Finance, institutions and economic development

Abstract

Using data from 72 countries for the period 1978-2000, we find that financial development has larger effects on GDP per capita when the financial system is embedded within a sound institutional framework. Moreover, we find that financial development is most potent in middle-income countries, where its effects are particularly large when institutional quality is high. Importantly, we also find that in low-income countries the influence of financial development is at its weakest; in these countries, more finance without sound institutions may not succeed in delivering long-run economic benefits. Copyright © 2006 John Wiley & Sons, Ltd.

Is the Relationship Between Financial Development and Economic Growth Monotonic? Evidence from a Sample of Middle-Income Countries

“…All three estimators consider the long-run equilibrium and the heterogeneity of the dynamic adjustment process (Demetriades and Law, 2006) and are computed by maximum likelihood. Pesaran and Smith (1995), Pesaran (1997) and present the autoregressive distributed lag (ARDL) model in error correction form as a relatively new cointegration test.…”

“…When the time dimension is not long enough to overextend the lags, one can impose a common lag structure across countries (see, Loayza and Ranciere, 2006;Demetriades and Law, 2006). countries (LMIC).…”

Sources and Effectiveness of Financial Development: What We Know and What We Need to Know

“…In their recent empirical analysis of the effectiveness of financial development across different groups of countries, Demetriades and Law (2004) estimate the following growth equation using panel cointegration techniques (see Pesaran et al 1999):…”

“…The data set on institutional quality indicators they employ was assembled by the IRIS Center of the University of Maryland from the ICRG, discussed earlier. Following Knack and Keefer (1995), Demetriades and Law (2004) use the following five indicators to measure the overall institutional environment: (i) corruption which reflects the likelihood that officials will demand illegal payment or use their position or power to their own advantage; (ii) rule of law which reveals the degree to which citizens are willing to accept established institutions to make and implement laws and to adjudicate dispute; it can also be interpreted as a measure of 'rule obedience' (Clague 1993) or government credibility; (iii) bureaucratic quality which represents autonomy from political pressure, strength and expertise to govern without drastic changes in policy or interruptions in government services, as well as the existence of an established mechanism for recruitment and training of bureaucrats; (iv) government repudiation of contracts which describes the risk of a modification in a contract due to change in government priorities, and (v) risk of expropriation which reflects the risk that the rules of the game may be abruptly changed. The above first three variables are scaled from 0 to 6, whereas the last two variables are scaled from 0 to 10.…”

“…2 Thus, if international policy makers are looking for easy solutions that work in all countries and at all times ('one-size fits all' type answers), they are likely to be disappointed. An important, albeit disturbing, example of this is recent findings by Rioja and Valev (2004) and Demetriades and Law (2004) which suggest that the relationship between finance and growth is very weak in low-income countries. Thus, financial development may well be ineffective in promoting growth and, because of this, may be ineffective in alleviating poverty in those countries where poverty is particularly concentrated or acute.…”