Financial Development and Economic Growth

Introduction

The relationship between economic growth and development of financial markets has always been a truly crucial subject in economics. Many studies have been conducted to determine impacts of developing financial institutions on economic growth, with each study coming up with meaningful explanations. Despite the fact that various economists have outlined the effects of financial institutions development on economic growth, they have held varied opinions on the direction of causality, meaning: whether developing financial markets leads to economic growth, or economic growth leads to development of financial markets and institutions (Levine 2010).

Some economists argue that financial development is not directly linked to increased rate of economic growth, and argue that the relationship between economic growth and financial growth is weak and unpredictable. However, some economists have associated the economic development of certain countries to their strong financial systems that contributed to high economic growth. It is apparent that development in financial institutions and markets relies on the rate of transfer of created resources from savings field to efficient investments. According to Levine, large financial development rate will increase the rate of economic growth if it is established that development of the financial system has a positive effect on economic growth (Levine, 2010). In their literature, McKinnon and Shaw (1973) endorse the opinion that liberalization of financial systems results in the deepening of financial sector and thereby increasing the rate of economic growth. However, of the contra opinion are Taylor and Buffy (1984), who argued that financial development decreases total credit supply and thereby preventing economic growth. This paper seeks to explain the relationship between financial development and economic growth in China.

China has witnessed a rapid economic growth coupled with a fast expanding financial intermediation sector in the last thirty years. The country has experienced a stable economic growth rate of 9.8% since the inception of reforms in the year 1978 (The China Statistical YearBook 2007). China presents a fascinating country of study, given its uninterrupted records of growth and rapidly expanding markets. The literature on the relationship between financial intermediation and economic growth on China presents conflicting points of view. Some studies conducted prior to the year 2000 indicate a negative relationship between the two variables, while most studies conducted after the year 2001 indicates a positive relationship between financial development and economic growth. Boyreau-Debray (2003) conducted a research using data between the periods (1990-1999) and found that financial inter-mediation had a negative relationship with economic growth in China. In her conclusion, she linked the negative relationship to the banking sector’s support of state owned enterprises which persistently made losses.

We begin by looking at financial sector reforms and developments that China has undertaken, and later relate them to its economic growth.

Financial Sector Reforms and Development

Financial development can be referred to the process of improving the quality, quantity and efficiency of the financial institutions and its intermediary services. Financial deepening has been linked to developments in the stock markets and banking sector. However, stock markets contribute immensely minimal net flows in developing countries (Suarez &Weisbord 1995). Stock markets, therefore, plays a minor role in economic growth; more often, they are likened to casinos where gambling take place. Banking sector reforms were initiated in China with the main objective of reforming the economy and turning it around. The guideline for reforms in the banking sector was creating an efficient banking system, where liberty of operations was given to commercial banks.

The reforms began in 1978 when the People’s Bank of China (PBC) was separated from the Ministry of Finance. The bank later in 1984 became the central bank. Since it could not continue operating as a commercial bank, it relegated its commercial banking activities to the newly formed Industrial and Commercial Bank of China (ICBC) and other specialized banks. As a central bank, PBC was charged with the responsibility of formulating and implementing macro-monetary policies, serving as treasury of the central government and regulating the financial institutions and markets. Apart from the central bank, China also embarked on financial sector reforms (Mehran & Quintyn 2009).

China’s financial sector reforms were stepped up in 1990’s, witnessed by consolidation and austerity measures taken in restructuring the banking sector (Holtz & Dewey, 2007). This is the time when banks were engaging in non-banking businesses, which could lead to insecure risk management system. To this effect the PBC began executing its full mandate of regulating the banking industry. It is then that the government launched the three policy banks: State Development Bank, Agricultural Development Bank and China Import and Export Bank. The introduction of these banks ensured that other commercial banks concentrated on ordinary banking activities with minimal engagement in policy matters.

In the year 2001, China formally entered the World Trade Organization (WTO). China experienced tremendous financial sector reforms after joining this trade organization. These reforms include interest rate liberalization, minimized restrictions on business ownership takeovers and more freedom on foreign banks establishment and operation.

Interest rate liberalization began in 1999, in the money markets and bond market. After joining the World Trade Organization, China started taking faster steps in relaxing restrictions on interest rates. Interest rate liberalization necessitated financial liberalization and efficient resource allocation. Another milestone was achieved in financial regulation when the China Banking Regulatory Commission (CBRC) was established in the year 2003. The establishment of this regulatory institution led to significant improvements in capital adequacy, asset quality, risk control and general operation of commercial banks and other financial institutions. Banks in financial distress could now be taken over or restructured by the China Banking Regulatory Commission.

Foreign investment in domestic banks was intensified from the year 2003 when the banking regulatory commission announced guidelines intended to encourage foreign share holding. This shows that Chinese banks need to improve their strategic operations through incorporating foreign strategic investors. This motive was illustrated in the year 2006 when CBRC issued new regulations, which stipulated that all newly-established commercial banks required at least one foreign strategic investor. It was later established that minority foreign ownership improved the efficiency of Chinese banks (Berger, Hassan & Zhou 2009).

In the year 2006, a leading American banking corporation merged with other corporate partners in China, so as to acquire a regional Chinese bank. This was among the latest banking sector reforms that the government of Peoples Republic of China implemented in the financial sector (Holtz & Dewey 2007).

Apart from reforms in the banking sector, the Chinese government has put up other financial institutions like Investment and Trust Companies, rural credit cooperatives and urban credit cooperatives were established in 1980s. Shanghai bank was established in the year 1986, the main bank that was charged with financial service provision.

Data Analysis

Variable Constructs

In order to analyze the relationship between financial development and economic growth, it is necessary to define the variables. In order to investigate whether exogenous component of financial deepening influences economic growth, we need to set up a growth regression model with annual real per capita GDP rate as the dependent variable and a variable representing financial development as an independent variable.

Indicators for Financial Development

China’s statistical data does not provide sufficient information for calculating such indicators as the value of credits provided to the private sector by financial intermediaries. Researchers who study the relationship between finance and growth have developed a set of indicators. This paper employs the use of these indicators to determine the relationship between financial development and economic growth. These include, as follows:

• Credit ratio- the ratio of total loans available in the financial system to GDP.
• Deposit ratio- the ratio of total deposits to GDP.
• Savings ratio is the ratio of total savings deposited by households in the financial system, to GDP.
• Corporate – this ratio represents the proportion of corporate deposits to total deposits. It measures China’s financial deepening in providing corporate banking services.
• Loans over Appro- this indicator measures the share of fixed investments in assets financed by domestic loans in relation to that financed by the state budgetary appropriation.

Apart from financial development indicators, other conditioning information sets are used in this research. This information is used to determine other factors that influence economic growth apart from financial development. Data is, therefore, collected on those control variables and used to examine the sensitivity of the empirical results obtained.

Data

A set of panel data is obtained from economic surveys for different cities in China for various years. The data is obtained from the China City Statistical Yearbook. This yearbook provides sets of data from both municipalities and urban regions. Because of data limitation, we use data for Loans Over Appro, Consumer Price Index and Government.

Analyses of Finance and Growth

A cross-sectional analysis of finance and growth focuses on the initial values of regressions, in which case, we use the values of financial indicators, the control variables and the average value of dependent variables. We use the following basic regression model:

Where Growth (dependent variable) is the real per capita GDP growth rate, Finance represents each of the financial indicators. The Conditioning Information Set is used to capture factors other than financial indicators that influence economic growth.

Cross-sectional analysis does not indicate the mode of causality. The initial values of regression raise two critical weaknesses: first, there is a possibility that a common influence to the dependent and independent variables during the same period affects the empirical findings; secondly, “contemporaneous” regressions ignore the endogenous explanation of dependent and explanatory variables (Levine 2010).

A table of different conditioning information sets indicates that there is a strong, positive relationship between economic growth and financial intermediation development. It indicates that all the five financial intermediation indicators are correlated to economic growth.

Methodology

When determining the impact of financial development to economic growth, the Generalized Method of Moments (GMM) estimators have been widely applied (Blundell and Bond, 1998). This is because of the various advantages associated with this method, which are not limited to the following: firstly, it enables us to control for time fixed effects; secondly, we can use lags in independent variables in dealing with possible regressor endogeneity (Benhabib &Spiegel 2000). The GMM estimators can, therefore, assist us in addressing these econometric problems by using lagged explanatory variables as internal instruments.

Let y represent the logarithm of real pre capita gross domestic product while x represent the explanatory variables, including either of the financial indicators and a control variable. Instruments available for an equation may be weak instruments especially when the explanatory variables are persistent with time (Alonso & Arellano, 2006). The presence of weak instruments can result in serious sample biases.

Results Using GMM Estimators

As reported in Table 2, the regression results show that there is a positive relationship between economic growth and the four financial development indicators i.e. Credit, Deposit, Corporate and Loan Over Appro ratios. All the three financial indicators except for the Deposit regression pass the Sargan test. As evidenced from the table, most p-values satisfy the significance level levels for the Sargan test with an average level of 0.354. However, the p-values difference in the Sargan test, which are suspected by Roodman (2009) as caused by validity of the instrument lagged growth, have an average value of 0.425. This is, therefore, a confirmation that the overall size of financial depth stimulates the development of financial intermediation and economic growth in China through corporate deposits.

According to the above information, the Loan Over Appro regression failed to pass any test. This means that the use of market-oriented and profit-driven transactions in the financial sector is positively associated with economic growth. From the system GMM, the coefficient of savings ratio turns to be negative. It is, therefore, difficult to conclude that savings positively contributes to the growth of the economy. In explanation to this, China has a savings rate standing at 40%, which is a remarkably high rate that may lead to a low household consumption as a percentage of GDP. This probably hurts the economic growth and is a possible explanation of poor relationship between savings and economic growth.

Summary of the analysis

A bigger portion of literature on economic research suggests that improvements in the financial sector should lead to an increased rate of economic growth. Under normal circumstances, financial sector works through efficient mobilization and utilization of resources, expanding the credit in order to increase investments.

In summary, we have been able to illustrate that development of financial intermediation in China, especially after China entered the World Trade Organization, has had a positive influence on the economic growth. This finding is in line with studies done on other countries in respect to the relationship between financial development and economic growth. However, the study differs with other existing studies on the relationship between finance and growth in China (Hassan, Wachtel & Zhou 2007; Guariglia & Poncet 2008). According to these studies, financial deepening did not facilitate economic growth in China. They argued that commercial banks continued to fund loss-making enterprises, channeling capital to regions that had a history of slow growth rates. The negative effect of financial deepening to economic development was, therefore, attributed to this inefficient allocation of resources. These results are expected since most of the studies were conducted during the period that China had not entered the World Trade Organization. The results in this paper include surveys carried after 2001, the period China entered the WTO. The implication of this phenomenon is that the financial sector reforms hat China carried out after joining the trade organization are beneficial to the economy, especially bank restructuring, and financial liberalization.

The positive estimated coefficients are large in value, hence, significant in economic growth. From the analysis, most control variables shows expected signs. There is evidence of convergence since the coefficients of per capita gross domestic product is smaller than unity in most of the regressions. It is also evident that human capital is directly proportional to economic growth. The State Owned Entities (SOEs) shows a negative impact on economic growth. This implies that state owned entities, especially entities in investment, reports poor performances and, therefore, hurts the economy.

Other variables that affect economic growth include: inflation, which has a negative effect on economic growth, size of the government that negatively affects the economy; and infrastructure development, which according to report, is insignificant. Foreign investment is seen to have an insignificant effect on economic growth (Boyreau-Debyar 2003).

Conclusion

The main objective of this research is to study and determine the relationship between financial development and economic growth with the Republic of China being the case country of study. The paper has, therefore, presented a brief history of financial sector reforms in China, indicating the achievements that were attributed to these reforms. The data, which have been used in this work, are extracted from reliable sources, collected from various Chinese Cities between 2001 and 2005. The study involved determining the exogenous element of financial development on economic development. In the research, an empirical relationship between measures of financial development and economic growth is studied with a unique set of data. The results indicate that financial development indicators are positively related to economic growth, given that other variables are associated with economic growth are controlled. The size of financial sector and the deepening of the financial intermediaries stimulate economic growth of a country.

The entry of China into the World Trade Organization is more relevant in illustrating the relationship between the country’s financial development and economic growth. After joining the organization, there were actively trading markets, profit generating financial transactions and mobilization of corporate deposits. These initiatives positively affected economic growth. Results from other cross-country studies portray the same relationship between financial developments as this research.

From this empirical research, there also arise some intriguing policy implications for the country under study. As has been concluded, the financial sector reforms in China have substantially increased financial depth in the country. This implies that it is imperative for the country to maintain a sound financial sector. Therefore, if the commercial banks continue allocating capital resources to non-performing sectors of economy like loss-making state owned enterprises, economic growth will be hampered.