Does Financial-Sector Development encourage Economic Growth?

Thesis - International Business & Management 2008

Does Financial-Sector Development

encourage Economic Growth?

- A study of ten of the largest Oil Exporting Nations.

Issam El Masri ‐ s1659790   

Dedication

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Table of Contents

Introduction ... 2

Main Resesarch Question ... 6

Litreature Review ... 7

Hypothesis I ... 8

Hypothesis II ...10

Methodology ... 11

Data ...11

Country Portfolio Information ...12

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1.

Introduction

Finance is probably one of the oldest concepts in our history. It possibly began with bartering of livestock, crops and other natural resources and evolved to the highly complex system as we know it today. Throughout time different nations had different financial concepts they would apply, a good example for those differences would be the accounting methods used in different economies. However, at present we are living in a time of globalization, the world can now be seen as a global village, somehow all the markets are related in one way or the other; if the USA would suffer from economic hardship the world will be affected similarly. Yet, even though the world economies show profound linkages there are also massive differences in the financial-structure they utilize, some nations have a market-based structure whereas others have a bank-based one. The existence of a financial structure is to facilitate potential investment opportunities, exert corporate control after funding projects, facilitate risk management, including liquidity risk, and ease savings mobilization (Levine, 1997). According to Demirgüc-Kunt and Levine (2001), two leading experts on the study of financial-structure, in bank-based financial-structure such as Germany, banks play a leading role in mobilizing savings, allocating capital, overseeing the investment decisions of corporate managers, and providing risk management vehicles. Whereas, in market-based financial structure such as the USA, securities markets share center stage with banks in terms of getting society's savings to firms, exerting corporate control, and easing risk management. These definitions sound rather simple, however I found that no one nation officially labels itself with being either bank-based or market-based. It is, however, possible to proxy whether a nation is bank-based or market-based through a series of calculations, using financial-sector

determinants that show activities evidential to either market-based or bank-based behaviors of an

economy. These financial-sector determinates will be explained further in the methodology section (also

see Appendix I for the calculations).

The main focus of this research is to investigate if there is evidence for developments in the financial-sectors, i.e. the financial industries, of ten of the largest oil-exporting nations in terms of volume of oil exported; furthermore whether either financial-structure, hosts better conditions for any kind of financial-sector improvements; for a list of these countries see Table 1.1. The motivation for this

4 stable and still growing economy once the oil has run out. In order to be able to determine whether the

above is the case I must first classify these countries as either market-based or bank-based. This is necessary because this research attempts to investigate whether there is possible evidence that either a market-based or bank-based can provide better mechanisms that stimulate overall financial-sector developments and hence lead to economic growth. A further motivation why I choose ten of the largest oil exporting nations for this analysis relies on the fact that little research has been done on these economies in regards to this subject. A possible reason for the lack of interest on these economies may lay in the fact that the main portion of these nations’ GDPs is contributed from the sale of their natural resources. In the research, “Addressing the growth failure of the oil economies: The role of the financial-sector development” by M. Nili & M. Rastad (2006) the authors found that oil nations, such as the Kingdom of Saudi Arabia (K.S.A.), have, compared to other nations worldwide, a smaller rate of economic growth not due to the lack of investments in overall financial-sector but due to the lack of efficiency of these investments. They note that the lack of efficiency in the investment projects of these nations could be explained by the fact that there is a deficiency of private savings. However, oil

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It is noticeable that the financial-structure is the overall financial-umbrella, and that within the

financial- structure; the financial intermediaries form the financial-sector.

In recent years, however, there is evidence that some of the more traditional oil exporting nations, for instance the K.S.A., have made attempts to free themselves from the dependency of their oil, for the obvious reason that their oil occurrences are diminishing. Therefore, I deem that it is necessary for these economies to expand and improve their financial-sectors in order to further

contribute to economic growth from other sources than the sale of crude oil and crude oil products. In Mamarinta P. Mababaya book The Role of Multinational Companies in the Middle East, the author found clear evidence, at least in the case of Saudi Arabia, that these countries’ dependency on oil has been declining over time, due to the rapid expansion in the- agricultural, industrial, manufacturing and the service –sector which also includes the financial-sector.

One milestone to answer the question of whether financial-sector developments affect economic growth was set in 1969, when Raymond W. Goldsmithsought to accomplish three goals. His first goal was to document how financial-structure - the mixture of financial instruments, markets, and intermediaries operating in an economy - changes as economies grow. Thus, he sought to trace the evolution of the structure of national financial-structure as economies develop. Second, Goldsmith wanted to assess the

6 impact of the overall financial-sector developments - the overall development in quantity as well as the quality of financial instruments, markets, and intermediaries - on economic growth. He sought to answer the question: Does finance exert a causal influence on economic growth? Finally, Goldsmith sought to evaluate whether financial-structure influences the pace of economic growth. Does the mixture of markets and intermediaries functioning in an economy influence economic development? Indeed, Goldsmith (1969) summarized his motivation for studying the last two questions as follows: ``One of the most important problems in the field of finance, if not the single most important one, almost

everyone would agree, is the effect that financial -structure and –sector developments have on economic growth'' Goldsmith (1969) met with varying degrees of success in achieving each of these three goals.

Levine et al. (2001) note, that following Goldsmith research, more recent researchers have made substantial progress in expanding the analysis of Goldsmith's (1969) second goal: the connection between financial-sector developments and economic growth. In particular, researchers have provided additional findings on the finance-growth nexus and have offered a much bolder appraisal of the causal relationship: firm-level, industry-level, and cross-country studies all suggest that the level of financial-sector development exerts a large, positive impact on economic growth.

On this basis I have come up with the following research question:

Is there evidence for developments 1in the financial-sector of ten of the largest oil exporting nations that contribute to economic growth?

I attempt to answer this question by reviewing the most applicable literature in this field, including the works of Ross Levine, Demirgüc-Kunt, Raymond Goldsmith, which are considered expert in the field of financial-development and economic growth. Further, I will review literature by authors who approach the concept of financial-development and economic growths, in a different manner, examples of theses authors are Lekha S. Chakraborty and Muzafar Shah Habibullah. Moreover I will supply some general information on the sample, and discuss the methodology used for the statistical analysis followed by a discussion of the findings and the conclusion.

1 _{The term development in context with financial-sector will always imply an improvement, hence a positive development}

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2.

A Review of Related Literature

The scope of this literature section contains initial attempts by authors dating back some 39 years by Raymond Goldsmith, who was a pioneer in the area of financial-sector development and economic growth. His theory however, that financial-sector development leads to economic growth, was at that time never tested, since the author lacked the resources largely nowadays available to us, for instance country specific data. Furthermore, this section will include the works of Levine, Demirgüc-Kunt and Beck who are experts in this field and it can be considered that these authors have picked up where Goldsmith has stopped. There also will be a discussion of different authors views and approaches on mastering the question whether financial-sector development leads to economic growth. The literature used here will eventually lead to the hypotheses of this thesis project.

Unfortunately, there is no uniformly accepted empirical definition of a bank-based or market-based financial-structure. Consequently, I use one definition developed by Levine et al, 2001 which is based on an assortment of measures of financial-structure based on the aggregate of a cross-country dataset constructed by Beck, Demirgüc-Kunt, and Levine (2001), therefore at this stage a country is considered to be market-based if it has above the sample mean values of the financial structure-indicators, which will be further explained in the methodology section, and vica versa is true for bank-based countries. However, in the classical conceptualization on financial-structures, a bank-based financial-structure would be considered to dominate in such a country where banks play a leading role in mobilizing savings, allocating capital, overseeing the investment decisions of corporate managers; whereas in a market-based financial-structure securities markets share center stage with banks in terms of getting society's savings to firms, exerting corporate control, and easing risk management, Levine et al. (2001). Therefore, from a classical point of view, some countries are still considered to be either market-based or based economies, yet in reality they are at one point in time market-based and at another bank-based. This can be clearly observed in developing countries, according to Levine et al. (2001), it is more likely that a developing country with bank-based financial-structure has more in common with a

8 developing countries. Based on the methodology by Demirgüc-Kunt and Levine (2001), which I will utilize, a country's financial-structure is considered underdeveloped if it has below median values of both bank and market developments in the sample.

Many countries praise themselves with having a working and sound financial-structural system which is superior to another system. In fact economists cannot come to a clear consensus when determining which financial-structure is better than the other. However, the popular debate in the 1980s is leaning in favor of the bank-based financial system. Roughly a decade ago, many observers claimed that Japan’s bank-based financial system would catapult it past the United States as the world’s foremost economic power (e.g., Vogel 1979; and Porter 1992). Although Japan’s recent troubles have pushed this particular example from center stage, policy makers and economists around the globe continue to analyze the relative merits of bank-based versus market-based financial-structures (e.g., Allen and Gale 1999).

Concerning the matter whether a bank-based or market-based economy provides the best conditions for economic growth it becomes evident that neither system is either superior or inferior to the other, Levine (1997). From a development perspective, Chakraborty and Ray (2003) argue that a bank-based system outperforms a market-based one — financial intermediation creates an environment more conducive for transforming a traditional economy into a modern one, were a modern economy serves as the building block for an efficient financial-structure. Levine (1997) on the other hand disagrees with this notion. In his research he aimed to determine which system provides more favorable conditions that effect

economic development, he found that it is not important to economic development which financial-structure is in place but rather if these financial-financial-structures can provide financial services, such as potential investment opportunities, exert corporate control after funding projects, facilitate risk

management, including liquidity risk, and ease savings mobilization, more or less effectively, different financial systems promote economic growth to a greater or lesser degree. With my first hypothesis I intend to test whether this is true for my sample.

H1: The financial-structure of a country will provide better mechanisms that promote positive

9 In Levine et al. (2001) cross-country analysis, the authors’ couldn’t confirm that financial-structure can influence financial-sector performance. I anticipate finding a varying result then that of Levine et al. (2001) given the fact that I use a different sample.

As previously mentioned, one major attempt to answer the question whether financial-sector

developments lead to economic growth dates back Goldsmith (1969). Nevertheless, the analysis of the role of the financial-sector as an engine for economic growth goes as far back as to Schumpeter’s (1934) work. He argued that the financial-sector leads to economic growth by acting as a provider of fund for productive investments and therefore could lead to accelerating economic growth. In more recent theoretical works on the link between the financial-sector and economic growth were provided, among others by Pagano (1993), Greenwood & Jovanovic (1990), Levine (1991), Bencivenaga & Smith (1991) and Saint Paul (1992). Pagano (1993) utilized a simple endogenous growth model called the AK model (Y = AK)2 to analyze the role of developments in the financial-sector and its effects on economic growth. This model assumes that long-run growth is not driven by some exogenous process, like exogenous technological progress. Instead the long-run growth rate depends on the economic decisions of economic agents.

Another stream of thought by Greenwood & Jovanovic (1990), Levine (1991), Bencivenaga & Smith (1991) and Saint-Paul (1992) indicate that efficient financial markets improve the quality of investments and therefore encourage economic growth. Bencivenaga & Smith (1991) indicate that in banks, as liquidity providers, permit risk-averse households to hold interest-bearing deposits and then use these obtained funds to channel them towards productive investment. By eliminating self-financed capital investment by firms, banks also prevent the unnecessary liquidation of such investment by entrepreneurs that need liquidity. In other words, financial intermediaries permit an economy to reduce the fraction of its savings held in the form of unproductive liquid assets, and to prevent misallocations of invested capital due to liquidity needs. According to M. S. Habibullah et al (2006) financial intermediaries may naturally tend to alter the composition of savings in a way that is favorable to capital accumulation, and if the composition of savings affects real growth rates, financial intermediaries will tend to promote growth.

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10 There is a major shortcoming in the research community with the comparisons of market-based versus bank-based financial-structures; they focus on a narrow set of countries with similar levels of GDP per capita, so that the countries have very similar long-run growth rates3.Beck, T., Demirgüç-Kunt, A., Levine, R. and Maksimovic, V. (2001) note that, empirical work on the subject over the last century has primarily involved studies of Germany and Japan as bank-based systems and the United States and the United Kingdom as market-based systems. However, the small sample limits the generality of the inferences that historians, economists, and policymakers can draw for other countries. According to these authors, these four countries have “similar” long-run growth rates, compared to some developing nations, so that it is difficult to correlate differences in financial structure with differences in long-run growth rates. Thus, if one can assume, for the more common and traditional assumption, that Germany and Japan are bank-based and that England and the United States are market-based, and if one

recognizes that these countries all have very similar long-run growth rates, then this implies that financial-structure did not matter much. To provide greater information on both the economic

importance and determinants of financial-structure, economists need to broaden the debate to include a wider array of national experiences, since most previous researchers have focused on the more

traditional countries such as, The USA, The UK, Germany and Japan (Demirgüc-Kunt and Levine 2001); in light of this, I have chosen a different to the mainstream choice of nations with the commonality that nearly all these countries’ major source of income rely on the export of oil.

According to several researches such as Levine (1997 & 2001), Demirgüc-Kunt (2001), Schumpeter (1934) and Goldsmith (1969), the key factor to economic development, in this context, under any financial-structural regime is the presence of an efficiently functioning financial-sector. To see whether this is the case I have come up with the following second hypothesis:

H2: Positive developments in the financial-sector stimulate economic growth in oil exporting nations.

In order to test my hypothesis I will run an Ordinary Least Square (OLS) regression analysis. The results of the regression analysis will show whether my model is a good fit in context of economic growth (real GDP per capita growth rates), in a function of the financial-sector development indicators:

11 Finance-activity, finance –size, finance-efficiency and finance-aggregate; these indicators give

information on the degree of financial-sector developments. They are derived from same methodology as Levine (1997) and Demirgüç-Kunt and Levine (2001) used in their research, on their 48 cross-country analysis. Their results confirm that financial-sector developments are positively correlated with economic growth and that simultaneity bias or reverse causality does not drive these results. I intend to find similar results for my sample. Surely there many different theoretical methods available that would provide me the tools needed to master my research ambitions. However, I choose this particular

approach by Levine (1997) since it is the most elaborate approach and frequently used by trustworthy institutions such as the World Bank. Furthermore, this method will allow me to use a unique database that is mostly relevant for this method. An additional advantage, I believe, this method has over others is that it allows me to get results, if not perfect, then at least at a very close proxy. Levine et al. used this method in their 48 cross country analysis; it allows measuring the causal relationship of the two

fundamental variables, financial-development vs. economic growth, in the context of financial structure. Additionally it allows to systematically classifying countries in either being bank-based or market-based. Two approaches needed to answer my two hypotheses and main research question. The difference of this research compared to that of Levine et al. is that I include countries that were not chosen in the authors analysis, in hope to broaden the knowledge base on structure and financial-development in close context to economic growth.

3.

Methodology Section

Data

12 the World Bank that can provide country national account data such as GDP and GDP growth rates per capita, still, no other database than the one created by Thorsten Beck on behalf of the World Bank can supply me with the data needed, to calculate the financial-sector and -structure development indicators.

Country portfolio information

As previously indicated, to provide greater information on both the economic importance and

determinants of financial structure, economists need to broaden the debate to include a wider array of national experiences (Demirgüc-Kunt and Levine 2001); that is why I chose a different to the

mainstream choice of nations with the commonality that all these countries’ major or at least partial source of income rely on the export of crude oil. The countries are selected on the basis on the list of the top ten oil exporting countries provided by the United States Energy Information Administration. Table 3.1 provides an overview of these ten countries.

List of 10 of the top oil-exporting nations Tabel 3.1

Rank Country Oil exports in thousands of barrels*

1 Saudi Arabia 8651

2 Russia 6565

3 Norway 2542

4 Islamic Republic Iran 2519

5 Venezuela 2203 6 Kuwait 2150 7 Nigeria 2146 8 Mexico 1676 9 Kazakhstan 1114 10 Canada 1071

*net oil export in 2006

The countries listed on this table are ten of the largest oil exporting countries; this implies that the oil production and exportation has a significant contribution towards the national economy. For example for Iran and Kazakhstan, oil and oil products amount to 80 percent and 58 percent respectively of their export commodities, whereas Nigeria’s export is for 95 percent covered by the oil exports (CIA World fact book, 2007). Deriving from this, the oil export takes a large share of these countries’ exporting income. Looking at the composition by sector; the industrial sector, which also includes the oil

production, contribute to a significant share of the total GDP; the same is true for most countries in my sample.

13 the financial-sector etc. a good example for those exceptions are Canada and Norway. This is an interesting fact in my research because with diminishing oil resources, the countries that are still relying on crude oil exports need to change their focus of income, whereas Canada and Norway have other sectors that contribute to economic growth.

In order to determine the importance of a financial-structure, to financial-sector developments, and to identify the type of financial-structure, I utilize the following four structure indicators: structure-activity, structure-size, structure-efficiency and structure-aggregate for each country, for each of the six years, furthermore, I included the financial-structure indicator finance-activity as a control variable to further support the structure view to economic growth. This approach is in line with the methodology of Levine et al. (2001) in their work on financial- structure and – sector developments relative to economic growth. The formulas for these four indicators are as follows:

Formula Table 3.1- Financial-Structure Indicators STRUCTURE-ACTIVITY log Total Value Traded*1  GDP STRUCTURE-SIZE log Market Capitalization Ratio*2  GDP STRUCTURE-EFFICIENCY

log Total Value Traded Ratio   Overhead Costs*3  

STRUCTURE-AGGREGATE

log Structure‐Activity   Structure‐Size   Structure‐Efficiency  

STRUCTURE-DUMMY

STRUCTURE‐AGGREGATE   Sample‐Median   1*4 

FINANCE-ACTIVITY

log Private Credit*5  Value Traded*6

*1 Total value traded equals the value of the trades of domestic equities on domestic exchanges divided by GDP

*2 The value Market Capitalization is defined as the value of listed shares divided by GDP

*3 Overhead costs equals to the ratio of bank overhead costs to the total assets of the banks

*4 When otherwise Dummy = 0

*5 The value of credits by financial intermediaries to the private sector divided by GDP

*6 The value of credits by financial intermediaries to the private sector divided by GDP

As previously specified, each element in these formulas is provided in the Thorsten Beck’s Database of the World Bank.

The Financial-Structure Indicators Definitions are as follows:

Structure-activity, is a measure of the activity of stock markets relative to that of banks. To measure the

14 market liquidity because it measures market trading relative to economic activity. To measure the

activity of banks, I use the bank credit ratio, which equals the value of deposit money bank credits to the private sector as a share of GDP. This measure excludes credits to the public sector (central and local governments as well as public enterprises). Thus, STRUCTUREACTIVITY equals the logarithm of the total value traded ratio divided by the bank credit ratio. Larger values of STRUCTURE-

ACTIVITY imply a more market-based financial system.

Structure-size, is a measure of the size of stock markets relative to that of banks. To measure the size of

the domestic stock market, I use the market capitalization ratio, which equals the value of domestic equities listed on domestic exchanges divided by GDP. Table 1 ranks and lists the market capitalization ratio. To measure the size of bank, I again use the bank credit ratio. It should be noted, however, that other measures of banking system size, such as the total banking system assets divided by GDP, yield similar results. Thus, STRUCTURE-SIZE equals the logarithm of the market capitalization ratio divided by the bank credit ratio.

Structure-efficiency, is a measure of the efficiency of stock markets relative to that of banks. To

measure the efficiency of stock markets, I use the total value traded ratio since it reflects the liquidity of the domestic stock market. I also used the turnover ratio, which equals the value of stock transactions relative to market capitalization. The turnover ratio measures trading relative to the size of the markets is also used as an indicator of market efficiency. Using the turnover ratio produces similar results to those obtained with the total value traded ratio. To measure the efficiency of the banking sector, I use

overhead costs, which equals the overhead costs of the banking system relative to banking system

assets. While subject to interpretational problems, large overhead costs may reflect inefficiencies in the banking system. Moreover, while many readers may question the accuracy of this index, I include it for completeness. I also used interest rate margins in place of overhead costs and obtained similar results. Thus, STRUCTURE-EFFICIENCY equals the logarithm of the total value traded ratio times overhead costs. Larger values of STRUCTURE-EFFICIENCY imply a more market-based financial system.

Structure-aggregate, is a conglomerate measure of financial structure based on activity, size, and

efficiency. Specifically STRUCTURE-AGGREGATE is the first principal component of

STRUCTURE-ACTIVITY, STRUCTURE-SIZE, and STRUCTUREEFFICIENCY. Thus, I construct STRUCTURE-AGGREGATE to be the variable that best explains (highest joint R-square) the first three financial structure indicators.

Structure-dummy makes a simple bivariate classification of bank-based versus market-based financial

15 structure-aggregate is greater than the sample median and zero otherwise. Thus structure-dummy equals one for “market-based” economies and zero for “bank-based” ones.

These indicators provide information about the type and possible effectiveness of the financial-structure in each country per year. The calculations will allow me to determine the status of the financial-structure, whether it is market-based or bank-based. The results will further serve me in testing my second

hypothesis. In order to determine whether a country has a market-based financial-structure or if it has a bank-based financial-structure I apply the determination that Demirgüç-Kunt and Levine (2001) and Levine (1997) use. In simple terms, a high value in activity, size or structure-efficiency indicates market-based structure in a country and vice-versa for bank-based. In Demirgüç-Kunt and Levine (2001) and Levine (1997) study, the authors took the mean of each indicator

respectively in their cross-country research on 48 countries. Above the median value indicates a market-based structure and below the median value indicates a bank-market-based structure. In extended terms, the final determination on whether a country is market-based or bank-based relies on the outcomes of each of the first three indicators, structure-activity, structure-size and structure-efficiency. The structure that has the majority in the outcomes of the indicators will be representative as the most likely financial-structure in that country. If for instance two financial-financial-structure indicators indicate that a country, is for that given year, bank-based and one indicator implies it is market-based, it can be concluded, according to Levine et al. (1997 & 2001), that it will be an economy with a bank-based financial-structure and vice-versa.

Note, however, that an economy can be classified as market-based or bank-based only relative to the other countries in the sample, since there is no absolute measure of market- or bank-based financial systems.

In order to test my second hypothesis, the next step is to use the results of the financial-structure

indicators in the analysis of the OLS regression. In this OLS regression analysis the real GDP per capita growth rate represents the dependent variable, and the four financial-structure indicators the independent variables.

16 intermediary and stock market development across countries.For the financial-sector development I have adopted the following indicators from Levine et al (2001); activity, size, finance-efficiency and finance-aggregate. The work of Levine et al (2001) is the most comprehensive approach using the most ample set of indicators that have been constructed to date for a cross-section of countries.

Formula Table 3.2 - Financial-Sector Development Indicators

FINANCE-ACTIVITY log Private Credit*1  Value Traded*2

FINANCE -SIZE          log Private Credit*₁  Market Capitalization*₃  

FINANCE

-EFFICIENCY log Total Value Traded Ratio   Overhead Costs*4  

FINANCE

-AGGREGATE log Finance‐Activity   Finance‐Size   Finance‐Efficiency  

FINANCE-DUMMY

  *5

*1 The value of credits by financial intermediaries to the private sector divided by GDP

*2 The value of credits by financial intermediaries to the private sector divided by GDP

*3 The value Market Capitalization is defined as the value of listed shares divided by GDP

*4 The value Overhead costs equals to the ratio of bank overhead costs to the total assets of the banks

*5 Takes value 0 if claims on private sector by banks as share of GDP and value traded as share of GDP are less than sample mean, 1 otherwise

The Financial-Sector Development Indicators Definitions are as follows:

Finance-activity, is a measure of the activity of stock markets and intermediaries. To measure the

activity of stock markets, I use the total value traded ratio. To measure the activity of banks, I use the

private credit ratio, which equals the value of financial intermediary credits to the private sector as a

share of GDP. This measure excludes credits to the public sector (central and local governments as well as public enterprises). Unlike the bank credit ratio used to construct STRUCTURE-ACTIVITY,

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Finance-size, is a measure of the size of stock markets and intermediaries. To measure the size of the

domestic stock market, I use the market capitalization ratio. As noted above, there are conceptual problems with simply using market size to gauge market development. Also, Levine and Zervos (1998) find that market size is not strongly linked with economic growth but market activity (as measured by the total value traded ratio) is a good predictor of economic growth. Nonetheless, we include this measure for completeness and to assess the Levine and Zervos (1998) finding with a different dataset. To measure the size of intermediaries, I again use the private credit ratio. Thus, FINANCE-SIZE equals the logarithm of the market capitalization ratio times the private credit ratio.

Finance-efficiency, is a measure of financial sector efficiency. To measure the efficiency of stock

markets, I use the total value traded ratio. To measure the efficiency of the banking sector, I use

overhead costs, which equals the overhead costs of the banking system relative to banking system

assets. Thus, FINANCE-EFFICIENCY equals the logarithm of the total value traded ratio divided by overhead costs.

Finance-dummy, simply isolates those countries identified by Demirguc-Kunt and Levine (1999) as

having underdeveloped banks and markets from other countries. Thus, FINANCE-DUMMY equals 0 if the country is highly underdeveloped financially and 1 otherwise.

Finance-aggregate, combines is the first principal component of the first three financial-sector

development indicators of activity, size, and efficiency.

Ordinary Least Square Regression Analysis

The formula below is an equation that is found by using the Ordinary Least Square regression analysis. This regression analysis will explain the evolution of the GDP growth rate in a function of structure-activity, structure-size and structure-efficiency. The results of this regression analysis will provide me with information on whether my hypotheses can be proven. The formula I use is as follows:

Growth

   α‘X

   βFD

  γFS

e

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4.

The indicators of financial structure are highly and sometimes significantly correlated with each other as indicated in table 4.1. While structure-activity and structure-efficiency are also positively correlated with many of the financial- sector development indicators indicating that financially more developed economies have more market-based financial systems. Structure-size is not correlated with any of the financial-sector development measures.

According to Levine et al. (2001) these indicators provide a measure of the comparative role of banks and markets in the economy. Furthermore, the underlying measures of bank development and stock market liquidity exert a strong influence on economic growth.

19 Although the financial-structure indicators show some significant correlations with each other and with the financial-sector indicators in my sample, they were not able to prove either of my two hypotheses. Unfortunately, correlation doesn’t equal causality. The results in table 4.2 indicate that

financial-structure, for my sample, is not significantly related to economic growth. Illustration 4.1 shows the ill fit of the model. Interestingly the financial-sector indicator Financial-Activity displays a negative

relationship between the financial-structure indicators. In other words when the financial-activity indicator increases by 1 then GDP growth will decrease by -0.006. This is in strong contrast to what Levine et al. (2001) found for their cross-country analysis. Although, my regression revealed a positive result for structure-size which was found by Levine et al. (2001) to be a negative value, it enters no statistical significance. The regression was run with OLS and used heteroskedasticity-consistent standard errors. None of the five structure indicators, however, enters significantly in the regression. These results, therefore, do not give support to either the market- or the bank-based view -

Table 4.2 OLS Regression Output Financial-Structure

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- as laying a foundation that would stimulate the financial-sector.Therefore the distinction between market- and bank-based financial-structure does not explain much of the variation in cross-country growth rates.

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Illustration 4.1 – Regression Line Fit of Financial-Structure

The results shown in table 4.3 confirm that the financial-sector indicators do not enter in a positive and significant relationship with GDP growth. Two out of the four indicators stand in a negative relationship with GDP growth. The other two returned a positive result, however with no statistical significance.

Table 4.3 – OLS Regression Output Financial-Sector

These results imply that the countries in my sample do not show an increase in financial activity nor is the size of their financial-sector expanding. The only positive implication that can be drawn from these results is that the efficiency of the financial sector is improving however at no significant level.

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Illustration 4.2 - Regression Line Fit of Financial-Sector development

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5.

Conclusion and Limitations

Limitations

At least two out of my ten countries utilize a partially Islamic banking system, which in definition prohibits the practice of usury i.e. interest rates, this circumstance could lead to distortions in my results. When I started this thesis project this aspect on Islamic banking did not strike me as significant at the time. Also since, the availability of such data is highly scarce I wasn’t able to insert any indicators that are related to Islamic Banking. Nevertheless, since these countries don’t use an entirely Islamic-banking system but more of a mixture between both, capitalistic and Islamic, I still anticipated in getting some valid results. A second limitation of this thesis is that my sample is much smaller than the sample used by the authors of this method, Ross Levine and Demirgüc-Kunt. The author used a sample of 48 countries, since my research is on ten of the largest oil-exporting nations, I initially chose fifteen of the largest oil-exporting nations, yet only ten proved to have usable data. A final limitation of this thesis is that I didn’t include the legal origin factor, e.g. German Law, French Law and British Common Law, which the authors used in their study, since again at least two countries of my sample use none of the three legal origins.

Conclusion

23 on economic growth. The final step was to calculate the financial-sector indicators, financial-size, financial-activity and financial-efficiency, and analyze their effects on economic growth.

As for my first hypothesis, whether the financial-structure (e.g. bank-based or market-based) could provide better mechanisms to stimulate financial-sector developments and hence lead to economic growth could also not be proven for this sample and time period. At this stage I firmly believe that this relationship could never be proven, for the following possible reasons: A) The first possible reason could be due to the rule of Islamic banking system and that the Islamic banking procedures have a much larger effect on the overall financial-sector as previously anticipated. B) This research and previous researches, for instance by Levine et al., showed that there is no clean cut when categorizing a nation in either being market-based or bank-based, and that the method I adopted from Levine et al. categorizes countries in either being bank-based or market-based only on the basis of its belonging to a specific sample. Therefore, it is at this point obvious that most nations in the world tend to choose what they believe is the best structure; which could be a mixture of elements from the textbook definition of both financial structures.

As for the second hypothesis I found that there was no clear evidence for the stated phenomenon, that positive developments in the financial-sectors to economic growth, for the chosen sample and time period. A possible reason for this development could be similar to the one previously mentioned in regards to Islamic banking, and that most of the countries in my sample are either Islamic or have large Islamic minorities in the country, meaning that the Islamic banking systems in these countries have a much larger effect on the financial-sector than anticipated. This could be relevant since the Islamic banking system differs immensely from the capitalistic banking system, in terms of the prohibition of interest rate earnings in the Islamic banking system. I believe that further research on these countries could prove to be interesting to the academic community.

24

References

Literature:

Beck, T., Demirgüç-Kunt, A. & Levine, R., (1999), A New Database on Financial Development and

Structure, Policy Research Working Paper Series, 1999

Beck, T., Demirgüç-Kunt, A., Levine, R. and Maksimovic, V. (2001),

Financial Structure and Economic Growth; A Cross-Country Comparison of Banks, Markets and Development,

The MIT Press, London, UK, ISBN 0-262-04198-7

Beck, T., Levine, R., and Loayza, N., (2000), Finance and the sources of growth Journal of Financial Economics, Oct/Nov2000, Vol. 58 Issue 1/2, pages 261-300.

Bencivenga, V. & Smith, S. (1991) Financial intermediate and endogenous growth Review of Economic Studies, Vol. 58(2), pages. 195–209.

Chakraborty, S. & Ray, T. (2003), Bank-based versus Market-based Financial Systems: A

Growth-theoretic Analysis

Journal of Monetary Economics, Elsevier, vol. 53(2), pages 329-350 Demirgüç-Kunt, A. & Levine, R., (2001), Financial Structure and

Economic Growth; A Cross-Country Comparison of Banks, Markets and Development, The MIT Press,

London, UK, ISBN 0-262-04198-7

Goldsmith, R. (1969), Financial Structure and Development

New Haven, CT: Yale University Press, 561 pages, ISBN: 0300011709

Habibullah, M.S. & Eng, Y. (2006), Does Financial Development Cause Economic Growth? - A Panel Data Dynamic Analysis for the Asian Developing Countries.

Journal of the Asia Pacific Economy Vol. 11, No. 4, 377–393, November 2006 King, R. & Levine, R. (1993), Finance and Growth: Schumpeter Might Be Right The Quarterly Journal of Economics, MIT Press, Vol. 108 (Aug. 1993), pages 717-37 Levine, R. (1997), Financial Development and Economic Growth: Views and Agenda Journal of Economic Literature Vol. 35 (June 1997), pp. 688-726

Levine, R. (2002), Bank-Based or Market-Based Financial Systems: Which is Better? Journal of Financial Intermediation Vol. 11(Oct. 4, 2002), pp. 398-428.

25 Mababaya, M. (2003), The Role of Multinational Companies in the Middle East: The Case of Saudi Arabia

Universal-Publishers 2003, ISBN:1581121725

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development

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Databases:

Financial Structure Dataset by Thorsten Beck (2007), World Bank Website:

http://econ.worldbank.org/WBSITE/EXTERNAL/EXTDEC/EXTRESEARCH/0,,contentMDK:215466 33~pagePK:64214825~piPK:64214943~theSitePK:469382,00.html

CIA world factbooks, 2000, 2001, 2002, 2003, 2004, 2005 and 2007

Website: https://www.cia.gov/library/publications/the-world-factbook/index.html

International Monetary Fund

Website: http://www.imf.org/external/pubs/ft/weo/2007/02/weodata/weoselgr.aspx

United States Energy Information Agency

Website: http://www.eia.doe.gov/emeu/cabs/topworldtables1_2.htm

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Appendix I