Holdings: An Empirical Reassessment of the Relationship Between Finance and Growth
Abstract. The relationship between financial development and economic growth has Growth-finance nexus: Empirical evidence from India. .. This leads to better credit assessment, punishing the less efficient ones and rewarding the. An Empirical Reassessment of the Relationship Between Finance and Growth. This paper reexamines the empirical relationship between financial development . “Financial development, property rights, and growth”, Journal of Finance, 58, pp. “An empirical reassessment of the relationship between finance and growth”.
Section 2 provides a theoretical basis, Section 3 offers a brief review of the literature. Section 4 provides the methodology used in this study, outlining the conceptual model, hypotheses and empirical methodology. Section 5 discusses the empirical results and Section 6 provides the policy implications of the empirical results and concluding remarks. Romer initially started a set of theoretical and empirical analyses focusing on the endogeneity of the growth process as compared to Solow-type neoclassical growth models Solow,which used an aggregate function approach and endogenous technical changes Roller and Waverman, Numerous papers since then have attempted to disentangle the elements of a national economy that create the economic growth see, for instance, Aghion and Howitt, The factors that determine economic growth can be grouped into three different types: This paper examines the impact of ICT infrastructure and financial development on per capita economic growth.
ICT-finance-growth nexus: Empirical evidence from the Next countries | Cuadernos de Economía
We cover some key economies namely, the Next countries. Over recent decades, these policymakers in most of these countries have devoted considerable effort to developing their financial markets and ICT sectors to elevate their economic growth. Some of these efforts have included investment expansion, financial regulation, as well as improvements in the ICT infrastructure inter alia. Therefore, our study formally investigates whether the development of ICT and financial sectors can be causal factors of growth for these countries and whether they also cause each other.
The balance of this section highlights the possible theoretical links between these variables. ICT infrastructure is generally recognized as an important factor in determining economic growth. There are three reasons why this may be the case: However, with the elevated role of ICT infrastructure, the issue of duality matters in the phases of economic growth Dutta, That means there is the possibility of bidirectional causal relationships between ICT infrastructure and economic growth.
Analogously, financial development can be considered as an important factor in determining economic growth. The degree to which financial market activities are pervasive in a country is believed to be largely a function of five factors: Again with the increasing importance of financial development, the issue of duality also matters in the phases of economic growth.
That means there is possibility of bidirectional causality between financial development and economic growth see Levine et al.
Finally, ICT infrastructure can be considered as an important factor for financial development. ICT generally allows expansion and access to financial services of the economy. It reduces transaction costs, especially the costs of running physical financial institution branches. Additionally, the increasing use of ICT services especially mobile banking has contributed to the emergence of branchless financial services, thereby improving financial inclusion in particular and financial development in general.
In sum, ICT provides better information flows, particularly with reference to improving access to credit and deposit facilities, and can allow efficient allocation of credit, facilitate financial transfers, and boost financial development Andrianaivo and Kpodar, Yet again with the increasing importance of ICT development, the issue of duality also matters here in the phases of financial development.
That means there is possibility of bidirectional causality between ICT infrastructure and financial development Pradhan et al. Our paper is directly related to these two stands of the literature. There are four schools of thought in the ICT-growth literature. Also, it includes time dummies in order to account for time- specific effects which are not reported in the regression results.
Now we can rewrite the above equation 2.
The transformed model takes the following form: Since the new error term Asa is by definition correlated with the lagged dependent variable, Ayjyt-i, one should use instrumental variables. The GMM approach uses all available lags of the dependent and the exogenous variables to form an optimal instrumental variable matrix.
Thus dynamic panel GMM technique could address potential endogeneity in the data. Since persistent in the explanatory variables may adversely affect the small sample and asymptotic properties of the difference estimator Blundell and Bond, ; Bond et al. Cross-Country and Panel Results 4. Table 1 demonstrates the basic result of cross-country regressions using several financial development indexes.
We test both average values of financial development indicators and initial values, considering that the regression using average value would be faced with more serious endogeneity problems Arestis and Demetriades, ; Arestis et al, When we use ; 32; Finance and Economic Growth: Financial Development and Growth Dependent Variable: Equation 3 Equation 4 IG — 0.
This result is robust even when we use initial values of all independent variables as KL report, as illustrated in Table 2. The contribution of financial development to economic growth is robust to inclusion of more control variables such as regional dummies. In general, our study demonstrates that initial financial development, causes long-run economic growth even after taking account of other factors important to growth and addressing possible en- dogeneity problems.
In order to address simultaneity bias in finance-growth regression, some recent researchers such as LLB use LLSV measure of legal origin as instrumental variable for financial develop- ; 33; 34 The Ritsumeikan Economic Review Vol. Equation 4 IG However, when we include this instrumental variable in our cross-country regression using 2SLS Two Stage Least Squarefinancial variables become insignificant in Table 3.
This 4 result opposes the finding of LLB while it supports Favara's result. Next, we test whether there is a non-linear effect of financial development on economic growth.
Some may think that financial development becomes more helpful as countries de- velop from very poor state due to the development of institutions however the benefit grows less in highly developed countries due to a decrease of marginal benefit. Then, there might be the inverted "U" relationship between financial development and growth. Our result in Table 4 finds this relationship where we use the quadratic term of private credit as a financial development index.
This result is robust to the inclusion of other control variables. One may argue that the finance-growth nexus as such varies across contexts. For instance, financial development can spur economic growth more in countries where other markets are more developed or institutional quality is higher with better financial regulation.
In addition, macroeconomic stability such as lower inflation and government consumption could be impor- tant conditions for financial development to stimulate growth more. We add interaction terms of the financial development index and other condition variables including the institutional variable, the level of GDP, and also inflation and government consumption so as to test this hypothesis.
An Empirical Reassessment of the Relationship Between Finance and Growth
The following Table 5 demonstrates results using the average value of private credit and ; 35; 36 The Ritsumeikan Economic Review Vol. Equation 4 IG — 0. The result appears to be opposite to conventional 6 arguments. The coefficients of interaction terms are significantly negative when the initial level of growth and educational attainment, and institutional variables are used as condition variables.
This suggests that the contribution of financial development to economic growth becomes lesser in countries where institutions are more developed and education is better and the GDP is higher.
It may be understandable if the growth impact of finance is larger in developing countries and lesser in already developed countries. This must be associated with our finding that the investment channel is much more significant rather than the productivity channel and investment is crucial for growth in developing countries. When we divide coun- tries into 3 subgroups according to the income level, again we find that the benefit of finan- ; se; Finance and Economic Growth: Equation 6 IG — 0. Inflation and openness are not relevant as conditions, while more government spending seems to be bad to the growth effect of financial development.
We have also examined if the benefit financial development conditional on precondition variables shows a non-linear relationship with conditions, as Klein argues in the case of financial opening Klein, The interaction variable of financial development and quadratic ; 37; 38 The Ritsumeikan Economic Review Vol. Financial Development and Investment Dependent Variable: As to channels from financial development to economic growth, many emphasize invest- ment and investment efficiency altogether.
IMF Working Papers
Financially developed countries must have higher investment since those economies can utilize more financial sources, and productivity should be higher in more financially developed countries since the capital allocation should be more efficient. We investigate this using the investment rate and productivity regressions. First, the following Table 6 reports that financial development indicators including all 3 measures have a positive impact on the ratio of investment to GDP though we report the result using private credit only.
The result is robust to inclusion of other control variables before we take account of regional differences. When we use the growth rate of capital stock ; ss; Finance and Economic Growth: In addition to the investment ratio, some may well expect that financial development promote the productivity of the whole economy.
In order to test this, we use several proxies for productivity including one used by Hall and Jones though it is a level variable for one year, and the average of output-capital ratio, though this depends on data availability from Penn World table. Different from the case of investment, there is no evidence that financial development promotes productivity in any case. Therefore we may conclude that the growth effect of financial development is mainly through the investment channel, and this would be one reason why the benefit of financial development is larger in developing coun- tries that crucially need more investment for growth.
We use the average value of financial development for each 5-year periods and test similar specification used in the former section. First, Table 8 reports the basic specification for economic growth using 5-year average values, using private credit. The coefficients of control variables including initial GDP, educa- tional attainment and institutions are with correct signs and high significance.
We find that the benefit of financial development is not important in general. In almost all cases, the coefficient is not significant. Only when we use the simple LSDV least square dummy variable method assuming fixed effects in the simplest equation the coefficient of financial develop- ment is statistically significant.
This result is same in regressions using other indexes. Our result suggests that financial development does not have short-term benefits to econo- mic growth, though in the long-run it may promote growth as we present in the former section.
Favara reports the similar result that the panel regression does not support the hypothesis that financial development spurs economic growth. While some studies including Beck, Levine and Loayza argue that the growth effect of financial development is clear in panel estimations, other studies such as Khan and SenhadjiTrabelsidemons- trate the coefficient of financial indicators in panel estimations are not statistically significant.
The commonly used 5-year average may capture the short-run relationship only, sometimes affected by economic cycles. It may take a long time for finance to exert a beneficial effect on economic growth though it is not important in long run.
It is indeed interesting that we find that the coefficient of financial development changes statistically significant when we use year averages. Not only using the regression using the private credit variable, but also that using M2 and M3 measure for financial development demonstrates the same result.
This and the result of cross-country regression assert that there is rather a long run relationship be- ; 39; 40 The Ritsumeikan Economic Review Vol. We also test whether there is an inverted-U relationship with financial development and growth in panel regressions, however we do not find it.
Rioja and Valev reports that when they divide countries into 3 categories by the level of financial development they find ; 40; Finance and Economic Growth: Doornik, This version may be used for academic research and teaching only" growth effects of financial development on in countries with middle level of financial develop- ment using panel regressions.
It is not the case of our regressions using the same method. When we either use the quadratic form or group countries into some subgroups we do not find any non-linear relationship in panel regressions. Turning to preconditions in panel specifications, again we do not find significant results using any financial variables, though not reported. Besides, the regression for the investment rate using panel regressions does not find that financial development promotes investment in the short run.
In sum, panel regressions show mixed results about the positive impact of financial development on growth. Conclusions The empirical results in this paper using more samples and long time periods confirm that there exist the positive and statistically significant long-run relationship between average financial development and economic growth in general in the cross-sectional analysis.
The same results have been found using initial values of financial development, which supports the argument that this finance-growth relationship is hardly a byproduct of endogeneity problem. However, using LLSV measures of legal origin as instrumental variable for financial development indicator, we do not find any significant relation, different from other studies.Role of Financial System in Economic Development (Management of Financial Services), Gurukpo
We also find that there is an inverted "U" relationship between finance and growth when we use private credit measure for financial development. The benefit of financial development is the clearest in countries with middle financial development in comparison with financially underdeveloped and highly developed countries.
Concerning preconditions, financial develop- ment promotes growth further in countries where the level of growth, institutional develop- ment and educational attainment are lower. We find that the lesser government consumption the larger the benefit of financial development. Finally, cross-country regressions exhibits that financial development spurs mainly investment but not productivity.
However, none of the financial development indicators demonstrates any significant relation with growth when the growth equations are estimated with 5-year averaged dynamic panel regressions.