Financial Development And Economic Growth Dynamics In South Asian Region

Abstract

This study investigates the relationship between financial development and economic growth in the context of five South Asian countries for the period 1985-2014. Pedroni, Johansen co-integration, and panel based Granger causality tests are employed to examine the long and short run relationship dynamics between economic growth and other instrumental variables estimated in this paper. A vector autoregressive model (VAR) is a constructive method of analyzing the impact of a given variable on itself and all other variables by using variance decompositions (VDCs) and impulse response functions (IRFs). To check the robustness of this study, fully modified least square (FMOLS) has been conducted. The results of Pedroni and Johansen co-integration tests confirm that the indicators of financial development have a co-integration relationship with economic growth in the long run. Granger causality test shows that bidirectional causality between economic growth to M2 and also real interest rate and domestic credit to private sector in the short run. Moreover, unidirectional causality exists among the total value of stock traded variable to economic growth, M2 to domestic credit to private sector and M2 to real interest rate in the short run. This paper also documents shocks in stock traded total value has strongly positive response to economic growth. Shocks to domestic credit to private sector, trade openness, M2 have positive response with economic growth but not very strong. The shocks response function of real interest rate to economic growth is negative and quickly returns to the equilibrium. The results of variance decomposition confirm that shocks in the variables of M2 and stock traded total value shock have more impact on economic growth in the long run. FMOLS is employed to check the robustness and shows that financial development and economic growth are holding same relationship except the real interest rate. Policy makers should take immediate steps to minimize the interest rate spread in the south Asian countries. An optimum real interest rate spread will spur the growth process in the south Asian region. The policy makers also should think for transformation of the financial system through upgrading and strictly imposing the financial rules and regulations. The financial institutions must be monitored closely and the policy makers should pay more attention on that issue.