From Raj Nallari and Breda Griffith's lecture notes.
A large body of both theoretical and empirical literature supports a positive causal link between a well-functioning financial system and economic growth. In particular, the economic growth studies of the last decade show that financial depth causes economic growth and that it is one of the few robust determinants of the subsequent growth path of countries.
An important related question is whether macroeconomic developments themselves can impact financial sector growth. As we demonstrate below, economic growth, macroeconomic stability, inflation, and balance of payment developments can all affect financial development.
Although the link between financial sector development and growth is well-established, the direct relationship between financial development and the income of the poor remains unclear. Several competing theoretical predictions exist about the impact of financial development on changes in income distribution and poverty alleviation. Recent empirical literature has, however, found that financial development reduces income inequality by disproportionately boosting the incomes of the poor. In particular, it has been found that countries with better-developed financial intermediaries experience faster declines in measures of both poverty and income inequality.
While financial development can be very beneficial, the data show that usage of financial services is far from universal in many developing countries. Countries can, however, undertake a variety of policy measures to increase access to financial services, including through strengthening their institutional infrastructures, liberalizing markets and fostering greater competition, and encouraging innovative use of know-how and technology.
In this and upcoming postings we will analyze each of these issues in turn. We will conclude by discussing other topics that are highly relevant to the general theme of financial development and poverty: the history of financial sector reform in developing countries in recent decades, the role of microfinance in providing credit to the poor, and the increasing importance of emigrants’ remittances for many developing countries.
Financial Development and Economic Growth
The proposition that financial sector development supports economic growth is fairly well established in the literature. Almost a century ago, Schumpeter argued that financial intermediation through the banking system played a key role in economic growth by improving productivity and technical change. Specific channels through which financial development might help economic growth include: (i) raising and pooling funds (allowing more and more risky investments to be undertaken); (ii) allocating resources to their most productive use; (iii) allowing effective monitoring of the use of funds; (iv) providing instruments for risk mitigation; (v) supporting firms’ growth opportunities, especially for small and medium-sized enterprises; and (vi) lowering inequality levels.
Turning to the empirical evidence, Jalilian and Kirkpatrick (2005) and Levine (2005) review the current state of play. Recent cross-country econometric analysis provides evidence that financial development is robustly related with economic growth. (See, for example, King and Levine, 1993, Arestis and Demetriades, 1997, Levine, 1997, Rajan and Zingles, 1998, and World Bank, 2001). This seems to work mainly through higher physical capital accumulation and economic efficiency improvements under well-developed financial systems.
More recent econometric techniques, which use the pooling of cross-country and time-series data, allows a strong test of the direction of causality between financial development and growth. These studies, which include Levine, Loayza and Beck (2000) and Beck, Levine and Loayza (2000), also find that there is a positive link between financial development and growth. The causal factors include the contribution of financial development to private savings, capital accumulation and productivity, with the latter playing the most important role.
In terms of the magnitude of this impact, the World Bank (2001) has found that a doubling of private sector credit to GDP – a common measure of financial depth – is associated with a two percentage point increase in the rate of GDP growth (debate remains, however, with, for example, Aghion, Howitt, and Mayer-Foulkes (2005) raising serious questions about whether financial development affects steady-state growth, or whether it instead influences the rate of convergence to higher income countries. Either way, however, financial development is seen as positive for economic growth). But the literature also finds there is substantial cross-country heterogeneity in the relationship between financial development and economic growth. This is unsurprising and reflects structural, institutional and policy differences in the economies included in the sample (Jalilian and Kirkpatrick, 2005).
Next week: Macroeconomic Fundamentals and Financial Development