Financial Development and Real Development : Some Observations

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Financial Development and Real Development : Some Observations
« on: February 07, 2019, 02:03:20 PM »
Financial Development and Real Development : Some Observations

Several empirical studies have confirmed that there is a strong link between financial development and economic growth. Countries with well-developed banking system and capital markets tend to enjoy faster growth than those without. A study by Rosel Levine and Sara Zervos examined forty seven countries from 1976 to1993. They found that stock market liquidity (the value of shares traded relative to stock market capitalization) and the size of the banking sector ( measured by the lending to the private sector as a percentage of GDP ) are good predictors of future rate of growth, even after controlling for other factors, such as initial level of income, education and political stability.

In rich economies, the assets of financial intermediaries and the size of the stock and bond markets all tend to be bigger in relation to GDP than in poor ones. In emerging economies, banking system is quick to develop, but capital markets take longer; because capital market need a financial infrastructure that provides, among other things, adequate accounting standards, a legal system that enforces contracts and protects property rights, and bankruptcy provisions.

However, the relationship between the real and financial components of the development process is, to a large extent, influenced by a large number of factors. They include factors affecting financial growth whose relationship with economic development is very difficult to pinpoint, for example, the degree of centralization of the economy, international relations, methods of financing public debt and the existence of acute or chronic inflation. Another set of factors which affect the structure and modus operandi of the economy and financial system include the subsistence nature of the economy, the degree of sectoral and spatial diversification, pattern and level of urban consumption compared with average disposable income, prevailing habits and forms of savings by economic agents. Although, the fundamental dynamics of development lie outside the banking system, the way the system is structured can either significantly hasten or retard development.

It must be remembered that the method of operation of the financial institutions and the way in which agents and functions are specialized depend to a large extent on the characteristic of each country, especially it’s policy guide lines, relation between the public and private sector as regards financial matters and the level of openness or self financing of the dominant enterprises.

One aspect of financial development which has drawn attention of economists and bankers is the phenomena of financial repression and financial liberalization.

Financial repression and financial liberalization

The formal banking and financial sector is repressed primarily by interest rate ceilings that are particularly binding when inflation is high and artificially low loan rates create an excess demand for loan able funds that may be rationed through favoritism to licensed importers, large scale exporters, protected manufacturers and government agencies. Unfavored enterprises are excluded from the long term finance of the formal banks and left to borrow at much higher rates from the informal financial sector of local money lenders, landlords, pawnbrokers etc. McKinnon makes this point clear by citing a truly alarming difference between official and unofficial lending rates in Ethiopia 6 to 9 percent versus 100 to 200 percent [McKinnon, Ronald I, 1973]. This is true for many other developing countries of Asia, Africa, and Latin America. Extending the usury ceiling to the informal sector by the government does not remedy the problem, but worsens it by making credit still less available.

The remedy lies in eliminating financial repression so that bank intermediated funding becomes available to the entrepreneur throughout the economy. With free entry into banking, the money lender can transform their own operations into formal or quasi formal banks.

In fact monetary and financial regulatory policies that stifle domestic intermediation, creating “financial repression” are primarily responsible for poorly functioning domestic monetary system and capital markets and thus for poor growth. Interest rate ceilings on deposits and loans, combined with inflationary rates of monetary expansion, are the most important policies creating financial repression.

In developing countries, there is considerable debate about the desirability of moving away from controlled economic order and toward a more liberal one. Financial market liberalization refers to decontrol of interest rates, the removal of exchange controls, the exchange rate float, the abolition of ration requirements etc.

According to Shaw [Shaw, Edward.S., 1986] financial liberalization (reforms) brings the following benefits to an economy:

(a) It tends to raise the ratios of private domestic savings to income.
(b) It permits the financial process of mobilizing and allocating savings to displace in some degree the fiscal process, inflation and foreign aid.
(c) It opens the way to superior allocations of savings by widening and diversifying the financial markets on which investment opportunities compete for the savings flow. Financial liberalization and financial deepening contribute to the stability and growth of output and employment.

Once an economy is sufficiently financially liberalized, these benefits ensue, whereas in a financially repressed economy, prices are distorted due to interventionist policy of the government. It is argued that piece meal reforms may not achieve the objectives for which reform measures are adopted [Mckinno, Ronald I,1986]. Where financial reforms have been successful, it involved complete or near complete removal of controls in favor of market generated solutions.

Money and Capital Markets:
The components of financial markets of developed countries can be roughly grouped into money and capital markets. Money markets are a source of short term financing. They have developed in response to the needs of governments, financial institutions and business for ready access to a supply of cash to meet immediate needs and a place to put cash temporarily. The financial instruments used in money market include government securities, commercial papers, certificates of deposits and bankers acceptances etc. Banks were the only formal institutions participating in the money markets, but there has been a significant increase over the years in the number of mutual funds and dealers that invest and trade in the money market.

Capital markets exist to provide long term financing for start up and expanding enterprises. Financing is obtained in the capital markets either by issuing debt instruments, typically bonds, or by selling equity in the enterprise through the sale of shares.

The sources of funds in the capital markets fall into two categories, non securities and securities, depending upon whether or not the financial instruments used to document the financial arrangement is transferable, that is negotiable. The securities component of capital market provide long term equity and loan funds through the use of negotiable instruments that can be highly effective in mobilizing domestic capital because the securities representing the investments can be readily sold to meet cash needs or other investment objectives.

The Securities segment of capital market consists of primary and secondary markets both of which are essential in attracting savings to investment. Companies obtain financing for the acquisition of the plant and equipment needed for production by issuing securities in the primary market. In developed countries, these securities are not generally sold directly to the public by issuers, but instead are distributed by brokers or purchased by underwriters for subsequent resale to institutional and individual investors. In this connection the establishment of a stock exchange is of utmost importance. It is the secondary market that assures liquidity to investor in both markets.

But the growth of capital and equity markets in most LDCs is retarded by the lack of requisite conditions for the development of private enterprise. As a result, the number, volume, and variety of stock traded in LDC equity markets are small and sometimes even these sparse markets are dominated by government debt securities. Of course, the corollary of such limited supply is the scarcity of the investors in these markets and limited volume of transactions. Therefore the equity raised through new public issue is not very significant relative to gross national product or to the value of funds channeled to the private sector through the non securities markets i.e. financial institutions. In view of the above, governments in LDCs should make all endeavor to develop a capital and equity market.

Capital and Equity Markets: Developmental and Regulatory Considerations

There is a growing recognition amount the government of developing countries that the expansion of the role of the private sector in economic development is a prerequisite for sustained economic growth and that equity markets play a crucial role in financing the growth in private investment. As a result many developing countries are putting increasing emphasis on the development of their capital markets. Therefore, a brief discussion on the problems of the issue of developing a capital and equity market is given below.

Capital and equity markets have to face the following problems:

Lack of unified government office to supervise and develop the market: In many developing countries, responsibility for the supervision and development of the capital market is segmented among different government agencies whose role may overlap or conflict and result in extensive duplicative and sometimes in consistent regulations.

Scarcity of adequate skills: Often regulatory staff does not have the requisite skills to conduct regulatory work or to promote the development of the securities markets.

Insufficient understanding of the markets: In many countries, existing regulatory bodies are run by officials and civil servants who have knowledge of regulation but lack knowledge of how a market works and what will make it grow. Generally, there are few practitioners with the real understanding of how security market operates.

Lack of authority to enforce regulations: Some times, even if they have qualified personnel, existing bodies often do not have enough authority to enforce rules or to promote regulations to develop the market.

Over emphasis on regulations and under emphasis on development: A common problem in securities market development is that too much emphasis is put on regulation and little on market development. It is essential not to divorce the objective of developing capital markets from the objective of regulating them [Berril, Sir, Kenneth, 1986]. Experience shows that countries such as Brazil and Korea, that had taken a developmental approach to capital market growth while at the same time attending to regulation have been more successful in their effort to develop the market.
The government should take appropriate measures to remedy the above problems for the development of capital and equity markets.
The development of a country`s capital and equity markets will only occur as a part of a comprehensive endeavor that addresses all the factors that affect the profitability and attractiveness of private enterprise for individuals. Capital and equity markets can develop and flourish only in market economies. But a free market is not sufficient for the successful development of a capital and equity market. Other factors including conditions of political instability and social turmoil or inadequate and restrictive laws and regulations also increase risk of investment. The challenge is to attain a delicate balance between a system that assures the adequate protection of the investors and one that does not deter market growth.

Professor Rafiqul Islam
Dept. of Business Administration
Daffodil International University