Financial Systems and Economic Development

Financial institutions and markets are together called the financial system. This financial system is the backbone of the national economy. This is because the efficiency with which the financial system works plays a very important role in the economic development of a nation.

The role of the financial system may not be apparent since we assume its existence to be a given. However, when we do start paying attention to the financial system, it is easy to see why it plays a foundational role in the economic development of a country.

This article lists down certain examples that explain how financial systems play an important role in the economic development of a nation.

Interest Rates Stabilization: The financial system ensures that all the organizations and institutions which it is composed of, behave as one unified system. Generally, healthy competition is promoted between the members of the system. This means that members have to compete with each other by lowering their costs. As a result, the benefits of lower interest rates are passed on to the consumers.

It is the existence of the financial system, which ensures that interest rates remain stable across the country. The banking system led by a central bank makes this possible. In the absence of a financial system, each region would have its own interest rate based on the availability of capital. However, with the financial system in place, interest rates remain the same across the entire country. As a result, businessmen and entrepreneurs throughout the country are on an equal footing.

Aids Trade and Commerce: Credit risk has always been the main factor that inhibits trade and commerce. If a seller is not sure about whether they will get paid for the goods which they sold, then they will not sell more goods till the earlier payment has been received. This reduces inventory turnaround and leads to a decline in trade and commerce. Financial systems ensure quick and timely payment.

With the advent of advanced technology, it is now possible to remit money to any part of the world within a few seconds. Hence, financial markets and institutions aid in trade and commerce and even improve the gross domestic product of a country.

Aids International Trade: The risks inherent in trade and commerce get multiplied several times when it comes to international trade. This is because firstly, the seller and buyer, are in different legal jurisdictions. Hence, the enforceability of contracts is reduced.

Secondly, the quantity of goods involved in import and export transactions is extremely large. Hence, the outstanding amounts also become large, and this ends up increasing the overall risk in the transaction.

Financial systems play a very important role in the international trade process. This is because importers and exporters generally use banks as an intermediary in the process. The importer deposits money with the bank in the form of a letter of credit. This letter of credit is then paid to the exporter by the bank when goods are received. As a result, neither party has to rely on each other. Instead, both of them can rely on the bank, which has a higher credit rating and therefore aids in the reduction of risk.

Similarly, countries have created special boards for export credit and promotion. These boards provide important services like insurance and payment guarantees in international trade. It would be fair to say that in the absence of financial markets and systems, international trade would be negatively impacted.

Aids in Attracting Capital: Stable financial markets raise investor confidence. As a result, investors from domestic as well as international markets start investing in the capital markets. As a result, more capital becomes available to domestic companies. They can then use this capital to increase economies of scale, which makes them more competitive in the international market. If these financial institutions and markets were not present, foreign investors would find it very difficult to locate investment opportunities and follow through with them.

Aids Infrastructure Development: Financial markets play a vital role in infrastructure development, as well. This is because the private sector may face great difficulties in raising large amounts of funds for projects with a high gestation period.

It is the financial markets that provide the liquidity required by investors. Investors can sell their securities and cash out whenever they want. It is not important for the same investor to hold on to the security for the entire tenure of the loan. Key sectors like power generation, oil, and gas, transport, telecommunication, and railways receive a lot of funding at concessional rates thanks to the financial markets.

Financial markets also allow governments to raise large sums of money. This enables them to continue deficit spending. In the absence of financial markets, governments would not be able to continue deficit spending, which is important to fund infrastructure projects in the short run.

Help in Employment Creation: The financial system provides capital to entrepreneurs who want to start a business. When these businesses come into existence, they, directly and indirectly, require the services of a wide variety of personnel. As a result, a lot of employment is generated in the economy.

The financial services sector provides a lot of employment. Many of these jobs are high paying white-collar positions that are capable of bringing the employed person into the middle class.

To sum it up, financial systems are like the foundation of a building. This is because the financial system is fundamental, and the economy cannot stand without it. However, until everything is working fine, no-one notices the financial system just like the foundation.