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This article examines the effects of permanent financial development on domestic investment and output in 41 countries between 1960 and 1993. The results reject the hypothesis that financial development simply follows economic growth and has very little effect on it. As the financial system develops, households substitute out of unproductive tangible assets, raising the total real supply of credit.
This article examines the effects of permanent financial development on domestic investment and output in 41 countries between 1960 and 1993. The results reject the hypothesis that financial development simply follows economic growth and has very little effect on it. As the financial system develops, households substitute out of unproductive tangible assets, raising the total real supply of credit.
This article examines the effects of permanent financial development on domestic investment and output in 41 countries between 1960 and 1993. The results reject the hypothesis that financial development simply follows economic growth and has very little effect on it. As the financial system develops, households substitute out of unproductive tangible assets, raising the total real supply of credit.
In this article, I use a multivariate vector-autoregressive (VAR) approach to examine the effects of permanent financial development on domestic investment and output in 41 countries between 1960 and 1993. The VAR approach permits the identification of the long-term cumulative effects of financial development on the domestic variables by allowing for dynamic interactions among these variables. The results reject the hypothesis that financial development simply follows economic growth and has very little effect on it. Instead, there is strong evidence that financial development is important to growth and that investment is an important channel through which financial development affects growth. (JEL E22, E44, E47, O16, O57) Keywords: economic growth, financial development, investment, vector-autoregression, impulse-response Headnote ABBREVIATIONS ARIMA: autoregressive integrated moving average BIC: Bayesian Information Criterion OECD: Organization for Economic Cooperation and Development FD: financial development IMF: International Monetary Fund INV: growth rate of real domestic investment M2: money supply VAR: vector-autoregression I. INTRODUCTION Interest in the relationship between financial development and economic growth dates back to early this century and has been growing since the 1980s.1 In the literature, three views have emerged concerning the potential importance of finance in economic growth. The first sees finance as a critical element of growth (Schumpeter [1911]; Goldsmith [1969]; McKinnon [1973]; Shaw [1973]; Fry [1978, 1988]; Bencivenga and Smith [1991]; King and Levine [1993a, 1993b]). In this view, services provided by the financial system are essential for growth, and a repressed financial system, characterized by price distortion, undersaving, negative or unstable returns on savings and investment, and inefficient allocation of savings among competing users, impedes growth.2 As the financial system develops, households substitute out of unproductive tangible assets, raising the total real supply of credit, the quantity and quality of investment, and thus the rate of economic growth. In addition, financial development can promote technological innovations and productivity growth (King and Levine [1993a]). The second view regards finance as a relatively unimportant factor in growth, essentially as the handmaiden to industry and commerce (Robinson [1952]; Lucas [1988]; Stern [1989]). In this perspective, the lack of financial development is simply a manifestation of the lack of demand for financial services. As the real sectors of the economy grow, the demand for various financial services rises and will thus be met by the financial sector. Based on this view, financial development simply follows economic growth and has very little effect on it. Like the first one, the third view ascribes effects to finance but focuses on its potential negative impacts on growth (Van Wijnbergen [1983]; Buffie [1984]). Economists holding this view contend that financial development can hinder growth by reducing available credit to domestic firms. This situation arises from the presence of informal curb markets. As the formal financial system develops, households are seen to substitute out of curb-market loans, thus reducing the total real supply of domestic credit. The reduction in the supply of credit can lead to a credit crunch, thereby lowering investment and slowing production and growth. Further, such a credit crunch can retard economic growth beyond the short term by lowering the steady-state capital stock (Wijnbergen [1983]). From these divergent views, three testable hypotheses emerge with sharply different policy implications. The first view suggests that government policies should be directed toward improving the financial system, since financial development has important causal effects on growth. The second view implies that government policies toward improving the financial system will have little effect on growth, since financial development results from growth and has little impact on it. Based on the third view, there is a potential danger of financial development. Under certain institutional arrangements, government efforts toward financial development can cost an economy its long-term growth by reducing total real supply of domestic credit. Therefore, to mitigate the potential negative effects of finance on economic growth, the government must reform its institutional environment first. So far, empirical studies of the effects of financial development on economic growth have produced mixed evidence. For example, in one cross-section study, Jao [1976) found no role for financial development in explaining per capita real GDP. But in another, Lanyi and Saracoglu [1983] found a positive relationship. In a more recent cross-section study of 80 countries over the 1960-89 period, King and Levine [1993b] found that various measures of the level of financial development are strongly and positively correlated with real per capita GDP growth, the rate of physical capital accumulation, and improved efficiency of physical capital. In another study, King and Levine [1993a] found that financial development also promotes technological innovations and productivity growth. The assumption that all countries have the same economic structure implied in the cross-section studies may be too strong. To account for different institutional environments and financial structures in different developmental stages, Jung [1986] performed Granger's [1969] causality tests using both time-series data for each of 56 countries in his sample and cross-section data based on the level of economic development. In both instances, Jung found positive effects.3 In a recent time-series study, however, Thornton [1996] performed Granger's [1969] causality tests for 22 developing countries and found no clear evidence of positive effects of financial development on economic growth. In this article, I use a multivariate vectorautoregression (VAR) framework to identify the effects of permanent financial development on domestic investment and output for a group of 41 countries. I include proxies for financial development, real GDP, and real domestic investment, the three variables that are widely used in earlier empirical studies. The multivariate VAR approach in this article is consistent with the previous literature's focus on causality as it incorporates the possible existence of short-term links between financial development and other domestic variables. In addition, it has the following advantages. First, it allows for different economic and institutional arrangements in each country. Second, it can deal with the simultaneity problem between financial development and other domestic variables, thus avoiding the difficult task of determining which variables are truly exogenous, as noted in Sims's [1980] influential work. Third, it permits us to identify not only the short-term effects but also the long- term cumulative effects of financial development on other domestic variables by allowing for interactions among these variables, including both the contemporaneous correlation and the dynamic feedback. It is essential to confront the simultaneity problem and to account for dynamic interactions among financial development and other domestic variables. Since the previous literature has largely ignored the dynamic interactions between financial development and other domestic variables, the incorporation of such dynamic interactions is an important element of this article. Clearly, while financial development can affect domestic investment and GDP, the latter variables can affect financial development as well. Such dynamic interactions between financial development and the domestic variables require that the equilibrium values of all variables be determined simultaneously. In addition, the effects of financial development on GDP and domestic investment can be enhanced or dampened over time by the feedback effects from the other variables. Therefore, a model testing the dynamic relationship between financial development and other domestic variables must properly deal with these two important issues. The multivariate VAR approach is well-suited for this purpose.4 The results found in this article clearly reject the second hypothesis that financial development simply follows economic growth and has very little effect on it. Instead, there is strong evidence that financial development is important to economic growth both in the short term and in the long term and that investment is an important channel through which financial development affects GDP growth. Although 14 of the 41 countries display negative long-term cumulative effects of permanent financial development on the growth of GDP and domestic investment, the remaining 27 countries show positive long-term cumulative effects. Interestingly enough, the countries showing negative long-term cumulative effects of permanent financial development on GDP growth are concentrated in Africa geographically and in the low- and lower-middle income group economically. Specifically, nine of the 14 countries with negative long-term effects are low- and lower-middle income African countries (Benin, Congo, Ghana, Mauritania, Morocco, Niger, Nigeria, Senegal, and Togo), three are small island countries (Costa Rica, Fiji, and Trinidad and Tobago), and the remaining two are highly government-regulated economies (India and Saudi Arabia). The results also show that for a group of countries the long-term cumulative effects of financial development on the growth of GDP and domestic investment are completely different from the short-term contemporaneous effects. Many countries are able to turn their short-term negative effects to positive ones in the long-term. The rest of the article is organized as follows. Section II outlines the variables used in this study, the sample, and the data sources. The multivariate VAR framework and its specification for each country are addressed in Section III. Section IV discusses the findings of the article based on the results of the impulse-response analysis. Section V provides a summary and concluding remarks. II. THE SAMPLE AND DATA To analyze the dynamic effects of permanent financial development on the growth of real domestic investment and real GDP, I selected 41 developing countries.5 These 41 countries have a broad representation. Geographically, they include seven Asian and Pacific countries, one Middle-Eastern country, three Caribbean countries, 15 African countries, 11 Latin American countries, and four European countries. Economically, they include 16 low income countries, 14 lowermiddle income countries, and 11 upper-middle income countries.6 The sample period is 1960-93 for most countries but slightly shorter for some. Annual data are used in order to include as many countries as possible. In this multivariate VAR framework, I include three commonly used variables-real GDP, real domestic investment, and an index of financial development.7 They were derived from the annual data collected from the World Bank's World Data CD-ROM [1995]. Nominal GDP, "GDP at market prices (cur. local)," nominal gross domestic investment, "Gross domestic investment (cur. local)," and GDP deflator, "GDP deflator (1987 = 100, index)," were taken from World Data to derive real GDP and real domestic investment, respectively. Although the derivation of the GDP and investment variables is straightforward, the derivation of the index of financial development requires some explanation. Several indicators have been used in the literature to measure the level of financial development; each focuses on one aspect.8 Among them, the size of the formal financial sector relative to economic activity is the most widely used (Goldsmith [1969]; McKinnon [1973); King and Levine [1993a, 1993b], Thornton [1996]). Underlying this common practice is the belief that the provision of financial services is positively related to the size of the financial intermediary sector. As the size of the financial intermediary sector grows, so does the provision of financial services. Hence, the level of monetization in an economy is a pertinent proxy for measuring the level of financial development. Following this traditional practice, I use the ratio of liquid liabilities of the formal financial intermediary sector to GDP as a proxy for the level of financial development. Liquid liabilities of the financial intermediary sector are measured by the sum of money and quasi-money (M2) less currency, that is, total bank deposits. Currency is excluded from the measure, because it is not intermediated through the banking system. "Money supply (broadly defined) (cur. local)" and "Currency outside banks (cur, local)" were taken from World Data as M2 and currency, respectively. The difference of the two (M2 minus currency) was then used to measure liquid liabilities of the financial intermediary sector. Since M2 and currency are stock variables (measured at the end of the year) and GDP is a flow variable (measured over the year), adjustment must be made to mitigate the problem of deflating stock variables by a flow variable. Following King and Levine [1993b, 720], I construct the index of financial development, that is, total bank deposits in GDP, using the geometric mean of this year's bank deposits and last year's bank deposits divided by GDP. Table I shows the profile of the index of financial development for each country in alphabetical order, along with the sample period. The values under the last column, A, show the ratios of average financial development between 1987 and 1993 to average financial development between 1961 and 1967. The use of a seven-year average is to eliminate the random effect that could influence M2, currency, and GDP in a particular year. Since the inverse of this index of financial development is a measure of the income velocity of bank deposits, the values reported in Table I provide information on the behavior of this velocity in the last three decades for each economy.9 Although the mean values allow for cross-country comparison of the average income velocity of bank deposits for the period of 1960-93, the values under column A illustrate the trend of this velocity in each economy. Based on the values under column A, the 41 countries can be divided into three groups: five economies (Peru, Ghana, Central Africa, Argentina, and Mexico) show a rising trend of the velocity in the last three decades, one economy (Malta) displays unchanged trend, and the remaining 35 economies show a declining trend of the velocity. III. THE METHODOLOGY VAR Specifications As noted earlier, the multivariate VAR approach is well suited for the purpose of this study. Yet two questions must be answered before we can proceed. The first question is whether we should difference the time series of real GDP, real domestic investment, and the index of financial development in this multivariate VAR framework. There are two considerations, one econometric and the other theoretical, for this question. First, appropriate differencing is important in time-series analysis because most algorithms used for fitting autoregressive integrated moving average (ARIMA) models will fail if the time series are nonstationary. In a VAR model, however, the asymptotic distribution that characterizes the estimates will be the same whether the model is estimated in levels or in differences (Park and Phillips [1988, 1989]; Sims, Stock, and Watson [1990]). In fact, Fuller [1976] shows in his Theorem 8.5.1 that differencing does not gain asymptotic efficiency in an autoregression, even if it is appropriate. But for small samples, the distributions of the estimates may be improved by estimating the VAR model in differences (Hamilton [1994, 553 and 652]). Second, innovations in financial development generally appear as periodic episodes. But what is important and interesting to policy makers and researchers are those policies with long-lasting or permanent effects on financial development. Innovations in the growth rates can capture such permanent changes in the level of financial development. First-differencing translates the log of levels into growth rates and thus allows us to examine the effects of permanent changes in the level of financial development on other domestic variables. Therefore, I use the first-difference of the log of levels for each series in the estimation, and I denote RGDP as the growth rate of real GDP, INV as the growth rate of real domestic investment, and FD as the change in the index of financial development. The second question concerns the specification of the VAR model for each country. We must decide in this VAR framework what deterministic components should be included and what appropriate orders of lag should be used. Since arbitrarily chosen specifications for a VAR model will most likely produce unreliable results, a databased model selection criterion is used to specify the VAR model for each economy in the sample. Among the various model selection criteria, the one proposed by Schwarz [1978], known as Schwarz's Bayesian Information Criterion (BIC), is shown to outperform other alternatives (Mills and Prasad [1992]). Therefore, the specifications of the VAR model for each economy are based on Schwarz's BIC. The BIC selected the specification of the first-order VAR model, that is, VAR(1), with a constant but no trend for Argentina, Benin, Bolivia, Chile, Congo, Costa Rica, Ghana, Guatemala, Myanmar, Niger, Nigeria, Pakistan, El Salvador, and Turkey, with a constant and a trend for Central Africa, Egypt, Fiji, Greece, Haiti, India, Jamaica, Morocco, Madagascar, Mexico, Peru, Philippines, Saudi Arabia, Senegal, Togo, Trinidad and Tobago, and Venezuela, and with no constant and trend for Honduras and Sudan. It chose a VAR(2) model with a constant but no trend for Paraguay, with a constant and a trend for Burkina Faso, Korea, Mauritania, and Mauritius, and without a constant and a trend for Thailand, and a VAR(3) model with a constant but no trend for Portugal and with a constant and a trend for Malta. Impulse-Response Analysis The inference of the effects of Fl) on INV and RGDP is based on the results of the impulse- response analysis, using the VAR specifications reported above. The focus of the analysis is the long-term and the short-term elasticities of RGDP and INV with respect to FD. The impulse-response function shows the effects on RGDP and INV of an exogenous once-and- for-all innovation in FD in the initial period and no innovations to any variables in the future. Since FD is allowed to be correlated with RGDP and INV within a period, there will be a contemporaneous effect. The short-term elasticity measures this contemporaneous effect of a one standard deviation FD shock today on current RGDP and INV. Since it does not include any feedback from the affected variables, the shortterm elasticity is static in nature. But there are dynamic effects as well. Since the FD innovation will affect all of the variables in the system both contemporaneously and with lags, every variable will change after the first period. In the second period, the autocorrelation of RGDP will affect RGDP; the lagged relationship between FD and RGDP will matter; and INV, which had been affected by the FD innovation, will also affect RGDP. The same is true for INV. Because of the dynamic interactions among the variables, the short-term effects of FD on RGDP and INV can be enhanced or dampened over a longer horizon. The effects of the dynamic responses will die out over time but not immediately; they are persistent. By summing up the effects in each period over a longer horizon, we get the long-term cumulative effects of an FD innovation on RGDP and INV. In estimations, the maximum periods for the impulseresponse analysis were set at 20 because in most cases the values of the impulseresponse function converge in fewer than ten periods and, in all the cases, the values converge within 20. Therefore, the long-term elasticity measures the cumulative effects of a one standard deviation FD shock today on RGDP and INV over 20 periods. It is normalized by dividing the cumulative impulse responses of RGDP and INV by the cumulative impulse responses of FD over 20 periods. It is well known that the results of impulse-response analysis depend on the specific ordering of the variables under investigation. Since the estimated matrix of variance and covariance is not diagonal, orthogonalization is necessary before a meaningful impulse-response analysis can be conducted. The orthogonalization strategy, however, is not unique. I confine the discussion of orthogonalization strategy to the use of triangular matrices under the Choleski decomposition method. This method uses all the information in the matrix of contemporaneous correlation among the estimated residuals. In this study, there are three possible scenarios depending on whether FD is ranked first, second, or third. These three scenarios completely determine the range of results in the impulse-response analysis. Among the three possible scenarios, two seem to be the most plausible a priori. Based on the first and third views discussed in the introduction, FD should be ranked first. In this case, shocks from FD affect RGDP and INV contemporaneously, but shocks from RGDP and INV have no immediate effects on FD. Based on the second view, however, FD should be ranked last, in which case the opposite is true. Between these two cases, the first one is chosen as the central case. The short-term and the long-term elasticities of FD on RGDP and on INV for the central case are reported in Table II. To establish the robustness of the central case, however, I also computed the values of the impulse-response function under all of the alternative orthogonalizations. There are a total of six possible orthogonalizations for each economy. Since the results of the impulse-response analysis are the same under several orthogonalizations, I need to report the values of the impulse- response function for only four different cases. The range of results across all possible orthogonalizations for the long-term elasticities is reported in Table III. IV. THE EFFECTS OF FINANCIAL DEVELOPMENT ON GDP GROWTH AND INVESTMENT In this section, I present the empirical results of the effects of FD on RGDP and on INV, based on the impulse-response analysis. The estimation of the VAR model for each country in the sample is performed using RATS (version 4.2). Financial Development and Long-term GDP Growth In Table II, while 14 of the 41 countries in the sample exhibit negative long-term cumulative effects of FD on RGDP, the remaining 27 countries show positive long-term cumulative elasticities. The range for all elasticities is between - 0.467 (Congo) and 0.543 (El Salvador). The estimated long-term elasticity for 31 countries ties within 0.20 in absolute value. Only four of the 41 countries display elasticities lower than - 0.20, and six countries show elasticities higher than 0.20. Of the 31 countries, the estimated long-term elasticity is less than 0.10 in absolute value for 21 countries, and less than 0.01 in absolute value for four countries (Costa Rica, Korea, Pakistan, and Paraguay). Hence, the long-term cumulative effects of FD on RGDP are concentrated in a relatively narrow range across countries. The results show some interesting patterns about the long-term cumulative effects of FD on RGDP. Based on geographic locations, the 14 countries that show negative long-term elasticities include two Asian and Pacific countries (India and Fiji), one Caribbean country (Trinidad and Tobago), one Latin American country (Costa Rica), one Middle-Eastern country (Saudi Arabia), and nine African countries (Benin, Congo, Ghana, Mauritania, Morocco, Niger, Nigeria, Senegal, and Togo). In other words, about two-thirds of the countries showing negative long- term effects of FD on RGDP are concentrated in Africa, which also accounts for 60% of the African countries in the sample. Based on economic structure and environment, Costa Rica, Fiji, and Trinidad and Tobago are island economies with small domestic markets. The economic structure and environment in such economies can largely be determined by their geographic locations. The remaining 11 countries with negative long-term elasticity, however, were all highly government-regulated economies in the sample period. For the nine African countries, most adopted interventionist government policies after their independence. While successful in some cases, the overall outcome has proved to be a failure. A number of these countries started their economic reforms supported by the World Bank and the International Monetary Fund (IMF) in the late 1980s or the early 1990s. For example, after nearly two decades of state-led development, Benin finally started an economic reform program aimed at changing its socialist-inspired state interventionism in 1989. In the early 1990s, Congo started its economic reform to improve public sector efficiency. Ghana has also undertaken wide-ranging financial reforms, including the abolishment of interest rate controls and sectional credit ceilings. India and Saudi Arabia had a similar economic environment as the African countries for the sample period. But unlike the African countries, there has been little government effort in improving the economic structure and environment in India and Saudi Arabia. According to the World Bank, India still has fundamental structural problems.10 For instance, state-owned banks in India continue to dominate the banking system and serve mainly as instruments for financing economic activities selected by the government. In addition, India's pervasive investment licensing regime made private investment decisions conditional on cumbersome government approvals and thus discouraged domestic investment. Based on the level of economic development, seven of the 14 counties with negative long-term elasticities are low-income countries (Benin, Ghana, India, Mauritania, Niger, Nigeria, and Togo), five are lowermiddle income countries (Congo, Costa Rica, Fiji, Morocco, and Senegal), and only two are upper-middle income countries (Saudi Arabia, and Trinidad and Tobago). Therefore, more than 85% of the countries showing negative long-term elasticities of RGDP with respect to FD belong to the group of tow- and lower-middle income countries. Alternatively, the countries with negative longterm elasticities account for 44% of the lowincome countries, for 36% of the lowermiddle income countries, and for 18% of the upper-middle income countries in the sample.11 From the perspective of the conventional wisdom on financial development and economic growth, the above results are informative and interesting. In the literature, it is argued that the effects of financial development on economic growth are related to the stage of economic development of a country (Patrick [1966]; Jung [1986]). Financial development can induce real innovation-type investment and economic growth primarily at the early stage of economic development, and the effect of financial development on economic growth diminishes as sustained economic growth gets under way (Patrick [1966, 177]). The results in this article, however, provide no support for this hypothesis. Instead, they clearly show the contrary-the number of countries showing negative long-term cumulative effects of FD on RGDP decreases as the level of economic development advances. This suggests that there is a positive correlation between the level of economic development and the beneficial effects of financial development on economic growth. Countries at the early stages of economic development typically face more structural constraints than do their counterparts. Although financial openness improves domestic financial systems and mobilizes financial resources, these additional constraints become critical because they can prevent the mobilized financial resources from being allocated efficiently to investors and firms. Such constraints will be less binding as these countries become economically more advanced. Therefore, as suggested by the third hypothesis, along with financial openness, countries at the early stages of economic development must pay close attention to the reform of their economic environment. It should also be noted that even for the countries at the same level of economic development, the effects of financial development on GDP growth can be different from country to country. Again, such differences are likely to result from differences in institutional, environmental, and financial structures. Although economic development can make economic institutions more uniform over time, one is likely to find such crosscountry differences continuing because of cultural and other social factors. Nevertheless, given the strong evidence that financial development has long-term effects on GDP growth, government policies toward financial development have an important impact on long-term economic growth and thus need to be carefully designed. Financial Development and the Growth of Domestic Investment The long-term effects of FD on INV are quite similar to those on RGDP. In Table 11, although 14 of the 41 countries display negative long-term cumulative effects of FD on INV, the remaining 27 countries show positive long-term elasticities. The range of all long-term elasticities for INV, however, is wider than that for RGDP. It is between -1.474 (Congo) and 1.612 (El Salvador). The values of the elasticities are greater than 1.00 in absolute value for ten countries, but less than 0.10 in absolute value for five countries. For the remaining 26 countries, the values of the elasticities fell in a narrower range between 0.10 and 0.37 in absolute value except Greece, Haiti, Honduras, Jamaica, and Togo, for which the values of the elasticities are between 0.540 (Togo) and 0.867 (Jamaica). Eight of the ten countries with an elasticity greater than 1.00 in absolute value show positive elasticities. Of the remaining 19 countries with positive long-term elasticities, the values of the elasticities are between 0.50 and 0.99 for five countries, between 0.25 and 0.50 for four countries, between 0.10 and 0.25 for seven countries, and less than 0.10 for three countries. For the 14 countries with negative long-term elasticities, the values of the elasticities are lower than - 1.00 for two countries, between -0.40 and -0.25 for four countries, between -0.25 and -0.10 for six countries, and greater than -0.10 for two countries. Twenty-one of the 27 countries displaying positive long-term effects of FD on RGDP also show positive long-term effects of FD on INV. On the other hand, eight of the 14 countries with negative long-term effects of FD on RGDP also show negative long-term effects on INV. This indicates that domestic investment is indeed an important channel through which financial development affects output. Yet for the remaining 12 countries, the long-term cumulative effects of FD on INV are different from those on GDP. For five countries (Chile, Korea, Pakistan, Portugal, and Thailand), the long-term effects of FD are negative on INV but positive on RGDP. For another seven countries (Mauritania, Morocco, Niger, Nigeria, Saudi Arabia, Togo, and Trinidad and Tobago), the opposite is true. This implies that in addition to domestic investment there exist other channels through which financial development can affect GDP, a result that is consistent with the argument by King and Levine [1993a]. Long-Term versus Short-Term Effects The short-term elasticities are also reported in Table II next to the long-term elasticities for comparison. The short-term elasticities show that shocks in FD have positive contemporaneous effects on RGDP for 12 countries. The values of the short-term elasticities for these 12 countries range from 0.018 (Honduras and Jamaica) to 0.232 (Portugal). On the other hand, the values of the short-term elasticities for the 29 countries with negative contemporaneous effects of FD on RGDP range from -0.471 (Malta) to -0.014 (Guatemala). Bolivia is the only country showing a near zero short-term negative effect of FD on RGDP. Further, the negative short-term effects in these countries are all diminished in the long-term, except for Congo, Ghana, India, Nigeria, Togo, and Trinidad and Tobago. Yet Ghana, India, Togo, and Trinidad and Tobago all experienced a small increase in negative effects in the long-term. For many countries, the negative contemporaneous effects of FD on RGDP in the short-term become the positive cumulative effects in the long-term. The short-term elasticities also show that shocks in FD have positive contemporaneous effects on INV for 21 countries with a range from 0.038 (Bolivia) to 1.306 (Venezuela). The range for the remaining 20 countries with negative short-term elasticities of FD on INV is between -0.788 (Greece) and -0.013 (Congo). Myanmar is the only country in this case to display a near zero shortterm elasticity. While the negative short-term effects are reinforced in the long-term for five countries (Chile, Congo, Costa Rica, Ghana, and Malta), 15 of the remaining 20 countries with negative short-term elasticities of FD on INV show reduced negative effects in the long-term. An interesting aspect of the results is that many economies are able to turn the negative short- term effects to the positive longterm effects. For 16 countries, the effect of FD on RGDP is negative in the short-term but positive in the long-term. Costa Rica is the only exception for which the opposite is true. As for the effects of financial development on domestic investment, although the effect of FD on INV is positive in the shortterm but negative in the long-term for three countries, nine countries are able to turn the short-term negative effects into the long-term positive effects. These results suggest that financial policies play an important role in economic growth and that governments must craft these policies with care. Sensitivity Analysis The above discussion is based on the orthogonalization strategy that seems the most plausible and meaningful based on a priori theoretical grounds. Yet as shown by Levine and Renelt [1992], since many factors are associated with economic growth, the empirical results on the relationship between one factor and economic growth is not always robust. Therefore, it is necessary to examine the robustness of the results reported in the previous sections, and a sensitivity analysis was performed by considering all possible triangular orthogonalizations using the Choleski decomposition. Table III shows the lower and upper bounds for the long-term elasticities of RGDP and INV with respect to FD under all possible orthogonalizations, as well as the number of positive outcomes out of four possibilities. The values of all RGDP elasticities are from -0.467 (Congo) to 0.725 (Thailand), which is only slightly wider than that in the central case already considered in the previous section. In 28 countries, the values in the central case coincide or are very close to the upper or lower bounds of the possible values. This suggests that the actual distribution of results across countries may be even narrower than the range identified in the central case. Of the 41 countries in the sample, 32 show absolute robustness and another four show strong robustness in terms of the qualitative nature of the results. In other words, the sign of the long- term elasticities of RGDP with respect to FD in the central case is maintained across all of the orthogonalization outcomes (four in four) for 32 countries and across most of the orthogonalization outcomes (three in four) for four countries. The 32 countries include 24 of the 27 countries that display positive long-term elasticities in the central case and eight of the 14 countries that display negative long-term elasticities in the central case. Of the four countries that show strong robustness, Guatemala and Mexico show positive longterm elasticities in the central case, whereas Benin and Costa Rica show negative longterm elasticities in the central case. For another four countries (Fiji, Niger, Mauritania, and Portugal), the sign of the long-term elasticities in the central case is maintained across half of the orthogonalization outcomes (two in four). Morocco is the only country for which the sign of its negative long-term elasticity can be maintained only in the central case. The range of results for the long-term cumulative effects of FD on INV is rather wide, from - 1.853 (Congo) to 2.739 (Mauritius). Yet with the exception of Congo, Mauritania, Mauritius, and Niger, the values of the long-term elasticities of INV with respect to FD fall in the range of the central case. There are 12 countries with upperbound elasticities greater than 1.00 and two countries with lower-bound elasticities lower than -1.00. The values in the central case coincide or are very close to the upper or lower bounds of the possible values for 24 countries. For the long-term cumulative effects of FD on INV, 27 of the 41 countries show absolute robustness; the sign of the long-term elasticities of INV in the central case is maintained across all of the orthogonalization outcomes (four in four). These 27 countries include 20 of the 27 countries that display positive long-term elasticities in the central case and seven of the 14 countries that display negative long-term elasticity in the central case. Another four countries show strong robustness across all of the orthogonalization outcomes (three in four). They include two countries (Burkina Faso and the Central African Republic) that displays positive long-term elasticity in the central case and two countries (Malta and Nigeria) that display negative long- term elasticities in the central case. For the remaining ten countries, the sign of the long-term elasticities in the central case is maintained across half of the orthogonalization outcomes (two in four) for six countries (Benin, Guatemala, Mexico, Saudi Arabia, Togo, and Trinidad and Tobago), and Fiji, Korea, Senegal, and Thailand are the countries for which the sign of their long-term negative elasticities can only be maintained in the central case. To summarize, the sensitivity analysis indicates that the central results on the longterm effects of FD on RGDP and on INV are robust for 36 and 31 of the 41 countries in the sample, respectively. Therefore, about 90% and 80% of the countries in the sample show, respectively, that the long-term elasticities of RGDP and INV obtained under the central case are the most plausible results. V. SUMMARY AND CONCLUDING REMARKS I use a multivariate VAR approach to investigate the effects of financial development as measured by total bank deposits in GDP on the growth of domestic investment and GDP for a sample of 41 countries. This methodology allows for different economic and institutional arrangement in each country and thus avoids the strong assumption that all countries have similar economic structures in the cross-section studies. It also deals with the simultaneity problem among financial development, domestic investment, and output. More important, it permits the identification of the long-term cumulative effects of permanent financial development on the growth of domestic investment and GDP by taking into account the dynamic feedback among financial development, domestic investment, and GDP as well as the short-term contemporaneous effects. The results of this study clearly reject the hypothesis that financial development simply follows economic growth and has very little effect on it. Instead, there is strong evidence that financial development is important to GDP growth and that domestic investment is an important channel through which financial development affects economic growth. In 41 countries, positive long- term effects of permanent financial development on the growth of domestic investment and GDP are detected for 27 countries in each case. Many countries are able to turn the short-term negative effects to long-term positive effects. Most important of all, these results are robust. Therefore, they provide time-series empirical evidence from a broad spectrum of countries that financial development is important to economic growth. Footnote 1. For an overview of the recent literature, see Pagano [1993]. 2. Price distortion is an inevitable outcome of a repressed financial system. Using a Harris- Todaro model, Feldman and Gang [1990] show that financial repression can cause lower price levels through ruralurban migrations. In a recent study, Xu and Feldman (1999] used cointegration tests to explain why real price levels are systematically lower in developing countries than in developed countries. They found an evidence of a long-run equilibrium relationship between financial development and international real price differences for most developing countries. As a developing country becomes financially more developed, its real price levels get closer to world real price levels. Footnote 3. There is no discussion in Jung's [1986] article on how the author dealt with two very important issues in causality tests: the unit root property of the data and the optimal lags in Granger's causality tests. Using Japan and Taiwan as a case study for the export-led growth hypothesis, Xu [1998] shows that causality inferences can be misleading when these two issues are not handled properly. Footnote 4. An alternative method can be the dynamic panel model proposed by Arellano and Bond [1991]. Yet this model is difficult to estimate. Complications in estimating the dynamic panel model arise from the fact that the lagged dependent variable in such a model is correlated with the disturbance, even if the disturbance is not itself autocorrelated (Green [1997]). Footnote 5. Based on the availability of data, 59 countries were originally chosen. Of the 59 countries, 18 are high-income Organization for Economic Cooperation and Development (OECD) countries. As shown by Levine [1991] and Bencivenga, Smith and Starr [1995], equity markets, along with the formal banking system, play an important role in economic growth for developed countries, where ownership of firms is continuously traded but the production process remains undisturbed. It suggests that the index of financial development used in this article may be inappropriate for developed countries because the time series of the index can show an inverse U-shaped pattern (Bordo and Jonung [1987]). While the upward portion of the index is consistent with the measure of financial development, the downward portion is not. Hence, the 18 OECD countries were dropped from the sample. Footnote 6. The classification for geographical location and incomes is based on the World Bank's World Data [1995]. 7. The use of real domestic investment allows us to examine the effects of financial development on the growth of domestic investment. An alternative to real domestic investment is the share of domestic investment in GDP. The results of the article, however, are not affected by the choice of these alternative measures. 8. For a discussion of these financial indicators, see King and Levine [1992]. Footnote 9. Because this index of financial development is a measure of the income velocity of bank deposits, both financial development and money demand can affect it. To ensure that the changes in the velocity reported in Table I do not result from changes in money demand because of the interest effect, I have tried an alternative definition for the index. In particular, I remove the effects of money demand on the income velocity of bank deposits by performing the following Ordinary Least Squares (OLS) regression for each country, IFD^ sub 1^ = alpha + Beta^ sub 1^T^ sub 1^ + Beta^ sub 2^(pi^ sub t^) + e^ sub t^ where IFD^ sub t^ is the index of financial development, T^ sub t^ is the time trend, pi^ sub t^, is the rate of inflation measured by the GDP deflator, alpha, Beta^ sub 1^, and Beta^ sub2^ are parameters, and e^ sub t^ is the error term. The conclusion of the article, however, is not much affected by the choice of this alternative index of financial development. Footnote 10. See TIDE Country Reports from the World Bank's World Data CD-ROM [1995] for a discussion of the economic condition for India and other countries. Footnote 11. To examine how these results fit in the previous literature, 1 used the pooled data to perform the OLS regression with RGDP as the dependent variable and INV and FD as the independent variables. 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"The Economics of Development: A Survey." Economic Journal, 100, 1989, 597-685. Thornton, John. "Financial Deepening and Economic Growth in Developing Economies," Applied Economics Letters, 3, 1996, 243-46. Van Wijnbergen, Sweden "Credit Policy, Inflation and Growth in a Financially Repressed Economy." Journal of Development Economics, 13, 1983, 45-65. World Bank. World Data. Washington, D.C.: World Bank, 1995. Xu, Zhenhui. "Export and Income Growth in Japan and Taiwan." Review of International Economics, 6, 1998, 220-33. Xu, Zhenhui, and David. H. Feldman. "Financial Development and Real Price Level Differences." Review of Development Economics, 3, 1999, 27-43. AuthorAffiliation ZHENHUI XU* AuthorAffiliation * I thank John Boschen, Robert King, Carl Moody, Alfredo Pereira, Roger Sherman, Charles Weise, John Whitaker, two anonymous referees, and the coeditor, Dennis Jansen, for helpful comments and suggestions. All remaining errors are entirely my responsibility. Xu: Associate Professor, Georgia College and State University, Milledgeville, Ga., Phone 1-912- 445-2592, Fax 1-912-445-5249, E-mail zxu@mail.gcsu.edu Copyright Western Economic Association Apr 2000