Abstract

We examine the relationship between financial sector development and the shadow economy in Indonesia from 1980 to 2020. We estimate the size of Indonesia's shadow economy using the “Modified Cash to Deposits Ratio” approach. We then construct a long-term model using the size of Indonesia's shadow economy as the dependent variable. We set financial sector development as the main independent variable in our model. We use per capita real gross domestic product, the misery index, and foreign direct investment as control variables in our model. We find that financial sector development and the size of Indonesia's shadow economy have a nonlinear relationship that shows an inverted U-shape curve. The size of the shadow economy expands at the early stages of financial sector development to a turning point and decreases when financial sector development increases further. We also find that foreign direct investment curtails Indonesia's shadow economy. Additionally, increases in income expand Indonesia's shadow economy while misery index shows ambiguous results. We suggest the Indonesian authorities widen access for micro, small, and medium firms to the credit markets and enhance existing programs to reduce poverty and narrow the income gap in the country. These efforts help to narrow the size of Indonesia's shadow economy.

Highlights

  • Many empirical economic studies have explored the relations between financial sector development and economic growth

  • The null hypothesis of non-cointegration is rejected for the Ordinary Least Square (OLS) and Autoregressive distributed lag (ARDL), while the null hypothesis of cointegration cannot be rejected for the Dynamic OLS (DOLS) and Canonical Cointegrating Regression (CCR)

  • The E-G test statistic, Bound Ftest statistic, and ecttÀ1 t-statistic are significant at the 1% level, while the Lc statistic is insignificant for DOLS and CCR

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Summary

Introduction

Many empirical economic studies have explored the relations between financial sector development and economic growth. There are mixed findings from previous studies on the impacts of financial sector development on Indonesia's economic growth. Sumarni (2019) finds a positive but weak impact of financial sector development (proxied by the size of financial assets of the commercial bank) on Indonesia's economic growth from 2005 to 2016. Fukuda (2012) and Habibullah (1998a,b) find that financial sector development (proxied by money supply to GDP ratio) has a positive impact on Indonesia's economic growth. Based on the findings from the studies by the ADB (2011) and Rothenberg et al (2016), we induce a hypothesis that using financial sector development to provide greater access for the population to financial resources can reduce Indonesia's shadow economy.

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