Academic journal article Journal of Business Economics and Management

Does Financial Development Hamper Economic Growth: Empirical Evidence from Bangladesh

Academic journal article Journal of Business Economics and Management

Does Financial Development Hamper Economic Growth: Empirical Evidence from Bangladesh

Article excerpt

1. Introduction

Financial repression refers to a notion where government regulations, laws, and other non-market restrictions prevent the financial intermediaries of an economy from functioning at their optimal capacity. Financial repression can be caused by interest rate ceilings, requirements to maintain high liquidity or reserve ratio, capital controls, restrictions on entry into the financial sector, credit restrictions, and ceilings on allocation, government ownership and control of banks.

McKinnon (1973) and Shaw (1973) first introduced the notion of financial repression. In theory, an economy with an efficient financial market should grow faster due to efficient allocation of capital. Government regulations create inefficiency in the capital market which lowers the rate of return, compared to competitive market. When financial intermediaries cannot function optimally, saving and investment is discouraged and overall economic growth is impeded. As a corollary, alleviation of financial repression can have positive impact on economic growth. This line of reasoning enjoys broad theoretical and empirical support (e.g. Romer 1986; King, Levine 1993; Levine, Zervos 1998; Wachtel 2003; Seetanah 2007; Ang 2008).

In the extant literature on the relationship between financial development and economic growth, two strands in research can be identified. First, researchers use a single measure of financial development and test its relationship with economic growth for a number of countries using cross section or panel data technique. Levine, Zervos (1998) explored the link between banking development and economic growth of the developed and less developed countries (1). Using the GMM method, he found a positive relationship between the two series. Luintel and Khan (1999) examined the causal relationship between financial development and economic growth for ten less developed countries (2) and found that financial depth positively affects real income and real interest rate. Their findings showed bi-directional causality between financial development and economic growth for the countries studied. Rousseau and Wachtel (2000) used the ratio of market capitalization to GDP and the value of trades to GDP, per capita trade value, per capita market capitalization, and real per capita M3 as indicators of banking and stock market development. They found that banking and stock market development have strong impact on economic growth. Yay and Oktayer (2009) used the data of bank credit (3) and stock market development as indicators of financial development for 21 developing (4) and 16 developed economies (5). They found that both stock market development and bank credit are positively related to economic growth in the developing countries; whereas only stock market affects economic growth in the developed countries. Second, researchers use time series techniques to examine the above noted relationship for a particular country (Murinde and Eng (1994) for Singapore; Lyons and Murinde (1994) for Ghana; Odedokun (1989) for Nigeria; Agung and Ford (1998) for Indonesia; and Wood (1993) for Barbados.) This paper contributes to this second strand of the literature.

The hypothesis that alleviation of financial repression can promote economic growth has prompted several developing nations to initiate financial liberalization policies beginning in the mid 1980's. The government of Bangladesh responded by launching Financial Sector Reforms policy early in the 1990s as a part of Structural Adjustment Program (SAP). The aim was to help improve the link between finance and economic growth. The reforms include liberalization of deposits and lending rates, indirect monetary management, modernization of the banking sector, development of capital market, loan classification, prudential regulations, strengthening the central bank's supervisory ability, and a legal framework for debt recovery.

The objective of this study is to empirically examine the long and the short run relationship between financial development and economic growth by constructing the first ever financial development index (FDI) for Bangladesh. …

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