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Optimal Financial Structure and Growth: The Indian Perspective

Pradeepta Sethi(, Brajesh Kumar(

Abstract

Financial structure, an assortment of financial markets, intermediaries and banks, varies over time and across countries. An efficient and well-developed financial structure usually fosters long-run economic growth. This paper builds on the above concept of ‘Optimal Financial Structure’ and examines its association with economic development in the Indian context. Specifically, the present paper intends to: (1) examine the evolving importance of banks and markets during the process of economic development in India; (2) evaluate the sensitivities of economic development towards increases in banks and stock markets development; (3) calculate the optimal financial structure for India and its dynamics with economic development; and (4) assess the impact of deviation from the optimal financial structure on the economic growth.

Using quantile regression, the study finds that the services provided by banks are comparatively more important than those provided by the stock markets in the economic growth process of India during the 1989-2009 periods. The results from the robust regression suggest that the financial structure gap has retarded the growth process, and deviation from the optimal structure has harmful effects on the economy. We observe mismatch between the industrial structure and financial structure which can hold the financial system from performing efficiently. The study result is consistent with the view that as economy grow they require different blend of financial services to operate efficiently.

JEL Classifications: O16; G18; G28

Keywords: Financial development, Financial Structure, Economic growth, Principal component analysis, Quantile regression, Robust regression

I. Introduction

Periodic occurrence of financial crisis has once again brought the finance-growth debate to the forefront of academicians, researchers and policy-makers. Over the decades, developing countries have embraced different methods of economic and financial liberalization in order to achieve higher growth rate (Ahmed and Islam, 2009). These measures generally include relaxation of capital control and interest rate barriers, opening up of the financial markets, increasing the availability of credit, integration of equity markets etc. Though, the measures and outcomes of these reforms have varied across countries, majority of the developing countries have now adopted a more market-based structure. India is no exception to this trend. Adopting this, strategy has helped in achieving higher growth rate; but simultaneously it has made the system more prone to systemic instability (Ranciere, Tornell and Westermann 2008; Bekaert, Harvey and Lundblad 2006). This can be pronounced from the ongoing financial and economic crisis. Hence, understanding the relative importance of financial structure[1] and its link with economic growth can provide vital policy implications which will help in strengthening and stabilizing the financial system.

Financial economists for decades have debated about the relative importance of banks and financial markets in a financial system without arriving at any consensus conclusion. Recently, Lin, Sun and Jiang (2009) re-ignited this debate while propounding the “Optimal Financial Structure” theory. According to their theory the demand for most financial services comes from the demands for serving the real economy. Hence, the analysis of financial structure on growth should start from the real economy, but surprisingly this aspect has been neglected in almost all the existing literature. An economy at each stage of its development has a specific endowment structure[2]. Similarly depending on the stages of economic development there exists specific industrial structure. The financial system would perform efficiently when the financial structure matches the industrial structure of...
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