Can the Finance-Growth-Nexus Bridge the Link between Financial Integration and Economic Growth?

by Andreas Grün (Author) Thomas Lange (Author)

Seminar Paper 2008 37 Pages

Business economics - Investment and Finance


Table of Contents

List of Tables and Figures

1 Introduction

2 Links between Financial Integration and Growth - Literature Review
2.1 The Direct Channel - Financial Integration, FDI and Economic Growth
2.2 The Indirect Channel - Financial Sector Development and Economic Growth
2.3 The Issue of Reverse Causality

3 How does Growth Depend on Intra-Country Financial Development?
3.1 Links between Financial Sector Development and Economic Growth
3.2 Strings of Causality
3.3 Research Methods Econometric Procedures

4 Own empirical findings
4.1 Data sources
4.2 Descriptive Analysis
4.3 Causality Check
4.4 Panel Analysis

5 Conclusion

6 References

7 Appendices

List of Tables and Figures


A1: Included countries in econometric sample

A2: Results of Dickey fuller test

A3: Correlogram Financial Development Indicators and Growth

A4: Regression analysis of GDP per Capita Growth on Fin. Development Variables

A6: Results of Granger Causality test, Germany and Global

A7: Results of Granger Causality test, Australia and Japan

A8: The Hausman test

A9: Benchmark equation without any specific explanatory variables

A10: Equation Specification that includes both variables for financial development

A11: Optimal equation, optimized according to Akaike/Schwarz criteria


A0: Main Framework

A5: Residuals of simple regressions

A12: Check of Results

1 Introduction

Mankiw (1995) ascertains that the large differences in national incomes between the world’s richest and the world’s poorest countries lead to corresponding divergences in the quality of life in the respective countries. So it is a well justified goal to find ways to increase the GDP per capita especially for poor countries. This can be done by finding and applying those mechanisms that stimulate GDP per capita growth. One possible lever to increase GDP per capita is financial integration. Investigating this hypothesis could provide important insights in answering questions such as “Can developing countries benefit from financial integration?” Levine (2005) adds that research clarifying the role of finance in economic growth will lead to concrete policy implications and also shape further policy-oriented research. More information that supports the impact of finance on economic growth will certainly have a strong influence on the priority that advisors and policy markers attribute to reforms of financial sector policies. Hence a convincing proof that the state of the financial system influences the long-run growth of an economy would promote the important need for additional research on the legal, political and regulatory determinants of financial development.

This paper intends to make a humble contribution to this research and is structured as follows: In chapter 2 we first introduce a framework that breaks down the overall topic into linked subcomponents. In sub-chapters 2.1 and 2.2 an overview over the literature that investigates the transmission-mechanisms (2.1: direct channel; 2.2 indirect channels) is given. Sub-chapter 2.3 focuses on the question of causality.

In chapter 3 we analyze in more detail the core of the link between financial integration and economic growth, which is the relationship between financial sector development and economic growth. The question of how these two characteristics are in fact associated with each other is a very important sub-question in the process of answering the question whether financial integration can stimulate economic growth. However, it also attracts scientific interest on its own and is often investigated under the expression “growth nexus”. Sub- chapter 3.1 asks whether there is actually a link between financial development and growth. Sub-chapter 3.2 further investigates this research which intends to understand the economic intuition behind the link while sub-chapter 3.3 analyzes three benchmark studies that set the stage for our own empirical research in chapter 4. Here the growth nexus is analyzed. We notice a definite association between financial sector development and growth (4.1) and even causality in some, however not all cases (4.2). Furthermore the panel analysis of 21 OCEDcountries (4.3) shows that the relationship under scrutiny has actual economic relevance. Chapter 5 concludes.

2 Links between Financial Integration and Growth - Literature Review

In order to structure the analysis the subsequent framework is used. It is based on the framework of Rogoff et al. (2006) but it has in our view two significant advantages: It permits to more specifically address the question of causality and it gives a more detailed overview of the various indirect channels which can even be linked, as the arrows between the various indirect channels easily show.

A0: Framework Financial Integration - Transmission Channels - Growth

Abbildung in dieser Leseprobe nicht enthalten

The framework consists of three major pillars: Financial Integration (at the top), Economic Growth (at the bottom) and an intermediary, gray-shaded area that links Financial Integration and Economic Growth via direct and indirect transmission channels (in between the two other parts). Central to the understanding of the overall topic is the analysis of how financial integration e.g. in form of capital account and financial market liberalization directly impacts economic growth (direct channel) and how it indirectly impacts growth via financial sector-, legal- and institutional development (indirect channel). In this context the financial sector development is above all determined by the degree of development of the capital market and the banking sector. The direct channel can be seen in the gray-shaded area on the left hand side denoted as (2.1) whereas the indirect channel is represented by the larger area in the center and on the right marked as (2.2).

2.1 The Direct Channel - Financial Integration, FDI and Economic Growth

In the neoclassical framework the key benefit of financial globalization arises from long-term net flows of capital from industrial to developing economies as e.g. described by Rogoff et al.

(2006). As industrial countries can be characterized by being endowed with high amounts of capital per capita and developing countries by low capital per worker ratios, liberalization generates welfare gains for both country groups. For example, limited domestic savings in relatively poor economies are enhanced by foreign capital i.e. so-called FDI (Foreign Direct Investment). Thus the cost of capital is decreased and additional investments are boosted. This more efficient international allocation of capital together with capital deepening and international risk-sharing are the channels of the traditional view in which financial integration directly impacts economic growth. This traditional view is opposed to more recent approaches that also take indirect effects into account (as described in detail in sub-section 2.2).

Mankiw (1995) juxtaposes two different explanation approaches for the direct channel: First the neoclassical growth model and second the endogenous growth approach. An excellent discussion of both models can be found in Frenkel and Hemmer (1999). The neoclassical growth model emphasizes the significance of capital accumulation over time and is e.g. discussed by Birchenall (2007) as well as Hakenes and Irmen (2007). Capital is traditionally defined as tangible capital such as the economy’s stock of equipment and structures. The return to this capital is the profit that is received by those in possession of the structures and equipment.

However, over the last decade a newer and broader definition of capital has been created that also incorporates human capital in form of e.g. schooling and on-the-job training (e.g. Bils and Klenow (2000)). While the neoclassical model implies that growth ultimately approaches the exogenous rate of technological process and thus explains international differences in growth rates, it does not succeed in explaining the persistence of economic growth. Therefore more recent models have been developed that are independent of the assumption of exogenous advances in technology and hence have been named endogenous growth models. These models are e.g. discussed by Farmer and Lahiri (2005), Greiner (2008), Lau (2008) and Sequeira (2008). In the neoclassical model savings lead to temporary growth but ultimately the economy approaches a state in which growth is independent of the saving rate. In contrast to that in the world of endogenous growth models savings lead to persistent growth.

With regards to the question if financial integration is directly beneficial for a ]country in terms of increased economic growth rates, existing research can be divided into two contrary positions. On one hand e.g. Rodrik (1998) and Stiglitz (2002) perceive increased capital account liberalization as a threat for global financial stability and demand capital controls and other instruments like the “Tobin Tax”. On the other hand e.g. Fischer (1998) and Quinn (1997) argue that capital account and financial market openness are vital if countries want to develop from lower- to middle-income status and moreover enhance the stability among industrialized countries. Moreover a large variety of papers e.g. Lensink and Morrisey (2002), Bonfiglioli and Mendicino (2004) find mixed results and thus does not arrive at precise policy recommendations.

To a certain degree financial integration apparently offers promising but also controversial growth opportunities for countries. These seem advantageous such as those emanating from trade liberalization. However, in this field there is much less dispute but rather a broad consensus that trade liberalization is beneficial with respect to economic growth as can be exemplified by Sachs and Warner (1995) and Dollar and Kraay (2001).

2.2 The Indirect Channel - Financial Sector Development and Economic Growth

Apart from the already described direct growth effects there is the potential of certain collateral benefits of financial integration which can possibly (i) promote the development of the domestic financial sector (especially in hindsight with the capital market and the banking sector), (ii) improve the legal environment (both public and corporate governance) and (iii) augment the quality of institutions such as macroeconomic policy or domestic firms. All these three major aspects (i-iii) are directly visible in the centre of the framework and will now be scrutinized in more detail. Due to the fact that existing research in this area is vast and very diverse we will refer only to the main papers in each area. Each of these sub-analyzes is split into two parts: First we will investigate the link between financial integration and the resulting improvement of the intermediary component. Then we analyze the link between the respective component and economic growth:

(i) Financial sector development

The framework suggests that financial integration could lead to general development in the financial sector. This is supported for example by Bailliu (2000) and Klein and Olivei (2006) who state that financially integrated economies have a better degree of development of the domestic financial sector in contrast to countries that continue to have capital account restrictions.

Capital market development: With respect to capital or equity market development the framework leaves space for assuming that increased financial integration improves efficiency. For example by scrutinizing emerging markets Levine and Zervos (1998a) arrive at the result that stock markets become more liquid and larger after financial market liberalization. This is supported by Levine (2001) who also adds that this increased stock market liquidity in turn boosts economic growth by promoting productivity growth and increasing the efficiency of capital allocation. This is, for example, due to the fact that investors in more liquid stock markets have greater incentives to use their money in order to research firms as found by Boot and Thakor (1997). Furthermore better developed stock markets make takeovers easier as Stein (1988) points out and facilitate to tighten the link between managerial payment schemes and actual performance as analyzed by Jensen and Murphy (1990). The link between stock market development and economic growth is supported by a broad range of literature e.g. based on firm-level analysis such as Demirgüc-Kunt and Maksimovic (1998) or based on time-series findings such as Rousseau and Wachtel (1998).

Banking sector development: Levine (1997) and Mishkin (2006) find that foreign ownership of banks can have several benefits: First the access to international financial markets is facilitated. Second it can improve the supervisory and regulatory frameworks of the banking industry. Third it can increase the quality of loans as governmental influence on the financial sector is in general reduced in more open economies. Fourth, foreign banks can introduce new technologies and financial instruments boosting competition and financial services quality. In addition to that increased presence of foreign banks raises competition in general and can thus evoke a decline in both bank overhead costs and profits as e.g. pointed out by Errunza (2001) and Claessens and Laeven (2004). Similar to the previous findings concerning stock market development, better developed banks in turn promote economic growth by boosting total factor productivity growth as pointed out, for example, by Levine (2001). Hence, if financial integration improves the domestic banking sector this can also lead to higher growth. Diverse academic research has focused on this link between the development of the banking sector and long-run economic growth such as studies focusing on the industry-level (Rajan and Zingales, 1998), country-case studies (Haber, 1991), time-series studies (Rousseau and Wachtel, 1998) and others. The exact functioning of the banking sector development channel is analyzed in more detail in chapter 3.

(ii) Legal development

Financial integration could possibly improve the quality of both public and corporate governance and thus boost economic growth.

Corporate Governance: Foreign investors can have knowledge and technologies that allow better monitoring of management than domestic investors are capable of doing. Furthermore the market for corporate control is transformed as managers are monitored in more detail by domestic shareholders as well as new potential shareholders from outside. Thus there is an incentive to improve corporate governance. These issues are for example discussed by Stulz (2005). In addition to that Doidge et al. (2004) argue that financial integration can lead to greater investment in corporate governance as the costs of such investments are reduced. Public Governance: The performance of public governance can be measured by the degree of corruption, the transparency of governmental policies and other indicators. Concerning the first aspect Wei (2000) finds that insufficient public governance measured by corruption reduces the inward flow of foreign direct investments. Looking at the other point, Gelos and Wei (2005) measure poor governance by a lack of governmental transparency and state that this bad public governance discourages inflows of foreign capital. These are examples where the causality flows from the intermediary component to financial integration. If a country thus wishes to financially integrate it has to improve its public governance.

Both good public and corporate governance promote economic growth. For example Hines (1995) shows that good public governance in terms of low corruption increases the inflow of FDI into a country lowering the cost of capital and stimulating investments that increase growth. Further Gelos and Wei (2005) measure governance quality by the degree of governmental and corporate transparency and find that countries with higher quality of governance are capable of attracting more foreign equity investment. Moreover the link between governance and growth is ascertained by Aidt et al. (2008) and Bekaert et al. (2005) that state that “countries with better legal systems […] and investor protection generate larger growth effects”. As seen, good public and corporate governance promote domestic economic growth. On the contrary the same is true for bad governance that damages growth opportunities: Collier et al. (2001) run a regression on 43 countries and find that worsening governance leads to capital flight out of the country.

(iii) Institutional development

Macroeconomic policy: Financial integration may increase the discipline of macroeconomic policies as weak policies are punished more severely and good policy decisions are rewarded more strongly as e.g. pointed out by Rogoff et al. (2006). Costs of bad decisions in form of financial crises become higher (country is more vulnerable to sudden shifts in capital streams) while growth opportunities are greater if a country has greater access to foreign capital. Concerning the beneficial effect on macroeconomic policy there is not much dispute in the academic research so that even authors that are very skeptical with regards to financial integration such as Stiglitz (2000) ascertain that this point is an important benefit.

Quality of domestic companies: We assume companies to be institutions. Financial integration can possibly make domestic firms more efficient due to increased foreign competition. This competition forces domestic companies to use their existing resources in a more efficient manner. Additionally, FDI can cause productivity spillovers from foreign firms to domestic firms especially in the same sector for example by the adoption of new production methods. This has been e.g. analyzed by Keller and Yeaple (2003) or Blalock and Gertler (2005).

Higher quality institutions e.g. in terms of better macroeconomic policy and more efficient domestic firms have a positive influence on economic growth as e.g. Klein (2005) finds a strong correlation between institutional quality and income per capita. In other words poorer countries tend to have lower quality institutions. This is also supported by the findings of Alfaro et al. (2006) and Bekaert et al. (2005) who point out that “the largest growth response [to financial liberalization] occurs in countries with high-quality institutions”. Thus an increase in the quality of institutions (including also the previously mentioned governance aspects) promotes growth by enabling the country to benefit from financial integration. This can be explained as follows: According to Rogoff et al. (2006), financial integrations bears - on one hand - the potential to promote collateral benefits that stimulate long-run growth and avoid financial crises as shown by Ishii et al. (2002). On the other hand, if a certain minimum level of development in terms of e.g. institutional quality, financial sector supervision, governance or macroeconomic policies is not yet established, the realization of the collateral benefits can be delayed and the country becomes more vulnerable to international financial crisis as e.g. stated by Aghion and Banerjee (2005). What is additionally important in this context is to ascertain that the named factors are in general only influenceable over a relatively long time horizon whereas it is probably very difficult to observe change in these fields in the short-run.

2.3 The Issue of Reverse Causality

The discussion of causality in the wake of the framework discussion is a crucial one. Typically the assumed direction of impact runs first from financial integration to economic growth, second from financial integration to the development of the legal environment, the financial sector and institutions and third from these three to economic growth. However it is also conceivable that there are - at least partly - reverse causalities in the opposite direction. The possibility of reverse causality is represented by the two-way arrows in the framework. Also concerning this question different studies arrive at different results: Acaravci, Ozturk and Acaravci (2007) find a strict “one-way causal relationship running from financial development to the economic growth” for the case of Turkey. The same is true for Chang and Caudill (2005) and Taiwan as they find a “unidirectional causality running from financial development (measured as the ratio of M2 to GDP) to economic growth. Others like Kemal et al. (2007) and Dawson (2003) don’t find a connection at all and state that like the latter that “financial development […] has an insignificant effect on economic growth: economic growth [in transition economies] is not constrained by underdeveloped financial sectors.” Güryay et al. (2007) also come to the result that financial development does not cause economic growth but on the other hand find evidence that there is a “causality running from economic growth to the development of financial intermediaries”. Furthermore Shan and Qi (2006) find in their study of China that “financial development and economic growth exhibit a two-way causality” in contrast to all authors mentioned before.

To sum it up reverse causalities may exist but evidence on this issue varies from study to study and may critically depend on the respective overall context.

3 How does Growth Depend on Intra-Country Financial Development?

The main focus of this paper is on the link between intra-country financial development and economic growth. The following analysis will elaborate on this in further detail. This choice of focus is made as financial globalization, as Rogoff et al. (2006) put it, provides rather “a catalytic role in generating an array of collateral benefits that may help boost long- run growth” instead of directly influencing the growth of the economy via capital accumulation. Thus the debate whether capital accumulation that is fostered via foreign capital inflows may actual stimulate growth can best be resolved by gaining a sound understanding of those indirect channels via which, according to Levine (2001) “international financial integration can influence long-run economic growth”. We decide to give a detailed analysis of the channel “financial development” and thus exclude other indirect channels such as the “legal environment” or “institutional quality” that could also be influenced by enhanced financial integration (see Rogoff et al., 2006 for a detailed overview or, of course, chapter 2 of this paper). One important supporter of the hypothesis of the existence of a link between growth and the financial sector is the World Bank (1989, p.11). It reports that “the success [of adapting to the shocks of the 1970s and 1980s among others] has more to do with…prudent fiscal and external borrowing policies…than with internationally competitive trade policies.” Even stronger (World Bank, 1989, p 31): “Financial liberalization matters for economic growth.” If even highly regarded institutions such as the World Bank are convinced of the existence of a link between financial development and growth it deserves further investigation. So the main question of the subsequent analysis is as follows: How and to which degree does financial development cause economic growth?

3.1 Links between Financial Sector Development and Economic Growth

While the above-stated world-bank statement is not utterly new, the occupation of the science community with this topic goes indeed back much further (for example Schumpeter, 1911). Patrick (1966) systematizes the various effects that the development of the financial sector may have on economic growth by dividing the overall effect into a “demand-following” (a) and a “supply-leading” (b) phenomenon.

According to the demand-following thesis (a) the fact that financial institutions do not yet exist implies that there is only a very low demand for their services. It means that the financial sector will eventually and gradually develop just to that degree that allows it to satisfy a growing demand. This demand-following hypothesis is supported, for example, by Greenwood and Jovanovic (1990) and Blackburn and Hung (1998). If it holds true most of the fascination of the topic will inevitably vanish as then in the words of Robinson (1952) “financial development simply follows economic growth” and it would be legitimate to look upon the relationship between financial and economic development as “overstressed” (Lucas, 1988).

The supply-leading hypothesis (b) argues that the development of the financial-sector is a prerequisite for persistent economic growth. This supply-leading point of view on the other side is backed up by findings, among others, of McKinnon (1973), Shaw (1973) and King and Levine (1993) but also Schumpeter (1934), who claims that banks provide entrepreneurs with the necessary funding that is needed to pursue innovative endeavors against all resistance. Thus there are in fact two opposite ways of looking upon the relationship between growth and financial sector development which brings up the question of causality. Both ways of looking upon the fact are supported by empirical findings and the question which hypothesis will proof to be ultimately correct has not yet been resolved.

Besides pondering the effects of financial-development on growth it is also important to understand how financial-development is actually measured. Tang (2006) explains that the development of the stock-market is mainly measured by the indicators of stock market turnover and the number of domestic companies while the banking-sector development is measured by the amount of available bank credit. The empirical studies themselves adopt, according to Shan and Qi (2006) in general two different methodologies: they either follow a cross-sectional modeling approach or they use time-series modeling to test their hypothesis.



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Otto Beisheim School of Management Vallendar
Financial integration economic growth international finance finance growth nexus


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    Andreas Grün (Author)

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    Thomas Lange (Author)


Title: Can the Finance-Growth-Nexus Bridge the Link between Financial Integration and Economic Growth?