Economic Growth and Financial Sector Development in India

Abstract

ABSTRACT: The Indian Economy has witnessed rapid developments in the past two decades, and has thus emerged as one of the fastest growing and most active economies in the Asian region. This has been made possible due to the reforms undertaken by various governments over the past seven decades. The soundness of an economy depends on various structural factors. A well developed financial system is one of those factors. The present Indian financial system has its roots in the British system. It is also very closely integrated with the global economy.

The financial system acts as an enabler that links the savings and investments in the economy. Idle funds are channelled towards productive uses which yield higher rates of return. It is therefore important to study financial development, savings, investment and economic growth. The literature on economic thought highlights this issue. The types of studies have changed, from descriptive to analytical, to evolved empirical works. The results of these empirical works clearly indicate that the magnitude and causality of the relationship between finance and growth still remains questionable. Many prominent economists have debated over this question. Subsequently, there have been different explanations, such as the demand-following, supplyleading, feedback and independent hypotheses. Each explanation has a separate rationale. The empirical literature reveals that factors like the variables, time period, region, econometric procedure etc. have a major impact on the results of the analysis. Hence, there exists a gap in the literature – relationships change as the scope of the study changes.

With this background, the present study investigates the crucial relationship between finance and growth in the Indian context. The study is conducted at the country and state level, using time series data. The main research objective of this study is to check for the simultaneous relationships between financial development, savings, investment and growth.

First, the study introduces the financial system of India. Next, the concepts of savings, investment, growth and financial development are discussed, along with the various factors which account for financial development. Key empirical works on these variables and their relationships have been summarised in the review of literature section. These variables are subsequently used in the empirical analysis of this study.

The empirical technique used is discussed in the chapter on methodology. The simultaneous relationships between the above mentioned set of variables are checked. Apart from these variables, the study also uses variables such as the real deposit rate, the real lending rate and per capita income as exogenous variables. The usage of endogenous and exogenous variables is also explained in that chapter.

The empirical analysis is divided into two sections. First, the study uses annual data at the national level, from 1972 to 2012. Second, the study uses annual data for fifteen major states of India, from 1993 to 2009. Data is analysed by using correlation analysis and tests of causality. The technique of simultaneous equations is used to arrive at estimates. The common theme observed for most states is that per capita income and savings are major determinants of financial development. Further, interest rate liberalisation also assists in the process. Per capita income, real deposit rates and financial development are major factors that affect savings. Investments are predominantly determined by savings and the real lending rate. Economic growth is not directly caused by either investments or finance. However, the literature states that the connection may not be direct. Therefore, it is not surprising that such results are observed.

The study hence attempts to develop a model of finance and growth, for national and state level data. It aims to contribute to the literature on the finance-growth nexus. The results will be useful to researchers, academicians, policy makers and students in this field. Further research in this area can be conducted in terms of a longer time period, more variables included in the index of financial development, and longer time period estimates of savings and investments at the state level.