Discuss the role of the financial sector in the growth and development of developing countries

Edexcel A-Level Economics Paper 2 June 2018 Extract

Discuss the role of the financial sector in the growth and development of developing countries. (15 marks)

One way the financial sector can be impactful is through microfinance schemes. Microfinance refers to small loans provided to entrepreneurs who lack access to traditional banking. They work differently to regular loans as they are much more flexible and usually have a more human touch. One example of these schemes is The Grameen Bank Model which involves offering loans to self-selected groups of five, where each member is responsible for covering any other member who fails to pay. Microfinance schemes enable small business owners to grow by giving them funds to increase investment, breaking the savings gap. As capital stock increases, the economy can grow, which can lead to higher incomes and higher savings, allowing for more reinvestment, reinforcing the cycle. Extract B mentions that poor people face 'higher risks of malnutrition' and 'lower chances of receiving key healthcare'. Overall, microfinance schemes can lead to an increase in real GNI per capita and therefore more economic development because higher incomes per person can improve the key indicators of the Human Development Index (HDI).

However, microfinance can be riskier than traditional loans so it will involve higher interest rates. This can put more customers at a higher risk of not being able to afford their repayments, which can lead to defaults. This can make it even harder for customers to borrow in the future, and puts them further at risk of poverty. As customers or groups default, this also increases the risk of a liquidity crisis for the lenders, making microfinance schemes potentially unsustainable.

The second benefit of a strong financial sector is that this facilitates savings. High street banks can accept deposits from some consumers and businesses and lend to others. Extract B mentions 'the goal of eliminating absolute poverty by 2030'. Likewise, countries like Vietnam target that 30% of adults open a savings account by 2030. The amount of saving and borrowing can vary depending on interest rates in the economy, which is the cost of borrowing and reward for saving.The Harrod-Domar model explains how a higher savings ratio enables banks to collect and therefore lend more money. More lending enables firms to increase investment in capital goods, which promotes greater productivity, and therefore more economic growth. As the economy grows, more jobs are created and incomes rise, which further reinforces this cycle. 

However, there is a risk of financial market failure especially if financial markets are not regulated strongly enough. Extract B mentions 'Most economies are struggling to recover from the global financial crisis that started in 2008'. The financial crisis was caused because of risky lending in the form of subprime mortgages. This caused panic and eventually a bank run. Banks became bankrupt and were unable to fulfil their own debts. This eventually led to a financial market failure due to the many interlinkages in the financial system. In a developing country, the risk of this can be especially high as there may be a lack of regulatory bodies. This means that banks may not act in the best interest of consumers, may lend irresponsibly, or may not maintain enough liquidity.

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