2.3 Literature review and empirical studies
2.3.2 Empirical studies on financial development and economic growth relationship
Levine et. al., (2000) highlighted the need to use ratio of credits offered by banks to private sector to GDP as one of key components in measuring financial development.
The authors argued that the higher level of financial services is, the higher level of financial development will be achieved (Levine et. al., 2000). By using the generalized method of moments with pure cross sectional instrument variables to investigate the finance – growth relationship in 74 countries for a period of 1960 -1995, the authors found out two main points. Firstly, the components of financial development (i.e. the ratio of credits offered by banks to the private sector to GDP, the ratio of commercial bank assets divided by the sum of commercial bank asset and central bank assets and the liquid liabilities of the financial system) positively correlate with economic growth.
Secondly, the causal correlation between financial development and economic growth mainly rely on the growth of total factor productivity (Levine et. al., 2000).
Furthermore, in the study carried out by Khalifa Al-Yousif in 2002, the authors use Granger test within an error correction model (ECM) developed by Bishop (1979) to investigate the relationship between financial intermediation and growth in 30 developing countries covering the period 1970-1999. They concluded that the connection between financial development and economic growth is positive two-way effect. The study also suggested that there are two effective indicators for measuring financial depth. They are the ratio of narrow money stock to GDP (M1) and the ratio of broad money to GDP (M2). It is implied that higher expansion in financial sector, the greater use of financial services, hence the greater financial development (Khalifa Al- 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 is from 1997 to 2004. The authors found out that technology and financial development have positive impact on real GDP. The authors also recommended that general government consumption expenditure as share of GDP should be used as explanatory variables in exploring the linkage between financial development and GDP growth.
Government expenditure is expected to have a negative impact on GDP due to crowding out effect to private sector investment. The additional economic indicators are supposed to use is foreign direct investment. They argued that foreign direct investment enhances the process of financial integration and then fosters the development of the financial sector. Flow of foreign direct investment is expected to have a positive impact on financial development (Zagorchev et. al., 2011).
Masten et al., (2008) employed the method of generalized method of moment estimators in analyzing how financial development and financial integration impact on economic growth in 31 countries in the European area. The observed period is from 1996 to 2004. The authors confirmed that the development of the domestic financial system and financial integration have a significant positive impact on economic growth. They found that the strong impact of financial development on economic growth exist in developing countries (Masten et al., 2008).
Investigating the two-way effect of financial development and economic growth, Calderón and Liu (2003) used panel data covering 109 developing and industrial countries for the period from 1960 to 1994. The econometric method is Geweke decomposition test. The authors found that the causal relationship between financial development and economic growth exist. The financial development significantly impacts on economic growth in both developing countries and developed countries.
The development in financial system enhances economic growth in those countries.
In their study, the authors suggested that two economic indicators should use to measure financial development. The first indicator is the ratio of broad money to gross domestic product (M2/GDP). The author argued that the financial system develop if the ratio of M2/GDP is high. Hence, financial sector becomes larger (Hassan et al., 2011).
The second economic indicator is the ratio of domestic credit offered by financial institutions to the private sector to gross domestic product (CREDIT/GDP). The authors confirmed that this indicator is the best way to measure financial depth.
CREDIT/GDP has significant impact on investment and economic growth. It is believed that a higher this ratio, the higher financial service expansion and then, the greater financial development (Calderón and Liu., 2003; Hassan et al., 2011).
Beside financial development measurements, economic indicators such as human capital, general government consumption as a percentage of GDP, blacked market exchange rate premium and real GDP growth rate are used to capture the economic growth (Calderón and Liu, 2003).
Employing the methodology of various multivariate time series analysis to investigate the role of financial development in context of economic growth in 168 countries during the period from 1980 to 2007. Hassan et al., (2011) classified those countries in six geographic areas and three income categories (i.e. countries with low income, countries with middle income, and countries and high income). This classification reflected a broad coverage across regions and levels of development. The authors gave a conclusion that there exist a strong linkage between financial development and economic growth in sample countries. In particular, the financial development has a positive impact on economic growth and vice versa in all regions except Sub- Saharan and East Asia and Pacific.
According to Hassan et al.,(2011), there are seven economic indicators capturing financial depth and economic growth used in their study. These economic indicators are that
- The domestic credit provided by the banking sector as a percentage of GDP. This ratio implies that if the functions of the financial system are well performed, it would positively impact on the financial system expansion (Levine, 1997)).
- The domestic credit to private sector as percentage of GDP. This ratio is used to explain that allocating capital resource to private sector requires higher development in the financial system in order to assessing and managing risks, monitoring businesses, facilitating a financial transaction and raising savings.
- The broadest definition of money as a percentage of GDP. The higher ratio implies higher development in the financial system.
- The gross domestic saving as a percentage of GDP. This ratio is believed that it positively impacts on real interest rate. Hence, it will enhance investment and growth.
- Trade openness as a percentage of GDP. This ratio positively impacts on the improvement of the economic growth through international trade openness.
- General government final consumption expenditure as a percentage of GDP. This ratio impacts on improvement of economic growth through government spending adjustment.
Lee and Chang, (2009) employed dynamic OLS and vector error correction model to examine the causal linkage between Foreign direct investment (FDI), financial development and economic growth. The period is observed from 1970 to 2002 covering 37 countries. The authors concluded that financial indicators, namely the liquid liabilities as a percentage of GDP, the domestic credit provided by the banking sector to the private sector as a percentage of GDP, positively correlate with economic growth. Furthermore, the developed-financial system strongly facilitates country to attract FDI flow. In turn, FDI enhances economic growth through increasing in investment capital and technology transfer (Lee and Chang, 2009).
Habibullah and Eng (2006) examined the causal impact of financial development on economic growth in 13 Asian developing countries. Sample period is from 1990 to 1998. The methodology is the generalized method of moment (GMM method). The authors concluded that there existed the positive causal relationship between financial development and economic growth in 13 Asian developing countries. They further confirmed that the developed financial system significantly contributes to the economic performance in 13 Asian developing countries.
Ang et al., (2007) examined the causal relationship between financial development and economic growth in Malaysia. They employed the methodology of vector autoregressive approach to test the issue. The observation period covers from 1960 to 2001. The finding shows that economic growth leads to development in the financial system. However, the financial development weakly impact on economic performance.
Christopoulos and Tsionas (2004) examined the causal relationship between financial development and economic growth in the long run term. Christopoulos and Tsionas (2004) used panel data covering 10 developing countries with an observed period of 1970-2000. The authors applied various econometric methods, such as panel unit root test and cointegration analysis to explore the issue. Results shown that the financial development has a significant and positive impact on economic growth in long run term. The results also indicated there is no evidence showing that economic growth leads to the development in the financial system in the short run term.
The main findings of the mentioned-above empirical studies on the finance-growth relationship are summarized as below:
Table 1: Summary of empirical studies:
No Authors Methodology Data Results
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 - development
instrument variables 1995 positively correlate
with economic
growth.
2 Khalifa Al- Granger test within an Both time series and The connection
Yousif error correction panel data are between financial
(2002) model (ECM) applied in 30 development and
developed by Bishop developing countries economic growth is
(1979) covering the period positive two-way
1970-1999. effect
3 Zagorchev et. Employing Panel data covering - Financial
al., (2011) generalized method of eight European development and
moments (GMM countries. technology have a
method) Observation period positive impact on
is from 1997 to real GDP.
2004 - Financial
development has positive impact on technology.
- Weak evidence
showing
technology
positively impact
on financial
development
4 Masten et al., Method of Panel data of 31 - Development of
(2008) generalized method of countries in domestic financial
moment European area. system and
Observed period is financial
from 1996 to 2004 integration has a positive impact on economic growth.
- A higher impact of financial
development on economic growth
in developing
countries
5 Calderón and Method of Geweke Panel data set - existence of causal Liu (2003) decomposition test covering 109 relationship
developing and between financial
industrial countries. development and Observation period economic growth.
is from 1960 to - Financial
1994 development
significantly
impacts on
economic growth
in developing countries than that
in developed
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
on investigating 2007 economic growth
- Financial development
impacts on
economic growth and vice versa in all regions except Sub- Saharan and
East Asia and
Pacific.
7 Lee and Dynamic OLS and Panel data set for - Financial indicators Chang, vector error period 1970 -2002 (liquid liabilities as
(2009) correction model to covering 37 percentage of
explore causal linkage countries. GDP; domestic
among Foreign direct credit provided by
investment (FDI), banking sector to
financial development private sector as
and economic growth. percentage of
GDP) positively correlate with
economic growth.
- A developed
financial sector facilitates country to attract more FDI flow.
8 Habibullah Generalized method Panel data set of 13 - Positive causal
and Eng of moment. Asian developing relationship
(2006) countries. between financial
Sample period is development and
from 1990 to 1998 economic growth.
- Developed
financial sector significantly
contributes to economic
performance
9 Ang et al., Vector autoregressive Time series data - Economic growth
(2007) approach covering period leads to
1960 – 2001 in development in
Malaysia. financial system.
- Financial development weakly impacts on economic
performance.
10 Christopoulos Various econometric Panel data covering - Financial
and Tsionas methods (panel unit 10 developing development has
(2004) root test and countries with significant impact
cointegration observed period on economic
analysis) 1970-2000. growth in long run
- No evidence
showing that
economic growth
leads to the
development in the financial system in the short run term.