Financial development and economic growth: Evidence from India

Abstract

The link between financial development and economic growth has been a widely discussed and much debated topic in extant literature. In one of the earliest studies, Schumpeter (1912) posits that financial intermediation, by deciding which firms will be using societies’ savings, financial intermediaries influence the course of economic development. Many subsequent studies establish a positive relationship between financial development and growth (Beck, Levine, & Loayza, 2000; Carlin & Mayer, 2003; King & Levine, 1993; Ross Levine, Loayza, & Beck, 2000). However, these studies analyse evidence from cross-country data. Results of such studies contain potential biases induced by measurement errors, simultaneity, omitted variables, and unobserved country-specific effects and therefore are not able to resolve the issue of causality (Beck, 2008; Levine et al., 2000). Use of cross country data underlies problem of omitted variable because across different countries, considerable heterogeneity exists in factors like capital flows, trade flows, labour movement, legal code and enforcement machinery etc. In this study, I analyse the finance-growth relationship using regions within a country- India. Factors like legal codes, labour mobility, and capital flows are likely to be much more homogeneous within a country as compared to between countries. Furthermore, any country-specific effects are also, by design, controlled for in a subnational study. Thus, such a construct, by providing an automatic control environment, overcomes many of the potential biases that plague the findings of existing cross-country studies (Beck, 2008). This study examines financial development and economic growth at the regional level (district) for India for the period 2001 to 2008, thus contributing the literature by providing evidence from a large developing country.