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September 23, 2019

Financial Deepening and Economic Growth

Financial deepening generally means an increase ratio of money supply to GDP or some price index. It refers to liquid money. The more liquid money is available in an economy, the more opportunities exits for continued growth. Financial deepening theory also defines the positive role of the financial system on economic growth by the size of the sector’s activity. That means that an economy with more intermediary activity is assumed to be doing more to generate efficient allocation. In development studies, financial deepening is very often refers to the increased provision of financial services with a wider choice of services geared to the development of all levels of society. The size of the financial sector is usually measured by two basic quantitative indicators “monetization ratio” and intermediation ratio. Whereas monetization ratio includes money-based indicators or liquid liabilities like broad money supply to GDP ratio, intermediation ratio consists of indicators concerning to bank-based measures like bank credit to the private sector and capital market-based measures such as capitalization ratio of stock market.
Economic growth and development of a country depends on the role of financial deepening. It also simply means an increase in the supply of financial assets in the economy. It can also play an important role in reducing risk and vulnerability for disadvantaged groups and increasing the ability of individuals and households to access basic services like health and education, thus having a more direct impact on poverty education. Financial Deepening is measured by ratio of gross domestic capital formation to GDP, ratio of gross domestic saving to GDP. Some countries especially USA and India have to intensify the financial sector and carry out crucial measures to reinforce the long run relationship between financial deepening and economic growth in order to maintain sustainable economic growth. These measures embrace more financial integration, minimization of government intervention in the financial systems, escalating the status of financial institutions etc. If is recommended that financial system need developed financial markets which may complete its deepening to affect economic growth optimistically. Therefore, the sum of all the measures of financial assets gives us the approximate size of financial deepening. That means that the widest range of such assets as broad money, liabilities of non bank financial intermediaries, treasury bills, value of shares in the stock market, money market funds, etc.., will have to be included in the measure of financial deepening. If the increase in the supply of financial assets is small, it means that the financial deepening in the economy is most likely to be shallow, but if the ratio is big, if means that financial deepening likely to be high. If an increase in the real size of the monetary system will generate opportunity for the profitable operation of other institutions as well via bill dealers to industrial bank and insurance companies.
Supply-leading hypothesis suggests that financial deepening spurs growth. The existence and development of the financial markets brings about a higher level of saving and investment and enhance the efficiency of capital accumulation. This hypothesis contends that well-functioning financial institutions can promote overall economic efficiency create and expand liquidity, mobilize savings, enhance capital accumulation, transfer resources from traditional (non-growth) sectors to the more modern growth inducing sectors and also promote a competent entrepreneur response in these modern sector of the economy. The demand-following view of the development of the financial market is merely a lagged response to economic growth (growth generates demand for financial products). This implies that any early efforts to develop financial markets might lead to a waste of resources which could be allocated to more useful purposes in the early stages of growth. As the economy advance this triggers an increased demand for more financial services and thus leads to greater financial development.
The economist Okoli (2010) examines the relationship between financial deepening and stock market returns and volatility in Nigeriam stock market for the period 1980-2009. The empirical results revealed that financial deepening measured as the ratio of value of stock traded to GDP do not affect the stock market and there is no news about volatility. But financial deepening measured as the ratio of market capitalization to GDP affect the stock market. It indicated that financial deepening reduces the level of risk (volatility) in the stock market. Result also recorded that the conditional volatility of return is slightly persistent. The study employs co-integration and error correction model (ECM) by making Gross Domestic Product as a function of lending rate, exchange rate, inflation rate, financial deepening (M2/GDP) and degree of openness as its financial liberalization indices. The study therefore concludes that financial deepening liberalization has a growth-stimulating effect on the developing countries.
References:
1. Show, Edward, Financial Deepening in Economic Development.
Oxford University Press.
2. Financial Deepening and Economic Growth in Nigeria 1986-2011.
OHWOFASA, Bright Onoriode School of General Studies.

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