Do Commercial Banks, Stock Market and Insurance Market Promote Economic

Growth? An analysis of the Singapore Economy

Tan Khay Boon
School of Humanities and Social Studies
Nanyang Technological University
50 Nanyang Avenue, Singapore 639798
Republic of Singapore
Tel: (65) 67904332 Fax: (65) 67911859
Email: mkbtan@ntu.edu.sg
Abstract
This paper conducts within sample and out-of-sample causality tests between finance and
growth in the Singapore economy. It uses bank loans, stock market capitalization value
and insurance funds as financial indicators with real GDP per capita and real gross fixed
capital formation per capita as growth indicators. The results show that the direction of
causality is dependent on both financial and growth indicators. The loan market is largely
demand following and the insurance market is supply leading. The stock market is
demand following in the short term and supply leading in the long term. In addition to
highlighting the benefits of using disaggregated financial data, the findings also
demonstrate that causality patterns vary with indicators used and therefore emphasizes on
the danger of very few and restrictive indicators in individual country studies.
1.

Introduction

The relationship between financial economic development and economic growth is

highly controversial. The supply leading theories consider the development of financial
sector as the precondition for economic growth, while the demand following theories
consider financial development as merely responsive to economic growth.
Understanding the relationship may allow appropriate government policies to be
implemented which will facilitate economic development. Yet empirical evidence
provided so far are inconclusive and contradictory.
This study hopes to add on empirical evidence to resolve this controversy. Singapore is
chosen because of its characteristics that may be able to shed more light in the
relationship between finance and growth. Being a small and high growth economy
without any natural resources, its growth is obtained through manufacturing and service
sectors and these sectors are closely link to the financial sector. Moreover, the lack of
internal monetary policy means there is no ad hoc change in monetary aggregates and the
bank loan becomes a better indicator of financial deepening. Finally, it has a welldeveloped financial sector with many different financial indicators available.
Section 2 provides a discussion of the theoretical foundation and the empirical evidence
between financial development and economic growth. Section 3 brings in the empirical
methodology of the research in this area and Section 4 explains the measurement and data
sources in detail. Section 5 presents the empirical findings and Section 6 concludes.

2.

Theoretical Discussion and Empirical Evidence

In the early days, Schumpeter (1911) had highlighted the importance of finance in
promoting entrepreneurship and economic growth. Several models were built to
incorporate the roles of financial development in economic growth. This includes the
growth model by Solow (1956) which shows that the development of financial sector can
encourage saving and lead to a higher output per worker. More recently, the endogenous
growth models by Greenwood and Jovanovic (1990), Bencivenga and Smith (1991) and
King and Levine (1993a) among others suggest that both the growth level and rate can be
affected by financial development. Pagano (1993) summarizes their finding succinctly
and explained that financial development promotes economic growth via three paths:
channel more savings to investment, raise the marginal productivity of capital and
encourage saving.1
However, there is also theory considers financial sector as following economic
development. This theory, suggested initially by Robinson (1952), believe that as
economic progresses, there will be increasing needs for sophisticated financial services
and this lead to the development of financial sector2. There are also economists such as
Lucas (1988) who believe that finance is not important at all. All these theories are
feasible and hence this issue can only be resolved empirically.
The exact relationship between finance and growth can only be resolved through
empirical analysis. However, the evidence so far is inconclusive. Although King and
Levine (1993b) use cross-sectional data on 80 countries to show finance causes growth,
their methodology is questionable. Evidence from time series individual countries
studies, such as by Jung (1986), Murinde and Eng (1994), Ahmed and Ansari (1998) and
Fase and Abma (2003) provide evidence of finance causes growth in developing
countries. Similarly, Wachtel and Rousseau (1996) and Rousseau and Wachtel (1998)
also show finance causes growth in developed countries. However, the empirical work
involving 16 countries provided by Demetriades and Hussein (1996) shows considerable
evidence of bi-directional causality and some evidence of growth causes finance. As for
stock market analysis, Levine (1991) and Levine and Zervos (1998) show that stock
market positively predicts growth. But Harris (1997) studies find no evidence of stock
market explains growth in per capita output.
The conflicting results highlight the danger of using aggregated data and inappropriate
financial indicators in performing causality test between finance and growth. Most of the
studies use highly aggregated data, such as M3 or domestic credit which did not
distinguish between bank loans, insurance funds and stock market funds. These data do
not exhibit the pathways which finance affects growth. This is an omission in the
existing work and it presents a gap worth covering.

The sign of this relationship is ambiguous. The effect on saving rates on economic development can be
positive or negative depends on risk sharing, household borrowing and interest rate effects.
2
Joan Robinson declares that "where enterprise leads finance follows" in her 1952 publication, p 86.
2

3.

Empirical Methodology

The conventional method in solving the causality issue between finance and growth is
using the Granger causality method on time series data. This method involves regressing
growth or finance indicators with lagged finance indicator and lagged growth indicator
and then apply F test in hypothesis testing. This method can test for finance causes
growth; growth causes growth, bi-directional causality or no causality.
The Granger causality method involves running the following two regression models:
m
n
Yt = iFt-i + jYt-j + U1t
i=1
j=1

(1a)

m
n
Ft = iFt-i + jYt-j + U2t
i=1
j=1

(1b)

where Y is an indicator of economic development, F is an indicator of financial

development and U1t and U2t are the disturbances which are assumed to be uncorrelated.
In this framework, there are four possible cases:
Case 1: Unidirectional causality from F to Y. This is indicated if i 0 and j = 0.
This outcome supports the view of Schumpeter.
Case 2: Unidirectional causality from Y to F. This is indicated if i = 0 and j 0.
This outcome is consistent with the view of Robinson.
Case 3: Bilateral causality. This is indicated if i 0 and j 0. This outcome
supports both Schumpeter and Robinson.
Case 4: Independence. This is indicated if i = 0 and j = 0. This is consistent with
the view of Lucas.
However, this type of causality test is only suitable if both data series are stationary. It
the data series are non-stationary, then appropriate level of differencing must be done to
make the series stationary before the test can be carry out. But Granger (1988) has
pointed out that complication will arise if the two series are cointegrated. By
differencing the series alone may actually lead to specification bias of the model that
produce spurious results. The appropriate method is to convert the model into an error
correction model (ECM) framework by including an error correction term. In the models
below, and are the estimates from the cointegrating vector and the term in parenthesis
is the error correction term.
m
n
Yt = + (Yt-1 - - Ft-1 ) + iFt-i + jYt-j + Ut
(2a)
i=1
j=1

m
n
Ft = + (Yt-1 - - Ft-1 ) + iFt-i + jYt-j + Ut
i=1
j=1

(2b)

When Yt and Ft are cointegrated, Ft can Granger cause Yt in two ways. One is through
the lagged short run dynamic terms i 0 and this can be tested using F test. The other
is through the lagged error correction term if 0 and this can be tested using using ttest. This link also represents the long run dynamics between finance and growth.
Failure to include the error correction term with cointegrated process will result in
models that are misspecified and the causality testing can lead to erroneous. The ECM
based causality tests offer the additional advantage that the source of causation can be
identified, in the form of either short run dynamics or long run disequilibrium adjustment.
Two methods to test for cointegration are commonly used in applied research. The first
method, suggested by Engle and Granger (1987), involves using Augmented Dickey
Fuller (ADF) test on the residual series of a cointegrated model. If the series are
cointegrated the residual series should not have unit root. The second method, suggested
by Johansen (1988), is a multivariate maximum likelihood estimation technique. It
involves estimating a vector error correction model (VECM) of the form:
Zt = + 1Zt-1+ 2Zt-2 + 3Zt-3 + + p-1Zt-p+1 + Zt-p + t
where Zt is a nX1 vector of I(1) variables indicating financial development and economic
growth, 1, 2, , p and are nXn matrices of parameters to be estimated. Existence of
cointegration implies that the matrix has non-zero rank r < n, equal to the number of
linear combinations of the variables in Zt that are stationary. Two tests can be used to
test for cointegration. One is the trace statistic while the other is the max statistic. The
statistic tests the null hypothesis of at most r cointegration vectors against an alternative
of at least r+1.3
Thus Granger causality test can be used on the level series (if series are stationary), on
the differenced series (if series are non-stationary and non-cointegrated), formulated in an
error correction model framework (if series are cointegarted) or using Johansen test. The
problem with this methodology is the difficulty in obtaining the appropriate framework
due to low power of unit root test and cointegration test, and also inability to detect
causal effect due to low power of Granger causality test.
It is not necessary to perform differencing on non-stationary series in order to test for
causality. Sims et al. (1990) have shown that in a tri-variate system, if there is a single
cointegrating relationship the Wald tests for Granger causality are asymptotically
distributed as chi-square. Thus Granger causality test can be done on the level for all the
three series. This is the method adopted by Rousseau (1999) in analyzing Japan and Bell
and Rousseau (2001) in analyzing India. In both papers, VAR models involving a
finance indicator, a growth indicator and a money supply indicator are used. However,
3

A full discussion of the test statistics is given in Johansen and Juselius (1990).

Toda and Phillips (1993) have doubted the usefulness of unrestricted levels Vector
autoregressions as it is valid only asymptotically and hence subject to many uncertainties.
They suggest the use of Johansen-type ECM which is more valid.
In a different perspective, Masih and Masih (1998) suggest the use variance
decompositions (VDC) and impulse response functions (IRF) to unearth deeper insights
of Granger causality test. The problem with the VECM, F- and t-tests is that they are
within-sample causality tests. These tests do not allow us to gauge the relative strength
of the Granger-causal chain among the variables beyond the sample period. The VDCs
and IRFs can be considered as out-of sample causality tests. The VDC involves
partitioning the variance of the forecast error of a certain variable into proportions
attributable to innovations in each variable in the system including its own. The IRF
maps out the dynamic response path of a variable due to a one-period standard deviation
shock to another variable. Thus in the analysis of VDC if a large portion of the forecast
error of the growth variable is explained by the finance variable, this provides further
evidence of finance cause growth. Similarly, using IRF if the responses of the growth
variable to shocks in the finance variables are positive and strong, it is more likely that
finance causes growth.
4.

Measurement and Data Sources

This paper investigates the relationship between financial development and economic
growth by using individual country time series data. This is also in line with the
approach by Arestis and Demetriades (1997) and Wachtel and Rousseau (1996).
Singapore is chosen because of its well-developed financial sector and its impressive
economic growth rate and it will be interesting to establish the causal effect between the
two. Although Masih and Masih (1996) recommend using annual data in this type of
research, quarterly data is used in this paper due to its relatively short history of
development and most of the required data are available on a quarterly basis.
Since there are different functions performed by financial sector and they influence
growth differently4, it is necessary to use different financial indicators and growth
indicators to study the linkage between finance and growth. The indicators used to
measure financial development and economic growth will have significant effect on the
outcome of research.
Based on the model by Pagano (1993), the growth indicators should reflect an
improvement in productivity, an increase in investment or an increase in saving rate.
Since the saving rate has an ambiguous effect on growth rate and the measurement of
total factor productivity tend to be unreliable, the seasonal adjusted real gross domestic
product per capita is used to approximate these two effects. The increase in investment
4

The survey by Levine (1997) highlights that financial sector performs five important roles that can
promote economic development. They are (i) facilitating the trading, hedging, diversifying and pooling of
risk, (ii) allocating resources; (iii) monitoring managers and exert corporate control, (iv) mobilizing savings
and (v) facilitating the exchange of goods and services.
5

can be captured by an increase in real gross fixed capital formation per capita and this is
the second growth indicator. The data for both series are available from March 1985 to
September 2002.
The problem of using aggregate financial data is that it will not explain how finance
affects growth. In this paper, three types of financial indicators are used to represent
three financial markets. The first type is the ratio of commercial bank loans to nominal
gross domestic product. This indicator will capture the functions of commercial banks
and the data is available from March 1985 to September 20025. The second indicator is
to represent the development of the stock market. It is proxied by the ratio of market
capitalization of the Singapore stock market to nominal GDP and the data runs from
December 1987 to September 20026. The final financial indicator is to represent the
development of the insurance market and this is proxied by the total insurance funds.7
The data runs from March 1991 to September 2002.
5.

Empirical Results

The investigation begins with testing for unit root on all the growth and financial
development series. Using ADF test, the null hypothesis is there is unit root and the
alternative hypothesis is the absence of unit root. Tests on all the series are conducted on
the level as well as the first difference. A visual inspection on the series is done to decide
on the inclusion of intercept and time trend in the ADF test. Table 1 below shows the
results of unit root test. The ADF test does not reject the null of a unit root for the data in
levels and rejects the null for each of the differenced series. The findings imply that it is
reasonable to model all of the relevant variables as non-stationary.
Table 1 : ADF Test for Unit Root
Data Series
Real gross domestic product per capita (GDP)
Real gross fixed capital formation per capita (GFCF)
Ratio of bank loans to nominal GDP (BANK)
Ratio of stock market capitalization to nominal GDP (STOCK)
Insurance funds (INSUR)

Level
-0.96
-0.87
-1.01
-2.35
-1.83

1st differences
-7.06*
-10.93*
-3.92*
-7.80*
-5.26*

A* denote rejections of unit root at 1% level. All variables are in log, with the exception of BANK and
STOCK.

As Singapore is a small open economy, whatever effects between real and financial
sector tends to reflect rapidly in the data. Thus a maximum of 8 lags is considered in the
Johansen test for cointegration. Table 2 below shows the results of cointegration test.
Rejectionn of the null hypothesis of no cointegration (r=0) coupled with a failure to reject

The data for bank loan are available monthly and hence aggregate of three months data is used.
The stock market capitalization is available monthly. Thus the data on the month of March, June,
September and December are used.
7
The insurance fund is not normalized with nominal GDP because of its small value.
6

the null of one cointgerating vector (r=1) provides evidence of a single long-run
relationship in a given system.
Table 2: Johansen Test for Cointegration
System
Trace
r=0
r=1
GDP and BANK (k=2)
19.01**
3.07
GFCF and BANK (k=1)
20.47**
2.11
GDP and STOCK (k=8)
21.34*
7.25
GFCF and STOCK (k=2)
16.55**
4.34
GDP and INSUR (k=8)
15.97**
0.78
GFCF and INSUR (k=6)
16.10**
4.81

Maximum eigenvalue
r=0
r=1
15.94**
3.07
18.37**
2.11
14.09**
7.25
12.21
4.34
15.19**
0.78
11.28
4.81

The term k is the lag at which the levels terms enter the test regressions. A * and ** denote rejection of the
null hypothesis of no cointegration at the 1% and 10% respectively.

Out of the six systems considered, the results show the presence of cointegartion in four
systems conclusively. The other two systems, GFCF and STOCK and GFCF and INSUR
have ambiguous results. While the trace test indicates the presence of cointegration, the
maximum eigenvalue test shows otherwise. In view of the low power of cointegration
test, these two systems are also treated as cointegrated. Thus the VECM models are
constructed (equation 2a and 2b) for the six systems. In all cases, the lag length is
selected using AIC criteria.
5.1

Bank Loans and Economic Growth

In Singapore, the commercial banks are the most important sources of finance for
enterprises. The regression results between GDP, GFCF and BANK are shown below.
The t statistics values are shown in parenthesis.
GDPt = 0.008 + 0.206GDPt-1 + 0.003BANKt-1 -0.0007(GDPt-1 -5.35 - 0.31BANKt-1)
(3.21) (1.45)
(0.613)
(-0.11)
(-4.24)
BANKt = 0.13 - 10.46GDPt-1 - 0.08BANKt-1 + 0.61(GDPt-1 -5.35 - 0.31BANKt-1)
(1.73) (-2.6)
(0.59)
(3.39)
(-4.24)
GFCFt = 0.006 - 0.41GFCFt-1 - 0.007BANKt-1 + 0.05(GFCFt-1 -3.8 - 0.36BANKt-1)
(0.92) (-3.33)
(-0.51)
(2.74)
(-5.35)
BANKt = 0.01 + 0.55GFCFt-1 + 0.07BANKt-1 + 0.45(GFCFt-1 -3.8 - 0.36BANKt-1)
(0.21) (0.51)
(0.58)
(2.59)
(-5.35)
The results clearly indicate the direction of causality is from BANK to GDP in both the
short run and the long run. But there is a long run bi-directional causality between GFCF
and BANK. The IRF also shows that BANK response vigorously to one standard
deviation shock in the GDP and GFCF.

R e s p o n s e t o C h o le s k y O n e S . D . I n n o v a t io n s
R espo nse of

GDP

to

GDP

R esponse of

.0 2 4

.0 2 4

.0 2 0

.0 2 0

.0 1 6

.0 1 6

.0 1 2

.0 1 2

.0 0 8

.0 0 8

.0 0 4

.0 0 4

.0 0 0

GDP

to B A N K

.0 0 0
1

R e s p o n s e o f B A N K to

10

GDP

10

10

10

10

R e s p o n s e o f B A N K to B A N K

.5

.5

.4

.4

.3

.3

.2

.2

.1

.1

.0

.0

-.1

-.1

-.2

-.2

-.3

-.3

-.4

-.4
1

10

R e s p o n s e t o C h o le s k y O n e S . D . In n o v a t io n s
R esponse of

GFCF

to

G FCF

R esponse of

.06

.06

.04

.04

.02

.02

.00

.00

-.02

-.02

-.04

GFCF

to B A N K

-.04
1

R e s p o n s e o f B A N K to

10

GFCF

R e s p o n s e o f B A N K to B A N K

.5

.5

.4

.4

.3

.3

.2

.2

.1

.1

.0

.0

-.1

-.1

-.2

-.2
1

10

5.2

Stock Market and Economic Growth

The stock market provides an alternative source of funds for companies. The regression
results between GDP, GFCF and STOCK are shown below.
GDPt =0.01- 0.02GDPt-1 + 0.002STOCKt-1 -0.02(GDPt-1 -7.97 - 0.15STOCKt-1)
(3.75) (-0.11)
(0.74)
(-1.35)
(-3.88)
STOCKt = 0.03 - 1.29GDPt-1 - 0.07STOCKt-1 + 1.17(GDPt-1 -7.97 - 0.15STOCKt-1)
(0.24) (-6.73)
(0.45)
(1.79)
(-3.88)
GFCFt = 0.012 - 0.31GFCFt-1 - 0.001STOCKt-1 - 0.09(GFCFt-1 -6.9 - 0.17STOCKt-1)
(1.58) (-2.51)
(-0.16)
(2.39)
(-3.62)
STOCKt = 0.02+0.25GFCFt-1 + 0.04STOCKt-1 +0.82(GFCFt-1 -6.9 - 0.17STOCKt-1)
(0.14) (0.14)
(0.27)
(1.59)
(-3.62)
The results shown that there is a short term causality effect from GDP to STOCK but no
long term disaggregate adjustment between GDP and STOCK. However, there is a long
term causality effect from STOCK to GFCF. The IRF shows that the reaction of STOCK
on a standard deviation shock in GDP and GFCF is stronger than vice versa.
R e s p o n s e t o C h o le s k y O n e S . D . I n n o v a t io n s
R espo nse of

GDP

to

GDP

R espo nse of

.0 2 0

.0 2 0

.0 1 6

.0 1 6

.0 1 2

.0 1 2

.0 0 8

.0 0 8

.0 0 4

.0 0 4

.0 0 0

GDP

to S T O C K

.0 0 0
1

R e s p o n s e o f S T O C K to

10

GDP

10

10

R e s p o n s e o f S T O C K to S T O C K

.8

.8

.7

.7

.6

.6

.5

.5

.4

.4

.3

.3

.2

.2

.1

.1
1

10

R e s p o n s e t o C h o le s k y O n e S . D . In n o v a t io n s
R e sp onse of

G FCF

to

G FC F

R espo nse of

.0 6

.0 6

.0 5

.0 5

.0 4

.0 4

.0 3

.0 3

.0 2

.0 2

.0 1

.0 1

.0 0

to S T O C K

.0 0
1

R e s p o n s e o f S T O C K to

10

G FCF

10

10

R e s p o n s e o f S T O C K to S T O C K

.9

.9

.8

.8

.7

.7

.6

.6

.5

.5

.4

.4

.3

.3

.2

.2

.1

.1
1

5.3

G FC F

10

Insurance Market and Economic Growth

The role of insurance market is mainly risk hedging. With sufficient hedging, a firm may
be more willing in committing investment projects that are more risky but returns are
higher. The regression results between GDP, GFCF and INSUR are shown below.
GDPt =0.007+ 0.14GDPt-1 + 0.019INSURt-1 -0.113(GDPt-1 -7.38 - 0.15INSURt-1)
(1.2) (0.16)
(0.18)
(-2.17)
(-4.0)
INSURt = 0.04 + 0.08GDPt-1 + 0.17INSURt-1 - 0.03(GDPt-1 -7.38 - 0.15INSURt-1)
(4.42) (0.35)
(1.06)
(-0.41)
(-4.0)
GFCFt = -0.001 - 0.34GFCFt-1 + 0.14INSURt-1 - 0.03(GFCFt-1 -16 + 0.83INSURt-1)
(-0.03) (-2.28)
(0.41)
(2.05)
(1.67)
INSURt = 0.04 - 0.01GFCFt-1 + 0.18INSURt-1 - 0.005(GFCFt-1 -16 + 0.83INSURt-1)
(4.56) (-0.19)
(1.15)
(-0.83)
(1.67)
The results show that there is a long term causality effect from INSUR to GDP and also
both a short and long term effects from INSUR to GFCF. It seems that only the
insurance market show conclusive evidence of finance causes growth. The IRF shows
that GDP and GFCF respond positively to a one standard deviation shock in INSUR but
the respond the other way round is much weaker.

10

R e s p o n s e to C h o le s k y O n e S . D . In n o v a t io n s
R espo nse o f

GDP

to

GDP

R esp ons e of

.020

.020

.016

.016

.012

.012

.008

.008

.004

.004

.000

GDP

to

IN S U R

.000
1

R e spo ns e o f

IN S U R

to

10

GDP

.032

.032

.028

.028

.024

.024

.020

.020

.016

.016

.012

.012

.008

.008

.004

.004

.000

R esp onse of

IN S U R

to

10

10

IN S U R

.000
1

10

R e s p o n s e t o C h o le s k y O n e S . D . In n o v a t io n s
R esp ons e of

GFCF

to

GFCF

R esponse of

.0 6

.0 6

.0 5

.0 5

.0 4

.0 4

.0 3

.0 3

.0 2

.0 2

.0 1

.0 1

.0 0

.0 0

-.0 1

-.0 1
1

R esponse o f

IN S U R

to

10

GFCF

.0 3 2

.0 3 2

.0 2 8

.0 2 8

.0 2 4

.0 2 4

.0 2 0

.0 2 0

.0 1 6

.0 1 6

.0 1 2

.0 1 2

.0 0 8

.0 0 8

.0 0 4

.0 0 4

.0 0 0

GFCF

to

R esponse of

IN S U R

to

IN S U R

10

10

IN S U R

.0 0 0
1

10

11

6.

Summary and Concluding Remarks

The main purpose of this paper is to discern the causal relationship (in the Granger sense)
between financial indicators and growth indicators in the Singapore economy. The
methodology involves using ADF test for unit roots and Johansen's test for cointegration,
followed by either unrestricted vector autoregression (if cointegration is absent) or vector
error-correction model (if cointegration is present). The impulse response functions are
also constructed to further capture the out-of-sample Granger causality.
The evidence suggests that in the presence of cointegration, the causality usually occurs
in the long run dynamics (the lagged error correction term). There are fewer cases where
causality solely occurs in the short run dynamics. This suggests that the relationship
between finance and growth is more likely to be a long term one. Thus it is important to
determine whether unrestricted VAR or VECM framework should be used in the
causality studies. The evidence from the IRF is largely consistent with the within sample
Granger causality test, thus enhances the conclusions obtained from the former.
This study did support the role of insurance market and stock market (over the long term)
in promoting economic growth. But it is more likely that the commercial banks
responsive passively to economic development to the need of enterprises, as predicted by
Robinson (1952). This contrasts with the evidences obtained by Murinde and Eng (1994)
and also by Fase and Abma (2003) which support the supply leading role. The
differences could be attributed to the use of disaggregated financial data since our
methodology is quite similar. This highlights the value of using suitable disaggregated
data in the study of financial development and economic growth as suggested by Pagano
(1993).
Another obvious outcome from the research is that the results are very much dependent
on the indicator used. If only one type of growth or financial indicator is used in the
study, the conclusion could be totally different. This also highlights the danger of
deriving conclusions based on very few indicators in multi-countries study. As different
countries have different institutional characteristics and policies, the pathway which
finance and growth affecting each other could be different. One should analyze the
institutional characteristics of each country and select the appropriate financial indicators
in a multi-countries study.

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