Description
The purpose of this paper was to survey the existing literature on the causal relationship
between bank-based financial development and economic growth, highlighting the theoretical and
empirical evidence from recent work. Although some previous studies have attempted to conduct a
survey of the existing research on the finance-growth nexus, the majority of these studies have failed to
distinguish between bank-based and market-based financial developments. To our knowledge, this
may be the first study of its kind to survey the existing research on the causal relationship between
bank-based financial development and economic growth – in both developed and developing countries.
Journal of Financial Economic Policy
Bank-based financial development and economic growth: A review of international
literature
Sheilla Nyasha Nicholas M Odhiambo
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To cite this document:
Sheilla Nyasha Nicholas M Odhiambo , (2014),"Bank-based financial development and economic growth",
J ournal of Financial Economic Policy, Vol. 6 Iss 2 pp. 112 - 132
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148-173http://dx.doi.org/10.1108/10867371211246830
Boopen Seetanah, Shalini T. Ramessur, Sawkut Rojid, (2009),"Financial development and economic
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Rihab Grassa, Kaouthar Gazdar, (2014),"Financial development and economic growth in GCC countries: A
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Bank-based fnancial
development and
economic growth
A review of international literature
Sheilla Nyasha and Nicholas M. Odhiambo
Department of Economics, University of South Africa,
Pretoria, South Africa
Abstract
Purpose – The purpose of this paper was to survey the existing literature on the causal relationship
between bank-based fnancial development and economic growth, highlighting the theoretical and
empirical evidence from recent work. Although some previous studies have attempted to conduct a
survey of the existing research on the fnance-growth nexus, the majority of these studies have failed to
distinguish between bank-based and market-based fnancial developments. To our knowledge, this
may be the frst study of its kind to survey the existing research on the causal relationship between
bank-based fnancial development and economic growth – in both developed and developing countries.
Design/methodology/approach – Overall, our study shows that most of the literature reviewed in this
paper either supports bidirectional causality between bank-based fnancial development and economic
growthor reinforces the conventional supply-leadingresponse phenomenon. Notwithstandingthis outcome,
the studyalsofnds the literature infavour of ademand-followingresponse tobe increasing–inbothnumber
and substance – especially in recent years.
Findings – The paper, therefore, concludes that the causal relationship between fnancial
development and economic growth is not clear-cut and that the notion that fnancial development
automatically leads to economic growth is merely based on prima facie or superfcial evidence.
Originality/value – Although some previous studies have attempted to conduct a survey of the
existing research on the fnance-growth nexus, the majority of these studies have failed to distinguish
between bank-based and market-based fnancial developments. To our knowledge, this may be the frst
study of its kind to survey the existing research on the causal relationship between bank-based fnancial
development and economic growth – in both developed and developing countries.
Keywords Economic growth, Causality, Bank-based fnancial development, Supply-leading,
Demand-following, Bi-directional
Paper type Literature review
1. Introduction
Academic literature on the relationship between bank-based fnancial development and
economic growth dates back to the early twentieth century (Schumpeter, 1911), but,
surprisingly, there is little consensus on the conclusions reached to date. The
inconsistency in the conclusion on, and the controversy surrounding the causal
relationship between, bank-based fnancial development and economic growth has left
policymakers confused.
JEL classifcation – G20, A12
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
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Journal of Financial Economic Policy
Vol. 6 No. 2, 2014
pp. 112-132
©Emerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-07-2013-0031
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The existing literature on the subject matter shows that different studies have
focused on different countries and groups of countries, time periods, proxy variables
and different econometric methods, which have been used in exploring the
fnance-growth nexus. The empirical outcomes of these studies have been varied, and
sometimes they have been found to be conficting. The policy implications of these
relationships can be signifcant – depending on what kind of causal relationship exists.
The earlier literature that focuses on the causal relationship between bank-based
fnancial development and economic growth is, however, inconclusive in providing
policy recommendations that could be applied uniformly across different countries.
These diverse results arise fromthe different datasets, alternative econometric methods
and different countries’ characteristics.
This paper aims to review the existing literature on bank-based fnancial
development and economic growth, highlighting both the theoretical frameworks and
the empirical evidence. The paper differs fundamentally fromprevious studies in that it
has divided fnancial development into bank-based and market-based fnancial
developments, and it has closely focused on bank-based fnancial development and
economic growth. Previous literature survey studies failed to make such a distinction –
and focused on fnancial development and economic growth – making their studies of a
more general nature.
Because of the scarcity of specifc literature on bank-based fnancial development
and economic growth, a good part of the literature reviewed in this paper is based on the
existing studies on general fnancial development and economic growth. However, this
paper has gone further to consider the bank-based-related variables used as proxies for
fnancial development in these studies.
The paper is divided into four sections. Section two reviews the theoretical literature
on the causal relationship between bank-based fnancial development and economic
growth. In section three, the empirical evidence on the causal relationship between
bank-based fnancial development and economic growth is reviewed. Finally, some
concluding remarks are presented in section four.
2. The causal relationship between bank-based fnancial development
and economic growth: a theoretical framework
The direction of causality between fnancial development and economic growth is a
hotly debated issue and is also crucial, as it has signifcantly different implications for
the development of policy. However, this causal relationship remains unclear.
The debate on the direction of causality between fnancial development and
economic growth has been ongoing since the nineteenth century. For a long time, the
conventional wisdom has been in favour of the supply-leading response, where the
development of the fnancial sector is expected to precede the development of the real
sector (Odhiambo, 2007). To date, three views exist in the literature regarding the
fnance-growth nexus. These are as follows:
(1) “The fnance-led growth hypothesis” or the “supply-leading hypothesis”;
(2) “the growth-led fnance hypothesis” or the “demand-following hypothesis”; and
(3) “the feedback hypothesis” or the “bidirectional causality view”.
The supply-leading hypothesis argues that bank-based fnancial development is
important and leads to economic growth. This viewhas recently been widely supported
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by McKinnon (1973), Shaw(1973) and King and Levine (1993b), among others. Although
Schumpeter (1911) is generally acknowledged as the frst proponent of the
supply-leading theory, the support for the supply-leading response can be traced as far
back as Bagehot (1873), who argued that the fnancial system played a critical role in
igniting industrialisation in England – by facilitating the mobilisation of capital for
“immense works”.
This view was reinforced by Schumpeter (1911), when he argued that fnance leads
economic growth and that fnancial institutions are necessary for the capitalistic
economy’s development. In Schumpeter’s view, a well-functioning banking system
spurs technological innovation – by identifying and funding those entrepreneurs with
the best chances of successfully implementing innovative products and production
processes.
In 1952, Robinson attempted to challenge Schumpeter’s viewby arguing that it is the
development of the real sector – economic growth – which leads the development of the
fnancial sector and that where there is economic growth, fnancial-sector development
follows (Robinson, 1952). According to Robinson (1952), fnance does not exert a causal
impact on growth. Instead, fnancial development follows economic growth, as a result
of the higher demand for fnancial services. As such, an increasing demand for fnancial
services might induce an expansion in the fnancial sector, as the real economy grows
(i.e. the fnancial sector responds positively to economic growth). This line of reasoning
is also supported by Gurley and Shaw (1967), Goldsmith (1969) and Jung (1986).
In 1966, Patrick reconciled the two conficting theories by arguing that the direction
of causality between fnancial development and economic growth changes over the
course of development – the Patrick’s hypothesis. In his view, fnancial development
induces real investment innovation before sustained modern economic growth gets
under way, and as modern economic growth occurs, the supply-leading impetus
gradually becomes less and less important, as the demand-following response prevails.
Thus, according to Patrick (1966), the supply-leading pattern dominates during the
early stages of economic development, while the demand-following pattern dominates
at later stages.
According to Patrick’s (1966) reconciliation, two possible directions of causality
between fnancial development and economic growth were identifed. These
relationships were labelled as the supply-leading and demand-following views. The
supply-leading view postulates a positive impact of fnancial development on
economic growth, which means that the creation of fnancial institutions and
markets increases the supply of fnancial services and thus leads to economic
growth. Patrick advocated for a supply-leading strategy that ensures the creation of
fnancial institutions and the supply of their assets, liabilities and related services in
advance of demand for them.
The supply-leading fnance performs two functions. The frst function is to
transfer resources from traditional (non-growth) sectors to modern high-growth
sectors and to promote and stimulate an entrepreneurial response in these modern
sectors. Second, he argued that supply-leading fnance would exert a positive
infuence on capital by improving the composition of the existing stock of capital,
effciently allocating new investments among the various alternative uses and
raising the rate of capital formation by providing incentives for increased saving
and investment. Thus, the supply-leading fnance spurs economic development
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through the transfer of scarce resources from savers to investors, according to the
existing highest rates of return on investment.
The supply-leading argument of Patrick (1966) is supported by the McKinnon –
Shaw hypothesis. McKinnon (1973) suggested a complementarity relationship
between the accumulation of money balances (fnancial assets) and physical capital
accumulation in developing countries. He developed an outside model of money
demand. McKinnon argued that because of underdeveloped fnancial markets in
most developing countries, there are limited opportunities for external fnance, and
all frms are limited to self-fnancing. Given that investment expenditures are
lumpier than the consumption expenditure, potential investors must frst
accumulate money balances prior to undertaking relatively expensive and
indivisible investment projects.
The “debt-intermediation” view proposed by Shaw (1973) was based on an inside
money model. Shaw (1973) argued that high interest rates are essential in attracting
more saving. With greater supplies of credit, fnancial intermediaries promote
investment and raise output growth – through borrowing and lending.
However, in the early 1980s the theoretical underpinnings of the fnancial
liberalisation theory were criticised by some economists, notably the neo-structuralists,
led by Van Wijnbergen (1983) and Taylor (1983), who predicted that fnancial
liberalisation would slow down economic growth (Kargbo and Adamu, 2009).
The demand-following view postulates a causal relationship from economic growth
to fnancial development. Patrick (1966) argued that the creation of modern fnancial
institutions, their fnancial assets and liabilities and related fnancial services are a
response to the demand for these services by investors and savers in the real economy.
Thus, economic growth creates a demand for developed fnancial institutions and
services.
Recently, there has emerged a large volume of literature which provides empirical
support for the fnance-led growth and the growth-led fnance hypotheses. This
evidence has been championed by recent literature on the endogenous growth theory.
Since the 1990s, several authors have incorporated fnancial institutions in their
analysis of endogenous growth. These models showthat economic growth performance
is related to fnancial development, technology and income distribution (Caporale et al.,
2003). Greenwood and Jovanovic (1990) assumed a positive two-way causal relationship
between fnancial development and growth.
On the one hand, fnancial institutions collect and analyse information to fnd the
investment opportunities with the highest return. They channel funds to the most
productive uses, thereby increasing the effciency of investment and growth. On the
other hand, growth provides the means needed to implement and develop a costly
fnancial structure.
King and Levine (1993b) identifed innovation as being the engine of growth,
which concurs with the line of reasoning of Schumpeter. They argued that an
effcient allocation of funds from fnancial intermediaries to entrepreneurs would be
able to lower the cost of investing in productivity enhancement, and thereby
stimulate economic growth. Financial intermediaries and securities markets enable
particular entrepreneurs to undertake innovative activity, which affects growth
through productivity enhancement. Financial systems can infuence the decision of
entrepreneurs to invest in productivity-enhancing activities by evaluating
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entrepreneurs, pooling resources, diversifying risk and valuing the expected profts
from innovative activities.
Consequently, fnancial intermediaries help the effcient allocation of resources,
which increase the probability of successful innovation. The rate of innovation can,
however, be reduced by the existence of distortions, like deposit-rate ceilings or high
reserve requirements.
3. The causal relationship between bank-based fnancial development
and economic growth: empirical evidence
3.1 The supply-leading response
Overall, the literature provides broad empirical evidence of a positive relationship
between bank-based fnance and economic growth, with the papers mainly differing in
the data coverage on countries and time periods, the estimation methods and the
variables selected. Several empirical fndings support the supply-leading hypothesis.
According to Thiel (2001, p. 20), the frst evidence that fnancial development accelerates
growth was presented by Goldsmith in 1969, in a study covering 35 countries over the
period 1860-1963, using the share of bank assets in gross domestic product (GDP) as a
proxy for fnancial development. However, his work did not control for other factors nor
did it allowfor the derivation of any conclusions on causality or the relative importance
of the different transmission channels.
Jung (1986) investigated the fnance-growth nexus, using cross-sectional data for 56
countries, including 19 industrialised countries. The ratio of currency to M1 and the
ratio of M2 to nominal gross national product (or GDP) were used as proxies for fnancial
development. Strong evidence for fnance-led growth was found. Jung concluded that
the supply-leading pattern occurs more frequently than the demand-following pattern in
the less-developed countries (LDCs).
Recent years have seen a rising vibrant interest in empirical research on the
fnance-growth nexus. In particular, the paper by King and Levine (1993a) provided
the starting point for intensifed research, which received a major impetus by the
construction of the fnancial-structure database compiled for the World Bank. King
and Levine (1993a) used bank-based fnancial development measures – the ratio of
the liquid liabilities of banks and non-bank institutions to GDP, the ratio of bank
credit to the sum of bank and central bank credit, the ratio of private credit to
domestic credit and the ratio of private credit to GDP – and found that the level of
fnancial development predicts future economic growth and future productivity
advances. The authors interpreted this as evidence of a causal relationship that runs
from fnancial development to economic growth.
Odedokun (1996a) used time-series regression analysis for 71 developing countries
for varying periods from 1960-80, and this author found that fnancial intermediation
promotes economic growth in 85 per cent of the sampled countries. The results further
indicated that the impact of fnancial development is found to be higher on low-income
LDCs than in high-income LDCs. In the same year, Odedokun (1996b) did a study on the
fnancial policy and the effciency of resource utilisation in 81 developing countries: this
time, using pooled cross-sectional data. Evidence for a supply-leading response was
found.
Neusser and Kugler (1998) examined the fnance-growth relationship for 13
Organisation for Economic Cooperation and Development (OECD) countries for the
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period 1970-91. Using the time-series analysis, the study showed a positive correlation
between fnancial development and growth, and the conclusion made was in support of
the supply-leading response. However, the authors used measures of the value-added
factor provided by the fnancial system – instead of simple measures of the size of the
fnancial system. Unlike Odedokun (1996a), Neusser and Kugler (1998) found that the
causal structure underlying the relationship varies widely across different countries.
Ahmed and Ansari (1998) investigated the relationship between fnancial sector
development and economic growth for three major South-Asian economies, namely,
India, Pakistan and Sri Lanka. Bank-based fnancial sector development was proxied by
M2/nominal GDP, quasi-money/nominal GDP and domestic credit/nominal GDP. The
results fromthe causality analysis indicated that fnancial sector development Granger
causes economic growth. This validated the supply-leading hypothesis. The regression
results, using pooled data based on time-series and cross-sectional observations,
reinforced the fndings of the causality analysis, suggesting that fnancial sector
development has made a signifcant contribution to economic growth in these countries.
In 1998, Rousseau and Wachtel (1998) examined the nature of the links between the
intensity of fnancial intermediation and economic performance that operated in the
USA, the UK, Canada, Norway and Sweden over the period 1870-1929. Vector-error
correction models established the quantitative importance of long-run relationships
among the measures of fnancial intensity and real per capita levels of output and the
monetary base. Granger causality tests then suggested a leading role for the
intermediation variables in real sector activity, while the feedback effects were largely
insignifcant. In conclusion, Rousseau and Wachtel suggested an important role for
intermediation in the rapid industrial transformations of all fve countries.
Ghali (1999) empirically investigated the question of whether fnancial development
leads to economic growth in Tunisia. Using the ratio of bank-deposit liabilities to
nominal GDP and the ratio of bank claims on the private sector to nominal GDP as
proxies for fnancial development, the paper focused on the causal link between fnance
and economic growth to discriminate between several alternative theoretical
hypotheses. The results suggested the existence of a stable long-run relationship
between the development of the fnancial sector and the evolution of per capita real
output that is consistent with the supply-leading hypothesis.
Beck et al. (2000) conducted a study on 63 countries for the period 1960-95, using
cross-country regression and dynamic-panel estimation. The legal origin indicators as
instruments to extract the exogenous component of fnancial intermediation were used
as fnancial indicators. Although the results for capital accumulation and the saving
ratio were not found to be robust or signifcant, banks were found to exert a strong,
causal impact on real GDP and total factor-productivity growth.
In a separate but related study, Levine et al. (2000) conducted a study on 71 countries
for the period 1960-95, using the ratio of liquid liabilities to GDP, the ratio of deposit
money banks’ domestic assets to deposit money banks’ domestic assets plus the central
bank’s domestic assets and the ratio of credit issued to private enterprises to nominal
GDP as fnancial indicators. The fndings supported a positive correlation between the
fnancial system and economic growth. The authors suggested that legal and
accounting reforms should be undertaken to strengthen creditor rights, contract
enforcement and accounting practices to boost fnancial intermediary development, and
thereby accelerating economic growth.
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Allen and Ndikumana (2000) used various indicators of fnancial development to
examine the role of fnancial intermediation in stimulating economic growth in southern
Africa. Using a reduced-formequation, relating the growth rate of real per capita GDPto
an indicator of fnancial development, while controlling for other factors that affect
economic growth, the results found evidence of a positive relationship between fnancial
development and economic growth, lending support to the fnance-led growth
hypothesis.
Graff (2002) studied the causal links between fnancial activity and economic growth
by using a cross-country analysis for 93 countries. Evidence of fnance leading economic
growth was found, though it was concluded that such a relationship was not stable.
In 2002, Shan and Morris (2002) used the Toda and Yamamoto (1995) causality
testing procedure to investigate the relationship, if any, between fnancial development
and economic growth, using quarterly data from 19 OECD countries and China. By
using total credit and interest spread as indicators of fnancial development, they found
evidence in support of the supply-leading hypothesis for one country.
Jalilian and Kirkpatrick (2002) empirically investigated the link between fnancial
development and economic growth in 42 countries (including 26 developing and 16
developed countries) using bank-deposit money assets as a proxy for fnancial
development. They utilised a pooled-panel data approach with both a time series and a
cross-section dimension within the simple ordinary least squares (OLS), panel and
two-stage least square frameworks. The results were consistent with the fnance-led
growth view.
In 2004, Chistopoulos and Tsionas conducted a study on ten developing countries to
examine the relationship between fnancial development and economic growth. The
authors used the ratio of total bank-deposit liabilities to nominal GDP as a measure of
bank-based fnancial depth, while the ratio of investment to GDP and the infation rate
were used as control variables. They made use of panel unit-root tests and panel
co-integration analysis to conclude that there is fairly strong evidence in favour of the
hypothesis that long-run causality runs from fnancial development to growth and that
the relationship is signifcant.
In the same year, Fatima (2004) examined the causal relationship between
bank-based fnancial development and economic growth in Morocco for the period
1970-2000. The ratio of liquid liabilities (M3) to GDP, the ratio of domestic credit
provided by the banking sector to GDP and the domestic credit to the private sector to
GDP were the fnancial depth indicators that were used in this study. Based on the
Granger causality test, the study found a short-run relationship between fnancial
development and economic growth, with causality running from bank-based fnancial
development to economic growth.
Shabri and Majid (2008) examined empirically the fnance-growth nexus during the
post-1997 fnancial crisis in Malaysia, using time-series data. The ratio of total
bank-deposit liabilities to nominal GDP was used to proximate fnancial development.
Granger causality tests revealed a unidirectional causality running from fnance to
growth, thus supporting the fnance-led hypothesis or the supply-leading view.
Odhiambo (2009a) examined the dynamic impact of interest rate reforms on
economic growth in Zambia. The ratio of M2 to GDP and the nominal deposit rate were
used to proximate fnancial development. Based on the co-integration-based error
correction model, the study found strong support for the positive impact of interest-rate
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liberalisation on fnancial deepening. In addition, the study found that fnancial
deepening, which results from interest-rate liberalisation, Granger causes economic
growth, regardless of whether the causality is estimated in the short-run or in the
long-run.
Akinlo and Egbetunde (2010) examined the long-run causal relationship between
fnancial development – proxied by the ratio of M2 to GDP – and economic growth for
ten countries in S-SA. Using the vector-error-correction (VEC) model, the study found a
long-run relationship between fnancial development and economic growth in the
selected S-SAcountries. The results further showed that fnancial development Granger
causes economic growth in the Central African Republic, the Congo Republic, Gabon
and Nigeria. The results showed the need to develop the fnancial sector through
appropriate regulatory and macroeconomic policies.
Ahmed and Wahid (2011) used the newly developed panel data co-integration
analysis and the dynamic time series modelling approach to examine the linkages
between fnancial structure and economic growth in a group of seven African countries
over the period 1986-2007. They found that higher levels of banking system
development were positively associated with capital accumulation growth and led to
faster rates of economic growth. Further results showed evidence of unidirectional
causality running from bank-based fnancial systems to economic growth.
Nwosa et al. (2011) examined the causal relationships among fnancial development,
foreign direct investment and economic growth in Nigeria over the period 1970-2009.
The results indicated the presence of co-integration among the variables. The study
concluded that fnancial development has a statistically signifcant causal infuence on
economic growth.
Hussain and Chakraborty (2012) empirically examined the relationship between
fnancial development and economic growth and their causality in the context of Assam,
a state in India. The study found a co-integrating relationship between bank-based
fnancial development and economic growth. Furthermore, causality tests showed that
fnancial development causes economic growth in the case of Assam.
Table I shows a summary of the studies consistent with the supply-leading
hypothesis.
3.2 The demand-following response
A number of studies on the fnance-growth nexus are in support of the
demand-following hypothesis. They conclude that it is economic growth that stimulates
the development of the bank-based fnancial sector.
Shan et al. (2001) used a Granger causality procedure to investigate the relationship
between fnancial development and economic growth for nine OECD countries and
China, based on the time-series approach within a vector autoregressive (VAR)
framework. They found evidence in favour of the demand-following hypothesis for
three of the countries.
In 2002, Shan and Morris (2002) used the Toda and Yamamoto (1995)
causality-testing procedure to investigate the relationship, if any, between fnancial
development and economic growth, using quarterly data from 19 OECD countries and
China. Using total credit and interest spread, as indicators of fnancial development,
they found evidence that economic growth “leads” fnancial development for fve
countries.
119
Bank-based
fnancial
development
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1
6
(
P
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Table I.
Studies in favour of a
unidirectional causality
from bank-based fnancial
development to economic
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6,2
120
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(
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121
Bank-based
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development
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I
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A
t
2
1
:
4
9
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
Odhiambo (2004) investigated whether fnancial development was still a spur to
economic growth in South Africa. He used the ratio of M2 to GDP, the currency ratio and
the ratio of bank claims on the private sector to nominal GDP as proxies of bank-based
fnancial development. Based on the Granger causality test in the context of the
Johansen – Juselius co-integration technique and the vector error-correction model, the
study revealed that the wholesale supply-leading hypothesis had been rejected in South
Africa. Indeed, there was an overwhelming demand-following response between
fnancial development and economic growth in South Africa, regardless of the
measurement for fnancial development. This implies that, for South Africa, it is
economic growth which drives the development of the banking sector.
Using the ratio of M3 to nominal GDP, the ratio of commercial bank assets to
commercial bank assets plus central bank assets and the ratio of domestic credit to
private sectors to nominal GDP as proxies of fnancial development, Ang and McKibbin
(2007) examined whether fnancial development leads to economic growth, or vice versa,
in Malaysia. Their argument was that the results obtained from cross-sectional studies
were not able to address this issue satisfactorily, and they highlight the importance of
country-specifc studies. Using the time-series data from 1960 to 2001, Ang and
McKibbin (2007) conducted co-integration and various causality tests to assess the
fnance-growth link, by taking savings, investment, trade and the real interest rate into
account. Contrary to the conventional fndings, their results supported the
demand-following hypothesis in the long run.
Zang and Kim (2007) used panel analysis to examine 74 countries over the period
1961-95. Using the ratio of liquid liabilities to GDP, the ratio of deposit-money-bank
domestic assets to deposit-money-bank domestic assets plus central bank-domestic
assets and credit issued to private enterprises as a share of GDP, the study found
substantial evidence that economic growth precedes any subsequent fnancial
development.
The fndings by Guryay et al. (2007) showed that there is a negligible positive effect
of fnancial development on economic growth in Northern Cyprus. The Granger
causality test found that fnancial development does not cause economic growth; rather,
the direction of causality was from economic growth to the development of fnancial
intermediaries.
Odhiambo (2008a) examined the dynamic causal relationship between fnancial
depth – proxied by the ratio of M2 to GDP – and economic growth in Kenya, by
including savings as an intermitting variable, thereby creating a trivariate causality
model. Using the co-integration and error-correction techniques, the empirical
results of this study revealed that there was a distinct unidirectional causal fow
from economic growth to fnancial development. The results also showed that
economic growth Granger causes savings, while savings drive the development of
the fnancial sector in Kenya.
In the same year, Odhiambo (2008b) examined the direction of causality between
fnancial development and economic growth in Kenya, using a dynamic Granger
causality model. The study used the three proxies of fnancial development, which were
the ratio of M2 to GDP, the currency ratio, and domestic credit to the private sector. The
empirical results revealed that although the causality between fnancial development
and economic growth in Kenya was sensitive to the choice of measure for fnancial
development, on balance, the demand-following response tended to predominate.
JFEP
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(
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Odhiambo (2009b) investigated the direction of causality between fnancial
development and economic growth in Kenya using the co-integration-based
error-correction mechanism. Using the ratio of M2 to GDP, the currency ratio and the
ratio of bank claims on the private sector to nominal GDP as proxies of bank-based
fnancial development and infation as a control variable, the study employed both
bivariate and trivariate causality tests to examine the causal relationship between
fnancial development and economic growth.
The study proceeded by frst conducting a dynamic Granger causality test within a
bivariate framework, and thereafter, it added the infation variable to make a trivariate
framework. The empirical results of this study found a distinct unidirectional causality
fromeconomic growth to fnancial development. This applied, regardless of whether the
causality was estimated in a bivariate framework or in a trivariate setting. The results
also showed that economic growth Granger causes infation in Kenya – both in the
short-run and in the long-run. The study, therefore, concluded that bank-based fnancial
sector development in Kenya is largely dependent on the demand for, rather than the
supply of, fnancial services.
Odhiambo (2009c) examined the dynamic causal relationship between fnancial
development, economic growth and poverty reduction in South Africa, using a trivariate
causality model. Financial development was proxied by the ratio of M2 to GDP. Using
co-integration and error-correction models, the empirical results of the study showed
that both fnancial development and economic growth Granger cause poverty reduction
in South Africa. The study also found that economic growth Granger causes fnancial
development, and therefore, it leads in the process of poverty reduction in South Africa.
This applies, irrespective of whether the causality test is conducted in the short-run or in
the long-run.
Odhiambo (2009d) examined the dynamic relationship between interest-rate
reforms, bank-based fnancial development and economic growth in South Africa,
using the annual time-series data. In assessing the causal relationship, the author
introduced investment as an intermittent variable to develop a trivariate causality
model. The study found that fnancial development does not Granger cause
investment and economic growth. Rather, there was evidence of a unidirectional
causal fow from investment to fnancial development and a prima facie causal fow
from investment to growth. The author, therefore, concluded that although interest
rate reforms have exerted a positive effect on fnancial depth in South Africa, the
causal relationship between fnancial depth and economic growth takes a
demand-following path.
Akinlo and Egbetunde (2010) examined the long-run causal relationship between
fnancial development – proxied by the ratio of M2 to GDP – and economic growth for
ten countries in S-SA. Using the vector-error correction model, the study found a
long-run relationship between fnancial development and economic growth in the
selected S-SA countries. The results further showed that economic growth Granger
causes fnancial development in Zambia. The results showed that emphasis needs to be
placed on economic growth to propel fnancial development in Zambia.
Rachdi and Mbarek (2011) empirically investigated the direction of causality
between fnance and growth based on a sample of ten countries, six from the OECD
region and four from the Middle East and North Africa (MENA) region during
1990-2006. Panel data cointegration analysis confrmed a long-term relationship
123
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(
P
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between fnancial development and economic growth for the OECD and the MENA
countries. The results further showed that causality is unidirectional for the MENA
countries, from economic growth to fnancial development.
Table II shows a summary of the studies consistent with the demand-following
hypothesis.
3.3 The bidirectional causality/feedback response
Despite the arguments in favour of the supply-leading response and
demand-following response, the empirical results from a number of studies have
shown that bank-based fnancial development and economic growth can Granger
cause one another. Some empirical studies have also supported the assertion that
growth has a feedback effect on fnancial intermediaries by creating the necessary
incentives for fnancial development.
Wood (1993) investigated the causal relationship between fnancial development and
economic growth in Barbados, using the ratio of M2 to GDP as a proxy for fnancial
development. The results were in favour of the feedback response, where bank-based
fnancial development and economic growth mutually cause each other.
Demetriades and Luintel (1996a), in their study on fnancial development, economic
growth and banking-sector controls in India, used data from the Reserve Bank of India
to examine the effects of various types of banking-sector controls on the process of
fnancial deepening. Although almost all of the controls used were found to infuence
fnancial deepening negatively, the exogeneity tests suggested that fnancial deepening
and economic growth are jointly determined. Thus, policies which affect fnancial
deepening could also have an infuence on economic growth.
Demetriades and Luintel (1996b) investigated the effects of banking-sector policies
on the process of fnancial development and economic growth in Nepal, using bank
deposit liabilities as a proxy for fnancial development. They found evidence of
bidirectional causality.
Berthelemy and Varoudakis (1996) tested the existence of a poverty trap linked to
the development of the banking sector in 95 countries, using multiple
endogenous-growth equilibria. The ratio of money plus quasi-money to GDP was
used as a proxy for banking-sector development. Their theoretical model exhibited
multiple steady-state equilibria due to a reciprocal externality between the banking
sector and the real sector. It was their conclusion that growth in the real sector
causes the fnancial market to expand, thereby increasing banking competition and
effciency. In return, the development of the banking sector raises the net yield on
savings and enhances capital accumulation and growth. Thus, the study lent
support to the feedback hypothesis.
Akinboade (1998) tested for causality between fnancial development and economic
growth in Botswana, using the annual time-series data. The ratio of bank claims on the
private sector to nominal non-mineral GDP and the ratio of bank-deposit liabilities to
nominal non-mineral GDP were used to measure fnancial development. The results
showed that fnancial and economic growth in Botswana were mutually causal.
Luintel and Khan (1999) used a multivariate vector auto-regressive framework to
examine the relationship between bank-based fnancial development – proxied by the
ratio of total deposit liabilities of deposit banks to one period-lagged GDP – and
JFEP
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Table II.
Studies in favour of a
unidirectional causality
from economic growth to
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125
Bank-based
fnancial
development
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economic growth, using a sample of ten LDCs. The results showed a bidirectional
causality between fnancial development and growth.
Shan et al. (2001) used a Granger causality procedure to investigate the relationship
between fnancial development and economic growth for nine OECD countries and
China, based on the time-series approach within a VAR framework. They found
evidence of bi-directional causality for fve countries.
Sinha and Macri (2001) looked at the relationship between fnancial development and
economic growth, using time-series data for eight Asian countries. Bank-based fnancial
development was proxied by M1, M2, M1 growth, M2 growth and the growth rate of
domestic credit as a ratio of GDP. The regression results showed a positive and signifcant
relationship between the income variables and the fnancial variables for India, Malaysia,
Pakistan and Sri Lanka. The multivariate causality tests showed a two-way causal
relationship between the income and the fnancial variables for most of the countries.
Shan and Morris (2002) used the Toda and Yamamoto (1995) causality-testing
procedure to investigate the relationship, if any, between fnancial development and
economic growth, using quarterly data from 19 OECD countries and China. Using total
credit and interest spread as indicators of fnancial development, they found evidence of
bidirectional causality in four countries.
Fase and Abma (2003) used individual country time-series data to study the
relationship between fnancial environment and economic growth in eight Asian
countries. The results were in support of the feedback-response hypothesis.
Calderon and Liu (2003) employed the Geweke decomposition test on the pooled data
of 109 developing and industrial countries from1960- to 1994 to examine the direction of
causality between fnancial development and economic growth. They used the ratio of
M2 to GDPandthe ratio of private sector credit to GDPas proxies of fnancial development.
The results revealed that while fnancial development generally leads to economic growth,
the Granger causality from fnancial development to economic growth and the Granger
causality from economic growth to fnancial development coexist. The results further
showed that fnancial deepening contributes more to the causal relationships in the
developingcountries thanit does inthe industrial countries; the longer the samplinginterval,
the larger the effect of fnancial development on economic growth, and that fnancial
deepening propels economic growth through both a more-rapid capital accumulation and
productivity growth, with the latter channel being the strongest.
In the same year, Shan and Jianhong (2006) used a VAR approach to examine the
impact of fnancial development – proxied by total credit – on economic growth in China.
Variance decomposition and impulse-response function analysis was applied to
examine the interrelationships between variables in the VAR system. Besides fnding
that fnancial development comes as the second force – after the contribution from
labour input – in leading economic growth in China, the study supported the viewin the
literature that fnancial development and economic growth exhibit a two-way causality.
Two years later, Ang (2008) estimated a six-equation model of fnancial development
and economic growth for Malaysia to shed light on the mechanisms linking these two
variables. The results indicated that fnancial development leads to higher output
growth via promoting both private savings and private investment. The fndings also
provide some support for the hypothesis of endogenous fnancial development and growth
models that fnance leads to higher growth through improved effciency of investment. The
results also lent some support to Robinson’s (1952) viewthat economic development leads to
JFEP
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6
(
P
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an improvement in the fnancial system. These fndings, put together, suggested that
fnancial development and economic growth in Malaysia show a bidirectional causality
pattern. Thus, the results support the endogenous fnancial development andgrowththeory,
which postulates a feedback relationship in the fnance-growth nexus.
Abu-Bader and Abu-Qarn (2008) examined the causal relationship between fnancial
development and economic growth in Egypt, during the period 1960-2001, within a
trivariate VAR framework. The authors employed four different measures of
bank-based fnancial development, and they applied Granger causality tests using the
co-integration and VEC methodology.
The results strongly supported the view that fnancial development and economic
growth are mutually causal. Akinlo and Egbetunde (2010) examined the long-run causal
relationship between fnancial development – proxied by the ratio of M2 to GDP – and
economic growthfor tencountries inS-SA. Usingthe VECmodel, the studyfoundalong-run
relationship between fnancial development and economic growth in the selected S-SA
countries. The results further revealed the bidirectional relationship between fnancial
development and economic growth in Kenya, Chad, South Africa, Sierra Leone and
Swaziland.
Acaravci et al. (2009) investigated the causality between fnancial development and
economic growth in S-SA for the period 1975-2005. The empirical fndings in the paper
showed a bidirectional causal relationship between the growth of real GDP per capita and
the domestic credit provided by the banking sector for the panels of 24 S-SAcountries.
Odhiambo (2011) examined a dynamic causal relationship between stock market
development, bank-based fnancial development and economic growth in South Africa
during the period 1980:1-2007:3, using a trivariate Granger causality model. The paper
attempted to answer the question of whether fnancial sector development Granger
causes economic growth, and which sector – bank-based sector or stock market sector –
leads in the process of fnancial development in South Africa when using a
co-integration-based error-correction mechanism. Although a distinct unidirectional
causal fow from stock market development to bank development was revealed, the
results also indicated that there is a bidirectional causal relationship between
bank-based fnancial development and economic growth.
Rachdi and Mbarek (2011) empirically investigated the direction of causality
between fnance and growth based on a sample of ten countries, six from the OECD
region and four from the MENA region during 1990-2006. Panel data cointegration
analysis confrmed a long-term relationship between fnancial development and
economic growth for the OECD and the MENA countries. The results further showed
that causality is bidirectional for the OECD countries.
Table III shows a summaryof the studies consistent withthe bi-directional causalityview.
4. Conclusion
In this paper, we review both the theoretical and the empirical literature on the causal
relationship between bank-based fnancial development and economic growth in both
developed and developing countries. Although the academic literature on the
relationship between bank-based fnancial development and economic growth dates
back to the early twentieth century (Schumpeter, 1911), there is little consensus to date
on the exact direction of causality between these two important macroeconomic
variables. Previous literature can be divided into three schools of thought:
127
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fnancial
development
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Table III.
Studies in favour of a
bidirectional causality
between bank-based
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economic growth
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JFEP
6,2
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(1) studies in favour of fnance-led growth response, which was initially popularised
by Schumpeter (1911);
(2) studies in favour of the growth-led fnancial development response, which was
largely popularised by Robinson (1952); and
(3) studies in favour of a bidirectional causality between fnancial development and
economic growth.
Even though a number of previous studies have attempted to conduct a survey of the
existing research on the fnance-growth nexus, the majority of these studies have failed
to distinguish between bank-based and market-based fnancial developments. To our
knowledge, this may be the frst study of its kind to survey the existing research on the
causal relationship between bank-based fnancial development and economic growth in
both developed and developing countries.
Our study shows that most of the previous literature reviewed in this paper either
reinforces the conventional wisdom of supply-leading response, or supports
bidirectional causality between bank-based fnancial development and economic
growth. Notwithstanding this outcome, the study also fnds the literature in favour of a
demand-following response to be increasing – in both number and substance –
especially in recent years. The study, therefore, concludes that the causal relationship
between fnancial development and economic growth is not clear-cut, and that the notion
that fnancial development automatically leads to economic growth is merely based on
prima facie or superfcial evidence.
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from developing countries”, Review of Financial Economics, Vol. 11 No. 2, pp. 131-150.
Corresponding author
Sheilla Nyasha can be contacted at: [email protected]
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doc_597908252.pdf
The purpose of this paper was to survey the existing literature on the causal relationship
between bank-based financial development and economic growth, highlighting the theoretical and
empirical evidence from recent work. Although some previous studies have attempted to conduct a
survey of the existing research on the finance-growth nexus, the majority of these studies have failed to
distinguish between bank-based and market-based financial developments. To our knowledge, this
may be the first study of its kind to survey the existing research on the causal relationship between
bank-based financial development and economic growth – in both developed and developing countries.
Journal of Financial Economic Policy
Bank-based financial development and economic growth: A review of international
literature
Sheilla Nyasha Nicholas M Odhiambo
Article information:
To cite this document:
Sheilla Nyasha Nicholas M Odhiambo , (2014),"Bank-based financial development and economic growth",
J ournal of Financial Economic Policy, Vol. 6 Iss 2 pp. 112 - 132
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Bank-based fnancial
development and
economic growth
A review of international literature
Sheilla Nyasha and Nicholas M. Odhiambo
Department of Economics, University of South Africa,
Pretoria, South Africa
Abstract
Purpose – The purpose of this paper was to survey the existing literature on the causal relationship
between bank-based fnancial development and economic growth, highlighting the theoretical and
empirical evidence from recent work. Although some previous studies have attempted to conduct a
survey of the existing research on the fnance-growth nexus, the majority of these studies have failed to
distinguish between bank-based and market-based fnancial developments. To our knowledge, this
may be the frst study of its kind to survey the existing research on the causal relationship between
bank-based fnancial development and economic growth – in both developed and developing countries.
Design/methodology/approach – Overall, our study shows that most of the literature reviewed in this
paper either supports bidirectional causality between bank-based fnancial development and economic
growthor reinforces the conventional supply-leadingresponse phenomenon. Notwithstandingthis outcome,
the studyalsofnds the literature infavour of ademand-followingresponse tobe increasing–inbothnumber
and substance – especially in recent years.
Findings – The paper, therefore, concludes that the causal relationship between fnancial
development and economic growth is not clear-cut and that the notion that fnancial development
automatically leads to economic growth is merely based on prima facie or superfcial evidence.
Originality/value – Although some previous studies have attempted to conduct a survey of the
existing research on the fnance-growth nexus, the majority of these studies have failed to distinguish
between bank-based and market-based fnancial developments. To our knowledge, this may be the frst
study of its kind to survey the existing research on the causal relationship between bank-based fnancial
development and economic growth – in both developed and developing countries.
Keywords Economic growth, Causality, Bank-based fnancial development, Supply-leading,
Demand-following, Bi-directional
Paper type Literature review
1. Introduction
Academic literature on the relationship between bank-based fnancial development and
economic growth dates back to the early twentieth century (Schumpeter, 1911), but,
surprisingly, there is little consensus on the conclusions reached to date. The
inconsistency in the conclusion on, and the controversy surrounding the causal
relationship between, bank-based fnancial development and economic growth has left
policymakers confused.
JEL classifcation – G20, A12
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
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Journal of Financial Economic Policy
Vol. 6 No. 2, 2014
pp. 112-132
©Emerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-07-2013-0031
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The existing literature on the subject matter shows that different studies have
focused on different countries and groups of countries, time periods, proxy variables
and different econometric methods, which have been used in exploring the
fnance-growth nexus. The empirical outcomes of these studies have been varied, and
sometimes they have been found to be conficting. The policy implications of these
relationships can be signifcant – depending on what kind of causal relationship exists.
The earlier literature that focuses on the causal relationship between bank-based
fnancial development and economic growth is, however, inconclusive in providing
policy recommendations that could be applied uniformly across different countries.
These diverse results arise fromthe different datasets, alternative econometric methods
and different countries’ characteristics.
This paper aims to review the existing literature on bank-based fnancial
development and economic growth, highlighting both the theoretical frameworks and
the empirical evidence. The paper differs fundamentally fromprevious studies in that it
has divided fnancial development into bank-based and market-based fnancial
developments, and it has closely focused on bank-based fnancial development and
economic growth. Previous literature survey studies failed to make such a distinction –
and focused on fnancial development and economic growth – making their studies of a
more general nature.
Because of the scarcity of specifc literature on bank-based fnancial development
and economic growth, a good part of the literature reviewed in this paper is based on the
existing studies on general fnancial development and economic growth. However, this
paper has gone further to consider the bank-based-related variables used as proxies for
fnancial development in these studies.
The paper is divided into four sections. Section two reviews the theoretical literature
on the causal relationship between bank-based fnancial development and economic
growth. In section three, the empirical evidence on the causal relationship between
bank-based fnancial development and economic growth is reviewed. Finally, some
concluding remarks are presented in section four.
2. The causal relationship between bank-based fnancial development
and economic growth: a theoretical framework
The direction of causality between fnancial development and economic growth is a
hotly debated issue and is also crucial, as it has signifcantly different implications for
the development of policy. However, this causal relationship remains unclear.
The debate on the direction of causality between fnancial development and
economic growth has been ongoing since the nineteenth century. For a long time, the
conventional wisdom has been in favour of the supply-leading response, where the
development of the fnancial sector is expected to precede the development of the real
sector (Odhiambo, 2007). To date, three views exist in the literature regarding the
fnance-growth nexus. These are as follows:
(1) “The fnance-led growth hypothesis” or the “supply-leading hypothesis”;
(2) “the growth-led fnance hypothesis” or the “demand-following hypothesis”; and
(3) “the feedback hypothesis” or the “bidirectional causality view”.
The supply-leading hypothesis argues that bank-based fnancial development is
important and leads to economic growth. This viewhas recently been widely supported
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by McKinnon (1973), Shaw(1973) and King and Levine (1993b), among others. Although
Schumpeter (1911) is generally acknowledged as the frst proponent of the
supply-leading theory, the support for the supply-leading response can be traced as far
back as Bagehot (1873), who argued that the fnancial system played a critical role in
igniting industrialisation in England – by facilitating the mobilisation of capital for
“immense works”.
This view was reinforced by Schumpeter (1911), when he argued that fnance leads
economic growth and that fnancial institutions are necessary for the capitalistic
economy’s development. In Schumpeter’s view, a well-functioning banking system
spurs technological innovation – by identifying and funding those entrepreneurs with
the best chances of successfully implementing innovative products and production
processes.
In 1952, Robinson attempted to challenge Schumpeter’s viewby arguing that it is the
development of the real sector – economic growth – which leads the development of the
fnancial sector and that where there is economic growth, fnancial-sector development
follows (Robinson, 1952). According to Robinson (1952), fnance does not exert a causal
impact on growth. Instead, fnancial development follows economic growth, as a result
of the higher demand for fnancial services. As such, an increasing demand for fnancial
services might induce an expansion in the fnancial sector, as the real economy grows
(i.e. the fnancial sector responds positively to economic growth). This line of reasoning
is also supported by Gurley and Shaw (1967), Goldsmith (1969) and Jung (1986).
In 1966, Patrick reconciled the two conficting theories by arguing that the direction
of causality between fnancial development and economic growth changes over the
course of development – the Patrick’s hypothesis. In his view, fnancial development
induces real investment innovation before sustained modern economic growth gets
under way, and as modern economic growth occurs, the supply-leading impetus
gradually becomes less and less important, as the demand-following response prevails.
Thus, according to Patrick (1966), the supply-leading pattern dominates during the
early stages of economic development, while the demand-following pattern dominates
at later stages.
According to Patrick’s (1966) reconciliation, two possible directions of causality
between fnancial development and economic growth were identifed. These
relationships were labelled as the supply-leading and demand-following views. The
supply-leading view postulates a positive impact of fnancial development on
economic growth, which means that the creation of fnancial institutions and
markets increases the supply of fnancial services and thus leads to economic
growth. Patrick advocated for a supply-leading strategy that ensures the creation of
fnancial institutions and the supply of their assets, liabilities and related services in
advance of demand for them.
The supply-leading fnance performs two functions. The frst function is to
transfer resources from traditional (non-growth) sectors to modern high-growth
sectors and to promote and stimulate an entrepreneurial response in these modern
sectors. Second, he argued that supply-leading fnance would exert a positive
infuence on capital by improving the composition of the existing stock of capital,
effciently allocating new investments among the various alternative uses and
raising the rate of capital formation by providing incentives for increased saving
and investment. Thus, the supply-leading fnance spurs economic development
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through the transfer of scarce resources from savers to investors, according to the
existing highest rates of return on investment.
The supply-leading argument of Patrick (1966) is supported by the McKinnon –
Shaw hypothesis. McKinnon (1973) suggested a complementarity relationship
between the accumulation of money balances (fnancial assets) and physical capital
accumulation in developing countries. He developed an outside model of money
demand. McKinnon argued that because of underdeveloped fnancial markets in
most developing countries, there are limited opportunities for external fnance, and
all frms are limited to self-fnancing. Given that investment expenditures are
lumpier than the consumption expenditure, potential investors must frst
accumulate money balances prior to undertaking relatively expensive and
indivisible investment projects.
The “debt-intermediation” view proposed by Shaw (1973) was based on an inside
money model. Shaw (1973) argued that high interest rates are essential in attracting
more saving. With greater supplies of credit, fnancial intermediaries promote
investment and raise output growth – through borrowing and lending.
However, in the early 1980s the theoretical underpinnings of the fnancial
liberalisation theory were criticised by some economists, notably the neo-structuralists,
led by Van Wijnbergen (1983) and Taylor (1983), who predicted that fnancial
liberalisation would slow down economic growth (Kargbo and Adamu, 2009).
The demand-following view postulates a causal relationship from economic growth
to fnancial development. Patrick (1966) argued that the creation of modern fnancial
institutions, their fnancial assets and liabilities and related fnancial services are a
response to the demand for these services by investors and savers in the real economy.
Thus, economic growth creates a demand for developed fnancial institutions and
services.
Recently, there has emerged a large volume of literature which provides empirical
support for the fnance-led growth and the growth-led fnance hypotheses. This
evidence has been championed by recent literature on the endogenous growth theory.
Since the 1990s, several authors have incorporated fnancial institutions in their
analysis of endogenous growth. These models showthat economic growth performance
is related to fnancial development, technology and income distribution (Caporale et al.,
2003). Greenwood and Jovanovic (1990) assumed a positive two-way causal relationship
between fnancial development and growth.
On the one hand, fnancial institutions collect and analyse information to fnd the
investment opportunities with the highest return. They channel funds to the most
productive uses, thereby increasing the effciency of investment and growth. On the
other hand, growth provides the means needed to implement and develop a costly
fnancial structure.
King and Levine (1993b) identifed innovation as being the engine of growth,
which concurs with the line of reasoning of Schumpeter. They argued that an
effcient allocation of funds from fnancial intermediaries to entrepreneurs would be
able to lower the cost of investing in productivity enhancement, and thereby
stimulate economic growth. Financial intermediaries and securities markets enable
particular entrepreneurs to undertake innovative activity, which affects growth
through productivity enhancement. Financial systems can infuence the decision of
entrepreneurs to invest in productivity-enhancing activities by evaluating
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entrepreneurs, pooling resources, diversifying risk and valuing the expected profts
from innovative activities.
Consequently, fnancial intermediaries help the effcient allocation of resources,
which increase the probability of successful innovation. The rate of innovation can,
however, be reduced by the existence of distortions, like deposit-rate ceilings or high
reserve requirements.
3. The causal relationship between bank-based fnancial development
and economic growth: empirical evidence
3.1 The supply-leading response
Overall, the literature provides broad empirical evidence of a positive relationship
between bank-based fnance and economic growth, with the papers mainly differing in
the data coverage on countries and time periods, the estimation methods and the
variables selected. Several empirical fndings support the supply-leading hypothesis.
According to Thiel (2001, p. 20), the frst evidence that fnancial development accelerates
growth was presented by Goldsmith in 1969, in a study covering 35 countries over the
period 1860-1963, using the share of bank assets in gross domestic product (GDP) as a
proxy for fnancial development. However, his work did not control for other factors nor
did it allowfor the derivation of any conclusions on causality or the relative importance
of the different transmission channels.
Jung (1986) investigated the fnance-growth nexus, using cross-sectional data for 56
countries, including 19 industrialised countries. The ratio of currency to M1 and the
ratio of M2 to nominal gross national product (or GDP) were used as proxies for fnancial
development. Strong evidence for fnance-led growth was found. Jung concluded that
the supply-leading pattern occurs more frequently than the demand-following pattern in
the less-developed countries (LDCs).
Recent years have seen a rising vibrant interest in empirical research on the
fnance-growth nexus. In particular, the paper by King and Levine (1993a) provided
the starting point for intensifed research, which received a major impetus by the
construction of the fnancial-structure database compiled for the World Bank. King
and Levine (1993a) used bank-based fnancial development measures – the ratio of
the liquid liabilities of banks and non-bank institutions to GDP, the ratio of bank
credit to the sum of bank and central bank credit, the ratio of private credit to
domestic credit and the ratio of private credit to GDP – and found that the level of
fnancial development predicts future economic growth and future productivity
advances. The authors interpreted this as evidence of a causal relationship that runs
from fnancial development to economic growth.
Odedokun (1996a) used time-series regression analysis for 71 developing countries
for varying periods from 1960-80, and this author found that fnancial intermediation
promotes economic growth in 85 per cent of the sampled countries. The results further
indicated that the impact of fnancial development is found to be higher on low-income
LDCs than in high-income LDCs. In the same year, Odedokun (1996b) did a study on the
fnancial policy and the effciency of resource utilisation in 81 developing countries: this
time, using pooled cross-sectional data. Evidence for a supply-leading response was
found.
Neusser and Kugler (1998) examined the fnance-growth relationship for 13
Organisation for Economic Cooperation and Development (OECD) countries for the
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period 1970-91. Using the time-series analysis, the study showed a positive correlation
between fnancial development and growth, and the conclusion made was in support of
the supply-leading response. However, the authors used measures of the value-added
factor provided by the fnancial system – instead of simple measures of the size of the
fnancial system. Unlike Odedokun (1996a), Neusser and Kugler (1998) found that the
causal structure underlying the relationship varies widely across different countries.
Ahmed and Ansari (1998) investigated the relationship between fnancial sector
development and economic growth for three major South-Asian economies, namely,
India, Pakistan and Sri Lanka. Bank-based fnancial sector development was proxied by
M2/nominal GDP, quasi-money/nominal GDP and domestic credit/nominal GDP. The
results fromthe causality analysis indicated that fnancial sector development Granger
causes economic growth. This validated the supply-leading hypothesis. The regression
results, using pooled data based on time-series and cross-sectional observations,
reinforced the fndings of the causality analysis, suggesting that fnancial sector
development has made a signifcant contribution to economic growth in these countries.
In 1998, Rousseau and Wachtel (1998) examined the nature of the links between the
intensity of fnancial intermediation and economic performance that operated in the
USA, the UK, Canada, Norway and Sweden over the period 1870-1929. Vector-error
correction models established the quantitative importance of long-run relationships
among the measures of fnancial intensity and real per capita levels of output and the
monetary base. Granger causality tests then suggested a leading role for the
intermediation variables in real sector activity, while the feedback effects were largely
insignifcant. In conclusion, Rousseau and Wachtel suggested an important role for
intermediation in the rapid industrial transformations of all fve countries.
Ghali (1999) empirically investigated the question of whether fnancial development
leads to economic growth in Tunisia. Using the ratio of bank-deposit liabilities to
nominal GDP and the ratio of bank claims on the private sector to nominal GDP as
proxies for fnancial development, the paper focused on the causal link between fnance
and economic growth to discriminate between several alternative theoretical
hypotheses. The results suggested the existence of a stable long-run relationship
between the development of the fnancial sector and the evolution of per capita real
output that is consistent with the supply-leading hypothesis.
Beck et al. (2000) conducted a study on 63 countries for the period 1960-95, using
cross-country regression and dynamic-panel estimation. The legal origin indicators as
instruments to extract the exogenous component of fnancial intermediation were used
as fnancial indicators. Although the results for capital accumulation and the saving
ratio were not found to be robust or signifcant, banks were found to exert a strong,
causal impact on real GDP and total factor-productivity growth.
In a separate but related study, Levine et al. (2000) conducted a study on 71 countries
for the period 1960-95, using the ratio of liquid liabilities to GDP, the ratio of deposit
money banks’ domestic assets to deposit money banks’ domestic assets plus the central
bank’s domestic assets and the ratio of credit issued to private enterprises to nominal
GDP as fnancial indicators. The fndings supported a positive correlation between the
fnancial system and economic growth. The authors suggested that legal and
accounting reforms should be undertaken to strengthen creditor rights, contract
enforcement and accounting practices to boost fnancial intermediary development, and
thereby accelerating economic growth.
117
Bank-based
fnancial
development
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Allen and Ndikumana (2000) used various indicators of fnancial development to
examine the role of fnancial intermediation in stimulating economic growth in southern
Africa. Using a reduced-formequation, relating the growth rate of real per capita GDPto
an indicator of fnancial development, while controlling for other factors that affect
economic growth, the results found evidence of a positive relationship between fnancial
development and economic growth, lending support to the fnance-led growth
hypothesis.
Graff (2002) studied the causal links between fnancial activity and economic growth
by using a cross-country analysis for 93 countries. Evidence of fnance leading economic
growth was found, though it was concluded that such a relationship was not stable.
In 2002, Shan and Morris (2002) used the Toda and Yamamoto (1995) causality
testing procedure to investigate the relationship, if any, between fnancial development
and economic growth, using quarterly data from 19 OECD countries and China. By
using total credit and interest spread as indicators of fnancial development, they found
evidence in support of the supply-leading hypothesis for one country.
Jalilian and Kirkpatrick (2002) empirically investigated the link between fnancial
development and economic growth in 42 countries (including 26 developing and 16
developed countries) using bank-deposit money assets as a proxy for fnancial
development. They utilised a pooled-panel data approach with both a time series and a
cross-section dimension within the simple ordinary least squares (OLS), panel and
two-stage least square frameworks. The results were consistent with the fnance-led
growth view.
In 2004, Chistopoulos and Tsionas conducted a study on ten developing countries to
examine the relationship between fnancial development and economic growth. The
authors used the ratio of total bank-deposit liabilities to nominal GDP as a measure of
bank-based fnancial depth, while the ratio of investment to GDP and the infation rate
were used as control variables. They made use of panel unit-root tests and panel
co-integration analysis to conclude that there is fairly strong evidence in favour of the
hypothesis that long-run causality runs from fnancial development to growth and that
the relationship is signifcant.
In the same year, Fatima (2004) examined the causal relationship between
bank-based fnancial development and economic growth in Morocco for the period
1970-2000. The ratio of liquid liabilities (M3) to GDP, the ratio of domestic credit
provided by the banking sector to GDP and the domestic credit to the private sector to
GDP were the fnancial depth indicators that were used in this study. Based on the
Granger causality test, the study found a short-run relationship between fnancial
development and economic growth, with causality running from bank-based fnancial
development to economic growth.
Shabri and Majid (2008) examined empirically the fnance-growth nexus during the
post-1997 fnancial crisis in Malaysia, using time-series data. The ratio of total
bank-deposit liabilities to nominal GDP was used to proximate fnancial development.
Granger causality tests revealed a unidirectional causality running from fnance to
growth, thus supporting the fnance-led hypothesis or the supply-leading view.
Odhiambo (2009a) examined the dynamic impact of interest rate reforms on
economic growth in Zambia. The ratio of M2 to GDP and the nominal deposit rate were
used to proximate fnancial development. Based on the co-integration-based error
correction model, the study found strong support for the positive impact of interest-rate
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liberalisation on fnancial deepening. In addition, the study found that fnancial
deepening, which results from interest-rate liberalisation, Granger causes economic
growth, regardless of whether the causality is estimated in the short-run or in the
long-run.
Akinlo and Egbetunde (2010) examined the long-run causal relationship between
fnancial development – proxied by the ratio of M2 to GDP – and economic growth for
ten countries in S-SA. Using the vector-error-correction (VEC) model, the study found a
long-run relationship between fnancial development and economic growth in the
selected S-SAcountries. The results further showed that fnancial development Granger
causes economic growth in the Central African Republic, the Congo Republic, Gabon
and Nigeria. The results showed the need to develop the fnancial sector through
appropriate regulatory and macroeconomic policies.
Ahmed and Wahid (2011) used the newly developed panel data co-integration
analysis and the dynamic time series modelling approach to examine the linkages
between fnancial structure and economic growth in a group of seven African countries
over the period 1986-2007. They found that higher levels of banking system
development were positively associated with capital accumulation growth and led to
faster rates of economic growth. Further results showed evidence of unidirectional
causality running from bank-based fnancial systems to economic growth.
Nwosa et al. (2011) examined the causal relationships among fnancial development,
foreign direct investment and economic growth in Nigeria over the period 1970-2009.
The results indicated the presence of co-integration among the variables. The study
concluded that fnancial development has a statistically signifcant causal infuence on
economic growth.
Hussain and Chakraborty (2012) empirically examined the relationship between
fnancial development and economic growth and their causality in the context of Assam,
a state in India. The study found a co-integrating relationship between bank-based
fnancial development and economic growth. Furthermore, causality tests showed that
fnancial development causes economic growth in the case of Assam.
Table I shows a summary of the studies consistent with the supply-leading
hypothesis.
3.2 The demand-following response
A number of studies on the fnance-growth nexus are in support of the
demand-following hypothesis. They conclude that it is economic growth that stimulates
the development of the bank-based fnancial sector.
Shan et al. (2001) used a Granger causality procedure to investigate the relationship
between fnancial development and economic growth for nine OECD countries and
China, based on the time-series approach within a vector autoregressive (VAR)
framework. They found evidence in favour of the demand-following hypothesis for
three of the countries.
In 2002, Shan and Morris (2002) used the Toda and Yamamoto (1995)
causality-testing procedure to investigate the relationship, if any, between fnancial
development and economic growth, using quarterly data from 19 OECD countries and
China. Using total credit and interest spread, as indicators of fnancial development,
they found evidence that economic growth “leads” fnancial development for fve
countries.
119
Bank-based
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JFEP
6,2
120
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121
Bank-based
fnancial
development
D
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l
o
a
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d
b
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P
O
N
D
I
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9
2
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0
1
6
(
P
T
)
Odhiambo (2004) investigated whether fnancial development was still a spur to
economic growth in South Africa. He used the ratio of M2 to GDP, the currency ratio and
the ratio of bank claims on the private sector to nominal GDP as proxies of bank-based
fnancial development. Based on the Granger causality test in the context of the
Johansen – Juselius co-integration technique and the vector error-correction model, the
study revealed that the wholesale supply-leading hypothesis had been rejected in South
Africa. Indeed, there was an overwhelming demand-following response between
fnancial development and economic growth in South Africa, regardless of the
measurement for fnancial development. This implies that, for South Africa, it is
economic growth which drives the development of the banking sector.
Using the ratio of M3 to nominal GDP, the ratio of commercial bank assets to
commercial bank assets plus central bank assets and the ratio of domestic credit to
private sectors to nominal GDP as proxies of fnancial development, Ang and McKibbin
(2007) examined whether fnancial development leads to economic growth, or vice versa,
in Malaysia. Their argument was that the results obtained from cross-sectional studies
were not able to address this issue satisfactorily, and they highlight the importance of
country-specifc studies. Using the time-series data from 1960 to 2001, Ang and
McKibbin (2007) conducted co-integration and various causality tests to assess the
fnance-growth link, by taking savings, investment, trade and the real interest rate into
account. Contrary to the conventional fndings, their results supported the
demand-following hypothesis in the long run.
Zang and Kim (2007) used panel analysis to examine 74 countries over the period
1961-95. Using the ratio of liquid liabilities to GDP, the ratio of deposit-money-bank
domestic assets to deposit-money-bank domestic assets plus central bank-domestic
assets and credit issued to private enterprises as a share of GDP, the study found
substantial evidence that economic growth precedes any subsequent fnancial
development.
The fndings by Guryay et al. (2007) showed that there is a negligible positive effect
of fnancial development on economic growth in Northern Cyprus. The Granger
causality test found that fnancial development does not cause economic growth; rather,
the direction of causality was from economic growth to the development of fnancial
intermediaries.
Odhiambo (2008a) examined the dynamic causal relationship between fnancial
depth – proxied by the ratio of M2 to GDP – and economic growth in Kenya, by
including savings as an intermitting variable, thereby creating a trivariate causality
model. Using the co-integration and error-correction techniques, the empirical
results of this study revealed that there was a distinct unidirectional causal fow
from economic growth to fnancial development. The results also showed that
economic growth Granger causes savings, while savings drive the development of
the fnancial sector in Kenya.
In the same year, Odhiambo (2008b) examined the direction of causality between
fnancial development and economic growth in Kenya, using a dynamic Granger
causality model. The study used the three proxies of fnancial development, which were
the ratio of M2 to GDP, the currency ratio, and domestic credit to the private sector. The
empirical results revealed that although the causality between fnancial development
and economic growth in Kenya was sensitive to the choice of measure for fnancial
development, on balance, the demand-following response tended to predominate.
JFEP
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122
D
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n
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4
9
2
4
J
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2
0
1
6
(
P
T
)
Odhiambo (2009b) investigated the direction of causality between fnancial
development and economic growth in Kenya using the co-integration-based
error-correction mechanism. Using the ratio of M2 to GDP, the currency ratio and the
ratio of bank claims on the private sector to nominal GDP as proxies of bank-based
fnancial development and infation as a control variable, the study employed both
bivariate and trivariate causality tests to examine the causal relationship between
fnancial development and economic growth.
The study proceeded by frst conducting a dynamic Granger causality test within a
bivariate framework, and thereafter, it added the infation variable to make a trivariate
framework. The empirical results of this study found a distinct unidirectional causality
fromeconomic growth to fnancial development. This applied, regardless of whether the
causality was estimated in a bivariate framework or in a trivariate setting. The results
also showed that economic growth Granger causes infation in Kenya – both in the
short-run and in the long-run. The study, therefore, concluded that bank-based fnancial
sector development in Kenya is largely dependent on the demand for, rather than the
supply of, fnancial services.
Odhiambo (2009c) examined the dynamic causal relationship between fnancial
development, economic growth and poverty reduction in South Africa, using a trivariate
causality model. Financial development was proxied by the ratio of M2 to GDP. Using
co-integration and error-correction models, the empirical results of the study showed
that both fnancial development and economic growth Granger cause poverty reduction
in South Africa. The study also found that economic growth Granger causes fnancial
development, and therefore, it leads in the process of poverty reduction in South Africa.
This applies, irrespective of whether the causality test is conducted in the short-run or in
the long-run.
Odhiambo (2009d) examined the dynamic relationship between interest-rate
reforms, bank-based fnancial development and economic growth in South Africa,
using the annual time-series data. In assessing the causal relationship, the author
introduced investment as an intermittent variable to develop a trivariate causality
model. The study found that fnancial development does not Granger cause
investment and economic growth. Rather, there was evidence of a unidirectional
causal fow from investment to fnancial development and a prima facie causal fow
from investment to growth. The author, therefore, concluded that although interest
rate reforms have exerted a positive effect on fnancial depth in South Africa, the
causal relationship between fnancial depth and economic growth takes a
demand-following path.
Akinlo and Egbetunde (2010) examined the long-run causal relationship between
fnancial development – proxied by the ratio of M2 to GDP – and economic growth for
ten countries in S-SA. Using the vector-error correction model, the study found a
long-run relationship between fnancial development and economic growth in the
selected S-SA countries. The results further showed that economic growth Granger
causes fnancial development in Zambia. The results showed that emphasis needs to be
placed on economic growth to propel fnancial development in Zambia.
Rachdi and Mbarek (2011) empirically investigated the direction of causality
between fnance and growth based on a sample of ten countries, six from the OECD
region and four from the Middle East and North Africa (MENA) region during
1990-2006. Panel data cointegration analysis confrmed a long-term relationship
123
Bank-based
fnancial
development
D
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w
n
l
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P
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2
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1
6
(
P
T
)
between fnancial development and economic growth for the OECD and the MENA
countries. The results further showed that causality is unidirectional for the MENA
countries, from economic growth to fnancial development.
Table II shows a summary of the studies consistent with the demand-following
hypothesis.
3.3 The bidirectional causality/feedback response
Despite the arguments in favour of the supply-leading response and
demand-following response, the empirical results from a number of studies have
shown that bank-based fnancial development and economic growth can Granger
cause one another. Some empirical studies have also supported the assertion that
growth has a feedback effect on fnancial intermediaries by creating the necessary
incentives for fnancial development.
Wood (1993) investigated the causal relationship between fnancial development and
economic growth in Barbados, using the ratio of M2 to GDP as a proxy for fnancial
development. The results were in favour of the feedback response, where bank-based
fnancial development and economic growth mutually cause each other.
Demetriades and Luintel (1996a), in their study on fnancial development, economic
growth and banking-sector controls in India, used data from the Reserve Bank of India
to examine the effects of various types of banking-sector controls on the process of
fnancial deepening. Although almost all of the controls used were found to infuence
fnancial deepening negatively, the exogeneity tests suggested that fnancial deepening
and economic growth are jointly determined. Thus, policies which affect fnancial
deepening could also have an infuence on economic growth.
Demetriades and Luintel (1996b) investigated the effects of banking-sector policies
on the process of fnancial development and economic growth in Nepal, using bank
deposit liabilities as a proxy for fnancial development. They found evidence of
bidirectional causality.
Berthelemy and Varoudakis (1996) tested the existence of a poverty trap linked to
the development of the banking sector in 95 countries, using multiple
endogenous-growth equilibria. The ratio of money plus quasi-money to GDP was
used as a proxy for banking-sector development. Their theoretical model exhibited
multiple steady-state equilibria due to a reciprocal externality between the banking
sector and the real sector. It was their conclusion that growth in the real sector
causes the fnancial market to expand, thereby increasing banking competition and
effciency. In return, the development of the banking sector raises the net yield on
savings and enhances capital accumulation and growth. Thus, the study lent
support to the feedback hypothesis.
Akinboade (1998) tested for causality between fnancial development and economic
growth in Botswana, using the annual time-series data. The ratio of bank claims on the
private sector to nominal non-mineral GDP and the ratio of bank-deposit liabilities to
nominal non-mineral GDP were used to measure fnancial development. The results
showed that fnancial and economic growth in Botswana were mutually causal.
Luintel and Khan (1999) used a multivariate vector auto-regressive framework to
examine the relationship between bank-based fnancial development – proxied by the
ratio of total deposit liabilities of deposit banks to one period-lagged GDP – and
JFEP
6,2
124
D
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6
(
P
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Table II.
Studies in favour of a
unidirectional causality
from economic growth to
bank-based fnancial
development
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125
Bank-based
fnancial
development
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
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U
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A
t
2
1
:
4
9
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
economic growth, using a sample of ten LDCs. The results showed a bidirectional
causality between fnancial development and growth.
Shan et al. (2001) used a Granger causality procedure to investigate the relationship
between fnancial development and economic growth for nine OECD countries and
China, based on the time-series approach within a VAR framework. They found
evidence of bi-directional causality for fve countries.
Sinha and Macri (2001) looked at the relationship between fnancial development and
economic growth, using time-series data for eight Asian countries. Bank-based fnancial
development was proxied by M1, M2, M1 growth, M2 growth and the growth rate of
domestic credit as a ratio of GDP. The regression results showed a positive and signifcant
relationship between the income variables and the fnancial variables for India, Malaysia,
Pakistan and Sri Lanka. The multivariate causality tests showed a two-way causal
relationship between the income and the fnancial variables for most of the countries.
Shan and Morris (2002) used the Toda and Yamamoto (1995) causality-testing
procedure to investigate the relationship, if any, between fnancial development and
economic growth, using quarterly data from 19 OECD countries and China. Using total
credit and interest spread as indicators of fnancial development, they found evidence of
bidirectional causality in four countries.
Fase and Abma (2003) used individual country time-series data to study the
relationship between fnancial environment and economic growth in eight Asian
countries. The results were in support of the feedback-response hypothesis.
Calderon and Liu (2003) employed the Geweke decomposition test on the pooled data
of 109 developing and industrial countries from1960- to 1994 to examine the direction of
causality between fnancial development and economic growth. They used the ratio of
M2 to GDPandthe ratio of private sector credit to GDPas proxies of fnancial development.
The results revealed that while fnancial development generally leads to economic growth,
the Granger causality from fnancial development to economic growth and the Granger
causality from economic growth to fnancial development coexist. The results further
showed that fnancial deepening contributes more to the causal relationships in the
developingcountries thanit does inthe industrial countries; the longer the samplinginterval,
the larger the effect of fnancial development on economic growth, and that fnancial
deepening propels economic growth through both a more-rapid capital accumulation and
productivity growth, with the latter channel being the strongest.
In the same year, Shan and Jianhong (2006) used a VAR approach to examine the
impact of fnancial development – proxied by total credit – on economic growth in China.
Variance decomposition and impulse-response function analysis was applied to
examine the interrelationships between variables in the VAR system. Besides fnding
that fnancial development comes as the second force – after the contribution from
labour input – in leading economic growth in China, the study supported the viewin the
literature that fnancial development and economic growth exhibit a two-way causality.
Two years later, Ang (2008) estimated a six-equation model of fnancial development
and economic growth for Malaysia to shed light on the mechanisms linking these two
variables. The results indicated that fnancial development leads to higher output
growth via promoting both private savings and private investment. The fndings also
provide some support for the hypothesis of endogenous fnancial development and growth
models that fnance leads to higher growth through improved effciency of investment. The
results also lent some support to Robinson’s (1952) viewthat economic development leads to
JFEP
6,2
126
D
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l
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2
4
J
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2
0
1
6
(
P
T
)
an improvement in the fnancial system. These fndings, put together, suggested that
fnancial development and economic growth in Malaysia show a bidirectional causality
pattern. Thus, the results support the endogenous fnancial development andgrowththeory,
which postulates a feedback relationship in the fnance-growth nexus.
Abu-Bader and Abu-Qarn (2008) examined the causal relationship between fnancial
development and economic growth in Egypt, during the period 1960-2001, within a
trivariate VAR framework. The authors employed four different measures of
bank-based fnancial development, and they applied Granger causality tests using the
co-integration and VEC methodology.
The results strongly supported the view that fnancial development and economic
growth are mutually causal. Akinlo and Egbetunde (2010) examined the long-run causal
relationship between fnancial development – proxied by the ratio of M2 to GDP – and
economic growthfor tencountries inS-SA. Usingthe VECmodel, the studyfoundalong-run
relationship between fnancial development and economic growth in the selected S-SA
countries. The results further revealed the bidirectional relationship between fnancial
development and economic growth in Kenya, Chad, South Africa, Sierra Leone and
Swaziland.
Acaravci et al. (2009) investigated the causality between fnancial development and
economic growth in S-SA for the period 1975-2005. The empirical fndings in the paper
showed a bidirectional causal relationship between the growth of real GDP per capita and
the domestic credit provided by the banking sector for the panels of 24 S-SAcountries.
Odhiambo (2011) examined a dynamic causal relationship between stock market
development, bank-based fnancial development and economic growth in South Africa
during the period 1980:1-2007:3, using a trivariate Granger causality model. The paper
attempted to answer the question of whether fnancial sector development Granger
causes economic growth, and which sector – bank-based sector or stock market sector –
leads in the process of fnancial development in South Africa when using a
co-integration-based error-correction mechanism. Although a distinct unidirectional
causal fow from stock market development to bank development was revealed, the
results also indicated that there is a bidirectional causal relationship between
bank-based fnancial development and economic growth.
Rachdi and Mbarek (2011) empirically investigated the direction of causality
between fnance and growth based on a sample of ten countries, six from the OECD
region and four from the MENA region during 1990-2006. Panel data cointegration
analysis confrmed a long-term relationship between fnancial development and
economic growth for the OECD and the MENA countries. The results further showed
that causality is bidirectional for the OECD countries.
Table III shows a summaryof the studies consistent withthe bi-directional causalityview.
4. Conclusion
In this paper, we review both the theoretical and the empirical literature on the causal
relationship between bank-based fnancial development and economic growth in both
developed and developing countries. Although the academic literature on the
relationship between bank-based fnancial development and economic growth dates
back to the early twentieth century (Schumpeter, 1911), there is little consensus to date
on the exact direction of causality between these two important macroeconomic
variables. Previous literature can be divided into three schools of thought:
127
Bank-based
fnancial
development
D
o
w
n
l
o
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(
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Table III.
Studies in favour of a
bidirectional causality
between bank-based
fnancial development and
economic growth
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(1) studies in favour of fnance-led growth response, which was initially popularised
by Schumpeter (1911);
(2) studies in favour of the growth-led fnancial development response, which was
largely popularised by Robinson (1952); and
(3) studies in favour of a bidirectional causality between fnancial development and
economic growth.
Even though a number of previous studies have attempted to conduct a survey of the
existing research on the fnance-growth nexus, the majority of these studies have failed
to distinguish between bank-based and market-based fnancial developments. To our
knowledge, this may be the frst study of its kind to survey the existing research on the
causal relationship between bank-based fnancial development and economic growth in
both developed and developing countries.
Our study shows that most of the previous literature reviewed in this paper either
reinforces the conventional wisdom of supply-leading response, or supports
bidirectional causality between bank-based fnancial development and economic
growth. Notwithstanding this outcome, the study also fnds the literature in favour of a
demand-following response to be increasing – in both number and substance –
especially in recent years. The study, therefore, concludes that the causal relationship
between fnancial development and economic growth is not clear-cut, and that the notion
that fnancial development automatically leads to economic growth is merely based on
prima facie or superfcial evidence.
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Corresponding author
Sheilla Nyasha can be contacted at: [email protected]
To purchase reprints of this article please e-mail: [email protected]
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