Impact of Financial……… Abasyn Journal of Social Sciences Vol. 6 No.

Impact of Financial Development on Economic Growth of

Pakistan

Azhar Mahmood1

Abstract
This research paper demonstrates the association between economic
growth and financial development in Pakistan for time period 1979 up
to 2008.The procedure of basic elements are used to develop FSDI
(financial sector development index) that is utilized to proxy sector
Development. With the help of method known as auto regression
distributed lag (ARDL), this research paper indicates co integrating
association between real deposit rate, real interest rates, financial
investment and development. According to the research findings,
economic growth is positively related to real deposit rate in long run
perspective but its impact is insignificant. Short run as well as long run
real interest rates responses are very low in comparison to variable of
financial development, giving implications that funds delivery is vital as
compared to its cost.

Keywords: Financial Development, Economic Development, Growth

1
MS Scholar, Institute of Management Sciences, Peshawar

Prolonged economic growth that is sustainable relies on

ability to accelerate the accumulation rates of human as well as
physical capital; to utilize the concluding efficient assets more
productively and to enable the approach of entire population to these
assets. Investment process is supported by financial intermediation
by mobilization of foreign and household savings for firm
investment, confirming that these funds are distributed to most
efficient use and delivering liquidity and risk spreading so that new
capacity is operated by forms more efficiently. Financial
development consists of institutions expansion and establishment,
markets and instruments that provide support to this process of
growth and investment. Historically the function of financial
intermediaries (both non-bank and bank) that ranges from stock
markets to pension funds, usually transform savings of household
into monitor investment, enterprise investment and distribute funds
and to spread and price risk.

Financial development begins with system of banking and

relies upon scriptural income diffusion, which is provided by
banking system. The proportion of system of banking falls down
within financial sector assets while in the case of institutions that are
Mahmood 106
Impact of Financial……… Abasyn Journal of Social Sciences Vol. 6 No. 2

more specialized and innovatively new such as insurance

companies, building societies, banking system financial assets,
retirement funds hold inferior value as compared to financial assets
that other financial institutions hold on, where as in categories of
under developed countries, economically revenue is regarded true.
For many centuries, discussion is going on the function of financial
sector in financial development and economic growth. Two
fundamental schools of thought are there in this regard. Limited part
is played in performing the real activity development by financial
development according to first school of thought. According to this
school of thought, financial system flourishes only if economy
develops. According to second school of thought, financial
development plays significant role in facilitating innovation, growth
process and economic development.

Shaw (1973), Goldsmith (1969) and McKinnon (1973) were

the pioneer’s researchers to show significant contribution in terms
of association between economic growth and financial development
that was main topic of discussion within emerging economies.
According to theoretical argument that associates economic growth
to financial development is that well established financial system
performs many important functions to promote the intermediation
productivity by eliminating transaction, information and monitoring
costs. Investment is promoted by updated financial system by
funding and identifying opportunities of good business,
mobilization of savings, evaluates managers performance, promotes
hedging, trading and risk diversification that enables the exchange
of services and goods. This function performs productive
distribution of resources, quick collection of human and physical
capital and efficient progress of technology that promotes economic
growth. Significant contributions have been made by Pakistan in
past few decades to reshape its financial system.

As financial sectors are kept in view as an important

component of macroeconomic policy, they produce important
economic advantages, mainly through productive domestic savings
mobilization as well as productive distribution of resources. From
1947 up to 1980’s, Pakistan government was keenly interested in
developing significant infrastructure to provide support to various
policies of macroeconomics. Financial sector of Pakistan was tightly
kept under control. In real terms, interest rates were assigned

Mahmood 107
Impact of Financial……… Abasyn Journal of Social Sciences Vol. 6 No. 2

negative sign and were administratively set. By means of direct

credit allocation, conduction of monetary policy took place. Money
market was not fully developed while equity and bond markets were
nonexistent from virtual point of view. Commercial banks mostly
used to lend minor concern to priority sectors for borrowing
profitability of firm. Despite of the fact that financial sector of non-
bank was established for investment of private ownership in mid-
1980’s, financial institutions of public sector held huge quantity of
deposits, assets, advances as well as financial sector investments at
the closing period of 1980’s.

Literature Review

Financial development and growth of economy enjoys a very

debatable association. Most of the authors have highlighted finance
an vital component of growth including king and Levine (1993),
Lucas (1988), McKinnon (1973) and Shaw (1973) where as other
authors considers it a small factor of growth (Lucas, 1988).The
banking sector was observed as an engine of economic growth via
its funding of efficient investment (Schumpeter, 1934).While on the
other hand side, Lucas (1968) gave the argument that the finance
role has been overstressed.

Financial intermediaries can accelerate capital distribution,

efficiency as well as growth by making improvement and efficient
changes inside corporate government. King and Levine (1993)
utilize monetary indicators and valuation of size and relative
significance of banking sector and also traced out positive and
important correlation between many other indicators belonging to
financial development and GDP per capita growth. More accurately,
they tracked a positive and important correlation between liquidity
of stock markets and economic growth, but didn’t trace out booming
association between dimension of economic market and economic
growth.

Fink, Haiss, & Mantler (2005) utilize sample consisting of

33 countries (where transition economies makes up 11 percent while
market economies makes up 22 percent of the sample population)
concluded that if we talk about positive growth impact of financial
development, we will take it for short term but not for prolonged
term. Fink, Haiss, & Vuksic, (2009) took nine EU-accession
countries and researched the effect of credit, bonded stock segments
Mahmood 108
Impact of Financial……… Abasyn Journal of Social Sciences Vol. 6 No. 2

for a time period of 1996-2000 and brought it in comparison with

mature market economies and to countries that exists at intermediate
phase. They concluded that transmission mechanisms are different
from each other’s and financial market segments with its association
with public segment (but not in comparison to stock market) applies
to sustainability and growth factor within transition economies.
Winkler (2009) explained the overall mechanism of quick financial
development and related dangers as well as vulnerability in regards
to southeastern European countries. He practically provided
evidence that the plan of acquiring financial deepening with help of
financial banks entry does not assures that financial position will be
stable. A strong debate has come in the last decade that well
performing financial intermediaries have an important effect on
growth of economy.

Research Methodology

ARDL is a type of model, where we employ equation of

regression to estimate the dependent variables current a value that
imposes upon explanatory variables current values as well as its past
period (lagged) values. In this technique, problems of endogeneity
are going to be addressed. Modeling of appropriate lags with ARDL
will correct for both endogeneity problems and serial correlation. If
estimated model of ARDL is free of serial correlation, there are less
chances of endogeneity problem. Almost all variables are supposed
to be endogenous and we simultaneously estimate long and short run
model parameters. As we know that casual association between
economic growth and financial development. As we do not ascertain
the casual association between economic growth and financial
development, so we give relevance to the matter of endogeneity.
According to the literature, there lies bidirectional association
between economic growth and financial development. The proxy
used for development of financial sector is endogenous variable that
is used in equation no 1, showing the justification of why we utilize
bounds methods. In comparison to co integration tests, ARDL
approach has excellent minor properties of sample. In order to
examine the underlying association, ARDL approach is very
suitable and its usage in empirical research studies is accelerating in
present

Timings. ARDL method is represented by following equation:

Mahmood 109
Impact of Financial……… Abasyn Journal of Social Sciences Vol. 6 No. 2

∆LRGDPt=β0+∑pi=1βli∆LRGDPt-1+∑pi=1β2i∆LINVGt-
1+∑ i=1+β3i∆LFSDIt-1+∑ i=1β4i∆RIRt-1+ᵟ1LRGDPt-1+ᵟ2LINVGt-
p p

1+ᵟ3LFSDIt-1+ᵟ4RIRt-1+ᵞ1WAR+ᵞ2FSLD+µt

In the above equation stands for lag length, ∆ stands for

difference operator, and it is assumed that µt is uncorrelated serially.
The following steps are involved in this approach. No co integration
association null hypothesis which is described as
H0=δ1=δ2=δ3=δ4=0 in the first step is analysis in regards to
alternative hypothesis of the existence of co integrating association.
It is expressed mathematically as h1≠δ1≠δ2≠δ3≠δ4≠0.Wald
statistics or F test is kept as a basis for the co integration test.
Distribution of F test is nonstandard. For test of co integration, two
sets of values having critical nature was provided by Pescara and
Pescara (1997).According to the assumption of critical value having
lower value, all most every variable is assigned I (0) which means
that variables are having no co integration and according to the
upper bound assumption, all variables are assigned I (1).the upper
critical bound is lesser than F statistics. Null hypothesis will not be
accepted if upper critical value is lesser than F statistics that suggests
that variables are having co integration. But there will be no co
integration among variables if lower critical value of bound is
greater than computed statistics.

Model Specification

If we follow the standard literature, financial development is

proxies by the means of financial depth. There is positive
relationship among real interest rate, real income and financial depth
according to the prediction of literature review. Due to the existence
of complimentarily between capital and money, a positive
correlation resulted between the financial depth and the level of
Output (Mackinnon, 1973).There is an assumption, investment is
categorized as self-finance and lumpy and until and unless if the
adequate savings are not concentrated in the shape of bank deposits,
investment cannot be materialized. Investment is promoted by
financial an intermediary that in response accelerates the output
level. (Shaw, 1973).With the help of accelerated volume of
mobilization of financial savings, financial depth is accelerated by
positive real interest rate and growth is promoted with the help of
accelerating the volume of capital efficiency. Positive impact on

Mahmood 110
Impact of Financial……… Abasyn Journal of Social Sciences Vol. 6 No. 2

average efficiency of physical capital is exerted by high real interest

rate which discourages investors that they should not invest inside
projects having low returns. Correlation between financial depth and
growth is mathematically represented as follow:

LRGDPt=α0+α1LFSDIt+α2LINVGt+α3RIRt+α4WAR+α5FSLD+εt
In above equation FSDI stands for financial depth evaluation, RGDP
stands for real GDP, RIR stands for deposit rate (real), INVG stands
for ratio of GDP business investment, FSDI, real GDP and INVG
are presented in natural log, ɛt stands for error term, WAR stands
for dummy variable that is used to highlight financial sector reforms
that were introduced in late 1980’s by government of Pakistan while
FSDL stands for interactive term that is used for highlight
Liberalization effect of financial sector.

Data Description

We have discussed three indicators of financial development

in this research report namely ratio of private sector credit to GDP,
ratio of banking deposit liabilities to GDP and the ratio of private
sector credit in domestic credit.
1. The first proxy that we can use for financial development is the
ratio of banking deposit liabilities to GDP that we calculate by
subtraction of circulation currency from M2 and divide it by GDP
(nominal).
2. The ratio of domestic credit to the private sector to GDP
brings exclusion of public sector and shows more productive
allocation of resource in economy since private sector has ability to
efficiently and productively utilize funds in comparison to public
sector.
3. The next ratio, private sector credit to domestic credit
illustrates the credit share to private sector in total domestic credit
and also evaluates the limit up to which banking system provides
funds to private sector to promote growth and investment.

Result Analysis

Test Analysis of Unit Root

This method is essential to eliminate the hurdles of spurious

interpretation. ADF test abbreviation of augmented Dickey-fuller
test is applied. In order to estimate the optimal ratio of lags that are
Mahmood 111
Impact of Financial……… Abasyn Journal of Social Sciences Vol. 6 No. 2

mentioned within the test, AIC and SBC are used that are
abbreviations of akaike-information criterion and Schwartz-
Bayesian criterion respectively Interpretation gives suggestion that
almost every variable belongs to 1 integration. This finding
interpretation provides support to the utilization of ARDL method
to find out prolong association between different variables. The
presence of prolong association between explanatory variables with
its GDP gives suggestion of estimation of dynamic parameters of
short run and coefficients of long run. ARDL model estimation is
focused upon (AIC) 16 that is the abbreviation of Akaike
information criterion. The static prolong findings and diagnostic test
mathematical figures of estimated model that is focused upon
estimates of short run are mentioned in table no.4.

Table 1. Unit Root Test

Variables lag ADL test With trend ADL test No trend
LRGDP 1 -1.4902 -4.0077 -0.52159 -4.5257
LFSDI 1 -1.6044 -4.2133 -0.51143 -4.9018
LINVG 1 -1.6566 -5.1899 -1.3886 -5.2099
RIR 0 -3.9921 - -4.3116 -

Co integration Result Analysis

We are going to utilize a lag length having an order of 2

within bound test according to the annual data use and a minor size
of sample (38).In terms of annual data, shin and Pescara (2007) have
given suggestion to use 2 lags maximum. Table 2 illustrates the
bound test interpretations.

Table 2. Result Analysis of Bound Test

Test value lag Bound Restricted
statistics critical intercept
values
F statistics 4.4378 2 - I (0) I (1)
F statistics - - 1% 4.321 5.900
F statistics - - 5% 3.115 4.907
F statistics - - 10% 2.512 3.991

For model, 4.4374 is the value of F statistic that is

accelerated than the value of upper critical bound (4.095) at
significance level of 5.this finding gives suggestion that there is
prolong association among financial development index (FDI), the
ratio of GDP investment, real GDP and deposit rate (real).when we

Mahmood 112
Impact of Financial……… Abasyn Journal of Social Sciences Vol. 6 No. 2

choose FDI as independent variable, there is no proof of presence of

co integrating association because the value of calculated F statistics
(1.4415) is lower than the value of lower critical bound (3.117).

Result of Long Run Statistics

The presence of prolong association between explanatory

variables with its GDP gives suggestion of estimation of dynamic
parameters of short run and coefficients of long run. ARDL model
estimation is focused upon (AIC) 16 that is the abbreviation of
Akaike information criterion. The static prolong findings and
diagnostic test mathematical figures of estimated model that is
focused upon estimates of short run are mentioned in table no.4.

Table 3. Long run estimates based on AIC-ARDL (1, 0, 0, 0, and 3)

Variable Coefficient Standard error T ratio
LFSDI 0.46398 0.082507 5.6237
LINVG 0.25567 0.12855 1.9891
RIR 0.0030792 0.0010466 2.9422
FSLD -0.0085178 0.0086906 -0.98012
INPT 0.22147 0.22147 38.8038
Note. Dependent variable is LFSDI

Dynamics of Short Run

The interpretations of dynamics of short run that was

interlinked with ARDL (1, 0, 0, 1, 2) are illustrated within table 5.we
have assigned negative value to the coefficient of lagged of error
term (-0.73798) and it is significant statistically at level of 1 percent.
The significant negative coefficient is the symbol of co integrating
association among financial development, real GDP, deposit rate
(real) and investment.

Table 4. Results of Short Run Dynamics

Variable Coefficient Standard error T ratio
DlFSDI 0.34242 0.092601 3.6978
DLINVG 0.18868 0.11091 1.7013
DRIR 0.0022723 0.0007488 3.0351
DFSLD -0.026605 0.011562 -2.3014

Stability and Diagnostic Test Analysis

ARDL model which is estimated shows findings of its

diagnostic tests that models has cleared serial correlation tests,
Mahmood 113
Impact of Financial……… Abasyn Journal of Social Sciences Vol. 6 No. 2

misspecification of functional form and errors that are non-normal

but hurdle of heteroscedasticity is present there. As we knows that
time series of ARDL equation that is estimated shows mixed
integration order I.e. I (1) and I (0), to track out heteroscedasticity is
a natural phenomenon. There is plot of stability tests of CUSUM
and CUSUMSQ within figure 3 shows estimated model coefficients
and illustrates that they are stable during period of study because
they lies within critical bounds range.

Construction of FDI

PCA is a component of principle analysis that is utilized to

develop FDI index with help of financial development three proxies.
This eliminates potentially accelerated association between various
evaluations of development of finance sector.

Table 5. Financial Sector Development Index (FSDI)

Year FDSI
1970 22.4
1975 15.07
1985 5.46
1989 9.76
1993 11.9
1994 3.58
1995 3.38
1996 3.36
2006 16.3
2007 19.6
2008 18.9

Figure 1. Financial Development Sector Index

Mahmood 114
Impact of Financial……… Abasyn Journal of Social Sciences Vol. 6 No. 2

Figure 2. CUSUMSQ Plots for test of stability

Figure 3. CUSUMS Plots for test of stability

Conclusion and Recommendations

This research paper has figured out association between

economic growth and financial development in Pakistan over time
period from 1979 up to 2008.For the estimation of prolong
association and short run model’s dynamic parameters, we adopted
bounds testing approach to co integration The test gives suggestion
that a unique co integrating association is present between financial
development, real GDP, real deposit rate and investment. From long
run and short run point of view, investment ratio to GDP, financial
development index and deposit rate (real) applied positive impacts
upon economic growth.

It confirms the presence of prolong association between

GDP as well as its determinants. The coefficient magnitude give
implications that disequilibrium 74 percent caused by stock of last
year’s converges back to equilibrium long run in the present year.
According to the suggestions given by plots of CUSUM and
CUSUMSQ test, there is presence of stable association between
financial development and economic growth.
Mahmood 115
Impact of Financial……… Abasyn Journal of Social Sciences Vol. 6 No. 2

According to the findings indications, a country can

stimulate its economic growth if it adopts both long run and short
run policies to enable financial sector development. Therefore
suggestions of policy for optimum economic growth will be
available for policy makers to enhance the financial institutions
establishment to accelerate delivery of credit to private sector
particularly in rural areas. Having limited approach to financial
services; create the legal atmosphere for transparent and productive
credit distribution to private sector with the help of reforms adoption
to strengthens rights of creditor and encourages commercial
agreements; to encourage the functioning and operation of
Pakistan’s stock exchange which is considered to be source of
medium and prolong finance for investment.

References
Fink, G., Haiss, P., & Mantler, H. C. (2005). The finance-growth-
nexus: Market economies vs. transition countries. Europa
Institue Working Paper No. 64.
Fink, G., Haiss, P., & Vuksic, G. (2009). Contribution of financial
market segments at different stages of development:
Transition, cohesion and mature economies
compared. Journal of Financial Stability, 5(4), 431-455.
King, R. G., & Levine, R. (1993). Finance and growth: Schumpeter
might be right. Quarterly Journal of Economics, 108, 717–
738.
Lucas, R. E. (1988). On the mechanics of economic development.
Journal of Monetary Economics, 22, 3–42.
McKinnon, R. I. (1973). Money and Capital in economic
development. Washington DC: Brookings Institution.
Schumpeter, J. A. (1934). The theory of economic development.
Cambridge, MA: Harvard University Press.
Shaw, E. S. (1973). Financial deepening in economic development.
New York: Oxford University Press.
Winkler, A. (2009). Southeastern Europe: Financial deepening,
foreign banks and Sudden Stops in Capital Flows. Focus on
European Economic Integration 1, 84-97.qccc

Mahmood 116