FINANCIAL STRUCTURES AND ECONOMIC DEVELOPMENT

CASIRJ

Volume 5 Issue 9 [Year - 2014]

ISSN 2319 – 9202

FINANCIAL STRUCTURES AND ECONOMIC DEVELOPMENT AUTHOR: SONAM BHATI (Assistant Professor in Delhi University)

CO-AUTHOR: SALONI BHATI ABSTRACT This paper discusses the emergence of financial structures and the three alternative ways in which the role of the financial structure helps in economic development. The three alternative views are: first, the primitive view by John G. Gurley and E. S. Shaw. Second, the functional approach by Ross Levine. The last one is the historical perspective by Alexander Gerschenkron. The three views are followed by the conclusion.

I.INTRODUCTION What is the role of financial structures in economic development? Financial structures play an important role in the development of the economy. We will come later to the role of financial structures. Firstly, we need to define what financial structures are? A financial structure consists of markets which consist of institutions. Within this framework, there exists a set of instruments which these institutions perform such as mobilizing resources, management of risk etc. Economic development is defined as qualitative and quantitative changes in the economy. This paper discusses three alternative ways in which the role of financial structures in economic development has been visualized. The first view discussed is The Primitive View as given by John G. Gurley and E. S. Shaw in their article financial structure and economic development in 1967. They show that there is positive relationship between real accumulation and financial accumulation with emergence of financial system. The second view discussed is The Functional Approach given by Ross Levine(1997). This approach helps in understanding the role of financial systems in economic growth. It also focuses on the relationship between growth and the quality and growth of the functions provided by the financial systems. The third view is The Historical Perspective given by economic historian Alexander Gerschenkron. This view talks about uneven development across the world, that backward International Research Journal of Commerce Arts and Science http://www.casirj.com

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CASIRJ

Volume 5 Issue 9 [Year - 2014]

ISSN 2319 – 9202

countries do not follow the same path as followed by the developed countries during their development. The three views are followed by the conclusion. II. THE PRIMITIVE VIEW The study by John G. Gurley and E.S. Shaw tells us that as countries rise in terms of wealth and incomethen their financial structures also grow in terms of financial assets, markets, and institutions. Therefore, they describe the relationship between real accumulation and financial accumulation.During Economic development, i.e. the progress of the economy, as the income of countries increases; they usually experience more growth in financial assets than in national wealth. In market economy, there is tendency for this positive relationship between degree of financial development and economic development, even in a regulated environment. This relation existed for the United States. There financial assets grew much faster than gross national products: the ratio increased from unity at the beginning of 19th century to 4.5 in 1960’s. Japan also had similar experience. The question which arises is that why this relationship occurs across time and countries? As economic development occurs, certain requirements emerge from the real economy which can be met by the financial structures. There are several reasons given by Gurley and Shaw for rise in financial assets. They can be studied in terms of financial development as dependent on division of labor and in terms of financial development dependent on conditions of demand and supply of financial assets. Financial development can be seen in terms of emergence of three types of division of labor. First, division of labor in production that involves exchange of factor services and outputs which implies lending and borrowing. As the barter system fails to meet transaction needs, there is emergence of money and growing monetization. It is expected that once monetization is complete at least in terms of transaction purposes, there is some kind of stability between of money and real GDP. Second, finance is associated with division of labor between savings and investment.In an economy some people save and some people invest. Investors (borrowers) will issue financial assets in primary securities and these would be bought in by savers (lenders). During the growth process, the division of labor becomes more complex, which implies there is rapid accumulation of primary debt and financial assets than real wealth. Financial accumulation corresponds with real accumulation when the institutional evolution approaches its limit. Factor inputs of the financial sector increase more rapidly for a time then inputs of other sectors, and balanced growth of inputs comes eventually. Third, finance in association with division of labor between holders of primary securities and savers. Financial intermediaries borrow from savings for which they pay certain rate of interest i.e. deposit rate and assume responsibility for allocation of savings, charging a primary rate of International Research Journal of Commerce Arts and Science http://www.casirj.com

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CASIRJ

Volume 5 Issue 9 [Year - 2014]

ISSN 2319 – 9202

interest from borrowers. But as the process unfolds, saver is not directly the holder of primary securities but a holder of say a fixed deposit and the financial intermediaries can allocate this money to different investors. Intermediaries allow a spread between the savers and investors, which incentivize the institution to warrant the activity of intermediation once costs are taken into account. With increase in competition there is a layering between the savers and issue of primary securities implying new instruments are coming in i.e. new financial assets as system becomes complicated. Thus, volume of financial assets increases relative to growth in national income so that there is financial development with real accumulation. The corresponding growth in real and financial growth can also be explained in terms of supply and demand conditions in real and financial markets. The income elasticity of savings is greater than unity at low levels of income, and the savings elasticity for demand for financial assets seems to remain above unity as income rises. Though decline in real rate of interest that accompanies development tends to reduce the level of saving and returns on financial assets as well as indirect financial assets which stimulate portfolio demands. Therefore, both income and price phenomena related with real development make finance more active. Thus, real sector sets demands and agendas and then there is emergence of the financial development. The positive relationship between real sector and financial sector can be seen. III. THE FUNCTIONAL APPROACH Functional approach like The Primitive View, talks about the relationship between growth and the functions provided by the financial system and the emergence of financial sector. These functions include facilitating the trading of risk, monitoring managers, easing the trading of goods and services, allocating capital, mobilizing savings, and financial contracts. These financial functions influence savings and investment decisions, and technological innovations and hence to economic growth. To influence savings and investment decisions, information is required to make these decisions. The cost of acquiring the information and making transactions create incentives for the emergence of financial markets and institutions. A theoretical approach to finance and growth is given by Levine (1997). Heexplains theoretical approach as follows: there are two types of market frictions- information costs and transaction costs. As cost of acquiring the information and making transactions create financial markets and intermediaries. These financial systems perform their functions as stated above. These functions lead to growth of economy in terms of capital accumulation and technological innovations. Now let us put some light on the financial functions. Firstly, trading of risk, there are two types of risk as discussed by Levine(1997) liquidity risk and idiosyncratic risk. Liquidity is the ease and speed with which you can get your hands on your cash by selling assets, bonds etc. Therefore, liquidity risk is that risk which arises from the difficulty of selling an asset. But due to informational asymmetries and transaction costs the intensity of liquidity risk is high. The link International Research Journal of Commerce Arts and Science http://www.casirj.com

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Volume 5 Issue 9 [Year - 2014]

ISSN 2319 – 9202

between liquidity and economic development arises when some high-return projects require long-term investments, but savers do not want to give away their savings for the long periods. Thus, if financial system does not augment liquidity of long-term investment, there will be less investment in high-return projects. Therefore, there are liquid financial markets where savers can hold liquid assets like equity, bonds or demand deposits and financial markets transform these instruments in long-term capital investments. And if savers want to sell their assets at any point of time there is emergence of secondary markets. Financial intermediaries try and minimize liquidity risks, and increase investment in high-return illiquid assets which accelerates growth in the economy. The other type of risk is risk associated with individual projects, firm etc. In this case financial intermediaries provide way for trading, pooling and diversifying risk. Risk diversification alters savings rate and resource allocation which leads to economic growth. As savers do not like risk and high-return projects are riskier. Thus, financial systems ease risk diversification influences a portfolio shift towards high-return projects. Second financial function is producing information and allocating resources. As large costs are associated with evaluating firms, managers and market conditions, individual savers may not have the ability to collect and process information on investments. Then high information cost may prevent capital to flow towards its proper use. Thus, financial intermediaries do the research in investment possibilities for firms, industries etc. With the reduced information costs there is improvement in resource allocation which accelerates growth. Stock markets may also stimulate the information about firms. As markets become larger and more liquid, agents have more incentive to spend on research. Another financial function given by Levine(1997) is mobilizing savings. The cost of mobilizing savings is generally high, as it involves transaction costs and information asymmetries. Since there is large number of savers it becomes difficult to collect savings from them and savers are not comfortable in relinquishing control of their savings for long-periods. Mobilization of savings can be done through intermediaries and financial markets. Through intermediaries as investors entrust their wealth to banks that invest their savings in number of firms. In financial markets there are multiple bilateral contracts between productive units and agents. Thus, when savings are mobilized, it leads to increase in capital accumulation and improvement in resource allocation which boosts technological innovations and hence growth. Facilitating exchange is another financial function. Financial arrangements try and minimize the transaction costs so that they can promote specialization, technological innovation and growth. The model given in connection between exchange, specialization and innovation (Greenwood and Smith 1997), shows that more specialization requires more transaction costs and the financial arrangements that lower transaction costs facilitate specialization. Hence, specialization leads to innovation and higher growth.

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CASIRJ

Volume 5 Issue 9 [Year - 2014]

ISSN 2319 – 9202

Thus, financial system is the part of mechanism that helps economy to reach its potential. Hence, difference between real sector and financial sector is not warranted, but financial sector is a component of real sector and its development actually pushes the economy to its potential by mitigating information costs and transaction costs. Therefore, there is only an artificial dichotomy between real sector and financial sector as financial sector is not merely a lubricant for real sector but much more. An important point to note is that the proliferation of financial system, markets, institutions and instruments is automatic and self-organizing and is one of the ways that capitalism works, there emergence is only that is required in the economy. The financial development is endogenous and self-propelling. IV. THE HISTORICAL PERSPECTIVE The Historical Perspective given by Gerschenkron, A. in 1962. The main Marxist proposition is that “the industrially more developed country presents to the less developed country a picture of the latter’s future.” The Gerschenkron’s main proposition is that industrialization processes of countries can vary in terms of speed of development and productive and organizational structures of industries. As less developed countries borrow the technology from developed country, they do not develop the technology, greater the technological backlog seems to provide promise of industrialization in less developed country. Cheap and abundant labor also plays an important role in contributing towards development. But due to lack of skilled labor, backward countries must focus on industries with modern technology to ensure development. Greschenkron shows a sharp difference between the Germany and England. England was an advanced country and Germany did not follow it on the path of development. As the Germany had Credit Mobilier type of banks, that is, “as a bank devoted to railradization and industrialization of the country.” And England had commercial banks. German banks accompanied industrial enterprise from “the cradle to the grave”, whereas, industrialization in England proceeded without any substantial utilization of banks for long-term investment purposes. The state also plays an important role in development of a country where banking system is scarce. Government should take certain steps. Greshenkron discussed regarding uneven development across the world. The presence of initial conditions such as primitive accumulation, emergence of working class, concentration of wealth, certain degree of development of technology etc. are essential for emergence and development of industrial country. Thus, this is why England experienced industrial revolution first in the presence of these requisites. This however, does not recognize that the late industrializing countries had to invest in more capital intensive technology as technology has evolved overtime. Also, the late industrializing countries do not follow the same path as England. Thus, empirical reality is to make huge investments in many areas. Hence, prospects of industrialization were supposed dim. International Research Journal of Commerce Arts and Science http://www.casirj.com

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CASIRJ

Volume 5 Issue 9 [Year - 2014]

ISSN 2319 – 9202

However, because of this difference in root of the early and late industrialisers, emergence of institutional substitutes was seen to help in mobilizing resources and capital intensive investment as well as help in channeling resources to long gestation projects. Thus, it can be concluded that there is a need for certain institutions to fill the gaps for transition to industrial countries. For example in Japan and Germany banking services provided services as opposed by the conventional opinion of what commercial banks were supposed to do. The industrialization was largely discontinuous. Hence, according to Greshenkron, emergences of financial structures are automatic which implies the inevitability of emergence of these substitute institutes.

V. CONCLUSION The three approaches can be concluded as: The Primitive View: Financial development is bridging the three division of labor. To ensure this, there is emergence of certain set of market institutions which multiply and become complex as economy expands. Therefore, there is self-propelling growth of financial structures. The Functional Approach: Cost of acquiring information and transaction costs affect the ability of the system to generate equilibria and surpluses implying a constraint on capitalist economy. To mitigate these costs, emergence of financial structures through insurance or banking sector. Therefore, we must not curb the growth of financial structures as system is endogenously developing this sector to deal with these costs. The Historical Perspective: Universal banks were largely private institutions. These institutions come up due to the need to fill the gaps. They provide long term finance to capital intensive projects which require immense monitoring. The deficit in entrepreneurship was filled by the monetary supervision of banks. Therefore multiple deficits were filled by financial structures such as management, technology and finance. Therefore, it appears that system is endogenously throwing up a financial structures and instruments for development of the economy. There is automaticity as per these theories. This leads to positive relationship between financial structures and economic development. In nonmarket economies, we do not need financial intermediaries for mobilizing funds. It can be done by budgets, taxation etc. which shows that there exists alternative routes for mobilizing and challenging surplus. But in market economies, financial intermediation plays an important role. Different preconditions leads to different kinds of institutions endogenously and therefore there is no need of intervention for establishing specialized institutions.

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CASIRJ

Volume 5 Issue 9 [Year - 2014]

ISSN 2319 – 9202

BIBLIOGRAPHY 

Gurley, John G. and E.S. Shaw (1967), “Financial Structure and Economic Development”, Economic Development and Cultural Change, Vol. 15 No 3.

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Ross Levine, "Financial Development and Economic Growth: Views and Agenda", Journal of Economic Literature, June 1997, Section II A to II H.

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Gerschenkron A. (1962), Economic Backwardness in Historical Perspective: A Book of Essays, Cambridge: Mass. Harvard University Press.

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C. P. Chandrasekhar, “Alexander Gerschenkron and Late Industrialization” in Jomo K.S. (ed.), The Pioneers of Development Economics: Great Economists on Development”, Delhi: Tulika Books and London: Zed Books, 2005.

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