2.2 Review of the causality between financial development and economic growth
There are many researches had been done on the role of financial developement in stimulating the economic growth. Besides of the role of financial devleopement on the economic growth, the causal relationship between them should not be neglect due to this investigation would help in producing policies that generate more promising economic growth to the country.
Patrick (1966) has stated that the possible patterns for causal relationship can classifies as two which are demand following and supply leading. The demand following is means the growth of economy led to the demand for the financial services and the supply leadings is means the development of financial sector causes the expansion of the economy. However, there are also some other researches shows that the relationship between this two variables may be bidirectional or also can be absence of the causal link.
2.2.1 Financial development driven economic growth
The economic growth effect from the financial development is expected to be influenced from two ways which is the level of financial development and the level of the country’s economy development. As referring to Masten, Coricelli and Masten (2008), they have stated that significant positive effect of financial integration on the growth of economy is only for countries with sufficient absorptive capacity, measured by the level of financial development. With the higher financial development level, a further financial integration will stimulates the economic growth through greater capital accumulation and technological progress and therefore higher total factor of productivity. This statement is supported by Calderón and Liu (2003) who worked out a granger causality framework whereby the financial development is represented by capital accumulation measured in capital per capita growth (M2/GDP) and economic growth represented by the productivity growth and obtained the result where as more rapid capital accumulation, it increased the economic growth in the developing countries.
As for the level of country’s economy development, the developing countries which represented by a group of transition countries have a much positive effect or causal relationship on economic growth as compared to the developed countries which might even have converse relationship with the development of financial markets (Calderón and Liu 2003) and (Masten, Coricelli and Masten 2008). This implies that the developing countries have more room for financial and economic improvement.
Several researches have indicated that there is an uni-directional causality between the financial development and economic growth in the developing and developed countries through the use of time series data and panel data. Those researches would be Yang and Yi (2008) in the case of Korea, Christopoulos and Tsionas (2003) that used panel data from 10 developing countries, Rousseau and Vuthipadadorn (2005) which used time series data from 10 Asian economies.
Even though the financial deepening able to contributes more to the causal relationships in the developing countries (Calderón and Liu 2003) but the effect may vanish as financial development approaches the levels characterizing the developed countries as mentioned by Masten, Coricelli and Masten (2008).
2.2.2 Growth driven financial development
This relationship is showing that a good performance of economic growth will stimulate the financial development of a country. According to the recently research done by Allen, Bartiloro, & Kowalewski (2006), they find that in fact it is economic structure that determines financial structure, the latter financial developments and prevails in response to the needs of the real economy.
According to Demirguc-Kunt & Levine (2001), it could also be that economic structure determines financial structure as countries develop, their financial sectors develop as well. Furthermore, financial systems are more developed in high income countries and that their stock markets will perform better than banks in terms of efficiency. Moreover, Demirguc-Kunt & Levine (1996) report that countries with well-developed market-based institutions also have well-developed bank-based institutions; and countries with weak market-based institutions also have weak bank-based institutions. A high economic growth tends to have a better financial development, whereas a low or negative economic growth wills not much emphasizes in financial development.
However, we find that the causality runs from growth to finance in South Asia and in Sub-Saharan Africa, the two poorest regions in our sample. This result supports the views of Gurley & Shaw (1967), Goldsmith (1969), and Jung (1986), they hypothesized that in developing countries, growth leads finance because of the increasing demand for financial services. Since the economy is growing, there is an increasing demand for financial services that induces an expansion in the financial sector. This view is supported by Gurley and Shaw (1967), Goldsmith (1969), and Jung (1986).
Robinson (1952) suggests that financial development does not lead to higher economic growth. Instead, financial development responds passively to economic growth as a result of higher demand for financial services. When an economy expands, households and firms demand more financial services. In response to this greater demand for financial services, more financial institutions, financial products and services emerge, thereby leading to expansion of financial systems. As such, wealthier economies have a greater demand for financial services and are more able to afford a costly financial system. This implies that the level of real economy activity crucially affects financial development. This statement supported by Berthelemy & Varoudakis (1996), they found an expansion of financial systems may also be induced by economic growth. That is to say economic growth may create demand for more financial services and hence the financial system will grow in response to economic expansion. As economic activities grow, there will be more demand for both physical and liquid capital. Hence, growth in the real sector induces the financial sector to expand, and thereby increasing competition and efficiency in the financial intermediaries and markets.
2.2.3Bidirectional relation between financial development and economic growth
Furthermore, there are the evidence that shows that causal relationship between financial developement and economic growth may also be bidirectional. According to the research conducted by Abu-bader & Abu-qarn (2007) found there are bidirectional causality between economic growth and financial development in the Egypt by using all the financial measures. The evidence of causality from financial development of economic growth is after the country implement on the controlling for investment. So that, lead to the enhancement of investment efficiency through the rise in the private investment lead to a rebound in economic performance of Egypt in the late of year 1990s.
Besides that, Tarlok Singh (2008) that using on a time series basic for the India through the ECM method found that there is bidirectional Granger-causality between financial development and economic growth. Furthermore through the impulse response and variance decomposition analyses also provided similar evidence for bi-directional Granger-causality from the evidence response of per capita real GDP to financial interrelations ratio (FIR) is weak as compare to its response to new issue ratio (NIR). The evidence as the economic reform that started since July 1991 recognized the role of the financial sector in the economic growth and emphasized the removal financial market imperfection and the development of a sound and efficient financial sector in the economy. Hence a number of policy measurements have been adopted to develop and strengthen the financial sector. Due to the effort made, the economy of India has moved to financial liberalization with the discernible reduction in preemptions on the investible resources of the bank.
Moreover, Cesar Calderona and Lin Liub (2002) have examined on the developing countries and industries countries found that, the Granger causality from financial development to economic growth and the Granger causality from economic growth to financial development coexist in 87 of the developing countries and 22 of the industrial countries. Last but not least as according to the argument stated by Sajid Anwar & Lan Phi Nguyen (2011), Generally speaking, financial development not only increases the supply of capital but, given the appropriate host-country policies, it can also facilitate technological innovation. Technological innovation contributes to human capital formation which can further enhance the prospects of economic growth (in fact, it can be argued that a bi-directional causality exists between technological innovation and human capital formation). In other words, financial development can facilitate economic growth through direct as well as indirect channels.
However, Apart from developing country, there is evidence found in the developed country as Greece implied a bi-directional result as according to the research conducted by Hondroyiannis, Lolos, & Papapetrou (2005). That the result generated a bi-directional causality exists between real economic activity and the stock market capitalization and also between the real economic activity and bank credit. However, the estimated coefficients are small in magnitude, suggesting that the interrelation of financing and overall economic activity is limited. Thus in the long run the economic performance is only partially related to financing through intimidation. Besides, the contribution of the stock market financing to the growth processes substantially smaller compared to bank financing.
2.2.4 The absence of any causal link
As for the no causal link between financial development and economic growth, neither one of these changes, improvement or worsen on one side will cause any effect on to another side. In the review that we had done on the previous review, the absence of any causal link between the variables is rarely to be happened. One of the researches that stated that there is no causal link between financial development and economic growth would be from Ram (1999). But the research done by Ram (1999) is based on cross country analysis instead of time series analysis.
So, it is important that we determine and confirm the causality between the variables first before constructing any policies as it might bring no benefit at all if the policy is implemented when there does not exist any causal link between the variables.