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

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIESVIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS RELATIONSHIP BETWEEN FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH: PANEL

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM - NETHERLANDS

RELATIONSHIP BETWEEN FINANCIAL DEVELOPMENT AND

HO CHI MINH CITY, October 2014

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

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 beenproperly acknowledged and referenced If this statement is untrue I understand that Iwill have committed an assessment offence

I have read the Regulations of Vietnam – Netherlands Programme for M.A InDevelopment 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 academicsupervisor, for his very carefully reading and editing of my thesis His valuablecomments and suggestions help me to improve the quality of this thesis throughout mythesis stage Thank to his valuable lectures, guidance and encouragement, I can fullycomplete 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 valuablelectures, 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 ofMDE course 18 and to a number of individuals for their encouragement in many waysthat 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

3.1.2 Research hypotheses: 33

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

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

and in Asean countries……… 70Figure 5: Gross domestic saving rates in Vietnam and in Asean countries……….71Figure 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 connectionbetween financial development and economic growth due to the important role offinancial development in the process of achieving the higher economic growth

To investigate the causal relationship between financial development and economicgrowth in twenty two developing countries in different regions from 1990 to 2011, weapply both Generalized method of moment with instrumental variable approach andOrdinary least square technique to examine how determinants of financial developmentimpact 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 betweenfinancial development and economic growth in selected developing countries We alsofind that the variable components such as the ratio of broad money to GDP, the ratio ofcredit offered by bank to private sector to GDP, the ratio of gross domestic savings toGDP and the ratio of domestic credit to the private sector to GDP play an importantrole in explaining financial development Furthermore, foreign direct investment,general government consumption and trade openness are important factors inaccounting for growth rate of GDP per capita We find out that the EXPORT issignificantly negative impact on economic growth This result is consistent with theargument that export specialization in developing countries may not benefit theeconomic growth

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

Keywords: Financial development, growth, causal relationship

CHAPTER 1: INTRODUCTION

1.1 Research problem

In recent years, the causal relationship between financial development and economicgrowth has been attracting a lot of attentions in the economic literatures It is believedthat 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 throughcapital allocation efficiency The capital allocation efficiency can be enhanced byperforming the functions of financial intermediaries, including the improvement of riskmanagement and the reduction of asymmetric information, as well as encouragement

of saving and investment This leads to the result in the improvement in total factorproductivity Therefore, a well-functioning financial system may foster economicgrowth (Hao, 2006; Odhiambo, 2004; Ghirmay, 2004)

There are numerous empirical studies providing supportive evidences on positivelinkage 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 financialdevelopment and economic growth has been investigated by using Vector AutoRegression (VAR) approach for analyzing panel data of 109 industrial and developingcountries for a period of 1960-1994 in the study of Calderón and Liu (2003) Theauthors found that financial development positively affects economic growth andeconomic growth positively affects financial development The authors also admittedthat the financial development impacts on economic growth through channels of arapid capital accumulation and productivity growth They further concluded that theimpact of financial development on economic growth should be well recognized inproviding 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 financialdevelopment and economic growth in 13 Asian less developed countries withobservations from 1990 to 1998 The authors concluded that financial developmentenhances economic growth They also agreed that a developed financial system willcreate more financial instruments These instruments improve the capital accumulation

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

Furthermore, by employing Granger causality test within the error correction model,Al-Yousif (2002) investigated the financial development and economic growthrelationship 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 toinefficient allocation of savings and investment during the 1980s (Al-Yousif, 2002).This means that there is a same direction movement on the relationship betweenfinancial 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 relationshipbecomes 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 andeconomic growth from different imcome groups of countries The selected countriesinclude countries with low income, countries with middle income, and countries withupper - middle and high income The period is observed from 1980 to 2007 Thefindings indicate that the financial development weakly facilitates short term economicgrowth in developing regions (Hassan et al., 2011; Wu et al., 2010; Ghirmay, 2004)

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

by employing econometric techniques, which measure of financial depth and economicgrowth The econometric techniques are widely used in many empirical literatures Anew dataset is used in attempting to provide further evidence on the causal impact offinancial development on economic growth The sample countries are twenty twodeveloping countries These countries are selected in different regions The observationperiod 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 WorldDevelopment Indicators (WDI) from World Bank database

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

- The first is the fact that the financial development has a significant impact on theeconomic growth in the developed countries Meanwhile, the impact of financialdevelopment 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 andAbma, 2003) Therefore, this research focus on investigating the causal relationship betweenfinancial 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 countriesover period 1990-2011 allows us not only to focus on examining the two way impacts offinance-growth relationship in long run, but also to have enough observations to effectivelyrun 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 financialdevelopment on economic growth and vice versa In this research thesis, we formulate

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

To gain more from the findings of this research, we will make an overview of therelationship between financial development and economic growth in Vietnam incomparison 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 financialdevelopment and economic growth, this research is expected to provide appropriatepolicy implications to Vietnamese policy makers for promoting financial developmentthat 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 economicgrowth in twenty two developing countries from different regions for the period of 1990 to2011

- Providing appropriate policy implications to Vietnamese policy makers forpromoting 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 relationbetween financial development and economic growth as the main issues in thisresearch Therefore, the questions should be raised as follows:

- Does financial development promote economic growth and vice versa?

- 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 betweenfinancial development and economic growth from numerous empirical studies Finally,

it explains why twenty two developing countries are selected, what main objectivesare, 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 partdescribes theoretical framework and empirical studies related to the issue Thedeterminants 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, whichmainly 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 offinance 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 financialdevelopment and economic growth in Vietnam in comparison between the results ofVietnam and other developing countries, especially, asian developing countries (i.e.Indonesia, Malaysia, Philippines, Thailand, China, Singapore) which having the samefinancial characteristics as Vietnam

Furthermore, taking advantage of the positive interaction between financialdevelopment and economic growth in developing countries, this research is expected toprovide appropriate policy implications to Vietnamese policy makers for promotingfinancial 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 financialresources, assessing and managing risks, monitoring businesses and facilitating goodsand 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 tomeasure 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 oneconomic 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 assessingbusinesses and business environment conditions As a result, such high transaction costmay increase the cost of using financial resources Moreover, in the context that thecapital is scarce, imperfect information on economic conditions may make investorsdeal with the high cost relating to accessing business activities and economicconditions (Levine, 2005)

Transaction cost and asymmetry of information may be reduced via exploringinvestment opportunities of financial intermediaries Levine (2005) pointed out theimportant role of financial intermediaries in reducing transaction cost In Levine(2005), efficiency of financial intermediaries might reduce a large cost occurred inacquiring and processing information In addition, by lowing transaction cost and betterinformation, capital will flow into profitable projects This implies that the effectivefinancial market increase fund mobilization and investment The increase in savingsand investment will encourage the efficiency of production and operation sector in thecommodity market (Levine, 2005) Levine (2005) also emphasized in his study that theefficient financial market with low transaction cost and high liquidity of financialmarket makes technological innovation increase by boosting incentives to thoseinvestors who have promising projects in goods and product expansion According toZagorchev et al (2011), technology innovation accelerates the business activity byenabling the progress of acquiring and processing information As a result, the increase

in production and the use of technology in economizing on information processing costhave improved the capital resource allocation, then boost the economic growth rate(Zagorchev, et al., 2011; Levine, 2005)

Finally, due to less information asymmetry, the financial resources will be effectivelyallocated; 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 differentlenders 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 informationrelating to attracting funds from a large number of savers and investors Secondly, theinformation asymmetry raise problem when savers or investors may not have valuableinformation in making their investment decisions (Levine, 2005)

According to Levine (2005), there are two ways bridging savings and investments Thedirect way is that mobilizing funds may come from numerous of savers and investorswho have surplus resource (i.e joint stock companies, enterprises, individual savers,firms, ) In this channel, the capital resources directly flow from the agents who havesurplus 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 theconsiderable transaction cost involving assessing business activities, investmentopportunities and economic condition

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

Furthermore, Levine (2005) confirms that savings mobilization can enhance resourceallocation and improve the innovation in technology Without access funds fromdifferent investors, many production processes may cope with out of date technology.Consequently, production processes would be constrained to inefficient economies ofscale (Levine, 2005) In addition, Levine (2005) definitely cites that better fundmobilization from society and efficient allocation of those funds provides for poolingrisks and diversifying among a large number of savers and investors via denominatedinstruments In other words, different kind of risks are shared and transferred amongsavers and investors and through different financial instruments These financialinstruments may keep capital invested in a diversified portfolio of risky projects fromflowing to higher return projects by reallocating the investment funds, resulting inpositive 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 toinformation and transaction costs Therefore, financial contracts, markets and financialintermediaries play an important role in facilitating resource allocation for trading,sharing and shifting risks among savers and investors in various forms in the context ofeconomic growth Levine (2005) has classified risk into three categories They arecross-sectional risk diversification, sharing payoff (intertemporal) risk, and risk ofliquidity

In term of cross-sectional risk diversification, financial institutions includingcommercial banks, merchant banks, investment banks, mutual funds, insurancecompanies, pension funds, securities markets, etc may reduce risks in connection withresource 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 tomake savers or investors not reluctant to invest in riskier activities with higher return

Financial systems can positively facilitate long run economic growth through theability of providing risk diversification instruments via affecting resource allocationand 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 Forexample, in the period of economic shock, intertemporal risk may be diversified byfinancial intermediaries via lowing contracting cost (Levine, 2005)

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

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

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

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

of banks in enhancing liquidity via allocating capital reduces liquidity risks Byreducing risk of liquidity, financial intermediaries can improve resource allocation ininvesting 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 tofocus on corporate governance The degree of how effectively monitor businesses andhow the influence of using capital offered by providers of capital on firms hassignificantly affected on both decisions associated with savings and resourceallocation In other words, the effective monitoring businesses and maximizing firmvalue make the investors or savers are more confident in investing in businessesactivities Thus, without financial arrangements in the context of improving corporategovernance, pooling savings from different resources of society may be limited andresulting in keeping capital resources from flowing to highest expected returninvestment (Levine, 2005) Levine (2005) also emphasizes that the national growth rate

is definitely impacted by how effective mechanism of corporate governance onbusiness performance

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

cost and transaction cost can be economized by financial intermediaries because thatall 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 wellfunctioning financial intermediaries improves corporate governance, then fostereconomic growth by increasing in productivity, facilitating capital accumulation andcapital allocation with positive growth effects

Levine (2005) concludes that even though capital is scarce or abundant, the profits ofinvestors have been definitely depended on the quality of monitoring performed byfinancial intermediaries Furthermore, the poor ability of monitoring businesses offinancial intermediary may keep diffuse investors or savers from effectively governingfirms 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 lowtransaction cost and less information asymmetry in enhancing specialization,innovation in technology and economic growth

In the Levine (2005), the relationship between specializations, goods exchange andinnovation are explained by using the model of such connections developed byGreenwood and Smith (1996) The more specialize in production, the more it requirestransactions Due to high information and transaction costs, financial instruments orarrangements and intermediaries may occur to enhance the specialization process.Resulting in increasing in productivity, then, encouraging the good and servicesexchange The more easing in making transaction in markets reflect the wellfunctioning of financial market development

In other words, by expanding specialization in productivity and lowing information andtransaction 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

In which k is denoted as capital stock per worker

From the said above function (2), Aghion, P., & Howitt, P (2007) confirms that totalfactor productivity parameter (A) is positively depended on labor productivity of eachworker (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

It is assumed that Population and labor force grow at the same rate So, G is deemed to

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 totalfactor productivity growth (A/A) and the “capital deepening”, which is known ascapital accumulation (αk/k) are used as components of growth rate Furthermore, Beck,T., Levine, R., & Loayza, N (2000) suggests that capital accumulation, productivitygrowth and rate of private savings should be used to evaluate the impact of financialdevelopment 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 linkagesbetween 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 InLevine, R (2002), Levine (2005) and Arestis et al., (2005) pointed out that thepositive role of financial intermediaries in providing financial functions, which isexpressed 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 marketbased theory Arestis et al., (2005) argues that though financial functions, financialintermediary can mitigate the problems of acquiring information faced by individualinvestors (i.e informational asymmetry, free-rider problem) This is because thefinancial intermediary has set up long time relationships with firms and does notdisclosure about the acquired information to publicity (Levine, 2005; Levine, 2002) Inaddition, by having close ties and long run relationships with firms, financialintermediary has advantages in managing, monitoring businesses and improvingcorporate governance Therefore, banks have the powerful ability to make pressure onfirms to repay their debts, especially in nations where the capability of contractenforcement is not strong (Levine, 2005; Levine, 2002) As a result, the bank basedtheory believes that a market based system will not properly perform due tofundamental reasons such as information acquisition, information processing, corporategovernance, agency problems, liquidity problem, managing risks and monitoringbusiness) Consequently, resource allocation and economic performance will not beproperly improved In contrast, a bank based system without preventing fromregulation restrictions on financial intermediary activities, can explore economies ofscale in acquiring information, processing information, mobilizing resources, reducingmoral hazard via effective corporate governance, managing risks and monitoringbusiness Thereby, financial intermediary can produce better enhancement on resourceallocation and better improvement on economic growth via financing industrialexpansion (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 inenhancing economic growth The role of well functioning markets is stressed throughfostering profit incentives due to trading in big and liquid markets; enhancing corporategovernance; easing customization of risk management instruments and diversification

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

by powerful banks Banks with its power can take advantage in extractinginformational rents and protect businesses, which have a close relationship with banksfrom fierce competition In addition, due to weak regulatory restriction on bankingactivities, the powerful banks may work together secretly or illegally with managers ofbusinesses, which have a close relationship with those banks in order to against othercreditors 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 systemcan reduce asymmetry of information signals and effectively transfer this informationamong users and providers of funds in aiming at beneficial implications for financialfinancing businesses and economic performance (Levine, 2002; Arestis et al., 2005).Finally, proponents of a market based system find that markets provide a variety ofcustomized instruments for risk management Meanwhile, bank based systems mayoffer basic risk management vehicles with inexpensive cost As a result, market basedsystem emphasizes that the market reduces the inherent shortcomings of the bankbased 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 theorymainly focuses on the important role of financial services provided by a financialsystem in new firm creation, industry expansion and economic growth Basically, thistheory includes both the bank based theory and market based theory However, thefinancial and services view reduces the importance of the bank based system andmarket based system

In financial and services theory, it emphasizes on the environment in which effectivefinancial services provided by intermediaries and markets The theory states that thesource of funds is not the main issue The main issue should be focused on is creating abetter 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 whichintermediaries and markets effectively provide financial services According to thistheory, financial arrangements (i.e contract, markets and intermediaries) reduce theimperfections of markets and offer sound and efficient financial services facilitatingbeneficial investment opportunities, pooling savings and management of risks.Furthermore, financial arrangements use its power to affect corporate governance andimprove liquidity (Arestis et al., 2005; Levine, 2002).

Finally, Levine (2002) concludes that the financial and services theory is totally inagreement with bank based theory and market based theory Levine (2002) alsodiscusses that the financial and services theory definitely highlight the importance ofhow to create a better environment in which the functioning bank and markets are wellperformed As a result, this theory strongly reduces the debate between bank basedtheory 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 isconsidered as the special case of the financial and services theory The role of the legalsystem in creating a growth-promoting financial sector is extremely stressed in thelaw–finance theory The theory states that finance - a set of contracts - with legal rightsand enforcement mechanisms facilitates the operation of markets and intermediariesunder the well functioning legal system Moreover, theory states that the legal systeminfluences overall financial sector performance As a result, the quality of financialservices will improve the efficient allocation of resources and growth

Contrary to the bank based theory and market based theory, the law and finance theoryemphasizes the well functioning legal system and enforcement mechanism play animportant role in stimulating economic growth via differentiating financial systemsrather than focusing on whether countries follow bank based system or market basedsystem (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 financialdevelopment 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 tonon 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 consumptionspending to GDP, inflation rate and trade openness

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, ε)i,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 ε)i,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 becausebanks 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 sectorrequires higher development in financial system An efficient allocation ofcapital resource requires that five financial functions are well performed viaassessing and managing risks, monitoring businesses, facilitating financialtransaction 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 thefinancial system Because this indicator captures the ability of the financialsystem 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 toinvestment Consequently, the volume of investment is increased due to the ratio

of gross domestic saving to GDP increase This ratio has a positive impact onreal 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 ofGDP This ratio positively impact on improvement of economic growth throughinternational 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 throughgovernment spending adjustment This indicator is expected to move in theopposite direction with economic growth because of crowding out effect ofpublic 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 financialdevelopment and economic growth, the basic equation to demonstrate the finance-growth linkage is suggested in this research as follow:

GROWTHit = αo + α1FDit + α2Xit + ε)it

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 Grossdomestic savings as percentage of GDP

Xit : The group of determinant variables of economic growth

These variables include the Foreign direct investment, the Generalgovernment consumption, Trade openness measured by the sum ofimport and export of goods

ε)it : Error termi,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 toprivate 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 offinancial development will be achieved (Levine et al., 2000) By using the generalizedmethod of moments with pure cross sectional instrument variables to investigate thefinance – growth relationship in 74 countries for a period of 1960 -1995, the authorsfound out two main points Firstly, the components of financial development (i.e theratio of credits offered by banks to the private sector to GDP, the ratio of commercialbank assets divided by the sum of commercial bank asset and central bank assets andthe liquid liabilities of the financial system) positively correlate with economic growth.Secondly, the causal correlation between financial development and economic growthmainly 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 useGranger test within an error correction model (ECM) developed by Bishop (1979) toinvestigate the relationship between financial intermediation and growth in 30developing countries covering the period 1970-1999 They concluded that theconnection between financial development and economic growth is positive two-wayeffect The study also suggested that there are two effective indicators for measuringfinancial depth They are the ratio of narrow money stock to GDP (M1) and the ratio ofbroad money to GDP (M2) It is implied that higher expansion in financial sector, thegreater use of financial services, hence the greater financial development (Khalifa Al-Yousif, 2002)

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 isfrom 1997 to 2004 The authors found out that technology and financial developmenthave positive impact on real GDP The authors also recommended that generalgovernment consumption expenditure as share of GDP should be used as explanatoryvariables in exploring the linkage between financial development and GDP growth.Government expenditure is expected to have a negative impact on GDP due tocrowding out effect to private sector investment The additional economic indicatorsare supposed to use is foreign direct investment They argued that foreign directinvestment enhances the process of financial integration and then fosters thedevelopment of the financial sector Flow of foreign direct investment is expected tohave a positive impact on financial development (Zagorchev et al., 2011).

Masten et al., (2008) employed the method of generalized method of momentestimators in analyzing how financial development and financial integration impact oneconomic 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 financialsystem and financial integration have a significant positive impact on economicgrowth They found that the strong impact of financial development on economicgrowth 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 industrialcountries for the period from 1960 to 1994 The econometric method is Gewekedecomposition test The authors found that the causal relationship between financialdevelopment and economic growth exist The financial development significantlyimpacts 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 tomeasure financial development The first indicator is the ratio of broad money to grossdomestic product (M2/GDP) The author argued that the financial system develop if theratio 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 financialinstitutions to the private sector to gross domestic product (CREDIT/GDP) Theauthors confirmed that this indicator is the best way to measure financial depth.CREDIT/GDP has significant impact on investment and economic growth It isbelieved that a higher this ratio, the higher financial service expansion and then, thegreater financial development (Calderón and Liu., 2003; Hassan et al., 2011).

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

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

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

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

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

- The domestic credit to private sector as percentage of GDP This ratio is used toexplain that allocating capital resource to private sector requires higher development in thefinancial 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 itpositively 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 toexamine the causal linkage between Foreign direct investment (FDI), financialdevelopment and economic growth The period is observed from 1970 to 2002covering 37 countries The authors concluded that financial indicators, namely theliquid liabilities as a percentage of GDP, the domestic credit provided by the bankingsector to the private sector as a percentage of GDP, positively correlate with economicgrowth Furthermore, the developed-financial system strongly facilitates country toattract FDI flow In turn, FDI enhances economic growth through increasing ininvestment capital and technology transfer (Lee and Chang, 2009)

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

1998 The methodology is the generalized method of moment (GMM method) Theauthors concluded that there existed the positive causal relationship between financialdevelopment and economic growth in 13 Asian developing countries They furtherconfirmed that the developed financial system significantly contributes to the economicperformance in 13 Asian developing countries

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

2001 The finding shows that economic growth leads to development in the financialsystem However, the financial development weakly impact on economic performance.Christopoulos and Tsionas (2004) examined the causal relationship between financialdevelopment and economic growth in the long run term Christopoulos and Tsionas(2004) used panel data covering 10 developing countries with an observed period of1970-2000 The authors applied various econometric methods, such as panel unit roottest and cointegration analysis to explore the issue Results shown that the financialdevelopment has a significant and positive impact on economic growth in long runterm The results also indicated there is no evidence showing that economic growthleads to the development in the financial system in the short run term

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

Table 1: Summary of empirical studies:

1 Levine et al., Generalized method Panel data covering Components of(2000) of moments and pure 74 countries for the financial

cross sectional period of 1960 - developmentinstrument variables 1995 positively correlate

with economicgrowth

2 Khalifa Al- Granger test within an Both time series and The connectionYousif error correction panel data are between financial

developed by Bishop developing countries economic growth is(1979) covering the period positive two-way

3 Zagorchev et Employing Panel data covering - Financial

al., (2011) generalized method of eight European development and

moments (GMM countries technology have amethod) Observation period positive impact on

is from 1997 to real GDP

development haspositive impact ontechnology

- Weak evidenceshowing

technologypositively impact

development

4 Masten et al., Method of Panel data of 31 - Development of(2008) generalized method of countries in domestic financial

Observed period is financialfrom 1996 to 2004 integration has a

positive impact oneconomic growth

- A higher impact offinancial

development oneconomic growth

in developingcountries

5 Calderón and Method of Geweke Panel data set - existence of causalLiu (2003) decomposition test covering 109 relationship

developing and between financialindustrial countries development andObservation period economic growth

in developingcountries than that

countries

6 Hassan et al., Methodology of Panel data of 168 - A strong linkage(2011) various multivariate countries during the between financial

time series analysis sample period 1980- development and

- Financialdevelopment

economic growthand vice versa inall regions exceptSub- Saharan andEast Asia andPacific

7 Lee and Dynamic OLS and Panel data set for - Financial indicatorsChang, vector error period 1970 -2002 (liquid liabilities as

explore causal linkage countries GDP; domestic

GDP) positivelycorrelate with

economic growth.

financial sectorfacilitates country

to attract moreFDI flow

8 Habibullah Generalized method Panel data set of 13 - Positive causaland Eng of moment Asian developing relationship

Sample period is development andfrom 1990 to 1998 economic growth

- Developedfinancial sectorsignificantly

contributes toeconomic

performance

9 Ang et al., Vector autoregressive Time series data - Economic growth

Malaysia financial system

- Financialdevelopmentweakly impacts oneconomic

performance