The Financial Express

Financial development and real development: An overview

| Updated: March 04, 2019 20:46:20

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Financial development and real development: An overview

The last four decades have seen something of a financial revolution. Advances in computing & telecommunications, financial innovation and liberalisation of capital controls have combined to reduce the costs of financial transactions. There has been a corresponding explosion in the volume of transactions. Since 1980, the global stocks of financial assets such as shares, bonds, bank deposits and cash increased more than twice as fast as the gross domestic product (GDP) of rich economies.

Both theoretical reasoning and empirical evidence suggest that the developed financial system can play a positive growth-inducing role. For example, a progressive financial system played an important role in the industrialisation of Japan and England. However, the evolutionary development of the financial system is the result of the process of economic development. But if financial institutions are established in advance of the demand for them, it may promote and stimulate an entrepreneurial response in the modern sectors. The new access to supply-leading funds may in itself have substantial favourable and psychological effects on entrepreneurs. A well-developed financial system may provide opportunities to induce real growth by financial means. Financial institutions not only mobilise savings, but also provide a channel of communication between potential savings and potential investments. As an economic institution, banking system is expected to be more positively related to the performance of an economy than non-economic institutions.

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 them. A study by Rose Levine and Sara Zervos examined 47 countries from 1976 to 1993. They found that stock market liquidity ( the value of shares traded relative to stock market capitalisation) 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. This is because capital markets 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 centralisation 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 specialised depend to a large extent on the characteristic of each country, especially its policy guidelines, relation between the public and the private sector concerning 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 liberalisation.

FINANCIAL REPRESSION AND FINANCIAL LIBERALISATION: The formal banking and financial sector is repressed primarily by interest rate ceilings that are particularly binding when inflation is high and artificially low (sometimes even negative) real returns discourage the holdings of bank deposits, leading to overall holding down intermediation through the banks and savings in total. On the other hand, artificially low loan rates create an excess demand for loanable funds that may be rationed through favouritism to licensed importers, large scale exporters, protected manufacturers and government agencies. Unfavoured 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 and pawnbrokers. McKinnon makes this point clear by citing a truly alarming difference between official and unofficial lending rates in Ethiopia six to nine per cent versus 100 to 200 per cent [McKinnon, Ronald 1, 1973]. This is true for many other developing countries of Asia, Africa, and Latin America. Extending the usury ceiling for 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 entrepreneurs throughout the economy. With free entry into banking, the money lenders 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 towards a more liberal one. Financial market liberalisation refers to decontrol of interest rates, the removal of exchange controls, the exchange rate float, the abolition of ratio requirements etc.

According to Shaw [Shaw, Edward. S., 1986] financial liberalisation (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 mobilising 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 liberalisation and financial deepening contribute to the stability and growth of output and employment.

Once an economy is sufficiently financially liberalised, these benefits ensue, whereas in a financially repressed economy, prices are distorted due to interventionist policy of the government. It is often argued that piece meal reforms may not achieve the objectives for which reform measures are adopted [McKinnon, Ronald 1,1986].Where financial reforms have been successful, it involved complete or near complete removal of controls in favour 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 businesses 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 banker's 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 provides long-term equity and loan funds through the use of negotiable instruments that can be freely traded by individuals as well as institutions. This component of the market can be highly effective in mobilising 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 the issuers. Instead, these 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 investors in both markets.

But the growth of capital and equity markets in most least developed countries (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 the 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 channelled to the private sector through the non-securities markets i.e. financial institutions. In view of the above, governments in LDCs should make all endeavours to develop a capital and equity market.

CAPITAL AND EQUITY MARKETS:DEVELOPMENTAL AND REGULATORY CONSIDERATIONS: There is a growing recognition among the governments 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 placing increasing emphasis on the development of their capital markets.

A brief discussion on the problems of the issue of developing a capital and equity market is given below.

  • 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. The roles of these agencies may overlap or conflict and result in extensive, duplicative and sometimes inconsistent 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 about 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 real understanding of how security market operates.
  • Lack of authority to enforce regulations: Sometimes, 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 that arises during the development of securities market is that too much emphasis is placed 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 governments should take appropriate measures to remedy the above problems for the development of capital and equity markets.

The wide-ranging exploration of financial institutions around the world reveals that capital markets are essential for economic development. Capital Market demonstrates how equity markets facilitate development.

THE IMPORTANCE OF CAPITAL MARKET:  Most long-term borrowings in any economy are carried out by government and firms. When firms make new issues of securities in order to raise new funds for investment, they have to issue those securities on terms that make them attractive to the lenders. This essentially means issuing them on terms which compete with those available on existing securities.

Secondly, the existence of an active secondary market has the effect of making security very liquid. Even large quantities can be bought and sold quickly at low brokerage charges. This makes them much more attractive to investors, lowers the return which they require and keeps down the cost of capital to the firms.  Furthermore, the behaviour of financial markets may have some indirect effect on the behaviour of firms' due to their impact upon general state of confidence in the economy.

Thirdly, it should be remembered that securities are assets in the portfolios of individuals and financial institutions. General Price movements, therefore, cause changes in wealth. People may change their spending plans as security prices rise or fall. Certainly banks and other lending institutions will reverse their lending plans as value of their assets rise or falls.  In many developing countries, bond markets are yet to be developed adequately. Bond market can play an important role in the economic development of a country.


  • Strengthens standard of corporate governance.
  • Creates ability to convert vast amounts of domestic savings into long-term development resources.
  • Financing of long-term investment through long-term capital.
  • Stimulates market liquidity.
  • Acts as a vehicle for foreign investment.
  • Assists in financing infrastructure developments.
  • Helps in creating diverse sources of financing.
  • Enhances stability and performances of investment portfolios.

The following important steps are recommended for developing countries to activate the debt market.

- Broadening the investor base

- Moving towards a single regulatory authority and selling up clearing house for coordinating settlement of debts

- Providing intermediaries access to institutional finance

-Adoption of uniform standard for valuation of investments for all classes of investors

Some experts suggest a three-dimensional strategy for developing a vibrant capital market. These are:

  1. Strengthening of stock market
  2. Building a bond market
  3. Designing a derivative market

In conclusion, it can be suggested that policymakers in developing countries must make all efforts to develop a sound financial structure with varieties of financial products and services. These can include an electronic trading system to trade derivatives in stock exchange, a carefully outlined series of regulation that governs the market judiciously and allowing market participants to contain systemic risk. It is most important for the public to educate themselves about the pros and cons of financial products, derivatives, bonds and stocks.

The development of a country's capital and equity markets will only occur as a part of a comprehensive endeavour 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. A free market is not sufficient for the successful development of equity and capital markets. 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.

Rafiqul Islam is a Professor, Department of Business Administration, Daffodil International University (DIU).

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