Financial Markets and Economic Growth

During the past decade, much of the "fad" and the emphasis have been placed on understanding the role of the financial sector, in part because earlier lessons were learned, and in part as a consequence of the financial crises of the 1990s. Understanding of the role of the financial sector has increased markedly, but research and insights continue to mount. As that has happened, some have turned to "governance issues" as "the key" to development, but lessons about the importance, and key role, of the financial sector in development have certainly been learned.

There has been no time at which economists and policy makers denied the role of the financial sector. However, I think it is fair to say that its importance was systematically underestimated prior to the experience of the 1990s. Certainly, I myself was guilty of nodding agreement with those who argued for its importance, while turning my focus almost immediately back to issues of trade, agriculture, public administration, and the like.

I start with a brief review of the earlier foci of analysis, noting how they interacted with understanding of development at the time. In the final part of my talk, I will then relate the earlier understandings and the role of financial variables in development. In between, I will come to financial markets, and the experience of the 1990s, illustrating with some data from the Korean experience. I will end with an analysis of the policy implications of the improved understanding of the role of the financial system and its components.

Analyzing Poverty and Growth

Prior to the Second World War, analysis of economic growth was almost the exclusive domain of economic historians, and focus was largely on how the west grew rich - in particular, the industrial revolution. Although everyone knew that citizens of some countries had much higher living standards than those in others, that seemed to be taken as a "state of nature", not an issue to be addressed or understood.

And, indeed, there appeared to be some justification for that bipolar view. Few countries were in the "middle". Ignoring the centrally planned economies, which were generally seen as sui generis, the world was seen as consisting of the "developed" and the "underdeveloped" (subsequently less developed, then developing) countries. Ignoring a few mineral rich places, generalizations could be made that almost all developing countries had low per capita incomes, low life expectancies, low levels of literacy and educational attainment, poor health statistics, little capital stock and low savings rates, and an economic structure heavily skewed toward subsistence agriculture with exports consisting overwhelmingly of primary commodities and imports of manufactured goods.

From these stylized, but mostly valid, generalizations, came the initial "fad" in development: poverty and low productivity were rife because of low levels of capital stock per worker; low levels of capital stock per worker resulted from the inability of poor people to save; and hence there was a "vicious" circle. The policy implications were seen, by most, to be that government had to take a leading role in development, and that development should be spurred by undertaking accelerated investments in industry (which was by hypothesis of higher productivity), doing so by increasing investment in both the public and the private sectors. The Government of India's Planning Commission, for example, concluded that, if India could reach a savings rate of 25 per cent of GDP within a quarter century, growth would accelerate sufficiently to result in economic development.

By the early 1960s, there came recognition that capital accumulation was insufficient: attention had to be paid to augmenting "human capital", and the focus shifted to education and other factors (such as health and nutrition) that would increase individuals' productivity in all areas including industry but also agriculture. With the notable exception of a few East Asians, however, development policy remained heavily oriented to developing industry (in the public and private sectors) and raising rates of investment. Moreover, efforts to encourage industrial development focused on protection of domestic industry from imports through import prohibitions or restrictive import licensing and high tariff levels.

One result, which happened in most developing - as they were then called - countries was that chronic "foreign exchange shortages" resulted in gross inefficiencies in a variety of ways, and certainly were a disincentive for the development of any new export activities. It came increasingly to be appreciated by the 1970s and 1980s that an overvalued exchange rate itself was one disincentive for development of exports, but so too were high tariff levels and prohibitions or restrictions on imports. Some East Asian countries were already following a development strategy that focused on shifting away from "inner oriented" growth toward "outer oriented" strategy. They experienced rapid growth of real output and exports, and were successful to a degree that had earlier not seemed feasible.

Hence, by the late 1980s, focus was on the reduction of trade barriers and an open economy as an essential part of the prescription for rapid economic growth, alongside education and other investments in humans, and high savings rates. At the same time, and both from direct experience and because of the collapse of central planning, skepticism grew regarding the efficacy of state-owned enterprises engaging in manufacturing activities. Recognition of the role of competition increased, although it was never a central fad.

With all of this, the experience of the East Asian "tigers" - Hong Kong, Singapore, South Korea, and Taiwan - was phenomenal. By 1990, South Korea had realized a rate of real economic growth that more than doubled per capita income every decade. The country, and others experiencing similar growth rates, was transformed. It no longer made sense to regard all non-industrial countries as homogeneous - a variety of distinctions (emerging markets, middle-income countries, etc.) came to be employed. But all those in the policy and academic communities concerned with development recognized the outstanding success of the "tigers" over a very long period of time. While they debated the relative contributions of different factors to those high growth rates, no one could doubt the sustained success of those economies over the decades.

By the 1980s, other Asian countries had begun to follow the same pattern. China, Thailand, Malaysia, and Indonesia all experienced real rates of growth that were very high contrasted with their earlier experience and with that of other countries in other regions. Thus, although Mexico experienced a crisis in 1994 (and Russia and Brazil crises in 1998 and 1999), the Asian "miracle" countries were widely regarded as immune from growth slowdowns, much less crises of the Mexican variety.

It should be noted that there had earlier been any number of "foreign exchange" or financial crises. In most instances, these had occurred when economic policies had sustained unrealistic (overvalued) exchange rates through the use of exchange controls and restrictions on capital flows, if not current account transactions. Those crises were normally precipitated by difficulties in domestic banking systems, in the case of financial crises (such as Sweden in 1992) or by a country's inability either to borrow further to finance its current account deficit (such as in Turkey in 1980) or to restrict its imports further.

It was the "Asian crises" of 1997 that shocked the world: seemingly unstoppable successful countries had apparently foundered. There was a relentless outflow of foreign exchange, and governments faced the possibility that they might be unable to honor their foreign obligations. Korea, for example, had experienced capital inflows of as much as l0 percent of GDP during the 1960s and 1970s, but had avoided the "debt crises" of other countries in the 1980s both because of the rapid growth of exports and because the debt-GDP ratio and debt-export ratio actually fell during that same period. As a symptom of their success, the Asian economies were regarded as highly creditworthy, so that the shocks of 1997 were all the greater.

The proximate "causes" of the crises were capital outflows, and the crises were initially blamed on "speculators", "hot money", "contagion', and the like. But further analysis showed that, although capital outflows were the "forcing" phenomenon that led to crisis, there were underlying factors that had come into play. While these factors differed from case to case, there were significant commonalities.

It is not the purpose here to review the panoply of lessons learned, nor to analyze the policy responses to the crises (about which there has been considerable controversy). Suffice it to say that there is widespread agreement that a fixed exchange rate regime in most cases removes a major shock absorber and can, in the absence of appropriate supporting policies, itself result in major difficulties. There are far fewer fixed exchange rate regimes in the world than there were in the mid-1990s. There is also a greatly heightened awareness of the need to examine debt sustainability, as well as current flows. And there is increased recognition of the importance of the need for consistency between domestic monetary and fiscal policy and the exchange rate regime. For all these reasons, there is certainly reduced risk of crisis. But, in addition, as the experience of the late 1990s has been further analyzed, recognition of the necessity of financial sector development in the course of economic growth has increased.