CAUSAL LINK BETWEEN FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH : THE CASE OF TRANSITION COUNTRIES

CAUSAL LINK BETWEEN FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH: THE CASE OF TRANSITION COUNTRIES Abstract. The financial market is an important element of any market economy. The study of the impact of financial development on the country’s economic growth is a very important and urgent topic. The financial sector plays a key role both in developed and developing countries. Financial markets play a critical role in the distribution of capital, financial intermediation, the transformation of available funds into investment, the distribution and diversification of risks. A well-functioning financial market increases productivity and significantly affects the country’s economic growth. The main objective of this study is to investigate the causal relationship between financial development, trade openness and economic growth. The empirical analysis of this study consists on panel data of 9 transition countries (Ukraine, Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Moldova and Tajikistan) over the period 1998 to 2015. In order to investigate the causal link between financial development and economic growth a three-stage Panel Granger causality test was employed. Firstly stationarity properties of the series are examined with the help of Pesaran (2007) panel unit root test. Then Westerlund (2007) panel cointegration method is applied. In the final stage Panel Granger causality test is performed. The results obtained suggest that there is evidence of a bidirectional causality between financial development and economic growth in the short-run. Policy makers in transition countries should consider the impact of financial development on economic growth.


Introduction.
The role of financial markets in the growth process has received recently significant attention.In this framework, financial development is considered by many economists and researchers to be of utmost importance for economic growth.
Services provided by the financial market are considered to be necessary for economic growth.In other words financial development level variables are also increasingly used in recent years in the economic growth model.Results indicate that there are four views explaining the finance-growth nexus [1].
The first one is the supply-leading view, which asserts a positive effect of financial development on economic growth [4,10,11,12,17].The second one is the demand following view, which postulates that finance responses to changes that happen in the real sector.In other words real economic activity leads to financial development [5,7].According to the third view there is bidirectional relationship between financial development and economic growth [6,9].Finally, according to the fourth view there is no causal relationship between finance development and economic growth at all.Some researches deny the existence of a nexus between financial development and economic growth, claiming that "economists are overestimating the value of finance in economic growth [14].
Based on the above-mentioned theories, this study aims to explore the linkages between economic growth and financial development.For this purpose panel data analysis have been applied to the annual data of nine transition countries (Ukraine, Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Moldova and Tajikistan) over the period 1998 to 2015.
The remainder of this study is structured as follows: A brief overview of financial development and economic growth in transition countries are given in the second part of the study.Information about the data and variables are discussed in the third part.Empirical methodology are evaluated in the fourth part.The results are presented in the fifth part.Conclusions are summarized in the final part.
Financial development and economic growth in transition countries.Especially in transition countries, the financial sector is very important for capital accumulation, financial intermediation, transformation of savings into investments, risk sharing and risk diversification.Highly developed financial sector also increase efficiency and notably affect economic growth [13].As can be observed from Figure 1 the financial sector growth showed upward trend during the period from 1998 to 2015.In most high income countries the ratio of broad money to GDP is at least 60% [8].Among transition countries financial depth is high in Ukraine, Moldova and Kazakhstan.As can be seen from Figure 1 in Tajikistan financial depth is still relatively low compared to other countries in transition process.From Figure 2 it is evident that per capita GDP growth rate is high in Kazakhstan while Tajikistan has the lowest rates of economic growth.It can be inferred from Figure 2 that economic growth rate in selected transition countries are increasing.
Data and variables.This study aims to explore the relationship between financial development and economic growth in transition countries 1 .For this purpose annual data for the period of 1998-2015 are used.Data are collected from the World Bank.All variables are transformed into logarithmic form.The detailed information about data are summarized in Table 1.

Variables
Definition Source GDP (Economic growth) GDP per capita (PPP, constant 2011 international $) World Bank FD (Financial development) Broad money (% of GDP) World Bank Methodology.To investigate the relationship between economic growth and financial development, the following model was employed: =  0 +  1   +   (1) where GDP it is real per capita output in country i and year t, FD it is a measure of financial development and   is an error term.
In this study a three-stage Panel Granger causality test was employed.Firstly stationarity properties of the series was examined by panel unit root tests.There two types of panel unit root tests: first generation and second generation panel unit root tests.Before applying panel unit root tests it should be investigated whether there is cross-sectional dependency between series.It is well known that not taking into consideration cross-sectional dependence leads to incorrect statistical inference [3].According to the results obtained it should be decided which type of panel unit root tests are appropriate.Pesaran (2004) proposes a test (called CD test) for cross-sectional dependence [15].Test statistics can be calculated as follows: where   is the simple correlation coefficient between residuals obtained from the estimation of each equation by least squares method.Second generation CADF unit root test suggested by Pesaran (2007) can be estimated as follows [16]: where ∆  =   −  ,−1 ;  ̅  =  −1 ∑    =1 and ∆ ̅  =  −1 ∑ ∆   =1 .  ̅  expresses the time average of all cross-sectional units.
In the second stage Westerlund (2007) panel cointegration test is applied [18].Cointegration of variables have been analyzed by employing second generation panel cointegration test proposed by Westerlund (2007), which allows for cross-sectional dependence.In the presence of crosssectional dependence bootstrap p-values should be estimated.Westerlund (2007) developed four panel cointegration test statistics.While two of the four tests are (G τ ve G α ) group mean and the other two tests are (P τ ve P α ) panel tests.It is important to determine lag/lead length.The tests aim to explore the presence of cointegration by determining whether error correction exists for individual panel units.
If panel co-integration is not found between the series, the standard Granger Causality test is performed: In these hypothesis, if  and/or ik 22  are not equal to zero, it can be inferred that there exist the causal relations between the series.If the series are co-integrated in the long-run, a panel-based error correction model is estimated for the panel Granger causality analysis.
Empirical Results.To test cross-sectional dependence CD (Cross-Section Dependence) test was implemented, proposed by Pesaran (2004) and the results are given in Table 2. Results indicate that null hypothesis is rejected at the 1% significance level for all variables.Accordingly, it can be concluded that there is cross-section dependence among variables.İn this case the stationarity property of the series should be analyzed by applying second generation CADF (Cross-Sectionally Augmented Dickey Fuller) test suggested by Pesaran (2007), which take into account cross-sectional dependence.The results of Pesaran (2007) CADF unit root tests are reported in Table 3.According to the findings obtained it can be concluded that all the variables contain unit roots (at 1% significance level), they are not stationary at level.In other words variables are integrated of order one.The next step will be employing panel cointegration techniques to test for the presence of long-run relationships among integrated variables.For this purpose second generation Panel cointegration test proposed by Westerlund (2007)  It can be inferred from Table 4 that the null hypothesis of no co-integration cannot be rejected.That is there is no co-integration across the cross sectional units.Thus, Westerlund (2007) tests provide strong evidence against the existence of equilibrium long-run relationship between the variables.In the next stage in order to investigate the short-term causal relationship between the variables Panel Granger causality test is employed.The results are summarized in Table 5. Conclusion.This study examines the causal relationship between financial development and economic growth.The study covers the 1998-2015 period and nine transition countries.A threestage Panel Granger causality analysis is employed to verify the research hypotheses.
According to the results obtained it can be concluded that there is a short-run bidirectional causal relationship between financial development and economic growth during the studied period.In other words it can inferred that an efficient and effective financial system positively affect GDP dynamics.In turn real economic activity also leads to an improvement in financial sector.Since the relationship between financial development and economic growth is bidirectional, policies implemented to improve one variable inevitably impact the other.Economic growth can be achieved through financial sector improvement and vice versa.

Fig. 1 .
Fig. 1.Financial depth in selected transition countries.Source:World Bank

Fig. 2 .
Fig. 2. Economic growth in selected transition countries Source:World Bank

Table 2
Results of Pesaran (2004) CD test

Table 3
is implemented.The results ofWesterlund (2007)test are presented in Table3.

Table 5
Results of Panel Granger Causality TestResults summarized in Table5indicate that there is bidirectional causal relationship between economic growth and financial development ( ↔  )