Manufacturing and Services Growth in Developing Economies: ‘Too Little’ Finance?

Abstract

This article explores the relationship between financial development and growth in manufacturing and service sectors in 77 developing economies over the period 1984–2013. Specifically, we examine whether the size of the financial sector matters and if it does, whether the size of the financial sector in these countries is of a sufficient scale for credit and liquidity expansion to benefit the economy. Using the two-step system generalized method of moments, we find a u-shaped relationship between either manufacturing or services growth and financial size, indicating that a critical level of financial scale has to be achieved for financial expansion to positively affect the growth. For some 50%–90 per cent of the economies in the sample, there is a robustly long-run adverse effect of financial expansion on both manufacturing and services growth, indicating a case of ‘too little’ finance, likely explained by a combination of weak institutions, market failures and the existence of large and lumpy investments that require sufficient financial scale.