finance, growth, and development
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KINGSTON UNIVERSITY, LONDONSCHOOL OF ECONOMICS
Monetary Economics in Developing Countries (FE3178), 2009-2010
Lecture 2
Finance, growth, and development
Chapter 2 GSF
Introduction
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The financial system plays a key role in promoting economic efficiency.
How? Mainly by overcoming pervasive information asymmetries in
lender-borrower relationships.
Financial institutions match:
Economic agents who can supply otherwise idle financial resources
Others who demand these resources for investing in specific projects
That is how financial institutions contribute to achieving better resource
allocation and faster long-run economic growth.
Financial institutions key operations include
Risk pooling -aggregating the risk of many creditors helps in
diversifying away overall risk
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Maturity shifting -effectively matching borrowers and lenders with
different financial needs in terms of timing
Promoting specialisation and innovation
Providing liquidity
Through these and other related functions that financial institutions
contribute to achieving better resource allocation in the economy.
This process implies that scarce funds are channelled towards the sector in
which their return is highest.
E.g. financial institutions played a key role in promoting new technologies
during the industrial revolution in England.
Funding illiquid, long-term, projects like railway building.
The financial system is also central to the effectiveness of monetary policy
and to overall macroeconomic stability.
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Implementing market-based monetary policy demands well functioning
interbank markets.
This lecture focuses on financial development and financial structure, and
on their linkages to economic growth and development.
Further distinguishing between the literatures on financial development
and financial structure is important.
There is ample theoretical and empirical work on how financial
development affects economic growth
We know much less about financial structure -i.e. an economys mix of
financial intermediaries, institutions, and markets- and how it affects
economic growth and development
The lecture contains three parts explaining:
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1. Why and how financial intermediaries can play an important role in
the economy, and how this role is related to economic growth and
development;
2. The importance of legal and other factors in determining financial
structure, and introduce issues related to banking regulation and
supervision;
3. Empirical evidence on financial development and growth.
Financial intermediaries
How do financial intermediaries foster economic growth and
development?
Gurley and Shaw (1955)the function of financial institutions is to
transform financial contracts and securities.
Banks take deposits from households and transform them into loans to
firms and entrepreneurs.
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Probably the key reason why banks are useful in providing this service is
the presence of transactions costs.
These costs, in turn, imply potential economies of scale in the provision of
the transactions technology.
Diamond and Dybvig (1983)banks are important because they offer
households a sort of insurance against liquidity shocks.
The key to this argument is that these shocks are only privately observed.
Bencivenga and Smiths (1991)(developing arguments from Diamond
and Dybvig) banks lead to higher investment productivity by channelling
funds to illiquid but high-yielding technologies, and by reducing potential
losses arising from early liquidation.
Adopting these new technologies can lead to faster economic growth.
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Diamond (1984)financial intermediaries process information for all the
potential investors a delegated monitoring function.
This role facilitates allocating funds to firms likely to succeed in a given
project, and is why some types of loans are better made by financial
intermediaries.
Gorton and Pennacchi (1990)banks can help in overcoming adverse
selection problems related to the creation of safe demand deposits.
But banks are not the only institutions that can provide that type of service.
In advanced economies there usually exist various types of public and
private bonds with relatively low default risk.
However, in developing countries where the governments financial
position tends to be rather weak, and where corporate bonds are not as
prevalent, banks indeed play a prominent role.
The models developed by Townsend (1978, 1983) and Greenwood and
Jovanovic (1990) highlight intermediation costs.
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These costs may take the form of fixed expenses to enter the financial
system, as well as marginal costs for undertaking subsequent transactions.
** Acemoglu and Zilibotti (1997)an economys level of development
is critical in determining economic outcomes.
Models features at early stages of development an economys growth
prospects are held back by project indivisibilities and by the related
uncertainty.
The scarcity of financial resources characterising these economies implies
that fewer projects will be implemented, which in turn slows down the
process of economic development, the level of productivity in these
economies will be endogenously lower.
Since diversification possibilities are limited, the chosen projects will
likely have to bear risk that would be potentially diversifiable in a more
developed financial context.
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So financial deepening moves alongside economic development. The
related higher level of intermediation and the presence of adequate
diversification can help to reduce the variability of economic growth.
Diamond and Rajan (2001)argue that the liquidity risk inherent in the
banking business, although usually seen as banks main weakness, is likely
to be a vital characteristic of these institutions
Banks commitment to honouring deposits creates liquidity because
these institutions possess loan collection skills.
In instances of illiquidity, arising, for instance, from an adverse shock, a
bank has the capacity to raise liquidity from other depositors through the
use of its collection skills as the fragile nature of its capital structure would
otherwise lead to a run on the bank.
In Diamond and Rajans model creating liquidity is in fact facilitated by
banks inherent financial fragility.
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As in Holstmrm and Tirole (1997, 1998), in Diamond and Rajans
model firms may be denied funding because their future profits are not
likely to be readily transferable to outsiders to the project.
Banks help in overcoming this problem by making adequate use of the
collateral pledged ex-ante in the contractual agreement between the
borrower and the bank.
But in addition to using the collateral efficiently, in Diamond and
Rajans model banks actually enhance the collaterals value.
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How dostock markets help in promoting growth and
development?
Stock markets are increasingly more important in understanding the
finance-growth link, particularly in developing economies.
Stock markets can foster economic growth and development through
several channels.
Facilitating equity trading, and by reducing the risk implicit in long term
investment projects.
But that lower risk may also work by reducing savings and capital
accumulation, and may actually end-up reducing growth prospects.
Stock market liquidity also helps in trimming down the costs involved in
undertaking long term projects yielding higher returns; those higher
returns imply higher returns on savings.
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The problem with this channel is that the second round effects may lead to
economic agents opting to save less because they now get more returns
from a given amount of savings. And that could ultimately slow down
economic growth.
Stock market liquidity may adversely affect economic growth by reducing
the amount of time economic agents devote to monitoring firms and
managers.
However, stock market liquidity could also lead to more intensive
monitoring, in which case the economy will ultimately gain (e.g.
Holmstrm and Tirole, 1993).
** The message from the above arguments is that ex-ante it is not
possible to make unambiguous predictions about stock markets and
their likely impact on the economy.
Even though stock markets are considered alongside banks as a potential
source of finance for developing economies these institutions are still
much less important in relative terms.
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This is true regardless of the fact that stock market capitalisation in
developing countries has grown considerably over the last two decades or
so, partly as a result of capital market liberalisation efforts (e.g. Henry,
2000a, 2000b).
Husler, Mathieson, and Roldos (2003) argue that activity in domestic
capital markets has not expanded enough to provide a solid alternative to
banking or international markets.
According to these authors, this situation arises largely due to the
underdevelopment of related markets, such as that forgovernment bonds.
** Fostering bond markets is important for:
Securing funding to undertake long-term government projects;
Designing and implementing a market-based monetary policy strategy like
inflation targeting;
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Protecting the government and the rest of the economy from adverse
economic shocks;
Fostering financial intermediation and competition in the financial system;
Promoting and safeguarding financial stability.
It important to note that, for instance, Singh (1997) argues that the
volatility characterizing stock market activities is unlikely to be helpful in
fostering investment in a developing economy context.
Also, pervasive interactions among the exchange rate market and the stock
market in the face of adverse economic shocks may actually aggravate
economic instability and slow down economic growth.
Further, banks in many developing countries are relatively successful, and
developing stock markets may generate adverse effects on these
institutions.
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But banks and stock markets may well provide complementary financial
services.
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Theory
Even if we are not sure that stock markets can actually help developing
countries in fulfilling their financial needs it is important to understand the
mechanics behind their operation.
Levines (1991) model employs elements from the endogenous growth
(highlighting human capital investment) and the financial structure
(particularly liquidity risk) literatures.
In Levines modelling a stock market arises to distribute productivity
and liquidity risks.
The framework predicts that economic agents will react to liquidity shocks
by selling shares to other investors in the stock market, i.e. by trading
ownership of firms. So in an economy with a stock market a firms
financial backing is less likely to be liquidated prematurely.
Such an outcome is possible because not all firms face liquidity shocks at
the same time.
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This liquidity role is important, because financing illiquid projects is not
curtailed by uncertainty concerning investors short-term liquidity
requirements.
Moreover, in the model, withdrawing funds from projects actually implies
less human capital accumulation and consequently lower economic
growth.
Furthermore, portfolio diversification in the stock market implies that the
risk individuals face is lower than in their absence.
Stock markets may be useful technologies to foster investment in illiquid,
but relatively more productive, projects.
Thus, for an economy as a whole, stock markets can increase overall
investment productivity and steady state economic growth rates.
Saint-Paul (1992) advances further interesting insights on financial
development and on how it affects economic outcomes.
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Saint-Pauls key argument is that stock markets allow firms to adopt
riskier technologies which, by their nature, demand greater division of
labour.
Thus, portfolio diversification via the stock market, which works by
spreading the risk inherent in the greater division of labour demanded by
the riskier technologies, can actually lead to higher steady-state growth.
This modelling seems to be useful for explaining why some countries may
be trapped in what Saint-Paul calls low output equilibrium i.e. one
characterised by little division of labour and by a correspondingly
underdeveloped financial market.
In contrast, countries that are able to develop sound financial markets will
also achieve a high level of division of labour and faster economic growth
rates.
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Given the costs involved in developing a sound financial market, Saint-
Pauls analysis implies that there may be a rationale for government
intervention to support financial development.
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Law and finance
There is a growing literature stressing the importance of a solid legal
environment in determining economic outcomes.
This research effort basically concludes that economic development
benefits from a system in which law and order effectively protect
investors rights.
La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998) contribute to
the law and finance approach to financial development by investigating the
relationship between a countrys legal system and its financial structure.
Their extensive research employs data on 49 economies and concludes that
a countrys legal origin is relevant in explaining a countrys financial
development.
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Banking regulation and supervision
Care should be paid to strike the right balance when designing, operating,
and reforming the legal frameworks regulating financial institutions.
Barth, Caprio, and Levines (2005) provide a detailed analysis of
banking regulation and supervision.
These authors aim at contributing to a better understanding of which
modality of banking supervision and regulation works best in practice.
They put together a substantial amount of information to gain insights on
banking regulation and supervision in over150 countries.
Barth, Caprio, and Levines plan involves considering institutional, and
particularly political, issues underlying a countrys decision on how to
shape its financial regulation and supervision structure.
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Such considerations are important because a series of agency problems
usually arise between bankers, regulators, and other market participants.
For instance, banking supervision institutions, in principle, aim at
monitoring banks as effectively as possible. But that supervisory role may
in fact be influenced by the political interests of those appointing or
monitoring the supervising officials.
Barth, Caprio, and Levines extensive data collecting exercise reveals
substantial heterogeneity between regulatory and supervisory systems
across-countries.
That is an important conclusion because it implies that formulating
banking regulation frameworks at an international level will probably
reach dead-ends or lead to undesirable results as diverse individual
economies attempt to implement these policies.
The study also draws concrete conclusions regarding Basel II and its likely
impact on adopting economies.
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Interestingly, they find that capital requirements do not seem to have a
significant impact on a banking systems development, efficiency, or even
that it helps in preventing banking crises.
What they do find is that strengthening banking system monitoring helps
in developing the banking sector, making it more efficient and less prone
to crises. But care should be taken in relation to deposit insurance policies.
The authors find that generous schemes tend to be related to a higher
probability of observing currency crises.
The channel underlying this problem works via the moral hazard arising
when depositors feel that their savings are safe and as a result do not
screen financial institutions adequately.
Finally, Barth, Caprio, and Levines most striking conclusion is that
merely increasing the powers of supervisory agents may not be enough to
improve the overall performance of banking systems.
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Note the clash with the spirit ofBasel IIs recommendations on
strengthening the powers of banking supervision bodies.
On the contrary, increased supervision may actually generate adverse
consequences.
That is a reasonable finding if one thinks about an economy in which
institutions are weak, and where those in charge of supervising the
financial system already have significant authority and are prone to
corruption.
But that does not imply that improving banking regulation according to
Basel II is an outright bad idea.
What it does imply is that reforming banking system regulation and
supervision should ideally proceed alongside wider-ranging improvements
in a countrys institutions.
In fact, work by Acemoglu et al (2003) finds that weak institutions
(notably political institutions that do not constrain politicians and political
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elites) tend to be related to poor macroeconomic policies and are a key
element in determining an economys volatility.
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Empirical evidence on finance and growth
Goldsmiths (1969) investigation is an early contribution to this area of
research. One of his main findings is that banks relative size tends to
increase alongside an economys development.
He also shows that stock markets and other financial intermediaries grow
in size relative to banks as an economy develops.
However, based on empirical analysis using data comprising 35 countries,
he does not reach a clear conclusion on the causality amongst financial
development and economic growth.
That question is the focus of a large and growing literature following
Goldsmiths work.
A further problem faced by that early literature and which still lingers is
upon agreeing on a satisfactory definition of financial development.
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*** King and Levine (1993) study a large sample of countries over the
period 1960-1989, focusing on the role of financial intermediaries.
They examine the following indicators of financial development:
(1) Financial depth defined as the ratio of liquid liabilities to GDP;
(2) The importance of deposit money banks vis--vis the central bank; and
two measures of commercial banks credit allocation to the private sector;
(3) Claims on the non-financial private sector to total claims;
(4) Gross claims on private sector to GDP.
King and Levine explore the relationship between these indicators and
long-run average real per capita GDP growth.
They also examine the link between the financial development indicators
and alternative measures of economic growth. The latter exercise aims at
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throwing further light on the channels via which the finance-growth link
potentially works.
To that end they analyse physical capital accumulation (average rate of
growth of real per capita capital stock) and a societys efficiency in
allocating capital (total productivity growth).
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The papers empirical strategy involves estimating the following
econometric model
+++= XFGij
.
In the equation all the variables are averaged over the period 1960-1989.
The variables definitions are as follows:
GGrowth indicators, with the subscript
j
standing for each of the
three different measures as detailed above;
F
Financial development indicators, with the subscript
i
standing
for each of the four different measures as detailed above
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XAncillary variables included to control for other elements
expected to influence economic growth: initial income, initial
secondary school enrolment rate, ratio of government
consumption expenditure to GDP, inflation, and the ratio of
export plus imports to GDP.
Note that King and Levines exercise involves running a total of 12
regressions (thus generating twelve
s, one for each growth measure as a
function of each financial development indicator plus the ancillary
variables) using a data set comprising a cross-section of 77 countries.
The econometric modelling finds that all the financial development
coefficients (
s) are statistically significant.
Thus financial development is associated with higher economic growth,
physical capital accumulation and improvements in efficiency.
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These results hold after controlling for a battery of ancillary variables
accounting for country and policy characteristics (
X
).
King and Levine further show that the predetermined components of the
financial development indicators are positively linked to future rates of
economic growth, physical capital accumulation and improvements in
efficiency.
They interpret that evidence as supporting the Schumpeterian view on the
financial sectors critical role in explaining economic performance.
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