Financial sector development - Sida

financial rather than real assets. Hence, higher real interest rates causing financial
deepening imply that more resources are intermediated to investments. Moreover, this
credit may be allocated to more productive investments through the lending competence in
the formal banking system.
In addition to this argument for financial liberalisation, evidence points to that subsidised
credit schemes often involve important drawbacks. Such schemes normally rely on an
administrative rationing of credit, implying an inefficient allocation of resources. In addition,
any rationing situation invites corrupt behavior by bank and government officials.
In many countries, financial liberalisation shows that the savings potential in developing
countries has previously been underutilised. In fact, even very poor households often
manage to save.
Nevertheless, the unconditional praise of financial liberalisation has been modified in the
last few years. For one thing, the positive association between real interest rates and
growth may be an indication of more stable macro-economic conditions, rather than the
level of interest rates themselves. Today, there is an emphasis on sequencing
liberalisation, carefully considering the general economic conditions at hand. The actual
effects of financial liberalisation have been very different across regions. Financial
liberalisation does not always mean that credit is allocated efficiently. Poor information
systems and weak enforcement mechanisms may motivate banks to exercise inefficient
credit limits even under liberalised conditions.
If formal financial institutions are suppressed or under excessive control, various forms of
informal finance are there to replace them. In many ways informal finance is an efficient
response to various transaction costs, but may fail in the agglomeration function that formal
banks perform. Once again, the institutional setting determine the possibilities for efficient
economic performance.
4.THE FINANCIAL SYSTEM IN THE DEVELOPMENT PROCESS
4.1 Financial markets and institutions in the development process
As referred to in the previous chapter, a well-functioning financial system is important for
achieving sustainable growth. The existence of an efficient and credible financial market
can, in combination with appropriate economic policies, contribute to raising the total
savings in an economy. Even more importantly, an efficient financial market channels the
savings into productive investments, thereby improving the efficiency of the stock of capital.
An efficient capital stock generates more production and thus higher incomes -- in short it
promotes higher standards of living. Therefore, the development of financial markets is a
key to economic progress.
As an economy develops, the financial system "deepens". This means two things: First, the
volume of financial transactions grows more rapidly than GDP, meaning for instance that
the stock of money in relation to GDP increases; second, that the average maturity of
financial contracts increases due to a shift from cash to bank deposits and to longer-term
claims such as pension rights, bonds etc.
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