Determinants of the link between financial and economic development: Evidence from a functional coefficient model

Outline

• Abstract
• Keywords
• 1. Introduction
• 2. Literature Review
• 2.1. Level of Economic Development
• 2.2. Level of Financial Development
• 2.3. Level of Inflation
• 2.4. Government Size
• 2.5. Degree of Openness to International Trade
• 3. Data and Methodology
• 3.1. Data
• 3.2. Methodology
• 3.2.1. the Parametric Model: Dynamic Ols
• 3.2.2. the Semiparametric Model
• 4. Empirical Results
• 4.1. Parametric Estimates
• 4.2. Functional Coefficient Estimates
• 4.2.1. Government Size
• 4.2.2. Financial Development
• 4.2.3. Openness to Trade
• 5. Conclusions
• Acknowledgments
• Appendix A. Semiparametric Modeling
• A.1. Estimation
• A.2. Inference
• Appendix B. List of Economies Included in Each Sample
• B.1. Low-Income Economies (15)
• B.2. Lower Middle Income Economies (18)
• B.3. Upper Middle Income Economies (15)
• B.4. High-Income Economies (25)
• References

Conclusions

We investigate economic factors underlying the FD nexus by means of semiparametric functional coefficient models on a data set comprising 73 economies over the period 1975–2011. We find that the FD link is dependent on an economy’s level of economic and financial development, government size, trade openness and financial openness. However, the dependence of the FD link on the level of inflation is weak. Moreover, the effects of the economic factors on the FD link are diagnosed to be variant across distinct stages of economic development.

We find the average FD link to be positive and to increase across income groups. In particular, low-income economies obtain the least benefit from financial development while high-income economies enjoy almost three times as much benefit. Similarly, financial development has a generally positive effect on the FD nexus, with the strongest FD link observed in low-income economies with a high level financial development. There are also cases where financial development could have an adverse effect on economic development. This is observed in low- and lower-middle-income economies when they have very large governments or are extremely open to international trade. The impact of openness to trade on the FD relationship varies between lower middle- and upper-middle-income economies. Upper-middle-income economies show a pronounced FD nexus when they are highly open to international trade. Yet, only a moderate level of trade openness is beneficial to lower-middle-income economies and being extremely open is found to induce a negative FD relationship. Finally, increasing financial openness strengthens the FD nexus to some extent, but very high levels of financial openness significantly weaken the FD nexus.

These results have three important policy implications. First, given that larger growth-promoting benefits of financial development are reaped as economies develop their financial and real sectors, low- and middle-income economies should continue developing their financial sector. In other words, they should not be discouraged by the smaller benefits they are currently obtaining from financial development. Regarding public policy tools for developing the financial sector, the burgeoning literature lists several policy and non-policy factors affecting the development of an economy’s financial sector (see for example, Baltagi et al., 2009; Demetriades and Andrianova, 2005; Yongfu, 2005). Perhaps a potential policy candidate, which many studies have found to induce financial development, is financial liberalization. Yet, it should be emphasized that financial liberalization might turn out to be growth retarding unless efforts are made to improve the quality of institutions, in general, and to closely supervise financial institutions, in particular (Ahmed, 2013). Second, the clear evidence on the negative impact of government size on the FD nexus implies the importance of less government involvements both in the financial and real sectors. However, the positive role of basic government expenditures like on protecting property rights and enforcing contracts on the FD link should not be undermined. Third, owing to the fact that trade promotes overall macroeconomic efficiency, policies encouraging an economy’s openness to international trade are likely to increase the benefit from financial development. However, the negative FD nexus we found in highly open low- and lower-middle-income economies highlights the need to protect domestic firms from excessive external competition and, by extension, from loss of valuable financial resources through the ensuing bankruptcy of firms.

As argued this study provides a first view at the dependence of the FD nexus on financial openness. It appears worthwhile to address in future research if more sophisticated, continuous measures of financial openness offer further insights into the joint importance of financial development and financial openness for the long-run linkage between financial and economic development. As a second direction of future work one may consider to trace back the diagnosed factor dependence that characterizes the FD nexus to institutional settings across economies. Similar to the heterogeneity of government expenditures (e.g. compensation of government employees or expenditures related to securing property rights), other factor variables are also highly