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Financial System and Economic Development


Economic Development and Financial System

Is it possible to influence the level of national income, employment, standard of living and social welfare through variations in supply of finance? No unanimity of views on the above. There are three points of view, namely
A: No generally accepted model to describe the relationship between Finance and economic development B: The importance of financial system on economic development depends on the desired nature of development. C: Financial system plays a crucial in the economic development of a nation

However the effects of Financial system on economic development can be understood by analyzing the following three effects it has on the economy:
A) Technological Progress is an endogenous factor which requires higher saving and investment which in return gets facilitated through the financial system

B) Capital Formation: Economic development depends to a great extent on the rate of capital formation. Relationship between capital and output is strong, direct and monotonic. Availability of capital at the correct time and amount depends on the efficacy of the Financial system.
C) Amplification of Markets over space and time:

Impact of Financial development on Savings and Investment

The importance of finance and the financial system in economic development can be understood better in an indirect manner, i.e. by analyzing their impact on Savings and Investment. There are few theories for the same, namely
A: Prior Voluntary Savings Theory B: Credit Creation Theory C:Inflationary Financing Theory D:Financial Repression Theory E:Financial Liberalization Theory

Prior Savings Theory

According to this theory Saving is an prerequisite to investment. Stresses the importance of monetary and fiscal policy for promoting and mobilizing savings voluntarily for investment. Theory states that a financial system has both scale and structural effect on savings and investment. It increases the growth of saving and investment and makes their allocation, composition and utilization more optimum. A financial system helps to create a bridge between ultimate savers ( surplus spending units) and ultimate investors (deficit spending units) and mobilize savings to the correct channels. Savers are benefited by a sound financial system as it offers a wide array of diversified portfolio of financial instruments. Investors are benefited through reduced cost and risk through insurance services and hedging. Also financial services in the form of guarantees, acceptances, discounting helps investors.

Credit Creation Theory

According to this theory, the contribution of financial system in economic growth is not restricted to prior- saving based investment. The theory addresses the issue in 2 steps Firstly, the Financial system plays a catalytic role for economic development not through prior- based-savings but by creating credit in anticipation of savings

Secondly, the credit created leads to investment which generates the appropriate level of income which in turn leads to an amount of savings which are equal to the investment already undertaken-in the process keeping the system in equilibrium

Theory of Forced Savings

The theory states that investment in an economy should be considered not with or without prior saving but with forced savings. It also states that investment is not determined by savings but it is savings which is determined by investment which can be increased autonomously through monetary expansion.

The theory states that in an economy with unemployed resources, an increase in investment will lead to an increase in aggregate demand, output and savings.
Secondly, even if the resources are fully employed, any expansionary policy will lead to inflation. Here inflation should be treated as a positive effect as it leads to reduction in real rate of return on financial assets which forces people to invest in physical assets leading to an increase in output and savings.

Should Financial Markets be regulated? A case for Financial Regulation Theory

Financial Markets are prone to failures and certain form of government intervention is required in order for them to function better. Financial system can help the economy to perform efficiently but in practice it is not efficient. Intervention in the form of interest rate regulation helps in increasing the quality of loan applications and improves the manner in which capital is allocated. Direct credit programs and Priority sector lending helps in overall economic development. In theory though perfect capital mobility exists and interest rate reaches equilibrium through local arbitrage. However due to asymmetric information capital does not flow freely across regions. Financial markets suffer from asymmetry, turbulence, discontinuity, stampedes and inefficiency. Intervention is essential during such circumstances. Bubbles and Bursts which are manifestations of speculations on the speculation of other speculators who are doing the same thing tend to distort prices.

Indicators of Financial Regulation and Repression in an economy: A: Indiscriminate distortion in financial variables like interest rates and exchange rate B: Imposition of Ceilings on Interest rates C: Prescribing High Reserve ratio D: Undesirable Directed Credit Program E: Restrictive EXIM Policy

Financial Liberalization Theory

According to this theory elimination of Financial repression through Liberalization, deregulation and privatization is essential to eliminate all the ill effects of financial repression Secondly with adequate degree of Liberalization developing countries can be put on the correct road of high investment, high savings and high growth. Third, the theory specifically points the beneficial effect of liberalization as mentioned below: a) Increase in interest rates as they would adjust to the effects of competitive market equilibrium b) Increase in saving, reduction in holding of real assets and increase in financial deepening. c)Expansion in the supply of real credit d) Increase in investment e) Increase in average productivity of investment f) Increase in allocative efficiency of investment

Then why has Financial liberalization failed in numerous occasion? Most common reasons cited are as follows: 1: Existence of implicit or explicit deposit insurance 2: Lack of Banking supervision 3: Macroeconomics instability 4: Excessive risk taking by banks

Financial Assets/Securities/Claims
Definition of a Financial asset: a claim to the payment of a sum of money sometime in the future (repayment of a principal) and/ or a periodic payment in the form of interest/dividend . For example, a Bond with a Face value of Rs 1000, a Coupon rate of 12%, maturity of 5 years and redeemable at par implies that the holder of the instrument would receive the following set of Cash flows

Buy the Bond






Features/Characteristics of Financial Assets

a. Liquidity b. Reversibility c: Tax Status d: Risk-Return Profile e: Embedded Options

Understanding Financial Claims and Financing

Direct Financing Direct Financing: efficient for large transactions if preferences match. Wholesale markets. DSUs receive funds quickly; SSUs earn timely returns on savings. Private placements are simplest. DSU sells whole security issue to one investor or investor group. Fast and relatively low transactions costs. Players in direct financing Investment bankers underwrite new issues of securities. Buy securities from DSUs and sell to SSUs to buy at higher price. Profit from difference is underwriting spread Brokers and dealers bring buyers and sellers of direct claims together. Brokers buy or sell at best possible price for their clients. Dealers make markets by carrying inventories of securities buy at bid price; sell at ask price Bid-ask spread is dealers gross profit

Indirect Financing
Indirect financing useful if SSU and DSUs have difference in preferences for Amount / Maturity / Risk / Liquidity (marketability) . Indirect financing - Financial intermediaries transform claims: raise funds by issuing claims to SSUs; use funds to buy claims issued by DSUs. Claims can have unmatched characteristics: SSU has claim against intermediary; Intermediary has claim against DSU.

Common intermediaries Commercial Banking - Take deposits and make loans Depositors are SSUs. Borrowers are DSUs.

Insurance Co - Issue policies, collect premiums, invest in stocks and bonds. Policyholders are SSUs; Businesses or governments are DSUs.

Role of Financial Intermediaries in Economic Development

Achieve economies of scale in the cost of transferring savings to the investors mainly through pooling of risk and reduced transaction costs Helps development by creating a more efficient payments, transfers and remittance mechanism. Helps in facilitating transactions in a safe and continuous basis. Generates confidence amongst buyers and sellers that instruments used in making payments will be accepted.

In a nutshell Financial Institutions and Intermediaries promote development through the following below mentioned functions:
A: Liability-Asset Transformation: Deposits from savers converted to Advances and Loans for Borrowers B: Size Transformation: Small deposits pooled from savers passed as Corporate Loans. C: Risk Transformation: Pool, distribute, reduce and manage risk through greater diversification D: Maturity Transformation: Offers savers alternate forms of deposits (Current, Term) and provide borrowers with loans of various maturities (Short Term,

Role of Financial Markets

Financial markets are critical for producing an efficient allocation of capital, which contributes to higher production and efficiency for the overall economy, as well as economic security for the citizenry as a whole Financial markets also improve the lot of individual participants by providing investment returns to lender-savers and profit and/or use opportunities to borrower-spenders. Enabling economic units to exercise their time preference Separation, distribution, diversification and reduction of risk Efficient payment mechanism Providing information Enhancing liquidity Providing portfolio management services.

Functions of Financial system

Mobilize and allocate savings Monitor corporate performance Provide payment and settlement systems Optimum allocation of risk bearing and reduction Disseminate prize related information Offer portfolio adjustment facility Lower the cost of transactions Promote the process of financial deepening and broadening

Key elements of a well -functioning financial system

A strong legal and regulatory environment Stable money Sound public finances and public debt management A central bank Sound banking system Information system Well -functioning securities market

Relationship between the Financial system and Economic growth

- Facilitates economic activity and growth - Helps accelerate the volume and rate of savings. - Lowers financial intermediation costs - Makes innovation least costly - Helps in evaluating assets - Helps in central bank to conduct monetary policy

- Monitors the management of companies

Indicators of Financial Development

Finance Ratio: is the ratio of total financial claims as a percentage of National Income. This is an indicator of the rate of financial development in relation to economic growth. Financial interrelations ratio: is the ratio of total financial issues to net domestic capital formation(physical assets). This measure reflects the relation between financial development and the growth of physical investment. New issue ratio: is the ratio of primary issues to net domestic capital formation. This ratio is indicative of the extent of dependence of the non-financial sector on its own funds in financing the capital formation. Alternately, it also indicates the extent to which investment has been financed by direct issues to the saver by the investing sectors. Intermediation ratio is the ratio between the financial instruments issued by the financial institutions (i.e., secondary issues) and the financial instruments issued by the non-financial sector (i.e., primary issues). This ratio reflects the importance of intermediation by banks and other financial institutions in financing real activities. Integrated financial sector domestically as well as internationally (i.e. rates of return should not differ between various groups of savers and investors as well as between domestic and foreign investments. Lower Transaction and Investment cost, Quick enforcement of financial contracts, Sound Payment system Proportion of Private Banks to Public sector banks should be high; Presence of Non Banking financial sector should be adequate Openness of the economy, minimum restriction of foreign ownership of assets, capital account convertibility and free repatriation of earnings