The relationship between Financial Development and Economic Growth in Emergent Economies

Table of Contents

  1. Introduction. 3

1.1. Background. 3

1.2. Rationale. 6

1.3. Aims and Objectives. 7

1.4. Research Questions. 8

  1. Literature review.. 9
  2. Methodology. 24
  3. Data Analysis. 25
  4. Presentation and discussion of findings. 36
  5. Conclusion. 39
  6. Recommendations. 41

References list 43

 

1. Introduction

1.1.  Background

Economic growth refers to the change (increase or decrease) in the market value of goods and services produced by a given economy over time. It is measured in terms of percentage increase in the real GDP of an economy. In the measurement of economic growth, the aspect of population is considered because it determines the measurement of GDP per capita, also known as per capita income. IMF (2013) suggests that the global economic growth is slowing down and the key drivers of growth are changing. One of the drivers is the financial sector. The dynamics of these drivers including the financial system lead to new policy changes.

According to the IMF, the advanced economies are growing again after slowing down since the 2008 financial crisis. On the other hand, the growth rates of emergent economies are decreasing. One of the challenges facing global economies is the destruction of the financial sector. For instance, 2008/2009 financial crisis and the 2011 Eurozone credit crunch caused world economies to slow down in terms of growth. As the world recovered from the 2008 financial crisis, the economic growth of emergent economies improved significantly, while the growth of advanced economies did not recover quickly. World Economic Outlook (2013) suggests that the real GDP growth in emergent and developing economies is disappointing while it has been in line with projections in advanced economies. Most of the challenges that caused the slow growth in emergent economies resulted from the rapid financial deepening. This shows that for the economy to grow in emergent economies, financial development is needed. The figure below indicates the GDP growth rates of emerging and developed economies.

Figure 1: GDP growth as annualized quarterly percentage change (World Economic Outlook, 2013).

However, emerging economies still have the highest rates of economic growths. Global Finance (2013) suggests that emerging economies contributed four-fifths of global GDP growth in the third quarter of 2012. One of the problems facing world economies is the European credit crunch.  The IMF projects the economic growth of emerging economies to be around 6% in 2014, down from 7-8% that was recorded between 2004 and 2007. This indicates that economic growth for the emerging economies has been disappointing since the financial crisis of 2008. Therefore, financial development should be considered as a key priority to improve the financial service sector in order to avoid future problems in the financial sector and improve the economic growth of the emerging economies.

Financial development refers to the improvement in production and dissemination of information about potential investment through financial markets, intermediaries and instruments. There are five functions of financial systems: production of information, risk management, mobilization of savings, investment monitoring, and exchange of goods and services. Financial development involves the improvement of these functions; hence making the financial system effective and efficient. These functions influence savings and investment decisions. As a result, they affect economic growth. If financial development increases, there will be more savings and reduced costs of financing; hence investments increase and the economy grows.

Growth opportunities in emergent markets are highly dependent on the strength of the financial sector. Developed nations are now relying on developing countries for their recovery from recent financial crisis and economic turmoil. The economic expansion of developing countries is stronger than that of developed countries, although the growth has slowed down in recent years. The economic expansion of developing nations, especially the BRIC countries has been enhanced by increasing financial and fiscal stability. Financial services will have a great impact mainly in three specific areas of emerging markets: consumer financial services, financing small and medium sized businesses, and corporate bonds. World Economic Forum (2012) suggests that new financial services in those three areas of emergent economies will drive economic growth and create value for shareholders and institutions.

World Economic Forum (2012) also suggests that developing markets are expected to continue being the epitome of global economic growth until 2015. The developing market GDP is expected to grow at around 10% by 2015, compared to 5% growth in developed countries. Due to this forecasted growth, emerging economies need to build the capacity and improve the offerings of their financial institutions (World economic Forum, 2012).

Financial services in emergent economies also enhance product and service innovation. Innovation in the financial sector is needed to improve financial development index of each emerging economy. It expands financial services market by encouraging lower barriers to entry, improved service delivery, and increased productivity. Financial institutions should develop their own innovative mechanisms in order to improve financial development of emerging markets.

1.2. Rationale

This dissertation seeks to establish the relationship between financial development and economic growth in emerging BRIC economies. In order to achieve this, the research will attempt to establish the measures of economic growth and financial development in emergent economies. The background of financial services and economic performance of emerging economies has been provided in earlier section, while the financial services and economic performance can be measured using existing methods suggested by World Economic Forum (2012).  These measurement approaches will be dealt with in depth within the literature review section. Once the level of financial development and economic growth in emerging countries have been measured, the two parameters can be linked to each other to predict the impact of one parameter on the other, i.e., the impact of financial development on economic growth.

This relationship between financial development and economic growth has become necessary especially since financial crisis of 2009. The countries that were most affected by the crisis experienced a decline in their economic growths. This elicited the need to establish the impacts of financial development on economic growth. This research therefore follows the footsteps of previous studies, and intends to provide an important unique perspective on the relationship between financial development and economic growth.

Financial system has been considered to be an important contributor of economic growth (World Economic Forum, 2013). Therefore, it is necessary for financial institutions to find a way of establishing the level of financial developments and economic growth in emergent economies. This research attempts to find a way to measure financial development and economic growth of emergent economies. This helps financial institutions in emergent economies to focus on achieving the right level of financial development. Its aim is to investigate the relationship between financial development and economic growth in emergent economies so that financial institutions in such economies can develop strategies that lead to the achievement of the desired level of financial development. As mentioned by World Economic Forum (2014), measurement of financial development against economic growth in an economy is important for business leaders and policy makers to identify and discuss key factors in development of financial systems and markets of the economy.

1.3. Aims and Objectives

The aim of this research is to find out the relationship between financial development and economic growth. It will measure financial development of emergent economies and relate them with the economic growth of such countries. This research is also aimed at providing the framework within which policy makers and business leaders in emergent economies can use to identify and utilize the key factors in the development of their financial markets. The following are the key objectives of the research:

  • To measure financial development against economic growth in emergent economies using available methods of measurement.
  • To establish the relationship between financial development and economic growth in emergent economies
  • To determine the linkage between financial system and real economy in emergent markets
  • To find out the role of financial intermediaries in economic growth and development of emergent economies
  • To establish the differences between financial development and economic growth of the emergent countries (BRIC).

The research intends to find out how the financial system can enhance economic growth through financial development. In order to achieve this, it is important to establish the general linkage between the financial system and the real economy as well as the role of financial intermediaries in the real economy. The objectives will be achieved by proving appropriate hypotheses that define the real objectives.

1.4. Research Questions

This research seeks to answer some questions related to its objectives. These questions include:

  • What are the measurements of financial development in emergent economies?
  • What is the link between financial system and real economy in emergent economies?
  • What is the role of financial intermediaries in economic growth and development of emergent economies?
  • What is the relationship between financial development and economic growth in emergent economies?

2. Literature review

The impact of financial development on economic growth

There are various researches, theories, and empirical models which explain the relationship between financial development and economic growth in emergent markets. Ekmekcioglu (2012) provides an important investigation on the relationship between financial development and economic growth. Ekmekcioglu cites early researchers such as Kohli (2008), Shumpeter (1912) and Hicks (1969) who have found out that financial development affects the economic prosperity of emergent markets. The study by Ekmekcioglu (2012) is therefore relevant and strong in forming a linkage between financial development and economic growth because it uses a wide range of theory and models to come up with its conclusions about the topic.

Ekmekcioglu (2012) argues that financial liberalization reduces barriers that may hinder performance growth of the financial sector. He also defines economic expansion as the increase in amount of goods and services in a given country over a given period of time. Liberalization of financial markets allows the transfer of financial services to rural populations; hence promoting development in such markets. This enables the rural population to participate in economic activities successfully and boost economic growth of the country.

Ekmekcioglu (2012) uses 2010/2011 financial performance index and economic index of BRIC countries. The study found out that Brazil has an improving financial index which was attributed to the stability of the country’s currency. According to Ekmekcioglu (2012), Brazil has a low degree of financial liberalization, which is one of the country’s greatest weaknesses in the financial sector. In terms of economic performance, China is the best performing country with an economic growth of 10.4% in 2010 and 9.2% in 2011. Ekmekcioglu (2012) suggests that this can be attributed to the country’s financial stability and strength. This is supported by Loayza and Ranciere (2004) who argue that although China’s business environment is weak, its financial intermediation remains one of the strongest in the world.

According to Ekmekcioglu (2012), the economic performance of India is strengthened by the performance of its non-banking financial sector. India is weak in terms of access to financial services but it has a strong financial intermediation which enhances positive results on foreign exchange, which in turn boosts the country’s economic growth.

The economic performance of Russia is also attributed to the stability of its currency (Ekmekcioglu, 2012). The country experiences strength in both non-banking financial sector and financial intermediation. However, Russia’s banking system is considered to be unstable (Ekmekcioglu, 2012). This is overweighed by good performance in other sectors of the economy. The findings of the study indicate that there is a positive relationship between financial development and economic growth in developing countries. Ekmekcioglu (2012) has found out that emerging markets exhibit an upward trend in terms of economic and financial performance. The study also indicates that all other sectors of the economy depend on the financial sector in order to grow.

This study by Ekmekcioglu (2012) has various weaknesses. First, there is no mechanism used to link financial development and economic growth. The study only lists the economic indices and financial development indices without using any statistical approach to combine and compare the relationship between the two variables. The study could be made more reliable by using line graphs or other tools of analysis to show the relationship between the two variables.

The view that financial liberalization enhances economic growth has also been supported by FitzGerald (2006) who argues that financial liberalization enhances the deepening of financial markets; hence enabling savers and investors to increase their financial intermediation. Another importance of financial development is that it promotes monetization in the economy and encourages efficient use and flow of resources among various economic agents. This increases savings and capital, and enhances the efficiency of allocation of investment by allowing the transfer of resources from less productive to more productive economic uses (FitzGerald, 2006). This promotes the growth of the overall economy.

Financial development is enhanced through five functions of the financial system. One of the functions is provision of information about investment. Secondly, financial system mobilizes savings and allocates capital in the economy. After providing finance, financial intermediaries also monitor investments to ensure that funds are utilized appropriately. Fourthly, financial system performs the function of managing risks and supporting diversification. The fifth function of financial system is that they enhance exchange of goods and services; making business transactions easier and effective in the economy.

There are three characteristics of financial intermediation that enhance greater financial development: its level, efficiency and composition. The effect of financial development on economic growth depends on the size of the financial system as compared to the overall economy. A larger financial system enables the economy to utilize economies of scale because there are fixed costs involved in financial intermediaries (FitzGerald, 2006). A large size of financial intermediation can also allocate capital more effectively and monitor the use of funds more effectively. A large financial system also enhances greater financing capability; hence increasing the resistance of the economy to external shocks (FitzGerald, 2006). A large financial system also promotes cross-sectional risk diversification and risk sharing. Inclusion of more individuals in a large financial system also promotes the sharing of risks. As a result, this boosts investment in physical and human capital; hence achieving higher growth rates.

In terms of financial liberalization, FitzGerald (2006) argues that financial liberalization enhances more liquid and efficient financial intermediation. However, it does not raise the aggregate amount of savings or investment. This proposition is supported by Levine (2004) who argues that finance may explain economic growth by highlighting how financial development affects the efficiency of allocating resources rather than aggregate savings. Accumulation of physical capital does not influence long-run economic growth.

Levine (2004) argues that financial development may influence economic growth negatively by improving resource allocation and reducing risks; hence lowering savings rates and decelerating economic growth and reduces welfare. This happens when reduction in savings and occurrence of externalities combine to produce a large effect. Levine (2004) also finds limitation in the proposition that capital flows towards the highest value use. He suggests that the flow of capital towards profitable projects is limited by lack of information. For savers to channel their funds towards profitable firms, they need to have good information about firms, market conditions, and managers. Financial intermediaries play the role of reducing the costs of acquiring information; hence improve the process of resource allocation.

Fink et al (2006) also show a positive relationship between financial development and economic growth. Using a sample of 11 transition and 22 market economies, Fink et al (2005) found out that financial development and economic growth exhibit a positive relationship in the short run.

According to World Economic Forum (2012), financial development is determined by various pillars, including intermediation in the financial market. Mohtadi and Agarwal (2001) carried out a study to determine the relationship between stock market development and economic growth for 21 emerging economies based on a 21-years period. This study is relevant because the stock market is a key element of financial markets. Therefore, stock market development is important for financial development. Mohtadi and Agarwal (2001) argue that there is a positive relationship between stock market development and economic growth in emerging economies. This means that financial development and economic growth are also positively related in emerging economies.

Mohtadi and Agarwal (2001) suggest that the positive relationship between stock market development and economic growth occurs because stock market development boosts private investment behaviour, which in turn leads to growth in the economy. The study uses two models to test the relationship between stock market development and economic growth. The first model tests the hypothesis that the stock market affects economic growth through two steps. The test involves a regression of the three measurements of stock market as well as the growth in investment. The second model examines the direct relationship between stock market development and economic growth without considering investment behaviour.

From the results of the study, the authors concluded that stock market development promotes economic growth both directly and indirectly. In this regard, Mohtadi and Agarwal (2001) suggest that the direct contribution indicates a positive impact of market liquidity on growth. On the other hand, the indirect impact of stock market development on economic growth occurs because the market size affects investment, which in turn affects economic growth.

Although the study by Mohtadi and Agarwal (2001) focuses on stock market development rather financial development which is the main focus of the current research, it still remains significant reference for this study because stock market development is a component of financial development. The study is also important for the current study because it highlights the contribution of financial markets to economic growth through investment. Furthermore, the different measures of stock market development in relation to economic growth are an important element in determining the relationship between financial development and economic growth in emerging markets. Therefore, Mohtadi and Agarwal (2001) provide relevant information that may guide the current research.

Another study that provides the link between financial development and economic growth in emerging markets was provided by Bekaert et al (2001). The study focused in the opportunities presented by the real economic growth of emerging markets after financial liberalization. The research found out that financial market liberalization in emerging markets has resulted in real growth rates of one percent per annum. According to this study, the relationship between financial liberalization and real economic growth is influenced by factors in the macroeconomic environment as well as stock market and banking development.

The issue of financial liberalization studied by Bekaert et al (2001) is considered by the World Economic Forum as one of the pillars of financial development. Therefore, while studying the relationship between financial development and economic growth it is apparently clear that the correlation between financial liberalization and real growth is important; hence the study by Bekaert et al (2001) is relevant in this study. However, it also has its own limitations like any other study that has ever been carried out. For instance, the dates for the study may provide misleading results because financial liberalization occurred at different dates for each of the emerging economies. Other factors such as cost of capital are also not taken into consideration; so the growth of the real economy may be due to such other factors and not necessarily financial liberalization.

Krishnan (2011) suggests that well functioning financial markets lead to long-term economic growth. This is promoted by the main pillars of financial development including banking institutions, financial stability, stock markets, non-banking institutions, etc.

Financial development and Growth opportunities in Emerging Economies

Various researches and other sources of literature indicate that there is an increased opportunities financial service in emerging markets. ResponsAbility (2013) states in its insight report that investors in emerging markets can take advantage of financial sector development opportunities as demand for financial resources in the financial market increases. This opportunity enables investors to acquire the capital needed to invest and achieve economic growth. ResponsAbility (2013) also notes that financial institutions serve micro, small and medium sized businesses in emerging economies in order to enhance their growth and investments. This leads to increased overall growth in the emerging economies.

Microfinance is one of the main pillars of financial development in emerging markets (ResponsAbility, 2013). The insight report o f responsibility suggests that microfinance investments have been increasing significantly in the recent years. Private funding is driven by individual and institutional investors who invest in microfinance institutions. Microfinance institutions also boost economic growth by providing funds to private investors who in turn invest in projects which contribute to high income and increased growth. ResponsAbility (2013) suggests that private investors have great chances of achieving high profitability. Furthermore, microfinance private equity investors diversify their assets; hence contributing to positive effects in financial development.

Financial institutions and investors may also work together to enhance financial development and economic growth. Financial institutions provide financial resources, market advice, strategic advice, and operational advice. These functions enhance growth and positive transition in both the financial sector and the real economy.

One of the main propositions of ResponsAbility (2013) is that economic growth is sustained by an inclusive financial sector. Effective regulation and policy implementation in the financial market also enhances growth of the economy and increased financial development. The insight report further argues that as the economic growth improves in terms of per capita income, demand for financial services also increase. As a result, competition in the financial sector increases, leading to improved financial service quality and innovation; hence financial development accelerates.

Financial Access Initiative (2009) provides a research which suggests that there is a moderate to strong correlation between financial development and economic growth in terms of per capita income.

PricewaterhouseCoopers (2011) also mentions in its research report that the leading seven emerging economies (E7) including China, Brazil, Russia, India, Indonesia and Mexico may become 25%-50% larger than the current seven largest developed economies (G7); and their financial services sectors may similarly experience a rapid expansion. This shows that the emerging economies have an increasing economic growth. Evidently, this growth is accompanied with an expansion of financial services sector.

World economic forum (2012) also carried out a study to determine the opportunity of emerging market in terms of financial services and economic growth. The insight report suggests that as the world emerges from difficult financial times, emerging economies have enjoyed an expanding economic growth. Therefore, the emerging economies have become good markets for companies in advanced economies. As a result, financial institutions have become essential elements of the emerging economies. Such financial institutions provide new financial services to low income earners who are undergoing transitions into the middle-income earners. The report of World Economic Forum (2012) suggests that the main immediate opportunities for financial institutions in emerging economies rely on consumer financial services, corporate bonds, and financing for medium-size enterprises. These three sectors enable financial institutions to drive broad economic growth.

World Economic Forum (2012) also suggests that product and service innovation accelerates financial development in emerging economies. Innovation accelerates growth and expands emerging markets. This expansion of financial services in emerging economies has been enhanced by various factors such as low barriers to entry, transformation of service delivery, and increased productivity in the overall economy.

According to the World Economic Forum (2012), economic growth of emerging economies also contributes to the growth of financial services sector in such economies. The economic growth of emerging economies accelerated faster than high-income economies between 2006 and 2010. The economic expansion of emerging economies contributed about $8 trillion which is approximately 60% of the world’s overall GDP growth. Alongside this robust economic growth, emerging economies have also experienced high levels of financial stability during the period of financial crisis in 2008/2009 (World Economic Forum, 2012). World Economic Forum (2012) also observes that economic performance and financial stability in emerging markets have led to several sovereign credit rating upgrades since 2010. Brazil is one of the main beneficiaries of such credit rating upgrades.

Through its insight report of 2012, World Economic Forum also developed a model in which High Growth + high returns = greater shareholder value. The World Economic Forum explains this model in a manner that illustrates how the economic growth of emergent economies contributes to superior value for financial institutions. It argues that emerging markets exhibit high economic growth which in turn contributes to higher return; hence making emergent economies to become viable areas for financial institutions.

World Economic Forum also suggests that there is a big difference between the shareholder value of emerging markets and that of developed markets. Using a five-year analysis of total shareholder return (TSR) in the global market, the World Economic Forum found out that most top institutions in emerging markets performed above the median level. Growth is the main driver of long term total shareholder return. High costs of equity in emerging markets are also offset by higher returns on equity.

World Economic Forum (2012) predicts that emerging markets will continue being the engine of global economic growth. IMF (2012) agrees with this prediction and forecasts that by 2015 the GDP of emerging markets will have grown by 10% annually. When compared with the forecasted growth of developed countries (5% by 2015), the growth of emerging economies will be the highest in the world.

The main argument of World Economic Forum is that economic growth accelerates financial development. This is the reverse of the argument presented by Levine (2004) and FitzGerald (2006) who argue that increased financial development promotes higher economic growth in emerging economies. It is therefore plausible to propose that economic growth and financial development of emerging economies have an interlinking forward and backward positive relationship.

However, World Economic Forum (2012) also observes that there is an effect of financial development on economic growth. The growth potential of emerging markets can be enhanced by financial institutions which need to build their capacity and promote greater financial development. This is agreed by ResponsAbility (2013) which suggests that financial institutions such as microfinance institutions allow for private equity investments which enhance corporate transformation.

Global competition has also enhanced the need for financial innovation. World Economic Forum (2012) suggests that financial institutions in emerging economies play a crucial role in the competitive global financial market. Banks in the emerging markets which appear in the world top 200 financial institutions tripled from 22 in 2005 to 66 in 2011. The emerging market now accounts for one third of the leading financial institutions of the world. Among the BRIC countries, China and Brazil contribute the highest number of banking institutions ranked among the top 100 in the world (World Economic Forum, 2012). This indicates that the emerging markets provide leading competitors in the financial market. This competition necessitates the growth of financial innovations.

Financial institutions in emerging markets have advanced in terms of financial innovations. This has led them to tap opportunities in the financial market and boost the growth of emerging economies. Innovativeness among financial institutions in emerging markets also enables such institutions to overcome infrastructural shortcomings and fulfill the needs and interests of their customers (Arestis et al, 2001). Financial institutions in emerging markets innovate in terms of distribution models, partnerships, and risk practices. For instance, some financial institutions use electronic channels to disburse financing to small business customers.

The World Economic Forum (2012) also proposes that financial providers in emerging economies should provide corporate bonds, consumer financial services and SME financing in order to enhance economic growth. Consumption is the main driver of economic expansion in emerging economies. World Economic Forum observes that there is a great opportunity to drive expansion in low income segment in emerging markets to earn economic and social benefits that contribute to economic growth. Expansion of financial services enables low income earners to afford more goods and services, and to move out of poverty. Financial development in terms of access to financial services and adoption of disciplined saving habit promotes poverty eradication and economic expansion (Basu, 2002).

World Economic Forum (2012) suggests that insurance products are a significant opportunity in emerging markets’ financial sector. Adverse effects that affect low-income consumers can be avoided or minimized through insurance in the financial market. This forms an essential cushion for the economic growth of emerging economies. There are three key services that the low-income earners demand: daily management of funds, long term savings, and borrowing for various needs. These requirements are often underprovided. With improved financial development, emerging economies can provide these services. As a result, the overall economy improves.

Emerging markets also experiences a credit paradox which affects SMEs. Credit and loans can be accessed by only one-third of all SMEs in emerging economies. However, three-quarters of the SMEs maintain savings and checking accounts in banks. SME financing is an essential element in emerging economies because SMEs are essential in economic development of emerging economies (Chanda, 2003). SMEs create more jobs than large firms in emerging economies. Therefore, SME financing id important for the financial development of emerging markets.

Corporate bonds are also foundations for long term growth in emerging economies. Local bond markets developed after the financial crises that hit emerging economies in 1990s. Bond markets are essentially the strongholds of corporate and bank restructuring needed to overcome financial crisis and accelerate economic growth and development. Corporate bonds also facilitate reduction of mismatches in currencies and maturities in their balance sheets. This reduces corporate sector vulnerability and enhances economic growth.

Measurement of Financial Development

Ekmekcioglu (2012) suggests that financial development can be measured using considering various factors such as depth, strength, effectiveness and access of the financial structure. The financial structure consists of financial markets, financial assets, intermediaries, regulations, and institutions. There are various indicators of the financial development that explain the differences in economic growth of various countries across the world.

Financial development applies in various sub-sectors of the financial sector including Banks, Non-banking Financial Institutions, intermediaries, and Stock markets (FitzGerald, 2006). Emerging economies are moving away from banking financial systems towards open capital markets and non-banking financial institutions which are supported by the financial market liberalization. According to FitzGerald (2006), this movement reflects the standard model of financial development.

Financial development can also be measured based on the three characteristics of financial development: level of financial intermediation, efficiency of financial intermediation, and composition of financial intermediation. The level of financial intermediation can be measured using the size of bank credit as compared to the size of the economy’s GDP. Efficiency can be measured using the turnover rate of the stock market, legal rules, and activities of corporate governance. The composition of financial intermediation can be measured using bank credit maturity and fixed income securities.

World Economic Forum (2009) suggests that ranking of countries in terms of financial development requires that the financial development of each country should be measured using Financial Development Index. This measurement of financial development is determined by certain factors that affect the financial sector including financial intermediation, financial access and policies. This is illustrated in the figure below.

Fig 2: Financial Development Index (World Economic Forum, 2009)

Mohtadi and Agarwal (2001) measure the stock market development as part of financial development. The authors argue that stock market development is measured in relation to GDP in three methods: Market Capitalization Ratio (MCR), Total Value Shares Traded Ration (STR), and Turnover Ratio (TR). Market Capitalization Ratio measures the stock market development by dividing the value of listed shares by GDP. Total Value of Shares Traded Ratio is determined by dividing the total value of shares traded in the stock market by the GDP. Lastly, the Turnover Ratio is calculated by dividing the value of total shares by market capitalization.

Krishnan (2011) also provides direction on how financial development can be measured. The study shows that the main method of measuring financial development was established by the World Bank in 1999. Krishnan argues that there are about thirty financial system indicators used by the World Bank to measure financial development. Some of the most common indicators include the size of the financial system (e.g. liquid liabilities), banking system indicators, financial globalization indicators, and capital market indicators. This method does not rank countries in terms of financial development indicators the way World Economic Forum does.

3. Methodology

The dissertation will utilise secondary sources of data collection. The researcher will collect the data from secondary sources: IMF and World Economic Forum websites. In this case, data from past research and reports from resourceful websites will be collected and used in the current study. Some of the sources include peer reviewed journal articles, company websites, financial reports, business newsletters and other relevant sources. The data will then be analysed using quantitative analysis involving a number of tables and figures. One of the internet sources that will be important in getting financial development reports for the literature review is World Economic Forum which can be accessed through the link: http://www.weforum.org/issues/financial-development. This link will provide good report to measure the financial development levels of emergent economies. It measures the financial developments of various financial markets of the world, and assigns each one of them a score according to their level of financial development. The information is collected by going into the website and recording the scores of each of the emergent economies to be studied.

Economic growth rates that will be used to do a comparison with financial development levels will be obtained from reliable sources including financial websites and institutions such as CIA WorldFactbook, World Bank, IMF, etc. IMF, World Bank and CIA are good sources of secondary information where economic growth rates of all countries of the world can be found. These website are reliable because they are trusted for research across the world, and has been used in several studies before including Ekmekcioglu (2012), Mordi (2010), and Levine (2004). The levels of financial development of each economy will be compared to the economic growth of such economies using relevant statistical methods and visual representations such as median, mean, standard deviation, graphs, etc.

This will lead to the development of a model that will involve financial development as an independent variable and Economic growth as a dependent variable. The most important method is to use a table and a line graph which will show different levels of economic growth (as the X-Axis) and financial development (as Y-Axis) in different countries. Excel spreadsheet software will also be used to find the correlation between financial development and economic growth.

4. Data Analysis

This study utilized two types of data to come up with its findings namely GDP growth rates and financial development indices. This data was obtained from various secondary sources, and covered the four-year period between 2009 and 2012 for the BRIC countries including China, India, Russia and Brazil.

Financial Development of BRIC economies

In terms of financial development index, the table below shows how the BRIC countries performed between 2009 and 2012.

Country 2009 2010 2011 2012
Brazil 3.46 3.53 3.61 3.61
Russia 3.16 3.21 3.18 3.30
India 3.30 3.24 3.29 3.29
China 3.87 4.03 4.12 4.00

Table 1: Financial Development Index for the BRIC between 2009 and 2012.

From the table above, it is clear that financial development for Brazil increased for the four-year period under study. Russia’s financial development fluctuated within the four years but in overall terms it was in an increasing trend. Similarly, India’s financial development fluctuated between 2009 and 2012, but the overall trend is decreasing. China’s financial development also fluctuated but its overall trend seems to be fairly constant. In the later chapters of this dissertation, we will relate these trends in financial development of the four emerging countries. The financial development of China is higher than the financial development of other BRIC nations, hitting an index of greater than 4 in the recent years.

Economic Growth of the BRIC countries

The economic growth of the BRIC countries for the period between 2009 and 2012 can also be shown in the figure below.

Country 2009 2010 2011 2012
Brazil -0.3 7.5 2.7 0.9
Russia -7.8 4.5 4.3 3.4
India 8.5 10.5 6.3 6.2
China 9.2 10.4 9.3 7.8

Table 2: Economic growth for the BRIC countries in percentage

The table above indicates that Brazil and Russia began with low rates of economic growth in 2009, and this can be attributed to the previous global financial crisis of 2008 which affected many countries of the world. However, the economy of the two countries grew significantly in the following year. In general, the economy of the four countries improved in around 2010 and slumped in the recent year of 2012.  China has recorded the highest levels of economic growth in the recent years, just like it has achieved in terms of financial development index. Therefore, it can be seen that a country like China which has high levels of development also has high levels of economic growth.

The relationship between Financial Development and Economic Growth in BRIC economies

Brazil

The indices of various measures of financial development such as Factors, Policies, and Institutions, Financial intermediation, and financial access are indicated below.

2009 2010 2011 2012
Institutional environment 3.54 3.61 3.73 3.72
Business environment 3.63 3.80 3.78 3.74
Financial stability 5.13 5.15 5.03 4.82
Banking Financial services 3.46 3.22 3.31 3.55
Non-banking financial services 3.20 3.56 3.47 3.60
Financial Markets 1.86 1.93 2.45 2.37
Financial access 3.31 3.42 3.51 3.48

Table 3: Pillars of Financial Development in Brazil

According to the table above, the key pillar Brazil’s financial development is Financial Stability. Brazil scored more than 5 in terms of financial stability from 2009 to 2011. The country performed poorly over the four years in terms of financial markets and financial access pillars.

As shown in the figure below, financial development represented by the blue line has been increasing fairly constantly while the Economic growth increased sharply in 2010 and declined subsequently until 2012.

Fig 3: Relationship between financial development and economic growth in Brazil

The correlation analysis of financial development and economic growth in Brazil can be shown in the table below.

2009 2010 2011 2012
Financial development 3.46 3.53 3.61 3.61
Economic Growth -0.3 7.5 2.7 0.9
0.088752

Table 4: Correlation analysis for financial development and economic growth of Brazil

As shown in the table above, the correlation coefficient of financial development and economic growth of Brazil is 0.089. This value is close to zero which indicates that there is a weak positive relationship between financial development and economic growth in Brazil.

Russia

The performance of Russia in terms of various pillars of financial development is shown in the table below.

2009 2010 2011 2012
Institutional environment 3.01 3.15 3.08 3.09
Business environment 4.21 4.43 4.58 4.50
Financial stability 4.50 4.17 4.15 4.19
Banking Financial services 1.80 2.05 2.35 2.37
Non-banking financial services 4.13 4.28 3.83 4.09
Financial Markets 1.76 2.05 1.74 2.09
Financial access 2.73 2.37 2.53 2.83

Table 5: Pillars of financial development in Russia

From the table above, it is clear that Russia performs poorly in terms of financial access, financial markets, and banking financial markets pillars of financial development. Russia has been strong in terms of non-banking services for the four years under consideration. It performs significantly well in securitization and equity market.

Fig 4: Relationship between financial development and economic growth in Russia

The figure above indicates that the financial development of Russia increases fairly slowly while its economic growth fluctuated and decreased in 2011 and 2012.

Financial development Economic Growth
3.16 -7.8
3.21 4.5
3.18 4.3
3.3 3.4
Correlation 0.503421561

Table 6: Correlation coefficient of financial development and economic growth of Brazil

The table above indicates that the correlation coefficient of financial development and economic development in Russia is 0.50. This shows that there is a medium positive relationship between financial development and economic growth in Russia.

India

The pillars of financial development in India for the four-year period between 2009 and 2012 are summarized in the table below.

2009 2010 2011 2012
Institutional environment 3.38 3.21 3.13 3.18
Business environment 3.51 3.35 3.42 3.39
Financial stability 4.23 4.03 4.02 3.95
Banking Financial services 3.12 3.06 3.12 3.14
Non-banking financial services 3.12 3.53 4.18 3.94
Financial Markets 2.96 2.81 2.35 2.48
Financial access 2.76 2.71 2.80 2.94

Table 7: pillars of financial development in India

The table above indicates that India enjoys a high score in financial stability pillar. This means that the country has a stable financial system. India performs poorly in terms of financial access and financial markets pillars, but financial access has increased over the four year period.

The relationship between financial development and economic growth in India can be analyzed using the line graph below.

Fig 5: Relationship between Financial Development and Economic growth in India

The graph shows that India enjoys a high but declining economic growth as compared to its low but increasing financial development. Its economic growth increased sharply in 2010 when its financial development index decreased with a small value.

The correlation analysis for India is shown below. It shows the degree of relationship between financial development and economic growth of India. The coefficient of correlation is -0.75; hence suggesting that there is a strong negative relationship between financial development and economic growth in India.

Financial Development Economic Growth
2009 3.3 8.5
2010 3.24 10.5
2011 3.29 6.3
2012 3.29 6.2
Correlation -0.751751366

Table 8: Correlation coefficient of financial development and economic growth of India

China

The key performance or scores of China in relation to pillars of financial development is shown in the table below.

2009 2010 2011 2012
Institutional environment 4.07 4.08 4.21 4.10
Business environment 4.09 4.26 4.01 3.96
Financial stability 4.83 4.53 5.10 4.89
Banking Financial services 4.77 4.91 4.92 4.43
Non-banking financial services 3.31 4.45 4.62 4.48
Financial Markets 2.74 2.14 2.41 2.98
Financial access 3.31 3.44 3.52 3.15

Table 9: pillars of financial development in China

China has recorded the best performance in terms of various pillars of financial development. However, scores for most pillars have dropped in 2012. The pillar that has boosted China is mainly Non-banking pillar which has increased even in 2012 when the scores of all other pillars have dropped. China also performs very well in terms of financial stability. All these factors contribute to the economic growth of the country as it will be discussed in the next chapters of this research.

The figure below shows how China performed in terms of financial development and economic growth over the four-year period between 2009 and 2012.

Fig 6: relationship between financial development and economic growth in China.

The relationship between financial development and economic growth of China can also be determined using the coefficient of correlation as shown in the table below.

Financial Development Economic Growth
2009 3.87 9.2
2010 4.03 10.4
2011 4.12 9.3
2012 4 7.8
Correlation 0.146646361

Table 10: Correlation coefficient of financial development and economic growth of China

From table 10 above, it is clear that the coefficient of correlation between financial development and economic growth of China is 0.1467. This indicates that there is a weak positive relationship between financial development and economic growth in China.

Relationship between financial development and economic growth of BRIC economies

In order to determine the overall relationship between financial development and economic growth of the BRIC emergent economies as a whole, it is necessary to find the average financial development indices and average economic rates for the four economies in the four-year period under consideration.

Country 2009 2010 2011 2012
Brazil -0.3 7.5 2.7 0.9
Russia -7.8 4.5 4.3 3.4
India 8.5 10.5 6.3 6.2
China 9.2 10.4 9.3 7.8
Total 9.6 32.9 22.6 18.3
Average 2.4 8.225 5.65 4.575

Table 11: Average rates of economic growth for the BRIC

Table 11 above shows that economic growth of the BRIC increased sharply from 2.4 in average in 2009 to 8.225 in 2010. This was followed by a decline in the subsequent years.

The average financial development indices for each year from 2009 to 2012 are indicated in the table below.

Country 2009 2010 2011 2012
Brazil 3.46 3.53 3.61 3.61
Russia 3.16 3.21 3.18 3.30
India 3.30 3.24 3.29 3.29
China 3.87 4.03 4.12 4.00
Total 13.79 14.01 14.2 14.2
Average 3.4475 3.5025 3.55 3.55

Table 12: Average financial development indices for the BRIC

The relationship between financial development and economic growth for the BRIC can now be determined by applying the correlation analysis on the averages of financial indices and economic growth for the four BRIC economies within the four years under study.

Financial Development Economic Growth
2009 3.4475 2.4
2010 3.5025 8.225
2011 3.55 5.65
2012 3.55 4.575
Correlation 0.409834141

Table 13: Correlation coefficient for the BRIC economies

The table above shows the overall coefficient of correlation for the BRIC. The correlation coefficient value is 0.4098. This shows that there is a weak positive correlation between financial development and economic growth in emergent economies of the BRIC.

5. Presentation and discussion of findings

The data presented above represent the economic growth rates and financial development indices of BRIC economies. This section will provide the presentation of the data in statistical format to determine the relationship between the two variables while relating the results with the studies, researches and theories presented in the literature review section. Discussion will also be provided to ensure that there is a clear understanding of the statistical presentation. The presentation and discussion will be provided for each of the four countries in turn. The correlation of the average financial development index and economic growth of the four countries will then be provided.

Brazil enjoys financial liberalization, but the government had to control the financial sector through market interventions and capital controls (World Economic Forum, 2012). The constant financial development index of Brazil in 2011 and 2012 indicates that the country failed to achieve good results in terms of financial stability, financial access and financial markets pillars. The country’s financial system is stable, but its currency and banking systems stability fell. Generally, financial development has been increasing over the four years from 2009 to 2012 as shown by Table 1.

In terms of economic growth, Brazil has been experiencing a declining trend. It rose to the highest level of 7.5% in 2010 and fell to lowest level of 0.9 in 2012.  This trend indicates that there is a weak relationship between financial development and economic growth in Brazil because the financial development indices of the country have been increasing over the four years while the economic growth has been fluctuating. The correlation analysis also indicates that Brazil has a correlation coefficient of 0.089 which is low coefficient reflecting a weak positive relationship between financial development and economic growth in Brazil.

Russia’s stronghold in terms of its pillars of financial development is the pillar of non-banking services. Its banking services have been poor for the four years under study. Generally, financial development of Russia is increasing. Its economic growth increased in 2010 and declined subsequently in 2011 and 2012. In terms of correlation analysis, Russia has a correlation coefficient of 0.5 which is shows a medium positive relationship between financial development and economic growth.

India performs poorly in terms of institutional and business environment pillars of financial development but enjoys a good financial stability. India also has a high performance in non-banking sector but has weak policies, factors and institutions. Generally, India has an average performance in terms of financial development as compared to other members of the BRIC.

The financial development indices of India increased from 2009 to 2012 while its economic growth rate increased only in 2010 and decreased subsequently in 2011 and 2012. This yielded a negative correlation coefficient which indicates that there is a strong negative relationship between financial development and economic growth in India.

China has the highest rates of economic growth over the four years between 2009 and 2012 compared to other countries of the BRIC. It also has the highest financial development indices compared to other countries considered in this study. This shows that countries with high economic growth are likely to have higher levels of financial development as indicated by the literature (Levine, 2004).

In overall, this study has found out that there is a weak positive relationship between financial development and economic growth. This weak relationship means that financial development can be related positively or negatively to economic growth. This is agreed by Levine (2004) who argues that that financial development may influence economic growth negatively by improving resource allocation and reducing risks; hence lowering savings rates and decelerating economic growth and reduces welfare.

Since the study shows a weak positive relationship between financial development and economic growth, it is clear then that the study agrees to a small extent with the findings of previous studies which have been shown in the literature review. From this study, it has been established that most of the emerging economies have performed well in terms of financial stability. This stability is related to the financial liberalization which has been considered by Bekaert et al (2001) as the main contributor of real economic growth. This stability alongside financial liberalization is therefore the highest contributing factor in the financial development of emerging economies.

In terms of economic growth, World Economic Forum (2012) and responsibility (2013) suggest that emerging economies may overtake developed economies in future. This study agrees with this proposition because the results indicate that economic growth of emerging economies has increased significantly over the past four years, and is accompanied with rapid expansion in financial development. A country like China which scores up to more than 5 in some financial development indices and ranking top 10 in the world in some of the financial development pillars have consequentially had a high rate of economic growth, which is similar to the findings of Financial Access Initiative (2009) which suggests that financial development as a moderate correlation with growth in per capita income. However, the results of this study differ with the results of Financial Access Initiative (2009) because Financial Access Initiative has found a moderate correlation between financial development and economic growth whereas the current study has shown a weak relationship between the two factors.

6. Conclusion

This study sought to answer various questions regarding to financial development and economic growth in emerging economies, especially with a special focus on BRIC countries. First, the study intended to find out how financial development and economic growth in emerging economies can be measured. It has been established that financial development is measured using financial development indices based on scores of a given country on various elements of financial development including  Institutional environment, Business environment, Financial stability, Banking financial services, Non-banking financial services, financial markets, and financial access. The average financial development indices for BRIC countries in 2009, 2010, 2011, and 2013 are 3.87, 4.03, 4.12 and 4 respectively. Economic growth is measured using GDP growth per year. The average economic growth rates of the four countries in 2009, 2010, 2011 and 2012 are 9.2, 10.4, 9.3 and 7.8 respectively.

The link between financial system and the real economy has also been determined in literature. The study found out that different countries of the BRIC have different strengths and weaknesses in terms of various elements of the financial system. For instance, Russia has a strong non-banking system which relates positively with the real economy. However, its weak banking system causes negative impacts on the real economy. Brazil also has a stable financial system which enhances a strong currency and a good environment for effective business activities.

The main purpose of the study was to find the relationship between financial development and economic growth in emergent economies. From the findings of the research, it is clear that there is a weak positive relationship between financial development and economic growth of Brazil as indicated by a correlation of 0.088752.  On the other hand, Russia exhibits a medium positive relationship between financial development and economic growth as represented by a correlation coefficient of 0.503421561. There is a strong negative relationship between financial development and economic growth in India as represented by a correlation coefficient of -0.752. Lastly, China shows a weak positive relationship between financial development and economic growth indicated by a correlation coefficient of 0.1467.

In general, there is a weak positive relationship between financial development and economic growth of emergent countries as indicated by an overall coefficient correlation of 0.4098 for the entire BRIC economies. This finding has differed with some previous studies while agreeing with others. Levine (2004) seems to be suggesting a similar result as this study because he suggests that the relationship between financial development and economic growth may be positive or negative. This means that the relationship between the two factors is weak.

7. Recommendations

Emergent economies, especially members of the BRIC, should take specific steps to ensure that financial development is used appropriately to improve their economic growth. Each country has its own weaknesses which when improved, economic growth may be realized, and perhaps the weak relationship between financial development and economic growth may be enhanced to achieve a stronger relationship.

First, the financial markets should be improved in order to achieve higher score in this pillar of financial development. Such economies should liberalize their financial markets fully in order to enhance easy transactions, faster and efficient allocation of resources, and increased competition in the financial market which may then lead to efficient financial services (World Economic Forum, 2012). This is also a key recommendation by Bakaert et al (2001). The main concern of financial markets as suggested by Levine (2004) is to intermediate between lenders and borrowers in order to reduce information asymmetry and encourage investment, resource allocation and utilization, and easy transactions. Financial markets should also be linked with the key sectors of the economy so that such sectors may utilize funds effectively and efficiently to achieve higher economic growth.

Economic growth may also be improved by consistently regulating the non-banking sector. Regulation of the non-banking sector provides an environment in which both the bank and non-bank financial service providers work together to protect the customer and provide effective financial services. Information collected from non-banking institutions through a regulated mechanism can deliver benefits for the economy such as risk assessment, utilization of resources and efficiency of financial services; hence improving economic growth of the emergent economies.

 

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