FINANCIAL DEVELOPMENT, HUMAN CAPITAL AND POLITICAL Free Essay Example

FINANCIAL DEVELOPMENT, HUMAN CAPITAL AND POLITICAL STABILITY

INTRODUCTION

This paper is to examine the empirical correlation between the level of Financial Development (Independent variable) and Socio-economic variables (Dependent variable) such as Human Capital and Political Stability.

Based on previous literature on the role of Human Capital in Economic Development by Abel and Todd. ( ), it was clearly claimed that there is a positive relationship between Human Capital and Economic Development. The both are directly proportional to each other; weak Human Capital would slow down the Economic Growth.

Joseph Schumpeter (1911) argued that the services provided by financial intermediaries are prerequisite for economic development. More recent theoretical reasoning and empirical evidence suggest a positive and significant relationship between financial development and economic growth. From Empirical analyses, including firm-level studies, industry-level studies, individual country studies and broad cross-country comparison, show a strong positive link between the functioning of the financial system and long-run economic growth.

This study makes use of cross-sectional analysis of 57 developing countries and the focus of this study is wholly on correlations and not causation.

This is unfortunately not possible due to the nature of data used to measure socio-economic variables and particularly human capital or political instability and both variables data are qualitative in nature.

The evidence presented in this study relates to the positive correlation between measures of financial development and measures of human capital development. Surprisingly, there is very little analysis on this particular issue and this empirical work appears to be the first investigation for developing countries.

Literature Reviews on the relationship between Financial Development and Economic Development

The imperative of an effective financial system to economic development was substantiated

by McKinnon (1973) and Shaw (1973) by arguing that an efficient Financial system can achieve growth and development through efficient capital allocation.

Its theoretically clear that financial repression inhibits growth.

However, several doubts have been raised with regard to this approach of liberalization (Laissez-faire) stance on financial development and remove all regulations and controls that create financial repression in the environment of less developed countries (Lucas, 1990) because many developing countries that liberalized their financial markets experienced crises partly because of the external shocks it introduces and can create short-term volatility despite its long-term gains. Also because of market imperfections and information Asymmetries, removing all public financial regulations may not yield an Optimal environment.

Previous researchers connote that the developing countries rather have a Supply-leading causality pattern of development than a Demand-following pattern (Fritz, 1984). Because under Supply-leading finance hypothesis by Cannon and Patrick. The financial intermediaries mediate the flow of financial assets from traditional sector to modern sector and stimulate economic growth through rapidly increasing credit facilities, savings and deposits. But in the case of Demand-following the financial services is in response to the demand for these services by investors and savers in the real economy. Many governments have indeed established new financial institutions under what has been termed a “Supply-leading approach” to financial development and have considered locally incorporated institutions or even state- owned monopolies an essential element of their economic (Baldwin, R.E. 1971)

Levine (1997) highlighted that comparisons of financial structure and economic development using only industrialized countries tend to suggest that financial structure is not at the same level and growth rate of economic development.

Undoubtedly, the financial system is also shaped by non-financial developments. Changes in technology (Merton, 1992), non-financial sector policies like fiscal policies (Bencivenga and Smith, 1991), the legal system (LaPorta et al., 1996)

EMPIRICAL MEASURES OF FINANCIAL DEVELOPMENT

Financial development is generally identified with the growth of the real size of the financial sector and in relation to GDP, i.e. financial deepening (Feldman and Gang, 1990).

Liu and Woo (1994) suggest as a proxy for the degree of financial sophistication the ratio of the long-term to short-term financial assets value. Money supply (M1) is used as the short-term financial assets value. The ratio of broad money to narrow money (M2/M1) should be positively related to a country’s level of financial development. Savings deposits increases more rapidly than transaction balances as the financial system expands. An alternative measure would be the “quasi-liquid liabilities” defined by King and Levine, (1993) as the difference between the broad and narrow money ratio to GDP.

The simplest indicator is the money/GDP ratio, which measures the degree of monetization in the economy. Financial development is generally identified with the growth of the real size of the financial sector and in relation to GDP, i.e. financial deepening (Feldman and Gang, 1990).

The ratio M2/GDP measures the overall size of the financial intermediary sector and is strongly correlated with both the level and the rate of change of the real GDP per capita. On the other hand, M1/GDP is not strongly associated with the level of economic development (King and Levine, 1993).

Broad money M2 is often taken as an adequate measure of the size of the financial sector, as well as because of the lack of data on other financial assets. The economies of scale factors are usually measured by the per capita gross domestic product (GDP). The analysis presented here is based on a cross-section of 57 developing countries for which two proxies of financial development have been calculated over the period 1988-1990

EMPIRICAL MEASURES OF SOCIO-ECONOMIC DEVELOPMENT

Human development is a process of enlarging people’s choice. The most critical ones are to lead to a long and healthy life, to be educated and to enjoy a decent standard of living. Human development is measured by human development index (HDI) – reflecting life expectancy, literacy and command over the resources to enjoy a decent standard of living.

The key component knowledge-literacy figures incorporated in the HDI index are only a crude reflection of access to education. Rapid improvements in basic education have sharply increased the ability of people in developing countries to read and write. Several developing countries have adult literacy rates above 90 per cent, comparable to the rates in industrialized countries. Skilled and well-educated people have generally better access to information and are more likely to behave as less risk adverse people (1980).

A standard approach is to treat human capital, or the average years of schooling of the labour force, as an ordinary input in the production function. The recent work of Mankiw et al. (1992) is in the tradition. Human capital endowment for each country is proxied by the percentage of the labour force with third-degree education (EDUC) as proposed by Baldwin, (1971).

As an alternative Benhabib and Spiegel (1994) propose a measure of human capital accumulation (HCA) to examine cross-country evidence of physical and human capital stocks on the determinants of the capacity of nations to adopt, implement and innovate new technologies.

Socio-political instability is hard to define and measure in an easy way which can be used for econometric work (Venieris and Gupta, 1986). It has been argued by Gupta (1990) that the inclusion of socio-political variables in general and the factors of political violence in particular,

changes the traditional model of economic growth. While investment in human capital is part of the income-increasing force, factors causing political instability, on the other hand, are part of the income-retarding force. The index published in Romer (1993), SPI (1), is used in this study.

Following Barro (1991) he measures political instability as the mean number of revolutions and coups per year. An alternative measure of socio-political instability SPI (2) calculated by Alesina and Perotti (1996) is also tested here. It is, however, available only for 43 countries.

Therefore, in this study the Dependent variable (Financial Development) indicators for measure are M2/M1 and M2/GDP. While the Independent variables (Human capital and Socio-political instability) indicators for measure are HDI, HCA, EDUC, SPI (1) and SPI (2).

EMPIRICAL RESULTS

To assess the strength of the partial correlations we include in the regressions those variables that might be expected to be associated with financial development (Greenwood and Smith, 1997). The results confirm that a significant relationship exists between the level of financial development and the variables associated to the measure of human resources development. However, the results differ slightly depending on the measure adopted in the analysis.

It may be argued that the level of financial development is determined endogenously and belongs to a general interdependent system of simultaneous equations. An alternative approach is to regress the measure of financial development on the GDP per capita, the average inflation rate, the real rate of interest, and a dummy variable associated to a monopolistic market.

There is disagreement in the literature on the actual effects of interest rate policy on savings, and the results depend partly on how real interest rates are estimated (Khatkhate, 1986). The bank discount rate reported for all countries in the International Financial Statistics Survey is used here. To calculate the real rate, the inflation averaged over the period 1987-1990 is subtracted to the current (1990) bank discount rate.

FINDINGS AND CONCLUSION

The main results of the data analysis, based on a cross-sectional analysis of 57 developing

countries, are as follows:

The correlations among the variables show (i) quite high positive correlations between measures of financial development and human capital measures, and (ii) smaller negative correlations between Romer’s measure of political instability and measures of financial development.

The linear regression analysis of measures of financial development on measures of human capital development and political instability confirm that measures of financial development are positively correlated with real GDP per capita and with measures of human capital development and negatively correlated in most cases but not significantly with measures of political instability;

In conclusion, the purpose of this paper is to compare the level of financial development in several

developing countries with different levels of economic development. The view that human resources development can be promoted only at the expense of economic growth poses a false tradeoff. It misstates the purpose of human development and underestimates for example the returns in education which in turn leads to more risk-taking by skilled and well-educated people.