Economic Growth and Financial Development - Example

Economic growth and financial development Contents Contents 2 Introduction 3 Theoretical Background 3 Empirical verification 5 Overview of Brazilian Economy 5 Global Convergence 6 Regional Convergence 8 Conclusion 10 Reference List 11 Introduction Convergence theory in economic growth models can be equated to the process wherein different countries with separate growth rates converge to a similar level of economic growth and development (Cai, Ye and Gu, 2014). The rationale behind the convergence in growth was provided by Solow who had stated that all world economies eventually reach steady state equilibrium. This statement implies that poorer countries tend to grow faster than the richer ones and are able to match up to the latter’s pace. The poorer countries catch up with the richer ones in terms of per capita income (Abreu, 2014). There are two types of convergence that has been identified in the existing literature. The first one is absolute convergence, which states that growth levels of the countries initially differ due to different levels of capital. Once the capital accumulation increases, poor countries are able to be at par with the rich ones in terms of economic growth. The second one is the concept of conditional convergence, which advocates that each country has its own steady state and they converge to their own level of steady state (Allen, J. Qian and M. Qian, 2005). The purpose of the current paper is to analyze the convergence hypothesis in case of Brazilian economy so as to determine whether or not the convergence theory is applicable in practical scenarios. This paper studies the aspect of convergence in the Brazilian economy with respect to the world economy and also that of convergence of different states in the economy. This research is essentially a secondary one and considers empirical study made by other scholars in the related field. Theoretical Background There has been an extensive debate regarding the aspect of convergence in economic growth theory. Before examining the empirical studies of convergence, one must study the theoretical background of convergence. Neoclassical theory of convergence provides one of the earliest explanations of the catching up concept. It states that factor of production capital has diminishing rate of return. In poor countries, the capital to labour ratio is relatively lower as capital endowment therein is lesser. Lower capital endowment implies that the marginal productivity of labour is increasing (Fabião, Teixeira and Borges, 2014). Increasing marginal productivity of capital in the initial stages will result in faster growth of the country relative to a developed economy, which has higher level of capital endowment. In the neoclassical economic theory of convergence, it is assumed that the level of savings and investment between the countries are similar (Ferrara, 2011). The neoclassical economic growth theory also advocates that a country should be open to free trade in order to ensure fast convergence between countries through equalization of product and factor prices. The model presented by Solow and Swan is consistent with the model presented in the neoclassical theory. The basic assumptions of Solow growth model are that factors of production and technological progress are exogenous to an economy and they have diminishing returns to scale (Ferrara, Guerrini and Mavilia, 2013). Solow model assumes that economies that have similar access to technology will reflect similarity in the pattern of savings and population growth. Productivity of countries converges in the long run, which in turn acts as one of the major reasons for convergence in economic growth. Solow model emphasises on this fact as the reason for which convergence in the advanced countries took place (Hermes and Lensink, 2013). The neoclassical theory of economic growth asserts that economic growth will take place, regardless of difference in the level of population growth and saving behaviour. Neoclassical theory states that in this case, poor economies will eventually catch up with the richer ones if the parameters of savings and population growth are controlled (Galor, 1996). Similar predictions were also made by the Solow growth model as it had supported the notion of neoclassical economic theory and established that farther a country is from its steady state, higher will be the rate of its economic growth. This idea can be treated as an alternative way to describe failure of the convergence model in a real world scenario (Caselli, Esquivel and Lefort, 1996). Hence, the steady state of output defined in the Solow and the neoclassical growth model implies that at a steady state, all economies converge and all countries have identical levels of per capita income growth. The endogenous model of economic growth can be considered as a positive criticism of the exogenous growth theory model proposed by neoclassical theory of economic growth. In endogenous economic growth model, technological progress and formation of human capital are two main sources that lead to the economic convergence between nations (Ha and Howitt, 2007). The endogenous growth theory was a major departure from the neoclassical and the Solow model of economic growth, which has been extensively debated in the economic literature. This growth theory states that improvement in the education level of population creates a powerful labour force and instils innovation in the production process (Romer, 1994). According to the endogenous model of economic growth, convergence will occur only when poor countries are able to absorb technological progress from developed countries. Therefore, efficiency in human capital and innovation improvement are reasons, which lead to the economic convergence between nations. Empirical verification Overview of Brazilian Economy A number of researchers have tried to explain the growth pattern theories over time. The current paper describes the type of growth and convergence pattern noted across regions of the Brazilian economy. In order to understand the convergence and growth of Brazil, one must realize structural changes of the Brazilian economy. This paper will examine both the case of regional convergence of the Brazilian economy and that of growth rates of the Brazilian economy with the global economy. The Brazilian economy has been one of the strongest growing economies of the Latin American countries, ever since opening up of its trade policies in the 1980s. The government of the country is stable and has undertaken policies of liberalization since 80s so as to reduce the trade barriers and bring in foreign investment. The efforts of the government have been reflected in the level of economic growth therein. The global financial crisis of 2008 was able to suppress the economic growth of Brazil only for two years. The economic growth of the country had reached the highest mark in 2010 attaining a value of 7.5% (CIA, 2013). The per capita income growth has reached a value $5280 in 2014 and the gross domestic saving was 16.1% of GDP in 2012 (Trading Economics, 2014). The value of per capita income has risen consistently from 2010. The Brazilian economy is heavily dominated by the manufacturing sector mainly comprising metallurgy, machinery, chemical products and so on and so forth. The contribution of the agricultural sector has weakened since 1970s. The importance of the service sector in Brazil has heightened throughout the period of 80s and 90s (Nassif, Feijó and Araújo, 2013). The government has taken necessary actions to liberalize the service sector, primarily in the areas of financial services, port and telecommunication. Brazil has been mainly found to export agricultural products. A research conducted by Ferreira and Facchini (2005) have pointed out that the Brazilian government has greatly reduced the level of average rate of trade protection between 1988 and 1994. Though the government has reduced the overall level of trade barriers in the country, yet certain industries of the manufacturing sector are heavily protected from the international competition through trade barriers. The Brazilian economy has undergone a steady transformation from an agricultural economy to an industrial one. Global Convergence The concept of conditional convergence described by Sala-i-Martin (1996) had clearly distinguished between the concept of unconditional convergence and conditional convergence. Two separate concepts of beta convergence and gamma convergence were introduced in case of conditional convergence. Beta convergence relates to the fact that countries converge to the same level of per capita income and gamma convergence occurs when dispersion in the level of per capita income reduces over time (Heichel, Pape and Sommerer, 2005). The world economy has entered a new age of convergence since beginning of the 90s. Post industrial revolution and era of colonialism, the wide income gap between the developed and developing countries have lessened. The growth of developed countries is linked to that of the developing ones and a cyclical relation has been observed in the growth rates. Per capita income of the developing and emerging countries has grown three times faster than that of the developed ones. The graph in the following figure presents the trend pictorially. Figure 1: Growth rate pattern of emerging, advanced and developing countries (Source: Derviş, 2012) The average rate of growth in the Brazilian economy in the period of 1948-1980 has been estimated to be around 6.4% per year (Nassif, Feijó and Araújo, 2013). This growth rate was considerably higher than that of developed as well as underdeveloped countries. The role of the manufacturing sector has been significant in maintaining the level of economic growth. An empirical research conducted by the United Nations had focused on historical growth of the Brazilian economy and related it with the theoretical considerations. According to the theory of Kaldor (1975), if an underdeveloped country begins its journey of matching pace with a developed one, then a structural change occurs in the former’s economy in the form of resource allocation from the traditional to the manufacturing sector. Furthermore, the theory of Kaldor had also stated that technological spillover occurs in a country while transforming from a primary to an industrial economy (Kaldor, 1975). In case of Brazil, contribution of the manufacturing industry in the total GDP had fallen from 31.3 per cent in 1980 to 14.6 per cent in 2010; yet, there has been allocation of resources from the traditional industries to technology-based ones. The findings had also confirmed that Brazil has fallen into the trap of deindustrialization and is lagging behind the world economy in terms of economic convergence. In the trading sector of the economy, although the demand elasticity of imports had risen from 1.97 to 3.36, elasticity of the exports has fallen from 1.36 to 1.33 (Nassif, Feijó and Araújo, 2013). According to a recent article published in a leading global newspaper, Brazil is one of the fastest growing middle income countries that have joined other countries such as, India and China, in terms of economic growth. Increased trade and entry of FDI in the country can be cited as the main reason that is propelling growth of the Brazilian economy. In 2012, economic growth of the country was 7.5%, which is nearly three times that of the U.S.A. However, the per capita income of Brazil remains lower than that of the U.S.A (Inman, 2011). Three main reasons for the rapid growth of Brazil in the past decade can be pointed out. Firstly, the advent of globalization has strengthened trade links between nations and Brazil is no exception to this trend. According to Frankel and Romer (1999), trade liberalization stimulates economic growth in a country by way of fostering innovation, employment and disseminating advanced technologies. Secondly, there has been a change in the demographic pattern of most developing and emerging countries in terms of lower birth rates and greater capital intensity. There has been a marked increase in the ratio of economically active population to the total population. Researchers have found a link between increase in total proportion of the workforce and economic growth of nations (Grossman and Helpman, 1991). The third source of economic growth and a reason for convergence is the high rate of savings and investment in the emerging countries such as, Brazil. Rise in savings and investment is related to that in productivity of labour by raising the quotient of capital for each labour (Derviş, 2012). Improvement in the process of production is facilitated through increase in total factor productivity. Incorporation of new technology and innovation occurs through increased investment in infrastructure. Endogenous growth models can be broadly divided into two groups. The first group considers technology as a public good. The second group can be classified as neoclassical-Schumpeterian model wherein technology is a general good. Concept of innovation and economic growth has found strong support in the works of Aghion and Howitt (1998), which stated that investment in research and development is the key process to generate high levels of economic growth in a nation. The research conducted by Prettner and Prskawetz (2010) had focused on age of the population and the economic growth theory. The research from their study has shown that population growth will result in positive economic growth only if the savings rate increases so as to support future consumption. Additionally, improvement in research and development coupled with population growth can also bring about positive rate of economic growth. In a recent study conducted by Ulku (2004) on OECD and non-OECD countries, it was established that in non-OECD countries including Brazil, there is a weak positive relationship between research and development and the level of economic growth. Stronger connections between economic growth and innovation growth have been observed in the OECD countries. Regional Convergence The case of absolute convergence in the Brazilian states was studied by Cavalcanti and Goes (1996 cited in Verner, 2004). Absolute convergence has been observed in case of the Brazilian states at an extremely slow pace. Their study had predicted that it would take almost ninety years for the states to converge to a singular steady state income. One of the plausible explanations behind this phenomenon was the fact that certain municipalities were better equipped than others, thereby generating non-uniform growth in the states. The findings of Quah (1993 cited in Laurini, Andrade and Valls Pereira, 2005) had concentrated upon the gamma convergence of Brazilian states. The findings were completely opposite to that of Cavalcanti and Goes (1996 cited in Verner, 2004). The municipalities with lower income did not reflect higher growth as compared to those that had higher income. Also, the dispersions of income did not appear to diminish between the states. Researchers have suggested that income inequality and regional growth disparity are inherent in the convergence hypothesis. The proponents of the new endogenous growth model like, Lucas (1988 cited in Mankiw, Romer and Weil, 1992), have also focused on the aspect of divergence in per capita income within the regions of a state. The study conducted by Azzoni (2001) had tested the aspect of income inequality and regional growth in Brazil in order to predict the convergence or divergence pattern of income growth among the states. The empirical study had confirmed that although there are indications pertaining to regional convergence of per capita income in Brazil, high levels of income inequality are present between the regions. The study had also confirmed that equalization of income among the Brazilian states is a time consuming process and the pace of convergence is also slower compared to that of the advanced countries. A strong divide has been observed in economies of the north and north-east regions and those of the south and south-east regions of Brazil. The rate of convergence appears to increase in the contemporary times. Hence, it can be argued that there are signs of conditional convergence for states in the Brazilian economy (Azzoni, 2001). Assumptions made in an empirical study are crucial for determining the results. Critical assumptions can alter the results obtained from an empirical framework. The study conducted by Lima, et al. (2010) had emphasised on the convergence of per-capita income of the Brazilian states based on time series data. The results obtained were considerably different from that of researchers who had focused on cross-section data of Brazil. ARIFMA models were used so as to comment on the extent of convergence that had occurred between the states. Results indicated that the convergence hypothesis does not hold true for the Brazilian states. There is a commonality in the conclusion provided by theoretical models, which highlighted on conditional β convergence. These theoretical models suggest that parameters such as, savings rate of the country, level of educational achievement and infrastructure, determine growth of each region of a country and based on these parameters, the regions converge to their own steady state. In context of Brazil, based on the broad theoretical literature, the case of absolute β convergence is a far cry from reality. Conditional convergence patterns are still observed to an extent. Conclusion Neoclassical growth theories have heavily propagated the role of convergence in growth rates of the developing and developed countries. The Solow growth model have supported the basic notion of the neoclassical growth theory and introduced the concept of conditional convergence in order to overcome shortcomings present in the absolute model of convergence. Endogenous growth theory opposed the basic idea of neo-classical growth theories and had stressed upon the role of technology and human capital development. The Brazilian economy had been studied in details in the current paper. Brazil is found to experience a high rate of growth in recent decade. Liberalization of the economy and improvement in its trade and commerce, rise in savings rates and transformation from agricultural to a manufacturing economy has resulted in fast economic growth of the country. These factors can be attributed to catching-up of the economy with the advanced countries. Yet, there are signs that the country may not converge with the global economic growth rate. Deindustrialization of Brazil is the main reason that can be accounted for slowing down of the growth rate. In terms of regional growth rates, the result is rather unclear. Most researchers working with cross-section data have concluded that convergence is observed in case of Brazilian states. However, time series data have revealed that Brazilian states do not show signs of convergence. 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