Law Siong Hook Universiti Putra Malaysia

1. Finance and Economic Growth:Cross-country and time series evidence & the role of banks and stock markets ECN5141 Financial Economics Law Siong Hook Universiti Putra Malaysia

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

3. This lecture Examines the empirical evidence on the relationship between finance and growth • Cross-country studies • Time series evidence • The role of banks and stock markets

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

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

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

7. Cross-Country Growth Regressions King and Levine estimate the following equation using data for 77 countries during 1960-89: gi = a + b FDi + cZi + ui where gi is the growth rate of country i, FDi is an indicator of financial development Zi is a vector of other possible determinants of economic growth (initial income, education, inflation, openness to trade, political uncertainty etc) a, b and c are parameters and u is an error term They find that the estimate of b is positive and highly significant statistically and suggests very large effects

8. Financial Development & Per Capita Income: 1981-2000

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

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

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

12. Role of Stock Markets • Most studies on finance-growth have ignored stock markets, focusing on banking indicators of financial development • Stock markets have witnessed enormous growth in the last 10-15 years (especially in emerging countries) • Boost from financial liberalization (high interest rates, unrestricted capital flows) • Efficient stock markets can promote growth: • Improve allocation of resources & facilitate corporate control • Inadequately regulated stock markets may be the source of distortions and fragility, such as bubbles (Singh, 1997)

13. Stock markets and the allocation of capital Two mechanisms: • Direct: the price of shares acts as a signal conveying information about the expected profitability of firms Directly affects the flow of finance to firms and sectors • Indirect: Stock markets are markets for corporate control Takeovers and mergers affect the ownership and control of corporations which affects the efficiency of resources

14. How well do stock markets allocate capital? Depends on how well ‘organised’ they are and how ‘efficient’ they are • ‘Organised’: means there is a set of rules • to prevent fraud and to ensure a level-playing field for all participants • To ensure corporations produce audited accounts and records and make all relevant information publicly available • To governs access to the exchange by new companies (usually good past record)

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

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

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

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

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

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