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1. Introduction
There exists a broad literature on the finance-growth nexus. Most studies have
documented a positive relationship between financial development and economic growth
(see, for example, Schumpeter, 1911; Hicks, 1969; Goldsmith, 1969; Mckinnon, 1973;
Shaw, 1973; Gelb, 1989; Roubini & Sala-i-Martin, 1992; King & Levine, 1993; Easterly,
1993; Fry, 1997; Khan & Sehadji, 2000; Pagano & Volpin, 2001; Levine et al., 2000;
Wang, 2000; Hung, 2003; Christopoulos & Tsionas, 2004 and Ergungor, 2008). Several
other studies, on the other hand, have documented a negative relationship between
financial development and economic growth (see, for example, Robinson, 1952; Kuznets,
1955; Friedman & Schwartz, 1963; and Lucas, 1988). On the other hand, Demetriades
and Hussein (1996) and Rousseau and Vuthipadadorn (2005) have documented a bi-
directional relationship between financial development and economic growth. The
purpose of this article is to investigate the impact of financial sector development on the
macroeconomic activity in China, one of the greatest transition economies whose
financial sector has been going through various reforms since 1979. China's transition
from a centrally-planned economy into a more market-oriented one has been
phenomenally successful1. Although there exists a plethora of theoretical and empirical
studies investigating the sources of economic growth in China (see, for example, Chow,
1993; Borensztein & Ostry, 1996; Yu, 1998; Wu, 2000; Shan et al., 2001; Chow & Li,
2002; Hao, 2006, and Liang & Teng, 2006), the role of financial development has not
been explored thoroughly. The present article offers a contribution to literature through
introducing a novel financial depth indicator using principal component analysis (PCA)
to combine three conventional measures of financial development. This composite
indicator is then used in the autoregressive distributed lag (ARDL) bounds testing
approach to cointegration to explore the finance-growth nexus in China using annual time
series data that spans from 1977 to 2006. The rest of the article is structured as follows:
Section 2 sets up the analytical framework, Section 3 defines the variables and explains
the methodology, Section 4 presents the empirical results, and Section 5 points out the
conclusions and the policy implications that emerge from the article.
1.0 Introduction:
2. Analytical framework
The empirical investigation carried out in the present article is based on the ‘AK’ model
introduced by Rebelo (1991) and then used by Pagano (1993), where output growth
depends on total factor productivity, the efficiency of financial intermediation, and the
saving rate: Y = AKt ð1Þ
where, Y, A and Kt denote the output, total factor productivity and capital, respectively.
A certain proportion of savings, the size of (1−λ) with o<λ<1, is the cost of financial
intermediation per unit of savings, i.e. the spread between borrowing and lending rates,
transaction fees and so on, which are the resources absorbed in producing intermediation
services. Only the fraction (λ) of total savings can be used to finance investment. The
smaller the spreads, the more efficient is the financial system. Therefore, the saving–
investment relationship can be written as It=λSt. The economic growth rate gy can be
expressed as:
Eq. (2) expresses that economic growth depends on the total factor productivity (A), the
efficiency of financial intermediation (λ), and the rate of savings (s). When the rate of
depreciation δ is assumed to be constant, economic growth depends on financial
development. In the long-run, gK approaches a permanently positive and exogenous
value which is determined by the difference between Aλst and δ. For a positive growth
rate in the long-run, the Aλst>δ must hold. The level of (λ) is determined by the level of
development of the financial service sector. Since this model represents a closed
economy, it does not take into account the capital flows. To overcome this shortcoming,
trade openness is included. As Beck (2002) explains, financial development results in
higher level of exports and trade balance of manufactured goods, which in turn, imply
higher economic development. Hence, trade openness is included to the model as China
is an open economy. Translating the theory into an empirical specification following
Christopoulos and Tsionas (2004) and Khan et al. (2005), the following equation is
obtained: Yt = α0 + α1IFDt + α2Kt + α3Rt + α4TRt + ut ð3Þ
where Y denotes the natural log of real per capita GDP, IFD denotes a proxy for financial
development, K denotes the natural log of real per capita capital, R denotes real deposit
rate and TR denotes the total trade to GDP ratio.
In addition to the measure of financial development and economic growth, this study uses
several control variables associated with either economic growth or financial
development. In this regard, real interest rate, capital stock and trade ratio are used. The
real interest rate, R is the deposit rate minus the inflation rates, while the trade ratio TR is
the total value of exports and imports as share of nominal GDP. The capital series ‘K’ is
constructed from the investment flows. The perpetual inventory method is used following
Khan (2005) and using a 5% rate of geometric decay following Perkins (1988) and Wang
and Yao (2003). The capital series is also converted into real terms (2000=100).