The finance-growth link in Latin America.

• Author: Blanco, Luisa

1. Introduction

   During the 1980s, most Latin American countries suffered from distorted financial systems. In this decade the government kept interest rate controls, allocated credit arbitrarily, and deterred the expansion of security markets and the creation of new financial institutions (Edwards 1999). Nonetheless, there has been a significant improvement on the levels of financial development in the region. While credit to the private sector as a share of gross domestic product (GDP) in the Latin American region was on average 12% in the 1960s, it grew to an average of 29% in the early 2000s. (1) Even though Latin American countries experienced significant financial reforms in the 1990s that promoted financial deregulation and the growth of the stock market, financial development indicators show that the region is financially underdeveloped when compared to other emerging regions. (2) Therefore, lack of financial depth may be a barrier to better economic performance in Latin America.

   The link between financial development and economic growth is complex because the direction of causation between the two variables may run both ways. Theoretical and empirical analyses support causality running from financial development to economic growth (supply-leading hypothesis), but there is also evidence that economic growth causes financial development (demand-following hypothesis). It has also been posited that the relationship between financial development and growth varies across countries depending on different economic and institutional conditions. Therefore, the goals of this paper are to determine whether financial development causes economic growth in the Latin American region and to determine whether there are specific conditions that allow this to happen.

   There is a vast literature on the analysis of the relationship between financial development and economic growth, but there are few empirical analyses that pool only Latin American countries. From a sample of 18 Latin American countries, with observations from 1962 to 2005, this paper focuses on determining the way of causation between financial development and economic growth. This paper also explores whether the relationship between financial development and economic growth is different across countries with different economic and institutional conditions. The indicators of financial development used are private credit, liquid liabilities, and bank deposits as a share of GDP.

   Using a vector autoregression (VAR) model, the Granger causality test supports the demand-following hypothesis for the whole region. The impulse response functions (IRFs) show that a shock to GDP growth causes greater financial development, but a shock to financial development has no impact on GDP growth. These findings are robust to different measures of financial development and model specifications.

   When the sample is divided according to different income levels, there is two-way causality only for the middle income group. When the sample is divided according to institutional setups, the same result is found for countries with stronger rule of law and creditor rights. While the flow from financial development to growth is weaker for the stronger rule of law and creditor rights sample than for the middle income sample, a shock to financial development causes greater economic growth for both subsamples. Although these findings support the argument that the finance-growth link is dependent on income levels and institutional settings, the impact of financial development on economic growth is relatively small for the middle income and higher institutional quality samples.

   To summarize, the main objectives of this analysis are to determine whether financial development causes economic growth in Latin America or vice versa, and whether the finance-growth link is different across countries with different economic and institutional conditions in this region. The rest of the paper is organized as follows: Section 2 presents a review of the literature on the relationship between financial development and economic growth and an overview on financial development in Latin America; section 3 describes the data; section 4 outlines the model specification; section 5 presents the empirical results; and section 6 concludes.

2. The Finance-Growth Link and the Latin American Case

   Financial Development and Economic Growth

   The level of financial development in a country is determined by the access that individuals have to credit and financial services. The primary function of the financial sector is to "facilitate the allocation of resources across space and time in an uncertain environment" (Levine 1997, p. 691). Financial development also decreases market frictions that result from imperfect information by connecting savers with investors and by allocating resources to profitable projects (Demirguc-Kunt 2006). Therefore, the financial sector plays a crucial role in the economy because it provides relevant information, monitors investment projects, promotes risk diversification, increases the amount of transactions, and affects any entrepreneurial and trading activity (Levine 2005).

   A country is considered financially developed if it has a large financial sector that successfully connects savers with investors (Beck et al. 2001). In the empirical literature, financial development has been frequently measured using private credit issued by deposit money banks as a share of GDP. Private credit not only reveals the ability of the financial sector to reach businesses and to allocate resources to profitable projects but also accounts for credit allocated only through private institutions to the private sector (Beck, Demirguc-Kunt, and Levine 2000). Liquid liabilities and bank deposits as a share of GDP are commonly used as alternative measures of financial depth because they account for the use of financial institutions for everyday transactions and savings purposes. Liquid liabilities is the addition of currency and interest bearing liabilities of financial intermediaries and nonbank financial intermediaries, and bank deposits is the value of demand, time, and saving deposits in deposit money banks.

   Although these indicators are commonly used in the literature, they are not perfect measures of financial development. To measure financial development, it is required to use indicators that account for the quality and quantity of the financial services available to society. While private credit, liquid liabilities, and bank deposits as a share of GDP account for true financial development, they are also related to financial cycles, which are linked to the demand of financial services. In fact, it is argued that the fast expansion of private credit does not necessarily represent an improvement in the financial sector if this expansion leads to an increase in risk at the microeconomic and macroeconomic level (Honohan 2004). Researchers acknowledge the limitations of the financial development indicators by using a group of indicators and econometric techniques that address these issues.

   There is a debate about the causality between financial development and economic growth, with some arguing that financial development causes economic growth, while others assert that economic growth causes financial development. Supporters of the causation running from financial development to economic growth state that the characteristics of the financial sector are relevant for economic activity and base their argument on Schumpeter's view of financial development as creative destruction (Rajan and Zingales 2003). On the other hand, others argue that financial development may be the consequence of economic growth because developed economies create the demand for developed financial sectors (Shan 2005). Empirical analyses on the relationship between financial development and economic growth use cross country, panel, and firm-industry data to support both sides of the debate.

   In a literature review on the relationship between financial development and economic growth, Levine (2005) concludes that financial development causes economic growth. The channels through which financial development causes economic growth are productivity and capital accumulation (Beck, Levine, and Loayza 2000). Financial development promotes the increase of technology because access to financial resources allows for labor specialization, which creates a virtuous cycle in the economy (Saint-Paul 1992). More efficient financial sectors are also associated with better resource allocation that leads to higher capital accumulation. (3)

   Cross-country and panel empirical analyses support the supply-leading hypothesis by showing that the exogenous component of financial development has a positive effect on economic growth (Beck, Levine, and Loayza 2000; Benhabib and Spiegel 2000; Levine, Loayza, and Beck 2000; Khan and Senhadji 2003), productivity, and capital accumulation (King and Levine 1993; Beck, Levine, and Loayza 2000; Nourzad 2002; Rioja and Valev 2004a). Analyses at the firm-industry level also support the argument that financial development is conducive to growth (Rajan and Zingales 1998; Beck 2002; Love 2003; Manning 2003; Kroszner, Laeven, and Klingebiel 2007).

   Although there is an extensive amount of work showing that financial development causes economic growth, others posit that financial development is just the consequence of economic growth. As stated by Shan, Morris, and Sun (2001), the relationship between financial development and economic growth may be a "chicken and the egg" problem, since financial institutions are usually developed in developed countries (DCs) and underdeveloped in less developed countries (LDCs). The theoretical explanation behind this hypothesis is that there is a virtuous cycle in developed economies, where an expansion in the real sector increases the demand for loanable funds (Greenwood and Jovanovic 1990...