If there is anything that is clear from development economics literature over the last two decades it is this: credit markets matter. From Stiglitz and Wiess (1981) to Banerjee and Duflo (2002), both theory and evidence have shown that credit markets are not perfect problems of moral hazard, adverse selection, and contract enforcement lead to credit rationing. Countries, people, or regions that can make credit markets more efficient have benefited and will continue to benefit from a higher GDP.
Beck, Demirguc-Kunt, and Levine (2000) compare financial markets in developed countries to those in developing countries, revealing that economies grow faster, industries depending on external finance expand at higher rates, new firms are created more easily, and firms grow more rapidly in economies with higher levels of overall financial sector development and in countries where legal systems more effectively protect the rights of outside investors.
Beck, Demirguc-Kunt, and Levine (1999) (hereafter BDL) present a new database on financial development and structure which shows that the market capitalization of public equity markets and public and private bond markets in less developed countries (LDCs) is zero to five percent of the GDP on average (Figures 5 and 7; Pages 33 and 35). Thus, most firms which need external finance must rely on private credit.
In rich countries private credit is also offered by banks and “other financial institutions” including other bank-like institutions, insurance companies, private pension funds, and development banks. In developing countries, however, BDL show that deposit money banks are the chief issuers of credit (Figure 4; Page 33).
To summarize, LDCs suffer from very shallow public equity and private and public corporate bond markets. The external credit that is provided in LDCs is provided primarily by deposit money banks. Yet, the amount of private credit extended in these countries as a percentage of GDP is only 10-20% compared to 60% in richer countries (Figure 2; Page 32).
Recent industry and firm level research shows that the level of banking sector development has a large, causal impact on real per capita GDP growth (Rajan and Zingales 1998; Demirguc-Kunt and Maksimovic 1999). Beck, Levine and Loayza (2000) extend this work by examining the channels by which banking sector development influences GDP growth. Using both cross country data and panel data, they find that banking sector development improves resource allocation and accelerates total factor productivity growth as opposed to physical capital growth or savings per capita growth which in turn increases long run economic growth.
