There has been renewed focus onfinancial systems, especially in the light of recentliterature that documents a positive and robust relationshipbetween development of financial systems and economicgrowth. Irrespective of how financial development ismeasured, there is a clear causal relationship with percapita income. King and Levine (1993) was the first paperthat examined economic growth for a dataset that spans from1960-1989 and found predictive power of financial systems ingrowth. Another richer dataset from 1960-1995 reinforces theexisting relationship between finance and growth, whiletaking into account the issue of reverse causality (Levine,Loayza and Beck 2000). The idea of reverse causality is thatit is also possible that economic growth may encouragedevelopment of financial systems and these results mayreflect reverse feedback rather than any effect of financeon growth. The authors use the recent discovery that systemswith English common law tend to have deeper financialsystems, to employ legal origins as an effective instrument.Their results rule out the thesis that the relationshipbetween finance and growth is driven by reverse causality.The policy prescription the authors provide is thatdeveloping countries should not attempt to engineer creditexpansion and financial system development. Instead theyshould create an environment conducive for participation ofindividuals in the market system, for financial system todeliver services effectively and functions most required byan economy are provided by finance (World Bank 2001). Anypolicies where government actively seeks to influencefinancial market outcomes are likely to have adverseeffects. The ensuing discussion in this report highlightsthe pervasive negative influence of the government infinance, in most emerging economies. It underscores andpoints out cases of efficiently performing financial systemsin countries where government has limited its involvement todeveloping a sound business environment.
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