Financial Development and Economic Growth essay

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Given the remarkable improvements in the stock market and banking industry in the last few years in Jordan, the article reviews whether financial development and market development have a barbering on economic growth. This is after a number of attempts that have been made to study the role that the financial sector plays in economic growth. The issue has raised heated debates among many economists for years. With the growing importance of stock markets, this is expected to generate more heat. The purpose of this study is to extend an earlier work by Levine and Zervos (1998) that had focused on the effects of the development of stock markets of the banking system. Mishal asserts that after speculation the stock market increases the economic growth of the countries by virtue of increasing the liquidity of financial assets. He, however, postulates that this has the implications of making risk diversification both locally and globally possible (by promoting wiser investment decisions). Usually, the stock market is termed as the indicator of directions that business will take. However, due to controversy that surrounds the issue, it was deemed vital to further research on the topic to discover the ways through which stock markets influence economic growth of the countries. Fry (1997) and Mayer (1988), argue that banks and stock markets are substitute sources of finance, and thus they suggest that stock market may hinder economic growth, if a firm issues new equity at the expense of growth of banks. This issue has not been thoroughly dealt in the Middle East in spite of the region’s tremendous growth in the past decade. The article, therefore, will review the implications in Jordan, because it is perceived to be more open to investors as the study conducted by Sedik and Petri (2006), through the Amman Stock Exchange shows. 

Data Used

Mishal analyzed data obtained over a period of 30 years, from the year 1978 to 2009. An annual data was used mainly because it was not easy to access monthly or quarterly data as sometimes it was not available for long periods. Three variables were used for this study including economic development, stock market development and banking system development. Economic development was measured by the country’s GDP, while stock market development was measured by market capitalization proxy value traded ratio and stock prices return, while banking system development measured by use of a domestic bank credit to the country’s GDP. Data obtained was subjected to diagnostic tests like the co-integration test and unit root tests earlier discussed. The purpose of these tests was to search for the best fit model for the data set. Empirical results for Jordan were based on annual interpretation and date obtained expressed in logarithms. An impulse function was then generated on multivariate Vector Error Correction Model (VECM). Variables used here include the annual growth rate of nominal GDP, market lending interest ratio, market capitalization ratio, banking credit ratio, value traded ratio and annual growth rate of share price index.

Method Used

Mishal relied on multivariate Granger causality tests. The first tests were performed on the macroeconomic series for stationarity performed through unit root tests. By use of unit root tests developed by Dickey and Fuller (1979, 1981) and Phillips and Perron (1988), the series were tested for its stationarity. The augmented two tests above, (Dick-Fuller; ADF) t-tests and the Phillips & Perron tests Z(tα ) were used to test the difference of a unit root and its individual time series. The reason for the use of the two tests was mainly to conquer criticism of unit root tests. Unit root tests have especially been criticized that they have restricted power when dealing with finite samples, thus rejecting the null hypothesis that is non-stationarity. Co-integration testing was the next step. Co-integration testing was used, because it is reliable and established a long-run relationship with financial market variables and macroeconomic variables. Mishal asserts that the study relied on VECM and the Johansen Co-integration Tests. The main reason was to avoid any type of bias arising from use of conventional modeling techniques. Mishal postulates that if variables used in the VAR model are to be integrated, then according to Engle and Granger (1987), the model may have to be misspecified. This is because it is excluded as a supplementary channel that results from a long-term relationship between the two variables. The last step was undertaken the causality tests along with the co-integrated variables. 

Summary of Major Events Covered

The dominant aim of this article is that the writer wants to present empirical evidence for the relationship that exists between financial developments and economic developments. He has shown a causal relationship that exists between the banking sector development, the GDP as well as the stock market development in a multivariate VECM. The study strongly supports the idea of a stable and long run relationship that exists between economic growth and the banking sector as well as between the stock market and the banking sector. There is evidence from the study that a bi-directional causality does exist between long-run economic growth and the banking sector development as there is causality between the stock market and the banking sector. It was interesting to discover that the causality goes from the GDP growth to the stock market and not vice versa. This implies that a stock market’s outlook does not reflect an improved economic situation in Jordan. However, it should be noted that Mishal’s findings have had some serious implications in the country’s stock market because of its suggestions that policies relating to stock market should not be viewed as serving a caterer that will just satisfy spectators’ needs but rather should be aimed at creating a transparent and long-term view for investors. 

Critique the author’s work. Answer the following questions

  1. 1.      Is the question worth asking?
  2. 2.      Are you persuaded by their answer?

Although Mishal offers to explain studies that attempt to explain whether a relationship exists between the development of financial markets and an overall output growth in Jordan, he never goes beyond to tell us what is the scenario in other developing and developed countries; whether the scenario is the same or whether the findings are just unique for Jordan. It is worth noting, however, that many of Mishal’s descriptions and experiences included in the research were either based on his opinions, research only or as a profession as they sometimes leave as to wonder. Examples include the assertion that the study will be an example for other emerging markets. Why could the writer not use a cross-country study to get facts first? This is because different countries may represent different scenarios as far as the relationship between development of banks and development of stock markets is concerned. He should have acknowledged his assertions as either personal observations, from research or from a professional point of view and give an example of a country that has the same scenario instead of just saying that “emerging markets of similar…” Markets may have a similar pattern, but when it comes to drawing policies, have a different approach altogether. He did not elaborate whether the characteristics that make “ASE a good representative of other emerging markets...” was also applicable to other emerging markets only in the Middle East or emerging countries all over the world. This lack of support and the assertions made, thus may undermine the potential benefit of Mishal’s study and presentation of issues, especially for the emerging markets, not only those in the Middle East, but all over the world.

What is the strongest/weakest aspect of the argument/evidence?

The weakest point according to me is the assertion that “it is possible that stock market development may hamper economic growth…” (20). I feel that the writer needs to do more research and support his ideas on this assertion and clearly state how stock market may hamper economic growth, this is because I feel that a robust stock market enhances growth of emerging nations rather than hampering their growth. 

What questions remain for you?

I still wonder whether Mishal’s argument will hold for all emerging nations, no matter where they are located or it only applies to the countries in Middle East. Another question is whether the argument also holds for developed markets or is just restricted for emerging markets.

What would be a good extension or elaboration of this work?

Mishal should do more research on his assertion and check out whether his ideas that stock market hampers growth of banks can hold any water and what the relation between the two is and general development of a country. 

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