The Impact of Banking Sector Development on Economic Growth: Empirical Analysis from Palestinian Economy

The Impact of Banking Sector Development on Economic Growth: Empirical Analysis from Palestinian Economy Mohammed T. Abusharbeh, Faculty of Administrative and Financial Sciences, Arab American University, Palestine. E-mail: Mohammed.abusharbeh@aauj.edu Abstract Whether banking industry development supports Palestinian economic growth or not is critical question empirically. Thus, this study examines the impact of some banking trend indicators (credit facilities, depositors fund, interest rate, and the number of branches) on gross domestic product using quarterly data from the period of 2000 to 2015. The empirical model was carried out using ordinary least square regression to prove that output is significantly influenced by boosting banking sector toward growth. The paper result reveals that banking credits are positively related to economic growth. This indicates that banking industry development tends to improve productive capacity of Palestinian economy as case of supply leading. However, interest rate, customers deposits and number of branches have no significant impact on economic growth. Finally, the result of this paper provides some important lesson to the Palestinian authority policymakers: there is strong real benefit from Banking credits policy due to significant effect on Palestinian economy. Key Words: Credit Facilities, Gross Domestic Product, Customer deposit, interest rate JEL Classification: C19, G13, G 14 1

1. Introduction Proceedings of the Sixth Middle East Conference on Global Business, Economics, Economic growth is considered the crucial objective of the world countries more than half a century. However, development process needs prerequisite requirements in order to satisfy human willingness and that may occurs through financing investment and production. Specially in developing countries that are suffering many economic problems such as unemployment, poverty, low living standards, and inflation. Thus, these countries always seek to maintain economic growth to increase their national income and to create more job opportunities in order to improve their living standards. In fact, financial and banking sector is playing a vital role in financing economic development. Moreover, the trend in banking sector leads to the increase in economic growth rates in any economy. This argument has been confirmed by many of empirical researches worldwide. Therefore, Economic growth theory believes that financial institutions specially bank is considered a useful instrument for improving the productive capacity of the economy and its important internal source of fund for any country specially in the birth stages of economic growth (Schumpeter, 1911). Obviously, banking system is important to the economic growth through its ability in gathering and attracting deposits from savers. Secondly, its role in providing loans to encourage investment and production. Thirdly, its ability in creating economic expansion to the most of economic sectors such as; Agriculture, industry and trade sector. Fourthly, its intermarry role between savers and borrowers. Finally, banking industry contributes to the formation of initial capital for investment projects. In Palestinian economy, the economic performance generally resulted more consistency during the last two years. Consequently, Palestine partially in west bank has witnessed a significant growth in private consumptions and constructions. Adversely, the economy faced an increased in trade deficit due to faster growth of imports compared to the exports (PMA, 2016). This indicates that Palestinian economy depends highly on import products that cannot be substituted by local products. Furthermore, Banking credits accessibility have been reformed by Palestinian monetary authority in order to ensure financial stability in banking sector to reduce nonperforming credits and also to promote the growth of Palestinian economy. However, despite the continuous tentative to revitalize banking credits, most of Palestinian economic sectors have remained relatively low supported by banks credits supply. Indeed, Palestinian case always unique and complex due to Israeli occupation and economic sanction, besides the challenges in utilizing the available economic and financial resources. Initially, the causality relationship between banking credits and economic growth has been widely debated and controversial in financial literatures. Hicks (1969) stated that financial system is boosting economic growth and development. This is called supply leading, because 2

financial institutions provide more fund to support economic activities and that leads banking credits cause economic growth. Similarly, King and Levine (1993) and Miller (1998) asserted that economic growth is result from financial development. This implies that financial development has significant positive impact on economic growth. Nevertheless, Goldsmith (1969) proved that economic development is a root or ground of financial development. Furthermore, the higher economic growth rates cause higher demand of credits. Therefore, this paper empirically examines the relationship between banking sector development and economic sectors growth. Defiantly, it aims at investigating the influence of banking credits on Palestinian economic growth. The purpose of this paper is to provide an empirical evidence through examining the relationship between banking credits supply and economic growth in Palestine. Further, it also evaluate the impact of monetary policy on the growth of Palestinian economy. Moreover, it examines the impact of credit facilities, banking deposits, interest rate on credits, and number of branches on gross domestic product (GDP) as proxy of economic growth rate. Therefore, the results contribute to the knowledge by appraising the influence of financial intermediations density on economic development. Consequently, this paper argues that there is a strong supply-leading relationship between banking industry development and economic growth. The algorithm of the study is organized as follows: section II focuses the previous literatures related to banking sector development and economic growth. Section III presents theoretical framework and research hypothesis. Section IV provides data sources and research methodology. Section V discusses the empirical findings. Finally, Section VI concludes the results. 2. Literature Review The existence previous literatures that discussed the linkage between banking sector development and economic growth are confirmed that the directional relationship between financing and economic growth is significant and positive. McKinnon (1973) believes that an increases in banking services and financial activities are accelerating economy toward growth. Similarly, King and Levine (1993) argued that providing more funds to the economy stimulates the movement of economic wheels. However, Demetriades and Hussein (1996) tested the causality between financial development and growth across 16 developing countries. They found that there is no meaningful relationship between financial development and economic growth. Similarly, Miwa et al (2000) explored the role of central banks on developing Japanese economy. They found Japanese firms did not grow through banking funds. They argued that the manufacturing firms in Japan raise of their funds through decentralized and competitive capital markets rather than banking credits supply. However, 3

Calderon and Liu (2003) tested mutual relationship between financial development and economic growth using data obtained from 109 countries for the period of 1960 to 1994. They found that the impact of economic growth on financial development becomes in significant over long periods (advanced countries). Therefore, they support supply-leading policy. Hshin-Yu Liang and Alan Reichert (2006) tested the casual relationship between financial sector development and economic growth in emerging and developed countries. They used Granger causality and Odedokun model to conclude the results. They argued that the production function of economic growth appears to be more informative. Their model is consistently indicate a strong supply leading relation between banking sector development and economic output. Moreover, Caporale M. et al (2009) examined the relationship between financial development and economic growth in 10 Europe union countries over the period of 1994 to 2007. They found that stock and money markets are still underdeveloped in these countries and their contribution to economic growth is limited and lack financial debts. Moreover, the result indicates that causality runs from financial development to economic growth, but not in the opposite direction. In Palestine, Alfara (2012) discussed the role of the banking sector in financing economic development in Palestine during the period of 1995 to 2011. Her thesis hypothesized that economic growth is affected with some financial indicators such as: banking credits, deposits, population size, interest rate on debt, and the number of bank branches. It concluded that banking credits has a positive effect on gross domestic product, but this relation is not well required level which ensures achieving the economic development in Palestine. But In some neighborhood countries, Owdeh (2012) studied the causality directional relationship between banking sector growth and economic development in Lebanon from period of 1992 to 2011. It used granger causality test to reveal the result. He found one way causality running from economic growth to banking sector. Inversely, banking credits to the resident private sector and economic efficiency. Similarly, Al-Khatib and Al-Saffar (2013) investigated the linkage between financial development and economic growth in Jordan between the period of 2001 and 2012. They concluded that banking sector development and economic growth has a strong demand-leading relationship. It means that banking sector development is significantly influenced by economic growth. Petkovski and Kjosevski (2014) examined the question whether central and south eastern Europe economic growth are influenced by developing in banking sectors. They used banking credits, interest rate, and the ratio of quasi money (RQM) as independent variables while gross domestic product as proxy variable. They found that banking credits and interest margin are negatively related to economic growth. However, Ehikiorya and Ismailia (2014) investigated the impact of commercial bank credits on Nigeria's small and medium enterprise. They employed some macroeconomic variables as factors of SMEs output. They revealed 4

time deposits and exchange rate have a significant impact of small and medium enterprises output. Further, It found that interest rate has adverse effect on firms output. However, their study concluded that commercial banks credits had insignificant impact on the country SMEs output. The study recommended that commercial banks should grant soft loans in order to boost Nigerian economy to the economic growth. Recently, Medjahed and Gherbi (2016) examined the impact of banking sector development on growth using 11 MENA countries from period 1980 to 2012. They found that financial development has negative impact on short and long run relation with economic growth of MENA countries. Similarly, Frikha and McMillan (2016) investigated the role of Islamic banks in the growth of domestic gross product in 10 developing countries (Bahrain, Egypt, Jordan, Kuwait, Pakistan, Saudi Arabia, Qatar, Sudan, Turkey and United Arab Emirates). Their study used ordinary least square regression for testing 120 banks from different developing countries. They found that conventional banks support economic growth. Moreover, the combination between Islamic and conventional way is also improves economic growth. However, the practice of Islamic banks is away from their theoretical mode in terms of participation results. Consequently, this paper concludes that there is a widely debated cases from different economies that some of them support supply leading policy and others argued with demand leading policy. Therefore, this study extends the existing literatures through examining the impact of banking trends on Palestinian economic growth. 2.1 Research Hypothesis This section presents the formulation of research hypothesis. So, the alternative hypothesis argues that the explanatory variables; banking credits, banks deposits, number of branches, and interest rate have a significant impact on gross domestic product as argued by McKinnon (1973), King and Levine (1993), and Ehikiorya and Ismailia (2014). Thus, the study hypothesis can be formulated as follows: H 1: There is significant impact of banking sector indicators on Gross domestic product. 3. Methodology 3.1 Data and Variables This research examines the impact of changes in banking sector on economic growth. It can be estimated by using time series data over the period 2000 2015. The study panel data are quarterly and obtained from financial stability reports of Palestinian Monetary Authority and the Palestinian Bureau of Statistics. The choice of the time period in this study was entrusted to the data variables availability included in the estimated model. On other hand, this paper uses some financial indicators to measure the banking industry development such 5

as credit facilities, banking deposits, the number of bank branches, and interest rate. Moreover, it uses gross domestic product as a proxy of economic growth. 3.2 The Research Model The econometric model in this research is employed in order to evaluate the effect of banking sectors trend on economic growth. Thus, the model specification includes some of banking and economic indicators which is formulated as follows: EG = ƒ (BC, BD, BB, IN) This hypothetical model can be specified including logarithm for banking indicators as follows: Where, EG BC BD BB IN β0 β1 β2 β3 β4 Et Log EG = β0 + β1 Log BC + β2 Log BD + β3 Log BB + β4 IN + et = Palestinian economic growth measured by Gross Domestic Product (GDP) = Banking credits provided to economic sectors. = Total banking deposits = Total number of banking branches = Interest rate on credits = Intercept or constant = Coefficient effect of credits facilities = Coefficient effect of banks deposits = Coefficient effect of number of branches = Coefficient effect of interest rate = Residual errors This study uses ordinary least square in order to estimate economic growth function (Gujarati 2004). Furthermore, it also uses Auto regression model (AR) to eliminate autocorrelation problem (Agung, 2009). However, some essential techniques are tested to make sure that estimated model is well fit to the data variables. Firstly, time series is stationary in order to make sure that mean and autocorrelation don t change over the time. Therefore, it can be estimated by using Augmented Dickey Fuller (ADF) test (Dickey and Fuller, 1981). Secondly, co-integration model is used to test the convergence status for the research variables as proposed by Engle and Granger (1987). Thirdly, Jarque-Bera test was used to check the normality among research variables. 4. Research Findings and Discussion Table 1 shows the result of unit root test for banking credits, customers deposits, the number of branches, and interest rate on loans. This result indicates that all variables stationary at first difference, because ADF value for each variable is greater than the critical values at first difference. 6

Table 1: Augmented Dickey Fuller Test Variables ADF values McKinnon 5% Sig. level 1 st difference Critical values EG 0.0598* -3.035-3.145 BC 0.0000* -8.399-3.119 BD 0.0223* -3.557-3.098 BB 0.0137* -3.159-3.119 IN 0.0082* -4.332-3.175 *denote significant level at 5%. Table 2 presents the results of Johansen co-integration test. It reveals that there is exist one co-integrating equation at 5% level of significance. The trace static is greater than upper critical bound and there is a one co- integrating vector in the present study for the period of 2005 to 2015. This implies that there is a long run association between banking indicators and economic growth. Hence, least square model can be estimated on long run. Therefore, the alternative hypothesis for co-integration test is; H 1: α 1 α 2 α 3 α 4 : Long-run association among variables exist. Trace statistic Table 2: long - Run Co-integration Test Johansen test Critical values 5% Hypothesized No. of CE(s) 21.077 14.624 None* 18.084 15.494 At most 1* 24.790 15.494 At most 1* 20.620 15.494 At most 1* 20.029 15.494 At most 1* 18. 535 15.494 At most 1* Trace test indicates 1 co-integrating equations at the 0.05 level Table 3 shows the descriptive statistics of research model. GDP has a mean value of $5.5 billion and deviated by 1535.9. Whereas, banks are provided loans on average $2.58 billion with standard deviation 1479.8. Meanwhile, customer deposits has a mean value of $5.6 billion during the study and deviated by 1989.7. Further, the number of branches had reached on average to 186 branch. On other hand, this table shows the result of Jarque- Bera test in order to measure the normality among research variables. It reveals the P-values for all explanatory variables are greater than significant of 5% level. Therefore, the null hypothesis is accepted and explanatory variables is normally distributed. Thus, the result shows that the estimated model is maintained the requirements and well fit in analysing the data variables. Mean Std. Dev. Skewness Kurtosis Table 3: Deceptive Statistics for the Variables EG 5501.400 1535.882-0.128162 2.045918 BC 2578.783 1479.824-0.015406 1.808754 BD 5590.673 1989.781 0.287129 1.788087 BB 186.5625 49.68698-0.051088 1.621145 IN 0.072394 0.006863 0.158304 1.571986 7

Jarque-Bera Probability Observations Proceedings of the Sixth Middle East Conference on Global Business, Economics, 0.650650 0.722293 64 1.199002 0.549085 64 0.946677 0.622919 64 1.274454 0.528757 64 0.946677 0.490096 64 Table 4 shows a high level of explanation and significance of impact for the explanatory variables. The structural parameter estimates obtained implies 90.5% of GDP is explained by selected variables. The coefficient of determination (R 2 ) indicates that 91% of variation in Palestinian economic growth are estimated by the variation of banking indicators. Moreover, F test is 58.5 and the probability of F test value 0.000 is less than the significant of 5% level. In addition, Durbin Watson is closed to the rule of thumb 2 and this means that there is no autocorrelation problem among the research variables. The result confirmed that estimated model is significant and very well fit. Therefore, the alternative hypothesis is accepted and the coefficients estimate from research model are stable. Table 4: The Regression Model Results (Dependent variable: GDP) Variable t-value Coefficient Std. Error Prob. Intercept (c) 3.705454 1.882316 0.507985 0.0035 BC 3.242405 0.378933 0.116868 0.0078 BD 0.898950 0.280628 0.312173 0.3879 BB -0.564555-0.193916 0.343484 0.5837 IN -0.277218-0.422430 1.523816 0.7868 R squared 0.905 F statistic 58.46 Prob (F-test) 0.000 Durbin-Watson 2.0608 Table 4 also reveals that there is a significant positive relationship between banking credits supply and gross domestic product. This concludes that the increase of funding economic sectors by one percent will boost gross domestic product to increase by 3.24 percent. Thus, this finding confirms the results of King and Levine (1993) and Miller (1998) in case the vital role of banking credits and services in economic growth. However, the result shows that banking deposits does not impact on economic growth. This indicates that the increase of customer deposits by one percent tend to increase output growth by 3.47 percent, but this relation is in significant. Meanwhile, the result shows that interest rate is negative but insignificant relationship with gross domestic product. this means that interest rate has indirect relationship with economic growth. This finding is in line with Olukayode and Somoye (2013) that argued interest rate has insignificant impact on economic development. 5. Conclusions Using least square model and regression analysis the researcher examined whether banking industry contributes to economic growth in Palestinian economy in the period from 2000 to 2015. This study used four explanatory variables to measure banking sector growth such as; banking credits facilities, customer deposits, number of branches, and interest rate on debts. It also used gross domestic product to measure economic growth in Palestine. 8

In summary, Gross Domestic Product is strongly influenced by some of banking indicators especially banking credits facilities. This paper found that more funding to economic sectors tends to enhance and improve economic conditions in Palestine partially local productivity in public and private sectors. Therefore, banking industry is considered one of prop for building productive capacity of Palestinian economy. Conclusively, banking credits are the main determinant of economic growth in Palestine and it considered the core internal funding source for Palestinian economy. However, funding economic sectors in Palestine is relatively low and under the required level. Therefore, this finding could be interesting for some policymakers in Palestine especially Palestinian Monetary Authority. This paper recommends that Palestinian banks should lower cost of debt to provide more domestic funding and to improve their credits policy in the aim of reinforcing local fund raising capacity and investments. Indeed, the most important implication for this study is that Palestinian Monetary Authority should develop an efficient credit allocation system in order to sustain economic growth. References Agung, 2009, I GUSTI NGRAH, "Time Series Data Analysis using Eviews", John Wiley & Sons (Asia) Pte Ltd. Alfara, M., 2012, The role of the banking sector in financing the Palestinian Economic Development (1995 2011). Master thesis. Islamic University. Gaza. Palestine. Al-khatib H., and Al-saffar, H. (2013). Financial Development and Economic Growth in Jordan (2001-2012). Interdisciplinary Journal of Contemporary Research in Business. Vol 6 No.6 Pp 176-189. Calderon, C., & Liu, L. (2003). The direction of causality between financial development and economic growth. Journal of development Economics 72, 321-334 Caporale M., Rault Leo, Sova R, and Sova A. (2009). Financial Development and Economic Growth: Evidence from Ten New EU Members. Economic and financial working paper series No. 03 37. Brunel University, West London. October. Dickey, D. and Fuller W. 1981. Likelihood Ratio Statistics for Autoregressive Time Series with a Unit Root Econometrica, 49: 1057-1072. Ehikiorya and Ismailia (2014). The Impact of Commercial Bank Credit on the Growth of Small and Medium Scale Enterprises: An Econometric Evidence from Nigeria. Journal of Educational Policy and Entrepreneurial Research. Vol.1, N0.2, Pp 251-26. Frikha, M and McMillan D. (2016) Banks and economic growth in developing countries: What about Islamic banks? Journal Cogent Economic and Finance. Vol. 4, No.1 Goldsmith, Raymond, W. Financial structure and development. New Haven, CT: Yale U. Press, 1969. Gujarati (2004), Basic Economics, fourth edition. The McGraw-Hill companies. Hicks, John. A theory of economic history. Oxford: Clarendon Press, 1969. Hshin-Yu Liang and Alan Reichert (2006). The Relationship between Economic Growth and Banking Sector Development. Banks and Bank Systems. Vol.1 No.2 King, R., & Levine, R., 1993, Finance and growth. Schumpeter might be right. Policy research. (Working papers, 1083). Lawrence Ehikioya, and Ismaila, Mohammed (2014). The Impact of Commercial Bank Credit on the Growth of Small and Medium Scale Enterprises: An Econometric Evidence from Nigeria (1986-2012). Journal of Educational Policy and Entrepreneurial Research. Vol., No. 2.Pp 251-261. 9

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