Recent developments in panel data econometrics allow researchers to estimate heterogeneous parameters. Given this novelty, the goal of this paper is to revisit the financial development-economic growth nexus for a panel of 76 developing counties using recent heterogeneous panel time series estimation methods. Findings indicate that results are very volatile across different empirical specifications. Overall, results provide a strong support of a negative impact that banking development on growth. At regional level, however, there is relatively little evidence of such relationship. On the side of the stock market, there is no much indication in favor of stock market-led growth hypothesis either at pooled panel or at regional level.
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The relationship between financial development and economic growth is not a new discovery. Bagehot (1873) identified the role of financial sector development on economic growth about 150 years ago. According to his study, the financial system plays a crucial role in stimulating industrialization in England by facilitating the mobilization of capital.
There are four different theoretical views about the relationship between financial development and economic growth. The first is supply-leading hypothesis, suggesting that the positive effects of financial development on economic growth, according to Schumpeter (1911). In this approach, causality runs from financial development to growth (see, for example: Roubini and Sala-i Martin, 1992; King and Levine, 1993a; b). Second, with the pioneer study of Robinson (1952), demand-following hypothesis states that the causality from economic growth to financial development (see, for example: Patrick, 1966; Jung, 1986; Ireland, 1994). The third approach, bi-directional causality hypothesis, emphasizes that there is a cause and effect relation between finance and growth (see, for example: Berthelemy and Varoudakis, 1996; Demetriades and Hussein, 1996; Blackburn and Hung, 1998). The fourth approach indicates that there is no causality between financial development and economic growth which is known as independent hypothesis (see, for example: Lucas, 1988; Stern, 1989; De Gregorio and Guidotti, 1995).