The Role of the Financial Sector in the Turkish Cypriot Economy: Evidence from Bounds and Causality Tests

Abstract

This paper investigates the link between financial development and economic growth in a small island economy, North Cyprus. Bounds testing approaches as well as causality techniques are conducted for analyzing an extended version of the augmented Solow growth model over the period 1977–2010. The empirical results suggest that investments in the financial and banking sectors are important drivers for real income growth in both the long and short terms of the North Cyprus economy. The findings also show that private credits in the financial sector do not cause output growth in either the long- or the short-term periods. The impact of physical capital for real income is not also found to be as strong as that of human capital in the case of the North Cyprus economy.

Notes

1. Schumpeter, The Theory of Economic Development (1911); McKinnon, Money and Capital in Economic Development; Shaw, Financial Deepening in Economic Development.

2. Patrick, “Financial Development and Economic Growth”; Pagano, “Financial Markets and Growth: An Overview”; Demirguc-Kunt, “Finance and Economic Development.” These three studies investigated the impact of financial development on economic growth.

3. Jenkins and Katircioglu, “The Bounds Test Approach”; Salih T. Katircioglu et al., “Financial Development, Trade and Growth Triangle.”

4. Ghura and Hadjimichael, “Growth in sub-Saharan Africa.”

5. State Planning Organization, The Economic and Social Indicators.

6. Katircioglu, “International Tourism, Higher Education, and Economic Growth.”

7. State Planning Organization, The Economic and Social Indicators.

8. Schumpeter, The Theory of Economic Development (1934).

9. Mckinnon, Money and Capital in Economic Development and Shaw, Financial Deepening in Economic Development.

10. Levine, “Financial Development and Economic Growth.”

11. Chang, “Financial Development and Economic Growth in Mainland China.”

12. Mazur et al., “Financial Sector Development and Economic Growth.”

13. De Gregorio and Guidotti, “Financial Development and Economic Growth.”

14. McKinnon, Money and Capital in Economic Development; King and Levine, “Finance and Growth”; Levine and Zervos, “Capital Control Liberalization and Stock Market Development”; Christopoulos and Tsionas, “Financial Development and Economic Growth”; and Levine, “Finance and Growth: Theory and Evidence.”

15. Lucas, Jr, “On the Mechanics of Economic Development”; Arestis and Demetriades, “Financial Development and Economic Growth.”

16. Levine, “Financial Development and Economic Growth.”

17. Greenwood and Smith, “Financial Markets in Development, and the Development of Financial Markets”; Al-Yousif, “Financial Development and Economic Growth.”

18. Patrick, “Financial Development and Economic Growth.”

19. Khan, “Financial Development and Economic Growth.”

20. Jung, “Financial Development and Economic Growth.”

21. Demetriades and Hussein, “Does Financial Development Cause Economic Growth? Time Series Evidence from 16 Countries.”

22. Luintel and Khan, “A Quantitative Reassessment of the Finance-Growth Nexus.” This study considered data from ten different sample countries and found that bidirectional causality exists between financial development and economic growth. Their result is similar to that of Patrick, “Financial Development and Economic Growth”; Greenwood and Jovanovic, “Financial Development, Growth, and the Distribution of Income”; and Berthelemy and Varoudakis, “Economic Growth, Convergence Clubs, and the Role of Financial Development.”

23. Hassan et al., “Financial Development and Economic Growth.”

24. Greenwood and Jovanovic, “Financial Development, Growth, and the Distribution of Income.”

25. King and Levine, “Finance and Growth: Schumpeter Might Be Right.”

26. Demirguc-Kunt and Huizinga, “Market Discipline and Financial Safety Net Design.”

27. Demirguc-Kunt and Huizinga, “Financial Structure and Bank Profitability.”

28. Beck et al., “Financial and Legal Constraints to Firm Growth.”

29. Levine and Zervos, “Stock Market Development and Long-Run Growth”; Levine and Zervos. “Capital Control Liberalization and Stock Market Development.”

30. Levine and Zervos. “Stock Market Development and Long-Run Growth.”

31. Levine and Zervos, “Capital Control Liberalization and Stock Market Development.”

32. Bekaert et al., “Does Financial Liberalization Spur Growth?”

33. It reduces risk-free rate in developing countries.

34. Increased risk-sharing abilities encourage a nation to take on more total investment, which leads to economic growth. Finally, the stock market becomes more liquid with increased capital flows, leading to decreased equity risk premium.

35. Foreign bank participation in the financial markets can improve a regulatory and supervisory framework in domestic banking industry and can often introduce new financial instruments, techniques, and technological improvements in domestic markets, leading to increased competition, which results in improved quality of financial services and allocative efficiency.

36. Kalemli-Ozcan et al., “Economic Integration, Industrial Specialization, and the Asymmetry.” This study states that better risk sharing is associated with higher specialization.

37. Halicioglu, “The Financial Development and Economic Growth Nexus.”

38. Ardic and Damar, “Financial Sector Deepening and Economic Growth.”

39. Jenkins and Katircioglu, “The Bounds Test Approach.”

40. See King and Levine, “Finance and Growth: Schumpeter Might Be Right”; Murinde, Development Banking and Finance; Odedokun, “Alternative Econometric Approaches”; Berthelemy and Varoudakis, “Models of Financial Development and Growth,” and others.

41. See Odedokun, “Alternative Econometric Approaches” for more details.

42. Schumpeter, The Theory of Economic Development (1911); Goldsmith, Financial Structure and Development; McKinnon, Money and Capital in Economic Development; Shaw, Financial Deepening in Economic Development; King and Levine, “Finance and Growth: Schumpeter Might Be Right”; Odedokun, “Alternative Econometric Approaches”; Demetriades and Hussein, “Does Financial Development Cause Economic Growth?”; and Levine, “Financial Development and Economic Growth: Views and Agenda.”

43. Mankiw et al., “A Contribution to the Empirics of Economic Growth.”; Knight et al., “Testing the Neoclassical Theory of Economic Growth”; Ghura and Hadjimicheal, “Growth in sub-Saharan Africa”; and Arestis et al., “Financial Development and Economic Growth: The Role of Stock Markets.”

44. Mankiw et al., “A Contribution to the Empirics of Economic Growth.”

45. Murinde, Development Banking and Finance.

46. State Planning Organization, The Economic and Social Indicators.

47. Per the existing literature, it is believed that GDP per worker has more explanatory power then GDP per capita because the former reflects the working population rather than whole population.

48. As far as economic history in TRNC is concerned, Ankara did not subsidize the private sector (i.e. financial sector) except in the year 2000 due to the banking crisis; 220 million US dollars were allocated for this purpose (see www.kktcmerkezbankasi.org for more details).

49. Not enough time-series breakdown for this type of data is available to gain further insight about the issue.

50. This proxy refers to the ratio of the number of local students graduated from the universities (abroad and home). In the last decade, a majority of graduates find jobs in the financial sectors such as banks, insurance companies, etc.

51. King and Levine, “Finance and Growth: Schumpeter Might Be Right,” Levine, “Law, Finance, and Economic Growth.”; and De Gregorio and Guidotti, “Financial Development and Economic Growth” argued that private sector (i.e. private credit) GDP is more directly linked to investment and economic growth. They also emphasized that private credit has a clear advantage over measures of the other financial indicators.

52. Beck, “Financial Dependence and International Trade.”

53. See Box and Jenkins, Time Series Analysis; Henry and Mizon, “Serial Correlation as Convenient”; and Davidson et al., “Econometric Modeling of the Aggregate Time Series Relationship.”

54. Johansen, “Statistical Analysis of Co-Integrating Vectors”; Johansen and Juselius, “Maximum Likelihood Estimation and Inference.”

55. Pesaran et al., “Bounds Testing Approaches to the Analysis.”

56. Johansen, “Statistical Analysis of Co-Integrating Vectors”; and Johansen and Juselius, “Maximum Likelihood Estimation and Inference.”

57. Laurenceson and Chai, Financial Reform and Economic Development in China.

58. See also Katircioglu, “Revisiting the Tourism-Led Growth Hypothesis.”

59. Sims, “Macroeconomics and Reality”; Holmes and Hutton, “A Functional-Form Distribution–Free Alternative.”

60. See Gujarati, Basic Econometrics, for more details.

61. Ibid.

62. Dickey and Wayne, “Fuller Likelihood Ratio Statistics”; Kwiatkowski et al., “Testing the Null Hypothesis”; and Phillips and Perron, “Testing for a Unit Root in Time Series Regression.”

63. MacKinnon, “Critical Values for Cointegration Tests.”

64. Engle and Granger, “Cointegration and Error Correction”; Johansen, “Statistical Analysis of Co-Integrating Vectors”; and Johansen and Juselius, “Maximum Likelihood Estimation and Inference.”

65. Laurenceson and Chai, Financial Reform and Economic Development in China.

66. Pesaran et al., “Testing for the Existence of a Long-Run Relationship.”

67. Cheng and Hsu, “Human Capital and Economic Growth in Japan: An Application of Time Series Analysis.”

68. Levine and Renelt, “A Sensitivity Analysis of Cross-Country Growth Regressions.”

69. Knight et al., “Testing the Neoclassical Theory of Economic Growth” and Islam, “Growth Empirics.”

70. Doucouliagos, “The Aggregate Demand for Labour in Australia.” This study uses the studies Romer, “Endogenous Technological Change” and Mankiw et al., “A Contribution to the Empirics of Economic Growth.”

71. Barro and Sala-i-Martin, “Public Finance in Models of Economic Growth.” This study modeled investment capital as private and public inputs and pointed out that both should have different impacts on growth. In this study, the level of technology depends on the degree of the economy and the level financial development policy factors where technological improvements increase through these two factors. Here, modeling private credits may create biased results when this proxy is included in the model with public credits. However, it is argued that government and private credits could have different impacts on output growth and should be considered together in a model. In the present study, the credits allocated in public sector are not worthy of use in the regression model.

72. Calderon and Liu, “The Direction of Causality Between Financial Development and Economic Growth”; Beck et al., “Finance and the Sources of Growth”; Levine et al., “Financial Intermediation and Growth: Causality and Causes”; and Chong and Calderon, “Institutional Quality and Income Distribution.”

73. State Planning Organization, The Economic and Social Indicators.

Additional information

Notes on Contributors

Sami Fethi is an associate professor of Economics at the Department of Business Administration of the Eastern Mediterranean University, Famagusta, Northern Cyprus. His major research fields are economic growth, financial development, underground economy, finance, and econometrics. His current research interests have evolved from the concept of economic growth such as testing the neo-classical growth models, the role of trade and government policies, and the disaggregated investment in a neo-classical modeling framework for small island economies. He has previously published articles in the national and international journals such as the International Journal of Manpower, Applied Economics Letters, Economia Internazionale, and International Journal of Economic Development, and presented many papers in national and international conferences.

Salih Katircioglu is a professor of Economics in the Department of Banking and Finance of Faculty of Business and Economics, Eastern Mediterranean University, Famagusta, North Cyprus, Via Mersin 10, Turkey. He graduated from the same institution and earned his PhD from Uludag University, Turkey. His research interests include applied time-series econometrics, international trade, international finance, tourism economics, and economic growth issues. He has previously published in a considerable number of international peer review journals such as Tourism Management, The World Economy, Applied Economics, Applied Economics Letters, International Journal of Manpower, Turkish Studies, International Journal of Bank Marketing, and International Journal of Social Economics.

Dilber Caglar is an assistant professor of Business Management in the Department of Accounting of Faculty of Business and Economics, Girne American University, Kyrenia, North Cyprus, Via Mersin 10, Turkey. She graduated from Eastern Mediterranean University, North Cyprus, earned an MSc in Finance from Leicester University, UK and earned her PhD from Girne American University, North Cyprus. Her research interests include financial development, energy consumption, international finance, and economic growth issues.