Financial deepening, trade openness and economic growth in Latin America and the Caribbean

Abstract

This contribution investigates the causal interactions between financial deepening, trade openness and economic growth in 13 Latin American and Caribbean countries. We construct a composite indicator for financial deepening and use it to detect Granger causality within a modified Vector Autoregressive/Vector Error Correction Model (VAR/VECM) framework. We find almost no evidence for the popular hypothesis of finance-led growth. Evidence of bidirectional finance–growth causality is stronger but mostly instable in the long run. Most results indicate a demand following or insignificant causal relationship between finance and growth. There is also no evidence that finance indirectly induces growth via the channel of trade openness. Hence, policies that prioritize financial and trade sector development cannot be supported.

Notes

¹ For a more extensive discussion of theoretical and empirical connections between finance and growth, we refer to the surveys of Pagano (1993) and Levine (2005).

² In the case of Colombia, a few data points are missing and therefore have to be imputed by average.

³ Our indicator is a common measure of trade openness (Harrison, 1996). Although more sophisticated measures for openness may exist, we remain with our measure because of its availability.

⁴ We use only the first unrotated principal component as DEPTH.

⁵ As shown by the component matrices, DEPTH does not measure exactly the same aspect of financial deepening across all countries.

⁶ For Chile and Suriname, we also use the Kwiatkowski–Phillips–Schmidt–Shin (KPSS) test because the results of the Phillips–Perron (PP) test are not always as expected. KPSS test results confirm that the time series are indeed first-difference stationary; unexpected PP test results for these countries may be attributed to the smaller number of observations.

⁷ Cointegration analyses are also conducted in all bivariate cases but not reported.

⁸ We do not consider more than one cointegration relationship in our analysis, even though this may not be ruled out completely in certain cases. The relative shortness of our time series and the desire for a good interpretation of the ECM motivate this more cautious approach.

⁹ Specifically, we test for finance–growth, finance-openness and openness-growth causality. The previous discussion of potential interactions between finance, openness and growth provides the ground for such analyses.

¹⁰ Poor economic performance in Latin America and the Caribbean has mainly been due to low investment or deficiencies in human capital (De Gregorio and Lee, 2004). As financial markets are important for actuating investments in physical and human capital, slow growth in Latin America may at least partially be attributed to a deficient match of financial and real sectors.