Nonlinearity between Financial Development and Productivity Growth in Emerging Markets

Abstract

ABSTRACT Although the finance-growth nexus has been extensively investigated in empirical literature, there is scare empirical evidence on the question of how financial development influences productivity growth in emerging market economies. Understanding this relationship is important, especially in the face of the sluggish actual and potential growth of emerging market economies in the recent years, followed by substantial financial deepening over the past few decades. The experience of the recent global financial crisis has called into question the need for further assessment of the relationship between financial deepening and productivity growth; to determine whether a threshold level of financial deepening exists, beyond which increasing financial deepening shall dampen the productivity growth in these economies. This study investigates the relationship using a Panel Smooth Transition Regression (PSTR) approach, employing data on a panel of 22 emerging markets economies spanning 1996-2014. The PSTR model allows time varying and heterogeneity in the parameter estimates. In doing so, this approach allows us to explore the nonlinearity between financial deepening and productivity growth, thereby determining the threshold level of financial deepening in the productivity growth of these economies. The results reveal a clear nonlinear relationship between financial deepening and productivity growth in emerging market economies. The results show an inverted U-shaped relationship between financial deepening and productivity growth in these economies. The evidence suggests that financial deepening accelerates productivity growth in emerging market economies up to a certain point. Increased financial deepening beyond the threshold dampens the productivity growth in such economies. The study finds the threshold of the ratio of private sector credit to the GDP at 68 percent, beyond which increasing the credit given to the private sector weakens productivity growth. This finding underlines the need for policy efforts to be directed towards improving the other components of financial development, such as increasing access to financial services and improving efficiency in the delivery of financial services for a more sustainable growth of these economies. Our study is motivated by the endogenous growth literature which suggests that financial development can influence economic growth by raising the total factor productivity growth. Secondly, this study allows the heterogeneous effect of financial development on productivity growth using the PSTR approach. To the best of my knowledge, this issue has not been addressed in the empirical literature assessing the nonlinearity between financial development and productivity growth.