FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH.

The purpose of this paper is to develop an analytical framework for discussing the link between financial systems and economic growth. Financial systems help overcome an information asymmetry between borrowers and lenders. If they do not function well, economic growth will be negatively affected. Economists have long recognized the importance of the financial system. In the year since the onset of the East Asian crisis we have increasingly heard that the financial system was one of the main causes of the crisis, that the financial system needs to be reformed in order to resolve the crisis, and that we need to pay attention to the effects of other reforms on the financial system. While there is a firm consensus that a well-functioning financial sector is a precondition for the efficient allocation of resources and the exploitation of an economy's growth potential, the economic literature is less consensual on how and to what extent finance affects economic growth. Economic theory suggests that sound and efficient financial systems--banks, equity markets, and bond markets--which channel capital to its most productive uses are beneficial for economic growth. Sound and efficient financial systems are especially important for sustaining growth in developing Asia because efficiency of investment will overshadow quantity of investment as the driver of growth in the region. Overall, our evidence supports the notion that further development of the financial sector matters for sustaining developing Asia‗s growth in the post crisis period. However, the primary role of financial sector development in growth is likely to shift away from mobilizing savings, thus augmenting the quantity of investment toward improving the efficiency of investment, and thereby contributing to higher economy wide productivity. [ABSTRACT FROM AUTHOR]