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MODELLING THE RELATIVE EFFECTS OF FINANCIAL SECTOR FUNCTIONS ON ECONOMIC GROWTH IN A DEVELOPING COUNTRY CONTEXT USING COINTEGRATION AND ERROR CORRECTION.

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Presentation on theme: "MODELLING THE RELATIVE EFFECTS OF FINANCIAL SECTOR FUNCTIONS ON ECONOMIC GROWTH IN A DEVELOPING COUNTRY CONTEXT USING COINTEGRATION AND ERROR CORRECTION."— Presentation transcript:

1 MODELLING THE RELATIVE EFFECTS OF FINANCIAL SECTOR FUNCTIONS ON ECONOMIC GROWTH IN A DEVELOPING COUNTRY CONTEXT USING COINTEGRATION AND ERROR CORRECTION METHODS PAPER PRESENTED AT THE FRANCIS CONFERENCE September 28 – 30, 2007 DAVID TENNANT, CLAREMONT KIRTON & ABDULLAHI ADBULKADRI DEPARTMENT OF ECONOMICS, UWI, MONA

2 OVERVIEW OF PRESENTATION: Background and Objectives Proxies of Financial Sector Functions Control Variables Methods Results and Findings Conclusions

3 BACKGROUND and OBJECTIVES The Monterrey Consensus (2002) notes that many developing countries increasingly depend on local funds to finance their development needs. Financial institutions can facilitate economic growth by mobilizing savings, allocating these savings to the most productive investments, and by facilitating the smooth flow of trade needed in a market-driven economy. Theoretical models supporting this view have been developed by many economists.

4 BACKGROUND and OBJECTIVES Cont’d Many of the empirical studies of the finance-growth relationship use broad proxies of financial sector development. It would however be very useful to determine which of the distinct functions of the financial sector have the greatest impact on economic growth. Holden and Prokopenko (2001), Levine and Zervos (1998), and De Gregorio and Guidotti (1995) all cite difficulties involved in developing proxies to accurately and comprehensively capture the many different functions performed by the financial sector.

5 BACKGROUND and OBJECTIVES Cont’d Levine’s (1997) five basic functions of the financial sector are used as the basis of this study. The Jamaican case study is used. In the post-liberalization phase of the evolution of the Jamaican financial sector, the country experienced a financial crisis, and a government-led restructuring and subsequent divestment of the sector. Important conclusions are presented regarding the relative importance of financial sector functions to the creation of economic growth, and the impact of financial crises on the economy.

6 PROXIES of FINANCIAL SECTOR FUNCTIONS: Savings Mobilization SMOB = Deposits / (Total Assets – Loans) A positive relationship between SMOB and economic growth is therefore expected. Risk Diversification The measure of risk diversification used (DRISK) focuses on the degree of diversification by sector.

7 PROXIES of FINANCIAL SECTOR FUNCTIONS: DRISK for each type of financial institution is calculated by first finding the percentage of total loans allocated by sector. The standard deviation of the percentage of total loans allocated to each sector is then used to measure the spread for each institution from the state of uniform distribution. A measure of the degree of diversification for the entire financial sector is calculated using a weighted average. A negative relationship between DRISK and economic growth is expected.

8 PROXIES of FINANCIAL SECTOR FUNCTIONS: Resource Allocation RESAL = credit to private sector production / total loans. It is expected that RESAL will have a positive relationship with economic growth. Corporate Control The proxy used for corporate control (CORPC) assumes that as connected party loans and/or connected party financial investments increase, then the ability of financial institutions to exert corporate control decreases.

9 PROXIES of FINANCIAL SECTOR FUNCTIONS: CORPC = connected party loans and financial investments / total loans and financial investments. CORPC is expected to have a negative relationship with economic growth. Ease of Trading Using the approach of Levine and Zervos (1998), ETRAD = value of shares traded / current GDP. Levine (1991) initially argued that a positive relationship with economic growth should be expected, he later notes the argument that very liquid markets encourage investor myopia, thus actually hurting economic growth (Levine 1996).

10 CONTROL VARIABLES A measure of trade openness (TRADE) was included, and calculated as the sum of the country’s imports and exports divided by current GDP. Exchange rate volatility (XRATEVOL) for each quarter is calculated as the standard deviation of the percentage change in the US$ real exchange rate for the four preceding quarters. Two dummy variables were used to account for structural changes affecting the Jamaican financial sector – liberalization and crisis.

11 METHODS Data Quarterly time series from Due to missing data most estimations limited to Augmented Dickey-Fuller test used to determine stationarity Cointegration Analysis Used to determine long-run relationships among data series Two specifications were considered: (1) using individual proxies (2) with interaction terms

12 METHODS Model (1): Model (2):

13 METHODS Error Correction Model Used to examine short-run dynamics Enables us to determine short-run adjustments to long-run equilibrium

14 RESULTS Stationarity LnGDP I(2), LnETRAD and LnTRADE I(0), all others I(1) Johansen Cointegration test indicated nine possible cointegrating relationships for Model (1) and six for Model (2) Selection of reported equation was based on conformity with theory

15 Table 1 – Estimates of Initial Model Cointegrating Equation with lnGDP as Dependent Variable Variable NameCoefficientt-Statistic CONSTANT-6.972* lnSMOB1.206*4.691 lnRESAL-1.870* lnCORPC lnDRISK-1.507* lnETRAD-0.145* CRISIS lnTRADE lnXRATEVOL0.286*8.085 * indicates significance at 1% level

16 Table 2 – Estimates of Alternative Model Cointegrating Equation with lnGDP as Dependent Variable * indicates significance at 1% level Variable NameCoefficientt-Statistic CONSTANT-6.441* lnCORPC-0.222* lnRESAL1.342* lnSMOB*lnRESAL1.232*9.985 lnSMOB*lnDRISK-0.785* lnSMOB*lnETRAD-0.361* CRISIS0.797* lnTRADE1.110* lnXRATEVOL-0.117*

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18 FINDINGS Model (2) outperforms Model (1) Has more significant variables and conforms better with theoretical expectations Establishes long-run relationship between GDP and dependent variables. ECM indicates No short-run relationship between GDP growth and dependent variables The speed of adjustment is ~35% CRISIS has a negative, though, insignificant effect on GDP growth, compared with positive and significant effect in the long-run

19 CONCLUSIONS Sophisticated proxies of financial sector function have been developed Based on Favara (2003) ensure accuracy and conformity to theory Savings mobilization is an essential factor through which other proxies impact economic growth Resource allocation Ease of trading Risk diversification

20 CONCLUSIONS Financial sector reform should: Focus on savings mobilization and the efficient allocation of mobilized savings Emphasize removal of government distortions in financial markets Not be expected to yield immediate results


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