Financial Development And Economic Growth

1226711 College of Business, Arts and Social Sciences

Financial Development and Economic Growth

An Empirical Analysis

BSc (Hons) Economics

College of Business, Arts and Social Sciences

Student Number: 1226711

Word Count: 7969

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1226711 College of Business, Arts and Social Sciences

Abstract

This study has reviewed the possible features of the banking and financial sector in 48

different income countries, over the recent period of 1999-2013 by estimating panel data

models. While subject to countervailing views, this paper is based on the hypothesis that the

existence of financial development leads to economic growth. There is an additional

hypothesis that inequalities and non-linearities among counties affect the regression results,

while the recent crisis contains a certain volume in this paper by exploring how financial

sector’s development has influenced growth differently.

Acknowledgements

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Contents

1. Introduction…………………………………………………………………………..4

2. Literature Review…………………………………………………………………..5

2.1. Does finance make a difference?……………………………………………………………..6

2.2. Financial structure and economic growth……………………………………..7

2.3. Financial Crises and the disappearance of the finance-growth relationship…..8

3. Data………………………………………………………………………………..10

3.1. Data Set……………………………………………………………………….10

3.2. Quartiles………………………………………………………………………10

3.3. Indicators to denominate economic growth…………………………………..11

3.4. Indicators to denominate the financial sector………………………………….11

3.5. Control Variables………………………………………………………………12

4. Descriptive Analysis……………………………………………………………….13

4.1. Summary Statistics……………………………………………………………13

4.2. Correlation Analysis…………………………………………………………..16

5. Methodology and Results………………………………………………………….20

5.1. The Model…………………………………………………………………….20

5.2. Results………………………………………………………………………….25

6. Conclusion………………………………………………………………………….38

7. References………………………………………………………………………….39

8. Appendix……………………………………………………………………………45

1.Introduction

This paper will attempt to combine the previous conducted studies and examine the effects

and possible influences of the financial system to economic growth. Levine’s 1997 paper is

taken severely into account, since its procedure is appearing to investigate every effect that

this paper aims to deal with.

Cross sectional dummy variables will be added to the models in the attempt to observe and

analyse country variations and year trends in this study. The paper is focusing on a 15 year of

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time span starting on 1999 and ending in the recent year of 2013, where observations and data

were more available.

This paper will be split into six sections; in the form of literature review the following section

will explain different perspectives of the existent literature, by comparing and contrasting

different analyses. The third section is a discussion of the data set with a combined

preliminary analysis of all the indicators used in this paper. The following section includes the

descriptive statistics analysis for the whole sample as well as the four quartile groups –

categorised by their income on 1999, which is the initial year of this study and a correlation

matrix analysis firstly for the whole data set and secondly, based on the years 1999, 2008, and

2013. The fifth section covers specific methodology and reasoning behind the proposed

econometric models. There will be an in depth analysis, of the findings and further

comparisons of the regressions. The last section will aim to summarize and propose

suggestions for the amelioration of the economy and the promotion of growth, by focusing on

the financial standpoint.

2. Literature Review

The recognition of a positive relationship between financial development and economic

growth dates back to Schumpeter (1934), who sees the financial market sector as the

accelerator of economic growth through its funding of productive investment. By specifically

stressing the role of the banking sector to the economy, he comes to a complete contradiction

to Lucas (1988) who argued that the financial role is an overstressed factor.

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In 1966, Patrick was the one to test two different hypotheses. First, whether; the financial

sector is a “demand-following phenomenon so that as the economy grows, it generates

additional demands for the financial services, and therefore, a financial institution expansion’’

(Stammer, 1972). Could the first not be the case, given certain stages of development, there is

the alternative “supply-leading” test, which explains why the widespread financial expansion

– given more attention to policy makers – is promoting and stimulating economic growth.

However, Goldsmith’s 1969 research paper was based on the investigation of the positive

relationship between financial development and GDP per capita growth. Likewise, Mckinnon

(1973) turned his attention to finance, as a mere automaton and a provisional integral of the

funding for capital accumulation and growth in a positive documentation of theoretical

research.

Existing theoretical studies have identified a number of channels throughout economic growth

can be promoted by integrating with finance. According to Levine (1991), efficient financial

institutions and markets improve the quality of investments and, therefore, increase the

average acceleration of maximum economic growth. Six years later, Levine illustrated how

the financial sector can possibly influence the economy through two specific channels: capital

accumulation and technological innovation. In essence, he focused on technological progress

as another form of capital accumulation, by stating that any market friction is a motive of the

financial sector. Therefore, channels such as savings, resource allocation, and corporate

control exertion; easing of risk management and trading can enhance economic growth.

2.1Does finance make a difference?

Although the diversity of conclusions are hesitantly stated, and gaps may still be remaining

regarding the importance of the financial system to economic growth; broad cross-country

comparisons, individual studies or even firm-level investigations, attempt to point into a more

coherent direction and pull together a diverse and active literature.

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There is an emphasis on variables and specific indicators that capture the size, activity,

efficiency, and competitiveness of the financial institutions and markets, even amongst

countries with different income levels. Jude (2010) uses a panel dataset smooth-regression

approach to identify whether finance affects growth. In his paper he includes, Deida and

Fattouh (2002) application of a verge regression model according to which there is an attempt

to answer whether a relationship between non-linear finance and growth exists. In essence,

what is meant to be answered here is whether financial development affects economic growth

differently in developed and developing countries; according to different income levels. More

analytically, Deida and Fattouh (2002) investigated the interaction between the banking sector

and the financial markets in regards to economic growth. By identifying, a non-linear

relationship between finance and growth, they showed that the financial development is

significant only in countries with higher income level. In contrary, even an advanced banking

sector, has only a weak impact on growth.

Lee and Wong (2005) pointed that inflation is a control variable which affects and makes a

difference in the financial sector development and its relationship with economic growth; by

promoting the latter under low or moderate inflation levels in their two research countries of

Taiwan and Japan. More recently, Pan and Wang (2003), tried to investigate that link and the

impact of finance on a new ankle after the financial breakdown in 2007. Using a Bayesian

dynamic factor model, they extracted the unobserved common factors of trace global and

regional economic episodes, concluding that financial development dynamics are driven more

by country-specific and idiosyncratic factors, and therefore, income variations should be taken

into account for any possible finance-growth interaction. This implies that different

government regulations, for instance, should regard in business cycle harmonization so as to

promote financial reform and liberalisation among all different environments. Another

arguable conducted study, is the determination of the inverted-U shaped curve, a hypothesis

concerning whether economic development moves along with inequality (Kuznets, 1955). An

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economy trying to develop the level of inequality; is expected to decline. Allen and

Ndikumana (2000) have enhanced in this subject by investigating the importance of finance in

approximately half of the Southern African countries. Even for this narrow selection of

countries, the evidence is positive.

2.2Financial Structure and Economic Growth

Another considerable debate stands for the financial structure, as many of the financial

differences exist across countries even at similar stages of economic development (World

Bank 1989). Levine (1997) explains how different structures can allow and thereby,

effectively enhance the allocation of capital and the exertion of corporate control, by

comparing the financial structure of Germany and the UK. Merton (1991) argued that a well-

structured financial system provides a payments system as a mechanism for pooling funds,

and a way to transfer resources and reduce the uncertainties and all asymmetric information

disturbances.