If we consider the definition provided by Koðar (1995),
that financial sophistication is brought about by financial innovations and
affects the nature and composition of monetary aggregates, it is reasonable to
measure it by the ratio of M2 to M1. This is because financial sophistication
will be characterized by introduction of credit cards, e-banking, more use of
checking accounts and all these are embodied in M2. Liu et al (1994) noted that
as the ratio of M2 to M1 increases, the more the technological improvements in
banking system.
Putting aside the distinction between financial depth and
sophistication, other indicators have been added as candidate to represent the
level of financial development within a country:
Levine (1997) included three extra proxies, namely: BANK,
PRIVATE, and PRIVY, defined as follows:
PRIVATE and PRIVY were chosen to correct weaknesses of BANK
measure because not only financial intermediaries provide financial functions
and the volume of credit given by banks may be flowing to public institutions
which does not indicate the level of financial penetration. Unfortunately,
PRIVATE and PRIVY could not correct for the weakness of considering only
financial functions delivered by financial institutions.
Other indicators used are: Gross domestic saving to GDP
(Hassan and JungSuk, 2007), some indicators of stock market development like
stock market capitalization, turnover ratio and the number of listed companies
(Yongfu, 2005). Fry (1989) identifies three quantitative measures of financial
conditions specific to developing countries, based on McKinnon (1973) and Shaw
(1973) theories of financial liberalization. These are: the real deposit rate
of interest, population per bank branch and a financial intermediation ratio.
He added investment as percentage of GDP and change in GDP to investment ratio
as proxies of investment efficiency and net saving ratio respectively.
This section goes through the theoretical and empirical
relationship between financial development and economic growth as identified by
scholars.
Views on the link between financial development and economic
growth can be divided into three hypotheses: The supply leading, demand leading
and no link hypotheses.
According to this view, the financial sector deepening leads
to economic growth. The explanation is that, according to Levine (1997),
financial development has five financial functions through which it affects
economic growth. These functions, shared by Bodie et al (2008), are:
· Producing cheaper information about possible investment
and allocating capital;
· Monitoring firms and exerting corporate governance;
· Trading, diversification and management of risk;
· Mobilizing and pulling of savings;
· Easing exchange of goods and services
The effect of financial innovations on economic growth is
presented by Tufano (2002) in three functions:
· Financial innovations mitigate the lack of free
movement of funds across time and space in incomplete markets and allow risk
sharing among individuals.
· Innovations address agency concerns and information
asymmetry with invention of new contracts like common stock which provides some
mechanisms to squeeze information from firms, a warranty offered by a seller
and income bonds linked to the availability of accounting information.
· They minimize searching and marketing cost: This is the
role of ATMs, smart cards, ACH technologies and many other new businesses.
These financial functions influence savings, investment
decisions, technological innovations and hence economic growth. Better
functioning financial systems ease the external financing constraints that
impede firm and industrial expansion. This implies that the creation of
financial institutions and their services occurs in advance of demand for them.
Thus, the availability of financial services stimulates the demand for these
services by the entrepreneurs in the modern, growth-inducing sectors.
This hypothesis has received a great number of supporters:
Schumpeter (1911)
argued that the financial sector deepening leads to
economic growth through
productively making out and funding economically efficient
projects. He put emphasis on banking sector which performs the function of
intermediation between possessors of productive means and those who wish to use
them and this is a key determinant in understanding capital formation.
McKinnon (1973) and Shaw (1973) developed a robust model of
financial development appropriate to LDCs, through which financial development
affects positively economic growth. Known as complementarity hypothesis, the
McKinnon (1973) and Shaw (1973) model is based on the positive relationship
between real deposit rate of interest and investment, contrary to previous
thought where this link was negative. The model stresses the negative effects
of financial repression on economic growth, characterizing developing
economies.
In fact, they argue that financial repression through
interest rate ceilings, directed credit, exchange rate controls, control on the
source of finance of banking institutions and other forms of financial
repression result in negative real deposit rate of interest. This reduces the
supply of loanable funds and force banking institutions to apply credit
rationing in front of excess demand of loanable funds. The outcome is the
allocation of funds not based on the productivity of investment rather on other
factors like transaction costs and apparent risk of default. This scenario
leads to economy being allocating credit to non productive investments which
decreases investment productivity and efficiency, thus slowing down economic
growth.
Financial liberalization was proposed as a model of financial
development which leads to economic growth through increase in real deposit
rate of interest, raising the saving mobilization and the financing of the
economy both from internal and external source, as a result of capital
liberalization. This model has been a central point for analysing effect of
financial development on economic growth, where most studies compare before and
post financial liberalization periods. They include Jankee (2006) in Mauritius,
Abebe (1990) in African LDCs, Demetriades and Luintel (1996) in India, Margaret
(2004) in USA and many others.
In the same idea of financial liberalization, Fry (1997)
explained the DiamondDybving financial intermediation in an
overlapping-generations model developed by Bencivenga, Smith, Greenwood and
Smith, and Levine. With banks acting as intermediaries between savers and
borrowers, avoiding uncertainty which leads to resource misallocation and
offering liquidity to savers, they produce higher capital/labour ratios and
higher rates of economic growth.
Levine and Zervos (1996) recognise that liquid stock markets
and growth banking sector lead to economic growth through increase in capital
accumulation and production.
According to Greenwood and Jovanovic (1990), financial sector
development will direct funds to higher yielding projects with the great
involvement of information: the financial intermediaries produce better
information, improve resource allocation and hence foster growth. Basically,
the role of financial sector in easing access to information and leading to
efficient financial market raises the quality of investment, leading to
technological innovation and consequently to economic growth.
Cameron (1961) confirmed the supply leading hypothesis after
his study in France where he found a positive impact of financial development
on economic development through mortgage.
2.2.1.2 Demand leading hypothesis
The supply leading hypothesis has not received unanimity
among economists. Some influential economists such as Robinson (1952), and
Friedman and Schwartz (1963) argued that the development of the financial
sector is induced by economic growth such that it comes as a result of higher
demand of financial services. Robinson supports that economic growth creates
supply for financial services which would cause a financial development. Levine
(2001) argued that economic growth may reduce the fixed cost of joining
financial intermediaries and the more people join, hence financial sector may
be caused by improvement in economic growth.
Kuznets (1955) supports this idea by saying that finance does
not exert a significant impact on economic growth but rather when the economy
grows, more financial institutions, financial products (financial innovation)
and services come into the market in response to higher demand of financial
services. For Thanvegelu (2004), enterprise guides then finance follows.
2.2.1.3 No link or negative effect
hypothesis
This hypothesis may be regarded as the criticism of the views
above about the link between financial development and economic growth. The
footstep of this theory may be drawn for the statement of Lucas (1988), who
noted that economists have a tendency to overemphasize the role of financial
factors in the process of economic growth. It is possible that the development
of the financial sector markets may result as an impediment to growth when it
induces volatility and discourages risk unenthusiastic investors from
investing. Singh (1997) and Mauro (1995) noted that financial innovation allows
risk reduction and may lower the precautionary savings and investments, thus
slowing down economic growth.
A radical criticism of the role of financial development to
economic growth mainly through financial liberalization comes from
neo-structuralists. They refuted the model of financial deregulation developed
by McKinnon (1973) and Shaw (1973) by attacking the assumption of competitive
market in banking institutions embodied in the model. The point is that in most
developing countries, the financial industry operates in oligopolistic or
collusive model without an apparent competition as assumed by McKinnon-Shaw's
theory.
Stiglitz (1994) argued that financial liberalization leads to
market failures rooted from costly information which leads to externalities
like a generalized bank crisis following a bankruptcy in one or two banks. He
supports some measures of financial regulation like keeping interest rates
below their market equilibrium, as corrective measures which will in addition
improve the efficiency of capital allocation. In addition, financial repression
was not the only source of credit rationing.
Again Stiglitz and Andrew (1981) demonstrated that other
credit rationing may exist in equilibrium situation, as a result of other
factors outside interest rate ceilings, like asymmetry information, collusion
in banking sector which set deposit rate below the market equilibrium,
consideration of transaction costs, anticipated risk of default, quality of
collateral and pressure from bank managers.
This view has been supported by many researchers like Buffie
(1989) who stated that if we give permission to reactions in markets, then
financial liberalization will be a dangerous enterprise. Diaz-Alejandro (1985)
summarized the effects of financial liberalization as «Good-bye financial
repression, hello financial crash» because in most developing countries,
financial crisis followed financial liberalization policies undertaken by
governments and the results were worse.
Fry (1989) lists a group of neo-structuralists who questioned
the validity of McKinnon-Shaw hypothesis and demonstrated that banks cannot
intermediate as efficiently as curb markets between savers and lenders because
reserve requirements constitute a leakage in the process of financial
intermediation through commercial banks. The group includes Taylor Lance,
Sweder Van Wijnbergen, Akira Kohsaka among others.
According to them, in practice, financial liberalization is
likely to reduce the rate of economic growth by reducing total real supply of
credit available to business firms. In short, the opponents of financial
liberalization base their facts on various failures observed in many countries
after liberalization, which led to financial distress and crisis. The list of
countries is long but Argentina, Chile, Uruguay, Turkey and Philippines come on
the top.
2.2.2 Empirical literature review o n the link between
financial development and economic growth
The evidence on the link between financial development and
economic growth covers a variety of studies using time series analysis,
cross-country growth regressions, panel studies, etc.
Financial Development and Economic Growth in Rwanda
2.2.2.1 Cross=cou ntry cases
The cross-country case studies have been carried out by many
researchers: Levine and King (1993) and Levine and Zervos (1996) found that
higher levels of financial development are positively correlated with economic
development. Their findings suggest that the legal environment facing banks can
have a significant impact on economic growth through its effect on bank
behavior.
Michael and Giovanni (2001) examined whether there is
evidence of a causal link from capital account liberalization to financial
deepening and, through this channel, to overall economic growth on
cross-section of developed and developing countries, over the period 1986 to
1995, as well as over the period 1976 to 1995. With regard to the link between
financial development and GDP growth, they noted a statistically significant
and economically relevant positive effect of open capital accounts on financial
depth and economic growth. However, this effect seems to be concentrated among
industrial countries, whereas a little evidence was found in developing
countries for financial depth brought about by capital account liberalization
to affect positively economic growth.
In Africa, Douglas (2003) investigated evidence of the
finance growth nexus in a sample of emerging Sub-Saharan African countries
using cointegration and a vector error-correction model. He found that
financial development and economic growth are linked in the long-run in seven
of eight countries and causality test revealed unidirectional causality from
finance to growth in Ghana, Nigeria, Senegal, South Africa, Togo and Zambia.
For Ivory Coast and Kenya, the causality run from growth to finance, confirming
the demand leading hypothesis in the two countries.
2.2.2.2 Panel data cases
Starting by Africa, Kesseven et al (2007) brought new
evidence of finance-growth relationship from developing countries by analyzing
a sample of 44 African countries from 1979 to 2002. They used both static and
dynamic panel analysis and random effect and found that the financial
development has been contributing to the level of output though the
contribution was not at the same
level across countries. However, the contribution of financial
development was observed to be on the lesser extent as compared to the other
explanatory variables.
Karim and Holden (2001) conducted a panel of 30 developing
countries to test the supply leading hypothesis. Using the alternative measures
of bank development and stock market development, they found a strong positive
link between stock market development and economic growth. However, contrary to
the findings of Levine et al (2000), they found a negative association between
credit allocation and economic growth. The reasons were the failure of
financial deregulation due to absence of prerequisites for successful
deregulation.
Fry (1989) examined over 15 years saving behavior in 14 Asian
developing countries and 28 developing countries heavily indebted to the World
Bank. It was found that a 1 percent rise in real deposit rate of interest
raises national saving ratio by about 0.1 percent. On the effect of financial
liberalization on investment productivity, Fry found positive and significant
relationship between the incremental output/capital ratio and the real deposit
rate of interest and also the real deposit rate of interest and economic growth
in those Asian developing countries.
2.2.2.3 Country case=studies
Spears (1991) examined the causal relationship between
financial intermediation and economic growth in a sample of five Sub-Saharan
African countries (Burkina Fasso, Cameroon, Ivory Cost, Kenya and Malawi),
using Granger causality and two-distributed-lag regressions. He used two
measures of the financial development: the ratio of money supply to real per
capita GDP and the ratio of quasi-money to money supply. He found no causality
between the later and economic growth and these results may be attributable to
wrong measure used rather than absence of causality between financial
development and economic growth. But the causality from financial development
to economic growth was found when the ratio of money supply to GDP was used.
Team (2002) used a VECM in 13 Sub-Saharan African countries
and found from the cointegration analysis that there exists a long-run
relationship between financial development and economic growth in twelve out of
thirteen countries and the causality run from finance to growth in eight of the
countries taken in the sample. Six countries provided evidence of
bi-directional causality.
Demetriades and Luintel (1996) found a bi-directional
causality between financial deepening and economic growth in India and a
negative impact of banking sector control on economic growth, in the model
linking financial depth and banking deregulation to economic growth using Error
Correction Model. Zhang (2007) examined if regional productivity growth is
accounted for by the deepening process of financial development in China, using
provincial panel data, and found that after controlling for other variables,
the depth of financial intermediation exerts significantly positive influence
on productivity growth in China during 1987-2001. The financial
intermediation-growth nexus in post reform China was strongly supported.
2.2.2.4 Industry and firm level case studies
Demirgüç-Kunt and Maksimovic (1998), in a firm
level data, showed that larger banking systems and more liquid stock markets
allow firms to grow faster than it would be had been internal resources used to
finance their investments. Using industry level data across countries, Rajan
and Zingales (1998) found that external finance benefits more to their users
and allows firm to grow faster than firms which only resort to domestic
financial markets.
A different approach was taken by Beck et al (2006) by
examining the effect of the size of the industry in financial
development-economic nexus. Using industry data, they concluded that economies
dominated by small firms grow faster in developed financial system than large
firm-based economies.
Raymond and Love (2004) used data of 37 industries in 43
countries over the period 1980-1990, to analyze the link between financial
development and interindustry resource allocation in the short and long-run,
and found that in the short-run, financial institutions allocate resources to
any industry that has experienced a positive shock to growth opportunities
irrespective of his source
of financing, whereas in the long-run, in countries with well
developed financial institutions, industries which rely heavily on external
financing (Debt-finance instead of equity-finance) will have a comparative
advantage and will capture a larger share of total production in the
economy.
