Finance-Growth Nexus in India : An Evidence from Co-Intergration & VECM

The paper attempts to test empirically the hypothesis of Finance-led growth in India. For this it traces the relationship between growth rate of GDP and the M3/GDP ratio, well researched indicator of Financial Deepening for the period of 39 years (i.e, 1971-2010) with the help of recently developed time-series techniques (i.e, Unit roots, Johansen's Co-integration test and VECM led causality). Unit roots were checked in the data with the help of ADF test and Phillips Perron Process. Two variables of interest i.e. GDP growth rate and M3/GDP are integrated at first difference level and significant at 5% level. Co-integration results obtained with the help of co-integration technique developed by Johansen and Juselius (1991) confirm one co-integrating vector which tells about long term equilibrium in the data. When normalized, 1% increase in the level of M3/GDP causes growth rate to rise by 0.54%. Then VECM is estimated. The coefficient of ECT which measures the speed of adjustment is found significant and sign is consistent and negative. The ECT is found to be (-0.6766) which implies 68% of the error is corrected within one year. The value of this parameter is high and indicates high speed of adjustment and sign is also consistent with the theory. The significance of ECT implies the presence of causal relations from independent variables to the dependent variable even in the case when the lagged independent variables are individually insignificant. Our results support the view that finance is a leading sector in the process of Economic development. We find considerable evidence of unidirectional (i.e. causality runs from finance to growth) in India. In other words, Indian financial system follows “Supply Leading Hypothesis.” The policy of increasing the level of Financial Deepening will serve as major determinant to the growth rate in India