Academic journal article Journal of Finance, Accounting and Management

Financial Development and Economic Growth: Evidence from States in India

Academic journal article Journal of Finance, Accounting and Management

Financial Development and Economic Growth: Evidence from States in India

Article excerpt

1. Introduction

The link between financial development and economic growth has been a widely discussed and much debated topic in extant literature. In one of the earliest studies, Schumpeter (1912) posits that by deciding which firms will be using societies' savings, financial intermediaries influence the course of economic development. Many subsequent studies establish a positive relationship between financial development and growth (Beck, Levine, & Loayza, 2000; Carlin & Mayer, 2003; King & Levine, 1993; Levine, Loayza, & Beck, 2000)1. However, these studies analyse evidence from cross-country data. Results of such cross- country studies contain potential biases induced by measurement errors, simultaneity, omitted variables, and unobserved country-specific effects and are not able to resolve the issue of causality (Beck, 2008; Levine et al., 2000). Use of cross country data underlies problem of omitted variable because across different countries, considerable heterogeneity exists in factors like capital flows, trade flows, labour movement, legal code and enforcement machinery etc. Because of these issues, Wachtel (2001) refers to the results of cross-country studies as "fragile", whereas Kendall (2012) cautions to be "sceptical" about findings of cross-country studies. Levine (2005) notes that despite presence of extensive literature focusing on solving the finance-growth puzzle, "we are far from definitive answer to the question: Does finance cause growth, and if it does, how?"

In this study, we analyse the finance-growth relationship using regions within same country - India. Factors like legal codes, labour mobility, and capital flows are likely to be much more homogeneous within a country as compared to between countries. Furthermore, any country-specific effects are also, by design, controlled for in a subnational study. Thus, such a construct, by providing an automatic control environment, overcomes many of the potential biases that plague the findings of existing cross-country studies (Beck, 2008). Existing literature has focused little attention on subnational level studies on finance and growth. Kendall (2012) studies the relationship between financial development and economic growth using evidence from Indian districts. He uses observations from two years: 1991 and 2001 and studies the changes in the variables in 2001 from their 1991 situation. The scope of his study is restricted in two basic aspects. First, he uses cross-sectional data and the period selected for the same may not be a proper representative for the results to be generalised. An economy's growth trajectory contains many phases. It would be interesting to examine how the finance-growth relationship behaves over these different phases. Second, he uses changes in variables over a gap of 10 years. This ignores the information contained in annual fluctuations (see Figure 1). In this study, we use a novel dataset which enables a panel-data study of the finance-growth relationship spanning over a long period of time (31 years). This offers a better representation of economic scenarios and provides a framework to analyse the research question over various phases of business cycle. Furthermore, this dataset also allows us to analyse the finance-growth relationship in a significantly greater detail and enables us to explore into research questions which have been addressed only to a limited extent. These are discussed in more details in the subsequent sections.

In this study, the finance-growth relationship is examined using regions within a large developing country- India. Annual observations are used for 32 states and union territories of India over the period 1981 to 20112. As can be seen in Figure 1, the period of study comprises of different phases of business cycles. This enables us to study the finance-growth relationship in presence of multitude of economic scenarios and regime shifts. This study uses growth in per capita state domestic product (NSDP) as a measure of economic growth and financial development is proxied by credit outstanding by the commercial banks3. …

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