Journal of Financial Economic Policy

Trade Openness, Financial Development Index and Economic Growth: Evidence from
India (1971-2012)
Dogga Satyanarayana Murthy Suresh Kumar Patra Amaresh Samantaraya
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Dogga Satyanarayana Murthy Suresh Kumar Patra Amaresh Samantaraya , (2014),"Trade Openness,
Financial Development Index and Economic Growth", Journal of Financial Economic Policy, Vol. 6 Iss 4 pp.
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JFEP
6,4
Trade Openness, Financial
Development Index and
Economic Growth
362 Evidence from India (1971-2012)
Dogga Satyanarayana Murthy, Suresh Kumar Patra and
Amaresh Samantaraya
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Department of Economics, Pondicherry University, Puducherry, India

Abstract
Purpose The purpose of this article is to examine the inter-relationship and direction of causality
among three macroeconomic variables such as trade liberalization, financial development and economic
growth.
Design/methodology/approach The empirical analysis is based on the principal component
analysis as method to construct financial development index (FDI), augmented DickeyFuller and
PhillipsPerron tests as the unit root test, Johansens co-integration test and VECM for direction of
causality in the long run among TOP, FDI and economic growth.
Findings The empirical results confirmed that there exists a long-run association among trade
openness, financial development and economic growth. This study has also found that there is
bidirectional causality between financial development and growth. However, the causality runs from
growth to finance is stronger than that from finance to growth. This study also observed unidirectional
causality that runs from financial development and economic growth to trade openness.
Research limitations/implications The policy implications that could be drawn from the present
study is that, initiation of financial reforms to improve the size of financial system would lead to higher
economic growth. Another key implication from this study is that because trade openness has no effect
on both domestic financial sector development and output growth, it would be better to deploy the
resources into creating a sustained domestic demand rather than concentrating more on the external
front in general and trade openness in particular.
Originality/value The study constructs a summary IFD for India by taking into account four broad
financial development indicators for the period 1971-2012. The present paper also suggests that it
would be better to deploy the resources to create a sustained domestic demand rather than
concentrating more on the external front in general and trade openness in particular.
Keywords Trade openness, Financial development index, Economic growth, VECM
Paper type Research paper

Journal of Financial Economic Policy
Vol. 6 No. 4, 2014
pp. 362-375
Emerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-10-2013-0056
1. Introduction
The relationship between trade openness, financial development and economic growth
has been widely discussed and debated in both the theoretical and empirical literature.
It is argued that trade openness and financial development policies positively influence
gross domestic product growth by reducing the distortion in the production process
(Atif et al., 2010). It is also widely evident from the fact that countries with high degree of
JEL classification F13, G21, O1, B23
 trade openness and well-developed financial system have been registering higher GDP Trade Openess,
growth as compared to the countries with low-financial sector development and restrictive
trade policies. Opening up of an economy for the cross border flows of goods and services
FDI and
creates high competitive environment, which will drive down the revenue of existing firms Economic
and diminish their profits, requiring them to search for external sources of finance Growth
(Quy-Toan and Levchenko, 2004). These sources of finance will be available only if the
financial system is able to solve the problem of asymmetric information and other 363
market imperfections in the present financial system. As a result, present firms and their
rich, elite owners will now have incentives to support the compulsory institutional
reforms to make the financial system efficient and well-functioning. The resulting
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reforms, in turn, will extend the size of the financial system and thereby foster economic
growth. Thus, free trade can be an important ingredient that stimulates economic
growth through domestic financial sector development. However, recent global
financial crisis that cropped up in July 2007 in the USA and later enveloped the entire
world has again re-opened the debate over open economy policy, as it resulted in
macroeconomic instability of the national economies and also put entire world economy
in trouble with falling outputs and rising unemployment levels across the world.
Similarly, the role of financial sector development in economic growth is the long-run
debated issues among economists (Schumpeter, 1911; Patrick, 1966; Goldsmith, 1969:
McKinnon, 1973; Shaw, 1973). With the unleashing of endogenous growth theory,
several studies have been attempted to know how the development of financial markets
and institutions may affect economic growth (Greenwood and Jovanovic, 1990;
Bencivenga and Smith, 1991; King and Levine, 1993; Arestis, 2005; Shahbaz et al., 2013).
Finance can affect growth in an endogenous growth model by allowing higher returns
on investment (Greenwood and Jovanovic, 1990), through increasing the rate of savings
(Bencivenga and Smith, 1991) and by rising human capital accumulation. It implies that
from the macroeconomic point of view, well-developed financial markets and
institutions of a country will able to convert a given amount of inputs, k, into larger
amount of output, Y. This is because the production function is a rising function of the
financial development of the economy (Roubini and Sala-I Martin, 1992).
The important question that rambles in the mind of many researchers whether there
exists any inter-relationships among trade openness, financial development and
economic growth. Hence, an attempt has been undertaken to know the inter-relation
between the above three variables in India for the period from 1970-1971 to 2011-2012.
India, like many developing countries, in 1991, as a part of the structural adjustment and
macroeconomics stabilization programmes, introduced various macroeconomic, trade
and financial sector reforms to promote economic growth. Thus, liberal financial policy
regime has been replaced in place of an old controlled regime. This resulted in
tremendous improvement in the financial system in terms of total financial assets, bank
credit to private sector as percentage of GDP, increase in the quality of bank assets, etc.
In 1991, financial assets as percentage of GDP were 17.61 per cent and it increased to
116.93 in 2011. Similarly, trade reforms in the form of removal of license-permit raj,
abolition of quantitative restrictions and reducing import tariff resulted in significant
rise in Indian foreign trade. In 1991, Indias foreign trade as percentage of GDP has been
increased from 6.72 per cent in 1991 to 73.14 per cent in 2011. The average growth rate
during this period (i.e. from 1991-2011) was 6.7 per cent.
 JFEP The present study constructs a summary index of financial development (IFD) by
applying principal component analysis (PCA) and uses co-integration test for long-run
6,4 association and vector error correction mechanism (VECM)-based Granger causality
approach to know the causality between trade liberalization, financial development and
economic growth. Thus, the major advantages of the presents study are constructing a
broad measure for assessing financial development in India by taking into account a
364 large set of variables, which together represent the development of financial system in
terms of its size, activity and using appropriate econometric tools while taking into
account non-stationarity of the time series data to examine the causal link between trade
openness, financial development and economic growth. Our results confirm the long-run
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association between these three macroeconomic variables in India. In addition to this,

our results based on Granger causality approach used in VECM framework strongly
support the old Schumpeter (1911) and Patricks (1966)[1] finance-led growth hypothesis
in the long run.
The rest of the paper is as follows. Section 2 describes theoretical and conceptual
framework of the study. Section 3 outlines the data and methodology. The empirical
results are reported in Section 4. The last section concludes.

2.Theoretical underpinning
2.1 Trade openness economic growth
The concept of absolute and comparative cost advantage theories emphasized that like
inter-regional trade, the international trade is also beneficial for the trading countries
because each country will specialize in the production of particular commodities but not
in the all commodities, and also countries differ in the resource endowments. Therefore,
when a country enters into trade with other country, it can export those commodities in
which its production cost is less, and can import those commodities in which its
production cost is high. This results in greater output and consumer welfare in both the
trading countries, which in turn, will lead to higher employment and hence economic
growth.
Thus, the classical economists were in favour of free trade policy, as they assumed
that free trade among different nations maximizes the output and employment of all the
participating countries (Salvatore, 2010). Edwards (1998) noted that countries that are
more open to the rest of the world are better placed in capturing the advanced
technologies of leading nations. If the costs of technological imitation are less than the
costs of domestic-developed innovations, then a poorer country will grow faster than a
high developed one. This faster rate of growth will continue as long as that country
remains opened to attract new ideas until, at some point, equilibrium is reached and the
rate of growth slows down.
However, economists like Prebish, Singer, Myint and Miyrdal argues that free trade
between developed and developing countries shifts the gains from developing to
developed nation because developing countries are largely dependent on the production
of primary goods, whereas the developed nations mostly hinge upon manufacturing
products. The demand and prices of the primary goods will often deteriorate as
compared to manufacturing product. Therefore, free trade leads to secular deterioration
in the terms of trade of developing countries.
 2.2 Trade openness financial development Trade Openess,
There are significant differences in financial sector development across countries and even
within the country over a period. This is mainly because financial development is also
FDI and
influenced by other factors like legal system in the country (Shleifer and Vishny, 1998), trade Economic
and financial openness (Rajan and Zingales, 2003). It is argued that the trade openness Growth
affects financial development because free trade will result in uncertainty and income
inconsistency of agents, which in turn raises the demand for insurance and other financial 365
services and thereby increases the size of the financial system (Newbery and Stiglitz, 1984).
Furthermore, free trade among different nations generally will increase the demand for
external finance, as they produce more financial-dependent goods. Thus, free trade increases
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the demand for external finance and thereby size and quality of the financial system.
However, Quy-Toan and Levchenko (2004) noted that if there is free trade between
rich and poor countries, in rich countries, more trade would be associated with faster
financial development as they are specialized in financial-dependent good. Whereas
more trade lead to deterioration in the size of the financial system in poor countries, as
they import financial-dependent goods rather than produce them domestically. While,
Rajan and Zingales (2003) postulate that trade openness is linked with financial market
development, especially when cross-border capital flows are free, and that changes in
openness are associated with changes in the size of financial markets.
Further, free trade helps to develop the domestic financial markets and then the
economic growth. Because free trade expands the size of the market for domestic goods,
which in turn encourages the domestic production and thus production of more goods
and services, more capital is required. Therefore, allowing foreign capital into domestic
financial markets by financial openness increases the availability of funds, which in
turn lowers the cost of borrowing and thereby increases the investment and economic
growth (Peter, 2003). Thus, trade openness and financial openness are not substitute
rather they are complementary to each other as their co existence will result in domestic
financial sector development and hence higher economic growth. Similarly, Rajan and
Zingales (2003) hypothesis also suggest that simultaneous openness of both trade and
capital flows are preconditions for financial development.

2.3 Financial development economic growth

Financial development affects economic growth mainly by increasing the marginal
productivity of capital through transferring funds from relatively less to relatively more
productive uses and also through increasing the rate of saving (Bencivenga and Smith,
1991). Financial institutions increase the rate of saving by pooling small savings from
different segments across country and making them into a huge amount of loans for
productive uses. Similarly, financial system can increase the marginal productivity of
capital because they are more efficient and experts in the collection and evaluation of
information on the different alternative investment projects and they can also reduce risk to
individual to undertake riskier and more productive investment by directing funds to
relative liquidity and higher-yield assets (Pagano, 1993). Thus, financial development first
increases the rate of saving and then to increase the marginal productivity of capital,
financial institutions transferring these funds to productive uses and thereby output growth.
Similarly, economic growth also encourages the development of financial markets and
institutions by creating demand for different types of financial services (Robinson, 1952;
Patrick, 1966). As economy grows, it creates additional demand for financial services, which
 JFEP bring about a supply response in the growth of the financial system. Similarly, as economy
grows, there will be a greater variance in the growth rates among different sectors in the
6,4 economy and thereby an increase in the demand for financial intermediation to transfer
funds from slow-growth sectors to fast-growing sector. Thus, financial development and
economic growth influences each other. More specifically, in initial stage of development
growth follows finance and in advance stage, finance follow economic growth (Patrick,
366 1966).

3. Data and methodology

This section reports the data and methods used to examine the causal link between
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financial development, economic growth and trade openness, and it also summarizes
various indicators used in the present study for assessing financial sector development.

3.1 Data and methods used

To construct a summary IFD for India, present study takes into account various
financial development indicators such as the ratio of broad money (M3) to narrow
money (M1), which is used as a proxy financial innovation ratio (FIR), money supply as
percentage of GDP (M3) and the ratio of banking credit to private sector to GDP.
Similarly, as an indicator for economic activity, the study used GDP at factor cost at
constant prices (2004-2005 100) and the amount of total trade i.e. sum of exports and
imports as percentage of GDP used as proxy of trade openness (TOP). The annual time
series data on the above variables has been collected from the Reserve Bank of India
handbook of statistics, 2012-2013.
The empirical analysis mainly consists of three parts:
(1) construction of financial development index (FDI) by using PCA;
(2) subsequently using this index, estimating Johansens co-integration test to
analyse the long-run association between real GDP growth, financial
development (IFD) and trade openness (TOP); and
(3) we proceed for causality test based on VECM framework.

3.2 Principal component analysis

The present study used PCA for construction of a summary IFD. The PCA is a
multivariate technique used to transform the original data consisting of a set of
variables into a linear combination of a small set of variables known as principal
components (PCs) so that the bulk of the variation in the original data is explained.
These PCs are new entities and they are extracted from the original data set of variables
after taking into account the correlation matrix. Among extracted PCs, the first PC
would be best component as it explains greater variance than the rest of the PCs.
Linear combinations of each components factor loading can be expressed as follows:

PCk 1k 1 2k 2 ......... nk n (1)

Where,
PCk is the kth PC.
X1, X2 [], Xn are the variables used in the PCA.
1k, 2k, [] nk are factor loadings of respective Xi in kth PC.
 The number of PCs extracted should be less than or equal to the number of variables Trade Openess,
used in the analysis.
FDI and
3.3 Unit root test Economic
We used the augmented DickeyFuller (ADF) test as test of unit root which is based on Growth
the assumption of serially correlated error terms. The ADF test consists of estimating
the following regression: 367
Yt t t1 1t1 ........ p1tp1 t (2)
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Where t is serially correlated.

The PhillipsPerron (1988) test is mostly used to examine time series whose
differences may have mixed autoregressivemoving average (p, q) processes of
unknown order in that the test statistic includes a nonparametric allowance for
heteroscedasticity and serial correlation in testing the regression. It involves estimating
the following equation:

t 0 1t1 2 ( t T/2 ) vt (3)

Where T indicates the number of observations and t represents the error term. There
will be no unit root if 11 0, as in the ADF test, and thus we can test the stationarity
of a variable without the trend by dropping the trend term.

3.4 Co-integration test

To evaluate the long-run relationship between real GDP growth (LGDP), financial
development (LIFD) and trade openness (LTOP), we have used the maximum likelihood
test procedure recognized by Johansen and Juselious (1990) and Johansen (1991).
Especially, the VAR (vector autoregression) with m-lag and Gaussian error can take the
following form (if Xt is a vector of n stochastic variables):

Xt 1 Xt1 m1 Xtm1 Xt1 t (4)

Where 1, p1 and are coefficient matrices, t is a vector of white noise process and
contains all deterministic elements.
Determination of the rank (r) of Matrix is the central point of conducting
co-integration procedure developed by Johansen. There are mainly three feasible
outcomes in the present application. Firstly, it can be of full rank (r n) (which would
imply that the variables are stationary processes), which contradicts the previous
finding of non-stationarity. Secondly, the rank of can be zero (r 0), which represents
no long-run relationship among the variables. It will be suitable to estimate the model in
either first differences or levels, when is of either zero rank or full rank, respectively.
Finally, when there is at most r co-integrating vectors 0 r n (i.e. reduced rank), it
suggests that there are (n r) common stochastic trends. On the basis of Akaike
information criterion (AIC), the lag in the VAR is chosen. Johansens co-integration
procedure deals with two likelihood ratio test statistics such as trace test and the
maximum eigenvalue (-max) test. But, in our study, we have taken into account the
trace test to determine which of the three as stated above is supported by the data.
 JFEP 3.5 Granger causality
If GDP growth (LGDP) has a long-run relationship with money financial development
6,4 (IFD) and trade openness (LTOP), the further step is to investigate the causal
relationship among these variables because if two or more variables are co-integrated,
there must exist causality in at least one direction (Engel and Granger, 1987). We,
therefore, move further to determine whether real GDP will Granger-cause financial
368 development and trade openness and vice-versa, using VECM which is given in the
following as form:
pi p1
zt t zt1 t yti x
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t ti t (5)
i1 i1

Where, is the first-difference operator. The long-run multiplier matrix as:

YY YX
XY XX
As the diagonal elements of the above matrix are unrestricted, the selected series can
follow either I(1) or I(0). If YY 0, then Y is I(0). On the contrary, if YY 0 then Y is I(1).
The VECM procedures described above are imperative in the testing of at most one
co-integrating vector between dependent variable yt and a set of explanatory
variables xt.
Hence, the VEC model is as follows:

LGDPt g(LGDPt1 a0 a1LTOPt1 a2LIFD) 11 (i)LGDPti

(6)
12 (i)LIFDti 13 (i)LTOPti gt

LIFDt m(LGDPt1 a0 a1LTOPt1 a2LIFD) (i)LGDPti

21
(7)
(i)LIFDti
22 (i)LTOPti mt
23

LTOPt P(LGDPt1 a0 a1LTOPt1 a2LIFD) 31 (i)LGDPti

(8)
32 32(i)LIFDti 33(i)LTOPti PT

The above system is a three variables VAR model augmented by et1. If s are zero, then
it is a simple VAR model and there is no co-integration. Hence, co-integration and error
correction are equivalent representation (Granger representation theorem).
In the view of Engle and Granger (1987), if there exists co-integration between two
variables, then a conventional causality test commonly known as error correction model
should be applied. The VECM specification restricts the long-run behaviour of the
endogenous variables to converge to their co-integrating relationships while allowing a
wide range of short-run dynamics (Granger causality). As the deviation from long-run
equilibrium is rectified gradually through a series of partial short-run adjustments,
co-integrating term is otherwise known as the error correction term.
 4. Report on empirical results Trade Openess,
In this section, we have reported results on construction of a summary IFD for India by
using PCA followed by empirical results for co-integration and causality tests.
FDI and
Economic
4.1 Constructing FDI Growth
In PCA, loadings or scores reflecting how each of the indicators included in each of the
index contributes to the PC were computed. The factor loadings from the best PC, which 369
explain more than 95 per cent of the total variance, are used for construction of the final
index.
Prior to using PCA, we test for factorability of the data used in the study. Bartletts
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test of sphericity and KaiserMeyerOlkin measure of sampling adequacy (KMO)[2] are

carried out to test the suitability of the data for PCA. For KMO, a value of 0.6 is required
for good PCA. Our data clearly supports the use of PCA for construction of index as
Bartletts test is highly significant (p 0.00) and the value of KMO (i.e. 0.64) is greater
than 0.6 (see Table I).
The construction of FDI can be written in the following terms:

IFD 1 q1 FIR q2 M3 q3 PRVT (9)

Where, FIR, M3 and PRVT are variables used and q1, q2, q3 [] [] qi are the factor
loadings of corresponding variable in each PC. The loadings or scores for the various
PCs estimated for construction of IFD are presented in Table II.
Because our first PC (PC1) itself captures 96 per cent of the total variance[3], its values
are used as weights to construct a summary IFD in India as per the formula given below:

IFDt (0.573) FIRt (0.586) M3t (0.573) PRVTt

Where, the subscript t refers to the year from 1970-1971 to 2011-2012.

For example, IFD value for 1970-1971 is calculated by multiplying the factor loadings
as given in equation 10 with the respective values of FIR, M3 and PRVT for the year
1970-1971. Table III reports IFD values for the period 1971-1972 to 2011-2012.

K KMO and Bartletts test

KMO measure of sampling adequacy 0.64 Table I.

Bartletts test of sphericity 318.3 Results of Bartlett and
(p-value) (0.00) KMO test

Eigenvectors (PCk)
Variables PC1 PC2 PC3

FIR 0.573 0.699 0.427 Table II.

M3 0.586 0.015 0.810 Variables and its factor
PRVT 0.573 0.715 0.401 loadings in each principal
Eigen values (Ek) 2.886 0.099 0.015 component
 JFEP Year IFD Year IFD
6,4
1970-1971 20.53 2001-2002 55.99
1971-1972 21.92 2002-2003 61.24
1972-1973 23.13 2003-2004 61.95
1973-1974 22.72 2004-2005 65.16
1974-1975 22.27 2005-2006 69.84
370 1975-1976 24.29 2006-2007 73.67
1976-1977 27.10 2007-2008 77.60
1977-1978 28.24 2008-2009 80.14
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1978-1979 31.65 2009-2010 82.47

Table III. 1979-1980 34.54 2010-2011 83.06
Index of financial 1980-1981 33.81 2011-2012 84.11
development 1981-1982 33.92

Subsequently, using the above index, we estimated long-run association and causal link
between economic growth (GDP), financial development (IFD) and trade openness
(TOP)[4] by using Johansen co-integration test and the Granger causality test used in the
VECM framework. Results of co-integration and causality tests are discussed in
Table IV.
The first step in applying the co-integration technique is to determine the degree of
integration of each variable in model. The above table presents the ADF test as the test
of unit root. In Table IV, it is seen that all variables are found to be non-stationary in
levels but stationary in first difference with intercept at 1 per cent level of significance.
Hence, all the variables are integrated of order 1 [I (1)]. Therefore, we proceed to apply
co-integration tests between the variables such as LGDP, LIFD and LTOP to detect any
possible long run equilibrium between the series.
After confirming the degree of integration of each variable, we proceed to estimate
long-run association among variables. To explore this relationship, the study
determines the optimal lag length of the model by using the VAR test and Lag 2 is
indentified as the optimal lag based on the Schwarz information criterion and Hannan
Quinn information criterion. The result is presented in Table V.
From the above Table VI, it is concluded that the null hypothesis of no co-integration
is rejected at 1 per cent level as p-value is less than 5 per cent. But, the null of both at most
1 and at most 2 co-integration relationship among the variables cannot be rejected
because the trace statistics, i.e. 12.05 and 0.17, are less than the critical value, i.e. 15.49
and 3.84, respectively. Therefore, trace test indicates three co-integrating equations at

ADF test PhillipsPerron test

Variables Levels First Diff. Levels First Diff.

LGDP 0.096 (0.96) 4.52 (0.00)* 0.40 (0.98) 4.53 (0.00)*

LIFD 0.58 (0.86) 4.80 (0.00)* 0.60 (0.85) 4.86 (0.00)*
LTOP 0.41 (0.90) 5.13 (0.00)* 0.41 (0.89) 5.13 (0.00)*
Table IV.
Unit root test results Notes: p-values are in the parentheses; * denotes significance at 1 per cent level
 Lag Log L LR FPE AIC SC HQ
Trade Openess,
FDI and
0 3.192895 NA 0.000199 0.010716 0.121244 0.035341
1 202.2382 353.8583 5.17e-09 10.56879 10.04095 10.38456 Economic
2 227.7135 41.04363* 2.10e-09 11.48409 10.56037* 11.16168* Growth
3 237.4825 14.11078 2.07e-09* 11.52681* 10.20721 11.06623
4 244.8779 9.449587 2.40e-09 11.43766 9.722181 10.83891
5 249.1337 4.728665 3.44e-09 11.17409 9.062734 10.43717
371
Notes: * Indicates lag order selected by the criterion; LR: sequential modified LR test statistic (each
test at 5 per cent level); FPE: final prediction error; AIC: Akaike information criterion; SC: Schwarz Table V.
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information criterion; HQ: HannanQuinn information criterion VAR optimal lag selection

Johansen test statistics

Testing hypothesis Critical value Table VI.
H0 HA trace 5 (%) Probability Johansens maximum
likelihood estimates for
r0 r0 42.09 29.80 0.00 the long-run relationship
r1 r1 12.05 15.49 0.15 between LGDP, LIFD and
r2 r2 0.17 3.84 0.67 LTOP

the 1 per cent level. Hence, there exists long-run association among all the variables.
Now, we can go for Granger causality approach using VECM.
The short-run error correction term, D [LGDP (1)] shows the short-run adjustment
of GDP to its own deviation from long run. This is of the correct sign and statistically
significant, indicating that deviation from the long-run rate of GDP is corrected by 51
per cent in the next period. Similarly, D [LIFD (2)] shows the short-run adjustment of
financial development to its own deviation from long run. This is of the correct sign, i.e.
negative and statistically significant, indicating that deviation from the long-run rate of
financial development is corrected by 28 per cent in the next period. Moreover, a
significant error correction confirms the existence of a stable long-run relationship
between the dependent variable, i.e. GDP, and the significant regressor, i.e. financial
sector development index, whereas the trade openness is not found to have any
significant relationship with LIFD and LGDP, both in the short run and long run. Hence,
the negative and significant error correction term also reveals that in the long-run
causality runs from financial development to economic growth but not vice versa (see
Table VII).
Since, we found long-run relationship between financial development, trade
openness and economic growth, the study proceeds to examine the short-run causality
link between these three key macroeconomic variables by applying the VEC Granger
causality/block exogeneity Wald tests. From Table VIII, it is clear that there is
bidirectional causality between financial development and economic growth measured
in terms of nominal GDP. However, the causality running from economic growth to
financial sector development is stronger than that of running from financial sector
development to economic growth. Similarly, it is also found that there is unidirectional
causality between GDP and trade openness, trade openness and financial development,
 JFEP Error correction D(LGDP) D(LIFD) D(LTOP)
6,4
CointEq1 0.07 (2.32)** 0.01 (0.50) 0.33 (3.70)
D(LGDP(1)) 0.52 (3.50)* 0.89 (8.30) 0.74 (1.82)
D(LGDP(2)) 0.37 (1.30) 0.11 (0.51) 1.30 (1.65)
D(LIFD(1)) 0.20 (0.77) 0.17 (0.91) 1.50 (2.06)
D(LIFD(2)) 0.29 (2.15)** 0.10 (1.06) 0.41 (1.13)
372 D(LTOP(1)) 0.04 (0.77) 0.05 (1.11) 0.00 (0.03)
D(LTOP(2)) 0.00 (0.01) 0.08 (1.65) 0.26 (1.47)
C 0.13 (2.93) 0.12 (3.77) 0.24 (1.99)
Table VII.
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Vector error correction Notes: t-values in parenthesis. * Indicates significance at the 1 per cent level; ** 5 per cent level of
mechanism significance

Null hypothesis 2 p-value

D(LIFD) does not Granger-cause D(LGDP) 4.79*** 0.07

D(LTOP) does not Granger-cause D(LGDP) 0.60 0.73
D(LGDP) does not Granger-cause D(LIFD) 72.21* 0.00
D(LTOP) does not Granger-cause D(LIFD) 3.47 0.17
D(LGDP) does not Granger-cause D(LTOP) 8.34** 0.01
Table VIII. D(LIFD) does not Granger-cause D(LTOP) 5.47*** 0.06
VEC Granger causality/
block exogeneity Wald Notes: * 1 per cent level of significance; ** 5 per cent level of significance; *** 10 per cent level of
tests significance

which is running from economic growth and financial development to trade

liberalization.

5. Conclusion
This study empirically investigates the inter-relation between trade liberalization,
financial development and economic growth in India for the period 1970-2011. Firstly,
this study constructs a summary IFD by using PCA and subsequently using this index,
the long-run association and causal link between financial development, economic
growth and trade openness in India have been examined by using Johansens
co-integration test and VECM-based Granger causality approach, respectively.
The results obtained using Johansens co-integration test confirms the long-run
association between the above three variables in India. Further, the Granger causality
approach based on VECM confirms the unidirectional causality that is running from
financial development to economic growth in India. Similarly, VEC Granger causality or
block exogeneity Wald test used for short-run causality also provides evidence of
bidirectional causality between financial development and economic growth. However,
it is found that in India, the demand following concept of financial development or
growth-led financial development is found to be more robust compared to the
supply-leading concept of financial development during 1971-2011. This is because
financial development measured by three parameters such as FIR, money supply (M3)
ratio and ratio of banking credit to private sector to GDP is more sensitive to growth.
 Thus, the empirical finds of the present study clearly associates with the old Trade Openess,
Schumpeterian hypothesis (1911)[5] and Patricks (1966) supply-leading hypothesis of
financial development for India. The stylized empirical evidence for the steady state
FDI and
effects of financial development on economic growth suggests the need to continue Economic
economic reforms to further develop and strengthen the financial sector and supplement Growth
the efforts aimed at achieving the national objective of high and sustained economic
growth. 373
The empirical evidence of the study, on the other hand, also reveals that trade
openness has no effect on both financial development and economic growth, rather it is
observed that both financial development and economic growth significantly affects
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trade openness, and that financial development and economic growth are more sensitive
to each other. Hence, the policy implication that could be drawn from the above
conclusion is that because trade openness has no effect on both domestic financial sector
development and output growth, it would be better to deploy the resources into creating
a sustained domestic demand rather than concentrating more on the external front in
general and trade openness in particular.
Finally, the empirical evidence of the present study provides certain policy lessons to
many countries, particularly to those countries like China and Germany that are so far
concentrated on boosting their export growth by maintaining competitive exchange rate
through costly intervention policies. Its time China and the countries resorting to
export-led growth models need to realize that the costs of this kind of policies would
outweigh the benefits and in the medium and long run, this would be counterproductive.
Hence, they should rather focus on improving the purchasing power of their domestic
populations by running deficits and spending their surpluses, instead of dumping them
in forex reserve accumulation.

Notes
1. According to Patricks (1966) supply-leading hypothesis, deliberative creation of new
financial institutions, instruments and services in advance of demand for them, leads to more
capital accumulation through increase the volume of savings, and hence economic growth.
2. The KMO test measures the sampling adequacy and used to test whether the partial
correlation among the variables are small. Bartletts test of sphericity is used to test the
correlation matrix is an identity matrix or not.
3. Ek 2.886 0.099 0.015 3.00. PC1 2.886/3.00 0.962
4. All the variables such as IFD, GDP and TOP used in the present study are calculated in log
form.
5. According to the Schumpeterian hypothesis, active and well-functioning financial system,
particularly banking system, promotes economic growth by identifying and funding the
entrepreneurs with finest chances of success as also implementing innovative products and
production methods.

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About the authors

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Dogga Satyanarayana Murthy is currently pursuing PhD in Economics in Pondicherry

University, India. I have qualified UGC NET and AP SLET and received PRATIBA AWARD in
BEd. I have also attended and presented papers in many national workshops, national and
international seminars and a paper also accepted and to be published in JHM, SAGE Publication,
Jaipur, India, and another paper to be published in Asian Economic Review, Indian Institute of
Economic Society, Hyderabad, India. I have also published two more papers in Global Journal of
Finance and Management as seminar proceedings. Dogga Satyanarayana Murthy is a
corresponding author and can be contacted at: murthy801@gmail.com
Suresh Kumar Patra is currently pursuing PhD in Economics in Pondicherry University, India.
I received a Gold Medal as the toper in MPhil in Economics from Pondicherry University and
qualified for the Tamil Nadu SET in 2013, and I am also receiving the ICSSR Fellowship. I do have
special interest in Mathematical Economics, Econometrics, Economic Growth and Development;
and also in Health Economics. I have also published one book on An Evaluation of National Rural
Health Mission In Odisha: With special reference to Puri District. I have also attended and
presented papers in many national workshops, national and international seminars and a paper
also accepted and to be published in JHM, SAGE Publication, Jaipur, India.I have also published
two more papers in Global Journal of Finance and Management as seminar proceedings.
Amaresh Samantaraya is presently working as Associate Professor in the Department of
Economics, Pondicherry University. He teaches courses on Macroeconomics, Economics of
Money & Banking and Applied Econometrics. His research interest is diverse, covering empirical
issues related to conduct of monetary policy in India, financial sector developments and
inter-regional disparity in Indian growth experience. He has published numerous research studies
in various national and international professional journals in economics and finance, and has
published a book on the conduct of monetary policy in India. Prior to joining academics, he worked
for over a decade in various capacities, undertaking economic research in the Reserve Bank of
India (RBI) the central bank and the monetary authority for India.

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