Is finance bad for growth?

The global financial crisis not only provoked widespread hostility toward the financial industry. It also highlighted how financial development might actually hinder growth.

As it turns out, there is some cause for skepticism about the role of the financial industry in economic growth. Recent studies find that unregulated financial sector growth can (and often does) have an adverse effect on the economies studied, wherein the increased strength of the financial system corresponds to a lowering of gross domestic product (GDP) growth.

Yet these studies have been limited to rich countries. Recent research by the Asian Development Bank shows that financial industry development has a bigger and more significant effect on growth in developing countries than in developed countries—and the positive effect is most pronounced in the developing countries in Asia. Furthermore, the growth effects of financial development seem to be the highest for lower income countries with underdeveloped financial systems, such as Bangladesh and Lao People’s Democratic Republic.

Notably, what matters for growth is overall financial development, rather than the composition of the financial system. It is thus not the development of banks, stock markets, or specific components of the financial system but rather the development of the financial system as a whole that contributes to growth.

This is important because development economists have long struggled with the question of how to sequence financial sector reforms. Should countries prioritize the development of domestic banking systems or capital markets? Are large banks or small banks preferable? For middle- and upper-middle-income Asian countries with mature banking sectors, a top priority has often been to broaden and deepen capital markets, especially bond markets. For lower-income Asian countries, a higher priority has been to develop and strengthen the banking sector.

In both cases, however, we demonstrate that the effects of reform are likely to be positive for growth. Our research shows clear positive growth effects when developing countries in Asia boost the ratio of liabilities as a share of GDP. For example, if countries increase currency plus checking and interest-bearing accounts in financial institutions from 65 percent to 75 percent, this adds almost 0.4 percentage points to average annual GDP growth per capita. Moreover, an increase of 10 percentage points in developing Asia’s average ratio of private credit to GDP (an alternative measure of financial depth) is associated with higher growth in GDP per capita by 0.3 percentage points per year.

These findings are consistent with the assumption that post–global financial crisis concerns about excessive finance and a potentially harmful impact of finance on growth are more relevant for advanced economies than for developing countries.

They also reinforce the notion that developing countries stand to reap large gains from correcting the imbalance between financial backwardness and real-economy dynamism. Financial development means fundamentally different things in the two groups of countries, which are at very different stages of financial development. In advanced economies, it refers to sophisticated, complex, and risky financial innovation that even regulators could not fully comprehend, let alone control. In contrast, in developing countries, it refers to the much more basic but vital task of building sound and efficient banks, as well as deep and liquid capital markets.

Financial development as an engine for growth

The overriding policy implication of the evidence is that financial development can serve as an engine of growth for developing countries, especially in Asia.

Of course, this is not the final word on the role of finance in the growth process, and future research can extend and strengthen the analytical framework in various ways. Above all, the analysis of the relationship between finance and growth would benefit greatly from better measurement of financial development. All studies of the finance-growth nexus measure financial development as the relative size of the financial sector. However, an alternative measure of financial development that captures the quality of finance—i.e., its soundness and efficiency—would more clearly illuminate the effect of finance on growth.

The cautionary tale of the global financial crisis underlines the potential risks of poorly regulated financial innovation for financial stability and economic growth. But it is equally important for developing countries—both middle and lower income—to continue to recognize the role finance plays in promoting growth. Whether in growing small businesses or attracting international investment, modern financial systems can play a big, positive role in developing countries’ economies.

This article is based on the ADB Working Paper: Financial Development, Financial Openness, and Economic Growth.