Funding Economic Development: A Comparative Study of Financial Sector Reform in Vietnam and China

Thế Du, Huỳnh and Jay K. Rosengard

Scholarly Articles from Harvard Kennedy School of Government

Abstract: Although there is considerable debate among economists as to the impact of financial sector development on economic growth, empirical evidence indicates a strong, direct link between the two. A recent comprehensive review of both the theory and research on this link between financial sector policies and economic development had a clear and unambiguous conclusion on the causal relationship between the two: A growing body of empirical research produces a remarkably consistent narrative: The services provided by the financial system exert a first-order impact on long-run economic growth. Building on work by Bagehot (1873), Schumpeter (1912), Gurley and Shaw (1955), Goldsmith (1969), and McKinnon (1973), recent research has employed different econometric methodologies and data sets in producing three core results. First, countries with better-developed financial systems tend to grow faster. Specifically, countries with (i) large, privately-owned banks that funnel credit to private enterprises and (ii) liquid stock exchanges tend to grow faster than countries with corresponding lower levels of financial development. The level of banking development and stock market liquidity each exerts an independent, positive influence on economic growth. Second, simultaneity bias does not seem to be the cause of this result. Third, better-functioning financial systems ease the external financing constraints that impede firm and industrial expansion. Thus, one channel through which financial development matters for growth is by easing the ability of financially constrained firms to access external capital and expand.3 This rationale might seem a bit puzzling in the context of Vietnam’s remarkable economic performance over the past two decades, with an average annual GDP growth rate of 7.2 percent, a four-fold increase in GDP, and a decline in poverty levels from three-quarters to one-fourth of the population.4 However, this performance could have been even better with a more efficient allocation of capital, for example, achieving GDP growth rates more in the range of China’s 9 to 10 percent per year - 2 percent of GDP per year is a high price to pay for low-return investments.5 Vietnam’s extremely high Incremental Capital Output Ratio (ICOR), rising from 3 to 5 since the early 1990s, well above the ICOR for high-growth economies (see Table 1 below), provides further cause for alarm in the current allocation of capital.

Date: 2009
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Published in Harvard Policy Dialogue Papers: Series on Vietnam’s WTO Accession and International Competitiveness Research

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