By Prakash Kumar Shrestha 

Introduction

The financial sector is a crucial macroeconomic sector, intricately interlinked with other major sectors of the economy. It plays a pivotal role in driving economic growth by efficiently allocating resources, facilitating investments, and fostering innovation. The relationship between the financial sector and economic growth has been extensively studied, with a consensus emerging that a well-functioning financial system is critical for sustained economic progress. However, despite these clear benefits, some countries struggle to achieve economic growth due to various structural, institutional, and policy related challenges. This article explores how the financial sector contributes to economic growth, the theories behind this relationship, and why Nepal has struggled to turn financial development into real economic momentum. 

The Nexus Between the Financial Sector and Economic Growth

Economic growth refers to the increase in a country's output of goods and services over time, typically measured by real Gross Domestic Product (GDP) growth. The financial sector encompasses banks, stock markets, insurance companies and other financial institutions that facilitate the mobilization of savings and the allocation of capital. A strong nexus exists between the financial sector and economic growth, evident through several key functions performed by the financial sector. According to Levine (2004), the financial sector contributes to economic growth by fulfilling five crucial functions:

• Producing information ex ante about potential investments and allocating capital efficiently
• Monitoring investments and exerting corporate governance after providing finance
• Facilitating the trading, diversification, and management of risk
• Mobilizing and pooling savings through financial intermediation
• and Easing the exchange of goods and services by providing efficient payment systems.

Let’s briefly explore these functions:

(a) Financial Intermediation:

The financial sector acts as an intermediary, channeling savings from surplus units (like households and businesses) to deficit units (those requiring funds for investment). This process, known as f inancial intermediation, is crucial for economic efficiency. By pooling resources from numerous savers, financial institutions can assess risks more effectively and allocate capital to the most promising investment projects. This efficient allocation of capital enhances productivity, fosters innovation, and drives economic growth. Financial intermediation, in fact, facilitates capital formation, a key driver of economic growth.

(b) Risk Management:

The financial sector offers a range of risk management tools, such as insurance and derivatives, that enable businesses and individuals to mitigate various risks. This risk mitigation promotes stability and encourages entrepreneurship by allowing individuals and businesses to pursue potentially profitable but risky ventures. By diversifying investments across a wide range of assets, financial intermediaries reduce the risk exposure for individual savers and investors. The financial sector actively supports innovative and potentially high-growth but risky projects, which can significantly contribute to economic growth.

(c) Liquidity Provision:

Financial institutions provide liquidity to markets, ensuring that firms and individuals can access funds when needed. This liquidity facilitates smoother economic activity and reduces disruptions in business operations. Financial intermediaries provide liquidity to savers by allowing them to withdraw their funds on demand, while simultaneously providing long term loans to borrowers. The financial sector plays a crucial role in bridging the gap between income receipts and expenditures, smoothing out cash flow fluctuations in the economy.

(d) Facilitating payment mechanism:

Efficient payment systems, including credit and debit cards, electronic transfers, and mobile banking, are essential for both domestic and international trade. These systems streamline transactions, reduce transaction costs, and facilitate specialization within the economy. Specialization, in turn, leads to increased productivity and innovation, driving economic growth.

(e) Information Dissemination and Corporate Governance:

Financial markets play a vital role in gathering and disseminating information about investment opportunities, risks, and the performance of companies. This flow of information improves decision-making for investors and enhances the efficiency of resource allocation. Well-functioning stock markets and active shareholder engagement foster strong corporate governance. By monitoring the performance of companies and exerting pressure on management, shareholders incentivize companies to maximize value, leading to improved efficiency and economic growth.

Empirical Insights and Debates

Numerous empirical studies, including seminal works by King and Levine (1993), Levine and Zervos (1998), Beck and Levine (2004), and Estrada et al. (2010), have consistently demonstrated a positive correlation between financial sector development and economic growth. Countries with deep and efficient financial systems generally exhibit faster growth rates, higher levels of innovation, and lower poverty rates. However, recent literature has challenged this conventional view. Sahay (2015) found that the positive finance-growth link weakens when analyzing data from the post-1990 period.

Furthermore, Aizenman, Jinjarak, and Park (2015), examining sector level data across 41 economies, discovered that the impact of f inance on growth is not linear but rather exhibits a non-linear relationship, increasing initially and then diminishing at higher levels of financial development. This suggests a potential "too much finance" hypothesis, where excessive financial sector development can have detrimental effects. Cecchetti and Kharroubi (2015) provide further support for this notion, highlighting the potential negative consequences of rapid f inancial sector expansion, such as reduced allocative efficiency and a diversion of human capital from the real sector towards the financial sector.

Theoretical Perspectives

There are several economic theories that provide insights into the relationship between the financial sector and economic growth. Some of them are as follows:

1. Schumpeterian Theory of Innovation: Joseph Schumpeter argued that financial intermediaries play a crucial role in fostering economic growth by financing innovation (Demirguc-Kunt & Levine, 2008). Banks and other financial institutions identify and fund innovative projects, enabling technological progress and productivity improvements. According to this theory, financial institutions provide the necessary capital for entrepreneurs to undertake innovative projects, which drive economic growth. Schumpeter argued that financial development is essential for the process of creative destruction, where new and innovative f irms replace outdated ones, leading to economic progress.
2. Endogenous Growth Theory: Endogenous growth theory emphasizes the role of financial development in fostering innovation and technological progress, which are key drivers of long-term economic growth (Demirguc-Kunt & Levine, 2008). According to this theory, financial institutions and markets facilitate the accumulation of human capital, support research and development, and enable the efficient allocation of resources to innovative projects. By reducing information and transaction costs, financial development enhances the productivity of investments and contributes to sustained economic growth.
3. McKinnon-Shaw Hypothesis: McKinnon and Shaw posited that financial repression, characterized by excessive government controls on interest rates and credit allocation, stifles economic growth (Levine, 1996). These interventions can distort financial markets, reduce the efficiency of resource allocation, and limit the availability of credit for productive investments. The theory suggests that liberalizing the financial sector and allowing market forces to operate freely can promote economic growth. They advocated for financial liberalization to promote savings, investment, and efficient resource allocation.
4. Supply-Leading Hypothesis: This theory suggests that f inancial sector development precedes and drives economic growth. By providing the infrastructure for savings and investments, financial development acts as a catalyst for economic expansion. According to this theory, the establishment and expansion of financial institutions and markets precede and stimulate economic development. Financial intermediaries mobilize savings, allocate resources efficiently, and provide the necessary capital for investment, leading to economic growth (Hunjra et al. 2021).
5. Demand-Following Hypothesis: In contrast, this hypothesis argues that economic growth creates demand for financial services, leading to the expansion of the financial sector. In this view, financial development is a consequence rather than a cause of economic growth. According to this theory, as an economy grows, the demand for financial services increases, leading to the development of financial institutions and markets. Economic growth creates new opportunities for investment and savings, which in turn stimulate the expansion of the financial sector (Hunjra et al. 2021).
6. Agency Theory: This theory highlights the role of financial institutions in reducing information asymmetry and agency costs between borrowers and lenders†. By mitigating these inefficiencies, the financial sector promotes more productive investments and accelerates economic growth. Financial intermediaries, such as banks and investment funds, play a crucial role in monitoring and evaluating investment opportunities, thereby reducing information asymmetry and agency costs. The development of financial markets and institutions enhances the ability to manage agency problems. For instance, stock markets provide a platform for shareholders to monitor and influence corporate management through voting rights and the threat of takeover. This oversight helps ensure that companies are managed efficiently, contributing to overall economic growth.
7. Financial Intermediation Theory: This theory emphasizes the role of financial intermediaries in pooling savings, diversifying risks, and lowering transaction costs, which collectively contribute to economic growth. Entrepreneurs and f irms are more likely to invest in new technologies and business ventures when they have access to financing and effective governance structures.

Economic Growth Failures in Nepal: Causes and Solutions

Despite the rapid expansion of the financial sector in Nepal, as evidenced by rising credit-to-GDP, broad money-to-GDP, and market capitalization-to-GDP ratios, economic growth remains sluggish, hovering around 4.0 percent on average even after the f inancial liberalization. While financial sector development has been significant, financial inclusion, particularly in credit and insurance, remains still limited. Furthermore, crucial segments of the financial system, such as the bond market and credit scoring systems, are still underdeveloped.

Several factors contribute to the disconnect between financial sector growth and real economic growth:

1. Limited Financial Access and Literacy: Although some progress has been made, many rural areas still lack access to formal banking services. Low levels of financial literacy further hinder the productive use of financial resources, while a lack of entrepreneurial skills constrains innovation and local economic dynamism.

2. Underdeveloped Capital Markets: Nepal’s stock market remains small and heavily speculative. It has yet to become a meaningful platform for mobilizing capital into productive sectors. The limited participation of companies from the real sector further compounds this problem.

3. Political Instability and Policy Inconsistency: A decade-long civil conflict, frequent changes in government, and overall political instability have disrupted policy continuity and discouraged both domestic and foreign investment. Prolonged electricity shortages in the past also significantly hindered industrial growth.

4. Urban-Centric Credit Allocation: A large share of bank credit is concentrated in urban areas, often flowing into real estate and imports. Meanwhile, critical sectors like agriculture and manufacturing—which are key to inclusive and sustainable growth—remain underfinanced.

5. Infrastructure Deficiencies: Poor transportation networks, unreliable electricity, and limited access to clean water and sanitation increase the cost of doing business. Weak public investment and inefficient budget implementation further worsen these bottlenecks.

6. Subdued Private Investment: Bureaucratic hurdles, regulatory uncertainty, and low investor confidence have limited private sector investment. High financing costs and stringent collateral requirements deter entrepreneurs and stifle innovation.

7. Regulatory and Governance Challenges: Corruption, lack of transparency, weak enforcement of laws, and declining social trust contribute to an unfavorable business environment, ultimately undermining economic development.

Way Forwards to Strengthen the Nexus

Nepal holds vast potential for economic growth through its financial sector if the right strategies are adopted. The following reforms are crucial to strengthening the link between financial sector development and real economic performance:

1. Expand Access: Extend banking and financial services to underserved rural areas through mobile banking, digital platforms, and fintech solutions.

2. Improve Financial Literacy and Entrepreneurship: Launch targeted financial literacy programs and promote entrepreneurship training to empower individuals and small businesses to use financial tools effectively.

3. Redirect Credit to Productive Sectors: Prioritize lending to agriculture, SMEs, manufacturing, tourism, ICT, and export-oriented industries to create jobs and broaden economic activity.

4. Enhance Regulatory Frameworks: Strengthen governance, enforce transparency, and maintain a balance between financial stability and outreach to foster trust in the financial system.

5. Develop Capital Markets: Diversify the stock market by introducing new financial instruments, encouraging private sector listings, and increasing participation from productive sectors.

6. Ensure Efficient Oversight: Improve regulatory oversight to enhance market transparency and ensure smoother financial intermediation processes that channel investment into the real economy.

Conclusion

The relationship between the financial sector and economic growth is multifaceted and dynamic. While theoretical frameworks and global experiences highlight the importance of a robust financial system in promoting innovation, productivity, and inclusive development, Nepal's experience reflects a more complex reality.

Despite expanding financial indicators, structural challenges have prevented the country from translating financial growth into sustained economic progress. Political instability, weak institutions, poor infrastructure, and an urban-centric financial focus have all limited the impact of financial development. Furthermore, recent research suggests that financial sector expansion must be balanced. Over financialization characterized by excessive credit growth and speculation can be just as harmful as financial underdevelopment.

To establish a meaningful link between financial development and economic growth, Nepal must adopt a strategic and targeted approach. This includes:

• Channeling financial resources into productive and innovative sectors

• Identifying niche markets where Nepal holds a competitive advantage

• Investing in human capital, entrepreneurship, and research

The time for a "business-as-usual" approach has passed. For Nepal to realize the full benefits of its financial sector, it must embrace bold reforms, address its unique constraints, and unlock the latent potential within its economy.