Relationship between financial development and economic growth panel data analysis of 22 developing countries

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

RELATIONSHIP BETWEEN FINANCIAL
DEVELOPMENT AND ECONOMIC GROWTH:
PANEL DATA ANALYSIS OF
22 DEVELOPING COUNTRIES

BY

TRẦN THỊ THU THỦY

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, October 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

RELATIONSHIP BETWEEN FINANCIAL
DEVELOPMENT AND ECONOMIC GROWTH:
PANEL DATA ANALYSIS OF
22 DEVELOPING COUNTRIES

A thesis submitted in partial fulfillment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS
BY
TRAN THI THU THUY

Academic supervisor
Dr. NGUYỄN MINH ĐỨC

HO CHI MINH CITY, October 2014


i
CERTIFICATION
I hereby confirm that this thesis, namely “the Relationship between Financial
Development and Economic Growth: a panel data analysis of 22 Developing
countries” is my own work. The work has not, in whole or part, been presented
elsewhere for assessment. Where material has been used from other sources it has been
properly acknowledged and referenced. If this statement is untrue I understand that I
will have committed an assessment offence.
I have read the Regulations of Vietnam – Netherlands Programme for M.A In

Development Economics and I am aware of the potential consequences of any breach
of them.
Signature:

Name: Trần Thị Thu Thủy
Date: Ho Chi Minh City, October 2014


ii
ACKNOWLEDGEMENT
I would like to express my gratitude to Dr. Nguyen Minh Duc, the academic
supervisor, for his very carefully reading and editing of my thesis. His valuable
comments and suggestions help me to improve the quality of this thesis throughout my
thesis stage. Thank to his valuable lectures, guidance and encouragement, I can fully
complete this thesis.
I also would like to extend my thanks to Dr. Truong Dang Thuy, other professors,
tutors and course co-instructors of Economics University who, through their valuable
lectures, tutorials and advices, help me during the courses and my study process.
Finally, many special thanks and gratefulness are given to my family, my classmates of
MDE course 18 and to a number of individuals for their encouragement in many ways
that strongly support me during my thesis stage.


iii

CONTENTS
Certifications………………………………………………………………………………….. i
Acknowledment......................................................................................................................... ii
Contents……………………………………………………………………………………… iii
List of tables…………………………………………………………………………………. iv

List of figures............................................................................................................................. v
Abstract………………………………………………………………………………………. vi
CHAPTER 1: INTRODUCTION............................................................................................ 1
1.1 Research problem ..............................................................................................................................1
1.2 Research objectives and research questions ......................................................................................4
1.2.1 Research objectives .................................................................................................................4
1.2.2 Research questions ..................................................................................................................4
1.3 Thesis Structure .................................................................................................................................5

CHAPTER 2: LITERATURE REVIEW ............................................................................... 7
2.1 Theoretical concepts related to economic growth and financial development....................................7
2.2 Financial development and economic growth: theoretical literatures .................................................7
2.3 Literature review and empirical studies ......................................................................................... 19
2.3.1 Theoretical framework on the relationship between economic growth and financial
development ................................................................................................................................... 19
2.3.2 Empirical studies on financial development and economic growth relationship .................. 22

CHAPTER 3: METHODOLOGY ........................................................................................ 32
3.1 General methods .............................................................................................................................. 32
3.1.1 Conceptual framework for the study ..................................................................................... 32
3.1.2 Research hypotheses: ........................................................................................................... 33


3.2 Research models and econometric methodology ............................................................................. 36
3.3 Data ................................................................................................................................................ 45
3.3.1 Determinants measuring financial development .................................................................. 46
3.3.2 Determinants measuring economic growth .......................................................................... 47
3.4 Research process ............................................................................................................................ 50

CHAPTER 4: ESTIMATION RESULT ANALYSIS AND DISCUSSION ...................... 52

4.1 Brief information on the dataset ....................................................................................................... 52
4.2 Regression results and discussion .................................................................................................... 55
4.2.1 Impact of economic growth on financial development ......................................................... 55
4.2.2 Impact of financial development on economic growth ......................................................... 59

CHAPTER 5: CONCLUSION AND IMPLICATION ........................................................ 64
5.1 Conclusion...................................................................................................................................... 64
5.2 Policy implications for Vietnam..................................................................................................... 66
5.2.1 An overview of the relationship between financial development and economic growth in
Vietnam .......................................................................................................................................... 66
5.2.2 Policy implications for Vietnam ........................................................................................... 73
5.3 Limitations and future research ...................................................................................................... 75
5.3.1 Limitations ............................................................................................................................ 75
5.3.2 Suggestion for future research............................................................................................... 76

APPENDIX
Appendix A……………………………………………………………………………… 78
Appendix B……………………………………………………………………………….79
Appendix C……………………………………………………………………………….84
REFERENCES……………………………………………………………………….………95


iv
LIST OF TABLES:
Table 1: Summary of empirical studies………………………………………………….…...27
Table 2: Expected signs of variables…………………………………………………………. 34
Table 3: Variable Description………………………………………………………………....37
Table 4: Summary of Variables………………………………………………………………49
Table 5: Descriptive statistics and correlations for selected variables……………………….. 53
Table 6: GMM estimation of Economic Growth and Financial Development…………..……56

Table 7: Regression Results of Economic Growth and Financial Development……………...61


v
LIST OF FIGURES
Figure 1: The relationship between financial development and
economic growth………………………………………………………………….. 32
Figure 2: Diagram of the main results………………………………………………………...66
Figure 3: Gross domestic savings in Vietnam
and in Asean countries……………………………………………………………. 68
Figure 4: Annual GDP per capita in Vietnam
and in Asean countries……………………………………………………………..70
Figure 5: Gross domestic saving rates in Vietnam and in Asean countries………………….71
Figure 6: Annual growth of domestic credits in Vietnam……………………………………. 72
and in Asean countries
Figure 7: Annual growth of Broad Money supply in Vietnam………………………………. 73
and Asean countries


vi
ABSTRACT:
In recent years, many researchers have taken into account the causal connection
between financial development and economic growth due to the important role of
financial development in the process of achieving the higher economic growth.
To investigate the causal relationship between financial development and economic
growth in twenty two developing countries in different regions from 1990 to 2011, we
apply both Generalized method of moment with instrumental variable approach and
Ordinary least square technique to examine how determinants of financial development
impact on economic growth and how the determinants of economic growth contribute
to develop finance system. We find that there is a two-way positive impact between

financial development and economic growth in selected developing countries. We also
find that the variable components such as the ratio of broad money to GDP, the ratio of
credit offered by bank to private sector to GDP, the ratio of gross domestic savings to
GDP and the ratio of domestic credit to the private sector to GDP play an important
role in explaining financial development. Furthermore, foreign direct investment,
general government consumption and trade openness are important factors in
accounting for growth rate of GDP per capita. We find out that the EXPORT is
significantly negative impact on economic growth. This result is consistent with the
argument that export specialization in developing countries may not benefit the
economic growth.
Finally, taking the advantage of positive relationship between financial and economic
development in developing countries, it is suggested that Vietnam needs to strengthen
its financial system in the context of the integration into the world economy. Vietnam
should provide the right incentives to promote the financial sector that will enable it to
have high economic growth.
Keywords: Financial development, growth, causal relationship


CHAPTER 1: INTRODUCTION
1.1 Research problem
In recent years, the causal relationship between financial development and economic
growth has been attracting a lot of attentions in the economic literatures. It is believed
that financial development plays a significant role in the process of economic growth
(Feng Lu & Yao, 2009; Fung, 2009; Fase & Abma, 2003; Ang & McKibbin, 2007;
Calderón & Liu, 2003). The financial development enhances economic growth through
capital allocation efficiency. The capital allocation efficiency can be enhanced by
performing the functions of financial intermediaries, including the improvement of
risk management and the reduction of asymmetric information, as well as
encouragement of saving and investment. This leads to the result in the improvement
in total factor productivity. Therefore, a well-functioning financial system may foster

economic growth (Hao, 2006; Odhiambo, 2004; Ghirmay, 2004).
There are numerous empirical studies providing supportive evidences on positive
linkage between financial development and economic growth (Fung, 2009; Anwar &
Nguyen, 2011; Ang, 2009; Jalil & Feridun, 2011; Habibullah & Eng, 2006; Chen Hao,
2006; Khalifa Al-Yousif, 2002). For instance, the causal relationship between financial
development and economic growth has been investigated by using Vector Auto
Regression (VAR) approach for analyzing panel data of 109 industrial and developing
countries for a period of 1960-1994 in the study of Calderón and Liu (2003). The
authors found that financial development positively affects economic growth and
economic growth positively affects financial development. The authors also admitted
that the financial development impacts on economic growth through channels of a
rapid capital accumulation and productivity growth. They further concluded that the
impact of financial development on economic growth should be well recognized in
providing the appropriate and meaningful implications for policy makers, which will

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enable them to obtain a higher economic growth and development (Calderón and Liu,
2003).
Habibullah and Eng (2006) investigated the causal relationship between financial
development and economic growth in 13 Asian less developed countries with
observations from 1990 to 1998. The authors concluded that financial development
enhances economic growth. They also agreed that a developed financial system will
create more financial instruments. These instruments improve the capital accumulation
in term of mobilizing savings, improving investment efficiency and increasing the total
factor productivity (Habibullah & Eng, 2006).
Furthermore, by employing Granger causality test within the error correction model,
Al-Yousif (2002) investigated the financial development and economic growth
relationship in thirty developing countries. The author found that the unhealthy system

of finance negatively impacts on growth in real GDP. The negative impact is due to
inefficient allocation of savings and investment during the 1980s (Al-Yousif, 2002).
This means that there is a same direction movement on the relationship between
financial development and economic growth.
However, the causal relationship between financial development and economic growth
is still unclear in some findings from previous studies. This causal relationship
becomes a highly debatable issue in the literatures. (Fung, 2009; Calderón & Liu,
2003; Levine et al., 2000; Chen Hao, 2006; Hassan et. al., 2011; Khalifa Al-Yousif,
2002). For example, in the study of financial development and economic growth,
Hassan et. al., (2011) investigated the connection between the financial depth and
economic growth from different imcome groups of countries. The selected countries
include countries with low income, countries with middle income, and countries with
upper - middle and high income. The period is observed from 1980 to 2007. The
findings indicate that the financial development weakly facilitates short term economic
growth in developing regions (Hassan et. al., 2011; Wu et. al., 2010; Ghirmay, 2004).

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Therefore, this thesis aims at re-examining the causal finance and growth relationship
by employing econometric techniques, which measure

of financial depth and

economic growth. The econometric techniques are widely used in many empirical
literatures. A new dataset is used in attempting to provide further evidence on the
causal impact of financial development on economic growth. The sample countries are
twenty two developing countries. These countries are selected in different regions. The
observation period is from 1990 to 2011. The sample developing countries includes
Malaysia, China, Indonesia, Sri Lanka, Turkey, Egypt, Jordan, Pakistan, Tunisia,

Bulgaria, Bolivia, Chile, Mexico, Benin, Cameroon, Thailand, Philippines, Peru,
Brazil, Paraguay, Vietnam, Singapore. The dataset is collected from data sources of the
World Development Indicators (WDI) from World Bank database.
The selection of twenty two developing countries over period 1990-2011 has several
reasons:
-

The first is the fact that the financial development has a significant impact on the
economic growth in the developed countries. Meanwhile, the impact of financial
development on the economic growth is weak in developing countries (Khalifa AlYousif, 2002; Masten et al., 2008; Calderón and Liu, 2003; Habibullah and Eng,
2006; Fase and Abma, 2003). Therefore, this research focus on investigating the
causal relationship between financial development and economic growth in the
developing countries.

-

The second is that the choice of sampled developing countries has an advantage in
providing policy implications (Hassan et al., 2011).

-

The third reason is that annual panel data set of twenty two developing countries
over period 1990-2011 allows us not only to focus on examining the two way
impacts of finance-growth relationship in long run, but also to have enough
observations to effectively run econometric analysis for purpose in line with the
objective of this research.

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Finally, this research aims at providing a thorough look at the causality of financial
development on economic growth and vice versa. In this research thesis, we formulate
a growth equation with components of financial development, which is widely used in
many empirical literatures.
To gain more from the findings of this research, we will make an overview of the
relationship between financial development and economic growth in Vietnam in
comparison between the analysis results of Vietnam and other developing countries,
especially, selected Asian developing countries (i.e. Indonesia, Malaysia, Philippines,
Thailand, China, Singapore) in the period from 1990 to 2011.
Furthermore, taking advantage of the positive interaction between financial
development and economic growth, this research is expected to provide appropriate
policy implications to Vietnamese policy makers for promoting financial development
that will enable Vietnam to have higher economic growth.
1.2 Research objectives and research questions
1.2.1 Research objectives
This research mainly focuses on the following objectives:
-

Examining the causal relationship between financial development and economic
growth in twenty two developing countries from different regions for the period of
1990 to 2011.

-

Providing appropriate policy implications to Vietnamese policy makers for
promoting financial development that will enable Vietnam to have higher economic
growth.

1.2.2 Research questions
As above mentioned, we attempt to address the investigation of the causal relation

between financial development and economic growth as the main issues in this
research. Therefore, the questions should be raised as follows:
-

Does financial development promote economic growth and vice versa?

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-

How does development of financial sector contribute to causal relationships?

1.3 Thesis Structure
This thesis is divided into five chapters.
Chapter 1: Introduction explains what causal relationship between financial
development and economic growth is and scientific literatures related to the problem to
be investigated. It also presents different point of views on the relationship between
financial development and economic growth from numerous empirical studies. Finally,
it explains why twenty two developing countries are selected, what main objectives
are, what research questions should be raised in this thesis.
Chapter 2: Literature review provides a review of economic theories relating to the
causal relationship between financial development and economic growth. This part
describes theoretical framework and empirical studies related to the issue. The
determinants of economic growth and financial development are mentioned in this part.
Chapter 3: Methodology is concerned with general methods and how to examine
causal relationship between financial development and economic growth, which
mainly involves following points:
-

analytical framework for the problem to be investigated

-

research hypotheses to be tested

-

variables or factors to be described to answer each research question

-

panel dataset and sample to be used to examine the causal finance-growth
relationship

-

method and technique to be used for processing and analyzing information

-

estimated regression models to be applied to test hypothesis and answer research
questions

Chapter 4: Estimation Analysis and Findings focuses on analyzing the estimation
results and result interpretation on how the economic growth effect on development of
finance system and vice versa.

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Chapter 5: Conclusions and Implications comes to the main findings of the research.
This part is expected to make an overview of the relationship between financial
development and economic growth in Vietnam in comparison between the results of
Vietnam and other developing countries, especially, asian developing countries (i.e.
Indonesia, Malaysia, Philippines, Thailand, China, Singapore) which having the same
financial characteristics as Vietnam.
Furthermore, taking advantage of the positive interaction between financial
development and economic growth in developing countries, this research is expected to
provide appropriate policy implications to Vietnamese policy makers for promoting
financial development that will enable Vietnam to have higher economic growth.

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CHAPTER 2: LITERATURE REVIEW
2.1 Theoretical concepts related to economic growth and financial development
Definition
Financial development
Financial development is defined that (Kunt and Levine 2008, p. 4-5):
“Financial development occurs when financial instruments, market, and
intermediaries ameliorates- though do not necessarily eliminate- the effects of
information, enforcement, and transaction costs and therefore do a
correspondingly better job at providing the five financial functions.”
The five main functions of financial system are mobilizing savings,

allocating

financial resources, assessing and managing risks, monitoring businesses and
facilitating goods and services movement (Kunt and Levine, 2008, p.4-5).

Economic growth
Economic growth is defined that (Perkins et. al., 2006, p. 12):
“A rise in national or per capita income and product. If production of goods
and services in a country rises, by whatever means, and along with it average
income increase. The country has achieved economic growth.”
Gross domestic product (GDP) or Gross national product (GNP) are uasualy used to
measure Economic growth.
2.2 Financial development and economic growth: theoretical literatures
2.2.1 The impact of financial system functions on economic growth
The financial system function can be listed in five categories that involve the influence
on allocation of the saving resources and investment decisions in the way that affect on
economic growth (Levine, 2005). These financial functions are:
-

Allocating financial resources and reducing information asymmetry

-

Mobilizing or pooling savings

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-

Assessing and managing risk

-

Monitoring businesses

-

Easing the goods and services flow

2.2.1.1 Allocating financial resources and reducing information asymmetry
Making an investment decision requires a large transaction cost involving assessing
businesses and business environment conditions. As a result, such high transaction cost
may increase the cost of using financial resources. Moreover, in the context that the
capital is scarce, imperfect information on economic conditions may make investors
deal with the high cost relating to accessing business activities and economic
conditions (Levine, 2005).
Transaction cost and asymmetry of information may be reduced via exploring
investment opportunities of financial intermediaries. Levine (2005) pointed out the
important role of financial intermediaries in reducing transaction cost.

In Levine

(2005), efficiency of financial intermediaries might reduce a large cost occurred in
acquiring and processing information. In addition, by lowing transaction cost and better
information, capital will flow into profitable projects. This implies that the effective
financial market increase fund mobilization and investment. The increase in savings
and investment will encourage the efficiency of production and operation sector in the
commodity market (Levine, 2005). Levine (2005) also emphasized in his study that the
efficient financial market with low transaction cost and high liquidity of financial
market makes technological innovation increase by boosting incentives to those
investors who have promising projects in goods and product expansion. According to
Zagorchev et al. (2011), technology innovation accelerates the business activity by
enabling the progress of acquiring and processing information. As a result, the increase
in production and the use of technology in economizing on information processing cost

have improved the capital resource allocation, then boost the economic growth rate
(Zagorchev, et. al., 2011; Levine, 2005).

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Finally, due to less information asymmetry, the financial resources will be effectively
allocated; hence, the economic growth will be improved in both short and long run
(Levine, 2005).
2.2.1.2 Mobilizing or pooling savings
Mobilizing savings would face the costly process of collecting capital from different
lenders or savers for investment. This process is associated with two issues which must
be overcome. The first issue is that the costs of acquiring and processing information
relating to attracting funds from a large number of savers and investors. Secondly, the
information asymmetry raise problem when savers or investors may not have valuable
information in making their investment decisions (Levine, 2005).
According to Levine (2005), there are two ways bridging savings and investments. The
direct way is that mobilizing funds may come from numerous of savers and investors
who have surplus resource (i.e. joint stock companies, enterprises, individual savers,
firms,..). In this channel, the capital resources directly flow from the agents who have
surplus fund resources to the agents who need capital for their profitable investment.
This direct mobilization may cause the fact that the lenders have to deal with the
considerable transaction cost involving assessing business activities, investment
opportunities and economic condition.
The indirect way is that mobilizing fund will be implemented through financial
intermediaries. In turn, the financial intermediaries with capital resources received
from savers and investors inject funds into financial markets. It is believed that
mobilization through financial intermediaries is an effective way in bridging savings
and investments due to economizing on transaction cost, reducing information
asymmetry and overwhelming the fact that investment is indivisible. As a result,

mobilizing funds through financial intermediaries is believed to accelerate the
economic growth via exploring economies of scale (Levine, 2005).

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Furthermore, Levine (2005) confirms that savings mobilization can enhance resource
allocation and improve the innovation in technology. Without access funds from
different investors, many production processes may cope with out of date technology.
Consequently, production processes would be constrained to inefficient economies of
scale (Levine, 2005). In addition, Levine (2005) definitely cites that better fund
mobilization from society and efficient allocation of those funds provides for pooling
risks and diversifying among a large number of savers and investors via denominated
instruments. In other words, different kind of risks are shared and transferred among
savers and investors and through different financial instruments. These financial
instruments may keep capital invested in a diversified portfolio of risky projects from
flowing to higher return projects by reallocating the investment funds, resulting in
positive acceleration in the rate of economic growth (Levine, 2005).
2.2.1.3 Assessing and managing risk
According to Levine (2005), risks are inherent in every financial transaction due to
information and transaction costs. Therefore, financial contracts, markets and financial
intermediaries play an important role in facilitating resource allocation for trading,
sharing and shifting risks among savers and investors in various forms in the context of
economic growth. Levine (2005) has classified risk into three categories. They are
cross-sectional risk diversification, sharing payoff (intertemporal) risk, and risk of
liquidity.
In term of cross-sectional risk diversification, financial institutions including
commercial banks, merchant banks, investment banks, mutual funds, insurance
companies, pension funds, securities markets, etc. may reduce risks in connection with
resource allocation by providing financial instruments for trading, pooling, hedging,

sharing and shifting risks from riskier projects to less risky projects (Levine, 2005).
Thus, by providing risk diversification instruments, financial intermediaries tend to
make savers or investors not reluctant to invest in riskier activities with higher return.

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Financial systems can positively facilitate long run economic growth through the
ability of providing risk diversification instruments via affecting resource allocation
and rate of savings in the context that capital is scarce; investors do not prefer risk;
projects with high expected returns are riskier than those with lower return (Levine,
2005).
In terms of sharing payoff (intertemporal) risk, the risks are believed not diversifying at
a specific point of time, especially in the period of economic recession. In such case,
the financial intermediaries have an advantage in reducing intertemporal risk. For
example, in the period of economic shock, intertemporal risk may be diversified by
financial intermediaries via lowing contracting cost (Levine, 2005).
In terms of liquidity risk, liquidity is known as the ability of easily converting financial
instruments into purchasing power. According to Levine (2005), liquidity risk may
occur due to the uncertainties associated with informational asymmetries and
transaction costs. High transaction costs and asymmetry of information reduce the
liquidity ability of financial instruments, resulting in increasing liquidity risk (Levine,
2005).
As noted by Levine (2005), the relationship between liquidity and economic
development is acknowledged through stock markets and the role of financial
intermediaries. With liquid stock markets, investors will not be reluctant to sell their
less liquid assets to others for eliminating of liquidity risk. Consequently, asset holders
can sell their less liquid with high expected return equity, while firms can receive funds
from initial shareholders. By such way, stock markets can reduce liquidity risk, then
the more liquidity of stock markets, the more increase in economic growth (Levine,

2005).
Furthermore, financial intermediaries can affect economic growth through enhancing
liquidity and reducing liquidity risks. As discussed in the Levine (2005), financial
intermediaries (i.e. banks) can provide savers with liquid deposits. Those financial

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institutions also offer a combination of high liquid but low expected return investments
and less liquid but high expected return on investments. By such way, banks provide
savers with an insurance vehicle in hedging liquidity risk, while simultaneously
enhancing the long run high expected return investments. In the Levine (2005), the role
of banks in enhancing liquidity via allocating capital reduces liquidity risks. By
reducing risk of liquidity, financial intermediaries can improve resource allocation in
investing in high profitable activities, and then foster economic growth.
2.2.1.4 Monitoring businesses
To understand economic growth and the role of financial factors, it is necessary to
focus on corporate governance. The degree of how effectively monitor businesses and
how the influence of using capital offered by providers of capital on firms has
significantly affected on both decisions associated with savings and resource
allocation. In other words, the effective monitoring businesses and maximizing firm
value make the investors or savers are more confident in investing in businesses
activities. Thus, without financial arrangements in the context of improving corporate
governance, pooling savings from different resources of society may be limited and
resulting in keeping capital resources from flowing to highest expected return
investment (Levine, 2005). Levine (2005) also emphasizes that the national growth
rate is definitely impacted by how effective mechanism of corporate governance on
business performance.
In the context of intermediaries, Levine (2005) cited the model developed by Diamond
(1984) to prove how a financial intermediary enhances corporate governance. Financial

intermediaries use the funds pooled from various investors (i.e. individuals, firms…) to
lend to the firms who need capital for their business. In the absence of financial
intermediary, each lender has to monitor, evaluate corporate governance of each
borrower. This may lead to the large fixed cost associated with monitoring business
performance due to information acquisition costs. Therefore, information acquisition

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cost and transaction cost can be economized by financial intermediaries because that
all these investors have financial intermediaries with a long run relationship with firms
to monitor and assess the effectiveness of businesses in which those funds are invested
(Levine, 2005).
In the context of economic growth, Levine (2005) cited a number of models developed
by Smith (1993), Sussman (1993) and Harison et. al (1999) to prove that a well
functioning financial intermediaries improves corporate governance, then foster
economic growth by increasing in productivity, facilitating capital accumulation and
capital allocation with positive growth effects.
Levine (2005) concludes that even though capital is scarce or abundant, the profits of
investors have been definitely depended on the quality of monitoring performed by
financial intermediaries. Furthermore, the poor ability of monitoring businesses of
financial intermediary may keep diffuse investors or savers from effectively governing
firms and then negatively effects on capital allocation and economic growth (Levine,
2005).
2.2.1.5 Easing the goods and services exchanges
As discussed in Levine (2005), it is believed financial arrangements with low
transaction cost and less information asymmetry in enhancing specialization,
innovation in technology and economic growth.
In the Levine (2005), the relationship between specializations, goods exchange and
innovation are explained by using the model of such connections developed by

Greenwood and Smith (1996). The more specialize in production, the more it requires
transactions. Due to high information and transaction costs, financial instruments or
arrangements and intermediaries may occur to enhance the specialization process.
Resulting in increasing in productivity, then, encouraging the good and services
exchange. The more easing in making transaction in markets reflect the well
functioning of financial market development.

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In other words, by expanding specialization in productivity and lowing information and
transaction costs, economic development can accelerate financial market development
(Levine, 2005).
2.2.2 The impact of financial development on economic growth: a view CobbDouglas aggregate production function:
According to Aghion, P., & Howitt, P. (2007), to better understand the relationship
between financial development and economic growth, the neoclassical aggregate
production function developed by Cobb-Douglas should be taken into consideration.
Productivity function is derived as follows:
(1)
Where
Y:

is denoted as aggregate production

A:

is referred to the level of total factor productivity parameter

K:

is denoted as Capital

L:

is denoted as Labor

α:

is denoted as the capital share

Dividing the function (1) by L, we have output for each worker (y):
(2)
In which k is denoted as capital stock per worker

From the said above function (2), Aghion, P., & Howitt, P. (2007) confirms that total
factor productivity parameter (A) is positively depended on labor productivity of each
worker (y). Furthermore, labor productivity for each worker (y) also positively impacts
on kα (capital stock per worker).
We call economic growth is represented by growth rate (G) of output for each person.
It is assumed that Population and labor force grow at the same rate. So, G is deemed to

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be the growth rate of output for each person. Then, the function (2) could be calculated
as follows:
(3)

Based on function (3), Aghion, P., & Howitt, P. (2007) concludes that the rate of total
factor productivity growth (A/A) and the “capital deepening”, which is known as

capital accumulation (αk/k) are used as components of growth rate. Furthermore, Beck,
T., Levine, R., & Loayza, N. (2000) suggests that capital accumulation, productivity
growth and rate of private savings should be used to evaluate the impact of financial
development on economic growth and sources of economic growth.
2.2.3 Theoretical views on the linkages between financial development and
economic growth
There are four theoretical views, which are widely used to investigate the linkages
between financial development and economic growth. They are the bank based theory,
the market based theory, the financial and services theory and law-finance theory
(Levine, 2005; 2002; Arestis et. al., 2005). We will briefly discuss them as following.
2.2.3.1 The bank based theory
The bank based theory mainly focuses on the role of banks in a positive way. In
Levine, R. (2002), Levine (2005) and Arestis et. al., (2005) pointed out that the
positive role of financial intermediaries in providing financial functions, which is
expressed via:
-

acquiring information about firms, managers, market condition, and then foster the
resource allocation and growth.

-

accessing, monitoring businesses and managing risk, and then improving the
efficiency in investment and economic growth.

-

mobilizing funds in order to exploit economies scale.

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Furthermore, the bank based theory also figured out the shortcomings of the market
based theory. Arestis et. al., (2005) argues that though financial functions, financial
intermediary can mitigate the problems of acquiring information faced by individual
investors (i.e. informational asymmetry, free-rider problem). This is because the
financial intermediary has set up long time relationships with firms and does not
disclosure about the acquired information to publicity (Levine, 2005; Levine, 2002). In
addition, by having close ties and long run relationships with firms, financial
intermediary has advantages in managing, monitoring businesses and improving
corporate governance. Therefore, banks have the powerful ability to make pressure on
firms to repay their debts, especially in nations where the capability of contract
enforcement is not strong (Levine, 2005; Levine, 2002). As a result, the bank based
theory believes that a market based system will not properly perform due to
fundamental reasons such as information acquisition, information processing, corporate
governance, agency problems, liquidity problem, managing risks and monitoring
business). Consequently, resource allocation and economic performance will not be
properly improved. In contrast, a bank based system without preventing from
regulation restrictions on financial intermediary activities, can explore economies of
scale in acquiring information, processing information, mobilizing resources, reducing
moral hazard via effective corporate governance, managing risks and monitoring
business. Thereby, financial intermediary can produce better enhancement on resource
allocation and better improvement on economic growth via financing industrial
expansion (Levine, 2005; Levine, 2002; Arestis et. al., 2005).
2.2.3.2 The market based theory
In Arestis et. al., 2005, the market based theory focus on the functions of market in
enhancing economic growth. The role of well functioning markets is stressed through
fostering profit incentives due to trading in big and liquid markets; enhancing corporate
governance; easing customization of risk management instruments and diversification

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