Impact of financial depth and domestic credit on economic growth the case of low and middle income countries from 1995 2014

UNIVERSITY OF ECONOMICS HO CHI MINH CITY VIETNAM ERASMUS UNVERSITY ROTTERDAM INSTITUTE OF SOCIAL STUDIES THE NETHERLANDS VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS IMPACTS OF FINANCIAL DEPTH AND DOMESTIC CREDIT ON ECONOMIC GROWTH: THE CASES OF LOW AND MIDDLE-INCOME COUNTRIES FROM 1995-2014 BY LE THI HOANG ANH MASTER OF ARTS IN DEVELOPMENT ECONOMICS HO CHI MINH CITY, OCTOBER 2016 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 IMPACTS OF FINANCIAL DEPTH AND DOMESTIC CREDIT ON ECONOMIC GROWTH: THE CASES OF LOW AND MIDDLE-INCOME COUNTRIES FROM 1995-2014 A thesis submitted in partial fulfilment of the requirements for the degree of MASTER OF ARTS IN DEVELOPMENT ECONOMICS By LE THI HOANG ANH Academic Supervisor: Dr Pham Thi Bich Ngoc HO CHI MINH CITY, OCTOBER 2016 ii ABBREVIATIONS OECD Organization for Economic Cooperation and Development IMF International Monetary Fund GDP Gross Domestic Product GNI Gross National Income ODA Official Development Assistance FDI Foreign Direct Investment FPI Foreign Portfolio Investment OLS Ordinary Least Squares FEM Fixed Effects Model REM Random Effects Model GMM Generalized Method of Moments IV Instrumental Variable iii ABSTRACT This paper focuses on the impacts of financial development on economic growth with the cases of 122 low and middle-income countries from 1995 to 2014 Indicators for financial development include the ratio of liquid liabilities to GDP and the ratio of domestic credit to private sector by banks to GDP Control variables include the inflation rate, the ratio of government final consumption expenditures to GDP, the ratio of exports and imports to GDP, and the total enrollment in secondary education Research results are drawn from estimation methods of Pooled OLS, FEM (Fixed Effects Model), REM (Random Effects Model) and GMM (Generalized Method of Moments) Accordingly, financial development is concluded to have negative effects on economic growth in countries with low and middle incomes during 1995-2014 Nevertheless, the estimation results have some differences due to the differences in the estimation methods In particular, the ratio of domestic credit to private sector by banks to GDP has negative impacts on economic growth rate, which is concluded by both FEM and GMM regression results However, the impacts of the ratio of liquid liabilities to GDP on economic growth rate are differently described by the two estimation methods According to the FEM regression results, the ratio of liquid liabilities is statistically significant and has negative influences on economic growth rate However, according to the GMM regression results, the ratio of liquid liabilities to GDP is statistically insignificant and has no effects on the economic growth rate Although the estimation results by FEM and GMM estimation methods have some variations, the final conclusions are considered to be identical: Financial development is proposed to have negative impacts on economic growth of countries with low and middle incomes The explanations for the negative impacts can be drawn from the fact that capital investments tend to have low productivity and weak efficiency in countries with low and middle incomes iv TABLE OF CONTENTS LIST OF TABLES viii LIST OF FIGURES .ix CHAPTER ONE: INTRODUCTION 1.1 Problem statements 1.2 Research objectives and questions .5 1.3 Research scope and data 1.4 Research structure CHAPTER TWO: LITERATURE REVIEW 2.1 Theoretical literature 2.1.1 Endogenous growth theory .8 2.1.2 Financial development and economic growth 10 2.1.2.1 Roles of financial system in the economic growth 11 2.1.2.1.1 Providing information and distributing resources 11 2.1.2.1.2 Reducing costs of information collection and transaction process 12 2.1.2.1.3 Mobilizing capitals 14 2.1.2.1.4 Facilitating transactions 15 2.1.2.1.5 Entrepreneur management strengthening .16 2.1.2.2 Theories of financial development 17 2.1.3 Measurements of explaining variables 19 2.1.3.1 Measurements of financial development indicators 19 2.1.3.1.1 Ratio of liquid liabilities to GDP 20 2.1.3.1.2 Ratio of domestic credit to private sector by banks to GDP 21 2.1.3.2 Determinants of economic growth 22 2.1.3.2.1 Inflation rate 22 v 2.1.3.2.2 Ratio of government expenditures to GDP .22 2.1.3.2.3 Ratio of exports and imports to GDP 23 2.1.3.2.4 Secondary education enrollment rate 25 2.2 Empirical studies 29 CHAPTER THREE: RESEARCH METHODOLOGY 37 3.1 Model specifications 37 3.2 Data collection 39 3.3 Research methodology 40 3.3.1 Common constant method (Pooled OLS) 41 3.3.2 Fixed effects method (FEM) 42 3.3.3 Random effects method (REM) 43 3.3.4 Generalized method of moments (GMM) 44 CHAPTER FOUR: RESEARCH RESULTS 47 4.1 Descriptive statistics of the sample 47 4.2 Empirical results 52 4.2.1 Results of Pooled OLS, FEM and REM tests for panel data regression model (Static regression model) .53 4.2.2 Discussions on the estimation results of FEM (Static regression model) 55 4.2.3 Discussions on the estimation results of GMM (Dynamic regression model) 61 CHAPTER FIVE: CONCLUSIONS AND POLICY IMPLICATIONS 68 5.1 Conclusions 68 5.2 Policy implications 72 5.3 Research limitations 74 5.4 Further researches 74 vi REFERENCES 76 APPENDIX A: LIST OF SELECTED COUNTRIES 85 APPENDIX B: SUMMARY OF EMPIRICAL LITERATURE REVIEWS 87 APPENDIX C: DESCRIPTIVE STATISTICS OF VARIABLES 91 APPENDIX D: PANEL DATA REGRESSION RESULTS 93 APPENDIX E: HAUSMAN TEST RESULTS 95 APPENDIX F: GMM REGRESSION RESULTS 96 vii LIST OF TABLES Table 2.1: Expected sign of variables .28 Table 3.1: Data collection 40 Table 4.1: Summary statistics of variables 47 Table 4.2: Correlations on the sample observation 51 Table 4.3: Results of Pooled OLS, FEM and REM regression model (Static regression model) 53 Table 4.4: Results of Hausman Test .54 Table 4.5: Results of GMM regression model (Dynamic regression model) 61 viii LIST OF FIGURES Figure 2.1: Analytical framework 27 Figure 4.1: Scatter diagrams among dependent variable (GROWTH) and financial development variables (DEPTH, CREDIT) 49 Figure 4.2: Scatter diagrams among dependent variable (GROWTH) and control variables (INFLATION, GOVERNMENT, TRADE, EDUCATION) 50 ix CHAPTER ONE INTRODUCTION 1.1 Problem statements From the ancient to modern time, economists have had endless discussions about the sources of economic growth and why countries had their own level and rate of economic development There have been such a lot of economic theories that have tried to explain how and why economic growth takes place in different countries during different periods of time Some of them draw attention to the process of capital and labor accumulation, international business expansion, educational strengthening strategies, etc There are many factors that influence the development of economic growth Among them, financial development is considered as one of the most important stimulators In these recent years, a lot of attention has been put into the position of financial development in the economic growth of a wide range of countries all over the world Particularly, in the time of international trade and cooperation, the development of financial markets is greatly appreciated Financial development and its effect on economic growth are common research objectives by economists from the past to present times For instance, according to McKinnon (1973) and Shaw (1973), there is positive relationship between financial development and economic growth Besides, Levine (1997) has proved that financial development contributed to economic growth through the processes of enhancing investing environments, minimizing investing expenses, gathering capital funds, stimulating technologies, and providing risk insurances However, besides the positive relationship between financial development and economic growth, some economists have stated other ideas about the relationship between them McKinnon (1973), King and Levine (1993b), Levine, Loayza and Beck (2000) have followed the finance-led-growth theory to point out McKinnon, Ronald I (1973) Money and capital in economic development Washington DC: The Brookings Institution McKinnon, Ronald I (1991) The order of economic liberalization financial control in the transition to a market economy Baltimore: Johns Hopkins University Press Merton, Robert C, & Bodie, Z (1995) A Conceptual Framework for Analyzing the Financial Environment The global financial system: A functional perspective Morales, M F (2003) Financial intermediation in a model of growth through creative destruction Macroeconomic Dynamics, 7, 363–393 Obstfeld, M (1994) Risk-taking, global diversification, and growth American Economic Review, 84, 1310-1329 Odedokun, M O (1996) Alternative econometric approaches for analyzing the role of the financial sector in economic growth: Time-series evidence from LDCs Journal of Development Economics, 50, 119–146 Pagano, Marco (1993) Financial Markets and Growth: An Overview European Economic Review, 37(2), 613-22 Patrick, Hugh T (1966) Financial development and economic growth in underdeveloped countries Economic Development and Cultural Change, 14, 174-189 Potiowsky, T, & Qayum, A (1992) Effect of Domestic Capital Formation and Foreign Assistance on rate of Economic Growth Economic Internazionale, 45, 223-227 Pritchet, L (2001) Where Has All the Education Gone? World Bank Economic Review, 15(3), 367- 391 Ram, Rati (1989) Government size and economic growth: A new framework and some evidence from cross-section and time-series data: Reply American Economic Review, 79(1), 281-284 82 Rebelo, S (1991) Long-run Policy Analysis and Long-run Growth Journal of Political Economy, 99, 500-521 Robinson, Joan (1953) Rate of Interest and Other Essays London: Macmillan Roubini, N, & Sala-i-Martin, X (1992) Financial repression and economic growth Journal of Development Economics, 39, 5–30 Rubinson, R (1977) Dependency, government revenue, and economic growth 1955 – 70 Studies in Comparative International Development, 12, 3-28 Saint-Paul, Gilles (1992) Technological choice, financial markets and economic development European Economic Review, 36, 763-781 Samargandi, Nahla, Fidrmuc, Jan & Ghosh, Sugata (2013) Is the relationship between financial development and economic growth monotonic for middle- income countries? Economics and Finance Working Paper, 13-21 Schumpeter, J A (1911) The theory of economic development Cambridge, MA: Harvard University Press Shaw, Edward S (1973) Financial deepening in economic development (Vol 39) New York: Oxford University Press Singh, Ajit (1997) Financial liberalization, stock markets and economic development Economic Journal, 107(442), 771–782 Sirri, E R, & Tufano, P (1995) The economics of pooling The Global Financial System: A Functional Approach: Harvard Business School Press, Boston, MA, 81-128 Smith, A (1776) An Inquiry into the Nature and Causes of the Wealth of Nations London: W Stahan & T Cadell Solow, R M (1956) A Contribution to the Theory of Economic Growth, Quarterly Journal of Economics, 70, 65–94 Stiglitz, J, & Weiss, A (1983) Incentive effects of terminations: Applications to credit and labor markets American Economic Review, 73(5), 912-927 83 Wu, Jyh-Lin, Hou, Han & Cheng, Su-Yin (2000) The dynamic impacts of financial institutions on economic growth: Evidence from the European Union Journal of Macroeconomics, 32(3), 879–891 Yanikkaya, Halit (2003) Trade openness and economic growth: a cross-country empirical investigation Journal of Development Economics, 72(1), 57-89 84 APPENDIX A LIST OF SELECTED COUNTRIES Table A.1: List of selected low and middle-income countries classified by the World Bank Afghanistan 42 Georgia 83 Niger Albania 43 Ghana 84 Nigeria Algeria 44 Grenada 85 Pakistan Angola 45 Guatemala 86 Panama Armenia 46 Guinea 87 Papua New Guinea Azerbaijan 47 Guinea-Bissau 88 Paraguay Bangladesh 48 Guyana 89 Peru Belarus 49 Haiti 90 Philippines Belize 50 Honduras 91 Romania 10 Benin 51 India 92 Rwanda 11 Bhutan 52 Indonesia 93 Samoa 12 Bolivia 53 Iran, Islamic Rep 94 Sao Tome & Principle 13 Bosnia & Herzegovina 54 Iraq 95 Senegal 14 Botswana 55 Jamaica 96 Serbia 15 Brazil 56 Jordan 97 Sierra Leone 16 Bulgaria 57 Kazakhstan 98 Solomon Islands 17 Burkina Faso 58 Kenya 99 South Africa 18 Burundi 59 Kosovo 100 Sri Lanka 19 Cape Verde 60 Kyrgyz Republic 101 St Lucia 20 Cambodia 61 Lao PDR 102 St Vincent & Grenadines 21 Cameroon 62 Lebanon 103 Sudan 22 Central African Rep 63 Lesotho 104 Suriname 23 Chad 64 Liberia 105 Swaziland 85 24 China 65 Libya 106 Syrian Arab Republic 25 Colombia 66 Macedonia, FYR 107 Tajikistan 26 Comoros 67 Madagascar 108 Tanzania 27 Congo, Dem Rep 68 Malawi 109 Thailand 28 Congo, Rep 69 Malaysia 110 Timor-Leste 29 Costa Rica 70 Maldives 111 Togo 30 Cote d'Ivoire 71 Mali 112 Tonga 31 Djibouti 72 Mauritania 113 Tunisia 32 Dominica 73 Mauritius 114 Turkey 33 Dominica Republic 74 Mexico 115 Uganda 34 Ecuador 75 Moldova 116 Ukraine 35 Egypt, Arab Rep 76 Mongolia 117 Vanuatu 36 El Salvador 77 Morocco 118 Vietnam 37 Eritrea 78 Mozambique 119 West Bank and Gaza 38 Ethiopia 79 Myanmar 120 Yemen, Rep 39 Fiji 80 Namibia 121 Zambia 40 Gabon 81 Nepal 122 Zimbabwe 41 Gambia, The 82 Nicaragua 86 APPENDIX B SUMMARY OF EMPIRICAL LITERATURE REVIEWS Table B.1: Summary of empirical literature reviews No References Data Methodology King & Levine Cross section data Cross (1993) of 77 Key conclusions country Financial countries regressions development can stimulate economic growth from 1960-1989 Levine & Cross section data Cross Zervose (1996) of 42 country Stock countries regressions development from 1976-1993 Levine et (2000) of 71 countries and variable panel data of 74 cross Beck et (2000) of 66 countries and variable Eng (2006) for positively Financial for positively correlated is with development correlated is with section economic growth for panel data developing countries development section economic growth & Panel data of 13 System GMM Asian positive from data and GMM 1960-1995 Habibullah have for panel data panel data of 77 cross Financial al Cross section data Instrument countries banking from data and GMM 1960-1995 and influence on economic growth al Cross section data Instrument countries market Financial development can stimulate economic growth from 1990-1998 Leitao (2010) Panel data of EU FEM countries Brazil, India and system GMM Russia, and and Financial China 87 development stimulate economic growth can from 1980-2006 Fase & Abma (2003) emerging Augmented Financial countries in South- Dickey-Fuller East Asia from unit 1974-1999 root and development has positive impacts on economic test growth causality test Wu et al 13 countries in EU Panel unit root Financial (2010) form 1976-2005 test and PMG positively development correlated is with method of economic growth in the long run Pesaran but negatively correlated in the short run Qayyum et al Low-income (2004) countries Panel unit root There is no correlation between from test, FEM and financial 1973-2001 development and panel causality economic growth analysis 10 11 Ang & Time series data of Vector McKibbin Malaysia (2007) 1970-2001 Ndlovu (2013) Data of Zimbabwe Granger Economic from autoregressive growth stimulates financial development approach from 1980-2006 causality Economic growth stimulates test, financial development panel unit root test and Johansen cointegration test 12 Apergis et al 15 OECD and 50 Panel (2007) non-OECD countries 1975-2000 13 Jun (2012) There is relationship between integration and financial from cointegration development and economic growth test Panel data of 27 Panel unit root There is relationship between Asian countries test and panel financial 88 development and from 1960-2009 cointegration economic growth test 14 Rachdi & 10 OECD and Panel Mbarek (2011) MENA There is relationship between countries cointegration from 1990-2006 financial development test and system economic GMM growth in and OECD countries but in MENA countries only economic positive growth impacts on has financial development 15 Hassan et al 168 countries from OLS (2011) 1980-2007 and There is relationship between Weighted Least financial development and Square, Vector economic growth in most of autoregressive and countries but in poorest countries Granger only causality test economic positive growth impacts on has financial development 16 Adamopoulos Data of Ireland Vector (2010) from 1965-2007 error Economic growth has positive correction, unit impacts root test, development cointegration test, Perera Paudel (2009) & Data of Sri Lanka Johansen form 1955-2005 and market there is and stock marker development There is relationship between cointegration and credit relationship between economic Granger growth causality test 17 on financial development and error economic growth correction 18 Jude (2010) Panel data of 71 Panel countries 1960-2004 Smooth The from Threshold Regression relationship financial between development and economic growth is not linear and depends on financial development indicators 89 19 Phan (2011) Data of provinces Vietnam 1997-2004 61 Pooled PLS, Financial development has in FEM, REM, IV positive impacts on economic from regression GLS 90 and growth APPENDIX C DESCRIPTIVE STATISTICS OF VARIABLES Figure C.1: Distribution graph of dependent variable Figure C.2: Distribution graphs of financial development indicators 91 Figure C.3: Distribution graphs of control variables 92 APPENDIX D PANEL DATA REGRESSION RESULTS Figure D.1: Pooled OLS regression results 93 Figure D.2: FEM regression results Figure D.3: REM regression results 94 APPENDIX E HAUSMAN TEST RESULTS Figure E.1: Hausman Test for FEM and REM 95 APPENDIX F GMM REGRESSION RESULTS Figure F.1: GMM regression results 96 ... DOMESTIC CREDIT ON ECONOMIC GROWTH: THE CASES OF LOW AND MIDDLE-INCOME COUNTRIES FROM 199 5- 2014 A thesis submitted in partial fulfilment of the requirements for the degree of MASTER OF ARTS IN... development and economic growth was based on the growth- led-finance theory Nevertheless, not all of economists support the idea that there is positive relationship between financial development and economic. .. conclusions In general, although financial development and economic growth have been widely investigated, analyzing the impacts of financial development on economic growth in the cases of low and middle-income