Financial Infrastructure and Economic Growth

Let us make in-depth study of the role of financial structure in process of economic growth of a country.

Financial Infrastructure and Economic Growth:

The financial infrastructure has a strong bearing on the process of economic growth.

In fact, it is as imperative for economic growth as a runway for an aero plane to take off. It implies that the growth of financial infrastructure is a precondition for launching the process of economic growth and also for its acceleration.

The term financial infrastructure signifies financial assets (primary securities as well as secondary securities), financial markets (money market and capital market) and financial intermediaries (banks and non-bank financial institutions). Thus the financial assets, financial markets and financial intermediaries are the three ingredients of the financial system of a country.

Though finance is not a substitute for real resources, it has a crucial role in the process of economic growth. It is for this reason that economic growth and growth of financial infrastructure go hand in hand. Schumpeter regarded the banking financial intermediaries as one of the two key agents (the other being entrepreneurship) in the whole process of economic growth.

He held the view that credit- creation by the commercial banking system is a monetary complement of the innovation process in the course of economic growth. Gurlay and Shaw, on the other hand, have considered non-bank financial intermediaries as highly essential to the growth process, because economic growth is accompanied by a process of financial innovation, in which primary securities become differentiated.

It implies that the non-banking financial intermediaries, on the one hand, mobilize funds from surplus-spending units (households) by issuing them their own securities, called secondary securities and, on the other hand, they put funds at the disposal of the deficit-spending units (corporate firms) by acquiring their securities, called primary securities.

The growth of financial infrastructure in an economy embraces within its purview:

(a) The expansion in size and number of specialized financial intermediaries;

(b) The diversification and increase in financial instruments and financial assets; and

(c) The growth of an organised network of supporting financial markets.

Financial Markets:

It needs to be emphasized that financial markets provide mechanism to trade in financial assets, through financial intermediaries. Thus, the financial markets by acting as a link between savers (households) and investors (firms) provide institutional arrangements to facilitate transfer of resources between them. Functionally, financial markets are broadly sub-divided under two heads: money market and capital market.

Money market deals with short term funds, borrowed and lent for working capital to finance current assets. In fact, money market is a short-term credit market. The capital market, on the other hand, deals with long-term funds, demanded and supplied to finance the creation or requisition of fixed assets.

The points of distinctions between money market and capital market can be summed up as follows:

(a) Money Market is a mechanism of the transfer of funds for a short period from surplus-spending units to deficit-spending units, whereas the Capital Market channelizes long-term funds.

(b) In money market, the important financial instruments used are Bills of Exchange, Certificates of Deposits (CDs), Commercial Papers (CP), Inter-Bank Participations (IBPs) and Treasury Bills, whereas in capital market, the important financial instruments in use are shares, bonds, Government Securities and UTI’s units.

(c) In money market, the important sub-markets are Inter-Bank call money market, Treasury bills market, Commercial bills market and Discount and Finance House of India (DFHI), whereas in capital market, the business is transacted through Industrial Securities Market (New Issue Market and Stock Exchange) and Government Securities Market (Gilt-edged Market).

(d) In money market, the main participants are commercial banks, whereas in capital market, the non-bank financial intermediaries are the main transactors.

(e) The money market is regulated by the Reserve Bank of India, whereas the capital market is regulated by the Securities Exchange Board of India (SEBI).

(f) The money market signals trends in liquidity and interest rates, thereby furnishing information for monetary policy formulation and management. In case of Capital Market, the role of monetary policy is indirect through bridge loans that banks provide to the corporate sector and direct through RBI’s open market operations in the gild-edged market.

To sum up, money market and capital market, despite being operative in different spheres, constitute the funds transfer mechanism of the financial infrastructure of a country. Since transfer mechanism is crucial to the process of capital formation and economic development, the growth of financial infrastructure is a necessary condition for economic development.

In view of this, since 1951, the RBI and the Government of India have been pursuing policies to build up a strong financial infrastructure. It may be noted here that the recent measures, on the lines of the recommendations of the Narasimham Committee, to liberalise the financial sector would lead to speedy growth of India’s financial infrastructure.