Financial systems and mechanisms of growth in different conditions of country risk

Abstract

This article uses panel data from 1976 to 2003 to investigate the ways in which banking and stock markets influence economic growth in situations of high and low country risk. The mean and Standard Deviation (SD) of country risk are adopted to classify 28 countries into Low Risk Low Volatility (LRLV) and High Risk High Volatility (HRHV) subgroups. Through the technique of error correction-based panel co-integration developed by Westerlund (2007), several results are obtained. First, LRLV countries can expand the capitalization of stock market to enhance long-term economic growth. Second, HRHV countries, on the other hand, use two distinct strategies to promote long-term economic growth. Initially they develop their equity markets, which promote economic growth directly. Strengthened equity markets, in turn, aid in the development of credit markets, which subsequently brings an economic boom. Finally, regardless of selected subgroups, the contribution of stock market capitalization to economic growth appears to be substantially larger than that of bank credit, highlighting the importance of stock markets.

Notes

¹See Table 1 for a more detailed description.

²Pedroni (1999, 2000, 2004) has made the most influential theoretical contributions regarding this category.

³It is worth mentioning that the period of 1991–2000 contains many financial crises that are characterized as strong contagion effects. These crises include the Indian monetary crisis in 1991, the Mexican peso crisis in 1994–1995, the Asian financial crisis of 1997–1998 and the Russian ruble crisis in the latter part of 1998. These crises also spread disaster to other countries around the world. During this turbulent period, healthy countries can easily be identified by their relative stability.