Determining the relationship between financial development and economic growth : An application of ARDL technique to Singapore 2 . 0

The relationship between financial development and economic growth has been subject to considerable debate in the literature of development and growth. While empirical studies often provide a direct relationship between financial development proxies and growth, much controversy remains about how these results should be interpreted. The study, therefore, attempts to unravel the causality direction of financial development and economic growth. We used an Autoregressive Distributed Lag (ARDL) method to assess the finance-growth relation taking Gross National Expenditure, Gross Fixed Capital Formation, exports, Foreign Direct Investments and Loans made to the Private Sector as financial development indicators for Singapore over the period from 1970 to 2013. Interestingly, we found that our financial development variables had no impact on economic growth. 1Mohamad Zaky Jailani, Graduate student in Islamic finance at INCEIF, Lorong Universiti A, 59100 Kuala Lumpur, Malaysia. 2 Corresponding author, Professor of Finance and Econometrics, INCEIF, Lorong Universiti A, 59100 Kuala Lumpur, Malaysia. Phone: +60173841464 Email: mansurmasih@inceif.org Determining the relationship between financial development and economic growth: An application of ARDL technique to Singapore 2.0 Introduction 2015 marks the 50th anniversary of Singapore's independence. With a highly developed and successful free-market economy, it currently enjoys an open and corruption-free environment, stable prices, and a per capita GDP higher than that of most developed countries. The economy depends heavily on exports, particularly in consumer electronics, information technology products, pharmaceuticals, and on a growing financial services sector. It is worth noting that more than two decades have passed since Singapore launched significant moves to develop as a financial center. The presence of institutions of international repute, the introduction of new financial instruments, the availability of expertise and the wide range and large volume of financial activities transacted in the Republic speak volumes of its status as a financial centre. Before the 1970s the financial sector merely fulfilled a subsidiary role andby the mid-1970s,Singapore had largely liberalized its financial system. The potential for the financial sector to become a growth sector, serving the needs of not only the domestic economy but also the regional and international economy, was recognized in the late 1960s. Cautious financial policies were then undertaken to improve investor confidence internally and externally, which has not only led to an increased monetization but also greater capital deepening of the economy. These efforts contributed to the rapid growth of the financial sector, which became the second largest contributor to both GDP (gross domestic product) and employment in the economy after manufacturing. The link between financial development and economic growth has attracted much attention in economics discussion. The study of the “finance– growth” nexus has been an issue of concern since finance is said to be a major contributor of the economy. While most economists contend that financial intermediaries mobilise, pool and channel domestic savings into productive capital and by doing so contribute to economic growth, others argue that financial development is a direct consequence of economic growth, as economic growth increases demand for sophisticated financial instruments which consequently leads to growth in the financial sector. So far availableempirical and theoretical evidence have been mixed as to whether financial development contributes to economic growth or economic growth leads financial development. The causal relationship of finance-growth nexus has important policy implications for the economy. If in the economy, financial development causes economic growth, reformation, creation and promotion of modern financial institutions become necessary and important for piloting economic growth. The consolidation of banks and non-bank financial institution like stock market and insurance companies becomes necessary and predictive conditions for the growth of the economy. If on the other hand, causation runs from economic growth to financial development, policy effects to reform and promote financial development would be a waste of scarce resources. The purpose of this paper therefore is to analyse the theoretical argument on the finance growth nexus and to determine whether financial development causes economic growth or vice versa. We will focus on Singapore's economy from 1970 to 2013, coinciding with the start of financial liberalisation in the city-state. Wewill utilise the autoregressive distributed lag (ARDL) model, in order to examine both potential longand short-term effects. Finally, as a direct result of our findings, we will analyse policy implications for Singapore. 3.0 Literature Review Generally, the literature has documented four views on the financegrowth nexus namely: supply leading, demand following, mutual impact of finance and growth and those that suggest that the role of finance in promoting economic growth is overemphasized. Among the initial influential contributions in this area is the work of Patrick (1966) as he developed the ideas of ‘demand-following’ and ‘supplyleading’ aspects of financial development. He hypothesised that demand for financial services was dependent upon the growth of real output and the commercialisation and modernisation of agriculture and other subsistence sectors. This demand-following hypothesis posits a unidirectional causation from economic growth to financial development. This implies that the increasing demand for financial services might lead to the aggressive expansion of the financial system as the real sector of the economy grows. Patrick (1966) also hypothesised that the supply-leading role of financial institutions was to act as productive inputs in the production process and to transfer resources from traditional to modern sectors. The supply-leading finance will cause economic development through the transfer of scarce resources from savers to investors according to the highest rates of return on investment. One of the earliest known proponents of the notion that finance could be an engine of growth were Schumpeter and Opie (1934) who highlighted the role of financial institutions in funding productive investments and encouraging innovation, both of which foster growth. This sentiment was echoed by Gurley and Shaw (1955) and Goldsmith (1969), who argued that more developed financial markets promote economic growth by mobilizing savings to finance the most productive investments. The “supply-leading” hypothesis to mention a few, has been subsequently advanced and supported by many famous economists like McKinnon (1973), Shaw (1973), Fry (1978), Calderon and Liu (2002), King and Levine (1993). Recent empirical work by Gelb (1989), Ghani (1992), King and Levine (1993), DeGregorio and Giudotti (1995), and Levine and Zervos (1996) have also lent support to the supply leading hypothesis through data obtained from many developing and developed countries. Their empirical results revealed positive and statistically significant coefficients on the proxies of financial deepening in the real economic growth equations. In a more recent study, Xu (2000) finds strong evidence that financial development, primarily via the investment channel, affects growth positively. Robinson (1952) argues that economic growth drives the demand for financial services rather than the other way round. Financial development follows economic growth as a result of higher demand for financial services. As such, an increasing demand for financial services might induce an expansion in the financial sector as the real economy grows (therefore, a positive response for the financial sector to economic growth). Odhiambho (2004) investigated the finance-growth nexus in South Africa using cointegration approach and vector error correction model on monetization ratio namely the ratio of M2 to GDP and intermediation ratio, the ratio of bank claims on the private sector to GDP against economic growth proxied by real GDP per capita. His results revealed demand-following response between financial development and economic growth and totally discredited the supply-leading hypothesis. Yet, there were still some studies that proved to be inconclusive. Arestis and Demetriades (1997) used Johansen cointegration on time series analysis for the United States and Germany and found insufficient evidence to claim that financial development spurs economic growth. Their data rather pointed to the direction that real GDP contributes to both banking system and stock market development. Lucas (1988) discounts altogether the possibility that the financial sector has any impact on growth. In Nigeria, Agu and Chukwu (2008) found that the Nigerian evidence supported the demand – following hypothesis for bankbased financial deepening variables like private sector credit and broad money. However, it supported the supply – leading hypothesis for “bank-based” financial deepening variables like loan deposit ratio and bank deposit liabilities. The importance of financial development has received renewed attention as the endogenous growth literature evolved since the 1980s (see Bencivenga& Smith, 1991). The strength of the finance–growth relationship is ultimately an empirical matter (Levine, 2005), and much of the subsequent literature has focused on the multi-faceted empirical aspects of this relationship. The emergence of endogenous growth theory (Lucas, 1988) generated renewed interest in the role of financial development in driving economic growth. The theoretical work of Greenwood and Jovanovic (1990) shows that financial intermediaries promote investment and growth by enabling a higher rate of return on capital, while the growth itself spurs the expansion of financi