The Dynamic Relationship Between Financial Development, Economic Growth, Foreign Direct Investment and Trade Openness: Evidence from South Asian Countries

Abstract

This study examines the nature of the association among financial development, economic growth, foreign direct investment and trade openness in four South Asian countries from the period 1990–2019. The study employed Granger Causality test in Vector Error Correction Model (VECM) framework to find out the dynamic relationship among the variables. Further, variance decomposition analysis (VDA) and impulse response function (IRF) is also applied to determine the relationships among the variables beyond the sample period. The empirical result shows support for growth-led financial development, growth-led foreign direct investment and growth-led trade openness hypothesis for India. For Pakistan, the results suggest growth-led financial development and growth-led foreign direct investment. In the case of Sri Lanka, the results suggest foreign direct investment-led growth and trade openness-led growth hypothesis. The results do not support any kind of causal relationship among the variables in the case of Bangladesh in the short run. Furthermore, no bidirectional causality among the variables was found for all the countries. The findings imply that all four countries should adopt policies to promote further trade liberalization, financial sector development and also need to fast-track reforms to improve the investment climate and attract investments to attain high economic growth in the long run.