Institutional quality thresholds and the finance – Growth nexus
Introduction
A large amount of literature has examined the relationship between financial development and economic growth using cross-country, time series, panel data, and firm-level studies (King and Levine, 1993a, King and Levine, 1993b, Demetriades and Hussein, 1996, Levine, 1997, Levine, 2003, Rajan and Zingales, 1998, Levine et al., 2000, Al-Yousif, 2002, Beck and Levine, 2004, Bertocco, 2008, Hasan et al., 2009, Jalil et al., 2010, Rahaman, 2011, Kendall, 2012).1 By and large, the empirical evidence has suggested that there is a positive long-run association between indicators of financial development and economic growth. According to Levine (1997), financial intermediaries enhance economic efficiency, and ultimately economic growth, by helping allocate capital to its best uses. Moreover, the existing evidence also demonstrates that this relationship is very likely to be nonlinear where the effect of finance on growth may vary by stage and level of economic development. For example, Deidda and Fattouh (2002) and Rioja and Valev (2004a) found that there is no significant relationship between financial development and growth in low-income countries, whereas the relationship is positive and significant in high-income countries.2 In addition, Rioja and Valev (2004b) pointed out that financial development exerts a strong positive effect on economic growth only when it has achieved a certain level or threshold; below this threshold, the effect is at best uncertain. Shen and Lee, 2006, Ergungor, 2008, Hung, 2009 and Cecchetti and Kharroubi (2012) also discovered patterns of nonlinearity in the relationship between financial development and growth.3 In general, all these papers suggested that a well-developed financial market is both growth-enhancing and consistent with the proposition of “more finance, more growth.”4
However, recent researchers have suggested that “better finance, more growth” is a more accurate proposition than “more finance, more growth.” These researchers have argued that a financial system embedded in a sound institutional framework is more important for growth. Arguably, an increase in financial development, as captured by standard financial development indicators, may not result in increased growth due to corruption in the banking system or political interference that may divert credit to unproductive or even wasteful activities. Demetriades and Andrianova (2004) and Arestis and Demetriades (1996) highlighted that varying relationships may reflect differences in the quality of finance, which is determined by the quality of financial regulation and rule of law. Likewise, Al-Yousif (2002) suggested that the relationship between financial development and economic growth cannot be generalized across countries because economic policies are country specific and their success depends on the efficiency of the institutions implementing them.
Although “better finance, more growth” is a plausible conjecture, there exists limited direct evidence to confirm that institutions make a difference in the way financial development affects economic growth. An exception is the study by Demetriades and Law (2006), who, using a linear interaction model, found that financial development has larger effects on economic growth when the financial system is embedded within a sound institutional framework. They also found that financial development is most potent in middle-income economies, where its effects are particularly large when institutional quality is high. In low-income economies, more finance without sound institutions may not succeed in delivering long-run economic development. The relevance of institutional quality is clearly supported by this finding; the researchers concluded that “better finance, more growth” has much wider application than “more finance, more growth.” However, this type of modeling strategy has one limitation. The interaction term (constructed as a product of financial development and institutions) used to capture the contingency impact of finance on growth imposes a priori restriction that the effect of financial development on economic growth monotonically increases (or decreases) with the level of institutional development. It may be that a certain level of institutional quality has to be attained before financial development can have any impact on growth. This conjecture requires a more a flexible modeling strategy that can accommodate different kinds of financial development-growth-institutions interactions.
This paper provides new evidence that sheds light on the role that institutions play in mediating the influence of financial development on growth. Specifically, we explore whether there exists an institutional quality threshold in the finance-growth relationship. This relationship may be contingent on institutional quality, where financial development promotes economic growth after institutions exceed a certain threshold level. The findings of the study may have important policy implications. If there is clear evidence that weak institutions significantly hamper the finance-growth nexus, then policy makers should propose measures that strengthen institutions economically to improve the functioning of financial markets and boost economic development. In addition, the paper highlights a potential effect of institutions on growth through indirect channels. For example, Law (2009) found that the institutional channel outperforms the competition channel in ensuring the positive effects of openness on financial development in developing countries. Mishkin (2009) also emphasized that globalization promotes financial development and economic growth in developing countries via institutional reforms.
This study extends the literature in four respects. First, we used a regression model based on the concept of threshold effects. The fitted model allowed the relationship between financial development and growth to be piecewise linear, with the institutions indicator acting as a regime-switching trigger. Second, we used a dataset sufficiently large to enable robust conclusions to be drawn; specifically, the sample used in this study consisted of annual data from 85 countries from 1980 through 2008. Third, two datasets were employed in the analysis, corresponding to institutions datasets from the International Country Risk Guide (ICRG) and the World Bank Worldwide Governance Indicators (WGIs). Finally, three financial development indicators were employed in the analysis-private sector credit, liquid liabilities, and commercial bank assets-to capture various aspects of banking sector development.
This paper is organized as follows: Section 2 lays out the empirical model, the threshold regressions of Hansen (2000) and Caner and Hansen (2004), and the data; Section 3 contains a discussion of the empirical findings; and Section 4 provides a summary and conclusions.
Section snippets
Empirical model
The empirical model is based on King and Levine, 1993a, King and Levine, 1993b and Levine and Zervos (1998). Since publication of their works, it has become common practice to examine the empirical linkages between finance and growth using the following linear cross-country growth equation:where GROWTHi is the average growth rate in country i, FDi is the country’s level of financial development, X is a vector of controls (initial income per capita, investment-gross domestic
Hansen (2000) threshold regression
Table 3 reports the results of estimating Eq. (2) using two institutional quality variables, taken from ICRG (INSICRG) and WGI (INSWGI). The statistical significance of the threshold estimate was evaluated by p-value calculated using the bootstrap method with 1000 replications and 15% trimming percentage. As shown in all models, the bootstrap p-values indicate that the test of no threshold effect can be rejected. Thus, the sample can be split into two regimes. For example, referring to Models
Conclusions
Using data from 85 countries covering 1980 through 2008, this study examined whether there exists an institutions threshold in financial development and growth. One major contribution of the paper was the adoption of the regression model based on the concept of threshold effect proposed by Hansen (2000) to capture rich dynamics in the relationship between finance and growth. The empirical results indicated that there is a significant institutions threshold in the financial development-economic
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