Those who wish to believe that finance is relatively unimportant to economic development can continue to do so. But the corss-country and firm-level data are beginning to tell a compelling story: finance matters
Financial intermediaries--the ones that mobilize savings, allocate capital, manage risk, ease transactions, and monitor firms--are essential for economic growth and development. That's what Joseph Schumpeter argued early in this century. Universal agreement since then? Hardly. Many development textbooks and leading economists assert that financial services play only a minor role in stimulating economic growth.[1]
Part of the reason for the debate is conceptual. Economic theory did not--until recently--link financial services with long-run growth in ways that pass the profession's litmus test of rigor. And part is empirical. Little evidence had been assembled to establish that finance causes growth.
Now there is evidence to support Schumpeter's view: financial services promote development.
Intermediaries can promote growth by increasing the fraction of resources society saves or improving the way society allocates savings.
Consider investments in firms. Large research, legal, and organizational costs are involved. These costs can include evaluating the firm, coordinating financing for the firm if more than one investor is involved, and monitoring managers.
The costs might be prohibitive for any single investor, but an intermediary--such as a bank, mutual fund, or pension fund--could perform these tasks for a group of investors and lower the costs per investor. So, by researching many firms and allocating credit to the best ones, intermediaries can improve the allocation of society's resources.
Intermediaries can also diversify risks and exploit economies of scale. For example, a firm may want to fund a large project with high expected returns, but the investment may require a large lump-sum capital outlay. Such profitable opportunities can often go unexploited without intermediaries to mobilize and allocate savings.
Intermediaries can initiate the creation and transformation of firms' activities. They also provide payment services. Modern economies--replete with complex interactions--require secure mechanisms to settle transactions. Without these services, many activities would be impossible, and there would be less scope for specialization--with a corresponding loss in efficiency.
In addition to improving resource allocation, financial intermediaries stimulate individuals to save more. The securities most useful to entrepreneurs--equities, bonds, bills of exchange--may not have the liquidity, security, and risk characteristics savers desire. By offering attractive financial instruments to savers--deposits, insurance policies, mutual funds--intermediaries can increase the fraction of resources that individuals save and the fraction of society's output devoted to productive activities. Intermediaries also tailor financial instruments to the needs of firms. Thus firms can issue--and savers hold--financial instruments more attractive to their needs than if intermediaries did not exist.
Growth can also spur the development of financial services. Improvements in computers and communications have triggered financial innovations over the past 20 years. And it may be that growth can increase the demand for financial services, sparking their adoption in developing countries.
Rather than focus on causality, past empirical work has relied largely on comparative case studies to document the links between financial and economic development.
This evidence (from Korea and elsewhere) strongly suggests that financial depth--the ratio of broad money (currency plus checking, savings, and time deposits) to GDP--almost always accompanies economic growth. It also suggests that highly restrictive policies toward financial institutions can thwart both financial and economic development.
A recent cross-country Bank study uses an expanded set of measures of financial services, controlling for other phenomena that may also explain economic development. It extracts the "exogenous" component of financial intermediary services to provide better evidence on whether financial intermediary services contribute independently to growth.
One measure of financial services--call it BANKS--is the credit issued by banks divided by the sum of the credit issued by banks and the credit issued by the central bank. This measure attempts to distinguish intermediaries that gather information and provide risk management from those that do not.
A second indicator--call it PRIVATE--measures the extent to which credit goes to the private sector. It is the credit issued to nonfinancial private firms divided by total credit.
Intermediaries that finance private firms probably provide more services than a system that simply funnels resources to the government or state-owned enterprises.
Measuring PRIVATE is subject to error. PRIVATE may simply reflect government borrowing from financial institutions or the size of the private sector and therefore not accurately indicate the provision of financial services.
Using the two indicators, the researchers studied whether financial intermediary services separately contribute to growth. They address two questions. After explaining everything we can about growth using a wide assortment of factors, do the measures of financial services provide additional help in predicting the rate of economic growth? If so, do financial services promote growth by increasing savings or by increasing the efficient allocation of savings?
The results are remarkable. The exogenous component of financial depth--BANKS and PRIVATE--explains much of the part of growth unexplained by the many variables and policies commonly thought to determine economic development.
The results imply that financial services have an independent, positive effect on growth and imply that the more intermediation that is done by banks and not the central bank and the more credit that goes to the private sector, the greater is economic growth, other things remaining the same.
Taken literally, the estimates suggest that if in 1970 Egypt and Zaire had raised the fraction of credit allocated by the financial system to the private sector from 20% to the average value for developing countries in 1970 (62%), the two countries would have been 20% richer in 1990.
In addition to cross-country data, firm-level investigations for Ecuador and Indonesia reveal significant increases in the extent to which credit flowed to more efficient firms following the onset of financial reform in the early 1980s.
Illustrative? Yes. Conclusive? No. But the combination of firm-level and cross-country data is beginning to tell a conclusive story: finance matters.