Determinants Of Financial Development In Pakistan Economics Essay

Financial development plays a very vital role in economy and has a positive impact on economic growth. There are two schools of thought towards this study. First is repressionist and second is structuralist.

According to the repressionist they conclude in their studies that financial development is a consequence of the maintenances of positive real interest rates. As in financial deepening it impacts positively on commodity sector growth. These include currency, demand deposits, time deposits (each as a portion of real DGP) and M2/real GDP. (Shaw & McKinnon 1973)

According to the structuralist they conclude that financial development impacts directly on investment growth and asset competition, ensure that the relationship between investment and real interest remain negative. In other cases financial sector may be under developed or over developed. If financial sector is underdeveloped it will not provide adequate channels for the mobilization of saving and they may keep it in the form of gold ornaments. If financial sector is overdeveloped then it may become a medium of transmitting saving from the domestic economy to world capital market. Several studies show that countries such as Japan, Taiwan and china are carefully paying attention to maintaining a balance between real and financial sector development. (Gerschenkorn 1962)

To find out the answer of all these relations that’s the reason why this study is very important for us. Our research would be finding out what contributes to the changing trend of financial development in Pakistan and how it affects macroeconomic indicators? For that we will be looking at some of the determinants of financial development and there resultant effect on variables. Normally the data will be collected from 2005 to 2010 from the state bank’s reports and economic survey of Pakistan etc.

Broad research question/Problem statement

The research question or Hypothesis for our study is:

What contributes to the changing trend of financial development in Pakistan and how it affects macroeconomic indicators?

To find out the answer of all these relations that’s the reason why this study is very important for us.

Determinants:

There are a lot of factors which determine financial development but for our work we are taking in to account following factors.

Savings

Advances to deposits ratio,

M2

Exports/ Imports

Size of Manufacturing Sector.

Effects:

Financial Development is set to effect large number of variables but here we are considering the following,

Economic Growth,

Stock Index

Consumer Price Index (CPI)

Foreign Direct Investment (FDI)

Exchange Rate.

Objectives OF THE STUDY:

Following will be the prime objectives of our study:

Finding the relationship between financial development and economic growth

and to test the direction of causality between variable such as financial

development and economic growth.

How Growth, Consumer Price Index and Stock index are affected by financial development.

To carry out an assessment of Financial Intermediaries and their resultant impact on Financial Development.

Rationale / Justification

The drive to gear an economy on path to development is more a mystery than a fact. Every nation in the world is striving to be amongst the strong economies of the world. This draws a line of distinction between developed and developing countries of the world. Developed countries have strong economies as compared to the developing countries. Economic growth is the prime objective of every nation that contributes towards its development but there are certain hurdles such as over population, illiteracy and political instability that curtail their economic growth. Economic growth of every nation is dependent on Financial Development. Policymakers and economists generally agree that financial development contributes towards financial institutions and markets, such as commercial and investment banks, and bond and stock exchanges which in turn lead to economic growth.

Significance of the study:

The purpose of the study is to find out how stock market, forex, GDP and exchange rate are affected by financial development. Financial development is an important economic factor which has impact on various aspects of economy. In this study, we will find how some of the important indicators of economy are influenced by financial development.

Literature Review :

I have studied articles related to financial development. These include articles from international and local authors. Following are the key points discovered by me from these articles.

Arellano et al (2009) suggested that financial restrictions can hinder firms’ ability to use inputs efficiently and affect firm growth Recent theoretical models of firm dynamics predict that limited credit makes inefficient small firms grow faster than large firms.1 However, evidence for the magnitude of these effects in actual firm-level data is scarce. The central goal of this paper is to use cross-country variation in financial market development to evaluate empirically and quantitatively the impact of financial frictions on firms’ financing choices and growth rates with firm-level datasets. The small firms grow disproportionately faster than large firms in less financially developed countries. The growth rate differential across firms’ sizes and countries is not only statistically significant but also economically important. The small firms in less financially developed countries finance their assets with disproportionately less debt than large firms. Small firms tend to have higher leverage ratios than large firms on average. But this difference shrinks or even reverses as financial market development worsens. The relation of the debt financing patterns and financial market development is also economically sizable.

Chakraborty (2008) suggested that the relationship between economic growth and developments in the financial sector has been one of the most discussed areas in economics for a long time and the direction of causality whether financial development causes economic growth or vice versa is by no means a settled issue. Schumpeter (1912) in his effort to analyze the importance of technological innovation in long-run economic growth, emphasized the crucial role that the banking system would play in facilitating investment in innovation and productive investment by the entrepreneur. Joan Robinson (1952), however, maintained that it was economic growth which would create the demand for various types of financial services to which the financial system would respond. The financial sector in India since the early nineties has been transforming through various changes in the banking system, liberalization of the rules pertaining to foreign participation in the financial market and concomitantly, a strong growth in the stock market. Even though apparently these developments in the financial market have been followed by good economic growth, one required an appropriate technique which would meaningfully relate these developments to the growth in GDP during the same period.

Koubi (2008) suggested that political institutions pertaining to government quality plays an important role in affecting financial markets. The depth of financial markets and the stability of the rates of return on financial assets (stocks) are inversely related to the quality of government as measured by the quality of bureaucracy and infrastructure and government’s respect for the rule of the law. The cross-country determinants of financial development have only recently become the subject of research1. Beck et al. (2001) identify two sets of fundamental, historical factors that may explain present international differences in financial development. The first set comes under the heading of law and finance and emphasizes a country’s legal traditions. For instance, Porta et al. (1997, 1998) argue that financial development, and in particular the ability of firms to raise external finance through either debt or equity, is related to the legal environment in place. They find that poor investor protection, as measured by the character of legal rules and the quality of law enforcement, results in smaller and narrower capital markets. The second set of factors comes under the heading of endowment and finance. This set consists primarily of country characteristics related to the disease and geography environment. According to Beck et al. (2001) these characteristics determined colonization strategy (settlement) and shaped property rights and institutions. They find that such factors matter significantly and that this is true even after controlling for political factors.

Mendoza et al (2008) suggested that global financial imbalances can be the outcome of financial integration when countries differ in financial markets development. Countries with more advanced financial markets accumulate foreign liabilities in a gradual, long lasting process. Differences in financial development also affect the composition of foreign portfolios: countries with negative net foreign asset positions maintain positive net holdings of non-diversifiable equity and FDI. The far reaching reforms that integrated capital markets during the 1980s and 1990s were predicated on the benefits that financial globalization would have for efficient resource allocation and risk-sharing across countries. But these arguments generally abstracted from the fact that financial systems differed substantially across countries, and those differences have remained largely unaltered despite the globalization of capital markets. In short, financial integration was a global phenomenon, but financial development was not. The countries with different financial markets characteristics choose different compositions of foreign portfolios.

Herger et al (2007) suggested that economic globalisation has had a particular profound impact upon financial development during the last four decades giving rise to a group of closely intertwined international markets on which banks, corporations, or government agencies trade an increasing amount of assets such as bonds, shares, or currencies. The transaction cost of accessing external funds has shrunk considerably, which facilitates investment and market entry, entails competitive pressures to innovate, mobilises savings to accumulate capital, and eventually induces further economic growth (Levine 1997, 2005). Still, in terms of financial development, considerable heterogeneity continues to exist around the world. While in the period 1990-1999 total capitalisation of stock markets in Hong Kong, Malaysia, or Luxembourg exceeded 100 per cent of GDP, many developing countries did not provide firms the possibility of gaining access to equity finance by selling shares. Moreover, even within the OECD, during the same period, the largest credit markets such as those of Japan or Switzerland granted about ten times more funds to their private sector than the least financially developed member states e.g. Turkey or Poland. The direct determinants of financial development, designated by solid arrows, have been discussed during the outset. To recapitulate, a shift from small-scale personal to complex impersonal financial exchanges requires institutions (INS) such as the rule of law or political checks and balances that protect intermediaries from expropriation.

Baltagi et al (2007) suggested that it is now widely accepted that financial development constitutes a potentially important means for long run growth (Levine, 2003; Demetriades and Andrianova 2004; Goodhart, 2004). The value of understanding the factors behind the time series variation in financial development, alongside those that shape the cross-country variation, cannot be over emphasised. While it is highly plausible – indeed almost tautological – that political economy factors have a key influence in shaping policies and institutions that affect the development of financial markets. The empirical evidence on the influence of either openness or institutions, or indeed both, on financial development remains thin. In short-run, the effects of trade and financial openness depend on the extent of financial and trade openness, respectively, as shown by the partial derivatives of financial development with respect to each of the openness variables. The two sets of stock market liquidity equations do not however provide much support to the openness thesis, while there is somewhat stronger support from the equations that explain the number of listed companies. The positive effect of trade openness on financial development is also robust, but the positive effects of financial openness and economic institutions is somewhat less robust.

Ozmen (2007) suggested that the persistence of a strong correlation between domestic saving and investment in spite of policy regime changes towards flexible exchange rates, financial liberalization and international capital mobility has often been interpreted as the Feldstein and Horioka puzzle since their seminal contribution (Feldstein and Horioka, 1980). In a world of capital immobility, investments are bound to be solely financed by domestic savings. The co integration of saving and investment with a unitary coefficient is consistent with a policy of current account targeting in an open economy with fixed exchange rates. The exchange rate adjustment under flexible exchange rates may lead to contemporaneous saving-investment (S-I) correlation to be less than unity. Under international financial integration, on the other hand, the S-I link tends to disappear as domestic investment can now be financed by the worldwide pool of saving. There are ample explanations for the FH puzzle ranging from empirical modelling issues to the discussion of the interpretation of the S-I interrelationship as a measure of the degree of capital mobility. A crucial point in the FH puzzle is that the S-I relationship may not be invariant to the prevailing policy regime. The FH literature often maintains that countries with compatible levels of financial intermediation can borrow and lend from each other with negligible transaction costs. However, varying degrees of financial development and exchange rate flexibility between countries can both potentially act as frictions to international financial integration.

Arshad et al (2005) suggested that Government restriction on the banking system such as interest rate ceiling, high reserve requirement and direct credit programmed hinder financial development and reduce output growth (McKinnon 1973 and Shaw 1973). McKinnon 1973 and Shaw 1973 postulate that the Government intervention in the pricing and allocation of loan able fund impedes financial repression mainly depressing real interest rate. Government are facing only limited option such as inflationary financing, thus even detoriating the real interest rate. There are many reasons for this generalized improvement in macroeconomics. Several authors have reported link between the degree of Central bank independence (CBI) and both the level and variability and inflation.

Guryay et al (2007) suggested that even though a growing body of work reflects the close relationship between financial development and economic growth it is possible to encounter especially empirical researches evidencing all possibilities as positive, negative, no association or negligible relationships. In this respect, the main aim of this study is to determine the relationship between financial development and economic growth in Northern Cyprus by conducting empirical analysis. Literature survey puts forward three views concerning the potential importance of finance in economic growth. While the first one of these considers finance as a critical element of growth (Schumpeter, 1911; Goldsmith, 1969; McKinnon, 1973; Shaw, 1973; Odedokun, 1996; King and Levine (1993a, 1993b), finance is regarded as a relatively unimportant factor in growth according to second view (Robinson, 1952; Lucas, 1988; Stern, 1989). Finally third view concentrates on the potential negative impact of finance on growth (Van Wijnbergen, 1983; Buffie, 1984). Parallel to these views, empirical studies of the effects of financial development on economic growth have produces mixed evidences showing specially no role or positive relationship (Xu, 2000). Regarding the existence of causality running from financial intermediary development to economic growth it is not possible to address the direction of causal relationship between two variables due to independent factors’ (Neusser and Kugler, 1996; Berthelemy and Varoudakis, 1998; Ram, 1999; Sinha and Macri, 2001).

Research Methods and Method of Analysis:

As we know that methodology is the way we are going to carry out this research and this includes the variables which are involved in study, how we will obtain and process the data and these are as follows according to our objectives.

OBJECTIVE 1:

“Finding the relationship between financial development and economic growth

And to test the direction of causality between variable such as financial development and economic growth “

Variables:

Financial Development (M2/ GDP)

Economic Growth

Data Sources:

The source of data for this objective will be:

Economic survey of Pakistan.

Processing:

Causality test technique.

OBJECTIVE 2:

“How Financial Development is associated with Growth, CPI and stock index.

Variables:

Financial Development (M2/ GDP)

Growth

Stock index

CPI

Data Sources:

The data source for our second objective will be:

State Bank of Pakistan publication (money and finance chapters)

www.finance.gov.pk

Processing:

Correlation technique .

OBJECTIVE 3:

“To carry out an assessment of Financial Intermediaries and their resultant impact on Financial Development”

Variables:

Financial Development (M2/ GDP)

Advances / Deposits

Imports and Exports

Gross national savings

Gross domestic investment

Data Sources:

The data source for our objective will be:

www.finance.gov.pk

State Bank of Pakistan publication

Processing:

Regression technique.

Resources :

The resources used in this research will be consisting of using materials available like studies, surveys, reports by using facilities like University library and using internet for gaining access to additional relevant material which is not available in the university library like Governmental reports, surveys etc.

Limitations :

The study will be done on Pakistan which is a developing country so the results could not be a basis for conformity for a developed country or vice versa. The prevailing conditions and pattern of growth may vary country to country. During my research I may encounter any further sources of limitation which I would be mentioning in the final report of my dissertation.

Timescale: (May – September)

First I will be giving introduction of the key concepts which will be covered in my project by defining them, soon after that for literature review I would be reviewing more articles and journals from different authors to further enhance my understanding of the topic. Then I would be Gathering Data from sources and compiling them together. After that with help of SPSS or STATA I will be using bivariate correlation technique and then linear regression techniques. Then I will be interpreting the results after data analysis. And then finally I would be concluding the project. In the mean time I would be looking at every stage for any kind of improvement in my work with the expertises and help from my supervisor.