FINANCE-LED GROWTH HYPOTHESIS IN THE PHILIPPINES:

A GRANGER CAUSALITY TEST

An Econometric Paper
submitted to the class of
Dr. Abraham C. Camba, Jr.
San Beda College, Mendiola, Manila

By

Carla Y. See
Steve C. Daniels
March 2010
 Abstract

The debate has been centered on whether it is the financial development that leads the

economic growth or vice versa. Although the relationship postulated is a causal one, most

empirical studies have addressed causality obliquely, if at all. Thus, this study examined the

empirical validity of the finance-led growth hypothesis in the Philippines for the period covering

1987-2008. The paper measured financial development using banking system indicators indexed

by the financial depth ratio, the ratio of bank claims to the private sector-nominal GDP and

interest margin. The economic growth follows the traditional and direct measures; the level of

real GDP per capita and nominal GDP.

The results show that real GDP per capita and nominal GDP are related with, and

significantly affected by financial depth ratio, ratio of bank claims to the private sector-nominal

GDP and interest margin. Using Granger causality test, no causal relation between the variables

can be diagnosed with any certainty. However, there is greater likelihood that changes in real

GDP per capita and nominal GDP precede changes in interest margin, and not the other way

around. This finding favors the growth-led finance hypothesis. On the other hand, there is no

evidence in line with the finance-led growth hypothesis.

Introduction

Economists have long believed that financial institutions are important factors in

supporting economic development. Financial development can facilitate the transfer of productive

capacity across agents and time from less productive users to those with greater potential. It also

enables the mobilization of resources and reduces fragmented capital markets and traditional self-

financed investments (Bencivenga and Smith, 1991). Berthelemy and Varoudakis (1996) stated

that insufficient financial development has sometimes created a poverty trap and may become a

severe obstacle to growth even in a country that has established other conditions (educational

attainment, macroeconomic stability, etc) for sustained economic development.

In the wake of a large body of empirical evidence, considerable research has been

devoted to modeling and understanding the strong positive linkages between real economic

growth and financial development. Much of this research has followed the so-called “functional

approach” in the analysis of such linkages. For example, it is argued that financial institutions can

affect capital accumulation because they can affect the real allocation of resources between

alternative technologies or because they can affect agents’ savings decisions by reducing liquidity

costs and offering greater opportunities for diversifying risks.

While much has been learned from the above research, many issues have still to be

explored and the co-evolution of the real and financial sectors of an economy remains a

fertile area for investigation. Undoubtedly, the development of financial institutions is a

complex process that is intimately connected to real economic activity. As such, the

metamorphosis and transformation of the financial system cannot be fully understood

unless this is interpreted as a truly endogenous process involving dynamic structural

change, which is linked to changes in the real economy. Without recognizing this, it

would be difficult to explain how financial institutions evolve and how new financial

arrangements emerge. There is a need for further research into many aspects of

financial development, which have so far received relatively little attention.

 The causality relationship between economic growth and financial development is a

controversial issue. Basically, the debate has been centered on whether it is the financial

development that leads the economic growth or vice versa. To date, there is no-clear cut

solution in which policy-makers could rely upon. Although the relationship postulated

is a causal one, most empirical studies have addressed causality obliquely, if at all.

Thus, the principle objective of this study is to examine the empirical validity of the

finance-led growth hypothesis in the Philippines for the period covering 1987-2008.

Review of the Literature

Recent empirical works also considers the relationship between economic development

and aggregate measures of financial system development.

Using a large cross section of 98 countries, Roubini and Sala-i-Martin (1992) analyzed

the relationship between the degree of financial development and growth performance from 1960-

1985. The study concluded that countries that repress their financial sectors grow less rapidly

than those countries that do not. Hence, financial development helps allocate inputs more

efficiently and, therefore, leads to aggregate output expansion.

Empirical work by King and Levine (1993a, b, c) used a cross-country model to

determine the relationship between financial intermediation development and economic growth.

The authors examined the effects of financial intermediation on economic growth and the sources

of growth, such as, capital accumulation and productivity growth. Measures of the level of

financial development include a ratio of money stock to nominal output, a ratio of bank credit to

bank credit plus central bank domestic assets, a ratio of credit allocated to private enterprises to

total domestic credit, and a ratio of private domestic credit to nominal output. Employing linear

regression with the controlling for other factors affecting long run growth, the paper successfully

showed a positive correlation between measures of macroeconomic performance and financial

development. However, the results do not strongly support a causal relationship between the

variables.
 Causal relationships between economic growth and financial intermediation was

observed by Jung (1986). Specifically, Jung (1986) found evidence for the causal relationship

between financial development and economic growth. Measures of financial development include

the ratios of M1 and M2 to nominal GDP. Employing the Granger causality test for 56 countries,

the results showed that there exists a close relationship between financial and real development.

The less developed countries are characterized by the causal direction running from financial to

economic development. The reverse causal directions characterized developed countries. This is

also supported by Beck, Levine and Loayza (1999).

In summary, financial intermediaries have played an important role in economic

development since they can reduce the cost of acquiring information, conducting transactions,

and facilitate saving mobilization. By providing these services, to economy, financial

intermediaries can enhance resource allocation and accelerate growth. A large theoretical

literature and empirical research shows that countries with more developed financial system will

grow faster than countries with less developed financial system. Particularly, financial

intermediaries exert causal influence on economic growth. Therefore, financial liberalization

actively does increase aggregate savings that are the channels via which financial intermediaries

affect economic growth.

The Model

This investigation follows the “finance-led growth” hypothesis that postulates the

existence of financial sector as well-functioning financial intermediations in channeling the

limited resources from surplus units to deficit units which would provide efficient allocation of

resources thereby leading the other economic sectors in their growth process. Thus, we measured

financial development using banking system indicators.

Banking development is indexed by the financial depth ratio (FINDEP), the ratio of bank

claims to the private sector to nominal GDP (CLAIMS) and interest margin (IMAR). Financial

depth ratio measures the absolute size of the banking system, and is an improvement over the
traditional financial depth ratio by subtracting currency from M2 to avoid a larger ratio due to

more intensive use of currency rather than an increase in the volume of deposits (Demetriades

and Hussein, 1996).1 On the other hand, private claims-GDP ratio indicates the activity of

financial intermediaries. This indicator improves on the sources of the liabilities and the

allocation of the funds, because it distinguishes private loans from public and government loans,

and money deposit banks from central banks (Levine and Zervos, 1998; Beck, Loayza, Levine,

2000). As for the interest rate margin, it measures the difference between deposit and lending

rates in the banking sector. The margin is likely a good indicator for efficiency in the banking

sector as it describes transaction costs within the sector. If the margin declines in transaction

costs, the share of savings going to investments would increase. As growth is positively linked to

investment, a decrease in transaction costs should accumulate economic growth (Blackburn and

Hung, 1998; Harrison, et al. 1999; Koivu, 2002).

The above relationships between economic growth and banking system development may

be summarized in a single functional statement, to wit:

ECOGRW = f[BANKDEV]

(1)

where:

ECOGRW = Economic growth

BANKDEV = Banking system development
The economic development indicators follow the traditional, direct measure, the level of

real GDP per capita (PERCAP) and nominal GDP (NGDP) (Roubini and Sala-i-Martin, 1992;

King and Lavine, 1993 a, b, c; Demetriades and Hussein, 1996).

This study supports the argument that financial intermediaries exert causal influence on

economic growth. To fit and simplify notations for the purpose of the study, the empirical model

1
Financial intermediaries serve two main functions: to provide liquidity services and saving opportunities,
the latter being relevant for promoting investment and consequently growth.
for testing the causal relationship between banking development and economic growth are

described below.

m m
Γ iBANKDEVt Γ j ECOGRW (2)
ECOGRWt = Σ + Σ + u1t
-1 t-j
k=1 k=1

where:
M = 1987, 1988,…,2008 (yearly)
Γ = estimated coefficients
u = error terms

Equation (2) postulates that economic growth is related to past values of itself as well as

that of banking system development indicators. Thus, the direction of causality would be

BANKDEV  ECOGRW. Except for the interest margin, all the variables are expressed in

natural logarithms for monotonic transformation due to a trend in the data series.

The Data

This study is carried out in the context of the Philippines. Governed by data availability,

the sample period covers 1987-2008. Per capita GDP, GDP at current market prices, money

supply (M2-currency), and bank claims on private sector were obtained from the Asian

Development Bank (ADB) Key Indicators.

Results

Philippine Economic Growth. The Philippines has posted an average of 5.2 percent

GDP growth rate from 2002 to 2006. The economy expanded 7.1 percent in 2007, the highest in

more than two decades. However, GDP growth slowed down to 3.8 percent in 2008. This was

mainly due to high food and fuel prices in the first half of 2008 combined with the global

financial meltdown and economic slowdown in the second half.

 Figure 1. Real GDP Growth

(in percent)

The economy was on the brink of recession as the economy grew by a measly 0.4

percent in Q1 2009 from the previous year. Seasonally-adjusted, the economy contracted

by 2.3 percent, the worst Q1 performance in 20 years. The National Statistical

Coordination Board (NSCB) reported that gross domestic product (GDP) rose 2.4 percent

in the second quarter of 2009 on a seasonally adjusted basis. Second-quarter GDP rose

1.5 percent from the year-earlier quarter, slower than the 4.2 percent annual growth a

year earlier, but better than the revised 0.6 percent in the first quarter. Consumer

spending, a key driver of GDP, rose 2.2 percent year-to-year following 0.8 percent

growth in the first quarter. Government spending increased 9.1 percent year-to-year in the

second quarter due to pump-priming activity. The domestic economy remains fragile

from the global crisis, as GDP grew by 0.8 percent in the third quarter of 2009 from 4.6

percent last year. The recovery of the global economy from the crisis paved the way for a

GDP growth of 1.8 percent in the fourth quarter of 2009, bringing the full year GDP

growth to 0.9 percent from 3.8 percent in 2008.

 The domestic economy could not keep pace with the population growth in 2009

as per capita GDP declined by 1.0 percent from a 1.8 percent growth in 2008 (see Table

1).

Table 1

Per Capita: Gross Domestic Product Annual 2008 and 2009

(at current and constant 1985 prices, in pesos)

Growth
GROSS DOMESTIC PRODUCT 2008 2009 Rate
(%)
1. Estimates in current pesos 82,063 83,155 1.3
2. Estimates in constant (1985) pesos 15,686 15,527 -1.0
3. Population (million persons) 90.46 92.23
Source: National Statistical Coordination Board (NSCB)

Philippine Banking System. The banking system continues to grow with total

number of branches close to 7,150 (see Table 2). According to the latest banking statistics

of the Bangko Sentral ng Pilipinas (BSP), Calabarzon and Central Luzon have the biggest

concentration of rural banks. Rural banks, as of end-September 2009, have a total of 642

head office and 1,388 branches, up from 1,372 a quarter earlier. Universal and

commercial banks have the most number of branches with a total of 38 head offices and

4,406 branches nationwide, 22 branches more than the previous quarter. But despite the

increasing number of banks nationwide, there are still some areas that do not have

banking services such as ARMM.

Banks’ total deposits as of end-September 2009 amounted to P3.2 trillion, around

10.3 percent higher than its year-ago level of P2.9 trillion. Savings deposits, which

accounted for almost half of the funding base, grew by 14.4 percent, higher than the 9.7

percent growth registered during the end of previous quarter. Demand deposits posted

year-on-year growth of 21.5 percent while time deposits contracted by 1.5 percent. Total
 resources of the banking system rose by 6.5 percent to P6.0 trillion as of end-September

2009 from its year-ago level of P5.6 trillion. The increase was due mainly to the rise in

debt securities, with universal and commercial banks continuing to account for almost 90

percent of the total resources of the banking system.

Meanwhile, outstanding loans of commercial banks, net of banks’ placements in

reverse repurchase agreements (RRPs) with the BSP, remained significant at 5.9 percent

as of end-September 2009, albeit slower than the 14.3 percent growth at end-June 2009.

Bank lending likewise grew by 6.1 percent, also lower compared to the 11.1 percent

growth posted at the end of the previous quarter. The banking system’s asset quality also

continue to improve as the non-performing loan ratio eased further to 3.9 percent as of

end-September 2009 compared to 4.5 percent a year ago.

Table 2

Banks under BSP Supervision/Regulation

End-March 2009 End-September 2009

Head Other Head Other
Total Total
Office Offices Office Offices
BANKS 7,876 811 7,065 7,914 797 7,117
A. Universal and Commercial Banks 4,422 38 4,384 4,444 38 4,406
Universal Banks 3,928 18 3,910 3,940 18 3,922
Private Domestic Banks 3,497 11 3,486 3,510 11 3,499
Government Banks 415 3 412 414 3 411
Branches of Foreign Banks 16 4 12 16 4 12

Commercial Banks 494 20 474 504 20 484

Private Domestic Banks 410 7 403 420 7 413
 Subsidiaries of Foreign Banks 69 3 66 69 3 66
Branches of Foreign Banks 15 10 5 15 10 5

B. Thrift Banks 1,297 76 1,221 1,298 73 1,225

C. Rural and Cooperative Banks 2,157 697 1,460 2,172 686 1,486
Rural Banks 2,025 653 1,372 2,030 642 1,388
Cooperative Banks 132 44 88 142 44 98
Source: Bangko Sentral ng Pilipinas (BSP)

The results show that at 2-tailed test, financial depth ratio (FINDEP), ratio of bank claims

to the private sector-nominal GDP (CLAIMS) and interest margin (IMAR) are significantly

correlated with real GDP per capita (PERCAP) and nominal GDP (NGDP).

Table 3

Correlation Matrix

BANKDEV PERCAP NGDP

FINDEP 0.9314 0.9276

CLAIMS 0.7920 0.7860
IMAR -0.7821 -0.7839
1/ Except for interest margin, all variables are expressed in natural logarithms
2/ real GDP per capita (PERCAP); nominal GDP (NGDP); financial depth ratio (FINDEP);
ratio of bank claims to the private sector to nominal GDP (CLAIMS); interest margin (IMAR)

11.5 11.5

11.0 11.0
LNPERCAP

LNPERCAP

10.5 10.5

10.0
10.0

9.5
9.5

9.0
0.70 0.75 0.80 0.85 0.90 9.0
0.70 0.75 0.80 0.85 0.90 0.95
LNM2/LNGDP
LNCLAIMS/LNGDP
 9.0 9.0

8.5 8.5
LNGDP

LNGDP
8.0 8.0

7.5 7.5

7.0 7.0

6.5 6.5
0.70 0.75 0.80 0.85 0.90 0.95
0.70 0.75 0.80 0.85 0.90

LNCLAIMS/LNGDP
LNM2/LNGDP

11.5 9.0

11.0 8.5
LNPERCAP

LNNGDP
10.5 8.0

10.0 7.5

9.5 7.0

9.0 6.5
2 4 6 8 10 12 14 2 4 6 8 10 12 14

INT INT

Figure 2. Correlation Patterns between Economic Growth and

Banking System Development Indicators

The computed correlation coefficients revealed that FINDEP (at 0.9314 and 0.9276) and

CLAIMS (at 0.7920 and 0.7860) are strongly and positively correlated with PERCAP and NGDP

(see Table 3 and Figure 2). Moreover, consistent with the study of Blackburn and Hung (1998),

Harrison, et al. (1999), Koivu (2002), the findings revealed that there is a strong and negative

correlation between PERCAP and IMAR at -0.7821 and NGDP and IMAR at -0.7839.

The corresponding correlation pattern in Figure 2 indicates some form of positive linear

association of real GDP per capita and nominal GDP with respect to financial depth ratio and the

ratio of bank claims to the private sector-nominal GDP; and negative linear association of real

GDP per capita and nominal GDP to interest margin.

 The conclusive findings of the OLS regression made on the data are given in Table 4.

The results of the regression analysis denote that FINDEP and CLAIMS have significant positive

effect on economic growth. Since the calculated t-values of FINDEP and CLAIMS are

significant at 1 percent level of significance.

Table 4

OLS Regression Analysis between Economic Growth

and Banking System Development

Std.
Variables Coefficient t-stat Prob.
Error
Dependent Variable: PERCAP
BANKDEV Regressors
Constant -2.5629 1.3456 -1.9046 0.0811
FINDEP 23.8138 2.0276 11.7446 0.0000
CLAIMS 8.8454 0.9204 9.6098 0.0000
IMAR -0.0367 0.0193 -1.9052 0.0810
R-squared = 0.9636
Adjusted R-squared = 0.9515
Durbin-Watson stat = 2.0720
F-statistics = 79.5122, Prob = 0.0000

Dependent Variable: NGDP

BANKDEV Regressors
Constant -8.5468 1.7169 -4.9781 0.0003
FINDEP 30.1869 2.5948 11.6336 0.0000
CLAIMS 11.3486 1.1922 9.5193 0.0000
IMAR -0.0459 0.0245 -1.8691 0.0862
R-squared = 0.9626
Adjusted R-squared = 0.9500
Durbin-Watson stat = 2.0354
F-statistics = 77.1107, Prob = 0.0000
1/ Except for interest margin, all variables are expressed in natural logarithms
2/ real GDP per capita (PERCAP); nominal GDP (NGDP); financial depth ratio (FINDEP);
ratio of bank claims to the private sector to nominal GDP (CLAIMS); interest margin (IMAR)

As the regression shows, IMAR has a negative effect on PERCAP and NGDP. IMAR is

an indicator of efficiency in the banking sector as it describes transaction costs within the sector.

A decrease in interest margin should accumulate economic growth in terms of real GDP per

capita and nominal GDP.

Causality Test. The causality relationships between financial development and

economic growth are summarized in Table 5. In Table 5, none of the probability values are
smaller than 0.05. Hence, using 5 percent significance level, none of the noncausality null

hypotheses can be rejected. In other words, on the basis of these tests no causal relation between

the variables can be diagnosed with any certainty.

Table 5

Pairwise Granger Causality Tests between Economic Growth

and Banking System Development

Null Hypothesis F-Statistics Probability

BANKDEV  PERCAP
• FINDEP does not Granger cause PERCAP 1.2806 0.3133
PERCAP does not Granger cause FINDEP 1.4693 0.2687
• CLAIMS does not Granger cause PERCAP 0.3738 0.6959
PERCAP does not Granger cause CLAIMS 0.3261 0.7279
• IMAR does not Granger cause PERCAP 0.6529 0.5381
PERCAP does not Granger cause IMAR 2.2476 0.0743
BANKDEV  NGDP
• FINDEP does not Granger cause NGDP 1.3068 0.3066
NGDP does not Granger cause FINDEP 1.2708 0.3158
• CLAIMS does not Granger cause NGDP 0.4050 0.6758
NGDP does not Granger cause CLAIMS 0.1953 0.8251
• IMAR does not Granger cause NGDP 0.5825 0.5735
NGDP does not Granger cause IMAR 2.2085 0.0839
1/ Observations: 17 (Lags: 2)
2/ Except for interest margin, all variables are expressed in natural logarithms
3/ real GDP per capita (PERCAP); nominal GDP (NGDP); financial depth ratio (FINDEP);
ratio of bank claims to the private sector to nominal GDP (CLAIMS); interest margin (IMAR)

There is, however, weak evidence of a Granger-causal relation from economic growth to

banking system development (ECOGRW  BANKDEV) because the probability value of the

related test is at least less than 10 percent. In particular, there is greater likelihood that changes in

real GDP per capita and nominal GDP precede changes in banking system development in terms

of interest margin. From a causal point of view, a change in economic growth causes a change in

banking system development, and not the other way around. That is, the short run changes in

economic growth are in part responsible for future changes in the financial development in terms

of interest margin. Higher economic growth promotes a faster financial development. The

“growth-led finance” hypothesis states that a high economic growth may create demand for

certain financial instruments and arrangements and the financial markets effectively response to
these demands and changes. The impact of economic growth on the financial development has

been documented in the works of Robinson (1952) and Romer (1990).

Conclusions

This paper examined the empirical validity of the finance-led growth hypothesis in the

Philippines for the period covering 1987-2008 using Granger causality test. Using Granger

causality test, no causal relation between the variables can be diagnosed with any certainty. The

study instead provides evidence on the growth-led finance hypothesis in the case of the

Philippines, a small, open emerging economy. The results suggest that there is greater likelihood

that changes in real GDP per capita and nominal GDP precede changes in banking system

development in terms of interest margin which is consistent with the growth-led finance

hypothesis.

The empirical findings also indicated that financial depth ratio, ratio of bank claims to the

private sector to nominal GDP and interest margin significantly correlated with real GDP per

capita and nominal GDP. The conclusive findings of the regression results denote that financial

depth ratio and ratio of bank claims to the private sector-nominal GDP have significant positive

effect on economic growth. The regression results also revealed a significant negative effect of

interest margin on economic growth in terms of real GDP per capita and nominal GDP.

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