The Finance- Growth Nexus

Published in New Business Age in 2014

The role of financial system is considered to be the key to economic growth. A well-developed financial system promotes investment by identifying and financing lucrative business opportunities, mobilizing savings, efficiently allocating resources, helping diversify risks and facilitating the exchange of goods and services. Economists have thus generally reached a consensus on the central role of financial system in economic growth. The theoretical argument is that policies to develop the financial system are expected to raise economic growth and, therefore, more developed countries have more developed financial systems. This supports the notion of Mackinnon and Shaw (1973) that the Government restrictions and policies hindering financial development (financial repression) ultimately impede the economic growth.

In developing countries, examples of these restrictions and policies include interest rate ceilings, high reserve requirements, directed credit programs, credit rationing and high inflation taxation. These conditions are collectively referred to as financial repression and such policies undermine economic growth. Encouraging competition within the system, developing a strong and transparent institutional and legal framework for financial system services, establishing a prudent regulatory and supervisory mechanism and ensuring strong creditor rights and contract enforcement are some of the key factors that lead to build-up a sound financial system in the country. Therefore, it is argued that the countries which adopt appropriate macroeconomic policies encouraging the financial system have experienced relatively higher growth and development than that of the countries which did not do so.

Financial Deepening

Financial deepening usually refers to the improvement or increase in the pool of financial services that are tailored to all the levels in the society. It also refers to the macro effects of financial services as indicated by an increased ratio of money supply (liquidity) to GDP. As it refers to liquid money, the more liquid money is available in an economy, the more opportunities exist for continued growth. It can also play an important role in reducing risk and vulnerability for disadvantaged groups, and increasing the ability of individuals and households to access basic services like health and education, thus having a more direct impact on poverty reduction. It basically supports the view of: Development in Financial sectors leads to development of the economy as a whole.

In this context, Gelbard and Leite (1999) have suggested a comprehensive index of financial development, which includes at least six areas: the market structure and competitiveness of the system, the availability of financial products, the degree of financial liberalization; the institutional environment under which the system operates; the degree of financial openness and the degree of sophistication of the instruments of monetary policy. According to them, this index is the major indicator of financial deepening and the higher ratio indicates greater financial sector development and vice versa.  It implies that people prefer to hold monetary assets, if they feel more confident and convenient to hold such assets keeping in mind the sense of liquidity, risk, return as well as security. The conclusion is that the higher the value of the index, the higher is the degree of financial development and both the level and the change in financial development have an effect on economic growth.

Similarly, King and Levine (1993) used four measures of financial development indicators. The first measure is the size of liquid assets/ liabilities of the financial system divided by Gross Domestic Product (GDP). The second measure is the ratio of bank credit divided by bank credit plus central bank domestic credit. The third measure of financial development equals the ratio of credit allocated to private enterprises to total domestic credit. The fourth measure is the ratio of credit to private enterprises divided by GDP.

Although economists have proposed a number of indicators and proxies to measure the level of financial deepening and the possible impact on the growth, all of these indicators may not be equally important to all the economies. Advanced economies have evolved a variety of financial markets in addition to having well developed banking sectors including commercial banks, security markets, foreign exchange mortgage and leasing companies, insurance companies, pension funds and many others. But, the case of developing countries may be quite different from that of the advanced countries and the choice of financial deepening indicators depends on market structure, institutional environment and the size of financial assets of the system. Most of the developing countries have a special characteristic of bank-dominated financial system. Therefore, in the case of developing countries, the financial deepening is commonly measured by the ratio of Narrow Money (M₁) to GDP, ratio of Broad Money (M₂) to GDP, the ratio of total assets of banking system to GDP and the ratio of banking credit to private sector to GDP.

Nepalese Context

Nepal being one of the developing countries its socio-economic structures are also in developing stage. In this connection, the financial sector of the country has also just been moving toward its developing stage from the embryonic stage. Therefore the country's financial system has almost same features that of the other developing countries where the financial system is bank dominated. Banks and Financial Institutions (BFIs), being the core financial intermediaries in almost all the areas, the banking system absorbs the vast majority of the financial assets. According to the classification of Nepal Rastra Bank (NRB), the central bank of Nepal, Banking System of Nepal comprises Commercial Banks (Class-A), Development Banks (Class-B), Finance Companies (Class-C) and Micro Finance Development Banks (Class-D); the role of Class-D financial institutions is negligible so far. Looking at the trend of major financial deepening variables; M2/GDP ratio, one can easily observe that the growth pattern is in favor of increasing financial deepening. It is however, over the time, the GDP growth rate itself was not so much encouraging compared to money supply growth, which ultimately helped maintain a higher ratio. Nonetheless, the present level of M2/GDP ratio (52.9 percent) in Nepal is more or less at the same level with the average ratio of low income countries. The M2/GDP ratios during late 1990s were tentatively 58.0 percent in low income countries, 65.0 percent in middle income countries and 88.0 percent in high income countries.

Concluding Remarks

Nepal, the country with the largest area of Hill and Mountain, poor infrastructures and gradually growing economy, is in the need of steady and stable economic growth. There have been noteworthy structural shifts in the Nepalese economy in the recent decades. The composition of GDP has changed with non-agriculture sector emerging as the largest sector and much financial deepening has taken place. But some fundamental indicators indicating the role of financial deepening on the economic growth of Nepal are yet to improve. Nor the strong relationships between gross fixed capital formation and financial deepening of Nepal have observed. However, it is believed that as economic sophistication deepens further with opening of the economy and financial deepening, macroeconomic relationships are bound to shift.

Therefore, as the Government of Nepal has been realizing the significance of the financial deepening in the economic growth, various policies and processes have been undertaken during the past two and half decades. This has resulted significant improvements in quantitative as well as qualitative dimensions of Nepalese financial system and its deepening. However, the role of financial deepening to the economic growth of Nepal is yet to improve to meet the development need of the country and the expectations of the policy makers.