International Journal of Scientific & Engineering Research, Volume 4, Issue 11, November ISSN

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1 International Journal of Scientific & Engineering Research, Volume 4, Issue 11, November The Causality Direction Between Financial Develoment and Economic Growth. Case of Albania Msc. Ergita KOKAVESHI, Prof. Dr. Tonin KOLA Abstract There is an ongoing debate about the fact that is the financial develoment that cause economic growth or the vice versa. This aer begins with a review of economic theory for the causality relationshi between financial develoment and economic growth. Later using a time series data which emloyed quarterly data from we will try to investigate about this relationshi in the case Albania. Based on that analysis we show that in Albania exist a bi directional causality relationshi between financial develoment and economic growth. Index Terms financial develoment, economic growth, suly leading hyothesis, demand following hyothesis, bi directional causality 1 Introduction because it is secific for different countries, deending on economic and financial conditions. Financial system, which is laying a crucial role in channeling funds to roductive users and the 2 Literature Review allocation of risk, is subject of various theoretical and It is an undeniable fact that technology lays an imortant emirical studies. Various economists, as Kasekende (2008) role in the economic develoment of a country. On the suort the argument that countries characterized by other hand, technological rocess requires huge efficient financial systems have faster economic investments, which are financed by the financial system, develoment and vice versa. Most economists define lacing it in the middle of economic develoment rocess. economic growth as a ositive change in national income or Desite economists agree on the existence of a ositive the level of roduction of goods and services by a country relationshi between financial develoment and economic during a given eriod of time. For a long time, in terms of growth, what remains unclear is the causality relationshi erfect markets, the financial system was not thought to between them. Based on the literature of financial lay an imortant role in economic growth. In develoing develoment and economic growth there are three ossible markets and with the creation of imerfections, this view hyotheses about causality relationshi. If it is financial was rejected. A sustained and long-run economic growth develoment causes economic growth, then this hyothesis deends on the ability to increase the rate of accumulation is known as the suly leading " because it is assumed of human and hysical caital, the allocation of factors of that financial develoment increases the suly of financial roduction and technological rogress in the traditional services thereby stimulating economic growth. Similarly, if way, the financial system is associated with the first two. economic growth resulting in increased demand for Also, it contributes even to technological rogress. During financial services, which in turn romotes the develoment eriods of raid technical rogress, the financial system is finance as known as the hyothesis of demand following. necessary to facilitate technological advantages in caital It may also haen that financial develoment and formation so countries can benefit from this develoment in economic growth also cause each - other, it is theoretically terms of a high economic growth rate. However, there is known as bi directional causality hyothesis. another grou of economists as Lucas (1988) and Stern Identifying the direction of this relationshi is imortant (1989) who argue that financial develoment lays a very small role on growth. because it has imortant imlications for olicy develoment, and thus hels to exlain the fact why countries are characterized by different rates of growth. Although it is believed that the develoment of the financial system that causes economic growth, it is difficult to determine because different studies conducted in different eriods have different results. This makes that the causal relationshi between them, should not be defined htt:// Schumeter (1911) has suorted the view that the develoment of the financial system and its efficient oeration through efficient allocation of savings and financing successful businesses facilitates technological innovation causing an increase in the overall level of

2 International Journal of Scientific & Engineering Research, Volume 4, Issue 11, November roduction. McKinnon (1973) and Shaw (1973) saw financial develoment as a strategy to achieve raid economic growth. They argued that the develoment of the financial system ushes individuals to increase savings and stimulate financial intermediation, thus increasing the suly of credit to the rivate sector. This in turn will stimulate investment and growth. King and Levine (1993) analyses 77 develoing and develoed countries. Emirical results show that financial develoment not only following economic growth, but it s also imortant for economic growth. Demirguc - Kunt and Levine (2008) found that countries with financial develoed system tend to develo quickly economically. Precisely they noted that financial intermediations, as well as financial markets are imortant for economic growth. Moreover, each of them is ositively associated with economic growth, so olicy makers should not only give riority to financial sector olicies, but should be careful to olicies that define financial develoment as a mechanism for romoting economic growth. On the other hand, Robinson (1952) based on the neoclassical growth model stressed that the financial system has a very small imact on investment and hysical caital, and thus on economic growth. He thought that was the economic activity leading by encouraging financial institutions to finance comanies. Also, Lucas (1988) believed that the roles of financial factors were overestimated because the financial system resonds assively to industrialization and economic growth. Liang and Reichert (2006) to assess the relationshi between financial develoment and economic growth in develoing and develoed countries were based on the model resented by Odedokun (1996). They concluded that in both cases was economic growth that causes financial develoment, but this relationshi aeared stronger in the case of develoing countries. Desite the above hyothesis, Patrick (1966) noted that in the early stages of growth, financial develoment through suly leading hyothesis romotes the formation of real caital. Innovation and develoment of new financial services create new oortunities for investors and savers, creating the conditions for sustainable economic growth. But while financial develoment and economic growth continues, characteristics of suly leading hyothesis begin to diminish, and gradually begin to emerge and dominate characteristics of demand following hyothesis. Demetriades and Andrianov (2004) argue that financial develoment through creating conditions for new oortunities stimulates economic growth. On the other hand, economic growth means increased savings in the banking sector, thus increasing credit to the rivate sector (a financial develoment indicator). 3 The Model The early econometric models of economic growth dating back to Barro (1991), where the deended variables do not included any indicator of financial develoment. Just two years later, King and Levine (1993) exand the model htt:// resented by Barro including four financial develoment variables. Including in their analysis of a samle of 80 countries, with the hel of a cross - section analysis, they had concluded that financial develoment cause economic growth. To study the causality between financial develoment and economic growth, in econometric research desite cross - section analysis, have recently begun to dominate the anel data and time series analysis. Because different analysts have used different econometric methods associated with various analyzed countries, different time eriods or deended variables; has made the emirical results to be different. To analyze the causality between financial develoment and economic growth, in this aer it will be used a time series analysis because it is focused secifically in the case of Albania. 3.1 The Data Another imortant issue is defining financial develoment and economic growth indicators, which then will be included in the model. In the aers resented by different authors, are used terms such as financial intermediation, finance, financial develoment, financial system, financial markets, etc... But desite this, all use indicators related to financial intermediation carried the banking system. This, because the banking system has a rimary imortance in the financial system, as well as in develoing countries is the only one that attracts rivate savings to a large extent. Related financial develoment, monetary aggregates rovide some ossible indicators, among them De Gregorio and Guidotti (1995) suggested the use of less liquid aggregates like M2 or M3 to GDP. Since M3 aggregate deends more on other than on financial develoment indicators (Dushku, 2010) and because in most literature is used more M2 aggregate, then in this aer will be use the latest indicator. This indicator measures the degree of monetization in an economy, thus reflecting the actual size of the financial sector. In develoing countries such as Albania, the M2 aggregate is reresented by money outside the banking system. In this way, an increase of this indicator may reflect a growing in using more money. For this reason, Demetriades and Hussein (1996) roosed using the deosit rate to GDP as a better reresentative of financial develoment. As financial develoment indicator can be used even the ratio of domestic credit to GDP. This indicator, which includes claims of banking system against ublic sector, rivate sector and individuals, occuies the largest share in the assets side of the balance sheet of the financial system.

3 International Journal of Scientific & Engineering Research, Volume 4, Issue 11, November Domestic credit is divided in loans to rivate and ublic sector (Attention: We are analyzing only the credit and not total borrowing, which includes borrowing by government securities). Of the two, rivate sector credit is what generates more investment and as a result a greater roductivity. Given this reasoning, the fourth indicator that will be used to directly measure the financial intermediation is the ratio of rivate sector credit to GDP As mentioned above, the greater weight of domestic credit goes to the rivate sector. From this we can say that the ratio of rivate sector credit to total domestic credit reflects the internal distribution of assets in the economy, and thus made it the last indicator to be used for measuring financial develoment. Based on the definition of economic growth, a ositive change in national income or the level of roduction of goods and services by a country over a eriod of time, as its indicator will be used the GDP growth estimate basic rices. If the first hyothesis is rejected, indicate that financial develoment causes economic growth, thus suorting the hyothesis of "suly-leading". Also, the rejection of the second hyothesis suggests that economic growth causes financial develoment confirming the hyothesis of "demand following". If both hyotheses are acceted then the variables are indeendent of each - other, but if they rejected both simultaneously, then we can say that there is a bi directional causality between financial develoment and economic growth. If the variables included in the model are I (1) and cointegrated, the traditional Granger Causality test is based on Fisher's values can t be used due to non-normal distribution. In this case, an accurate estimate will be obtained from the evaluation of the VECM model (Vector Error Correction Model). The model limits the long run behavior of endogenous variables in order to congregate towards their cointegrated relationshi The VECM model can be resented as follows: The data set emloyed quarterly data on all indicators mention above from The Methodology To test the causality between financial develoment and economic growth this aer will be based the method introduced by Granger in Under this aroach, economic growth is caused by financial develoment if it can be better redicted by ast values of financial develoment and economic growth. GDP(t) = A 11j GDP t j + A 12j FIN t j GDP t 1 = A 11j GDP t j FIN t 1 = A 11j FIN t j + u t Also, financial develoment will be caused by economic growth if it can be better redicted by ast values of economic growth and financial develoment. FIN(t) = A 21j FIN t j + A 22j GDP t j + v t In equations (1) and (2), is the maximum number of observations in the samle, matrices A containing model coefficient and ut vt residuals (redicted errors) for each time series. (1) (2) + A 12j FIN t j + 1 ε 1t 1 + u t + A 12j GDP t j + 2 ε 2t 1 + v t Where ε 1t 1 and ε 2t 1 reresent errors time lags resulting from the following cointegrated equations: GDP t = α + ψfin t + ε 1t (5) FIN t = δ + φgdp t + ε 2t (6) In this model, the causality relationshi between financial develoment and economic growth follows the stes below: The first ste is testing if each of the variables included in the model, are stationary and cointegrated in the same order. For this test will be used ADF test (Augmented Dickey - Fuller), which is based on the evaluation of the following three regressions: (3) (4) Based in this method, based hyotheses to be tested were: H0: A12j = 0; for j = 1... this hyothesis imlies that financial develoment does not cause growth H1: A22j = 0; for j = 1... this hyothesis imlies that economic growth does not cause financial develoment y t = δy t i + u t (7) y t = α + δy t 1 + u t (8) y t = α + βt + δy t 1 + u t (9) As noted, equation (7) imlies neither constant nor trend variable, equation (8) includes only constant, and finally, htt://

4 International Journal of Scientific & Engineering Research, Volume 4, Issue 11, November equation (9) also includes constant and trend. Are these gradually add-ons that eliminate a ossible autocorrelation. In this case, the basic hyothesis is that the series are not stationary (δ = 0) and will be rejected if δ is statistically significant (δ 0). If statistical values calculated by ADF test are greater than the McKinnon critical value, the basic hyothesis is acceted. If the series are not stationary in their levels, then they can return into stationary taking their first difference. After all variables are returned in stationary I (1), then the next ste has to do with testing for cointegrated connection between variables. This is accomlished through the methodology resented by Johansen (1988) and Johansen and Juselius (1990) which is based on a VAR model resented as follows: 4.2 Johansen and Juselius Cointegration Test Table 2a. Unrestricted Cointegration Rank Test (Trace) Eigenvalue Trace Statistic P- value GDP None Domestic Credit At most cointegrated GDP None Private Credit At most cointegrated GDP None M2 Aggregate At most not cointegrated GDP None Deosit At most cointegrated GDP None Private Credit to Domestic Credit At most not cointegrated y t = µ + A 1 y t A y t + ε t (10) This can be rewritten in the form: 1 y t = µ + Πy t 1 + Γ i Δy t i + ε t i=1 (11) Where Π = A i I dhe Γ i = A j (12) i=1 j=i+1 In equation (12), Γi and Π reresent vectors involving resectively matrices of short and long run coefficients. This method to determine the order of cointegration is based on two tests: trace statistic and maximum eigenvalue. From the above tables it is observed that there is no If variables are cointegrated, this indicates the existence of a cointegration between economic growth and the M2 long-run causality relationshi and thus can be roceed with testing direction defined by equations (1) and (2). 4 Emirical Table 2b. Unrestricted Cointegration Rank Test (Maximum Eigenvalue) Trace Eigenvalue Statistic P- value GDP None Domestic Credit At most cointegrated GDP None Private Credit At most cointegrated GDP None M2 Aggregate At most not cointegrated GDP None Deosit At most cointegrated GDP None Private Credit to Domestic Credit At most not cointegrated aggregate, and between economic growth and the ratio of rivate credit to domestic credit. While has shown a ositive cointegration between other financial develoment indicators and economic growth. 4.1 Augmented Dickey Fuller Table 1. ADF -test results First Level difference Time Series Intercet Intercet Intercet & trend None Intercet & trend None Domestic Credit * * * * Private Credit * * * * M2 Aggregate * * * * Deosit * * * Private Credit to Domestic Credit * * * GDP * * * * Note * means that H 0 hyothesis of unit root is acceted, series are not stationary From the above table, we can see that none of the variables is stationary, but with the hel of the first difference, all series return into stationary. 4.3 Granger Causality Based on the results of cointegration test, assessment of causality direction between the not stationary and not cointegrated series will be obtained from the evaluation of the VAR model. The assessment of causality direction between not stationary and cointegrated series will be obtained from the evaluation of the VECM model. The following tables resent the analogous results of the two models. Table 3. Granger Causality test for stationary and not cointegrated series FD EG robability EG FD robability GDP - M2 Aggregate * * GDP - Private Credit to Domestic Credit * * Note * means that there is no Granger causality relationshi htt://

5 International Journal of Scientific & Engineering Research, Volume 4, Issue 11, November Table 4. Granger Causality test for not stationary and cointegrated series value for EC coefficient value for SR coefficient EG FD EG FD GDP-Domestic Credit SR: bi - directional causality LR: bi - directional causality GDP-Private Credit SR: bi - directional causality LR: bi - directional causality GDP - Deosit SR: not evidenced any relation LR: FD caused EG 5 Conclusions Based on the above emirical results, we can say that in case of Albania there is a bi directional causality between financial develoment and economic growth. This conclusion was reached even by Dushku (2010). Only in the case of deosits was verified the suly leading hyothesis. also show that there is no Granger causality relationshi between economic growth and financial develoment when as indicator of financial develoment is used the M2 aggregate and the ratio of rivate sector credit to total domestic credit. This conclusion can be exected as in develoing countries such as Albania, the M2 aggregate is reresented by money outside the banking system than financial develoment. Also the greater weight of domestic credit goes to the rivate sector and it makes this ratio to be nearly the same at all times and therefore not exected to have an imact. 6 References [1] Barro, R. J. (1991).Economic Growth in a Cross Section of Countries., Quarterly Journal of Economics Vol. 106, No 2, [2] De Gregorio, J. & Guidotti P. E. (1995) Financial Develoment and Economic Growth, World Develoment, 23(3): [3] Demetriades P. & Andrianova S. (2004) Finance and Growth: What We Know and What We Need to Know. University of Leicester. [4] Demetriades O. P. & Hussein A. K. (1996) Does Financial Develoment cause Economic Growth? Time Series evidence from 16 countries Journal of Develoment Economics vol. 51, Issue 2, [5] Demirguc-Kunt, A. & Levine R. (2008) Finance, Financial Sector Policies and Long Run Growth The World Bank Develoment Research Grou, Policy Research Working Paer [6] Dushku E. (2010) Zhvillimi Financiar dhe Rritja Ekonomike Discussion Paer, Bank of Albania. [7] Kasekende L. (2008) Develoing a Sound Banking System Paer resented at IMF Seminar, Tunisia. [8] King, R.G., & Levine, R. (1993a). Finance and Growth: Schumeter Might Be Right. Quarterly Journal of Economics, 108, [9] McKinnon R. (1973) Money and Caital in Economic Develoment (Washington: The Brookings Institute). htt:// [10] Liang, H.Y., & Reichert, A. (2006). The relationshi between economic growth and banking sector develoment. Bank and Bank Systems, vol. 1 (2), [11] Lucas, R. (1988). "On the Mechanics of Economic Develoment." Journal of Monetary Economics 22, [12] Odedokun, M. O. (1998) Financial intermediation and economic growth in develoing countries Faculty of Commerce, University of Swaziland, Swaziland. [13] Patrick, H. (1966) Financial Develoment and Economic Growth in Underdeveloed Countries Economic Develoment and Cultural Change 14, [14] Robinson, J. (1952). "The Generalization of the General Theory." In The Rate of Interest, and Other Essays. London: McMillan [15] Stern, N. (1989). "The Economics of Develoment: A Survey," Economic Journal, Royal Economic Society, vol. 99(397), [16] Schumeter, J. A. (1911) The Theory of Economic Develoment. Cambridge MA: Harvard University Press. [17] Shaw, E. S. (1973) Financial Deeening in Economic Develoment Oxford University Press, New York.