1. The Political Economy of Financial Development: A Review

Evidence suggests that there is a two-way causality between financial development and growth (e.g., Calderon & Liu, 2003). The rationale for the causality running from financial development to economic growth is discussed below, and the rationale for the causality running in the other direction is that growth “provides the means to implement costly financial structures” (Greenwood & Jovanovic, 1990: pp. 1076).

The source of information cost is well understood in the context of financial markets. Firm managers typically know more about the project portfolio of the firms than outsider investors. This creates two different problems, namely, the ex ante problem of adverse selection and the ex post problem of moral hazard. In addition, in primary equity markets, some investors may be better informed than other investors, thereby adding another dimension to the information asymmetry problem. In the credit market, the adverse selection problem is overcome using mechanisms such as relationship banking, collateral, credit ratings, and debt covenants, while the moral hazard problem is mitigated using other mechanisms such as a credible threat to liquidate borrowers’ assets in the event of default and/or breach of covenants. In the equity market, the existence of adverse selection can lead to non-issuance of equity by firms or underpricing of equity during IPOs, and, subsequent to issue of equity, external investors mitigate the moral hazard problem using corporate governance mechanisms such as the board of directors. For discussion of these issues, see, for example, Myers and Majluf (1984), Rock (1986), Bhattacharya and Thakor (1993), Rajan and Winton (1995), Boot (2000), Garleanu and Zwiebel (2009), and Oshry, Hermalin, and Weisbach (2010).

Other criticisms include, for example, the presumption about the de facto ability of courts in common law countries to adapt the laws to a changing economic environment. Armour and Lele (2009) use data to demonstrate that in the Indian context, the courts are so overburdened, with a very high volume of pending cases, that the judiciary may not have significant ability to rapidly adapt laws to the changing economic environment.

There has always been considerable interest among economists about political economy of financial crises and government’s regulatory response to these crises, e.g., Haggard (2000), Congleton (2009), Coffee Jr. (2012), and Wolfson and Epstein (2013). However, as we have mentioned above, in this paper, we focus more on the process of financial development that is characterized by greater access to external finance by a wide range of private agents, including nonincumbents.

It is stylized in the legal origin literature that common law countries provide better investor protection than French civil law countries (La Porta et al., 1998).

Financial development is by no means the only sphere of policymaking that is influenced by a country’s political economy. As discussed by Persson and Tabellini (2000), political economy (and the political process that underpins it) influences policies about a wide range of issues such as fiscal policy, provision of public goods, and redistributive policies.

Since firms are able to mitigate the asymmetric information problem in financial markets better with age and size turnover (Berger & Udell, 1998), lending to (or investing in) incumbents is likely to carry less risk than lending to (or investing in) potential entrants. Hence, to the extent that interest rates are positively correlated with risk, an upward limit on interest rates will disproportionately affect the ability of potential entrants to access external finance.

However, liberalizing only trade or only capital flows may not have the desirable impact on financial development. For example, as argued by Rajan and Zingales (2003), in the event of only trade liberalization, incumbent firms experiencing greater import competition may actually see greater financial repression to reduce competition from domestic sources, and incumbent financial institutions may also find strengthening of the relationship-based businesses with incumbent firms less challenging than facing additional competition that may arise from financial development, by way of entry of new financial institutions.

For details about the windows over which the changes in financial development and relative strength of the promoters are computed, refer to Braun and Raddatz (2008).

Arguably, the statutory liquidity requirement (SLR) that Indian banks have to meet is an example of such preemption. Prior to the start of the economic liberalization process in India, in 1991, the SLR for Indian banks was 38.5%, i.e., 38.5% of their deposits in liquid assets, government securities being the dominant form of such assets. For more detailed discussion of initial conditions of the Indian banking sector in 1991 and the changes thereafter, see Bhaumik and Dimova (2004) and Bhaumik and Piesse (2009).

For example, cost of contract enforcement is high in emerging market contexts, and, as a consequence, concentrated ownership structures for firms, often by way of family control, is the optimal way to mitigate agency conflicts between insider managers and outsider investors (Bhaumik & Dimova, 2014; Young, Peng, Ahlstrom, Bruton, & Jiang, 2008). However, where ownership is concentrated in the hands of controlling families, there is significant risk of expropriation of minority shareholders by majority shareholders, and this could reduce the firms’ ability to raise external equity capital.

Available evidence suggests that, prior to 1832, only about 3% of the total population of England had the right to vote, and in Scotland, the proportion of males with suffrage was 2.6% of the population (source: http://​www.​nationalarchives​.​gov.​uk/​pathways/​citizenship/​struggle_​democracy/​getting_​vote.​htm). The first Reform Act of 1832 sought to expand suffrage, but it was extended only to men who occupied property with annual value of £10, which excluded about 60% of males from the voting process. Despite two other Reform Acts, in 1867 and 1884, universal suffrage, which granted voting rights to women, albeit not to those under the age of 30, did not arrive until 1918.

According to the Economist Intelligence Unit’s democracy index, as of 2016, a large number of emerging market economies including Argentina, Brazil, Chile, Colombia, India, Indonesia, Mexico, Peru, and South Africa are (flawed) democracies.

For a discussion of median voter models, see Congleton (2004).

Evidence of such tactical positioning by political agents, albeit at the legislature rather than at the party level, can be found in Cox and McCubbins (1986) and Gerber and Lewis (2004).

Examples of such trade-offs in the context of other policy issues can arguably be found in the trade-off between the expected economic benefits of remaining in the European single market and the ideological benefits of a “hard” Brexit for a section of the UK electorate. Where ideological benefits are certain and immediate, while expected economic benefits lie in the future, the choice may depend on the extent to which the economic benefits are state contingent and the extent to which the contract about ex post rent (or benefit) sharing is incomplete.

It is possible to argue that there is a thin line between this world and the Mexican case discussed earlier in this paper. In the Mexican case, however, there is a distinction between the political elite and the economic elite, such that policy choice is an outcome of bargaining between these two groups. In many emerging market contexts, however, the separating line between these two types of elites is blurred; many powerful politicians (or their families) have strong business interests and, by the same token, people hailing from powerful business families find it in their interests to participate in electoral politics. Further, as noted earlier in the paper, many emerging countries of today are democratic and hence electoral considerations have to be taken into account.

State capture is largely discussed in the context of Central and Eastern Europe (e.g., Hellman, Jones, & Kaufmann, 2003; Innes, 2013), but there is discussion of state capture in other contexts as well (e.g., Auty & Gelb, 2000; Rijkers, Freund, & Nucifora, 2014), with considerably more anecdotal evidence about contexts that are not discussed in the academic literature.

For a theory of regulatory capture, see Laffont and Tirole (1991).