CHAPTER 15
Finance and Fiscal Policy for Development
ABSTRACT
The financial system of a country is an important tool for economic development
of the country. It helps in creation of wealth by linking the savings with investments. It
also facilitates the flow of funds from the households (savers) to business firms
(inventors) to aid in wealth creation and development of both the parties. Not only that,
the financial system of a country is concerned with the allocation of savings, provision of
funds, facilitating the financial transactions, developing the financial markets, provision
of legal financial framework and provision of financial and advisory services in the
country. A financial system comprise of financial institutions, financial services, financial
markets and financial instruments. These constituents are closely related and work in
conjunction with each other.
INTRODUCTION
Finance is the elixir that assists in the formation of new businesses, and allows
businesses to take advantage of opportunities to grow, employ local workers and in turn
support other businesses and local, state and federal government through the remittance
of income taxes. The strategic use of financial instruments, such as loans and
investments, is key to the success of every business. Financial trends also define the
state of the economy on a global level, so central banks can plan appropriate monetary
policies. Finance is the process of creating, moving and using money, enabling the flow of
money through a company in much the same way it facilitates global money flow. Money
is created by the sales force when they sell the goods or services the company produces;
it then flows into production where it is spent to manufacture more products to sell.
According to Prof. Robinson, the primary function of a financial system is “to
provide a link between savings and investment for creation of wealth and to permit
portfolio adjustment in the composition of existing wealth”. The financial system plays a
vital role in the economic development of a country. It encourages both savings and
investment and also creates links between savers and investors and also facilitates the
expansion of financial markets and aids in financial deepening and broadening. It aids in
increasing the national output of the country by providing the funds to the corporate
customers to expand their respective business. It helps to promote the development of
weaker section of the society through rural development banks and co-operative
societies. The financial institutions helps the customers to make better financial decisions
by providing effective financial as well as advisory services.
The financial system bridges the gap between savings and investment through
efficient mobilization and allocation of surplus fund and also helps to a business in capital
formation. A financial system is the system that covers financial transactions and the
exchange of money between investors, lender and borrowers. A financial system can be
defined at the global, regional or firm specific level. Financial systems are made of
intricate and complex models that portray financial services, institutions and markets that
link depositors with investors. Through the financial system, backward areas could be
developed by providing various concessions. This ensures a balanced development
throughout the country and this will mitigate political or any other kind of disturbances in
the country. It will also check migration of rural population towards towns and cities. It
aids in the increase in financial assets as a percentage of GDP and increasing the
number of participants in the financial system.
Objectives
1. Examine the difficult road to macroeconomic stability
2. Scrutinize developing country finance system in more detail
3. Investigate stock markets in developing countries and consider its strengths and
weaknesses
4. Examine increasingly prominent role of microfinance in developing countries
5. Probe the rebate over the privatization of state-owned enterprises
15.1 The Role of Finance System in Economic Development
As we all know, financial system is a network of financial institutions, financial
markets, financial instruments and financial services to facilitate the transfer of funds.
The system consists of savers, intermediaries, instruments and the ultimate user of
funds. The level of economic growth largely depends upon and is facilitated by the state
of financial system prevailing in the economy. Efficient financial system and sustainable
economic growth are corollary. The financial system mobilizes the savings and
channelizes them into the productive activity and thus influences the pace of economic
development. Economic growth is hampered for want of effective financial system.
Broadly speaking, financial system deals with three inter-related and interdependent
variables such as money, credit and finance.
On the other hand, there is an evidence that finance can also be a limiting factor
in economic development and the need for finance can be seen everywhere in the
developing world. Hugh Patrick also offers a “stages of development” argument that
financial development causes growth at the start of modern development, but once the
financial system is established, it mainly follows the real sector. Most likely, the causality
runs in both directions.
What is Financial Sector?
The financial sector is a section of the economy made up of firms and institutions that
provide financial services to commercial and retail customers. This sector comprises a
broad range of industries including banks, investment companies, insurance
companies, and real estate firms.
Six Major Function of Financial Sector
1. Providing payment services— payment options are now faster and safer than ever
before. Financial institutions allows us to make cashless payments for goods
and services through cards, mobile phones or the internet. It presents a number
of advantages, including cost and time savings, increased sales and reduced
transaction costs.
2. Matching savers and investors— financial systems bring together savers and
investors, or borrowers, which fuels investment and economic growth. Financial
intermediaries including banks and other financial institutions, accept funds
from savers to make loans to investors. The presence of banks or stock markets can
greatly facilitate matching in an efficient manner where small-scale saver simply deposit
their savings and let the bank decide where to invest.
3. Generating and distributing information— example of this are the stock and bond
prices in the daily newspapers of developing countries that represents the average
judgment of investors based on the information they have available about these
investment. In fact, these informations are one of the most important components of
capital of a bank and it has been said that financial markets represents the “brain” of the
economic system.
4. Allocating credit efficiently— allocational efficiency occurs when organizations in
public and private sectors spend their resources on projects that will be the most
profitable and do the most good for the population, thereby promoting economic growth.
5. Pricing, pooling, and trading risks— exchange of risks is considered here as a
transferable-utility, cooperative game, featuring risk averse players. Like in competitive
equilibrium, a core solution is determined by shadow prices on state-dependent claims.
And like in finance, no risk can properly be priced merely in terms of its marginal
distribution. Pricing rather depends on the pooled risk and on the convolution of
individual preferences.
6. Increasing asset liquidity— one of the services that financial system provides for
savers and borrowers is liquidity, which is the ease with which an asset can be
exchanges for money to purchase other assets or exchanges for goods and services.
Most of the savers view the liquidity as a benefit. If an individual need their assets for
their own consumption and investment, they can just exchange it. Liquid assets allow an
individual or firm to respond quickly to new opportunities or unexpected events. Bonds,
stocks, or checking accounts are created by financial assets, which have more liquid
than cars, machinery and real estate.
Differences between Developed and Developing-Country
Financial Systems
Developed Country Developing Country
Monetary and financial policy is developed Most developing countries have operated
to expand economic activity in times of under a dual monetary system. Also,
unemployment and surplus capacity and to Money supply may be difficult to measure
contract that activity in times of excess and more difficult to control under
demand and inflation. conditions of currency substitutions
The ability of governments to expand and The ability of governments to regulate the
contract their money supply and to national supply of money is constrained by
raise/lower the cost of borrowing in private the openness of their economies.
sector is made possible by existence of Markets and financial institutions are
highly organized, economically highly unorganized, often externally
interdependent, and efficiently functioning dependent, and spatially fragmented.
money and credit markets.
Interest rates are regulated both by Investment decisions are not very
administrative credit controls and by sensitive to interest rate movements.
market forces of supply and demand. There exist a limited information, lack of
transparency, and incomplete credit
markets.
15.2 The Role of Central Banks and Alternative Arrangements
What is central bank?
Central bank is a financial institution given privileged control over the production
and distribution of money and credit for a nation or a group of nations. In modern
economies, the central bank is usually responsible for the formulation of monetary
policy and the regulation of member banks.
Functions of a Full-Fledged Central Bank
1. Issuer of currency and manager of foreign reserves— the central bank is given
the sole monopoly of issuing currency in order to secure control over volume of
currency and credit. These notes circulate throughout the country as legal tender
money. It has to keep a reserve in the form of gold and foreign securities as per
statutory rules against the notes issued by it.
2. Banker to the government— it provides bank deposit and borrowing facilities to the
government while simultaneously acting as the government’s fiscal agent and
underwriter. It also carries out all banking business of the government. Government
keeps their cash balances in the current account with the central bank. Smilarly, central
banks accepts receipts and make payment on behalf of the government.
3. Banker to domestic commercial banks— central bank also provides bank deposit
and borrowing facilities to commercial banks and act as a lender of last resort to
financially troubled commercial banks. It is the custodian of their cash reserves and they
are required to keep certain percentage of their deposits with the central bank.
Whenever banks are short of funds, they can take loans from the central bank and get
their trade bills discounted.
4. Regulator of domestic financial institutions— it ensures that financial institutions
such as commercial banks and others conduct their business in accordance with
relevant laws and regulations. They are also monitoring reserve ratio requirements and
supervise the conduct of local and regional banks.
5. Operator of monetary and credit policy— central bank controls credit and money
supply throughits monetary policy which consist of currency and credit. Central bank
has monopoly of issuing notes and thereby can control the volume of currency.
Currency Boards
A currency board is an extreme form of a pegged exchange rate, in which
management of the exchange rate and the money supply are taken away from the
nation's central bank, if it has one.
Under a currency board, the management of the exchange rate and money
supply are given to a monetary authority that makes decisions about the valuation of a
nation’s currency, specifically whether to peg the exchange rate of the local currency to
a foreign currency, an equal amount of which is held in reserves. Often this monetary
authority has express instructions to back all units of domestic currency in circulation
with foreign currency. In this way a currency board operates not unlike the gold
standard.
Alternatives to Central Banks
1. Transitional central banking— can be formed as intermediate step between a
currency board and a central bank, with the government exerting a strong influence on
its financial activities, however, is checked by statutory limitations on the monetary
authority’s discretionary powers.
2. Supranational central bank— may be created to undertake central banking
activities for a group of smaller countries participating in a monetary union, perhaps also
as part of a customs union. Examples of monetary unions with regional, central banks
include the West African Economic and Monetary Union, and Central African Economic
and Monetary Community, which use separate but equally valued versions of the CFA
franc (African Financial Community).
3. Currency Enclave— might be established between the central banking institution in
a developing country and the monetary authority of a larger trading partner, often the
former colonial power. Such arrangements provides a certain degree of stability to the
developing country's currency, but the dominating influence of the partner, with its own
priorities, renders the enclave almost as dependent as a colony with respect to
monetary policy.
4. Open-economy central banking institution— both commodity and international
capital flows represent significant components of national economic activity, the
monetary environment is likely to be subject to fluctuations in world commodity and
financial markets. As a result, the central banking institution will be engaged primarily in
the regulation and promotion of a stable and respected financial system.
The Role of Development Banking
Development bank is essentially a multi-purpose financial institution with a broad
development outlook. A development bank may, thus, be defined as a financial
institution concerned with providing all types of financial assistance (medium as well as
long term) to business units, in the form of loans, underwriting, investment and
guarantee operations, and promotional activities — economic development in general,
and industrial development, in particular. In short, a development bank is a
development- oriented bank.
Main functions of Development banks would include:
1. It is a specialized financial institution. It provides medium and long term finance to
business units. Unlike commercial banks, it does not accept deposits from the public. It
is not just a term-lending institution. It is a multi-purpose financial institution.
2. It is essentially a development-oriented bank. Its primary object is to promote
economic development by promoting investment and entrepreneurial activity in a
developing economy. It encourages new and small entrepreneurs and seeks balanced
regional growth.
3. It provides financial assistance not only to the private sector but also to the public
sector undertakings. It aims at promoting the saving and investment habit in the
community. Its motive is to serve public interest rather than to make profits. It works in
the general interest of the nation.
