Financial depth versus more comprehensive metrics of financial development in tests of the finance-growth nexus

Abstract

First, the paper gives a critical appraisal of recently proposed quality adjustments of the ratio of private credit to the gross domestic product (GDP) as a proxy for finance in empirical tests of the finance-growth nexus and cautions against such heuristic measures. Second, in response to the unidimensional feature of conventionally applied proxies for finance, the paper constructs a variable for financial development (FD metric) that measures the relative distance of a financial system from its best attainable performance in terms of depth, access, efficiency, and stability. The measurement is grounded in the principles of data envelopment analysis for ratio data and is built on structural indicators available in the Global Financial Development Database by the World Bank. Using annual data for 157 countries over the period 1993–2020, the paper then explores the finance-growth nexus using several financial metrics in panel-data regression models and considering nonlinearity in both a parametric and semiparametric manner. Economic growth is found to react negatively to finance, whereas this detrimental effect strengthens beyond a certain level of financial depth. In contrast, the access, efficiency, and stability of the financial sector are less important for growth. Hence, the findings lend weight to an economic policy focused primarily on a minimal size of the financial sector that permits its smooth operations, without the need to ensure that the financial sector performs qualitatively at its best.