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**Applied Economics Letters
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Financial development and economic growth: an ARDL approach for the case of the small island state of Mauritius

Boopen Seetanah a a University of Technology, Mauritius, Pointes aux Sables, Mauritius First Published:August2008

To cite this Article Seetanah, Boopen(2008)'Financial development and economic growth: an ARDL approach for the case of the small

**island state of Mauritius',Applied Economics Letters,15:10,809 — 813
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Pointes aux Sables. Dawson (2003). 15. Refer to King and Levine (1993) for a comprehensive theoretical overview. 2 1 Applied Economics Letters ISSN 1350–4851 print/ISSN 1466–4291 online ß 2008 Taylor & Francis http://www.com DOI: 10. Mauritius E-mail: b.mu Downloaded By: [University of Leeds] At: 15:35 22 September 2008 The article investigates the dynamic empirical link between financial development and economic performance for the case of the developing small island state of Mauritius using a unique time-series data set over the period 1952 to 2004. However until now most studies have been focused on developed countries cases and it is only lately that scholars have been implicitly dealing with the issue of causality and dynamics in the financial development and economic growth link (Levine et al. Neusser and Kugler (1998).2 see King and Levine (1993). The structure of this article is as follows: Section II describes the preferred modelling function used. The results suggest that financial development have been contributing to the output level of the economy in both short and long run.intnet. Demirgu ¸ -Kunt and ¨c Maksimovic (1998). Mauritius. Introduction The importance of the financial sector in the economic development has received much attention in the recent literature. It thus highlights the economic importance of financial development and provides new evidence for the case of island economies using recent cointegration approach. Jayaratne and Strahan (1996). I. for instance. Rajan and Zingales (1998).1 A strong consensus has emerged in the last decade that well-functioning financial intermediaries have a significant impact on economic growth.Applied Economics Letters. Levine and Zervos (1998). Studies using time-series analysis for developing country cases have been scarce and to our knowledge no studies have been performed for the case of developing small island states.informaworld. (2000). Ross and Levine (1997). 809–813 Financial development and economic growth: an ARDL approach for the case of the small island state of Mauritius Boopen Seetanah University of Technology. Wachtel (2003).1080/13504850600770889 809 ..seetanah@utm. Ram (1999) among others. The analysis was performed using two different proxies for financial development in an ARDL framework. There are however some empirical works which could not establish a significant link. The aim of the article is thus to investigate the empirical link between financial development and economic performance for the case of the developing small island state of Mauritius using a unique time-series data set over the period 1952 to 2004 and allowing for dynamics. It is hoped that the study will add new insights to and also to fill a gap in the literature. Levine et al. 2008. Empirical findings from developed countries’ cases are not directly applicable and relevant to island states given their special characteristics and vulnerability. Chowdhury (1997). 2000).

B. it excludes credits issued by the central bank. government agencies and public enterprises. Furthermore. The main sources of our independent variables are from the World Bank’s and the IMF’s ‘International Financial Statistics’ (IFS) except for the case of SER. Section III concludes and deals with policy implications. The econometric model and preliminary tests Recall models 1 and 2 aforementioned and taking logs on both sides of the equation and denoting the lowercase variables as the natural log of the respective uppercase variable. The dependent variable output was proxied by the real GDP per capita at constant price (Y) and was generated from the IFS. 2000). PRIGDP has been used extensively as an indicator because it improves on other measures of financial development (Levine et al. where the country’s Central Statistical Office’s biannual digest of Statistics has been consulted. Seetanah PRIGDP isolates credit issued to the private sector. The time period of the study is over the years 1952 to 2004..810 elaborates on the data collection and investigates the empirical link between financial development and economic growth for the case of Mauritius. as opposed to credit issued to governments. Higher levels of PRIGDP are interpreted as higher levels of financing services and therefore greater financial intermediary development. This proxy shall also be utilized to investigate and consolidate the financial development and economic growth. results in the following: y ¼ .

0 þ .

1 ivtgdp þ .

2 xmgdp þ .

3 ser þ .

PRIGDPÞ model 2 where IVTGDP is the country’s investment divided by its gross domestic product (GDP. (2001) technique can be implemented regardless of whether the variables are integrated of order (1) or (0) and can be applied to small finite samples. XMGDP. this is discussed below). it is important to investigate the univariate properties of all data series and to determine the degree to which they are integrated. the proxy for openness which is an I(0) variable. Liquid liabilities include currency plus demand deposits and interest-bearing liabilities of banks and nonbank financial intermediaries. This is a typical measure of ‘Financial Depth’ and has been widely used (McKinnon (1973) and King and Levine (1993)). For the specification 1 and 2 above. To measure financial development we use monetary aggregates. In addition. investment ratio). XMGDP is total of export and imports divided by the GDP of the country and is measure of openness and SER is the secondary enrolment ratio and proxies for the quality of human capital. SER. more specifically LIQGDP (refer to model 1) which is the ratio of liquid liabilities to the country’s GDP. SER. In fact the procedure allows for different long-run relationships and short-run dynamics and this is important for the estimation of the equilibrium conditions. Testing for cointegration using the ARDL In this part we test the existence of a long-term relationship (cointegration) in using testing and estimation procedure advanced in Pesaran and Shin (1999). . in specifying the economic model subsequently.4 liqgdp þ " ð 1Þ y ¼ 0 þ 1 ivtgdp þ 2 xmgdp þ 3 ser þ 4 prigdp þ " ð 2Þ Before considering the appropriate framework of the econometric model. the Pesaran et al. has been the value of credits by financial intermediaries to the private sector divided by GDP. Test for stationarity (refer to Tables 1 and 2) shows that all our variables are integrated of order 1 (I(1) and thus stationary in difference) except ivtgdp. see King and Levine (1993). The second widely used measure. LIQGDPÞ model 1 Downloaded By: [University of Leeds] At: 15:35 22 September 2008 y ¼ fðIVTGDP. XMGDP. Levine et al. (2000). (2001). This measure of financial development is more than a simple measure of financial sector size. y ¼ fðIVTGDP. the recently developed cointegration procedure by Pesaran et al. PRIGDP (refer to model 2). Levine and Zervos (1998). Both the augmented Dickey–Fuller (ADF) (1979) and Phillips–Perron (PP) (1988) unit-roots tests have been employed for that purpose and the results are summarized in Tables 1 and 2 given further. Wachtel (2001). Ross and Levine (1997). The economic model We follow the standard literature. the error correction versions of the ARDL model in the II. the autoregressive distributed lag model (ARDL) procedure will be applied. Methodology and Analysis Causality and dynamic issues and ARDL model To allow for causality and dynamics and given that not all of our time-series are stationary to the same order (some are I(0) while others are I(1).

508 À3.924 À2.51 À3. xmgdp.508 À3.936 À2.91 À1. Dickey–Fuller (with time trend.79 Critical value À3.936 À2.936 À2.924 À2.Financial development and economic growth Table 1.91 À0.74 À2.23 4.51 À3.59 À2.508 À3.51 À3. t) À8.57 À8.22 À1.51 À3.83 2.924 À2.51 À3.284 À2.924 À2.97 3. Dickey–Fuller (time trend.13 0.46 À3.22 Phillips– Perron 2.508 À3.56 Critical value À2.74 Critical value À2.45 Critical value À3.23 Phillips–Perron À8.03 À4.78 À5. t) À2.924 À2. Summary results of unit-root tests in first difference: D/F and Phillips–Perron test Variables (in log) Áy Áxmgdp Áser Áliqgdp Áprigdp Lag selection 0 0 0 0 0 Aug.65 À4.2 À4. invgdp.11 À1.18 À0. Dickey–Fuller À8.58 À2.936 À2.29 3.79 À0. Summary results of unit-root tests in level form: Dickey–Fuller and Phillips–Perron test Variables y ivtgdp xmgdp ser liqgdp prigdp Lag selection 1 1 1 1 1 1 Aug.77 À4.45 À5. Dickey–Fuller 1.508 Variable type I(0) I(0) I(0) I(0) I(0) Downloaded By: [University of Leeds] At: 15:35 22 September 2008 variables y. ser and liqgdp (model 1) and prigdp (model 2) are given respectively by Á y ¼ .56 À0.34 À3.936 Variable type I(0) I(0) I(0) I(0) I(0) Aug.98 À8.51 811 Variable type I(1) I(0) I(1) I(1) I(1) I(1) Table 2.924 Variable type I(1) I(0) I(1) I(1) I(1) I(1) Aug.75 À4.

3. 4 6¼ 0. 4 and 5. the hypothesis that is being tested is the null of ‘nonexistence of the long run relationship’ defined by Ho : 1 ¼ 2 ¼ 3 ¼ 4 ¼ 5 ¼ 0 And the alternative hypothesis is H1 : 1 6¼ 0.0 þ þ n X n X i¼1 b i Á y tÀ i þ n X i¼1 For model 1. 2 6¼ 0. 3 6¼ 0. 2. Computation of this F-statistic requires running the following regression Áyt ¼ . 5 6¼ 0 The recommended statistic is the F-statistics for the joint significance of 1.

(1996) have tabulated the appropriate critical values for different number of regressors and whether the regressors contain an intercept or a time trend.34 (This is also confirmed by the maximum eigen values and trace values of the Johansen test for cointegration) and exceeds the upper bound of the critical value band. liqgdp) turned out to be 6. we chose n ¼ 1 for the maximum order of lags in the ARDL model in both cases and carry out the estimation over the period of study. The F-Statistics F(y/ivtgdp. We thus reject si ÁliqgdptÀi þ 1 ytÀ1 þ 2 ivtgdptÀ1 þ 3 xmgdptÀ1 þ 4 sertÀ1 þ 5 liqgdptÀ1 þ "t ð4Þ Since we have annual observations. . ser. 1 ytÀ1 .0 þ bÁytÀ1 þ cÁivtgdptÀ1 þ dÁxmgdptÀ1 þ eÁsertÀ1 þ fÁliqgdptÀ1 þ "t ð 5Þ ci ÁivtgdptÀi ei ÁsertÀi di ÁxmgdptÀi þ n X i¼1 þ i¼1 n X i¼1 fi ÁliqgdptÀi þ 1 ytÀ1 þ 2 ivtgdptÀ1 þ 3 xmgdptÀ1 þ 4 sertÀ1 þ 5 liqgdptÀ1 þ "t ð3Þ Áy ¼ 0 þ þ þ n X i¼1 n X i¼1 n X i¼1 mi ÁytÀi þ n X pi ÁivtgdptÀi ri ÁsertÀi qi ÁxmgdptÀi þ i¼1 n X i¼1 and a variable addition test is subsequently made by including the following. 5 liqgdptÀ1 It should be however be noted that the distribution of the F-statistic is nonstandard. 4 sertÀ1 . 2 ivtgdptÀ1 . xmgdp. 3 xmgdptÀ1 . Pesaran et al. In fact the same lag length was chosen when using the final prediction error due to SBC. irrespective whether regressors are I(0) or I(1).

. Error correction representation for the selected ARDL model Regressor Áivtgdp Áxmgdp Áser Áliqgdp ECM(À1) R-square DW Coefficient AIC (1.69*** 0. 1) Model 2 0.187** 0. * significant at 10%.403*** 0.23 1. The coefficients for the other explanatory variables are well-behaved and have the expected sign and significance.06 1. 0.93 1.76 t-ratio 4. 1) Model 1 0.35 2. *** significant at 1%.23 4. 0.1.18 3.96 1.187* 0.57 Dependent variable is y.100** 0.401*** 0. 3 The point estimates are not too different under both specifications.154** 0. ** significant at 5%.84 5.861*** 0.43 2. prigdp) of 4. The SBC criteria select the ARDL (1. the unrestricted error correction representation of the ARDL model is given by Equations 3 (for the case of liqgdp) and 4 (for the case of prigdp) respectively. This confirms the existence of a stable long-run relationship and points to a long-run co-integration relationship between variables. Substituting liqgdp by prigdp as the alternative proxy for financial development and replicating the same procedure as above yielded an F-Statistics F(y/ ivtgdp. The link is also confirmed by using prigdp as the proxy and it was estimated to be slightly lower at 0. From Table 4 both models suggest that the impact of financial development on the output of Mauritius has been positive and significant. 0. 1. Table 4.54 which implied the existence of cointegration in this alternative specification as well. 0. for the case of Mauritius.065* À0. It is observed that financial development may have contributed positively to the output of the country in the long run. 0. the investment level and the extent of openness of the economy have been the main ingredients for economic development.12 1.584*** 0.66 À4. 0.919*** 0. The quality of human capital is also reported to have been an important factor. 0. 0.526 1. while AIC selects the maximum relevant lag length.12 3.131* 7. 1. the null hypothesis of no long-run relationship between the variables irrespective of their order.4 in both cases and Pesaran and Smith (1998) found that SBC is preferable to AIC. * significant at 10%.622*** B. ser.69 3. Given that both specifications are cointegrated. the coefficient of the ECM of the selected ARDL (1. The coefficient of the ECM is around À0. Seetanah t-ratio 10. The order of the distributed lag on the dependent variable was selected by the Schwartz Bayesian Criterion (SBC)3 and turned out to be one. 1. The test results thus suggest that there is a long-run relationship between the variable. *** significant at 1%. 1. As expected.97 2.81 t-ratio 4. The long-run estimated coefficients are shown in the Table 3.3% increase in output level.361*** 0.83 Coefficient SBC (1.162** 0.812 Table 3.415*** 0. 1.58 1. 0. Moreover. Estimation results. The ECM represents the speed of adjustment to restore equilibrium in the dynamic model following a disturbance. as it is a parsimonious model that selects the smallest possible lag length.00 4. 1. 1) Model 1 0. 0. ** significant at 5%.21 Coefficient SBC (1. 0. 1) is negative and highly significant at 1% level.731*** 0. 0. The next stage of the procedure would be to estimate the coefficients of the long-run relations and the associated error correction model (ECM) using the ARDL approach. In fact a 1% increase in the liquid liabilities to GDP ratio (liqgdp) is associated with a 1. xmgdp.6 2.596*** 0.43 Downloaded By: [University of Leeds] At: 15:35 22 September 2008 Dependent variable is y. Estimated long run coefficients based on ARDL approach Regressor invtgdp xmgdp ser liqgdp prigdp Constant Coefficient SBC (1. 1) for both models respectively.38*** t-ratio 14.152** 0.75 2. 1) Model 2 0.

(1993) Finance and growth: schumpeter might be right. R. and economic growth.. Pesaran. 289–326. 75. Y. 427–831. (1998) Structural analysis of cointegrating VARs. R. DAE Working Papers 9622. 111. B. Applied Economics. and Fuller. Dickey. (1997) The financial structure and the demand for money in Thailand. OECD Economics Department Working Papers. P. Shin. 639–70. and Maksimovic. R. IV. banks. OECD Publishing. A. and firm growth. King. 35. Storm. M. Wachtel. Journal of the American Statistical Association. 75. H. A. 53. and Smith. 401–9. Rajan. Neusser. R. Pesaran. 16. 2107–39. Ram. and Smith. C. 10. Mc Kinnon. V. (2000) Financial intermediation and growth: causality and causes. Rajan. 33–47. (2003) How much do we really know about growth and finance? Federal Reserve Bank of Atlanta Economic Review. 813 Jayaratne. (1998) Manufacturing growth and financial development: evidence from OECD countries. (1999) An autoregressive distributed lag modelling approach to cointegration analysis. Loayza. H. Journal of Finance. 88. Dawson. (1996) The finance-growth nexus: evidence from bank branch deregulation. and Zingales. R. which is corrected by about 40% after each year. 537–58. L. Pesaran. Biometrica. D. M. Department of Applied Economics. G. M. and Levine. Brookings Institution. and Beck. No 265. 833–6. J. J. Journal of Applied Econometrics. and Smith. and Zervos. American Economic Review. Chapter 11. Washington DC. . The analysis was also performed using two different proxies for financial development and the results suggest that financial development have been contributing to the output level of the economy in both short and long run. 819. R. King. and Kugler. To account for the fact that not all of the series were integrated to the same extent and also to incorporate dynamics in the analysis. (1998) Law. Quarterly Journal of Economics. Y. and Zingales. Pesaran. Cambridge. American Economic Review. University of Cambridge. Error correction modelling was used to confirm the existence of a stable long-run relationship and moreover determined a deviation from the long-run equilibrium following a short-run shock. R. 88. 29. (2000) The great reversals: the politics of financial development in the 20th century. 335–46. 471–505. 717–37. P. L.. P. Levine. Journal of Monetary Economics. The Ranger Firsch Centermial Symposium. Summary of Results The article investigated the relationship between financial development and the economic performance for the case of the developing small island state of Mauritius over the period 1952 to 2004. 12. G. R. Working Paper No. Applied Economics Letters. P. Washington DC. and Levine. and Strahan. 164–74. Levine. in Econometrics and Economic Theory in the 20th Century (Ed. The above results highlight the importance of financial development and moreover provide new evidences for the case of island economies using recent innovative cointegration approach. T. Shin. (2001) Bounds testing approaches to the analysis of level relationships. 88. W. Demirgu ¸ -Kunt. P. (1998) Financial dependence and growth. (1998) Stock markets. R. R. 46. (1979) Distributions of the estimators for autoregressive time-series with a unit root. 108. Journal of Economic Survey. an ARDL approach was used. (1992) Financial indicators and growth in a cross section of countries. (1999) Financial development and economic growth: additional evidence. and Shin. (2003) Financial development and growth in economies in transition. (1988) Testing for a unit root in time series regression. N. Downloaded By: [University of Leeds] At: 15:35 22 September 2008 References Chowdhury. K. Quarterly Journal of Economics. Review of Economics and Statistics. R. 559–86. 80. and Perron.. (1973) Money and Capital in Economic Development. Y. A. A. A. Cambrigde University Press. (1996) Testing for the existence of a long-run relationship. Phillips. H. P. 638–48. M. M. 31–77. ¨c finance.) S.Financial development and economic growth this implies that a deviation from the long-run equilibrium following a short-run shock is corrected by about 40% after each year. R. World Bank. Journal of Development Studies.

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