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The Finance-Growth Nexus and Financial Sector Environment: New Evidence from Southeast Europe

This paper presents new evidence on the finance-growth relationship in Southeast Europe (SEE) since the early 1990s, focusing on the financial sector environment. The study finds no evidence of growth-supportive effects of financial depth in SEE, indicating that the poor environment of the banking sector has been a hindrance to financial development. However, there have been recent improvements, suggesting the potential for real financial development.

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The Finance-Growth Nexus and Financial Sector Environment: New Evidence from Southeast Europe

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  1. The finance-growth nexus and financial sector environment: new evidence from Southeast Europe Arnaud Mehl and Adalbert Winkler Directorate General International and European Relations European Central Bank Dubrovnik, 27 June 2003

  2. Scope and motivations of the paper • Give evidence on the finance-growth relation since the early 1990s in Southeast Europe (SEE): - Bulgaria, Romania + Moldova - Albania, Bosnia & Herzegovina, Croatia, FYR Macedonia, Serbia & Montenegro • Motivations: - Few empirical studies on finance-growth nexus in transition - SEE countries under-researched (=/= CEE countries) - Substantial change in financial sector environment - Countries moving closer to the EU, with some implications on banking reform

  3. Main results • No evidence of growth-supportive effects of financial depth in SEE since the early 1990s • Contrasts with conventional wisdom on finance-growth nexus • Interpretation: reflection of banking sectors’ poor environment in the largest part of the last decade • Financial sector environment has improved in recent years => Real start now of financial development?

  4. The finance-growth nexus in the literature: brief overview • Positive (and causal) relation between finance and (future) growth • Standard econometric specification: Real GDP per capita growth = Control variables + Financial depth indicator • Finance’s contribution to growth is through productivity improvement

  5. Applying the standard empirical framework to SEE • Specific challenges to transition economies: 1 - The standard set of controls may not apply 2 - Short time series 3 - Instability in earlier years of transition & war • Modelling framework: 1 - Data for the 8 SEE countries over 1993-2001 2 - Financial depth: monetisation & intermediation 3 - Controls: inflation & private sector to GDP

  6. Empirical evidence • Financial depth is not significantly correlated with real GDP per capita growth in SEE • Results insensitive to: 1 - Endogeneity (IV estimation) 2 - Initial conditions (country fixed-effects) 3 - Set of control variables 4 - Robust estimation 5 - War dummy

  7. A conceptual framework to interpret the evidence Financial development: quantity and quality FINANCIAL DEPTH Shallow Deep Socialist financial system Non-developed financial sector Poor Financial sector prone to inflation and crises ENVIRONMENT QUALITY Stable financial sector but not actively growth-supportive Developed and growth supportive financial sector Good

  8. Applying this framework to SEE countries’ experience (1) Up to the late 1990s - Deep financial sector, poor environment: 1 - Insufficient restructuring of state-owned banks and poor governance 2 - Lax regulation on licensing new private banks and connected lending 3 - Lack of human capital and credit technology 4 - Inadequate banking supervision 5 - Poor institutional and legal environment

  9. Applying this framework to SEE countries’ experience (2) The crises years - Shallower financial sector, persistently poor environment: 1 - Outbreak of financial crises 2 - Shrinking of financial depth 3 - Output losses

  10. Applying this framework to SEE countries’ experience (3) The late 1990s - Improved environment: 1 - Hardening of budget constraints 2 - Tightening of banking supervision and regulation 3 - Banking sector consolidation and opening to foreign investors

  11. Today, financial sectors in SEE are liquid...

  12. …but intermediation, crucial to growth, remains overall low...

  13. …due to a number of factors: • Cautious lending behaviour • Characteristics of non-financial private sector • Time required to adjust to the new environment • Room for improvement in the legal framework • Short maturity of deposits and potential of currency mismatch • High demand for liquid and risk-free assets

  14. although, in some countries, credit has recently been more dynamic

  15. Conclusion (1): Interpreting SEE countries’ experience FINANCIAL DEPTH Shallow Deep Socialist financial system Non-developed financial sector Poor Financial sector prone to inflation and crises ENVIRONMENT QUALITY Stable financial sector but not actively growth-supportive Developed and growth supportive financial sector ? Good

  16. Conclusion (2): implications • No growth-effects of finance due to financial sectors’ specific evolution • However in some countries financial development may have started • Address bottlenecks to financial intermediation in most countries • Monitor rapid credit growth in some countries

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