Relationship between financial development and economic growth panel data analysis of 22 developing countries

To investigate the causal relationship between financial development and economic growth in twenty two developing countries in different regions from 1990 to 2011, we apply both Generali

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY THE HAGUE

VIETNAM THE NETHERLANDS

VIETNAM - NETHERLANDS

RELATIONSHIP BETWEEN FINANCIAL

DEVELOPMENT AND ECONOMIC GROWTH:

PANEL DATA ANALYSIS OF

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY THE HAGUE

VIETNAM THE NETHERLANDS

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

RELATIONSHIP BETWEEN FINANCIAL

DEVELOPMENT AND ECONOMIC GROWTH:

PANEL DATA ANALYSIS OF

22 DEVELOPING COUNTRIES

A thesis submitted in partial fulfillment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

i CERTIFICATION

I hereby confirm that this thesis, namely “the Relationship between Financial

Development and Economic Growth: a panel data analysis of 22 Developing countries” is my own work The work has not, in whole or part, been presented

elsewhere for assessment Where material has been used from other sources it has been

properly acknowledged and referenced If this statement is untrue I understand that I

will have committed an assessment offence

I have read the Regulations of Vietnam – Netherlands Programme for M.A In

Development Economics and I am aware of the potential consequences of any breach

of them

Signature:

Name: Trần Thị Thu Thủy

Date: Ho Chi Minh City, October 2014

ii ACKNOWLEDGEMENT

I would like to express my gratitude to Dr Nguyen Minh Duc, the academic

supervisor, for his very carefully reading and editing of my thesis His valuable

comments and suggestions help me to improve the quality of this thesis throughout my

thesis stage Thank to his valuable lectures, guidance and encouragement, I can fully

complete this thesis

I also would like to extend my thanks to Dr Truong Dang Thuy, other professors,

tutors and course co-instructors of Economics University who, through their valuable

lectures, tutorials and advices, help me during the courses and my study process

Finally, many special thanks and gratefulness are given to my family, my classmates of

MDE course 18 and to a number of individuals for their encouragement in many ways

that strongly support me during my thesis stage

iii

CONTENTS

Certifications……… i

Acknowledment ii

Contents……… iii

List of tables……… iv

List of figures v

Abstract……… vi

CHAPTER 1: INTRODUCTION 1

1.1 Research problem 1

1.2 Research objectives and research questions 4

1.2.1 Research objectives 4

1.2.2 Research questions 4

1.3 Thesis Structure 5

CHAPTER 2: LITERATURE REVIEW 7

2.1 Theoretical concepts related to economic growth and financial development 7

2.2 Financial development and economic growth: theoretical literatures 7

2.3 Literature review and empirical studies 19

2.3.1 Theoretical framework on the relationship between economic growth and financial development 19

2.3.2 Empirical studies on financial development and economic growth relationship 22

CHAPTER 3: METHODOLOGY 32

3.1 General methods 32

3.1.1 Conceptual framework for the study 32

3.2 Research models and econometric methodology 36

3.3 Data 45

3.3.1 Determinants measuring financial development 46

3.3.2 Determinants measuring economic growth 47

3.4 Research process 50

CHAPTER 4: ESTIMATION RESULT ANALYSIS AND DISCUSSION 52

4.1 Brief information on the dataset 52

4.2 Regression results and discussion 55

4.2.1 Impact of economic growth on financial development 55

4.2.2 Impact of financial development on economic growth 59

CHAPTER 5: CONCLUSION AND IMPLICATION 64

5.1 Conclusion 64

5.2 Policy implications for Vietnam 66

5.2.1 An overview of the relationship between financial development and economic growth in Vietnam 66

5.2.2 Policy implications for Vietnam 73

5.3 Limitations and future research 75

5.3.1 Limitations 75

5.3.2 Suggestion for future research 76

APPENDIX Appendix A……… 78

Appendix B……….79

Appendix C……….84

REFERENCES……….………95

iv LIST OF TABLES:

Table 1: Summary of empirical studies……….… 27

Table 2: Expected signs of variables……… 34

Table 3: Variable Description……… 37

Table 4: Summary of Variables………49

Table 5: Descriptive statistics and correlations for selected variables……… 53

Table 6: GMM estimation of Economic Growth and Financial Development………… ……56

Table 7: Regression Results of Economic Growth and Financial Development……… 61

v LIST OF FIGURES

Figure 1: The relationship between financial development and

economic growth……… 32 Figure 2: Diagram of the main results……… 66 Figure 3: Gross domestic savings in Vietnam

and in Asean countries……… 68 Figure 4: Annual GDP per capita in Vietnam

and in Asean countries……… 70 Figure 5: Gross domestic saving rates in Vietnam and in Asean countries……….71 Figure 6: Annual growth of domestic credits in Vietnam……… 72

and in Asean countries

Figure 7: Annual growth of Broad Money supply in Vietnam……… 73

and Asean countries

vi ABSTRACT:

In recent years, many researchers have taken into account the causal connection between financial development and economic growth due to the important role of financial development in the process of achieving the higher economic growth

To investigate the causal relationship between financial development and economic growth in twenty two developing countries in different regions from 1990 to 2011, we apply both Generalized method of moment with instrumental variable approach and Ordinary least square technique to examine how determinants of financial development impact on economic growth and how the determinants of economic growth contribute

to develop finance system We find that there is a two-way positive impact between financial development and economic growth in selected developing countries We also find that the variable components such as the ratio of broad money to GDP, the ratio of credit offered by bank to private sector to GDP, the ratio of gross domestic savings to GDP and the ratio of domestic credit to the private sector to GDP play an important role in explaining financial development Furthermore, foreign direct investment, general government consumption and trade openness are important factors in accounting for growth rate of GDP per capita We find out that the EXPORT is significantly negative impact on economic growth This result is consistent with the argument that export specialization in developing countries may not benefit the economic growth

Finally, taking the advantage of positive relationship between financial and economic development in developing countries, it is suggested that Vietnam needs to strengthen its financial system in the context of the integration into the world economy Vietnam should provide the right incentives to promote the financial sector that will enable it to have high economic growth

CHAPTER 1: INTRODUCTION

1.1 Research problem

In recent years, the causal relationship between financial development and economic growth has been attracting a lot of attentions in the economic literatures It is believed that financial development plays a significant role in the process of economic growth (Feng Lu & Yao, 2009; Fung, 2009; Fase & Abma, 2003; Ang & McKibbin, 2007; Calderón & Liu, 2003) The financial development enhances economic growth through capital allocation efficiency The capital allocation efficiency can be enhanced by performing the functions of financial intermediaries, including the improvement of risk management and the reduction of asymmetric information, as well as encouragement of saving and investment This leads to the result in the improvement

in total factor productivity Therefore, a well-functioning financial system may foster economic growth (Hao, 2006; Odhiambo, 2004; Ghirmay, 2004)

There are numerous empirical studies providing supportive evidences on positive linkage between financial development and economic growth (Fung, 2009; Anwar & Nguyen, 2011; Ang, 2009; Jalil & Feridun, 2011; Habibullah & Eng, 2006; Chen Hao, 2006; Khalifa Al-Yousif, 2002) For instance, the causal relationship between financial development and economic growth has been investigated by using Vector Auto Regression (VAR) approach for analyzing panel data of 109 industrial and developing countries for a period of 1960-1994 in the study of Calderón and Liu (2003) The authors found that financial development positively affects economic growth and economic growth positively affects financial development The authors also admitted that the financial development impacts on economic growth through channels of a rapid capital accumulation and productivity growth They further concluded that the impact of financial development on economic growth should be well recognized in providing the appropriate and meaningful implications for policy makers, which will

enable them to obtain a higher economic growth and development (Calderón and Liu, 2003)

Habibullah and Eng (2006) investigated the causal relationship between financial development and economic growth in 13 Asian less developed countries with observations from 1990 to 1998 The authors concluded that financial development enhances economic growth They also agreed that a developed financial system will create more financial instruments These instruments improve the capital accumulation

in term of mobilizing savings, improving investment efficiency and increasing the total factor productivity (Habibullah & Eng, 2006)

Furthermore, by employing Granger causality test within the error correction model, Al-Yousif (2002) investigated the financial development and economic growth relationship in thirty developing countries The author found that the unhealthy system

of finance negatively impacts on growth in real GDP The negative impact is due to inefficient allocation of savings and investment during the 1980s (Al-Yousif, 2002) This means that there is a same direction movement on the relationship between financial development and economic growth

However, the causal relationship between financial development and economic growth

is still unclear in some findings from previous studies This causal relationship becomes a highly debatable issue in the literatures (Fung, 2009; Calderón & Liu, 2003; Levine et al., 2000; Chen Hao, 2006; Hassan et al., 2011; Khalifa Al-Yousif, 2002) For example, in the study of financial development and economic growth, Hassan et al., (2011) investigated the connection between the financial depth and economic growth from different imcome groups of countries The selected countries include countries with low income, countries with middle income, and countries with upper - middle and high income The period is observed from 1980 to 2007 The findings indicate that the financial development weakly facilitates short term economic

Therefore, this thesis aims at re-examining the causal finance and growth relationship

by employing econometric techniques, which measure of financial depth and economic growth The econometric techniques are widely used in many empirical literatures A new dataset is used in attempting to provide further evidence on the causal impact of financial development on economic growth The sample countries are twenty two developing countries These countries are selected in different regions The observation period is from 1990 to 2011 The sample developing countries includes Malaysia, China, Indonesia, Sri Lanka, Turkey, Egypt, Jordan, Pakistan, Tunisia, Bulgaria, Bolivia, Chile, Mexico, Benin, Cameroon, Thailand, Philippines, Peru, Brazil, Paraguay, Vietnam, Singapore The dataset is collected from data sources of the World Development Indicators (WDI) from World Bank database

The selection of twenty two developing countries over period 1990-2011 has several reasons:

- The first is the fact that the financial development has a significant impact on the economic growth in the developed countries Meanwhile, the impact of financial development on the economic growth is weak in developing countries (Khalifa Al-Yousif, 2002; Masten et al., 2008; Calderón and Liu, 2003; Habibullah and Eng, 2006; Fase and Abma, 2003) Therefore, this research focus on investigating the causal relationship between financial development and economic growth in the

developing countries

- The second is that the choice of sampled developing countries has an advantage in

providing policy implications (Hassan et al., 2011)

- The third reason is that annual panel data set of twenty two developing countries over period 1990-2011 allows us not only to focus on examining the two way impacts of finance-growth relationship in long run, but also to have enough observations to effectively run econometric analysis for purpose in line with the objective of this research

Finally, this research aims at providing a thorough look at the causality of financial development on economic growth and vice versa In this research thesis, we formulate

a growth equation with components of financial development, which is widely used in many empirical literatures

To gain more from the findings of this research, we will make an overview of the relationship between financial development and economic growth in Vietnam in comparison between the analysis results of Vietnam and other developing countries, especially, selected Asian developing countries (i.e Indonesia, Malaysia, Philippines, Thailand, China, Singapore) in the period from 1990 to 2011

Furthermore, taking advantage of the positive interaction between financial development and economic growth, this research is expected to provide appropriate policy implications to Vietnamese policy makers for promoting financial development that will enable Vietnam to have higher economic growth

1.2 Research objectives and research questions

1.2.1 Research objectives

This research mainly focuses on the following objectives:

- Examining the causal relationship between financial development and economic growth in twenty two developing countries from different regions for the period of

1990 to 2011

- Providing appropriate policy implications to Vietnamese policy makers for promoting financial development that will enable Vietnam to have higher economic growth

1.2.2 Research questions

As above mentioned, we attempt to address the investigation of the causal relation between financial development and economic growth as the main issues in this research Therefore, the questions should be raised as follows:

- How does development of financial sector contribute to causal relationships?

1.3 Thesis Structure

This thesis is divided into five chapters

Chapter 1: Introduction explains what causal relationship between financial

development and economic growth is and scientific literatures related to the problem to

be investigated It also presents different point of views on the relationship between financial development and economic growth from numerous empirical studies Finally,

it explains why twenty two developing countries are selected, what main objectives are, what research questions should be raised in this thesis

Chapter 2: Literature review provides a review of economic theories relating to the

causal relationship between financial development and economic growth This part describes theoretical framework and empirical studies related to the issue The determinants of economic growth and financial development are mentioned in this part

Chapter 3: Methodology is concerned with general methods and how to examine

causal relationship between financial development and economic growth, which mainly involves following points:

- analytical framework for the problem to be investigated

- research hypotheses to be tested

- variables or factors to be described to answer each research question

- panel dataset and sample to be used to examine the causal finance-growth relationship

- method and technique to be used for processing and analyzing information

- estimated regression models to be applied to test hypothesis and answer research questions

Chapter 4: Estimation Analysis and Findings focuses on analyzing the estimation

results and result interpretation on how the economic growth effect on development of finance system and vice versa

Chapter 5: Conclusions and Implications comes to the main findings of the research

This part is expected to make an overview of the relationship between financial development and economic growth in Vietnam in comparison between the results of Vietnam and other developing countries, especially, asian developing countries (i.e Indonesia, Malaysia, Philippines, Thailand, China, Singapore) which having the same financial characteristics as Vietnam

Furthermore, taking advantage of the positive interaction between financial development and economic growth in developing countries, this research is expected to provide appropriate policy implications to Vietnamese policy makers for promoting financial development that will enable Vietnam to have higher economic growth

CHAPTER 2: LITERATURE REVIEW

2.1 Theoretical concepts related to economic growth and financial development Definition

Financial development

Financial development is defined that (Kunt and Levine 2008, p 4-5):

“Financial development occurs when financial instruments, market, and intermediaries ameliorates- though do not necessarily eliminate- the effects of information, enforcement, and transaction costs and therefore do a correspondingly better job at providing the five financial functions.”

The five main functions of financial system are mobilizing savings, allocating financial resources, assessing and managing risks, monitoring businesses and facilitating goods and services movement (Kunt and Levine, 2008, p.4-5)

Economic growth

Economic growth is defined that (Perkins et al., 2006, p 12):

“A rise in national or per capita income and product If production of goods and services in a country rises, by whatever means, and along with it average income increase The country has achieved economic growth.”

Gross domestic product (GDP) or Gross national product (GNP) are uasualy used to measure Economic growth

2.2 Financial development and economic growth: theoretical literatures

2.2.1 The impact of financial system functions on economic growth

The financial system function can be listed in five categories that involve the influence

on allocation of the saving resources and investment decisions in the way that affect on economic growth (Levine, 2005) These financial functions are:

- Allocating financial resources and reducing information asymmetry

- Mobilizing or pooling savings

- Assessing and managing risk

- Monitoring businesses

- Easing the goods and services flow

2.2.1.1 Allocating financial resources and reducing information asymmetry

Making an investment decision requires a large transaction cost involving assessing businesses and business environment conditions As a result, such high transaction cost may increase the cost of using financial resources Moreover, in the context that the capital is scarce, imperfect information on economic conditions may make investors deal with the high cost relating to accessing business activities and economic conditions (Levine, 2005)

Transaction cost and asymmetry of information may be reduced via exploring investment opportunities of financial intermediaries Levine (2005) pointed out the important role of financial intermediaries in reducing transaction cost In Levine (2005), efficiency of financial intermediaries might reduce a large cost occurred in acquiring and processing information In addition, by lowing transaction cost and better information, capital will flow into profitable projects This implies that the effective financial market increase fund mobilization and investment The increase in savings and investment will encourage the efficiency of production and operation sector in the commodity market (Levine, 2005) Levine (2005) also emphasized in his study that the efficient financial market with low transaction cost and high liquidity of financial market makes technological innovation increase by boosting incentives to those investors who have promising projects in goods and product expansion According to Zagorchev et al (2011), technology innovation accelerates the business activity by enabling the progress of acquiring and processing information As a result, the increase

in production and the use of technology in economizing on information processing cost have improved the capital resource allocation, then boost the economic growth rate

Finally, due to less information asymmetry, the financial resources will be effectively allocated; hence, the economic growth will be improved in both short and long run (Levine, 2005)

2.2.1.2 Mobilizing or pooling savings

Mobilizing savings would face the costly process of collecting capital from different lenders or savers for investment This process is associated with two issues which must

be overcome The first issue is that the costs of acquiring and processing information relating to attracting funds from a large number of savers and investors Secondly, the information asymmetry raise problem when savers or investors may not have valuable information in making their investment decisions (Levine, 2005)

According to Levine (2005), there are two ways bridging savings and investments The direct way is that mobilizing funds may come from numerous of savers and investors who have surplus resource (i.e joint stock companies, enterprises, individual savers, firms, ) In this channel, the capital resources directly flow from the agents who have surplus fund resources to the agents who need capital for their profitable investment This direct mobilization may cause the fact that the lenders have to deal with the considerable transaction cost involving assessing business activities, investment opportunities and economic condition

The indirect way is that mobilizing fund will be implemented through financial intermediaries In turn, the financial intermediaries with capital resources received from savers and investors inject funds into financial markets It is believed that mobilization through financial intermediaries is an effective way in bridging savings and investments due to economizing on transaction cost, reducing information asymmetry and overwhelming the fact that investment is indivisible As a result, mobilizing funds through financial intermediaries is believed to accelerate the economic growth via exploring economies of scale (Levine, 2005)

Furthermore, Levine (2005) confirms that savings mobilization can enhance resource allocation and improve the innovation in technology Without access funds from different investors, many production processes may cope with out of date technology Consequently, production processes would be constrained to inefficient economies of scale (Levine, 2005) In addition, Levine (2005) definitely cites that better fund mobilization from society and efficient allocation of those funds provides for pooling risks and diversifying among a large number of savers and investors via denominated instruments In other words, different kind of risks are shared and transferred among savers and investors and through different financial instruments These financial instruments may keep capital invested in a diversified portfolio of risky projects from flowing to higher return projects by reallocating the investment funds, resulting in positive acceleration in the rate of economic growth (Levine, 2005)

2.2.1.3 Assessing and managing risk

According to Levine (2005), risks are inherent in every financial transaction due to information and transaction costs Therefore, financial contracts, markets and financial intermediaries play an important role in facilitating resource allocation for trading, sharing and shifting risks among savers and investors in various forms in the context of economic growth Levine (2005) has classified risk into three categories They are cross-sectional risk diversification, sharing payoff (intertemporal) risk, and risk of liquidity

In term of cross-sectional risk diversification, financial institutions including commercial banks, merchant banks, investment banks, mutual funds, insurance companies, pension funds, securities markets, etc may reduce risks in connection with resource allocation by providing financial instruments for trading, pooling, hedging, sharing and shifting risks from riskier projects to less risky projects (Levine, 2005) Thus, by providing risk diversification instruments, financial intermediaries tend to

Financial systems can positively facilitate long run economic growth through the ability of providing risk diversification instruments via affecting resource allocation and rate of savings in the context that capital is scarce; investors do not prefer risk; projects with high expected returns are riskier than those with lower return (Levine, 2005)

In terms of sharing payoff (intertemporal) risk, the risks are believed not diversifying at

a specific point of time, especially in the period of economic recession In such case, the financial intermediaries have an advantage in reducing intertemporal risk For example, in the period of economic shock, intertemporal risk may be diversified by financial intermediaries via lowing contracting cost (Levine, 2005)

In terms of liquidity risk, liquidity is known as the ability of easily converting financial instruments into purchasing power According to Levine (2005), liquidity risk may occur due to the uncertainties associated with informational asymmetries and transaction costs High transaction costs and asymmetry of information reduce the liquidity ability of financial instruments, resulting in increasing liquidity risk (Levine, 2005)

As noted by Levine (2005), the relationship between liquidity and economic development is acknowledged through stock markets and the role of financial intermediaries With liquid stock markets, investors will not be reluctant to sell their less liquid assets to others for eliminating of liquidity risk Consequently, asset holders can sell their less liquid with high expected return equity, while firms can receive funds from initial shareholders By such way, stock markets can reduce liquidity risk, then the more liquidity of stock markets, the more increase in economic growth (Levine, 2005)

Furthermore, financial intermediaries can affect economic growth through enhancing liquidity and reducing liquidity risks As discussed in the Levine (2005), financial intermediaries (i.e banks) can provide savers with liquid deposits Those financial

institutions also offer a combination of high liquid but low expected return investments and less liquid but high expected return on investments By such way, banks provide savers with an insurance vehicle in hedging liquidity risk, while simultaneously enhancing the long run high expected return investments In the Levine (2005), the role

of banks in enhancing liquidity via allocating capital reduces liquidity risks By reducing risk of liquidity, financial intermediaries can improve resource allocation in investing in high profitable activities, and then foster economic growth

2.2.1.4 Monitoring businesses

To understand economic growth and the role of financial factors, it is necessary to focus on corporate governance The degree of how effectively monitor businesses and how the influence of using capital offered by providers of capital on firms has significantly affected on both decisions associated with savings and resource allocation In other words, the effective monitoring businesses and maximizing firm value make the investors or savers are more confident in investing in businesses activities Thus, without financial arrangements in the context of improving corporate governance, pooling savings from different resources of society may be limited and resulting in keeping capital resources from flowing to highest expected return investment (Levine, 2005) Levine (2005) also emphasizes that the national growth rate is definitely impacted by how effective mechanism of corporate governance on business performance

In the context of intermediaries, Levine (2005) cited the model developed by Diamond (1984) to prove how a financial intermediary enhances corporate governance Financial intermediaries use the funds pooled from various investors (i.e individuals, firms…) to lend to the firms who need capital for their business In the absence of financial intermediary, each lender has to monitor, evaluate corporate governance of each borrower This may lead to the large fixed cost associated with monitoring business

cost and transaction cost can be economized by financial intermediaries because that all these investors have financial intermediaries with a long run relationship with firms

to monitor and assess the effectiveness of businesses in which those funds are invested (Levine, 2005)

In the context of economic growth, Levine (2005) cited a number of models developed

by Smith (1993), Sussman (1993) and Harison et al (1999) to prove that a well functioning financial intermediaries improves corporate governance, then foster economic growth by increasing in productivity, facilitating capital accumulation and capital allocation with positive growth effects

Levine (2005) concludes that even though capital is scarce or abundant, the profits of investors have been definitely depended on the quality of monitoring performed by financial intermediaries Furthermore, the poor ability of monitoring businesses of financial intermediary may keep diffuse investors or savers from effectively governing firms and then negatively effects on capital allocation and economic growth (Levine, 2005)

2.2.1.5 Easing the goods and services exchanges

As discussed in Levine (2005), it is believed financial arrangements with low transaction cost and less information asymmetry in enhancing specialization, innovation in technology and economic growth

In the Levine (2005), the relationship between specializations, goods exchange and innovation are explained by using the model of such connections developed by Greenwood and Smith (1996) The more specialize in production, the more it requires transactions Due to high information and transaction costs, financial instruments or arrangements and intermediaries may occur to enhance the specialization process Resulting in increasing in productivity, then, encouraging the good and services exchange The more easing in making transaction in markets reflect the well functioning of financial market development

In other words, by expanding specialization in productivity and lowing information and transaction costs, economic development can accelerate financial market development (Levine, 2005)

2.2.2 The impact of financial development on economic growth: a view Douglas aggregate production function:

Cobb-According to Aghion, P., & Howitt, P (2007), to better understand the relationship between financial development and economic growth, the neoclassical aggregate production function developed by Cobb-Douglas should be taken into consideration Productivity function is derived as follows:

(1) Where

Y: is denoted as aggregate production A: is referred to the level of total factor productivity parameter K: is denoted as Capital

L: is denoted as Labor α: is denoted as the capital share Dividing the function (1) by L, we have output for each worker (y):

(2)

In which k is denoted as capital stock per worker

From the said above function (2), Aghion, P., & Howitt, P (2007) confirms that total factor productivity parameter (A) is positively depended on labor productivity of each worker (y) Furthermore, labor productivity for each worker (y) also positively impacts

on kα (capital stock per worker)

We call economic growth is represented by growth rate (G) of output for each person

be the growth rate of output for each person Then, the function (2) could be calculated

as follows:

(3)

Based on function (3), Aghion, P., & Howitt, P (2007) concludes that the rate of total factor productivity growth (A/A) and the “capital deepening”, which is known as capital accumulation (αk/k) are used as components of growth rate Furthermore, Beck, T., Levine, R., & Loayza, N (2000) suggests that capital accumulation, productivity growth and rate of private savings should be used to evaluate the impact of financial development on economic growth and sources of economic growth

2.2.3 Theoretical views on the linkages between financial development and economic growth

There are four theoretical views, which are widely used to investigate the linkages between financial development and economic growth They are the bank based theory, the market based theory, the financial and services theory and law-finance theory (Levine, 2005; 2002; Arestis et al., 2005) We will briefly discuss them as following

2.2.3.1 The bank based theory

The bank based theory mainly focuses on the role of banks in a positive way In Levine, R (2002), Levine (2005) and Arestis et al., (2005) pointed out that the positive role of financial intermediaries in providing financial functions, which is expressed via:

- acquiring information about firms, managers, market condition, and then foster the resource allocation and growth

- accessing, monitoring businesses and managing risk, and then improving the efficiency in investment and economic growth

- mobilizing funds in order to exploit economies scale

Furthermore, the bank based theory also figured out the shortcomings of the market based theory Arestis et al., (2005) argues that though financial functions, financial intermediary can mitigate the problems of acquiring information faced by individual investors (i.e informational asymmetry, free-rider problem) This is because the financial intermediary has set up long time relationships with firms and does not disclosure about the acquired information to publicity (Levine, 2005; Levine, 2002) In addition, by having close ties and long run relationships with firms, financial intermediary has advantages in managing, monitoring businesses and improving corporate governance Therefore, banks have the powerful ability to make pressure on firms to repay their debts, especially in nations where the capability of contract enforcement is not strong (Levine, 2005; Levine, 2002) As a result, the bank based theory believes that a market based system will not properly perform due to fundamental reasons such as information acquisition, information processing, corporate governance, agency problems, liquidity problem, managing risks and monitoring business) Consequently, resource allocation and economic performance will not be properly improved In contrast, a bank based system without preventing from regulation restrictions on financial intermediary activities, can explore economies of scale in acquiring information, processing information, mobilizing resources, reducing moral hazard via effective corporate governance, managing risks and monitoring business Thereby, financial intermediary can produce better enhancement on resource allocation and better improvement on economic growth via financing industrial expansion (Levine, 2005; Levine, 2002; Arestis et al., 2005)

2.2.3.2 The market based theory

In Arestis et al., 2005, the market based theory focus on the functions of market in enhancing economic growth The role of well functioning markets is stressed through fostering profit incentives due to trading in big and liquid markets; enhancing corporate

of risk management (Levine, 2002) The market based theory also highlights the disadvantages of the bank based theory It concludes that innovation can be prevented

by powerful banks Banks with its power can take advantage in extracting informational rents and protect businesses, which have a close relationship with banks from fierce competition In addition, due to weak regulatory restriction on banking activities, the powerful banks may work together secretly or illegally with managers of businesses, which have a close relationship with those banks in order to against other creditors and hamper the efficiency of corporate governance (Levine, 2002; Arestis et al., 2005)

Arestis et al., (2005) further concludes that a well functioning market based system can reduce asymmetry of information signals and effectively transfer this information among users and providers of funds in aiming at beneficial implications for financial financing businesses and economic performance (Levine, 2002; Arestis et al., 2005) Finally, proponents of a market based system find that markets provide a variety of customized instruments for risk management Meanwhile, bank based systems may offer basic risk management vehicles with inexpensive cost As a result, market based system emphasizes that the market reduces the inherent shortcomings of the bank based system and foster the economic growth (Arestis et al., 2005; Levine, 2005; Levine, 2002)

2.2.3.3 The financial and services theory

Arestis et al (2005) and Levine (2002) argue that the financial and services theory mainly focuses on the important role of financial services provided by a financial system in new firm creation, industry expansion and economic growth Basically, this theory includes both the bank based theory and market based theory However, the financial and services view reduces the importance of the bank based system and market based system

In financial and services theory, it emphasizes on the environment in which effective

financial services provided by intermediaries and markets The theory states that the

source of funds is not the main issue The main issue should be focused on is creating a

better functioning banks and markets, not the type of financial structure (Arestis et al.,

2005; Levine, 2002) The theory suggests that it should create an environment in which

intermediaries and markets effectively provide financial services According to this

theory, financial arrangements (i.e contract, markets and intermediaries) reduce the

imperfections of markets and offer sound and efficient financial services facilitating

beneficial investment opportunities, pooling savings and management of risks

Furthermore, financial arrangements use its power to affect corporate governance and

improve liquidity (Arestis et al., 2005; Levine, 2002)

Finally, Levine (2002) concludes that the financial and services theory is totally in

agreement with bank based theory and market based theory Levine (2002) also

discusses that the financial and services theory definitely highlight the importance of

how to create a better environment in which the functioning bank and markets are well

performed As a result, this theory strongly reduces the debate between bank based

theory and market based theory (Arestis et al., 2005; Levine, 2002)

2.2.3.4 The law-finance theory

Arestis et al.,(2005) and Levine (2002) argue that the law –finance theory is

considered as the special case of the financial and services theory The role of the legal

system in creating a growth-promoting financial sector is extremely stressed in the

law–finance theory The theory states that finance - a set of contracts - with legal rights

and enforcement mechanisms facilitates the operation of markets and intermediaries

under the well functioning legal system Moreover, theory states that the legal system

influences overall financial sector performance As a result, the quality of financial

services will improve the efficient allocation of resources and growth

Contrary to the bank based theory and market based theory, the law and finance theory emphasizes the well functioning legal system and enforcement mechanism play an important role in stimulating economic growth via differentiating financial systems rather than focusing on whether countries follow bank based system or market based system (Arestis et al., 2005; Levine, 2002)

2.3 Literature review and empirical studies

2.3.1 Theoretical framework on the relationship between economic growth and financial development

Levine (1997) modeled the causal relationship between economic growth and financial development as follows:

GROWTHj = f(Fi, X, ε) Where:

GROWTHj : represented by GDP growth rate at jth in ranking

Fi : represented by the determinants of financial development They are

the liquid liability to GDP (DEPTH), the sum of ratio of bank credit divided by domestic money banks and central bank domestic credit (BANK), ratio of credit to the private sector to GDP (PRIVY), the ratio of credit to non private sector of domestic credit (PRIVATE)

X : represented by the explanatory variables of economic growth,

including school rate in secondary stage, the ratio of government consumption spending to GDP, inflation rate and trade openness

Ε : denoted as Error term Furthermore, Hassan et al.,(2011) modeled the finance-growth relationship as bellow:

GROWTHi,t = f(FINi,t, GDSi,t, TRADEi,t, GOVi,t, INFi,t, εi,t )

In which, FIN is referred to financial development FIN includes DCBS, DCPS and M3 i and t are referred to country i and time t respectively εi,t is error term

Hassan et al.,(2011) suggested that there are seven economic indicators capturing financial depth and economic growth These economic indicators are:

(i) Domestic credit provided by banking sector measured in percentage of GDP

(DCBS)

This ratio implies that the functions of the financial system are well performed,

it would positively impact on financial development (Levine, 1997) Moreover, Hassan et al.,(2011) believed that the higher ratio of Domestic credit provided

by the banking sector, the higher financial development is required because banks need to perform five financial functions (Hassan et al.,2011)

(ii) Domestic credit to private sector measured in percentage of GDP (DCPS)

This ratio explains that the allocation of capital resource to private sector requires higher development in financial system An efficient allocation of capital resource requires that five financial functions are well performed via assessing and managing risks, monitoring businesses, facilitating financial transaction and raising savings (Hassan et al.,2011)

(iii) Broadest definition of money measured in percentage of GDP (M3)

It is believed that a higher liquidity ratio implies higher development in the financial system Because this indicator captures the ability of the financial system to provide saving opportunities and financial transaction services (Hassan et al.,2011; Jeanneney, S G., & Kpodar, K.,2011 )

(iv) Gross domestic saving measured in percentage of GDP (GDS)

Financial deepening affects growth through channeling fund savings to investment Consequently, the volume of investment is increased due to the ratio

of gross domestic saving to GDP increase This ratio has a positive impact on real interest rate Then, it enhances investment and growth (Hassan et al.,2011) (v) Trade openness measured in percentage of GDP (TRADE)

This ratio is the sum of import and export of goods and services as percentage

of GDP This ratio positively impact on improvement of economic growth through international trade openness (Hassan et al.,2011)

(vi) General government final consumption expenditure measured in percentage of

GDP (GOV)

This indicator impacts on the improvement of economic growth through government spending adjustment This indicator is expected to move in the opposite direction with economic growth because of crowding out effect of public investments on private investment and consumption (Zagorchev, A., Vasconcellos, G., & Bae, Y.,2011)

(vii) Inflation rate (INF)

This indicator is used to control price changing

Based on the previous empirical studies relating causal relationship between financial development and economic growth, the basic equation to demonstrate the finance-growth linkage is suggested in this research as follow:

GROWTHit = αo + α1FDit + α2Xit + εit

In which,

GROWTHit : Growth rate of GDP per capita

FDit : The indicators of financial development

The indicators of financial development are the Ratio of Broad money

to GDP, the Ratio of credit offered by bank to private sector to GDP, and the Ratio of domestic credit to private sector to GDP and the Gross domestic savings as percentage of GDP

Xit : The group of determinant variables of economic growth

These variables include the Foreign direct investment, the General government consumption, Trade openness measured by the sum of import and export of goods

εit : Error term i,t : Country i and time t respectively

αs : Coefficient of independent variables

2.3.2 Empirical studies on financial development and economic growth relationship

Levine et al., (2000) highlighted the need to use ratio of credits offered by banks to private sector to GDP as one of key components in measuring financial development The authors argued that the higher level of financial services is, the higher level of financial development will be achieved (Levine et al., 2000) By using the generalized method of moments with pure cross sectional instrument variables to investigate the finance – growth relationship in 74 countries for a period of 1960 -1995, the authors found out two main points Firstly, the components of financial development (i.e the ratio of credits offered by banks to the private sector to GDP, the ratio of commercial bank assets divided by the sum of commercial bank asset and central bank assets and the liquid liabilities of the financial system) positively correlate with economic growth Secondly, the causal correlation between financial development and economic growth mainly rely on the growth of total factor productivity (Levine et al., 2000)

Furthermore, in the study carried out by Khalifa Al-Yousif in 2002, the authors use Granger test within an error correction model (ECM) developed by Bishop (1979) to investigate the relationship between financial intermediation and growth in 30 developing countries covering the period 1970-1999 They concluded that the connection between financial development and economic growth is positive two-way effect The study also suggested that there are two effective indicators for measuring financial depth They are the ratio of narrow money stock to GDP (M1) and the ratio of broad money to GDP (M2) It is implied that higher expansion in financial sector, the greater use of financial services, hence the greater financial development (Khalifa Al-

In addition, Zagorchev et al., (2011) employed generalized method of moments (GMM method) to investigate the relationship between financial development, economic growth and technology in eight European countries The Observed period is from 1997 to 2004 The authors found out that technology and financial development have positive impact on real GDP The authors also recommended that general government consumption expenditure as share of GDP should be used as explanatory variables in exploring the linkage between financial development and GDP growth Government expenditure is expected to have a negative impact on GDP due to crowding out effect to private sector investment The additional economic indicators are supposed to use is foreign direct investment They argued that foreign direct investment enhances the process of financial integration and then fosters the development of the financial sector Flow of foreign direct investment is expected to have a positive impact on financial development (Zagorchev et al., 2011)

Masten et al., (2008) employed the method of generalized method of moment estimators in analyzing how financial development and financial integration impact on economic growth in 31 countries in the European area The observed period is from

1996 to 2004 The authors confirmed that the development of the domestic financial system and financial integration have a significant positive impact on economic growth They found that the strong impact of financial development on economic growth exist in developing countries (Masten et al., 2008)

Investigating the two-way effect of financial development and economic growth, Calderón and Liu (2003) used panel data covering 109 developing and industrial countries for the period from 1960 to 1994 The econometric method is Geweke decomposition test The authors found that the causal relationship between financial development and economic growth exist The financial development significantly impacts on economic growth in both developing countries and developed countries The development in financial system enhances economic growth in those countries

In their study, the authors suggested that two economic indicators should use to measure financial development The first indicator is the ratio of broad money to gross domestic product (M2/GDP) The author argued that the financial system develop if the ratio of M2/GDP is high Hence, financial sector becomes larger (Hassan et al., 2011) The second economic indicator is the ratio of domestic credit offered by financial institutions to the private sector to gross domestic product (CREDIT/GDP) The authors confirmed that this indicator is the best way to measure financial depth CREDIT/GDP has significant impact on investment and economic growth It is believed that a higher this ratio, the higher financial service expansion and then, the greater financial development (Calderón and Liu., 2003; Hassan et al., 2011)

Beside financial development measurements, economic indicators such as human capital, general government consumption as a percentage of GDP, blacked market exchange rate premium and real GDP growth rate are used to capture the economic growth (Calderón and Liu, 2003)

Employing the methodology of various multivariate time series analysis to investigate the role of financial development in context of economic growth in 168 countries during the period from 1980 to 2007 Hassan et al., (2011) classified those countries in six geographic areas and three income categories (i.e countries with low income, countries with middle income, and countries and high income) This classification reflected a broad coverage across regions and levels of development The authors gave

a conclusion that there exist a strong linkage between financial development and economic growth in sample countries In particular, the financial development has a positive impact on economic growth and vice versa in all regions except Sub- Saharan and East Asia and Pacific

According to Hassan et al.,(2011), there are seven economic indicators capturing financial depth and economic growth used in their study These economic indicators

- The domestic credit provided by the banking sector as a percentage of GDP This ratio implies that if the functions of the financial system are well performed, it would positively impact on the financial system expansion (Levine, 1997))

- The domestic credit to private sector as percentage of GDP This ratio is used to explain that allocating capital resource to private sector requires higher development in the financial system in order to assessing and managing risks, monitoring businesses, facilitating a financial transaction and raising savings

- The broadest definition of money as a percentage of GDP The higher ratio implies higher development in the financial system

- The gross domestic saving as a percentage of GDP This ratio is believed that it positively impacts on real interest rate Hence, it will enhance investment and growth

- Trade openness as a percentage of GDP This ratio positively impacts on the improvement of the economic growth through international trade openness

- General government final consumption expenditure as a percentage of GDP This ratio impacts on improvement of economic growth through government spending adjustment

Lee and Chang, (2009) employed dynamic OLS and vector error correction model to examine the causal linkage between Foreign direct investment (FDI), financial development and economic growth The period is observed from 1970 to 2002 covering 37 countries The authors concluded that financial indicators, namely the liquid liabilities as a percentage of GDP, the domestic credit provided by the banking sector to the private sector as a percentage of GDP, positively correlate with economic growth Furthermore, the developed-financial system strongly facilitates country to attract FDI flow In turn, FDI enhances economic growth through increasing in investment capital and technology transfer (Lee and Chang, 2009)

Habibullah and Eng (2006) examined the causal impact of financial development on economic growth in 13 Asian developing countries Sample period is from 1990 to

1998 The methodology is the generalized method of moment (GMM method) The authors concluded that there existed the positive causal relationship between financial development and economic growth in 13 Asian developing countries They further confirmed that the developed financial system significantly contributes to the economic performance in 13 Asian developing countries

Ang et al., (2007) examined the causal relationship between financial development and economic growth in Malaysia They employed the methodology of vector autoregressive approach to test the issue The observation period covers from 1960 to

2001 The finding shows that economic growth leads to development in the financial system However, the financial development weakly impact on economic performance Christopoulos and Tsionas (2004) examined the causal relationship between financial development and economic growth in the long run term Christopoulos and Tsionas (2004) used panel data covering 10 developing countries with an observed period of 1970-2000 The authors applied various econometric methods, such as panel unit root test and cointegration analysis to explore the issue Results shown that the financial development has a significant and positive impact on economic growth in long run term The results also indicated there is no evidence showing that economic growth leads to the development in the financial system in the short run term

The main findings of the mentioned-above empirical studies on the finance-growth relationship are summarized as below:

Table 1: Summary of empirical studies:

1 Levine et al.,

(2000)

Generalized method

of moments and pure cross sectional instrument variables

Panel data covering

74 countries for the period of 1960 -

1995

Components of financial

development positively correlate with economic growth

Both time series and panel data are applied in 30 developing countries covering the period 1970-1999

The connection between financial development and economic growth is positive two-way effect

3 Zagorchev et

al., (2011)

Employing generalized method of moments (GMM method)

Panel data covering eight European countries

Observation period

is from 1997 to

2004

- Financial development and technology have a positive impact on real GDP

- Financial development has positive impact on technology

- Weak evidence showing

technology positively impact

on financial development

4 Masten et al.,

(2008)

generalized method of moment

Panel data of 31 countries in European area

Observed period is from 1996 to 2004

- Development of domestic financial system and financial

integration has a positive impact on economic growth

- A higher impact of financial

development on economic growth

in developing countries

5 Calderón and

Liu (2003)

Method of Geweke decomposition test

Panel data set covering 109 developing and industrial countries

Observation period

is from 1960 to

1994

- existence of causal relationship

between financial development and economic growth

- Financial development significantly impacts on

in developing countries than that

in developed countries

6 Hassan et al.,

(2011)

Methodology of various multivariate time series analysis

on investigating

Panel data of 168 countries during the sample period 1980-

2007

- A strong linkage between financial development and economic growth

- Financial development impacts on economic growth and vice versa in all regions except Sub- Saharan and East Asia and Pacific

Panel data set for period 1970 -2002 covering 37 countries

- Financial indicators (liquid liabilities as percentage of GDP; domestic credit provided by banking sector to private sector as percentage of GDP) positively correlate with

economic growth

- A developed financial sector facilitates country

to attract more FDI flow

Sample period is from 1990 to 1998

- Positive causal relationship

between financial development and economic growth

- Developed financial sector significantly

contributes to economic

performance

9 Ang et al.,

(2007)

Vector autoregressive approach

Time series data covering period

1960 – 2001 in Malaysia

- Economic growth

development in financial system

- Financial development weakly impacts on economic

performance

10 Christopoulos

and Tsionas

(2004)

Various econometric methods (panel unit root test and cointegration

analysis)

Panel data covering

10 developing countries with observed period 1970-2000

- Financial development has significant impact

on economic growth in long run

- No evidence showing that economic growth leads to the development in the financial system in the short run term