Does Financial Development Necessarily Lead to Economic Growth? Evidence from China’s Cities, 2007–2014

Abstract

Abstract. Using data from 286 Chinese cities over the period [2007][2008][2009][2010][2011][2012][2013][2014], this paper investigates the impact of financial development on economic growth. Our results from traditional cross-sectional regressions, first-differenced GMM and system GMM regressions all show that financial development does not have any significant positive effects on economic growth, while some indicators of financial development show significant negative effects on growth. Our results are consistent with many existing studies that a state-ruled banking sector, such as that of China, hinders economic growth because of the distoring nature of the government. To examine the sensitivity of our results, different sets of control variables sets are experimented with. Our results are shown to be robust. Our finding shows that to let the financial sector play a more efficient and effective role in promoting real economic growth, China has to further reform its financial system. IntroductionJoseph Schumpeter argued in his seminal work The Theory of Economic Development (1911) [1] that the services provided by financial intermediaries are essential for technological innovation and economic development. They mobilize savings, evaluate projects, manage risk, monitor mangers, and facilitate transactions. Earlier empirical works by Goldsmith (1969) [2] and McKinnon (1973) [3] illustrate the close ties between financial and economic development for a few countries. Numerous influential economists, however, believe that finance is a relatively unimportant factor in economic development. Notably, Robinson (1952) [4] argues that financial development simply follows economic development. Lucas (1988) [5] terms the relationship between financial and economic development 'over-stressed.' In this paper we study whether higher levels of financial development are positively associated with economic growth using data on 286 Chinese cities from 2007 through 2014.To examine whether Schumpeter (or Lucas) was right, we must define 'financial development' empirically. We construct four indicators of financial development that are designed to measure the services provided by financial intermediaries. First, we compute the traditional measure of financial depth, which equals the overall size of the formal financial intermediary system, i.e. the ratio of loans to GDP. Second, we measure the ability of financial intermediaries to mobilize capital, i.e., the ratio of deposits to GDP. Third, the ratio of households savings to GDP to measure the ability of financial intermediaries to attract household savings. Fourth, share of fixed asset investment financed by bank loans relative to state budgetary appropriation. It is believed that bank loans have more role than government appropriation in disciplinary the recipients. Although each financial indicator has shortcomings (sometimes due to data limitations), using this array of indicators provides a richer picture of financial development than if we used only a single measure.China ha...

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