Although financial development is good for long-term growth, not all countries pursue policies that render full financial development. This paper builds on an extensive political economy literature to construct a theoretical model showing that the intensity of opposition to financial development by incumbents depends on both their degree of credit dependency and the role of governments in credit markets. Empirical evidence for this claim is provided, and the results suggest that lower opposition to financial development leads to an effective increase in credit markets’ development only in those countries that have high government capabilities. Moreover, improvements in government capabilities have a significant impact on credit market development only in those countries where credit dependency is high (thus, opposition is low). This paper therefore contributes to this rich literature by providing a unified account of credit market development that includes two of its main determinants, traditionally considered in isolation.
Financial development, defined as the existence of deep and stable credit markets in an economy, is good for economic growth (Levine, 2005). An economy without credit cannot move forward (Levine, 1997, Levine and Zervos, 1998, Rajan and Zingales, 1998, Beck et al., 2000b and Levine et al., 2000). At the most basic level, credit is the mechanism through which savers connect to borrowers, enabling firms to carry out investment projects that are the basis for the process of capital accumulation. But credit does not only foster economic growth through investment. It also promotes productivity growth in a number of ways: by helping firms sustain long gestation periods when developing new technologies or processes (Aghion et al., 2005); by fostering a better allocation of resources across firms and economic sectors (Bencivenga et al., 1995, Jeong and Townsend, 2007, Buera and Shin, 2009 and Arizala et al., 2009), and by reducing the incidence of informality, understood as lack of firm or worker registration, or tax evasion and social security registration avoidance (Catão et al., 2009). Finally, access to finance allows firms to cope better with macroeconomic volatility (Cavallo et al., 2009).
Politics matter for financial development. Otherwise, if countries were managed by benevolent social planners, they would have all moved towards full financial development. Greater access to credit has important implications for the development of an economy, as it allows firms to enter markets and grow, and the resources move to the most productive activities. However, while financial development increases overall welfare in the long run, it also affects the distribution of rents in the short run. Incumbents may see their profit margins shrink, countries may face a higher probability of a negative shock, and governments may lose some of their sources of revenue. The combination of interest groups that try to safeguard their rents and governments that vie for political survival may prove lethal for financial development; this paper proves that point.
