Financial structure and economic growth

Policies and Sustainable Economic Development | 115 Financial Structure And Economic Growth NGUYEN THI UYEN UYEN University of Economics HCMC - uyentcdn@ueh.edu.vn TU THI KIM THOA University of Economics HCMC - tkthoa@ueh.edu.vn PHAM THIEN BACH University of Economics HCMC - bachphamthien@gmail.com Abstract Using the FMOLS method on a data sample of six Asian countries provided by World Bank, this paper aims at examining the effects of financial structure and development on a country’s economy and also economic growth Our results show that financial structure and development affect a country’s economy and economic growth There also exists a diversity in countries’ suitability with each type of financial structure South Korea and Malaysia suit a bank-based financial system, whereas Vietnam suits a market-based financial system, and Thailand favors a neutral system, benefiting from the growth of financial services’ growth in quality and quantity Besides the main estimation function, the results of additional estimation functions also support our original conclusion Keywords: financial structure; economic growth; Asian countries 116 | Policies and Sustainable Economic Development Introduction Whether a country’s financial system affects its economic growth remains a controversial topic among researchers In general, there exist four schools holding different views on this subject; they are the bank-based school, market-based school, financial services/neutral school, and law and finance school The bank-based school upholds banks’ (both commercial and stateowned) role in stimulating economic growth In contrast, the market-based school argues for a strong and efficient financial market with excellent liquidity This school believes that such a market would stimulate overall growth, increase company efficiency, diversify, and optimize risk management tools, which in turn makes it easier for companies to maximize their asset value The neutral school, however, disagrees with the other two Those belong to this school dismiss the emphasis on financial structure’s importance, on the contrary, they believe that it is the quality and quantity of financial services provided by the financial market that affects economic growth The last school, the law and finance school, believes in the utmost importance of overall orderliness of a financial market as well as upholding the underlying financial law Each school has its own advocates and supporting empirical evidence, providing a perfect research environment and opportunity Therefore, this paper seeks to determine the true effects of financial structure and development on economic growth as our primary concern We also set out to examine the possible suitability difference among countries with different economic backgrounds as well as different average income Furthermore, we also test the effects of financial liberation and development on Vietnam’s economy Since the “Doi Moi” plan effectively kicked in 1986, the Vietnam government has imposed many important economic liberalization policies Two of those are the opening of the Vietnam’s stock market in July 28, 2000 and the emergence of commercial banks in the 1990s The Vietnamese financial market has since flourished, unlocking hitherto unknown potentials and helping new businesses fund their operations In order to achieve our academic goals, we employed the FMOLS method first introduced by Pedroni (2001), which has been proven very effective in examining small size sample Our estimation results showed that both the financial system as a whole and the very nature of a country's financial system play an important role in promoting economic growth in most countries in our sample To achieve our goals, this paper will focus on these primary questions: First and foremost, is there a direct, one-way relationship between financial structure and development and economic growth? Second, does the suitability of countries’ economy to different types of financial system shift when such countries achieve a higher level of economic development? Literature summary Policies and Sustainable Economic Development | 117 2.1 Benefits of a sound financial system One of the most important roles of a financial system is that of a capital channel The amount of available and liquid capital in an economy plays a crucial role in determining said economy’s prosperity Free and private capital in an economy mostly comes from the remainder after spending An ideal financial system will collect this amount of capital, transform it into working capital by issuing standardized financial instruments to help capital owners invest and earn back interest, as well as diversify their investments A country’s financial system can also transform low liquidity assets into high liquidity ones With these high liquidity assets, investors as well as debtors can hold financial instruments and convert them back to money if they need Financial systems also help investors to diversify their investments and reduce information asymmetries An efficient financial system will also eliminate “friction” or costs that investors burden themselves with in order to obtain a well-diversified portfolio 2.1.1 Bank-based school The bank-based school represented by Gerchenskron (1962); Diamond (1984); Stiglitz (1985); Boyd and Prescott (1986); Bencivenga and Smith (1991); Bhide (1993) and Stulz (2002) all uphold the importance of banks in stimulating the economic growth In a bank-based country, the health of said country’s economy depends a lot on the health of its banking system Banks’ profit mostly comes from lending interest which is also the source of their financial power Banks in this type of financial system scarcely have to deal with competition from the rest of the market Therefore, companies and new businesses not have many options to fund their operation other than accepting banks’ services Some studies suggest a link between a country’s level of economic development and its suitability to a specific type of financial system Specifically, a country with a lower level of economic development will favor a bank-based financial system and vice versa The reason for this lies in the need for personal investments of the private sector In general, financial markets, especially stock markets which have always been infamously risky does not exactly match the risk profile and the taste of people with no to little knowledge in finance and not a lot of reserve capital 2.1.2 Market-based school The market-based school represented by the likes of Jansen and Murphy (1990); Holstrom and Tirole (1993); Boot and Thakor (1997); Levine (1997); Boyd and Smith (1998); Wenger and Kaserer (1998) instead favors a large and efficient financial market in the role of economy stimulation As the name would have suggested, in this type of financial system, power lies within the market Strangely, more banks would be involved in the day-to-day activities of the market; however, banks’ profit mostly comes from underwriting activities rather than the interests from loans For obvious reasons, a market-based financial system will be favored over a bank-based one when a country achieves higher levels of economic development 2.1.3 Neutral school 118 | Policies and Sustainable Economic Development Unlike the aforementioned two schools, scholars belong to this school simply think that a sound financial system as a whole plays a crucial role in stimulating growth They differ significantly thanks to their indifference view on the matter of favoring the banking system or the financial market There is surely a type of pragmatism to this school Scholars belong to this school advocate strongly for expanding the scope and the scale of the financial market, improving the quality, and increasing the quantity of financial services available 2.2 Literature review One of the first papers seriously debating this subject is Demetriades (1996), which used the VAR method with appropriate cointegration tests on a data set of carefully selected and filtered countries was unable to find a direct relationship between financial and economic development Christopoulos (2004) applied the FMOLS (fully modified OLS) first proposed by Pedroni (2001) on a data set composed of countries with different economic backgrounds and found contrasting results Duisenberg (2001) criticized the need to distinguish between a bank-based and market-based financial system and advocated strongly for a cooperating relationship between these two factors in a financial system According to Duisenberg (2001), scholars should only care about the nature of financial services provided by these two factors Luintel and Khan (1999) also applied the VAR model on a data set composed of 10 countries; however, this paper differs greatly from its precedents by considering, not discarding the fundamental political and historical differences between countries Calderon (2002) used the Geweke analysis method on a comprehensive panel data set of 109 countries from 1960 to 1994 and found evidence for a direct causal relationship between financial development and economic growth Levine (2002), nevertheless, failed to find such a relationship in his study of 48 countries from 1980 to 1985 when all the obtained results indicate that financial development could not explain economic progress in these countries This result is mirrored by that of Beck and Levine (2002) which constructed a coherent data set based on financial and economic data of 36 industries in 42 countries into perhaps the most comprehensive variable set measuring both economic and financial development They found that financial development cannot explain neither overall economic growth nor other measures such as specific industry growth or the number of new businesses While examining a data set of 41 countries from 1976 to 1993, Levine and Zevros (1996a, 1996b) found supporting evidence for their claim that overall liquidity in financial markets promote higher levels of capital accumulation and productivity which ultimately lead to higher economic prosperity Rajan and Zingales (1998) came to the same conclusion Arestis et al (2001) through their research concluded that the health of a country’s financial market is crucial to said country’s economy Choe (1999) closely examined the effects of both the financial market and the banking system of South Korea on its booming economy through the 1970s period and came to the conclusion that in South Korea, a strong banking system is more favorable but also admitted that such a system may only be suitable to South Korea with its unique economic and historic characteristics Choe (1999) is also one of the few papers which can demonstrate via econometric methods that the supposed superiority of one system over another, in this case, is the banking Policies and Sustainable Economic Development | 119 system Bencivenga (1991) found evidence supporting the mere existence of banks in an economy in general and in a financial market specifically can be beneficial by easing the flow of capital Model and estimation methods 3.1 Model Based on the legacy of Luintel et al (2007), we regress countries’ GDP per capita on per capita fixed investment as well as financial structure and financial system development using the following function: S D log (Q/L)t = a0 + a1log (K/L)t + a2log (F )t + a3log (F )t + e1 in which, Q is GDP, L is the total Dlabor force or population, K is the S amount of fixed investment, F and F in order are variables representing the financial structure and the degree of financial development, and e is the error term P During the regression, we use real GPD per capita (Y ) and real fixed P investment per capita (K ) Based on the way these two variables were S constructed, a higher value of F will indicate a more market-based D financial system; a higher value of F will indicate a more developed financial system Function (1) therefore will be our main estimation function We care more about the statistically significance of a and a3 than their signs since a statistically significant a will confirm a country’s financial system’s effect on its economy Theoretically, the market-based school predicts a positive and statistically significant a 2; in contrast, the bank-based school predicts a negative and statistically significant a The neutral school on the other hand predicts a statistically insignificant a All three schools expect a3 to be positive and statistically significant 3.2 Data and variable description 3.2.1 Data description The data used in this paper is economic and financial data of six Asian countries which are South Korea, Malaysia, Thailand, India, Philippines, and Vietnam with different economic development backgrounds Economic data composed of data on total GDP, total GFI (gross fixed investment), inflation rate, and total population is obtained through the selection of available data provided by World Bank website Specialized financial data composed of data on Stock Market Capitalization, Total Stock Value Traded, Total Stock Market Return and Private Credit Ratio is provided by World Bank’s Financial Development and Structure Dataset Since we not intend to pool data from different countries into one set of panel data, instead we use FMOLS to run a time series regression, the difference between countries’ data timeline is not a concern Most time series in our sample has a range from 1989 to 2014, except for Vietnam’s case since its stock market was not officially opened until 2000 and financial data took four years to be truly reliable, Vietnam’s time series start from 2004 and end in 2014 120 | Policies and Sustainable Economic Development 3.2.2 Variable description P 3.2.2.1 Dependent variable – GDP per capita (Y ) We deflate nominal GDP per capita to achieve real GDP per capita and P then divide it by the total population An increase in Y signals economic growth P Y = 3.2.2.2 Independent variables - Physical capital stock per capita (K/L) P We deflate nominal GFI data obtained (?) through World Bank and then divide it by the total population For obvious reasons, we expect this variable’s coefficient to be statistically significant and positive P (K/L) = S - Financial structure – F Two variables used to describe a country’s financial system are: (1) Structure Activity – SA; and (2) Structure Size (SZ) Structure Activity is calculated as the logarithm of the ratio of Total Stock Value Traded to Total Private Credit This variable is a proxy to measure the relative activity of the stock market compared to the banking system The correct measurement of this variable is crucial, which arises from the need to distinguish between two unrelated notions: stock market activity versus stock market size Since a big stock market with many listed companies can still be a ghost market with little to no trading activity Structure Size is calculated as the logarithm of the ratio between Total Stock Market Capitalization and Total Private Credit This variable is a proxy to S measure stock market’s size compared to the rest of the financial sector F representing financial structure as a whole is the weighted average of all the principal components of SA and SZ, therefore being able to capture the variations in financial structure This is an important independent variable since its coefficient’s characteristics will determine the relationship between financial structure and S economic prowess Since a higher level of F signifies a more market oriented financial system, the bank-based school expects its coefficient to be negative and statistically significant, while the market-based school expects its coefficient to be positive and statistically significant On the S other hand, the neutral school expects F ’s coefficient to be statistically insignificant D - Financial development - F Two variables used to measure the level of financial development are: (1) Financial Size (FZ); and (2) Financial Activity (FA) FZ is calculated as the logarithm of the product between Total Private Credit and Total Stock Market Capitalization This variable measures the total size of the financial market as a whole FA is calculated as the logarithm of the product between Total Private Credit and Total Stock Value Traded This variable measures the level of activity of the D financial system F is Policies and Sustainable Economic Development | 121 the weighted average of all the principal components of FZ and FA All D aforementioned schools predict a positive and statistically significant F 3.2.2.3 Construction variables - Total Private Credit This variable is calculated as the ratio between the total amount of credit possessed by the financial system which includes banks as well as private financial entities and GDP - Total Stock Market Capitalization This variable is calculated as the ratio between the total stock market capitalization value and GDP - Total Stock Market Turnover This variable is calculated as the ratio between the total stock value traded and average stock market capitalization for the period - Total Stock Value Traded This variable is calculated as the ratio between the total stock value traded and GDP Table gives an overall description of variables, and Table presents their calculation formulas We chose six Asian countries with different economic, political, and historical backgrounds Vietnam has the lowest level of GPD per capita (68.523 USD), while South Korea has the highest one (9959.447 USD) based on the 1989 USD Malaysia has the fastest average GDP per capita growth rate (3.1%), while Vietnam even has negative average GDP per capita growth (-1.6%), we also recorded many instances of negative GDP per capita growth in India and Philippines However, we notice a sample wide trend of leaning towards a more market oriented financial system By observing an ever more increasing PC or specifically PCg of all countries except for India and Philippines, albeit with different degrees in each country Interestingly, Vietnam is the only country in our sample with double-digit average growth in Total Private Credit (11.3%) This has demonstrated the intensive changes made to Vietnam’s financial market and their results Vietnam’s average growth rate in Total Private Credit also dwarfs other countries’ However, the average growth rate of Total Stock Market Capitalization and Total Stock Value Traded are far more pronounced This trend is presented in all countries in our sample 122 | Policies and Sustainable Economic Development Table Variable summary Yp Yg South Korea 9959.447 Malaysia 4306.833 Thailand 2456.529 India 334.22 Philippines 509.933 Vietnam 68.523 STm STg South Korea 197.502 Malaysia 39.076 Thailand 83.926 India 103.943 Philippines 24.102 Vietnam 58.88 Policies and Sustainable Economic Development | 123 SZm SZ South Korea 0.671 Malaysia 0.285 Thailand 0.5 India 1.306 Philippines 1.451 Vietnam 0.134 Notes: Yg is the average annual growth rate of GDP per capita PC = Private Credit by Deposit Money Banks and Other Financial Institutions to GDP ratio SM = Stock Market Capitalization to GDP ratio SA = Stock Market Total Value Traded to Private Credit by Deposit Money Banks and Other Financial Institutions SZ = Stock Market Capitalization to Private Credit by Deposit Money Banks and Other Financial Institutions Subscripts S, E, M and G are the average value of the first five years, the average value of the last five years, the mean value of the sample period and the average annual growth rate respectively 124 | Policies and Sustainable Economic Development Table Variables definition Variable Formula Real GDP Total Population Real GFI Total Population Total Private Credit P Y GDP Total Stock Market Capitalization GDP Total Stock Value Traded Average Market Capitalization for the period Total Stock Value Traded GDP (K/L)P PC SM ST STD SA ln( FZ ln(PC*SM) FA ln(PC*STD) SZ ln( ) ) Results ADF tests with our independent variables show that all of them are all unit root processes Therefore, we regress the logarithm of these variables instead Table presents the regression results: Policies and Sustainable Economic Development | 125 Table Main regression function estimation results log (Q/L)t = a0 + a1log (K/L)t + a2log (FS)t + a3log (FD)t + e1 South Korea Malaysia Thailand India Philippines Vietnam Notes: *** statistically significant at 1%; ** statistically significant at 5%; * statistically significant at 10% According to three schools’ predictions, a country will be classified as having a bank-based financial market when: (1) a 2’s coefficient is negative and statistically significant and (2) a 3’s coefficient is positive and statistically significant On the other hand, a country will be classified as having a marketbased financial market when (1) a 2’s coefficient is positive and statistically significant; and (2) a3’s coefficient is positive and statistically significant Finally, a country will be classified as having a neutral financial market when: (1) a2’s coefficient is statistically significant; and (2) a3’s coefficient is positive and statistically significant Based on these expectations, we have classified six countries in our sample into three groups: - Countries with bank-based system: South Korea and Malaysia - Countries with market-based system: Vietnam - Countries with neutral system: Thailand Overall results show that five out of six countries have positive and P statistically significant K This conforms to the original Cobb – Douglas S inspiration F is also statistically significant in five out of six countries namely South Korea, Malaysia, India, Philippines, and Vietnam Our results show that South Korea and Malaysia are more suitable to a bank-based financial system This result reflects one achieved by Choe (1999) Choe (1999) also found evidence supporting the superiority of South Korean banking system over its financial system in the role of growth stimulation Furthermore, when we look at the economy of Malaysia, its banking system’s effects on its economy are profound The Malaysian economy still performs relatively well after two financial crises at the end of the 1990s and 2008, thanks in part to its well-developed financial system The Malaysian financial systems in general and its players specifically are put under a strict and well enforced set of rules, which gives every financial institution an equal chance to succeed The financial 126 | Policies and Sustainable Economic Development services provided by the Malaysian financial system fueled the growth of small and medium businesses and created 40% of new private sector jobs for the Malaysian economy The only country in our sample that shows suitability with a market-based financial system is surprisingly Vietnam Our result confirms the fruitfulness of financial liberation efforts made by the Vietnamese government Based on this estimation result, we also propose an even more liberated financial reform to fully take advantage of the hidden potentials within Vietnamese financial system Thailand is the only recorded case of fitting the neutral school’s expectation In conclusion, our results have shown the diversity in financial system suitability within six Asian countries with different economic, historical, and political backgrounds Conclusion Based on the study of Luintel et al (2007), this research is performed to examine the connection between a country’s financial system and its economic growth Using a data set composed of specialized financial data provided by World Bank’s program on the same matter and general economic data from World Bank’s website, with the FMOLS method first proposed by Pedroni (2001), we have conducted separate time series analysis regression for six Asian countries in our sample, which are South Korea, Malaysia, Thailand, India, Philippines and Vietnam Our estimation results show that: (1) financial system does affect economic growth, at least for five of our sample countries; and (2) there exists diversity in countries’ suitability to certain types of financial system South Korea and Malaysia fits a bank-based financial system, Vietnam favors a market-oriented system and Thailand benefits simply from an expansion of financial services’ quality and quantity Our results also show that in the long term, to unlock Vietnam’s dormant economic potentials, more liberating financial reforms should be taken The set of rules applied to the financial system in Vietnam should also be updated to conform to new boundaries of activity allowed of the financial institutions References Arestis, P., Demetriades, P O., & Luintel, K B (2001) Financial development and economic growth: The role of stock markets Journal of Money, Credit and Banking, 33(1), 16-41 Atje, R., & Jovanovic, B (1993) Stock markets and development European Economic Review, 37(2-3), 632-640 Beck, T., & Levine, R (2002) Industry growth and capital allocation: Does having a market- or bank-based system matter? Journal of Financial Economics, 64(2), 147-180 Bencivenga, V R., & Smith, B D (1991) Financial intermediation and endogenous growth The Review of Economic Studies, 58(2), 195-209 Bhide, A (1993) The hidden costs of stock market liquidity Journal of Financial Economics, 34(1), 31-51 Boot, A W A., & Thakor, A V (1997) Financial system architecture The Review of Financial Studies, 10(3), 693-733 Boyd, J H., & Prescott, E C (1986) Financial intermediary-coalitions Journal of Economic Theory, 38(2), 211-232 Boyd, J H., & Smith, B D (1998) The evolution of debt and equity markets in economic development Economic Theory, 12(3), 519-560 Policies and Sustainable Economic Development | 127 Calderón, C., & Liu, L (2003) The direction of causality between financial development and economic growth Journal of Development Economics, 72(1), 321-334 Choe, C., & Moosa, I A (1999) Financial system and economic growth: The Korean experience World Development, 27(6), 1069-1082 Christopoulos, D K., & Tsionas, E G (2004) Financial development and economic growth: Evidence from panel unit root and cointegration tests Journal of Development Economics, 73(1), 55-74 Demetriades, P O., & Hussein, K A (1996) Does financial development cause economic growth? Time-series evidence from 16 countries Journal of Development Economics, 51(2), 387-411 Diamond, D W (1984) Financial intermediation and delegated monitoring The Review of Economic Studies, 51(3), 393-414 Dickey, D A., & Fuller, W A (1979) Distribution of the estimators for autoregressive time series with a unit root Journal of the American Statistical Association, 74(366), 427431 Duisenberg, W F (2001) The role of financial markets for economic growth Retrieved from https://www.ecb.europa.eu/press/key/date/2001/html/sp010531.en.html Gerschenkron, A (1962) Economic backwardness in historical perspective: A book of essays London: Harvard University Press Holmstrom, B., & Tirole, J (1993) Market liquidity and performance monitoring Journal of Political Economy, 101(4), 678-709 Jansen, M C., & Murphy, K J (1990) Performance pay and top-management incentives Journal of Political Economy, 98(2), 225-264 Levine, R (1997) Financial development and economic growth: Views and agenda Journal of Economic Literature, 35, 688-726 Levine, R (2002) Bank-based or market-based financial systems: Which is better? Journal of Financial Intermediation, 11(4), 398-428 Levine, R., & Zervos, S (1996) Stock market development and long-run growth The World Bank Economic Review, 10(2), 323-339 Levine, R., & Zevros, S (1998) Stock markets, banks and economic growth The American Economic Review, 88(3), 537-558 Luintel, K B., & Khan, M (1999) A quantitative reassessment of the finance-growth nexus: Evidence from a multivariate VAR Journal of Development Economics, 60(2), 381-405 Luintel, K B., Khan, M., Arestis, P., & Theodoridis, K (2007) Financial structure and economic growth Journal of Development Economic, 86(1), 181-200 Pedroni, P (2001) Purchasing power parity tests in cointegrated panels The Review of Economics and Statistics, 83(4), 727-731 Rajan, R G., & Zingales, L (1998) Financial dependence and growth The American Economic Review, 88(3), 559-586 Stiglitz, J (1985) Credit markets and the control of capital Journal of Money, Credit and Banking, 17(2), 133-152 Stulz, R M (2002) Financial structure, corporate finance, and economic growth In A Demirguc-Kunt & R Levine (Eds.), Financial structure and economic growth: Crosscountry comparisons of banks, markets and development (pp 143-188) MIT Press, Cambridge, MA Wenger, E., Kaserer, C (1998) The German system of corporate governance: A model which should not be imitated In S W Black & M Moersch (Eds.), Competition and convergence in financial markets: The German and Anglo-American models (pp 4047) North Holland, New York 128 | Policies and Sustainable Economic Development World Bank (2001) Finance for growth: Policy choices in a volatile world A World Bank Policy Research Report Washington, DC: The World Bank  ... Credit and Banking, 17(2), 133-152 Stulz, R M (2002) Financial structure, corporate finance, and economic growth In A Demirguc-Kunt & R Levine (Eds.), Financial structure and economic growth: ... of causality between financial development and economic growth Journal of Development Economics, 72(1), 321-334 Choe, C., & Moosa, I A (1999) Financial system and economic growth: The Korean experience... of Jansen and Murphy (1990); Holstrom and Tirole (1993); Boot and Thakor (1997); Levine (1997); Boyd and Smith (1998); Wenger and Kaserer (1998) instead favors a large and efficient financial