2. growth and finance

8/7/2019 2. Growth and Finance

http://slidepdf.com/reader/full/2-growth-and-finance 1/45

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 forcreating economic growth’



View 2: Finance hurts growth

Adams“banks have done more harm tothemorality, tranquility, and evenwealth 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 hurts

growth

Finance

promotes growth

Finance

doesn’t matter

Finance

follows growth

Finance matters

for crises



To assess who is right, lets look at

• Concepts

• Evidence



Concepts

What financial intermediaries and

markets dodo ...



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 theindustrial 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 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

• Some 3rd 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

Dependent Variables:

Real per Capita

GDP Growth

Real per Capita

Capital Growth Productivity Growth

DEPTH 2.4** 2.2** 1.8**

(0.007) (0.006) (0.026)

R2

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, managingrisk, 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

Dependent Variables:

Real per Capita

GDP Growth

Real per Capita

Capital Growth Productivity Growth

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

(0.001) (0.001) (0.001)R

20.61 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 growt

0

1%

2%

3%

Financial depth, 1960

Per capita GDPgrowth, 1960-98

11% 22% 33% 65%



Finance predicts growth ...

• ... And the link runs through

– Productivity growth

– Not, savings or capital accumulation ...



Financial depth predictsfuture productivity growth

0

1%

2%

3%


Productivitygrowth, 1960-98

11% 22% 33% 65%



Financial depthdoes not predict savings

41% 76% 107% 168%0

0.1

0.2


Private saving, 1976-98



But …

• Other components of the financial system

– Does stock market development predict growth

and, if yes, through what channels?



Stock market liquidity predicts growth

0 1 2 3 4

Very liquid

Liquid

Illiquid

Very illiquid

Value traded / market capitalization

Per capita growth %



Stock market liquiditypredicts productivity growth

0.06% 0.50% 2.20% 15%0

1%

2%

Stock market liquidity, 1976(value traded ratio)

Productivitygrowth,1976-98



Liquidity does not predict savings

0.06% 0.50% 2.20% 15%

0

0.1

0.2

Private saving rate



Market size does not predict growth

0 1 2 3 4 5

Very small

Small

Large

Very large

Market capitalization / GDP in 1976

Per capita growth %



Market volatility does not predict growth

0 1 2 3 4

Very stable

Stable

Volatile

Very volatile

Stock market volatility

Per capita growth %



Impact of finance on growth ...

• Runs primarily through productivity!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 isIt is notnot market size per se, it is liquiditymarket 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, OLSestimator is biased. Correl can be due to omitted variablesthat cause X, Y; errors in measuring the variables, andsimultaneity

• Solution – find a variable Z such that Z,X highlycorrelated, but Z, ε not correlated.

– Estimate first stage relationship between Z and X, then plug intosecond 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) = a X 1(i,t) + b X 2(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

• X 1= Lagged explanatory variables

• X 2 = Contemporaneous expl. variables



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)

Panel GMM Estimates

Naïve and modeled impact of financial



Naïve and modeled impact of financial

development on growth

Private credit as percentage of GDP (log)

Average GDP growth 1960-95, percent per annum

-4

0

4

8

10 100

Model

Naïve



Impact of finance on growth is ...

• Not due to reverse causality

• Robust to other country traits

• BigBanks 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 financingconstraints 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 FSDenjoy fewer credit constraints, lower i.

• Rousseau-Wachtel: positive effects of FSD decreasewith 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

Share of firms reporting cost of/access to finance (percent)

0 10 20 30 40 50 60 70

High income

East Asia & Pacific

Europe & Central AsiaLatin America & Caribbean

Middle East & North Africa

South Asia

Sub-Saharan Africa

Access to finance

Cost of finance



Private Credit and Access

2. growth and finance

Documents