Does Financial Development Cause Economic Growth? The Case of India

Abstract

This article examines whether financial development has ‘caused’ economic growth in India since 1996. The dynamic interactions between the growth of real Gross Domestic Product and indicators of financial development are investigated using the concept of Granger Causality after testing for cointegration using both the Engle-Granger and Johansen techniques. The ADF test for cointegration proposed by Gregory and Hansen (1996) reveals that there has been both the level shift and regime shift in the specifications relating economic growth and financial development. The empirical results obtained by the Johansen method and ADF test suggest the existence of a stable long-run relationship between stock market capitalization, bank credit and growth rate of real GDP. The growth rate of real GDP is also found to be cointegrated with financial depth. However, causality runs from the growth rate of real GDP to stock market capitalization. The sector-wise rates of growth of the industrial and services sectors are found to be cointegrated with the stock market development as well as banking sector development and financial depth. The direction of causality for both the sectors runs from the rate of growth to stock market capitalization. We also observe that financial depth causes industrial growth and causality runs in both directions between bank credit and industrial growth. Furthermore, volatility in stock prices is cointegrated with each growth rate—of GDP, of industrial sector output and of the service sector output. The article establishes that, in an overall sense, economic growth has ‘caused’ financial development in India.