Factors driving financial development in top and bottom globalized developing economies: Does economic globalization matter?

• Published date: 01 February 2022
• Author: Shreya Pal,Mantu Mahalik
• Date: 01 February 2022
• DOI: http://doi.org/10.1002/pa.2292

ACADEMIC PAPER

Factors driving financial development in top and bottom

globalized developing economies: Does economic globalization

matter?

Shreya Pal | Mantu Kumar Mahalik

Department of Humanities and Social

Sciences, Indian Institute of Technology,

Kharagpur, India

Correspondence

Dr. Mantu Kumar Mahalik, Assistant Professor

of Economics, Department of Humanities and

Social Sciences, Indian Institute of Technology,

Kharagpur, West Bengal-721302, India.

Email: mkm@hss.iitkgp.ac.in

Funding information

This manuscript is not funded by any institute/

university.

The “globalization-led financial development”hypothesis of Mishkin (2009) postu-

lates that globalization through the channel of institutional quality can improve finan-

cial development in developing economies. In this context, our study is motivated to

examine the effects of economic globalization and institutional quality on financial

development in top and bottom globalized developing countries using the panel data

of 1984–2016. We consider a sample of 15 European and Central Asian and 4 South

Asian countries as top and bottom globalized developing regions. Economic growth,

government investment and inflation are also included as a set of control variables in

financial development function. The battery of panel cointegration tests (Pedroni,

2004; Westerlund, 2007) is utilized, indicating the presence of long-run association

between the series. The findings from using Pesaran's et al. (2001) panel Auto-

regressive Distributed Lag (ARDL) model indicate that economic globalization and

institutional quality promote financial development in both the developing regions

but the effect of economic globalization on financial development is higher in top

globalized developing region than the bottom globalized developing region. Economic

globalization also enhances financial market and impedes the development of finan-

cial institutions in top globalized developing region, while it performs the opposite in

bottom globalized developing region. We find the varying effects of government

investment and inflation on financial development, while economic growth enhances

it in heterogeneous developing regions. These results are robust across alternative

panel techniques. Our findings suggest that economic globalization is an instrument

for the policymakers to improve developing countries’financial development in the

long-run.

1|INTRODUCTION

The debate over the financial development plays in stimulating

growth process (Christopoulos & Tsionas, 2004; De Gregorio &

Guidotti, 1995; Levine, 1997) has generated more heat than light fol-

lowing the Global Financial Crisis of 2008–2009 (Rousseau &

Wachtel, 2011

1

; Beck et al., 2014a). Beck et al. (2014a) also argue

that the financial system development all over the world has grown

by leaps and bounds but the financial development in developing

countries is still catching up. However, the development in the finan-

cial institutions and markets (i.e., financial development) is an impor-

tant ingredient which developing economies can utilize to augment

their qualitative and quantitative development process by reducing

income inequality (Agnello & Sousa, 2012; Beck, Demirgüç-Kunt, &

Levine, 2004; Zhang & Naceur, 2019), fostering economic growth

(Beck et al., 2014b; Beck, Levine, & Loayza, 2000; Calderón &

Liu, 2003; Caporale, Howells, & Soliman, 2004; Choong, Yusop,

Law, & Sen, 2003; Demetriades & Hussein, 1996; Hassan, Sanchez, &

Received: 28 June 2020 Revised: 13 July 2020 Accepted: 14 July 2020

DOI: 10.1002/pa.2292

J Public Affairs. 2022;22:e2292. wileyonlinelibrary.com/journal/pa © 2020 John Wiley & Sons Ltd 1of17

https://doi.org/10.1002/pa.2292

Yu, 2011; Herwartz & Walle, 2014; Jedidia, Boujelbène, &

Helali, 2014; Khan & Senhadji, 2000; King & Levine, 1993; Law,

Azman-Saini, & Ibrahim, 2013; Levine, 1997; Levine & Zervos, 1998;

Rajan & Zingales, 1998; Schumpeter & Redvers, 1934) and promoting

well-being of the people (Alam, Shahbaz, & Paramati, 2016; Castelló-

Climent & Doménech, 2008; Shahbaz, Shafiullah, & Mahalik, 2019).

The developing economies to be more effective in addressing these

developmental challenges, financial development must be healthy.

Mastering greater globalization is one of the key driving factors in

promoting healthy financial development in developing economies

(Mishkin, 2009). Mishkin (2009) further argues that the developing

countries with greater globalization can only enjoy the benefit of sus-

tainable growth in the financial institutions and markets if improved

institutional quality continues to exist in the form of strong property

rights, effective legal systems and sound financial regulations. An

improved institutional quality being the key channel of globalization

promoting the healthy financial development will mobilize the finan-

cial resources effectively among the competing uses and reduce the

misallocation of savings and investments in developing economies.

The role of globalization through the channel of institutional qual-

ity in promoting financial development has been stressed in the cur-

rent literature. Few studies have shed light on the nexus between

globalization and financial development in developing and developed

countries (Kandil, Shahbaz, & Nasreen, 2015; Law, Tan, & Azman-

Saini, 2015; Nasreen, Mahalik, Shahbaz, & Abbas, 2020; Shahbaz

et al., 2018a; Shahbaz et al., 2018b). Moreover, they find the hetero-

geneous effects of globalization and institutional quality on financial

development which may be due to the type of economy and econo-

metric technique used in their analysis. The originality of our study is

that it extends the current literature by raising a research question of

whether economic globalization equally or differently matters in the

promotion of financial development for the top and bottom globalized

developing regions of the world. The comparative empirical verifica-

tion on the link between economic globalization and financial devel-

opment in top (i.e., European and Central Asian region) and bottom

(i.e., South Asian region) globalized developing economies has seri-

ously lagged. This extension is important, especially in a comparative

empirical investigation because many of the sample countries are

developing in nature grappling with multifaceted challenges of poor

financial development, rising income inequality and poverty. More-

over, it handles this research gap following the “globalization-led

financial development”hypothesis of Mishkin (2009) and also tackles

the empirical testing by using different panel econometric techniques

for heterogeneous developing economies. To the best of our knowl-

edge, this is the first comparative study exploring the linkage between

economic globalization and financial development for top and bottom

globalized developing regions relying on the panel framework of the

annual observations between 1984 and 2016 by controlling institu-

tional quality, economic growth, government investment and inflation

as additional important determinants in financial development func-

tion. We choose these control variables for empirical investigation of

financial development function based on the existing studies

(e.g., Falahaty & Law, 2012; Kandil et al., 2015; Khan et al., 2000;

Khan, Senhadji, & Smith, 2006; Law & Azman-Saini, 2012; Nasreen

et al., 2020; Samargandi, Fidrmuc, & Ghosh, 2014; Samargandi,

Fidrmuc, & Ghosh, 2015; Shahbaz et al., 2018b; Shahbaz, Mallick,

et al., 2018; Tovar García, 2012) where they indicate the importance

of these control factors influencing financial development in the long-

run.

2

The basis of adding control factors in financial development

function would also guide policymakers about the sources of financial

development dynamics in heterogeneous developing countries while

conducting the long-term economic and financial policies. In doing

this, finding of this study based on the usage of appropriate panel

techniques and historical sample data can be generalized to other

developing countries while dealing with an objective of promoting

financial development in the long-run.

However, the reason for choosing the heterogeneous developing

economies in our empirical setting is partly because of “globalization-

led financial development hypothesis”recently proposed by

Mishkin (2009) who sees its greater relevance largely for the develop-

ing countries. The financial development is essential for the develop-

ing countries because of rising investment required to stimulate

economic activities. When developing economies are interconnected

with each other in terms of trade and financial flows, they need the

growing role of economic globalization as “mushroom”which can

grow the financial cake in the long-run. The rising financial cake

appears to be a strong source of savings for balancing the greater

investments in economic activities of the developing countries. Given

that Mishkin's ‘globalization-led financial development’hypothesis is

not yet tested empirically for heterogeneous developing countries

within a panel framework. The developing countries are also expected

to account for approximately 60% of world gross domestic product

(GDP) by 2030.

3

Moreover, the recent estimates of the World Bank

and International Monetary Fund shown in Figures 1 and 2 indicate

that Europe and Central Asia developing region is highly globalized

and also contributing greater share of the world GDP per capita than

the South Asian developing region. Interestingly, South Asian devel-

oping region is the bottom globalized among developing countries and

also contributes less to the world GDP per capita. Feldstein and

Horioka's (1979) hypothesis

4

is an another basis of choosing both

top and bottom globalized developing regions among the developing

countries forthe empirical analysis of this study.Figure 3 further shows

that the correlation between domestic savings and investments is high

for the South Asian developing region, whereas it is minimal for the

Europe and Central Asian developing region. Finally, it enables us to

conclude that South Asian region is bottom globalized developing

region, and Europeand Central Asian are also top globalizeddeveloping

region.

Our estimates for a panel of 15 and 4 in top and bottom global-

ized developing countries for the period 1984–2016 show that both

economic globalization and institutional quality matter for financial

development in both the developing regions but the effect of eco-

nomic globalization on financial development is higher in top global-

ized developing region than the bottom globalized developing region.

Economic globalization also enhances financial market and impedes

the development of financial institutions in top globalized developing

2of17 PAL AND KUMAR MAHALIK