Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 5 Bank Credit

Analytical Issues on The Role of Credit

Financial development, i.e., the existence of well-functioning financial institutions and markets, is believed to contribute to economic growth through a number of channels:

1. acquisition of information on firms;

2. intensity with which creditors exert corporate control;

3. provision of risk-reducing arrangements;

4. pooling of capital and

5. ease of making transactions.

Financial institutions are better suited than individuals to identify potentially successful projects because these institutions have better information gathering and processing ability and the requisite personnel skills to monitor the efficiency and productivity of projects. By reducing the costs of acquiring and processing information, financial institutions improve resource allocation and encourage the mobilisation of savings to invest in large projects. They also facilitate the pooling and hedging of risks inherent in individual projects and industries. Well-developed financial markets augment liquidity in the economy. Adequate liquidity enhances savings in the economy by reducing liquidity risk of securities holders' by allowing them to sell their securities easily without affecting firms' access to the funds initially invested. By exerting effective corporate governance, financial systems can help to retain domestic savings at home. Thus, well-developed financial markets and institutions can generate growth by increasing the pool of available funds and by reducing the risk and ensuring productive uses of funds mobilised from savers. The endogenous 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 has often been forcefully emphasised. By facilitating borrowing for accumulation of skills, financial systems can promote the accumulation of human capital.

Several studies have attempted to examine the relationship between various alternative indices of development (such as, the ratio of consumer credit to GDP, market capitalisation to GDP and bank credit to GDP) and growth rates. Illustratively, using cross section data for 77 countries for the period 1960-1989, King and Levine (1993) found statistically and economically significant positive relationship between the measures of financial development and growth. The measures of financial development used in this study as well as most subsequent studies are, however, quite different from what the theory suggests. Benhabib and Spiegel (2000) found that financial development affects growth both through capital accumulation and productivity increases engendered by knowledge creation.

The issue of causality between finance and growth, however, remains unsettled. Financial development may promote growth simply because financial systems develop in anticipation of future economic growth. Furthermore, differences in political systems, legal traditions or institutions may be responsible for driving both financial development and economic growth. Rajan and Zingales (1998) attempt an industry-wise analysis to circumvent the issue of causality between finance and growth and find that industries that are relatively more dependent upon external finance grow relatively faster in countries that have well-developed financial systems. Fisman and Love (2003), however, argue that the external dependence measure of Rajan and Zingales (op cit.) may be capturing good global growth opportunities rather than the role of finance.

According to Favara (2003), the relationship between financial development and economic growth is, at best, weak. Moreover, the relationship is nonlinear in the sense that finance matters for growth only at intermediate levels of financial development. The effects of financial development are found to differ considerably across countries and display no obvious pattern. In contrast to Favara's findings of non-linear effects, Bossone and Lee (2004) find empirical support in favour of 'systemic scale economies' (SSE) hypothesis, i.e., larger, deeper and more efficient systems enable banks to save on the resources needed to manage the higher risks associated with larger production. Small banks in large systems are more cost efficient than small banks in small systems. Banks in small systems are found to over-utilise financial capital and vice versa. Finally, Bassone and Lee also find that large banks in large systems operate at an approximately optimal capital level.

In brief, the empirical evidence suggests that there exists a positive correlation between finance and growth. There is also an emerging consensus that the causation runs from finance to growth. Differences in financial development can alter economic growth over long time horizons and, therefore, well-developed financial sector is crucial for all economies. Healthy and competitive financial markets are an extraordinarily effective tool in spreading opportunity and fighting.

In India, the role of finance in promoting growth was recognised early on after Independence. The First Five-Year Plan (1951) observed that central banking would have to take on a direct and active role in creating the machinery needed for financing developmental activities and ensuring that the finances available flow in the directions intended. With the initiation of the reform process in the early 1990s, although there has been a paradigm shift in the credit allocation process from micro-management to a greater role for market forces in credit allocation, the Reserve Bank continues to pursue with its efforts to improve the credit delivery mechanism in the economy. For India, empirical evidence confirms the positive role of finance on growth (RBI, 2001).