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Financial development and economic growth in Rwanda

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par Deogratias MR. DUSHIMUMUKIZA
University of Mauritius - Masters Degree in Economics 2010

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2.1. Measuring financial development

We begin this section by defining what financial development is by breaking it into two components: Financial deepening and financial sophistication. Financial depth or deepening can be regarded as the measure of the size of financial intermediaries. This follows the definition of McKinnon (1973), Shaw (1973) and Levine and King (1993) where they define financial deepening as the process which involves banking liberalization from state control, reduction or abolition of credit rationing and marketization of financial parameters in financially repressed economies.

On the other hand, financial sophistication is defined as the act of creating and popularizing new financial instruments as well as new financial technologies, institutions and markets (Tufano, 2002). The innovation can be regarded into two areas: product or process innovation. In product innovation, new derivatives, contracts, new corporate securities or new forms of pooled investments products are created whereas in process innovation, new means of distributing securities, processing or pricing transactions are discovered and used widely.

Financial Development and Economic Growth in Rwanda

2.1.1 Proxies of financial depth

Many proxies have been used to measure the level of financial depth. Some researchers simply used the ratio of monetary aggregates (M1, M2 or M3) to GDP as a proxy of financial depth, depending on the level of financial development of a country. This view is inspired by the work of Levine (1997) in which financial depth was defined as the ratio of liquid liabilities to GDP.

In line with this view, Hassan and Jung-Suk (2007) used the ratio of M3 to GDP as a proxy of financial depth. They argue that other monetary aggregates like M1 and M2 may be poor proxies in economies with underdeveloped financial system, where a high ratio of money to GDP exists because money is used as store of value in the absence of other more attractive alternatives.

Others prefer to use the ratio of money supply or the broad money (M2) to GDP (Loayza et al, 2000). However, this measurement was exposed to the criticism that deep financial market may cause a decrease in the M2/GDP ratio in countries having developed capital markets. This situation can be seen as less problematic than situations in developed countries with a dominant banking sector (Sakutukwa, 2008).

A reasonable explanation of the weaknesses of the broad money as measure of financial deepening has been provided by Firdu and Struthers (2003) that with financial liberalization, capital inflows add to the funds available for credit expansion by banking system. However, these foreign funds do not increase money supply since they are excluded from it by definition. Therefore, increase in credit expansion, which is a good indicator of financial deepening, may not be reflected in the movements of the money supply in financially deregulated economies with important capital inflows. In addition, government borrowing from the banking system reduces the amount of credit available to domestic private sector and may have a strong negative effect on economic performance but this will not be reflected in the trends of money supply.

To support challengers of the ratio of liquid liabilities as proxy of financial depth,
Zhang et al (2007) used the ratio of claims on private enterprise to GDP as

proxy of financial depth in investigating on the financial deepening-productivity nexus in China over the period 1987-2001, unlikely to previous studies in China which used M2/GDP, total credit/GDP or banking financial assets/GDP as proxy of financial depth. They argued that as financial sector is gradually liberalized, the rising depth of financial intermediation is most likely to be a result of commercialization of state banks and should be closely related to the change in the relative share of bank financing between state owned enterprises and a variety of newly emerged enterprises. Due to lack of data, they proposed the ratio of claims on private sector to GDP as a better proxy of financial depth.

Karima and Holden (2001) supported this view holding that though the ratio of liquid liabilities to GDP (or M3/GDP) indicates the level of the liquidity provided to the economy, a weakness is that it does not reflect the allocation of savings and so may not be an accurate indicator of the activities of financial intermediaries. The true measure of financial depth remains an empirical issue.

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