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8/2/2019 Dr. David Tennant
1/20
MODELLING THE RELATIVEEFFECTS OFFINANCIAL SECTOR FUNCTIONS ONECONOMIC GROWTH IN A DEVELOPING
COUNTRY CONTEXT USING COINTEGRATION
AND ERROR CORRECTION METHODS
PAPER PRESENTED AT THE FRANCIS CONFERENCE
September 28 30, 2007
DAVID TENNANT, CLAREMONT KIRTON &ABDULLAHI ADBULKADRI
DEPARTMENT OF ECONOMICS, UWI, MONA
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OVERVIEW OF PRESENTATION:
Background and Objectives
Proxies of Financial Sector Functions
Control Variables
Methods
Results and Findings
Conclusions
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BACKGROUND and OBJECTIVES
The Monterrey Consensus (2002) notes that many
developing countries increasingly depend on local funds to
finance their development needs.
Financial institutions can facilitate economic growth by
mobilizing savings, allocating these savings to the most
productive investments, and by facilitating the smooth flow
of trade needed in a market-driven economy.
Theoretical models supporting this view have been
developed by many economists.
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BACKGROUND and OBJECTIVES Contd
Many of the empirical studies of the finance-growth
relationship use broad proxies of financial sectordevelopment.
It would however be very useful to determine which of the
distinct functions of the financial sector have the greatestimpact on economic growth.
Holden and Prokopenko (2001), Levine and Zervos (1998),
and De Gregorio and Guidotti (1995) all cite difficultiesinvolved in developing proxies to accurately and
comprehensively capture the many different functions
performed by the financial sector.
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BACKGROUND and OBJECTIVES Contd
Levines (1997) five basic functions of the financial sector
are used as the basis of this study.
The Jamaican case study is used.
In the post-liberalization phase of the evolution of theJamaican financial sector, the country experienced afinancial crisis, and a government-led restructuring andsubsequent divestment of the sector.
Important conclusions are presented regarding the relativeimportance of financial sector functions to the creation ofeconomic growth, and the impact of financial crises on theeconomy.
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PROXIES of FINANCIAL SECTOR
FUNCTIONS:
Savings Mobilization
SMOB = Deposits / (Total Assets Loans)
A positive relationship between SMOB and economicgrowth is therefore expected.
Risk Diversification
The measure of risk diversification used (DRISK) focuses
on the degree of diversification by sector.
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oFUNCTIONS:
DRISKfor each type of financial institution is calculated by
first finding the percentage of total loans allocated by sector.
The standard deviation of the percentage of total loans
allocated to each sector is then used to measure the spread foreach institution from the state of uniform distribution.
A measure of the degree of diversification for the entire
financial sector is calculated using a weighted average.
A negative relationship betweenDRISKand economic
growth is expected.
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PROXIES of FINANCIAL SECTOR
FUNCTIONS:
Resource Allocation
RESAL = credit to private sector production / total loans.
It is expected that RESAL will have a positive relationship
with economic growth.
Corporate Control
The proxy used for corporate control (CORPC) assumesthat as connected party loans and/or connected partyfinancial investments increase, then the ability of financialinstitutions to exert corporate control decreases.
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PROXIES of FINANCIAL SECTOR FUNCTIONS:
CORPC = connected party loans and financial investments/ total loans and financial investments.
CORPCis expected to have a negative relationship witheconomic growth.
Ease of Trading
Using the approach of Levine and Zervos (1998),ETRAD =value of shares traded / current GDP.
Levine (1991) initially argued that a positive relationshipwith economic growth should be expected, he later notes theargument that very liquid markets encourage investormyopia, thus actually hurting economic growth (Levine
1996).
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CONTROL VARIABLES
A measure of trade openness (TRADE) was included,
and calculated as the sum of the countrys imports andexports divided by current GDP.
Exchange rate volatility (XRATEVOL) for each quarter
is calculated as the standard deviation of the percentage
change in the US$ real exchange rate for the four
preceding quarters.
Two dummy variables were used to account for
structural changes affecting the Jamaican financial
sector liberalization and crisis.
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METHODS
Data
Quarterly time series from 1986-2005 Due to missing data most estimations limited to
1989-2005
Augmented Dickey-Fuller test used to determine
stationarity
Cointegration Analysis
Used to determine long-run relationships among data
series
Two specifications were considered: (1) using
individual proxies (2) with interaction terms
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METHODS
Model (1):
Model (2):
ttttt
ttttt
eSTRUCTURESMOBRESALDRISK
CORPCETRADXRATEVOLTRADEGDP
+++++
++++=
8765
43210
lnlnln
lnlnlnlnln
tt
ttttt
ttttt
eSTRUCTURE
DRISKSMOBETRADSMOBRESALSMOB
RESALCORPCXRATEVOLTRADEGDP
+++++
++++=
8
765
43210
ln*lnln*lnln*ln
lnlnlnlnln
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METHODS
Error Correction Model
Used to examine short-run dynamics Enables us to determine short-run adjustments to long-
run equilibrium
tt
L
l
ltltl
L
l
ltltllt
L
l
ltl
L
l
ltl
L
l
ltl
L
l
ltl
L
l
ltltt
STRUCTUREDRISKSMOB
ETRADSMOBRESALSMOBRESAL
CORPCXRATEVOLTRADEECTGDP
+++
+++
++++=
=
=
=
=
=
=
=
8
0
7
0
6
0
5
0
4
0
3
0
2
0
11
ln*ln
ln*lnln*lnln
lnlnlnln
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RESULTS
Stationarity
LnGDP I(2), LnETRAD and LnTRADE I(0), allothers I(1)
Johansen Cointegration test indicated nine possible
cointegrating relationships for Model (1) and six for
Model (2)
Selection of reported equation was based on conformity
with theory
T bl 1 E ti t f I iti l M d l C i t ti
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Table 1 Estimates of Initial Model Cointegrating
Equation with lnGDP as Dependent Variable
Variable Name Coefficient t-Statistic
CONSTANT -6.972* -10.329
lnSMOB 1.206* 4.691
lnRESAL -1.870* -3.503
lnCORPC 0.224 1.432
lnDRISK -1.507* -9.442
lnETRAD -0.145* -5.513
CRISIS 0.270 0.791
lnTRADE 0.271 0.736
lnXRATEVOL 0.286* 8.085
* indicates significance at 1% level
T bl 2 E ti t f Alt ti M d l C i t ti
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Table 2 Estimates of Alternative Model Cointegrating
Equation with lnGDP as Dependent Variable
* indicates significance at 1% level
Variable Name Coefficient t-Statistic
CONSTANT -6.441* -48.186
lnCORPC -0.222* -7.686
lnRESAL 1.342* 15.490
lnSMOB*lnRESAL 1.232* 9.985
lnSMOB*lnDRISK -0.785* -7.704
lnSMOB*lnETRAD -0.361* -12.317
CRISIS 0.797* 15.474
lnTRADE 1.110* 13.285
lnXRATEVOL -0.117* -15.842
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FINDINGS
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FINDINGS
Model (2) outperforms Model (1)
Has more significant variables and conforms better with
theoretical expectations
Establishes long-run relationship between GDP and
dependent variables.
ECM indicates
No short-run relationship between GDP growth and
dependent variables
The speed of adjustment is ~35%
CRISIS has a negative, though, insignificant effect on
GDP growth, compared with positive and significant effect
in the long-run
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CONCLUSIONS
Sophisticated proxies of financial sector function
have been developed Based on Favara (2003)
ensure accuracy and conformity to theory
Savings mobilization is an essential factor through
which other proxies impact economic growth
Resource allocation
Ease of trading
Risk diversification
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CONCLUSIONS
Financial sector reform should:
Focus on savings mobilization and the efficient
allocation of mobilized savings
Emphasize removal of government distortions in
financial markets
Not be expected to yield immediate results
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