The Impact of Financial Development On Economic Growth in Middle-Income Countries PDF

J. Int. Financ. Markets Inst.
Money 59 (2019) 74–89
Contents lists available at ScienceDirect
Journal of International Financial

Markets, Institutions & Money
j o u r n a l h o m e p a g e : w w w . e l s e v i e r . c o m / l o c a t e / i n t fi n
The impact of financial development on economic growth in

middle-income countries
Fan Yang
Department of Finance and Management Science, University of Saskatchewan, Canada
a r t i c l e i n f o a b s t r a c t
Article history: Whether an economy can be categorized as middle-income or not is an empirical issue. We
Received 16 November 2018 apply the World Bank’s standard to divide middle-income economies into trapped middle-
Accepted 26 November 2018 income economies and graduated middle-income economies, and compare them with
Available online 29 November 2018
high-income economies. This paper tests how financial system development positively
impacts a nation’s economic development among the above-mentioned three groups of
JEL classification: economies. We combine models and methodology from previous studies (King and
E41
Levine, 1993a; Levine and Zervos, 1998; Rousseau and Wachtel, 2000, 2002; Xu, 2000).
E44
G15
Augmenting these models with new measures and relations of financial development,
O16 we find that (1) consistent with previous studies, financial development contributes signif-
icantly to economic growth through channels of physical capital stock and total factor pro-
Keywords: ductivity; (2) there is Granger causality between equity market development and
Financial development economic growth for all three groups of economies, although some stronger and some
Economic growth weaker; (3) there is a reverse causality between economic growth and equity market
Money supply
development in high-income economies, which is not detected in other economies; (4)
Middle-income economy
strong evidence of Granger causality and feedback between banking system development
Granger causality
and inflation is found only in the trapped middle-income economies.
Ó 2018 Elsevier B.V. All rights reserved.
1. Introduction
Whether an economy can be categorized as middle-income or not is an empirical issue. The most prevailing standard is
set by the World Bank. In each fiscal year, The World Bank collects Gross National Income per capita (GNI per capita) from all
available economies, converts them into US dollar denominated figures using the Bank’s in-house-constructed Atlas
conversion factor (instead of exchange rates). Based on this GNI per capita information, the Bank, then, decides thresholds
for low-, middle- and high-income economies. For example, ‘‘As of July 1st, 2016, . . . lower middle-income economies are
those with a GNI per capita between $1026 and $4035; upper middle-income economies are those with a GNI per capita
between $4036 and $12,475; high-income economies are those with a GNI per capita of $12,476 or more.”1
As an economy develops sustainably, GNI per capita grows steadily. Over the past five decades from the 1970s to the
2010s, many low-income economies grew into middle-income ones, and many middle-income economies broke the barrier
and joined the high-income club. It seems that all economies experience growth during this period; however, some
experience more rapid growth than others, and some enjoy smoother development than others. These observations can
E-mail address: yang@edwards.usask.ca

1
The World Bank data help desk, https://blogs.worldbank.org/opendata/new-country-classifications-2016. Last accessed July 2017.
https://doi.org/10.1016/j.intfin.2018.11.008
1042-4431/Ó 2018 Elsevier B.V. All rights reserved.
F. Yang / J. Int. Financ. Markets Inst. Money 59 (2019) 74–89 75
be summarized by a popular topic often discussed in headline news: Why do some countries fall into the middle-income
trap, while others enjoy a quick and smooth transition to high-income economies? While the keyword ‘‘middle-income trap”
is a vague definition by the mass media, it describes vividly the awkward situation of some economies that either grow very
slowly (e.g., Mexico or Colombia), or experience high volatility in growth (e.g., Argentina or South Africa), so that they are
trapped in the swamp of middle income for many decades, while other countries take less than one decade to break the
middle-to-high barrier (e.g., Singapore). Economists have discovered many factors that affect a nation’s economic growth,
such as capital accumulation, labor growth, technological innovation, legal system improvement, and, of course, financial
development. We would like to review briefly the history of economic growth before exploring how the factors of financial
development contribute to sustainable economic growth in some countries but not in others.
Solow (1956) and Swan (1956) independently construct two similar growth models that express the aggregate produc-
tion as a function of labor and capital, while taking technology change as neutral and augmenting labor. The model assumes
exogenous capital accumulation rate (which is considered the same as saving rate) and labor growth rate (considered equal
to the natural rate of population growth). Thus, each economy has its specific steady state of growth which is decided by the
exogeneous capital-labor ratio when capital stock expands at the same rate as that of the labor force. An economy can tem-
porarily deviate from this state, it will converge to the state ‘‘in the long-run”. More specifically, further away from the
steady state, faster the speed converging to it, and higher the growth rate of output. For example, if an economy starts at
a very low GDP level relative to that in its steady state, such as China or India in the 1970s, it is likely that its actual GDP
will grow rapidly for some extended years to converge to the steady-state GDP. Mankiw et al. (1992) augments the
Solow-Swan model by adding human capital accumulation as a factor of growth. This model predicts that capital stock, pop-
ulation growth, and education explain the cross-country variation in per capita GDP. These models are called exogenous
models because capital-labor ratio, the decisive factor to economic growth, is decided exogenously.
Cass (1965) and Koopmans (1965) assume that the rate of saving is determined by consumer optimization. However,
endogenous growth models still consider technology as an external shock and is excluded from the production function.
These models predict that the steady state is set by an arbitrarily given level of technology, through an optimal capital-
labor ratio. Economies grow as consumers make choices in consumption and savings, driving the actual capital-labor ratio
to the optimal one. When the actual ratio equals the optimal ratio, economy arrives at the steady state where per capita GDP
growth, growth rates of capital stock and consumption are all zeros. Technology shock occurs exogenously and upward shifts
production function, resulting in a higher level of optimal capital-labor ratio, and a new steady state. When reaching the new
steady state, per capita GDP growth still turns zero. If the endogenous model has described the real world, we would observe
some economies (likely those high-income economies) stay zero growth for some extended years before quickly jumping
into another extended period of zero growth at a higher level of per capita GDP, which we do not really observe empirically.
It is until the late 1980s when Romer (1987, 1990) introduce endogenous technological change into the Solow-Swan
model, allowing technological innovation to increase the number of intermediate products that can be used by other pro-
duction processes. Relative to the Romer model, Schumpeterian empirical studies (e.g., Aghion and Howitt, 1992) endogenize
technological innovation as the quality of output, rather than the number of intermediate products. Based on Schumpeter’s
idea of ‘‘creative destruction”, innovators create high-quality product or service, drive their predecessors’ products out of the
market and eliminate the monopoly profit enjoyed by these predecessors (who have driven their predecessors out of the
market and grabbed monopoly profit temporarily). Despite the difference in the roles technological innovation plays, both
models predict that technological innovation is a choice made within the model, it will adjust the optimal capital-labor ratio,
such that the steady state extends with the endogens adjustment. The endogenous technological innovation models propose
a significant empirical conjecture: if an economy continuously invests in innovation and manage innovation properly, it will
extend its steady state continuously and endogenously. In this way, an innovation-fueled economy will enjoy constant, and
above-zero growth in per capita GDP in the long-run. It seems that countries such as the U.S. and Canada experience this kind
of growth.
Pagano (1993), King and Levine (1993a), and Levine (1997) emphasize that the development of domestic financial service
can be considered as one category of innovation that can drive economic growth. King and Levine (1993a) and Levine (1997)
empirically decompose per capita GDP growth into real per capita physical capital stock (PKS) growth and everything else, or
total factor productivity (TFP) growth, and associate these three indicators of economic growth to finance innovation, which
consists of banking system innovation and stock market innovation. A large number of empirical studies, such as Greenwood
and Jovanovic (1990), King and Levine (1993a, 1993b), Levine (1998), Levine and Zervos (1998), Levine (1999), Levine et al.
(2000), Beck and Levine (2004), McCaig and Stengos (2005), and others show that banking system innovation contribute to
economic growth, while Goldsmith (1969), Atje and Boyan (1993), Levine and Zervos (1996, 1998), Demirguc-Kunt and
Maksimovic (1998), Peress (2014), and others present a positive association between stock market growth and economic
growth. Furthermore, Boyd and Smith (1998) and Merton and Bodie (2004) argue that the banking system and stock markets
can reinforce each other and function as complements rather than substitutes when driving economic growth. Using Vector
Autoregression (VAR) model, Rousseau and Wachtel (2000, 2002), Xu (2000), and Calderón and Liu (2003) show that eco-
nomic growth and financial development such as liquid liabilities (Broad money) and stock market development (market
capitalization to GDP and total value of stock traded to GDP) mutually reinforce each other, and the growth of the financial
development indicators lead economic growth.
Based on the previous findings that financial development positively impacts a nation’s economic development, this
paper compares how differently financial development affects economic growth between the economies that are trapped
76 F. Yang / J. Int. Financ. Markets Inst. Money 59 (2019) 74–89
by the middle-income swamp and those that are not. The ultimate goal is to detect factors of financial development that
contribute to high growth rates in some economies, but fail to do so in others. This study augments the models and method-
ology of previous research (King and Levine, 1993a; Levine and Zervos, 1998; Rousseau and Wachtel, 2000, 2002; Xu, 2000)
with new measures and relations in financial development. By using a sample of 47 economies that are either high-income
(HI-group), trapped middle-income (TRAP-group), or middle-to-high graduates (GRAT-group), our study finds: (1) consistent
with previous studies, financial development contributes significantly to real per capita GDP growth through the two chan-
nels of physical capital stock (PKS) growth and total factor productivity (TFP) growth; (2) the banking development has a
stronger cross-sectional impact on economic growth in the TRAP-group than in other two groups; (3) there is Granger
causality between equity market development and economic growth for all three groups of economies, although some stron-
ger and some weaker; (4) there is a reverse causality between economic growth and equity market development in the HI-
group only. It seems that for a typical high-income economy, there is continuous circulation of funds allocated by equity
market that drive economic growth, and funds generated by economic growth that can be invested in the equity market
to expand the market for further economic growth; (5) there is strong evidence of Granger causality and feedback (reverse
causality) between banking system development and inflation in the TRAP-group. It seems that for a typical troubled-
economy, funds provided by the banking system have partially channeled to inflation rather than economic development,
resulting in high inflation and slow economic growth.
The main contribution of this paper is to include a new equation in the system of VAR models. Previous studies include
economic growth and financial development indicators in the VAR system to show dynamic relationships between financial
development and economic growth. This paper extends the VAR system to include an additional equation of consumer’s
price index (CPI), which allows factors of financial development to ‘‘fuel” inflation if such a relationship exists. It seems that
the model does catch the vicious loop between banking system development and inflation: we observe that for a typical
trapped-economy, high domestic credit to private sector (CREDIT) precedes inflation, which leads the next period CREDIT.
When CREDIT is channeled to inflation, economic development slows down. Another contribution of this paper is, instead
of using each of the 47 sample countries’ respective time series to test causality and feedback relations, we construct an
equally-weighted portfolio to represent each group of economies. For example, per capita GDP of the HI-group for each year
is obtained by taking the summation of the per capita GDP of all countries in the HI-group, divided by the number of econo-
mies in that group. Aggregating countries into groups allows us to focus on the main feature of the group, and to reach a
conclusion for a ‘‘typical” economy. Equally weighted portfolio prevents a large economy from dominating a specific group.
The rest of the paper is organized as follows: Section 2 explores the theoretical framework and develop hypotheses, fol-
lowed by Section 3 of sample, variable and descriptive statistics. Section 4 presents regression results, analysis and interpre-
tation. Section 5 concludes the paper.
2. Theoretical framework
King and Levine (1993a) recognizes Schumpeter’s arguments (Schumpeter, 1911) that financial intermediaries’ innova-
tion also contributes to economic growth. The papers place financial intermediaries’ innovation either into the framework
of Romer (1987) and (1990)’s endogenous ‘‘production process model” or Grossman and Helpman (1991) and Aghion and
Howitt (1992) endogenous ‘‘product quality model”. The former claims that financial intermediaries’ innovation constantly
expands steady state through the channel of physical capital stock (PKS) growth, while the latter claims that financial inter-
mediaries’ innovation affects steady-state expansion through technological innovation, which is an important component of
total factor productivity (TFP) growth. Following this line of reasoning, the paper decomposes per capita GDP growth into per
capita PKS growth and per capita TFP growth. It then relates these three growth indicators to four measures of banking
development, namely ‘‘liquid liability of the financial system to GDP” (LLY), ‘‘the ratio of deposit money bank domestic assets
to the summation of deposit money bank domestic assets and central bank domestic assets” (BANK), ‘‘claims on private sec-
tor to domestic credit” (PRIVATE), and ‘‘claims on private sector to GDP” (PRIVY). The selection of these four measures are
based on the function of the banking system: LLY present the sheer size of the banking system – a large LLY indicates ade-
quate funds and service for economic development. BANK measures the bank’s ability to provide information and manage
risk. PRIVATE and PRIVY are introduced to catch the size of domestic asset allocation. Empirically, King and Levine (1993a)
confirms a strong and robust association between the banking development to per capita GDP growth through both channels
of PKS growth and TFP growth, and concludes that the financial intermediary like the banking system ‘‘exerts a first-order
influence on economic growth”.
When financial systems perform well, they serve to reduce information asymmetry, mobilize savings, allocate funds,
facilitate trade, enhance corporate governance, and diversify risks (e.g., Pagano, 1993; Levine, 1997). In such an economy,
information of demand and supply of funds is spread promptly and accurately in the market, capital is allocated to projects
where it can generate the best result, such as high NPV project, promptly. A firm with all its projects bringing higher or equal
to zero NPV will build up capital stock quickly and expand the size of the firm rapidly. The economy, with majority firms
experiencing high growth, will continuously accumulate capital and grow until it reaches the steady state. Before reaching
the steady state, capital and labor play an important role in growth. As both factors are physical, they are easy to measure
and manage. Accordingly, the financial system is likely to be efficient in allocating funds, managing risk and exerting gov-
ernance in capital- or labor-intensive projects. When an economy reaches the steady state, its physical capital stock expands
at the same rate as that of the labor force, the economic growth stops if there were no other force to drive economic growth.
Schumpeterian endogenous growth theory identifies the internal engine of economic growth in the steady state – techno-
logical innovation. A well-developed financial system will motivate corporate insiders to nourish technology advancement
or innovation, by providing innovators with excess return. This may explain why in an efficient market, there is still positive
NPV. The financial system motivates innovators by temporarily allowing them to enjoy monopolistic profit, as a reward to
the resource they have spent and the risk they have borne when initiating the innovation. However, if we allow innovators to
exploit technological advantages and permanently gain monopoly profits, they may lose motivation for future innovation.
Furthermore, this may also drive investment away from the optimal level when corporate insiders forego positive NPV pro-
jects for concern of distributing existing shareholders’ value to potential new shareholders (Myers and Majluf, 1984), which,
in turn, may hinder overall economic development. A financial system has to walk the fine line between motivating-
protecting innovators and encouraging technology being spread quickly enough to inspire the next generation of innovators,
this makes it difficult for the financial system to serve innovation-intensive projects.
Empirically, we observe that countries in the HI-group maintain considerable and stable growth in per capita GDP for half
a century after they become rich. It seems that this observation is consistent with the endogenous technological-innovation
theory: as a HI-group economy settles in its steady state, the economic growth does not stop, instead, financial systems help
to allocate funds to a variety of innovations, which expands the steady state and drives GDP growing continuously. Given
that financing innovation involves the delicate balance between motivating and regulating innovators, we expect that the
efficiency of financing these innovation-intensive projects is likely to be low, and its marginal contribution to the growth
of an economy that is already in steady state is likely to be small. On the other hand, we observe that the per capita GDP
in trapped economies is much lower relative to that of both HI- and GRAT-groups, and there is still a long way to go before
the TRAP-group reach steady state. As predicted by previous models, further away an economy is from its steady state, more
important roles labor and physical capital play in economic growth, and it is likely that financing labor- and capital-intensive
activities is more effective in driving economic growth. Based on the above discussion, we propose our hypothesis with
respect to the cross-sectional impact of financial system development on economic growth:
H1. Financial development has a stronger positive association with per capita PKS growth, per capita TFP growth, and per
capita GDP growth in trapped economies than in graduated and high-income economies.
Using VAR models, Rousseau and Wachtel (2000, 2002), Xu (2000) show that economic growth and the two financial
development indicators (e.g. liquid liabilities and stock market development) mutually reinforce each other, and the two
financial development indicators lead economic growth. Economic growth needs funds as fuel. A well-developed financial
system helps to provide fuel to economic growth. Thus, we may observe a supply-side signal (or a supply-push), i.e., financial
system development precedes PKS, TFP, and GDP growth. If the supply-push is utterly successful, financial systems channel
funds to physical capital investment and technological innovation. Accordingly, firms are established and they generate real
output, which signals a good start for economic growth. When firms are operating successfully, we will observe that many
entities in manufacturing, industrial or service sectors demand following-up funds for further expansion (or, we observe
demand-pull). Accordingly, we will detect a feedback relationship between economic growth and financial system develop-
ment. The supply-push and demand-pull create a healthy circulation of funds between financial system and industries,
which help to form an upward spiral between financial system development and economic growth. On the other hand, if
the supply-push completely fails, such as capital allocated by financial system is wasted, and industrial development does
not respond to financial system development. We will observe no relationship between financial development and growth.
Worst of all, if wasted funds trigger inflation, which, in turn, may absorb and consume funds in the next period and leaves no
room for economic growth. In this case, we will observe a circulation between funds and inflation, and a downward spiral
between financial development and economic growth: the more funds injected into the economy, higher the inflation and
lower the economic growth.
Empirically, we observe that a typical successful-economy enjoys sustainable long-term growth. This may be attributed
to the healthy lead-and-feedback relation between financial development and growth. We also observe that a typical
trapped-economy has failed to obtain sustainable long-term growth. Some countries experience a brief high growth rate
and fall back to very low growth, while other countries keep jumping between high and very low growth rates. This obser-
vation indicates that the circulation between financial system development and economic growth may have broken. We sus-
pect that the factor that helps to break the circulation is inflation. Based on the above discussion, we form two hypotheses of
the dynamic relationship between financial development and economic growth.
H2. In an economy with sustained growth, financial development leads economic growth, and economic growth conversely
leads financial development.
H3. In an economy with sluggish and unstable growth, financial development leads inflation and inflation conversely leads
financial development.
3. Data and methodology
3.1. Data and sample
Our main data is from the World Bank World Development Indicators (WDI-data) and the World Bank Physical Capital
data (PKS-data).2,3 WDI-data is available for the period from 1960 to 2016, however, some key variables are missing over
the first decade, the actual WDI-data window is from 1970 to 2016. PKS-data spans from 1950 to 1990. We take PKS-data from
1970 to 1990 and apply its methodology to construct physical capital stock (PKS) from 1991 to 2016.
To construct the sample, we start with the World Bank 2015 country group of high-income and upper-middle-income
economies.4 Among the 77 high-income and 56 upper-middle-income countries, we delete countries without variables such
as per capita GDP, physical capital stock (PKS), and fixed capital formation (GDFI).5 This leaves us with 49 economies. We further
delete China and Thailand since their initial GDP levels are extremely low. Table 1 explains how we categorize these economies
into three groups. According to the World Bank criteria, a high-income economy is one with a GNI per capita of $12,476 or more
in 2015, while the benchmark for dividing economies in the 1970s is set by Venezuela, the economy with the highest per capita
GDP in 1970, that is still grouped as the upper-middle class in 2015.
Using these two criteria collectively, we have three groups: (1) the high-income group (HI-group) includes economies
already categorized as high-income in 1970, and remain as high-income in 2015; (2) the middle-to-high graduates
(GRAT-group) includes economies considered as middle-income economies in 1970, but now categorized as high-income
economies; and (3) the trapped middle-income group (TRAP-group) includes economies considered as middle-income in
1970 and remain as middle-income till 2015. Appendix A presents member countries. To make the benchmark robust, we
change the initial year from 1970 to 1969, and to 1971, the membership does not change. There are three economies deserv-
ing some special remarks. The first is Israel, it has higher than Venezuela’s (the benchmark country that distinguishes
middle- from high-incomes) per capita GDP in 1970, but lies closer to Venezuela than to Iceland (see Appendix A for detail).
We include Israel in the GRAT-group since it has higher initial GDP than Venezuela. For robustness check, we delete Israel
from the sample. Other two are China and Thailand. The 1970 per capita GDP of these two countries are too low relative to
other trapped economies. We delete them from our sample. This leaves the sample size to 47 countries spanning 47 years.
For Robustness check, we redo tests including China and Thailand in the TRAP-group.
Table 2 presents descriptive statistics of key variables, spanning 47 years of observations for 47 countries. All variables are
converted into real terms (2010 constant US dollar) and are winsorized at 1% before constructing ratios to GDP or growth
rates.
3.2. Methodology and variables
3.2.1. Cross-sectional tests

Our first goal is to test the contribution of financial development to cross-sectional variations in economic growth over
the sample period from 1970 to 2016 among the three groups of economies. Following Solow (1956) growth model
Y ¼ AK a L1a , King and Levine (1993a) constructs the following model
a
y ¼ k tfp ð1Þ
where Y is total GDP and y is per capita GDP, k is per capita physical capital stock (PKS), and tfp is everything else or total
factor productivity (TFP). Taking logarithm and then the first difference, the model turns into:
Gy ¼ aGk þ Gtfp ð2Þ
where Gy is the percentage growth of per capita GDP, Gk is the percentage growth of per capita PKS, and Gtfp is the percent-
age growth of per capita TFP. Gy and Gk are directly measured while Gtfp is obtained by subtracting a portion of Gk from Gy
(Gtfp ¼ Gy aGkÞ. where the constant a is set at 0.3 by the vast majority of empirical studies. Eq. (2) decomposes per capita
GDP growth into two channels: PKS mainly includes real physical capital and TFP includes labor, human capital, and tech-
nological innovation.
King and Levine (1993a, 1993b), Levine (1997) and other cross-country studies then express cross-country variation of
growth with:
y ¼ a þ bx þ cz þ e ð3Þ
where y includes the three growth indicators, x financial development indicators, and z control variables.
2
http://econ.worldbank.org/WBSITE/EXTERNAL/EXTDEC/EXTRESEARCH/0,contentMDK:20699834~pagePK:64214825~piPK:64214943~theSitePK:46938200.
html By Nehru and Dhareshwar (1993). Last accessed in June 2017.
3
https://datacatalog.worldbank.org/ Last accessed in June 2017.
4
https://data.worldbank.org/income-level/upper-middle-income?view=charthttps://data.worldbank.org/income-level/high-income?view=chart. Last
accessed in June 2017.
5
Although GDFI is not a direct growth indicator, it is used in constructing PKS.
Table 1
Rubric for membership in economic development.
2015 GNI per capita: higher than $12,476 2015 GNI per capita: equal to, or lower than,
(2015 current US dollar) $12,476 (2015 current US dollar)
1970 per capita GDP: higher than Venezuela (2010 HI-group: includes high-income N.A.
constant $14,329) economies
1970 per capita GDP: Equal to, or lower than, GRAT-group: includes graduated middle- TRAP-group: includes trapped middle-income
Venezuela (2010 constant $14,329) income economies economies
According to the World Bank criteria, the bench mark between hi-income and middle-income economies is GNI per capita of $12,476 in 2015, this is the first
criterion. We select all middle-income economies and rank them back in 1970 based on per capita GDP in 1970. Venezuela ranks first with respect to per
capita in 1970 ($14,329). This is the second criterion. Any economy with per capita GDP higher than $14,329 in 1970 and GNI per capita higher than $12,476
in 2015 is grouped as high-income economy (HI-group). Any economy in 1970 lower than $14,329, but higher than $12,476 in 2015 is graduated middle-
income economy (GRAT-group). The rest are trapped economies (TRAP-group). No economy that has higher per capita GDP than $14,329 in 1970 has less
than $12,476 in 2015. GDP figures are in 2010 constant US dollar, while GNI figures are in 2015 current US dollar.
Table 2
Descriptive statistics.
CODE Definition in WDI-data Mean Std. Deviation Min Median Max Obs.
GDPPC Per Capita GDP Growth 2.15 4.61 65 2.17 53.94 2160
PKS/GDP Physical Capital Stock (% Of GDP) 302.65 76.68 74.13 291.32 743.24 2158
PKSPC Per Capita Physical Capital Stock Growth 4.2 4.24 31.98 3.45 90.46 2111
TFPPC Per Capita Total Factor Productivity Growth 1.25 3.6 29.05 1.4 22.83 2111
CREDIT/GDP Domestic Credit to Private Sector (% Of GDP) 62.12 46.92 1.27 47.11 312.12 1721
GREDIT Domestic Credit to Private Sector, Growth 6.34 14.75 84.05 5.33 94.13 1666
M3/GDP Broad Money (% Of GDP) 55.45 37.05 10.08 46.49 242.83 1545
M3 Broad Money, Growth 6.54 17.24 73.54 5.43 313.72 1507
CLAIM/M3 Claims on Private Sector (Annual Growth As% Of Broad Money) 25.82 58.59 18.84 12.66 460.72 1474
MKTTRD/GDP Stocks Traded, Total Value (% Of GDP) 28.18 41.8 0 10.19 320.99 1316
MKTTRD Stocks Traded in Total Value, Growth 25.62 72.71 83.69 9.04 382.08 1268
MKTSIZ/GDP Market Cap. Of Listed Domestic Companies (% Of GDP) 59.89 53.69 0.4 43.06 326.36 1173
MKTSIZ Market Cap. Of Listed Domestic Companies, Growth 13.86 43.16 70.37 8.44 246.06 1125
GOVCSP/GDP Central Government Consumption (% Of GDP) 16.6 5.22 2.33 16.6 43.38 2177
GOVCSP Central Government Consumption, Growth 3.37 5.66 24.89 2.86 67.46 1938
CPI Inflation, Consumer Prices (Annual %) 16.43 41.51 0.88 5.66 342.96 2207
Log(EXCHG) Official Exchange Rate, Per Us Dollar, Logarithm 1.57 4.8 26.94 1.71 10.34 1975
TRADE/GDP Total Trade (% Of GDP) 77.23 63.6 0.02 59.61 441.6 2181
TRADE Total Trade, Growth 4.79 10.63 25.54 4.28 39.89 2133
LEGAL Strength of Legal Rights Index (0 = Weak To 12 = Strong) 4.88 2.81 0 5 11 47
log(IPOP) Initial Population In 1970, logarithm 9.07 1.57 5.32 9.18 12.23 47
log(IGDP) Initial GDP Per Cap In 1970, logarithm 8.99 0.96 7.17 8.88 10.48 47
log(ISECERL) Initial Secondary School Enrolment Rate In 1970, logarithm 6.44 2.6 1.62 6.85 11.68 47
Dependent variables include per capita GDP growth (GDPPC) and its two components, per capita physical capital stock growth (PKSPC), and per capita total
factor productivity growth (TFPPC). Independent variables include banking system efficiency, i.e., domestic credit to private sector (CREDIT), broad money
(M3), equity market efficiency, i.e., total value of stocked traded (MKTTRD) and market capitalization of listed domestic companies (MKTSIZ), and fiscal
policy efficiency, i.e., government final consumption expenditure (GOVCSP). Control variables include variables found in previous studies. All values except
those in logarithm, are expressed in percentage: for example, GDPPC of 2.15 means 2.15%.
All variables are converted into real terms (2010 constant US dollar) and are winsorized at 1% before constructing ratios to GDP or growth rates.
We expand this model with a categorical variable, TRAP, to fit the research interest of this study: comparison between the
three groups of trapped, graduated, and high-income economies with respect to the cross-sectional impact of financial devel-
opment on growth, this leads to Eq. (4):
y ¼ a þ b1 x þ b2 TRAP þ b3 x TRAP þ cz þ e ð4Þ
The dependent variable y includes the three economic growth indicators by King and Levine (1993a) and Levine (1997)
decomposition. We construct these indicators with the World Development Indicator (WDI-data) and Physical Capital data
(PKS-data) as follows:
(1) Overall economic growth is obtained by taking the difference of log (per capita GDP);
(2) Physical capital stock (PKS) growth: The World Bank has published PKS-data constructed by Nehru and Dhareshwar
(1993); however, PKS-data spans from 1950 to 1990.6 We estimate physical capital stock (PKS) from 1991 to 2017 using
Nehru and Dhareshwar (1993) method: Starting with PKS in 1990, the last year’s observation in PKS-data, we apply the
6
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html By Nehru and Dhareshwar (1993). Last access July 2017.
perpetual inventory method and geometric decay of capital stock assumption that are used in Nehru and Dhareshwar
(1993) to estimate PKS in following years. Alternatively, we start with the 1970s PKS from PKS-data, add it to 1971s gross
fixed capital formation (GDFI in WDI-data), and deduct 1971s consumption of fixed capital (DKAP defined in WDI-data,
which is an estimation of depreciation of fixed capital), to obtain PKS in 1971. Rolling iteratively forward, we obtain the
rest of the PKS series. Converting these two estimations of PKS into percentage growths, we obtain two measures of PKS
growth;
(3) TFP growth is obtained by subtracting a portion of per capita PKS growth from per capita GDP growth
(TFP growth ¼ GDP growth 0:3 PKS growthÞ, where the coefficient of 0.3 is widely used by previous literature.
Based on the two measures of PKS growth, we obtain two measures of TFP growth. We use the Nehru and
Dhareshwar (1993) PKS and its paired TFP in the main regression while using the other pair as robustness check
variables.
The main explanatory variable x represents three groups of financial development indicators, two groups are found in
previous studies and we introduce one extra group in this paper:
(1) Bank efficiency indicators: Broad money to GDP (M3/GDP) and growth of Broad money (M3) are the same as the LLY
defined in King and Levine (1993a,b) and Levine (1997). These variables measure the depth and liquidity of the bank-
ing system. We introduce credit to private sector to GDP (CREDIT/GDP) and growth of domestic credit to private sector
(CREDIT) and claims on private sector to broad money (CLAIM/M3) as a proxy of credit to private sector to measure the
efficiency of the banking system in collecting information, assessing risks, and allocating funds to private sectors. As
discussed in King and Levine (1993a), when banks funnel funds to private sectors, they carefully select investment
projects, evaluate managers’ performance, and balance the pool of risk they choose. An efficient allocation of credit
to private sector is critical to economic growth;
(2) Equity market efficiency indicator: we use total value of stocks traded to GDP (MKTTRD/GDP), which is the value
traded ratio defined in Levine (1997), to catch the liquidity of the stock market; we also include Market capitalization
of listed domestic companies to GDP (MKTSIZ/GDP), this variable measures the size of the stock market. A large and
liquid equity market promote the circulation of funds between users and suppliers, which, in turn, contributes posi-
tively to economic growth. We construct the percentage growth of these two variables as well;
(3) High-income economies are mainly market-oriented where the efficiency of private sectors or the financial market is
critical to economic growth, and government intervention is often overlooked, but it is not necessarily true for devel-
oping economies. We cannot ignore the influence of government planning on economic growth in developing econo-
mies. Thus, we introduce another financial development indicator, fiscal policy efficiency. We use the ratio of
government final consumption expenditure to GDP (GOVCSP/GDP) to capture fiscal policy efficiency (or dis-
efficiency) since this consumption largely includes national defense and education, which either has something to
do with technological innovation or human capital accumulation. Levine (1997) uses the initial value of GOVCSP as
a control variable in its cross-sectional regression;
TRAP is a categorical variable assuming three values, representing TRAP-, GRAT-, and HI-groups respectively. We intro-
duce this variable to detect whether financial development has different impact on economic growth among the three
groups. A significant b3 will confirm the variation in the impact.
The control variable z is selected based on previous studies. which includes initial per capita GDP (IGDP), initial human
capital stock (IPOP), initial secondary school enrollment ratio over population (SECERL), initial physical capital stock (IPKS),
trade over GDP (TRADE/GDP), Strength of legal rights index (LEGAL), (range from 0 to 12 for weak to strong legal protection)
average inflation measured by CPI, and official exchange rate (LEXCHG) (we use this variable to approximate the black-
market exchange rate given lack of data). According to endogenous growth models, an economy that is far from its steady
state experiences a higher growth rate. The IGDP, IPOP, and SECERL are measures of how far away the economy, at its starting
point, is from its steady state. TRADE/GDP measures the openness of the economy. Studying economic development in
today’s global market cannot ignore the impact of international trade on economic growth. However, it is not part of the
domestic financial system, previous studies use openness to account for the contribution of openness to growth. Institutional
framework affects economic growth significantly, LEGAL is a proxy of the institutional framework of an economy, some
paper uses legal origin, we use LEGAL since it is available to most of the countries in our sample.
An efficient financial system contributes to economic growth through efficiently cumulating physical capital stock, and/or
motivating technological renovation, which is a main component of TFP. We expect b1 in Eq. (4) to be significantly positive in
regressions using all three development indicators. Furthermore, we hope that b3 will detect variations in the cross-sectional
impact of financial development indicators on economic growth among the three categories of economies.
3.2.2. Time series tests

Rousseau and Wachtel (2000, 2002), Xu (2000), and Calderón and Liu (2003) employ a VAR system to detect whether
there are dynamic relations, such as causality and feedback, between economic growth indicators Dx1 (GDP, PKS, TFP), finan-
cial intermediaries, or credit market, Dx2 (M3) and equity market Dx3 (MKTSIZ, MKTTRD).
X
k X
k X
k
Dx1;t ¼ a1;0 þ a1;i Dx1;ti þ b1;i Dx2;ti þ c1;i Dx3;ti þ U 1;t ð5aÞ
i¼1 i¼1 i¼1
X
k X
k X
k
Dx2;t ¼ a2;0 þ a2;i Dx1;ti þ b2;i Dx2;ti þ c2;i Dx3;ti þ U 2;t ð5bÞ
i¼1 i¼1 i¼1
X
k X
k X
k
Dx3;t ¼ a3;0 þ a3;i Dx1;ti þ b3;i Dx2;ti þ c3;i Dx3;ti þ U 3;t ð5cÞ
i¼1 i¼1 i¼1
We borrow this VAR system and add a new equation to it in order to test the possible leakage of funds in economic
growth. We first reduce this system of three equations into two by using Dx2 to represent financial development in both
credit (M3, CREDIT) and equity (MKTSIZ, MKTTRD) markets, we also include government final consumption (GOVCSP) as
well. We then add the third equation into the system, CPI. This equation is to measure the possible leakage of funds to
inflation.
X
k X
k X
k
Dx1;t ¼ a1;0 þ a1;i Dx1;ti þ b1;i Dx2;ti þ c1;i DCPIti þ U 1;t ð6aÞ
i¼1 i¼1 i¼1
X
k X
k X
k
Dx2;t ¼ a2;0 þ a2;i Dx1;ti þ b2;i Dx2;ti þ c2;i DCPIti þ U 2;t ð6bÞ
i¼1 i¼1 i¼1
X
k X
k X
k
DCPIt ¼ a3;0 þ a3;i Dx1;ti þ b3;i Dx2;ti þ c3;i DCPIti þ U 3;t ð6cÞ
i¼1 i¼1 i¼1
where
x1 includes three economic growth indicators, namely GDP, PKS, and TFP;
x2 represents financial development indicators, namely CREDIT, M3, MKTSIZ, MKTTRD, GOVCSP;
CPI is the consumer price index;
D is the differencing operator
t represents time, and t-i is i-year-lagged observation.
In order that variables Dx focus on common features of each group of economies, we form three equally-weighted port-
folios of high-income, graduated-, and trapped-economies. For each portfolio, we obtain portfolio per capita GDP, portfolio
per capita PKS, portfolio per capita TFP, portfolio financial development indicators, and portfolio CPI. Relative to previous
studies where they run VAR for each economy, we run VAR models for each portfolio at the aggregate level. For example,
per capita GDP for the high-income portfolio in 1970 is obtained by taking summation of per capita GDP of all member coun-
tries in the high-income group in this year, divided by the number of countries in the group. Repeating this calculation for
each year, we obtain a time series of per capita GDP for the high-income portfolio. Focusing on VAR regression at an aggre-
gate level rather than at individual country level allows our model to capture the main feature of that portfolio. Suppose M3
leads per capita GDP in most of the members of the high-income group, then, the portfolio regression will capture this fea-
ture. Suppose CREDIT leads per capita GDP only for a couple of countries in the trapped group, then, we won’t detect this in
the portfolio regression. Using an equally weighted portfolio allows us to ignore factor that affects only one or two members
of the group, even if the member is a big economy, and focus on factor that affects most members.
A significant coefficient a1,i in Eq. (6a) indicates that economic growth in previous ith year has a significant impact on the
current year’s economic growth. Since our focus is on dynamic relations between financial development and economic
growth, our focus is on the following coefficients, namely b1,i, a2,i, b3,i, and c2,i. The rationale is, first, a significant coefficient
b1,i demonstrates that previous year’s financial development Granger causes the current year’s economic growth, signaling a
supply-push. Insignificant or even negative b1,i indicates no supply-push from this specific financial development indicator.
Second, a significant positive b1,i and a significant positive a2,i, jointly indicate that while financial system precedes economic
growth, the latter also leads financial system development. This means both supply-push and the demand-pull take effect,
such that the member countries will achieve phenomenal per capita GDP level, this is the ideal case for economic growth
discussed in hypothesis development section. Third, a significant and positive b3,i demonstrates that financial development
leads inflation. Fourth, a triplet of a significant b3,i, a significant c2,i, and a significant c1,i, jointly demonstrate that not only
finance development stimulates inflation, inflation, in turn, affects finance development and economic growth, this depicts
the worst scenario in economic growth.
4. Results and interpretation
We first present comparisons of key variables among the three groups of economies in Table 3. Given that all values are in
2010 constant US dollar, all growth rates are in real terms. Over the past five decades, GRAT-group experiences the highest
annual per capita GDP growth of 3.26%, while TRAP-group the lowest at 1.91%. With respect to PKS, HI-group has the highest
PKS/GDP (314%) and lowest per capita PKS growth (3.4%), while GRAT-group has the lowest ratio (275%) and highest growth
(5.15%). the TRAP-group has higher PKS growth than HI-group and higher PKS/GDP than GRAT-group. Comparing PKS/GDP,
PKS growth and GDP growth among the three groups, we observe that the physical capital grows faster than GDP in all of
them, but by far, TRAP-group has the largest gap between PKS growth and GDP growth of 2.73%. It seems that HI-group
economies are reaching the steady state, but with considerable TFP growth of 1.26% and PKS growth of 3.4%, they still enjoy
positive GDP growth of 2.08%. This observation is consistent with the endogenous technological-innovation growth model
where innovation helps to extend steady state. TRAP-group has the lowest GDP growth of 1.91%. Moreover, F-tests show that
TRAP-group has significantly higher volatility than those in both GRAD- and HI-groups with respect to all three indicators of
economic growth. This observation confirms that trapped economies experience either slow or volatile growth.
The means of the financial indicators of the TRAP-group are insignificantly lower than those in the GRATE-group. We
observe that TRAP-group has significantly lower CREDIT/GDP, M3/GDP, MKTTRD/GDP, MKTSIZ/GDP, and GOVCSP/GDP than
both GRAT- and HI-groups. Despite lower ratios of financial development to GDP, TRAP-group has greater standard deviation
than other groups with respect to almost all financial development indicators. If we check the initial ratios of financial indi-
cators to GDP, we find that in 1970, all financial indicators have similar ratios to GDP between the TRAP- and the GRAT-
groups, and those of HI-group are not significantly higher. In summary, it seems that the TRAP- and GRAT-groups start at
similar initial levels of development. Over the past five decades, the GRAT-group has a stable development in its financial
sector, successfully cumulates PKS and improves TFP such that it enjoys fast and stable economic growth. On the other
hands, the TRAP-group experiences volatile financial system development, fails to use physical capital in economic growth,
so that it has slow and unstable economic growth.
We run panel regression, adjusting for year fixed effect, and using clustered standard error to cope with possible serial
correlation in the same cluster (country) over years. Table 4 reports regression results with three groups of independent vari-
ables: banking system development in models M01 to M04, stock market development in models M05 to M08, and govern-
ment fiscal policy in models M09 to M10, odd numbered models use ratios to GDP as independent variables while even
Table 3
Comparisons of mean and standard deviation.
Means T-test comparing Standard deviation F-test comparing

means StdDev
TRAP- GRAT- HI- TRAP vs TRAP vs TRAP- GRAT- HI- TRAP vs TRAP vs
group group group GRAT HI group group group GRAT HI
GDPPC 1.91 3.26 2.08 4.7*** 0.8 6.02 4.17 2.28 2.1*** 7.0***
PKSPC 4.64 5.15 3.40 1.8* 5.7*** 5.81 3.80 1.76 2.3*** 11.0***
PKS/GDP 300.0 275.2 314.2 5.6*** 3.5*** 100.5 55.97 49.35 3.2*** 4.1***
TFPPC 0.96 2.07 1.26 4.6*** 1.7* 4.42 3.83 2.14 1.3*** 4.3***
CREDIT 6.90 8.39 5.90 1.4 1.2 17.22 15.01 10.90 1.3*** 2.5***
CREDIT/GDP 37.22 58.98 103.3 10.4*** 22.0*** 29.87 31.85 54.96 1.1 3.4***
M3 6.72 8.52 4.67 1.2 2.6*** 17.72 23.38 9.70 1.7*** 3.3***
M3/GDP 43.86 61.64 76.24 8.0*** 12.9*** 25.58 34.22 47.55 1.8*** 3.5***
MKTTRD 26.36 34.43 29.57 1.2 0.6 78.85 84.85 69.12 1.2 1.3***
MKTTRD/GDP 11.82 32.34 34.05 6.8*** 9.3*** 18.13 43.04 49.43 5.6*** 7.4***
MKTSIZ 15.94 16.39 14.77 0.1 0.4 46.80 43.48 42.60 1.2 1.2*
MKTSIZ/GDP 51.71 76.39 56.49 4.2*** 1.2 63.74 63.92 43.15 1.0 2.2***
GOVCSP 4.18 4.08 2.61 0.2 5.1*** 7.72 6.35 2.09 1.5*** 13.6***
GOVCSP/GDP 13.98 15.51 19.64 4.7*** 26.4*** 4.87 5.80 3.43 1.4*** 2.0***
CPI 27.66 17.93 5.79 3.5*** 11.1*** 57.22 40.86 7.24 2.0*** 62.5***
log(IPCGDP) 8.20 8.87 10.02 2.9*** 12.2*** 0.58 0.65 0.24 1.2 6.0***
IPKS/IGDP 234.7 234.8 271.2 0.0 1.2 107.8 84.60 57.34 1.6 3.5**
ICREDIT/IGDP 24.01 24.77 48.32 0.1 1.8 12.47 13.26 34.98 1.1 7.9***
IM3/IGDP 27.82 34.91 52.45 1.1 3.9*** 12.53 18.27 20.80 2.1 2.8*
IMKTTRD/IGDP 3.49 2.88 9.49 0.4 1.3 3.37 2.67 10.74 1.6 10.2**
IMKTSIZ/IGDP 40.48 25.94 38.22 0.6 0.1 44.21 23.05 24.46 3.7 3.3
IGOVCSP/IGDP 12.94 15.35 16.03 1.1 2.5** 3.92 7.45 3.22 3.6** 1.5
This table reports T-test results that compare means, and F-test results that compare standard deviations, of key variables among the three groups of
economies. The focus is on that between GRAT-group and TRAP-group, and that between HI-group and TRAP-group. All values except those in logarithm,
are expressed in percentage: for example, mean GDPPC of 1.19 means 1.19%. IGDP is initial year per capita GDP, IPKS/IGDP is initial ratio of PKS to GDP,
ICREDIT/IGDP, IMKTTRD/IGDP, IMKTSIZ/IGDP, and IGOVCSP/IGDP represents initial year’s ratios respectively. All indicators have 1970 as the initial year
except IMKTTRD/IGDP, IMKTSIZ/IGDP, whose initial year is 1985 given data availability.
* ** ***
, , represent significance levels of 0.1, 0.05 and 0.01 respectively.
Table 4
Panel regression.
M01 M02 M03 M04 M05 M06 M07 M08 M09 M10
Ind. Variables are CREDIT/GDP CREDIT M3/GDP M3 MKTTR/GDP MKTTRD MKTSIZ/GDP MKTSIZ GOVCSP/GDP GOVCSP
Panel A: Dependent variable is per capita physical capital stock growth (PKSPC)
Intercept (TRAP) 9.44* 8.70 8.24 7.93 19.91*** 19.94*** 20.27*** 20.59*** 13.31*** 12.04**
1.85 1.68 1.57 1.48 3.19 3.78 3.86 3.62 2.71 2.53
GRAT-group 2.63 1.94* 2.28 2.14** 1.54 1.63* 1.50 1.93** 1.86 0.55
1.13 2.02 1.07 2.13 1.09 1.94 1.33 2.39 0.92 0.69
HI-group 2.37 1.74 1.80 1.66 1.19 1.69 0.54 1.47 3.94 0.06
1.36 1.38 1.17 1.31 0.67 1.31 0.36 1.17 1.46 0.05
Ind. Variable 0.02 0.04*** 0.01 0.03*** 0.01 0.003** 0.01 0.001 0.05 0.10***
1.62 4.16 0.41 3.01 0.61 2.57 1.43 0.59 0.37 2.86
GRAT * Ind. Variable 0.01 0.01 0.004 0.02* 0.001 0.004** 0.001 0.01** 0.02 0.02
0.56 0.37 0.15 1.7 0.04 2.41 0.14 2.2 0.16 0.4
*
HI Ind. Variable 0.01 0.02 0.001 0.02 0.01 0.004*** 0.03*** 0.004* 0.11 0.09
0.98 0.62 0.08 0.82 0.85 2.71 3.22 1.94 0.79 1.05
TRADE/GDP 0.01** 0.01*** 0.01*** 0.01*** 0.01** 0.004* 0.01* 0.002 0.01** 0.01***
2.27 3.46 2.93 3.35 2.48 1.73 1.7 0.82 2.63 4.51
CPI 0.01*** 0.01*** 0.01*** 0.01*** 0.01*** 0.01*** 0.02*** 0.02*** 0.01*** 0.01***
5.12 5.05 4.84 5.82 3.81 3.39 5.44 4.12 4.73 3.78
Log(EXCHG) 0.01 0.01 0.01 0.01 0.06 0.07 0.01 0.01 0.001 0.001
0.2 0.22 0.24 0.27 1.04 1.32 0.16 0.1 0.01 0.03
LEGAL 0.04 0.03 0.01 0.001 0.04 0.07 0.05 0.11* 0.03 0.02
0.5 0.41 0.15 0.01 0.58 1.22 0.69 1.78 0.35 0.34
Log(IPOP) 0.31 0.41* 0.55* 0.49** 0.05 0.01 0.02 0.04 0.45** 0.28**
1.13 1.98 2.02 2.25 0.38 0.11 0.12 0.27 2.16 2.27
Log(IGDP) 1.09* 1.07* 1.17** 1.11* 2.08*** 2.02*** 2.05*** 2.02*** 1.70*** 1.49***
1.83 1.88 2.1 1.94 3.06 3.89 4.48 4.34 2.82 2.8
Log(ISECERL) 0.30 0.21 0.14 0.17 0.05 0.03 0.08 0.02 0.18 0.18*
1.37 1.03 0.71 0.93 0.42 0.27 0.64 0.17 0.98 1.7
F-value 13.8*** 14.7*** 14.1*** 14.8*** 13.9*** 12.9*** 15.6*** 13.0*** 9.5*** 21.5***
Adj-R2d 0.34 0.36 0.34 0.35 0.38 0.37 0.45 0.41 0.21 0.41
Obs. 1426 1416 1449 1400 1106 1059 957 912 1850 1696
Panel B: Dependent variable is per capita total factor productivity growth (TFPPC), independent variables are the same as those in Panel A
Intercept (TRAP) 5.68** 4.30** 6.00*** 5.45*** 8.10*** 7.42*** 9.63*** 7.65*** 8.03*** 5.57***
2.55 2.64 2.82 2.99 3.64 2.95 4.15 3.12 2.95 3.42
GRAT-group 2.81*** 1.31*** 1.79*** 1.35*** 1.48*** 1.18*** 1.43** 1.34*** 1.39 1.69***
5.68 4.83 3.33 4.96 3.36 4.3 2.68 4.07 1.2 5.48
HI-group 2.73*** 1.16** 1.61** 1.48*** 2.14*** 1.85*** 1.90*** 1.67*** 0.82 1.42***
3.43 2.54 2.26 3.36 3.41 3.75 2.71 3.72 0.62 3.41
Ind. Variable 0.01* 0.08*** 0.02** 0.05** 0.03*** 0.01*** 0.01 0.01 0.23*** 0.15***
1.85 6.21 2.14 2.5 2.73 3.46 1.68 0.85 4.09 5.1
GRAT * Ind. Variable 0.03*** 0.05** 0.01 0.03 0.02** 0.001 0.002 0.003 0.17** 0.10**
4.24 2.3 0.76 1.27 2.28 0.16 0.55 0.37 2.18 2.04
HI * Ind. Variable 0.01** 0.04* 0.002 0.01 0.03*** 0.01** 0.001 0.004 0.14* 0.11**
2.14 1.97 0.3 0.72 3.42 2.07 0.31 0.67 1.99 2.16
TRADE/GDP 0.01*** 0.004*** 0.01*** 0.004*** 0.004 0.003** 0.003 0.001 0.01** 0.004**
4.42 3.68 3.69 3.39 0.28 2.18 1.29 1.39 2.03 2.34
CPI 0.01*** 0.01*** 0.01*** 0.01*** 0.01** 0.01** 0.01*** 0.01*** 0.02*** 0.01***
3.02 2.79 3.25 3.78 2.45 2.51 3.7 4.59 3 3.02
Log(EXCHG) 0.05** 0.02 0.04 0.04 0.05** 0.05* 0.07* 0.05 0.02 0.04
2.18 1.07 1.65 1.62 2.53 1.86 1.98 1.33 0.75 1.58
LEGAL 0.05 0.03 0.07** 0.04 0.08* 0.03 0.06 0.05 0.06 0.003
1.32 1.32 2.12 1.26 1.87 0.84 1.16 0.98 1.37 0.1
Log(IPOP) 0.31*** 0.11 0.29*** 0.10 0.18** 0.07 0.20*** 0.10 0.01 0.04
2.76 1.68 3.15 1.51 2.3 0.9 2.75 1.44 0.14 0.59
Log(IGDP) 0.90*** 0.61*** 0.89*** 0.72*** 0.69*** 0.73*** 0.78*** 0.67*** 0.53** 0.67***
4.41 3.81 4.38 4.38 3.17 3.27 3.57 3.22 2.13 4.59
Log(ISECERL) 0.08 0.03 0.10 0.003 0.19*** 0.14* 0.23*** 0.18** 0.11* 0.03
1.02 0.57 1.66 0.01 2.72 2 3.21 2.31 1.77 0.65
F-value 6.8*** 9.3*** 6.4*** 7.1*** 7.5*** 7.6*** 6.6*** 6.0*** 8.9*** 9.9***
Adj-R2d 0.19 0.25 0.18 0.19 0.24 0.25 0.24 0.22 0.20 0.23
Obs 1426 1416 1449 1400 1106 1059 957 912 1850 1696
Panel C: Dependent variable is per capita GDP growth (GDPPC), independent variables are same as those in Panel A
Intercept (TRAP) 9.32*** 7.07*** 9.17*** 8.17*** 13.84*** 13.28*** 15.67*** 14.07*** 13.94*** 8.87***
2.98 2.9 3.33 3.34 4.21 4.01 4.83 4.39 3.38 3.92
GRAT-group 4.02*** 2.14*** 2.81*** 2.20*** 2.28*** 1.91*** 2.25*** 2.13*** 0.99 2.30***
4.59 5.43 3.04 5.29 3.39 4.55 3.27 4.61 0.63 5.21
(continued on next page)

Table 4 (continued)
M01 M02 M03 M04 M05 M06 M07 M08 M09 M10
Ind. Variables are CREDIT/GDP CREDIT M3/GDP M3 MKTTR/GDP MKTTRD MKTSIZ/GDP MKTSIZ GOVCSP/GDP GOVCSP
HI-group 4.14*** 2.14*** 2.80*** 2.47*** 3.16*** 2.91*** 2.54*** 2.71*** 0.64 2.06***
3.76 3.2 2.98 3.89 3.51 4.03 2.97 4.17 0.51 3.5
Ind. Variable 0.01 0.09*** 0.02* 0.05** 0.02** 0.01*** 0.004 0.01 0.23*** 0.18***
0.83 6.29 1.86 2.65 2.13 3.72 0.92 0.85 3.63 4.92
GRAT * Ind. Variable 0.03*** 0.05** 0.01 0.03 0.02* 0.001 0.001 0.002 0.20* 0.10*
3.51 2.24 0.7 1.39 1.96 0.29 0.2 0.25 1.86 1.74
HI * Ind. Variable 0.01* 0.03 0.003 0.01 0.03** 0.01** 0.004 0.01 0.14* 0.13**
1.88 1.45 0.31 0.41 2.58 2.33 0.82 0.78 1.75 2.3
TRADE/GDP 0.01*** 0.01*** 0.01*** 0.01*** 0.002 0.004** 0.001 0.001 0.01*** 0.01***
4.48 4.6 4.02 4.74 1.09 2.09 0.57 0.83 3.09 3.34
CPI 0.02*** 0.01*** 0.02*** 0.02*** 0.01*** 0.01*** 0.02*** 0.02*** 0.02*** 0.02***
3.31 3.35 3.54 4.37 2.77 2.72 4.16 4.62 3.73 3.32
Log(EXCHG) 0.04 0.02 0.03 0.03 0.06** 0.06* 0.07 0.04 0.001 0.03
1.42 0.71 0.94 1 2.3 2 1.26 0.82 0.02 1
LEGAL 0.07 0.03 0.10** 0.04 0.08 0.04 0.06 0.07 0.10 0.005
1.38 0.89 2.1 1.26 1.6 0.78 0.94 1.02 1.6 0.13
Log(IPOP) 0.45** 0.23** 0.47*** 0.23** 0.15 0.06 0.17* 0.11 0.18 0.13*
2.67 2.09 3.29 2.3 1.52 0.62 1.77 1.15 1.67 1.74
Log(IGDP) 1.41*** 0.99*** 1.38*** 1.12*** 1.34*** 1.36*** 1.43*** 1.33*** 1.29*** 1.13***
4.31 3.75 4.62 4.29 3.82 4.17 4.63 4.7 3.14 4.47
Log(ISECERL) 0.01 0.03 0.07 0.05 0.21** 0.17* 0.25** 0.21** 0.06 0.02
0.11 0.32 0.72 0.62 2.35 1.96 2.68 2.23 1.02 0.29
F-value 7.5*** 11.0*** 7.4*** 8.5*** 8.4*** 8.6*** 7.6*** 7.2*** 7.6*** 12.2***
Adj-R2d 0.20 0.28 0.20 0.22 0.26 0.27 0.27 0.26 0.17 0.27
Obs. 1453 1442 1476 1422 1111 1063 960 914 1893 1705
This table presents results of regressing economic growth on financial development indicators (Eq. (4)). Panels A, B and C report per capita physical capital
stock growth (PKSPC), per capita total factor productivity growth (TFPPC) and per capita GDP growth (GDPPC) as dependent variables respectively. Each
panel includes 10 columns with each representing one regression result. Columns M01 to M10 display five financial development indicators, namely
domestic credit to private sector (CREDIT), broad money (M3), total value traded (MKTTRD) and market capitalization (MKTSIZ), and government final
consumption (GOVCSP). Odd columns are expressed in percentage of GDP, while even columns are expressed in growth rate. All models use cluster-robust
standard error and adjust for year fixed effects.
* ** ***
numbered models use growth of independent variables. The purpose of the regression is to compare the impact of financial
system development on economic growth among the three groups of economies. We control for the effects of other factors
included in previous studies. Table 4, panel A shows, that consistent with previous studies, PKS growth is significantly pos-
itively associated with banking system development (CREDIT in model M02 and M3 in model M04). the coefficient of 0.04 in
model M02 shows that, within the TRAP-group, a country with 1% higher CREDIT growth enjoys 0.04% higher growth in per
capita PKS than its peers. If we compare TRAP-group and other groups, it seems that the coefficients are insignificantly dif-
ferent among these three groups. Similar observations can be found with M3 and GOVCSP, i.e., there are insignificant differ-
ences between TRAP-group and the other two with respect to the impact of the banking system and fiscal policy on PKS
growth. It seems that stock market size (MKTSIZ in model M08) has no impact on PKS growth within the TRAP-group,
and the differences between TRAP-group and the other two groups are moderately significant, resulting in insignificant
cross-sectional difference. However, the coefficients of the stock market liquidity (MKTTRD in model M06) show significant
cross-sectional variation with the TRAP-group. The impact of this indicator is significant less in the other two groups.
Panel B shows the cross-sectional impact of financial development indicators on TFP growth. Coefficients of cross-term
with CREDIT, MKTTRD and GOVCSP show that there are significant differences between the TRAP-group and the other
two groups. Panel C presents the cross-sectional impact of financial development indicators on GDP growth. Coefficients
in GDP regressions show patterns similar to those in TFP regressions, i.e., CREDIT, MKTTRD and GOVCSP have significantly
different impacts on GDP growth between the TRAP-group and the other two groups. It seems that both domestic credit to
private sector (CREDIT), equity market liquidity (MKTTRD), and government final consumption expenditure (GOVCSP) have
larger impacts on TFP and GDP growth in the TRAP-group than in the other two. Results in Table 4 are partially consistent
with Hypothesis 1 that some of the financial development indicators have significantly different impacts on economic
growth among the three groups. To be specific, the growth of domestic credit to private sector (CREDIT) and growth of total
value of stock traded (MKTTRD) have stronger positive impacts on economic growth in the TRAP-group than in other groups.
Obviously, there is come inconsistency here: despite the importance of CREDIT as a contributor to economic growth in the
TRAP-group shown in Table 4, Table 3 demonstrates that on average these countries use small amount of CREDIT during the
past five decades, significantly smaller relative to that in other groups (CREDIT/GDP of 37.22% in TRAP-group relative to
58.98% in GRAT- and 103.3% in HI-groups), and does not increase much relative to their own initial level (24.01%). This incon-
sistency hints us that something related to the banking system in the trapped economies may prevent them from extending
a large amount of credit to economic growth. We will explain this inconsistency together with results from Table 5.
Table 5
Vector autoregression.
Dx1;t ¼ GDP Dx1;t ¼ PKS Dx1;t ¼ TFP

GDPt1 CREDITt1 CPIt1 PKSt1 CREDITt1 CPIt1 TFPt1 CREDITt1 CPIt1
Panel A reports VAR with domestic credit to private sector (CREDIT) as the financial development indicator (D x2)
TRAP-group Dx1;t 0.38** 0.03* 0.03** 0.39** 0.01 0.01** 0.33** 0.02* 0.02**
CREDITt 1.46 0.05 0.36*** 2.46 0.05 0.28** 1.61 0.02 0.36***
CPIt 0.91 1.38*** 0.43** 4.56 1.45*** 0.41** 1.61 1.40*** 0.42**
GRAT-group Dx1;t 0.69*** 0.00 0.02*** 1.24*** 0.00 0.01*** 0.63*** 0.00 0.02***
CREDITt 1.39 0.09 0.03 1.01 0.01 0.01 1.83 0.14 0.04
CPIt 0.72 0.26 0.10 0.81 0.22 0.07 0.34 0.28 0.10
HI-Group Dx1;t 0.65*** 0.04 0.02*** 0.95*** 0.01 0.00 0.41*** 0.05* 0.02***
CREDITt 0.81 0.29** 0.11*** 0.89* 0.28** 0.12*** 0.75 0.33** 0.11***
CPIt 1.18 0.46 0.03 0.29 0.57 0.02 1.87 0.44 0.04
Panel B reports VAR with broad money (M3) as the financial development indicator (D x2)
TRAP-group Dx1;t 0.45*** 0.04* 0.01 0.83*** 0.03* 0.00 0.35** 0.03 0.01
M3t 1.47* 0.19 0.09** 1.51* 0.17 0.09** 1.41 0.20 0.09**
CPIt 1.43 2.27*** 0.20 0.87 2.27*** 0.20* 1.65 2.26*** 0.19
GRAT-group Dx1;t 0.70*** 0.01 0.02*** 1.32*** 0.01 0.01*** 0.62*** 0.01 0.02***
M3t 0.60 0.21 0.04 6.08 0.06 0.03 0.92 0.27 0.04
CPIt 0.12 0.09 0.09 0.98 0.02 0.06 0.26 0.12 0.09
HI-Group Dx1;t 0.32** 0.25*** 0.02*** 0.88*** 0.05** 0.00 0.20 0.18*** 0.02***
M3t 0.64 0.61** 0.04 0.98 0.38 0.05 0.52 0.73*** 0.04
CPIt 1.41 0.41 0.06 1.30 1.53 0.03 2.18 0.44 0.06
Panel C reports VAR with market capitalization (MKTSIZ) as the financial development indicator (D x2)
TRAP-group Dx1;t 0.31** 0.04*** 0.00 0.27 0.01 0.00 0.31** 0.04*** 0.00
MKTSIZt 0.30 0.12 0.11 1.73 0.29 0.07 0.49 0.13 0.11
** * *
CPIt 1.31 0.28 0.39 15.02 0.65 0.59*** 1.28 0.27 0.39**
GRAT-group Dx1;t 0.76*** 0.03*** 0.01 1.25*** 0.01*** 0.00 0.63*** 0.03*** 0.01
MKTSIZt 1.39 0.15 0.16 3.79 0.00 0.07 1.20 0.17 0.17
CPIt 0.88 0.10 0.01 5.43 0.23 0.09 1.29 0.10 0.01
HI-Group Dx1;t 0.59*** 0.05*** 0.01** 0.95*** 0.01** 0.00 0.42*** 0.05*** 0.01**
MKTSIZt 2.75** 0.15 0.18* 2.93** 0.18 0.16* 3.01* 0.12 0.18*
CPIt 1.13 0.39 0.06 1.66 0.42 0.07 0.95 0.36 0.07
Panel D reports VAR with total value traded (MKTTRD) as the financial development indicator (D x2)
TRAP-group Dx1;t 0.22 0.02** 0.00 0.69*** 0.01* 0.00 0.21 0.01* 0.01
MKTTRDt 0.01 0.10 0.13 3.22 0.06 0.12 1.23 0.12 0.13
CPIt 0.30 0.20 0.36** 0.28 0.21 0.36** 0.49 0.20 0.36**
GRAT-group Dx1;t 0.79*** 0.00 0.02*** 0.96*** 0.003** 0.00 0.64*** 0.00 0.02**
MKTTRDt 3.53 0.12 0.27 3.67 0.14 0.24 3.69 0.14 0.27
CPIt 1.53 0.07 0.04 0.84 0.04 0.02 2.31 0.07 0.04
HI-Group Dx1;t 0.66*** 0.01 0.03*** 0.95*** 0.002** 0.00 0.45*** 0.01 0.02***
MKTTRDt 4.02* 0.21 0.35*** 3.34* 0.27* 0.33** 4.61 0.24 0.36***
CPIt 2.19 0.28 0.15 2.04 0.26 0.17 2.34 0.26 0.15
Panel E reports VAR with government final consumption (GOVCSP) as the financial development indicator (D x2)
TRAP-group Dx1;t 0.30* 0.14 0.01* 0.32* 0.08 0.00 0.31* 0.09 0.01
GOVCSPt 0.57* 0.14 0.00 0.17 0.16 0.00 0.58 0.22 0.00
***
CPIt 4.86 1.52 0.54 10.25 0.78 0.52*** 4.68 1.87 0.55***
GRAT-group Dx1;t 0.67*** 0.17 0.02*** 1.25*** 0.01 0.01*** 0.58*** 0.18 0.02***
GOVCSPt 0.08 0.34 0.00 0.13 0.14 0.00 0.09 0.40* 0.00
CPIt 0.22 0.21 0.08 4.82 1.48 0.03 0.15 0.81 0.09
HI-Group Dx1;t 0.31* 0.62 0.02*** 0.96*** 0.01 0.00* 0.34** 0.38 0.02***
GOVCSPt 0.02 0.68*** 0.00 0.45*** 0.37*** 0.01 0.03 0.50*** 0.00
CPIt 3.15 0.55 0.02 3.32 2.99 0.08 3.98 2.52 0.06
This table presents empirical results of VAR models with a system of three equations, namely economic growth (x1), financial development (x2), and
inflation (CPI). There are three economic growth indicators, per capita GDP, per capita physical capital stock, and per capita total factor productivity. There
are five financial development indicators, namely domestic credit to private sector (CREDIT), broad money (M3), total value traded (MKTTRD) and market
capitalization (MKTSIZ), and government final consumption (GOVCSP).
P P P
Dx1;t ¼ a1;0 þ ki¼1 a1;i Dx1;ti þ ki¼1 b1;i Dx2;ti þ ki¼1 c1;i DCPIti þ U 1;t ð6aÞ
Pk Pk P
Dx2;t ¼ a2;0 þ i¼1 a2;i Dx1;ti þ i¼1 b2;i Dx2;ti þ ki¼1 c2;i DCPIti þ U 2;t ð6bÞ
Pk Pk P
DCPIt ¼ a3;0 þ i¼1 a3;i Dx1;ti þ i¼1 b3;i Dx2;ti þ ki¼1 c3;i DCPIti þ U 3;t ð6cÞ
The order of the VAR model is decided by Akaike’s Information Criterion. Most models have optimal lag-order of 1, however, there are still a few with lag-
order of 2 or 3. We only report the coefficient of AR1 (xi, t1) since higher order’s AR coefficients are generally insignificant. Although the T-values are not
reported for each coefficient, stars are presented with the coefficients to indicate significance level. A significant coefficient of an AR1 independent variable
indicates that the independent variable Granger causes the dependent variable. We run VAR model for three equally waited portfolio, TRAP-group, GRAT-
group, and HI-group.
* ** ***
Next, we analyze VAR results to gain some insight on the dynamic relations among economic growth, financial develop-
ment, and inflation. As discussed earlier, we will investigate whether financial development leads economic growth, whether
economic growth has a feedback effect on financial development, whether financial development leads inflation, and
whether inflation has a feedback effect on financial development. The VAR is run at the aggregate level for each group of
economies, rather than for each individual economy. One VAR system has three times series, namely economic growth ser-
ies, financial development series and inflation series. Each time series serves as the dependent variable of models 6a, 6b, and
6c respectively. Lags of all three variables serve as independent variables. We first test stationarity of each time series. Aug-
mented Dickey-Fuller (ADF) Test shows that most series are stationary. This is reasonable, since all variables are aggregated
at the portfolio level, and they are also measured as the rate of growth. We then use Akaike’s Information Criterion (AIC) to
select the optimal lag-order of the autoregressive regression. Majority of optimal lag-order is AR (1), and a few series have AR
(2) or AR (3). We report only one lag in Table 5 for two reasons: first, almost none of the AR (2) and AR (3) coefficients are
significant at 0.01 level; second, Table 5 has a limited size.
Table 5 presents the VAR results in five panels, each with one specific financial development indicator as the main vari-
able. Panel A’s main variable is domestic credit to private sector (CREDIT). The VAR regression results are summarized in nine
3 by 3 matrixes. Matrixes 1–3 summarizes regression results for TRAP-group, Matrix 1 presents a system of VAR regression
of GDP, CREDIT and CPI, Matrix 2 of PKS, CREDIT and CPI, Matrix 3 of TFP, CREDIT and CPI. Matrixes 4–6 summarizes results
of the same VAR system for GRAT-group and matrixes 7–9 summarizes results of the same VAR system for HI-group. First,
none of the coefficients b1,1 in all three groups and all three VAR equations are significant at more significant than 0.05 sig-
nificance level. This indicates that CREDIT does not sufficiently granger cause PKS, TFP, and GDP growth for any group. Next,
none of the coefficient a2,1 is significant at 0.05 level, indicating no feedback relation between economic growth and CREDIT.
However, we do observe a triplet of significant coefficients in TRAP-group only, a positive and significant b3,1, a positive and
significant c2,1, and a significantly negative c1,1. For example, in matrix 1, b3,1 is 1.38, which means a 1% increase in CREDIT
last year, will Granger cause a 1.38% increase in inflation rate this year; c2,1 is 0.36 and c1,1 is - 0.03, which shows that a 1%
increase in inflation last year calls for a 0.36% increase in CREDIT and a 0.03% drop in GDP growth this year. This is exactly
what we forecast as the worst scenario: in typical TRAP-group, CREDIT fails to provide fuel to PKS, TFP and thus GDP, instead,
it stimulates inflation which calls for an increase in CREDIT and a decrease in growth. This finding is consistent with Hypoth-
esis 3, where we predict that in troubled economies, there may be a circulation of credit and inflation, which leads to a down-
ward spiral between financial development (here measured by CREDIT) and economic growth. We do not observe similar
dynamic relationship for a typical GRAT- or HI-economy.
Panel B reports Broad money (M3) as the main finance development indicator. We observe a pair of significant coeffi-
cients in TRAP-group. In Matrix 1, the coefficient of 2.27 in cell b3,1 and 0.09 in c2,1. This means, a 1% growth of M3 at
t 1 contributes 2.27% to growth in CPI at t, which contributes 0.2% (0.09 2.27) to M3 at t + 1. Matrixes 2 and 3 con-
firms findings in Matrix 1. This finding is consistent with Hypothesis 3, where we predict that if a financial development
indicator (here measured by M3) fuels inflation rather than fueling PKS growth, TFP growth, or GDP growth, then, the eco-
nomic growth will fall behind.
Panel C presents VAR results with equity market growth (MKTSIZ) as the main finance development indicator. We
observe 8 out of 9 b11 coefficients are positive and significant. This demonstrates that of all three economies, growth in
MKTSIZ contributes positively and significantly to GDP, PKS and TFP (except one occasion where MKSIZ does not contribute
to PKS growth in TRAP-group). What is more interesting, we observe two pairs of Granger causality and feedback relation-
ship between both GDP and PKS with MKTSIZ. For example, in Matrix 7, the coefficient of 0.05 in b1,1 shows that 1% increase
in MKTSIZ will lead 0.05% increase in GDP; and coefficient of 2.75 in a2,1 shows that 1% increase in GDP at t 1 will lead to
2.75% increase in MKTSIZ at t. This observation is consistent with Hypothesis 2, which predicts that with causality and feed-
back between a financial indicator (MKTSIZ in this case) and economic growth, an upward spiral between GDP and equity
market size will form, which jointly drives the economy to a considerable level in a typical high-income economy. We do not
observe such a positive reinforcement in TRAP-group or GRAT-group.
Panel D presents results with another equity market development indicator, the total value of stocks traded (MKTTRD). It
seems that for most of the regressions, MKTTRDt1 has some positive contribution to GDP, PKS and/or TFP for all three
groups, although some coefficients are not significant at 0.05 or smaller level. There is a similar observation of reinforcement
between MKTTRD and PKS growth in HI-group, but not as statistically significant as that in MKTSIZ. Panel E presents results
with fiscal policy indicator (GOVCSP). There is no consistent and significant impact of GOVCSP on GDP, PKS or TFP.
In summary, VAR regressions present results consistent with Hypotheses 2 and 3. It seems that the banking system in the
TRAP-group, represented by M3 and CREDIT, lead to inflation, which induces relaxed credit and monetary supply. The bank-
ing system and inflation form a circular movement to reinforce each other rather than funneling funds to fuel to economic
growth. This helps to explain the inconsistency observed in Tables 3 and 4, that the TRAP-group has significantly lower
CREDIT to GDP ratio, and slower growth in CREDIT than other two groups despite CREDIT have a positive association with
growth in that group. The causality and feedback between CREDIT and inflation cast a credible threat that prevents the use of
CREDIT. We also observe that equity market growth, such as MKTSIZ and MKTTRD fuels economic growth in all three groups.
More interestingly, in the HI-group we detect strong cause-and-feedback relations between MKTSIZ and all three indicators
of economic growth, and some considerable cause-and-feedback relation between MKTTRD and PKS growth. It seems that
the equity market serves economic growth well in all three groups. Furthermore, a large equity market supplies adequate
funds to pull the economy to grow, as the economy grows it generates demand for funds, which pushes the equity market
to expand. The implication of these observations is that the banking system is not as efficient as the equity market in driving
economic growth; more significantly, the banking system in troubled economies help to promote inflation.
We do robustness tests by replacing key dependent variables, e.g. PKS and TFP, with alternative measures discussed in
Section 3 in the cross-sectional and time-series regressions. The results remain the same, although not as significant as
the main tests in some regressions. We also use alternative measures to replace some key independent variables, such as
using claims to private sectors to M3 as a bank efficiency indicator, and the results remain the same as that of CREDIT.
We include China and Thailand in the TRAP-group, and this changes the regression results significantly. A closer examination
shows that these two countries start at extremely low initial GDP and have experienced phenomenal growth in all indicators
in the past decades. For example, per capita GDP growth in China is much greater than that in almost all other economies in
the sample. Including both China and Thailand in the TRAP-group biases all indicators significantly upward. Deleting Israel
from the GRAT-group does not change the results.
5. Conclusion
This paper tests the impact of financial systems on economic growth in cross-sectional and time series frameworks. It
seems that consistent with previous research, a country with higher growth in Broad money (M3), credit to private sector
(CREDIT), larger and more liquid stock market (MKTTRD, MKTSIZ) will enjoy significantly faster accumulation of physical
capital stock (PKS) and economic growth than its peers. Furthermore, the impacts of CREDIT and MKTTRD on economic
growth vary among the three groups of economies, namely the TRAP-, the GRAT-, and the HI-groups.
VAR results demonstrate that banking system development (both M3 and CREDIT) Granger causes inflation (CPI) in a typ-
ical country that is trapped in the middle-income swamp. It seems that bank credits and funds Granger cause inflation, and
inflation absorbs and requires more credits and funds from banks. This forms a downward spiral between financial devel-
opment and economic growth: the more funds and credits are provided to the economy, higher the inflation, and lower
the economic growth rate. We observe neither causality nor feedback between banking system development and inflation
in other groups of economies. It is a common belief that hyperinflation grants trapped economies with their current states.
We now discover evidence that the hyperinflation has a strong tie with the banking system. It is not that the banking system
provides too much money or credit in a typical trapped-economy: HI-group has a much larger quantity of money supply and
credit. It is that money and credit in the trapped economies are channeled to inflation that hinders economic growth. Fur-
thermore, the credible threat of hyperinflation prevents these countries from using bank credit as much as other countries.
It seems that equity market development has a healthy impact on growth in all three groups of economies. We observe
that stock market growth leads physical capital accumulation, total factor productivity growth and economic growth in all
economies. This means the supply-push from the stock market motivates the economy to grow in general. This is an encour-
aging observation for trapped economies since the stock market is efficient in directing funds to real sectors in these econo-
mies. More significantly, we observe a positive feedback effect between stock market growth and economic growth in a
typical high-income economy. The feedback confirms that the demand-pull also occurs in high-income economies and there
is an upward circulation of funds from the stock market to real sectors of the economy, and real sectors, in turn, generate
more funds to enlarge the stock market. As funds circulate within this economy, the economy enjoys sustainable growth.
These findings, particularly, the downward spiral of banking system development and economic growth calls for atten-
tion from policymakers in economies that have been trapped in the middle-income group for many decades: there may be
some factors within the banking system that prevent funds and credit from fueling physical capital accumulation and/or
technological innovation. Instead, these factors may assist to funnel credit and money to inflation. Future research on the
banking industry in the troubled economies (e.g., along the lines of Brock and Suarez, 2000; Gelos, 2009; Olivero et al.,
2011; Tovar et al., 2012) is critical in order to identify these factors and break the link between banking system development
and inflation.
Acknowledgement
This paper was presented at the 2017 Cross Country Perspectives of Finance Conference held in Chengdu, China and Chi-
ang Mai, Thailand.
We are grateful for the encouragement from the editor, helpful comments from the two anonymous referees, the partic-
ipants and the discussant of the Journal of International Financial Markets, Institutions and Money. All errors are our own.
Appendix A. Member economies
Based on information from the two columns GDPPC_1970 (per capita GDP in 1970) and 2015_WDI_Group (2015 World
Bank’s grouping on its member countries), we define three groups of economies, high-income economies (HI-group) include
those categorized as high income in both 1970 and 2015. Graduated economies (GRAT-group) include the middle-income
countries that are middle income in 1970 but high income in 2015. Trapped economies (TRAP-group) are the middle-
income country that remains as middle income since 1970.
Country Code GDPPC_1970 GNIPC_2015 2015_WDI_Group Category in This Study

LUX 35,457 73,530 Hi-income HI-group
NOR 32,276 93,050 Hi-income HI-group
DNK 30,542 60,170 Hi-income HI-group
SWE 26,464 57,880 Hi-income HI-group
AUS 26,020 60,360 Hi-income HI-group
CAN 24,629 47,460 Hi-income HI-group
NLD 24,369 49,030 Hi-income HI-group
USA 23,310 56,300 Hi-income HI-group
SAU 22,134 23,810 Hi-income HI-group
BEL 20,105 44,230 Hi-income HI-group
FRA 20,091 40,730 Hi-income HI-group
DEU 19,625 45,790 Hi-income HI-group
AUT 19,515 47,630 Hi-income HI-group
JPN 18,435 38,880 Hi-income HI-group
FIN 18,374 46,630 Hi-income HI-group
GBR 17,880 43,720 Hi-income HI-group
ITA 17,653 32,970 Hi-income HI-group
ISL 16,083 49,960 Hi-income HI-group
ISR* 14,477 36,080 Hi-income GRAT-group
VEN** 14,329 12,055 Md-income TRAP-group
ESP 13,543 28,420 Hi-income GRAT-group
GRC 13,392 20,360 Hi-income GRAT-group
IRL 12,324 51,850 Hi-income GRAT-group
PRT 8770 20,440 Hi-income GRAT-group
TTO 7202 18,840 Hi-income GRAT-group
ARG 7057 12,300 Md-income TRAP-group
SGP 6507 54,020 Hi-income GRAT-group
IRN 6230 5340 Md-income TRAP-group
ZAF 6121 6070 Md-income TRAP-group
HKG 5796 41,180 Hi-income GRAT-group
URY 5671 15,830 Hi-income GRAT-group
MEX 5213 9860 Md-income TRAP-group
BRA 4706 10,100 Md-income TRAP-group
CHL 4657 14,270 Hi-income GRAT-group
JAM 4581 4730 Md-income TRAP-group
TUR 4221 12,000 Md-income TRAP-group
MLT 3743 24,690 Hi-income GRAT-group
CRI 3707 10,500 Md-income TRAP-group
PAN 3402 11,480 Md-income TRAP-group
PER 3382 6160 Md-income TRAP-group
COL 2760 7130 Md-income TRAP-group
DZA 2692 4830 Md-income TRAP-group
ECU 2486 6000 Md-income TRAP-group
MYS 1993 10,450 Md-income TRAP-group
GUY 1926 4060 Md-income TRAP-group
KOR 1815 27,250 Hi-income GRAT-group
DOM 1637 6250 Md-income TRAP-group
THA*** 929 5710 Md-income TRAP-group
CHN*** 228 7950 Md-income TRAP-group
GDPPC is in 2010 Constant US$. GNIPC is in 2015 current US$.
*
Israel, although has GDPPC higher than the benchmark ($14,329) in 1970, its GDPPC is closer to Venezuela than to that of Iceland. In robustness tests,
we delete it from the sample.
**
Venezuela’s GNI in 2015 is estimated by the World Bank as $12,055.
***
Thailand and China’s 1970 GDPPCs are too low to be considered as the same as other middle-income economies. We delete them from the sample in the
main tests and include them in the robustness tests.
Appendix B. Supplementary material
Supplementary data associated with this article can be found, in the online version, at https://doi.org/10.1016/j.intfin.
2018.11.008.
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J. Int. Financ. Markets Inst.

Money 59 (2019) 74–89

Contents lists available at ScienceDirect

Journal of International Financial

The impact of financial development on economic growth in

E-mail address: yang@edwards.usask.ca

3. Data and methodology

3.1. Data and sample

3.2. Methodology and variables

3.2.1. Cross-sectional tests

Gy ¼ aGk þ Gtfp ð2Þ

3.2.2. Time series tests

4. Results and interpretation

Means T-test comparing Standard deviation F-test comparing

(continued on next page)

Dx1;t ¼ GDP Dx1;t ¼ PKS Dx1;t ¼ TFP

Appendix A. Member economies

Country Code GDPPC_1970 GNIPC_2015 2015_WDI_Group Category in This Study

Appendix B. Supplementary material

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