Decision (September 2014) 41(3):245–259
DOI 10.1007/s40622-014-0056-y
RESEARCH PAPER
Development of banking sector and economic growth:
the ARF experience
Rudra P. Pradhan • Sasikanta Tripathy •
Debaleena Chatterjee • Danish B. Zaki •
Bidisha Mukhopadhyay
Published online: 18 July 2014
 Indian Institute of Management Calcutta 2014
Abstract The paper examines the long-run relation-
ship between banking sector development and eco-
nomic growth in 25 ARF countries for the period
1960–2012. Using principal component analysis for
the construction of development index and vector
auto-regressive model for testing the Granger causal-
ities, the study finds the presence of both unidirec-
tional and bidirectional causality between banking
sector development and economic growth. The policy
implication of this study is that the economic policies
should recognize the differences in the banking sector
development and economic growth in order to main-
tain sustainable development in the 25 ARF countries.
Keywords PCA  Panel VAR  Banking sector 
Economic growth  Granger causality
R. P. Pradhan (&)  S. Tripathy  D. Chatterjee 
D. B. Zaki  B. Mukhopadhyay
Vinod Gupta School of Management, Indian Institute of
Technology, Kharagpur 721302, WB, India
e-mail: rudrap@vgsom.iitkgp.ernet.in
S. Tripathy
e-mail: tripathy.faculty@gmail.com
D. Chatterjee
e-mail: debaliena@gmail.com
D. B. Zaki
e-mail: danishbzaki@gmail.com
B. Mukhopadhyay
e-mail: dishaecon@gmail.com
Introduction
The relationship between financial development and
economic growth has attracted a lot of attention among
economists and policy makers for a long time, partic-
ularly since the emergence of the new theories of
endogenous economic growth (see, for instance, King
and Levine 1993a, b; Bencivenga and Smith 1991;
Greenwood and Jovanovic 1990). Although different
economists fasten different degrees of importance to
financial development, its role in economic growth can
be theoretically postulated and has been supported by
more and more empirical evidence (Pradhan 2013).
Theoretically, finance can facilitate economic growth
by multiple channels: (i) providing information about
possible investments so as to allocate capital efficiently;
(ii) monitoring firms and exerting corporate gover-
nance; (iii) risk diversification; (iv) mobilizing and
pooling savings; (v) easing the exchange of goods and
services and (vi) technology transfer (see, inter alias,
Zhang et al. 2012; Levine 2005; Goodhart 2004; Levine
2003; Beck et al. 2000; Garcia and Liu 1999; Levine
1997; Fritz 1984; Drake 1980).
Empirically, most of the research based on cross-
country panel data suggests a positive relationship
between financial development and economic growth
(see, Law and Singh 2014; Beck and Levine 2004;
Levine 2003, Beck et al. 2000, 1997; King and Levine
1993a, b). However, the relevance of the finding is
compromised by the problematic issue of causality and
the potential bias arising from the joint determination of
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Table 1 Summary of the studies viewing a causal link between banking sector development and economic growth
Studies Study area Method of study Time period

Group 1: studies support DFH

Pradhan et al. (2013) 15 Asian countries MVGC 1961–2011
Kar et al. (2011) 15 MENA countries MVGC 1980–2007
Odhiambo (2010) South Africa MVGC 1969–2006
Panopoulou (2009) 5 countries MVGC 1995–2007
Colombage (2009) 5 countries MVGC 1995–2007
Odhiambo (2008) Kenya TVGC 1969–2005
Ang and McKibbin (2007) Malaysia MVGC 1960–2001
Liang and Teng (2006) China MVGC 1952–2001
Group 2: studies support SLH
Menyah et al. (2014) 21 African countries TVGC 1965–2008
Hsueh et al. (2013) Ten Asian countries BVGC 1980–2007
Bojanic (2012) Bolivia MVGC 1940–2010
Chaiechi (2012) South Korea, Hong Kong, UK MVGC 1990–2006
Kar et al. (2011) 15 MENA countries MVGC 1980–2007
Wu et al. (2010) European Union MVGC 1976–2005
Jalil et al. (2010) China TVGC 1977–2006
Abu-Bader and Abu-Qarn (2008b) Egypt TVGC 1960–2001
Ang (2008b) Malaysia MVGC 1960–2003
Naceur and Ghazouani (2007) MENA region MVGC 1979–2003
Boulila and Trabelsi (2004) Tunisa BVGC 1962–1987
Agbetsiafa (2004) Sub-Saharan Africa TVGC 1963–2001
Calderon and Liu (2003) 109 countries MVGC 1960–1994
Thornton (1994) Asian countries BVGC 1951–1990
Group 3: studies support FBH
Pradhan et al. (2014) 34 OECD countries TVGC 1960–2011
Pradhan et al. (2013) 5 BRICS countries BVGC 1989–2011
Chow and Fung (2011) 69 countries TVGC 1970–2004
Wolde-Rufael (2009) Kenya QVGC 1966–2005
Dritsakis and Adamopoulos (2004) Greece TVGC 1960–2000
Craigwell et al. (2001) Barbados MVGC 1974–1998
Ahmed and Ansari (1998) India, Pakistan, Sri Lanka MVGC 1973–1991
Note 1 The definition of banking sector maturity varies across studies
Note 2 MMs mature markets, EMs emerging markets, BVGC bivariate granger causality, TVGC trivariate granger causality, QVGC
quadvariate granger causality, MVGC multivariate granger causality

financial development and economic growth (see, for
instance, Hassan et al. 2011; Hao 2006).
Hence, this study initiates a fresh look on the
relationship between financial development and eco-
nomic growth with a view in identifying stunning
issues and contributing some suggestions about how
these may be addressed in future. The main innovation
in this paper, compared to the existing literature on
finance-growth nexus, is twofold. First, we use a large
sample of 25 ASEAN1 regional forum (ARF) coun-
tries, including three sub-groups (Member countries,
Dialogue Partner countries and Observer countries),
both developed and developing, over a long and recent
span of time (1960–2012). As Table 1 reveals, this
group of countries has thus far not been studied in this
1
ASEAN stands for Association of South-East Asian Nations.

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literature. However, the main focus of this paper is to
study the relationship between banking sector devel-
opment and economic growth. Second, we use com-
posite index concept, by using principal component
analysis, to study the interrelationships between
financial development and economic growth.
The rest of the paper is organized as follows.
‘‘Literature review’’ section discusses the literature
review. ‘‘Proposed hypotheses and data structure’’
section highlights the methods of study. ‘‘Econometric
methods’’ section discusses the empirical results.
Finally, we summarize and conclude in ‘‘Conclusion
and policy implications’’ section.
Literature review
The asseveration that banking sector development is
one of the basic indicators of economic growth (as seen
in, for instance, Pradhan et al. 2014; Ang 2008a; Levine
2005; Demetriades and Hussein 1996) has encouraged
economists to investigate whether there is in fact such a
relationship. In this section, we highlight four strands of
literature for the interrelationships between banking
sector development and economic growth.
The first strand is supply-leading hypothesis (SLH)
which contends that banking sector development is a
necessary pre-condition to economic growth (King and
Levine 1993a, b; Shaw 1973). Here, the causality runs
from banking sector development to economic growth.
The proponents of this hypothesis maintain that bank-
ing sector development may induce higher economic
growth by directly facilitating and increasing savings in
the form of financial assets, thereby spawning capital
formation and hence promoting economic growth (see,
for instance, Quartey and Prah 2008; Abu-Bader and
Abu-Qarn 2008a, b; Christopoulos and Tsionas 2004;
Levine et al. 2000; Neusser and Kugler 1998; Levine
1997). The impact of the banking sector on the real
(production) side of the economy can hardly be over-
emphasized. Indeed, Calderon and Liu, (2003) and
Linag and Teng (2006) quote Goldsmith (1969) who
states that ‘one of the most important problems in the
field of finance….is the effect that banking structure
and financial development have on economic growth’.
A second strand is the demand-following hypothesis
(DFH) which suggests that causality runs instead from
economic growth to banking sector development.
Supporters of the demand-following hypothesis suggest
247
that banking development plays only a minor role in
economic growth and that is merely a by-product or an
outcome of economic growth in the real side of the
economy (Gries et al. 2009; Ang 2008b; Odhiambo
2008; Liang and Teng 2006; Jung 1986; Goldsmith
1969; Gurley and Shaw 1967; Robinson 1952). The
idea is that as an economy grows, additional banking
institutions and banking products and services emerge
in the market in response to higher demand for financial
services. Thus, the dearth of banking institutions in
developing countries indicates a lack of demand for
their services. Accordingly, as the real side of the
economy grows, the banking system develops further,
thereby increasing opportunities for funding investment
and diversifying risk (Gries et al. 2009; Quartey and
Prah 2008; Ang 2008b).
The third strand is the feedback hypothesis (FBH)
which suggests that economic growth and banking
sector development can complement and reinforce each
other, making banking sector development and real
economic growth mutually causal. The argument in
favour of the bidirectional causality is that banking
sector development is indispensable to economic
growth, and economic growth inevitably requires a
developed banking system (Pradhan et al. 2013; Prad-
han and Gunashekar 2012; Hassan et al. 2011; Mukho-
padhyay et al. 2011; Wolde-Rufael 2009; Odhiambo
2007; Calderon and Liu 2003; Shan et al. 2001; Khan
2001; Levine 1999; Luintel and Khan 1999; Blackburn
and Huang 1998; Demetriades and Hussein 1996).
The fourth strand is neutrality hypothesis (NLH)
which suggests that banking sector development and
economic growth are independent to each other. The
proponents of this hypothesis maintain that banking
sector development has no role towards economic
growth (Chandavarkar 1992). Table 1 provides a
summary of studies which supports these four hypoth-
eses, indicating the direction of the causal effect.
Proposed hypotheses and data structure
In this study, we use Granger causality test to present new
evidence on the relationship between banking sector
development and economic growth using a sample of 25
ARF countries over the period 1960–2012. We also use
cointegration tests to reveal whether these variables are
cointegrated; that is, whether there is a long-run
equilibrium relationship between them.
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248
Fig. 1 The Conceptual
Framework of the Possible
Patterns of Causality BRM
between the Variables from
a Theoretical Point of View.
Note PGD is per capita
economic growth, BSD is
banking sector development
CPS
index, BMS is broad money
supply, CLP is claims on
private sector, DCP is
domestic credit to private
sector, DCB is domestic DCP
credit provided by banking
sector
DCB
The novel features of this paper are that (a) it uses a
large sample of countries, being both developed and
developing, over a recent span of time; and (b) it
utilizes fairly sophisticated econometrics—and cer-
tainly empirical approaches until now are not taken in
these literatures—to answer questions concerning the
nature of the causal relationship between the variables
both in the short-run and long-run. The Fig. 1 depicts
the possible patterns of causal relations between
banking sector development and economic growth.
The study intends to test the following hypotheses:
H1 Development of Banking sector (DOB) in any
year Granger-causes economic growth. This is termed
the BSD-led economic growth hypothesis.
H2 Economic growth (GDP) in any year Granger-
causes banking sector development. This is termed the
GDP-led DOB hypothesis.
These two hypotheses are tested, both at the index
level and component-wise. The DOB is recognized here,
both at the index-level banking sector development
index (BSD) and component-wise. The components of
DOB are broad money supply (BMS), claims on private
sector (CLP), domestic credit to private sector (DCP) and
domestic credit provided by banking sector (DCB). The
Table 2 presents the definitions for all variables.
The above two hypotheses are tested at the individ-
ual country (25 countries) and at the panel levels
(4 panels). The countries included in the study are
Brunei, Burma, Cambodia, Indonesia, Laos, Malaysia,
Philippines, Singapore, Thailand, Vietnam, Australia,
Canada, China, European Union, India, Japan, New
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Decision (September 2014) 41(3):245–259
BSD GDP
Table 2 Definition of variables
Variables Definition
BSD Composite index of banking sector development:
This is based on four banking sector development
indicators: broad money supply, claims on
private sector, domestic credit to private sector
and domestic credit provided banking sector—
derived through principal component analysis
BRM Broad money supply: This is the ratio of broad
money (currency plus demand deposits and
quasi-money) to GDP
CLP Claims on private sectors: It includes gross credit
from the financial system to private sector
DCB Domestic credit provided by the banking sector: It
includes all credit to various sectors on a gross
basis, with the exception of credit to the central
government. It is expressed as a percentage of
gross domestic product
DCP Domestic credit to the private sector: This credit
(expressed as a percentage of gross domestic
product refers to financial resources provided to
the private sector, such as through loans,
purchases of non-equity securities and trade
credits and other accounts receivable that
establish a claim for payment
GDP Economic growth: Percentage change in per capita
gross domestic product used as our indicator of
economic growth
Note1 All monetary measures are in US dollars
Note2 All these indicators are used here as a proxy for ‘‘levels
of banking sector development’’
Zealand, Korean Republic, Russian Federation, United
Sates, PNG, Mongolia, Pakistan, East Timor, Bangla-
desh and Sri Lanka. The four panels are (i) ARF—
Decision (September 2014) 41(3):245–259 249

Table 3 Summary statistics on the variables

Countries Variables
PGD BSD BMS CLP DCP DCB

Panel A: MEC
Brunei 1.16 [0.06] 0.64 [0.09] 1.83 [0.07] – [–] 1.64 [0.09] 1.34 [0.25]
Burma 1.22 [0.20] 0.42 [0.14] 1.44 [0.06] 1.73 [0.06] 0.71 [0.20] – [–]
Cambodia 0.85 [0.26] 0.13 [0.23] 1.23 [0.25] 1.81 [0.07] 0.95 [0.30] 0.94 [0.22]
Indonesia 1.24 [0.26] 0.37 [0.16] 1.57 [0.15] 1.78 [0.37] 1.46 [0.20] 1.56 [0.22]
Laos 0.69 [0.19] 0.31 [0.15] 1.25 [0.16] 1.85 [0.10] 0.92 [0.18] 0.98 [0.19]
Malaysia 1.26 [0.10] 0.15 [0.30] 1.89 [0.26] 1.78 [0.07] 1.73 [0.39] 1.81 [0.40]
Philippines 1.20 [0.12] 0.39 [0.14] 1.52 [0.17] 1.80 [0.09] 1.41 [0.14] 1.57 [0.16]
Singapore 1.30 [0.11] 0.43 [0.16] 1.91 [0.13] 1.79 [0.06] 1.86 [0.15] 1.67 [0.27]
Thailand 1.27 [0.13] 0.14 [0.29] 1.77 [0.24] 1.80 [0.09] 1.71 [0.37] 1.83 [0.33]
Vietnam 0.75 [0.10] 0.21 [0.22] 1.75 [0.27] 1.87 [0.05] 1.68 [0.30] 1.71 [0.29]
Panel B:DPC
Australia 1.23 [0.05] 0.28 [0.17] 1.74 [0.13] 1.79 [0.05] 1.67 [0.28] 1.80 [0.19]
Canada 1.23 [0.06] 0.21 [0.21] 1.83 [0.18] 1.78 [0.07] 1.83 [0.28] 1.92 [0.25]
China 1.37 [0.05] 0.45 [0.19] 1.96 [0.24] 1.84 [0.06] 1.94 [0.13] 1.97 [0.16]
European Union 12.4 [0.05] 0.21 [0.12] – [–] – [–] 1.86 [0.16] 1.96 [0.13]
India 1.25 [0.09] 0.36 [0.17] 1.57 [0.19] 1.77 [0.02] 1.31 [0.22] 1.59 [0.17]
Japan 1.25 [0.09] 0.48 [0.22] 2.17 [0.18] 1.76 [0.11] 2.16 [0.15] 2.29 [0.21]
New Zealand 0.78 [0.41] 0.25 [0.25] 1.76 [0.21] 1.81 [0.09] 1.81 [0.32] 1.86 [0.28]
Korean Republic 1.30 [0.09] 0.19 [0.37] 1.56 [0.23] 1.88 [0.09] 1.64 [0.28] 1.64 [0.27]
Russian Federation 1.15 [0.26] 0.43 [0.11] 1.47 [0.16] 1.91 [0.11] 1.32 [0.25] 1.46 [0.09]
United States 1.23 [0.06] 1.22 [0.11] 1.86 [0.04] 1.74 [0.03] 2.08 [0.13] 2.18 [0.12]
Panel C:OBC
Papua New Guinea 1.16 [0.14] 0.55 [0.09] 1.54 [0.08] 1.74 [0.04] 1.28 [0.12] 1.40 [0.12]
Mongolia 1.27 [0.10] 0.19 [0.24] 1.46 [0.19] 1.86 [0.13] 1.21 [0.34] 1.23 [0.24]
Pakistan 1.24 [0.06] 0.88 [0.05] 1.63 [0.04] 1.77 [0.03] 1.38 [0.07] 1.67 [0.06]
East Timor 1.25 [0.09] 0.27 [0.19] – [–] – [–] 1.86 [0.20] 1.93 [0.18]
Bangladesh 1.24 [0.06] 0.19 [0.22] 1.44 [0.25] 1.79 [0.04] 1.19 [0.034] 1.444 [0.23]
Sri Lanka 1.26 [0.05] 0.51 [0.11] 1.49 [0.09] 1.77 [0.11] 1.24 [0.20] 1.55 [0.09]
Note 1 PGD is per capita economic growth, BSD is banking sector development index, BMS is broad money supply, CLP is claims on
private sector, DCP is domestic credit to private sector, DCB is domestic credit provided by banking sector, MEC is ARF member
countries, DPC is ARF dialogue partner countries, OBC is ARF observer countries
Note 2 Values reported here are the natural logs of the variables
Note 3 Open values represent the mean of the variables, while [] represents the standard deviation of the variables

Member countries (AMC), which includes Brunei,
Burma, Cambodia, Indonesia, Laos, Malaysia, Philip-
pines, Singapore, Thailand and Vietnam; (ii) ARF—
Dialogue Partner countries (ADC),2 which includes
Australia, Canada, China, India, Japan, New Zealand,
2
We observe only nine countries, which are used for our
analysis. To include the European Union, the tenth member,
would have meant double-counting of a couple of countries like
Australia, Canada and Japan.
Korean Republic, Russian Federation and the United
States; (iii) ARF—observer countries (AOC), which
includes Papua New Guinea, Mongolia, Pakistan, East
Timor, Bangladesh and Sri Lanka; and (iv) ARF—
Total countries (ATC), which all the 25 countries. Our
analysis utilizes annual time series data over the period
1960–2012. The data are abstracted and transformed
from World Development Indicators, published by the
World Bank. The Table 3 presents the descriptive
statistics of these variables.

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The procedures of testing these two hypotheses We use the below prescribed models for detecting
(H1–H2) are explained in Sect. Econometric methods. the causal nexus between banking sector development
and economic growth.
Econometric methods Model 1 If the variables are integrated of order one
[i.e., I (1)] and not cointegrated, then the
We deploy two techniques to study the banking sector test of causality requires the estimation of
development-economic growth nexus: Principal Com- the following:
ponent Analysis (PCA) and Granger causality (GC) test.
X
p
The PCA is used to construct the composite indices DGDPt ¼ g1 þ a1j DGDPtj
of banking sector development, which can signal the j¼1
overall position of banking sector in the economy. On X
q

the other hand, panel vector auto-regressive (VAR) þ b1j DDOBtj þ e1t ; ð1Þ
j¼1
model is used to know the causal nexus between
banking sector development and economic growth. X
p

The advantage of this method is to exploit individual DDOBt ¼ g2 þ a2j DDOBtj

j¼1
time series and cross-sectional variations in data and X
q
avoids biases associated with cross-sectional regres- þ b2j DGDPtj þ e2t ; ð2Þ
sions by taking the country-specific fixed effect into j¼1
account (see, for example, Levine 2005).
where GDP is per capita economic growth,
The OECD (2008) clarifies the methodology of
DOB is development of banking sector
composite indices by defining the ten steps: theoretical
(proxy for both composite index of bank-
framework, data selection, imputation of missing data,
ing sector and its individual components),
choosing multivariate data analysis, normalization,
p and q are the number of lags selected for
weighting and aggregation, uncertainty and sensitivity
the estimation, D is the first difference
analysis, back to the data, links to other indices and
filter, eit (for i = 1 and 2) is an indepen-
visualization of results. Following these steps, variables
dently and normally distributed random
are selected to construct the composite index of banking
error with a zero mean and a finite
sector development (BSD). The BSD is prepared on the
heterogeneous variance (r2i ).
basis of the following steps: first, data are arranged in the
Model 2 If the variables are I (1) and cointegrated,
same order to create the input matrix for PCA; second,
then the test of causality requires the
data matrix is normalized based on the min–max
estimation of the following:
method. Using PCA, eigen values, factor loadings and
PCs are derived. Finally, the PCs are used to construct
these two indices separately for each country for each X
p
DGDPt ¼ g3 þ a3j DGDPti
year (see, for more details, Hosseini and Kaneko 2012, j¼1
2011; Jalil et al. 2010; Joliffe 2002; Sharma 1996; X
q
Manly 1994). The variables that included in the þ b3j DDOBtj
construction of BSD are stated in Table 2. j¼1

The Granger causality test is applied to know the þ d1 ECT1t1 þ e3t ; ð3Þ
direction of causality between banking sector devel- X
p
opment and economic growth. We use GC test for DDOBt ¼ g4 þ a4j DDOBti
individual country analysis and at the panel setting. j¼1
X
q
The traditional GC (Granger 1988, 1981) is used for þ b4j DGDPtj
the individual country analysis, while panel VAR j¼1
(Holtz- Eakin et al. 1988) is used at the panel setting. þ d2 ECT2t1 þ e4t ; ð4Þ

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where GDP is per capita economic growth,
DOB is development of banking sector
(proxy for both composite index of
banking sector and its individual
components), ECT is error correction
term, which is derived from cointegration
equation, p and q are the number of lags
selected for the estimation, D is the first
difference filter; eit (for i = 3 and 4) is an
independently and normally distributed
random error with a zero mean and a finite
heterogeneous variance (r2i ). We use the
following models for the panel setting to
study the causal nexus between banking
sector development and economic growth.
Model 3 If time series variables are 1 (1) and not
cointegrated, then the test of causality
requires the estimation of the following:
X
p
DGDPit ¼ g5j þ a5ik DGDPitk
k¼1
X
q
þ b5ik DDOBitk þ e5it ;
k¼1
ð5Þ
X
p term, which is derived from cointegration
DDOBit ¼ g6j þ a5ik DDOBitk
k¼1
X
q selected for the estimation, D is the first
þ b6ik DGDPitk þ e6it
k¼1
ð6Þ
where i = 1, 2…., N represents the coun-
try in the panel, t = 1, 2…., T represents
the year in the panel, GDP is per capita
economic growth, DOB is development of
banking sector (proxy for both composite
index of banking sector and its individual
components), p and q are the number of
lags selected for the estimation, D is the
first difference filter, Ejit (for j = 5 and 6)
is an independently and normally distrib-
uted random error with a zero mean and a
finite heterogeneous variance (r2i ). We use
the following models for the panel setting
to study the causal nexus between banking
sector development and economic growth.
251
Model 4 If the variables are 1 (1) and
cointegrated, then direction of causality
is tested by using error correction model.
The process requires the estimation of
the following:
X
p
DGDPit ¼ g7j þ a7ik DGDPitk
k¼1
X
q
þ b7ik DOBitk
k¼1
þ d3i ECT3it1 þ e7it ; ð7Þ
X
p
DDOBit ¼ g8j þ a8ik DDOBitk
k¼1
X
q
þ b8ik GDPitk
k¼1
þ d4i ECT4it1; þ e8it ð8Þ
where i = 1, 2…., N represents the coun-
try in the panel, t = 1, 2…., T represents
the year in the panel, GDP is per capita
economic growth, DOB is development of
banking sector (proxy for both composite
index of banking sector and its individual
components), ECT is error correction
equation, p and q are the number of lags
difference filter, Ejit (for j = 7 and 8) is an
independently and normally distributed
random error with a zero mean and a finite
heterogeneous variance (r2i ).
It can be noted that the choice of a particular model
depends upon the order of integration and the co-
integrating relationship. We deploy unit root test and
cointegration test, both at individual country and the
panel setting, for knowing the order of integration and
the presence of co-integrating relationship.
The traditional Augmented Dickey Fuller (Dickey
and Fuller 1981) unit root is used for individual
country analysis, while LLC (Levine et al. 2002) and
the Fisher-ADF and PP panel unit root tests [Maddala
and Wu 1999, 1998] are used for the panel settings.
On the other hand, Johansen (Johansen 1988) cointe-
gration test is deployed for individual country ana-
lysis, while Pedroni (2004, 1999) panel cointegration
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test3 is used for the panel setting. The details of these
two tests (unit root and cointegration) are not
discussed here due to space constraints and can be
incorporated, if there is any need of the requirement.
Empirical results and discussion
The Granger causality tests are used to examine the
causal nexus between banking sector development and
economic growth. A necessary step for this test is to
check for the stationarity of the time series variables
and their co-integrating relationship. The discussion
begins with the stationarity issue. Using unit root
(ADF test at the individual country level and LLC at
the panel level), we reject the null hypothesis of unit
root at the first difference but not for the levels (see
Tables 4 and 5). This indicates that banking sector
development (both at index level and component-
wise) and economic growth are non-stationary at the
level data but are stationary at the first difference. This
is true for all the 25 ARF countries, both individually
and collectively (i.e. at the panel setting). This
suggests that both banking sector development (at
index level and component-wise) and economic
growth are integrated of order one [i.e. I (1)] which
opens the possibility of cointegration between them.
In the next step, we deploy the Johansen Maximum
Likelihood cointegration test (by kTra and kMax test) at
the individual country level and Pedroni panel
3
Pedroni (1999) suggests two types of test to determine the
existence of heterogeneity of the cointegration vector. The first
is a test which uses the within-dimension approach (a panel test).
It uses four statistics, namely a panel v-statistic, a panel q-
statistic, a panel PP-statistic and a panel ADF-statistic. These
statistics pool the auto-regressive coefficients across different
panel members for the unit root tests to be performed on the
estimated residuals. The second is a test based on the between-
dimensions approach (a group test). It includes three statistics: a
group q-statistic, a group PP-statistic and a group ADF-statistic.
These statistics are based on estimators that simply average the
individually estimated auto-regressive coefficients for each
panel member. There are basically five steps to obtain these
cointegration statistics. The mathematical exposition and the
asymptotic distributions of these panel cointegration statistics
are contained in Pedroni (1999). Under an appropriate stan-
dardization, based on the moments of the vector of Brownian
motion function, these statistics are distributed as standard
normal. Accordingly, the null of no cointegration is then tested,
based on the above description of standard normal distribution.
The detailed discussions of these tests are available in Pedroni
(2000).
123
Decision (September 2014) 41(3):245–259
cointegration test at the panel setting for checking
for the existence of cointegration between banking
sector development and economic growth. The results
of both the test statistics are reported in Tables 6 and 7.
These results indicate that, in most cases (both at the
country level as well as at the panel level), the
variables considered in our study are cointegrated,
suggesting the existence of long-run relationships
between them. However, cointegration, in some cases,
does not exist for some countries like Cambodia, Laos,
Russian Federation, Mongolia and Bangladesh. Thus,
for these countries, we test the Granger causality by
using a VAR model instead of a vector error correction
model (VECM).
Having confirmed the existence of cointegration
between the variables, the next step is to determine the
direction of causality between banking sector devel-
opment (both by index and component-wise). Using
Granger causality test, the estimated results (see
Table 8) suggest the following.
Case 1: between composite index of banking sector
development (BSD) and economic growth (GDP)
For Cambodia, Indonesia, Malaysia, Thailand, Viet-
nam, Canada, Japan, Korean Republic, Papua New
Guinea, Mongolia, Pakistan and Sri Lanka, there is a
unidirectional causality from economic growth to
banking sector development (GDP =[ BSD), whereas
for Laos, Philippines, India, New Zealand, Russian
Federation, and the United States, banking sector
development causes economic growth
(BSD =[ GDP). Furthermore, for Burma, Australia,
China and European Union, East Timor and Bangla-
desh, there is bidirectional causality between banking
sector development and economic growth
(BSD \=[ GDP), while in the context of Singapore,
economic growth does not cause banking sector
development (GDP \#[ BSD). The latter case results
may be due to low sample size only.
Case 2: between broad money supply and economic
growth (GDP)
For Malaysia, Canada, Japan, Papua New Guinea,
Pakistan and Sri Lanka, there is a unidirectional
causality from economic growth to banking sector
 Decision (September 2014) 41(3):245–259
Table 4 Results of unit root test (individual country analysis)
Countries Variables

PGD BSD BMS CLP DCP DCB

Panel A: MEC
Brunei – [–] – [–] – [–] – [–] – [–] – [–]
Burma -0.07 [-11.2*] -0.99 [-8.69*] -0.29 [-8.15*] 0.32 [-6.29*] -0.79 [-5.83*] – [–]
Cambodia -0.74 [-5.52*] 0.72 [-3.72*] 3.37 [-5.45*] -0.37 [-4.99*] 3.26 [-2.09**] 2.89 [-1.99**]
Indonesia -0.38 [-8.49*] 0.32 [-4.31*] 0.67 [-2.67*] -0.49 [-9.17*] 0.64 [-4.17*] 0.57 [-3.66*]
Laos 0.13 [-8.74*] 0.84 [-3.04*] 2.12 [-3.41*] -0.25 [-3.38*] 1.36 [-2.76**] 0.95 [-7.93*]
Malaysia -0.24 [-9.24*] -0.81 [-3.50*] 1.52 [-6.56] -0.04 [-10.5*] 2.59 [-2.84*] 1.91 [-5.44*]
Philippines -0.22 [-6.79*] 0.19 [-5.72*] 1.72 [-6.30*] -0.38 [-8.13*] 0.17 [-4.42*] 0.44 [-5.22*]
Singapore -0.32 [-9.66*] 1.65 [-7.02*] 1.54 [-6.87*] 0.02 [-8.33*] 1.94 [-6.51*] 1.70 [-6.93*]
Thailand -0.36 [-7.66*] 0.11 [-4.49*] 2.71 [-3.82*] -0.04 [-6.10*] 1.77 [-3.20*] 1.76 [-3.78*]
Vietnam -0.52 [-3.65*] 0.23 [-4.45*] 3.01 [-2.06**] 0.03 [-4.00*] 3.72 [-2.19**] 3.37 [-3.08*]
Panel B:DPC
Australia 0.02 [-10.8*] 1.35 [-7.20*] 2.47 [-5.99*] 0.15 [-7.22*] 5.36 [-3.90*] 3.52 [-5.20*]
Canada -0.27 [-9.10*] -0.21 [-8.35] 1.24 [-7.22] -0.06 [-6.98*] 1.91 [-6.39*] 2.10 [-6.63*]
China 0.01 [-5.18*] 1.61 [-2.41*] 4.41 [-2.61*] 0.32 [-6.71*] 2.30 [-4.58*] 2.69 [-4.98*]
European Union -0.78 [-8.20*] 3.77 [-8.02*] – [–] – [–] 3.73 [-6.33*] 4.56 [-7.18*]
India 1.87 [-9.53*] 2.58 [-11.3*] 4.29 [-4.09*] 0.53 [-14.3*] 4.34 [-2.87*] 3.70 [-4.82*]
Japan -1.25 [-7.55*] 3.23 [-6.41*] 2.68 [-6.69*] -0.77 [-11.4*] 1.10 [-5.96*] 3.12 [-5.89*]
New Zealand -0.88 [-8.66*] 0.27 [-6.22*] 1.61 [-4.74*] -0.26 [-9.07*] 1.98 [-4.57*] 1.65 [-5.15*]
Korean Republic -0.13 [-6.60*] -0.76 [-16.2*] 1.98 [-4.10*] -0.40 [-8.11*] 2.46 [-3.59*] 2.31 [-4.42*]
Russian Federation 0.24 [-6.30*] 3.01 [-4.13*] 4.17 [-5.64*] -1.13 [-6.04*] 2.02 [-5.99*] 0.19 [-3.95*]
United States -0.76 [-6.21*] 3.06 [-3.41*] 1.03 [-5.52*] -0.37 [-6.81*] 3.12 [-3.33*] 3.01 [-6.62*]
Panel C:OBC
Papua New Guinea -0.19 [-7.79*] 0.38 [-5.80*] 0.61 [-6.47*] -0.17 [-7.81*] 0.20 [-3.87*] 0.47 [-5.88*]
Mongolia 4.75 [-4.80*] 1.58 [-4.34*] 1.58 [-4.34*] -0.19 [-5.56*] 1.46 [-4.97*] 0.88 [-6.76*]
Pakistan -0.06 [-8.33] 0.51 [-5.84*] 0.53 [-6.41*] 0.02 [-8.78*] 1.21 [-4.69*] 0.29 [-5.29*]
East Timor -0.48 [-8.23*] 2.78 [-2.71**] – [–] – [–] 1.16 [-2.48**] 2.89 [-3.07*]
Bangladesh 0.75 [-6.23*] -0.02 [-6.43*] 3.83 [-4.48*] 0.14 [-5.83*] 2.93 [-4.21*] 3.31 [-4.65*]
Sri Lanka 0.47 [-11.2*] 0.24 [-9.10*] 0.79 [-5.81*] 0.10 [-12.3*] 0.64 [-6.55*] 0.58 [-7.68*]
Panel D: TAC

Note 1 PGD is per capita economic growth, BSD is banking sector development index, BMS is broad money supply, CLP is claims on private sector, DCP is domestic credit to private sector, DCB is
123

domestic credit provided by banking sector

Note 2 MEC is ARF member countries; DPC is ARF dialogue partner countries, OBC is ARF observer countries; TAC is ARF total countries

253
Note 3 * indicates statistical level of significance at the 1 % level; ** indicates statistical level of significance at the 5 % level; and – [–]: not available
254 Decision (September 2014) 41(3):245–259

Table 5 Results of unit root test (for panel setting)

PGD BSD BMS CLP DCP DCB

Panel A: MEC
LLC -3.25 [-19.3*] 2.06 [-13.0*] 3.22 [-10.0*] -4.95 [-17.2*] 1.07 [-10.2*] 1.08 [-9.50*]
ADF 53.18 [458.7*] 8.26 [198.5*] 4.36 [143.2*] 50.5 [422*] 10.2 [139.4*] 9.23 [131*]
PP 68.0 [144.2*] 8.26 [430*] 4.42 [320*] 71.2 [128.0*] 7.69 [219.7*] 10.0 [219*]
Panel B:DPC
LLC -0.60 [-21.0*] 0.81 [-10.7*] 4.91 [-9.99*] -4.04 [-19.4*] 5.35 [-8.89*] 6.70 [-9.98*]
ADF 9.29 [551*] 24.3 [138.4*] 0.89 [129.8*] 50.4 [397.8*] 1.08 [117.6*] 0.93 [133.3*]
PP 11.2 [176.8*] 21.4 [261.5*] 0.66 [238.8*] 80.7 [186.8*] 0.72 [238.3*] 0.79 [284.9*]
Panel C:OBC
LLC 0.59 [-14.0*] 0.54 [-10.5*] 1.91 [-9.14*] -3.45 [-14.5*] 2.12 [-7.09*] 1.38 [-9.47*]
ADF 3.24 [213.7*] 2.56 [112.0*] 1.74 [99.4*] 25.3 [229.0*] 2.84 [67.6*] 2.59 [98.4*]
PP 3.21 [100.5*] 2.91 [263.0*] 1.46 [147.2*] 41.4 [862.0*] 1.99 [109.5*] 3.31 [153.2*]
Panel D:TAC
LLC 0.23 [-32.1*] -0.07 [-23.3*] 6.14 [-16.6*] -6.95 [-29.6*] 5.59 [-15.1*] 6.53 [-16.4*]
ADF 21.5 [125.2*] 74.9 [546.6*] 6.99 [372.4*] 126.25 [1050*] 14.2 [325.0*] 12.7 [362.9*]
PP 22.6 [420.5*] 81.1 [140.0] 6.54 [706.4*] 193.3 [401.0*] 10.4 [568.0*] 14.2 [657.3*]
PGD is per capita economic growth, BSD is banking sector development index, BMS is broad money supply, CLP is claims on private
sector, DCP is domestic credit to private sector, DCB is domestic credit provided by banking sector
LLC Levine-Lin-Chu statistics, ADF augmented Dickey Fuller test, PP Phillips and Perron test, LD level data, FD first difference
data
MEC is ARF member countries, DPC is ARF dialogue partner countries, OBC is ARF observer countries, TAC is ARF total countries
[] the parentheses include the values of test statistics at the first difference level, and the open figures are the values of test statistics at
the level data
Note 5 * indicates significance at 1 % level, and ** indicates significance at 5 % level

development (GDP =[ BRM), whereas for Laos,
Philippines, Singapore, India, New Zealand, Korean
Republic, Russian Federation, the United States,
Mongolia and Bangladesh, banking sector develop-
ment causes economic growth (BRM =[ GDP).
Besides, for Burma, Cambodia, Vietnam, Australia,
China and all the panels (MEC, DPC, OBC and TAC),
there is bidirectional causality between banking sector
development and economic growth (BRM \=[ GDP),
while in the context of Indonesia, economic growth
does not cause banking sector development
(GDP \#[ BRM).
there is a unidirectional causality from economic
growth to banking sector development
(GDP =[ CLP), whereas for Burma, Thailand, New
Zealand, Korean Republic, Russian Federation and
Papua New Guinea, banking sector development
causes economic growth (CLP =[ GDP). Addition-
ally, for Laos, Australia, Canada, India, DPC, OBC
and TAC, there is bidirectional causality between
banking sector development and economic growth
(CLP \=[ GDP). However, we do not find any
countries that have no causality between banking
sector development and economic growth [i.e. finance
is unimportant for economic growth].

Case 3: between claims on private sector (CLP)

and economic growth (GDP)
For Cambodia, Indonesia, Malaysia, Philippines,
Singapore, Vietnam, China, Japan, the United States,
Mongolia, Pakistan, Bangladesh, Sri Lanka and MEC,
Case 4: between domestic credit to private sector
(DCP) and economic growth (GDP)
For Burma, Laos, Thailand, Canada, European Union,
Korean Republic, Russian Federation, Papua New

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Decision (September 2014) 41(3):245–259 255

Table 6 Results of cointegration test (for individual country Vietnam, India, New Zealand, the United States,
analysis) MEC and DPC, banking sector development causes
Countries Variables (with PGD) economic growth (DCP =[ GDP). In addition, for
Cambodia, Australia, China, Japan, East Timor, and
BSD BMS CLP DCP DCB
Bangladesh, there is bidirectional causality between
Panel A: MEC banking sector development and economic growth
Brunei – [–] – [–] – [–] – [–] – [–] (DCP \=[ GDP), while in the context of Indonesia
Burma 2 2 2 2 2 and Singapore, economic growth does not cause
Cambodia 0 1 2 0 0 banking sector development (GDP \#[ BSD). The
Indonesia 2 2 2 2 2 case of Indonesia and Singapore may be due to low
Laos 0 1 0 0 0 sample size only.
Malaysia 2 1 2 2 2
Philippines 1 1 2 2 2
Singapore 1 1 2 2 1 Case 5: between domestic credit provided
Thailand 1 1 2 1 1 by banking sector (DCB) and economic growth
Vietnam 1 1 1 1 1 (GDP)
Panel B: DPC
Australia 1 1 2 1 1 For Cambodia, Indonesia, Malaysia, Thailand, Canada,
Canada 1 1 2 2 1 European Union, Korean Republic, Russian Federa-
China 1 2 2 1 1 tion, Papua New Guinea, Mongolia, Pakistan, Sri
European Union 1 – [–] – [–] 1 1
Lanka, OBC and TAC, there is a unidirectional
India 1 1 2 1 1
causality from economic growth to banking sector
development (GDP =[ DCB), whereas for Laos,
Japan 2 1 2 1 2
Philippines, Australia, New Zealand, the United States
New Zealand 1 1 2 1 1
and DPC, banking sector development causes eco-
Korean Republic 1 1 2 1 1
nomic growth (DCB =[ GDP). Moreover, for Viet-
Russian Federation 0 0 1 0 1
nam, China, India, Japan, East Timor and MEC, there
United States 1 1 1 1 1
is bidirectional causality between banking sector
Panel C: OBC
development and economic growth (DCB \=[ GDP),
Papua New Guinea 2 2 2 1 2
while in the context of Singapore, economic growth
Mongolia 1 0 1 1 1
does not cause banking sector development
Pakistan 2 2 2 2 2
(GDP \#[ BSD). The case of Singapore is again
East Timor 1 – [–] – [–] 1 1
probably may be due to low sample size only.
Bangladesh 0 1 1 2 0
As is evident by these individual country results,
Sri Lanka 1 1 2 1 1 the nature of the causal relationship between the two
Note 1 PGD is per capita economic growth, BSD is banking variables are very much country specific. In some
sector development index, BMS is broad money supply, CLP is cases, banking sector development (both by index and
claims on private sector, DCP is domestic credit to private
component-wise) causes economic growth, while in
sector, DCB is domestic credit provided by banking sector
the latter case, it is economic growth that affects
Note 2 MEC is ARF member countries, DPC is ARF dialogue
partner countries, OBC is ARF observer countries, TAC is ARF banking sector development. Again in some cases,
total countries they reinforce each other, while in some other cases;
Note 3 0 no co-integrating vector, 1 indicates one co- they do not cause each other, i.e. they are neutral.
integrating vector, 2 two co-integrating vector, and – [–] not
available
Conclusion and policy implications
Guinea, Mongolia, Pakistan, Sri Lanka, OBC and
TAC, there is a unidirectional causality from eco- This paper examined the interrelationship between
nomic growth to banking sector development banking sector development and economic growth for
(GDP =[ DCP), whereas for Laos, Philippines, the 25 ARF countries using time series date from 1960

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Table 7 Results of pedroni cointegration test (for panel setting)

Test statistics M1 M2 M3 M4 M5

Panel 1: MEC
Panel v-statistics 3.28 [0.00] 3.66 [0.00] 1.85 [0.03] 3.70 [0.00] 1.37 [0.05]
Panel q-statistics -12.1 [0.00] -12.4 [0.00] -15.7 [0.00] -12.1 [0.00] -10.3 [0.00]
Panel PP-statistics -6.57 [0.00] -6.72 [0.00] -8.22 [0.00] -6.61 [0.00] -5.76 [0.00]
Panel ADF-statistics -4.39 [0.00] -4.43 [0.00] -5.54 [0.00] -4.58 [0.00] -3.93 [0.00]
Group q-statistics -6.25 [0.00] -6.74 [0.00] -9.13 [0.00] -6.10 [0.00] -5.28 [0.00]
Group PP-statistics -6.32 [0.00] -6.92 [0.00] -8.45 [0.00] -6.30 [0.00] -5.52 [0.00]
Group ADF-statistics -4.90 [0.00] -5.13 [0.00] -6.10 [0.00] -4.87 [0.00] -4.41 [0.00]
Panel 2: DPC
Panel v-statistics 1.030 [0.05] 2.53 [0.00] 1.14 [0.12] 3.42 [0.00] 2.88 [0.00]
Panel q-statistics -11.1 [0.00] -10.9 [0.00] -13.9 [0.00] -11.3 [0.00] -10.9 [0.00]
Panel PP-statistics -14.5 [0.00] -13.5 [0.00] -9.12 [0.00] -13.3 [0.00] -15.5 [0.00]
Panel ADF-statistics -7.63 [0.00] -7.43 [0.00] -5.41 [0.00] -7.11 [0.00] -8.11 [0.00]
Group q-statistics -11.8 [0.00] -11.3 [0.00] -12.5 [0.00] -11.8 [0.00] -11.6 [0.00]
Group PP-statistics -14.2 [0.00] -14.6 [0.00] -11.6 [0.00] -13.8 [0.00] -14.6 [0.00]
Group ADF-statistics -10.2 [0.00] -10.4 [0.00] -7.86 [0.00] -9.97 [0.00] -10.3 [0.00]
Panel 3: OBC
Panel v-statistics 1.97 [0.02] 2.96 [0.00] 2.62 [0.00] 2.23 [0.01] 1.41 [0.07]
Panel q-statistics -7.46 [0.00] -7.89 [0.00] -6.85 [0.00] -7.78 [0.00] -7.10 [0.00]
Panel PP-statistics -10.5 [0.00] -10.5 [0.00] -9.32 [0.00] -9.98 [0.00] -8.62 [0.00]
Panel ADF-statistics -4.76 [0.00] -4.82 [0.00] -3.20 [0.00] -4.70 [0.00] -3.51 [0.00]
Group q-statistics -9.83 [0.00] -9.83 [0.00] -8.69 [0.00] -9.72 [0.00] -9.39 [0.00]
Group PP-statistics -12.8 [0.00] -13.2 [0.00] -10.8 [0.00] -12.9 [0.00] -11.7 [0.00]
group adf-statistics -4.88 [0.00] -5.08 [0.00] -2.97 [0.00] -4.91 [0.00] -3.94 [0.00]
Panel 4: TAC
Panel v-statistics 1.47 [0.07] 5.05 [0.00] 2.01 [0.02] 6.72 [0.00] 3.14 [0.00]
Panel q-statistics -20.1 [0.00] -20.2 [0.00] -21.6 [0.00] -20.9 [0.00] -21.0 [0.00]
Panel PP-statistics -16.4 [0.00] -17.9 [0.00] -15.6 [0.00] -17.6 [0.00] -18.4 [0.00]
Panel ADF-Statistics -11.3 [0.00] -12.07 [0.00] -9.62 [0.00] -11.7 [0.00] -12.7 [0.00]
Group q-statistics -16.4 [0.00] -16.6 [0.00] -16.7 [0.00] -16.6 [0.00] -16.5 [0.00]
Group PP-statistics -18.5 [0.00] -20.3 [0.00] -16.4 [0.00] -20.2 [0.00] -19.4 [0.00]
Group ADF-statistics -13.1 [0.00] -13.9 [0.00] -10.1 [0.00] -13.5 [0.00] -13.5 [0.00]
Note 1 M1 is cointegration between PGD and BSD, M2 is cointegration between PGD and BMS, M3 is cointegration between PGD
and CLP, M4 is cointegration between PGD and DCP, M5 is cointegration between PGD and DCB
Note 2 PGD is per capita economic growth, BSD is banking sector development index, BMS is broad money supply, CLP is claims on
private sector, DCP is domestic credit to private sector, DCB is domestic credit provided by banking sector
Note 3 MEC is ARF member countries, DPC is ARF dialogue partner countries, OBC is ARF observer countries, TAC is ARF total
countries
Note 4 Figures in square brackets are probability levels indicating significance

to 2012. The main message from our study for
researchers and policy makers alike is that inferences
drawn from research on economic growth that
excludes the dynamic interrelation of the two variables
will be unreliable. It is the conjoint interplay between
these variables that distinguishes our study and guides
the future research on this topic.
Our study yields mixed evidence on the nexus
between these two variables (banking sector develop-
ment and economic growth), both at the index level

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Decision (September 2014) 41(3):245–259 257

Table 8 Results of granger causality test and component-wise, in the 25 ARF countries that we
Test statistics BSD BMS CLP DCP DCB
consider.
The findings, at the index level, suggest that in the
Panel A: MEC DFH FBH DFH SLH FBH case of Cambodia, Indonesia, Malaysia, Thailand,
Brunei – – – – – Vietnam, Canada, Japan, Korean Republic, Papua
Burma FBH FBH SLH DFH – New Guinea, Mongolia, Pakistan and Sri Lanka,
Cambodia DFH FBH DFH FBH DFH economic growth leads to banking sector develop-
Indonesia DFH NLH DFH NLH DFH ment, lending support to the demand-following
Laos SLH SLH FBH SLH SLH hypothesis. This implies that economic growth deter-
Malaysia DFH DFH DFH DFH DFH mines the level of banking sector development. In the
Philippines SLH SLH DFH SLH SLH case of Laos, Philippines, India, New Zealand, Rus-
Singapore NLH SLH DFH NLH NLH sian Federation and the United States, banking sector
Thailand DFH SLH SLH DFH DFH development leads to economic growth, lending
Vietnam DFH FBH DFH SLH FBH support to the supply-leading hypothesis. This implies
Panel B:DPC SLH FBH FBH SLH SLH that economic growth depends upon the level of
Australia FBH FBH FBH FBH SLH banking sector development of these countries.
Canada DFH DFH FBH DFH DFH In the case of Burma, Australia, China and Euro-
China FBH FBH DFH FBH FBH pean Union, East Timor and Bangladesh, banking
European Union FBH – – DFH DFH sector development and economic growth cause each
India SLH SLH FBH SLH FBH other, lending support to both the demand-following
Japan DFH DFH DFH FBH FBH and supply-leading hypotheses. That means they are
New Zealand SLH SLH SLH SLH SLH self-reinforcing and subject to feedback consistent
Korean Republic DFH SLH SLH DFH DFH between banking sector development and economic
Russian Federation SLH SLH SLH DFH DFH
growth.
United States SLH SLH DFH SLH SLH
The mixed evidence is also visible in the nexus
Panel C:OBC DFH FBH FBH DFH DFH
between the components of banking sector develop-
ment (such as broad money supply, claims on private
Papua New Guinea DFH DFH SLH DFH DFH
sector, domestic credit to private sector and domestic
Mongolia DFH SLH DFH DFH DFH
credit provided by banking sector) and economic
Pakistan DFH DFH DFH DFH DFH
growth. In some cases, it supports demand-following
East Timor FBH – – FBH FBH
hypothesis, while in other cases, it supports both
Bangladesh FBH SLH DFH FBH SLH
supply-leading and feedback hypotheses. The study
Sri Lanka DFH DFH DFH DFH DFH
finally suggests that in order to promote economic
Panel D:TAC DFH FBH FBH DFH DFH
growth, attention must be paid to policies that promote
Note 1 PGD is per capita economic growth, BSD is banking banking sector development. This in turn requires
sector development index, BMS is broad money supply, CLP is efficient allocation of financial resources combined
claims on private sector, DCP is domestic credit to private
sector, DCB is domestic credit provided by banking sector with sound regulation of the banking system.
Note 2 MEC is ARF member countries, DPC is ARF dialogue
Furthermore, an establishment of a well-developed
partner countries, OBC is ARF observer countries, TAC is ARF financial system, including well-functioning banks
total countries and other financial institutions can facilitate further
Note 3 DFH is demand-following hypothesis, indicating the investment and easier means of raising capital to
flow from economic growth to development of banking sector, support the economic activities in the economy. Given
SLH is supply-leading hypothesis, indicating the flow from
development of banking sector to economic growth, FBH is
the possibility of reverse or bidirectional causality for
feedback hypothesis, indicating the bidirectional causal some countries, policies that increase economic
relationships between development of banking sector and growth (such as measures to stimulate investment)
economic growth; and NLH is neutrality hypothesis, indicating would be desirable to bring about banking sector
no causal flow between development of banking sector and
economic growth
development.

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258
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