INTRODUCTION The conventional wisdom is that openness to international trade and financial developmenthas a positive impact on economic growth

.The study of causal relationship between financial development, openness to international trade and economic growth is a much debated issue in the empirical literature. The question that whether financial development proceeds or follows the economic growth has been an extensive subject of empirical research since last few decades. Well-developed financial systems channel financial resources to the most productive use. The explanation initiated by Robinson (1952) argues that finance does not exert a causal impact on growth. Financial development follows economic growth as a result of higher demand for financial services. When an economy grows, more financial institutions, financial products and services emerge in the markets in response to higher demand of financial services. . Schumpeter (1911) contends that the services provided by financial intermediaries are essential drivers for innovation and growth. The McKinnon-Shaw(1973) school of thought proposes that government restrictions on the operation of the financial system such as interest rate ceiling, direct credit programs and high reserve requirements may hinder financial deepening. This may in turn affect the quality and quantity of investments and hence has a significant negative impact on economic growth. Therefore, the McKinnon-Shaw financial repression paradigm implies that a poorly functioning financial system may retard economic growth. This paper is thus an attempt to contribute to the empirical literature on the relationship between financial development and economic growth by testing the causality between M2 as a ratio of GDP,GDP per capita and trade openness.The proxy for financial depth is taken to be the ratio of M2 to GDP, the proxy for economic growth is taken to be GDP per capita and trade openness as a ratio of GDPdevelopment and economic growth in India. The conventional wisdom is that openness to international trade and financial development has a positive impact on economic growth. The reason for the argument is partly based on the conclusions of many empirical studies, which claim that outward-oriented economies consistently have higher economic growth rates than inward-oriented economies. It is also partly due to the failures of import-substitution strategies, particularly in the 1980s and overstated expectations from trade liberalisation (Yanikkaya, 2003: 57). Lloyd and MacLaren (2000) argue that the fast-growing East Asian economies were partly a result of their early openness to international trade; less openness of economies to international trade will slow down their economic growth rates. The objective of this study is to investigate the causal relationship between financial development, trade openness and economic growth in India. The objectives are to examine whether in India , 1)Trade openness and financial development have causal effects on economic growth; 2) Trade openness and economic growth have causal effect on financial development; and 3) Economic growth and financial development have causal effects on trade openness This study is structured as follows: Section 2 introduces the theory and the literature review on the causal relationship between financial development, trade openness and economic growth. Section 3 is concerned with the econometric methodology, while Section 4 presents and discusses the findings of the study, consequently Section 5 concludes with a summary.

Vamvakidis (2002) and Harrison (1996). and facilitate deeper financial systems are associated with a more effective supply of these financial services to the real sector. On the one hand. trade openness and economic growth Yucel (2009) examined the causality relations between financial development. time series studies are largely devoted to finding the causality patterns suggested by Patrick (1966)¶s hypotheses. namely. mobilize savings. 2000). De Gregorio and Kim. Openness to international trade can lead to an increase in specialization that will accelerate productivity growth by more fully realizing economies of scale. Huge empirical studies have emerged since the 1990s.g.2. the more open economy is expected to face more competitiveness and which stimulates productivity. 1993). We therefore review country specific study to see the direction of causality among financial development. King and Levine. which in turn stimulates economic growth. although more country-specific researches are required to explain the heterogeneity across the countries. These studies can be roughly divided into two lines. While cross-country studies usually start with the priori assumption that finance influences growth. financial development has a negative effect on growth.The thesis that financial development can influence economic growth and structural change has received strong theoretical underpinnings that identify two distinct. The allocation channel focuses on the rising efficiency of resource allocation which is caused by financial deepening and which subsequently enhances growth (e. In addition. yet complementary channels. amongst others reported openness to international trade affects economic growth positively. trade openness and economic growth (GDP) for the Turkish economy for the period 1989 to 2007. The econometric method employed was the Johansen and Juseliuscointegration and Granger causality to test for causality test among the variables. 1993. Pagano. Moreover. Put briefly. supply leading and demand-following. Literature Review Financial markets perform several functions which in turn exert a positive influence on growth (see Levine (1997)): they reduce liquidity and idiosyncratic risks. improve monitoring and corporate control. it is argued that the financial sector may influence growth through the accumulative channel and the allocative channel. The accumulation channel emphasizes the finance-induced positive effects of physical and human capital accumulation on economic growth (e. Moreover. the Granger causality test results revealed the presence of bi-causal . he argued that the direction may gradually shift from the former to the latter over time as an economy develops. those studies have mostly concluded that financial development positively contributes to the economic growth. stated that the relationship between financial development and economic growth is bidirectional. enhance the allocation of resources towards to their more productive uses.g. The findings of the study showed that while trade openness has a positive effect.

trade openness and growth indicating that economic policies aimed at financial development and trade openness have a statistically significant impact on economic growth. Hassan and Islam (2005) examined whether financial development and openness to international trade can play any positive role in reducing poverty in Bangladesh through their growth enhancing effect for the period 1974-2003 Standard Granger-causality test is employed to ascertain whether financial development and trade openness cause growth. and between real income and domestic credits. trade and economic growth in Japan except between domestic credit (second measure of financial development). unidirectionalcausality was investigated that runs from real income to exports and imports. a measure of openness to international trade and financial development. However. Variables are found first difference stationary without having any co-integrating relationship as reported by Johansen co-integration test. and financial development and growth. international trade. The paper does not find any causal relationship between trade openness and growth. and growth after employing unit root tests to see if the variables underconsideration are stationary. Results suggest that a long run equilibrium relationship exists between financial development. Bidirectional causality has also been obtained between real income and M2. Finally. Furthermore. Results reveal that there is a long-run equilibrium relationship between financialdevelopment. Katiricioglu. Annual datacovering the 1965-2004 period have been used to investigate co-integration and Granger causality tests betweenfinancial development.relationship between financial development. The results of Granger Causality tests suggest that financial development as proxied by broad money gives causation to economic growth that supports the supply-leading growth hypothesis for the Japanese economy and support thegrowth-driven trade (GDT) hypothesis. from exports to imports. no direction of causality has been obtained between M2 and domestic credits.. This implies that financial development and trade openness do not reduce poverty through their effect on growth. M2domestic credits. where the real GDP per capita is specified as a function of the employment. the capital. Soukhakian (2007) empirically investigated the causal relationship between financial development. international trade and real income growth in the case of India. from M2 to imports. The empirical model in the study is based on an augmented production function. trade and growth. The study uses different measures of financial development. As such Granger-causality test is carried out in first difference VAR. Kahyalar and Benar (2007) aimed at investigating the possible co-integration and the direction ofcausality between financial development. trade openness and economic growth in Japan covering the period 1960-2003. The unit root test . international trade and economic growth in India. which claims that economic growth causes ³more efficient imports andexports´ for Japan. Wong Hock (2005) investigated the impact of openness to international trade and financial development on economic growth in Malaysia. bidirectional causal link evidenced between financial development and trade openness indicates that these two can contribute to poverty reduction directly through their mutual effect on each other. from imports to domestic credits.

However .results show that on the whole all the variables are found to have a unit root.. more evidence of the positive impact of openness to international trade on economic growth is found when a longer time series data is used. However. the results of the Johansen (1988) multivariate cointegration procedure show that economic growth. a measure of openness to international trade and financial development are cointegrated. Openness to international trade positively affects economic growth. ECMs are estimated. The results of Grangercausality suggested that the causality between openness to international trade and economic . The results showed that there was no positive relationship between openness to international trade and economic growth before 1970. The results show openness to international trade and financial development to have a significant impact on economic growth. Generally. Moreover. significantly associated with economic growth. The finding may suggest that openness to international trade when protection in the world economy is high does not result in economic growth benefits. particularly for developing countries and they were consistent with the findings of theoretical economic growth. the results showed that trade barriers were positively and.e. Yanikkaya (2003) examined the impact of openness to international trade on economic growth of over 100 developed and developing countries using panel data from 1970 to 1997. the employment. This may suggest the importance of analyzing the short-run and long-run impact of openness to international trade. the results were quite robust. Harrison (1996) examined the relationship between openness to international trade and economic growth in developing countries using cross section and panel data for the period from 1960 to 1987. the results suggest that openness to international trade and financial development are important for economic growth in Malaysia. when data set 1970-1996 is used. The empirical estimation is based on an augmented production function. Grangercausality between financial development and economic growth was found to be less robust. Estimating economic growth over a long period provides useful conclusions on the robustness of openness to international trade and other explanatory variables in the empirical model. depending on the measure of financial development. The results showed that openness to international trade does not have a simple and straightforward relationship with economic growth. there is strong evidence that openness to international trade Granger causes economic growth and not vice versa. However. in most specifications. except the measures of financial development in Model 3 and Model 4. The relationship was found to be negative. it was sensitive to the measures of openness to international trade. Vamvakidis (2002) examined the relationship between openness to international trade and economic growth in developed and developing countries using cross-section data over the period 1920-1990. i. Generally.contrary to the conventional view on economic growth effects of trade barriers. All the variables are found to have the expected signs. The results suggested that the choice of time period for analysis is critical. The positive relationship between openness to international trade and economic growth was only a recent phenomenon. the capital. Furthermore.

Description of data is presented first. that there is a bidirectional effect. In relation to the first problem. 3. Verifying the relationship between financial development and growth has at least two problems. Johansen co-integration test is described followed by Granger-causality methodology in VAR and finally the section is concluded with the discussion on stability of the estimated VAR. Next. it is necessary to assume a measure for financial development. financial development and economic growth in Nigeria. Several indicators of financial development have been proposed in the literature.(1) The function can also be represented in a log-linear econometric format thus: log FD t = + log GRt+ log TO t + --------------------------. 3)while the Growth rate of real per capita GDP is used as the indicator of economic growth The primary model showing the causal relationship among financial development. and then procedure to examine stationarity of underlying time series is described. TO) ----------------------------------------------------------------------. many econometrics articles about this lemma do not use a theoretical model. it will be used variables as a proxy to financial development which includes: 1). 3.e. i. Private credit as a percentage of Gross Domestic Product (GDP) 2)The sum of export and import as a percentage of GDP is used as a measure of trade openness (hereafter TO). more openness to international trade precedes a higher economic growth and a higher economic growth leads to more openness to international trade.(2) . And.1Overview of the variables (Data) used In recent years there have been different empirical works which have shown that causation runs from financial development to economic growth. Different indicators will proxy different aspects of the relationship between the financial system and economic performance. trade openness and economic growth in Nigeria using annual data from 1970 to 2005. First. some papers have even made a case for independent causation between growth and finance. or that economic growth leads to financial development.growth runs in both directions. Methodology The present study examines the causal relationship among financial development. trade openness and economic growth in Nigeria can be specified thus: FDt = f (GR. Grangercausality test in Vector Auto Regression (VAR) framework is employed to examine causal relationship among trade openness. secondly.

The general form of ADF test is estimated by thefollowing regression Where: Y is a time series. Augmented Dickey-Fuller test relies on rejecting a null hypothesis of unitroot (the series are non-stationary) in favor of the alternative hypotheses of stationarity. n is the optimumnumber of lags in the dependent variable and e is the random error term. we test the presence or otherwise of cointegration between the series of the same order of integrationthrough forming a cointegration equation. Since financial development is being proxied by three variables we separate the three variables in determining the Granger causality with Growth rate and Openness to form these three models: DC = + GR + TO + ---------------------------------.1) PC = + GR + TO + ---------------------------------. and 0 is the constant term.1 Unit Root Test The first step involves testing the order of integration of the individual series under consideration. and the Phillip-Perron (PP) due to Phillips(1987) and Phillips and Perron (1988). 3. However. 3. Researchershave developed several procedures for the test of order of integration. The basic idea behind cointegration is that if. is the first difference operator.3) 0.3.(3. the second equation includes both drift and linear timetrend pp. and µ ¶ is the random error term.2 Co-integration test Secondly. The tests are conductedwith and without a deterministic trend (t) for each of the series. 1981).3 Estimation Technique 3. and others are as explained above. t is a linear time trend.(3. the difference between equation (1) and(2) is that the first equation includes just drift. 0 is a constant.2) M = + GR + TO + ------------------------------------. The most popular ones are AugmentedDickey-Fuller (ADF) test due to Dickey and Fuller (1979. in the long-run. two ormore series move closely together. 0 and 0 are constant terms.Where: FD is financial development proxied by Private Credit (PC) and Money Supply (M2) GR is Growth rate of GDP TO is Trade Openness.3. even though . µt¶ is the time trend.(3.

We employ the maximum-likelihood test procedure established by Johansen and Juselius (1990) and Johansen(1991). Johansen (1988..4 Granger-causality Test After the testing of the Cointegration relationship.Specifically. A lack of cointegration suggests that such variables have nolong-run relationship: in principal they can wander arbitrarily far away from each other (Dickey et. an Error Correction term (ECT) isrequired to be included (Granger. Tradeopenness and Economic Growth in Nigeria.3. If the variables are cointegrated. the testcalculated as follows: Where: T is the number of usable observations. 1989) and Johansen and Juselius (1990)suggested two statistic test. al. It tests the null hypothesis that the number ofdistinct cointegrating vector is less than or equal to q against a general unrestricted alternatives q = r. if the reverse is the case we will go ahead to test our causalityusing the following multivariate equation: MODEL 1 Where: DCt is Direct Credit as a proxy financial development PCt is Private Credit as a proxy for financial development . we test for causality among financial development. if Yt is a vector of n stochastic variables. the first one is the trace test ( trace). and the 1. 1991). as the differencebetween them is stationary (Hall and Henry.the series themselves are trended.s are the estimated eigenvalue from the matrix. This VAR can be rewritten as1 To determine the number of co-integration vectors. 3. however. 1989). the difference between them isconstant. then there exists a p-lag vector auto regression withGaussian errors of the following form: Johansen¶s methodology takes its starting point in the Vector Auto regression (VAR) of order P given by Where: Yt is an nx1 vector of variables that are integrated of order commonly denoted (1) and t is an nx1 vector ofinnovations. It is possible to regard these series as defining a long-run equilibrium relationship. 1988).

Linear Trend Lag Length: 1 (Automatic based on SIC. We use both the Augmented Dickey Fuller (ADF) tests to find theexistence of unit root in each of the time series. The results of both the ADF and PP tests are reported in Table 1 Null Hypothesis: D(GDP) has a unit root Exogenous: Constant.754821 -4. Unit root test result is reported first followed byJohansen cointegration test result and lastly. -4.Mt is broad Money Supply also used as a proxy for financial development TOt is Trade Openness GRt is Growth Rate of GDP 4.1 Unit Root Test The first step is to test whether the relevant variables in equation (2) are stationary and to determine their ordersof integration.0096 . MAXLAG=2) t-Statistic Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values.728363 -3.759743 -3. Empirical Results This section presents results of empirical analyses of the paper.324976 Prob. 4.* 0. Granger-causality test result.

Linear Trend Lag Length: 1 (Automatic based on SIC.616209 -3.* 0. -4.297799 Prob.0065 .0030 Null Hypothesis: D(CURRACC) has a unit root Exogenous: Constant.297276 -4.710482 -3. MAXLAG=2) t-Statistic Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values.Null Hypothesis: D(PVTCR) has a unit root Exogenous: Constant.* 0.673616 -3.277364 Prob.532598 -3.755680 -4. Linear Trend Lag Length: 0 (Automatic based on SIC. -5. MAXLAG=2) t-Statistic Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values.

0023 . This can be seen by comparing theobserved values (in absolute terms) of both the ADF and PP test statistics with the critical values (also inabsolute terms) of the test statistics at the 1%.61718 0. the result reveals that all the variables were stationary at first difference. Following from the above result.e.05 Critical Value 42. share a common trend and long-run equilibrium as suggestedtheoretically. We started the cointegration analysis by employing the Johansen and Juselius multivariatecointegration test. As shown in table two. i.91525 Prob. the null hypothesis is accepted and it is sufficient to conclude thatthere is a presence of unit root in the variables at levels. Date: 12/31/10 Time: 10:38 Sample (adjusted): 1990 2008 Included observations: 19 after adjustments Trend assumption: Linear deterministic trend (restricted) Series: LCURRACC LGDP LPVTCR Lags interval (in first differences): 1 to 1 Unrestricted Cointegration Rank Test (Trace) Hypothesized No.2 Cointegration Result After confirming the stationarity of the variables at 1(1). all the variables weredifferenced once and both the ADF and PP test were conducted on them. TO and the different measures of financial development.The result in table 1 shows that all the variables were not stationary in levels. suggesting thatthere is no cointegrating relations between GDP. From the result both trace statistic andmaximum Eigenvalue statistic indicated no cointegration at the 5 percent level of significance. Table 3 and 4 shows the result of the cointegration test. 5% and 10% level of significance. of CE(s) None * Eigenvalue 0. Therefore. it means that financial development. we proceed to examine the issue of cointegrationamong the variables. Result from table 1 providesstrong evidence of non stationarity. 1(1). When a cointegration relationship is present. tradeopenness and economic growth finance. the null hypothesis of non-stationarity is rejected and it is safe to conclude that the variables are stationary. 4.** 0.This implies that the variables are integrated of order one. On the basis ofthis.844447 Trace Statistic 54.

05 level **MacKinnon-Haug-Michelis (1999) p-values Unrestricted Cointegration Rank Test (Maximum Eigenvalue) Hypothesized No.39645 LPVTCR -42.247426 0.26254 8.87211 12.46744 3. of CE(s) None * At most 1 At most 2 Eigenvalue 0.439957 0.034834 0.5118 0.05 Critical Value 25.38704 12.352136 Max-Eigen Statistic 35.844447 0.247426 25.352136 19.05 level * denotes rejection of the hypothesis at the 0.662712 Unrestricted Adjustment Coefficients (alpha): .0021 0.143938 -3.** 0.01511 8.098029 LGDP 23.82321 19.691937 -0.05 level **MacKinnon-Haug-Michelis (1999) p-values Unrestricted Cointegrating Coefficients (normalized by b'*S11*b=I): @TREND(89 ) 1.51798 0.325107 -10.51798 Prob.At most 1 At most 2 0.439957 0.2321 Trace test indicates 1 cointegratingeqn(s) at the 0.85257 -2.975417 1.05 level * denotes rejection of the hypothesis at the 0.2321 Max-eigenvalue test indicates 1 cointegratingeqn(s) at the 0.2655 0.545320 LCURRACC -2.273863 -3.35464 11.

02561) D(LPVTCR) -0.054043 0.28601 Normalized cointegrating coefficients (standard error in parentheses) @TREND(89 ) LCURRACC LGDP LPVTCR .042021 (0.327411 (0.181825 0.09840) LCURRACC 1.13731) Adjustment coefficients (standard error in parentheses) D(LCURRAC C) 0.77845 Normalized cointegrating coefficients (standard error in parentheses) @TREND(89 ) -0.17704) LPVTCR 18.018480 0.32052 (1.84572 (2.003618 -0.036623 0.143989 D(LGDP) D(LPVTCR) -0.000821 0.024347 0.744081 (0.083277 (0.17952) D(LGDP) 0.D(LCURRAC C) -0.000000 LGDP -10.001802 1 Cointegrating Equation(s): Log likelihood 83.00976) 2 Cointegrating Equation(s): Log likelihood 89.

10158) 4.080014 (0.06349 0.4325 0.9388 0.079379 (0.05139) D(LPVTCR) -0.01963) -2.47471) -0.000000 -1.027639 (0. 0.930221 (0.000000 1.075171 (1.421646 (0.43153 4.10019) 0.0377 .856730 (0.89040 0.19848) Adjustment coefficients (standard error in parentheses) D(LCURRAC C) -0.774465 (1.18059 Prob.000000 -1.1.395418 (0.000000 0.6867 0.01164) 0.38611 0.6579 0.70816) 0.28495) D(LGDP) 0.3 Granger Causality Test Pairwise Granger Causality Tests Date: 12/31/10 Time: 10:43 Sample: 1988 2008 Lags: 2 Null Hypothesis: LGDP does not Granger Cause LCURRACC LCURRACC does not Granger Cause LGDP LPVTCR does not Granger Cause LCURRACC LCURRACC does not Granger Cause LPVTCR LPVTCR does not Granger Cause LGDP 19 19 Obs F-Statistic 19 0.26597) 0.075157 (0.

94786 0.0000 3.19970 60. respectively.000000 Std.071569 0. -2. The results are reported in Table 5.0001 Dependent Variable: LGDP Method: Least Squares Date: 12/31/10 Time: 10:34 Sample: 1988 2008 Included observations: 21 Variable C LCURRACC LPVTCR R-squared Adjusted R-squared S.857036 0. 2 and 3.155516 Hannan-Quinn criter. 0.189284 Mean dependent var S.048094 t-Statistic 13.529446 0. we carried out the Granger-causality.304733 Schwarz criterion -2.882525 11.0099 0.Table 6 and Table 7.06261 2.D.139219 0.00846 Prob.LGDP does not Granger Cause LPVTCR 18. dependent var Akaike info criterion -2. 6 and 7 shows the results of model 1.0000 0.506221 Having found no cointegration among the variables of financial development (DC.048298 0.149925 0. Error 0.3590 0. PC and M2).871333 0.272349 Durbin-Watson stat 0.092199 27. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) Coefficient 1.E. trade openness(TO) and economic growth (GR).132224 0.727184 0. . Where table 5.

Our result showsthat there are no cointegrating relations between GR.PC and M2). suggesting that there is no long-run relationship between financial development. but stationary in first differences. As noted. The econometric methodology employed was the Cointegration and Granger Causality test. trade openness andeconomic growth. The null hypothesisthat LTO does not Granger Cause LPC is rejected which indicates that Uni-directional causality runs from Tradeopenness to Private credit. . thestationarity properties of the data and the order of integration of the data were tested using the AugmentedDickeyFuller (ADF) test . which indicates causality running from Economic growth to Private credit. The null hypothesis whichstates that LM2 does not Granger Causes LTO is rejected which implies a uni-directional causality running fromMoney supply to Trade openness. that is. which indicates that uni-directionalcausality runs from economic growth to trade openness.growth was found to have causal effect on trade openness implying support for growth-led trade but no supportfor trade-led growth. First. Private creditand broad money. the nullhypothesis that LTO does not Granger cause LDC is rejected. TO and the three measures of financial development (DC. The null hypothesis that LGR does not Granger CauseLDC is rejected which shows that causality runs from Economic growth to Domestic credit. Model 2 Granger-causality results reported in Table 6 shows that the null hypothesis that LGR does not Granger causesLPC is rejected. in Japan. as a percentage of GDP have no causal impact on economic growth rather economic growthwas seen to necessitate these credits and the supply of money. On the other hand. Conclusion The purpose of this study is to examine the causal relationship among financial development. Model 3 Granger-causality results reported in Table 7 indicates that the null hypotheses that LGR does not Granger causeLM2 is rejected.Model 1 Our model was estimated using two lags for the variables. trade openness andEconomic Growth in India using annual data sourced from International financial statistics and the world bank report from 1988-2008. We applied the Johansenmultivariate approach to cointegration to test for the long-run relationship among the variables. The Granger-causality results suggest that trade openness and financial development does have causal impact oneconomic growth. Granger causality test is carried out with two lag length. which indicates causality from Economic Growth to Money supply. 5. conversely growth does have causal impact on trade and financial development. this follows the findings of Soukhakian (2007). they are integrated of order one 1(1). Granger-causality results reported in Table 5 suggestthat the null hypotheses that LGR does not Granger cause LTO is rejected. We found that the variables were non-stationary inlevels. In absence of cointegration. Domestic credit. which consequently means that LTO Grangercauses LDC. Lastly.

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