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Published on: Jul 10, 2024
#Financial Markets
Every country strives for a stable financial situation. Understanding the importance of financial stability is essential. But what is financial stability, and exactly how can one determine such a state?
Key Takeaways
• Financial stability indicates that a country has enough resources, utilities, and jobs for its people.
• Several factors determine an economy's steadiness, including gross domestic product (GDP), inflation, fiscal deficit, which is the difference between the government’s earnings and spending; trade deficit, which is the difference between imports and exports, interest rates, employment rates, income inequality, and the flow of money or cash flow.
• A country with a stable economy can spend more of its money on the needs of its population, including free education, free health care, clean water, affordable transport, and better roads and bridges.
It assures that everything is as it should be, giving a sense of confidence for the future.
Most of the 21st century has been plagued with years of economic unrest. 2008 saw the global financial crisis (GFC) hit us, engulfing most major economies. The COVID-19 virus spread worldwide, leading to a global pandemic-led economic recession during 2020-22. 2023 remained marred with inflation and slow growth rates amid the banking crisis in the US and Europe. Therefore, it is essential that we understand the importance of financial stability.
But what is the state of being financially stable, and exactly how can one determine such a state? This article will explain all the factors that lead to financial stability and the signs to look for.
Financial stability represents the time when the financial system remains resilient and can endure economic shocks and imbalances. It is defined as a financial situation devoid of system-wide episodes of financial crises during which an economy completely collapses.
Image: Financial instability can lower quality of life
While avoiding a financial crisis is impossible, a financially stable system can keep the economy running despite such unfortunate events. Thus, most national economies aim to achieve financial stability for a secure long-term future for their countries.
Some of the defining features of financial stability of an economy include:
• Robust economic system
• Absence of system-wide episodes
• Resilient against economic shocks
• Quick assessment and control of financial volatility
• Relatively stable employment and inflation levels
For example, starting in early 2019, Sri Lanka entered a long period of financial instability due to several factors, such as a foreign exchange crisis, farming policy changes, and corruption. The country's ongoing economic crisis led to unprecedented inflation, shortages of medical supplies, and a downhill in citizens' standard of living.
Here is a concept to better understand financial stability: Several businesses and enterprises exist in any economy. Many of them grow, many turn stagnant, and many collapse. In this way, an economy keeps expanding or contracting over time. A financial system is considered stable when it can run smoothly even when there are volatile developments in the market, such as a sudden collapse of a few large banks or an unprecedented price rally of a few leading stocks.
Large economic participants, such as businesses, families, communities, or regions, are usually more stable and not severely affected by such movements.
• Enterprises can engage in large transactions for business purposes
• Families can still take loans for children’s education or a house
• A community’s benefits are not put to a standstill
• A region’s infrastructure projects do not stall
India is a great example. The country’s economy was not as impacted as other economies during the global financial crisis of 2007 to 2009. South Asia’s biggest economy withstood such a massive global economic shock to some extent because it was relatively insulated from the broader Western economy.
Financial stability is the key to sustainable economic growth, ensuring that an economy runs smoothly and that different participants can fulfil their financial responsibilities and partake in benefits or returns with little difficulty.
The main role of the central banks in most countries, such as the US Federal Reserve and major international monetary institutions, such as the International Monetary Fund (IMF), is to maintain financial stability in the local and global economy. However, such institutions cannot constrain the natural trajectory of the economy in the pursuit of financial stability, as this could lead to highly protectionist policies, violating the principles of a liberal economic agenda.
Financial stability has become a mainstay of most national economies' economic policies since the 1980s. Since then, most economies have witnessed exponential growth but have fallen prey to extremely volatile economic crises. To understand the importance of financial stability, one must look at the costs of financial instability—Sri Lanka is a prominent example.
By 2022, Sri Lanka had accumulated much local and international debt. In April of the same year, the Sri Lankan rupee reached its record low and was the worst-performing currency against the US dollar. Thus, pursuing financial stability is crucial for a healthy economy's growth. Here is why:
• In a financially stable system, the flow of finance runs smoothly among the different intermediaries, such as banks, non-banking financial institutions (NBFIs), enterprises, contractors, salaried individuals etc.
• Employment and labour opportunities remain stable and grow per industry's changing demands in a financially stable economy.
• If a financial system is stable, government expenditure can be dedicated to providing infrastructure, free or subsidised education, healthcare, and critical welfare schemes to empower the less privileged sections of society.
• Growth in production in an economy is synonymous with a financially stable system. Gross domestic product (GDP) is expected to grow at a reasonable rate of 5%—7% per annum.
• Unless decent GDP growth is matched with a similar increase in the living standards of most people, the financial system cannot be said to be stable.
• A high GDP growth rate is often accompanied by rising income inequality, which can lead to systematic failures later. A financially stable economy assists in lessening income inequality in the system.
If a region or country is experiencing volatile economic activity, there is a high chance it could lead to financial instability in the near future. In an increasingly interconnected economy, such conditions are not limited to a particular region, as the crisis can quickly spill over to the connected areas.
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Multiple economic problems have occurred in the 21st century. The global financial crisis in 2008 affected almost all the world's large economies. Then, the COVID-19 pandemic caused an economic recession from 2020 to 2022. The conditions of 2023 were characterised by high inflation and low growth rates, mainly due to the banking crisis in the US and Europe.
Financial stability can usually be seen in an economy with a sound economic structure, less vulnerability to economic disturbances, the ability to manage the risks of financial instability, and reasonable rates of employment and price stability.
Sri Lanka has been experiencing a severe economic crisis since the beginning of 2019 owing to factors such as the forex crisis, shifts in agriculture policies, and corruption. This has resulted in high inflation, scarcity of medical facilities and items, and a generally inferior quality of life.
India, one of the fastest-growing economies in the world, also witnessed the impact of the global financial crisis from 2007 to 2009. Still, India’s economy did not suffer as much as the other economies during this period. This came mainly because the Indian economy was still somewhat disconnected from the general global economy, which was in a deeper crisis.
Financial stability is an important factor that is required for the achievement of economic development. It also ensures the proper movement of funds from one participant, like a bank or a company, to another. It also ensures stability and the continued creation of employment and labour market opportunities. Also, economic growth, as represented by GDP, is more stable and should be around 5%—7% annually, which can positively impact living standards and decrease income disparity.
This article is for informational purposes only and not intended as investment or financial advice. It contains opinions and speculations that are subject to change without notice.
The author and publisher disclaim any liability for decisions made based on the content of this article. Readers are advised to conduct their own research and consult a financial advisor before making investment decisions.
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