Financial development, investment, and economic growth

ZHENHUI XU [*] In this article, I use a multivari ate vector-autoregressive (VAR) approach to examine the effects of permanent financial development on domestic investment and output in 41 countries between 1960 and 1993. The VAR approach permits the identification of the long-term cumulative effects of financial development on the domestic variables by allowing for dynamic interactions among these variables. The results reject the hypothesis that financial development simply follows economic growth and has very little effect on it. Instead, there is strong evidence that financial development is important to growth and that investment is an important channel through which financial development affects growth. (JEL E22, E44, E47, 016, 057) Keywords: economic growth, financial development, investment, vector-auto-regression, impulse-response I. INTRODUCTION Interest in the relationship between financial development and economic growth dates back to early this century and has been growing since the 1980s. [1] In the literature, three views have emerged concerning the potential importance of finance in economic growth. The first sees finance as a critical element of growth (Schumpeter [19113; Goldsmith [19691; McKinnon [19733; Shaw [1973]; Fry [1978, 1988]; Bencivenga and Smith [1991]; King and Levine [1993a, 1993b]). In this view, services provided by the financial system are essential for growth, and a repressed financial system, characterized by price distortion, undersaving, negative or unstable returns on savings and investment, and inefficient allocation of savings among competing users, impedes growth. [2] As the financial system develops, households substitute out of unproductive tangible assets, raising the total real supply of credit, the quantity and quality of investment, and thus the rate of economic growth. In addition, financial development can pro mote technological innovations and productivity growth (King and Levine [1993a]). The second view regards finance as a relatively unimportant factor in growth, essentially as the handmaiden to industry and commerce (Robinson [19521; Lucas [1988]; Stern [1989]). In this perspective, the lack of financial development is simply a manifestation of the lack of demand for financial services. As the real sectors of the economy grow, the demand for various financial services rises and will thus be met by the financial sector. Based on this view, financial development simply follows economic growth and has very little effect on it. Like the first one, the third view ascribes effects to finance but focuses on its potential negative impacts on growth (Van Wijnbergen (1983]; Buffie [1984]). Economists holding this view contend that financial development can hinder growth by reducing available credit to domestic firms, This situation arises from the presence of informal curb markets. As the formal financial system develops, households are seen to substitute out of curb-market loans, thus reducing the total real supply of domestic credit. The reduction in the supply of credit can lead to a credit crunch, thereby lowering investment and slowing production and growth. Further, such a credit crunch can retard economic growth beyond the short term by lowering the steady-state capital stock (Wijnbergen (1983]). From these divergent views, three testable hypotheses emerge with sharply different policy implications. The first view suggests that government policies should be directed toward improving the financial system, since financial development has important causal effects on growth. The second view implies that government policies toward improving the financial system will have little effect on growth, since financial development results from growth and has little impact on it. Based on the third view, there is a potential danger of financial development. Under certain institutional arrangements, government efforts toward financial development can cost an economy its long-term growth by reducing total real supply of domestic credit. …