Amiruddin et al.—Test for Dynamic Relationship between Financial Development and Economic Growth in Malaysia
Gadjah Mada International Journal of Business
January-April 2007, Vol. 9, No. 1, pp. 61–79
TEST FOR DYNAMIC RELATIONSHIP
BETWEEN FINANCIAL DEVELOPMENT
AND ECONOMIC GROWTH
IN MALAYSIA
A Vector Error Correction Modeling Approach
Rosilawati Amiruddin
Abu Hassan Shaari Mohd Nor
Ismadi Ismail
This paper purports to study the effectiveness of financial
development to Malaysian economic growth utilizing quarterly
data. In view of the priority given to dynamic relationship in
conducting this study, Vector Autoregressive (VAR) method
which encompasses Johansen-Juselius’ Multivariate
cointegration, Vector Error Correction Model (VECM), Impulse
Response Function (IRF), and Variance Decomposition (VDC)
are used as empirical evidence. The result reveals a short-term
and long-term dynamic relationship between financial develop-
ment and economic growth. The importance of financial sector
in influencing the economic activity is proven as a clear policy
implication.
Keywords: financial development; economic growth; VECM
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, Gadjah Mada International Journal of Business, January - April 2007, Vol. 9, No. 1
Introduction opportunities, mobilizing savings, moni-
toring the performance of managers,
Solow (1956),1 a Neo-classical enabling the trading, hedging, and di-
economist, states that in addition to versification of risk, and facilitating the
capital and labor, investment gener- exchange of goods and services. These
ated through financial sector plays a functions result in a more efficient
significant role in the growth process. allocation of resource, a more rapid
Meanwhile, endogenous growth theory accumulation of physical and human
introduced in the end of 1980s by Romer capital, and faster technological
(1986) and Lucas (1988) brings an progress, which in turn feed economic
array of theoretical and empirical stud- growth.
ies to observe the causal factor of
In actual fact, this theory has long
economic growth. Since then, a large
been introduced dating back to 1911;
empirical literature has concentrated
Joseph Schumpeter stresses that na-
more on the sources of long-term
growth, such as investment and real tional savings distribution to firms will
capital, human capital, tax and technol- encourage the process of economic
ogy (Barro 1991); (Barro and Sala-i- growth and development which are
Martin 1997); (Benhabib and Spiegel channeled through an increase in pro-
1994); (Mankiw et al. 1992).2 The ductivity and technological advances.
effect of financial sector development In other words, the introduction of
on economic growth has been a topic miniaturization in the financial sector
of interest and debate in recent years. will be transformed to the form of
Several financial measurement prox- credit creation which will support eco-
ies have been used to examine the nomic activities resulting in higher eco-
relationship. In theory, financial devel- nomic growth. Notwithstanding the
opment can influence the economic facts discussed above, the statement is
growth through resource allocation. still debated as a variety of results have
The theoretical argument for linking been obtained from previous studies
financial development to growth is that depending on the methodology, sample,
a well-developed financial system per- and estimation procedures adopted.
forms several critical functions to en- Since previous empirical studies
hance the efficiency of intermediation provide mixed findings on the direction
by reducing information, transaction, of causality, this study will continue the
and monitoring costs. A modern finan- efforts of earlier researchers (Choong
cial system promotes investment by et al. 2003; Ang and McKibbin 2005)
identifying and funding good business using the Malaysian time series data to
1
Depicted from discussion in Christopoulos and Tsionas (2004).
2
The extensive studies in relation to the growth theory and the factors that cause it, the empirical
results are mixed as reviewed by Face and Abma (2003).
62
, Amiruddin et al.—Test for Dynamic Relationship between Financial Development and Economic Growth in Malaysia
re-examine the relationship between Johansen’s cointegration tests to ex-
financial development and economic amine the relationship between finan-
growth dynamically. The objectives of cial development and economic growth.
this study are: (1) to conduct stationary The results of the studies vary based on
tests on all time series under consider- the period and the sample utilized in
ation, (2) to conduct Johansen’s multi- those studies, depending on economic
variate cointegration test, (3) to con- environment faced by the sample.
duct Granger’s causality test in Vector Arestis and Demtriades (1997) show a
Error Correction Model (VECM) positive and significant association be-
framework; and in addition to existing tween financial development and real
studies we will (4) view the Impulse economic growth in Germany whilst
Response Function (IRF) and Vari- insufficient proof is obtained for the
ance Decomposition (VDC) in sup- data of the United States. Neusser and
porting the VECM findings. Kugler (1998) find an existence of
long-term relationship between finan-
Previous Studies cial activities and Gross Domestic Prod-
uct for manufacturing sector in 13
There are two forms of study OECD countries. Shan et al. (2001)
often performed by researchers in ob- show the prevalence of causal rela-
serving the relationship between finan- tionship, depending on economic con-
cial development and economic growth, dition, in nine OECD countries and
either by using the cross-section or China. They state that financial devel-
using time series data. Researchers opment is not exactly the primary cause
who used the cross-section data ap- for economic growth. Using Granger’s
plied the GMM (Generalised Method causal relationship in the error correc-
of Moments) and Instrumental Vari- tion framework, Ghali (1999), Chang
able (IV) estimation methods in ana- (2002), and Khalifa (2002) find that the
lyzing the data. The finding on the results depend on the specific nature of
effectiveness of financial sector devel- the country under observation and the
opment to economic growth varies, proxies used as indicators of economic
depending on the case or country under growth.
studied. King and Levine (1993), Levine In Malaysian context, Choong et
et al. (2000), Beck et al. (2000), and al. (2003) provide evidence on the
Nourzad (2002) agree that a positive finance-led growth hypothesis. Using
relationship exists between financial autoregressive distributed lag (ARDL)
indicators and economic growth after bound test approach and VECM frame-
taking into consideration biases and work, their examination reveals that
specific effect in the sampling frame- the evolution of stock market (a proxy
work. for financial development) is the lead-
Those who used the time series ing sector in stimulating domestic
data applied the Engle-Granger’s and growth. Ang and McKibbin (2005)
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