Thresholds of financial development in the Euro area

• Author: Munusamy Dharani,Vighneswara Swamy
• DOI: http://doi.org/10.1111/twec.12902
• Date: 01 June 2020
• Published date: 01 June 2020

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wileyonlinelibrary.com/journal/twec World Econ. 2020;43:1730–1774.

© 2019 John Wiley & Sons Ltd

Received: 22 October 2018

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Revised: 9 October 2019

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Accepted: 12 November 2019

DOI: 10.1111/twec.12902

ORIGINAL ARTICLE

Thresholds of financial development in the Euro

area

VighneswaraSwamy1

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MunusamyDharani2

1Department of Economics, ICFAI Business School (IBS) (A Constituent of IFHE, Deemed to be University), Hyderabad,

India

2Department of Finance, ICFAI Business School (IBS) (A Constituent of IFHE, Deemed to be University), Hyderabad, India

KEYWORDS

dynamic panel threshold, economic growth, financial development, non-monotonicity

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INTRODUCTION

Does the inordinately high level of finance cause a decline in economic growth? Does the positive

effect of finance on economic growth vanish as the financial thresholds are surpassed? Is there an

"optimal" level of financial development that is more vital in accelerating growth? These have been

the more often asked important questions in the finance–growth nexus debate.

As the financial development indicators in Euro area countries are growing at astonishingly high

levels, there is a need being felt among the researchers and policymakers to understand the effects of

the upsurge of financial development on economic growth. The macroeconomic data reveal that while

the domestic credit in Spain has more than doubled from 74% to 171% of GDP over the last three

decades, economic growth has gone into a negative trajectory from 1.77% to −1.23%. The domestic

credit in Portugal has more than doubled from 73% to 169% of GDP, while the economic growth has

plummeted from −0.17% to −1.36%. Similarly, domestic credit grew from 47% to 117% of GDP in

Italy, and the economic growth slumped from 1.17% to −1.93%. Chong, Mody, and Sandoval (2017)

observe that a negative association between bank credit and economic growth has emerged stronger

after 1990 and was exceptionally prominent in the Eurozone, consistent with the view that an over-

grown financial sector wanes economic growth potential. This leads us to ask: Is there a non-mono-

tonic relationship between higher financial development and economic growth as growing finance is

linked with less growth? However, we do not find a comprehensive study that explores the finance–

growth nexus in the Euro area. Therefore, this paper investigates the presence of thresholds in Euro

area countries beyond which the financial development changes in magnitude.

The global financial crisis has, indeed, necessitated a re-examination of the role and benefits of

financial development, predominantly from the perspective of the upsurge of complex financial in-

struments. The sophisticated contemporary finance has intensified the gravity and frequency of crises

while producing not enough gains to the broader economy. Financial innovation and liberalisation,

in this notion, has in fact favoured a few substantially but hurt many. In this context, Rodrik (2008)

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asks: Is there evidence of the benefits of financial innovation in the societal perspective in making our

lives measurably and unambiguously better off? In a similar critical viewpoint, Wolf (2009) observes

that something is wrong with a condition in which, "instead of being a servant, finance had become

the economy's master." This, indeed, has triggered the revival of the debate on the appropriate levels

of financial development and the approach towards financial development for achieving sustainable

economic growth.

One strand of the finance–economic growth literature maintains finance is an engine of

growth (Bencivenga & Smith, 1991; Gurley & Shaw, 1955; King & Levine, 1993; Levine, 2005;

Levine, Loayza, & Beck, 2000; McKinnon, 1973; Schumpeter & Opie, 1934). Although finan-

cial development has a major role in furthering economic development, sceptics suspect the

finance–growth nexus hypothesis at higher levels of financial development and dispute that the

role of financial development is overstated (Lucas, 1988; Panizza, 2012; Robinson, 1952; Rodrik

& Subramanian, 2009). This thread of the literature claims that economic growth steers the need

for financial services instead of the other way around. Deidda (2006) argues that as the economy

reaches a certain level of economic development, financial development occurs endogenously.

In a controversial paper, at that time, Rajan (2005) emphasised the hazards of financial develop-

ment, as the presence of an enormous and complicated financial system enhances the likelihood

of a "catastrophic meltdown." Gennaioli, Shleifer, and Vishny (2010) claim that in the presence

of some overlooked tail risk, financial innovation can trigger off financial fragility, even in the

absence of leverage.

Apropos of the ongoing finance–growth nexus debate, from an empirical perspective, this paper

makes three contributions to the finance–growth literature: first, we focus especially on the Euro area

economies in view of their significantly higher levels of financial development. Second, in exploring

the finance–growth nexus, there is a need to focus on the developed countries with very high levels of

financial development, as averaging across developing countries alone would make inferences intri-

cate. Third, we allow for a very flexible approach to account for unobserved heterogeneity (and thus

endogeneity) in our model, which could arise from the omitted variables and/or global shocks whose

impact differs across the countries. Furthermore, this study seeks to know the following: (a) Is there a

threshold for financial development in the Euro area? (b) Is the relationship between financial devel-

opment and economic growth weak in financial development levels below the threshold? (c) Is there

a waning negative relationship between financial development and growth as the threshold levels are

crossed? (d) How critical would the impact of financial development on growth be beyond its thresh-

old? This study offers a new discrete empirical evidence based on an exclusive Euro area country data

set, well beyond the selective anecdotal evidence. The results have potentially important implications

for financial regulation.

This study overcomes the issues related to data adequacy, exclusive coverage of countries, hetero-

geneity, endogeneity and non-linearities. We analyse the finance–growth relationship within a stan-

dard neoclassical growth framework. Empirical research, of late, has focused on the possibility of

non-linearities within the finance–growth relationship, with explicit attention to high financial devel-

opment levels. The empirical literature on this topic remains sparse as very few studies use non-linear

impact analysis (Deidda & Fattouh, 2002). We provide an in-depth econometric analysis that allows

for non-linear estimation between financial development and economic growth in order to investigate

the possibility of the economy being adversely affected due to "too much" finance.

The remainder of the paper is organised as follows: Section 2 reviews the literature on financial

development–economic growth relationship. Section 3 details the data set. Section 4 describes our

estimation strategy. Section 5 provides a detailed discussion of the results. Finally, Section 6 is the

conclusion.

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REVIEW OF LITERATURE

One strand of financial development literature observes that finance stimulates rapid, long-run growth.

Greenwood and Jovanovic (1990) observe the presence of a two-way relationship as the financial in-

termediaries stimulate investment and growth drives the growth of financial development. Examining

the endogenous emergence of a financial sector at a certain critical level of economic development by

assuming a fixed cost of financial transactions, Saint-Paul (1992), Zilibotti (1994) and Blackburn and

Hung (1998) conclude that financial development is predominantly growth-enhancing. Some studies

emphasise the bank credit channel of financial development and show that financial development can

boost or deteriorate economic growth based on the types of bank credit (Aghion, Angeletos, Banerjee,

& Manova, 2010; Beck, Buyukkaraback, Rioja, & Valev, 2012; Beck, Degryse, & Kneer, 2012; Sassi

& Gasmi, 2014). The positive effect of financial development on economic growth is mostly powered

by enterprise credit rather than consumer credit (Beck, Buyukkaraback, et al., 2012; Beck, Degryse, et

al., 2012). However, some studies question the robustness of the finance–growth nexus. Demetriades

and Hussein (1996) claim that they did not find substantiation of a causal relationship moving from

finance to growth in their study comprising 16 countries. Demetriades and Law (2006), while un-

derscoring the role of institutional factors, demonstrate that financial depth does not cause growth

in countries with inefficient institutions. Emphasising the inflation channel, Rousseau and Wachtel

(2002) notice that growing finance does not contribute to economic growth in countries with double-

digit inflation. Further, Rousseau and Wachtel (2011) also notice a waning effect of financial depth

and indicate that credit to the private sector has no statistically significant impact on GDP growth. The

general critique of the research based on cross-sectional data using standard OLS estimation meth-

ods which envisaged the finance–growth nexus is that conclusions based on cross-sectional analysis

are unreliable and have numerous econometric problems (Barro, 1991; Beck, Buyukkaraback, et al.,

2012; Christopoulos & Tsionas, 2004).

Another thread of literature stems from the perspective that the large financial system is just a

by-product of the overall process of economic development and is well symbolised by the assertion

that "where enterprise leads, finance follows" (Robinson, 1952). Some researchers, since the 1990s,

have claimed that there exists a causal link going from finance to growth. King and Levine (1993)

highlighted financial depth as a predictor of economic growth. Further, evidence in this direction

evolved from Levine and Zervos (1998) who demonstrated that stock market liquidity is a predictor of

economic growth. Likewise, Levine et al. (2000) used different types of instruments and economet-

ric techniques to notice the presence of a causal relationship running from finance to growth. In this

direction, the much-cited evidence came from Rajan and Zingales (1998) as they demonstrated the

causal link going from financial to economic growth through the industrial sectors.

The second feature of this study is the issue of non-linearity in the finance–growth nexus. In

the models (e.g., Acemoglu & Zilibotti, 1997; Greenwood & Jovanovic, 1990) where endogenously

emerging financial institutions usually have a positive effect on growth, the magnitude varies with

the level of economic development. These present a non-linear relationship between financial and

economic development. Interestingly, very few studies have explored the non-monotonic relation-

ship between financial and economic development (Aghion, Howitt, & Mayer-Foulkes, 2005; Deidda

& Fattouh, 2002; Easterly, Islam, & Stiglitz, 2000; Rioja & Valev, 2004; Shen & Lee, 2006) and

illustrate that there is a convex and non-monotonic relationship between financial depth and the vol-

atility of output growth. Some of the recent studies establish a non-linear relationship between fi-

nance and growth in which higher financial development may strengthen economic growth before a

certain threshold of financial development is reached (Arcand, Berkes, & Panizza, 2012; Cecchetti

& Kharroubi, 2012; Samargandi, Fidrmuc, & Ghosh, 2015). Likewise, Law and Singh (2014) use a