Part I
The importance of finance in emerging market economies
1 Finance and development
Introduction
What is the role of financial development in economic development? Surprisingly, this is a question that did not pique the interest of many economists until relatively recently. For over 100 years, the conventional wisdom on this question was that financial development would happen automatically and by itself, but only after macroeconomic development had already occurred. The economist Joan Robinson (1952) summarized this âlaissez-faireâ view of finance as: âWhere enterprise leads, finance follows.â This thinking is still implicit in the way that many historians have told the story of economic development in the United States and Europe, including the Industrial Revolution, where the role of financial development is typically down-played and the role of technological development (that somehow takes place magically with little investment in research and capital accumulation) takes center stage.
This view of finance as passively responding to overall progress is one that is not consistent with the larger scope of history. In the words of historian Niall Ferguson (2008): âThe evolution of credit and debt was as important as any technological innovation in the rise of civilization, from ancient Babylon to present-day Hong Kong.â Empiresâfrom Rome to Britainârose and fell based on their ability to marshal financial resources when they needed them to prosecute wars or to keep their populations pacified.
A few prominent economists did argue that finance plays an important role in initiating, not just following behind, economic growth. Joseph Schumpeter's (1912) model of creative destruction and technology cycles emphasized the important role of finance in allocating resources to entrepreneurs. Through financial intermediation, entrepreneurs are able to gain access to the resources needed to create the new technologies that are the engines of growth. According to him, entrepreneurship is impossible without the âbankers and other financial middlemen who mobilize savings, evaluate projects, manage risk, monitor managers, acquire facilities and otherwise redirect resources from old to new channels.â1 Schumpeter identified Britain's strong and efficient financial system as a primary reason why the Industrial Revolution began there and not elsewhere.
Interestingly enough, the root meaning of the word finance is consistent with Schumpeter's view of why it is so important. As noted by Robert Shiller (2012), the word finance derives from the Latin finis, which is often translated as âendâ but was also used as a synonym for âgoal.â In this context, finance can be thought of as part of the process of facilitating the economic goal of development and growth.
But despite the arguments of a few economists such as Schumpeter, the Nobel Prize winning economist Robert Lucas (1988) essentially summarized the consensus opinion of economists in the early 1990s when he said that the role of finance in economic development was âover-stressed.â Given how little it was actually stressed in the literature, this in essence meant that it should not be stressed at all.
Over the last 20 years, however, economistsâ thinking about the interaction between financial development and economic development has changed quite dramatically, because of both theoretical advances and improved empirical research. On the theory side, many new models have been developed by economists such as Ben Bernanke and Mark Gertler (1989, 1990) and Joseph Stiglitz and Andrew Weiss (1981), who show how market failure in financial markets can limit financial development and create instability that can limit economic growth. These models will be the focus of subsequent chapters. On the empirical side, both econometric research and the experiences of emerging market economies, including many in Asia such as Hong Kong and Singapore, have clearly illustrated exactly how financial development can stimulate economic development. This empirical research is summarized by Patrick Honohan (2004), World Bank economist and Governor of the Central Bank of Ireland, as follows: âThe causal link between finance and growth is one of the most striking macroeconomic relationships uncovered in the last decade.â
Setting aside the research of economists, anyone who has spent time in much of the emerging world understands the trap that many of the poor find themselves in when they lack the financial resources today that will eventually help to feed them tomorrow. The development economists Abhijit Banerjee and Esther Duflo (2011) tell the story of a street vendor in Chennai, India that paid her supplier an effective interest rate of slightly less than 5 percent a day. While this may not sound like much, borrowing $1 today at these rates would lead to a debt of nearly $20 million if left unpaid for a year. Many of these poor not only cannot affordably borrow through formal channels, they also cannot save their money safely with reasonable returns and have no access to insurance to smooth consumption and offset unexpected expenses. The lack of affordable finance is a large part of the poverty trap that plagues much of the developing world.
This chapter examines the nature of finance and discusses why, intuitively, financial development is crucial to economic growth. This is followed by a brief review of the empirical literature examining the relationship between financial development and economic growth. Next, the chapter provides an introduction to the primary methods of financeâfinancial intermediaries (principally banks), bonds, and stocksâand a discussion of the merits and disadvantages of each. The relative importance of these alternative methods of finance differs across countries. To understand how, a brief survey of the financial structure of a selection of emerging economies is examined, including a look at the empirical evidence regarding whether financial structure matters for economic growth. This chapter concludes with a look at one source of finance unique to the emerging market economies: remittances from migrant workers in developed nations back to their families and friends still living in emerging economies.
What is finance and why is it important to economic growth?
Finance is not an easy concept to define. For most, they know finance âwhen they see it.â The simplest definition is that financial intermediation is the trading of money across time. By money, economists mean any asset that is generally accepted in trade. Money is a tool for eliminating the need for barter and provides three significant benefits to its holders. First, money is a medium of exchange, making trade easier as compared to bartering. Barter requires a double coincidence of wants, meaning that you have to have what your trading partner wants and your partner has to have what you want. Money allows individuals to break this link by allowing them to separate the selling of the things that they have from the purchase of the things that they want. Second, money is a store of value, meaning it is a way to save and, as a result, conduct your purchases at a time that is different from when you sell your wares. Third, money conveys important information by being a unit of account, or a common standard by which to measure value and denote prices. This reduces confusion and increases efficiency.
In modern economies, the most commonly used methods of measuring money are M1 (currency in circulation and checking account deposits at banks payable on demand) and M2 (M1 plus savings deposits, money market deposits, and small certificates of deposits issued by banks). M1 includes assets that are clearly money, while M2 includes additional assets that, while not generally used in payments for goods and services, are clearly very liquid, meaning that they can be easily converted into money. Of course, historically many different assets have served as money, from gold to sea shells to cigarettes. The disadvantage of these commodity monies is that their supply is inflexible and highly variable, leading to constraints on trade and unpredictable changes in the prices denoted in these monies. With paper, or fiat money, governments can control the aggregate supply of money and, with proper management that maintains the public faith in its value, regulate the supply of money in a way that enhances price and economic stability.
Given the importance of money, it is obvious why individuals who have productive uses for it now but do not currently have sufficient amounts of it would be willing to trade money in the future for money today. This is exactly what financial intermediation facilitates. What makes finance unique from other economic transactions is this element of time. Anyone who trades money today for money tomorrow is accepting significant risk from many different sources. For example, there is risk regarding future changes in how much money is worth, or its purchasing power, based on changes in the prices of goods and services in the future (i.e. inflation or deflation). There is also the risk that the borrower will not meet their obligations and fail to pay the lender on the terms agreed upon (i.e. default).
Time is also a crucially important element in the economic development of emerging market economies. Because of the power of compounding, small increases in growth rates which are sustained over time lead to large increases in the level of output. A ...