Financial Development & Growth

Questions ...
• Do countries with better developed banks and
financial markets enjoy substantially greater
economic success?

• Should financial development be a public

policy priority?
Economists hold startlingly different
views about the impact of banks and
markets on long-run economic growth.
View 1: Finance promotes growth

Hamilton-Bagehot-Schumpeter
‘banks are the happiest engines
that ever were invented for
creating economic growth’
View 2: Finance hurts growth

Adams
“banks have done more harm to
the
morality, tranquility, and even
wealth of this nation than they
have done or ever will do good”
View 3: Finance follows growth

Robinson
“... where enterprise leads
finance follows.”
View 4: Finance doesn’t matter

Solow Growth Accounting …

‘growth is mainly due to
technological progress,
leaving little role for finance’
View 5: Finance matters because
there are crises

IMF/World Bank
 Who is right?
Finance Finance hurts
promotes growth growth

Finance
doesn’t matter

Finance matters
Finance
for crises
follows growth
 To assess who is right, lets look at

• Concepts
• Evidence
 Concepts

What financial intermediaries and

markets do ...
Intermediaries & markets promote growth by all
5 functions, e.g....
• Mobilizing savings
– “immense works”
• Allocating capital and monitoring firms
– “… the banker authorizes the entrepreneur in the name of
society to innovate …”
– Implications for small firms and poverty
• Augmenting liquidity and managing risk
– “the financial revolution was a necessary precondition for the
industrial revolution” Sir John Hicks
But, this will not necessarily boost growth ...
• Income and substitution effects
– better finance means greater returns to saving
– but, greater returns may lower saving rates
– it is possible that growth actually falls

• Risk diversification and precautionary savings

– better finance means lower risk
– but, lower risk may lower savings
– it is possible that growth will then fall

rd
• Some 3 factor may be driving finance & growth
– so that finance really doesn’t matter for growth
 Empirical evidence

Banks, markets, & economic growth

1st Generation: Goldsmith, et al:
Drawbacks
• Only 35 countries -- problem?
– Only correlations initially
• Omitted variables bias- other factors causing growth not
included
• Measures of financial sector development? Just size -- M2
• What kind of regressions? OLS only. Problem?
– Simultaneity bias or reverse causality.
• Evidence of channels ?
• Evidence of the importance of banks or stock markets?
 I. Cross-country evidence
G(j) = a + bDEPTH + cX + µ
• G(j)
– Real per capita GDP growth
– Capital per capita growth
– “Productivity” growth
• DEPTH: liquid liabilities/GDP
• LL = CURR + DD + other interest-bearing liabilities of
all FIs
• X: other growth determinants
Table 1: Growth and Financial Intermediary Development, 1960-89

Real per Capita Real per Capita

Dependent Variables: GDP Growth Capital Growth Productivity Growth

DEPTH 2.4** 2.2** 1.8**

(0.007) (0.006) (0.026)
2
R 0.50 0.65 0.42

Source: King and Levine (1993b), Table VII

* significant at the 0.10 level, ** significant at the 0.05 level
(p-values in parentheses)
Observations: 77

Economic size: move from smallest quartile of DEPTH to largest

would increase growth by 1 percentage point. The difference
between the slowest and fastest quartile is 5 percentage points.
 Problems …
• Causality?
• Omitted variables? Bias?
• DEPTH = financial development?
– Researching firms, exerting corporate control, managing
risk, providing liquidity, pooling/mobilizing savings, etc?
• Channel?
– Capital accumulation?
– Productivity growth?
• Other components of the financial system
 Finance in 1960 predicts growth
over the next 40 years!

Growth and Initial Financial Depth, 1960-00

Real per Capita Real per Capita

Dependent Variables: GDP Growth Capital Growth Productivity Growth

DEPTH in 1960 2.8** 1.9** 2.2**

(0.001) (0.001) (0.001)
R2 0.61 0.63 0.58

Based on: King and Levine (1993b), Table VIII; and Levine (1997), Table 3
* significant at the 0.10 level, ** significant at the 0.05 level
(p-values in parentheses)
Observations: 57
Financial depth predicts future growth
Per capita GDP
growth, 1960-98

3%

2%

1%

0
11% 22% 33% 65%
Financial depth, 1960
 Finance predicts growth ...
• ... And the link runs through
– Productivity growth
– Not, savings or capital accumulation ...
 Financial depth predicts
future productivity growth
Productivity
growth, 1960-
98 3%

2%

1%

0
11% 22% 33% 65%
Financial depth, 1960
 Financial depthdoes notpredict savings
Private saving, 1976-98

0.2

0.1

0
41% 76% 107% 168%
Financial depth, 1976
 But …
• Other components of the financial system
– Does stock market development predict growth
and, if yes, through what channels?
 Stock market liquidity predicts growth
Value traded / market capitalization

Very illiquid

Illiquid

Liquid

Very liquid
0 1 2 3 4
Per capita growth %
 Stock market liquidity
predicts productivity growth
Productivity
growth,
1976-98
2%

1%

0
0.06% 0.50% 2.20% 15%
Stock market liquidity, 1976
(value traded ratio)
 Liquidity does not predict savings
Private saving rate

0.2

0.1

0
0.06% 0.50% 2.20% 15%
 Market size does not predict growth
Market capitalization / GDP in 1976

Very large

Large

Small

Very small
0 1 2 3 4 5
Per capita growth %
 Market volatility does not predict growth
Stock market volatility

Very volatile

Volatile

Stable

Very stable
0 1 2 3 4
Per capita growth %
 Impact of finance on growth ...
• Runs primarily through productivity!
– “ … the banker authorizes the entrepreneur in the name of society to
innovate …”

• Not through savings

– which helps explain development community’s pessimism about the
finance-growth nexus.
– If savings matter, countries that got funds from IFIs would have taken off,
but biggest recipients of funding did not grow the most (or much at all).
Thus:

It is not banks vs. markets

It is banks and markets

 Findings, but
• Findings
– banking sector development and stock market
liquidity predict future growth
– It is not market size per se, it is liquidity
• But,
– Predictability, but causality?
– Measures of bank & stock market development
 Dealing with Simultaneity
G(j) = a + bF(i) + cX + µ

F(i) = α + ß Z + є

Find Z that explains F well

Find Z that is exogenous, so uncorrelated with
µ, є. Legal Origin works!
 Qualities of Good Instruments?
• If Y = α + β X + ε , and X, ε are correlated, OLS
estimator is biased. Correl can be due to omitted variables
that cause X, Y; errors in measuring the variables, and
simultaneity
• Solution – find a variable Z such that Z,X highly
correlated, but Z, ε not correlated.
– Estimate first stage relationship between Z and X, then plug into
second stage equation and run that.
– If Z explains a lot of the variation in X, and is exog,( not
correlated with error) than a good instrument
• Still problems?
– Country specific effects
 II. Panel
(Arellano/Bond; Arellano/Bover;
Blundell/Bond)
y(i,t) = aX1(i,t) + bX2(i,t) + C(i) + T(t) + u(i,t)

• Exploit time-series variation

• Country-specific effects, Time-sepcific effects
• Control for endogeneity of all the regressors
• X1= Lagged explanatory variables
• X2 = Contemporaneous expl. variables
 Panel GMM Estimates OLS
(1) (2) (3) (3)
Constant 1.898 6.156 3.113 1.884 0.0361
(0.394) (0.182) (0.189) (0.430) (0.012)
Ln(income per capita) -0.683 0.048 -0.619 -0.723 -0.49
(0.275) (0.945) (0.249) (0.239) (0.030)
Schooling -3.004 -3.738 -3.221 -2.979 0.44
(0.277) (0.119) (0.157) (0.283) (0.450)
Government -2.581 -0.07
(0.111) (0.020)
Inflation -1.976 -1.41
(0.079) (0.063)
Black Market Premium -0.069 -0.01
(0.966) (0.030)
Bank Credit 2.202 1.762 1.954 2.262 1.65
(0.001) (0.025) (0.003) (0.001) (0.030)
Turnover Ratio 0.993 0.944 0.950 1.058 1.09
(0.012) (0.064) (0.008) (0.014) (0.000)
 Naïve and modeled impact of financial
development on growth
Average GDP growth 1960-95, percent per annum
8

Model

4 Naïve

-4
10 100
Private credit as percentage of GDP (log)
Impact of finance on growth is ...
• Not due to reverse causality
• Robust to other country traits
• Big
Banks if Mexico had average, per capita
growth would have been 3-points faster
Markets if Mexico had average, per capita
growth would have been 1-point faster
 How about microeconomic evidence?

• Rajan/Zingales -- industry evidence:

– Naturally heavy users of external finance benefit
disproportionately from financial development.
• Demirguc-Kunt/Maksimovic-- firm-level evidence:
– Countries with better financial systems ease financing
constraints and allow firms to grow faster.
• Beck, Demirguc-Kunt, Laeven, & Levine:
– Small firms benefit from financial development.
• Jayaratne & Strahan - states liberalizing banking faster had
faster growth
 More evidence
• Guiso, Sapienza, Zingales: regions with better FSD
enjoy fewer credit constraints, lower i.
• Rousseau-Wachtel: positive effects of FSD decrease
with high inflation
• Historical evidence: N. Italy, Netherlands, Scotland,
England, U.S., Germany, Belgium, Meiji Japan,
Taiwan, 15 other countries 1850-1997. Finance,
then growth.
• Haber: U.S. - Mexico difference 19th century
 Summing up on Growth
• Cross-Country, firm level, industry-level,
within country case studies, panel data,
historical data … all tell the same story.
– Finance Matters!
• What other empirical methodology is there?
 But …
• This is about growth!
• This is about financing firms!
• What about poverty …?
• Half of the world’s households do not have
a bank account
 ...and access is seen as a problem
Access to finance
High income Cost of finance

East Asia & Pacific

Europe & Central Asia

Latin America & Caribbean

Middle East & North Africa

South Asia

Sub-Saharan Africa

0 10 20 30 40 50 60 70
Share of firms reporting cost of/access to finance (percent)
Private Credit and Access
0
10
20
30
40
50
Bangladesh
Pakistan
Philippines
Uruguay
Ghana
Mozambique
Thailand
Lebanon
Madagascar
Ethiopia
Albania
Egypt, Arab Rep.
Chile
Bulgaria
Dominican Republic
Nepal
Czech Republic
India

Sri Lanka
France
Mexico Average
Bolivia
Indonesia 10.69 days
Sierra Leone
Cameroon
Bosnia and Herzegovina
Lithuania
Number of days to process SME loan application

Zambia
Colombia
Median

Jordan
8.33 days

Hungary
Armenia
Trinidad and Tobago
Australia
Belarus
Malta
…and process

Kenya
Georgia
Croatia
Turkey
Moldova
South Africa
Zimbabwe
Slovenia
Peru
Brazil
Belgium
Slovak Republic
Switzerland
Korea, Rep.
Greece
Spain
Israel
Denmark
 Barriers and financial exclusion
Share of population unable to afford
checking account fees
Malawi
Uganda
Sierra Leone
Kenya
Swaziland
Nepal
Cameroon
Chile
Madagascar
Ghana
South Africa
0 20 40 60 80 100
Percent
 Poverty and Finance
G(j) = a + bDEPTH + cX + dGROWTH + ε
• G(j)
– Income Growth of the poor
– Growth of Income Inequality
– Poverty Growth
• DEPTH: Bank Credit to Private Firms/GDP
• X: other growth determinants
• Growth: Average per capita Growth
 Finance is also pro-poor
Financial depth and poverty alleviation
Growth in poverty headcount
0.3

0.2

0.1

-0.1

-0.2

-0.3

-0.4
-2 -1 0 1 2
private credit
Finance  Poverty Alleviation ... Big!

• If Peru had the level of financial

development as Chile 13% vs. 54%),
then ...
2% living on less than $1/day
Actual level: 15%
 …with significant indirect effects
• Welfare impact of direct access of the poor – mixed
results
• Aggregate studies – that take into account spill-over
effects - suggest stronger impact
• General equilibrium models and natural experiments
also suggest indirect effects of financial development
may be quite significant for the poor – i.e. having jobs
and higher wages
⇒ To promote pro-poor growth it is important to
improve access for all excluded (not only the poor)
 Take away points …

• Financial systems
– Mobilize savings (economies of scale)
– Allocate and monitor the use of society’s savings
– Facilitate risk amelioration and trading
• Well-Functioning financial systems
– Improve capital allocation and economic growth.
– Reduce income inequality
– Lower poverty & Inequality