The role of the financial sector in economic development Essays

The role of the financial sector in economic development Essays The role of the financial sector in economic development Essay The role of the financial sector in economic development Essay The topic of my essay covers one of the most distinguished areas in the theory of economics financial sector. There is an enormous corpus of literature dedicated to this particular aspect and it was my intention to review only those that are very closely related to the role of financial system and financial liberalisation. To be able to assess the role of the financial sector and financial liberalisation, it is convenient to divide the title of this paper into several categories. In a subsequent section the role of the financial sector will be reviewed. In separate sections I will introduce the present theory of financial liberalisation, its advantages and risks inherent to it. Given a constraint of a world limit it is impossible to go through all the arguments within the scope of the topic, that is why, I tried to choose only those, which were in my opinion of the most prominence. It is by now widely agreed that finance contributes to long-term prosperity. It is obvious that advanced economies have sophisticated financial systems. What is not obvious, but is borne out by the evidence, is that the services delivered by these financial systems have contributed in an important way to the prosperity of those economies. Getting the financial systems of developing countries to function more effectively in providing the full range of financial services is a task that will be well rewarded with economic growth. An efficient and stable financial sector is important for economic growth and poverty reduction. The financial crises that have afflicted many countries in recent times have been a costly and painful reminder of the disastrous consequences for development of weak financial markets. Financial stability is crucial for sustained economic growth and cannot be achieved without strong financial systems. Weak financial systems can destabilise local economies, making them more vulnerable to external shocks, and may threaten global financial markets. In practice an efficient financial system can simultaneously lower the cost of external borrowing, raise the returns to savers, and ensure that savings are allocated in priority to projects that promise the highest returns, all of which have the potential for affecting economic growth rates. 1 Holden and Rajapatirana (1995), stress the importance of financial sectors suggesting, that economic growth and, in particular, the development of the private sector cannot occur without a financial system that effectively intermediates between savers and investors. A healthy financial sector allows financial resources to be allocated toward activities with high rates of return; allows efficient intermediation, which implies lower resource costs; and yields better information processing, which allows innovative investments to be identified. 2 Gibson and Tsakalotos (1994) emphasize how crucial the organisation of the financial sector is and add that the financial sector can actively help to promote growth. 3 To understand why the financial system is so crucial to development, it is useful to outline the advantages of financial intermediaries. 4 They suggest that a well-functioning financial system might permit a higher level of saving and investment and, therefore, economic growth. For many years, governments followed a policy of financial repression, which relied on fixing interest rates below market levels and controlling the allocation of credit. The economic distortions induced by these policies were considerable. Financial systems remained under-developed, lending patterns were inefficient and failed to achieve their distributional goals. Negative real interest rates led to low savings and encouraged capital flight. Macro-economic performance also deteriorated countries with large negative real interest rates experienced lower allocative efficiency and growth rates. In the state-owned banking sector, poor lending decisions (often politically influenced) and low repayment rates led to bank insolvency and large budgetary bailouts of depositors and creditors. 5 McKinnon-Show analysis of a financially repressed economy suggests that interest-rate ceilings stifle savings by promoting current consumption, reduce the quantity of investment below its optimal level and reduce the quality of investment by encouraging banks to finance only low-return projects. The clear policy implication is the removal of interest-rate ceilings and more generally other government regulations, which prevent the loan market from operating competitively. A growing awareness of the economic costs of financial repression, led to financial liberalisation as the dominant policy paradigm over the past two decades.