Financial development impact on domestic investment: does income level matter?

Abstract

Financial development significantly bolsters a country’s economic growth and resilience. Despite increasing focus on the relationship between financial development and economic growth, few studies examine the impact of financial development on domestic investment across countries’ income levels. Therefore, this study employs the system Generalized Method of Moments estimator and the Pooled Mean Group estimator to investigate this relationship, utilizing a panel of 152 countries from 1980 to 2021. The empirical findings affirm that financial development positively influences investment performance until a specific threshold over time. However, while increasing financial development benefits investment, further deepening the financial sector may eventually diminish its impact on domestic investment. Specifically, the benefit of investment growth remains valid only up to a threshold of 0.5147, beyond which it becomes a hindrance. In the short run, financial development changes do not substantially impact investment. Additionally, the marginal effect of financial development on investment is more pronounced in low- and middle-income countries. These empirical findings provide valuable reference for enhancing financial development to foster investment growth.

PUBLIC INTEREST STATEMENT

Investment is pivotal for sustaining long-term economic growth, fostering development, expanding market access, promoting innovation, and reducing transaction costs. This research aims to examine the impact of financial development on domestic investment across countries with varying income levels. Utilizing the system generalized method of moments (GMM) and the pooled mean group (PMG) estimator, the study analyzes a panel of 152 countries from 1980 to 2021. The findings reveal a positive influence of financial development on investment performance, particularly up to a certain threshold in the long run. Importantly, as countries’ income levels rise, the significance of financial development on investment performance becomes more pronounced in low- and middle-income countries. However, with the deepening of the financial sector, its effect on domestic investment may eventually diminish. These results underscore the importance of considering the optimal level of financial development to foster investment growth.

Keywords:

• Financial development
• financial institution
• domestic investment
• income level
• system GMM and PMG estimator

JEL CLASSIFICATION:

• E20
• G10
• G28
• O16

REVIEWING EDITOR:

• Abdul Majeed, Huanggang Normal University, China

SUBJECTS:

• Economics and development
• economics
• finance

Authors’ contributions

Yizhou He: Conceptualization; Formal analysis; Roles/Writing – original draft; Validation; Methodology; Tae Hwan Yoo: Supervision; Conceptualization, Visualization; Modelling; Writing - review and editing.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Data availability statement

The datasets generated and/or analyzed during the current study are available from the corresponding author upon reasonable request.

Geolocation information

South Korea

Notes

1 Furthermore, Levine (2005) states that the financial system promotes economic growth because it can provide information related to future investment in advance.

2 For instance, Mlachila et al. (2016) states that financial development has supported growth and reduced its volatility in many Sub-Saharan African countries whose financial development is below its benchmark. Also, Xu (2000) and Sinha and Shastri (2023) examine the effects of financial development on domestic investment for 41 countries and Indian economy, respectively.

3 Many previous studies suggest that the impact of financial development on economic growth becomes negative upon reaching a certain threshold, indicating an inverted U-shaped relationship. For further details, see Arcand et al. (2015), Sahay et al. (2015), Xu (2000), and Zhang and Zhou (2021).

4 Data on the Financial Development Index are available for the period (1980–2021) from the Financial Development Index Database by the International Monetary Fund. For more details on the construction of the index, see Svirydzenka (2016).

5 Appendix A lists all countries included in this study.

6 For instance, investment decision theory focuses on how organizations and individuals make investment decisions in various economic environments. For further details, see Aharoni (2015).

7 According to Pesaran et al. (1999), the PMG estimation method permits short-term parameters to differ within groups while requiring long-term coefficient equivalence.

8 The IPS test is beneficial for handling datasets that show different dynamics over time by controlling heterogeneity across different panel units (Im et al., 2003). According to Choi (2001), the Fisher-ADF test combines the p-values of individual ADF unit root tests to evaluate the null hypothesis that all series in the panel contain a unit root against the alternative that at least one series in the panel is stationary. Further, the non-parametric aspect of the PP test is one of its main advantages over the ADF test (Phillips & Perron, 1988). Instead of requiring the addition of lag difference terms, as is the case with the ADF test, it corrects for any serial correlation and heteroskedasticity in the test equation’s error terms.

9 This result is consistent with those of previous studies that have confirmed that an effectively operating financial system can greatly raise savings and investment rates, which will eventually result in economic growth (Afonso & Blanco-Arana, 2018; Asteriou & Spanos, 2019; Becsi & Wang, 1997; Guru & Yadav, 2019; Hassan et al., 2011; Law & Singh, 2014; Valickova et al., 2015). Moreover, Xu (2000), Arcand et al. (2015), Sahay et al. (2015), and Zhang and Zhou (2021) show that investment is an imperative channel through which financial development affects growth.

10 The threshold value for FD is determined by calculating the derivative of Column (3) in Table 4 with respect to FD and setting the derivative equal to zero (i.e. 1.3651-2*1.3261FD = 0). Solving this equation yields the threshold value for FD as 0.5147.

11 This result is consistent with prior findings that fast-growing financial sectors may be costly for the economy. For details, see Arcand et al. (2015) and Sahay et al. (2015).

Additional information

Notes on contributors

Yizhou He

Yizhou He is currently a research associate at Zhejiang Normal University’s Institute of African Studies and also holds a position at the New Key Professional Think Tank in Zhejiang, China. Her research spans economic development, regional cooperation, Sino-African relations, and international cyberspace governance.