Are financial institutions simply casinos where the affluent people come to place their bets, make immense profit and earn fat bonus? Or, do the services provided by financial institutions affect the rate of long-run economic growth? The role of financial sector development in economic growth in any economy is a central issue among economists, researchers and policymakers all over the world. However, the ‘finance-growth casual relationship’ is still not a prominent issue in public discourse. The success of a society or a nation cannot be imagined in the absence of a well-developed formal financial sector. The role of the financial sector is thus crucial in enabling the prosperity of the mass.
Source: Macroeconomic indicators of Nepal, Nepal Rastra Bank, July 2009
The economic theory in “casual growth-finance relationship” provides ambiguous predictions concerning the question of whether financial development exerts a positive and causative impact on long-run economic growth. Theoretical models in “growth-finance nexus” show that financial instruments, markets and institutions may arise to lessen transaction costs. By ameliorating market frictions, financial arrangements change incentives and eliminate the constraints faced by economic agents. Thus, financial systems may influence saving rates, portfolio management, investment decisions and technological innovations, and hence ultimately affect the long-run economic growth rate in any economy.
Even putting aside causal issues, a host of theoretical constructs, concepts and models in financial economic discipline illustrates the reductions in financial market frictions that increase expected rates of return and improve risk diversification and portfolio management opportunities that could increase economic growth rates depending on the general equilibrium effects on aggregate saving rates in any economy. Furthermore, a modern, efficient financial sector is a powerful contributor to economic growth and development that all of us would intuitively agree on.
The universally accepted theory that financial sector growth and economic development go hand in hand has so far proved wrong in the case of Nepal. While financial institutions have mushroomed, real economic growth rate has remained dismal.
Apart from that, the importance of well-functioning financial institutions and their role in promoting and enabling capital accumulation and economic development has been understood since at least the 19th century, if not earlier, and even if one only limits oneself to just the last 50 years, literature on finance-growth relationship is extensive. One of the thoughts is that a modern efficient financial sector is probably a necessary condition for broad-based economic prosperity; however it is certainly not a sufficient one. Since economist Joseph Schumpeter in 1912 put forward arguments pointing at the productivity and growth-enhancing effects of the services provided by a well-developed financial sector, a considerable amount of theoretical and empirical literature has emerged. Initially, this literature focused on the question whether the financial sector plays a causal role in economic growth or if financial intermediaries merely originate from rapid industrialization. Some economists stressed the propulsive role that the financial sector can play in the process of economic growth.
In the last 15 years, a wide range of studies has been devoted to huge statistical analysis to elucidate the finance-growth relationship. These studies have been able to establish that financial development and economic growth are clearly related in a positive manner. More than four growth-finance economists were awarded the Nobel Prize in recognition for their economic literature on this matter. Yet, the institutional channels is inadequately conceptualized and poorly understood. Even the direction of causality remains unresolved. It might partly be attributed to the lack of a generalized or unifying theory and partly to the myopic way conventional financial economics approaches the issue.
Thus, there is heterogeneity of views about the role of finance in economic growth. The whole array of literature on finance-growth relationship can be divided into two broad categories – ‘supply-leading’ hypothesis and ‘demand-following’ hypothesis. According to ‘supply-leading’ hypothesis, finance is a contributing factor in economic growth. Financial sector transfers resources from the traditional low-growth sector such as agriculture and land rents to modern high-growth sectors, and promotes and stimulates entrepreneurial responses in modern sectors. This implies that creation of financial institutions and the supply of financial services are well in advance of demand for them. The empirical findings of financial economics support this proposition. The other literature, dubbed as ‘demand-following’ hypothesis, views finance as dependent upon economic growth, that is, the creation of modern financial institutions and financial services are a response to the demand for these services by investors and savers in the real economy. The financial system adapts itself to the financial needs of the real sector and fits in with its autonomous development, playing a relatively passive role in the growth process.
In a market-led economy, the financial sector has a special and pivotal role as it mobilizes resources and allocates them to those investments that are capable of generating the highest returns on capital. The better the financial sector can perform this role, the better the economy will perform in the long run. The better the financial sector, the lesser the frictions in the economy.
Source: Macroeconomic indicators of Nepal, Nepal Rastra Bank, July 2009
All discussions above are theoretical concepts, constructs and literary semantics of the finance-growth economics, which each college graduate in economics generally knows. However, what actually and why it is happening is a crucial question in Nepal. We all are bystanders of perennially low real economic growth rate. Despite the perennially low growth, as figure 2 shows, the financial sector development is astonishingly gigantic in the economy. Real sector development is dismal due to lack of comparative advantage in production of manufactured goods, lack of infrastructures, the small economy of scale in production, lack of investment incentives, energy crisis, low productivity in industry, political instability and labor disputes. Even this low growth is “cosmetic” in nature sustained only by remittance inflow and foreign aid/grant and INGOs spending in their “development enterprises”. The high rate of unemployment and underemployment is one of the key factors behind low growth. However, increases in aggregate demand and national income have increased due to remittance inflow, donor’s funding and INGO’s spending, not because of real sector development. These factors are behind the mushrooming of financial institutions in Nepal. However, mere financial sector development cannot lead to economic growth both in the short and long term. The financial sector development is channeling savings only to mass consumption of imported consumer goods and the real-estate sector in Nepal. For sustainable economic growth, agriculture and industry are preconditions in any economy. Thus, the empirically valid and universally accepted theory of “finance-growth nexus” has so far proved a paradox in Nepal’s case.
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