The theoretical contention that surrounds the finance-growth relationship relates to the causality issue. Using the construct of Granger causality which makes usage of statistical predictability, the argument can be summarized as follows,
Levine ( 1997 ) cites Bagehot ( 1873 ) and Hicks ( 1969 ) as supplying statements that finance mobilizes capital which is in bend used to fund large undertakings. Furthermore, Schumpeter ( 1912 ) as cited in King and Levine ( 1993 ) advocates that Bankss that are executing good, promote invention on the technological side, through its ability to separate between those thoughts that have the best opportunities of being profitable and accordingly financing them.
Robinson ( 1952 ) as cited in Levine ( 1997 ) claims that “ where endeavor leads finance follows ” . In other words, the development generate the demand for specific kind of fiscal set ups, which the fiscal system consequentially responds to. Lucas ( 1988 ) , as cited in King and Levine ( 1993 ) , states that the relationship between finance and economic growing has been exaggerated.
It is anticipated that fiscal development pursues economic growing, since the latter causes more nest eggs to come into the fiscal system, which so leads to more recognition being extended and the rhythm to reiterate itself. However, finance is in add-on, expected to spearhead growing, therefore taking to the bi-directional statement ( Demetriades and Andrianova, 2003 ) .
Some economic experts refer to factors such as labor, capital and land as doing growing ( Jalil and Ma, 2008 ) . However, they make no mention to finance. Levine ( 1997 ) states that amongst those include three Nobel award Laureates.
2.0. Measures of Financial Development and Economic Growth
Levine ( 1997 ) , King and Levine ( 1993 ) and Levine ( 2002 ) list the indexs for fiscal development ; of which in sum there are six steps for banking sector development, three steps for stock market development and four steps for overall fiscal development. In add-on, four steps of economic growing are provided. They are as follows:
2.1. Measures for Banking Sector Development
LLY measures fiscal deepness, which is the size of fiscal mediators. It does non see how capital is allocated or how the fiscal system is executing in the countries of quality of information collected for hazard direction intents and the existent managing of hazard. Even though LLY has this restriction, utilizing a scope of other indexs alongside it, provides a better image of fiscal development that if merely one step had been used.
where liquid liabilities comprise of currency plus demand and interest-bearing liabilities of Bankss and nonbank fiscal mediators. That is, M3.
M2 measures monetarisation more than fiscal deepness, Furthermore, it merely includes sedimentations held by bank, which does non capture other establishments within the fiscal sector. Economies with less advanced fiscal systems tend to hold an elevated ratio of money to GDP, since there is no other avenue for hive awaying value.
where liquid liabilities comprise of currency plus demand and interest-bearing liabilities of Bankss. That is, M2.
This ratio, when used in concurrence with LLY ( 1 ) allows the degree of hard currency versus sedimentations, to be gauged.
BANK, measures the grade to which the cardinal bank in comparing to commercial Bankss is apportioning recognition. In other words, the sum of nest eggs that goes into investing, after Bankss have identified those purportedly feasible ventures.
The restriction of this ratio is that whilst Bankss are more likely to supply recognition, they are non the lone establishment that does so in the fiscal system. Furthermore, they could merely be imparting to authorities or to public organic structures, therefore smothering entree of the private sector to recognition.
The fifth and 6th steps partly address concerns about the allotment of recognition. High ratios for these denote good working banking systems.
2.2. Measures for Stock Market Development
A state with a well-developed market is more inclined to hold a larger market capitalisation ratio as measured by:
The value traded ratio steps merchandising in relation to the size of the economic system, or the extent of stock market liquidness.
The turnover ratio steps merchandising in relation to the market size. It is besides a liquidness index of the stock market.
The two liquidness steps act as a addendum to the size ( market capitalisation ratio ) since the stock market could be large, but non active.
2.3. Measures for Overall Financial Sector Development
The three overall steps for fiscal sector development ( FD ) are:
FD size=log ( market capitalisation ratio*LLY or LLY ( 1 ) or LLY ( 2 )
This measures the size of the stock market and fiscal mediators.
FD activity=log ( entire value traded ratio*PRIVATE or PRIVY )
This measures the activity of the stock market and fiscal mediators.
FD ( efficiency ) =log ( entire value traded ratio/banks ‘ operating expense cost ratio )
This measures the efficiency of the fiscal sector.
2.4. Measures of Economic Growth
The four steps for economic growing are:
GYP=average rate of growing in existent per capita GDP
The undermentioned two indexs measure the extent of accretion of capital
GK=average growing rate of existent per capita physical capital stock
INV=average one-year domestic investing to GDP ratio
EFF=Total productiveness growing or Solow residual ; finance affects growing through the entire factor productiveness of Cobb-Douglas production map ( , where y=output, A=total factor productiveness, K=capital and L=labour ) . When I±=0.3,
3.0. Empirical Approachs
Assorted surveies have been used to prove the finance-growth relationship. This includes the usage of pure-cross subdivision, panel and clip series informations. These are elaborated further in this subdivision, together with their chief findings, strengths, every bit good as restrictions.
3.1. Pure-cross Section
Cross subdivision informations denote informations collected at a minute in clip, on one or more variables ( Brooks, 2008 ) .
Levine ( 1997 ) summarises the work of Goldsmith ( 1969 ) who performed a cross state survey from 1860 to 1963 and concluded that the nexus between finance and growing is at that place when informations for a figure of decennaries are analysed and that economic systems that had grown more were by and large associated with higher than mean rate of fiscal development. However, the failings from this survey were that:
It was limited to merely 35 states,
It did non methodically let for other factors that can impact on growing,
The beginning of growing was non identified decently,
It merely measured fiscal intermediation which may non be a good step of how the fiscal system is runing,
It did non foreground the way for the relationship between finance and growing.
Subsequently surveies have attempted to rectify these defects. For case, King and Levine ( 1993 ) used transverse state informations on 77 states from 1960 to 1989 to analyze the finance-growth relationship as per the arrested development:
More specifically, one of the equations can be specified as:
initial income ( Y0 ) captures convergence consequence,
g steps human capital accretion,
G1 to GDP is a placeholder for financial policy,
?? is a placeholder for pecuniary policy, and
X+M to GDP steps openness to merchandise.
From Table 1, it can be observed that as a lower limit, at the 5 per centum degree, the fiscal development indexs are positive and important in the arrested development ( King and Levine, 1993 ) .
Table 1: Growth and fiscal indexs 1960-1989
** important at the 0.05 degree, *** important at the 0.01 degree.
Comparable consequences were obtained when the causality was investigated farther, based on 57 states ( King and Levine, 1993 ) . This relates to the relationship between the size of fiscal development statistics in 1960 being the start of the period and the attendant economic growing utilizing ordinary least square arrested developments. From the cross subdivision consequences in Table 2, it can be observed that at 5 per centum degree, the independent variable LLY is positively and significantly correlated with economic growing over the coming 30 old ages, in malice of commanding the conditions that existed ab initio and holding used different economic indexs and state specific indexs.
Table 2: Growth and initial fiscal deepness ( Dependent variable is mean GYP 1960-1989 )
( 1 )
( 2 )
( 3 )
( 4 )
log YO/GDP in 1960
log g/GDP in 1960
log G1/GDP in 1960
log ?? in 1960
Import & A ; Export/GDP in 1960
Index of civil autonomies
Number of revolutions
Number of blackwashs
Sub-Saharan Africa silent person
Latin American silent person
LLY in 1960
* important at 0.10 degree, ** important at 0.05 degree, *** important at 0.01 degree.
Levine and Zervos ( 1996 ) as cited in Levine ( 1997 ) conducted a cross state study on 49 states from 1976 to 1993 to measure the relationship between stock market liquidness and growing indexs. The consequences as summarized in Table 3, which shows that the degree of liquidness in the stock market as measured by the value traded or turnover ratio, is statistically important in calculating economic growing, the accretion of capital and growing in productiveness over the subsequent 18 old ages. This indicates that the liquidness that stock markets provide is needed for long-run growing.
Table 3: Growth and initial stock market liquidness, 1976-1993
Value Traded Ratio
Employee turnover Ratio
Real per capita GDP growing
Real per capita capital stock growing
** important at 0.05 degree, *** important at 0.01 degree.
The advantage to utilizing transverse state surveies is that they allow for a big figure of states to be examined over a long period of clip, therefore concentrating on growing in the long-run ( Levine, 2003 ) . Based on the afore-mentioned consequences, pure-cross state analyses report positive consequences on the causing between finance and growing both from the banking sectors and stock markets.
However, it is difficult to set up causality when covering with transverse state informations. Zhu et Al ( 2002 ) as cited in Demetriades and Andrianova ( 2003 ) showed that the result was driven by the East Asiatic Tigers, which when excluded from the sample, consequence in an undistinguished positive relationship.
Besides, when utilizing mean figures this assumes that there is no significant fluctuation across states. Hence, a few outliers could act upon the information therefore doing the result worthless for the non-outlier states, from a policy view-point. In add-on, altering the control variables, frequently affect the statistical significance of the fiscal development coefficient, which makes it hard to do sense of the consequences ( Demetriades and Andrianova, 2003 ) . Christopoulos and Tsionas ( 2004 ) province that “ Using cross-sectional informations foliages open the inquiry of specious correlativity originating from non-stationarityaˆ¦ ”
Panel survey possesses the characteristics of both transverse subdivision and clip series informations ( Brooks, 2008 ) . It allows for the use of larger samples and takes advantage of informations fluctuation. However, if the averaging is done over a little clip period this may non be adequate to take out the consequence of concern rhythms such that the long-term relationship can be examined ( Demetriades and Andrianova, 2003 ) . In add-on, by taking first difference, panel arrested development rids itself of conditions that are state specific. By utilizing instrument variables, it allows for commanding endogeneity ( Levine, 2003 ) .
Panel information is used by Beck and Levine ( 2002 ) to look into the map of stock markets and Bankss on economic growing. The sample constituted of informations averaged over five old ages, on 40 states from 1975 to 1998 and the Generalized Method of Moments ( GMM ) is used as calculators. The consequences as shown in Table 4 conclude that developments in stock markets and Bankss have positive effects on economic growing, and given that simultaneousness, omitted variables and country-specific effects have been dealt with, the consequences were non due to these factors. Furthermore, the turnover ratio enters the arrested development significantly and so does bank recognition, with the exclusion of when rising prices and trade openness are included in the arrested developments. The installations offered by stock markets are different from those of fiscal mediators such as Bankss since otherwise, they would non individually yield important consequences in a individual arrested development.
Table 4: Stock markets, Bankss and growing, GMM Estimator
( 1 )
( 2 )
( 3 )
( 4 )
( 5 )
Logarithm of initial income per capita
Average Old ages of Schooling
Black Market Premium
Employee turnover Ratio
* , ** , *** indicate significance at the 10 % , 5 % , and 1 % degree.
Panel unit root and cointegration analyses, concluded that fiscal development causes growing in the long-term, but there is no bi-directional flow ( Christopoulos and Tsionas, 2004 ) .
3.3. Time series
Time series informations refer to informations that have been gathered on one or more variables over a clip interval ( Brooks, 2008 ) .
From the surveies utilizing clip series it appears one theoretical account does non use to all fortunes, given that assorted consequences are obtained. Demetriades and Husein ( 1996 ) usage informations from 16 developing states from 1960 to 1990. They observed a steady long-run relationship for 14 states, although the causality way was to a big extent different from state to state. Bi-directional causality was obtained for seven states whilst rearward causality ( that is finance follows growing ) was revealed for six states.
Similarly, Odedokun ( 1996 ) after analysing 71 developing states over different periods from 1960s to 1980s convey diverse result of the impact of fiscal intermediation on growing from state to state, although in 85 per centum of the instances it was concluded that fiscal intermediation encourages economic growing.
De Gregorio and Guidotti ( 1995 ) convey that the relationship between fiscal development and growing was negative in 12 Latin American states from 1950 to 1985. The consequences may be attributed to fiscal liberalisation that many Latin American states undertook in the 1970s and 1980s, without proper monitoring and which have been blamed for the fiscal crises that later occurred, which amongst other things included slack loaning processs.
Demetriades and Andrianova ( 2003 ) province that clip series informations permit the use of relevant statistical pattern such as co-integration to look into long-run relationship and utilizing multivariate causality in the short and long term. However, the handiness of informations is its chief job because utilizing informations over short clip period can take to undependable tax write-offs. Preferably one would necessitate no less than a century ‘s worth of informations to execute such analyses with an elevated degree of assurance, but this is merely gettable for a few states. However, the dependableness of the appraisals can be enhanced by utilizing quarterly informations ; over 25 old ages this amounts to 100 observations.
Using multivariate clip series on 10 states, Luintel and Khan ( 1999 ) concluded that bi-directional relationship exists between finance and growing. They attributed the assorted consequences from old surveies to the misspecification given that multivariate differs from bivariate surveies. Theoretical literature predicts fiscal deepness to be a positive map of existent income and the existent rate of involvement. Hence, they used a placeholder for fiscal development which is a map of fiscal deepness ( LLY ) and existent involvement rate ( R ) . LLY in bend is a map of the logarithm of existent per capita capital stock ( LKP ) . The vector car arrested development hence encompassed four variables ; FD, LYP, LKP, R over 36 to 41 old ages.
From Table 5 it can be observed that in seven of the 10 states, a negative correlativity was recorded between fiscal deepness and growing ( CDY, FD ) , which is in resistance with the positive result of cross state surveies described in subdivision 3.1. However, when the survey is considered cross-sectionally by averaging, there is a positive correlativity of 0.17 between fiscal development and growing, connoting that cross state surveies so can conceal certain state differences. The positive correlativity remains when a panel information set is used, although of a lesser size. The information show a strong positive correlativity between fiscal deepness and per capita end product in all the states ( CY, FD ) . The conflicting results for CDY, FD compared to CY, FD advocate that a long-term relationship between fiscal development and economic growing exists. In contradiction to decision of cross subdivision surveies that higher turning economic systems show a more important correlativity between fiscal development and growing, no form could be made out in this survey. For case, Philippines had the lowest growing rate but its fiscal deepness was non the lowest ( Luintel and Khan, 1999 ) ..
Table 5: Drumhead statistics on fiscal deepness and the rate of growing ( CDY, FD ) and degree of fiscal deepness and existent per capita income ( CY, FD )
From Table 6, it can be observed that two cointegrating vectors indicate bi-directional flow between finance and growing. The first demonstrates that long-term fiscal deepness is positively and significantly influenced by existent per capita income in all the states. The 2nd vector is besides positive and extremely important denoting that for all the states, per capita end product in the long-run is a positive map of capital stock per capita. The coefficient I± being the mistake rectifying coefficient is negative and extremely important ; higher negativeness implies faster accommodation to disequilibrium, from the long-term equilibrium value ( Luintel and Khan, 1999 ) .
Table 6: Consequences of cointegrating vectors
First cointegrating vector
Fiscal deepness relationship
Second cointegrating vector
End product relationship
FD=-0.16**+0.03LYP**+ 0.001R** ; I±=-0.67**
LYP=-4.12**+1.29LKS**+0.02R** ; I±=-0.05**
FD=-3.05**+0.31LYP** ; I±=-0.15**
LYP=4.15**+0.59LKS**+0.01R** ; I±=-0.12**
FD=0.20**+0.03LYP**+ 0.01 R** ; I±=-0.25**
LYP=4.61**+0.62LKS**+ 0.01R** ; I±=-0.27**
FD=-3.41**+0.41LYP**+0.01 R** ; I±=-0.02**
LYP=3.31**+0.60LKS**+0.01R** ; I±=-0.44**
FD=-1.57**+0.12LYP**+0.003R** ; I±=-0.34*
FD=-3.67**+0.48LYP**+0.03R** ; I±=-0.36**
FD=-6.93**+0.79LYP**+0.03R** ; I±=-0.26*
LYP=6.82**+ 0.24LKS**-0.02R** ; I±=-0.19**
FD=-1.75**+0.21LYP**+0.02 R** ; I±=-0.34**
LYP=5.38**+0.41LKS**-0.05R** ; I±=-0.64**
FD=-4.31**+0.59LYP**+0.03R** ; I±=-0.25**
LYP=-0.42**+0.96LKS**+0.19R** ; I±=-0.20**
FD=-4.96**+0.57LYP**+0.05R* ; I±=-0.24**
LYP=0.88**+0.89LKS*+ 0.07R** ; I±=-0.41**
** and * indicate significance at 1 % and 5 % , severally.
4.0. General Policy Implications
Given the nature of transverse state or panel arrested developments, it is non easy to deduce dependable policy illations. Whilst this is possible for time-series survey in relation to single states, it may non be possible to generalise the result. However, on the whole there is a batch of grounds that points to fiscal development holding a big causal consequence on economic growing ( Beck et al, 1999 ) .
Jalil and Ma ( 2008 ) performed a time-series survey on China and Pakistan from 1960 to 2005 to amongst other things, gauge the consequence of fiscal reforms on growing, which China undertook in 1978 and Pakistan in 1990. The survey revealed that fiscal reforms in both states led to additions in fiscal deepness. In the instance of Pakistan, positive and important relationship was noted between fiscal development and economic growing. Likewise, China recorded a positive and important relationship for sedimentation liability ratio. However, with respects to recognition to the private sector, the relationship was positive but non important, which implies that in China, the recognition allotment may non be efficient in that the banking sector concentrated by the four largest province owned Bankss, are non efficaciously administering recognition. If this were to transport on, it could hinder on economic growing. Hence, farther reform to cover with this issue is recommended.
Supplying grounds on causality should bring on the importance of policy alterations geared at promoting growing of fiscal intermediation, proposing that fiscal reforms can hold positive consequence on growing. If the grounds shows that there is no causality from finance to growing this could be due to a figure of factors. For case, finance could be traveling to unproductive ventures due to information and monitoring jobs of Bankss such that lower quality, shorter term undertakings get finance. Reverse causality may be due to basic macroeconomic troubles, for case political and economic insecurity such that nest eggs do non travel towards domestic investing, but instead stop up abroad ( Demetriades and Andrianova, 2003 ) .
It can be concluded that based on the diverse consequences there can be no individual position of the causality relationship between finance and growing. The quality of policies, effectivity of their execution, will impact the success of economic growing.