It is a long-held view that the more a financial system develops the more the corresponding economy develops. In this school of thought, the role of financial systems in economic development is ancillary. Many empirical studies support this belief. It does follow that as an economy develops there are likely to be more complex and convoluted business relationships. Take for example equity finance for businesses which have developed the simple investment instrument of ordinary shares to a complex arrangement such as redeemable fixed interest debentures. The role of financial systems in economic development is to support the needs of the economic participants in their transactions.
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What is the financial system?
A financial system is a set of institutions, such as banks, insurance companies, and stock exchanges, that permit the exchange of funds. Financial systems exist on firm, regional, and global levels. Borrowers, lenders, and investors exchange current funds to finance projects, either for consumption or productive investments, and to pursue a return on their financial assets. The financial system also includes sets of rules and practices that borrowers and lenders use to decide which projects get financed, who finances projects, and terms of financial deals.
The primary role of financial systems in economic development is to complete the savings-investment relationship. Those with surplus funds will look for a way to use their funds productively but that is not always simple for the majority of people. On the other end of this relationship many individuals, organisations and enterprises have a project they want to undertake but lack the funds to do so. Financial institutions act as intermediaries between the two groups and connect the savings of the surplus group to the investments of the deficit group.
Growth Of Capital Markets
Financial systems include stock exchanges which are financial institutions that connect companies with the public for investment. Stock exchanges are referred to as capital markets because they provide a platform for those seeking capital to those who have it. The role of financial systems in economic development is to grow the capital markets. A larger capital market benefits economic development through improving access to capital, reduced cost of capital and improved investment relationships.
Foreign Exchange Markets
Modern economics is built on international trade and a lot of it. Whether through direct importation or the growth of domestic investment by multinational corporations many cases warrant consistent and sometimes complex foreign exchange dealings. Forward rates and currency swaps are two examples of situations that require foreign exchange markets. The role of financial systems in economic development is to provide foreign exchange markets to meet the needs of economic participants. Such services are provided through banks and Central Banks depending on the rules in the country.
Governments also find themselves in the position of requiring capital at times. There are a variety of options available to governments but the most popular of these are treasury bills and bonds. Treasury bills are short term debt securities with maturities shorter than 365 days while bonds are medium to long term debt securities. These instruments are sold on open markets and have a secondary market that allows holders of these instruments to dispose of them before the maturity of the debt and payback. The role of financial systems in economic development is to provide markets for these instruments that keep them attractive and enable governments to source funds when they need to.
Infrastructure is critical to economic development. Without adequate or appropriate infrastructure economic development can be stalled or halted altogether. The role of financial systems in economic development is to provide funding for infrastructure. Insurance companies are the best example of this. Pension funds to be specific take small payments of premiums monthly from their clientele. They, in turn, invest the money in long term infrastructure projects which will generate income over time and eventually the pension payouts to clients. Insurance companies also invest a lot of money in other businesses including those that develop critical infrastructure to economies such as information communication technology.
We’ve already seen that international trade is an important part of economic development. The role of financial systems in economic development in terms of trade does not start and end with providing foreign exchange markets. Bankers provide many trade-related services to businesses including letters of credit, order finance and invoice financing or factoring. Letters of credit are guarantees from banks to potential suppliers that the buying business has the funds to pay for the items at an agreed date. This allows international suppliers to extend credit to the buyer. Order financing occurs when a business has agreed on an order with a customer and seeks the funding to fulfil the order. The bank or financial institution provides the money to back the order expecting to be paid from the proceeds. Invoice factoring occurs when a financial institution offers to pay an invoice holder money before the maturity of the invoice and collects when the invoice is paid.
Another important role of financial systems in economic development is to support employment growth. Financial systems do not directly grow employment save the people they employ directly which can be many as the financial systems develop. The role of financial systems in economic development is to provide finance and support to those who have ideas that can be turned into businesses and they, in turn, employ people to carry out their visions. Employment growth is a very important measure of economic development in a country. More people employed roughly means the Gross Domestic Product and Gross National Income of a country will also grow.
Venture capital is a type of financing for start-up companies that involves patient capital willing to invest in innovative ideas from the ground up. Venture capitalists are generally willing to wait very long periods for companies to grow and will not demand or expect dividends during the growth phase. Traditional investment has a bias towards medium-term returns through dividend or disposal. The role of financial systems in economic development is to promote funding systems such as venture capital which support important innovative enterprises.
Balanced Economic Growth
The final role of financial systems in economic development we will discuss is balancing the economic growth. By connecting those with surplus money to those with a deficit and allowing more options for people to direct their savings, financial systems give the people and investing institutions the right to decide where the capital should be allocated to. Generally speaking, businesses which are addressing problems faced in economies effectively and efficiently generate high income and therefore high profit. They are therefore able to reward investors and investors are attracted by high returns. The role of financial systems in economic development is to simply offer the platform for net savers to direct their savings to investments of their choice.
The role of financial systems in economic development are many and they work together. They fulfil the savings-investment relationship, facilitate international trade and boost economic growth through business and employment growth. Evidently, financial system development leads to economic development.