Financial Deepening and Economic Growth in Advanced and Emerging Economies

Keshab Bhattarai

Review of Development Economics, 2015, vol. 19, issue 1, 178-195

Abstract: While over-financing caused crises and slow growth in advanced economies including Germany, France and the UK after 2008, more prudent financial deepening sustained higher economic growth in China and India—two major emerging economies in the world. The actual financial deepening ratios (AFDR) observed in the non-consolidated balance sheet from the OECD exceeded by factors of 3.5, 2.4 and 5.1 the optimal financial deepening ratios (OFDR) obtained from the solutions of dynamic general equilibrium (DGE) models of those three advanced economies. The corresponding factors were 2.3 and 0.49 for China and India respectively. Labor intensive production technology and a low OFDR relative to a high AFDR in China allowed it to grow at 10% between 1990 and 2010 period that ended with the global financial crisis. With a reasonable OFDR and low AFDR India also managed to grow at 6.5%. Thus huge gaps between the optimal and actual financial deepening ratios led to massive macroeconomic consequences as observed after the crises in 2008. Smooth, sustainable and efficient economic growth requires adoption of strategies for separating equilibria in line of Miller–Stiglitz–Roth mechanisms avoiding problems of asymmetric information in the process of financial intermediation with as narrower gaps as possible between the AFDRs and OFDRs.

Date: 2015
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