A review of economic growth and financial development literature

A review of economic growth and financial development literature Introduction It is the wish of every country to realize improved and sustainable economic growth and financial development in order to improve the living standards of the greatest majority among its citizenry. Improved economic and financial development is also central to a country’s ability to safeguard its survival in a world that is increasingly facing uncertainties, and unforeseeable risks.Advertising We will write a custom essay sample on A review of economic growth and financial development literature specifically for you for only $16.05 $11/page Learn More For these reasons, countries with visionary and development conscious leaders devise the most feasible economic blueprints that can enable them to reach greater heights of economic and financial success. In reality, a developmental state is a product of superior economic design; not accident, chance, or miracle. That is the bitter truth that the world’s poor and developing countriesâ⠂¬â„¢ leaders must embrace or condemn their countries to terminal economic and financial stagnation. This paper is a review of China’s economic growth and financial development. Economic growth Economic growth refers to a rise in the capacity of a country to generate goods and services, as compared from one period of its history to another (Barro Sala-i-Martin 2004, p.52). Economic growth is measured in real and nominal terms (Cypher Dietz 2008, p.33). Nominal terms include inflation while real terms are adjusted for inflation. Comparative studies of economic growth of different countries use GDP or GNP per capita because these variables take into account population differences between countries (Cypher Dietz 2008, p.33). Economic growth is normally attributed to technological advancement in a given society (Barro Sala-i-Martin 2004, p.52). United States is a prime example where enormous economic growth was realised following the introduction of the internet technology. I t is pertinent to note that, the growth of a country’s economy should not be seen in terms of an increase in its productive capacity only, but also as an improvement in the quality of life of its citizenry. In short, economic growth is a process through which a country’s wealth accumulates over an extended period. Therefore, economic growth can best be thought of as a process of transformation.Advertising Looking for essay on business economics? Let's see if we can help you! Get your first paper with 15% OFF Learn More According to Fitzgerald, a country’s long-term sustainable economic growth depends on its ability to increase its pace of accumulating physical and human capital, to use the resulting productive assets more efficiently and guarantee the reach of the entire population to these assets (2006, p.1). Financial Development Financial development refers to the â€Å"creation and expansion of instruments, institutions and markets that support a country’s investment and economic growth process† (Fitzgerald 2006, p.1; King Levine 1993, p.3). Banks and non-banking financial intermediaries such as stock markets and pension funds â€Å"play the role of translating household savings into enterprise investment, keep an eye on investments and distribute funds, as well as, to price and mitigate risks† (Fitzgerald 2006, p.1). Financial intermediation provides liquidity so that companies can operate the new capacities efficiently. Some economists hold that, financial development and economic growth are intimately related (Jeanneney et al 2008, p.3). Financial development influences a country’s economic growth, and helps to alleviate poverty because economic growth is a potential way of reducing poverty (Jeanneney et al 2008, p.3). Financial development helps alleviate poverty indirectly by motivating growth, and directly by enhancing transactions and enabling the poor to gain from financial services that raise their income, which facilitate their ability to undertake productive investments and other activities. Literature review on China’s economic growth and financial development The People’s Republic of China, popularly known as China is the most populous country with over 1.3 billion citizens. It is situated in East Asia (LaFleur 2003, P.3). It is a de jure one-party state ruled by the Communist Party of China (CPC) (LaFleur 2003, P.3). China is the third largest country by a total area and the second largest by land area (LaFleur 2003, p.3). During 1990s, the international community started to acknowledge that China’s economy is self-motivated and rapidly growing; therefore, its swift growth would continue for some time (Chow 1994, p.1). Today, china is one of the fastest growing economies internationally.Advertising We will write a custom essay sample on A review of economic growth and financial development literature specifically for you for only $16.05 $11/page Learn More Since 1978 when economic liberalization was introduced in China, China’s investment and export-led economy has grown 90 times bigger and is currently the fastest growing leading economy in the world (Wang et al 2007, p.85; Bramall 2009, p.464). According to the International Monetary Fund (IMF), during the period 2001-2010, China’s annual average GDP growth was 10.5 percent. This growth is anticipated to grow at 9.5 percent during the period 2011-2015 (Morrison 2011, p.2). Between 2007 and 2010; China’s economic growth rate was equivalent to all of the G7 countries put together (Morrison 2011, p.2). The link between economic growth and financial development has triggered a protracted debate from Smith to Schumpeter. According to research results over the years, financial development stimulates economic growth (Burzynska 2009, p.8). He argued that via the services that financial intermediaries bring about like mobilizing savings, containing risk and enhancing transactions technological and economic development is motivated (Burzynska 2009, p.8). For him, financial intermediaries facilitate technological innovation. Technological advancement according to Schumpeter is a process of continuous substitution of old production methods and goods with improved processes, services and goods by innovation and invention (Burzynska 2009, p.8). It has long been agreed amongst economists that financial institutions can enhance economic growth. For instance, Hicks put emphasis on capital formation, which he argued can be influenced by financial intermediaries by either changing savings rate or by redistributing savings among different capital generating technologies. There are, however, distinguished economists who oppose the view that financial developments stimulate economic growth. For example, for Robinson an economy in which enterprise is leading finance development follows (Robinson 1952, p.4 3). In other words, financial development takes place as an automatic response to rising varied financial needs. Other scholars were concerned that economists overemphasized the importance financial factor in economic growth (Lucas 1988, p.4).Advertising Looking for essay on business economics? Let's see if we can help you! Get your first paper with 15% OFF Learn More Financial intermediaries play six main roles. First, they pool household savings and make them available for lending (Burzynska 2009, p.9). Doing so reduces transaction costs for firms, as well as, households themselves. Secondly, financial intermediaries distribute savings and decide who gets loans (Burzynska 2009, p.9). Thirdly, financial institutions mitigate the overall risks of doing business by way of spreading investor’s funds among the diverse investment opportunities. Fourth, they produce liquidity. Fifth financial in situations facilitate trade by extending credit and guaranteeing payment (Burzynska 2009, p.9). Finally, they exert corporate control and monitoring of managers. A properly functioning financial system should ensure increased savings and investments which either via capital accumulation or technological change leads to rise in output and consequently economic growth (Burzynska 2009, p.9). China’s outstanding economic growth during the last two de cades has attracted considerable attention particularly from economists. Most empirical studies show that improvement in China’s productivity can account for an important portion of its striking growth (Morrison 2011, p.5). The source of China’s remarkable growth has two aspects namely domestic and international even though the two are intimately related. Since 1978, China backed free trade and gradually removed trade restrictions. The government transformed its policy of management of foreign trade by the Ministry of Foreign Trade and gave provincial governments a substantial autonomy in foreign trade and permitted private sector to take part in foreign trade (Morrison 2011, p.2; Chow 2005, p1). According to Chow (2005), during the period 1978 to 2002, total volume of exports and imports rose from $ 20.64 billion to a staggering $620.8 billion in 2002. This accounted for 65 % of china’s GDP and a growth rate of 35% annually (Chow 2005, p.1). Consequently, China became the third largest trading economy behind Germany and the United States. Presents Chinese exports are found all over the world. In the year 2001, China acquired World trade Organization membership. WTO pushed it to lower its tariffs for manufactured and agricultural products (Chow 2005, p.1; Bao et al 2006, p.181). The lowering of tariffs helped to increase competition among Chinese manufacturers and farmers and ended up providing inexpensive products for Chinese consumers. According to Chow (2005), foreign trade has boosted China’s economic growth in three aspects. International specialization, which occurs as each country produces the goods for which it has a comparative advantage in generating, has enabled China to procure more goods than by national production only (Chow 2005, p.1). Secondly, exports are a part of aggregate demand and rise in cumulative demand has helped China to raise its national output. Thirdly, trade in conjunction with foreign investment has b rought in modern technology and methods of management that has increased China’s productivity (Chow 2005, p.1). Another major cause of China’s economic growth was an increase in foreign investment, and domestic investments (Chow 2005, p.2; Morrison 2011, p.5; Zhang 1995, p.2). Even though available statistics show that private consumption fell from 49 percent of GDP in 1990 to 35 % in 2008, investment increased from 35% to 44 percent of GDP by the same date (Chow 2005, p.2). According to Clow (2005), flow of physical capital in the form of foreign direct Investment (FDI) has been exemplary in advancing China’s economic growth. After the introduction of the 1978 economic reforms, China’s foreign investment policies have positively changed. The 1978 economic reforms became a point of departure for China from seeing foreign investment as a form of exploitation by outsiders, to embracing it for purposes of China’s economic growth and development (Chow 2005, p.2; Morrison 2011, p.2). For instance, in 2001, an amount of FDI of $ 49.7 billion dollars was utilized while in 2003 $ 56.1 billion was utilized. Foreign investment has helped China’s economic growth through the provision of physical and financial capital, new technology and managerial skills to China (Chow 2005, p.2; Morrison 2011, p.5). Through the 1978 reforms the government also encouraged individual citizens to start their own businesses. Additionally, control of prices for various commodities by the state was gradually removed. Clow, however, points out that, foreign investment is not a basic economic factor in China’s outstanding economic growth, but only a vehicle boosting that growth (Chow 2005, p.2). Instead, there are three significant factors including availability of high quality human resources, which comprise properly trained and hardworking labourers, and creative entrepreneurs. Adequately properly functioning market institutions and chinaâ€⠄¢s standing as a late comer who can embrace new technology from the already developed countries (Chow 2005, p.3). These three fundamental factors have enabled china to create a centre of attention for foreign investors. Moreover, the investors would have invested their capital in other economies. Today, China is exporting capital to developing countries, as well as, United States. For instance, Chinese investment has boosted economic development of some African and Asian countries. Morrison has attributed China’s swift economic growth to two main factors namely large-scale capital investments and a swift productivity growth (Morrison 2011, p.5). These capital investments were financed by both foreign investments and domestic savings. Economists view these two factors as having moved hand in hand. Economic reforms resulted into higher efficiency in China’s economy, which in turn, enhanced national output and raised resources for additional investment within the economy (Morrison 2011, p.5). Furthermore, economists have concluded that productivity growth, or increases in efficiency have been a fundamental factor in China’s striking economic growth. This improved productivity is attributed to reallocation of resources to more productive areas particularly sectors that were previously strictly controlled by the government like services, trade and agriculture (Morrison 2011, p.5). For example, improvements in agriculture promoted production and set workers free to pursue employment in a more dynamic manufacturing sector (Morrison 2011, p.5). In addition, economic decentralization encouraged the rise of private companies. The private firms that emerged tended to follow more productive activities than the State Owned Enterprises (SOEs), and were more market-oriented and for this reason more efficient (Morrison 2011, p.5). The export sector of the Chinese economy got exposed to competition. Provincial and Local governments were permitted to estab lish and run a wide range of enterprises based on market forces and principles, without central government interference (Morrison 2011, p.5). Additionally, China has attained high rates of total factor productivity than even most of the developed economies including United States. These high rates of TFT growth are attributed to China’s ability to reach and make use of existing foreign technology and expertise. Apart from the causes of rapid Chinese economic growth reviewed above, economists have explored the role played by financial development in boosting economic development in China over the two last decades. Like other sectors, since the introduction of the 1978 economic reforms, the Chinese financial sector has experienced fundamental changes. For example, the place of mono banking was taken over by commercial banking; stock markets emerged; and modern regulatory bodies were established (Burzynska 2009, p.11; Zhang 2008, p.12). Stock markets were introduced in China in 1990. Stock markets were established in main cities including Shanghai which is a China’s oldest financial centre and Shenzhen, a fast growing city in the southern part of china for purposes of balance (Burzynska 2009, p.13). More than 75 percent of stock trading takes place in shanghai and the rest in Shenzhen. Unfortunately, even though indexes may reach greater heights and transactions prosper within China’s stock markets, some shares are not tradable (Burzynska 2009, p.14). For example, combined capitalization of Shanghai and Shenzhen stock markets as at the end of 2007 was 133% of GDP even though only 37% of GDP was tradable (Burzynska 2009, p.13). Furthermore, stock in china is more of a political affair and thus plays a minor role in financing enterprises. Politics within the stock market has led to incorrect pricing of the stock with overpricing and under pricing alternating depending on the prevailing political conditions (Burzynska 2009, p.13). Loans offered 80% of financing compared to 13% of equity in year 2007. Foreign companies are only permitted to obtain loans from banks only and can not borrow from other companies. According to Burzynska (2009), even though the debt market in china is developing it is considerably narrow, fragmented and inadequate in liquidity. It was not until 1990 that the government started to take charge of and control the bond markets seriously, which began unofficially in 1980s (Burzynska 2009, p.15). In 1997 trading of government bonds was started on the inter-bank market. The corporate bond market was reserved for various SOEs, and a considerable period remained remarkably small (Burzynska 2009, p.14). The government and policy banks issue most of the bonds. However, the volume of bonds traded has grown significantly especially since 1998 due to expansionary monetary policies (Burzynska 2009, p.14). For example, as of the end of year 2007 total bond issuance accounted for 32% of GDP (Burzynska 2009, p.14) . In a nut shell, it is the Chinese banking sector that plays the most significant role within the Chinese financial sector and is thought to have the strongest link with economic growth. Chinese financial system has numerous banking institutions. Hence, over the last decade total bank loans have accounted for over 105% of GDP (Burzynska 2009, p.15). China’s banking sector is categorized into four principal types of banks including commercial banks, state owned banks, foreign banks and rural credit cooperatives (Burzynska 2009, p.15). There are also non-banking institutions. The People’s Bank of China has served as the central bank of china since 1983. It formulates and put into practice monetary policies and controls financial markets (Burzynska 2009, p.16). However, it is not an independent entity because the government has apparent control over expansion of new financial products and levels related to interests rates on loans. The momentous question today revolves a round whether the relatively weak financial intermediaries in China have been a fundamental contributing factor to China’s rapid economic growth. Influential economists, some of which are respected authorities on Asian economic studies, have positively focused on the role of China’s financial system in its rapid economic growth. Others had used the case of China’s outstanding economic growth to prove that financial development follows economic growth given the fact that, by the time china was emerging as a dynamic economy, its financial system was poorly developed. Therefore, for such scholars current financial development is merely responding to presently required financial arrangements in a growing economy. There is, however, evidence showing that Chinese has historically maintained a high of savings even in the absence of a properly developed financial system. For example, when economic reforms were introduced in 1978 domestic savings stood at 32% of GDP (Mor rison 2011, p.5). Even though, much of these savings were produced by profits of SOEs, the 1978 economic reforms which entailed economic decentralization, resulted into a considerable rise in Chinese household savings, as well as, company savings (Morrison 2011, p.5). Consequently, Chinese gross savings as a proportion of GDP have drastically grown; it reached 53.9% in 2010; therefore, is one of the highest savings rates in the world (Morrison 2011, p.5). According to Morrison (2011), the high level of savings has allowed China to boost national investment. It is estimated that Chinese domestic saving margins surpass its domestic investment levels making China one of the largest net global lenders (Morrison 2011, p.5). Therefore, there is no dispute that financial intermediaries have contributed to Chinese rapid economic growth especially during the years following initialization of the 1978 economic reforms. These reforms apparently created a developmental space in which competitio n within the financial sector could thrive, and in the long run enabled it to contribute to China’s astounding economic growth. There is empirical evidence showing that financial development has significantly contributed to China’s high rates of total factor production (Guillaumont et al 2008, p.3). Empirical evidence has continually shown that financial development promotes China’s productivity by increasing efficiency. Financial development caused a positive and significant impact on efficiency both through expansion of credit to the private sector and through promotion of competition within the financial sector, which in turn robustly promotes China’s productivity growth (Guillaumont et al 2008, p.3; Hasan et al 2007, p.4; Calomiris 2007, p.364). However, economists, such as Maswana, have asserted that China’s rapid economic growth and financial development outcomes are irreconcilable because; its financial system is seriously weak and inefficie nt (Maswana 2008, p.1). Avid critics of the said link between China’s remarkable economic growth and its financial development cite intermediation inefficiencies such as non-performing loans and government controlled loan allocation (Maswana 2008, p.2). Conclusion China’s economic growth is certainly remarkable and hence the enormous attention it has attracted among influential economic scholars across the globe. More literature on China’s economic growth and financial development will keep on surfacing, since its rapid economic growth rate is anticipated to continue for a considerable period in the foreseeable future. This argument is anchored on the fact that there is an unresolved debate on the connection between China’s rapid economic growth and its financial development. However, it expected that as China’s technological advancement starts to catch up with that of principal developed countries, its level of productivity advantages and real GDP growth could slow considerably from its spectacular 10% economic growth rate, unless China transforms itself into a centre of new innovation and technological revolution. Furthermore, thriving of business in all sectors especially with regard to foreign investment depends largely on government’s ability to implement free-trade policies, which are in line with WTO principles. References Bao, S., Lin, S., Zhao, C., 2006. The Chinese economy after WTO accession. Hampshire, UK: Ashgate Publishing, Ltd. Barro, J., Sala-i-Martin, X., 2004. Economic growth. New York, NY: MIT Press. Bramall, C., 2009. Chinese economic development. New York, NY: Taylor Francis. Burzynska, K., 2009. Financial Development and Economic Growth: The Case of Chinese Banking Sector. 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