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  • Writer's picturePooja Ambala

Role of Financial System in Economic Development

Updated: May 12, 2022

Any country's development is determined by the amount of economic growth it achieves over time. Economic growth is concerned with investment and production and the size of a country's Gross Domestic Product. If this grows, people will only experience growth in the form of an improved standard of living, i.e., economic development.

The following are the roles of the financial system in a country's economic development.

Relationship between savings and investments

A country's economic development requires increased investment and production. This is only possible if there is a provision for saving. As a result, savings are channelled into productive resources via acquisition. Financial institutions play an essential role here, as they encourage people to save by offering attractive interest rates. These funds are channelled through lending to various businesses involved in production and distribution.

Financial systems contribute to the expansion of the capital market.

Fixed capital and working capital are two types of capital that every business requires. Fixed capital is used to fund the purchase of fixed assets such as plants and machinery. Working capital is used to run a business on a day-to-day basis. It's also used for buying raw materials and turning them into finished goods.

Fixed capital is raised by issuing debentures and shares on the stock exchange. The government and other financial institutions invest in them to generate a reasonable return with minimal risk.

We have the money market for working capital, where people in business can raise short-term loans by issuing various credit instruments such as bills, promissory notes, and so on.

Exporters and importers can use the foreign exchange market to receive and raise funds for transaction settlements. It also makes it possible for the banks to borrow from and lend to customers in various foreign currencies. The market also allows banks to profit from their short-term idle funds by investing them in the market. Governments benefit as well, as they can use this market to meet their foreign exchange needs.

The market for Government Securities:

The financial system allows state and federal governments to raise both short-term and long-term funds by issuing bills and bonds with attractive interest rates and tax benefits. The only way to close the budget gap is to use the government securities market. As a result, the capital market, money market, foreign exchange market, and government securities market help businesspeople, industrialists, and governments meet their credit needs. The financial system ensures the economy's development in this manner.

The financial system aids infrastructure and growth:

The infrastructure determines any country's economic development it has in place. Other industries will be hampered if critical sectors like coal, power, and oil are not developed. Financial services play a vital role here by providing funds to expand infrastructure industries. The private sector will have difficulty raising the massive capital required to establish infrastructure industries. For a long time, India's infrastructure industries were solely funded by the government. However, due to the economic liberalization policy, more private sector industries have stepped forward to start infrastructure projects. These industries benefit from the assistance of Development Banks and Merchant Banks in raising capital.

The financial system aids trade development:

The financial system aids both domestic and international trade. Financial institutions finance traders, and the financial market aids in discounting financial instruments such as bills. Commercial banks provide pre-shipment and post-shipment financing, which promotes international trade. They also issue Letters of Credit in the importer's favour. As a result of the presence of a financial system, the country earns valuable foreign exchange. The best thing about the financial system is that the seller and buyer never meet, and the documents are negotiated through the bank. The economic system thus benefits not only traders but also various financial institutions. Some capital goods are sold on hire purchase and instalment basis in domestic and international trade. As a result of all of this, the country's growth has accelerated.

Employment The financial system helps to boost growth:

The presence of a financial system in the country will result in more job opportunities. The money market, part of the financial system, provides working capital to entrepreneurs and manufacturers, resulting in increased production and more job opportunities. With increased competition in various sectors, the service sector, such as sales, marketing, and advertising, has increased, resulting in more job opportunities. Leasing, factoring, merchant banking, and other financial services will also increase employment. The expansion of trade in the country also creates job opportunities. Venture capital financing opens up more opportunities for techno-based industries and jobs.

VC (Venture Capital):

The lack of growth of venture capital firms in India can be attributed to several factors. When more ventures that require modern technology and venture capital are promoted, a country's economic development will accelerate. Individual companies cannot provide venture capital because it entails more significant risks. More financial institutions will contribute a portion of their investable funds to promote new ventures only through the financial system. As a result, the financial system facilitates the formation of venture capital.

The financial system ensures balanced growth

Economic development necessitates balanced growth or growth in all sectors simultaneously. The primary, secondary, and tertiary sectors require sufficient funds to grow. The authorities will set up the country's financial system so that the available funds are distributed evenly across all industries, resulting in balanced growth in the industries, agriculture, and service sectors.

The financial system aids fiscal discipline and economic control

The government can create a favourable business environment through the financial system, ensuring neither excessive inflation nor depression. The economic system should provide adequate protection to the industries to meet their credit needs even during this difficult time. On its part, the government can raise sufficient funds to meet its financial obligations, ensuring that economic development is not hampered. The government can also regulate the financial system by enacting appropriate legislation to prevent unwanted or speculative transactions. Black money's growth could also be limited.

The role of the financial system in achieving balanced regional development

Backward areas could be developed through the financial system by providing various concessions or sops. This ensures that the country produces in a balanced manner, reducing the likelihood of political or other disruptions. It will also keep an eye on the rural population's migration to towns and cities.

The financial system's role in attracting foreign investment

The financial system encourages the development of the capital market. A vibrant capital market can attract funds from both domestic and international sources. The investment will increase with more capital, hastening a country's economic development.

The role of the financial system in economic integration

Different countries' financial systems are capable of promoting economic integration. This means that standard economic policies, such as joint investment, trade, commerce, commercial law, employment legislation, old-age pensions, and transportation coordination, will be implemented in all of those countries. We have a long-standing example of the European Common Market, which has gone so far as to create a common currency and represents several Western European countries.

The Financial System's Contribution to Political Stability

All countries with a developed financial system will have stable political conditions. An unstable political environment will harm their financial design and economic development.

The financial system aids uniform interest rates.

The financial system can bring a uniform interest rate across the country, allowing for a balanced flow of funds between centres and ensuring capital availability for all types of industries.

The role of the financial system in electronic development:

Transactions have increased dramatically due to technological advancements and the introduction of computers into the financial system, ushering in changes for the country's overall development. In all of its member countries, the World Trade Organization (WTO) promotion has improved international trade and the financial system.

The financial system is made up of financial institutions and markets. This monetary system supports the national economy. This is because the financial system's efficiency significantly impacts a country's economic development. The role of the financial system may be overlooked because we take its existence for granted. However, when we start paying attention to the financial system, it's easy to see why it's so crucial to a country's economic development.

Stabilization of Interest Rates: The financial system ensures that all organizations and institutions that make it up to act as one unified system. In general, the system members are encouraged to compete healthily. As a result, members must compete by lowering their prices. As a result, the savings from lower interest rates are passed on to customers. The financial system's existence ensures that interest rates remain consistent across the country. This is made possible by the banking system, which a central bank leads. In the absence of a financial plan, each region's interest rate would be determined by capital availability. Interest rates remain the same across the country now that the financial system is in place. As a result, all businessmen and entrepreneurs in the country are treated equally.

Aids Trade and Commerce: Credit risk has long been a significant impediment to trade and commerce. If a seller is unsure whether or not they will be paid for the goods they sold, they will not sell any more until the last payment is received. Inventory turnover is slowed, and trade and commerce suffer as a result. Payments are made quickly and on time, thanks to financial systems. With the advancement of technology, it is now possible to send money to anyone in the world in a matter of seconds. As a result, financial markets and institutions aid trade and commerce while also improving a country's gross domestic product.

Aids International Trade: When it comes to international trade, the risks of trade and commerce are multiplied several times. This is because, first and foremost, the seller and the buyer are from different legal jurisdictions. As a result, contract enforceability suffers. Second, the volume of goods transacted in import and export transactions is enormous. As a result, the outstanding amounts grow in size, increasing the overall risk of the transaction.

In the international trade process, financial systems play a critical role. Banks are frequently used as a middleman between importers and exporters. The importer uses a letter of credit to deposit funds with the bank. When the goods are received, the bank pays the letter of credit to the exporter. As a result, neither party is dependent on the other. Instead, they can both rely on the bank, which has a higher credit rating and thus helps to mitigate risk.

Similarly, countries have established export credit and promotion boards. These boards provide essential services such as insurance and payment guarantees in international trade. International trade would be negatively impacted without financial markets and systems; it is fair to say.

Stable financial markets increase investor confidence, which helps to attract capital. As a result, domestic and international investors begin to invest in the capital markets. As a result, domestic businesses have access to more capital. They can then put this money to work, expanding their economies of scale making them more competitive in the global market. Foreign investors would have difficulty locating and executing investment opportunities if these financial institutions and markets were not present.

Financial Markets Assist Infrastructure Development: Financial markets also play an essential role in infrastructure development. Raising large sums of money for projects with a long gestation period may be difficult for the private sector. The financial markets provide the liquidity that investors require. Investors have the option to sell their securities and cash out at any time. The same investor doesn't need to keep the security for the entire loan term. The financial markets provide a lot of funding at low rates to critical sectors like power generation, oil and gas, transportation, telecommunications, and railways.

Governments can also use financial markets to raise large sums of money. This allows them to keep spending on deficits. Governments would be unable to continue deficit spending in the absence of financial markets, which is necessary to fund infrastructure projects in the short term.

The financial system assists in creating jobs by providing capital to entrepreneurs who want to start a business. When these businesses are established, they require the services of a wide range of people, both directly and indirectly. As a result, the economy generates a large amount of employment. The financial services industry employs a large number of people. Many of these jobs are high-paying white-collar jobs that can propel workers into the middle class.

To summarize, financial systems are similar to the foundation of a structure. This is since the financial system is essential to the economy's survival. However, until everything is in order, the financial system, like the foundation, goes unnoticed.

Funds flow from those who have excess funds to those who have a shortage of funds in the financial system, either directly through market-based financing or indirectly through funding bank-based. "Finance is, as it were, the stomach of the country, from which all the other organs take their tone," former British Prime Minister William Gladstone said in 1858 of finance's importance to the economy.

All financial markets, instruments, and institutions are part of the financial system. Today, I'd like to discuss whether the design of the financial system impacts economic growth. Yes, in my opinion, is the answer to this question. According to cross-country comparisons, individual country studies, and industry and firm-level analyses, a positive relationship exists between financial system sophistication and economic development. While there are still some gaps, I believe the financial system is inextricably linked to economic performance. Nonetheless, economists disagree about the underlying mechanisms that explain the positive relationship between financial system development and economic development.

Some economists do not believe that the relationship between finance and growth is significant. Robert Lucas, for example, claimed in 1988 that economists grossly exaggerate the importance of financial factors in economic development. In addition, Joan Robertson stated in 1952 that "where business leads, finance follows." According to this viewpoint, economic growth generates demand for specific financial arrangements, which the financial system automatically responds to.

Other economists believe that the financial system is critical to economic growth. They deal with the question of what the ideal monetary system should entail. In general, it appears that the best financial strategy, when combined with a well-developed legal system, should include elements of both direct and indirect, bank-based finance. A well-developed financial system should make financing decisions more efficient, allowing for better resource allocation and thus economic growth.

Financial systems based on the market and those based on banks each have their own set of advantages. Market-based financing is advantageous for some industries at certain stages of development. Financing through stock markets, for example, is ideal for enterprises with rapid technological advancements and little agreement on how companies should be managed. The stock market examines whether the manager's assessment of the firm's output is reasonable. Bank-based financing is preferable in other industries. This is especially true in industries where there are significant information gaps. Financing through financial intermediaries is an excellent way to avoid adverse selection and moral hazards between lenders and borrowers. Banks, in particular, have honed their skills in identifying good and bad borrowers. As a result, economies with well-developed banking and capital markets have an advantage. Furthermore, in a crisis in one system, the other system can act like the fabled spare wheel.

The financial system is also critical in reallocating capital, thus providing the foundation for the economy's ongoing restructuring, which is required to support growth. We see a higher proportion of investment going into relatively fast-growing sectors in countries with a well-developed financial system. When we look back more than one century ago, during the Industrial Revolution, we see that England's financial system did a better job identifying and funding profitable ventures than other countries in the mid-1800s. As a result, England achieved more tremendous economic success than the rest of the world. Walter Bagehot, a banker and former editor of "The Economist," put it this way in 1873: "However, in England, capital flows as surely and instantly where it is most needed, and where there is the most profit to be made, as water flows to find its level."

A lack of a well-developed stock market today would be a significant disadvantage for any economy. The emergence and growth of innovative businesses require equity. Young, innovative high-tech firms will be the primary drivers of future structural change, critical to a country's long-term growth potential. Given today's enormously increased international competition, rapid technological progress, and the increased role of innovation for growth performance, the contribution of financial markets in this area is necessary for maintaining an economy's competitiveness.

In recent years, "new markets," or stocks of young and growing companies, have grown in popularity in the eurozone. Given the uncertainty of the economic return, equity financing is particularly advantageous for these companies and their investors. With equity financing, you get a share of the outcome, whether positive or negative, as the term "shares" implies. On the other hand, banks may be hesitant to lend to these businesses due to their higher risk profile and greater exposure to a loan contract's adverse outcome.

The total market capitalization of five euro area countries' new markets increased from EUR 7 billion in January 1998 to EUR 167 billion in December 2000. While some of this growth can be attributed to the overall rise in share prices during this time, it's worth noting that the number of publicly traded companies increased almost every month. The total number of companies listed on these new markets in the eurozone increased from 63 in January 1998 to 564 in December 2000. The last 12 months have been abysmal. On the other hand, new markets are more volatile than established markets due to the uncertainties surrounding future developments for the companies listed on these markets.

Bank-based finance plays a critical role in ensuring a well-balanced growth process for many companies in need of capital. The economic literature on "relationship banking" has shown that banks can help clients cope with the effects of unexpected economic shocks. Banks are prepared to provide funds to many customers even under challenging circumstances, such as when financial markets' liquidity is depleted.

The banking sector plays a vital role in allocating funds to the most profitable investment opportunities. As previously stated, banks are financial intermediaries that add cost to a capital allocation by their very nature. As a result, for banks to thrive in a market economy, they must offer additional benefits. If a bank loan is large enough, the fixed costs of accessing debt markets become negligible; it is difficult to compete with the debt securities market. However, securities markets are not always sufficiently liquid, and some businesses, tiny and medium-sized businesses, cannot meet their liquidity needs through securities markets due to high fixed costs of entry. Another advantage of bank-based financing stems from the banking industry's inherent nature. Due to significant information gaps between borrowers and potential lenders, some projects cannot be financed directly by the market. Banks can close this gap by leveraging their comparative advantages in evaluating and monitoring investment projects, which helps to eliminate information gaps.

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