CHAPTER 3 METHODOLOGY
3.2 Research Framework
3.2.1 Shadow Economy and Financial Development . 24
According to Becker (1968), the researcher argued that rational individuals tend to gain advantages from the informal economy sector as well as rational entrepreneurs, they also tend to operate informally to avoid tax burden. This will lead to an increase in the size of shadow economy, hence hampering the development of financial sector. Firms and businesses make productive investment by obtaining capital or funding from the financial institutions, but sometimes obtain funding from official economy sector could be costly.
This will lead to an increase in the size of informal economy since firms and businesses must prepare a minimum level of initial assets as collateral in order to participate into the financial system and obtain capital to make
Shadow Economy
Natural Resources
Technological
Innovation Financial
Development Trade
Openness
Human Capital
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productive investment. Because of this, some firms and businesses who unable to meet the minimum level of initial assets will tend to involve in the informal sector to avoid the high costs incurred in the formal sector.
However, obtain funding from financial institutions may bring some advantages to the firms and businesses such as reduce in the interest rate.
When the firms and businesses tend to involve in the formal sector to take advantages, this will lead to a decrease in the size of shadow economy and leading to a higher development of financial sector.
On the other hand, an increase in the size of shadow economy will lead to a decrease in the development of financial sector as well (Straub, 2005). This can be supported by Ihrig and Moe (2004), when there is an increase in the size of shadow economy it will lead a reduction in government tax revenue.
In this situation, it will increase the government debts since government have to find ways to increase its revenue and one of the ways is through issuing bonds to public. This will increase the government default risk in public debts and bring financial stress to the country as well, hence hindering the financial development (Ihrig & Moe, 2004). Hence, we expected that there is an inverse or negative relationship between shadow economy and financial development in both developing and developed countries.
3.2.2 Natural Resources and Financial Development
According to Smith (1776) and Ricardo (1911), they argued that natural resources abundance is considered as an important factor for a country to do expansion and this could indirectly promote the development of the financial sector as well as the economic growth of a country. However, there is an argument saying that a country with abundant natural resources may lead to resource curse (Moradbeigi & Law). Resource curse is a situation when a country that has abundant natural resources is experiencing stagnation in economic growth frequently. The reason for resource curse is
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mainly due to the behavior of rent-seeking, failure of economic policy, weak political and financial institutions in a country (Sachs & Warner, 1995;
Rosser. 2006; Caselli and Cunningham, 2009; Van der Ploeg & Venables, 2009). The problem of resource curse can be solved if a country is able to utilize the natural resources more efficiently and this is mainly attributable to the educational level.
In developing countries, there is more likely a negative relationship to be found between natural resources and financial development (Sachs &
Warner, 1995). This may be due to lack of educational people in developing countries, causing the natural resources are not being utilized efficiently (Lederman & Maloney, 2007; Gylfason, 2001). Besides, the negative relationship between natural resources and financial development also may occur when the financial system is less developed. (Zoega & Gylfason, 2001). These two scenarios often occurred in developing countries, hence we expect that the relationship should be negative in developing countries.
In developed countries, the relationship between natural resources and financial development is found to be positive since there are more educated people. In this situation, they are able to allocate and use the resources in a more efficient and effective way which will promote the development of the financial and economic sector of a country (Hatemi-J & Sham-suddin, 2016;
Barro & Lee, 2013). Based on the findings of Shahbaz, Naeem, Ahad &
Tahir (2018), they found that a country with abundant natural resources tends to stimulate the economy growth by reducing the unemployment rate and increasing the income level of people. When the income level increases, investment activities will increase as well, hence promoting the development of the financial sector of a country. In this situation, we expect that the relationship between the natural resources and financial development tend to be positive in developed countries.
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3.2.3 Technological Innovation and Financial Development
Technological innovation is considered as one of the important factors to boost up the development of the financial sector of a country. This is because it can help to improve and strengthen the financial system of a country as well as ensuring its stability by strengthening the competitive advantage of firms (Aghion et al., 2009; Hsu et al., 2014; Laevan et al., 2015). There is more likely that technological innovation tends to promote financial development if a country possesses more educated or skilled workers. Hence, the impact of technological innovation could be more significant in developed countries as compared to developing countries.
This is related to human capital a country possesses since they are able to use their specialization and skills to contribute to a higher level of technological innovation, hence leading to a more developed financial system (Sibel, Kadir, Ercan, 2015). In this situation, we expect that the relationship between technological innovation and financial development should be positive in both developing and developed countries.