Financial intermediation and growth: theory and some cross-country evidence.
Shabbir, Tayyeb
Well-functioning financial markets can have a positive effect on
economic growth by facilitating savings and more efficient allocation of
capital. This paper characterises some of the recent theoretical
developments that analyse the relationship between financial
intermediation and economic growth and presents empirical estimates
based on a model of the linkage between financially intermediated
investment and growth for two separate groups of countries, developing
and advanced. Empirical estimates for both groups suggest that financial
intermediation through the efficiency of investment leads to a higher
rate of growth per capita. The relevant coefficient estimates show a
higher level of significance for the developing countries. This
financial liberalisation in the form of deregulation and establishment
and development of stock markets can be expected to lead to enhanced
economic growth.
I. INTRODUCTION
After a long period of apparent neglect, the Schumpeterian idea
that developed and presumably well-functioning financial markets can
positively affect economic growth by facilitating savings and more
efficient allocation of capital has come to enjoy new popularity amongst
academicians and policy-makers alike. This renewed interest in the idea
has spurred a flurry of theoretical work and a few interesting empirical
studies both for the developed as well as the developing countries.
Though it may appear as an intuitively appealing idea that the
various financial intermediaries such as the money, bond and foreign
exchange markets as well as the stock markets should be essential for
economic growth since they facilitate mobilisation of savings, efficient
allocation of capital, risk management through portfolio diversification
and positive inducement for the society to increase its rate of savings,
there has been a surprising lack of consensus among economists on the
nature of the role of capital markets in economic growth. As a matter of
fact, until recently, with the exception of the seminal papers of
McKinnon (1973) and Shaw (1973), most economists generally dismissed as
secondary at best the potential role of financial intermediaries in
promoting economic development. A part of the reason for this state of
affairs was conceptual--perhaps a lack of rigor in theories linking
financial intermediation to growth--and other part empirical since
little reliable evidence existed regarding the link between finance and
economic growth. However, recent theoretical developments more firmly
link finance with steady-state growth [Greenwood and Jovanovic (1990)]
and, concurrently, empirical evidence has been accumulating which
implies that financial intermediation positively affects economic growth
[Goldsmith (1969); King and Levine (1993); Atje and Jovanovic (1993);
Gregorio and Guidotti (1995) and Levine (1997)]. A related study of
interest is Ratcliffe (1994) which uses the Lucas (1990, 1993) framework
to address the issue of why capital does not flow from the rich to the
poor countries when rates of return on it differ even alter adjustments
for degree of financial intermediation, human capital and tax incidence.
On account of the great interest in the recent phenomenon of the
emerging stock markets, the issue of the relationship between financial
markets and growth and international capital flows has gained an
additional measure of importance. Financial deregulation/liberalisation
and a tremendous inflow of portfolio investment of the recent past has
spurred a phenomenal growth in emerging equities markets, especially in
such Asian countries as China, Philippines, and Malaysia. The somewhat
disconcerting shocks in the currency markets and ensuing disruptions in
economic activity since the summer of 1997 are further evidence that
fragility of the financial sector is certainly not neutral in terms of
impact on the real sector.
The main purpose of this paper is to characterise some of the
recent theoretical developments that analyse the relationship between
financial intermediation and economic growth and present empirical
estimates based on a model of the linkage between financially
intermediated investment and growth. These estimates are provided for a
group of Developing Countries as well as a group of Advanced Countries.
The rest of the paper is organised such that Section II briefly notes
the major functions of the financial markets, Section III outlines a
recent model of the relationship between financial sector and growth.
(1) Further, Section IV presents empirical estimates and the last
section draws some relevant policy conclusions.
II. ROLE OF THE FINANCIAL MARKETS
In general, well-functioning financial markets play many important
roles that affect economic growth.
* First, by spreading the risks of long-term investment projects,
the growth of the financial markets can lead to a lower cost of equity
capital and thereby stimulate investment and growth.
* Second, by acting as a monitor and a facilitator these markets
could lead to a greater efficiency of the available investment funds.
* Third, by attracting foreign portfolio capital, developed
financial markets can serve to enhance the supply of investable
resources particularly in the developing countries. This feature is
particularly attractive for highly indebted developing countries whose
traditional sources of foreign financing such as grants, and
concessional loans are rapidly drying up.
* Fourth, financial markets also play a role in domestic resource
mobilisation and the provision of fresh equity capital to the corporate
sector. This is particularly important in emerging capital markets where
the economy expansion of stock markets is often characterised by an
increase in the number of companies going public.
In terms of the Developing Countries, some preliminary useful work
already has been done which tries to enumerate the nature of the
linkages between financial development and economic growth [see Clemente
and Mariano (1993) and Dailami and Atkin (1990)]. However, there is a
significant remaining need to generate formal empirical evidence on this
question.
III. MODELLING THE RELATIONSHIP BETWEEN FINANCIAL SECTOR AND
ECONOMIC GROWTH
(a) Physical Capital, Financial Development, and Economic Growth
Following Atje and Jovanovic (1993), we can formalise the above
ideas regarding the effects of financial development and economic growth
(2) with the following aggregate production function as a starting
point:
Y = K min [(L, [L.sup.*]).sup.a] a > 0 ... (1)
where output (Y) is expressed in terms of physical capital (K) and
labour (L); and [L.sup.*] represents labour capacity constraint. At full
employment of labour we get the following constant returns to scale
production function:
Y = K[(L).sup.a] = m K ... (1')
where m = [(L).sup.a] = Y/K = output - capital ratio (at
full-employment).
The capital accumulation in this economy is given by:
[K.sub.t+1] = (1-d) [K.sub.t] + R([F.sub.t]) [I.sub.t] ... (2)
Here d represents the rate of depreciation of capital stock, I
represents investment, F is the level of financial intermediation, and R
is a function of F and is meant to formalise the positive impact of
financial intermediation on the rate of return on investment. This
impact essentially works through improved allocation of investable
resources on account of portfolio diversification and informational
efficiencies. Atje and Jovanovic (1993) assume R(x) to be an increasing
function of F. A more general approach would be to model R(x) more
explicitly, starting with a non-monotonic formulation to allow for an
empirical test of the monotonicity of R.
Letting [g.sub.x] = ([X.sub.t+1] - [X.sub.t])/[X.sub.t] i.e. the
annual rate of growth of a variable X. Then [g.sub.K] is given by the
following expression:
[g.sub.K] = -d + R([F.sub.t]) ([I.sub.t]/[K.sub.t]) ... (3)
= -d + R([F.sub.t]) ([Y.sub.t]/[K.sub.t])([I.sub.t]/[Y.sub.t])
= - d + m R([F.sub.t]) [z.sub.t] at full-employment
where [z.sub.t] is the investment-output ratio. At steady state,
where output, capital, and labour are growing at the same rate, the
growth rate of income per worker is then
[g.sub.Y] - [g.sub.L] = [g.sub.K] - [g.sub.L] = -d - [g.sub.L] + m
R([F.sub.t]) [z.sub.t] ... (4)
Using a first-order Taylor's expansion of R around F = 0 gives
us
R([F.sub.t]) [approximately equal to] R(0) + R'(0)[F.sub.t]
[g.sub.Y] - [g.sub.L] = -d - [g.sub.L] + m R(0) [z.sub.t] +
mR'(0) [z.sub.t] [F.sub.t] ... (5)
One of the major issues of interest is the nature of the financial
intermediation index, F. and numerical proxies for it. Though far from
representing a consensus. Atje and Jovanovic (1993) considered the
following indices (all normalised by GDP):
B = {Credit extended by private and government banks}/GDP.
[F.sub.1] = {Annual value of all stock market trades}/GDP.
[F.sub.2] = {Value of stocks outstanding}/GDP.
While each of the above indices can be used by themselves.
(B+[F.sub.2]) can be used as a composite measure of bank loans and value
of equity. However adding B and [F.sub.1]. is not feasible as former is
a stock and the latter is a flow.
In principle, once a decision is made regarding how best to measure
F, one needs only to assume that m (inverse of capital output ratio) is
invariant across countries to be able to use Equation (5) to estimate
cross-country regressions.
Then the following derivative would give the estimated
'importance of finance' in terms of the growth rate of pet
capita income:
[partial derivative]([g.sub.Y] - [g.sub.L])/[partial derivative]F =
mR'(0)z = [[beta].sub.z].
For an empirical implementation of this model, Equation (5)
suggests the regression of ([g.sub.y] - [gsub.L]) on the growth rate of
labour ([g.sub.L]), the investment-output ratio, and the interaction
between financial intermediation and the investment-output ratio (F x
z). (3)
IV. EMPIRICAL RESULTS
(a) Definition of Variables
Following are the definitions and sources of the major variables
used in the empirical estimates for this study.
(i) [g.sub.y] = Annual growth rate of GDP per capita (Source:
International Financial Statistics: IMF).
(ii) F = Measure of Financial Intermediation = {(D + E)/K} where
D = Cumulative credit to domestic residents (issued by private and
government banks). (Source: International Financial Statistics; IMF).
E = Market Capitalisation of the stock Market or the value of
shares outstanding (Source: Datastream and Emerging Markets Fact Book;
IFC).
(iii) K = Physical capital Stock in millions of units of the
domestic currency (Source: Penn World Tables: Summers and Heston).
(vi) [g.sub.L] = Annual growth rate of population (Source:
International Financial Statistics; IMF).
(v) Z = Investment to Output Ratio (Source: international Financial
Statistics; IMF and Penn World Tables).
(b) Description of the Sample
The estimates are presented for each of the following group of
countries separately for the years 1982-92.
(i) Pooled Sample of the Following Developing Countries
South Korea, Indonesia, Malaysia, India, Pakistan, Bangladesh,
Philippines and Thailand.
(ii) Pooled Sample Of the Following Developed Countries
U.S., U.K., Canada, Japan, Singapore.
(c) Empirical Estimates and Discussion
The empirical estimates are presented in Table 1, separately for
the Developing Countries and the Developed Countries. (4) Overall the
estimates are consistent with the model we outlined in the earlier
section. The important result is that the coefficient estimate for ZF is
positive for both the developing as well as the developed countries thus
implying that financial intermediation, through efficiency of
investment, leads to a higher rate of growth per capita. However, the
relevant coefficient estimate for the Developing Countries exhibits a
relatively higher level of significance than that for the Developed
Countries. This may result if for the more Advanced Countries, the
simultaneity between financial intermediation and economic growth is
relatively more pronounced--an important issue which is not explicitly
explored further in this paper.
In any event, it is important to note that the coefficient
estimates of ZF are robust against inclusion of lagged values of output
per capita and secondary school enrollment ratio in the country (see
column 2 and column 3 for each of the pooled samples).
In conclusion, the empirical specification estimated in Table I
implies that the greater degree of financial intermediation leads to
higher growth in output per capita. (5)
V. POLICY SIGNIFICANCE AND CONCLUDING REMARKS
Given the relatively strong pro-growth effect of financial
intermediation, the clear policy implication is that financial
liberalisation in the form of say deregulation and establishment and
development of stock markets can be expected to lead to enhanced
economic growth. However, an important emerging issue relates to the
optimal speed of introducing such financial deregulation is not directly
addressed in this paper but is an important element of the agenda for
future research related to the important question of the links between
financial intermediation and economic growth.
Author's Note: The author is grateful to Roberto Mariano and
Lawrence R. Klein for helpful comments. Jarred Whitaker and Peter Kan
provided excellent research assistance.
REFERENCES
Atje, Raymond, and Boyan Jovanovic (1993) Stock Markets and
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Clemente, Lilia C., and Roberto S. Mariano (eds) (1993) Asian
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Securities Industry Institute.
Dailami, Mansoor, and Michael Atkin (1990) Stock Markets in
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Series No. 515.)
Goldsmith, R. W. (1969) Financial Structure and Development. New
Haven: Yale University Press.
Greenwood, Jeremy, and Boyan Jovanovic (1990) Financial
Development, Growth, and the Distribution of Income. Journal of
Political Economics 98:5 pt. 1.
Gregorio, Jose De, and Pablo E. Guidotti (1995) Financial
Development and Economic Growth. World Development 23:3.
King, Robert G., and Ross Levine (1993) Finance and Growth:
Schumpeter Might Be Right. Quarterly Journal of Economics August.
Levine, R. (1997) Financial Development and Economic Growth: Views
and Agenda. Journal of Economic Literature June.
Lucas. R. (1990) Why Doesn't Capital Flow From Rich to Poor
Countries? American Economic Review Papers and Proceedings 80: 92-96.
Lucas, R. (1993) Making a Miracle. Econometrica 61:251-272.
Mariano, Roberto M., and Tayyeb Shabbir (1996) The Relationship
Between Growth and Financial Markets: Some Outstanding Theoretical
Issues. In Dios and Fabella (eds) Choice, Growth and Development. Essays
in honour of Jose Encarnacion. University of the Philippines Press.
Mckinnon, Ronald I. (1973) Money and Capital in Economic
Development. Washington, D. C.: The Brookings Institute.
Ratcliffe. Ronald (1994) Why Doesn't Capital Flow From Rich to
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(1) Some of the discussion in this paper relies on an earlier
(joint) work of the author: Mariano and Shabbir (1996).
(2) In fact, much of the discussion in Atje and Jovanovic (1993)
uses Greenwood and Jovanovic (1990) as their point of departure.
(3) Atje and Jovanovic (1993) ran regressions of this type, with
the following numerical estimates of the impact of financial
intermediation on the growth of per capita income:
[partial derivative]([g.sub.y] - [g.sub.L])/[partial derivative]F
[approximately equal to] .05z.
Note that .05 is the estimated coefficient of F x z in the
regression of [g.sub.y] - [g.sub.t] described above.
(4) This empirical specification is in the spirit of the
theoretical model outlined earlier in this paper.
(5) This result, of course, is subject to the assumptions embedded
in the model presented in Section 11, in particular, the implicit
assumption of lack of simultaneity between financial intermediation and
economic growth.
Tayyeb Shabbir is Senior Research Economist at the Pakistan
Institute of Development Economics, Islamabad.
Table 1
Growth of GDP Per Capita (Dep. Var. = [g.sub.Y/L])
Pooled Developing Asian Countries
(1) (2) (3)
Constant 0.01 0.02 0.03
(0.55) (0.88) (1.24)
[g.sub.L] -0.84 -0.77 -0.95
(1.67) (1.57) (1.86)
Z 0.26 0.13 0.16
(1.56) (0.76) (0.90)
ZF 0.64 * 0.44 0.56 *
(2.62) (1.74) (2.07)
Sec. Enrol. -0.02
(1.20)
[([g.sub.Y/L).sub.-1] 0.27 * 0.24 *
(2.43) (2.14)
N 88 88 88
Adj. [R.sup.2] 0.24 0.28 0.29
Pooled Developed Countries
(1) (2) (3)
Constant 0.01 -0.01 0.02
(0.44) 0.00 (0.35)
[g.sub.L] -0.80 -1.16 * -1.111 *
(1.45) (3.19) (3.02)
Z 0.35 0.28 0.23
(1.85) (1.11) (0.85)
ZF 0.29 0.35 0.36
(1.05) (1.10) (1.09)
Sec. Enrol. -0.02
(0.51)
[([g.sub.Y/L).sub.-1] 0.24 0.23
(1.71) (1.62)
N 55 55 55
Adj. [R.sup.2] 0.21 0.34 0.33
* Significant at 95 percent level
(t-statistics are given in the parentheses).