Financial developemnt and economic growth in ten asian countries

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 DEVELOPEMNT AND ECONOMIC GROWTH IN TEN ASIAN COUNTRIES BY DUONG DINH TRIEU MASTER OF ARTS IN DEVELOPMENT ECONOMICS HO CHI MINH CITY, DECEMBER 2013 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 DEVELOPEMNT AND ECONOMIC GROWTH IN TEN ASIAN COUNTRIES A thesis submitted in partial fulfilment of the requirements for the degree of MASTER OF ARTS IN DEVELOPMENT ECONOMICS By DUONG DINH TRIEU Academic Supervisor: TRUONG DANG THUY HO CHI MINH CITY, DECEMBER 2013 TABLE OF CONTENTS ABSTRACT CHAPTER 1: INTRODUCTION 1.1 Problem statement 1.2 Research questions 1.3 Objectives of the study 1.4 Scope of the research 1.5 Structure of the thesis CHAPTER 2: THEORETICAL AND EMPIRICAL BACKGROUND 2.1 Theoretical background 2.2 Empirical review 14 CHAPTER 3: RESEARCH METHODOLOGY 19 3.1 The conceptual framework 19 3.2 Variables 20 3.2.1 Dependent variable 20 3.2.2 Explanatory variables 21 3.3 Econometric model 23 3.4 Data and Descriptive Statistics 26 3.5 Correlation among independent variables 27 CHAPTER 4: RESEACH FINDINGS 29 4.1 Test for Multicollinearity 39 4.2 Testing for Heteroskedasticity 40 4.3 Testing for Autocorrelation 41 4.4 Panel Unit Root Test 42 CHAPTER 5: CONCLUDING OBSERVATION AND POLICY IMPLICATION 44 5.1 Main findings and policy implications 44 5.2 Limitation of the research and recommendation for further studies 48 REFERENCES 50 APPENDIX 1: List of Economies and Number of Observations 54 APPENDIX 2: Definition of Variables and Their Data Sources 55 LIST OF FIGURES Figure 1: GDP growth rate and Inflation rate in Vietnam (1996-2012) Figure 2: Stock market capitalization (% GDP) and Inflation rate in Vietnam (19962012) Figure 3: Asian Countries Recovery after the crisis in 1997 Figure 4: Relation between Financial Development and Economic Growth LIST OF TABLES Table 1: Descriptive Statistic on the sample observations 26 Table 2: Correlation Matrix 28 Table 3: Regression results: Fixed Effects Model and Random Effects Model Table 4: Hausman test result between Fixed Effects Model and Random 30-31 33 Effects Model Table 5: Regression result of the optimal Fixed Effects model 34-35 Table 6: Collinearity Diagnostics 39-40 Table 7: Result of Test for autocorrelation Table 8: Panel Unit Root Test Results 41 42-43 ABBREVIATIONS INF : Inflation Rate IMF : International Monetary Funds WB : World Bank WDI : World Development Indicators INT : Interest Rate GDP : Gross Domestic Products OLS : Ordinary least square FEM : Fixed Effects Model REM : Random Effects Model X : Import M : Export ABSTRACT Financial-sector-derived economic crises happened recently in Asia area and in Vietnam create a question about the growth-promoting role of financial system against the economy After reviewing the theory of growth-finance nexus and many empirical studies about the link between financial development and economic growth, this paper is implemented to examine whether financial development really promotes economic growth in Asia including Vietnam and its nine neighboring nations Collecting data of ten Asian countries over period from 1980 to 2012 from IMF and World Bank and using econometric analysis method are the tools used in this report Due to the inadequate data of Vietnam before 1986 and of some other developing countries, the analyzed data is unbalance panel form GDP per capita growth is proxy for economic growth which is dependent variable in the regression model The indicators for financial development which is the main studied object in this paper include the ratio of private credit to GDP, the efficiency of financial institutions measured the spread between saving rate and lending rate, capital inflows as share of GDP and the ratio of total market value of all listed companies to GDP Besides, the regression model is added some control independent variables consist of the inflation rate measures the less stability of economies, and the two variables whose values measured in percentage against GDP: ratio of foreign trade to GDP and expenditure of Governments divided by GDP The regression result of Fixed Effects model affirms all four indicators of financial development promote economic growth The private credit is significantly necessary for growth The relationship between private credit ratio and economic growth is quadratic The increase in stock market capitalization leads to increase in investment in turn fosters growth While financial openness promotes economic growth significantly Lastly, the narrow of spread between lending and saving rates lowers the cost of investment so investment increases, in turn economic growth is accelerated Page CHAPTER 1: INTRODUCTION 1.1 Problem statement Vietnamese economy has been continuously developing at a high rate since the beginning of 90s One of many reasons may be the economy opening policy of Vietnam Government including the policy of liberalizing the financial system gradually The expanding of Vietnamese financial system with the evidence of the increasing in quantity of domestic joint stock banks and the appearance of many foreign commercial banks, financial companies and insurance institutions They help economic components especially private enterprises and households to access easily to financial resources Besides, the Vietnamese securities market which has been established in 2000 plays a more and more important role in the economy It operates as the second fund mobilization channel of enterprises The domestic stock market, one component of securities market, has been rapidly developing in term of the market value of listed companies The ratio of Vietnamese market capitalization of listed companies to GDP increased from 0.87% in 2005 to 27.52% in 2007 (WDI) However, the volatility of Vietnam economy recently such as the high domestic inflation rate from 2007 and the crash of the stock market in 2008 have restrained the growth rate Some causes are raised to explain the volatility, they include the rapidly over expanding of Vietnamese banking system and the easy credit provision of domestic commercial banks The average GDP growth rate of Vietnam is 7.42% in the low inflation rate period of 4.74% from 1996 to 2007 However, from 2008 to 2012 the growth rate reduced and only reached an average level of 5.88% because Vietnam suffered a high average inflation rate of 13.36% in this period On the other hand, the economic volatility also affects heavily on the stock market of Vietnam In 2008, when the inflation rate speeded up at the number of 23.12% from the rate of 8.35% in the previous year, the ratio of market capitalization to GDP declined sharply at 10.53% from the rate 27.52% of 2007 Therefore, what is the cause makes inflation rate be Page high? The WDI data shows that domestic credit provided by Vietnamese banking sector (% of GDP) over grew in 2007 This rate increased by about 21% to the number 93.35% of GDP from the rate 71.21% of GDP in 2006 GDP growth rate and Inflation rate 25.00 20.00 Rate (%) 15.00 10.00 Inflation Rate, 9.09 GDP Growth Rate, 5.03 5.00 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 (5.00) Source: World Bank, World Development Indicators Online, at data.worldbank.org Figure 2: GDP growth rate and Inflation rate in Vietnam (1996-2012) The neighboring nations of Vietnam have experienced the period of fast economic growth before Vietnam Some of them became developed countries such as Japan, Korea Republic, Singapore, while the economies of other countries are less developed than our economy such as Philippines And they also have better financial systems than Vietnam including well functioned financial markets, sound financial institutions, diversified financial instruments and fully worked-out financial infrastructure However, having better a financial system does not mean problems not exists in the economy In fact, Asian countries suffered the financial crisis derived from the crisis in banking system in 1997 and than their economies were destroyed seriously Page GovExp CapInf 5.6357 8.5018 (0.0000) (0.0000) -4.2397 -4.3510 (0.0000) (0.0000) The Im-Pesaran-Shin (2003) has the null hypothesis that all panels contain a unit root, while the alternative hypothesis that some panels are stationary From the result above, all the dependent variable GDPCapGrowth and independent variables including StockCap, IntSpread, INF, CapInf PriCredit2, TradeOpenness2, GovExp are stationary at levels and the first differences Page 43 CHAPTER 5: CONCLUDING OBSERVATION AND POLICY IMPLICATION 5.1 Main findings and policy implications This paper investigates the relationship between the financial development and economic growth for a panel of 10 Asian countries including developing and developed countries over the period 1980–2012 by using Fix Effected model type for regression model On the other hand, this study also proves the positive connection between capital inflows and economic growth, through capital inflows foster economic growth The outcomes achieved from this analysis again affirm the important of the financial development and its positive contribution to an economy There are a number of messages which outstand from this empirical research for policy makers of ten Asian economies The most outstanding finding that financial development indicators which measured by private credit divided by GDP, margin between deposit and lending rates and ratio of stock market value to GDP has a consistent and significant effect against growth This suggests that financial development will be a key engine of the area’s medium and long–run growth machine Firstly, the evidence of the ratio of private credit to GDP and per capita growth rate has a significant positive nexus reveal that private sector uses financial resources more efficient than public sector (the regression result proves that the bigger size of Government in the economy will lessen the growth rate) A special thing is that private credit ratio has a quadratic relationship with growth This helps economies to grow faster by double times than a linear relationship when private credit increases However, recent crises derived from financial sector (crises in Vietnam and USA) shows that using credit to promote economic growth is an uncertain solution There are many state owned enterprises play a dominant role in some Asian economies, especially in China and Vietnam These enterprises access loans easily from domestic banking sector via the guarantees or instructions of the governments and most of these Page 44 loans were used to invest into inefficient projects Eventually, the loans will cause banking crisis once they become non-performing loans To prevent any future bank crises, affects negatively to the real economy, policy makers in this area should give up the intervention in credit allocation processes of commercial banks and equitize stateowned enterprises including state-owned commercial banks as soon as possible After equitization is finished, these commercial banks will allocate financial resources more explicitly and more effectively This is the basic characteristic of a sound banking sector Moreover, a highlight problem in developing Asian countries is banking sector prefers to locate in urban areas and to serve the urban middle class, large private companies and state-owned enterprises while poor rural residents and small medium enterprises are excluded Consequently, expanding and improving access to financial services for both households and companies will remain a key policy priority for financial development This solution will help a large part of the poor and rural population to reach loans and other services so that they can invest into themselves by education projects or start up business projects Increase in income of rural population and easy access finance of small medium enterprise via banking sector are the two of many solutions to foster economic growth Moreover, new firms are promoted to enter markets and efficiently innovatory activities are financed through easier loans The fund-allocating role of financial system to the most effective uses in Asia is limited when the large part of the economy is outside the financial system Local government should promote the equality in policies, institutions and opportunity so that economic components can access finance more widely Setting up a credit registry that allows lenders to share together the information of borrowers about their repayment records and reduces the transaction costs is a necessary policy The higher interest margin rate will decline the economic growth rate, this is verified in this research paper and many previous studies A sound and efficient financial system must reduce the transaction and managing costs, i.e reduces the spread between Page 45 deposit and lending rates Among significant financial development indicators, the interest rate spread is the strongest factor affects economic growth therefore decreasing this spread will speed up growth more impressively than other solutions The prime objective of reducing interest rate spread is to lower the lending rates in order to stimulate investment and bring higher economic growth The first propose is developing alternative risk assessment mechanism Since some Asian countries are developing, there is no efficient risk assessment mechanism exists Commercial banks, especially in emerging countries tend to apply a high interest rate spread so that it can filter high-risk borrowers Central Banks should assist commercial banks by building financial institutions for managing possible risks Potential borrowers of banks will be measured by modern and efficient techniques of such institutions and their risk profiles will be disseminated to banks Besides, credit bureaus and credit rating agencies should be established so that credit rating process becomes professional and transparent Sharing and exchanging credit information widely among credit institutions and other stakeholders need be implemented Firms must adopt a rigorous accounting standards built by domestic Government and disclose information periodically Generally, central banks in developing countries maintain a higher required reserves rate and the same thing also exists in Asia Commercial banks pay high cost for required reserves, in fact borrowers are the objects must suffer this cost via paying the corresponding higher lending rate Consequently, policy maker in Asian Central Banks should select a more suitable required reserves rate The instability of the economy is considered to increase the spread rate The large part of savings in banking sector is short-term, while most of bank loans are provides for medium and long term The combination of this asymmetry and the economic instability makes commercial banks impose a high lending rate i.e the higher interest rate spread The status asymmetric of short-term mobilization and medium and long-term finance is inevitable in any banking system Therefore, the sole solution to cut down lending rate is Governments ensure the macroeconomic to be Page 46 stable in medium and long term When corporations are convinced about the long-term stability of the domestic economy, they will expand their investments and commercial banks will provide loans with a lower lending rate The interest rate spread narrowed by this event is good for the economy to grow up In order to maintain a low acceptable interest rate spread, lenders must access to credible and timely information of financial and credit markets Hence, a mechanism for ensuring both accountability and greater transparency is installed seriously On the other hand, the existing asymmetric in access to information for stakeholders and banks need to be reduced A positive effect of a stock market on per capita GDP growth is verified in this paper However, the capital markets in some Asian countries are still developing The market size of some markets is rather small in compare with GDP while there are still many less efficient state-owned enterprises A solution proposed is equitizing all state-owned enterprises as soon as possible, the results of this solution include: the ratio stock market size to GDP increases and the corporation governance of these companies is improved The two consequences both positively affect on economic growth In addition, the large proportion of products of the bonds market in Asia is Government bonds The corporation bonds market in this area is still underdeveloped Borrowing of firms by issuing corporation bonds is an alternative fund mobilization channel besides issuing stocks and borrowing from banking sector Compare with getting loans from commercial banks, securities markets provide capital with lower cost and are more stable characteristic In order to develop securities markets, the Government should build financial institutions and infrastructure so that corporate bonds exchanged easily and economically Accordingly, financial markets in Asia especially bond markets should be integrated rapidly This can benefit substantially for the financial development of the region However, the financial integration in Southeast Asia is still in a low level though intra-region foreign trade among the nations reaches a high level Page 47 This implies transferring capital flows from a nation to other in Asia is still strictly controlled The result of this regression analysis also shows benefits of financial openness measured by total capital inflows Therefore, increasing the level of financial integration is encouraged in order to attract private international capital flows in turn benefit economic growth There are some outstanding benefits for the region when financial integration occurs including: financial markets becomes more liquid and more efficient, the market capitalization becomes bigger Companies can mobilize fund from a bigger number of investors instead of only domestic investors, hence the cost of repaying will be reduced, in turn increasing the effectiveness of investment projects To strengthen the level of financial integration among Asian countries, some policy options are recommended: present obstacles of cross-border investment must be removed through cooperate closely among nations in the region, new financial instruments need to be created such as regional index fund, consolidating accounting and auditing standards, credit rating, legal and regulatory framework is necessary, and the last is building a credit rating agency for the whole region which enhance quality of credit risk assessment However, opening financial markets can cause some problems for each nation Transferring capital easily among countries can make a banking system be illiquid or stock markets crash rapidly when foreign capital floods out of border of a nation Therefore, Vietnam as well as neighboring nations need supervise strictly capital market before opening all financial markets 5.2 Limitation of the research and recommendation for further studies Although the paper is explained carefully about the reason why the topic is selected, collecting variables as well as economic model is applied, there are some limitations for the research and need some further studies Firstly, dataset might be unreliable and inadequate The period of 1980-2012 studied is enough long however the 1990-before data of Vietnam is not available Furthermore, due to Vietnamese financial market is Page 48 still not enough explicit the data about interest rate spread between lending rate and saving rate (one of three financial development indicators) is not exact The future studies should collect data after 1990 or later and refer more exact data about interest rate spread in Vietnam Secondly, the trade openness, one of control variables included in the empirical model and economic growth have a quadratic relationship This relationship is the same with the nexus between the private credit, one indicator measures financial development and growth However, the paper does not analyze the relationship between financial development and foreign trade The further studies can examine the way financial development impacts foreign trade and then promotes economic growth Page 49 REFERENCES Adams, C (2008) Emerging East Asian Banking Systems Ten Years after the 1997/1998 Crisis Working Paper Series on Regional Economic Integration No 16, Asian Development Bank, Manila Andrew Berg and Anne Krueger (2003) Trade, Growth, and Poverty: A Selective Survey Anh Tuan Tran (2008) Financial development and economic growth in the case of Vietnam, La Trobe University-Melbourne, Victoria, Australia Barro, R., and J.-W Lee (2010) A New Data Set of Educational 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31 Indonesia 33 33 25 33 33 33 33 32 Malaysia 33 33 25 33 33 33 33 33 Singapore 33 33 25 33 33 33 33 33 Japan 33 33 25 33 33 33 33 33 33 25 25 33 33 31 33 25 10 Hong Kong Page 54 APPENDIX 2: Definition of Variables and Their Data Sources Variable Definition Data Source GDPCapGrowth GDP per capita growth (annual %) World Bank, World Development Indicators online database PriCredit Domestic credit to private sector refers to World Bank, World financial resources provided to the private Development sector, such as through loans, purchases of Indicators online non-equity securities, and trade credits and database other accounts receivable, that establish a claim for repayment For some countries these claims include credit to public enterprises (% of GDP) StockCap Market capitalization of listed companies World Bank, World (% of GDP) Development Indicators online database IntSpread Interest rate spread (lending rate minus World Bank, World deposit rate, %) Development Indicators online database TradeOpenness The sum of exports and imports of goods World Bank, World and services measured as a share of gross Development domestic product (% of GDP) Indicators online Page 55 database INF Inflation, consumer prices (annual %) World Bank, World Development Indicators online database GovExp General government final consumption World Bank, World expenditure (% of GDP) Development Indicators online database CapInf Private capital flows consist of net foreign World Bank, World direct investment and portfolio Development investment Foreign direct investment is Indicators online net inflows of investment to acquire a database lasting management interest (10 percent or more of voting stock) in an enterprise operating in an economy other than that of the investor It is the sum of equity capital, reinvestment of earnings, other long-term capital, and short-term capital as shown in the balance of payments The FDI included here is total net, that is, net FDI in the reporting economy from foreign sources less net FDI by the reporting economy to the rest of the world Portfolio investment excludes liabilities constituting foreign authorities' reserves and covers Page 56 transactions in equity securities and debt securities (% of GDP) GDP = gross domestic product Page 57 ... components including financial institutions, financial markets, financial instruments and financial infrastructure Among financial intermediaries, commercial banks are dominant in most countries all... Vietnam including well functioned financial markets, sound financial institutions, diversified financial instruments and fully worked-out financial infrastructure However, having better a financial. .. for financial development indicators promote growth in ten Asian countries - To recommend general policy for sustainable development in term of financial system and economy of ten East Asian countries