Role of Financial Services in Economic Growth: Policy Implications for Pakistan

By Uppal, Jamshed Y.; Mangla, Inayat U. | The Lahore Journal of Economics, July-December 2018 | Go to article overview

Role of Financial Services in Economic Growth: Policy Implications for Pakistan


Uppal, Jamshed Y., Mangla, Inayat U., The Lahore Journal of Economics


1.Background

Notwithstanding the earlier dismissal by neo-classical economists of the role of finance in economic development (Lucas, 1988; Robinson, 1952), the nexus between the development of financial sectors and economic growth is now so widely accepted that "[the idea] that financial markets contribute to economic growth is a proposition too obvious for serious discussion" (Miller, 1998). Pioneering studies by Gurley and Shaw (1955) and McKinnon (1973) firmly established the finance-growth link, which is well-stated in the following: "The preponderance of theoretical reasoning and empirical evidence suggests a positive, first-order relationship between financial development and economic growth" (Levine, 1997, p. x).

The theoretical underpinning and the empirical evidence are summarized in review studies such as those by Thiel (2001) and Levine (2005). The economic theory and extant empirical evidence also suggest plausible rationales for why well-functioning financial systems matter for growth: by reducing information costs and allocating capital; monitoring firm behavior and exerting corporate governance; facilitating the hedging, trading, and pooling of risk; mobilizing savings for investment; and reducing the transactions costs of economic exchange and activity.

The key message for economic policy-makers which emerges from the understanding of the finance-growth nexus is that financial development should be a crucial piece in any country's strategy for economic growth. In particular, developing countries need to strengthen institutional infrastructure by building effective legal and regulatory frameworks, and adopting best accounting and auditing standards and practices. The Global Financial Crisis (2008-09) has underscored the havoc that financial instability can wreak on the real economy and the critical importance of financial stability for growth. A resilient financial sector bolstered by prudential regulation will better equip developing countries to deal with the speed and scope of financial innovation, and new financial products, services and technologies in a globalized world.

In the last couple of decades, the financial services sector in Pakistan has seen remarkable growth and structural development. However, it is debatable if its financial markets and institutions have contributed meaningfully towards promoting growth in the real economy. This paper provides a brief background of the theoretical and empirical literature on the linkage between the financial services sector and economic growth. Next, it evaluates the development of Pakistan's financial markets and institutions in comparison to a cohort of developing countries. The country's governance and regulatory environment in light of these theories and the empirical evidence is compared with other countries. The weaknesses in the linkages between finance, economic growth and governance are identified within the framework of the theoretical models and the relevant empirical evidence. The final section discusses the challenges Pakistan faces in its financial services sector becoming an effective driver of economic growth and proposes policy recommendations.

2.Finance and Growth

Among development economists, a consensus has emerged that a well-functioning financial sector is a precondition for the efficient allocation of resources and for achieving an economy's full potential for growth. Levine (2005, 2004) has presented a comprehensive review of the theory and evidence on the connections between the operation of the financial system and economic growth. The study concluded that "the preponderance of evidence suggests that both financial intermediaries and markets matter for growth and that reverse causality alone is not driving this relationship." This implies that "better developed financial systems ease external financing constraints facing firms, which illuminates one mechanism through which financial development influences economic growth. …

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