Trade Openness, Financial Development Index and Economic Growth

Abstract

Purpose – The purpose of this article is to examine the inter-relationship and direction of causality among three macroeconomic variables such as trade liberalization, financial development and economic growth. Design/methodology/approach – The empirical analysis is based on the principal component analysis as method to construct financial development index (FDI), augmented Dickey–Fuller and Phillips–Perron tests as the unit root test, Johansen’s co-integration test and VECM for direction of causality in the long run among TOP, FDI and economic growth. Findings – The empirical results confirmed that there exists a long-run association among trade openness, financial development and economic growth. This study has also found that there is bidirectional causality between financial development and growth. However, the causality runs from growth to finance is stronger than that from finance to growth. This study also observed unidirectional causality that runs from financial development and economic growth to trade openness. Research limitations/implications – The policy implications that could be drawn from the present study is that, initiation of financial reforms to improve the size of financial system would lead to higher economic growth. Another key implication from this study is that because trade openness has no effect on both domestic financial sector development and output growth, it would be better to deploy the resources into creating a sustained domestic demand rather than concentrating more on the external front in general and trade openness in particular. Originality/value – The study constructs a summary IFD for India by taking into account four broad financial development indicators for the period 1971-2012. The present paper also suggests that it would be better to deploy the resources to create a sustained domestic demand rather than concentrating more on the external front in general and trade openness in particular.