Financial Development Trade Openness and Economic Growth in Developing Countries Recent Evidence From Panel Data

• Author: NABILA ASGHAR and ZAKIR HUSSAIN

Abstract The study investigates the causal relationship between financial development and economic growth in developing countries over the period of 1978-2012. The study empirically explores the channels through which financial development may influence economic growth more specifically in the context of Foreign Direct Investment (FDI) and trade openness. The financial development index is constructed and panel co- integration tests are applied to check the existence of long-run relationship between the variables of interest. The findings of the study show that there are strong evidences of the long-run relationship between financial development and economic growth in developing countries. There exists bi-directional causation between financial development and FDI. Furthermore trade openness has impact on financial development in all the countries which calls for the introduction of effective policy measures to promote trade between countries.

Keywords: Financial development Economic growth Panel causality analysis Panel cointegration

1. INTRODUCTION

   Finance-growth nexus can be traced back to Bagehot (1873) and Schumpeter (1911) who strongly believed that well organized financial systems could surely spur innovation and future real growth with respect to identification and funding of productive investment. These models support supply-leading view by demonstrating that financial development reduces informational friction and improves resource allocation efficiency. Furthermore the empirical evidence related to importance of financial system to long-run economic growth was substantiated by Goldsmith (1969) Hicks (1969) Fry (1978) Levine et al. (2000) Ndikumana (2000) and King and Levine (1993; 2003; 2005) among others. Endogenous growth theories postulate that saving behaviour directly influences not only equilibrium income level but also growth rate and highlight the role of financial development in promoting economic growth (see for example Obstfeld 1992; Bencivenga et al. 1995;

   Greenwood and Smith 1997; Saint-Paul 1992; Pagano 1993).

   Several empirical studies that have analyzed the finance growth nexus are available in the existing literature. These studies end up with mixed results due to several reasons including the use of variety of estimation techniques and proxies of financial development measures in the analysis. The existing literature has identified various channels through which financial development may promote economic growth. Levine (2004) argues that financial development encompasses enhancements in the production of ex ante information about possible investments monitoring of investments trading pooling of savings and mobilization and exchange of goods and services. These factors may influence investment and trade in an economy. Through these channels financial development causes economic growth indirectly. However existing literature mainly ignores these potential channels while studying finance-growth nexus.

   This study is highly important as it intends to fill the existing gap in the literature by taking the advantages of recent development in non-stationary heterogeneous panel data techniques. It fills the gap in several ways. First this study employs relatively more comprehensive measures of financial development in scope and methodology. Second this study uses most appropriate estimation methodology to quantify the linkages between financial development and economic growth such as panel causality tests and panel cointegration tests. Third this study explores the channels through which financial development exerts impact on economic growth. It includes foreign direct investment trade openness and other related variables in the model. Lastly the main concern of this study is to observe whether developing countries included in the sample have benefited in terms of economic growth from financial development or otherwise.

   This study is organized as follows. Following the introduction section II presents review of literature. Section III is the description of dataset model specification and econometric methodology. Section IV establishes empirical results and interpretations and last section concludes the study with policy implications.

2. REVIEW OF LITERATURE

   EVIDENCE FROM TIME SERIES DATA

   Since the 1990s the relationship between financial development and economic growth has received considerable amount of attention of the researchers and policy makers. Using time series data several studies have analyzed the finance growth nexus over time and end up mixed results (see for example Wachtel and Rousseau 1995; Demetriades and Luintel 1996; Arestis and Demetriades 1997; Rousseau and Wachtel 1998; Luintel and Khan 1999; Shan et al. 2001; Arestis et al. 2001; Calderon and Liu 2003; Thangavelu et al. 2004; among others).

   Most of the studies conclude the existence of positive relationship between financial development and economic growth (see for example Wachtel and Rousseau 1995; Khan et al. 2006; Yang and Yi 2008; Sindano 2009; Atif et al. 2010; among others) while Kar and Pentecost (2000) fail to find any relationship between financial development and economic growth.

   Some studies find bi-directional causality between financial develop- ment and economic growth. Al-Yousif (2002) examines the nature and direction of the relationship between financial development and economic growth using both time-series and panel data of 30 developing countries for the period of 1970-1999. The empirical results strongly support the existence of bi-directional causality between the variables.

   Some studies point out the mixed results regarding the causal relationship between the variables. Alrayes (2005) empirically investigates the hypothesis of causality between financial development and economic growth in seven Middle East and North African (MENA) countries using time series data. The results of the study provide evidence of uni-directional and bi-directional causality between financial development and economic growth in four cases no causality in two cases and no significant relation between financial development and economic growth in one case.

   The above-mentioned literature reveals that the time series studies present contradictory results. Furthermore the results of time series data are not much reliable because of short length of data set inappropriate estimation technique and biases brought about by omitted variables.

   EVIDENCE FROM CROSS-SECTION DATA

   Various studies have used cross section data and most of the studies support positive relationship between financial development and economic growth after accounting for potential biases brought about by simultaneity omitted variables and unobserved country specific effects (for example King and Levine 1993a; 1993b; Demetriades and Hussein 1996; Levine and Zervos 1998; Rajan and Zingales 1998; Khan and Ssnhadji 2000; Lensink 2001; Dawson 2003; Liu and Hsu 2006; among others).

   Hermes and Lensink (2003) argue that well developed financial system is essential for Foreign Direct Investment (FDI) to have positive impact on economic growth. The study concludes that the development of financial system plays an important role in enhancing the positive relationship between foreign direct investment and economic growth in developing countries.

   Law and Demetriades (2005) use cross-country and dynamic panel data techniques on 43 developing countries for the period of 1982-2000 and observe that if a country's borders are simultaneously open to both capital flows and trade help financial development to enhance. The study points out that institutional quality is robust and statistically significant determinant of financial development.

   Alfaro et al. (2004) use simple OLS cross-country regressions and analyze the effect of FDI on economic growth. The study finds the support for the countries with well-developed financial markets gain significantly from FDI via total factor productivity (TFP) improvements.

   One of the important drawbacks of cross-section studies is that these studies are helpless in discussing integration and cointegration properties of data. Furthermore these studies cannot examine the direction of causality between financial development and economic growth.

   RECENT DEVELOPMENT: PANEL DATA ANALYSIS

   Recent panel data studies provide evidence of positive relationship between financial development and economic growth. These studies appear to be more authentic and reliable as these studies attempt to overcome the possible drawbacks of time series and cross section studies. Luintel and Khan (1999) examine the relationship between financial development and economic growth by using a sample of ten less developed countries and find a bi- directional causality between financial development and growth.

   Levine et al. (2000) use panel techniques to support the existence of a causal relationship from financial development to economic growth. Using a panel of 77 countries for the period of 1960-1995 the study finds that higher levels of banking sector development produce faster rates of economic growth and TFP growth. The study concludes that the strong positive relationship between financial development and output growth can be partly explained by the impact of the exogenous components like finance development on economic growth.

   Christopoulos and Tsionas (2004) examine the long-run relationship between financial development and economic growth for 10 developing countries using panel cointegration analysis and confirm uni-directional causality from financial development to economic growth.

   Deidda (2006) concludes that when financial development is sustainable the credit market becomes more competitive and more efficient over time and it eventually contributes to economic growth.

   Kiran et al. (2009) investigate the long-run relationship between financial development and economic growth for a panel of 10 emerging countries over the period of 1968-2007 by...