Financial Development and Economic Growth in Malaysia

James B. Ang

• Publisher: Routledge
• Year: 2008
• ISBN:
  9781134035106
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

This book is concerned with the role of financial intermediation in economic development and growth in the context of Malaysia. Using an analytical framework, the author investigates the Malaysian economy from 1960 onwards to examine how far financial development has progressed in the course of economic development, and whether it has been instrumental in promoting economic growth.

A significant improvement in the Malaysian financial system, coupled with rapid economic growth and a rich history of financial sector reforms, makes Malaysia an interesting case study for this subject. The author shows that some government interventions seem to have impacted negatively on economic growth, whereas repressionist financial policies such as interest rate controls, high reserve requirements and directed credit programmes seem to have contributed positively to financial development. The analysis concludes that financial development leads to higher output growth via promoting private saving and private investment.

Shedding light on the evolutionary role of financial system and the interacting mechanisms between financial development and economic growth, this book will be of interest to those interested in economic and financial development, financial liberalization, saving behaviour and investment analysis and Asian Studies.

1 Introduction

1.1 Introduction

The financial system comprises banking institutions, financial markets, other financial intermediaries such as pension funds and insurance companies, and a large regulatory body: a central bank, which oversees and supervises the operations of these intermediaries. Every economy requires a sophisticated and efficient financial system to prosper. A more efficient financial system provides better financial services, and this enables an economy to increase its real GDP growth rate. Conversely, a weakened financial system spills over unfavourably into the economy. An inadequately supervised financial system may be crisis-prone, with potentially devastating effects. The important role of financial intermediaries and financial markets therefore merits more attention from researchers and policy makers.

Although economists attach different degrees of importance to financial development, its role in contributing to long-term growth can be theoretically postulated, and this has been increasingly supported by the findings of growth empirics. Due to the lack of sufficient time series data for developing countries, empirical research on this subject has been dominated by cross-country studies. These studies have consistently shown a positive relationship between financial development and economic growth. However, economists have not reached a consensus with regard to the direction of causality between these two variables, nor do they provide a satisfactory solution on the endogeneity of the variables used in their analyses. Furthermore, the results may vary considerably due to different institutional and structural characteristics of each economy. Given the above, the assertion that financial development contributes to output growth may be an unqualified assumption, and its validity has to be tested within specific cases. For that reason, more empirical case studies are needed to throw light on the issue.

This chapter proceeds as follows:

• Section 1.2 describes the purpose, scope, and contribution of this study;
• Section 1.3 explains the motivation behind why Malaysia is chosen as the case study for this subject;
• Section 1.4 provides the definition for the key financial terms used in this research; and
• Section 1.5 provides an overview of the thesis structure.

1.2 Purpose and contribution of this study

This thesis seeks to provide some insight into how financial development and economic growth are related in the context of Malaysia. The central issue is how, and to what extent, improvement in Malaysia’s financial system contributes to the process of economic development. It is hoped that this analysis will add to understanding of the evolutionary role of financial system and the interacting mechanisms between financial development and economic growth.

The purpose of this book is three-fold:

• to conduct a survey of both the theoretical and empirical evidence on this subject, and critically assess the evidence and validity of the theories. There is a vast literature on the issue of financial development and economic growth. It is essential, therefore, to identify studies that have made the greatest contribution to the understanding and development of this subject, and to try describing the relationship between each study. In doing so, the inadequacies and problems associated with the existing theories and empirical models will be identified, so that appropriate refinements can be introduced;
• to develop an analytical framework for examining the relationship between financial development and economic growth based on a critical survey of the existing literature. A well-specified model that explains the mechanisms of how financial development is linked to economic growth (and vice versa) is essential in understanding the underlying transmission channels of the finance–growth nexus;
• to conduct an in-depth case study for Malaysia using this analytical framework to gain a deep insight into the role of financial intermediation in the process of economic development. There must be serious doubt about the validity of any inference drawn based on the results of cross-country studies, given that each country has its own unique institutional setting and economic history. For that reason, only one country is chosen here as a case study as opposed to the conventional broad comparative examination that involves a much larger sample.

This book contributes to the existing body of finance and development literature in several aspects:

• it develops an analytical framework to provide an understanding of how financial development and economic growth are related by analysing the mechanisms linking them. Such a theoretical construct is often bypassed in many studies of this nature;
• the literature on this subject has been dominated by cross-country studies. Notwithstanding the contributions of these studies, they offer little guide for policy formulation. This study adds to the existing body of literature by providing further time series evidence on the issue and using this to help inform policy debates;
• it adopts a multi-equation approach by taking into account the possibility of financial development being an endogenous variable, rather than treating it as an exogenous variable, as is usually done in most cross-country studies. This ameliorates the serious problems of misspecification bias, and adequately deals with simultaneity bias;
• despite its status as a leading developing country, the economy of Malaysia remains substantially under-researched. It is hoped that the results of this study will serve as a useful guide in policy making for countries in the same region or for other less-developed countries.

Most of the available studies on the role of financial sectors in economic development in Malaysia are largely descriptive in nature (e.g. Drake, 1969; Lee, 1981; Rao, 1977). A more recent study by Yaakop (1988) employs a three-equation model to assess the impact of financial development on economic growth in Malaysia. However, the static regressions employed in his study fail to adequately explain the evolution of the economic behaviour of the key variables observed over time. With the advantage of using a longer time series, this study aims to disentangle the dynamics involved in the relationship between financial development and economic growth using recently developed time-series econometric techniques.

1.3 Why Malaysia?

Malaysia provides an interesting case study of this subject for several reasons. With rapid economic growth following the industrial transformation that took place in the 1970s and 1980s, Malaysia has evolved in recent years to be a leading country in the developing world. Accompanying this development has been a significant improvement in its financial system. Financial development, in terms of the emergence of more financial institutions and financial instruments, has improved tremendously. However, little attention has been paid to understanding the evolutionary development process of Malaysia’s financial system.

Malaysia has a rich history of financial sector reform. Various financial restructuring programmes that aim to achieve a better financial system have been launched since the 1970s. However, there is little empirical evidence providing policy makers with the necessary information as to whether these reforms have had any impact on the financial system, and hence on economic growth. Such an interesting historical background provides the motivation behind using Malaysia as the case study for this subject.

The fact that Malaysia has a relatively good database by the standard of developing countries provides an added incentive for the research. The availability of a set of sufficiently long time-series data allows for a meaningful time series investigation. This is critical given that economic growth is a long-run phenomenon, which necessitates analysing the evolution of the variables of interest over time in order to relate the findings to policy designs (Solow, 2001).

1.4 Definition of key financial terms

Financial terms are sometimes inconsistently and ambiguously used in the literature.¹ It is therefore necessary to define the financial terms used in the context of this study:

• Financial institution refers to an individual member in the financial industry, such as the central bank, a commercial bank, or an insurance company (Tobin and Brainard, 1963). There are two broad categories of financial institutions: banking institutions including commercial banks, finance companies, merchant banks, national savings banks, etc.; and non-bank financial institutions, such as pension funds, insurance companies, etc.
• Financial intermediary refers to the entire industry of financial institutions. Thus, all commercial banks constitute one intermediary, all finance companies another, and so on.
• Financial intermediation is the process of transforming financial capital into more widely preferred types of financial assets by linking lenders and borrowers.
• Financial markets provide the exchange of capital and credit. They include stock markets, bond markets, money markets, future markets, foreign exchange markets, etc.
• Financial instruments refer to money, forwards, options, swaps, future contracts, etc.
• Financial system comprises financial intermediaries, financial markets, and financial instruments. Asymmetric information and transaction costs lead to the creation of a financial system. The primary function of a financial system is to ensure the efficient allocation of resources in the presence of an uncertain environment. Most literature focuses on a specific aspect of financial system by considering only banks, stock markets or money.
• Financial structure refers to the composition of a financial system, such as banks, stock markets, provident funds, etc., that makes up the whole financial sector. The extent of a financial system refers to how easy it is for firms and households to access financial services. The efficiency of a financial system refers to how effective financial markets and financial intermediaries are in reducing information and transaction costs for firms and households.
• Financial deepening is often referred to as the improvement in the extent or efficiency of a financial system. In the literature, a financial sector is said to deepen when:
  • the range of financial products and services broadens;
  • the accessibility to financial products and services improves;
  • the types of institutions operating in the financial sector expands;
  • the extent to which financial resources intermediated through the financial sector increases;
  • the amount of financial capital allocated to the private sector increases; and
  • the quality of regulation and stability of the financial sector is enhanced.

1.5 Organization of the book

The rest of the book is organized as follows:

• Chapter 2 reviews the theoretical and empirical works on financial development and economic growth. While the theory was initiated in the 1950s, most of the empirical counterparts have only been developed from the 1990s, following the seminal work of King and Levine (1993a). However, the focus has been largely on assessing the cross-country evidence. The chapter highlights the drawbacks of these broad comparative analyses by providing evidence on sensitivity of the results, and argues in favour of a country in-depth case study.
• Chapter 3 provides an overview of the Malaysian economy and development of its financial system in order to set the stage for the ensuing analyses. The policy context and growth experience of the Malaysian economy are discussed. Components of the Malaysian financial system are also described.
• Chapter 4 discusses data, variable construction, and econometric techniques. The autoregressive distributed lag (ARDL) bounds procedure is used as the cointegration test in favour of alternative tests given its desirable statistical features. An unrestricted error-correction model, which accounts for omitted lagged variable bias, is used to estimate the long-run relationships. An instrumental variable technique is adopted to correct for endogeneity bias so that reliable inference can be drawn from the estimated results.
• Chapter 5 examines the determinants of financial deepening by taking real per capita GDP, real interest rates, and a set of financial sector policies into consideration. The technique of principal component analysis is used to construct a summary measure of financial sector policies in order to account for the joint influence of interest rate controls, reserve and liquidity requirements, and directed credit programs imposed on the Malaysian financial system.
• Chapters 6 and 7 then analyse the patterns and determinants of private saving and private investment respectively in Malaysia. In the former, the analytical framework is constructed using the life-cycle model with appropriate modifications to account for the structural and institutional features of the economy. In the latter, a static private investment function is derived from the neoclassical framework, with appropriate extensions to account for the features of the Malaysian economy. A cost-minimization problem, which assumes firms optimize investment level with respect to a quadratic loss function, is adopted to obtain a dynamic investment model suitable for estimation.
• Chapter 8 looks at the dynamic link between domestic saving and investment rates. The empirical specification of this dynamic relationship is derived based on an intertemporal current account model. Given that these two variables are cointegrated, the correlation is estimated using an error-correction model with a cointegrating framework to allow for an analysis of both the short-run and long-run dynamics of the saving– investment relationship.
• Chapter 9 examines the role of financial intermediation in the Malaysian economy. First, a growth accounting exercise is performed to shed light on the sources of growth by decomposing the growth rate of real GDP into TFP (total factor productivity) growth rate, and the growth rates of physical capital and labour input. The impact of financial development on economic growth, via the qualitative channel, is then tested using the standard neoclassical model, augmented with financial development.
• Chapter 10 provides some concluding remarks. The results of the five empirical results from Chapters 5 to 9 are summarized and analysed in this concluding c...