The Role Of Financial System In Economic Development

By: Watsala Shakya

What a Financial System Does?

Every country has its financial system that is a set of banks and financial institutions. Under this category of institutions falls banks, insurance companies, stock exchanges, etc. The financial system plays an important role in the utilization of surplus money by channeling idle funds into investment. In doing so, the financial system creates two parties, the lenders and the borrowers. The lenders are usually households that hold surplus funds, usually the disposable income or savings of households that can be invested in financial instruments issued by businesses and industries in need of funds. The parties that require the funds are the borrowers. In this deal between the lenders and borrows, both the parties gain in return for their participation. The lenders get an investment opportunity from which they can earn interest and dividend. On the other hand, the borrowers are able to operate their businesses and earn profit in return.

For business houses, when determining the sources to raise capital from within the financial system, a business manager has two choices. Should financing be done via central planning or through the market economy, or a combination of the two would also be suitable route to take. While selecting the central planning route, an important factor to consider is that it is structured around the government, which implies that economic decisions of manufacturing and distribution is country specified. On contrary, a market economy provides pricing of good and services that are generally dictated by the aggregate decision of consumers and businesses in the economy, through demand and supply.

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9 Roles of Financial System in Economic Development

Financial system to a county is like coal to flame, it keep the country going and growing. Businesses and industries are financed by financial system which in turn generates growth, employment and domestic as well as international trade. Major roles a financial system has in the development of the economy are:

1. Saving-Investment Relationship

The financial system directs savings to investments efficiently through Banks and Financial Institutions (BFIs). The BFIs provides a route which directs depositors to invest money in return of interest rates that keep depositors interested. The deposits are then directed to various businesses as credit, which are then used to aid production and distribution.

2. Capital Market Growth

Every business requires capital: fixed capital and working capital. Due to this business entities use the financial system to raise funds or capital for their short term or long term requirements. Both types of capital have different roles in the activities of the business. For instance Fixed Capital is used to invest in fixed assets (such as machinery, furniture, vehicles, plant, etc.). Fixed capital is financed through issuing shares and debentures through public or private financial institutions. On the other hand, working capital is used for day to day activities such as purchasing raw materials and everything in between to convert them into finished goods. Working capital is financed through the money market where short term loans can be raised using financial instruments such as bills, promissory notes, among others.

3. Government Securities

The financial system aides the government at times when funds for national project and other activities are required. The state or the central government is able to raise short term and long term funds at lower interest rates. The government issues bonds and bills which provide attractive interest rates to investors, which makes the money market, capital market and the foreign market aid the development of trade, industry and commerce.

4. Foreign Exchange Market

Importers and Exporters are crucial variables in an economy that need funds to make transactions. Foreign exchange market enables BFIs to borrow from and lend to various customers in any currency that is required.  The foreign exchange market or FOREX as some like to call it, also provides an opportunity for BFIs to invest idle funds for short terms enabling profit generation. In this process the bank benefits as well as the government as its foreign exchanges requirements are met.

5. Trade Development

The financial system promotes both domestic and foreign trade. In doing so, financial institutions are able to finance traders in the financial market by helping in discounting financial instrument such as bills. Traders are helped by the financial system as foreign trade is promoted due to pre and post shipment that are financed by commercial banks. Letter of Credit or LOC is also what favors traders, importers to be specific, which allow importers credit when trading.

6. Infrastructure and Growth

The economic development of a country depend on the infrastructure of the country. The stronger the infrastructure, the stronger the economy will be. In absence of infrastructure industries and businesses that fuel the economy will not be able to flourish. The financial system aids in the growth and development of the infrastructure of the economy by providing funds via privates and public sectors.

7. Balanced Economic Growth

Economic development must be balanced so that it is sustainable. If economic growth is not sustainable, it hampers the economy in the long term. Sustainable and continued growth can be attained by instigating growth in all sectors simultaneously. The financial system aids in allocating savings to investments which mobilizes savings into various sectors. The available and sometime idle funds are therefore used leading to productive activities and distribution of growth among industries, agriculture and the service sector.

8. Employment Growth

The financial system generates jobs and employment opportunities in every country. The money market functions to provide working capital to businessmen, which in turn increase production, resulting in a growth of employment opportunities in the economy. As employment in organized and unorganized sectors increase, business and industrial activities also increase leading to increase in various employment opportunities in fields of sales, marketing, advertising, information and technology and so on to match up to the competition in the economy; while financial services such as leasing, factoring, venture capital, etc. will also generate employment.

9. Venture Capitalism

Start-ups are all the rage in the present business world. Innovations and ideas can be found abundantly, but unfortunately, funds are scarce. The lack of sufficient funds to aid the start-ups is a modern problem that is to be solved. As more businesses emerge, more production is possible due to which employment and growth of the country rises. This in turn will aid in the economic development of the country. As venture capital involves more risk it cannot be provided by individual companies, due to which the financial system must be used to mitigate risks. It is only through the financial system that more financial institution will be able to contribute and invest in the promotion of new venture and enable creation in the economy.

From The Author:

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