OCR A Level Economics: The financial sector in developing and emerging economies (H460)

This guide follows the OCR A Level Economics (H460) specification, Version 3.0, dated June 2026 and first assessed in 2021. It teaches the topic The financial sector in developing and emerging economies, part of The financial sector in Component 2, Macroeconomics (H460/02). The specification labels no content as AS or Extension. Every country, firm and number below is invented for illustration and is not a real statistic.

Related pages: the revision notes, the practice set, the Macroeconomics overview, the hub for OCR A Level Economics, the printable checklist and the free diagnostics.

What this unit covers

Outcome in the specification	Section
Explain the role of the financial sector in promoting development	1
Explain the role of saving and investment in development, for example with the Harrod-Domar model	2
Explain what is meant by microfinance	3
Evaluate the role of microfinance in supporting development	3
Evaluate how far international financial markets have influenced capital flows into and out of these economies	4
Evaluate the impact of public and private sector debt	5
Explain what is meant by remittances	6
Evaluate the impact and importance of remittances to economies	6
Evaluate the role of the financial sector in promoting development	1 and 7

Money, banks and interest rates, borrowing in advanced economies, and central banks and regulation are separate topics. They appear here only where they explain a point about developing and emerging economies.

1. The role of the financial sector in development

The financial sector is the set of institutions and markets that channel funds from savers to borrowers: banks, credit unions, microfinance lenders, stock and bond markets, insurers and payment systems. In a developing or emerging economy it can promote development through several roles.

• Mobilising saving. Safe places to hold money make saving more attractive than hoarding cash or buying gold.
• Allocating funds to investment. Banks and markets lend to the firms with the best prospects, which raises the productivity of capital.
• Providing credit to households and small firms, so they can buy tools, stock or education.
• Managing risk. Insurance and diversification protect a farmer or firm from a bad harvest or a price fall.
• Payment systems and foreign links. Cheap transfers lower transaction costs, and links abroad let the economy borrow or attract investment.

The sector’s weaknesses limit these roles. Many people are financially excluded: they live far from a branch, lack identity papers or have no collateral. Much lending is informal, at high rates. Banks may lend mainly to the government or to a few large firms. Weak regulation allows crises, which destroy saving and cut real output. Mobile payments cut the cost of access, because an account needs a phone, not a branch.

Chain of reasoning. More accounts and safer deposits raise saving, so more funds are available to lend. Lower borrowing costs raise investment. A higher capital stock raises productive capacity, so potential output grows. Employment and incomes follow. Development is wider than growth, so also ask about who gets the credit and whether people’s health, education and security improve.

2. Saving, investment and the Harrod-Domar model

Saving matters because it finances investment. The Harrod-Domar model links growth to saving:

g = s / k

where g is the growth rate of national income, s is the savings ratio (saving as a proportion of income) and k is the capital-output ratio, the amount of extra capital required for each extra unit of output. A low k means capital is productive. The model assumes that all saving is invested.

Worked example. Country Alpha is an invented economy. Its savings ratio is 12% (0.12) and k = 3.

1. Growth: g = 0.12 / 3 = 0.04, or 4%.
2. Target growth of 6%: the savings ratio needed is s = g × k = 0.06 × 3 = 0.18, or 18%.
3. National income is 200 units. Investment needed = 0.06 × 3 × 200 = 36. Domestic saving = 0.12 × 200 = 24.
4. The savings gap is 36 − 24 = 12 units, which is 6% of national income. Foreign aid, foreign direct investment or borrowing could fill it.
5. A different route is to cut k. If better roads and skills lower k to 2.4, growth is 0.12 / 2.4 = 5% with no extra saving.

So there are two routes: raise s, or lower k. If you want the model to allow for wear and tear, subtract a depreciation rate from g. With 2% depreciation, g in the first step falls from 4% to 2%.

Evaluation of the model

• The assumption that all saving is invested is weak. Money may be held as cash, lent abroad or lost in a crisis.
• Capital is not the only constraint. Skills, institutions, infrastructure and political stability matter too.
• k is not fixed. It changes with technology and with the quality of investment.
• Raising s means cutting consumption now, and growth is not the same as development.

3. Microfinance

Microfinance means financial services, mainly small loans but also savings accounts and insurance, offered to poor people and very small businesses that banks usually exclude. Many lenders use group lending: members guarantee one another, so social pressure replaces collateral. Loans are repaid in frequent small instalments.

Worked example. A bakery owner in an invented village borrows 300 units to buy an oven. The oven adds 20 units of net income a month, which is 240 a year.

• Microfinance lender: a flat 24% a year costs 0.24 × 300 = 72 in interest. Net gain = 240 − 72 = 168.
• Informal moneylender: 10% a month on the original sum costs 0.10 × 300 × 12 = 360 a year, which is 120% a year. Net result = 240 − 360 = −120, a loss.

The loan helps only when the return on the project exceeds the interest rate.

Evaluation

• Benefits: access to credit, investment in micro-enterprises, smoothing of income when shocks hit, empowerment where lenders focus on women, and a route into the formal financial sector.
• Limits: interest rates are often higher than bank rates because small loans are costly to administer. Borrowers can fall into over-indebtedness. Loans are often used for consumption, not production. Tiny firms may not grow, because the market is small.
• Microfinance reaches poverty directly but cannot replace infrastructure, education or jobs. It works best alongside them.
• Judgement: it is useful where there is real demand for small-scale capital and where lenders treat borrowers fairly. It is weaker as a main route to economy-wide development.

4. International financial markets and capital flows

Capital flows into and out of developing and emerging economies in several forms.

Form	What it is	Typical behaviour
Foreign direct investment (FDI)	Buying or building productive assets abroad	Long term, hard to withdraw
Portfolio investment	Buying shares and bonds	Can be sold quickly
Bank lending	Loans from foreign banks	Often reduced fast in a crisis

Why flows move. Pull factors are high expected returns, rapid growth, a stable political system and open markets. Push factors are low interest rates and weak returns in rich economies, and investors’ willingness to take risk. Flows can reverse sharply when interest rates abroad rise or when investors fear a crisis. This is a sudden stop.

Worked example. Country Beta is an invented emerging economy with national income of 500 units.

	Year 1	Year 2
FDI	+15	+14
Portfolio investment	+20	−30
Bank lending	+10	−25
Net flow	+45 (9.0% of income)	−41 (−8.2% of income)

The swing in net flows is −86 units. FDI barely moves; portfolio and bank flows cause the whole reversal. Capital leaving puts downward pressure on the currency. Suppose firms owe 40 units of foreign currency and the exchange rate moves from 2 to 3 local units per unit of foreign currency. The local-currency cost of the debt rises from 80 to 120, a rise of 50%. Higher interest rates may be needed to hold investors, which cuts investment.

Evaluation of how far markets have influenced flows

• Global conditions are strong drivers, so the influence is large, especially for portfolio flows.
• Domestic factors still matter: institutions, policy credibility and growth prospects decide which economies attract funds.
• Inflows bring finance, technology (through FDI) and deeper markets. They can also fuel asset bubbles, appreciate the currency and add to external debt.
• Economies with large reserves, flexible exchange rates and little foreign-currency borrowing cope better. Some use controls on short-term flows.

5. Public and private sector debt

Public sector debt is owed by the government and state bodies. Private sector debt is owed by households and firms. Debt can be domestic or external, and external debt may be in foreign currency. Useful measures are the debt-to-GDP ratio, the debt service ratio (repayments of principal and interest as a share of export earnings) and interest payments as a share of government revenue.

Worked example. Country Gamma has public debt of 60 units and national income of 100, a ratio of 60%. The interest rate is 6% and nominal growth is 3%. Government revenue is 20.

• Interest = 0.06 × 60 = 3.6, which is 18% of revenue.
• With no primary surplus, next year’s debt is 60 × 1.06 = 63.6 and income is 103. The ratio is 63.6 / 103 = 61.7%.
• The ratio rises when the interest rate exceeds growth. Holding it at 60% needs a primary surplus of about 1.8% of current income (1.8 units).
• If export earnings are 120 and debt repayments are 18, the debt service ratio is 15%.

Impact

• Borrowing can finance infrastructure and smooth shocks, if the return exceeds the cost.
• Heavy debt service crowds out spending on health, education and infrastructure. It may force tax rises or cuts, and may deter investors.
• Foreign-currency debt exposes the country to depreciation (see section 4).
• Private debt can threaten the banking system. If banks fail, the government may step in, turning private debt into public debt.
• Debt relief can free resources, but may raise future borrowing costs.
• Judgement: debt is a problem when its cost exceeds the growth it creates, so the key questions are what was financed, in which currency and on what terms.

6. Remittances

Remittances are money sent home by migrants working abroad. They are a transfer, not a payment for goods or services.

Worked example. Country Delta is an invented economy. National income is 400 units, remittances are 36 and exports are 120.

• Remittances are 36 / 400 = 9% of national income and 36 / 120 = 30% of export earnings.
• A fee of 7% on a transfer of 200 costs 14 and leaves 186. At 3% the fee is 6 and 194 arrives.
• Suppose the multiplier is 1 / 0.6 = 1.67, since the marginal propensity to withdraw is 0.6. Remittances of 36 could raise output by about 60.

Evaluation

• Benefits: they lift recipients’ income, may fund education, health and small businesses, support the balance of payments and are often steadier than portfolio flows.
• Costs: a large inflow can appreciate the currency and hurt exporters. Recipients may depend on them, and the emigration of skilled workers (brain drain) removes human capital. Fees are high on small transfers. Remittances can fall in a downturn abroad.
• Importance varies. They matter most where they are a large share of national income and reach poor households.

7. Evaluating the financial sector’s role

Judge the sector on three questions. Does it mobilise and allocate saving well? Does it reach the poor and small firms? Is it stable? Deeper finance helps development only when institutions are sound and credit goes to productive uses.

Common errors

• Writing Harrod-Domar as s × k instead of s / k.
• Calling every capital inflow good, or every outflow bad.
• Using the debt-to-GDP ratio alone, without the interest rate and growth rate.
• Treating remittances as payment for exports.
• Listing benefits of microfinance with no judgement about its limits.

Official syllabus

This guide follows the OCR A Level in Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021, published by OCR (Oxford Cambridge and RSA Examinations).