Financial Development and Economic Growth - Coursework Example

A review of empirical literatures on the relation of financial development and economic growth Introduction: The relation between financial growth and economic development is a much debated issue within the realm of economics. From the end of the 19th century to the end of 20th century many economists devoted their time and effort to provide satisfactory theoretical and empirical explanation on this issue, but at the end both theoretical propositions and empirical findings failed to reach a common consensus. On one hand economists like Bagehot (1873), Schumpeter (1912), Hicks (1969) and Grossman and Miller (1988) spoke highly about the positive role of financial development to the economic growth and on the other Robinson (1952) and Lucas (1988) opined that financial development at most might qualify as a supplementary condition to economic growth and at times extremely over emphasized. Again, MacKinnon (1973) and Shaw (1973) provide theories on how distortion in financial market hinders growth. The present paper choses to conduct a comprehensive study of empirical literatures on financial development and economic growth nexus related with China; relates the findings with the present theories on the same domain and thereafter moves to reach a conclusion. Literature review and theoretical link ups: Shan and Morris (2002) used panel data for 19 OECD countries along with China over the period 1985 to 1998 to test the association between financial development and growth through a VAR model. The empirical result obtained this way depicts weak association between financial development and economic growth and cast doubts on the much celebrated association between the two. The results obtained this way is in tune with the theoretical proposition of Robinson (1952) and Lucas (1988) who have mentioned that financial development can at most be a supplementary condition to economic growth and not the propelling factor for the same. Liang (2005) has developed a theoretical model at first referring that financial intermediaries can affect economic growth. Then the author has empirically tested the model using panel data for 29 Chinese provinces over the period 1990 to 2001 through applying GMM techniques of panel data analysis. The result obtained this way refers to the fact that financial development together with government deregulation in financial sector have contributed significantly and positively to Chinese economic growth. Regarding the theoretical support; the empirical results are in tune with theoretical propositions of Bagehot (1873), Schumpeter (1912), Hicks (1969) and Grossman and Miller (1988) regarding the relation between financial development and economic growth and refutes the proposition of Robinson (1952) and Lucas (1988) regarding the same. Liang and Teng (2006) have examined the relation between economic growth and financial development for China over the time frame 1952 to 2001. They have considered data on variables relevant to their research for China from 1952 to 1995 and ran a vector auto regressive (VAR) analysis to judge the long run relationship between economic growth and financial development for China. The empirical results found this way points to the fact that there is a unidirectional causality between economic growth and financial development and financial development is less likely a major factor to economic growth. Their findings confirms Robinson’s (1952) proposition that financial development initially follows economic growth and the propelling factors of growth lies somewhere else. Moreover the findings of the article is also in tune with the proposition of Robinson (1952) and Lucas (1988) that financial development is of little importance as far as economic growth is concerned and reacts passively to economic growth. Lu et al. (2007) have considered annual data for China over the period 1952 to 2005 and used co-integration and Granger causality test in a Vector Auto regression frame work to test the relationship between financial development and capital accumulation as well as productivity. The empirical results thus obtained states that the relation between financial development and productivity is statistically weak. On the other hand there exists either bidirectional Granger causality between financial development and capital accumulation or granger causality from capital accumulation to financial development. Overall it is confirmed that financial development boosts economic growth through facilitating capital accumulation. The result confirms the theoretical proposition of Bagehot (1873), Schumpeter (1912), Hicks (1969) and Grossman and Miller (1988) and refutes the same of Robinson (1952) and Lucas (1988) regarding the relation between financial development and economic growth. Guariglia and Poncet (2008) have used data for thirty Chinese provinces on relevant variables to analyse the relationship between finance and real GDP, capital as well as factor productivity growth. Their regression results have found that relation between traditional financial development indicators and China specific indicators of financial development measuring state intervention in finance are actually negatively associated with economic growth. This again implies that distortion in financial market leads to negative economic growth. MacKinnon (1973) and Shaw (1973) have opined that government intervention in financial development would impose negative impact on economic growth of the concerned country and findings of Guariglia and Poncet (2008) acknowledges the same. However, the market driven indicators of financial development are positively associated with economic growth. At the end the authors have extended an explanation to the China paradox regarding financial development and economic growth. The authors have opined that surge of FDI is actually lessening the negative impact ofdistortion in financial market in China and helping the country to realise high rate of growth over time. This has turned financial distortion and thereby financial development not a significant hurdle to China’s phenomenal economic growth rate.This finding is in tune with theoretical proposition of Robinson (1952) and Lucas (1988) who have mentioned of passive or no relation between financial development and economic growth. Hasan et al. (2009) have considered panel data for the thirty one Chinese provinces from 1986 to 2002 to consider the impact of legal bodies, financial deepening and political pluralism on economic growth rate. The authors have applied generalized method of moment procedure for panel data analysis. The two indicators used to depict financial development namely ratio of bank loan to GDP and capital market activity to GDP displays opposing results. The impact of the first ratio on growth of GDP is negative and the impact of the second is positive. Since during the time frame of the study the Chinese banks were mostly under government supervision; extending loan to the inefficient state owned enterprises resulting in bad loans; hence this is quite expected. On the other hand the capital market was more indulged with the efficient private sector, so contributing favourably to economic growth. It is apparent from the findings of the authors that financial deepening if market led then only promotes economic growth and government intervention creates distortion in financial market and becomes a hindrance to economic growth. The findings of the concerned study confirms the theoretical proposition of MacKinnon (1973) and Shaw (1973) who have opined that government led financial development eventually becomes a hindrance to economic growth. Moreover the stress from the Chinese government to ensure finance to the state owned enterprise to boost up economic growth has failed and that again refers to the theoretical proposition of Lucas (1988) that finance is overemphasized as far as ensuring economic growth is concerned. Lu and Yao (2009) consider data for twenty nine Chinese provinces over the period 1991 to 2001 to run a regression analysis and show that in an economy suffering from financial repression, enhancing the law alone would not ensure financial development and would have a substantial negative impact on economic growth through lessening the share of private investment in total investment of the economy. This happens as strengthening the law eventually hinders the reallocation of financial resources from inefficient public sector to the efficient private sector. This finding for China is in confirmation to MacKinnon (1973) and Shaw (1973) theories of financial repression that have referred that financial repression is an ambience characterized by specific set of policies, laws, formal and informal regulations and controls imposed on the financial sector by the government. Since the financial sector in its repressed state is already under flawed but stringent laws hence strengthening the same would actually aggravate the situation instead of addressing the problem and would eventually impact economic growth in a negative way. Cheng and Degryse (2010) have considered panel data for twenty seven Chinese provinces over the period 1995 to 2003 to visualize the impact of banks and non-banks on economic growth of the concerned country. The authors have considered correlations and GMM estimators to analyse the stated impact. The findings of the article displays that the developments of the banks and non-banks have statistically significant positive economic impact on economic growth. The findings of the paper support the theoretical proposition of Bagehot (1873), Schumpeter (1912), Hicks (1969) and Grossman and Miller (1988) that financial development is immensely important to economic growth in a positive sense. Jalil et al. (2010) considered annual time series data from 1977 to 2006 and performed a principal component analysis (PCA) to combine three indicators of financial development and used the composite indicator obtained this way in autoregressive distributed lag bound testing (ARDL) approach to co-integration analysis in order to explore the finance-growth relation with respect to China. The findings point out to the fact that financial development in China indeed fosters growth. The empirical findings of the paper regarding financial development and economic growth relation thus support the theoretical proposition of Bagehot (1873), Schumpeter (1912), Hicks (1969) and Grossman and Miller (1988) that financial development significantly and positively influences the economic growth of a country. Chang et al. (2010) have considered panel data of bank loans and deposits at branch level for thirty one provinces of China over the time period 1991 to 2005 and ran a regression analysis to display the relation between financial development and economic growth. The result obtained from the data analysis points to the fact that at least for China economic growth leads to financial development, not the other way around. There is no statistically significant positive impact of loan extended by the banks on the economic growth of China. Considering the empirical findings of the paper it might be stated that for ChinaBagehot (1873), Schumpeter (1912), Hicks (1969) and Grossman and Miller (1988) theories on financial development-economic growth nexus that opine significant positive impact of financial development on economic growth prove wrong and Robinson’s (1952) and Lucas’s (1988) theory on the same that regards financial development as a result of growth than causehold true. He (2012) has considered data on relevant variables for 27 provinces over the period of 1978 to 1998 and ran successive regressions to confer that financial reform; mostly financial deregulation through financial development contributes positively and significantly to economic growth. To be precise the findings of the paper suggests that financial reforms through reallocation of credit from inefficient to efficient sectors rather than change in savings and investment rate promotes economic growth for China. The empirical results of the paper confirms the theoretical propositions of Bagehot (1873), Schumpeter (1912), Hicks (1969) and Grossman and Miller (1988) regarding the relation between financial development and economic growth and refutes Robinson (1952) and Lucas (1988) theories on the same. Zhang et al. (2012) have considered panel data for 286 Chinese cities over the period 2001 to 2006 to initially run an ordinary regression analysis followed by first differenced and system GMM estimations in order to determine the financial development-economic growth nexus for China. The time frame has been carefully chosen to witness the mentioned relation during China’s accession to WTO. The result obtained through the concerned empirical analysis confirms that financial development has a strong positive and significant impact on economic growth as far as China is concerned. The empirical findings of the paper are in tune with the theoretical proposition of Bagehot (1873), Schumpeter (1912), Hicks (1969) and Grossman and Miller (1988) regarding the relation between financial development and economic growth and refute the theories of Robinson (1952) and Lucas (1988) regarding the same. Wang and You (2012) have considered data for 12400 firms from 30 Chinese provinces to analyse the relation between corruption and firm growth. Though the prime objective of the paper is something else than exploring the relation between financial development and economic growth. But the empirical analysis of the data considered in the paper through using ordinary least square and two steps least square provides interesting results regarding financial development and economic growth. The authors state after their analysis that financial development and corruption are substitutes; either a firm grows through corruption or financial development. However, this is more prominent in countries with less developed financial sector. As the financial sector develops firms tend to grow more with financial development in places where there are less corruption. The empirical findings of the concerned paper are in tune with the theoretical proposition of Bagehot (1873), Schumpeter (1912), Hicks (1969) and Grossman and Miller (1988) who have highlighted the significant positive correlation between financial development and economic growth and refutes the theoretical proposition of Robinson (1952) and Lucas (1988) who have opined that financial development is a secondary factor in economic growth. Shahbaz et al. (2013) have considered data for China over the time frame 1971 to 2011 and applied ARDL bounds testing for co-integration analysis to check along other relations; the relation between financial development and growth. The empirical result obtained that way confirms that there exists significant positive impact of financial development on economic growth. These findings by the authors confirms he theoretical propositions of Bagehot (1873), Schumpeter (1912), Hicks (1969) and Grossman and Miller (1988) regarding the relation between financial development and economic growth and refuse that of Robinson (1952) and Lucas (1988). Compare and Contrast: All the literatures considered above can be divided into two broad categories. One category is stating that for China; financial development and economic growth are significantly and positively correlated and financial development promotes economic growth. The other category is stating that financial development and economic growth either has no relation or at most weakly associated that turn financial development just another factor to economic growth along with other more important factors. On one hand, Shan and Morris (2002), Liang and Teng (2006), Guariglia and Poncet (2008), Hasan et al. (2009), Chang et al. (2010) all has empirically proven that considering the financial development and economic growth relation the theoretical propositions of Robinson (1952) and Lucas (1988) that opines; there is no or weak relation between financial development and economic growth holds for China. On the other Liang (2005), Lu et al (2007), Jalil et al. (2010), and Cheng and Degryse (2010), He (2012), Wang and You (2012), Zhang et al. (2012), Shahbaz et al. (2013), all have empirically proven that the relation between financial development and economic growth is positive and significant with financial development as cause and economic growth as effect. All these findings are in tune with the theoretical propositions of Bagehot (1873), Schumpeter (1912), Hicks (1969) and Grossman and Miller (1988) that opines there is strong and positive economic relation between financial development and economic growth. Conclusion: It is obvious from the literature review conducted so far that a common consensus regarding the relation between financial development and economic growth is not only theoretically but even empirically almost impossible to reach. The same is true for China. However, the frequency of articles favouring theories proposing positive and statistically significant relation of financial development is little higher. Another important aspect is that in recent studies the positive and significant association between financial development and economic growth is reflecting more than the opposite theoretical opinion. It seems that after China’s accession to WTO and gradual development of the financial system over the years; financial development is influencing the economic growth significantly and positively to a greater magnitude. It might be the case that in earlier stages of financial development the relation between financial development and economic growth was not that transparent but with time it has become more and more prominent. Guariglia and Poncet (2008) have found that FDI is combating the financial distortion that is present in China. Question might be raised that whether inflow of FDI is more prone to economies with developed financial system. It is obvious that foreign institutional entrepreneurs would also like to safe guard their investment that is only possible in an economy with developed financial system or at least with a promise towards a developed financial system. If this is true then FDI inflow is an indirect result of developed financial system and the positive impact of FDI on Chinese economic growth might be considered as an indirect positive and significant impact of financial development on economic growth of the concerned country. Financial development takes time to get absorbed into the system and therefore its impact is often lagged and felt only in long run; it is expected that over the time the positive impact of financial development on economic growth of China would be felt at a higher magnitude and would reflect through data analysis in an unambiguous way. References: Bagehot, W.(1873), Lombard Street, Homewood, IL: Richard D. Irwin, 1962 edition Chang, P.C., Jia, C. and Z. Wang (2010), Bank fund reallocation and economic growth, Journal of Banking & Finance, Vol. 34, 2753-66 Cheng, X. and H. Dengryse (2010) The Impact of Bank and Non Bank Financial Institutions on Local Economic Growth in China, J. Finance Serv Res, Vol. 37, 179-199 Hicks, J. (1969), A theory of economic history, Oxford: Clarendon Press Grossman, S. J. and Miller, M. H. “Liquidity and Market Structure,” J. Finance, July 1988, 43(3), pp. 617–33. Guariglia, A. and Poncet, S. (2008), Could financial distortions be no impediment to economic growth after all? Evidence from China, Journal of Comparative Economics 36, 633-657 He, Q. (2012), Financial Deregulation, credit allocation across sectors, and economic growth, Journal of Economic Police Reform, Vol. 15, No. 4, 281-199 Hasan, I. Wachtel, P. and M. Zhou (2007), Institutional development, Financial deepening and economic growth, Journal of Banking & Finance, Vol. 33, 157-170 Jalil, A. Feridun, M. and Y. Ma (2010) Finance-growth nexus in China revisited, International Review of Economics and Finance, Vol. 19, 189-95 Liang, Q. and J.Z. Teng, (2006), Financial Development and Economic Growth, China Econ Review Vol. 17, 395-411 Liang, Z. 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Morris (2010), Does Financial Development ‘Lead’ Economic Growth?, International Review of Applied Economics, Vol. 16, No. 2, 153-68 Shahbaz, M. Khan, S. and M.I. Tahir (2013), The dynamic links between energy consumption, economic growth, financial development and trade in China, Energy Economics, Vol. 40, 8-21 Schumpeter, J. A. (1912). The theory of economic development. Cambridge, MA7 HarvardUniv. Press. Wang, Y. and J. You (2012), Corruption and firm growth, China Economic Review, Vol. 23, 415-433 Zhang, J. Wang, L. and S. Wang (2012), Financial development and economic growth, Journal of Comparative Economics, Vol. 40, 393-412 Read More