The role of the financial sector in economic development

Finance can indeed be regarded as the mainstay of modern economies, and its role in the process of economic development has been aptly put by Bhatt (1989:1) that: “Money as a unit of account and medium of exchange and reduces the transaction and search costs involved in barter transactions. Money as a store of value provides time for making purchase decisions, thus reducing the risk of ill-formed and hasty decisions.”

Finance can indeed be regarded as the mainstay of modern economies, and its role in the process of economic development has been aptly put by Bhatt (1989:1) that: “Money as a unit of account and medium of exchange and reduces the transaction and search costs involved in barter transactions. Money as a store of value provides time for making purchase decisions, thus reducing the risk of ill-formed and hasty decisions.”

It is expected that the development of financial sectors of an economy would have both positive and direct impact on the development of the sector. However, this proposition has drawn a lot of debate as to the direction of causation in such a relationship and in the following paragraphs we examine accordingly.

The earliest recorded work on the influence of financial development seems to be that of Hamilton (1781). He argued that banks were the happiest engines that were ever invented to spur economic growth.

According to this view, banks would avail the required capital to facilitate the growth process by financing innovativeness, which would enhance the accumulation of goods and services.

The role of banks in development were, however, questioned by Adams (1819) who asserted that banks would in fact harm the morality, tranquillity and even wealth of nations if they were not prudently regulated to ensure equitable distribution of resources.

The positive role of banks in economic development was also articulated by Schumpeter (1912), who contended that well-functioning banks spur technological innovations by identifying and funding those entrepreneurs with the best chance of successfully implementing innovative products and production processes.

According to Schumpeter, a banking system and entrepreneurship were two crucial factors and development agents. He observes that the capacity of the banking system to create credit empowered entrepreneurs with the necessary purchasing power with which to command the directional use of productive resources to where there were better rewards.

Thus, the Schumpeterian view of the relationship between finance and development is premised on the impact of financial intermediaries on productivity, growth and technological change.

In contrast, however, Robinson (1952:86) observes that the relationship between financial development and economic development is consequential, and argues that “where enterprise leads finance follows.”

Therefore, according to this view, economic development creates a demand for financial services; and the financial system would then respond automatically to provide the required services.

That is, financial systems do not spur growth, but rather financial development simply responds to the development needs of the real economic sector.

However, the role of financial systems in development have been dogged by financial crisis that in extreme cases, can wreck an economy if they are not mitigated head on.

A financial crisis occurs when demand for money rises faster relative to supply for money in an economy, and this may have many underlying causes, ranging from distortions  in macro/micro economic fundamentals, a stock market crash, huge withdrawals of capital from an economy (capital flight), and speculations both in economy or polity.

Since a country’s financial markets are dependent on international development, it means that they are influenced by such external developments to the extent that a financial crisis in one country is very likely to cause a financial crisis in another (contagion effect), as happened in 1997-1998 Asian financial crisis.

Nevertheless, given that financial development is indeed crucial to spur and sustain economic growth and thus development, one can then appreciate the serious concerns of policy makers in developed countries over the current financial turmoil in these economies.

To appreciate the enormity of this financial crisis, it is worth noting that major banks and other financial institutions in the world have reported losses of over US $240 billion, which has wiped out the entire balance sheets of some of these financial institutions, leading to liquidation of some of them, takeover of others, and mergers of yet a small number of these financial institutions.

The problem took on global dimension owing to the form of financial engineering called securitization (a structured financial process in which assets, receivables, or financial instruments are acquired, classed into pools, and offered as collateral for third party payment).

Many mortgage lenders across the world had passed on their rights to mortgage payments and by extension related credit/default risk to third party investor via mortgage backed securities (MBS), and others through what is known as collateralised debt obligations (CDO).

Thus, individuals and or corporate investors who are widely spread throughout the world faced heavy losses as the value of the underlying assets declined significantly.

This was aggravated by the fact that such instruments were brought through securities markets (stock markets) and by virtue of their nature a fall in value of such instruments sends a negative signal not only to the instruments in question, but also other stocks that in one way or the other are sold by similar financial institutions.

This also affected the ability of corporations to raise funds by way of commercial paper, one of the quickest means of raising finance by credit worth corporations. Thus for instance available evidence point out that some of the world’s major financial houses lost billions of dollars as a result of this crisis, eg, Citigroup lost US$39.1 billion, UBS AG. US$37.7 billion, Merrill Lynch, US$29.1 billion and Morgan Stanley, US$11.5 billion just to mention a few.

The total sum of this is a financial crisis arising out of the widespread credit risk that has given rise to credit crunch which in turn constrains growth of the underlying economies.

Sub-prime mortgage crisis is serious considering that the value of US Sub-prime mortgage alone is estimated at 1.3 trillion, not to mention the contagion impact of this figure throughout world financial systems.

Also, given that a large percentage of these were discounted to other parties in other financial markets throughout the world, paints a grim picture of mortgage financial markets in the short-run.

Financial crisis on an economy can be so serious that an entire economy is pushed into recession (where an economy records negative growth for at least a period of six months consecutively) and it costs policy makers more than innovative means to put an economy out of recession.

Nevertheless, central banks in the affected economies have intervened (as it is expected) to bail out financial institutions that were affected, so as to wad off the spread of this problem to other financial institutions and impact this would then have on the entire economies concerned.

Such intervention included lowering of interest rates, (one of the monetary tools used under such conditions), to make credit cheap, and stimulate consumer spending, and through it growth. The other means used has been cash injection into the institutions concerned to enable them meet their obligations in mortgage financing.

Other central banks have carried out open market operations to ensure that banks have access to funds. Banks in this kind of situation are also given short-term loans by the central bank collateralised by government securities.

Financial crisis on an economy can be so serious that an entire economy is pushed into recession (where an economy records negative growth for at least a period of six months consecutively) and it costs policy makers more than innovative means to put an economy out of recession.

Contact: mnshuti@yahoo.com

 

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