Financial development and economic growth: Convergence or divergence?

Abstract

This study tests for convergence in financial development and economic growth by incorporating the interaction between the real and financial sectors into an otherwise traditional test for convergence. The results show strong evidence for conditional convergence. Middle- and high-income countries conditionally converge to parallel growth paths not only in per-capita GDP, but also in financial development. The mutually reinforcing relationship between financial development and economic growth is stronger in the early stage of economic development, and this relationship diminishes as sustained economic growth gets under way. As such, low-income countries with a relatively well-developed financial sector are more likely to catch up to their middle- and high-income counterparts, and those with a relatively under-developed financial sector are more likely to be trapped in poverty. This finding explains the observed “great divergence” between poor and rich countries. Another finding is that, while human capital is more important to growth in the early stage of economic development, economic freedom becomes more important in the later stage.