5 The Role of
Financial
Institutions in
Economic-
Development- a
Theoretical Analysis
Basant K. Kapur
NATIONAL UNIVERSITY OF SINGAPORE
The endemic 'fragmentation' of financial markets in less-devel-
oped countries (LDCs) is by now a widely documented fact. 1 The
phenomenon owes its origin primarily to governmental policies which
foster the development of certain 'priority' sectors in the economy
through the liberal provision of highly subsidised bank credit to
them. Since a large portion of the available supply of credit is
absorbed by these sectors, only a limited volume remains available
for allocation to the remaining sectors of the economy, which are
perforce constrained to pay much higher rates of interest on whatever
loans are provided to them. The resultant wide dispersion in interest
rates charged on bank loans, simply on account of differences in the
sectoral allocation of these loans, constitutes the essence of the
phenomenon of financial fragmentation.
Considerable progress has been made in analysing the implications
of such financial policies. There are ample indications that they are
inimical to allocative efficiency and to sustained rapid economic
development. However, it would be of interest to investigate in detail
the precise mechanisms through which such presumptively adverse
effects are generated. For example, one would wish to elucidate the
exact processes through which such policies as changes in bank lend-
ing rates, bank reserve ratios, and the rate of monetary expansion,
83
A. Gutowski et al. (eds.), Financing Problems of Developing Countries
© International Economic Association 1985
84 Domestic Financing
affect the inter-sectoral allocation of resources, as well as relative
prices within the economy, and its rate of growth.
To this end, this paper constructs and examines a two-sector
growth model of a 'typical' financially repressed LDC economy.
Owing to the complexity of the model, we confine ourselves to an
examination of alternative steady-state growth paths, and do not
attempt to characterise the dynamics of the transition from one
steady-state path to another. Nonetheless, manipulation of the model
yields quite a few revealing insights. In Section I the model is
specified and its steady-state equilibrium identified, while in Section II
we examine the effects of various financial policies upon that steady
state. Finally, Section III presents some concluding observations.
I THEMODEL
An adequate formalisation of 'financial dualism' must minimally
allow for two sectors. One is the priority sector charged a low rate of
interest, while the other sector (which represents the rest of the
economy) pays the market-clearing rate. We shall adopt the sugges-
tive and not excessively unrealistic convention of referring to the
privileged enclave as the industrial sector, while terming the other
the agricultural sector. Each sector is assumed to produce its output
using capital and labour inputs, according to a linear-homogeneous
production function:
Q1 = ~(K,, LJ = LJlkr) (1)
QA = FA(KA 'LA)= LAfA(kA) (2)
Here, Q; = level of output of good i; K; and L; are capital and labour
respectively employed in sector i; k; = K;IL;; and [;(k;) = F;(k;, 1)
(i can represent I and A, where subscript I represents the industrial,
and subscript A the agricultural, sector).
The agricultural sector is assumed to be purely competitive. More-
over, in accordance with the well-known Lewis (1954) model, the
economy is assumed to be in labour-surplus, and to face an 'unlim-
ited' supply of labour at a wage rate (w) that is fixed in terms of the
agricultural good. 2 We thus have, for agriculture:
aQA _
- - = fA(kA)- kAf~(kA) = W, (3)
aLA
where the prime denotes differentiation.
