Financial Development, Financial Repression, And Growth In Developing Economies

Abstract

Many studies have examined the relationship between economic growth and finance. A continuing question is the choice of a clear proxy for financial development. This paper attempts to elucidate this issue from a developing country perspective, while controlling for financial repression. The proxy of choice is the ratio of currency outside the banking system to real output (CB). This proxy is unique in that it is related to the degree of financial repression, and thus relates differently to economic growth depending on the level of financial development. The statistics support the hypothesis of a U-shaped behavior of CB with financial liberalization. The empirical results show that CB relates negatively to growth in countries that are less financially liberalized and positively with growth in countries that are more financially liberalized. The literature has used real interest rates as a measure of financial repression. An innovative measure of financial repression is then proposed that combines the use of currency inside banks and currency outside banks, and is tested concurrently with a broad money depth measure. The study is carried out using a panel approach, and the sample is also divided into different geographical regions, in order to see whether the relationship differs between geographical regions. The study concludes that there is overwhelming evidence that financial repression, which is indicative of financial under-development, is negatively related to growth.