ASIAN JOURNAL OF MANAGEMENT RESEARCH Online Open Access publishing platform for Management Research

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1 Online Open Access publishing platform for Management Research Copyright by the authors - Licensee IPA- Under Creative Commons license 3.0 Research Article ISSN Assistant Professor, Symbiosis International University, Pune sharmiladevi@scmspune.ac.in ABSTRACT This research examines the relationship between financial deepening (FD), Foreign Direct Investment (FDI) and economic growth for India during the time period 2000 to A Multiple Regression Model is built taking economic growth as dependent variable and financial deepening and FDI as independent variables. Results of the regression indicate that 87.1% of the variations in economic growth are explained jointly by FD and FDI. The paper suggests that India needs well developed and stable financial structure to bring investors confidence and foreign direct investment into the economy, which facilitates higher economic growth. Keywords: Financial deepening, economic growth, foreign direct investment. 1. Introduction The increasing role played by Foreign Direct Investment (FDI) in enhancing Economic Growth of the emerging and developing economies have kindled the interest of many researchers which brought forth many research studies examining the positive link between FDI and Economic Growth. (Quazi, 2007, Vadlamannati et al., 2009; Wang, 2009; Pradhan, 2006), FDI is essential for India, at least for fulfilling the following three gaps. 1. Technology Gap, (Findlay, 1978, Kinoshita, 1998; Sjöholm, 1999), 2. Saving and Investment Gap, (Garibaldi et al (1999); Holland and Pain (1998)), 3. Foreign Exchange Gap (Kojima 1973, 1985), (Banga 2003), There are mounting literatures which examines the relationship between FDI and Economic Growth. (Lankes and Venables, 1996; Resmini, 2000; Bevan and Estrin, 2000; Nunes et al., 2006; Sahoo, 2006), However, empirical studies investigating the relationship and links between FDI and economic growth on the one hand, and the role played by the circumstances FDI is confronted with when it enters a recipient country on the other hand, are scarce. (Hermes and Lensink, 2003) Generally, it is believed that the financial system of a recipient country plays a positive role in the FDI performance of that country. A well-developed financial system of the recipient country is an important precondition for FDI to have a positive impact on economic growth as it enhances the efficient allocation of resources and improves the absorptive capacity of a country with respect to FDI inflows. This paper examines the empirical relationship between financial deepening, foreign direct investment and economic growth. Financial deepening improves economic conditions through increased competitive efficiency within financial markets thereby indirectly benefiting non-financial sectors of the economy. In the literature of development economics, it is usually held that depth of financial progress boost economic growth by two ways. First, it facilitates by efficient mobilization of resources, reduced the transaction cost of financing investment and therefore induces more investment 56

2 (Merton and Bodie 1995), Secondly, it helps in improving the allocative efficiency of financial resources which boost the productivity (King and Levine 1993; Beck et al. 2000), Moreover, Financial deepening also helps in increases the provision and choices of financial services which would come through its financial infrastructure. 2. Review of literature A large body of empirical research supports the view that development of the financial system contributes to economic growth (Rajan and Zingales, 2003), Finance becomes a vital element for economic growth (Schumpeter, 1934; Goldsmith, 1969; McKinnon, 1973; Shaw, 1973; King and Levine, 1993), Empirical evidence consistently emphasizes the nexus between finance and growth, though the issue of direction of causality is more difficult to determine. Greenwood and Jovanovic (1990) studied the dynamic interaction between finance and growth by viewing bi-directional causality between them. At the cross-country level, evidence indicates that various measures of financial development (including assets of the financial intermediaries, liquid liabilities of financial institutions, domestic credit to private sector, stock and bond market capitalization are robustly and positively related to economic growth (King and Levine, 1993; Levine and Zervos, 1998), A positive relationship between financial development and growth at the industry level holds valid (Rajan and Zingales, 1998), King and Levine (1993) used several monetary indicators and measure the size and relative importance of banking institution and reports a significant relationship among financial development indicators and GDP per capita. Pradhan (2010) explores the relationship among financial deepening, FDI and economic growth for India. The outcome of the study shows the existence of long run relationship among the tested variables. Furthermore, the Error Correction Model reports bi-directional causality between FDI and economic growth and uni-directional causality between financial deepening to FDI. Giri and Mohapatra (2012) explore the relationship between financial development and economic growth for India. The study tested the demand sided hypothesis and supply leading hypothesis. The study reports the long run association among financial development variables and economic growth. Onoriode and Coris (2013) studied the level of financial development in the banking industry and its impact on the economic conditions in Nigeria. The results of the study establishes long run relationship among variables. Wycliffe et al (2013) examines the relationship between financial deepening and economic growth in Kenya. The study states that, Kenya has made significant stride in financial deepening which enhances the countries competitiveness through wide range of financial infrastructure, reducing operation cost and product diversifications. 2.1 Research gaps Studies pertaining to understanding the relationship between financial deepening, foreign direct investment and economic growth at the macro level for India, is scarce and this paper will try to bridge this gap and makes an addition to the existing literature on financial deepening, foreign direct investment and economic growth. 3. Methodology The objective of this study is to examine the existence of a relationship between financial deepening, foreign direct investment and economic growth. If they are related, then, to check the weather economic growth is influenced by financial deepening and foreign direct 57

3 investment. Data for ratio of money supply to GDP is taken as a proxy for explaining financial deepening, GDP factor cost at constant price is used as a proxy for economic growth and inward foreign direct investment were taken. The period taken for study is from to , secondary data is taken from Reserve Bank of India database and data for financial deepening is taken from World Bank. The original data has been converted into their natural log form so as to overcome the problem of stationarity, associated with time series data. In order to identify the relationship between the three examined variables correlation is checked between financial deepening, FDI and economic growth. A Multiple Regression Model is built, keeping economic growth (GDP) as the dependent variable and, financial deepening and inward foreign direct investment as independent variable. Their statistical relations in the form of multiple regressions are depicted in equation 1. GDP =β0+ β1 FD+ β2 IFDI+ ɛ------eq. (1) Where GDP stands for Gross Domestic Product FD stands for Financial Deepening IFDI stands for Inward Foreign Direct Investment β0, β1, β2 stands for regression coefficients ɛ stands for residue term 3.1 Hypotheses The following null hypotheses are framed for the study H1: There is no significant relationship between GDP and FD H2: There is no significant relationship between GDP and IFDI 4. Empirical findings Results of Pearson Correlation suggest that there is a positive correlation between financial deepening (FD), Inward FDI (IFDI) and GDP. There is a strong positive correlation between IFDI and GDP to the tune of 0.933, and correlation between FD and GDP is at Table 1.1 provides the results of Pearson Correlation Coefficient Estimates Table 1: Pearson Correlation Coefficient Variables FD GDP IFDI FD GDP IFDI Regression analysis is used to identify the effects of FD and IFDI on GDP. Table 1.2 and 1.3 provides the results of regression analyses. The Model Summary in table 1.2 shows that this model is able to explain 87.1 % of variations in the dependent variable that is GDP. The R 2 value is (87.1 %), which means that, 87.1% variations in GDP can be explained jointly by FD and IFDI. The Durbin-Watson statistics is 1.7, which is close to 2, indicates that the residuals are free from auto correlation. From the ANOVA table shown in Table 1.3, we can understand that the model is statistically significant. In table 1.4, showing Coefficients, the VIF (Variance Influence Factor) value is 4.97 for both the independent variables, which 58

4 ensures that this model is free from multi collinearity. All the above parameter findings, states the statistical strength of this regression model. Model R R Square Table 2: Model summary Adjusted R Square Standard Error of Estimate Durbin-Watson Statistics Table 3: ANOVA Model Sum of Mean Df Squares Square F Sig. Regression a Residual Total Mode l 1 a. Predictors: Constant : IFDI, FD b. Dependent Variable: GDP c. Unstandardized Coefficients B Constan t Std.Erro r Table 4: Coefficients* Standardize d Coefficients Beta FD 0/ IFDI a. Dependent Variable : GDP t Sig % Confidence Interval for B Lowe r Boun d Upper Boun d Collinearity Statistics Tolerenc e VIF Conclusion The purpose of this paper is to identify the existence of relationship between financial deepening, foreign direct investment and economic growth and also to check whether economic growth is influenced by financial deepening and foreign direct investment. The results of the Pearson Correlation Coefficient and the Regression Model jointly indicate that financial deepening together with foreign direct investment is having a high impact upon explaining economic growth. This can be well understood with the strong positive correlation between FD, IFDI and GDP. The regression model explains the variations in GDP to the tune of 87.1%, which are jointly explained by financial deepening and FDI. Hence the null hypotheses H1 and H2, are rejected. The above findings clearly documents the fact that financial systems and FDI are instrumental for bringing economic development. This paper also helps us to understand that 59

5 the synergistic role played by financial deepening and inward foreign direct investment have a strong contributing effect in enhancing economic growth. This study also makes one to understand that, in addition to the existing reforms, there is a need for bringing in more reforms in the Indian financial system in order to bring more FDI, which invariably aids in creating more financial deepening accompanied with higher economic growth in India. 6. References 1. Banga, R. (2003), Impact of Government Policies and Investment Agreements on FDI Inflows, Working Paper No: 116, Indian Council for Research on International Economic Relations. 2. Bevan, A.A. and Estrin, S. (2000), Patterns of foreign direct investment and trade in central and eastern Europe, Mimeo, Financial Economics 58, pp Findlay, R. (1978), Relative Backwardness, Direct Foreign Investment and the Transfer of Technology: A Simple Dynamic Model, Quarterly Journal of Economics 92, pp Garibaldi, P., Mora, N., Sahay, R. and Zettelmeyer, J. (1999), What Moves Capital to Transition Economies, IMF Conference A decade of transition, Washington, DC, February. 5. Giri, A. K., & Mohapatra, G. (2012), Financial Development and Economic Growth: Evidence from Indian Economy. International Journal of Applied Research & Studies, 1(2), pp Goldsmith, R. W. (1969), Financial Structure and Development. New Haven, CT: Yale University Press. 7. Greenwood J., & Jovanovic, B. (1990), Financial Development, Growth, and the Distribution of Income, Journal of Political Economy, University of Chicago Press, 98(5), pp Hermes, N., & Lensink,R. (2003), Foreign Direct Investment, Financial Development and Economic Growth, Journal of Development Studies, 40, pp Holland, D & N Pain, (1998), the Diffusion of Innovations in Central and Eastern Europe: A Study of the Determinants and Impact of Foreign Direct Investment, NIESR Discussion Paper No King, R.G. and R. Levine (1993), Finance and Growth: Schumpeter might be right, Quarterly Journal of Economics 108, pp Kinoshita Y, (1998), Micro-determinants of Japanese Foreign Direct Investment in Asia, Eastern Economic Association and Japan Economic Seminar at Columbia University. 12. Kojima, K. (1973), A Macroeconomic Approach to Foreign Direct Investment. Hitotsubashi Journal of Economics 14 (1), pp

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7 29. Vadlamannati, K.C., Tamazian, A., & Irala, L.R. (2009), Determinants of Foreign Direct Investment and Volatility in South East Asian Economies. Journal of the Asia Pacific Economy, 14, pp Wang, M. (2009), Manufacturing FDI and Economic Growth: Evidence from Asian Economies. Applied Economics, 41, Wycliffe, M., Jonathan, M, Tabby, G, Ruth, N, & Kitheka, S. (2013), Financial Deepening and Economic Competitiveness in Kenya: The Strides to Being an Economic Power House, International Journal of Management & Information Technology. 6(2), pp