Financial development and economic growth in vietnam a quantitative assessment

UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL STUDIES
THE HAGUE
THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

FINANCIAL DEVELOPMENT AND
ECONOMIC GROWTH IN VIETNAM:
A QUANTITATIVE ASSESSMENT

BY

LÊ TẤN BỬU DUY

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, April 2014


UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL STUDIES
THE HAGUE
THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

FINANCIAL DEVELOPMENT AND
ECONOMIC GROWTH IN VIETNAM:
A QUANTITATIVE ASSESSMENT
A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

LÊ TẤN BỬU DUY

Academic Supervisor:
DƯƠNG NHƯ HÙNG


ACKNOWLEDGEMENT

I want to send special thanks to my academic supervisor, Dr. Duong Nhu Hung, for his
patience as well as his continuous supports and valuable comments during my thesis
writing process.
I am also thankful to all of the lecturers in VNP for their wonderful lessons, to all
administrators in the VNP Office for their supports, and especially to Mr. Nguyen Dinh
Quy for being so helpful every time I come to the VNP Library.
Finally, I want to show my gratitude to my family and my friends for their endless
encouragements to me so that I could finish the program as well as the thesis.

ABSTRACT
The thesis employs two quantitative methods to explore the relationship between
economic growth and financial development in Vietnam using quarterly data from 1999
to 2012. Firstly, the ARDL cointegration test developed by Pesaran and Shin (1999), and
Pesaran, Shin, and Smith (2001) was used to search for a long run relationship among
economic growth, financial development, and other macroeconomic variables including
exports, imports, inflation, and real interest rate. The existence of such long run
cointegration relationship is confirmed through the ARDL bound testing procedure with
all four indicators of financial development, namely ratio of M2 to GDP, ratio of deposits
to GDP, ratio of credits to GDP, and ratio of credits provided to the private sector to
GDP. Secondly, Toda and Yamamoto (1995) causality test was employed to determine
the causal relationship between economic growth and financial development under a
multivariate VAR framework. Evidence of causality running from financial development
to economic growth is found for all indicators of financial development. These results
provide strong support to the supply-leading hypothesis on the relationship between
economic growth and financial development for the case of Vietnam.


ACRONYMS AND ABBREVIATIONS


TABLE OF CONTENTS
CHAPTER 1: INTRODUCTION ..................................................................................................... 8
1.1

PROBLEM STATEMENT .......................................................................................................... 8

1.2

RESEARCH OBJECTIVES AND QUESTIONS ...................................................................... 10

1.3

RESEARCH METHODOLOGY ............................................................................................... 11

1.4

STRUCTURE OF THE THESIS ............................................................................................... 11

CHAPTER 2: LITERATURE REVIEW ....................................................................................... 12
2.1

KEY CONCEPTS ...................................................................................................................... 12

Economic Growth................................................................................................................................. 12
Financial Development......................................................................................................................... 12
2.2

THEORETICAL REVIEW ........................................................................................................ 12

2.2.1 Theoretical Hypotheses ............................................................................................................. 12
2.2.2 Financial Repression Theory ..................................................................................................... 14
2.2.3 Financial Liberalization Theory ................................................................................................ 15
2.2.4 Financial Structure Theory ........................................................................................................ 17
Bank-based Theory ................................................................................................................ 17
Market-based Theory............................................................................................................. 19
Other Views in Financial Structure Theory ........................................................................... 21
2.2.5 Endogenous Growth Theory...................................................................................................... 22
2.2.6 Summary of Theoretical Predictions ......................................................................................... 25
2.3

EMPIRICAL REVIEW .............................................................................................................. 26

2.3.1 Traditional Cross-Country Analysis ........................................................................................... 26
2.3.2 Panel Cointegration and Causality Analysis .............................................................................. 27
2.3.3 Time series analysis.................................................................................................................... 29
VECM Approach .................................................................................................................. 29
VAR Approach ..................................................................................................................... 32
2.3.4 Previous empirical studies about Vietnam ................................................................................ 35
2.3.5 Summary of findings from previous empirical studies ............................................................. 35
2.4

CONCEPTUAL FRAMEWORK ............................................................................................... 26

CHAPTER 3: RESEARCH METHODOLOGY AND DATA COLLECTION ........................... 38
3.1

ANALYTICAL FRAMEWORK ............................................................................................... 38

3.2

MODEL SPECIFICATION AND DATA COLLECTION ........................................................ 39
Economic Growth (EG) ......................................................................................................... 39
Financial Development (FD) ................................................................................................. 40


Trade (EX, IM) ...................................................................................................................... 41
Inflation (INF) ....................................................................................................................... 43
Real Interest Rate (RIR) ........................................................................................................ 44
3.3

ECONOMETRIC TECHNIQUES ............................................................................................. 45

3.3.1 Seasonal Adjustment ................................................................................................................. 45
3.3.2 Unit Root Test ........................................................................................................................... 47
3.3.3 ARDL Cointegration Test ......................................................................................................... 48
3.3.4 Toda and Yamamoto Causality Test ......................................................................................... 50
CHAPTER 4: OVERVIEW OF ECONOMIC GROWTH AND FINANCIAL
DEVELOPMENT IN VIETNAM ..................................................................................................... 53
4.1

ECONOMIC GROWTH ............................................................................................................ 53

4.1.1 Overview ................................................................................................................................... 53
4.1.2 Results ....................................................................................................................................... 53
Structural Changes ................................................................................................................ 53
Global Integration ................................................................................................................. 55
4.1.3 Challenges ................................................................................................................................. 56
Investment-driven Economic Growth .................................................................................... 56
Inefficient SOEs and Public Investments ............................................................................... 57
Macroeconomic Instability .................................................................................................... 58
4.2

FINANCIAL DEVELOPMENT ................................................................................................ 58

4.2.1 Overview ................................................................................................................................... 58
4.2.2 Results ....................................................................................................................................... 59
Banking Market ..................................................................................................................... 59
Stock Market .......................................................................................................................... 62
4.3 A FIRST LOOK ON THE RELATIONSHIP BETWEEN ECONOMIC GROWTH AND

FINANCIAL DEVELOPMENT .......................................................................................................... 64
CHAPTER 5: EMPIRICAL RESULTS ........................................................................................... 65
5.1 Seasonal Adjustments................................................................................................................... 65
5.2 Preliminary Analysis .................................................................................................................... 66
5.3 Unit Root Test .............................................................................................................................. 69
5.4 ARDL Cointegration Test ............................................................................................................ 70
5.5 Toda and Yamamoto Causality Test ............................................................................................ 72
CHAPTER 6: CONCLUSIONS ........................................................................................................ 77
6.1 Summary and Conclusions ........................................................................................................... 77


6.2 Limitations.................................................................................................................................... 78
6.3 Directions for Further Research ................................................................................................... 79
REFERENCE ..................................................................................................................................... 80


LIST OF TABLES
Table 2.1: Summary of theoretical predictions .................................................................................... 25
Table 2.2: Findings from previous empirical studies ........................................................................... 36
Table 3.1: Critical values for ADF test ............................................................................................ 48
Table 3.2: Critical values for bound F-test ...................................................................................... 50
Table 4.1: Proportion of output from different economic sectors ................................................ 54
Table 4.2: Industrial output share by ownership ............................................................................ 54
Table 4.3: : Investment share by ownership .................................................................................... 55
Table 4.4a: Structure of goods exports by kinds of economic sector .......................................... 56
Table 4.4b: Structure of goods imports by kinds of economic sector ......................................... 56
Table 4.5: Growth accounting of Vietnam from 1990 to 2007 .................................................... 56
Table 5.1: Descriptive statistics ............................................................................................................ 68
Table 5.2: Correlation coefficients ................................................................................................... 69
Table 5.3: Results of ADF test ............................................................................................................. 70

Table 5.4: AIC, SBC, F-statistic, t-statistic, and LM for different lag-lengths .......................... 71
Table 5.5: Optimal lag-length p chosen by AIC, SC, and LR test ....................................................... 73
Table 5.6: Results of VAR residual autocorrelation LM test ............................................................... 74
Table 5.7: Toda and Yamamoto causality test results .......................................................................... 75

LIST OF FIGURES
Figure 4.1: Openness, export, import, and net export (as percents of GDP) of Vietnam ........ 55
Figure 4.2: The incremental capital-output ratio (ICOR) of Vietnam in 1991-2009................ 57
Figure 4.3: Number of banks in Vietnam from 2006 to 2010 ..................................................... 60
Figure 4.4a: Deposit market share according to type of banks in 2005-2010 ........................... 60
Figure 4.4b: Credit market share according to type of banks in 2005-2010 .............................. 60
Figure 4.5: Ratio of banking credits and deposits to GDP ........................................................... 61
Figure 4.6: GDP growth and credit growth of Vietnam from 2000 to 2012.............................. 64
Figure 5.1: Real GDP and nominal GDP from 1999Q1 to 2012Q3 .................................................... 65
Figure 5.2: Seasonal adjusted real GDP and nominal GDP from 1999Q1 to 2012Q3............. 66
Figure 5.3: Graphical presentations of all variables from 1999 to 2012 .............................................. 66


CHAPTER 1: INTRODUCTION
The chapter introduces the necessary of a quantitative analysis of the relationship between
financial development and economic growth of Vietnam. Then it will discuss about the
objectives of the thesis, the questions to be answered in the thesis, and the econometric
techniques used to answer those questions. The chapter ends by providing the structure of the
thesis.

1.1

PROBLEM STATEMENT

The relationship between financial development and economic growth was first examined in

a research by Schumpeter in 1911 (as cited in King and Levine, 1993a). However, it only
receives great attention from economists since the seminal studies of McKinnon (1973),
Shaw (1973), and King and Levine (1993b). Despite of the high volume in both theoretical
and empirical research, the direction in the relationship is still not conclusive yet. The
research results on the relationship could be classified into five categories, each supporting
one of the followings hypotheses:
i.

Supply-leading hypothesis (Patrick, 1966): financial development increases the
efficiency in the allocation of economic resources and thus could promote economic
growth eventually.

ii.

Demand-following hypothesis (Patrick, 1966): financial development might passively
follow economic growth as higher level of income will lead to higher demand for
financial services.

iii.

Bi-directional causality hypothesis: financial development causes economic growth
and conversely the development of the economy also induces the development of the
financial sector.

iv.

Independent hypothesis: the role of financial development in economic growth
process is overstated; there is no relationship between financial development and
economic growth.

v.

Stage of development hypothesis (Patrick, 1966): in the early stage of economic
growth, the supply-leading hypothesis takes the lead. Then, the demand-following
hypothesis dominates.

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Most of the initial empirical studies on the relationship between growth and financial
development are cross-country based. Such studies are usually criticized for their robustness,
especially on the econometric methods being employed. Arestis et al (2001), Abu-Bader and
Abu-Qarn (2008a) argued that these cross-country studies could not explore the dynamics in
the relationship between growth and finance to answer questions related to causality. When
the growth regressions in these studies return a significant coefficient for financial
development, it might just because there is an association between economic growth and
development, and thus this result could not be interpreted as the evidence of causality.
Moreover, cross-country studies could only provide the broad view on the relationship
between finance and growth. Results from such studies might be correct in general but not
necessary be true in a particular country due to differences in economic or political
characteristics. Thus cross-country studies might not be very useful for policy making
purposes at specific countries. For those purposes, time series based studies are needed.

However, there are a few limitations associated with the current time series based studies on
the relationship between economic growth and financial development. Firstly, although
country-specific time series studies are helpful for policy making, they are usually criticized
about the model specification being used. Luintel and Khan (1999), and Odhiambo (2008)
argued that many of the previous time series studies employ bi-variate or tri-variate models
thus they are vulnerable to omitted variable issues and might return biased causal relationship
between financial development and economic growth. Secondly, financial development is a

complex concept thus there is no single variable could reflect accurately the whole level of
financial development of a country. However, many empirical studies only use one or two
indicators of financial development and hence might subject to the question about robustness
of the results. In short, results from previous time series based studies are subjected to the
questions regarding to misspecification or omitted variables problem, and the question related
to robustness as usually only a few financial measures are employed in a single study. This
thesis attempts to address those limitations by providing a time series analysis based on a
high dimension multivariate model with several different indicators of financial development
being used.

For the case of Vietnam, as shown in Nguyen (2011), most of the previous studies on the
growth-financial development nexus are qualitative-based and only a few recent papers such
as Anwar and Nguyen (2009), and Nguyen (2011) employ quantitative analysis in studying
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the link between them. However, these later studies employ traditional panel data analysis
method and thus subject to the criticisms by Abu-Bader and Abu-Qarn (2008a), Lee and
Chang (2009) as this method is not appropriate to examine the causal relationship. Briefly,
there has been no time series analysis so far on studying the growth-finance relationship in
Vietnam. The thesis is among the very first attempts to examine the relationship between
growth and financial development in Vietnam using recent developed time series economic
techniques such as Toda and Yamamoto causality test (Toda & Yamamoto, 1995), and
autoregressive distributed lag (ARDL) cointegration test (Pesaran, Shin & Smith, 2001).

The examination of the relationship, especially the causality link, between economic growth
and financial development in Vietnam is important especially in the current context. Vietnam
has experienced a long time of high growth rate but it is now facing serious problems of
macro-instability. On April 2012, Vietnam’s government postulates a strategy to stabilize the
economy as well as achieve sustainable economic growth. The strategy aims to reconstruct

three major fields which are the financial sector, public investments, and state-owned
enterprises. Given the limitations of economic resources, appropriate priorities should be
assigned to these three projects. Within this context, the analysis of the causal relationship
between financial development and economic growth in Vietnam become more necessary.
The reason is that different causal results might return different implications for policy
making. According to Calderon and Liu (2003), if the evidence supports the supply-leading
hypothesis, policy to reconstruct the financial sector should have higher priority. Conversely,
in the demand-following case, the government should focus and give higher priority for other
policies to improve economic growth. Thus, the analysis of the causal relationship between
economic growth and financial development could be useful for considerations and
constructions of future growth enhancing policies for Vietnam.

1.2

RESEARCH OBJECTIVES AND QUESTIONS

The general objective of the research is to examine the relationship between financial
development and economic growth in Vietnam and then propose some suggestions for policy
making. In details, the research will focus on the following goals:
1. To determine the long run relationship among economic growth, financial
development and other macroeconomic variables in Vietnam.

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2. To determine the causal relationship between economic growth and financial
development in Vietnam.
In other words, the research will attempt to answer to the following research questions:
1. Is there any long-run relationship among economic growth, financial development
and other macroeconomic variables in Vietnam from 1999 to 2012?

2. What is the causality relationship between economic growth and financial
development in this period?

1.3

RESEARCH METHODOLOGY

To answer the first research question about the long run relationship among economic
growth, financial development and other macroeconomic variables in Vietnam the thesis will
employ the ARDL bound testing procedure. In seeking for the answer to the second research
question related to the causality relationship between economic growth and financial
development, this thesis will employ the Toda and Yamamoto (1995) causality test.

1.4

STRUCTURE OF THE THESIS

This thesis is organized into six chapters. Chapter I is introduction. Chapter II is literature
review. Chapter III describes the research methodology. Chapter IV explores economic
growth and financial development of Vietnam in recent years. Chapter V shows the empirical
results of the thesis. And finally Chapter VI includes the conclusion, limitations of the thesis,
and direction for further research.

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CHAPTER 2: LITERATURE REVIEW
The chapter begins by providing definition to the main concepts of economic growth and
financial development. After that, theoretical hypothesis and models on the links between
economic growth and financial development are reviewed. Finally, results from previous

empirical studies on the relationship are discussed.

2.1

KEY CONCEPTS

Economic Growth
Perkins et al (2006) defines economic growth as the increase in income per capita and the
increase in production of goods and services in a country. In other words, a country has
gained economic growth if it has produced more goods and services and also the average
income of the people has increased.

Financial Development
According to Levine (2005), as the financial system provides various functions, its
development should include various conditions reflecting how great these functions are
provided. Specifically, financial development consists of improvements in facilitating the
transactions of goods and services, better attracting of savings and allocation of capital, cost
reduction in gathering and processing information about potential investments, enhancements
in corporate governance and overseeing investment projects, improvements in risk
management and risk diversification. Calderon and Liu (2003) have a more simple definition
of financial development. According to them, financial development is referred to as the
enhancements in the “quantity, quality, and efficiency of financial intermediary services”
(Calderon and Liu, 2003).

2.2

THEORETICAL REVIEW

2.2.1 Theoretical Hypotheses
Schumpeter (as cited in King and Levine, 1993a) is among the earliest economists who

advocate the hypothesis that financial development is important to economic growth. He (as
cited in Ang, 2008) argued that firms need access to credits to finance their employment of
new production facilities and techniques. Then banks through their intermediary activities
could identify and finance the most productive firms and hence promote economic growth at
the aggregate level. Patrick (1966) named this hypothesis as “supply-leading” because in this
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case, the supply of financial intermediate services has led to economic growth. According to
Patrick (1966), within growing industries, the demand for credit would be high and thus
financial intermediate activities could enhance economic growth by attracting savings from
none or slow growing industries and channeling these savings to high growing industries.

In contrast to the hypothesis above, Robinson (as cited in King and Levine, 1993a) supports
the reverse hypothesis that financial development simply follows the growth of an economy.
Patrick (1966) also termed this hypothesis as “demand-following” since economic growth
generates higher demand for financial services. When the economy of a country grows, firms
will need more capital to expand their productions and hence the demand for financial
intermediate services will increase. This increasing in demand for financial services will in
turn induce the expansion of the financial sector. Thus in this case, financial development
passively follows economic growth.
Besides these two hypotheses, Patrick (1966) also proposes the “stage of development”
hypothesis which argued that the relationship between growth and financial development will
change according to the stage of development of a country. Specifically, the “supply-leading”
phenomenon could take the important role during the early development stage by providing
finances to productive investments. And when the industries which are financed through the
“supply-leading” process have achieved sustainable growth, the “demand-following”
phenomenon takes the leading role. Patrick (1966) noted that this chain of “supply-leading”
and “demand-following” might not only happen at the country level but also at the industry
level. This means while some industry has achieved high growth rate and is dominant by

“demand-following”, another industry might still be at the “supply-leading” stage.

Another pattern in the relationship between financial development and economic growth is
bi-directional causality. Lewis (as cited in Patrick, 1966) supports this hypothesis and
believes that economic growth would lead to the expansion and development of the financial
sector and as the financial system becomes more effective it could becomes the engine for
further economic growth. Depart from the above four hypotheses in which there’s always a
causality link between growth and finance though with different direction, there exists the last
hypothesis which views financial development and economic growth as unrelated matters.
Lucas (1988) argued that economists had overestimated the role of financial development to
economic growth.
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2.2.2 Financial Repression Theory
In 1950s and 1960s, governments at developing countries intervened intensively in their
financial markets. The governments as these countries viewed their financial systems as
underdeveloped and could not support the industrialization and economic growth processes
thus their interventions are needed. This motive is derived from the financial repression
theory which was originated from the studies of Keynes (1936) and Tobin (1965).

As cited in Fry (1988), Keynes uses the liquidity preference theory and the liquidity trap to
explain how financial repression is needed to induce economic growth. In the model of
Keynes, consumers allocate their wealth in two kinds of asset which are money and
productive capital like government bond of which the value moves conversely with market
interest rate. The allocation decision of consumers will depend on their expectation about the
market interest rate, e.g. if they expect the market rate to fall which means that the bond value
is expected to go up, they will prefer buying and keeping bonds. Based on the liquidity
preference theory, Keynes introduces the liquidity trap phenomenon in which at a given point
of time, consumers consider some specific level of interest rate as “normal”. When the

interest rate falls below this normal level, consumers will expect it to rise. Conversely, when
the interest rate rises above the normal level, it is expected to fall back.
In Keynes’ model, when the monetary policy increases money supply, consumers will realize
that they are keeping more money than needed and thus shifting their wealth into government
bonds. This reaction would increase bond prices while lowering the interest rate. The same
phenomenon will occur continuously if money supply keeps increasing. However, this will
stop when the interest rate fall to a specific level called liquidity trap interest rate. The reason
is that at this level, the interest rate has fallen so much below the “normal” interest rate thus
consumers will expect the market rate to rise and prefer to keep the increase in money supply
rather than investing in productive capital like government bonds. Keynes had proposed an
alternative to this adjustment process. If the government represses the financial system by
imposing a ceiling interest rate, and as the same time maintains fixed price level so that future
expectations about price level will be stable, the expansion monetary policy would be benefit
to economic growth. With the introduction of a ceiling interest rate and a fixed price level,
the expansion monetary policy could reduce interest rate to stimulate investments and thus
promote economic growth.
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Another model which also advocates financial repression is represented in Tobin (1965). In
this model, consumers will devote their income for either consumption or savings purpose.
Regarding the savings part, consumers will partly invest in physical capital and hold the rest
as money balances. Thus physical capital and money balances are the only two assets in the
model and they are substitutes of each other. In the monetary growth model of Tobin (1965),
by lowering the yield on holding money balances, the return from investments into capital
stock will become more attractive comparing with the return from holding money and thus
the consumers will allocate a higher fraction of their wealth into productive capital assets.
This reaction of the consumers will increase the capital to labor ratio which reflects a higher
productivity of labor. The transition of the capital to labor ratio from low to high will
accelerate economic growth. Thus the policy implications behind Tobin’s model is that

government should lower the yield from holding money to prevent the flowing of savings to
money balances which is unproductive. This could be accomplished by setting ceilings on
interest rate, or imposing tax on holding money balances.

2.2.3 Financial Liberalization Theory
In 1970s, the financial repression view was challenged by the seminal research of McKinnon
(1973) and Shaw (1973). These authors had established the theoretical framework for the
financial liberalization theory. This new theory criticized the financial repression view that
government’s interventions in the financial systems at developing countries such as ceilings
on interest rate, high reserve requirements, and credit directing had brought negative effects
to savings, lead to inadequate and ineffective investments, and as a result impede economic
growth. The implications from financial liberalization theory is that the government at
developing countries should remove distortions in the financial system, let the market
determines the real interest rate itself, and allow the financial institutions to allocate credits to
the most productive investment projects. According to the McKinnon (1973) and Shaw
(1973), such liberalized financial system would be beneficial to economic growth.

McKinnon (1973) argued that in developing countries, the financial systems are inefficient
and thus investments are usually self-finance, i.e. investors must accumulate enough funds in
form of money balances before investments could take place. In the model of McKinnon,
money and capital are complements rather than substitutes as in financial repression theory.
The complementing roles of money and capital are expressed in McKinnon’s model in two
ways. Firstly, he believed that the demand for money react positively real return of capital
8


due to the desire of economic agents in making investments. The reason is that when real
return of capital increases, agents would like to invest more and due to the self-finance nature
of investment, the demand for money will arise accordingly. Secondly, McKinnon (1973)
argued that investment depend positively on real interest rate of money balances. This is

because when real interest rate of money balances increases, the accumulation of money
balances will occur and thus more funds are available for investments. The implication
behind the complementing roles of money and capital in McKinnon’s model is that
government in developing countries should remove the repressions in the financial system
such as interest rate ceilings, high reserve requirements, or credit directing. The withdrawal
of these distortions would lead to a higher real interest rate of money balances which will
speed up capital accumulation process and boost economic growth.

An alternative theoretical framework for financial liberalization could be found in Shaw
(1973)’s model. In this model, money is debt of the financial intermediary system and an
increase of money stock in the economy reflects a higher level of financial intermediation
activities between savers and borrowers. Shaw (1973) argued that the liberalization of the
financial system would lead to the expansion of the financial intermediary system. This
development in the financial system will in turn promote economic growth through the
savings effect and investment effect respectively.

According to the savings effect, the propensity to save of the people tends to increase in line
with the higher level of money stock in the economy. Shaw explained that this effect may be
a result of the income effect discussed earlier as the increase in savings might be simply a
result of the increase in income. The increase in savings could be simply a direct result of
liberalization since savings might be depressed earlier by government’s intervention and now
as the financial system is liberalized, savings increases to its normal level. Moreover, the
removal of financial repressions would increase real interest rate of money balances to reflect
the scarcity of savings, and this high real interest rate will in turn attract more savings.
Another explanation by Shaw (1973) for the increase in savings is that with real money
growth, entrepreneurs tend to save more to accumulate equity in order to apply for additional
loans.

The investments effect of real monetary growth is explained in the model of Shaw (1973) as
follows. He argued that the financial market at developing countries is fragmented and the

9


development of the financial intermediary system reflected by real money growth would
unify and widen the financial market. Thus the pooling of savings would be more efficient
while the level of investments would increase since investors could now access to a larger
market and the higher liquidity provided by the unified market will encourage large and longterm investments. Moreover, the average return from investments will increase since the
financial system is now allowing for more discriminating choice among investments. Finally,
the investments will be taken more efficiently since the development of the financial
intermediary system will reduce risks through diversification, lower costs to investors
through economies of scale.

2.2.4 Financial Structure Theory
Although the main debate in financial structure theory is which type of financial structure is
superior for promoting economic growth, the theoretical studies in this theory also provide
some useful insights on how a financial system could promote economic growth. A financial
structure could be thought as the foundation of the financial system as it indicates how
financial activities are arranged within the economy (Stulz, 2000). Competing views in
financial structure theory maintain their own views on how a specific type of financial
structure is beneficial to economic growth. Currently there exist four distinct views in the
debate which are bank-based, market-based, financial services, and finally law and finance.

Bank-based Theory
The bank-based theory often stresses the important role of banks in facilitating economic
growth. For example, in the model developed by Diamond and Dybvig (1983), banks could
promote economic growth by reducing the liquidity risks associated with long-term and highreturn investment projects. According to the authors, consumers invest part of their savings
into long-run, high-return but illiquid projects. When some consumers receive shocks, they
will need to access their savings earlier and this could lead to the liquidation of those
projects. Banks could eliminate this liquidity risk by providing demand deposits which are
short-term and liquid assets that consumers could exchange into cash whenever they want.

The demand deposits provided by banks act as the insurance against liquidity risk since these
could satisfy the early consumption need of the consumers who receive shocks. Thus the
presence of banks and their demand deposits could enhance economic growth by preventing
the liquidation of long-run and high-return investment projects when consumers receive
shocks.
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A bank-based system could also be beneficial to economic growth through its positive effect
on the capital allocating process. For instance, in the financial intermediation model of
Diamond (1984), banks introduced cost advantage when mobilizing capital from savers to
borrowers. The information cost is minimized as bank act as a delegated agent in monitoring
loans to individual firms. Without banks, there would be “duplication of effort” if every
savers tend to monitor their loans directly or there would be a free-rider issue if none of the
savers monitor borrowers. Diamond (1984) argued that although banks received deposits
from savers, their utilization of funds through intermediary activities need not to be
monitored like in the case of normal borrowers because banks could diversify their lending
portfolio to reduce the risks associated with their loans. Thus the delegated monitoring role
and risk diversification ability of banks should enhance efficiency in capital allocation.
While Diamond (1984) explores the advantage of banks in solving asymmetric information
problem occurs after providing loans, Boyd and Prescott (1986) stresses the important of
banks in resolving asymmetric information issue which arises before signing loan contracts or
investment have taken place. In the later model, financial intermediaries are coalition of
agents and they are identical with banks since their activities include receiving deposits from
savers, providing loans, and making investments. According to Boyd and Prescott (1986),
these financial intermediaries could prevent the adverse selection issue and thereby improve
the capital allocation process since they evaluate and produce information about possible
projects before making investment decisions. Thus financial intermediaries have undertaken
the costly process of searching and evaluating of possible investments for individual
investors. In the model of Boyd and Prescott (1986), the presence of competing financial

intermediaries could support the Pareto efficiency allocation of capital in the economy.
Another channel through which a bank-based system could accelerate economic growth is its
positive effect on investments. Banks encourage investments through their financial supports
to new firms’ establishments. According to Stulz (2000), stage-financing, i.e. additional
finances will be provided when the investment project develops positively, is the optimal
mechanism to finance new entrepreneurs. This is because the entrepreneur would have better
information about his own project than any potential investors and this asymmetric
information problem creates a risk for any investors intending to provide finance for the
project. The solution is that the investors might provide initial funds so that the entrepreneur
might start the project at small scale then if they discover that the project is profitable they
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would provide additional finances. Stulz (2000) argued that securities market is not wellsuited to this funding mechanism due to its nature while banks could allow this by providing
loans to the entrepreneur and provide renewal or expansion of the contract if the project
develops positively and profitably.
Advocates of bank-based view not only emphasize the positive role of banks but also stress
the adverse effects of a market-based system on economic growth. Stiglitz (1985)
emphasized that the asymmetric information problem occurs in the market-based system
would bring negative impact to corporate governance. A downgrade in corporate governance
means that the firms in the economy are not doing well which in turn implied that the capital
mobilized into production is not utilized efficiently and thus impede economic growth. In a
market-based system, firms are owned by many shareholders who legally have the right to
control and replace the management team if the firm is not performing well. However Stiglitz
(1985) argued that in reality, to make such decision stockholder must spend resources in
collecting information to evaluate the performance of the firm and the management team.
This is a costly process and since assuring good governance of the firm is similar to a public
good to shareholders, there will be inadequate resources and efforts dedicated to ensure it.
Market-based Theory
On the contrary with bank-based theory, the market-based view emphasizes the positive

contribution of well-functioning stock market to economic growth. For instance, in the model
of Levine (1991), the utilization of physical capital during the production process accelerates
the accumulation of human capital within firms. Based on this positive externality of physical
capital, Levine (1991) argued that stock market could promote economic growth in two
channels. Firstly, the stock market could help risk-averse investors to easily diversify their
portfolio to limit the adverse effect of productivity risks associated with the firms they invest.
Thus a higher fraction of physical capital would be attracted and provided to firms to support
the human capital accumulation process which in turn accelerate economic growth. Secondly,
the stock market could reduce the liquidity risks associated with the investments of economic
agents into firms. The liquidity introduced by the stock market has lowered the exit costs thus
investors could inexpensively sell their shares when they receive liquidity shocks, i.e. the
shocks which force investors to consume their funds before their investments mature. As a
result, physical capital is not withdrawn unnecessarily from firm and thus the human capital
accumulate process could continue to engine economic growth.
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Allen and Gale (1999) developed a model in which securities market could promote
economic growth by facilitating the formation of new industries and new technology
changes. Their argument is that when new products or innovative technologies are
introduced, there is “diversity of opinion” among investors regarding the efficiency of these
products or technologies. In the model of Allen and Gale (1999), securities market is superior
to financial intermediaries like banks in the case where there is “diversity of opinion” among
investors. In such situation, investors in the securities market will individually base on their
own beliefs to gather information and make judgement about the effectiveness of the new
product or technology. Finally, those who are optimistic about the new product or technology
will provide the necessary finances. In contrast, Allen and Gale (1999) had shown in their
model that the ability of financial intermediaries like banks to provide finances to innovative
projects is limited when there is “diversity of opinion” among investors. The reason is that in
their model financial intermediaries are group of investors in which one of them will pointed

as the manager and when there is “diversity of opinion” among investors, the disagreement
on which information to be collected to evaluate the effectiveness of innovative projects
arise. Thus even if the manager of the financial intermediary is optimistic about the project,
the disagreement from other investors within the intermediary would prevent the decision to
provide finances to be executed.

Besides their support for a market-based system, the market-based view also stresses the
short-comings associated with a bank-based system. According to Rajan and Zingales (2001),
although lending and investment activities in a bank-based financial system are not always
inefficient, there are many problems associated with this system. Firstly, the poor price signal
in a bank-based system might lead to misallocation of funds. This is because banks possess
some monopoly power to the borrowing firms and this monopoly power allows banks to form
a long-run relationship with these firms by providing them “below-market rate” in the shortrun or in the firms’ hard time and then charging them “above-market rate” in the long-run or
when the firms are doing well. This deviation from market rate could lead to inefficient
allocation of funds since in this case, the cost of undertaking investment projects by
borrowing firms only depend on their loan contracts with banks. For instance, with long-term
access to banks’ credit, firms might continuously making investments even when they are
having problems with their cash flows.

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Secondly, Rajan and Zingales (2001) shown that banks may cooperate with borrowing firms
to secure returns from their loans and these actions would prevent the optimal resource
allocation in the economy. For instance, when there is catastrophic shocks to the economy,
banks might not let their borrowing firm becoming bankrupt easily; instead they would
provide additional finances to save those firms. These distortions of banks might against the
natural structural adjustment of the economy in which real financial distressed firms get
bankrupt while the healthier and more efficient firms survive. Thirdly, a bank-based system
might not be able to accelerate economic growth since it is only well-suited for financing

traditional industries where physical capital are used intensively. Banks could easily provide
loans to firms in these industries since the borrowing firms could provide collateral by their
tangible assets. Rajan and Zingales (2001) argued that a bank-based system might not be able
to support new and innovative industries since the monopoly power over their borrowing
firms allows banks to extract profits from these firms this could impede the effort of these
firms in creating innovative products. This is not the case with traditional industries where
the banks could not extract much profit because these industries are already well-understood.

Other Views in Financial Structure Theory
The two later theories about financial structure get rid of the bank-based and market-based
debate and focus on other factors in explaining growth. Specifically, the financial services
view originated from Merton and Bodie (1995) and Levine (1997) puts less attention on
whether the financial system is bank-based or market-based. Instead, it reconciles both views
by arguing that it is not the type of the financial system but rather the financial services
provided by the system is crucial to economic growth. Besides this view, La Porta et al
(2000) advocate the law and finance view in which the role of the legal environment in
creating a growth promoting financial system is stressed.

The functional services view proposed by Merton and Bodie (1995) is based on two
arguments. First, the form of financial institutions fluctuates more than the financial services
provided by them over time. Second, the financial institution forms depend on the financial
functions. Within this view, six functions provided by financial institutions include
facilitating exchange, pooling of economic resources, mobilizing those resources between
savers and borrowers, managing risks, providing price signals to assist decision-making in the
economy, resolving the incentive problems. Merton and Bodie (1995) then argued that “the
functional perspective views financial innovations as driving the financial system toward the
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goal of greater economic efficiency”. Thus for the goal of economic growth, the type of the

financial system is not important than how well are the financial functions provided by the
system. Levine (1997) also proposed the functional approach when studying the relationship
between growth and finance. He argued that the functions provided by the financial system
including facilitating exchange, pooling and mobilizing capital, risk management, corporate
governance are the same across countries. However, what matters in the relationship between
economic growth and finance is the quality of providing those financial functions.

Similarly, the law and finance theory proposed by La Porta et al (2000) also get rid of the
debate between bank-based and market-based theories and argued that the legal system is
crucial in creating a growth-enhancing financial system. La Porta et al (2000) argued that
when creditors and minor stockholders provide finances to firms, the yields on their
investments will be affected by expropriation activities initiated by the controlling
shareholders. Those expropriation activities include selling firm’s assets or products to other
firms owned by these controlling shareholders with low prices, putting their relatives into the
firm’s management team, paying higher than usual for the management board. If the legal
system does not provide enough protection for outside investors such as creditors and minor
stockholders, there would be high probability that these expropriation actions by the
controlling stockholders will take place. In turn, this would not only lower the performance of
the firm but also discourage the incentive of making investment by outside investors. Thus,
the implication of the law and finance view by La Porta et al (2000) is that a strong legal
environment and enforcement mechanism in protecting outside investors would open up
more opportunities for firms to attract investments from external sources and increase the
efficiency of using capital from those sources through corporate governance enhancement.

2.2.5 Endogenous Growth Theory
Endogenous growth theory is originated from the seminal studies of Romer (1986) and Lucas
(1988). In original studies advocating this economic school of thought, the role of financial
development is often omitted or not discussed directly. Within the framework of this theory,
the role of financial system in inducing economic growth only get into attention after new
endogenous growth models were introduced in 1990s. These new models have incorporated

financial activities in explaining economic growth. The notably models in this strand are
introduced in Greenwood and Jovanovic (1990), Bencivenga and Smith (1991), King and
Levine (1993b), and Pagano (1993).
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In the endogenous growth model developed by Greenwood and Jovanovic (1990), there is a
bidirectional causality relationship between economic growth and financial development.
They argued that the establishment of financial institutions is costly thus in initial
development stage of the economy, there is merely no institutions. When the economy has
reached its intermediate development stage, large financial institutions appear. Then these
institutions induce further economic growth through various financial activities. According to
Greenwood and Jovanovic (1990), the development of financial institutions could affect
economic growth through two channels. First, financial institutions could pool savings and
allocate to investment projects which provide higher returns. Without financial institution,
when individual investors face two types of investment projects, i.e. liquid projects with low
returns and illiquid projects with high returns, they might choose the latter as they would not
like to tie their funds in a longer period of time and expose to more risks. Second, financial
institutions could diversify their portfolios more efficient than individual investors thus the
investments of individual investors through financial institutions would be less risky. In
summary, the development of the financial system could affect economic growth as it could
allocate capital to higher return investments in a less risky manner.

Bencivenga and Smith (1991) formulated an endogenous growth model in which financial
intermediaries facilitating economic growth by changing the behaviour of agents in allocating
their savings and by preventing unnecessary and early liquidation of investment projects. In
this model, economic agents have randomly liquidity needs and to satisfy those needs in an
unfavourable time, all agents will have to allocate their savings not only in productive
investments but also in liquid assets which are usually unprofitable. Bencivenga and Smith
(1991) pointed out that the presence of financial intermediaries in the economy could

eliminate such inefficient capital allocation. The reason is that agents now do not have to
invest part of their savings in unproductive assets anymore; instead they could deposit it to
financial intermediaries. In turn, those intermediaries will keep part of the deposits as reserve
to satisfy the randomly liquidity need of agents and turn the rest into productive capital by
intermediary activities. Thus at the aggregate level, financial intermediaries have promoted
economic growth by turning unproductive assets into productive capital. Bencivenga and
Smith (1991) also suggested that financial intermediaries could induce growth by altering the
nature of investments made by economic agents. Without financial intermediaries, agents
invest using their own funds and thus those investment projects might be liquidated early if
the agents face liquidity shocks. Conversely, if the investments are financed through
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