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Project on Indian Financial Market - Module: 1
Financial Development and Economic Growth in India

[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Channels of Interaction between Finance and Growth

Financial development and growth has been a crucial subject of public policy for long. As early as in the 19th century, a number of economists stressed the importance of financial development for the growth of an economy.9 The banking system was recognised to have important ramifications for the level and growth rate of national income via the identification and funding of productive investments. This, in turn, was expected to induce a more efficient allocation of capital and foster growth. A contrary view also prevailed at the same time suggesting that economic growth would create demand for financial services. This meant that financial development would follow growth more or less automatically. In other words, financial development could be considered as a by-product of economic development.

The issue of sources of finance gains importance in this context. The preferred modes of finance get to a substantial extent determined by the level of financial development, institutional practices, legal structures and other country-specific features. For instance, in the absence of a well-developed stock market, the traditional treatment about the availability of choice between banks and stock markets as providers of liquidity at the short-end and the long-end would be of limited relevance for countries. In certain other cases, the stock-markets might not be efficiently functioning and could create a wedge between the preferred financing hierarchy of the firms and the one that could support accelerated growth of corporate investment and output. If the markets are competitive, complete and well functioning, financing choices would be rendered irrelevant by the sheer efficiency of the markets. However, in practice, the instances of financial markets having developed and matured to such an efficient state are few and far between. As such, given the market imperfections, financial development becomes a crucial determinant of the growth, with links being provided through the processes of saving and investment as also the choices that economic units exercise between the alternate sources of financing investment.

t is important to note in this connection the several functions that a financial system is expected to perform. First, in the presence of informational asymmetries, financial markets could still develop in order to facilitate trading and hedging of risks. Risk mitigation and economising on information acquisition and processing reduce uncertainty and enable resources to flow towards most profitable projects. Such a situation would raise the efficiency of investments and the rate of growth. Secondly, by acting as an efficient conduit for allocating resources, the financial system enables an improvement in technical progress. Technological innovations take place when entrepreneurs exploit the best chances of successfully imitating technologies in their production processes and introducing new products. Over time, as skills develop, and as the economy experiments with adaptations of the existing technologies, and creates a base for research and development of new technologies, growth rates are likely to move upward. This is particularly valid in financial systems that are more effective at pooling the savings of individuals and permitting continuous upgradation of technologies for promoting growth on a sustained basis. Finally, to the extent that financial development leads to the creation of financial infrastructure and enables better and more efficient provision of goods and services, costs of transactions would be lower, with positive spillover on economic growth.

These possibilities may not be in evidence in many developing economies where distortions in the financial systems impact the growth process adversely and result in dead-weight loss. In a number of developing economies, interest rate ceilings, high reserve ratios and directed credit programmes are generally noticed. Such requirements though necessitated by the initial conditions, limit the degrees of freedom for the conduct of monetary and financial policies.

The recent growth literature, building on 'learning by doing' processes, assigns a special role to finance. Finance is seen as a crucial factor of production like knowledge and the influence of institutional arrangements in regard to finance on growth rates has often been forcefully emphasised. These models offer important insights on the impact of financial development on economic growth which are of relevance to the Indian
context (Box III.1).


Box III.1
Endogenous Growth and Financial Development

The linkage between finance and economic development has been resurrected over the past decade by the endogenous growth theory. The new growth models trace the steady-state growth rate (g) in terms of three crucial parameters, viz., the level of technology, as captured by social marginal productivity of capital (A), the proportion of savings channelled to investment (f) and the saving rate (s). Ignoring depreciation, the new theories seek to establish that g = A f s. Financial development could influence economic growth by increasing the productivity of capital, or lowering of intermediation costs (via an increase in f), or by enhancing the saving rate.

An efficient financial system allocates funds to projects with the highest marginal product of capital and thereby fosters economic growth. However, this process is costly. First, in order to find the most profitable project, financial systems need to monitor or screen alternative projects. Even if high-return projects are identified, they could carry high risks, discouraging individuals from investing in these projects. In such situations, financial systems play a role in risk-sharing and inducing individual investors to invest in high-return, albeit riskier, projects. Specifically, the role of financial institutions is to collect and analyse information so as to channel investible funds to investment activities that yield the highest returns [Greenwood and Jovanovic (1990)]. In the analytical framework of Greenwood and Jovanoic, capital may be invested in a safe, low-yield technology or a risky, high-yield one. In contrast to individual investors, financial intermediaries with their large portfolios can acquire better information on the aggregate productivity shock and choose the technology that is most appropriate for realisation of the shock in the current period. The financial intermediaries would help channelise savings into such areas and help realise higher productivity of capital and higher growth.

This phenomenon could be seen from a different angle. Individuals face uncertainty about their future liquidity needs and therefore need to either invest in a safe, low-productive liquid asset, or in a risky, high-return illiquid asset. In such a set-up, financial intermediaries allow individuals to reduce risks associated with their liquidity needs and channel savings into activities with high productivity [Bencivenga and Smith (1991)].

Alternately, consumers' liquidity risk can be shared via security markets [Levine (1991)]. Individual investors can sell shares in the stock market when they face liquidity problems. These markets also enable the individual investors to diversify their rate-of-return risks by devising appropriate portfolios. This two-fold insurance function promotes willingness to invest in less liquid, more productive projects and also helps to avoid unnecessary terminations. Portfolio diversification via stock markets expected to have a growth enhancing effect, by way of encouraging specialisation of production by firms.

There could also be the feedback relationships among banking specialisation, costs of monitoring and growth [Harrison et al. (1999)]. Growth increases banks' activity and profits, and promotes entry of more banks. The entry shortens the average distance between banks and borrowers, facilitates regional specialisation and lowers in the process the cost of financial intermediation, which, in turn, boosts investment, and thereby growth.

There are a number of possible routes through which financial development could affect saving rates. These involve idiosyncratic risks, rate-of-return risks, interest rates and liquidity constraints. First, a reduction in endowment and liquidity risks by insurance and finance markets might lower the level of precautionary saving by households, and therefore the growth rate. If country-specific endowment risks are shared via the international capital markets, saving rate and economic growth would be lower than would otherwise be the case. Thus, a reduction in these two kinds of risks as a result of financial development can have different effects on growth. Secondly, financial development, for example, by reducing 'financial repression' could lead to increase in the interest rates paid to households, but the effect of such an interest rate hike on saving might not be necessarily favourable due to the presence of well-known income and substitution effects. Empirically, however, financial repression is generally found to be growth retarding [Roubini and Sala-i-Martin (1992)]. Thirdly, easing liquidity constraints on households by liberalising consumer credit and mortgage markets may lower the saving rate, since younger generations in their overlapping generations model would dissave much more in the absence of liquidity constraints [Jappelli and Pagano (1994)]. Thus, in the endogenous growth theory, the overall effect on saving rate is not unequivocally clear and financial development could well reduce saving via the effect on the growth rate.




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