Evaluating the Impact of Financial Development on Economic Growth ...

International Research Journal of Finance and Economics ISSN 1450-2887 Issue 94 (2012) © EuroJournals Publishing, Inc. 2012 http://www.internationalresearchjournaloffinanceandeconomics.com

Evaluating the Impact of Financial Development on Economic Growth in Jordan Idries Mohammed Al-Jarrah Faculty of Business Administration The University of Jordan/ Amman 11942 Jordan E-mail: [email protected] Zu’bi M. F. Al-Zu’bi Faculty of Business Administration The University of Jordan/ Amman 11942 Jordan E-mail: [email protected] Osama Omar Jaara Faculty of Business Administration The University of Middle East/ Amman 11610 Jordan E-mail: [email protected] Muhammad Alshurideh Faculty of Business Administration The University of Jordan/ Amman 11942 Jordan E-mail: [email protected] Abstract This study aims to examine the impact of financial development on economic growth in Jordan over the period 1992-2011. The most widely financial development measures used in earlier literature are employed and grouped into currency ratios, monetary ratios, financial ratios and percent of credit to private sector while the economic growth is measured by growth in real GDP per capita. The correlation coefficients between financial development indicators and economic growth indicator are observed over the study period to discern those indicators that are highly correlated with economic growth and these variables are entered in the later phases of analysis. The notable finding in this phase is that despite the noticeable growth in most financial development indicators especially the percent of credit to private sector as a percent of GDP (P2) over the last two decade, the parallel progress in economic growth is relatively much lesser. In the next phase of analysis, we regressed the most important financial development indicators detected in the earlier phase that include the ratio of currency outside banks as percent of narrow money supply (C1), the ratio of narrow money supply as percent of GDP (M2), the ratio of banking sector assets as percent of GDP (F1) and the ratio of private sector credit as percent of total banking sector credit (P1) on the economic growth (Y) and find that these variables explain about sixty-five percent of the economic growth over the study period. Our results indicate that apart from monetary ratio M1 (narrow money supply as percent of GDP), all the other employed financial ratios are

International Research Journal of Finance and Economics - Issue 94 (2012)

124

significantly correlated with economic growth indicator. In the last phase of analysis, we employed Granger Causality Test to detect the direction of relationship between financial development indicators in one hand and the economic growth indicator on the other hand and find narrow evidence that the financial development indicators and particularly the ratio of banking sector assets as percent of GDP (F1)Granger causes the economic growth. Our main remark based on this analysis is that despite employing large number of financial development indicators which proven to be high correlated with each other and have witnessed significant growth over the study period, the impact of these variables on economic growth is limited which necessitate further studies to detect the main obstacles that deter the economic growth in Jordan.

Keywords: Financial deepening, economic growth, developing countries, GrangerCausality, Jordan.

1. Introduction Since the early of the last century, various economic studies have documented the role of the financial sector in economy especially across various European countries and USA. Studies attempt to address whether economic growth enhances the process of financial intermediation. Meltzer (1998) refers to an early study of Bagehot (1873) who argued that financial intermediation was critical for the rapid industrialization of England in the early nineteenth century and stressed the importance of financial intermediation in pooling funds, which were sufficiently large to fund risky and large-scale projects. Among the early studies that suggest positive and significant relationship between financial development and economic growth include those of Schumpeter (1911), Gurley and Shaw (1955), Goldsmith (1969), McKinnon (1973), Shaw (1973) and Fry (1978). For instance, Goldsmith (1969), Fry (1988), and Bencivenga and Smith (1991) argued that financial superstructure accelerates economic growth and improves economic performance as it facilitates the migration of funds to the best users. Thus, economic and financial reforms might promote the growth of the financial system, and financial developments can be traced by examining the structure aspects of the economy. Furthermore, changes in a country’s financial structure can be noted by reviewing the sequence in which different types of financial institutions have appeared over time, and the relative importance of different financial instruments in the balance sheets of financial institutions. Similarly, Greenwood and Jovanovic (1990) and King and Levine (1993), argued that financial development affect economic growth by improving efficiency of investment through project selection, innovation and entrepreneurship growth. The risk-sharing role of the financial intermediaries also allows financial intermediaries to pool the liquidity risk of depositors and invest funds in more illiquid and productive projects (Diamond and Dybvig, 1983, and Levine, 2004). Other recent studies also recommend improving banking sector and stock market to enhance the economic growth (Neusser and Kugler 1998; Rousseau and Wachtel 1998, Levine et al. 2000; Beck and Levine and Loayza 2000). Some of the studies conducted focused on the direction of the relationship between financial development and economic growth. For instance, some argue that a properly organized financial sector can improve the efficiency of asset allocation, which lead to higher levels of economic growth (Bencivenga and Smith, 1991; Saint-Paul, 1992; Levine and Zervos, 1998; Rajan and Zingales, 1998;Odedokun, 1998; Levine et al., 2000; Cetorelli and Gambera, 2001; Beck and Levine, 2004). Other studies argue that economic growth tends to stimulate the development of the financial sector and thus creating a “virtuous circle” (Demetriades and Hussein, 1996; Calderon and Liu, 2003; Hondroyiannis et al., 2005). By contrast, some empirical evidence indicate that the relationship between financial development and growth is weak or insignificant (Arestis and Demetriades, 1997; Harris, 1997; Deidda and Fattouh, 2002).

125


In the context of evaluating the impact of financial development on the economic growth, various studies inspect the degree of financial deepening in a given economy. Financial deepening is taken as an all-inclusive indicator for the involvement of the financial sector in economic growth. It refers to the availability of various financial services that fit the needs and desire of various sectors of the economy. In this regard, financial superstructure is described by the presence, nature and relative size of financial instruments and financial institutions while financial infrastructure is measured by national wealth and national product (Jao, 1976, Frey, 1978 and Ogun (1986). The degree of financial intermediation involvement in the economy can be measured broadly by total financial assets in the economy or narrowly by money supply as a percent of GDP. The quantitative aspects of financial structure include the distribution of total financial assets and liabilities among financial institutions and non-financial economic units. In particular, change in the ratio of the financial assets of the financial sector to the total volume of total financial assets outstanding may reflect the institutionalization of the process of savings and investment. Similarly, changes in the distribution of the total financial assets of financial institutions reveal the changes in the role of the banking system in the process of promoting saving (Al-Sahlawi, 1997). In the context of the importance of financial development on economic growth documented in the earlier literature, our study aims to evaluate the impact of financial development on the economic growth in Jordan over the last two decades. Our findings are supposed to provide feedback for the financial authorities to evaluate the impact of their stand and endeavors in economic growth. In addition to this introduction, this study is composed of five sections: Section 2 presents a survey for the literature that sheds the light on the role of financial development on economic growth. Section 3 provides the data, study methodology and discusses the main results. Finally, Section 4 summarizes and concludes the paper.

2. The Role of Financial Development in Economic Growth: Literature Survey Given the availability of a wide research that has evaluated the relationship between financial development and economic growth, we will confine our review in this section to the more relevant and recent literature. As indicated earlier, the financial system intermediate between savings and investing economic units. This includes selecting investment projects and the final users of financial resources according to their creditworthiness and monitoring the use of these resources. Greenwood and Jovanovic (1990) emphasize the role of financial intermediaries in risk-pooling and monitoring functions. By pooling savings for diversified investment projects and by monitoring the behavior of the borrowing firms, banks ensure higher expected rates of returns that help to promote economic growth. Seminal work by Schumpeter (1911, 1939) emphasized that financial intermediaries play an important role in promoting economic growth by redirecting funds toward innovative projects. Bencievenga and Smith (1991) and Diamond and Dybvig (1983) have stressed the role of financial intermediaries in managing liquidity. Financial intermediaries reduce the volume of low-return investment due to premature liquidation and redirect funds into longer-term, high-yield projects, leading to faster growth. Therefore, economic growth is directly affected by the increase in the quality of aggregate investment through enhancing profitable opportunities, which is accomplished partly through the informational role of intermediation. Goldsmith (1969) analyzed data from thirty-five countries over the period 1860 to 1963 and found that financial growth and economic development are positively correlated over periods for several decades. He measured financial development by the financial intermediation ratio (the ratio of financial intermediary assets divided by gross national product). This indicator used also to capture the financial intermediaries’ role in overcoming frictions and enhancing growth through quality enhancement (to the extent that these assets measure the provision of credit to firms as opposed to


126

households and government, as the former, are argued to be more efficient in utilizing financial assets). However, Goldsmith wondered whether financial development leads to economic growth or vice versa. Levine (1991) incorporates both portfolio diversification and liquidity management aspects to show the role of financial intermediaries in pooling consumers’ liquidity risks via the securities market and concludes that setting up a stock market enhances economic growth. Chen, Chiang and Wang (1996) also suggest that financial intermediation increases investment projects and spurs economic growth by utilizing more sophisticated and specialized production processes. King and Levine (1992, 1993a, b) consider financial development over various periods starting in 1960 for a comprehensive cross-section of countries. They expand the set of financial development measures to capture the various services provided by financial intermediaries. One of the employed measures is the liquidity-providing role of financial intermediaries through liquid liabilities (currency plus demand and interest-bearing deposits, or M2) as a percentage of country GDP. Another measure is the ratio of credit provision to private firms as a percent of GDP (to capture monitoring, screening and control activities as well as the pooling of funds and diversification of risks). The first measure approximates the intermediaries’ role in overcoming technological frictions, while the second approximates their role in overcoming incentive frictions. King and Levine (ibid.) find that these measures are positively correlated with real GDP growth rates, even after controlling for initial conditions, government spending, inflation, political stability and some other policy measures. They also show that subsequent growth rates are positively correlated with initial liquidity ratios. Financial markets also provide a crucial source of information that helps coordinate decentralized decisions throughout the economy. Rates of return in financial markets guide households in allocating income between consumption and savings, and in allocating their stock of wealth. Merton (1995) summarizes that the overall objective of regulating the financial sector should be to ensure that the system functions efficiently, helping to deploy, transfer and allocate resources across time and space under conditions of uncertainty. A well-functioning financial systemalso makesa critical contribution to economic performance by facilitating transactions, mobilizing savings and allocating capital across time and space (Herring and Santomero, 2000). In addition, financial institutions provide payment services and variety of financial products that enable the corporate sector and households to cope with economic uncertainties by hedging, pooling, sharing and pricing risks. A stable and efficient financial sector reduces the cost and risk of investment. In sub-Saharan African countries, Ndebbio (2004) examine the relationship between financial development and economic growth using Ordinary Least Squares regression. The author measures the degree of financial depth by the degree of financial intermediation and the degree of growth rate in per capita real money balances. Broad money supply (M2) was used as numerator in both measures. The results indicate that lack of growth of output is caused by shallow finance or due to the insufficiency of financial assets that properly enhance financial deepening. The author recommends that the economies involved in his studies should strive hard to accelerate the growth of moneybalances and should improve financial development/intermediation. Financial intermediaries also enhance economic efficiency by overcoming frictions through channeling resources toward the most efficient investment, giving households access to economies of scale in processing information that enables the identification of investment projects and ensures that business acts in ways that do not conflict with saver’s interests. Becsi and Wang (1997) note that while there is no single general model that explains why banks exist, fundamental market frictions are probably the main rationale for the existence of financial intermediaries. Market frictions can be classified into either technological or incentive. Gurley and Shaw (1960) introduce the role of financial intermediaries in overcoming technological frictions.Theyexplain that financial intermediaries transform bonds and stocks issued by firms into demand or savings deposits for households. They transform savings into investments by repackaging wealth and transferring capital and information. On

127


the other hand, incentive frictions occur because information is costly and individuals are differentially informed and act in their self-interest. The impact of financial development on economic growth in Turkey over 1996-2001 is evaluated by Ardic and Darmar (2006). The study period employed is characterized by weak regulated and relatively unsupervised expansion of the banking sector, which led to the 2001 financial crisis. The results indicate a strong negative relationship between financial deepeningand economic growth. Zhang et al. (2007) study the financial deepening – productivity relationship in China over the period 1987 through 2001. Relying on provincial panel data, they examine if regional productivity growth is accounted for by the deepening process of financial development. Towards this end, an appropriate measurement of financial depth is constructed and then included as a determinant of productivity growth. The studyconcludes that significant and positive nexus exists between financial deepening and productivity growth. Gobbi and Zizza (2007) investigate the relationship between underground activities and financial deepening in Italian credit market. Using panel data on Italian regional credit markets, they find a strong negative impact of the share of irregular employment on outstanding credit to the private sector. According to estimates, a shift of 1 per cent of the employees from regular activities to irregular ones corresponds to a decline of about 2 percentage points in the volume of business lending and of 0.3 percentage points in outstanding credit to households, both expressed as ratios to GDP. Conversely, the feedback effects from financial deepening to the size of the informal sector are weak and statistically not significant. As can be seen from this review for the earlier literature, various studies have been conducted all over the world examining the impact of financial development on economic growth and most of these studies document the importance of financial sector on economic development. Various financial development measures are also employed to gauge the importance of financial development on economic growth and some of the studies tried to evaluate the direction of the relationship between financial development and economic growth.

3. Study Data, Methodology and Results This section of the study is composed of 4 subsections that together compose the study data, methodology and discusses the main findings. The first two subsections present the operational definitions and descriptive statistics of the variables employed. Then subsection 3.3 provides preliminary appraisals for the relationship among these variables. The last subsection specify our study model and conduct the causality tests between financial development variables in one hand and the economic growth measure on the second hand. 3.1. Operational Definition of the Study Variables Earlier literature mostly indicates that economic growth is positively related to financial development. In the present study, we will employ the most widely indicators employed in the earlier literature to examine the strength of the relationship between financial development and economic growth in Jordan over the last two decades. In our study, we will employ the real per capita GDP to measure the economic as this measure is widely utilized in the earlier literature. As for the financial development indicators, we divided these indicators into fourcategories that include currency ratios, monetary ratios, financial ratios and credit to the private sector to identify which categories of these indicators are the chiefdrivers of economic growth in Jordan over the study period. The first financial development indicators group includes the currency ratios, represented by the currency outside the banks as percent of of narrow money supply (M1) and as a percent of broader money supply (M2). When these ratios rise at the early stage of development, the real economy is expected to grow due to monetization (because of the safety of holding currency instead of tangible


128

assets). However, these ratios are expected to decline as more financial instruments are created by financial institutions with more attractive attributes. The second group is the monetaryratios, denoted by money supply (M1), broader money supply (M2) and the banking sector deposit borrowing as percent of the GDP. These ratios capture the evolution of the financial system and are also used to indicate the velocities of currency circulation. These ratios increase gradually as the financial system and economy develop and progress ahead. Furthermore, using money supply as a percent of GDP reflects the ability of the financial system to channel funds from deposits to investment opportunities. Ang and Mckibbin (2007) note that this ratio might be relevant in developing countries where substantial part of the broad money is held outside the banking system, giving supports to the McKinnon’s outside money model in which the accumulation of real money balances is necessary for self-financed investment (Evans et al., 2002). Furthermore, the general increase in these ratios reflects higher confidence in the financial system. Finally, these measures also reflect the degree of the financial depth of the financial intermediaries and the degree of monetization in the economy, as indicated by Gelb (1989), Feldman and Gang (1990), King and Levine (1993) and Levine (2003). The third financial development group includes the ratios of the banking system assets and the banking sector credit as percent of GDP. These ratios are used to measure the importance of the financial institutions in the financing process and reflect the importance of the banking system relative to the rest of the financial system. These are sometimes called financial interrelationsratios andare meaningful especially in developing countries where the banking sector is the main source of credit for various constituents of the economy. The last financial development indicators include the percent of credit to private sector as a percent of total credit of the banking sector and as percent of GDP. The volume of credit to the private sector is used as a proxy to examine whether reforms have actually led to a more efficient allocation of credit, because it is assumed that the private sector uses resources more efficiently than the public sector. The use of these measures agree with the inside money model of McKinnon and Shaw, in which these ratios are responsible for the quantity and quality of investment and therefore on the economic growth. Demetriades and Hussein (1996) opine that bank credit to the private sector is a superior measure for financial development, since the private sector is able to utilize funds in a more efficient and productive manner. Table 1:

Definition of the study variables

Indicators

Symbol

Definition

References Hasan, I., P. Wachtel and M. Zhou (2008), Hakeem, M. (2010), Wu, H., C. Chen and F. Shiu (2007), Seetanah, B. and S. Ramessur (2008), Odhiambo, N. (2010)

Economic Growth

Y

Annual growth rate in real per capita GDP (market prices)

Currency Ratios

C1 and C2

Include currency outside banks as % of money supply (M1) and as % of broader money supply (M2).

Oloyede, 1998, Nzotta, S. and E. Okereke, (2009).

M1, M2 and M3

Include narrow money supply (M1), broader money supply (M2), and bank deposit borrowings as a percent of real GDP at market prices. When the ratios rise at the early stages of development, the real economy is expected to grow. However, these ratios are expected to decline as more favorable financial instruments are created by financial institutions.

Money supply/ GDP: Oloyede, 1998, Ezirim, C., B. oi, E. Amuzie and M. Muoghalu, (2010), Nwezeaku, N. and G. Okpara (2010), Odhiambo, N. (2010), Nzotta, S. and E. Okereke, (2009), Hakeem, M. (2010). Liquid and Interest-bearing liabilities of banks/ GDP: McKinnon 1973; King and Levine, 1993a and b, Seetanah, B. and S. Ramessur (2008), Hakeem, M. (2010), Nzotta, S. and E. Okereke, (2009)

Monetary Ratios

129 Table 1:

International Research Journal of Finance and Economics - Issue 94 (2012) Definition of the study variables - continued

Financial Interrelations Ratios

Percent of credit to private sector

F1 and F2

The ratio of bankingsector assets as a percent of real GDP at current market prices, and the ratio of total credit as a percent of real GDP at market prices. These ratios measure the importance of the financial institutions in the financial system and the importance of these institutions in the economic developments. Total credit of the private sector as a percent of total credit of the banking sector and as a percent of real GDP at market prices

T. credit/ GDP: Ezirim, C., B. Noi, E. Amuzie and M. Muoghalu, (2010), Oloyede, 1998, Hakeem, M. (2010), Nwezeaku, N. and G. Okpara (2010), Hasan, I., P. Wachtel and M. Zhou (2008). Assets of non-bank institutions/ Assets of financial system: Oloyede, 1998 Private sector credit/GDP: Levine at al., 2000a and b, King and Levine (1993); Levine (2003), Nzotta, S. and E. Okereke, (2009), Hakeem, M. (2010).

3.2. A Brief Descriptive Statistics of the Variables Employed In this section ofstudy, we will provide some preliminary analysis for the variables employed and evaluate their trends over the last two decades and provide some explanation for the observed trends. This provides more support for the results we expect to get in the later phases of our analysis. First, the dependent variable of our study is real growth in per capita GDP which is used to gauge the economic growth in the country under study. For the financial development indicators, we group these into four main classes: the currency ratios, the monetary ratios, the financial ratios and the percent of credit to the private sector. The currency ratios include the currency outside the banks as percent of narrow money supply (C1) and as percent of broader money supply (C2). The monetary ratios include the narrow money supply (M1), broader money supply (M2) and bank deposit borrowing (M3) as percent of real GDP. The financial ratios include the banking sector assets (F1) and banking sector credit (F2) as percent of real GDP. Finally, the credit to private sector as percent of total credit (P1) and as percent of real GDP (P2) are also employed. Figure 1 below shows the real GDP growth indicator versus the growth in the currency indicators over the study period. As indicated earlier, the relative decline in these ratios over the last two decades is mainly attributed to the new financial instruments created by financial institutions with more attractive attributes and indicates that the real economy might grow due to the enhanced role of the financial system in the economy. Figure 1: Currency Ratios versus Real GDP Growth, 1992-2011


130

Figure 2 below shows that growth in the monetary ratios over the last two decades is much higher than the growth observed in the real GDP growth indicator. This might indicate that the financial system in Jordan is quite developed and may also reflect the high velocities in currency circulations. Furthermore, the increase in these ratios may reflect the high confidence in the financial system and is expected to have positive impact on the economic growth later on. Figure 2: Monetary Ratios versus Real GDP Growth, 1992-2011

The financial ratios exhibit similar patterns to those of monetary ratios especially F1 (the total assets of the banking system as a percent of GDP), as Figure 3 below shows. The observed trend reflects the importance of the banking system relative to the rest constituents of financial system especially in the developing countries where the banking institutions are the main source of credit for business sector. Figure 3: Financial Ratios versus Real GDP Growth, 1992-2011

131


Finally, Figure 4 shows that the percent of credit to private sector is high and quite stable in Jordan (P1) over the last two decades. As for the credit to private sector as a percent of GDP, this ratio has witnessed steady increase over the last two decades. As indicated earlier, the percent of credit to private sector is used as a proxy to examine whether financial reforms have led to more efficient allocation of credit to the private sector which is assumed to be more efficient in employing credit compared to the public sector. Figure 4: Credit to private Sector versus Real GDP Growth, 1992-2011

To conclude this part, we can notice that most of the financial development indicators have witnessed noticeable growth over the last two decades but this growth has not been reflected on the economic growth indicator as measured by real GDP per capita growth. 3.3. Appraisals of the Correlations among Variablesemployed This study aims to provide empirical evidence about the impact of financial development on economic growth in Jordan over the last two decades. To achieve this objective, a panel data methodology that account for dependent and independent variables over the study period are employed. As noted by Hsiao (1986), the use of panel data increases degrees of freedom and reduces the estimation bias and multicollinearity. This results in a better model specifications and more robust parameter estimations. It further provides more informative results and more conclusive diagnostic testing procedures (Baltagi, 1995;Evans et al.,2002). In this study, we will measure the relationship between the independent variables (financial development indicators) and the dependent variable (economic growth indicator) using Ordinary Least Squares (OLS) model. In addition, both the fixed effect and random effect models will be estimated to reduce the heterogeneity problem that might be associated with estimation using the Ordinary Least Squares (OLS). Before conducting estimation of the study models, pairwise correlation coefficients are calculated for the explanatory variables to mitigate multicollinearity problem. In case, the correlation coefficients among various groups of explanatory variables are high and statistically significant, we removed the variable with lower coefficient of correlation with the dependent variable. Moreover, some sensitivity tests are used to obtain robust results for the study model. The robustness is evaluated based on how the estimated coefficients are not sensitive to the inclusion of different variables. Only the robust results of the empirical model are presented.


132

First, as table 2 below shows, the correlation coefficients between currency ratios and real per capital GDP growth is negative though the correlation coefficient between the 2nd ratio and the real GDP growth indicator is statistically insignificant. Based on these results and given the correlation coefficient between currency ratio 1 and 2 are noticeably high and statistically significant, we will employ only the first ratio in our later analysis. Table 2:

The correlation Coefficients Matrix for the Currency Ratios with themselves and with the Real GDP growth indicator Variable

Y -0.557 0.013 C2 -0.380 0.108 P-values of observed statistical significance are reported below the coefficients of correlations.

C1

C1

0.760 0.000

As for the correlation coefficients between economic growth indicator and monetary ratios, table 3 shows positive correlations between these variables but the strength of the correlations are statistically insignificant. On this basis and given the high correlation coefficients among monetary ratios, we will utilize only the first which is noticeably has the highest correlation coefficient with economic growth indicator. Table 3:

The correlation Coefficients Matrix for the Monetary Ratios with themselves and with the Real GDP growth indicator Variable

Y M1 0.340 0.155 M2 0.271 0.931 0.262 0.000 M3 0.263 0.910 0.276 0.000 P-values of observed statistical significance are reported below the coefficients of correlations.

M2

M1

0.997 0.000

As for the correlation coefficients between economic growth indicator and financial ratios, table 4 shows positive correlations among these variables though this correlation is statistically insignificant. On this basis, and given the high correlation coefficient between the financial ratios themselves, we will use only the first ratio given this ratio exhibit the highest correlation with economic growth indicator. Table 4:

The correlation Coefficients Matrix for the Financial Ratios with themselves and with the Real GDP growth indicator Variable

Y F1 0.356 0.134 F2 0.258 0.951 0.287 0.000 P-values of observed statistical significance are reported below the coefficients of correlations.

F2

F1

Finally, as for the correlation coefficients between the economic growth indicator and the percent of credit to private sector as percent of total credit and as percent of GDP, table 5 shows significant correlation with the first variable but insignificant correlation with the 2nd variable. On this

133


basis, and given the significant correlation coefficients between P1 and P2, we will employ only the first variable in our analysis. Table 5:

The correlation Coefficients Matrix for the Credit to Private Sector with themselves and with the Real GDP growth indicator Variable

Y 0.603 0.006 P2 0.309 0.198 P-values of observed statistical significance are reported below the coefficients of correlations.

P1

P1

0.641 0.002

Based on this preliminary evaluation of various financial development indicators, we will focus on four main financial development indicators that includeC1 (currency outside banks as a percent of narrow money supply M1), M1 (narrow money supply as percent of real GDP), F1 (bank sector assets as percent of real GDP) and P1 (private sector credit as percent of total banking sector credit). 3.4. Specifying the Study Model, Causality Tests and Results Our analysis in the forthcoming phase will be confined to four explanatory variables C1 (currency outside banks as percent of narrow money supply), M1 (narrow money supply as percent of real GDP), F1 (the banking sector assets as percent of real GDP) and P1 (the credit to private sector as percent of total banking sector credit). The trends in the financial development indicators along with the indicator of growth in real GDP are presented in Figure 5. As can be seen, apart from growth in financial ratio F1 (bank sector assets as percent of real GDP) which has witnessed high growth over the last two decades, the growth rates in other financial development indicators over the last two decades are modest and comparable. Figure 5: Financial Development Indicators versus Real GDP Growth, 1992-2011

The correlation coefficients among the employed financial development indicators will be calculated to count for the expected multicollinearity among these variables. As table 6 shows, the correlation coefficients between real GDP growth indicator and two of the financial development indicators are statistically significant (C1 and P1). Furthermore, the correlation coefficients among all


134

financial development indicators are statistically significant though the sign of correlation is not consistent so we are to count for the collinearity problem that might arise in later analysis. Table 6:

The correlation Coefficients Matrix among financial development indicators

Variable

Y C1 M1 -0.557 0.013 M1 0.340 -0.888 0.155 0.000 F1 0.356 -0.877 0.871 0.134 0.000 0.000 P1 0.603 -0.759 0.652 0.006 0.000 0.002 P-values of observed statistical significance are reported below the coefficients of correlations.

F1

C1

0.720 0.000

To mitigate the collinearity problem, we are to consider excluding M1 (narrow money supply as percent of GDP) and F1 (the ratio of banking assets as percent of GDP) given their correlation coefficients with Y (growth in real per capita GDP) are statistically insignificant. Furthermore, the correlation coefficients for these variables with the other explanatory variables (C1 and P1) are high and significant. To guard against possible model under-specifications, we run two models one with all the variables and then tested for variables redundancy using log-likelihood ratio given these models are nested. The redundancy tests reject omissions of these variables from analysis and necessitate the inclusion of these variables in the analysis. Table 7:

Redundant Variables Test

Specification: Y C C1M1F1P1 Redundant Variables: M1F1 F-statistic Likelihood ratio F-test summary: Test SSR Restricted SSR Unrestricted SSR Unrestricted SSR LR test summary: Restricted LogL Unrestricted LogL

Value 5.460733 10.95677

df (2, 14) 2

Probability 0.0177 0.0042

Sum of Sq. 0.002517 0.005742 0.003226 0.003226

df 2 16 14 14

Mean Squares 0.001258 0.000359 0.000230 0.000230

Value 50.03107 55.50946

df 16 14

The next step is to examine the explanatory power of the the model that includes the four financial development variables in explaining the growth in the real GDP per capita. The estimated model is presented below: Table 8:

Regression Output of Economic Growth on Financial Development Measures

Dependent Variable: Y Variable C C1 M1 F1 P1

Coefficient -0.203067 -0.221135 0.004602 -0.038351 0.501751

Std. Error 0.180264 0.117769 0.071659 0.013037 0.151755

t-Statistic -1.126502 -1.877704 0.064228 -2.941707 3.306332

Prob. 0.2777 0.0800 0.9496 0.0101 0.0048

135 Table 8:

International Research Journal of Finance and Economics - Issue 94 (2012) Regression Output of Economic Growth on Financial Development Measures - continued

R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic)

0.647983 0.554111 0.015595 0.003648 57.71463 6.902884 0.002329

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat

0.026600 0.023354 -5.271463 -5.022530 -5.222868 1.734895

The specified model using ordinary least squares analysis (analysis based on fixed and random effects models provide similar conclusion and thus their results are ignored for brevity) shows that the employed independent variables (financial development indicators) explain about 65 percent of the growth in real GDP per capita growth in Jordan over the last two decades. The currency ratio C1 (narrow money supply as percent of real GDP) and the financial ratio F1 (the total banking assets as percent of real GDP) have negative sign and statistically significant given their observed levels of significance in term of p-value are less than 10 percent. On the other hand, the percent of credit to private sector as percent of total credit (P1) is positively related to real GDP per capita growth and statistically significance. The F-statistic also indicate that the overall explanatory power of the model is statistically significant given the observed p-value of the statistic is less than 1 percent. Furthermore, the Durbin-Watson test of serial correlation indicates that the problem of serial correlation is not important to cast doubt on model specifications. The last step in our analysis is to examine whether financial development indicators cause the growth in real GDP per capita growth or the opposite, we employed Granger causality tests whose results are reported in table 9. The results of causality tests between C1 (currency outside banks as percent of narrow money supply), M1 (narrow money supply as percent of GDP and P1 (the total credit to private sector as percent of total banking sector credit) in one hand and Y (the real GDP per capita growth) on the other hand have shown absence of causality relationship in either directions between the independent variables employed and the dependent variable. However, the results of testing the hypothesis that F1 (the total banking sector assets as percent of GDP) does not Granger Cause Y (the real GDP per capita growth) is rejected at about 2 percent significance level but the result of testing the hypothesis that Y does not Granger causes F1 is not rejected. Table 9:

Pairwise Granger Causality Tests

Sample: 1992 2011 Null Hypothesis: C1 does not Granger Cause Y Y does not Granger Cause C1 M1 does not Granger Cause Y Y does not Granger Cause M1 F1 does not Granger Cause Y Y does not Granger Cause F1 P1 does not Granger Cause Y Y does not Granger Cause P1

Obs 18 18 18 18

F-Statistic 0.12133 0.27073 1.56813 0.27905 6.01996 0.13443 0.17427 0.34905

Prob. 0.8867 0.7670 0.2454 0.7609 0.0199 0.8754 0.8420 0.7118

Thus, based on this limited evidence, the banking sector assets as a percent of GDP seem to have some role in leading the economic growth. However, the other financial development indicators seem to have been just correlated with the real GDP growth indicator.


136

4. Conclusion This study aims to examine the impact of financial development on economic growth in Jordan over the period 1992-2011. The most widely financial development measures used in earlier literature are employed and grouped into currency ratios, monetary ratios, financial ratios and percent of credit to private sectors while the economic growth is measured by growth in real GDP per capita. The currency ratios include the currency outside banks as percent of narrow money supply (C1) and the currency outside banks as percent of broader money supply (C2). The monetary ratios include the narrow money supply as percent of GDP (M1), the broader money supply as percent of GDP (M2) and the banking sector deposit borrowings as percent of GDP (M3). The financial (interrelations) ratios include the banking sector assets as percent of GDP (F1) and the total banking sector credit as percent of GDP (F2). The correlation coefficients between financial development indicators and economic growth indicator are observed over the study period and help to discern those financial development measures that are highly correlated with economic growth and these variables are entered in the forthcoming phases of analysis. Apart from the currency ratios, most of the financial development indicators have witnessed significant growth over the last decades especially the percent of credit to private sector as percent of GDP (P2). Furthermore, the correlation coefficients among the financial development indicators are found highly correlated and statistically significant. However, despite the high growth in financial development indicators over the study period, the parallel growth in economic growth indicator is relatively much lesser, a finding that clearly indicates existence of other factors that hinder the economic growth. In the next phase of analysis, we regressed the most important financial development indicators detected in the earlier phase that include the ratio of currency outside banks as percent of narrow money supply (C1), the ratio of narrow money supply as percent of GDP (M2), the ratio of banking sector assets as percent of GDP (F1) and the ratio of private sector credit as percent of total banking sector credit (P1) on the economic growth (Y) and conclude that these variables explain almost sixtyfive percent of the economic growth over the study period. Our results indicate that apart from monetary ratio M1 (narrow money supply as percent of GDP), all the employed financial ratios are significantly correlated with economic growth indicator. In the last phase of analysis, we employed Granger Causality Test to detect the direction of relationship between financial development indicators in one hand and the economic growth indicator on the other hand and find narrow evidence that the financial development indicators and particularly the ratio of banking sector assets as percent of GDP (F1) Granger causes the economic growth. Our main remark based on this analysis is that despite employing large number of financial development indicators which proven to be high correlated with each other and have witnessed significant growth over the study period, the impact of these variables on economic growth is limited which necessitate further studies to detect the main obstacles that deter the economic growth in Jordan.

References [1]

[2] [3] [4] [5]

Al-Sahlawi, K. (1997), “The role of industrial development banks in financing and promoting technological change: the case of the Saudi Industrial Development Fund”, PhD thesis, University of Wales, Bangor. Ang, J. and W. Mckibbin 2007), “Financial liberalization, financial sector development and growth”, Journal of Development, Vol. 84, No. 1, pp. 215-33. Ardic, O., and H. Damar (2006), “Financial Sector Deepening and Economic Growth: Evidence from Turkey”, http://www.econ.bound.edu.tr/ardic. Arestis, P. and Demetriades, P. (1997), “Financial development and economic growth: assessing the evidence”, Economic Journal, Vol. 107 No. 442, pp. 783-99. Bagehot, W. (1973), “Lombard Street, Homewood, IL: Richard D.”, Irwin, (1962 Edition).

137 [6] [7] [8] [9] [10] [11] [12]

[13] [14] [15] [16] [17]

[18] [19]

[20]

[21] [22] [23] [24] [25] [26]

[27] [28]

International Research Journal of Finance and Economics - Issue 94 (2012) Baltagi, B. (1995), “Econometric Analysis of Panel Data”, Wiley, New York, NY. Beck, T. and Levine, R. (2004), “Stock markets, banks, and growth: panel evidence”, Journal of Banking and Finance, Vol. 28 No. 3, pp. 423-42. Beck, T., Cull, R. and Jerome, A. (2005), “Bank privatization and performance: empirical evidence from Nigeria”, Journal of Banking and Finance, Vol. 29 No’s 8-9, pp. 2355-79. Becsi, Z. and P. Wang (1997), “Financial development and growth”, Federal Reserve Bank of Atlanta Economic Review, Fourth Quarter, 46-62. Bencivenga, V.R. and Smith, B.D. (1991), “Financial intermediation and endogenous growth”, Review of Economic Studies, Vol. 58 No. 194, pp. 195-209. Calderon, C. and Liu, L. (2003), “The direction of causality between financial development and economic growth”, Journal of Development Economics, Vol. 72 No. 1, pp. 321-34. Cetorelli, N. and Gambera, M. (2001), “Banking market structure, financial dependence and growth: international evidence from industry data”, Journal of Finance, Vol. 56 No. 2, pp. 61748. Chen, C.H. (2002), “Interest rates, savings and income in the Chinese economy”, Journal of Economic Studies, Vol. 29 No. 1, pp. 59-73. Chen, Been-lon, Y. Chiang and P. Wang, (1996), “A Schmpeterian Model of Financia Innovation and Economic Growth”, Working Paper, Penn State University. Chen, C.H. and Wu, H.L. (2005), “Determinants of regional growth disparity in China’s transitional economy”, Journal of Economic Studies, Vol. 32 No. 5, pp. 406-19. Deidda, L.G. and Fattouh, B. (2002), “Non-linearity between finance and growth”, Economics Letters, Vol. 74 No. 3, pp. 339-45. Demetriades, P.O. and Hussein, K.A. (1996), “Does financial development cause economic growth? Time-series evidence from 16 countries”, Journal of Development Economics, Vol. 51 No. 2, pp. 387-411. Diamond, D. and P. Dybvig (1983), “Banks runs, deposit insurance and liquidity”, Journal of Political Economy”, Vol. 91, pp. 401-19. Evans, D, C. Green and V. Murinde (2002), “Human capital and financial development in economic growth: new evidence using the translog production function”, International Journal of Finance & Economics, Vol. 7, pp. 123-40. Ezirim, C., B. Noi, E. Amuzie and M. Muoghalu, (2010), "Financial Deepening and the Economies of Less Developed Countries: Empirical Evidence from Nigeria", International Journal of Business and Economics Perspectives, Vol. 5, No. 2. Feldman, D., and I. Gang (1990), “Financial Development and the price of services”, Economic Development Cultural Change, Vol. 38, No. 2. Fry, M. (1978), “Money, and capital or financial deepening in economic development”, Journal of Money, Credit and Banking, Vol. 10, No. 4, pp. 464-75. Fry, M. (1980), “Savings, Investment, growth and the cost of financial repression”, World Development, 8(4), 317-327. Fry, M. (1988), “Money, Interest and Banking in Economic Development”, John Hopkins University Press, Baltimore. (2nd edition in 1995). Gelb, A. (1989), “Financial policies, growth and efficiency”, Policy Planning and Research Working Papers, No. 202, World Bank, Washington, DC. Gobbi, G. and Zizza, R. (2007), “Does the underground economy hold back financial deepening? Evidence from the Italian credit market”. Centre for Economic Performance, London School of Economics and Political Science, London, UK, CEPDP, 789. Goldsmith, R. (1969), “Financial Structure and Development”. Yale University Press. Greenwood, J. and B. Jovanovic (1990), “Financial developments, growth and the distribution of income”, Journal of Political Economy”, Vol. 98, pp. 1076-107.

International Research Journal of Finance and Economics - Issue 94 (2012) [29] [30] [31] [32] [33] [34] [35]

[36] [37] [38] [39]

[40] [41] [42] [43]

[44] [45] [46] [47] [48] [49] [50]

[51]

138

Gurley, J. and E. Shaw (1955), Financial Aspects of economic development”, American Economic Review, Vol. 45, pp. 515-38. Gurley, J. and E. Shaw (1960), “Money in a Theory of Finance”, Washington D.C.: The Brookings Institution. Hakeem, M., (2010), "Banking development, human capital and economic growth in SubSaharan Africa (SSA)", Journal of Economic Studies, Vol. 37, No. 5, pp. 557-577. Harris, R.D.F. (1997), “Stock markets and development: a re-assessment”, European Economic Review, Vol. 41 No. 1, pp. 139-46. Hasan, I., P. Wachtel and M. Zhou (2008), "Institutional development, financial deepening and economic growth: Evidence from China", Journal of Banking & Finance. Herring, R. and A. Santomero (2000), “What isOptimal Financial Regulation?”, Financial Institutions Centre, Wharton, 00-34. Hondroyiannis, G., Lolos, S. and Papapetrou, E. (2005), “Financial markets and economic growth in Greece, 1986-1999”, Journal of International Financial Markets, Institutions & Money, Vol. 15 No. 2, pp. 173-88. Hsiao, C. (1986), “Analysis of Panel Data”, Cambridge University Press, New York, NY. Jao, Y. (1976), “Financial deepening and economic growth: A cross-section analysis”, The Malayan Economic Review, XXI (1, April): 47-58. King, R. and R. Levine (1992), “Financial Indicators and Growth in a Cross Section of Countries”, World Bank Workding Paper No. 819. King, R. and R. Levine (1993a), “Financial intermediation and economic development”, in Meyer, C. and Vives, X. (Eds), Financial Intermediation in the Construction of Europe, Centre for Economic Policy and Research, London, pp. 156-89. King, R. and R. Levine (1993b), “Finance and growth: Schumpeter might be right”, Quarterly Journal of Economics, Vol. 108, pp. 717-37. Levine, R. (1991), “Stock markets, growth and tax policy”, Journal of Finance, 46(4), 14451465. Levine, R. (2003), “Denying Foreign Bank Entry: Implications for Bank Interest Margins”, University of Minnesota mimio. Levine, R. (2004), “Finance and Growth: Theory, Evidence and Mechanisms”, In Handbook of Economic Growth, Eds. P. Aghion and S. Durlauf, Amesterdam: North-Holland Elsevier Publishers. Levine, R. and Zervos, S. (1998), “Stock markets, banks, and economic growth”, American Economic Review, Vol. 88 No. 3, pp. 537-58. Levine, R., Loayza, N. and Beck, T. (2000), “Financial intermediation and growth: causality and causes”, Journal of Monetary Economics, Vol. 46 No. 1, pp. 31-77. Liang, Z. (2005), “financial development, market deregulation and growth: evidence from China”, Journal of Chinese Economic and Business Studies, Vol. 3 No. 3, pp. 247-62. McKinnon, R.I. (1973), “Money and Capital in Economic Development”, Brookings Institution, Washington, DC. Meltzer, A. (1998), “What’s Wrong with the IMF?” Paper prepared for Federal Reserve Bank of Chicago Conference: Asia: An Analysis of Financial Crises, October 8-10. Merton, R. (1995), “Financial Innovation and Management and Regulation of Financial Institutions”, Journal of Banking and Finance, 19 (January). Ndebbio, J.E. U. (2004). “Financial deepening, economic growth and development: Evidence from selected sub-Saharan African countries”. African Economic Research Consortium, AERC Research Paper 142, August. Neusser, K. and M. Kugler (1998), “Manufacturing growth and financial development: Evidence from OECD Countries”, Review of Economics and Statistics, 80, 638-646.

139


[52]

Nwezeaku, N. and G. Okpara (2010), "The Effects of Financial Deepening on Stock Market Returns and Volatility: Evidence from Nigeria", International Research Journal of Finance and Economics, ISSN 1450-2887 Issue 40. Nzotta, S. and E. Okereke (2009), “Financial Deepening and Economic Development of Nigeria: An Empirical Investigation. African Journal of Accounting, Economics, Finance and Banking Research, Vol. 5, No. 5, pp. 55-66. Odedokun, M.O. (1998), “Financial intermediation and economic growth in developing countries”, Journal of Economic Studies, Vol. 25 No. 3, pp. 203-24. Odhiambo, N. (2010), "Interest rate reforms, financial deepening and economic growth in Tanzania: a dynamic linkage", Journal of Economic Policy Reform, Vol. 13, No. 2, 201-212. Ogun, O. (1986), “A Note on Financial Deepening and Economic Growth: Evidence from Africa”, Nigerian Journal of Economic and Social Studies, 28 (2). Olyide, A. (1998), “The Financial Systems Role in Resource Mobilization and Investment: An Analysis of Financial Deepening in Nigeria’s Financial Sector”, Economic and Financial Review, Abuja. Rajan, R.G. and Zingales, L. (1998), “Financial dependence and growth”, American Economic Review, Vol. 88 No. 3, pp. 559-86. Rousseau, P. and P. Wachtel (2000), “Equity markets and growth: Cross-country evidence on timing and outcomes, 1980-1995”, Journal of Banking & Finance, Vol. 24, Issue 12, pp. 19331957. Saint-Paul, G. (1992), “Technological choice, financial markets and economic development”, European Economic Review, Vol. 36 No. 4, pp. 763-81. Schumpeter, J. (1911), “The Theory of Economic Development”, Cambridge, Mass.: Harvard University Press. Schumpeter, J. (1939), “Business Cycles: A Theoretical, Historical and Statistical Analysis of the Capitalist process”, New York Toronto London: McGraw-Hill Book Company. Seetanah, B. and S. Ramessur (2008), "Financial Development and Economic Growth", Journal of Economic Studies, Vol. 36, No. 2, pp. 124-134. Shaw, E.S. (1973), “Financial Deepening in Economic Development”, Oxford University Press, New York, NY. Wang, Y. (2010). “Why isn't financial deepening happening in the poor countries?” Growth and Crisis (GC) Program of the World Bank Institute. Accessed on 8th February 2010. by Yahoo Search Engine at http://blogs.worldbank.org/growth/ Wu, H., C. Chen and F. Shiu (2007), "The impact of financial development and bank characteristics on the operational performance of commercial banks in the Chinese traditional economy", Journal of Economic Studies, Vol. 34, No. 5, pp. 401-414. Zhang, J., Wan, G., & Jin, Y. (2007). “The financial deepening – productivity nexus in China: 1987 - 2001”, UNU World Institute for Development Economics Research (UNU- WIDER) Paper No. 2007/08. Katajanokanlaituri 6 B, 00160 Helsinki, Finland.

[53]

[54] [55] [56] [57]

[58] [59]

[60] [61] [62] [63] [64] [65]

[66]

[67]