Chapter 2 Literature Review
2.12 Financial Deepening, Economic Stability And Growth
2.12.1 Financial Deepening And Economic Growth: Recent Evidence
Economidou, 2007, Kar, Nazlıoğlu, and Ağır, 2011, Rousseau and Wachtel, 2011, Levine, 2005, Cecchetti and Kharroubi, 2012). Recent studies employing more up-to-date data have revealed that the relationship is no longer as strong as it was found to be by pioneering studies from 1960 to
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1989. According to Rousseau and Wachtel (2011), excessive and rapid financial deepening leads to fast growth in credit which may trigger inflation and weaken financial systems and in turn lead to growth-inhibiting financial crisis. Furthermore, there is not enough evidence to suggest that the growth of stock markets in recent years has replaced debt financing, meaning that financial deepening plays a minimal role in enhancing growth (Rousseau and Wachtel, 2011). In contrast, Hasan et al. (2009) argue that the growth of financial institutions, establishment of regulatory frameworks and respect for property ownership rights lead to robust economic performance.
Apergis et al. (2007) investigate the financial linkage between economic and financial development utilizing dynamic heterogeneous panel data on 15 OECD and non-OECD states and observe the existence of one long-run equilibrium relationship among financial deepening, economic growth and a set of constant variables. The study further establishes a two-way causality relationship between financial deepening and economic growth. Similarly, Klein and Olivei (2008) find that capital account liberalization has a significant impact on financial institution growth and economic performance across countries. It was found that economies with greater financial depth also experienced higher economic growth over the 20-year period. The deepening of financial markets is believed to promote growth of the economy in two ways, firstly, by mobilizing investments and secondly, through increasing the rate of return on financial resources which in turn raises productivity (Jun and Yu, 2005). Jun and Yu (2005) use provincial panel data to investigate whether financial deepening can account for growth in productivity. Their study reveals a significant and positive link between the deepening of financial markets and productivity growth.
Odhiambo (2008) utilizes a tri-variate causality model and establishes a clear uni-directional causal flow from economic performance to financial development. It is further revealed that output growth Granger causes savings and savings promote financial development in Kenya. In this case, the findings contradict conventional wisdom that financial deepening unambiguously drives economic growth (Odhiambo, 2008). In agreement with Odhiambo’s findings, Ang and McKibbin (2007) utilize time series data for Malaysia to conduct co-integration and causality tests to examine the correlation between finance and economic growth. Although a positive association is observed between financial depth and economic growth, the study reveals that the performance of the economy drives financial market development, particularly in the long term.
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In terms of the relationship between deepening financial markets and the rise of the economy in the long-term, Bagehot and Schumpeter (1912) suggested the existence of a positive relationship which was confirmed by Levine (2005). However, this has been challenged by several recent studies using more up-to-date data such as Arcand, Berkes, and Panizza (2015), Law and Singh (2014), and Rousseau and Wachtel (2011). Easterly, Islam, and Stiglitz (2001) argue that financial growth measured by the proportion of private credit to real GDP can reduce production variability only up to a certain level, beyond which it increases productivity volatility. Several other studies have shown the existence of an inverse connection between financial deepening and economic growth beyond a certain level of financial growth, estimated at 80-100% of private credit to GDP (Cecchetti and Kharroubi, 2012, Griffith-Jones et al., 2014). Faster growth in finance has also been shown to be harmful to aggregate long-term real growth. Furthermore, the IMF (2012a) provides empirical evidence that large financial sectors may have negative impacts on productivity growth.
De la Torre et al. (2012) argue that too much finance is consistent with positive but decreasing returns of financial deepening, which at some level will be less than the cost of financial instability.
African financial systems seem to exhibit features which increase their exposure to global shocks in the economic and financial system due to limited financial market regulation and political pressure to deepen financial markets so as to develop the real economy (Griffith-Jones et al., 2014).
A comprehensive study on the linkages between financial growth and economic performance utilizing panel regressions of data from low- and middle-income economies also confirms a positive relationship in developing countries (Hassan, Sanchez, and Yu, 2011). However, short- term multivariate analysis shows mixed results, i.e., the existence of a two-way causal relationship for most regions and one-way directional linkage from growth to finance for the two poorest regions. It is further argued that economic growth is significantly explained by some factors from the productive sector such as trade and government expenditure. Hence, Hassan et al. argue that a well-developed financial market is a crucial but adequate condition to promote output growth in developing countries. However, there is disagreement pertaining to the direction of causality between financial depth and economic development. Kar et al. (2011) reached the same conclusion in their wide-ranging research on Middle East and North African (MENA) economies employing Granger causality tests. Gries, Kraft, and Meierrieks (2009) examined the relationship among financial depth, trade liberalization and economic development among 16 sub-Saharan African
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economies utilizing the Hsiao-Granger approach. They found limited evidence to support conventional wisdom of finance-led growth and that growth strategies that prioritize financial or trade sector growth cannot be held as the SSA countries investigated failed to benefit from financial deepening. In an earlier study, Shan (2005) utilized the Vector Autoregression (VAR) model rather than the popular Granger causality tests to examine the connection between financial development and economic growth using data from OECD economies and China. The study found very little evidence to support the hypothesis of finance-led growth.
2.12.2 CHALLENGES OF FINANCIAL DEEPENING IN DEVELOPING COUNTRIES