Financial development and economic growth in vietnam a quantitative assessment

UNIVERSITY OF ECONOMICS HO CHI MINH CITY VIETNAM INSTITUTE OF SOCIAL STUDIES THE HAGUE THE NETHERLANDS VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN VIETNAM: A QUANTITATIVE ASSESSMENT BY LÊ TẤN BỬU DUY MASTER OF ARTS IN DEVELOPMENT ECONOMICS HO CHI MINH CITY, April 2014 UNIVERSITY OF ECONOMICS HO CHI MINH CITY VIETNAM INSTITUTE OF SOCIAL STUDIES THE HAGUE THE NETHERLANDS VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN VIETNAM: A QUANTITATIVE ASSESSMENT A thesis submitted in partial fulfilment of the requirements for the degree of MASTER OF ARTS IN DEVELOPMENT ECONOMICS By LÊ TẤN BỬU DUY Academic Supervisor: DƯƠNG NHƯ HÙNG ACKNOWLEDGEMENT I want to send special thanks to my academic supervisor, Dr Duong Nhu Hung, for his patience as well as his continuous supports and valuable comments during my thesis writing process I am also thankful to all of the lecturers in VNP for their wonderful lessons, to all administrators in the VNP Office for their supports, and especially to Mr Nguyen Dinh Quy for being so helpful every time I come to the VNP Library Finally, I want to show my gratitude to my family and my friends for their endless encouragements to me so that I could finish the program as well as the thesis ABSTRACT The thesis employs two quantitative methods to explore the relationship between economic growth and financial development in Vietnam using quarterly data from 1999 to 2012 Firstly, the ARDL cointegration test developed by Pesaran and Shin (1999), and Pesaran, Shin, and Smith (2001) was used to search for a long run relationship among economic growth, financial development, and other macroeconomic variables including exports, imports, inflation, and real interest rate The existence of such long run cointegration relationship is confirmed through the ARDL bound testing procedure with all four indicators of financial development, namely ratio of M2 to GDP, ratio of deposits to GDP, ratio of credits to GDP, and ratio of credits provided to the private sector to GDP Secondly, Toda and Yamamoto (1995) causality test was employed to determine the causal relationship between economic growth and financial development under a multivariate VAR framework Evidence of causality running from financial development to economic growth is found for all indicators of financial development These results provide strong support to the supply-leading hypothesis on the relationship between economic growth and financial development for the case of Vietnam ACRONYMS AND ABBREVIATIONS TABLE OF CONTENTS CHAPTER 1: INTRODUCTION 1.1 PROBLEM STATEMENT 1.2 RESEARCH OBJECTIVES AND QUESTIONS 10 1.3 RESEARCH METHODOLOGY 11 1.4 STRUCTURE OF THE THESIS 11 CHAPTER 2: LITERATURE REVIEW 12 2.1 KEY CONCEPTS 12 Economic Growth 12 Financial Development 12 2.2 THEORETICAL REVIEW 12 2.2.1 Theoretical Hypotheses 12 2.2.2 Financial Repression Theory 14 2.2.3 Financial Liberalization Theory 15 2.2.4 Financial Structure Theory 17 Bank-based Theory 17 Market-based Theory 19 Other Views in Financial Structure Theory 21 2.2.5 Endogenous Growth Theory 22 2.2.6 Summary of Theoretical Predictions 25 2.3 EMPIRICAL REVIEW 26 2.3.1 Traditional Cross-Country Analysis 26 2.3.2 Panel Cointegration and Causality Analysis 27 2.3.3 Time series analysis 29 VECM Approach 29 VAR Approach 32 2.3.4 Previous empirical studies about Vietnam 35 2.3.5 Summary of findings from previous empirical studies 35 2.4 CONCEPTUAL FRAMEWORK 26 CHAPTER 3: RESEARCH METHODOLOGY AND DATA COLLECTION 38 3.1 ANALYTICAL FRAMEWORK 38 3.2 MODEL SPECIFICATION AND DATA COLLECTION 39 Economic Growth (EG) 39 Financial Development (FD) 40 Trade (EX, IM) 41 Inflation (INF) 43 Real Interest Rate (RIR) 44 3.3 ECONOMETRIC TECHNIQUES 45 3.3.1 Seasonal Adjustment 45 3.3.2 Unit Root Test 47 3.3.3 ARDL Cointegration Test 48 3.3.4 Toda and Yamamoto Causality Test 50 CHAPTER 4: OVERVIEW OF ECONOMIC GROWTH AND FINANCIAL DEVELOPMENT IN VIETNAM 53 4.1 ECONOMIC GROWTH 53 4.1.1 Overview 53 4.1.2 Results 53 Structural Changes 53 Global Integration 55 4.1.3 Challenges 56 Investment-driven Economic Growth 56 Inefficient SOEs and Public Investments 57 Macroeconomic Instability 58 4.2 FINANCIAL DEVELOPMENT 58 4.2.1 Overview 58 4.2.2 Results 59 Banking Market 59 Stock Market 62 4.3 A FIRST LOOK ON THE RELATIONSHIP BETWEEN ECONOMIC GROWTH AND FINANCIAL DEVELOPMENT 64 CHAPTER 5: EMPIRICAL RESULTS 65 5.1 Seasonal Adjustments 65 5.2 Preliminary Analysis 66 5.3 Unit Root Test 69 5.4 ARDL Cointegration Test 70 5.5 Toda and Yamamoto Causality Test 72 CHAPTER 6: CONCLUSIONS 77 6.1 Summary and Conclusions 77 6.2 Limitations 78 6.3 Directions for Further Research 79 REFERENCE 80 LIST OF TABLES Table 2.1: Summary of theoretical predictions 25 Table 2.2: Findings from previous empirical studies 36 Table 3.1: Critical values for ADF test 48 Table 3.2: Critical values for bound F-test 50 Table 4.1: Proportion of output from different economic sectors 54 Table 4.2: Industrial output share by ownership 54 Table 4.3: : Investment share by ownership 55 Table 4.4a: Structure of goods exports by kinds of economic sector 56 Table 4.4b: Structure of goods imports by kinds of economic sector 56 Table 4.5: Growth accounting of Vietnam from 1990 to 2007 56 Table 5.1: Descriptive statistics 68 Table 5.2: Correlation coefficients 69 Table 5.3: Results of ADF test 70 Table 5.4: AIC, SBC, F-statistic, t-statistic, and LM for different lag-lengths 71 Table 5.5: Optimal lag-length p chosen by AIC, SC, and LR test 73 Table 5.6: Results of VAR residual autocorrelation LM test 74 Table 5.7: Toda and Yamamoto causality test results 75 LIST OF FIGURES Figure 4.1: Openness, export, import, and net export (as percents of GDP) of Vietnam 55 Figure 4.2: The incremental capital-output ratio (ICOR) of Vietnam in 1991-2009 57 Figure 4.3: Number of banks in Vietnam from 2006 to 2010 60 Figure 4.4a: Deposit market share according to type of banks in 2005-2010 60 Figure 4.4b: Credit market share according to type of banks in 2005-2010 60 Figure 4.5: Ratio of banking credits and deposits to GDP 61 Figure 4.6: GDP growth and credit growth of Vietnam from 2000 to 2012 64 Figure 5.1: Real GDP and nominal GDP from 1999Q1 to 2012Q3 65 Figure 5.2: Seasonal adjusted real GDP and nominal GDP from 1999Q1 to 2012Q3 66 Figure 5.3: Graphical presentations of all variables from 1999 to 2012 66 CHAPTER 1: INTRODUCTION The chapter introduces the necessary of a quantitative analysis of the relationship between financial development and economic growth of Vietnam Then it will discuss about the objectives of the thesis, the questions to be answered in the thesis, and the econometric techniques used to answer those questions The chapter ends by providing the structure of the thesis 1.1 PROBLEM STATEMENT The relationship between financial development and economic growth was first examined in a research by Schumpeter in 1911 (as cited in King and Levine, 1993a) However, it only receives great attention from economists since the seminal studies of McKinnon (1973), Shaw (1973), and King and Levine (1993b) Despite of the high volume in both theoretical and empirical research, the direction in the relationship is still not conclusive yet The research results on the relationship could be classified into five categories, each supporting one of the followings hypotheses: i Supply-leading hypothesis (Patrick, 1966): financial development increases the efficiency in the allocation of economic resources and thus could promote economic growth eventually ii Demand-following hypothesis (Patrick, 1966): financial development might passively follow economic growth as higher level of income will lead to higher demand for financial services iii Bi-directional causality hypothesis: financial development causes economic growth and conversely the development of the economy also induces the development of the financial sector iv Independent hypothesis: the role of financial development in economic growth process is overstated; there is no relationship between financial development and economic growth v Stage of development hypothesis (Patrick, 1966): in the early stage of economic growth, the supply-leading hypothesis takes the lead Then, the demand-following hypothesis dominates Table 5.5: Optimal lag-length p chosen by AIC, SC, and LR test Notes: M2 = ratio of M2 to GDP, DEP = ratio of bank deposits to GDP, CRE = ratio of bank credits to GDP, PCRE = ratio of credits to private sector to GDP LR = Likelihood ratio test statistic, AIC = Akaike information criterion, SC = Schwarz information criterion * indicate the optimal lag-length chosen by the criterion Source: self-calculation using Eviews The results from Table 5.5 shown that while both LR test and the AIC criterion choose as the optimal lag-length for our VAR system, the choice of SC criterion is From these results, we will choose as the optimal lag-length in the first step of the Toda and Yamamoto test The reason is that with this choice, in the second step of the Toda and Yamamoto causality testing procedure, the modified Wald test is performed against the VAR(5) system which is best mitigated from the autocorrelation problem, comparing with other lag-lengths as shown in Table 5.6 below 67 Table 5.6: Results of VAR residual autocorrelation LM test Notes: M2 = ratio of M2 to GDP, DEP = ratio of bank deposits to GDP, CRE = ratio of bank credits to GDP, PCRE = ratio of credits to private sector to GDP Source: self-calculation using Eviews Recall that in the unit root test results in Table 5.3 had shown that the maximum order of integration among all variables is k = Also p = has been chosen as the optimal lag-length for our VAR system in step The second step in the Toda and Yamamoto causality test is setting up the following VAR (p + k) = VAR (5) model: yt  B0  B1 yt 1  B2 yt 2   B p yt  pk   t 68 where GDPt  1     EX t     y t   IM t  , B0     INF   t     FDt          1t    i ,11 i ,12 i ,15   2t     i,21 i,22 i,25     , B  (i = 1,2, ,5) ,  t   3t    i        4t  i,51 i,52 i ,55         5t  In the above VAR (5) model, the 5th lagged values of all variables enter exogenously so that the modified Wald test statistic in Toda and Yamamoto (1995) could follow a Chi-squared distribution and hence the conventional causality test could be employed Results from causality test on the above VAR (5) model are shown in Table 5.7 below Table 5.7: Toda and Yamamoto causality test results Notes: M2 = ratio of M2 to GDP, DEP = ratio of bank deposits to GDP, CRE = ratio of bank credits to GDP, PCRE = ratio of credits to private sector to GDP ***, **, *: significant at 1%, 5%, and 10% respectively Source: self-calculation using Eviews Results from Table 5.7 show that the modified Wald test statistics are significant All four indicators of financial development are found to have Granger cause to economic growth at 5% level of significance However, the reverse causality running from economic growth to financial development is not found for any indicator This result implies that financial development is taking the lead in its relationship with economic growth The explanation for this result is as follows According to the estimations of CIEM (2010) and World Bank (2012b), economic growth of Vietnam from 2000 to 2010 relied heavily on investments 69 because Vietnam’s growth accounting shown that capital always made up around an average of 71% of economic growth in this period Additionally, the nature of investments in developing countries is debt-financing (Shaw, 1973) or self-financing after a period of capital accumulation through savings Thus, the development of financial activities of Vietnam, which is reflected by rapid credit expansion, increasing in the ability of capital attraction, and high level of monetisation in this period, should have lift up the potential capital constraints in a Vietnam’s developing economy, speed up the investment rate and hence become a source of economic growth for Vietnam The result from Toda and Yamamoto causality test provides strong support for the theoretical supply-leading hypothesis of Patrick (1966) Moreover, given that Vietnam has just begun a lower middle income country in 2010 and the financial system of Vietnam could not be considered as a highly developed one, results of the causality test also provide initial support for the theoretical stage of development hypothesis of Patrick (1966) On the empirical side, results of causality test from the thesis are in line with many of the previous empirical studies on the relationship between economic growth and financial development at Asian or developing countries Such evidences in favour of the supply-leading hypothesis could be found in the study of Chang and Caudill (2005) on Taiwan, Rousseau and Vuthipadadorn (2005) on 10 Asian countries, Ang and McKibbin (2007) on Malaysia, and Bojanic (2012) on Bolivia However, results from the thesis are contrast with previous empirical studies on developed and high income country such as the study of Shan, Morris, and Sun (2001) on OECD countries plus China, and Thangavelu and Ang (2004) on Australia These facts are understandable via the predictions of the stage of development hypothesis postulated by Patrick (1966) whereas at initial stage of development the supply leading hypothesis takes place, until the country has achieved some level of economic development, the relationship between economic growth and financial development switch to the demand-following phenomenon 70 CHAPTER 6: CONCLUSIONS This chapter will begin by summarizing the empirical results of this thesis and then providing the conclusions on the relationship between economic growth and financial development in Vietnam from 1999 to 2012 After that, the limitations of the thesis are discussed Finally, the directions for further research are mentioned 6.1 Summary and Conclusions This thesis employs two quantitative methods to explore the relationship between economic growth and financial development in Vietnam using quarterly data from 1999 to 2012 Firstly, the ARDL cointegration test developed by Pesaran and Shin (1999), and Pesaran, Shin, and Smith (2001) was used to search for a long run relationship among economic growth, financial development, and other macroeconomic variables including exports, imports, inflation, and real interest rate The existence of such long run cointegration relationship is confirmed through the ARDL bound testing procedure with all four indicators of financial development, namely ratio of M2 to GDP, ratio of deposits to GDP, ratio of credits to GDP, and ratio of credits provided to the private sector to GDP Secondly, after some priori relationship among economic growth, financial development and other macroeconomic variables has been established, Toda and Yamamoto (1995) causality test was launched to determine the causal relationship between economic growth and financial development under a multivariate VAR framework Evidence of causality running from financial development to economic growth is found for all indicators of financial development Theoretically, results from the thesis provide support to the supply-leading hypothesis of Patrick (1966) which is predicted by most of the theoretical models and studied in the literature such as financial liberalization theory, bank-based theory, and endogenous growth theory that financial development could boost the capital accumulation process as well as enhance the productivity of capital utilization within the economy The thesis also provides evidence supporting the prediction of bank-based theory for the case of a developing country like Vietnam On the empirical front, such causality direction in the relationship between economic growth and financial development in Vietnam is similar with results from previous empirical studies at developing countries or countries in the Asian region such as Chang and Caudill (2005), Rousseau and Vuthipadadorn (2005), Ang and McKibbin (2007), Bojanic 71 (2012) From the policy making perspective, this important role of financial development to economic growth has several policy implications Firstly, reforms of the banking system such as restructuring banks and resolving bad debts in the system should have higher priority in government’s policy of stabilizing the macroeconomic environment because it also has positive spill-over effects to economic growth Secondly, similar to the suggestion in Calderon and Liu (2003), such support of the supply-leading hypothesis should give financial development higher priority in future economic growth policy of Vietnam Thirdly, the financial markets of Vietnam are still not considered as being developed thus according to the bi-directional hypothesis of Patrick (1966), Vietnam’s government should spend effort to implement further financial development policy so that the positive relationship between economic growth and financial development could be tightened, enhanced and become a twoway relationship Finally, the stock market of Vietnam is still small comparing with the banking market and is still being underdeveloped comparing with other countries in the region and in developed countries thus there is still a large room for further development Vietnam’s government should provides the necessary conditions so that the stock market could evolve and become another important and efficient channel of mobilizing surplus capital into to businesses within the economy and thus promote further economic growth 6.2 Limitations The thesis followed many of the previous empirical studies in choosing standard indicators to cover different aspects of the financial system to capture its development level However, these variables only represent the quantity but not the quality of the financial services being provided in the economy This limitation of data availability not only in Vietnam but also in other developing countries has prevented the utilization of any indicator reflecting how effective the financial activities are arranged in the economy to our empirical study The second limitation of the thesis is related to the sample size of the dataset used in the thesis All the econometric methods employed in the thesis including ADF unit root test, ARDL cointegration test, and Toda and Yamamoto test are very sensitive to the choice of lag-length to be included in the estimations However, the limitation of the number of observations available for the variables representing economic growth, financial development, exports, imports, and inflation of Vietnam has prevented us to choose higher lag-lengths so that the estimations in the econometric procedures listed earlier could be more efficient and accurate 72 The third limitation of the thesis is also related to the small sample size problem Due to this problem, the thesis could not employ any structural change test such as Chow’s break point test or Quandt-Andrews break point test against the data set being used in the thesis The reason is that to detect any structural change problem for a particular estimation, those tests will make the estimation twice, one for a sub-sample separated by the pre-determined break point (Chow’s break point test) or gradually moving break point (Quandt-Andrews break point test), then compare the two estimation results for any structural change However, our limitation of the number of available observations not allows us to make such estimation with many lags 6.3 Directions for Further Research Once financial development has been found to have significant and positive to economic growth, it is worth to research to determine the growth transmission channels and the marginal effects through each channel Having this 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