Same Financial Development Yet Different Economic Growth-Why?

By Shen, Chung-Hua; Lee, Chien-Chiang | Journal of Money, Credit & Banking, October 2006 | Go to article overview

Same Financial Development Yet Different Economic Growth-Why?


Shen, Chung-Hua, Lee, Chien-Chiang, Journal of Money, Credit & Banking


THE QUESTION AS TO WHETHER financial development stimulates economic growth or whether the reverse causation is at play has spurred a great deal of attention over the years. A more developed financial sector provides fertile ground for the allocation of resources, better monitoring, fewer information asymmetries, and economic growth. Furthermore, still in accordance with this standard theory, it should come as no surprise that financial development follows economic growth given that when the real economy grows, there should be more savings entering the financial system, which in turn should allow it to extend new loans, and so on (Robinson, 1952, Lucas, 1988). Thus, in theory, financial development and economic growth, which are here forth referred to as "the nexus", are commonly regarded as being positively linked. However, important to bear in mind is that some uncertainty as to the exact factors that affect such a link still remains.

Empirical studies supporting the positive nexus between financial development and economic growth are voluminous. Pooling 77 countries during the 1960-89 period, King and Levine (1993), for example, showed that the degree of financial development helps to explain long-run growth. Levine and Zervos (1998) and others also support this evidence. Rousseau and Wachtel (2000, 2001), Beck, Levine, and Loayza (2000) along with Levine, Loayza, and Beck (2000) have also found that measures directed toward financial sector development do, indeed, have a significant positive causal effect on growth in panel VAR estimates. In this regard, comprehensive surveys have been provided by Pagano (1993), Levine (1997), Wachtel (2003), Driffill (2003), and Andersen and Tarp (2003). (1)

True that most studies confirm the existence of a positive nexus, but counterevidence also exists. Some studies have even gone so far as to challenge the notion of a positive nexus by claiming that banking development may actually hinder growth. More specifically, they assert that by enhancing resource allocation, and hence the returns on savings, banking development may even lower savings rates. If there are sufficiently large externalities associated with savings and investments, then banking development, they hold, slows long-run growth. (2) Ram (1999) has also argued that the results pertaining to the finance-growth nexus are, at best, uncertain and ambiguous. His studies have shown that immense structural heterogeneity is observed, which by and large is indicative of a negligible, or perhaps negative, association between financial development and growth. (3) Khan and Senhadji (2003) have similarly demonstrated that certain banking development indicators become statistically insignificant when growth equations are estimated through the use of panels. Their paper proposes three possible explanations for this finding. (4) About the same time, when considering both panel data and time-series data for eight Asian economies, Zhang (2003) has shown that there was a significantly negative connection between banking development and economic growth during the 1960-99 period.

Arestis, Demetriades, and Luintel (2001) have argued that stock markets and banks are clearly substitutive sources for corporate finance; they base this on the grounds that when a firm issues new equity, its borrowing requirements from the banking system decline. From this viewpoint, it seems that the relationship between bank development and growth may, therefore, not be so robust.

Levine (2002), in a recent article, has put forth three reasons to account for the fact that banking development may hinder growth. First, banks may be involved with intermediaries with a huge influence over firms, and this influence may manifest itself in negative ways. For example, in terms of new investments or debt renegotiations, banks with power can extract more of their expected future profits from those firms. As for the second reason, banks also have an inherent bias toward prudence, so their banking development may impede corporate innovation and growth.

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