The objective of this chapter is to provide a theoretical and empirical literature review on financial development, human capital and economic growth. Therefore, it is important to determine what financial development relates to, how the financial sector and overall economy are related to each other, and the implications of such a relationship for other sectors of the economy. In the following of this chapter, the study will first review the theory of financial development, whereby explaining the framework of financial system. The next part will focus on the growth-finance. Further, effects of human capital and financial development on the economic growth will be discussed. The next section will review the existing empirical studies between financial development, human capital and economic growth.
2.2 THEORETICAL BACKGROUND
2.2.1 Financial Market
(i) Financial System
A financial system is "a network of markets and institutions that bring savers and borrowers together" (Hubbard, 1997). Financial systems have become the keystone of most economies around the world. This field is of great interest to economists, who research mainly the causes and impacts of its development. Through years, economists have revolutionized their perceptive about the nature of relationship that exist between financial system and economic growth. Bagehot (1873) established the pioneering theory on the link relating financial system and economic growth. He found that financial markets facilitate the accumulation of capital and these markets manage the risk from relative investments and business strategies. [1]
(ii) Functions of Financial System
Levine (1997, 1999), has first depicted this link clearly. Levine demonstrated five main functions of the financial markets that affect the economic growth. More specifically, Levine pointed out that financial system:
Facilitate risk management, hedging, diversifying
Monitor managers and apply corporate control,
Allocate resources,
Mobililize savings, and
Facilitate trading of goods and services.
The schema below highlights the idea of Levine (1999).
Financial markets
& Intermediaries
Reduce
• Information cost
•Transaction cost
Through:
•Facilitating risk management
•Corporate control
•Allocation of resources and provide information
•Mobilization of savings
•Facilitating trade
Through:
• Capital Accumulation
• Technological innovations
Economic Growth
Unlike other economists, Levine (1999) produced a comprehensive way of showing the significant role for financial markets. The impact on economic growth occurs through the following channels according to Levine.
Economists have held the views that the development of the financial sector is crucial for stimulating economic growth. Financial development can be defined as the ability of a financial sector acquire effectively information, enforce contracts, facilitate transactions and create new incentives for the different types of financial obligations, markets and intermediaries, and all should be at a low cost. [2] Financial development increases the accessibility to financial instruments and institutions which decreases transaction cost and thus channeling funds to efficient investors who are able to invest in both physical and labour intensive capital thereby fostering growth. The financial functions or services may influence saving and investment decisions of an economy through capital accumulation and technological innovation and hence economic growth, Levine (1999). Capital accumulation can either be modeled through capital externalities or capital goods produced using constant returns to scale but without the use of any reproducible factors to generate steady-state per capita growth. [3] Through capital accumulation, the financial system affects the steady growth rate by controlling the rate of capital formation. Indeed, the financial system affects capital accumulation either by changing the savings rates or by reallocating savings among different capital levels. Through technological innovation, the focus is to look for new horizons for the production of processes and goods. [4] As market frictions and laws, regulations and policies differs to a greater extent across economies and over time, the impact of financial development on the economy may have various impacts for resource allocation and welfare in the economy.
2.2.2 Relationship between Financial Development and Economic Growth
(i) Finance Led Growth Theories
In the traditional development economics, there exist two distinct views of the finance-growth nexus. Back in 1911 Joseph Schumpeter argued that financial development induces economic growth. He discussed that through the services that financial intermediaries offer are essential drivers of innovation and growth. Financial intermediaries enable this technological innovation (King, Levine, 1993). Hicks (1969) also noticed that financial institutions facilitate growth, though he focused on capital formation. According to Hicks the industrial revolution in England was mainly caused by the capital market improvements that moderated liquidity risk (Levine, 1997).
The above general view was also shared by scholars like Goldsmith (1969), McKinnon (1973) and Shaw (1973), who also opted for the practical function of financial services. Goldsmith (1969) assumed that the size of a financial system is linked with the supply and quality of financial intermediation and his analysis on 35 sample countries proved a positive correlation between the financial development and economic growth. MacKinnon (1973) and Shaw (1973) suggested that state involvement in the development of financial systems can be an obstacle for economic growth. This view was further seconded by King and Levine (1993); Pagano (1993); Fry (1995); Zervos and Levine (1996, 1999); Christopoulos (2004); Manoj and Kamat (2007); Hasan, Watchel and Zhou (2008) and Seetanah (2009) where all believed that financial development is a catalyst for economic growth.
(ii) Growth Led Finance Theories
The alternative view suggests that economic growth is the major driving force behind the development of the financial sector. This idea is very much stressed in the work of Robinson (1952). According to him, as an economy grows, more financial institutions, financial products and services emerge in markets in response to a higher demand for financial services. Further, the Patrick's hypothesis (1966) was introduced with the supply leading and demand following, which is important to determine the finance-growth nexus. The demand following view explains the demand for financial services is dependent upon growth and modernization of main sectors. Thus, modern financial institutions, financial assets and liabilities are encouraged in response to the demand of these services by investors in the real economy. Therefore, the more rapid growth of real national income, the greater will be the demand by enterprises for external funds (the savings of others) and therefore financial intermediation. Also, with a given aggregate growth rate, the greater the variance in the growth rates among different sectors or industries, the greater will be the need for financial intermediation to transfer saving from slow-growing industries to fast-growing industries. In this case, an expansion of the financial system is induced because of real economic growth. The next arm of the theory is the supply leading view by. The supply- leading hypothesis has two functions. To transfer resources from the traditional low-growth sector to the modern high-growth sector is first, and secondly, to promote a feasible response among investors in these modern sectors. Thus, financial services from the system stimulate the demand for these services in modern and developing sectors.
(iii) Causal relationship between finance and growth
The development of new theories of endogenous economic growth has given a new scope for financial intermediation in influencing economic performance (Liu, Shu, 2002). Thus, financial markets can have a strong impact on real economic activity. Certainly, Hermes (1994) argues that financial liberalization theory and the new growth theories assume that financial developments lead to economic growth. However, Murinde and Eng (1994), Luintel and Khan (1999) argue that a member of endogenous growth models show the causal relation between financial development and economic growth.
2.2.3 Financial Development, Human Capital and Economic Growth
(i) Human Capital
According to Schultz (1993), human capital includes the key element of improving a firm assets and employees so as to increase productivity and to sustain competitive advantage. Human capital involves the processes that relate to training, education and other professional projects in order to increase the level of knowledge, skills, abilities, values and social assets of an employee which will impact on the firm value and on the economy as a whole. Rastogi (2000) stated that human capital is an important input for organizations especially for the continuous improvement of workers mainly on knowledge, skills, and abilities. Thus, the Organization for Economic Co-Operation and Development (2001) defined human capital as "the knowledge, skills, competencies and attributes that an individual needs to possess for further facilitation of creation of personal, social and economic well being."
(ii) Relationship of human capital, financial development on economic growth
Economists like De Gregorio (1992); Pagano (1993); De Gregorio (1996); Outrivelle (1999); Evans, Green & Murinde (2002) and Papagni (2006), have tried to explain the relationship between financial development and human capital. All of them except Outrivelle (1999) and Evan et al. (2002) analyzed the liquidity constraints on human capital accumulation by arguing that borrowing constraints increase aggregate savings leading to reduction of human capital accumulation and thus negative effects on the economic growth. De Gregorio (1992) argued that if households borrow to finance accumulation of human capital, the effect of this liquidity constraint on growth is uncertain but the human capital accumulation will raise the saving rate in the long-run but lowering the productivity of investment in the short-run. Thus, a low level of human capital reduces overall savings in the economy and increases domestic credit to private sectors that caters for proper education system. Papagni (2006) further argued that if liquidity constraints of the youths are reduced by their parents' assertion of loan repayment with their income, then human capital can be enhanced and so is the growth. Parents invest in their children's education with a positive net return to both the children and the children are expected whereby parents choose collateral which depends positively on their family income and negatively on the family size.
Evans et al. (2002) suggest that there exists a positive relationship between money and human capital and provide evidence for the complementarity between financial development and human capital. Hence, concluding that a developed financial system is an essential complement to human resources or manpower development in the growth process. However, Ukenna, Ijeoma, Anionwu & Olise (2010) opines that training and skills are better predictors of human capital that have a direct impact on growth. To achieve positive returns, industries will have to train and retrain their staff so as to acquire the needed skills that are essential for high performance stimulating economic growth.
2.3 EMPIRICAL BACKGROUND
Having reviewed the significant theories underlying the effect of financial development and human capital on economic growth, it is important to review some main researches that have been done in the field. This is to determine whether the theory reflects the reality whereby determining the effect of financial development and human capital on economic growth as suggested in theories in both developed and developing countries.
Therefore, the empirical analysis will be in two main parts, namely, the reviewing the research about the finance-growth nexus and secondly the relationship between human capital and economic growth. The first part will be subdivided according to different level of industrialization and developed an economy is, showing whether economies follow a supply-leading relationship between financial development and growth or a demand-leading relationship. The second part will further review how the human capital has affect economies and the causality effect of both financial development and human capital on economies. Finally, there will be a section concluding with a few remarks.
2.3.1 Finance-Growth Nexus
The results found in past literature between the link of financial development and economic growth can be summarised as follows:
Relationship between financial development and growth
Finance Led Growth
This is known as the supply leading hypothesis as resources from financial sectors are needed to boost the economy from a low growth sectors to productive sectors. The literature that supports this relationship include King and Levine (1993, 1999, 2000); Pagano (1993); Fry (1995); Zervos and Levine (1996, 1999); Rioja and Valev (2003); Christopoulos (2004); Hasan, Watchel and Zhou (2008) among others.
Growth Led Finance
This relationship is called the demand leading hypothesis whereby individuals and firms from the real economy demand for modern financial services surging from the development of financial sector. Hurlin and Venet (2004) and Vazakidis and Adamopoulos (2009) are among the researchers that believe that financial development follows growth.
Causality Between Financial Development And Economic Growth
Here, some researchers found that the relationship is reciprocal, that is, economic growth develops financial system and an efficient financial system spur the growth. Murinde and Eng (1994); Luintel and Khan (1999); Calederon and Liu (2002); Abu-Bader and Abu-Qarn (2008) had supported this idea through their experiments.
No Relationship between financial development and growth
The development of a financial system does not always have an impact on growth. Some studies found no relationship at all. Such studies are Von Furstenburg (2004); Aziakpono (2005a; 2005b); Mohapi and Motelle (2006) and Gries (2009). This happens because effects of financial development and growth are caused by external factors.
2.3.1. A Studies of developed countries
Researches based on the finance-growth nexus in developed countries find a positive significant relationship. Table 1 below presents a review of relevant studies showing this relationship.
Insert TABLE 1
Table 1 provides a summary of some empirical studies that have been conducted regarding relationship between growth and financial development. Studies involving only developed economies are explained as follows. Vazakidis and Adamopoulos (2009) and Ghirmay (2006) used time series to analyse the link between financial development and growth on developed economies where they found that a supply-leading hypothesis is favored but for Greece, Vazakidis et al. found that the relationship runs from economic growth to financial development, through an industrial production based. Kemal et al. (2004) through panel causality found direct finance is significantly and positively related to developed economies' growth but the results were not conclusive across countries. Also, Rousseau and Watchel (1998) conducted his studies by a vector autoregressive model only in developed countries whereby he found a one-way causality that is finance causes growth. Moreover, Levine (1998) showed that countries with a good legal system protecting creditors favour a robust and positive impact on the economic growth. Rajan and Zingales (1998) found that industries that depend mainly on external source of finance grow faster in economies with higher financial and industrialized level However, Neusser and Kugler (1996), studying 13 OECD countries found that in most developed countries economic growth promotes financial development except in USA, Japan and Germany where the reverse causality was found.
To further continue, studies involving both developed and developing economies as shown from the empirical evidence in Table 1 indicate how financial development and economic growth are related and how financial intermediaries foster growth. Studies using cross-sectional regression model, like King and Levine (1993 c) and De Gregorio and Guidotti (1995) found that all the indicators of financial development were significantly and positively related to the economic growth in developed and developing countries. Levine et al. (2000) using the generalized methods of moment support their findings. Also, Rioja and Valev (2004) modeled their work through generalised method of moments GMM on 74 countries and they found that financial development significantly affects growth in middle and high economies whereas in low economies, finance may have a negative effect on growth. Calderon and Lui (2003) used a sample of both developed and developing countries in order to investigate the finance-growth link by using Geweke decomposition test. They found that financial development has a greater effect on less developed countries than in more developed ones.
Further studies using both developed and developing countries as their sample, such as Jung (1986), Xu (2000), and Apergis et al. (2007) show that the supply-leading hypothesis is supported in low-income economies while the demand-leading hypothesis is supported in high/middle-income economies. These authors found that finance caused economic growth more frequently in developing countries than in developed ones and in developed countries, growth caused financial development more often. In following the similar line, Deidda and Fattouh (2002) and Ram (1999), using a sample of both developed and developing countries concluded a positive relationship between finance and growth only in high-income countries, with a causal effect from growth to finance.
2.3.1. B Studies of developing countries
Table 2 below summarises several relevant studies showing the relationship that exists between finance and growth in developing countries.
Insert TABLE 2
Ndikumana and Allen (2000) modeled their work through pooled cross-sectional regression on 12 Sub-Saharan African countries. They concluded that there exists only a positive relationship between financial development and growth when the ratio of liquid liability to GDP is used. Trabelsi (2002) conducted his study on 69 developing counties using both cross-sectional and pooled cross-section time-series regressions. They found that the development of financial sector only seems to affect growth with cross-sectional regression while panel data analyses do not provide any empirical support for the growth-finance relationship. Benhabib and Spiegel (2000) used GMM on four emerging countries and found that financial development has a positive influence on a total factor productivity growth and rate of factor accumulation. Additionally, Jeanneney Hua and Liang (2006) examined the relationship between financial development and productivity growth in China through GMM for panel data analysis. The results obtained coincided with the theories showing that financial development significantly contributes to China's productivity growth through efficiency. Ndikumana (2005) further confirms that financial development facilitates domestic investment to the extent that it is accompanied by an increase in the supply of funds to investors.
Various studies from empirical Table 2 such as Odedokun (1996) KhalifaGhali (1999), Agbetsiafa (2003), Ghirmay (2004), Christopoulos and Tsianos (2004) and Habibullah and Eng (2006) conducted their studies only on developing countries. They found that in almost all the developing countries, financial development contributes to economic growth significantly. In the same line, Nasri and Mouawiya (2005) investigated the linkage between financial development and economic growth both in short and long run through panel co-integration on Middle East countries. The authors found that in long-term, financial development is related to some extent and in short-term, the panel causality tests indicate that real growth causes changes in financial development. On the other hand, Khan and Qayyum (2006) applied a bound testing approach to co-integration within the framework of Autoregressive Distributed Lag (ARDL) to investigate the joint impact of trade liberalization and FD on growth in Pakistan and the results show that there is a relationship between real GDP, trade liberalization, financial development and the real interest rate in the long run.
Using further the abovementioned methodologies, studies in Table 2 above provide mixed results. Some studies conducted in developing countries support some evidence of a supply-leading pattern, while others only support a demand-following pattern. Demetriades and Hussein
(1996), Habibullah (1999), Odhiambo (2007) and Boulila and Trabelsi (2004) conducted their studies only on developing countries and supported little evidence that finance causes growth whereby most of the time, they found strong and significant evidence that growth causes finance. Other studies, such as Waqabaca (2004), revealed that there is a significant relationship between financial development and growth with causality running from growth to finance. Also, Yousif (2002) showed that some developing countries follow the supply-leading and some follow demand-following pattern but concluded that they are not as significant as the bidirectional one. Luintel and Khan (1999) conducted their study on 10 developing countries whereby they only found bi-directional causality for all the countries in their sample.
Moreover, Demetriades and Luintel (1996) focused on India and they found a two-way causal relationship between financial development and economic growth. Using the same data and model in Tanzania, Odhiambo (2005) suggested that the causal relationship between financial development and economic growth depends on what indicator is being used. When the ratio of broad money to GDP is used, financial development leads to growth and when the two other indicators of financial development, that is, ratio of currency to GDP and ratio of banks claims on private sector to GDP, are used, bidirectional causality prevails. More recently, Zang and Kim (2007) examined the real causality between financial development and economic growth in developing countries and they found no statistically significant and positive evidence of the causal relationship between financial development and economic growth.
Human Capital & Economic Growth
The last two decades have witnessed ample empirical studies that try to quantitatively investigate the relation of human capital as education on economic growth. The general result of those various studies shows that there exists a positive correlation between economic growth and human capital Indeed, since investment in human capital is taking place through training and education, there is a strong rationale in favor of government intervention. More specifically, government policies intended to affect publicly-provided education and training will determine the process of growth of the whole economy as stated in Lucas (1988), Shaw (1992), Romer (1994), Barro and Sala-i-Martin (1995), Aghion and Howitt (1998), Kaganovich and Zilcha (1999) and Capolupo (2000), controlling the endogenous growth model accordingly. Barro (1991) found that output growth was significantly positively determined by both primary and secondary school enrolment which were the proxy of human capital, in the presence of other determinants. Graff (1995) examined the role of human capital on economic and he concluded that the accumulation of human capital, physical capital and technological progress all to be significant determinants of the growth process.
Additionally, several empirical works have indentified many non-financial factors on financial development. Certain of these factors include technology (Merton, 1992), fiscal policies (Bencivenga and Smith, 1991), legal system (La Porta et al., 1996), institutional qualities (Demetiades, 2005), political economy (Rajan and Zingales, 2003) among others. However, from various analyses performed such as De Gregorio (1992); Pagano (1993); De Gregorio (1996); Outrivelle (1999); Evans et al. (2002) and Papagni (2006), the causal relationship between human capital and financial development has not been supported sufficiently. Nevertheless, in Hakeem and Oluitan (2012), this causal relationship has been studied over South Africa, where a strong relationship between financial development and secondary school enrolment rates which was a proxy used for human capital has been identified, yet this study is not conclusive.
2.4 Conclusion
This chapter reviewed both theoretical and empirical literature mainly on the relationship between financial development and economic growth and to some extent the causal relationship between human capital and economic growth. The first section discussed the theoretical relationship while the second section reviewed the empirical literature according to different level of economies. The empirical review shows the impact of sample size, choice of countries, methodology and variables of the results. It also supported different explanations given in the literature. Therefore, one can conclude that those studies using cross-sectional regressions have fond that financial development positively affects economic growth through productivity of capital and accumulation of saving. However, such studies failed in explaining the real direction of causality between financial development and economic growth. Studies that used time series techniques have mostly focused on studying the causality between financial development and economic growth and they are more recent than studies using cross-sectional regression. In general, the view that in developing countries, finance causes growth in the earlier stages of economic development and in developed countries, growth causes financial development. It has also found that significant number of studies detected a two-way causal relationship. Regarding, the relationship of human capital on economic growth, there exists a positive correlation between these two variables. The authors had manipulated the endogenous growth model equation several times in order to explain the underlying relationship between economic growth and human capital. Also, meager analyses have concluded a causal relationship between financial development and human capital.
It is obvious that the causal relationship between financial development, human capital and economic growth depend on three main elements, namely, indicators of financial development used, the level of development of the financial sector and the indicators used for explaining human capital. Therefore, individual countries have to be studied and general conclusions have to be treated cautiously. The next chapter will further seek to identify certain differences in terms of the two studied countries namely Cameroon and South Africa, which will builds on the background and development of the countries.
