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Law Siong Hook Universiti Putra Malaysia

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1 Law Siong Hook Universiti Putra Malaysia
Finance and Economic Growth: Cross-country and time series evidence & the role of banks and stock markets ECN4141 Financial Economics Law Siong Hook Universiti Putra Malaysia Copyright Law 2006

2 Financial Development & Growth: theory
In Traditional Models (McKinnon/Shaw): financial liberalization => financial deepening (or saving) investment and output (development) In New Growth Theory: financial intermediation increases productivity of capital and long-run growth some government interventions in the financial system reduce growth Copyright Law 2006

3 This lecture 1. How finance will affect growth?
2. Examines the empirical evidence on the relationship between finance and growth Cross-country studies Time series evidence The role of banks and stock markets

4 The role of Finance in Influencing Growth
Pagano (1990) demonstrate that financial development can affect growth through: Private saving rate Proportion of savings channeled to productive investment Marginal productivity of capital

5 The role of Finance in Influencing Growth…
Greenwood and Jovanovic (1990), financial development Can select to allocate funds to the most promising firms and mangers Can produce a more efficient allocation of capital and faster growth Can stimulate the rate of technological innovation by providing loans to entrepreneurs

6 The empirics of finance & growth
Broad consensus in literature: there is a strong & robust positive association link between financial development, measured by a range of indicators, and economic growth, or the level of economic development Some authors argue that the link is causal: More finance => more growth It is, however, possible that the positive association reflects reverse causality more growth => more finance Copyright Law 2006

7 Potential Causal Effects
1. Finance-led growth Also known as ‘supply-lending” hypothesis (Patrick, 1966) Increases the supply of financial services leading to real economic growth In early stages of economic development

8 Potential Causal Effects….
2. Growth-driven finance Also known as ‘demand following’ hypothesis (Patrick, 1966) Demands on financial products and services by the economic agents are highly dependent on the growth of real output, commercialisation, and modenisation of agriculture and other subsistence sectors Higher the growth, the greater the demand on financial resources by entrepreneurs in making their investment

9 Potential Causal Effects….
3. Bi-directional causal relationship Combination of the supply-leading and demand-following hypotheses Two variables are link together via feedback A country with well-developed financial system could promote a high economic expansion through technological changes, product and services innovation (Schumpeter, 1934) This in turn will create high demand on the financial arrangements and services (Robinson, 1952)

10 Potential Causal Effects….
4. Interdependence between Finance and growth Stern (1989) completely ignored the role of financial development in the economic growth process Lucas (1988) argues that financial economists emphasise the role played by the financial markets

11 The causality issue Economists use the notion of ‘Granger causality’
If variable X helps to predict the future time path of variable Y, X is said to Granger-cause Y Not the same as true causality A variable Z may be the true cause of both X and Y, but X responds first Does it matter? Not really, as finance is at best a facilitator of economic growth, the true cause must be sought in the real sector (new ideas and technological innovations etc) Granger causality is a minimal test of a well-functioning financial system Copyright Law 2006

12 Reverse (Granger) causality
Normally, we would expect to see a feedback relationship between finance and growth: finance <=> growth Reverse causality (growth just => finance) may reflect Funds diverted to non-productive activities because of microeconomic inefficiencies or political interference in the financial system (e.g. building WMD) International character of financial system More innocuous (e.g. UK or US) Copyright Law 2006

13 Cross-Country Growth Regressions
King and Levine estimate the following equation using data for 77 countries during : gi = a + b FDi + cZi + ui where gi is the growth rate of country i, FDi is an indicator of financial development Zi is a vector of other possible determinants of economic growth (initial income, education, inflation, openness to trade, political uncertainty etc) a, b and c are parameters and u is an error term They find that the estimate of b is positive and highly significant statistically and suggests very large effects Copyright Law 2006

14 Financial Development & Per Capita Income: 1981-2000
Copyright Law 2006

15 Problems with cross-country regressions
Difficult to establish Granger causality using cross sectional data King and Levine use the initial (1960) level of financial development in an attempt to address causality; however, Granger causality requires a time-series approach Cross-country regressions results are also sensitive to outliers (one country can drive the results) Sensitive to changing the control variables Difficult to interpret, as they relate to average effects across countries Copyright Law 2006

16 Causality in time series studies
Demetriades and Hussein (JDE, 1996) argue that cross-country correlations only provide broad-brush conclusions using time-series methods for 16 LDC’s, they find: positive long run relationship between banking sector development and output BUT causality varies substantially across countries in six LDC’s (El Salvador, Greece, Pakistan, Portugal, South Africa and Turkey) financial development follows economic growth, but not vice-versa Other studies report similar (or more disturbing) results Arestis and Demetriades (1997), De Gregorio and Guidotti (1995) Copyright Law 2006

17 Regions of financial development
A recent study by Rioja and Valev (2003, JDE) suggests 3 different regions of financial development: FD Finance=>growth Low not significant Medium High High Low Interesting but further work needed to understand the differences Copyright Law 2006

18 Financial Development Indicators
1. Banking sector development Liquid liability (M3/GDP) also known as broad money, or M3 Private sector credit financial resources provided to the private sector Domestic credit includes all credit to various sectors on a gross basis (private and government)

19 Financial Development Indicators….
2. Stock Market Development Stock market capitalization the share price times the number of shares outstanding Number of companies listed/Population domestically incorporated companies listed on the country's stock exchanges at the end of the year Total share value traded

20 Malaysia: Banking Sector Development and Real GDP Per Capita

21 Malaysia: Stock Market Development and Real GDP Per Capita

22 Role of Stock Markets Most studies on finance-growth have ignored stock markets, focusing on banking indicators of financial development Stock markets have witnessed enormous growth in the last years (especially in emerging countries) Boost from financial liberalization (high interest rates, unrestricted capital flows) Efficient stock markets can promote growth: Improve allocation of resources & facilitate corporate control Inadequately regulated stock markets may be the source of distortions and fragility, such as bubbles (Singh, 1997) Copyright Law 2006

23 Stock markets and the allocation of capital
Two mechanisms: Direct: the price of shares acts as a signal conveying information about the expected profitability of firms Directly affects the flow of finance to firms and sectors Indirect: Stock markets are markets for corporate control Takeovers and mergers affect the ownership and control of corporations which affects the efficiency of resources The first function, even though relates to the price of ‘second-hand’ securities, it also determines the price at which new securities can be issued, hence it determines the cost of capital for firms. The second mechanism is especially true in Anglo-Saxon stock markets, such as those of the US and the UK, where takeovers and mergers are frequent. In Germany, Japan and France such activity is much less frequent. Copyright Law 2006

24 How well do stock markets allocate capital?
Depends on how well ‘organised’ they are and how ‘efficient’ they are ‘Organised’: means there is a set of rules to prevent fraud and to ensure a level-playing field for all participants To ensure corporations produce audited accounts and records and make all relevant information publicly available To governs access to the exchange by new companies (usually good past record) Stock exchanges are not good sources of finance for newly established firms that have high but risky prospects. Such companies opt for second-tier markets (such as venture capital board or unlisted companies markets) or find intermediaries in the form of venture capital firms. Copyright Law 2006

25 Stock markets, banks and growth
Stock markets may promote growth by Promoting specialization (allowing diversification), encouraging acquisition and dissemination of information Reducing the cost of mobilizing savings Enhancing corporate control and improving efficiency Stock markets and banks are substitutes as sources of corporate finance Some authors, including Stiglitz, argue that banks are better able to address problems of corporate control than stock markets If stock markets develop at the expense of banks investment and growth may suffer

26 Capital-market based vs ‘bank-based’ systems
Capital market based systems: Banks have arms length relationships with the companies they lend to and do not own equity in companies Stock markets exercise corporate control (frequent takeovers and mergers) Examples: UK and US ‘Bank-based’ systems: Banks have close relationships with their borrowers (sit on board, proxy rights) Stock market relatively unimportant Typical examples: Japan and Germany

27 Relative merits of two systems
Bank based Addresses agency problems well by opening information channels between firms and banks Effective corporate control exercised by banks Encourages long-term horizons Capital-market based Limits the power of banks Encourages entry and innovation Avoids ‘cronyism’ and corruption May result in ‘short-termism’ Encourages speculation and volatility

28 Stock Markets & Growth: Cross-Country Evidence
Levine and Zervos (1998) utilising cross-country growth regressions find that stock markets have large effects on growth Causality issue difficult to interpret Results sensitive to the outliers: exclusion of East Asian tigers renders them insignificant (Zhu, Ash and Pollin, 2002) Copyright Law 2006

29 Stock Markets and Growth: Time Series Evidence
Arestis, Demetriades and Luintel (JMCB, 2001) examine the relationship between finance and growth in UK, US, Germany, Japan and France. They find: In Germany, Japan and France, both banking sector and stock market development have a long-run causal effect on real GDP per capita; banks have a much larger effect In the UK there is a weak causal link from financial development to real GDP per capita In the US there is no statistically significant causality from financial development to real GDP per capita The UK and US finding to some extent may reflect international character of those financial systems. However, it may indicate that bank-based financial systems are better able to promote economic growth than capital-market-based ones Copyright Law 2006

30 Banks, Stock Markets and Growth
Beck and Levine (2002) find that: the results do not support either the market or bank based views their results are supportive of the financial services (both banks and stock markets are important) and the legal based views (legal code and protect outside investors)

31 Banks, Stock Markets and Growth…
Beck and Levine (2004) find that stock markets and banks positively influence economic growth Kassimatis and Spyrou (2001) find that stock markets have a role to cause economic growth only in relatively liberalized countries; does not effect growth in financially repressed countries, and negative relationship in the nature of the stock market has been speculative.

32 Finance and Growth: Summary of the Evidence
A positive long-run association between indicators of financial development and growth (or level of GDP per capita). Less sure about causality Normally expect to see bi-directional causality Reverse causality may indicate weaknesses in financial system Irrespective of causality, well functioning financial systems can help to promote growth Conclusion: Better, if not more, finance is likely to result in more growth Copyright Law 2006

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