Financial Development and Economic Growth: The Role of Financial Liberalization

Abstract

This paper addresses the issue whether excessive liberalization has caused the financial development to lose its effectiveness in generating economic growth. We employ a dynamic panel data analysis for 88 countries over the period of 1973 to 2005. Our index for the financial sector liberalization covers seven aspects: credit controls and reserve requirements, interest rate controls, entry barriers, state ownership, policies on securities markets, banking regulations and restrictions on capital market. We use a comprehensive financial development indicator constructed through principal component analysis of five different indicators: bank private credit to GDP ratio, liquid liability to GDP ratio, deposit money bank assets to total bank assets ratio, deposit money bank assets to GDP ratio, and bank credit to bank deposit ratio. The results indicate that the positive effect of financial development on long-run growth continues to decline as the financial sector becomes more liberalized. Our results are robust to changes in the financial development indicators and dis-aggregation of financial liberalization index.