Recently, the issues of the development of financial sector have captured the attention of all countries policies maker to ensure a steadily economic growth. Hence, some of the researchers have focused to emphasize the importance of financial developing would to proper economic growth. Therefore many researches were being conducted to examine the financial development and the economic growth.
Most of the empirical studies suggest that there are positive relationship between the financial development and economic growth (Dermihan et al. , 2011, Masih and Khan, 2011, Christopoulos and Tsionas,2004, Bittencourt, 2012,),. Besides that, Calderon and Liu (2003) supports the positive impact of financial development on the economic growth. Financial development is stimulating the economic growth through rapid capital accumulation and productivity growth (Calderon and Liu, 2003). On the other hand, financial development has contributed to the economic growth through the increase of the attraction for foreign direct investment ( Anwar and Cooray, 2012). Ang (2008) that study about the mechanism linking the financial development and economic growth for Malaysia purpose the financial development is promoting the economic growth by promoting the private saving and private investment. It supports the hypothesis of endogenous financial development and growth models that financial sector is promoting higher economic growth through improved efficiency of investment (Ang, 2008).
Although the positive role of financial development is clear, it can also negatively affect economic growth. Kindleberger (1978) put forward that the instability of expectation and asset speculation regarding overleveraged situations can have severe negative consequences for an economy. According to Minsky’s (1991) “financial instability hypothesis”, during an economic boom, it will encourage the adoption of a riskier behavior. This will transform the economy to a boom phase fuelled by speculative economic activities and induce firms to default on their loan repayments. Consequently, higher financial costs and lower income can both lead to higher delinquency rates. When bankruptcies occur, the economy can experience economic recession. According to the empirical results of Eichengreen & Arteta (2000) using a sample of 75 emerging markets for the period 1975-1997, the finding indicate that rapid domestic credit growth is one of the key determinants of emerging market banking crises. Similarly, Borio & Lowe (2002) using annual data for 34 countries from 1960 to 1999, their finding show that when sustained rapid credit together with a large increases in asset prices, the probability of financial instability seem to be increase.
McKinnon (1973) and Shaw (1973) proposes that government restrictions on the operation of the financial system such as interest rate ceiling, direct credit programs and high reserve requirements may hinder financial deepening. This may in turn affects the quality and quantity of investments and retards the development in the financial systems. This implies that a poorly functioning financial system may negatively influence economic growth. Similarly, the financial endogenous growth developed by King & Levine (1993) also shows that financial repression may have a negative impact on financial development. During financial repression, financial development is less likely to be effective in stimulating economic growth in the presence of a repressed financial system. Rossi (1999) suggests that financial restraints can hamper financial development, implying that economic growth would be retarded if financial restraints imposed on the financial system are relaxed. Some extent of financial repression helps promote stable economic growth in Malaysia. However, an increase in the extent of financial liberalization seems to be harmful for development of the Malaysian financial system. (Ang, 2008)
Besides the result of positive and negative effect of financial development on economic growth, there is the research stated that financial development is not a important explanatory variable for explaining the economic growth ( Anwar and Sun, 2011).
Interestingly, there are also the mixed results from empirical studies for finance led growth. The results of Campos and Tan (2011) indicate that financial development is negatively affecting the economic growth in the short run and the positive effect of financial development contributing on economic growth is at the long-run relation. The most interesting result from this research is the financial development affects the growth is directly but not through growth volatility. On the other hand, Hassan et al. (2011) found out that the financial development is positively affecting the economic growth for the developing countries but for the developed countries financial development seems to have negative effect on the economic growth.