Finance-Growth Nexus: Evidence from Indian Economy using Causality Co-Integration Test based on Error Correction Model


Master's Thesis, 2009
65 Pages, Grade: A

Excerpt

Table of Contents

Acknowledgments

List of table

List of Figures

Chapter 1
Background of Finance-Growth Nexus

Chapter 2
Trends of financial growth and economic development in India
Finance-Growth Nexus: The Indian Experience
Objective of the study

Chapter 3
Literature Review

Chapter 4
Data Description

Chapter 5
Theory, Empirical Model and Methodology
Empirical model specification and estimation technique
Stationarity Test
Cointegration Test
Vector Error Correction Estimate
Granger Causality using Unrestricted VAR

Chapter 6
Results and Interpretations
Stationarity Test
Cointegration Test
Vector Error Correction Estimate
Granger Causality using Unrestricted VAR

Chapter 7
Conclusion
Policy Implication
Limitation and Scope of study

Appendix
Lag length determination test result
Cointegration test results
Impulse Response Function Figures

Bibliography

ACKNOWLEDGEMENTS

I would like to express my sincere gratitude to Prof. Neil Canaday, my advisor for his supervision, advice, and guidance as well as giving me extraordinary experiences throughout the work. I am indebted to Prof. Suhas Ketkar for providing me unflinching encouragement and support in various ways. I am very much thankful to Mrs. Mouzon Siddiqi and Mrs. Marie Kelley for their love and help throughout my stay in Vanderbilt University.

I am honored to meet and be friend with few people during my stay in Vanderbilt University. I want to thank few nice hearts; Daniela, Eissa, Ely, Jeannie, Juliao, Raffi, Sait, Neil, Marshall, Tola and Patric for their love and meaningful friendship. My special thanks to Daniela and Fred for more than one reason.

I would like to thank International Ford Foundation for giving me an opportunity to pursue my studies at Vanderbilt University.

My parents deserve special mention for their inseparable support and prayers. I am deeply grateful to my parents and my sister for their love and understanding

List of Tables

Table 1 Financial Infrastructure

Table 2 Summary of Literatures Review

Table 3 Stationary Test

Table 4 Overall (1950-2007)

Table 5 Pre-reform (1950-1990)

Table 6 Post Reform (1991-2007)

Table 7 Error Correction Estimate Summary Statistics

Table 8 Overall Direction of Granger Causality

Table 9 Pre-reform Direction of Granger Causality

Table 10 Post Reform of Granger Causality

Table 9 VAR Lag Length Test Criteria

Table 10 Overall Error Correction Estimates

Table 13 Pre-Reform Error Correction Estimates

Table 11 Post Reform Error Correction Estimates

List ofFigures

Figure 1 GDP growth

Figure 2 GDP growths in three different periods

Figure 2 Financial Indicators

Figure 4 selected indicators

Figure 3 Correlation

Figure 4 Financial depths of South Asian Countries

Figure 7-14 Impulsion Response Function (Overall, Pre-reform and Post-reform)

Chapter 1

Background of Finance-Growth Nexus

One of the most debatable topics in development economics literature is the direction of causality between financial growth and economic development. The discussion dates back to 1911 when Joseph Schumpeter argued that the services provided by financial intermediaries - i.e. mobilizing savings, evaluating projects, managing risk, and facilitating transactions - stimulate technological innovation and economic development. Other early studies were undertaken by Goldsmith (1969), McKinnon (1973), and Shaw (1973) who stressed the connection between a country's financial superstructure and its real infrastructure. Economists like Robert Solow advocated the role of capital, labor and technology as the sources of growth and ignored any possible role of the financial sector. Similarly, Lucas (1988), and Robinson (1952) found that the role of finance is considerably over-stressed. Levin and King (1993) emphasized in their papers that financial development is strongly associated with GDP growth, the rate of capital accumulation and improvement in efficiency. However, Luintel and Khan (1999) have a different point of view; they found that there is a causal relationship between financial growth and economic development.

There are many differences among economists regarding the Finance-Growth nexus in the development literature. They can be grouped in three broad categories: Supply Leading approach (finance-led growth), Demand Following (growth-led finance) and Cautionary or Feedback approach. According to the Supply Leading approach, financial activity is a major determinant for economic development. The argument is that well functioning financial intermediations provide a much needed platform for users and savers in channeling surplus and deficits, which helps to efficiently allocate resources in the economy. Secondly, the demand following approach suggests that the financial sector development is the result of economic growth. In other words, economic development generates a demand for more financial services in the economy. Finally, the Feedback approach suggests a two-way causal relationship between financial development and economic growth. It means that a developed financial sector helps the economy to grow faster through capital mobilization and technological innovation. Subsequently, this creates a demand for efficient and expanded financial services or arrangement in the economy. Therefore, financial growth and economic development are interdependent and their relationship could lead to feedback causality.

This paper is organized as follows: Chapter 2 discusses the trends of financial growth and economic development in India, and objective of the study. Chapter 3 reviews the literature on the finance-growth nexus in general and India in particular. Chapter 4 describes the data set and provides descriptive statistics. Chapter 5 illustrates the empirical model specification and estimation techniques. Chapter 6 analyses the empirical results. And finally, chapter 7 is conclusion and policy recommendation which also includes limitation and future scope of the study.

Chapter 2

Trends of financial growth and economic development in India

India has a very interesting growth story. It maintained a growth rate of 3.5 percent for almost four decades after its independence in 1947. Policy makers in India believe that the state has an important role to play in guiding the national economic development because the state alone can identify and pursue the common interest, which is superior to the sum of private interests. In this model, the market was allowed to work but only under the close supervision of the state, which controls almost every aspect of economic life like production, finance, consumption and high taxation. This model proved to be a failure because it did not eradicate poverty. More than 51 percent of the population were below the poverty line at the end of the 1970s. The first wind of change came in 1980-81 when the Indian economy was liberated from the food constraint by the Green Revolution and, to a more limited degree, from the foreign exchange constraint. The significant improvement in management capacity in the public and private sectors also improved the economic performance after 1980-81. But the change was not sustainable. In the 1980s, India did not see a substantial change in its position in the global economy. Export promotion and attracting foreign investment were stated as goals of policy but the macro economy, including the exchange rate, was not oriented toward this end. In 1990, India faced the most severe financial crisis in post independence years because of large fiscal imbalance, mounting trade deficit, declining foreign exchange reserve and an alarming inflationary situation in the economy. It is against this backdrop that India took some sweeping decisions in 1991 to revamp its economy. The three most significant decisions were the devaluation of its currency, the partial liberalization of the domestic financial sector, and a gradual opening up of the external sector. After that India made a paradigm shift, and the India story began in 1991. To highlight a few growth indicators, GDP at market prices has increased from US$ 20 billion in 1950-51 to US$ 912 billion in 2006-07 and is expected to cross a trillion dollars in the current year. In terms of purchasing power parity, India's GDP at US$ 4 trillion in 2006-07 accounted for 6.3 percent of the global GDP. The average annual economic growth, which had been constant and tardy at 3.5 percent during the first thirty years of Independence, increased to 5.7 percent during the 1990s and, since 2003-04, the average rate has increased further to 8.6 percent. 2006-07, in particular, was a splendid year with the GDP growing at 9.4 percent. During this period, the rate of growth of employment was 2.9 percent per year. Most important of all, the proportion of people living below the poverty line in India has declined from 51.3 percent in 1977-78 to about 22 percent in 2004-05.

The financial growth chronicle is as remarkable as the economic growth in India. The USD 28 billion Indian financial sector has grown at around 15 percent in the last decade and has displayed stability for the last several years, even when other markets in the Asian region were facing a crisis. The financial sector is in a process of rapid transformation since 1991 when the government of India initiated an overall structural reform aimed at improving the productivity and efficiency of the economy.

The Indian financial system has been regulated by independent regulators in the sectors of banking, insurance, capital markets, competition and various services sectors. In a number of sectors, the government plays the role of regulator. The Reserve Bank of India (RBI), established in 1935, is the Central bank. RBI is the regulator for the financial and banking system. It formulates monetary policy and prescribes exchange control norms. India has commercial banks, co-operative banks and regional rural banks. The commercial banking sector is comprised of public sector banks, private banks and foreign banks. The public sector banks comprise the 'State Bank of India' and its seven associate banks and 19 other banks owned by the government. Currently, India has 88 scheduled commercial banks (SCBs) - 27 public sector banks, 29 private banks (these do not have government stake; they may be publicly listed and traded on stock exchanges) and 31 foreign banks. They have a combined network of over 53,000 branches and 17,000 ATMs. According to a report by ICRA Limited, a rating agency, the public sector banks hold over 75 percent of total assets of the banking industry, with the private and foreign banks holding 18.2% and 6.5%.

India has a two-tier structure of financial institutions with 13 all India financial institutions and 46 institutions at the state level. All India financial institutions comprise term-lending institutions, specialized institutions and investment institutions including insurance. State level institutions are comprised of State Financial Institutions and State Industrial Development Corporations providing project finance, equipment leasing, corporate loans, short-term loans and bill discounting facilities to corporate. The government holds the majority of shares in these financial institutions. Non-banking Financial Institutions provide loans and hire-purchase finance, mostly for retail assets and are regulated by the RBI. The insurance sector in India has been traditionally dominated by state owned Life Insurance Corporation and General Insurance Corporation and its four subsidiaries. The government of India has now allowed FDI in insurance sector up to 26%. Since then a number of new joint venture private companies have come into existence and the general insurance sectors and their share in the insurance market is rising. The Insurance Development and Regulatory Authority (IRDA) is the regulatory authority.

The RBI also regulates foreign exchange under the Foreign Exchange Management Act (FEMA). India has liberalized its foreign exchange controls. The rupee is freely convertible on current account. It is also almost fully convertible on capital account for non-residents.

The Securities and Exchange Board of India (SEBI), established under the Securities and Exchange Board of the India Act in 1992, is the regulatory authority for capital markets in India. India has 23 recognized stock exchanges that operate under government approved rules, bylaws and regulations. These exchanges constitute an organized market for securities issued by the central and state governments, public sector companies and public limited companies. The Stock Exchange, Mumbai and National Stock Exchange are the premier stock exchanges.

There has been a remarkable increase in the financial infrastructure over the last four decades in India which can be seen from the table below:

Table 12 Financial Infrastructure

illustration not visible in this excerpt

Finance-Growth Nexus: The Indian Experience

India has experienced a striking combination of financial growth and economic development in the last decades. This section shows various financial indicators to investigate previous literature on this topic. On the basis of these facts and figures I will propose my objective, hypothesis, model and measurement indicators and test its causality. Graph 1 shows the growth rate in GDP over the period of time from I960 to 2007. There has been a lot of fluctuation in the rate of growth in the Indian economy due to several economic and non economic factors like famine, war, oil crisis and others.

Figure 5

illustration not visible in this excerpt

The growth rate can be better explained if we take the average growth rate in the pre­reform (Pre 1991) and post-reform eras (after 1991). The graph below shows that the average growth rate from 1950 to 1990 is slightly above four percent and the average growth rate from 1991 to 2007 is slightly below seven percent. In the early 1990s India initiated the new economic policy following the worst ever financial and fiscal crisis.

Figure 6

illustration not visible in this excerpt

The new economic policy in 1991 has brought a structural reform to India in both the financial sector and in the international trade. India has not only opened up its economy for the global market but has also taken several majors to increase the efficiency in the financial sectors. The key reforms initiated are Central Bank reorganization, financial sector supervision and regulation, capital market development, bank restructuring and privatization, and insurance sector reform and privatization. All these reforms have led to a substantial improvement in the Indian financial sector. Graph 3 presents two sets of financial sector indicators showing the pre- and post-reform trends for the last 47 years.

Figure 7 Financial Indicators

illustration not visible in this excerpt

Figure 8

illustration not visible in this excerpt

Objective of the study:

It is evident from the literature on this topic that financial growth and economic development are closely related in any economy. The superior financial infrastructure has a greater impact on economic development and a higher economic development leads to a better and more efficient financial infrastructure in the economy. The debate regarding the nature and direction of the causal relationship between financial growth and economic development still continues. The majority of studies are based on cross­country macro data which generalizes the causal relationship between the financial development and economic growth across countries. Usually, the cross-sectional method fails to address potential biases that exist in a specific country if it is grouped together with countries that are at different stages of development and have different growth stories and events. The Indian economic growth story has been eventful and dramatic since its independence as we have seen in the previous section. The current study will attempt to investigate the inter-temporal causal relationship between

financial growth and economic development in India. First of all, this paper will find the time-series properties of financial growth indicators and economic development in India. Secondly, using cointegration tests and the vector error correction model, I will discuss the long-run and short-run relationship between financial growth and economic development for India from 1950 to 2007. Finally, this study will investigate the role of the financial sector reform on the economic growth in India. The study will look at three periods: pre-reform (1950-1990), post-reform (1991-2007) and overall period (1950­2007) to see the finance-growth nexus in India's case.

Chapter 3

Literature Review

There is a plethora of literature on dynamic interactions between financial development and economic growth using different econometric procedures ranging from simple OLS to multivariate cointegration test. There existthree conflictingviews in the research literature regarding the relationship between financial development and economic growth. The first view argues that financial development is important and leads to economic growth. The seminal works on finance-growth nexus by Bagehot (1873), Schumpeter (1912), Robinson (1952), Gurley and Shaw (1955), Patrick (1966), Goldsmith (1969) and McKinnon (1973) have attracted many researchers to work in this field. In later years, King and Levine (1993), Beck, Levine and Loayza, (1999) thoroughly studied the modern financial indicators and their relation with economic growth.

All these studies could be categorized in two broad segments: First, cross-country comparisons and second, individual countries using time series analysis. Several econometric tests have been used such as ordinary least square, cointegration, causality and VAR to test the finance growth nexus. In cross-country studies many factors like economic structures, technology, fiscal policy, trade openness, political stability, social development etc. are taken into account as well as the financial sector growth indicators. The major problem with these studies is to control all the unobserved country-specific differences; hence there is a potential risk of biasness in the results. The majority of the cross-sectional studies found a positive relationship between finance and growth and the time series analysis resulted in mixed conclusions. Here I will briefly review some of the empirical studies done in this field.

King and Levin (1993) concluded in their seminal work that Schumpeter might have been right about the importance of finance for the economic development. They used cross-country data from 80 countries from I960 to 1989. They tried to find out whether higher levels of financial development are significantly and robustly correlated with faster current and future rates of economic growth, physical capital accumulation, and economic efficiency improvements. King and Levin used four financial indicators: 1) Financial Depth (overall size of the formal financial intermediary system, i.e. ratio of the liquid liabilities to GDP), 2) Bank (ratio of domestic deposit money bank domestic assets to deposit money bank domestic assets plus central bank domestic assets, 3) Private (credit allocated to private enterprises by the financial system, 4) Privy (ratio of claim on the nonfinancial private sector to GDP). They took four growth indicators to test the correlation such as: 1) Real GDP per capita growth, 2) Rate of physical capital accumulation (GK), 3) Ratio of domestic investment to GDP (INV), 4) Efficiency of physical capital allocation. They found that indicators of financial development - i.e. the size of the financial intermediaries relative to GDP, the importance of banks relative to the central bank, the percentage of credit allocate to private firms, and the ratio of credit issued to private firms to GDP - are strongly and robustly correlated with growth, the rate of physical capital accumulation, and improvements in the efficiency of capital allocation.

[...]

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Details

Title
Finance-Growth Nexus: Evidence from Indian Economy using Causality Co-Integration Test based on Error Correction Model
College
Vanderbilt University  (Graduate Program in Economic Development)
Course
Masters in Economics
Grade
A
Author
Year
2009
Pages
65
Catalog Number
V137673
ISBN (eBook)
9783640456741
ISBN (Book)
9783640456949
File size
1802 KB
Language
English
Tags
Finance-Growth, Nexus, Evidence, Indian, Economy, Causality, Co-Integration, Test, Error, Correction, Model
Quote paper
Manoj Dora (Author), 2009, Finance-Growth Nexus: Evidence from Indian Economy using Causality Co-Integration Test based on Error Correction Model, Munich, GRIN Verlag, https://www.grin.com/document/137673

Comments

  • Manoj Dora on 1/27/2011

    Amazing insight into the financial development and economic growth. Thorough step-by-step approach for econometrics solutions. I love it!!!

  • Manoj Dora on 5/17/2011

    Thank you all for good review!

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