Early models of economic growth highlighted the importance of saving rates (i.e. how much an economy saves as a proportion of its income) and population growth rates in determining income per person (neoclassical growth theory). One implication of such models is that rich and poor countries? levels of income per person should converge. Difficulties in reconciling the „convergence hypothesis? with the actual data led to the development of „endogenous? growth models that did not feature the same implication (i.e. countries need not converge to the same level of income per person). This framework opened the way for considerations of other determinants of long term growth such as fiscal policy and financial development. The latter has become the focus of a growing literature in the last two decades.
The key role of the financial sector in economic growth is introduced by Schumpeter (1911). He argued that the service provision by financial intermediaries including savings mobilization, risk management, projects evaluation, monitoring the managers, and facilitating transactions are necessary for technological improvement and economic growth. Financial intermediaries need to be capable of efficient allocation of resources facilitating in that way higher returns and desirable risk transformation. The modern literature on economic growth was actually started in mid 1950s when Robert Solow (1956) presented his growth model. At that time the focus was kept on the functioning of labour and capital resources rather than financial markets. Some leading economists like Goldsmith (1969), McKinnon (1973), Levine (1993) emphasized that finance can be an essential component for the growth of an economy.
The key question for the policymakers in less developed economies is how to have a process of sustained economic growth. Underdeveloped countries have the agenda to support financial sector reforms. A better developed financial system reduces transaction, information and monitoring costs. It increases the efficiency of resource allocation and in turn spurs the growth. A well developed financial system promotes investment opportunities to potential businesses, mobilizes savings, enables trading, monitors the workings of managers, offers hedging, and diversifies risk (Levine 1993).
A proper legal and policy structure is required to have a strong financial system. Most of the underdeveloped economies are facing financial repression in the form of high inflation rates, directed or subsidized credits, credit rationing, loan and deposit interest rate ceilings. According to Roubini and Sala-i-Martin (1992) strong financial repression can reduce per capita GDP by one percentage point an year. The governments sometimes adopt the policies of financial repression and raise the inflation rate to get the effortless inflationary income, but that lowers the amount of financial services in the economy. All these actions stimulate the individuals to store nominal money. The negative effects of financial repression reduce the marginal product of the capital input and therefore reduce the economic growth (Roubini and Salai Martin, 1992).
An efficient financial system offers improved financial decisions, supports the better distribution of resources and thereby accelerates economic growth. A strong financial sector needs to have deep rooted domestic and international banking system as well as liquid stock markets. The current paper by using the recent data sets attempts to assess whether the level of the financial development is a strong indicator for economic growth. Attention is paid to the issue of causality: is it financial development that causes economic growth or economic growth causes financial development? Before we proceed, certain contributions to the literature on finance and growth is summarised in a table and given below.
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