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Economic Development and Financial Deepening:
A Study of Causation and Dynamics
Dr. Richard G. Fritz
University of Central Florida
ABSTRACT
The direction of causality between financial deepening and economic
development is tested. Using factor analysis, two indexes are developed to
represent the two economic phenomena for the Philippines. Time series
causality tests are used to evaluate the direction of causality. The results
indicate the causal pattern reverses over the history of the sample. Reversal
is viewed as the result of financial repression. The structural dynamics
implied by the empirical time series test is evaluated using a system
dynamics model. The growth promoting and growth inhibiting roles of the
financial sector are simulated in the dynamic structure of a dynamic economic
development model.
INTRODUCTION
The role financial institutions and new credit creation plays in deter-
mining the rate of economic development continues to be debated. Most modern
treaties on the subject refer to Schumpeter's Theory of Economic Development
as the basis for the growth-inducing character of improved financial institu-
tions. This "Schumpeterian" logic of capitalist economic development has
been supported with modern analysis, which attempts to estimate the relative
impact of the degree of improvement in financial institutions on the
economy's development potential (Abdi).
The positive growth-inducing aspect of "supply-leading" financial
development is attributed to its allocative efficiency and to its encourage-
ment of enterprise (Goldsmith; Patrick). This activity transfers resources
from non-growth producting sectors to sectors of an economy with higher
growth potential. It is also possible that financial development is "demand-
following." As the economy moves from traditional subsistence production,
grows more complex, and generally becomes monetized, certain demands are
generated for the services of financial institutions. The financial repres-
sion hypothesis advocated the efficacy of financial development in contri-
buting to real growth (Cameron; McKinnon; Shaw). They contend that financial
institutions are invariable growth-inducing and that only when they are
repressed would they fail to make a positive contribution or act as an
obstacle to real growth. Following Gerschenkron, the structuralist hypo-
theses is derived from historical interpretations of the role of banks in the
capital formation processes of industrialization. This thesis allows banks a
primary role in differentiating among patterns of development. Gerschenkron
attributes to these institutions a greater influence in the period and
process of industrialization of some countries than any other economic
institution.
The policy implications are critically different depending upon the
causal direction implied by both sides of the debate. Recently a few studies
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have concluded that the contributions of the entrepreneural character of
financial institutions may follow a cyclical path (Drake.) The life cycle of
financial deepening implied protrays the process as having a supply leading
role in the early stages of development followed by a demand following stage
later when the country has reached a more industrialized production process.
In order to determine the characteristics of the causal process which may
result in this directional shift, a system dynamics approach has been
explored in this study. Such a modeling procedure can aid in capturing the
interactions between economic development and the maturation process of the
financial sector in the less developed economy. Revealing the components of
the switching points in the direction of causation is critical to estab-
lishing policy guidelines for using financial deepening as an economic
development instrument. Sensitivity to policy changes can be tested through
the feedback analysis of the system dynamics model.
This paper will test the direction of causality between financial
development and economic development. Using factor analysis, two indexes
will be developed to represent the two economic phenomena for the Philippines
between 1947 and 1982. Time-series causality test (Granger, 1980) will be
used to evaluate the direction of causality. The structural dynamics implied
by the empirical time series test will be evaluated using a system dynamics
model. The impact of financial deepening on economic development in the
modern Philippine economy will be simulated.
ECONOMIC BACKGROUND ON DEVELOPMENT AND FINANCIAL DEEPENING
Throughout the world, less developed countries (LDC's) are facing
financial crisis (Silk). Major financial institutions throughout the world,
as well as the World Bank have extended credit to these countries expecting
the resulting economic development to yield the necessary dividends for
repayment. However the most expeditious road to economic development has
never been a certain one for LDC's. One controversy deals with the degree
and timing of maturity of the financial institutions and financial markets.
Previous published research polarizes the role of financial institutions in
the process of economic development between the supply-leading position and
the demand-following hypothesis. However, the large proportion of re-
searchers in the field believe in the affirmation effect of financial
maturity on the economic development process.
The statistical evidence is compelling. Raymond Goldsmith (1969)
attempted to measure the degree of institutional maturity in the financial
market using the ratio of total financial assets to national wealth. He
showed that the higher the financial interrelations ratio (FIR) value, the
greater a nation's level of financial development. This and several other
instruments have been used to denote the relative dimensions of financial
structure in different countries over long periods of time in order to
identify the association between financial development and real economic
growth (Adelman and Morris, 1967; Cameron, et al, 1972; Patrick, 1966; Shaw,
1973; Gurley, 1967; Viksnins, 1980; Drake, 1980; Von Pischke, Adams and
Donald, 1983; Ayres, 1983).
Drake summarizes this literature by identifying three focal points.
Financial institution development: (1) augments the quantities of real
saving and capital formation from any given national income, (2) increases
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net capital inflow from abroad, and (3) raises the productivity of aggregate
investment by improving its allocation (p. 35). Porter has added (4)
improved macroeconomic stabilization, arguing that "greater stabilization of
the economy through monetary controls is attainable when the banking system
is more widespread" (1966, p. 356). Cameron goes a step further. Banks
provide a basic intermediary function between savers and investors, or
surplus and deficit spending units, but they are unique in being able to (5)
supply liquidity to the economy by creating money, “They are in a position
not merely to serve as the custodians of the stock of money but also to
increase or decrease that stock. The consequence of this power for society
at large can be considerable--and either favorable or unfavorable" (1972, p.
7). Cameron further suggests that the banking system may function as (6) the
provider of entrepreneurial talent and guidance for the economy as a whole.
As potential entrepreneurs, they may set their country on the road to contin-
uing growth, or they may waste its resources in uneconomical or fraudulent
activities (Cameron, p. 8).
The direct role of money in economic growth has been discussed at some
length in the modern literature since Tobin constructed a neoclassical macro
model combining the aggregate production function and the monetary sector in
1955. This work was modified by Levhari and Patinkin and others to include
the use value of money more explicitly and the inter-temporal utility maximi-
zation of saving behavior.
However, the direction of causality has not been resolved. Some who
have criticized the foundational propositions of these "monetary" growth
models concede that there are important "financial breakthroughs" which
provide efficiency and utility (Pierson). These breakthroughs have tremen-
dous effects when they occur, but thereafter contribute little. Their
marginal products are significant and initially large but thereafter they
rapidly decrease. Pierson holds that the establishment of a credit system
and the establishment of an intermediary system are two critical growth
promoting breakthroughs, both of which can exist without a medium of ex-
change. The introduction of a medium of exchange is a third great financial
breakthrough, saving time, effort, and physical resources in the process of
exchange. Pierson and others believe that with few exceptions, financial
institutions and markets develop following the lead of general economic
development.
This "demand-following" type of financial development is viewed as
somehow accommodating or reacting passively to the growth of the real
economy. As the economy moves from traditional subsistence production, grows
more complex, and generally becomes monetized, certain demands are generated
for the services of financial institutions. Such demands are created by the
growing needs of firms for external finance, as their retained profits fall
short of their investment expansion needs. In this approach to financial
development, emphasis is placed on the demand for financial assets, and the
responsiveness of existing or new financial institutions is taken for granted.
The case of demand creating its own supply. A distinction of the demand-
following type of financial development is that its contribution to economic
development is minimal.
Much of the dispute over the role of financial deepening as it relates
to LDC's is concerned with the difference between theoretical benefits
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associated with monetization and the growth of financial intermediaries and
the actual realized benefits. Viksnins points out that in the bulk of the
less developed world the population will be found in rural areas engaged pri-
marily in subsistence farming. For the average peasant farmer, income and
consumption are usually closely matched. Most farm surplus income is used to
buy additional consumer goods (or used to enhance ceremonial-religious
activities) rather that saved or transformed into productive investments.
Viksnins notes several additional inhibitions to a growth promoting financial
sector in LDC's. With a large surplus, the farmer is likely to buy more
land, farm animals or agricultural implements. With supply of these items
relatively fixed during the period of surplus, prices of land and investment
goods are bid up and real investment remains about constant. Cultural and
physical barriers may be a significant problem. Traveling to the provincial
capital and depositing funds in a financial institution, filling out forms
and dealing with clerks from different social groups would probably not even
be considered by the rural farmer.
Not only are financial institutions generally unavailable and inacces-
sible, but markets in LDC's may often allocate the scarce funds to less
efficient project uses due to "financial repression". Both Shaw and McKinnon
(1973) discuss this phenomenon, which results in the average saver being
consistently offered a negative real rate of return on financial assets. In
such markets the expected inflation rate is above the interest rate paid on
deposits and securities. The real rate of interest becomes negative, the
demand for loanable funds increases while the supply declines resulting in
many borrowers and no willing lenders. The fragmented money and capital
markets of LDC's that result are inefficient.
Market fragmentation reinforces the urban-rural split. An organized
financial market in an LDC's in the past has meant the urban financial
market. Nisbet (1973) found in rural Chile that only about 30 percent of the
population had any dealings with financial institutions with the remainder
having access only to money lenders or shopkeepers. Such imperfections
stimulate average high interest rates in the unorganized rural sector. The
fragmentation also results in a consistent bias for export of domestic
savings. Economic agents who are active in the export sector will seldom
convert their foreign exchange back to local currency, either because nega-
tive real interest rates are offered on assets in the organized money market
or because they anticipate future convertibility limitations. Financially
repressed economies also tend to develop a propensity to issue short-term
instruments rather that long-term. The planning horizon of savers becomes
logically short. Asset holders try to maximize their liquidity, avoiding
being locked in at a very low or negative real rate for a long time period.
This results in investors attempting to finance capital projects by borrowing
large amounts in the short-term money market.
While the supply-leading approach has much to suggest a more prosperous
overall economy resulting from financial deepening; improved savings mobili-
zation as lenders offer positive interest rates, average rates charged to
borrowers falling as the organized money market is merged with "curb finance"
and perhaps an improved distribution of income, there is one final restraint
retarding short-run financial reform. Owens and Shaw (1974) and Viksnins
hold that politically powerful elites generally benefit from the existing
conditions of financial repression. The elite groups support the dual
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society government which encourages large-scale, capital-intensive indus-
tries. Politically favored entrepreneurs are offered subsidized credit to
mass their empires in land or large industries. Foreign exchange has been
over valued so the rich can import at artificially low prices their capital
goods and luxury consumables.
The example selected for this study, the Philippines, remains an essen~
tially dualistic economy, with low income levels in the agriculture sector in
contrast to the more progressive industrial and export sectors. The
Philippines have had the consistently slowest GNP growth rates among the
ASEAN countries (Singapore, Malaysia, Philippines, Thailand and Indonesia)
throughout the post war decades. Narasimham and Sabater (1974) report that
in the post war period between 1947 and 1969, agriculture experienced a
growth of 4.8 percent, while industrial production recorded an 8.4 percent
annual growth rate. The early post war stimulus for industrialization
favored industries in assembling and packaging. These industries rely
heavily on imported raw materials which helped keep the growth in imports
ahead of the moderate export expansion. The depletion of foreign reserves
and the heavy debt burden resulting from a nearly unbroken annual trade
deficit, resulted in severe economic problems for the country by the mid
1970's.
In order to judge the causal impact of financial deepening, if indeed
one exists, there must be a suitable definition of financial deepening. The
following section attempts to specify the primary characteristics of this
process.
DEFINING THE FINANCIAL DEEPENING PROCESS
As is often the case with other socio-economic processes, financial
deepening involves a combination of several activities and institutions.
From at least the time of the German Historical School, economists have
attempted to evaluate the developmental impact of increasing the amount of
financing of production and investment through specialized and organized
markets. In the last twenty-five years this study has been referenced as
financial deepening. Recently some economists have attempted to improve on
the use of the term by careful attention to the definition and application.
Cheng (1980) notes that in developing economies, the term is associated with
increases in the activity of financial intermediaries, like commercial banks
and savings institutions. In developed economies, financial intermediation
is often dominated by direct placement or capital markets. For the Pacific
Basin countries, Cheng suggests the degree of financial intermediation be
measured by the proportion of national wealth held through financial inter-
mediaries. This is measured by the ratio of the consolidated assets of each
nation's financial intermediaries to national output. The ratio is also
calculated on the basis of domestically held assets and foreign held assets.
This follows the tradition of Goldsmith of searching for a single ratio to
identify "financial interrelation".
Viksnins avoids the single ratio methodology by reporting "Selected
Measures of Monetization", (p. 17). These include; Money Supply (MI),
GNP/Money Supply, Quasi-money (M2), GNP/Quasi-money, Real Money (M1/P), Real
Quasi-money (M2/P), M2/M1 (real terms), Currency Outside Banks (C), C/Ml, and
Monetization (SDRs per capita). While these variables are not used in a
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ratio, nor are they combined in any composite index weighted for their
relative importance. A combined index, with each variable weighted according
to its relative importance would constitute a robust measure of financial
deepening. Such an index would be superior to a single ratio of financial
assets as well as reduce the selectivity associated with a tabular data
report. Following Cheng, there is no reason why the index of financial
variables need use the same set of weights for any two countries. Nor for
that matter, the relative weights may logically change over a sufficiently
long period of the nation's economic history, as a developing nation reaches
higher levels of economic development. Such an index was developed for the
Philippines using the eigen value approach of factor analysis (Fritz, 1984).
From the factor loadings, indexes were developed for both financial
deepening and economic development for the Philippines. Table 1 summarizes
the components of each index with the relative weight associated with each.
Table 1: Indexes and Weights for Philippines Development
Financial Deepening Economic Development
Variables Weights Variables Weights
SDR 2.94 Cement 2.41
Currency 1.83 Electrical Production 3.62
Demand Deposits 1.98 Manufactured Gas -2.47
Time & Saving Deposits 1.34 Exports 3.63
Bonds 0.17 GNP 3.33
Domestic Credit 1.49 Shipping 2.70
Money (MI) 1.84 Copper Ore 3.21
Development Bank Deposits 1.45
Consumer Prices 1.89
Monetization 1.71
Proportion of Commonality = 947 Proportion of Commonality = 822
When these indexes were tested for causation, the Granger (1980) time
series method indicated that over the early period (1969-1975), financial
deepening caused economic development while the latter period (1975-1981)
reversed the order of causation. The entire time series when taken as a
whole did not meet the statistical requirements for Granger time series
causality (Fritz, 1984). Graph 1 plots the relationship of the two indexes
over time.
The switching of causal pattern indicates the probable presence of a
structural feedback within the LDC which transformed the economy into a new
set of development conditions. The nature of these feedbacks is explored in
the following section.
FINANCIALLY AUGMENTED DEVELOPMENT
One possible explanation for the apparent switch in causation may be the
effect that negative feedback loops have on regulating positive feedback
loops. A suggested interpretation of the empirical analysis of LDC's develop-
ment pattern, as viewed from a system dynamic perspective, begins with the
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Graph 1
Financial Deepening and Economic Development
The Philippines, 1969-1981
90 be eee ees
1969 1971 1973 1975 1977 1979 1981
B Financial Deepening + Econ, Development
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positive loops associated with capital accumulation in the capital and
resource sectors. Following the basic model structure of N. Forrester's
(1973) “life cycle of economic development," financial deepening may be seen
as a factor that reduces the fraction of labor time that is nonproductive.
The relation between the fraction of labor time nonproductive and the need
for additional nonproductive time is determined to be negative. As the
fraction of labor time nonproductive increases, there are diminishing returns
to nonproductive time. If the fraction of labor time nonproductive only
allows eating and sleeping, then the need for additional nonproductive time
is very high.
Reducing the fraction of labor time which is nonproductive may be
accomplished through a technological innovation. Lopez (1982) argues that
financial intermediation follows the sequential process of technological
innovation, which involves introduction, diffusion, and institutionalization.
This process conveys the notion that the contributions of an
innovation is defined not only in terms of the initial appli-
cation (introduction) of the new technique, knowledge or
institution but in that (it) brings about other uses
(diffusion) beyond its original application and how well it
becomes integrated (institutionalized), improved upon, or
aborted to generate other technological innovations;...
(Lopez, pp.131-32)
Financial intermediation is introduced into the Forrester development life
cycle model in the service sector and the demographic sector. Thereby the
innovations which constitute financial deepening may augment the development
process. Consider the flow diagram of desired expenditures, Figure 1.
Figure 1: Computer Model of Desired Expenditures (*Demographic Sector and
Services Sector are adjusted for Financial Deepening effect.)
7 esources
| Capital ¢~ [Agricultural
pa Sector Sector Sector
| Goods
Sector
Services
Sector*
Demographic Sector
Labor Allocation Consumer Sector J
Population
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In order for the supply of financial instruments and institutions to be
development augmenting, the retarding effect of financial repression must be
overcome. The assumption made here is that the expansion of the economy
attributable to financial deepening can be introduced into the life cycle
model with a positive loop added to the Services Sector. Without a con-
straint, this would always result in a more rapid path of economic expansion.
However, the effect of financial repression will constrain this growth
promoting process. Consequently a negative loop representing the constraint
from cultural, social and technological conditions is added to the Demo-
graphic Sector. The supply-leading effect of financial deepening is con-
sidered first.
EFFECT OF FINANCIAL DEEPENING ON SERVICE SECTOR
The introduction of money for transactions purposes is a clear example
of the introduction of an innovation. The applications of an innovation by a
business firm depends upon the marginal benefit-marginal cost decision
process. In the case of money transactions, a firm should be willing to pay
for the use of it because it releases labor and capital from barter activ—
ities, resulting in higher output and higher profits (Moreney, 1972).
However, in developing countries it is possible that both the private marginal |
benefit-cost ratio and the social marginal benefit-cost ratio may not exceed
unity for the innovation of financial intermediation (Lopez p.132 and Porter).
The diffusion phase of a financial innovation is characterized by the
reduction of risk. Establishment of a bank reduces the risk of specializa-
tion of credit by pooling and spreading risk among borrowers. Both introduc-
tion and diffusion of a financial innovation may result in rejection.
Introduction may be rejected on the decision that marginal benefit-cost
ratios are not high enough. Diffusion may be rejected because of excessive
government regulation, lack. of entreprenurial skills, lack of sufficiently
large markets to sustain the needed economies of scale, or corruption (Bhatia
and Khatkhati, 1975). If the innovation becomes an integrated part of
society, other technological changes are likely to occur. The final stage is
characterized by institutionalization of the innovation. What had been new
becomes common throughout the system. As the system's dynamics evolve, the
previous "innovations" come to dominate the status quo and thus act as
constraints to further innovation. The institutionalized components of the
financial system become potential sources of financial repression.
A logical hypothesis would be that financial deepening can be a positive
source for economic development as long as the constraint of financial
repression is. weak or removed. Further, there are numerous sources of
financial repression including political instability (Saeed, 1983), institu-
tional retrenchment within the financial market, social mores and others.
These sources are the result of a continuous interaction between the sectors
of the economy throughout the life cycle of economic development. Figure 2
represents the systems behavior used to introduce the dynamic effects of
financial deepening into the Forrester model.
The Index of Financial Deepening (IFD) is a level which is controlled by
two rates. The Rate of Institutional Adoption (RIA) may operate to acceler-
ate financial deepening or it may be turned off through the feedback from the
Propensity for Financial Repression (PFR). The Rate of Rejection (RFR) may
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deplete the accumulating effect of financial deepening, resulting in greater
use of naive institutions and instruments; Self Finance and Barter (SFB).
The Propensity for Financial Repression is an auxiliary, which receives
information from the capital sector and services sector of the economy and
the demographic sector and sends information to the rates controlling finan-
cial deepening as well as the auxiliary, Innovation Introduction (II).
Figure 2: Financial Deepening and Financial Repression Causal Loops
Social sag:
Pressure ts Degree of
to Ny ‘Sy Self-Finance
Retard 1 XN and Barter
Demographic Change 1 bse
we eww ema nend
Sector “7 Degree _—s ”~
of a Propensity (+)
nae co” "ananttal ~"® face of
Regulation “wy Repression Financial
Repression
Sr 7
--
Index of
Rate of Financial
Diffusion
Economi Deepenin:
G te eae o ae
\agy Innovation
2
‘
N
.
Service s
Rate of
bares Index of
“6 .
Economic Institutional
Sector Ss Innovation
~ Adoption
~ Development Introduction Spee
K ~ oC
ae ~ .
~.LOTS ’
Se ~ 7
> - a
The financial repression auxiliary is the key to understanding the
switch in the direction of causation between financial deepening and economic
development. The Index of Economic Development (IED) is an accumulation
process which is part of the positive causal loop linking the technological
innovations in finance through the Index of Financial Deepening to the
service sector of the economy. The net effect will be to reduce the level of
the Fraction of Labor Time Nonproductive (FLN), augmenting the Rate of
Economic Growth (REG). This positive feedback characteristic within the
closed loop causes further change in the same direction in an unending
process (Richardson and Pugh, 1981). The Propensity for Financial Repression
is a component of the negative feedback loop which constrains the development
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oriented positive loop. Negative feedback is characterized by goal-directed
or goal-oriented behavior. Such terms as self-governing, self-regulating,
self-equilibriating, homeostatic, or adaptive, all implying the presence of a
goal, define negative feedback systems (Richardson and Pugh, 1981).
Figure 3 represents the positive loop associated with financial deep-
ening.
Figure 3: Positive Financial Deepening/Economic Development Loop
Adoption of
Financial
Financial
(+), Technology (+) Deepening
(-)
Index of
Index of (+) Fraction of
Economic Labor Time
Development Nonproductive
G2)
(-)
Rate of
Economic
Growth
Figure 4 represents the negative loops associated with financial repres-
sion.
Figure 4: Negative Financial Repression Loop
+)
(-) Index of
Fraction of
Financial Labor Time
(-) Deepening Nonproductive
Self-Finance, (-)
Barter, etc. Index of
(+) (-) Economic
f Development
Rate of
Financial
Rejection
(+)
Propensity for (+)
Financial
Repression
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The interaction of these two forces represent the problem of interpreting the
causal relationship between financial deepening and economic development.
CONCLUSION
Public policies for fostering economic growth in developing countries
has focused on finding ways and means to alleviate the condition responsible.
Over the last four decades much has been done in the developing countries to
accelerate economic growth, through increasing savings and encouraging
investment, through foreign aid, through employment of resources in regions
and sectors of the country considered more efficient, and through exploita-
tion and export of natural resources. These efforts appear fruitful when
collective growth performance of the developing countries over the past
thirty years are considered. The GNP per capita of the developing countries
as a group grew at an average rate of 3.4% per year during 1950-75 (Saeed, p.
455). This growth rate, however, obscures the variance in performances, both
among the developing countries in the group and over different points in time
in a single country.
One explanation for this phenomena lies in an understanding of the role
financial deepening plays in the development process. There is debate over
the direction of causation between financial deepening and economic develop-
ment. Using the transfer function approach, Fritz has shown that, in the
case of the Philippines, the causal pattern shifts from financial deepening
leading economic development to economic development causing increases in
financial deepening. This paper develops the first stage of using the
nonlinear technique of system dynamics to evaluate the positive and negative
feedbacks associated with the financial deepening process within the frame-
work of the life cycle of economic development.
The logic is developed for the "supply-leading" hypothesis and is
illustrated in Figure III. The positive closed loop outlines the development
promoting nature of financial deepening. Figure IV describes the negative
loops associated with the "demand-pull" hypothesis. Financial repression is
the key to the logic of reversing the direction of causation. If the condi-
tions from the economy, political environment, or social environment rein-
force the propensity for financial repression, then the negative loop can
dominate the development promoting positive loop. The next step is to run
the complete development life cycle system dynamics model, testing for the
sensitivity of each loop.
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