Academic journal article The Journal of Developing Areas

Modelling the Effects of Financial Sector Functions on Economic Growth in a Developing Country: A Cointegration and Error Correction Approach

Academic journal article The Journal of Developing Areas

Modelling the Effects of Financial Sector Functions on Economic Growth in a Developing Country: A Cointegration and Error Correction Approach

Article excerpt

ABSTRACT

This study develops proxies for each of Levine's (1997) five functions of the financial sector, and models the relationship between these functions and economic growth using methods that more accurately conform to theory, and which broaden our understanding of the mechanisms through which the financial sector impacts on growth. Our analytical models provide for inferences about the relative importance of each of the functions of the financial sector and cointegration and error correction methods are used to distinguish between the long and short-run impacts of financial sector intermediation on economic growth. Our results suggest that if financial sector reforms are to be more effective, greater focus has to be placed on mechanisms through which savings mobilization can be maximized, and the allocation of resources to productive uses can be facilitated. Policymakers should also not expect immediate results from such reforms, as although the functions of the financial sector were shown to have statistically significant long-run impacts on GDP, none of the functions had significant short-term effects on growth.

JEL Classifications: E44, O16, G20

Keywords: Financial markets, financial crisis, economic growth, developing countries

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

Despite the spread of globalization, the Monterrey Consensus (2002) notes that many developing countries increasingly depend on local funds to finance their development needs. The domestic financial sector in these countries is expected to play an important role in the development process since it is widely accepted that financial institutions facilitate economic growth by mobilizing savings, allocating these savings to the most productive investments, and by facilitating the smooth flow of trade needed in a market-driven economy. Theoretical models supporting this view have been developed by many economists.1 This large body of theoretical literature presents convincing arguments concerning the ability of a well-functioning financial sector to foster economic growth in developing countries.

Numerous authors have conducted tests of the finance-growth relationship and there is a growing consensus that financial sector development contributes positively to economic growth.2 Many of these studies, however, use broad proxies of financial sector development, which do not give clear indications of the channels through which the financial sector impacts economic growth. This is important because the theoretical models strongly suggest that the financial sector contributes to economic growth by performing a number of distinct functions. It would therefore be very useful to determine which of these functions have the greatest impact on economic growth, in order to highlight to policymakers the areas in which policy reforms would yield the greatest returns. Such conclusions have, however, not yet been made in the literature, as authors such as Holden and Prokopenko (2001, p. 5), Levine and Zervos (1998, p. 542), and De Gregorio and Guidotti (1995, p. 436) all cite difficulties involved in developing proxies to accurately and comprehensively capture the many different functions performed by the financial sector. Favara (2003, p. 27) thus asserts that more sophisticated proxies of financial sector intermediation are required to deepen the understanding of the finance-growth relationship.

Our analysis attempts to contribute significantly to the finance-growth literature by developing such proxies. The five basic functions of the financial sector, as outlined by Levine (1997), are used as the basis of this study; attempts are made to derive proxies that accurately reflect the effectiveness with which the financial sector performs each of these functions. Cointegration and error correction methods are used to analyse and compare long and short term impacts of each of the theorized functions of the financial sector on economic growth. …

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