves through foreign investment inflows. In either case, economic growth could be assured in an economy which eventually spurs up innovative activities in the same. Role of Financial Institutions behind Economic Growth Financial institutions are often regarded as the face of an economy, being the foremost aspect evaluated by the investors prior to making ventures. A properly functioning financial sector can positively influence the operations of domestic industries and hence, boosting up prospects of a steady rate of economic growth. Firstly, financial institutions often emerge as the rescuer of industrial units which suffer from a dearth of funds, and hence are compelled to constrict their mode of operations. Given the role being played by the financial institutions, these economic units can easily lay their hands upon funds which do not belong to them. If the units on the other hand, can make appropriate use of these funds, they can bail themselves out of their looming plight, all by themselves. Here comes a question about the precision of the financial sector of a nation. Ideally in a capitalist economy, driven by profit motives, once the financial sector comes to the rescue of the industries, possibilities of reaping better margins of profit grow. By means of enhancing the prospects of indigenous industries, the financial institutions also create a positive impression of the domestic business houses in front of foreigners. Foreign investors are not much aware about the prevailing situations in an economy and thus, pursue a good degree of research prior to making their investment decisions. The financial institutions hence have to operate on a long term basis to build up a favourable image of the domestic industries. In fact, if the point be elucidated further, it could be observed that with rising demand for credit from financial institutions, there is a rise in the economic growth rate of the concerned nation. This increased rate of economic growth induces other investors to expand their respective businesses as well to cope up with the increased demands and out of their urge of not letting go of the opportunities to earn profit. However, in such cases, it might not be possible for the national financial sector to advance the required sum to each and every entity. Here comes the scope of foreign financial institutions which advance their financial assistance to such needy entities thus facilitating globalisation. In contrast, if the financial sector of a nation is characterised by imperfect governance and asymmetric information, they cannot accomplish the economic target of a speedy growth. An able and ideal financial sector must have the capacity to identify the industries which have a good prospect of growth if given a chance. Such a stance will enable them to reap long term gains which are far more important than short-term profits. Instead, if these bodies are engaged in maximising their short run profits more than their long term gains, such industries which if protected can yield a hefty profit margin. Secondly, apart from attracting foreign investors towards themselves, the financial institutions are also responsible for a proper circulation of money in an economy. To be precise, the central and the commercial banks are the two distinct bodies of entities which are entrusted with the tasks of framing and properly implementing the monetary policies in an economy. Importance and need for monetary policies are especially felt during times of financial crises, such as inflations or recessions. However, this particular function is performed not only by the financial institutions core to a capitalist economy. On the other hand, this is perhaps the most important role being played by the financial sector. It requires a good amount of precision and a committee far-sighted enough to visualise the long-term gains being reaped out of a particular monetary policy. For instance, the recent global financial recession that originated in the economy of USA in the year 2007 had its roots planted in monetary policies undertaken by the Federal government back in 2001-02. The myopic nature of the policymakers initiated the Federal government to introduce reduced rates of interest, so as to avoid chances of a looming recession post the dot com bubble. However, the exact degree up to which to recede had not been calculated beforehand. This is the reason why there had been an excessive supply of credit within the nation thus creating ruckus about a possible inflation. This was when the monetary policy authorities decided to raise the rate of interest all of a sudden leading to an unavoidable recessionary effect in the economy. It was only when the monetary policy makers realised their follies that they decided to reduce the rate of interest once again but by a lesser value. Had the financial authorities acted with a better amount of precision, such a development could have been avoided and simultaneously, the immense loss incurred out of it be prevented. Last, but not the least, financial sectors indigenous to an economy can trigger growth through the support of micro-finance institutes as well. The concept though is a new one, introduced mostly in developing economies, is one that targets both towards economic and human development. According to the concept, the financial institutions aid the deprived fraction of the society to set up their own businesses at nominal rates. The banks grant them loans on a collective basis, i.e., to an entire group of people so that the burden of repayment does not fall upon any one of them and hence they do not back off in the name of loans. Such facilities are assisting even the most deprived people in a society to evolve out of their chronic problems of poverty. This is how the financial sector of an economy helps to build up an egalitarian society even in a capitalist economy. On the other hand, through provision of such financial assistance, the banks also help in expanding the aggregate production of the economy, as idle resources of yesterday begin their participation in full-fledged production process. Role of Financial Institutions behind Innovation Financial institutions core to a nation are also responsible for bringing about innovation in the economy or rather to the domestic industrial units. The role that the financial institutions play leads to an expansion of domestic industrial units abroad and those of foreign industrial units within the nation. Primarily, the foreign industrial units are invited to assist the national authorities in building up a suitable infrastructure in the nation. This might be a channel through which innovation takes place or the knowledge about newer and better modes of production is being absorbed by the domestic business houses. Innovation in the true sense of the term implies a renovation of an already existing process so as to derive more value out of it. Financial institutions however, do not have a direct implication upon the innovation aspect. On the other hand, the indirect implications that these financial bodies may have, are discussed underneath. Firstly, to accomplish innovation at the very first place, financial or monetary assistance comes to the forefront as one of the most important issues. Financial institutions, in this case, are found to boost the domestic investors through facilitating such aids. Many economies nowadays are found to advance their help to such industrial units eager to make it big in the field of research and development. Though the financial houses rarely do so without a profit motive, the help which they advance often do not go unnoticed. However, here too comes the question of precision that the financial institutions must be aware of while making decisions. This is because providing loans for research and development purposes generally constitute of a large amount. In case that the organisation that demands a loan fails to repay it back within the stipulated time period, the bank that credits it with the same, suffers a loss in the form of bad debts. On the other hand, if the bank acts with wisdom from the very initial stage, the role that it could play can be treated as nothing less than that of venture capitalists. However, the financial institutions need to conduct their own amount of research in the field as well, which affirms both the positions of the firm as well as that of the firm. This is also the reason why the economy must be characterised by financial institutions which are featured by good governance. In addition, there must not be any scope of asymmetrical information which might prevent the financial bodies from acquiring the needful information. Secondly, it is the image of the financial sector in a particular nation that attracts foreign investors in any economy. Any foreign investor is likely to take a note of the robustness of the financial institutions in an economy prior to venturing out or pouring her resources in the said country. This is because the financial sector is responsible for deciding and implementing the monetary policies core to a nation, which gain their importance especially at times of financial crisis. In fact, to be frank, unless monetary policies are being framed in a suitable manner, enactment of fiscal policies could not be made in an appropriate fashion as well. Hence, if these two types of policies are to be ranked, it is the monetary policy that comes in advance of the fiscal policies. While the latter is responsible for deciding the arenas in an economy which need to be boosted, the former is responsible for channelling the resources in the required fields. Thus, unless an economy is characterised by a sturdy financial sector, it rarely can win over the confidence of foreign investors. Foreign direct investment or foreign investment essentially means long term participation by an investor belonging to a foreign land in within the domestic territories. These investors are different from institutional investors who are interested only about investing in financial assets of various domestic industrial units. Foreign direct investors often show their interest in building up infrastructure in the nations where they invest through joint-ventures. Joint ventures on the other hand would readily imply the inflow of technologies and expertise being used in the process of production. If the domestic industrial units are aware enough, they can easily pick up these skills and knowledge from the foreigners and make suitable use of them. Moreover, if a large number of foreign investors show their interest in the domestic economy, there will be scores of new technological choices open to the domestic industrial units, out of which they can choose the most feasible one. Added with the support from national financial institutions, such a task can easily be accomplished and hence innovation takes place. Literature Review Financial institutions as already have been described form the very fundamental base of any economy which is responsible for bringing order into an economy during times of crisis as well as be on its look-out to protect the nation against any such looming discrepancies. In fact these institutions, if are found to be playing their part efficiently, can trigger the rate of economic growth in a nation. Role of Financial Institutions behind Economic Growth The role being played by financial institutions in developing economies is quite a stimulating one. In most of the cases, an efficient financial sector is found to bail out a developing economy from the clutches of an impending financial crisis. Examples could be taken from the cases of Mexico and China where the domestic financial institutions taught the national authorities how to surpass their entrance into debt traps which generally are aroused out of an excessive dependence on foreign investment inflows rather than upon domestic resources. In fact, the hyper-inflationary period experienced by Mexico had been the result of their excessive dependence on foreign reserves rather than preferring a greater circulation of domestic money. Too much dependence stole away the nation’s independence resulting to a sharp decline in the value of domestic currency and hence inflation (Hock & Wong, 2009; Hermes & Lensink, 1996). Another such example is that of Turkey, which had to surpass a phase of economic recession between 1996 and 2001. The primary cause behind the crisis had been the nation’s decision to liberalise the economy, which led a sudden gush of foreign reserve inflows into the nation. Such was the situation in the nation that the economy soon became a victim of inflationary pressures and huge government budget deficits. This development made the Turkish Treasury to increasingly relying upon the commercial banks through sale of government securities to the latter. Commercial banks on the other hand, when perceived a fat net interest margin between what they earned through acquiring government securities and what they could earn through advancing loans, preferred to follow the footsteps being defined by the Treasury. However, prior to their dependence upon the national commercial banks, the Treasury had tried its luck in the foreign financial market. However, as the nation was passing through an inflationary phase suggestive of imperfect financial governance, the former could not avail any suitable creditor. Hence, finally the financial authorities had to incline towards their indigenous reserves that eventually led to the mobilisation of domestic resources. Had the national government been more vigilant or wiser in making its previous moves, the economy could have avoided such developments (Ardic & Damar, 2006). It had also been empirically found that financial sector developments can have an immense impact upon the economic development of a transition economy. To be precise, rate of interest is found to have a negative impact upon the economic growth rate of a nation, as is the case for the net accumulation of bad debts. These results are quite in line with theoretical background given that higher the rate of interests go, lower will be the motivation of potential customers towards demanding loans from domestic financial institutions which might have a heavy toll upon the economy. This is because given the same quantity of national resources, accepting credit from abroad would imply a rise in the currency base of a nation, eventually leading it towards an inflationary phase. Moreover, the accumulation of bad debts would make negative implications upon the efficiency of the financial sector or rather the governance of the same. Both the factors thus, are drawbacks to an economy’s growth process, especially if it is passing through a transitory phase (Koivu, 2002). In fact, such a stance had been a common one among developing economies during the post-liberalisation era. On the other hand, instances could be drawn from the Asian financial crisis of 1997 that was primarily caused due to a lack of wisdom in actions of the domestic financial sectors of a handful of South-East Asian nations. Immediately after the liberalisation move, these nations completely opened up their doors for foreign banks and financial institutions. This act was found to be rather a myopic one in the latter periods especially since the domestic financial institutions were provided no protection from the competition they faced from the former. Given the potentials of these nations, many foreign banks were found to be interested in expanding their businesses in these territories. However, in the absence of protection, the indigenous financial houses had to deploy certain schemes through which they could attract more and more customers, thus being able to capture a larger market share. In their urge to keep themselves afloat, the financial houses started investing in profitable but risky projects and soon their lack of precision gave way to immense losses. Such were the size of the losses that the financial sector of these nations crashed down completely. Gradually, all foreign investors, who had shown immense interest in the proceedings of the region, deserted the land and the economic growth rate declined dramatically almost overnight. This is a suitable instance that proves the deep association that the operations of domestic financial institutions have upon the economic growth rate of a nation (Chowdhury, 2010). A similar event occurred in the recent past in the United States of America where the myopic nature of the monetary authorities led the commercial banks to invest in risky projects with a hope of reaping extraordinary profit margins. Soon however, their dream shattered as the monetary authorities having realised their previous folly tried to make an untimely correction of the same. Financial institutions indigenous to capitalist economies especially have a huge responsibility entrusted in their hands. Capitalist economies are mainly driven by profit motives and so are their respective financial institutions which generally are found to support those who have a good credit-worthiness, i.e., the high-income group, over those with a poor level of income. Hence, many-a-times, the savings of the population are found to go into wrong channels which are more likely to induce unequal distribution of wealth than an all-round growth. It has often been found that nations which especially aim at enhancing prospects of growth in any particular industry compel the respective domestic financial institutions to frame monetary policies in favour of the particular segment as well. Often such a stance on parts of the fiscal and monetary authorities, are found to go against the interests of other industries (Adelman & Moris, 1973). Thus, it might not be claimed with certainty that a perfectly functioning financial sector is the only factor which might lead a capitalist economy towards the path of unprecedented economic growth. Simultaneously, it is also necessary for the respective national authorities to act with a certain degree of precision while framing fiscal policies. Role of Financial Institutions behind Innovation On the other hand, even though a perfectly functioning financial sector is found to have direct implications upon the economic growth rate, it might not be so in case of innovations in the nation. This is because economic growth rate is the outcome of a combined effect of all sectors upon the economy. However, innovative activities in a particular might not be affected in a similar pattern out of a development in the financial structure of the nation. In fact, though supported theoretically, capitalist economies are generally found to focus their attention upon sectors which display a marvellous prospect within the short run future. These policies are framed essentially in line with the decisions being undertaken by the national government of any nation. In most of the cases it is found that the national authorities in their urge to attract foreign investors (both direct and institutional), concentrate upon industries that have the best prospects, thus neglecting others in the game. Since the financial institutions act according to the decisions being made by the fiscal authorities, most of the domestic savings are poured into as investment funds in these few chosen sectors. Hence, even though these sectors are found to benefit out of financial sector developments, others might not be as fortunate as the former. Hence, it is more likely for the former industrial units to conduct research and development facilitating them to progress faster, than it is for units belonging to other industries (Block, 2002). Conclusion and Recommendations The present paper primarily aimed at evaluating whether financial sector of any economy can have any implications upon the economic development and innovation being carried out in the same. Many research papers have found a direct association between the developments being made in the financial structure of a nation and that in its rate of economic growth. There are theories as well which support the empirical evidences suitably. Position of the financial sector of any economy is actually the reflection of the economy upon foreign investors who in turn are eager to venture out at places that contain potential. Hence once the robustness of the financial sector is proven, an economy generally is flooded with investment proposals from abroad, which in turn could lead the said nation towards a path of steady economic progress. Foreign investments on the other hand would mean transfer of new technology which could actually be a leeway for innovations in the host nation. Even though such innovative activities are not carried out in each and every sector in a nation, at least some of them stay better off. Moreover, economic growth would naturally imply betterment in the standard of living of the population and hence, abolishment of a huge number of economic vices. Eradication of these hurdles can in turn motivate the residents of a nation in a number of ways so as to influence them towards participating in the growth process of the economy. Hence it is found that in a capitalist society, even though development in the financial sector strongly means an improvement in the economic growth rate of the nation, it might not mean so in the field of innovation as well. Here comes the role of the fiscal policy makers, who must pay an equal attention to other domains too. Thus, it is recommended to the policymakers to think more deeply prior to framing policies, with the long term future of the nation also in view. References Adelman, I. & Moris, C. T. (1973). Economic growth and social equity in developing countries. USA: Stanford University Press. Ardic, O. P. & Damar, H. E. (2006). Financial Sector Deepening and Economic Growth: Evidence From Turkey. Available at http://www.luc.edu/orgs/meea/volume9/PDFS/Damar%20Ardic%20-%20paper.pdf (Accessed: November 25, 2010). Block, T. (2002). Financial systems, innovation and economic performance. MERIT-Infonomics Research Memorandum series. Available at http://www.merit.unu.edu/publications/rmpdf/2002/rm2002-011.pdf (Accessed: November 24, 2010). Chowdhury, A. (2010). Financial Sector Regulation in Developing Countries: Reckoning after the crisis. Available at http://www.ideaswebsite.org/featart/feb2010/Anis_Chowdhury.pdf (Accessed: November 25, 2010). Hermes, N. & Lensink, R. (1996). Financial development and economic growth: theory and experiences from developing countries. London, UK: Routledge. Hock, S. & Wong, J. (2009). Regional Economic Development in China. Singapore: ISEAS Publishing. Koivu, T. (2002). Does financial sector development affect economic growth in transition countries?. Available at http://www.bof.fi/NR/rdonlyres/5504D400-66AF-4DAB-9565-35BC1E2C13E4/0/finsector.pdf (Accessed: November 25, 2010). Read More