Modeling the interaction between financial institutions development and economic growth

Modeling the interaction between financial institutions development and economic growth

Published Jan 2004

Author

R. Afanasiev

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Russian firms need cheaper credit and greater transparency to grow faster

[The full text of this paper is in Russian language only.] The author uses mathematical modeling and statistical analysis to assess the impact of the degree to which a country’s financial institutions are developed on the country’s GDP growth rate.

According to the author, the effect is uncertain. On the one hand, financial institutions have a positive impact on economic growth for the following reasons:

  • underdevelopment of the financial sector results in less than complete diversification of investment projects, which in turn leads to increased risk of investment income and a reduction in savings
  • underdevelopment of the financial sector leads to a reduction in investment
  • the reduction of transaction and information costs in the financial sector is necessary for sustained economic growth

On the other hand, the author claims that highly developed financial institutions may lead to a reduction in economic growth, since the government will be able to finance the budget deficit by the issuance of debt. This, in turn, would mean less capital available.

Statistical analysis by the author shows that the effect of the level of financial institutional development on economic growth is nonlinear. The author finds that:

  • for countries with undeveloped financial institutions the effect is not significant;
  • those with an average level of financial institution development the effect is significantly positive
  • the ones that have highly developed institutions the effect is not statistically significant

The author also analyses how the effect of the level of financial institutional development on economic growth differs among countries with different rates of financial institutional development. The author finds that:

  • the effect is strongly positive for the group of countries with highly volatile rates of development
  • the effect is positive, low, but still statistically significant for countries with moderately volatile rates of development
  • the effect is insignificant for countries with stable rates of development

The author concludes that Russia is a country whose financial institutions are moderately developed, and that their continued development will have a strong impact on economic growth.

The author makes the following policy recommendations:

  • more credit should be made available to small and medium business since this would affect long-run economic growth
  • the existing cost gap between internal and external finance should be decreased (through an improved contract law, greater transparency of firms, etc.)
  • banking credit should be more accessible than trade credit, government, credit, and internal finance

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