Working Paper Series no. 719: Financial Deepening, Terms of Trade Shocks and Growth in Low-Income Countries

While financial development and its effects on economic growth have attracted considerable attention in the literature, far less work has been done on the relationship between financial deepening and macroeconomic volatility. Is the financial system a shock-absorber or a shock-amplifier? Is there something like too much finance?^[1] The 2008 financial crisis has brought back these questions to the front. Few studies have also examined the possible importance of the structure of the financial system, i.e. whether financial intermediation is performed through banks or markets, for macroeconomic volatility. Theory provides conflicting predictions. Empirically, the results have been equally mixed.

Yet, macroeconomic stability is a prerequisite for durable, sustainable and inclusive growth. Furthermore, it has been observed that faster growing economies on average do not necessarily grow faster than others in good times but manage to be more resilient and limit the extent of a downturn in bad times. Therefore, understanding what contributes to macroeconomic volatility and identifying options to improve global resilience of economies become critical.

On average, most of the explained growth volatility stems from external factors, which in turn are the result mainly of terms of trade volatility. This is particularly the case in countries where trade is concentrated on a narrow range of products, such as small states and resource-rich countries. Positive shocks increase domestic demand, which translates into higher economic growth as domestic supply reacts to higher domestic demand. In contrast, negative shocks lead to domestic demand contraction and ultimately lower economic growth. The channel of transmission can also arise through domestic production costs with a more direct impact on the supply side.

In this paper, we examine the impact of financial sector development on growth volatility, and look specifically at terms of trade shocks to see how the financial sector dampens or amplifies these shocks. We also try to assess the role of the structure of the financial system by examining to what extent both banking and stock market development play out in the transmission of external shocks.

Given the high vulnerability of low-income countries to terms of trade shocks, but yet their financial sectors remain shallow, we focus the analysis on this group of countries (38 in total) with data over the period 1978-2012. Should greater effort be paid in developing financial sectors in LICs to make them more resilient to external shocks and allow them to reap the benefits of greater globalization while containing its downside risks? This paper attempts to reach more conclusive results on the potential shock-absorber role of the financial sector.

The results from different econometric methodologies (fixed effect, system GMM, and local projections) provide support to the hypothesis that banking sector development acts as a shock-absorber in poor countries, including through dampening the transmission of terms of trade shocks to growth volatility. Nevertheless, by enlarging our sample to 121 developing countries, we find that this role fades away as economies grow richer. Stock market development, by contrast, appears neither to be a shock-absorber nor a shock-amplifier for most cases. Financial deepening achieved through the expansion of banks would thus be associated not only with the usual arguments of better access to finance, but also be more resilient in the face of external shocks, especially at early stages of economic development.