Is financial development the magic bullet for growth?

While being interconnected, relationship is much more complex

Tehreem Husain July 10, 2017

NORTHAMPTON: The relationship between financial development and growth has always remained controversial. Some academics see finance as an important contributor to growth-promoting saving; through risk diversification, improving resource allocation, the provision of information on investment projects and easing exchange by reducing transaction costs.

However, there are others who hold a contrasting view and believe that there is a much more complex relationship between finance and growth. They believe that for a particular country this depends on the level of its economic and financial development as well as the quality of its institutions.

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A recent example of this has been provided by an academic research, which has found that the level of financial development that is good for growth is between 90 and 100% of GDP and turns negative for high income countries.

These studies do not reject the positive effect of finance on growth but suggest that the relationship between the two may be more nuanced. A recent IMF Working Paper also lends credence to this argument. Using a sample of 145 countries in a time period ranging from 1960-2011, the authors find that there is no unambiguously positive relationship between finance and growth. The paper finds that the effect of finance on growth depends on country characteristics such as income levels and institutional quality. Moreover, the effect of financial development on growth is also thought to vary over time amongst other factors affecting it, financial depth for example having a positive effect on growth prior to 2005.

Financial development
in Pakistan

Academics have employed four dimensions to study financial development; depth, efficiency, stability and openness and lastly, access to financial services. The above four mentioned dimensions are measured through the extensive Global Financial Development database consisting of data on 206 economies.

Using this database one can determine the level of financial development that Pakistan stands at by analysing the country’s progress over the years on each of these dimensions. The results present a disappointing picture. In terms of access to financial services, only 8.7% of the respondents aged 15+ had an account at a formal institution in 2014. Moreover, a mere 8% of firms used banks to finance purchases of fixed assets.

In terms of financial depth, Pakistan has shown a mixed picture. Deposit money banks to GDP stood at 37% in 2014, up from 33.7% in 2011. Domestic credit to private sector as a percentage of GDP is also used to indicate the level of financial depth in a country. At 28.7% in 2008, it has witnessed significant deterioration and stood at 15.6% in 2014.

In terms of financial efficiency, the banking sector’s net interest margin, calculated as a ratio of its net interest revenue to its average interest earning assets, has also dropped in recent years and stands at 4.4%. Profitability of the banking sector, also an indicator of efficiency, however, remains sound.

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Lastly, indicators of financial stability for Pakistan, due to a strong regulatory framework of the State Bank of Pakistan, remained sound as shown by a regular improvement in bank capital to total assets and a decline in bank non-performing loans as a proportion of gross loans.

The nexus between financial development and growth

The relationship between the channels through which financial development affects growth (productivity and investment) remains complex. The efficacy of these channels in contributing positive towards the growth process hinges on individual country characteristics.

Financial stability, however, remains key in this process as a country can only tread on the path of growth if it has addressed risks to its financial stability. It is the responsibility of both banks and a strong regulatory framework (central bank) to ensure that financial stability remains the supreme concern at all times.

The writer is an economist and ex-central banker

Published in The Express Tribune, July 10th, 2017.

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