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Journal of the Asia Pacific Economy

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Does Financial Development Cause Economic Growth? A Panel Data Dynamic Analysis for the Asian Developing Countries
Muzafar Shah Habibullah & Yoke-Kee Eng
a b a b

Department of Economics, Universiti Putra Malaysia, Selangor, Malaysia

Faculty of Accountancy and Management, Universiti Tunku Abdul Rahman, Kajang, Selangor, Malaysia Available online: 27 Jun 2007

To cite this article: Muzafar Shah Habibullah & Yoke-Kee Eng (2006): Does Financial Development Cause Economic Growth? A Panel Data Dynamic Analysis for the Asian Developing Countries, Journal of the Asia Pacific Economy, 11:4, 377-393 To link to this article: http://dx.doi.org/10.1080/13547860600923585

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Journal of the Asia Pacic Economy Vol. 11, No. 4, 377393, November 2006

Does Financial Development Cause Economic Growth? A Panel Data Dynamic Analysis for the Asian Developing Countries
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MUZAFAR SHAH HABIBULLAH & YOKE-KEE ENG

Department Faculty

of Economics, Universiti Putra Malaysia, Selangor, Malaysia of Accountancy and Management, Universiti Tunku Abdul Rahman, Kajang, Selangor,

Malaysia

ABSTRACT This paper examines the causal relationship between nancial development and economic growth of the Asian developing countries from a panel data perspective and uses the system GMM technique developed by Arellano & Bover (1995) and Blundell & Bond (1998) and conducts causality testing analysis. The panel data sets involve 13 Asian developing countries: Bangladesh, India, Indonesia, South Korea, Lao PDR, Malaysia, Myanmar, Nepal, Pakistan, Philippine, Singapore, Sri Lanka and Thailand for the period 19901998. The result of our study is in agreement with other causality studies by Calderon & Liu (2003), Fase & Abma (2003), and Christopoulos & Tsionas (2004) that nancial development promotes growth, thus supporting the old Schumpeterian hypothesis and Patricks supply-leading hypothesis. KEY WORDS: Finance-growth nexus, demand-following, supply-leading, Asian countries JEL CLASSIFICATIONS: O11, O16, O53

Introduction Capital formation has been widely accepted as a prerequisite for economic growth (Lewis, 1955; Nurkse, 1962). Nevertheless, in the fragmented and distorted nancial system of the developing economies, capital is hard to come by. In the 1960s and early 1970s, the developing countries had been described as nancially repressed economies (McKinnon, 1973; Shaw, 1973). Pervasive government intervention in controlling interest rates and the allocation of credit tends to distort nancial markets and, as a result, lead to fragmentation of nancial markets and nancial disintermediation. McKinnon recommends the liberalization of the interest rates to attain their
Correspondence Address: Muzafar Shah Habibullah, Department of Economics, Faculty of Economics and Management, Universiti Putra Malaysia, 43400 Serdang, Selangor, Malaysia. E-mail: muzafar@ econ.upm.edu.my ISSN 13547860 Print/14699648 Online/06/04037717 DOI: 10.1080/13547860600923585
C

2006 Taylor & Francis

378 M. S. Habibullah & Y.-K. Eng true equilibrium level and by determining credit allocation on the basis of viability and productivity of projects. The recommendations made by McKinnon are well taken by majority of the developing countries of Latin America, Africa and Asia. Many of these developing countries attempted to increase the role of market forces in the determination of interest rates, the allocation of credit and the overall scale of nancial intermediation in the late 1970s and the 1980s. However, the results of the process of nancial liberalization in many developing countries have varied from a disastrous one to a successful transition to a more efcient and market-oriented nancial system. While the Southern Cone region of Latin America-Argentina, Chile and Uruguay experienced bank panics and collapses as a result of nancial liberalization (Diaz-Alejandro, 1985), the other countries in this region in particular, Colombia, Brazil and Mexico have abandoned nancial liberalization programs (Fry, 1989). Nonetheless, nancial liberalization in a number of Asian countries has helped make nancial systems more efcient and has enhanced the effectiveness and exibility of monetary policies.1 In the early 1960s, the nancial system of almost all countries in Asia were characterized by one or more of a range of restrictive nancial measures, including interest rate regulations, selective credit allocation controls, explicit and implicit taxes on nancial institutions, government ownership of nancial institutions, segmentation and international capital controls, among others. However, such features have either become less distinct or completely removed as deregulation, market-orientation and internationalization of banking and nance have proceeded at a rapid pace since the early 1980s. Asia, South Korea, Taiwan and the countries of the ASEAN region have beneted greatly from the nancial liberalization exercises.2 For instance, the development of monetization and the nancial deepening3 in selected Asian countries are shown in Table 1. The degree of monetization in the Asian countries has been signicant over the 195694 periods. The use of money (M1), relative to GNP (gross national product), has stabilized in most of the Asian countries, and declined in Myanmar, Singapore, Sri Lanka, and Thailand. However, increasing use of broad money (M2) is evident in all the Asian countries, as shown by the consistent rise in the countries M2/M1 and M2/GNP ratios during the periods, reecting the movement towards higher level of monetized economy. During the deregulation period of 198694, Thailand registered the highest M2/M1 ratio of 7.46, followed by Korea (4.00), Singapore (3.75), Malaysia (3.61), Philippines (3.38) and Indonesia (3.34). Other Asian countries show a ratio of less than 3.00. During the same period, other indicators of monetization, the holdings of money per capita and total bank deposits per capita, suggest that Singapore and Taiwan have signicantly higher levels of monetization relative to those in the remaining eight Asian countries. Table 1 also presents the relationship between total assets of the nancial system and national income, which measure the stage of nancial intermediation in a country. More interestingly, the dominance of the banking system (comprising only the Central Bank and commercial banks) in all the Asian nancial system was particularly marked,

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Table 1. Selected measures of monetization and nancial deepening in selected Asian countries, 196694
Indonesia 196675 197685 198694 196675 197685 198694 196675 197685 198694 196675 197685 198694 196675 197685 198694 0.08 0.11 1.33 0.60 12 8 0.29 0.15 0.14 0.29 0.22 0.26 0.48 197194 1.24 1.05 1.37 1.24 Singapore 0.27 0.61 2.29 0.44 829 744 0.97 0.07 0.86 0.92 0.38 1.42 1.80 197194 1.41 2.50 1.31 1.41 1.26 1.04 1.20 1.16 0.54 1.97 2.50 0.16 0.38 0.53 0.20 0.66 0.86 197194 0.24 0.70 0.93 1.90 2.63 0.64 1.05 1.45 0.54 0.24 0.24 0.48 0.74 0.30 0.37 0.67 197194 1.11 1.04 1.23 1.14 0.25 0.66 2.63 0.51 4243 4249 0.24 0.89 3.75 0.46 12503 12889 0.11 0.29 2.59 0.45 94 82 0.11 0.34 3.28 0.46 556 578 0.10 0.39 4.00 0.41 2276 2524 0.17 0.25 1.51 0.53 44 28 0.14 0.29 2.18 0.50 77 62 0.13 0.31 2.40 0.54 146 113 0.72 0.25 0.44 0.69 South Korea Sri Lanka 0.18 0.44 2.46 0.34 316 244 1.09 0.32 0.63 0.94 1.53 1.46 1.50 1.47 1.15 0.89 1.76 1.15 1.38 1.20 1.62 1.37 Taiwan 0.27 0.74 2.70 0.27 1759 1290 1.55 0.35 0.96 1.31 197194 1.39 1.24 1.45 1.37 1.47 1.47 3.16 0.18 12449 9617 2.59 0.63 1.55 2.18 0.14 0.30 2.24 0.62 69 53 0.58 0.21 0.31 0.52 0.26 0.60 0.86 0.17 0.40 0.57 0.23 0.72 0.95 197194 0.40 1.23 1.63 0.39 0.13 0.51 0.34 1.10 1.44 197194 0.45 1.39 1.84 0.12 0.07 0.19 0.18 0.21 0.38 197194 0.24 0.30 0.54 0.48 0.86 0.65 1.19 2.17 0.51 1.44 1.84 0.19 0.39 0.54 0.58 0.16 0.34 0.50 0.94 0.29 0.54 0.82 197194 1.20 1.25 1.23 1.22 Thailand 0.10 0.43 4.34 0.67 278 250 0.89 0.20 0.52 0.72 197194 1.38 1.06 1.46 1.34 0.09 0.70 7.46 0.69 1116 1062 1.36 0.23 0.86 1.09 0.11 0.19 1.73 0.45 82 61 0.12 0.40 3.34 0.41 239 211 0.18 0.37 2.02 0.50 180 145 0.20 0.57 2.91 0.47 924 803 0.23 0.81 3.61 0.41 1985 1668 0.23 0.25 1.11 0.83 22 6 0.21 0.27 1.29 0.91 44 14 0.21 0.30 1.44 0.91 175 58 0.09 0.12 1.36 0.69 10 4 0.12 0.24 2.00 0.64 31 21 0.14 0.32 2.35 0.69 55 40 0.10 0.21 1.98 0.52 54 59 0.08 0.23 2.74 0.53 127 148 0.08 0.27 3.38 0.67 205 180 0.99 0.41 0.49 0.90 Malaysia Myanmar Nepal Philippines

Financial indicators

M1/GNP M2/GNP M2/M1 Currency/M1 M2 per capita (US$) Per capita total bank deposits (US$) Total nancial assets/GNP Assets/GNP: Central Bank Commercial banks Total banking system

Income elasticity of net issues: Financial system, of which; Central Bank Commercial banks Total banking system

Financial indicators

196675 197685 198694 196675 197685 198694 196675 197685 198694 197075 197685 198694 196675 197685 198694

Does Financial Development Cause Economic Growth?

M1/GNP M2/GNP M2/M1 Currency/M1 M2 per capita (US$) Per capita total bank deposits (US$) Total nancial assets/GNP Assets/GNP: Central Bank Commercial banks Total banking system

Income elasticity of net issues: Financial system, of which; Central Bank Commercial banks Total banking system

379

Sources: Habibullah (1999b), and Habibullah & Smith (1997).

380 M. S. Habibullah & Y.-K. Eng ranging from 0.54 for Nepal to 2.50 for Singapore. The income elasticity of assets of nancial institutions to national income is just as revealing. As indicated in Table 1, the income elasticity of nancial assets during the deregulation era was way above unity for all the Asian countries. The income elasticity of nancial assets in Malaysia, which was 1.53 during the period 197194, is one of the highest among the Asian countries. The success of increasing the role of the nancial sector in enhancing growth in the Asian developing countries has received positive response from the World Bank. The World Bank (1989, p. 11) reports that, in East Asia the newly industrialized economies and several others have pursued sound macroeconomic policies and maintained the competitiveness of the exports. They have generally adapted well to the shocks of the 1970s and early 1980s. The populous economies of South Asia have also achieved good results. Their success has more to do with macroeconomic stability, prudent scal and external borrowing policies and rural modernization than with internationally competitive trade policies. Furthermore, a comprehensive study by the World Bank (1989) on those developing countries that have embarked on nancial liberalization programs supports the contention that nancial liberalization matters for economic growth. The World Bank (1989, p. 30) reports that, faster growth, more investment and greater nancial depth all come partly from higher saving. In its own right, however, greater nancial depth also contributes to growth by improving the productivity of investment. Investment productivity is signicantly higher in the faster growing countries, which also have deeper nancial systems. This suggests a link between nancial development and growth. As a matter of fact, the role of nancial sector has been well recognized in the development literature. The seminal work of Patrick (1966) has resulted in widespread investigations into the role of the nancial sector as an engine for economic growth. Patrick points out two possible relationships between nancial development and economic growth. First, as the economy grows, it generates demand for nancial services, which he calls a demand-following phenomenon. According to this view, the lack of nancial institutions in developing countries is an indication of lack of demand for their services. Second, the establishment and the widespread expansion of nancial institutions in an economy may actively promote development, which Patrick called supply-leading phenomenon. This latter view, which has been dubbed the nancial-led growth hypothesis, has been popular among governments in several developing countries as a means to promoting development. Moreover, there are two views in which the nancial system can be manipulated for enhancing economic growth. The Struturalist School recommends an expansion in the structure of the nancial system, such as an increase in the number of nancial institutions. This school also encourages an increase in the array of nancial instruments made available to the public (Goldsmith, 1969; Patrick, 1966). Neo-liberals on the other hand, advocate the liberalization of the nancial system, by which they

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mean the relaxation of controls imposed on the nancial systems by the monetary authorities (McKinnon, 1973; Shaw, 1973). Neo-liberals believe that administratively determined (as opposed to market-determined) low rates of interest may not encourage savings. Without savings there cannot really be any investment. Thus, according to this school, the freeing of interest rates is the key to capital formation and growth. Goldsmith (1969), McKinnon (1973), Shaw (1973), Fry (1988) and more recently King & Levine (1993a, 1993b) are among others who have provided evidence that nancial development is a prerequisite for economic growth. The objective of this paper is to provide further evidence on the nancial-led growth hypothesis proposed by Patrick using the dynamic panel data analysis popularized by Arellano & Bond (1991). Since long series of data are scarce for the developing countries, by using the panel data approach, it is possible to analyze the issue of nancial-led growth using pooled cross-sectional and time-series data. To explore the causal relationship between nancial deepening and economic growth, we use the Generalized Method of Moments (GMM) panel estimates proposed by Arellano & Bover (1995) and Blundell & Bond (1998) to extract consistent and efcient estimates on the role of nancial development on economic growth in the Asian developing countries. The selected Asian countries included in the present study are Bangladesh, India, Indonesia, South Korea, Lao PDR, Malaysia, Myanmar, Nepal, Pakistan, Philippine, Singapore, Sri Lanka and Thailand. This paper is organized as follows. The next section briey reviews the theoretical and empirical aspect on the role of nancial development on economic growth. The section after discusses on the method of estimation, and the discussions of the empirical results are presented in the subsequent section. Lastly, our concluding remarks are given in the nal section.

A Review of Related Literature Theoretical considerations The importance of the saving and investment process in economic development arises partly because capital goods depreciate over time, a signicant ow of saving must be generated and transferred into productive investment just to maintain a nations capital stock and preserve existing living standards. For living standards to rise, a healthy ow of saving and investment must be sustained. As a general proposition, the greater the proportion of current output saved and invested, the more rapid the rate of economic growth. In a modern society, as a result of specialization and division of labor, the process of investment is separated from the savings process. Thus, it is the function of the nancial institutions to provide the mechanism to channel funds from the savers to the investors. By reducing the asymmetry of information for borrowers and lenders, the allocation of funds to the most productive sectors can be made, thereby increasing economic efciency and social welfare.

382 M. S. Habibullah & Y.-K. Eng The role of the nancial sector as the engine of growth or supply-leading one in enhancing growth goes far back to the work of Schumpeter (1934). Schumpeter argues that nancial sector leads economic growth by acting as a provider of fund for productive investments and therefore could lead to accelerating economic growth. The theoretical work linking the nancial sector to economic growth was provided in later years, among others by Pagano (1993), Greenwood & Jovanovic (1990), Levine (1991), Bencivenaga & Smith (1991) and Saint-Paul (1992). Pagano (1993) provides a simple endogenous growth model called the AK model to look at the impact of nancial development on economic growth. To illustrate how nancial development affects growth, we draw heavily from Pagano (1993) by assuming the following aggregate production function

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Yt = A t K t

(1)

where output is a linear function of the aggregate capital stock. This production function can be seen as a reduced form as a result (a) as in Romer (1989), that a rm in a competitive economy with external economies faces a technology with constant returns to scale but productivity is an increasing function of the aggregate capital stock K t ; and (b) as in Lucas (1988), assuming K t be a composite of physical and human capital, then the two types of capital are reproducible with identical technologies. Assuming in the model that there is no population growth and the economy produces only one good which can be consumed or invested, if it is invested, and given the rate of depreciation per period as , then the gross investment equals It = K t+1 (1 )K t (2)

The role of nancial institutions is to transfer savings into investment. In the process, they absorb resources so that a dollar saved by savers will generate less than a dollars worth of investment. Assume as the fraction of each dollar saved that is available for investment, while the remainder (1- ) is retained by the nancial institutions as a reward for the services rendered. In a closed economy, the capital market equilibrium requires that gross saving St equals gross investment It . The following equation ensure equilibrium in the capital market St = It Next we derive the growth rate at time t + 1 from equation (1) as gt+1 = (Yt+1 /Yt ) 1 = (K t+1 /K t ) 1 (4) (3)

Does Financial Development Cause Economic Growth?

383

Rewriting equation (2) as K t = It + (1 )K t+1 and substituting into equation (4) we have gt+1 = (It + K t K t K t )/K t = (It /K t ) (5)

Rewriting equation (1) as K t = Yt /A and, together with equation (3), substituting into equation (5) and dropping the time indices, we have the steady-state growth rate as g = A(I /Y ) = As (6)

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where s denotes the gross savings rate (S/Y ). Equation (6) reveals that there are two ways in which the development of the nancial sector might affect economic growth. First, banking sectors that operate in a more competitive environment, are likely to become more efcient in the process of transferring saving into investment, and as a result can be raised. As rises in equation (6), it also increases the growth rate g. Second, to their best interest, nancial institutions can allocate funds to those projects where the marginal product of capital is highest. In this model, banks increase the productivity of capital, A, thereby promoting growth. Thus, savings channeled through nancial institutions are allocated more efciently, and the higher productivity of capital results in higher growth. Other theoretical work by Greenwood & Jovanovic (1990), Levine (1991), Bencivenaga & Smith (1991) and Saint-Paul (1992) indicate that efcient nancial markets improve the quality of investments and promote economic growth. Bencivenga & Smith (1991) contend that banks as liquidity providers permit risk-averse households to hold interest-bearing deposits and the funds obtained are then channeled to productive investment. By eliminating self-nanced capital investment by rms, banks also prevent the unnecessary liquidation of such investment by rms who nd that they need liquidity. In other words, nancial intermediaries permit an economy to reduce the fraction of its savings held in the form of unproductive liquid assets, and to prevent misallocations of invested capital due to liquidity needs. This suggests that nancial intermediaries may naturally tend to alter the composition of savings in a way that is favorable to capital accumulation, and if the composition of savings affects real growth rates, nancial intermediaries will tend to promote growth. Levine (1991) demonstrates that stock markets help individuals manage liquidity and productivity risk and, as a result, stock markets accelerate growth. According to Levine, in the absence of nancial markets, rm-specic productivity shocks may discourage risk-averse investors from investing in rms. However, the stock markets allow individuals to invest in a large number of rms and diversify against idiosyncratic rm shocks. This raises the fraction of resources allocated to rms, expedites human capital accumulation and promotes economic growth. In other words, Levine

384 M. S. Habibullah & Y.-K. Eng concurs that growth only occurs if society invests and maintains a sufcient amount of capital in rms that augment human capital and technology in the process of production. The more resources allocated to rms, the more rapid will be economic growth. Saint-Paul (1992) relates the relationship between the nancial sector and economic growth by emphasizing the complementarity role between nancial markets and technology. According to Saint-Paul, if nancial markets are underdeveloped, then individuals will choose poorly productive, but exible technologies. Given these technologies, producers do not experience much risk, and hence there is little incentive to develop nancial markets. On the other hand, if nancial markets are developed, technology will be more specialized and risky, thereby resulting in a positive impact on productivity. Financial markets, therefore, contribute to growth by facilitating a greater division of labor. Thus, an economy that possesses highly developed nancial markets, that allow the spreading of risk through nancial diversication among the economic agents, will be able to achieve a higher level of development than an economy in which the nancial markets are not very developed. The theoretical argument by Bencivenga & Smith (1991), Levine (1991), and SaintPaul (1992) support the proponents of the supply-leading hypothesis proposed by Schumpeter (1934) and Patrick (1966). However, Robinson (1953) has questioned this one-way causality, arguing that nance follows rather than leads economic growth. This line of argument is shared by Greenwood & Jovanovic (1990), Blackburn & Hung (1998), and Harrison et al. (1999) who demonstrate two-way causal relationships between nancial development and economic growth. According to Greenwood & Jovanovic (1990) economic growth fosters investment in organizational capital, which in turn promotes further growth. In this respect, nancial intermediaries collect and analyze information and provide this valuable information to allow investors resources to ow to their most protable use. Apart from this, intermediaries also play the traditional role of pooling risks across large numbers of investors. Thus, by investing through nancial intermediaries, individuals obtain both a higher and a safer return. The development of nancial superstructure, since it allows a higher return to be earned on capital investment, in turn feeds back on economic growth and income level. Greenwood & Jovanovic conclude that economic growth provides the avenue to develop nancial structure, while developed nancial structures stimulate higher economic growth since investment could be more efciently undertaken. On the other hand, Harrison et al. (1999), and Blackburn & Hung (1998) argue that nancial intermediation encourages economic growth because it reduces the cost of project appraisal. As the number of projects increases in a growing economy, more banks enter the markets as banks activity and prot increases. This entry reduces the average distance between banks and borrowers, promotes regional specialization and reduces the cost of intermediation.

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Does Financial Development Cause Economic Growth? Some empirical evidence

385

Goldsmith (1969), McKinnon (1973), Shaw (1973), Fry (1988), Jung (1986), Gupta (1984) and King & Levine (1993a, 1993b) are among those who have provided evidence that nancial development is a prerequisite for economic growth. Nevertheless, other researchers are skeptical with respect to the nancial-led growth hypothesis. Dornbusch & Reynoso (1989) have questioned the conclusions of previous inuential studies and argue that the evidence in support of the nancial-led growth paradigm is episodic and a vast exaggeration. Despite the skepticism, the testing of the nexus between nance and growth has ourished. Demetriades & Hussein (1996), Arestis & Demetriades (1996), Murinde & Eng (1994) and Thornton (1994, 1996) are among the few studies that have tested the nancial-led hypothesis on several Asian countries. Using annual data from 1965 to 1992, Demetriades & Hussein found that among the Asian countries covered under the study; only in the case of Sri Lanka did the evidence support the nancial-led growth hypothesis. For Pakistan, their result indicates that economic growth causes nancial development. Further, Demetriades & Husseins study suggests that bidirectional causal relationships are evident for India, South Korea and Thailand. In another related study, Arestis & Demetriades further support the evidence that the relationships between nancial development and economic growth for India and South Korea are bidirectional. Murinde & Eng (1994) test the nancial-led hypothesis on Singapore using quarterly data for the period 1979:1 to 1990:4. Using an array of nancial indicators, they found that the results strongly support the nancial-led hypothesis for Singapore. On the other hand, Thornton provides some empirical evidence on the supply-leading hypothesis in several Asian countries. Using annual data as far back as 1950s to 1990, Thornton (1994) found that the nancial-led hypothesis was supported by monetary data of Nepal, the Philippines and Thailand. The demand-following hypothesis was supported by Myanmar and Korea monetary data. However, a bidirectional relationship between the monetization variable and economic growth is evident for Malaysia. For India and Sri Lanka, the results suggest that there is no causal relationship between economic growth and the nancial indicator. In another study, Thornton (1996) found that the Philippines, Malaysia, Nepal and Thailand support the nancial-led hypothesis, while demand-following are supported by Myanmar and Korea. On a sample of six Asian countries, Luintel & Khan (1999) examine the long-run causality between nancial development and economic growth employing the multivariate VAR framework. They found bi-directional causality between nancial development and economic growth in all six countries, namely; India, Korea, Malaysia, Philippines, Sri Lanka and Thailand. In another study on Asian economies, AlYousif (2002) found that Philippines and Korea support the nancial-led hypothesis; Sri Lanka and Pakistan support the demand-following hypothesis, while Malaysia and Singapore show a two-way causal effect between nancial development and growth,

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386 M. S. Habibullah & Y.-K. Eng but the result for Thailand suggests nance is irrelevant for growth. Habibullahs (1999a) study on seven Asian developing countries suggests that only the Philippines support the nancial-led growth hypothesis. The cases of demand-following growth hypothesis are supported by Malaysia, Myanmar, and Nepal. On the other hand, a bi-directional causality between growth and nance are evident for Indonesia, Sri Lanka and Thailand.4 Further evidence on the nancial-led hypothesis is documented by Fase & Abma (2003). Using pooled data on Bangladesh, India, Malaysia, Pakistan, Philippines, Singapore, South Korea, Sri Lanka, and Thailand, Fase & Abma conclude that nancial development matters for economic growth and that causality runs from the level of nancial intermediation and sophistication to growth. The supply-leading hypothesis is also supported by more recent studies by Calderon & Liu (2003) on 109 developing and developed countries, and Christopoulos & Tsionas (2004) on 10 developing countries. Both studies conclude that the supply-leading hypothesis is the dominant force behind the relationship between nance and the sources of growth; in particular, nancial depth contributes more to the causal relationship in developing countries. Methodology Our task is to determine the causal direction between the two variables in question. Does nancial development lead economic growth or otherwise? Do the monetary data in the Asian developing countries support the supply-leading or demand-following growth hypothesis? There are at least three reasons for conducting a causality test: (a) to ensure that there is causal relationship between the two variables and to avoid spurious regressions, (b) ordinary least squares will yield inconsistent estimates of the parameters if two-way causal relationships are detected, and (c) for policy making purposes, it is important for understanding whether the impact is short-run or long-run. Since the inuential work of Granger & Newbold (1974) and Engle & Granger (1987), on the treatment of integrated time series data, many studies have been conducted employing the cointegration methodology in order to avoid the spurious regression problems, particularly in causality testing. The cointegration approach provides a way in which the long-run information of the integrated series in levels is conserved into equations that comprise stationary components (called the error correction model) that give valid statistical inferences. The majority of the studies reviewed earlier employed this method. However, in the present study, we are using a sample of 13 Asian developing countries with nine years of annual observations for the period 1990 to 1998. To circumvent the problem of the short time period we apply a newly developed GMM technique for panel data to conduct the causality test. To illustrate, we assume the endogenous variables are generated by a time stationary VAR(m) process in a panel data context (see Holtz-Eakin et al., 1988, 1989). The set of endogenous variables includes the growth of output per capita (y) measured by real

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Does Financial Development Cause Economic Growth?

387

GDP per capita, and the nancial development indicator (x) measured using the ratio of domestic credit to GDP, observed for N countries over T periods. The following equations are ready for estimation, with growth of output per capita as the dependent variable in equation (7) while the nancial development indicator is the dependent variable in equation (8), as follows
m m

yt = 0 +
i=1 m

i yti +
i=1 m

i xti + i + it

i = 1, . . . , N ; t = 1, . . . , T (7)

x t = 0 +

i yti +
i=1 i=1

i xti + i + it

i = 1, . . . , N ; t = 1, . . . , T (8)

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where i and t denote countries and time respectively. For example, the test of whether x causes y is simply a test of the joint hypothesis that 1 = 2 = = m are all equal to zero. If this null hypothesis is accepted, then it means that x does not cause y. To account for the individual effects, the intercept is often allowed to vary with each unit in a panel analysis, which is represented as i and i in the above equations. The error terms it and it are assumed to be independently distributed across countries with zero mean, but may be heteroskedastic across time and countries. Arellano & Bond (1991) point out that they can be either serially uncorrelated or moving average. Although including lagged dependent variables in the panel enables the examination of the dynamics between the variables in study, Nickell (1981) shows that this leads to biased estimation, especially when N is much larger than T , like in this study. To overcome this problem, the standard procedure is to eliminate the individual effects by a rst difference transformation (Anderson & Hsiao, 1981). Indicating with the rst difference operator, equation (7) and (8) become equation (9) and (10) respectively as follow
m m

yt =
i=1 m

i yti +
i=1 m

i xti + i xti +
i=1

it it

i = 1, . . . , N ; t = 2, . . . , T

(9)

xt =
i=1

i yti +

i = 1, . . . , N ; t = 2, . . . , T (10)

Focusing on the growth of output per capita (equation (7)), if the errors are serially uncorrelated, they will be moving average of order one in equation (9). In general, if the errors are moving average of order k in the model at levels, they will be moving average of order k + 1 in the model in rst differences. Therefore, the errors in equation (9) are correlated with some of the explanatory variables, and consistent estimation of the parameters requires some instrumental variables method as suggested by Anderson & Hsiao (1981).

388 M. S. Habibullah & Y.-K. Eng However, the instrumental variable estimator as proposed by Anderson & Hsiao (1981) does not necessarily yield efcient estimates, since it does not make use of all the available moment conditions and also does not account for the differenced structure of the new error terms. In this study, therefore, we employ the GMMSystem estimator proposed in Arellano & Bover (1995) and Blundell & Bond (1998). This estimator combines in a system the transformed equations (3) and (4) and the level equations (1) and (2), and estimates the parameters by exploiting two sets of GMM-style instruments: one for the differenced equations and one for the level equations.5 Thus, the system consists of the stacked regressions in differences and levels, with the moment conditions E[yis it ] = E[xis it ] = 0 for s < t , i = 1, . . . , N applied to the rst part of the system, the regressions in differences, and the moment conditions E[ yit1 (i + it )] = E[ xit1 (i + it )] = 0 i = 1, . . . , N applied to the second part, the regressions in levels. Given that lagged levels are used as instruments in difference regressions, only the most recent difference is used as an instrument in the level regressions. Using Monte Carlo experiments, Blundell & Bond (1998) show that the GMM-System estimator reduces the potential biases in nite samples and asymptotic imprecision associated with the difference estimator. The key reason for this improvement is the inclusion of the regression in level, which does not eliminate cross-country variation or intensify the strength of measurement error. The consistency of the GMM estimator depends both on the validity of the assumption that the error term, , does not exhibit serial correlation and on the validity of the instruments. To check the correct specication of instruments we perform a set of tests: the m2 test for second-order serial correlation of the differenced residuals, and the Sargan-Hansen test of over-identifying restrictions. Full details on these tests and the estimation procedure may be found in Arellano & Bond (1991, 1998), and Arellano & Bover (1995). Results and Discussions Apart from avoiding the problem of a short span of time series data for a causality type study for several countries, a GMM panel data analysis has several advantages over cross-sectional or time-series in the following ways: (a) working with a panel, we gain degrees of freedom by adding the variability of the time series dimensions; (b) in a panel context, we are able to control for unobserved country-specic effects and thereby reduce biases in the estimated coefcients; (c) the panel estimator controls for the potential endogeneity of all explanatory variables by using lagged values of the explanatory variables as valid instruments (see Levine et al., 2000); (d) the small number of time-series observations should be of no concern given that all the asymptotic properties of the GMM estimator rely on the size of the cross-sectional dimension of the panel (Beck et al., 2000); and (e) when the number of cross-sectional units is much larger than the number of time-series periods, the non-stationarity problem commonly seen in time-series data can be reduced (Holtz-Eakin et al., 1988).

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Results of the causality test between nancial developments (measured using the ratio of domestic credit to GDP) and economic growth (real GDP per capita) for the period 1990 to 1998 for 13 Asian developing economies6 is presented in Table 2. The results reported are the one-step estimator, for which inferences based on the
Table 2. GMM estimates of panel causality tests for the Asian countries Dependent variable Constant Growth (-1) Growth 0.1048 (1.4607) 0.75405 (2.0510) 0.5976 (1.4829) 0.79463 (1.3176) 0.0828 (0.7756) 0.50935 (2.1179) 0.206 (0.8796) 0.497 (0.620) 1.8924 [32] (0.999) 0.0764 [8] (0.9999) 1.40059 (0.496) 8.3171 (0.040) All lagged y and x dated t-4 and earlier xt 3 and yt 3 Finance 0.2082 (2.5047) 0.5406 (2.4806) 0.1564 (1.3777) 0.1705 (0.7893) 0.5491 (1.6132) 0.5735 (1.4255) 1.0752 (2.1643) 1.519 (0.129) 5.8436 [32] (0.999) 0.0238 [8] (0.9999) 2.7159 (0.257) 5.7759 (0.123) All lagged yand x dated t-4 and earlier xt 3 and yt 3

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Growth (-2) Growth (-3) Finance (-1) Finance (-2) Finance (-3) m2 ( p-value) Sargan-Hansen [d.f] ( p-value) Sargan Difference [d.f] ( p-value) Hausman-Arellano ( p-value) Causality Wald test Instrumental variables: Differenced equation Level equation

Notes: 1) t-statistics are in parenthesis. Standard errors and test statistic are asymptotically robust to heteroskedasticity. 2) Time dummies were included in all equations. 3) m2 is test for rst- and second-order serial correlation in the rst-differenced residuals, asymptotically distributed as N (0,1) under the null of no serial correlation. 4) Sargan-Hansen test is a test of over-identifying restriction. 5) Sargan-Hansen Difference is a nested test for the additional instruments variables of the level equation. 6) Hausman-Arellano test is a Hausman type test for the absence of mean independence, and more generally, for the instruments set for the equation in levels. Asterisk ( ) denote statistically signicant at the 5 percent level.

390 M. S. Habibullah & Y.-K. Eng asymptotic variance matrix has been found to be more reliable than the two-step estimator.7 In this study, we choose a lag length of three years as suggested by the Holtz-Eakin et al. (1988) that the lag length should be less than one-third of the total time period to avoid the over-identication problem as a result of incorrect estimates of the covariance matrix. Using three lags structure, after differentiation, ve observations per individual unit are available.8 As to the specication tests: the Sargan-Hansen test of over-identifying restrictions accepts the validity of instruments. Moreover, both the Sargan-Hansen and Arellanos version of the Hausman test do not reject the validity of the addition moment condition used in the levels equations, suggesting that the unobservable country specic effect is uncorrelated with the differences of the regressors. On the other hand, the m2 test of serial correlation in the rst differences residuals is consistent with the maintained assumption of no serial correlation in the residual terms. According to all these tests, therefore, the choice of instruments seems to be correct. To infer causality between nancial development and economic growth, the Wald test is used to test the null hypothesis that the estimated coefcients, say i , in equation (1) are all zero. Focusing on the output equation as presented in column two of Table 2, the null hypothesis that supply-leading has no role in the Asian economies can be rejected at the 5 percent level of signicance. Focusing on the coefcients of the indicator of nancial development, we observe that the coefcients of the lagged nancial development indicators are statistically insignicantly different from zero except one. The coefcient of the second lagged of the nancial development indicator, on the other hand, is highly signicant and has the expected positive sign. This result suggests that nancial development has a causal positive impact of economic growth in the Asian developing countries. On the other hand, focusing on the nancial development indicator equation as presented in column 3 in Table 2, the insignicance of the Wald test suggests that the demand-following growth hypothesis can be rejected at the 5 percent level. Conclusion This paper examines the causal relationship between nancial development and economic growth from panel data perspectives using the GMM technique developed by Arellano & Bover (1995) and Blundell & Bond (1998) by conducting causality testing analysis. The panel data sets involve 13 Asian developing countries: Bangladesh, India, Indonesia, South Korea, Lao PDR, Malaysia, Myanmar, Nepal, Pakistan, Philippine, Singapore, Sri Lanka and Thailand for the period 19901998. As pointed out earlier, the study on the direction of causality between nancial development and economic growth is important because it has different policy implications on economic strategy to enhance growth, particularly, in the developing nations. The present study supports the belief that there is a strong link between the nancial sector and economic growth as found by King & Levine (1993a, 1993b).

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Our study supports the contention made by Calderon & Liu (2003) that nancial depth contributes more to the causal relationships in developing countries. Our result suggests that the supply-leading growth hypothesis indicates that nancial intermediation promotes economic growth in the nine Asian developing nations for the period 19901998. It implies that the policy of liberalization and nancial reforms adapted by these Asian countries has shown to improve economic growth. Our study is in agreement with other causality studies by Calderon & Liu (2003), Fase & Abma (2003), and Christopoulos & Tsionas (2004) that nancial development promotes growth, thus, supporting the old Schumpeterian hypothesis and Patricks supply-leading hypothesis.

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Acknowledgment We thank the editor of this journal and an anonymous referee for helpful comments and suggestions on the earlier draft of the paper. All remaining errors are sole responsibility of the authors.

Notes
1. See Habibullah (1999b) for further discussion and description on nancial liberalization in ten Asian developing countries. 2. The Association of South East Asian Nations (ASEAN) was founded in 1967 with the signing of the ASEAN Declaration. At the time of writing, the ASEAN member countries included Brunei, Cambodia, Indonesia, Lao PDR, Malaysia, Myanmar, Philippines, Singapore, Thailand and Vietnam. 3. Shaw (1973) denes nancial deepening as the phenomenon in which the nancial sector grows at a rate faster than the real sector of an economy. On the other hand, the process of monetization refers to the size as well as the composition of the stock of money (money supply) in an economy. Chandavarkar (1977) notes that the difference between monetization and nancial intermediation is that the latter refers to the process of mediation through institutions and instruments between primary savers and lenders and ultimate borrowers and is measured by the nancial interrelations ratio. Thus, it connotes nancial deepening rather than widening (enlargement of the money exchange economy), which is the phenomenon expressed in the term monetization. 4. In this study, Habibullah (1999a) has proposed the use of the divisia monetary aggregates as an alternative proxy for the nancial development indicator. In general, the proposed divisia monetary aggregates do well in explaining the role of nance on economic growth in those Asian countries under study. 5. Arellano & Bond (1991) propose the two-step GMM estimator. In the rst-step, the error terms are assumed to be independent and homoskedastic across countries and over time. In the second-step, the residuals obtained in the rst-step are used to construct a consistent estimate of the variancecovariance matrix, then to relax the assumptions of independence and homoskedasticity. 6. All data were compiled from the various issues of the International Financial Statistics published by the International Monetary Fund. 7. If the residuals are not only serially uncorrelated but also homoskedastic, the rst-step estimate is asymptotically equivalent to the two-step estimator. 8. Longer lag structures would reduce too much the time dimension of the data, and the resulting estimates would be unreliable as warned by Holtz-Eakin et al. (1988, 1989).

392 M. S. Habibullah & Y.-K. Eng

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