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Gaps, cracks and lacunae: The finance and growth nexus in low-income countries

Financial development and growth have long been linked. This column argues that there remain fundamental lacunae in our understanding of the finance-growth nexus. Three main areas for future research are identified: aid, institutions and technology.

Are quantitative and qualitative improvements in financial markets, institutions, instruments, and intermediaries positively and closely associated to the processes of economic growth and development? Does finance cause growth? Once upon a time, economists were deeply divided on these issues. Until about 1990, when endogenous growth gained prominence, there were few economists (notably Joseph Schumpeter) that believed financial development drove growth. The Schumpeterian view is that growth is driven by innovation and innovation is driven by credit. Without finance there is no growth. Joan Robinson (and most economists until the early 1990s) thought instead that finance followed growth. Growth is driven by the accumulation of factors of production (capital, labour, human capital) and by technological progress.

What drives technological progress is of course the question that defines the scholarship on endogenous growth. One of the various answers is finance. This literature has developed models examining the various mechanisms through which financial development may affect per capita GDP growth and technological change. It has constructed extensive datasets that helped to document the many facets of financial development and inclusion. And, last but not least, it has put forward a voluminous body of econometric evidence arguing for a causal and positive effect of finance on growth (cf. Beck 2013, and references therein).

Finance-growth nexus: State of play

Financial instruments, markets, and institutions arise to ameliorate the effects of information, enforcement, and transactions costs. How efficiently the financial system is able to reduce these costs has enormous and widespread effects on savings and investment decisions, on the pace of technological innovation, and ultimately on per capita GDP and productivity growth rates. Financial systems work by producing and disseminating information about investments projects and allocating resources accordingly, by monitoring these investments, and by managing and diversifying their risks. Furthermore, financial systems mobilise savings and ease exchange.

The metrics of financial development have traditionally focused on depth, often proxied by narrow money (M1) over GDP or credit to the private sector over GDP. Data are now available for various other important dimensions (such as access, stability and efficiency.) Despite severe data availability issues (especially regarding low-income countries), these more recent efforts unveil a more detailed (but still worrisome) picture. Low-income countries’ financial systems are internationally comparable mostly regarding stability. As for depth, low-income countries’ financial systems are about a fourth (half) of those in high (lower-middle) income countries, while in terms of efficiency these ratios are half and two-thirds and regarding access a tenth and a quarter, respectively. Such aggregate measures show that depth is far from the only important issue for low-income countries, with efficiency and access being even more pressing issues (Figures 1 and 2).

Figure 1. Financial institutions (average circa 2010)

Source: Data from Cihak et al. (2013)

Figure 2. Financial markets (average circa 2010)

Source: Data from Cihak et al. (2013)

The empirical literature on finance and growth is supported by cross-country growth regressions, time-series analyses, panel-data studies, industry and firm-level studies, and historical evidence. One important message is that the relationship between finance and growth seems to be causal and unidirectional, from finance to growth. Five recent findings are worth mentioning. One is that the long-run effect of finance on growth is indeed positive and dominates the short-term effect that tends to be negative. This was first uncovered on a cross-country setting by Kaminsky and Schmukler (2003) and Loayza and Ranciere (2006) (see Campos et al. 2012 for within-country evidence.) The second is that the relationship may be non-linear. Beyond a certain threshold (calculated to be above 100% of GDP) finance is associated with negative growth (Berkes et al. 2012). A noteworthy third finding refers to distribution. Who gets credit matters. Household credit seems to have little growth payoffs, while private sector credit has large growth payoffs (see Beck, 2013, and references therein). Fourth, financial development reduces income inequality and exerts a disproportionally positive impact on the bottom quintile. One may think finance is pro-growth and pro-rich but evidence only supports the former (Beck et al. 2007). Fifth and finally, different financial liberalisation policies have contrasting effects on income inequality. For instance, Delis et al. (forthcoming) reports that capital stringency and supervisory power regulation lower inequality, while market discipline and activity restrictions may exacerbate it.

Given these recent findings, how can one say there are gaps? How can one talk about cracks and fundamental lacunae? One reason is that when it comes to the poorer countries we still do not have enough high-quality data and, hence, we still lack sufficient rigorous analysis. Filling this gap is important (Rousseau and D’Onofrio 2013.) It is important for poorer countries for obvious reasons. Effective development policy reform is difficult enough with uncertainty, but it is almost impossible with ignorance. But filling this gap also matters for the literature on finance and growth. Filling this gap means having a more complete view of this relationship because it will throw further light on this relation at lower levels of per capita income. It also means further opportunities to test non-linearities (Law et al. 2013) and exploit contexts and circumstances that may offer a more detailed view on whether and how finance drives growth. In light of the still relatively small size of low-income countries’ financial systems, answering how financial development can be triggered in the poorest countries will, as growth ensues, help to distil and refine the lessons from the literature on the finance-growth causal nexus.

Future directions

We delineate three areas for future research. They are about international, institutions and technology aspects. These are conceived in addition to issues that arise naturally when focusing on the lowest income countries such as how does financial development emerges, what structure of the financial system is more conducive to growth (e.g. what is the potential role of public banks), and deeper insurance and risk aspects (Clarke and Dercon 2009.)

The first area focuses on international finance. This is one that has been somewhat neglected in the scholarship of finance and growth in poorer countries, yet international capital flows have a crucial role to play. We need a more detailed and overarching picture of the actions and possibilities offered by international actors (public and private) and the various sources of capital flows. The role of private capital flows needs to be further studied in low-income countries, in terms of portfolio investment, cross-border banking, remittances and foreign direct investment (particularly if financial development is an important pre-condition for poorer countries). More effort should go into understanding the role of foreign aid (and of the donor community in general) in shoring up financial development in poorer countries. How does foreign aid flows interact with private capital flows? Does the type of foreign aid matters (e.g. technical assistance versus budget support, bilateral or multilateral, official or from private foundations)? Does foreign aid play a part in changing the structure of domestic financial systems in poorer countries (microfinance and informality)? What should donors do?

The second important area for future research refers to institutions. Although economists have struggled to reach agreement on precisely which institutions may be central, historians have long privileged financial institutions. In this light one can envisage three main related research avenues. One investigates the relationship between financial institutions in fragile states, focusing in particular on how finance connects economic and political elites. The second stresses efforts to carry out financial liberalisation, structural reforms, or policy more generally, and how these efforts have been fostered or undermined by the domestic financial system. The third concerns the micro-macro link. This may prove crucial to understand the key constraints to financial development in low-income countries. How do banks in low-income countries function? How are loan officers performing? Which firms receive credit? What can we tell from research on the returns to lending across different types of borrowers?

The final area refers to technology. It highlights the specificities of financial sector policy in economies that are not diversified (in particular, those reliant on natural resources). The most common reasons presented for the low levels of financial development observed in poorer countries are low savings and population density. This is where new technologies are having a great impact. Mobile banking has spread very fast in low-income countries. How do these new forms of banking interact with more traditional ones? How can foreigners (donors, banks and firms) play a truly developmental role? Is it worthwhile to think of ways of relating these new forms of banking to more traditional government activities, for instance, cash transfers programs or salary payments?

We believe these three areas for future research (focusing on international, institutions and technology aspects) may not only further the literature on the finance-growth nexus, but create important benefits for low income countries themselves.

Note: The views expressed in this column are those of the authors and do not represent those of the institutions with which they are affiliated. This column reflects on-going background work for an upcoming Research Call from DFID (Economic Growth Team) and is part of the consultation process underpinning this work.


Beck, Thorsten, Asli Demirguc-Kunt and Ross Levine (2007), “Finance, Inequality, and the Poor,” Journal of Economic Growth 12, 27-49.

Beck, Thorsten (2013), “Finance for Development: A Research Agenda,” ESRC-DFID DEGRP Research report (at www.degrp.sqsp.com)

Berkes, Enrico, Ugo Panizza and Jean-Louis Arcand (2012), “Too much finance?” International Monetary Fund Working Paper 12/161

Campos, Nauro, Menelaos Karanasos and Bin Tan (2012), “Two to Tangle: Financial Development, Political Instability and Economic Growth in Argentina since 1890,” Journal of Banking and Finance, 36 (1): 290- 304.

Cihak, Martin, Asli Demirgüč-Kunt, Erik Feyen and Ross Levine (2013), “Financial Development in 205 Economies, 1960 to 2010,” NBER Working Paper No.18946.

Clarke, Daniel and Stefan Dercon (2009), “Insurance, Credit and Safety Nets for the Poor in a World of Risk,” United Nations, Department of Economics and Social Affairs, WP 81.

Delis, Manthos, Iftekhar Hasan and Pantelis Kazakis (forthcoming), “Bank Regulations and Income Inequality: Empirical Evidence,” Review of Finance.

Kaminsky, G. and S. Schmukler (2003), “Short-Run Pain, Long-run Gain: The Effects of Financial Liberalization,” NBER Working Paper No. 9787.

Law, Siong, W. Azman-Saini and Mansor Ibrahim, (2013), “Institutional quality thresholds and the finance-growth nexus,” Journal of Banking and Finance 37: 5373–5381.

Loayza, Norman and Romain Ranciere (2006), “Financial Development, Financial Fragility, and Growth", Journal of Money Credit and Banking, 38(4):1051-1076.

Rousseau, Peter and D’Onofrio, Alexandra (2013), “Monetization, Financial Development, and Growth: Time Series Evidence from 22 Countries in Sub-Saharan Africa,” World Development 51, 132-53.

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