FINANCIAL SECTOR DEVELOPMENT AND ECONOMIC GROWTH NEXUS: An Empirical Analysis of Pacific Melanesian Countries

Author: Solomon Awili

Awili, Solomon, 2015 FINANCIAL SECTOR DEVELOPMENT AND ECONOMIC GROWTH NEXUS: An Empirical Analysis of Pacific Melanesian Countries, Flinders University, Flinders Business School

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The main objective of this thesis was to examine the relationship between financial development (FD) (measured by financial indicators) and economic growth (proxied by real per capita GDP) for Melanesian Spearhead Group (MSG) countries in the Pacific namely, Papua New Guinea (PNG), Fiji, Solomon Islands and Vanuatu. The empirical analysis uses annual time series data for the period 1976 to 2010. The random effects (REs) with general-to-specific (GS) sequential modelling procedure for panel data and the vector error correction model (VECM) for time series data with accompanying econometric tests of unit root and cointegration were employed. This study was motivated by the lack of information on the topic in MSG countries and the MSG countries’ recent attempts towards increased trade and integration among themselves and in the region. The use of four commonly used financial indicators to determine whether FD induced growth, or vice versa, plus the concurrent use of panel and time series models are unique to this study.

To test the validities of the hypotheses framed in Chapter 1, this study draws upon the endogenous growth theory (EGT) and financial intermediary theories. In the absence of a standard conceptual model, a model for the link between FD and growth has been developed for this thesis. Though it is claimed that studies on the finance-growth nexus are important to guide economic policy formulation there is no evidence to support or refute this when applied to MSG countries. This study has three main aims: (1) to investigate the extent of the contributions of the financial system to growth, or vice versa; (2) to determine factors that cause changes in the financial sector and the real economy; and (3) to develop knowledge that can support evidence-based policy formulation, institutional reforms and resource prioritisation, as the more efficient an economy is in allocating resources the greater its contribution to productivity and growth. This study, like previous studies, does not attempt to resolve the issue of determinants of FD and economic growth. Nonetheless, the dissertation does attempt to shed light on whether financial sector development influence growth, or vice versa, in MSG economies.

There are several substantial reasons for conducting this study: (1) to use new country-region specific data to fill the gap in research; (2) to extend the literature on FD and growth; (3) to contribute to knowledge about MSG economies; and (4) to generate evidence to guide policy formulation and resource allocation.

Empirical results showed that FD had a significantly positive effect on growth. This main evidence suggests that a positive finance-growth relationship is present in MSG economies. For PNG the Granger-causality test results revealed the presence of uni-directional causality with causality running from FD to growth. This implies that developments during the reviewed period positively influenced financial sector performance in the MSG countries. This in turn provided strong stimulus for the growth process in the countries studied. There is also evidence to conclude that growth in the prior period had a significant impact on current growth rates of the MSG economies. Additionally, as other variables such as trade, gross capital investment and inflation also had a significant effect on growth, it seems that a well-functioning financial system is a necessary, but not a sufficient condition to reach steady growth in the MSG countries. However, the finance-leading growth hypothesis was supported by the data. This main finding is consistent with the dominant assumption in the finance-growth nexus literature that FD induces growth.

Finally, as the finding of a positively significant association between FD and growth suggests that FD is one of the policy variables that determine growth in the MSG countries, policy makers, regulators, governments and development partners need to undertake essential measures to deepen the financial sector to strengthen economic growth in the long-term. Several primary and secondary measures related to financial sector deepening in terms of: how to grow the banking and non-bank sectors; improving financial infrastructure; improving the informal sector; adoption of technology; financial integration; and financial education to support the growth of the financial sectors are identified and proposed. This would in turn induce positive growth leading to improvements in key socio-economic indicators such as reduction in income inequality.

The absence of empirically supported and theoretically sound policy advice that contributes to ineffective policy formulation, which in turn may have resulted in inefficient resource allocation and utilisation with adverse effects on overall economic progress, is now challenged. The implications for policy and theory, the study’s contributions, limitations encountered in this study, plus avenues for future research are identified and proposed.

Keywords: financial development, economic growth, finance-growth nexus, Pacific Melanesian countries, Granger-causality, panel model, vector error correction model

Subject: Business thesis

Thesis type: Doctor of Philosophy
Completed: 2015
School: Flinders Business School
Supervisor: Professor Sarath Delpachitra