Financial Development and Economic Growth in India

Abstract

This article examines the impact of the developments in the financial sector on economic growth in India in the post-reform period. The model of Mankiw et al. (1992) was extended to establish a relationship between financial development and economic growth. The model was then estimated using quarterly data for the period 1993 to 2005 for India, using the techniques of cointegration and vector error correction method. Cointegration results show that capital–output ratio and rate of growth of human capital have positive effects on real rate of growth of GDP, irrespective of the indicator of stock market development. An increase in the market capitalization dampens economic growth, whereas turnover has no significant effect, and an increase in the money market rate of interest has a positive effect on economic growth. Real wealth, debt burden, real effective exchange rate and the rate of growth of labour have negative effects. Vector error correction method shows that the ECM term relating to market capitalization and inflation help adjust short-run dynamics of economic growth when we use market capitalization as the indicator of the stock market development. The findings lend no support to the theoretical prediction that the stock market development would play an important role in enhancing economic growth in India. On the contrary, reform measures on the market rate of interest that were introduced in the Indian banking system appear to have promoted economic growth significantly.