The effect of financial development on economic growth evidence from asian countries

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 THE EFFECT 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

THE EFFECT OF FINANCIAL DEVELOPMENT

ON ECONOMIC GROWTH: EVIDENCE FROM

ASIAN COUNTRIES

BY

TRẦN THANH GIANG

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, JULY 2014

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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

THE EFFECT OF FINANCIAL DEVELOPMENT

ON ECONOMIC GROWTH: EVIDENCE FROM

ASIAN COUNTRIES

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

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

TRẦN THANH GIANG

Academic Supervisor:

ASSOC PROF DR NGUYỄN VĂN NGÃI

HO CHI MINH CITY, JULY 2014

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DECLARATION

This is to certify that this thesis entitled “The effect of financial development

on economic growth: evidence from Asian countries”, which is submitted by me in fulfillment of the requirements for the degree of Master of Art in Development Economic to the Vietnam – The Netherlands Programme The thesis constitutes only my original work and due supervision and acknowledgement have been made

in the text to all materials used

Trần Thanh Giang

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ACKNOWLEGEMENT

I would not be able to write and finish my dissertation without the help and support

of people surrounding me

Above all, I would like to express my greatest appreciation to my supervisor, Assoc

Prof Nguyễn Văn Ngãi, for his invaluable comments and advices, patient guidance,

encouragement in during the time of doing this thesis I have been strikingly lucky

to have supervisor who cared so much my thesis and answered to all my questions

Without his guidance, my thesis would not have been possible

I would also like to offer my special thanks to Dr Trương Đăng Thụy and Dr Phạm

Khánh Nam for the econometric guidance and valuable suggestions that help to

develop this thesis

Besides my mentors, special thanks also to all the lecturers at the Vietnam –

Netherlands Program for their knowledge of all the course, during the time I studied

at the program

In addition, I would like to thank my friends and people who are always beside me

and support for my thesis but are not above mentioned

Last, but not least, I am very deeply grateful to my family Without their warm

encouragement and attention, I would not be possible to complete this dissertation

GLS Generalized Least Squares

OLS Ordinary Least Squares

FEM Fix Effects Model

REM Random Effects Model

GMM The Generalized Method of Moments Estimation

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ABSTRACT

This study estimates the effect of financial development on economic growth in Asian countries in the period from 2000 to 2011 Based on unbalanced panel data, this effect is examined by Fixed effects model (FEM) and the first difference Generalizes Methods of Moments approach (GMM) The findings indicate that financial development has significant impacts on economic growth on both estimation techniques However, these impacts depend significantly on estimation methods and proxies for financial development The results of FEM and first difference GMM imply that financial depth and domestic credit to private sector have negative impact on growth, but there is no relationship between stock market development and economic growth On the other hand, while a positive relationship between the ratio of commercial – central bank assets and growth rate of real GDP per capita is shown by FEM, this indicator is not related to growth rates in GMM results

Key words: Financial development, Economic growth, relationship, effect,

endogeneity, fixed effects, random effects, Asian countries

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TABLE OF CONTENTS

LIST OF TABLES ix

LIST OF FIGURES x

CHAPTER 1: INTRODUCTION 1

1.1 Problem statements 1

1.2 Research objectives 4

1.3 Research scope and data 4

1.4 Research structure 5

CHAPTER 2: LTERATURE REVIEW 6

2.1 Theoretical literature 6

2.1.1 Endogenous growth theory 6

2.1.2 Theories of financial development 7

2.2 Empirical studies 16

CHAPTER 3: RESEARCH METHODOLOGY 29

3.1 Model Specification 29

3.2 Measurements of Variables 31

3.2.1 Measurements of financial development 31

3.2.2 The determinants of economic growth 34

3.3 Data collection 39

3.4 Research methodology 39

3.4.1The common constant method (Pooled OLS) 40

3.4.2 The random effects method (REM) 41

3.4.3 The Fixed effects method (FEM) 41

3.4.4 Choice of panel regression model 42

3.4.5 The generalized method of moments estimation (GMM) 45

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CHAPTER 4: RESEARCH RESULTS 48

4.1 Overview the economic growth and the financial development in the regions of Asia 48

4.1.1 Overview the economic growth in the regions of Asia in the period 2000 - 2011: 48

4.1.2 Overview the financial development in the regions of Asia in 2000 - 2011 50

4.2 The descriptive statistic of the sample 57

4.3 Empirical results 62

4.3.1 Results of tests for panel regression model 62

4.3.2 Discussions on the research results 65

4.3.3 Discussions on the results of first difference GMM 69

CHAPTER 5: CONCLUSION AND POLICY IMPLICATION 75

5.1 Conclusions 75

5.2 Policy implications 77

5.3 Research limitations 78

5.4 Suggestions for further research 79

REFERENCES 81

APPENDIX A 85

APPENDIX B 91

APPENDIX C: DESCRIPTIVE STATISTIC OF VARIABLE 94

APPENDIX D: PANEL REGRESSION MODEL 96

APPENDIX E: RESULTS OF BREUSCH – PAGAN LM TEST 102

APPENDIX F: RESULTS OF HAUSMAN TEST 103

APPENDIX G: THE REGRESSION MODEL RESULTS OF FIRST – DIFFERENCE GMM 105

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LIST OF TABLES

Table 3.1: The expected sign of variables in model 38

Table 3.2: Tests for choosing a panel regression model 44

Table 4.1 Descriptive statistics of the sample observation 58

Table 4.2: The corrrelation on the sample observations 61

Table 4.3: The results of F test and Breusch – Pagan test 63

Table 4.4: The results of Hausman test 63

Table 4.5: The results of FEM regression model 64

Table 4.6: The results of first difference GMM 70

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LIST OF FIGURES

Figure 2.1: The role of financial development in economic growth 27

Figure 3.1: Analytical framework 37

Figure 4.1: The average growth rate of real GDP per capita in Asia regions in 2000 – 2011 50

Figure 4.2: Financial development in Central Asia 51

Figure 4.3: Financial development in South - East Asia 51

Figure 4.4: Financial development in South Asia 52

Figure 4.5: Financial development in Eastern Asia 53

Figure 4.6: Financial development in Western Asia 54

Figure 4.7: The ratio of liquid liabilities to GDP across Asia regions 55

Figure 4.8: The ratio of domestic credit to private sector to GDP across Asia regions 55

Figure 4.9: The ratio of commercial – central bank assets across Asia regions

56 Figure 4.10: The ratio of stock market capitalization to GDP across Asia regions

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Figure 4.11: The scatter diagram among dependent variable and financial development variables 59

Figure 4.12: The scatter diagram among dependent variable and control variables 60

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foster capital accumulation, thus higher economic growth in the first stage of growth Obviously, these findings support the finance – led growth hypotheses In the later stages, the expansion of financial sector results from increasing demands for financial services in the growth stage As a result, it implies a causal direction runs from growth to finance and it favors the growth – led – finance hypotheses However, there is an opinion proposes that financial development is not the most important factor of growth (Robinson, 1953) In other words, (Lucas Jr, 1988) even rejected viewpoint that finance plays a major factor of economic growth Its role has been over emphasized by economists

In recent years, many studies have been developed to show the role as well

as the contribution of finance to economic growth in some countries and regions in the world However, this relationship is still an ambiguous issue Besides some studies also emphasize the positive contributions of financial development to growth, other investigations provide opposite evidences For instance, studying 109 developing and industrial countries in 1965 - 1994, (Calderón & Liu, 2003) suggested that the contribution of financial development to growth is higher in developing countries than industrial countries Moreover, this study also supports for view that financial development can accelerate economic growth through rapid capital accumulation and technological change In particular, the causal relation from finance to TFP growth is stronger in developing countries, but the direction from TFP growth to finance is stronger in industrial countries This result is also similar to capital accumulation In addition, after combining both cross sectional and time series data, the result of (Christopoulos & Tsionas, 2004) exhibited that although there was no bidirectional causality between financial development and output growth in both long - run and short – run, the positive causality from financial development to growth was still manifested in 10 developing countries from 1970 – 2000 (Loayza & Ranciere, 2006), however, suggested that financial system is able to cause economic recession due to financial crisis Specifically, financial development is not always positively related to economic growth Its

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effect depends on the characteristic of financial system of each country, institution, the study period or the measurments of financial development (De Gregorio & Guidotti, 1995; Hassan, Sanchez, & Yu, 2011; Wu, Hou, & Cheng, 2010)

In general, in spite of the same research subject, it is likely to lead to different results In other words, the debatements about the relationship between financial development and economic growth have been outlined in literatures of studies by some following reasons The first controversial issue is the choice of measurements of financial development because each indicator can lead to various conclusions The second aspect is the direction of relationship between these two issues While the supply – leading hypothesis, demand – following hypothesis and two-way causality relationship appear to be supported by some papers, other studies provide no clear correlation between measures of financial development and economic growth The third, the channels through which financial development impacts economic growth are also disputable issue

Consequently, finance and economic growth are always an interesting subject with economists and researchers If the role of financial development is clarified, policymakers can outline the judicious development directions and propose appropriate policies to speed up the national growth

On the other hand, nowadays, countries not only focus on developing industrial sector, but they also expand the development of financial sector through the establishment of financial center, banking system, stock market, etc Beginning from the financial crisis in the United State during 2007 – 2009, it has spread to other countries to create the global crisis The consequence is the collapse of financial system in a number of countries and leads to macroeconomic instabilities According to the level of financial development and specific characteristics of each country, the effect of financial crisis on economic growth will be different in those countries For this reason, this study is performed to investigate the impact of financial development on economic growth in Asian countries

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1.2 Research objectives

This study aims to:

Analyze the situation of financial development and economic growth in regions of Asia in the period 2000 – 2011

Evaluate the impact of financial development on economic growth in Asian countries

From the achieved findings, this research will provide some suggestions to promote the development of financial sector

1.3 Research scope and data

The research focuses on in Asian countries due to some reasons First, as mentioned previously, many studies have examined the effect as well as the relationship between financial development and economic growth However, various conflict findings have been also found different country groups as well as different periods In addition, Asian countries, as a whole, have been benefited from financial liberalization It yields a more efficient financial system, intensifies the efficiency and the adjustability of monetary policies Thus, Asian countries succeeded in raising the role of financial system in promoting growth in the period before 1995 After that, Asian economy went through some large fluctuations because financial crisis and serious economic recession have consecutively happened since 2000 Especially, 1997 Asian financial crisis, later on, economic crisis in 2007 – 2008 caused adverse effects on both financial system and growth in most Asian countries For these reasons, this study examines, under such circumstances, how financial development affects economic growth in Asian countries in the period 2000 – 2011 From the obtained research findings, we provide some suggested solutions to overcome several limitations and improve the contribution of financial sector to the growth

This study relies on unbalanced panel dataset of 32 countries in 12 years (2000 – 2011) Most data were gathered from the World Development Indicator of World

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Bank’s database List of countries is described in detail in the table A.1 (Appendix A)

1.4 Research structure

The paper contains five chapters:

Chapter 2 introduces theoretical and empirical studies about the role and the relationship between financial development and economic growth

Chapter 3 presents regression model and research methodology as well as key variables used in this study

Chapter 4 provides an overview about the situation of growth and financial development in these countries Moreover, the descriptive statistics of the sample are also refered in this chapter Concurrently, analyzing and discussing the regression results are also mentioned in this part

Finally, chapter 5 summarizes the analyses and the results from the previous parts to propose recommendations and related policies as well as the limitations of this study

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CHAPTER 2: LTERATURE REVIEW

This chapter introduces two main parts The first section provides definitions of financial development and reviews theoretical backgrounds about the role of financial development in economic growth The second section summarizes previous empirical researches Based on relevant contents, the final will depict the construction of conceptual framework for this study

2.1 Theoretical literature

2.1.1 Endogenous growth theory

Based on the foundations and limitations of neoclassical growth theory, endogenous growth theory has been developed to clarify the issues of economic growth as well as the determinants of growth Neoclassical growth theory assumes that the growth is due to the improvement of exogenous factors in production technology, human capital accumulation, population growth and saving rate These are exogenous elements for growth However, endogenous growth theory predicts that the growth is determined by factors generated in the production process instead

of outside factors It implies that one or more these elements are defined directly in the growth model, thus they become endogenous variables Ak model, which is also called endogenous growth model, is established from the production function:

Y = AK(HL)1-  (2.1)

A is the production technology We assume that H = K/L (2.2), which means human capital and has positive relation with the capital endowment per worker Substitution of (2.2) into (2.1) gives a new production function Y = AK If this new equation is divided both sides by L, it will give: y = Ak This production function indicates that the marginal productivity of capital A does not reduce when the capital stock increases In other words, this theory still assumes constant return to scale, but it does not assume the diminishing returns to scale

The function y= Ak considers capital as an important input that contributes directly to the production and increases human capital, thereby output rises linearity

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with the capital stock Besides, the Ak model shows that countries with higher saving rates and investment rates will lead to higher growth rate of per capita In addition, higher population growth rates will result in lower income growth per capita Unlike neoclassical growth model, endogenous growth model can explain the growth per capita can continue in countries where do not base on exogenous technology changes Furthermore, this theory does not necessarily conclude that the poor countries will grow faster than rich countries because growth does not imperatively slow down when income raises Hence, there is no convergence of income Generally, to be similar with Solow growth model, endogenous growth model also emphasizes the important role of accumulation of production factors as well as an increase in productivity in the growth process

2.1.2 Theories of financial development

Financial development is defined as an improvement ịn quality, quantity and efficiency of financial system This process involves the combination of many activities and institutions According to (Levine, 2005), financial development happens when financial instruments, markets and intermediaries are improved better, then they affect the information, enforcement and transaction costs Therefore, financial development includes the improvement in allocating resource, monitoring investment, mobilizing saving, diversifying and managing risk Besides, the enhancement in controlling corporate governance after providing finance and the facilitation in exchanging goods and services are also stimulants to financial development Each of these functions is likely to influence saving and investment decisions, thereby they affects economic growth In addition, the presence of financial intermediaries, such as banking system, can make the transmission process

of savings from surplus agents to deficit agents is performed conveniently Moreover, the banking sector also helps decrease asymmetric information between the lender and the borrower as well as allocates funds to the productive opportunities The importance of financial intermediaries to economic growth appears to be supported by (King & Levine, 1993a; Levine et al., 2000; McKinnon,

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1973; Shaw, 1973) They emphasize that the essential reason for different economic growth of each country derives from the differences in the quality and quantity of services provided by financial intermediations The main roles of financial system will be discussed in detail in the below part

2.1.2.1 The role of financial system in the economic growth

The relationship between financial development and economic growth has been investigated since several decades by many methods and dataset, such as time series, cross section and panel data However, researchers have been published various views and results about this issue (Goldsmith, 1969; McKinnon, 1973; Shaw, 1973) who are early researchers point out the finance – growth nexus Their papers indicate that financial deepening means not only higher productivity of capital but also higher saving rate, thus investment is higher However, (McKinnon, 1973) and (Shaw, 1973) rely on two different models to analyze this issue (McKinnon, 1973) considers an outside money model that the company is constrained to self – finance Hence, to invest in projects, the firm must accumulate sufficient savings as monetary assets Inversely, an inside money model applied by (Shaw, 1973) emphasizes that real interest rate is main factor to attract savings As you know, the credit is influenced by real interest rates If credit is supplied more, financial intermediaries can further more investments and higher growth Simultaneously, it has been claimed that the difference in growth rate in each country is due to the differences in the quantity and quality of services provided by financial intermediations

In the research model of (Bencivenga & Smith, 1991) represents that individual must face the choice between either investment in the liquid asset, which brings safety but low productivity, or illiquid asset, which carries risk but higher productivity By enhancing more savings to high productivity and allocating investment efficiently, financial intermediation can improve economic growth

Two above researches are evidences supporting the supply - leading hypothesis (Christopoulos & Tsionas, 2004; King & Levine, 1993b; Levine et al.,

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2000; McKinnon, 1973) It means that the formation of financial institutions and financial markets may raise the supply of financial services, thus it leads to economic growth In other words, as to this view, there are two channels that financial intermediation stimulates higher growth The first channel is an increase in the efficiency of capital accumulation (Goldsmith, 1969) The other is a rise in saving rate and investment rate (McKinnon, 1973; Shaw, 1973) Because of an increase in savings and an improvement in the efficient investments, financial development results in economic growth (Bencivenga & Smith, 1991; Greenwood

& Jovanovic, 1989)

The second view is the demand -following hypothesis This viewpoint is interpreted that the expansion of financial sector comes from an increase in demand for financial services (Goldsmith, 1969; Jung, 1986; Shaw, 1973) Because economic activities raise, demand for both liquid capital and physical capital may also rise Eventually, financial sector is expanded This enlargement contributes to improving the efficiency and increasing the competition of financial intermediaries and markets

The third view is the existence of the bidirectional causality between financial development and economic growth This evidence was developed by (Greenwood & Jovanovic, 1989) who found the positive bidirectional causal relationship between financial development and growth The role of financial institution is collecting and analyzing information to guide investors in higher yield projects, thus enhancing indirectly the efficiency of investment and growth Inversely, the process of growth will also expand financial institution because higher economic growth will create more demand for transaction and greater participation in financial market

The fourth view, contrary to viewpoints above, (Lucas Jr, 1988) claimed that there is no causal relationship between financial development and economic growth Following this view, any policy or strategy stimulating the development of financial system may produce a waste of resources Thus, policymakers should be concerned

A number of theoretical models have been investigated to clarify the role of financial development in economic growth As given by the neo – classical growth theory, growth rates of labour force and advances in technology are two important conditions for economic growth in long – run As to this theory, to achieve the level

of output growth in short – run, the economy cannot ignore the role of savings Hence, the effect of financial intermediation on growth is ambiguously mentioned through the channel of savings The introduction of endogenous growth theory implies that the specific role of financial intermediations in growth is represented by enhancing Research and Development and investing in human capital (Pagano, 1993) based on the endogenous growth model to study the impact of financial development on economic growth AK model assumes that the production function

is linear and constant returns to scale, but it is not decreasing marginal returns to scale Therefore, the output is a function of aggregate capital stock according to the aggregate production function:

Yt =At*Kt (2.3) Return to scale is constant, but the productivity increases owing to the aggregate capital stock Kt, including the physical and human capital The model

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assumes that there is no population growth, and economy only produces one good Certainly, those goods can be consumed or invested In the case of those commodities are used for purposes of investment, it has the depreciation rate per period δ The gross investment is:

It = Kt+1 – (1-δ)Kt (2.4) Based on previous literature, financial institutions are channel through which savings are transferred to investments A dollar saved by savers will have worth less than the value of a dollar for investment So, θ denotes each dollar saved, and it is used for investment (1- θ) is retained by financial institutions In the close economy, gross saving equals gross investment: θSt = It (2.5) From equation (2.3) we have:

gt+1 = (Yt+1 / Yt ) – 1 = (Kt+1/ Kt ) – 1 (2.6) Equation (2.4) can be rewritten as: Kt = It + (1 – δ)*Kt+1 , and substitute into equation (2.6) we have:

gt+1 = ( It + Kt – δKt – Kt )/ Kt = (It/Kt) – δ (2.7) From equation (2.3): Kt = Yt/A and combine with equation (2.5), then substitute into equation (2.7), we set up the following steady state growth rates

g = A*(I/Y) – δ = Aθs – δ (2.8)

s is gross saving rate (S/Y) From equation (2.8), the development of financial sector is likely to impact economic growth through three ways The first one is an increase in θ that is the proportion of saving channeled to investments If the banking sector can be operated in more competitive environment and the transition from saving to investment is implemented more efficiently, which cause θ can be increased, thereby growth rate is higher Secondly, financial institutions, such as the bank, can increase the productivity of capital (A) by allocating funds to the projects having the highest margin product of capital and distributing savings more efficiently Hence, higher growth results from higher productivity of capital The third channel is private saving rates (s)

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Similarly, in the model of (De Gregorio & Guidotti, 1995), the growth rate of output yt = stθt is a function of saving rate s and marginal productivity of capital θ This function also proves that financial development affects growth through two channels The first, the development of domestic financial market may improve the efficiency of capital accumulation (increasing θ) The second, financial sector contributes to raising saving rate, thereby higher investment rate (increasing st) Moreover, the author also supports evidence that the effect of financial development

on economic growth is essential through the efficiency of investment rather than its volume

In summary, from studies above demonstrate that the base of economic growth is the factors of production and the efficient use of those factors

Another important function of financial system is monitoring managers and exerting corporate control Financial arrangements are constructed by the owners of the firm because these compromises will oblige firm managers operate in the best interests of the owners Similarly, banks can also use financial arrangements to enforce the owners and the managers run enterprises according to the benefits of banks On the other hand, outside investors must pay more costs to verify the return levels of projects because insider investors are likely to distort information about the project returns to outside investors These costs, however, can deter investment decision and decline economic efficiency Hence, financial contracts that have lower monitoring and enforcement costs can increase investment efficiency (Khan, 2001) emphasized the role of external finance channel in the process of economic growth Due to the informational asymmetries between borrowers and lenders, when the producer want to approach loans to invest, the lender must spend more costs to verify the production capacity and the financial situation of firms Therefore, the presence of financial intermediaries may perform debt contracts, which include costs when borrowers are unlikely to repaid loans An increase in the provision of external finance leads to an increase in borrowers’ collateral net worth, which proves higher firm’s solvency This issue declines the costs of the contract of

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finance Concurrently, a decline in the costs of supplying external finance will narrow the spread between the borrowing and lending rate As a result, financial contracts become more efficiently, which in turn induce higher return on investment and higher economic growth In conclude, financial arrangements which reduce asymmetric information and ameliorate corporate control will better the allocation

of resources This is foundation to further faster capital accumulation and economic growth

Besides, to attain more funds for projects, insiders must seek for financing from many outsiders Meanwhile, financial intermediaries can mobilize savings from many individuals, then they lend these resources to the project owners In this relationship, both savers and intermediaries can monitor borrowers while savers do not need to supervise intermediaries because these institutions manage well diversified portfolio, and they always ensure to pay deposit interest rate on schedule

to depositors Consequently, due to lower information costs and monitoring costs, financial intermediaries may improve investment efficiency and better resource allocation

On the other hand, the appearance of asymmetric information and transaction cost will increase liquidity risk This is foundation leads to the establishment of markets and financial institutions Savers do not like risk As you know, investment projects which have high returns always accompany with higher risks, while the projects with lower risk will bring lower yields Financial market with capacity for diversifying portfolio will move savers to the projects with higher expected yields Thus, by eliminating risk of liquidity, banks can also enhance savings and increase investment in high return projects and illiquid assets, so they may stimulate the growth Therefore, financial intermediaries, such as bank, stock market and fund provide services of risk diversification Besides, the well function of risk diversification not only improves the efficient resource allocation and higher saving, but also affects capital accumulation and technological innovation

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(Saint-Paul, 1992) developed a model to clarify how the financial market affects the technological choice The first strategy is high flexibility and allows the productive diversification but has low productivity The other strategy is more productive and more specialize The financial market helps individuals who hold diversified portfolio against negative demand shock and choose high productive technology Because the individual can be diversified their portfolio via the stock market, they can reduce risk and increase the proportion of resource allocated to firm and encourage the specialization of production, thereby economic growth is higher Later on, (Levine & Zervos, 1996) concluded that the liquidity of stock market and the development of banking system correlate positively and significantly with economic growth, capital accumulation and productivity Furthermore, the correlation among financial depth and indicators of growth over time was found in (King & Levine, 1993a) It means that based on the level of financial development in this period, economists can forecast economic growth, physical capital accumulation and economic improvement in the following period Especially, (Beck, Levine, & Loayza, 2000) and (Levine, 1997) study not only the relationship between financial development and economic growth but also the nexus between finance and sources of growth, such as private saving rates, physical capital accumulation and total factor productivity The results prove that higher financial development leads to higher economic growth and total factor productivity Also, better allocation of savings and rapid capital accumulation, which can be achieved by increasing domestic saving rates and attracting foreign capital, foster technological innovation Before that, the importance of financial development on technological innovation was also mentioned in (King & Levine, 1993b) Following this, financial market can identify and evaluate the potential innovative projects, thus allocating resources efficiently Therefore, the nation with

a better function of financial system can conduct a successful innovation On the contrary, a decrease in the rate of innovation produced by policies distorting financial system will decline growth rate Consequently, as to (Beck et al., 2000;

2.1.2.2 Financial liberalization and repression:

According to the McKinnon – Shaw hypothesis, government restrictions on the activities of financial system, such as interest rate ceiling and high reserve requirement, not only obstacle financial deepening but also implies a poor function financial system This issue may negatively influence economic growth It is generally agreed that the real interest rates can affect economic growth through investment and saving (McKinnon and Shaw, 1973) As you know, investment has

a negative relationship with real interest rates, thus the investment curve is downward sloping Conversely, saving curve is upward sloping because saving is a positive function of real interest rates Therefore, low real interest rates discourage savings; so, lower savings will reduce the loanable funds for investment Lower investment results in lower economic growth In other hands, higher interest rates will encourage savings and reduce investments of entrepreneurs in low return projects On the contrary, lower interest rates strengthen the investment into projects having high - expected return As a result, the investment efficiency will increase

As to this school, if the financial repression is removed or financial system is liberalized more, financial sector can stimulate saving and investment, ultimately economic growth is higher

Moreover, the endogenous growth theory appears to favor financial liberalization (King & Levine, 1993b), for example, argued that the government intervention on financial system, such as financial repression, can negatively influence on financial development and economic growth Similarly, (Pagano, 1993) also mentioned that interest rate controls and reserve requirement can affect the financial intermediary activities

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Clearly, as discussed in previous section, economic growth can be affected

by financial intermediation via the productivity and the capital formation For the first channel, financial intermediaries are convenient for managing risks, identifying potential projects and exchanging goods and services These factors lead

to improvement in total factor productivity The second channel of capital formation

is through saving rates However the relation between money and capital formation

is complements rather than substitutes because individual must accumulate more funds to perform investments in case of self – finance (McKinnon, 1973) Hence, if low interest rates are kept, it may be unfavourable domestic saving, capital formation and economic growth

Nevertheless, some papers suggest that if the policy of financial liberalization is not carried out appropriately, it can cause the destabilization of financial system and is the reason of financial crisis The linkage between financial crisis and financial liberalization has been found in some studies (Loayza & Ranciere, 2006) demonstrated that financial liberalization associates with both financial depth and financial fragility In the long run, the effects of financial liberalization and financial depth influence positively on investment and growth, but the result is converse in the short run Financial fragility, which derives from financial volatility and banking crisis, may produce negative growth Moreover, these influences depend on the stage of financial development of each country The countries where higher crisis level and larger financial volatility may have more negative impacts than countries with low crisis level and the low and medium volatility in the short run

2.2 Empirical studies

As mentioned in literature review, (Goldsmith, 1969; McKinnon, 1973; Shaw, 1973) indicated the positive role of financial development in economic growth, nonetheless, their study may have some limitations For example, (Goldsmith, 1969) only relied on data of 35 countries in the period 1860 – 1963 Firstly, the authors just investigated in a limited number of countries and did not

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consider other components related to economic growth Simultaneously, the authors also overlooked the direction of causal relationship and the inappropriate measurements of financial development As the case of (Goldsmith, 1969) only measures the size of financial intermediary sector Therefore, to overcome the limitations of (Goldsmith, 1969), (King & Levine, 1993b) collected data from 77 countries in the period 1960 – 1989 The findings showed the positive relationship between financial development and economic growth, capital accumulation and productivity growth Regression model of cross section for 77 countries was applied

as follows:

G(j) = ∞ + βF(i) + γX + ε (2.9)

G is the average growth rate of real GDP per capita, the average growth rate

of capital stock person and total productivity growth F denotes the value of the ith

measurement of financial development X includes other factors, which associate with economic growth such as income per capita, education, exchange rate, trade, fiscal and monetary policy

In spite of increasing sample size of observations and improving measures of financial development, this paper still has few shortcomings They concentrate on one section of financial systems, such as banks, and they do not identify the causal relationship To remedy drawbacks of previous studies, (Levine & Zervos, 1996) added development indicators of stock market to their investigation Analyzing cross section data of 42 countries during period 1976 – 1993, they proposed some following findings Firstly, there are positive associations between the liquidity level of stock market and the development of banking sector with economic growth Secondly, the contribution of financial development to the economy is mainly through the growth of capital productivity rather than capital accumulation Nevertheless, (Levine & Zervos, 1996) did not find the significant correlation between stock market development and productivity growth, capital accumulation and economic growth

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On the other hand, to accurately study the relationship between finance and growth, (Beck et al., 2000; Levine et al., 2000) analyzed this issue on both cross section and panel data over 1960 – 1995 (Beck et al., 2000) used dataset of 63 countries to estimate cross sectional estimator and 77 countries for panel data (Levine et al., 2000) also collected data of 71 countries for cross section and 74 countries for panel dataset Especially, they take average data over five year periods

is one observation, thus one country has seven observations

The model regression for cross sectional analysis takes the form:

GROWTHi =  + βFINANCEi + γ[CONDITIONING SET]i + i (2.10) The dynamic panel model is used for estimating panel dataset as follows:

yi,t – yi,t-1 = ( -1)yi,t-1 + βXi,t + ŋi + i,t (2.11) Above regression equation can rewritten:

yi,t =  yi,t-1 + βXi,t + ŋi + i,t (2.12)

Two papers applied two econometric techniques to answer the finance – growth nexus Firstly, the approach of instrumental variable estimator is used for estimating equation (2.10) with legal origin used as instrumental variable, which may only affect growth through the indicators of financial development and other determinant variables of growth The other, which is applied to estimate equation (2.12), is method of moments (GMM) dynamic panel estimators

The results after being estimated on both panel and cross sectional data from (Beck et al., 2000; Levine et al., 2000) argued that financial development is positively correlated with economic growth, which is in line with finance – led growth Moreover, omitted variables and problem of reverse causation do not cause the potential biases, which influence this positive linkage Besides, the effect of exogenous factors can partially contribute to this correlation Especially, (Beck et al., 2000) do not only examine the impact of financial intermediary development on growth of economy, but they also mention about its effect on total factor productivity growth, physical capital accumulation and private saving rate

papers also give contrasting results as well as various evidences Firstly, there are a

number of evidences supporting the supply – leading hypothesis, such as (Fase & Abma, 2003; Habibullah & Eng, 2006; Leitão, 2010; Phan, 2011; Qayyum, Siddiqui, & Hanif, 2004; Wu et al., 2010) For instance, Phan (2011), who has the same argument with (King & Levine, 1993b), claims that financial development positively impacts on economic growth in Vietnam through four main channels These channels include the efficiency of saving, the productivity, the quantity and the quality of investment Simultaneously, financial development essentially affects growth through increasing the quantity of foreign direct investment rather than its quality These results are confirmed after (Phan, 2011) bases on dataset of 61 provinces in Vietnam from 1997 to 2004 and applies the techniques of panel data These methods include pooled OLS, fixed effects and random effects, Instrumental variables regression and Generalized Least Squares

(Leitão, 2010) performed his research with dataset including The European Union Countries and Brazil, Russia, India and China during the time 1980 – 2006 The author used two indicators including private credit and deposit money banks to represent the financial development variables The static panel data (fixed effects approach) and dynamic panel data (system GMM) are two principal methods The findings from both techniques suggest that the development of financial sector has the important role in the process of economic development Besides, the development of this sector also encourages international trade

Similarly, to determine the relationship as well as the role of financial development in economic growth in 13 Asian developing countries over period

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1990 - 1998, (Habibullah & Eng, 2006) used the system GMM approach This technique is likely to decrease biases in the coefficients because it helps to control unobserved country specific effects Secondly, by applying the lagged values of independent variables as valid instruments, GMM also controls for the problems of the endogeneity of explanatory variables in the model Therefore, GMM will give the consistent and efficient estimates Consequently, by doing this, the author provided evidences to show owing to the financial reform, the development of finance sector can stimulate growth in these countries

Similar results were also found in the study of (Fase & Abma, 2003) when examining the impact of financial environment on economic growth in some Southeast Asia nations from 1974 - 1999 The study emphasized that economic growth could be ameliorated by the improvement of financial structure and the financial reform

Even though the majority of studies favor a positive relationship between financial development and economic growth as discussed in studies above, other investigations have still found the evidence against these positive effects A negative correlation between two issues can be due to some reasons According to (De Gregorio & Guidotti, 1995), its effects depend on the characteristic of financial system of each country, the study period and the level of income Thus, financial development may negatively correlate to growth, such as in the case of Latin America in 1970s and 1980s This case results from the weakness of financial environment, which might lead to inefficient allocation of savings, thereby growth

is negative Moreover, the different results are due to various measurements of financial development Therefore, countries with different level of financial development derive from the difference in policies and institutions (Khalifa Al-Yousif, 2002)

An other case, (Wu et al., 2010) applied panel mean group estimator for 13 countries in European Union during period of 1976 – 2005 to investigate the relation between credit market, equity market and economic development Their

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findings concluded that there exists a long run relationship among economic growth, development of banking system and stock market Besides, the capitalization and liquidity of stock market can encourage growth in the long – run Inversely, financial depth exhibits a negative impact on economic development in the long – run However, the influences of the liquidity of stock market on output growth are negative in the short – run Also, economic development can be also promoted by the risk diversification and the improvement of commercial banking services In short, this paper highlights a decisive role of stock market and banking system in economic performance

Comparing with previous studies, (Qayyum et al., 2004) used panel unit root test, fixed effect model estimation and cointegration test to evaluate both aspects of indirect finance and direct finance Furthermore, this paper also estimates the impacts of inflation on financial development in the low - income countries Through this research, the effects of indirect finance and direct finance on growth are different Although the nexus between indirect finance and economic growth is negative, there is an existence of positive relation between direct finance and growth Especially, the author emphasized that if the country has high inflation rates, the economy can be damaged by the development of financial sector rather than other nations It also means that higher inflation is more harmful for economic development of countries with higher developed financial system compared to lower developed financial system Moreover, the findings of causality test imply that financial development does not encourage economic growth whereas growth is unlikely to result in developing finance sector As a result, the findings from this study have similar viewpoint with (Lucas Jr, 1988) when indicating the role of finance is overestimated in literatures

In summary, the outcomes of (Qayyum et al., 2004; Wu et al., 2010) demonstrate that the impact of financial development on economic growth, positive

or negative, depends partially on the feature of financial system of each country, the study period and the measures of financial development

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Especially, the demand – following hypothesis is favored by (Ang & McKibbin, 2007) who researched this link in the case of Malaysia Based on time series data from 1970 – 2001, (Ang & McKibbin, 2007) employed a vector autoregressive approach to examine the correlation as well as the causal relationship between finance and growth Main variables used in the model include financial development index, real GDP per capita, real interest rates and the extent of financial repression Firstly, these results of this paper reported here are consistent with McKinnon and Shaw hypothesis and (King & Levine, 1993b; Pagano, 1993)

It proves that financial repression and real interest rate impact negatively on financial deepening Accordingly, it favours financial liberalization, which stimulates the development of financial sector Secondly, the development of finance seems to be an outcome of the growth process in Malaysia Hence, the results of this study give support to the demand following hypothesis In other words, there is no bidirectional relation and only economic growth leads to higher financial development This viewpoint is also similar with (Goldsmith, 1969; Jung, 1986; Robinson, 1953; Shaw, 1973) Furthermore, the growth – led finance hypothesis was found by (Ndlovu, 2013) who suggested one-way causality from economic growth to financial development in Zimbabwe in the period of 1980 –

2006 This causal direction was shown by employing not only the Ganger causality test but also panel unit root test and Johansen cointegration test Because financial system development is not positive influences on economic growth in this country, policies should focus on expanding trade liberalization and other related activities

to promote growth, for instance, encouraging more investments and attracting more foreign investments

On the other hand, the positive bidirectional causality between finance and growth has been developed in some studies First of all, the study of (Apergis, Filippidis, & Economidou, 2007) examined the long – term linkage between financial development and economic growth using data of the 15 OECD and 50 non – OECD countries in the period 1975 – 2000 Applied techniques consists of panel

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integration and cointegration test Also, three different indicators have been used to measure financial development: liquid liabilities of financial system, bank credit and private sector credit Results suggested the bidirectional causal interrelation between development of finance and economic growth The study also underlined the importance of policies improving the function and the activity of financial market In particular, it is necessary for regions where the impacts of financial sector on developing countries are stronger than industrial countries Simultaneously, a positive interrelationship between the development of this sector and economic growth is found in these country groups in the long - run Moreover, macroeconomic stability policies, trade openness and investment in physical and human capital are also important resources contributing to the improvement of growth

Similarly, (Jun, 2012) employed the technique of unit root test and panel cointegration estimation to clarify the link between financial development and growth based on panel data of 27 Asian countries in during 1960 – 2009 Findings exhibit that growth still has a long – run association with both indirect finance and direct finance sectors Clearly, output growth has a positive relation with broad money, domestic credit and the rate of stock market capitalization in both directions In other words, the development of finance market can stimulate economic growth in these countries, on the contrary, output growth also can boost financial development Besides, developing countries also need to have a reasonable policy to promote the domestic financial market development because the development of banking and securities sector has an important role in growth strategy in developing economies

The paper of (Rachdi & Mbarek, 2011) using panel data cointegration and GMM system approaches demonstrates these two issues Firstly, there is a long – term linkage between financial development and economic growth Secondly, a strong positive correlation between development of finance and GDP growth has been exhibited in OECD and MENA countries However, the direction of causality

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varies in OECD and MENA countries In particular, bidirectional causality between finance and growth is discovered in OECD countries Converse findings are arisen for the MENA countries where only manifest the direction of causality from economic growth to financial development Besides, financial crises have a negative effect to the development of financial sector, but this field still has positive contributions to economic growth if the function of financial sector is improved better

The positive relationship between economic growth and finance development was also found in the paper of (Hassan et al., 2011) Their researches provide evidences for the negative linkage between the indicators of domestic credit provided by banking, domestic credit to the private sector and growth in high income countries Nonetheless, the positive relationship between factors above is reported in low and middle income countries Inversely, the liquid liability indicator

is negatively related to growth in high income In addition, there exists a bidirectional causality between finance and growth in the most low and middle income countries, but there is only unidirectional nexus from economic growth to finance in the poorest countries Besides the role of finance sector, trade and government expenditure have also the important function to growth It proves that the development of financial system is only necessary condition, but it is not sufficient condition for economic growth

From the results of vector error correction model and Granger causality test, (Adamopoulos, 2010) indicated two - way causality between the development of stock market and economic growth In Ireland, this paper only finds one – way causality direction from economic growth to development of credit market in the period 1965 – 2007 Simultaneously, there was unidirectional causality linkage from credit market development to stock market development The paper also mentioned that the effect of the development of stock market on economic growth was larger than the impact of credit market development

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Correspondingly, from the findings of (Adamopoulos, 2010; Hassan et al., 2011; Rachdi & Mbarek, 2011) reflect that not only does the direction of causality depend on how financial system and economy of country groups develop, but it is also influenced by measures of financial development This argument is similar to the supply – leading hypothesis and the demand – following hypothesis For instance, to check specifically the causal relation between finance and growth in Sri Lanka during 1955 – 2005, (Perera & Paudel, 2009) put Johansen cointegration test and Error Correction Model into their research Especially, this study chooses six proxies of financial development to make clearly the role of finance in growth: broad money stock to normal per capita GDP, the ratio of narrow money, total deposit, ratio of the credit of private sector, total credit and the credit of private sector to total domestic credit Final findings reported the feedback causality between broad money and growth In spite of unidirectional causality from private credit to growth, private credit sectors still have positive contributions to economic growth Besides, there is one - way causality from growth to the other variables such as narrow money, total credit and private sector credit to total domestic credit

The study of (Jude, 2010), which applied panel threshold regression model, concludes that the coefficients of finance and growth are influenced by the threshold variables, such as inflation rate, government size, openness of trade and indictors of financial development These coefficients vary across time and country

It maintains more stable in developed countries than in developing countries In the countries where high level of government consumption ratio may decline the impact

of financial development on growth Besides, in the countries with high trade openness and strong financial system, economic growth is less sensitive to financial development As a result, the relationship between financial development and economic growth is not linear because its change depends on indicators of financial development and determinants of economic growth

On the other hand, the study of (Fung, 2009) provides evidence for conditional convergence in both economic growth and financial development It

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occurs in the middle and high - income countries Moreover, the low - income countries where well developed financial sectors are still able to catch up the middle and high income nations Nonetheless, if financial sectors of these countries are under developed, they are less capability to catch up developed countries

In general, in spite of existing either the bidirectional or unidirectional causality between financial development and growth, or because of various measurement techniques, the development of financial system has still significant contributions to the growth of economy This relationship, however, is still nonlinear because its impact can be negative in some cases In addition, these effects depend on regions, study periods, characteristics of financial system, etc Besides, most researches do not only offer that financial crisis and financial repression are harmful for financial development, but these papers also underline the role of financial reforms and liberalization

Table A.2 (Appendix A) summarizes empirical studies discussed in this study Based on literature review, the impacts of financial development on economic growth are summarized in table 2.1

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Figure 2.1: The role of financial development in economic growth

This table illustrates the role of financial system in economic growth generally In accordance with (Levine, 2005), the development of financial market and institutions can promote economic growth through some channels: increasing the liquidity, managing and diversifying risks, establishing the payment system, trading goods and services more easily, reducing information costs and transaction costs, providing information about enterprise to allocate capital efficiently Especially, the function of savings mobilization from individual and investor in the

Financial development

Establish the payment system

Mobilize saving Diversify risk, manage

liquidity risk and monitor

the ability of

entrepreneurs, reduce

of goods and services

Increase financial deepening and reduce information cost, transaction cost

Increase saving and investment

Improve the resource

allocation

Increase capital accumulation

Increase the efficiency

of capital

Technolgical innovation

Economic Growth Increase the efficiency

of investment

28 economy contributes to raising capital accumulation, thereby economic development is faster

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CHAPTER 3: RESEARCH METHODOLOGY

This chapter includes four main sections The first section introduces empirical model relied on previous researches The next section provides measures to estimate financial development and determinants of economic growth Based on theoretical foundation, this study graphs the analytical framework to illustrate the relationship among dependent variables and independent variables The last parts will describe data collection as well as discuss the estimation strategy, which will be employed to answer research questions

3.1 Model Specification

In order to construct a regression model examining the impact of financial development on economic growth, this study bases on previous researches to choose suitable model and variables Normally, cross – country regressions and panel data techniques are common methods for investigating the finance – growth nexus Cross section analyses, however, have some potential limitations because it

is likely to suffer from omitted variable bias, or the regressors are endogenous Moreover, the unobserved country specific effects are not able to control by cross section analyses If cross section estimator is performed, it only controls for the endogeneity of financial development but cannot control for the endogeneity of all explanatory variables The coefficients of financial development indicators can be biased and inconsistent Consequently, to overcome these shortcomings, recent papers have been suggested using dynamic panel data approach instead of cross section Dynamic panel data model not only allows to address the omitted variable bias and accounts for the unobserved country specific effects, but this model also deals with endogeneity of one or more regressors As has been shown in reviewing the empirical studies, (Beck et al., 2000; Levine et al., 2000) also performed dynamic panel data model to estimate the relationship between finance and growth

The general dynamic panel model which examines the effect of financial development on economic growth is described as follows:

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yit =  + βyi,t-1 + γxit + ni + λt + uit (3.1) where yit is the average growth rate of real GDP per capital

yi,t-1: is the lagged values of dependent variable

Xit is explanatory variables, including financial development indicators and other determinants of economic growth

ni is unobserved country specific effects

λt is a time – specific effect

uit is the error term

Obviously, besides proxies for financial development indicators are the most important explanatory variables, other factors affecting economic growth are also involved in the research model According to the research of (Beck et al., 2000; King & Levine, 1993b; Levine et al., 2000; Loayza & Ranciere, 2006), these papers used the secondary school enrolment ratio to represent the human capital Besides, inflation and ratio of government consumption to GDP are also used as proxies for fiscal policy and macroeconomic stability To estimate the degree of trade openness, the authors utilized the volume of trade as a percentage of GDP

Based on the empirical studies and the basic theories, this study establishes the general model researching the effect of financial development on economic growth as follows:

GROWTHit =  + βGROWTHi,t-1 + χ1Fit + χ2INFit + χ3GOVit +χ4TOit + χ5EDUit

where: i denotes the country and t denotes the time

GROWTHit: growth rate of real GDP per capita as a proxy of economic growth GROWTHi,t-1: is the one – year lag of growth rate of real GDP per capita

Fit: measure of financial development indicators

INF: inflation rate (the change in rate of GDP deflator)

GOV: The ratio of government consumption to GDP

TO: The trade openness

EDU: The secondary school enrollment ratio