In the theoretical literature on financial liberalisation and growth three types of views are available. First, Joseph Schumpeter argued that the services provided by financial intermediaries, encourage economic development through channelling society's funds to the most innovating entrepreneurs. Goldsmith defined the positive link between financial development and economic activity.
Hicks stated that industrialisation needs funds for long-term capital investment. These funds are available through a developed financial system. McKinnon and Shaw presented the concept of financial liberalisation, enhancing growth. Further, the New Growth theories of Romer, Barro, Japelli and Pagano explained that the presence of financial markets enabled savers to hold such assets, making liquid funds available for long-term investment. Industrialisation could not occur without this liquidity transformation. According to this view, financial system offered financial services that are crucial for economic growth.
The second view states that finance is relatively less important for economic growth. Robinson argues that economic growth leads to financial development. Lewis observed that financial markets expand as a result of economic growth. Lucas stated that physical capital, human capital and technological change are the only factors, influencing economic growth. According to this view, the real sector increases the demand for various financial services, which is met by the financial sector. This view proposes that financial development simply pursues economic growth.
The third view departs yet further to argue that financial development could have a potential negative impact on growth. Van Wijnbergen and Buffie stated that financial development can have no impact or indeed a negative impact on economic growth. As the formal financial system develops, funds move from the controlled market to the formal market.
Due to the restrain (reserve requirement) in formal markets all the funds cannot advance. This reduces domestic credit supply, giving rise to a credit crunch which can retard economic growth by lowering investment and slowing production. Stiglitz stated that certain forms of financial repression can have a positive effect, for example, improving the average quality of loan applicants by lowering the interest rate; increasing firm equity by lowering the price of capital and accelerating growth if credit is targeted towards profitable sectors such as exports or sectors with technological spillovers.
Pakistan started to liberalise the financial sector in the late 1980s on the advice of the World Bank (WB) and the International Monetary Fund (IMF). The main aim of these reforms was to increase economic growth through an increase in capital productivity, lowering the cost of intermediation through competition, increase efficiency and the saving rate.
In a recent study, we have tried to explore the impact of financial liberalisation on industrial sector growth by computing a financial liberalisation index for the first time for Pakistan by using eleven policy measures, ie. Islamization; interest rate deregulation; credit controls; stock market reforms; prudential regulations; privatisation of financial institutions; removal of entry barriers; non-performing loans; external account liberalisation; debt management reforms and open market operations.
Principal component method was used for deriving weights for aggregating the policy variables into an aggregate index denoted by FLI, which shows that 1990-96 was the time period when most liberalisation measures were undertaken by Pakistani policy-makers.
We used Phillips and Perron's unit root test in order to determine that the data do not suffer from econometric problems that would lead to a spurious correlation and the Autoregressive Distributed Lag Model (ARDL) to determine the long-run and short-run relationship between the variables, as proposed by Pesaran et al. The technique is state of the art and has many econometric advantages in comparison to other co-integration procedures. The most important of these is that the problem of endogeneity is avoided.
The annual time series data during 1971-2007 is taken from the Hand Book of Statistics on Pakistan's Economy, Monthly Statistical Bulletin published by the State Bank of Pakistan (SBP) and various issue of the Pakistan Economic Survey. Gross domestic product and gross fixed capital formation in industrial sector are measured in millions of rupees. Industrial sector labour force is in million of numbers. The real interest rate is defined as nominal deposit rate (r) minus the inflation rate.
Empirical results indicate that the financial liberalisation index and the real interest rate are negatively (statistically significant) associated with industrial growth, while labour and capital are positively associated with economic growth in accordance with the postulates of growth theory. In the short-run, the financial liberalisation index and the real interest rate, both show a robustly positive (statistically significant) relationship with economic growth lending support to McKinnon and Shaw, etc. But financial liberalisation impedes economic growth in the long run confirming the post Keynesian and Structuralist views. The study recommends further research on developing a financial liberalisation model that is consistent with growth and stability.
(The writers are Head and Visiting Faculty, respectively, Economics Department, College of Business Management (CBM), IOBM, Karachi.)