Financial sector development and growth in small open economies

Abstract

This article investigates the Granger causal relationship between financial development and economic growth for four small open economies over the period 1960 to 2003. Both long- and short-run Granger causality tests are used to assess the finance-growth nexus. The results suggest that there is a positive association between financial development and growth in all countries. However, the long-run causality tests show that growth tends to lead financial development in Singapore and Jamaica, financial development leads growth in Trinidad and Tobago and there is a bidirectional link in Barbados. These results therefore suggest that cross-country studies could overstate the impact of financial development on growth, since they ignore differences – even in relatively homogenous groups.

Notes

¹ If X is an n × k data matrix, the first principal component is a vector z = a ₁₁ x ₁ + ··· + a _1k x _k that minimizes the sum of squared distances from the various vectors in X (see Jolliffe, 2002, for more details).

² Structural changes, especially changes to monetary regimes, could impact on the coefficient estimates obtained. However, the cointegration graph suggested that the relationship was relatively stable over the sample period.