Global Financial Crisis: Lessons for Developing Economies

Part V Stiglitz (1989) posits a cautious approval of the role of financial markets in the development of LDCs. He argues that they have played a limited role even among the well-organised developed countries and that their role within the LDCs is likely to be even more circumscribed. On a similar note Darrat et al. (1989:73) consider the assumption of finance leading growth as “… a considerable flaw and a serious methodological error.” This is consistent with the observation of Greenwood and Jovanovic (1990), who contend that causality probably runs in both directions, further questioning the direction of the causal relationship7. Such contradictions in the role of financial development put in question the financial development strategies designed by many LDCs, most of which are intended to boost the capacity of their financial systems, so as to mobilise savings and ensure their subsequent efficient allocation. If the theory of causality cannot be validated, it would also mean that such countries should consider alternative approaches to boost their growth and as a result, financial development would respond to the needs of financial services by the real sector, and grow accordingly. A study by Demetriades and Hussein (1996) attempted to mitigate limitations inherent in cross-sectional studies. Results of this study indicate evidence of a stronger relationship between indicators of financial development and real GDP per capita in 13 of 16 countries sampled. Two countries in which no evidence of such a relationship was observed were Pakistan and Sri Lanka, where financial development and indeed the degree of monetisation of their economies is rather low (a situation that is attendant in Rwanda) thus conclude that “Evidence obtained provides very little support to the view that finance is the leading sector in the process of economic development. On the other hand, we find evidence that in quite a few countries economic growth systematically causes financial development. On the balance, however, most of the evidence seems to favour the view that the relationship between financial development and economic growth is bi-directional”. ibid 1996:406-7. The findings of this study renders support to the earlier findings in the study by Greenwood and Jovanovic (1990) who earlier observed that the relationship is rather that of cause and effect, and that this can work both ways depending on the level of a particular country’s development (that is, a virtuous cycle). However, results of the study by Demetriades and Hussein (1996) above seem credible given the methodology which mitigated limitations of other cross-country studies highlighted above and, in particular, the fact that it was country specific to a large extent. It specifically questions the ‘lumping’ together of countries in earlier cross-sectional studies, compromising results, which cannot accurately account for any of the countries involved. If this is the case, this study would put to question a number of policies, not only financial, but many others that have been prescribed as solutions to their developmental dilemma on the basis of inconclusive evidence, and in some cases research that lacks consensus and was conducted in different environmental settings, different from that in which it is supposed to be implemented. This concern has at last been acknowledged by the (World Bank, 1993) which when commenting on the ‘East Asian Miracle’, accepted that economic policies are country specific, and that their success depends to a large extent on the effectiveness of the institutions which implement them. The situation, however, remains that, these very institutions outlined by the World Bank are yet to evolve in most LDCs and where they have evolved, they are too weak to implement, let alone design any meaningful policy framework. Ngugi (2002) points out that financial development influences economic growth by increasing the rate of savings channelled into investments and the social marginal productivity of the investments generated. In all, whereas existing literature is unanimous with regard to the role of financial development in economic development nevertheless serious methodological and statistical flaws inherent in the aforementioned studies have failed to establish the casual relationship between financial development and economic development. As such, advancing the theory of economic development on account of financial development, from the perspective of cause and effect, is not academic prudence. Lack of unanimity in the theoretical underpinnings of this relationship is complicated by the fact that the complex process of economic growth, and thus economic development is influenced by many complicated, interrelated and interacting variables, that to decipher and or disentangle which factor influences which, is difficult. Thus, the debate as to whether financial development and economic development have a casual relation is faced with conceptual, as well as empirical problems. Conceptually, economic theory has not proved the existence of such a relationship beyond doubt, neither has there been strong empirical evidence to resolve the same, which has frustrated many models of development put in place in some LDCs, based on evidence from research whose results has been and still remains controversial with regard to such a relationship. Given this scenario, it is no surprise that many LDCs, which have undertaken many prescribed, and sometimes imposed financial reforms, have not made any headway in their economic growth and thus, economic development. The fundamental reason behind such reforms was the assumption that, mobilisation of savings was crucial for their economic growth and putting financial reforms in place would facilitate the mobilisation of savings. As will be argued in chapter five however, such countries did not put in place measures, which would bolster savings, which the intermediation so advocated would then mobilise. Later in chapter five it will be shown that measures such as human capital development with the attendant increase in income per capita, stable monetary and fiscal policies, monetised economy, strong institutional, legal andregulatory systems, as well as stable political systems are all crucial for enhancing savings as they do for growth of the real sector, and that no measure of financial development can hardly substitute these bottom line factors, most of which remain illusive to LDCs. This dissertation will examine the role of the financial system in development of Rwanda and the extent to which the above literature review is relevant to this relationship. The author is a Senior Presidential Advisor on Economic Affairs and can be reached at mnshuti@yahoo.co.uk