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If Finance enhances Growth, does more Finance enhances More Growth in An Economy

If Finance enhances Growth, does more Finance enhances More Growth in An Economy? Some New Perspectives from Recent Research

Posted by: Partha Ray
Professor, Economics, IIM Calcutta
Aug 18, 2015

The relationship between finance and economic growth is one of the key questions that should haunt economists and finance specialists. Since the perspective of shareholders value maximization in corporate finance literature is somewhat narrow, in some sense the finance growth relationship gives a welfare context to finance from a utilitarian sense. The views, however, differed and sometimes differed widely. For example, the view that when enterprise comes in finance follows seems to be diametrically at variance with the opinion that finance is an essential ingredient of growth.

While the question seems to be at the heart of the process of growth and development, finance was a neglected issue in mainstream models of economic growth till recently. This is understandable as the mainstream growth literature is a theoretical paradigm that, “focuses on the fundamental mechanisms of the growth process, whereas finance is like the lubrication that reduces frictions and thereby enables the machinery to function” (Aghion and Howitt 2009).As far as this relationship between finance and economic growth is concerned, the literature distinguishes between two kinds of complementary channels.

  1. In the first channel Innovative financial technologies tend to lessen the informational asymmetries that act as impediments to the efficient allocation of funds, thereby improving total factor productivity (for example, Greenwood and Jovanovic 1990).
  2. The second channel focuses on the “spread of organized finance at the expense of self finance and the former’s ability to overcome indivisibilities through the mobilization of otherwise unproductive resources” (Bell and Rousseau 2001)

Besides, there is a large empirical literature on the role of finance in industrialization in the historical context. Illustratively, accounts of industrialization in Europe showed how late industrializing countries of continental Europe created bank finance for long-term lending to overcome the lack of financial markets and played an active role in speeding up the pace of industrialization (Gerschenkron 1962).

But is this relationship linear? If finance leads to growth, does more finance lead to more growth? This question has increasingly started popping up in the aftermath of the global financial crisis. Is there a point beyond which the benefits of financial development begin to decline and costs start to rise? Is the relationship inverted U-shaped? Using a new data-base and constructing a new measure of financial development5, a recent IMF Staff Discussion Notes delves into these questions and came up with some startling findings (Sahay et. al., 2015).

In particular, while this line of research continues to underscore that many benefits in terms of growth and stability can still be reaped from further financial development in most emerging markets (EMs), the effect of financial development on economic growth is found to be bell-shaped: it weakens at higher levels of financial development (Chart 1). This is in stark contrast with the earlier academic results that use narrower measures of financial development, such as the private credit to GDP. Besides, the benefits from developing financial institutions are larger at low income levels and decline as income increases, whereas the opposite is true for markets (Chart 2). This research tends to indicate that the pace of financial development matters so much so, “When it proceeds too fast, deepening financial institutions can lead to economic and financial instability. It encourages greater risk-taking and high leverage, if poorly regulated and supervised. In other words, when it comes to financial deepening, there are speed limits. This puts a premium on developing good institutional and regulatory frameworks as financial development proceeds.”



What are the implications for India from this line of research? Two features stand out. First, contrary to popular belief, India’s financial development index is lower than China, South Africa or Brazil (Chart 3). Second, considering the fact that financial development indices of all these countries and India are higher than that of Poland (which corresponds to the threshold in Chart 1), possibility of emergence of a perverse relationship between finance and growth cannot be ruled out in these countries.

Finance dev

The IMF is an organization that is not known for its financial conservativeness. On the contrary, it tended to at the vanguard of financial liberalization. Thus, this kind research coming from the IMF perhaps shows the limits of financial globalization. The authors of the study have mentioned rightly in an accompanying blog, “Financial development entails trade-offs. Beyond a certain level of financial development, the positive effect on economic growth begins to decline, while costs in terms of economic and financial volatility begin to rise.” Going forward this has profound implications for financial sector liberalization in a country like India.

Note: Reproduced from Artha, May 2015

Article By: Partha Ray
Professor, Economics, IIM Calcutta


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