In the recent years, Asia has been developing fast and contributing significantly to the growth of the world economy. In this report, the literature related to economic growth and finance development in Asia will be reviewed. Before discussing the relationships between economic growth and finance development in greater details, the two variables, namely, economic growth and finance development will firstly be defined. Technically speaking, a nation’s economic growth can be measured by the changes in goods or services produced by all sectors in the economy of the nation. Often, a country’s economic growth can be measured as the growth of Gross Domestic Products (GDP) of the particular country (Abdullah, Sanusi, Kamil & Hasan, 2008). From the other perspective, the definition of finance development is more complex. Different aspects may be included as a component of finance development. Nevertheless, according to Ansari (2002), finance development include the following: deepening, broadening and liberalization of financial sector, that include comprehensiveness of the roles of financial institutions, development of financial instruments, deregulation of interest rates, free flow of capital, as well as removal of restrictive practices.
Having defined economic growth and finance development, the report will proceed to discuss the relationships between finance developments to economic growth in the context of Asia. The report is structured as follow. Firstly, the theories related to financial development and economic growth will be discussed. Then, empirical evidences related to the topic in the context of Asia will be presented. After that, conclusion will be drawn to conclude the relationships between economic growth and finance development from the Asia perspective.
As discussed by Waheed & Younus (2010), financial market is crucial to eliminating the market frictions related to transaction and information costs. A developed financial market is essential to reduce costs related to savings and investment decisions – so that resources can be allocated efficiently, thereby enhancing productivity, which is in turn essential to economic growth. Indeed, an entirely efficient financial system is crucial for economic growth. As argued by Pradhan (2010), an efficient financial system will encourage investment activities and optimal allocation of resources, through funding of business opportunities available, mobilizing and pooling of household savings, risk mitigation and diversification, as well as by facilitate exchange of good, services and assets. All of these will contribute to economic growth. Pradhan (2010) commented that financial development is important mechanism for long term economy growth. Specifically, it is suggested that bi-directional causality may exist between both finance developments to economic growth. This is rational because, in such a view, both finance development and economy growth mutually supportive and cause each other. Then, Chee and Nair (2010) further argued that development of financial sector is crucial for economic growth for the several reasons: (a) channeling the resources from traditional to growth industries, (b) enable market participants to collect and analyze information related to firms and markets, and (c) enable society to diversity and share the risks to enhance innovation.
Although the arguments concerning importance of finance development to economic growth is rational and logical, there are, however, contradicting opinions on such statement. Waheed & Younus (2010) pointed out that finance development, which aim to improve efficiencies of resources allocation, may not necessarily lead to higher economy growth. Indeed, in certain circumstances, higher returns on savings due to development of financial sector may reduce saving rates until the overall economy slow down. The lowering of savings rate may also caused by the lower liquidity constraints of individuals. Then, as asserted by Chimobi (2010), it is also reasonable to argue that there is no causality from finance development to economic growth. Instead, economic growth lead finance development – as when the economy growth, people demand better financial services. Then, in a similar vein as pointed out by Cheng & Degryse (2010), there are researchers arguing that finance development and economic growth may be largely independent phenomenon. Specifically, finance development may not be the fundamental reason leading to economic growth, but the development of financial markets as an indication or preparation for higher economic growth in the future. Under such a view, finance simply reacts to expectation of growth. Nonetheless, Cheng & Degryse (2010) further asserted that such a view is often dismissed by scholars due to abundance of literature discovering evidences related to importance of finance to economic growth.
Aside from the debate if finance development is related or causing economic growth, there are other perspectives worth mentioning on the topic of the relationship between finance development and economic growth. Indeed, the dynamics between finance development and economic growth may not be as simple as can be described through linear or causal relationships between the two variables. Some arguments related to such context are presented as follow.
Firstly, Jude (2010) however argued that although empirical evidences tend to show positive relationships between finance developments to economic growth, the relationships between the two variables may not be linear. Then, it is also commented that the coefficient between finance developments and economic growth may not be constant. This is rational as in the different countries; the two variables may have different impacts to each others. Indeed, in their study on a total of 71 countries around the world, it is found that the relationships between economic growth and finance development are non-linear. The coefficients between finance developments and economic growth are affected by the following variables: inflation rate, ratio of government expenditure, degree of openness to trade as well as the degree of financial development.
Then, Demirhan, Aydemir & Inkaya (2011) argued that relationships between financial development and economic growth is highly country specific. It is asserted that the role of finance development as contributor to economic growth for those already industrialized nations is less relevant. In other words, finance development as a contributor of economic growth is applicable mostly to emerging nations – that are still lacking efficient financial system facilitating economic growth in these nations. Indeed, such a view is supported by empirical evidences provided by Rabiul (2010), whereby finance development is more crucial towards economic growth in the developing countries.
Aside from these discussions, it is essential to keep in mind that there are other highly important economic factors affecting economic growth besides, financial development. For example, Demirhan, Aydemir & Inkaya (2011) commented that that besides, financial development, other factors such as resources endowment, the degree of macroeconomic stability, educational attainment, institutional development, effectiveness of legal system and structure, openness to international trades, and ethnic diversity are crucial impacts affecting economic growth.
Overall, it is found that most scholars perceive that there are relationships between finance development and economic growth. The notion that there are no relationships between finance development and economic growth is less common. However, the causal relationships between finance development and economic growth are somehow contradictory. There are evidences supporting if finance development cause economic growth, or vice versa. Indeed, there are also empirical evidences suggesting existence of bi-directional causality between finance development and economic growth. Such a situation is possible, considering that the factors affecting economic growth in real world are dynamic and interdependent. It is pointed out that the relationships between finance development and economic growth may not be linear. Furthermore, the relationships may differ depending on the country specific context or environment. Indeed, it is crucial to remember that finance development, at best, is only one of the factors affecting or related to economic growth. The potential impacts of other economic variables, such as resources endowment, macroeconomic stability, educational, institutional development, legal system, international trades, and ethnic diversity should never be neglected as well.
In this section, the studies related to the topic of finance development and economic growth in Asia is presented. Generally speaking, finance development is deemed to have the predictive power of economic growth (Abdullah, Sanusi, Kamil & Hasan, 2008). Indeed, having reviewed the literature related to finance development and economic growth comprehensively, Demirhan, Aydemir & Inkaya (2011) commented that there are growing bodies of empirical evidences supporting that countries with better-developed financial systems tend to grow at a faster and higher rate. In the following paragraphs, empirical evidences supporting the notion that finance development is crucial and significantly related to economic growth in the context of Asia will be presented.
In China, according to a research conducted by Cheng & Degryse (2010), it is found that finance development contribute to economic growth in China. In the study, it is found that bank development as well as bank credit, significantly contributing to the respective province growth in China. However, there are no evidences supporting the notion that development of non-bank financial institution is related to growth. Overall, the authors concluded that the finance-growth nexus only apply to development of formal banking financial institution in China.
In India, Pradhan (2010) had conducted a study, from year 1994 to 2010, on the issues related to finance development and economic growth of India under the globalization era. It is found that there are long term equilibrium relationships between internationalization of trade, finance development and economic growth during the research period. There are empirical evidences supporting bi-directional Granger causality between finance development and economic growth in the research period. In accordance to the research findings, the author strongly suggest that policies encouraging internationalization of trade and enhancement of financial development should be implemented and improved in the future, to promote further economic growth in India.
There are other studies focuses on more countries in Asia. For example, according to a study conducted by Abdullah, Sanusi, Kamil & Hasan (2008), there are empirical evidences supporting that there are positive and statistically significant relationships between financial depth and economic growth in 12 countries in Asia. Based on their findings, it is suggested that governments of low income countries should take several initiatives as follow to stimulate economy: effective supervision and regulation of banks, enhancement of legal and accounting practices, and contract enforcement.
Then, similarly, a study conducted by Szilagyi & Batten (2004) found that financial development (particularly on issues such as clarity and enforcement of property rights), are positively related to high level of growth in China, India and other smaller Asia pacific countries. It is also found that other economic variables, such as the legal system (be it based on civil or common laws), wealth of individuals, quality of commercial infrastructure are not important in affecting high level of growth in these countries being investigated. The authors suggested that in order to enhance economy growth of the countries in this region, regulatory and policy reforms should focus on finance development, particularly concentrating on the enhancement of property rights and corporate governance framework in the regions. Both of these elements are argued to be the precondition for sustainable growth, as evidenced from empirical evidences in the countries being investigated.
Apart from that, a study carried by Choong, Yusop & Soo (2004) found that development of financial sector is crucial in technological diffusion and transfers to East Asian countries, namely, in Japan, Korea, Indonesia, Malaysia, Philippines, Singapore and Thailand. According to their study, the development of financial sector is crucial to enhance Foreign Direct Investment (FDI) to the countries, which later enhance diffusion of technology that promote economic growth in the countries being investigated, despite the different countries being investigated are having different fiscal policy, industrial development and affected by other domestic specific determinants. Nevertheless, the presence of FDI and its impacts in creating long term technological diffusion process is dependent upon the evolution of domestic financial system. Before the development of financial system reach a minimum level, the diffusion of technology is not obvious. Thus, the authors asserted that development of financial sectors is crucial to economic growth.
Last but not least, a study conducted by Chee and Nair (2010) also found that financial development is indeed important factor leading to economic growth in the 44 countries being investigated from Asia. In the research, it is found that financial sector development, is crucial precondition leading to foreign direct investment (FDI), which subsequently essential in contributing to further economic growth in the Asia region. The authors further presented empirical evidences that show that development of financial sector and attracting FDI are complementarily contributing to economic growth in the least developed countries. Overall, the study confirms the importance of development of financial sector to economic growth. Nevertheless, the authors argued that other issues, such as education, training and development, as well as adoption of new technologies are also crucial elements that cannot be neglected for economic growth in these nations.
Nevertheless, it is acknowledged that not all studies yield similar results that finance development will definitely contribute to economic growth in Asia. There are some studies contradict the research findings from the literature presented above. One of these studies contradict the discussion by pointing that economic growth is indeed accelerating finance development, but not vice versa. Accordingly, Pradhan (2010) had conducted a study to investigate the causal relationships between finance development, poverty reduction and economic growth in India (from year 1951 to year 2008). In the study, unidirectional causality is found from poverty reduction to economic growth, from economic growth to finance development, from finance development to poverty reduction, and lastly, from economic growth to poverty reduction. However, there is no causality found from finance development to economic growth, as well as from poverty reduction to finance development. The author suggested that economic growth is indeed accelerating finance development; and both economic growth and finance development should be considered seriously in poverty reduction policy. Then, a study conducted by Choong & Lam on the impacts of Foreign Direct Investment and financial development to economic growth in a total of 70 countries around the world (of which many of these nations from Asia). Employing data from 1988 to 2002, it is found that the impacts of FDI to economy growth are ambiguous. To be specific, in contrast to the idea that FDI may not lead to economy growth, as other economic variables are crucial in affecting if a country can truly benefit from the presence of FDI.
Overall, it is discussed that in theory, it is widely accepted that there are relationships between finance development and economic growth. Although there are some opinion arguing that there are no relationships between finance development and economic growth, such a perception is less acknowledged by researchers. A review of the empirical studies on such context in Asia confirms such a view. For example, as articulated above, studies conducted by Cheng & Degryse (2010); Abdullah, Sanusi, Kamil & Hasan (2008); Szilagyi & Batten (2004); Choong, Yusop & Soo (2004); as well as Chee and Nair (2010) indicate that finance development is related to economic growth.
The more contradictory issues, however, is regarding the directions of causality between finance development and economic growth. Theories regarding such issues are not conclusive. Similarly, the discussion on such issue in the context of Asia is not conclusive. As discussed before, Pradhan (2010) found that there is no causality found from finance development to economic growth in India. Then, Choong & Lam found that the impacts of FDI to economy growth are ambiguous (in certain countries in Asia).
As argued before, it is stated that it is highly intuitive, reasonable and logical to believe that factors affecting economic growth in real world are dynamic, interacting, complex and interdependent. Thus, the relationships between finance development and economic growth may not be characterized easily. In this report, most of the studies support the notion that finance development is related to economic growth. Indeed, many studies performed contribute to empirical evidences that particularly in the context of emerging countries in Asia; finance development is crucial elements giving rise to the high rate of growth in economy. This is perhaps due to the fact that the importance of finance development towards economy growth in emerging countries is more prevalent and obvious. At the time of this writing, most nations in Asia are developing nations; and the growth methods by these nations are similar – i.e., a reliant on liberalization of trade, development of financial system and institutional as well as encouragement of FDI (Yusuf, 2002).
Having to mention that, it is essential to highlight that the relationships and importance of finance development towards economy growth in other region may not be similar to the case discussed in this report. For example, there are arguments that finance development is influential towards economic growth in developing countries, but not in the already developed or industrialized nations. Thus, in other region, such as in Europe, finance development may not contribute to economic growth, as least at the same degree as the roles or importance of finance development in Asia. Besides, it is essential to acknowledge that finance development is just portion of the picture related to economic growth. From the perspective of policy makers, there are many other importance economic factors that should not be taken for granted for sustainable economic growth.
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