Financial Sector Reform and Its Impact on Investment and Economic Growth: An Econometric Approach

The financial sector is central to economic development as it serves the role of intermediary by mobilising savings and subsequently allocating credit for productive activities. However, in many developing countries including Pakistan, administered interest rate, domestic credit controls, high reserve requirements, use of captive banking system to finance large budgetary requirements of the government and controls on international capital inflows have remained the main features of the monetary policy. These repressive policies had their repercussions in the form of excess liquidity with the banking system, disintermediation of cash flows, segmentation of financial markets, underdeveloped money and capital markets, etc. [McKinnon (1973) and Shaw (1973)], therefore, argued that low interest rate ceilings unduly restrict the real flow of loanable funds, thus depressing the quantity of productive investment. Financial liberalisation, on the other hand, is defined as policy measures designed to deregulate certain operations of the financial system and transform its structure with a view to achieving a liberalised market oriented system with an appropriate regulatory framework. The financial sector reforms would lead to increase in loanable funds by attracting more household savings to bank deposits due to higher interest rates. This, in turn, would result in greater investment and faster economic growth.