The Financial Markets Development and Economic Growth

The literature argues that financial markets are the fundamental channel through which most governments attempt to regulate their economies’ performance including combating inflation, promoting economic growth in the output of goods and services, and providing employment (Merton, 1990). It has been noted that the most successful economies have well developed financial markets (Levine and Zervos, 1996). While in theory causation can run in both directions, for example from growth to financial market development, current research has increasingly stressed the role of financial markets in promoting growth (Beck et al., 2000).

Financial development can increase economic growth in three manners: first, by enhancing savings; second, by channelling these savings into real investments, thereby fostering capital accumulation; third, to the extent that financiers exercise a degree of control over the investment decisions of the entrepreneurs, financial development allows capital to flow toward more productive uses, thus improving the efficiency of resource allocation. All three channels can in principle have large effects on economic growth (Beck et al., 2000).

At the macroeconomic level, a seminal study of 35 countries between the periods 1860 to 1963, carried out by Goldsmith (1969), found evidence to suggest that periods of rapid economic growth have often been associated with more developed financial systems. Accordingly, King and Levine (1993a, 1993b, and 1993c) have found that both stock market and banking development are good predictors of economic growth, capital accumulation, and productivity growth.

Further studies support the contention that stock market liquidity is an instrumental component of economic growth even after controlling for initial income and political stability (Jovanovic, 1993; Levine and Zervos, 1998).  Predictions of economic growth according to Rousseau and Wahtel (2000) and Arestis et al. (2000) are indicated by banking development and stock market liquidity. The stated empirical studies support the theoretical predictions of Levine and Zervos (1996) that stock markets can strongly underpin economic development.

There is some evidence for a two way relationship between financial market development and economic growth. The empirical work of Luintel and Khan (1999) – in a multivariate time series framework using data from a sample of 10 developing countries – suggests that economic growth makes the development of financial systems profitable and that the establishment of an efficient financial sector contributes to stimulating economic development. Shan et al. (2001) affirm these conclusions by utilizing a sample of nine OECD nations.

Rajan and Zingales (1998) use industry level data to show that industries requiring further external finance are likely to grow faster in more developed financial markets. Thus, they argue that financial development affects growth by reducing the differential cost of external finance. On a national level, Hasan and Zhou (2006) examine the relationship between financial development and economic growth in China. They employ a panel covering 31 Chinese provinces during the important transition period from a rigid central planning economy to a dynamic market economy between 1986 and 2002. Their evidence suggests that the development of financial markets, institutions, and instruments have been robustly associated with economic growth in China.

Given the apparent importance of the development of financial markets for underpinning economic growth, then, if minority shareholder protection facilitates financial market development, it will in turn be associated with economic growth. The following section explores the link between minority shareholder protection and economic growth.

Leave a Reply

Your email address will not be published. Required fields are marked *