Economic freedom and financial development: international evidence.

• Author: Hafer, R.W.
• Position: Report

This article arises from two related research programs. One examines the relationship between financial development and economic growth. The basic conclusion from this work is that countries that experience greater financial development also experience faster rates of economic growth and higher levels of income per capita (King and Levine 1993a, 1993b; Levine and Zervos 1998; Rousseau and Wachtel 1998; Levine et al. 2000; and Levine 2003). Under this umbrella also are studies that test for the role of property rights and regulation on financial development. Shehzad and De Haan (2008) find that financial liberalization--a reduction in regulations--reduces the probability of a banking crisis and, therefore, promotes economic growth. Baier et al. (2012) find that countries with relatively low levels of regulation--more economic freedom--are less likely to experience a financial crisis in the near future (five years out) than countries with more regulation. Like De Haan et al. (2009), Baier et al. find that in the period immediately following a crisis there generally is a diminution of economic freedom that steins from increased regulation, portending slower economic growth in the future.

The other line of research investigates the institutional sources of economic growth. In addition to physical and human capital, researchers have considered a number of institutional factors as diverse as colonial background and religious preferences (overviews can be found in Sala-i-Martin 2002, Barro and Sala-i-Martin 2004, and Loayza and Soto 2002). A number of studies also have employed indexes of economic freedom to proxy for the socio-economic institutions that may affect economic growth. The weight of evidence from this work suggests that countries with higher levels of economic freedom experience faster economic growth (Gwartney et al. 2006, Weede and Kampf 2002, Weede 2006).

The question addressed in this article is whether greater economic freedom leads to a higher level of financial development. While there is evidence that more economic freedom is associated with improvements in credit allocation at the micro level (Hartarska and Nadolnyak 2007, Crabb 2008, Enowbi-Batuo and Kupukile 2009) and to better sovereign credit ratings (Roychoudhury and Lawson 2010), there does not appear to be any study that explicitly tests for the link between economic freedom and financial development.

The next section discusses the methodology and data used. It considers the role of economic freedom within the framework used by Levine et al. (2000) to explain the development of financial intermediaries across countries. Regression results are presented in the third section followed by a concluding section. Looking ahead, the results of this article do not reject the hypothesis that countries with higher levels of economic freedom are more likely to experience greater development of their financial intermediaries in subsequent years. Given previous research, this article thus identifies a path through which improving social institutions ultimately affect economic growth.

Methodology and Data

To assess the role that economic freedom plays in explaining differences in financial intermediary development across countries, I adopt the approach used by Levine, Loayza, and Beck (2000; hereafter, LLB). To explain observed differences in financial intermediary development, LLB estimate the regression

(1) [FINANCE.sub.i] = [alpha] + [beta]1 [LEGAL.sub.i] + [beta]2 log ([RGDPCAP.sub.i]) + [[epsilon].i]

where FINANCE represents a measure of financial development for the ith country, LEGAL represents the origin of the ith country's legal system, RGDPCAP is the ith country's per capita real GDP in the initial year of the sample period, [alpha] and the [beta]s are parameters to be estimated, and [epsilon] is the error term. Because the financial measures used in LLB are averages for the period 1960-95, initial per capita real GDP is the value in 1960.

LLB focus on three possible measures of financial intermediary development. (1) One is Liquid Liabilities, calculated as the ratio of liquid liabilities of the financial system--equal to currency plus demand deposits and interest-bearing liabilities of banks and nonbank financial intermediaries--relative to GDP. This is a common gauge of financial depth and the overall size of the financial sector (see King and Levine 1993a, 1993b, and the references cited therein). Though popular, LLB note that because it includes deposits among financial intermediaries, this can give rise to a degree of double counting. In addition, the ratio may not adequately capture the ability of the financial sector to reduce transactions costs and informational asymmetries. Even with these caveats, if the general size of the financial sector is positively correlated with the overall provision of financial services, then Liquid Liabilities is a serviceable indicator of the development of financial intermediation.

Another indicator of financial intermediary development is Bank Assets, which is equal to the ratio of commercial bank assets to the sum of commercial bank and central bank assets. This variable, also used in King and Levine (1993a, b), reflects how much of an economy's savings is .allocated by commercial banks relative to the central bank. The motivation for using this measure is that commercial banks are profit maximizers and, therefore, are more likely to identify and pursue investments than a central bank. In addition, given their objective functions, commercial banks probably invest in more oversight activities and are actively engaged in risk management and the allocation of financial resources among savers and borrowers in an efficient and socially effective manner. The downside is that Bank Assets may not accurately reflect the quality and quantity of financial services provided by intermediaries.

The third measure used is Private Credit, the ratio of credits by financial intermediaries made to the private sector to GDP. Private Credit isolates the role of the private sector. Considered by LLB as their "preferred" measure of financial intermediary development, it does not, however, capture the reduction in information and transactions costs thought to be the fundamental reason for financial intermediation. Still, LLB argue that higher values of Private Credit indicate "higher levels of financial services and therefore greater financial intermediary development" (p. 39).

Equation (1) controls for the initial level of economic development by including the initial (pre-financial development) level of per capita real GDP. Including the initial value of real income controls for the level of overall economic development prior to the period over which financial intermediary development is measured. Including the variable LEGAL draws on LaPorta et al. (1998), who found that the origin of a country's legal structure is important in establishing the rules that affect financial transactions, including contract enforcement...