Like so many things it is easy to get a taste for, beyond a certain point, financial development brings diminishing returns and rising costs.
Sometimes called financial deepening, deeper markets and better access to financial services can still spur economic growth, especially in emerging markets, but this is not an endless process, according to a new study by the International Monetary Fund.
“Our analysis uncovers evidence of ‘too much finance’ in the sense that beyond a certain level of financial development, the positive effect on economic growth begins to decline, while costs in terms of economic and financial volatility begin to rise,” Ratna Sahay, Martin Cihak and Papa N’Diaye, three of the authors of the study, write.
While many emerging market countries, notably Gambia and Ecuador, can likely still see further financial deepening and get an increasing impact on their economic growth rate, several developed nations such as Japan and the US now look to be on the downslope.
The concept of financial deepening was cited by former US Treasury Secretary Tim Geithner as partial justification for preserving large banks, on the grounds that the US needed institutions which could benefit from what he expected would be huge growth in emerging markets in the consumption of finance.
This study is significant then, in part because it carries the imprimatur of the IMF which has at times in the past shown an enthusiasm for the concept of financial deepening.
It also tends to undermine the argument for big banks, to the extent that, if policy-makers take notice, we should see less, and less fast, development of finance.
Crucially, the study found that strong regulation can work to blunt the negative impact of too much finance, or of too fast a growth in finance.
“The analysis shows that these tradeoffs can be improved by strong institutions and a sound regulatory and supervisory environment. In other words, regulatory reforms can increase the benefits from financial development while reducing the risks,” Sahay, Cihak and N’Diaye write.
The study uses a broader definition of financial deepening than most previous studies, which usually use bank credit.
Instead the IMF looks at the size and liquidity of markets and institutions, access of individuals to services, and measures of efficiency such as capital markets activity.
High cost of volatility
The problem with finance isn’t that it doesn’t accelerate growth, clearly it does. Instead the issue lies with the quality of that growth and the way in which financial over-development can lead to crises and, or, volatile economic growth.
As with investment, so it is with economic growth.
Volatility, especially the kind of steep downturn the world suffered after the great financial crisis in 2008, imposes costs, both in terms of sub-par growth after the fact and in the huge sunk costs from mis-allocations of capital.
One of the interesting findings of the study was that high levels of financial development don’t slow capital accumulation but lead to lower efficiency in investment.
In other words, it isn’t that overly financialized economies have a dearth of money to put to work, but rather that they tend to do a worse job of finding good projects in which to deploy that capital.
Think here of the acres, and probably miles, of granite countertops which went into speculative real estate development, or indeed were put in by owners of houses who were borrowing against their equity. Putting aside the dubious pleasure of granite work surfaces, those were often seen as investments but yielded poor returns.
Similarly, think of all the countertop installers, and construction workers, who gained skills in the housing boom for which they found poor demand afterwards.
The pace at which financial deepening happens is important, with faster growth being linked to GDP and inflation volatility and financial instability.
The study did find that strong institutions, good regulations and strong supervision can help to blunt the negative effects of rampant financialization.
“One of the effects of the global regulatory reforms has been a deleveraging in advanced countries, implicitly confirming that there had been ‘too much finance.’ A complete implementation of these regulatory reforms would augur well for the growth and stability prospects of all countries”, the report said.
For investors, one potentially interesting implication of this study is the relationship between returns and financial deepening. The study did not address this, but it may be that investors should concentrate on the sweet spot of countries which are both allowing financial deepening, regulating it well, and not now encumbered with a too big financial sector.
Two benefits to this strategy seem possible. One it is a way to identify lower volatility economies. And secondly these economies might see better use of capital and higher quality of corporate stewardship, both of which may lead to better returns to investors.
So, Ghana looks worth a look, but perhaps not, on this measure, Japan.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
