672763

research-article2016
AEXXXX10.1177/0569434516672763The American EconomistHajilee and Al Nasser

Article
The American Economist
2017, Vol. 62(1) 19­–30
Financial Depth and The Author(s) 2016
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DOI: 10.1177/0569434516672763
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Massomeh Hajilee1 and Omar M. Al Nasser1

Abstract
It is empirically well established that financial depth increases the power of the financial system
and helps both government and the private sector to have access to adequate funds without a
noticeable change in asset prices and exchange rates. Exchange rate uncertainty is considered
one of the many factors that affect financial market performance. In this study, we try to
determine the short-run and long-run effects of exchange rate volatility on financial depth in 26
selected countries, classified as developed, developing, and emerging economies over the period
1980-2011. Our findings indicate that exchange rate volatility has short-run and long-run effects
in the majority of countries in this study. We found for 16 countries out of 26, financial depth
responds significantly to exchange rate volatility (nine positive, seven negative). Furthermore,
using the bounds testing approach shows that exchange rate volatility has significant impact on
financial deepening in 20 out of 26 countries in the short run. The results show that despite
similar classification and grouping, the estimated results could be very country specific depending
on each country’s particular characteristics. We suggest that for every country, it is crucial to
choose and implement appropriate financial market and exchange rate policies.

JEL Classifications: F1, G28, O16

Keywords
exchange rate volatility, financial depth, bounds testing, developed countries, developing
countries, emerging economies

Financial depth is widely believed to confer important stability benefits, not only in developing
countries but also in emerging and advanced countries. Financial depth could enhance the ability
of the financial system to supply funds to the private sector without large swings in asset prices
and exchange rates. In addition, deeper markets can provide alternative sources of funding in
support of economic development (Aydemir & Demirhan, 2009; King & Levine, 1993; Rajan &
Zingales, 2003).
The theoretical literature suggests that macroeconomic variables have an important effect on
countries’ financial depth such as government policies, gross domestic product, inflation rate,

1University of Houston–Victoria, Katy, TX, USA

Corresponding Author:
Massomeh Hajilee, School of Business Administration, University of Houston–Victoria, 2002 W Grand Pkwy N, Katy,
TX 77449, USA.
Email: hajileem@uhv.edu
20 The American Economist 62(1)

exchange rates, and political instability. Aghion, Banerjee, and Piketty (1999) investigated how
financial depth affects productivity-enhancing investment, volatility, and economic growth. They
found that countries with less developed financial systems tend to be more volatile as a result of
financial market imperfections and unequal access to investment opportunities. Moreover,
Denizer, Iyigun, and Owen (2002) examined the effects of financial depth on economic growth,
consumption, and investment volatility for a panel of 70 countries from 1956 to 1998. Their
empirical results showed that countries with higher financial depth tend to have fewer fluctua-
tions in economic growth, consumption, and investment rate.
Demetriades and Law (2006) showed that financial depth does not affect growth in countries
with poor institutional factors in 72 countries from 1978 to 2000. Rousseau and Wachtel (2002)
examined the impact of inflation on the relationship between financial depth and economic
growth for 84 countries from 1960 to 1995. The results showed that financial depth has no effect
on economic growth in countries with high inflation rates. Similarly, Yilmazkuday (2011) found
that high inflation crowds out the positive effects of financial depth on economic growth for 84
countries from 1965 to 2004.
Considerable debate among policy makers and researchers centers on the impact of exchange
rate volatility on financial market development. Exchange rate uncertainty is considered as one
of the many factors that would have an impact on financial market performance and development
(Kurihara, 2006). Maku and Atanda (2010) argued that exchange rate instability is expected to
affect the performance of the stock market, as it can affect international competitiveness and
trade balance between countries.
Recently, the relationship between financial market development and exchange rates has been
a subject of great interest among economists. Nieh and Lee (2001) examined the relationship
between exchange rates and stock market development for G-7 countries. The results showed no
significant relationship between the two variables. Tsai (2012) showed that no significant long-
run relationship exists between exchange rates and stock market development for six Asian coun-
tries. Diamandis and Drakos (2011) studied the causality relationship between exchange rates
and stock market development for four Latin American countries and found a uni-directional
causality from exchange rates to stock market development in Brazil and Argentina, a bidirec-
tional causality in Chile, and uni-directional causality from stock market development to
exchange rates in Mexico. Their results also indicated no significant long-run relationship
between the two variables in any countries. In addition, Ajayi and Mougoue (1996), as well as
Bahmani-Oskooee and Domac (1997), found a long-run relationship between the two variables,
whereas Bahmani-Oskooee and Sohrabian (1992) and Zhao (2010) noted that there is no signifi-
cant long-run relationship between exchange rates and stock prices.
Although several theoretical and empirical studies have devoted considerable attention to the
relationship between financial market development and exchange rates, much disagreement and
debate remain in the literature on the issue of whether exchange rate volatility affects financial
market development. Furthermore, the empirical results appear to be sensitive to the estimation
techniques used, the sample of countries used, and the measures of financial depth considered.
The main contribution of this study is to empirically examine the relationship between
exchange rate volatility and financial depth for 26 developed, developing, and emerging coun-
tries over the period 1980-2011. We believe that the present study could be instructive and com-
plementary to the existing literature on the exchange rate volatility–financial depth nexus for a
variety of reasons. First, we exclusively investigate the impact of exchange rate uncertainty on
developing and emerging countries’ financial depth rather than those of developed economies.
Second, we examine the short-run and the long-run relationship between exchange rate volatility
and financial depth by using the bounds testing approach to cointegration and error-correction
modeling proposed by Pesaran, Shin, and Smith (2001). Finally, understanding the nature of the
relationship between the two variables is specifically useful for policy makers as well as portfolio
Hajilee and Al Nasser 21

investors and international traders, as it may offer a mechanism through which financial depth
and exchange rate exert their influences on economic growth.
The remainder of the article is organized as follows: “Data Description” section discusses the
data sources and variable definitions, “The Model and the Estimation Method” section outlines
model specification and estimation methodology, “The Empirical Results” section presents the
empirical findings, and “Conclusion and Summary” section summarizes the major findings and
offers some policy implications. Data definitions and sources are provided in the appendix.

Data Description
This section provides a brief description of the variables used in this study. We investigated the
short- and long-run effects of exchange rate on financial depth for 26 developed, developing, and
emerging countries over the period 1980-2011.1 We used the real effective exchange rate (RE),
which is the weighted average of a country’s currency relative to basket of other major currencies
adjusted for the effects of inflation. Following Bahmani-Oskooee and Hegerty (2009), we used a
measure of real exchange rate volatility (VRE), which is the 12-month rolling window of the
standard deviation of the RE. The data for the RE and VRE were obtained from the International
Monetary Fund (IMF) International Financial Statistics (IFS) database.
Financial depth is often understood to mean that financial intermediaries and markets are able
to deploy larger volumes of capital and provide a broad range of quality investment and risk-
sharing instruments to investors. In addition, financial depth markets can provide alternative
sources of funding in support of economic development (King & Levine, 1993). To measure
financial depth, we used the private credit (PC) issued by deposit money banks and other finan-
cial institutions to GDP. More specifically, the measure is defined as domestic PC to the real
sector by deposit money banks as a percentage of GDP. The PC, therefore, excludes credit issued
to governments, government agencies, and public enterprises. It also excludes credit issued by
central banks.
The primary advantage of this measure is that by isolating credit to the private sector, it mea-
sures more precisely the contribution of financial institutions in funding private-sector invest-
ment (Al Nasser, 2015; Beck & Levine, 2004; Boyd, Levine, & Smith, 2001; Levine & Zervos,
1998; Rousseau & Wachtel, 2002). Several studies have used PC as an indicator of financial
depth in which countries with higher levels of PC to GDP tend to grow faster and experience
faster rates of poverty reduction (Beck, Demirgüç-Kunt, & Levine, 2007; Kagochi, Al Nasser, &
Kebede, 2013).
An alternative measure to private credit to GDP is the ratio of total banking assets to GDP (the
ratio of total assets of deposit money banks as a percentage of GDP) and the ratio of liquid liabili-
ties of the financial sector to GDP (the sum of currency, demand, and interest-bearing liabilities of
bank and non-bank financial intermediaries as a percentage of GDP). As noted by King and Levine
(1993), these measures do not consider the allocation of capital between the private and public
sector. In addition, these measures are available for a smaller number of economies and have been
used less extensively in the literature on financial development (Cihak, Demirgüç–Kunt, Feyen, &
Levine, 2013). Financial depth data were obtained from the Financial Structure and Economic
Development (FSED) database. In addition, we used the real GDP (Y) as a measure of economic
growth and inflation rate (P) as an indicator of macroeconomic stability. The data for the real GDP
and inflation rate were obtained from IMF IFS database.

The Model and the Estimation Method2

In this section, we formulated the short- and long-run models of the exchange rate volatility or
uncertainty effect on PC issued by deposit money banks and other financial institution to GDP
22 The American Economist 62(1)

(as one of the measures of financial depth). The log linear form of the model is expressed as
follows:

Ln PCt = a + b LnYt + c Ln Pt + d Ln REt + e LnVREt + εt , (1)

where PC is the measure of financial market depth, we used the PC issued by deposit money
banks and other financial institutions as a percentage of GDP; Y is a measure of real income; P is
inflation rate; RE is the real exchange rate; and a measure of variability or RE is denoted by
VRE.3
We expected to find that the economic growth process plays an important role in financial market
deepening and that there is a very strong correction between financial depth and economic activities. In
a growing economy, investors become more optimistic about future economic activities and will invest
more, eventually resulting in more banking activities. Thus, we would expect an estimate of b to
be positive. In this article, we pursued the idea that the rate of inflation affects activity in the finan-
cial market. As suggested by the empirical literature, an increase in the inflation rate would have
an adverse effect on financial market performance (see Khan, Senhadji, & Smith, 2006). Therefore,
we expected that an estimate of c would be negative. As mentioned before, real exchange rate is
specified as the RE. A decrease reflects real depreciation, and an increase reflects real apprecia-
tion. If real depreciation results in an increase of real investment by the public, it is expected that
an estimate of d will be negative. Thus, an estimate of d could be either positive or negative
depending on whether domestic currency depreciation encourages the public to hold more or less
of their domestic currency. We expected an estimate of e could be positive or negative, because
exchange rate uncertainty can be an incentive to people to hold domestic currency or to invest,
depending on their expectation (Bahmani-Oskooee & Hajilee, 2013).
Coefficient estimates of Equation 1 yield the long-run impact of exogenous variables on
financial depth. Following the common practice, we specified Equation 1 in an error-correction
modeling format; therefore, it is possible to infer short-run impacts. Before moving on to the
long-run modeling, it is important to mention that the majority of time-series variables are non-
stationary; therefore, if the necessary condition is not met, the coefficient estimates of Equation 1
will be spurious. Following Engle and Granger (1987), if all variables in Equation 1 are inte-
grated of the same order f , the residuals must be integrated of any order less than f if we are
to avoid spurious estimates or if all variables are to be cointegrated.4 We established a cointegra-
tion relation by including the dynamic adjustment process into convergence toward long-run
equilibrium and made sure that during the adjustment process, the difference between the two
sides of Equation 1 would be smaller over time. To do this, we followed Pesaran et al.’s (2001)
bounds testing approach, which was also adopted by Bahmani-Oskooee and Hajilee (2010) as
Equation 2:
n1 n2 n4
∆ Ln PCt = α + ∑
i =1
βi ∆ Ln PCt −i + ∑
i =0
δi ∆ LnYt −i + ∑ η ∆ Ln P
i =0
i t −i +
(2)
n5 n5

∑ λ ∆ Ln RE
i =0
i t −i + ∑ λ ∆ LnVRE
i =0
i t −i + ψ εt −1 + µt .

Equation 2 is commonly referred to as an error-correction model (ECM). Variables own lags

(as instruments) are included and, thus, they are endogenized. Furthermore, εt −1 is the lagged
stationary residual, which comes from Equation 1. A main advantage of this methodology is that
both short- and long-run coefficients are estimated in one step by applying the ordinary least
squares (OLS) technique to Equation 2. The short-run affects are shown in coefficient estimates
attached to the first-differenced variables, whereas long-run effects are included in the coefficient
Hajilee and Al Nasser 23

estimates attached to lagged-level variables (after being normalized on the dependent variable).
Two steps are followed. In the first step, Equation 1 is estimated, and in the second step, the
lagged residuals from Equation 1 are included in the ECM (Equation 2), and then Equation 2 is
estimated. An estimated significantly negative coefficient for the lagged error-correction term Ψ
explains the convergence toward long-run equilibrium, and the estimate of Ψ itself is an indica-
tion of the adjustment speed.
As mentioned previously in this article, the majority of the macro variables are I(1). There is
a possibility that some variables in Equation 1 are I(1) as total output, whereas some are I(0), like
the volatility measure of the exchange rate. When some variables are I(1) and some I(0), Pesaran
et al.’s (2001) bounds testing approach offers a solution. Following this method, we solve
Equation 1 for ε and lag the solution by one period, as in Equation 3:

εt −1 = Ln PCt −1 − a − b LnYt −1 − c Ln Pt −1 − d Ln REt −1 − e LnVREt −1 . (3)

By substituting the right-hand side of Equation 3 for εt −1 in Equation 2, Equation 4 is arranged

as follows:
n1 n2 n3
∆ Ln PCt = α + ∑ β ∆ Ln PC
i =1
i t −i + ∑ δ ∆ LnY + ∑ η χ LnP
i =0
i t −i
i =0
i t −i

n4 n5
(4)
∑i =0
ηi ∆ LnREt −i + ∑ λ ∆ LnVRE
i =0
i t −i + ρ0 Ln SMCt −1 +

ρ1 LnYt −1 + ρ2 Ln REt −1 + ρ3 LnVREt −1 + µt .

Equation 4 is an ECM, and a linear combination of lagged-level variables has replaced the
lagged error term (ECM) in the Engle and Granger (1987) setting. Equation 4 has several advan-
tages over Equation 2. Estimating Equation 4 requires only one step rather than two. Furthermore,
using the one-step estimation method, the short- and the long-run coefficients are being estimated
simultaneously. Short-run effects are the coefficient estimates of all first-differenced variables.
Long-run effects are the estimates of ρ1 − ρ3 , all normalized by ρ0 . 5
To find out if the long-run relationship exists, we looked at the joint significance of lagged-
level variables or F-test value. Pesaran et al. (2001) calculated new critical values of upper bound
and lower bound F-test values. If all variables are I(1), they provide an upper bound critical value,
and when the assumption is that they are all I(0), they provide a lower bound critical value. In this
methodology, the upper bound critical value is still valid even though some variables are I(1) and
some are I(0). Thus, another main advantage of this estimation methodology is that there is no
need for pre-unit-root testing, which is an important requirement in other cointegration methods.

The Empirical Results

In this section, we provided the estimates of the ECM in Equation 4 for 26 countries, classified
as developed, developing, and emerging economies (based on the availability of data) for the
period 1980-2011. Following previous studies, in practice, the estimated results of the F test are
often sensitive to the lag numbers applied to each first-differenced variable.6 Then, we estimated
Equation 4 with the OLS. Our approach was to use a maximum of four lags on each first-differ-
enced variable (see Hajilee & Al Nasser, 2014). We used Akaike’s information criterion (AIC) to
determine the optimum number of lags. Tables 1 and 2 present the results for each model and for
all 26 countries. Table 3 reports the selected diagnostic statistics results.
Our main purpose here is to demonstrate the short- and long-run effects of exchange rate
volatility on financial market depth in selected countries. Table 1 presents the impact of
24 The American Economist 62(1)

Table 1.  Short-Run Coefficient Estimation for Financial Depth Model for Selected Countries.

Country ΔLn VREt ΔLn VREt − 1 ΔLn VREt − 2 ΔLn VREt −3

Selected developed countries
 Australia 0.863 (0.11) −0.010 (0.24) −0.013 (0.47) −0.011 (1.67)
 Belgium 0.146 (1.01) 0.095 (0.15) 0.085 (0.22) 0.119 (0.57)
 Canada −0.155 (3.21)*** 0.582 (5.69)*** 0.337 (5.78)*** 0.148 (5.11)***
 Denmark 0.159 (1.41) −1.748 (3.26)*** −1.359 (3.50)*** −0.774 (3.78)***
 France 2.036 (2.67)** −4.027 (3.85)*** −4.070 (6.43)*** −0.455 (3.29)***
 Germany −0.414 (0.95) −0.396 (4.16)*** −0.174 (4.07)  
 Greece −0.014 (0.37) −0.344 (2.73)** −0.323 (3.02)*** −0.145 (3.03)***
 Italy −0.012 (2.52)** 0.105 (2.42)** 0.047 (1.65) 0.014 (0.99)
 Japan −0.431 (1.29) 0.036 (0.91) 0.008 (0.51)  
 Spain −0.023 (5.18)*** −0.003 (0.21) −0.012 (1.47) −0.011 (2.17)**
 Switzerland 0.033 (4.56)*** −0.166 (5.98)*** −0.136 (6.75)*** −0.062 (6.04)***
 United 0.095 (3.88)*** −0.110 (2.64)** −0.111 (2.41)** −0.057 (2.31)**
Kingdom
 United 0.007 (0.70) −0.034 (1.28) −0.013 (0.59) −0.014 (0.91)
States
Selected developing countries
 Brazil −0.552 (2.51)** −0.146 (0.58) 0.453 (1.87)* −0.167 (1.58)
 Chile −0.051 (0.63) 0.285 (1.20) 0.177 (1.36) 0.077 (1.21)
 Mexico −0.015 (0.30) 0.395 (3.14)*** 0.195 (3.28)***  
 Pakistan 0.008 (0.50) 0.189 (3.20)*** 0.084 (2.02)** 0.054 (2.57)**
 Peru 0.049 (1.22) 0.034 (0.42) 0.042 (0.87)  
 Philippines −0.019 (3.95)*** −0.192 (0.84) −0.162 (4.36)*** −0.046 (1.77)*
 South −0.019 (0.28) −0.207 (1.00) −0.236 (1.39) −0.033 (0.43)
Africa
Selected emerging economies
 China 0.623 (0.35) −0.458 (1.08) −0.410 (1.42) −0.231 (0.71)
 Hungary 0.106 (14.14)*** −0.687 (18.95)*** −0.445 (16.53)*** −0.120 (11.81)***
 India 0.070 (1.83)* −0.158 (2.58)** 0.091 (2.29)** −0.026 (1.32)
 Malaysia 0.042 (1.78)* −0.251 (2.22)** −.171 (2.21)** −0.087 (2.06)**
 Turkey −0.027 (0.98) 0.004 (0.14) 0.087 (1.97)* −0.101 (3.88)***
 Venezuela −0.124 (2.89)** 0.083 (2.72)** 0.070 (2.09)** 0.095 (3.83)***

Note. Numbers inside parentheses are the absolute values of t statistics. VRE = exchange rate volatility.
*Significance at 10% level. **Significance at 5% level. ***Significance at 1% level.

exchange rate uncertainty on PC issued by deposit money banks and other financial institutions
to GDP, which is an indicator for financial market deepening for each country in our sample.
The short-run results show that there is evidence of at least one significant coefficient for
exchange rate uncertainty (at a 10% level of significance) in all countries except Belgium,
Japan, and the United States in our selected developed countries; Chile, Peru, and South Africa
in the group of selected developing countries; and China in the emerging economies. This
implies that exchange rate volatility has short-run effects on financial depth in 20 countries out
of 26 selected countries.
Table 1 reports the estimated results of the long-run coefficient for all variables of the model.
The estimated results indicate that in 15 countries—Canada, Denmark, France, Germany, Italy,
Japan, Switzerland (developed countries); Brazil, Mexico, Pakistan, the Philippines (developing
countries); Hungary, India, Malaysia, and Turkey (emerging economies)—there is a long-run
impact of exchange rate uncertainty on financial deepening. Our estimated results show that in
Hajilee and Al Nasser 25

Table 2.  Long-Run Coefficient Estimation for Financial Depth Model for Selected Countries.
Country Constant LY LP LVRE LRE

Selected developed countries

 Australia −2.619 (1.52) 1.699 (18.87)** −0.032 (1.08) −0.013 (0.31) −0.081 (0.27)
 Belgium −18.368 (0.13) −0.994 (0.11) 3.579 (0.22) −2.140 (2.22)** 2.364 (0.07)
 Canada 0.706 (0.31) 4.277 (10.48)*** −5.445 (7.64)*** 0.500 (11.57)*** −2.090 (4.03)***
 Denmark −22.371 (1.75)* 24.181 (6.25)*** 28.352 (7.06)*** −1.642 (6.63)*** −1.676 (1.75)*
 France 22.972 (1.189)* 6.275 (2.92)** −6.597 (2.65)** 30.164 (2.031)** −25.92 (1.76)*
 Germany 137.926 (1.11) 1.455 (8.47)*** −14.239 (1.67) −4.239 (1.02) −12.620 (2.11)**
 Greece −9.047 (4.60)*** 2.350 (4.81)*** −0.662 (9.61)*** 0.263 (2.69)** −1.226 (2.45)**
 Italy −5.107 (1.61) 2.979 (3.16)*** −1.167 (2.15)** −0.283 (3.87)*** −0.293 (1.99)*
 Japan −6.052 (2.84)** 0.486 (2.51)** 2.424 (3.31)*** −0.078 (2.14)** 0.521 (4.41)***
 Spain 12.215 (0.09) 47.15 (2.17)** 85.797 (0.18) −3.506 (0.18) −40.961 (0.18)
 Switzerland −3.120 (3.22)*** 1.148 (5.49)*** −0.494 (2.27)** 0.287 (10.51) −1.137 (4.56)***
 United −1.762 (0.82) 2.184 (4.22)*** −0.810 (2.49)** 0.283 (2.31)** 0.101 (0.30)
Kingdom
 United 0.519 (1.07) 1.128 (4.49)*** −0.169 (0.58) 0.033 (1.83)* 0.070 (0.93)
States
Selected developing countries
 Brazil 0.191 (0.13) 0.594 (2.92)** −0.048 (1.37) −0.276 (2.19)** −0.294 (1.69)
 Chile −8.238 (0.99) −0.299 (0.85) 0.177 (0.39) −0.434 (0.52) 2.603 (1.49)
 Mexico −296.74 (0.13) .781 (5.21)*** 12.812 (0.13) −24.827 (0.14) −40.007 (2.13)*
 Pakistan 7.803 (3.93)*** −0.791 (2.48)** −0.171 (2.35)** −0.473 (2.39)** −0.097 (2.63)**
 Peru −2.871 (0.38) 2.231 (0.75) 0.637 (0.51) 0.565 (1.17) −1.01 (0.63)
 Philippines −7.448 (2.54)** 1.190 (4.83)*** 0.331 (1.27) 0.548 (2.22)** 0.887 (1.76)*
 South −9.414 (1.54) 2.149 (2.49)** 0.270 (0.53) −0.359 (2.91)** 0.906 (1.19)
Africa
Selected emerging economies
 China −2.619 (1.51) 1.699 (18.87)*** −0.326 (1.88)* −0.13 (0.31) −0.081 (0.27)
 Hungary −11.346 (79.83)*** 3.843 (58.65)*** 0.468 (115.82)*** 0.454 (35.62)*** −0.779 (19.36)***
 India 4.745 (2.97)** 0.731 (7.44)*** 0.375 (3.73)*** 0.544 (5.78)*** −1.162 (2.61)**
 Malaysia −6.427 (2.32)** 1.174 (5.31)*** 0.345 (3.38)*** 0.464 (2.45)** 1.067 (2.76)**
 Turkey 15.459 (0.21) 0.073 (3.32)*** −0.624 (2.54)** −0.018 (0.21) −2.399 (2.10)**
 Venezuela −101.501 (0.11) 21.657 (7.11)*** −1.096 (0.17) 13.611 (0.12) −0.291 (0.05)

Note. Numbers inside parentheses are the absolute values of t statistics.

*Significance at 10% level. **Significance at 5% level. ***Significance at 1% level.

14 out of 20 countries, the short-run effect is significant and is being seen in the long run (Canada,
Denmark, France, Germany, Italy, Switzerland, Brazil, Mexico, Pakistan, the Philippines,
Hungary, India, Malaysia, and Turkey). Furthermore, the estimated coefficient for real income
(Y) is significant in all countries except Belgium, Chile, and Peru, and as we expected, it is posi-
tive, which is an indication that higher real economic growth is associated with more financial
activities. The estimated coefficient for inflation rate (P) shows a significant relationship between
inflation rate and financial depth in the majority of countries including Canada, Denmark, France,
Germany, Greece, Italy, Japan, Switzerland, the United Kingdom, Pakistan, China, Hungary,
India, Malaysia, and Turkey. The estimated coefficient is negative (as expected) in Canada,
France, Italy, United Kingdom, Pakistan, China, and Turkey and positive in the rest of the coun-
tries. It is worth noting that in the presence of any market frictions (including moral hazard,
adverse selection, or other costs), inflation negatively affects financial market development and
eventually economic growth. On one hand, the presence of high inflation could increase credit
rationing and minimize bank credits and eventually decrease investment and economic growth.
On the other hand, a nonlinear relationship between inflation and financial depth with threshold
effects (threshold level of inflation between 3% and 6% a year) can explain the estimated positive
26 The American Economist 62(1)

Table 3.  Diagnostic Statistics for Financial Depth Models for Selected Countries.
Diagnostic statistics

Country F ECMt-1 LM RESET Normality CUSUM CUSUM SQ Adjusted R2

Selected developed countries

 Australia 39.277 −1.247 (21.55)*** 13.085 9.619 1.301 S S .989
 Belgium 2.449 −0.186 (2.56)** 12.628 20.109 0.684 S S .721
 Canada 16.662 −1.593 (11.78)*** 13.856 3.879 0.201 S S .933
 Denmark 6.548 −1.125 (7.67)*** 19.252 13.510 0.812 S S .837
 France 4.492 −0.230 (6.11)*** 3.122 8.128 0.285 S S .949
 Germany 8.271 0.117 (8.02)*** 3.757 0.226 1.018 S S .844
 Greece 4.686 −1.424 (7.06)*** 4.552 2.462 0.626 S S .973
 Italy 14.114 −0.547 (11.27)*** 16.827 0.269 0.632 S S .969
 Japan 2.655 −1.503 (5.56)*** 14.454 0.642 0.316 S S .905
 Spain 38.759 −0.005 (19.68)*** 7.569 0.303 6.678 S S .994
 Switzerland 50.782 −1.037 (27.59)*** 19.698 0.064 0.331 US S .984
  United Kingdom 4.980 −0.839 (7.52)*** 19.919 0.191 0.303 S S .920
  United States 2.498 −1.991 (5.39)*** 5.580 0.031 3.181 S S .903
Selected developing countries
 Brazil 5.785 −3.322 (8.21)*** 11.932 2.643 0.581 S S .873
 Chile 1.025 −0.653 (3.45)*** 6.570 10.726 1.317 S S .644
 Mexico 4.881 −0.019 (6.98)*** 11.617 1.076 0.042 S S .941
 Pakistan 6.294 −0.514 (6.72)*** 3.692 2.553 0.121 S S .892
 Peru 1.488 −0.168 (4.16)*** 0.138 0.003 0.199 S S .975
 Philippines 11.577 −0.264 (9.53)*** 11.576 1.245 0.827 S S .975
  South Africa 10.112 −1.042 (4.06)*** 16.658 0.173 0.420 S US .678
Selected emerging economies
 China 117.832 −1.247 (21.55)*** 13.085 9.619 1.301 S S .997
 Hungary 131.806 −2.209 (44.46)*** 11.412 0.921 0.659 S S .999
 India 5.489 −0.657 (7.41)*** 12.810 0.551 4.308 S US .952
 Malaysia 36.114 −0.712 (23.27)*** 4.485 0.151 4.223 S S .993
 Turkey 7.332 −0.054 (9.24)*** 15.894 3.023 0.244 S US .939
 Venezuela 12.325 −0.017 (13.59)*** 16.649 0.252 0.314 S S .984

Note. Numbers inside parentheses are the absolute values of t statistics. The upper bound critical value of the F statistic at the usual 5% level
of significance is 3.52. This comes from Pesaran, Shin, and Smith (2001, Table CI-Case III, p. 300). LM is the Lagrange multiplier test for serial
correlation. It has a χ2 distribution with one degree of freedom. The critical value at the 5% level of significance is 3.84. RESET is Ramsey’s
Specification Test. It has a χ2 distribution with only one degree of freedom. The critical value at the 5% level of significance is 3.84. The
normality test is based on test of skewness and kurtosis of residuals. It has a χ2 distribution with only two degrees of freedom. The critical
value at the 5% level of significance is 5.99. ECM = error-correction model; LM = Lagrange multiplier; S = stable; US = unstable.
*Significance at 10% level. **Significance at 5% level. ***Significance at 1% level.

sign of inflation rate in our model (Khan et al., 2006). Thus, inflation rate below this threshold
has a positive impact on financial depth, and above the threshold, the effect is negative.
Also, the long-run estimated results for real exchange rate (RE) shows that except for Canada,
Denmark, France, Germany, Greece, Italy, Japan (developed countries); Brazil, Mexico, Pakistan,
the Philippines, South Africa (developing countries); Hungary, India, Malaysia, and Turkey
(emerging economies), the estimated results are significant. As we expected, it is negative for all
countries except for Italy, the Philippines, and Malaysia, which implies that exchange rate uncer-
tainty impedes financial activities. But, as discussed earlier, it is possible to have either a negative
or positive estimated coefficient depending on whether domestic currency depreciation encour-
ages the public to hold more or less of their domestic currency. It is worth noting that despite simi-
lar classification and grouping, the estimated results could be very country specific depending on
each country’s particular characteristics. By including macro variables, all structural differences,
such as laws and banking or foreign exchange regulations, have been captured in each model.
Hajilee and Al Nasser 27

In Table 2, we reported the results of the selected diagnostic statistics including the F test. The
upper bound critical value for this model is 3.52, and clearly the calculated F statistics in all
countries are greater than this critical value (except for Belgium, Japan, the United States, Chile,
and Peru). This is an indication of cointegration or long-run relationship between exchange rate
uncertainty and financial depth. Also, the error-correction term ECM t −1 is significantly negative
for all the countries in this study, which is considered as another indication of cointegration.
These results show that in all countries in our sample categorized as developed, developing, or
emerging economies, variables adjust toward their long-run equilibrium values. For example, for
the Philippines, the estimated confident of ECM t −1 is −0.264 (9.53), indicating that 26% of the
adjustment toward long-run equilibrium takes place in 1 year. The Lagrange multiplier (LM) test
statistics, with χ2 distribution with one degree of freedom for residual serial correlation, Ramsey’s
Specification Test for functional misspecification, and the Normality test, indicate that in all
estimated models, they are less than their critical values. Thus, we can say that all models are
well specified, the residuals are normally distributed, and there is no sign of autocorrelation. The
two stability test statistics are CUSUM and CUSUM SQ. Finally, the adjusted R2 reported in
Table 3 confirms goodness of fit for all models in this study.

Conclusion and Summary

The financial market is an important channel affecting economic growth. A deep and well-func-
tioning financial sector plays a key role in economic development in every country. As there is a
lack of empirical research on the direct relationship between exchange rate volatility and finan-
cial depth, we believe that the present study could be a valuable addition to the existing literature
on the exchange rate volatility–financial depth nexus.
The main contribution of this article is to empirically explain the relationship between finan-
cial depth and exchange rate variability in a relatively large group of countries with different
economic and financial structures. We attempted to find an answer for this question by analyzing
the short- and long-run effects of exchange rate volatility on the depth for a group of 26 different
countries classified as developed, developing, and emerging economies for the period 1980-2011
by using annual data, the bounds testing approach to cointegration, and error-correction model-
ing proposed by Pesaran et al. (2001). Considering important similarities among each group of
countries (developed, developing, and emerging), additional evidence suggests that the link
between financial depth and exchange rate volatility works via each country’s specific structure.
We estimate our model for each country separately using time-series data. Therefore, the macro
variables included in our models capture the structural differences, including their specific regu-
latory systems. As discussed in this article, despite similar classification and grouping, the esti-
mated results could be very country-specific depending on each country’s particular characteristics.
To reiterate, by including macro variables in our models, all structural differences, such as laws
and banking or foreign exchange regulations, have been captured in each model.
The main conclusion that can be drawn from this study is that despite the countries’ classifica-
tion, exchange rate uncertainty has significant impact, both in the short run and the long run, on
financial depth in the large group of countries in our sample. The results here indicate that there
is a significant short-run effect of exchange rate uncertainty on depth in the majority of 26 coun-
tries, explaining the fact that in the short run, there exists a strong link between exchange rate
uncertainties or risks and financial deepening. We are able to show that in 14 out of 20 countries,
the short-run effects have been seen in the long run too, and the cointegration relationship is
confirmed in almost all the models.
To summarize this article’s result, we can conclude that in several of the countries in our sample
(except Belgium, Japan, and the United States in our selected developed countries; Chile, Peru, and
South Africa in the group of selected developing countries; and China in the emerging economies),
28 The American Economist 62(1)

exchange rate volatility had significant short-run effects. However, this effect lasted long term in
only 14 countries. Finally, it is worth noting that despite the fact that countries in this study are clas-
sified in similar groups, the long-run estimated result varies. Our estimated results indicate that in
nine countries (Canada, France, Greece, Switzerland, United Kingdom, United States, the
Philippines, Hungary, and Malaysia), exchange rate volatility has a positive significant effect on
financial deepening, and as we expected, in seven countries (Belgium, Denmark, Italy, Japan,
Brazil, Pakistan, and South Africa), it negatively affects financial depth. This again is an indication
of country-specific results, depending on each country’s economic and financial structure.
The novelty of this study is to identify that in the majority of these countries, exchange rate
uncertainty has significant impact on financial depth. This can clarify how under an uncertain
financial environment, there will be less opportunity to develop a deep financial sector in this
group of countries. Finally, the nature of the relationship between the two variables is specifically
useful for policy makers as well as portfolio investors and international traders, as it may offer a
mechanism through which financial depth and exchange rate exert their influences on economic
growth.

Appendix
Data Definition and Sources
All data used in the study are annual over the 1980-2011 period and come from the following
sources:

a. International Monetary Fund (IMF) International Financial Statistics (IFS).

b. Financial Structure and Economic Development (FSED) Database.

Variables

PC = Private credit by deposit money banks and other financial institutions to GDP. Data were
obtained from (b).
RE = Real effective exchange rate which is the weighted average of a country’s currency rela-
tive to basket of other major currencies adjusted for the effects of inflation. Data were obtained
from source (a).
VRE = Volatility measure of RE. Following Bahmani-Oskooee and Hegerty (2009), each
year’s volatility measure is calculated by taking the standard deviation of the 12 monthly RE
values within that year. Data were obtained from source (a).
Y = Real GDP (2010 = 100). Data were obtained from source (a).
P = The consumer price index (2010 = 100). Data were obtained from source (a).

Declaration of Conflicting Interests

The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or
publication of this article.

Funding
The author(s) received no financial support for the research, authorship, and/or publication of this article.

Notes
1. Developed countries in the sample are Australia, Belgium, Canada, Denmark, France, Germany, Greece,
Italy, Japan, Spain, Switzerland, the United Kingdom, and the United States. Developing countries in
Hajilee and Al Nasser 29

the sample are Brazil, Chile, Mexico, Pakistan, Peru, Philippines, and South Africa. Emerging coun-
tries in the sample are China, Hungary, India, Malaysia, Turkey, and Venezuela. Countries are classi-
fied according to the International Monetary Fund (IMF) classification system based on their level of
development. The choice of the sample countries is dictated by the availability of long-run time-series
data (IMF, 2015).
2. The methodology closely follows Bahmani-Oskooee and Tanku (2008).
3. Other variables that affect financial depth, such as political instability, were excluded from the analysis
because of data limitation.
4. A variable is integrated of order, say n, if that variable becomes stationary after being differenced n
times. Therefore, if all variables in Equation 1 are I(1), the residuals must be I(0) for cointegration.
5. For a more detailed explanation and derivation of this approach, see Bahmani-Oskooee and Tanku
(2008).
6. For more details, refer to De Vita and Kyaw (2008) and Mohammadi, Cak, and Cak (2008).

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Author Biographies
Massomeh Hajilee, PhD, Associate Professor of Economics, School of Business Administration,
University of Houston-Victoria.
Omar M. Al Nasser, PhD, Assistant Professor of Finance, School of Business Administration, University
of Houston-Victoria.