Linkages between Real & Financial Sector : Empirical Evidence from India Using ARDL Approach

Real economic growth of a nation is supported by its financial sector. This paper examines the relationship between real and financial sectors of India, an advanced emerging market of the world, over the period 2004-2014. Domestic credit and BSE Stock market capitalization are taken as proxy of financial sector development while real economy is represented by GDP. The data has been analyzed using ADF unit root test, Granger causality test, Auto Regressive Distributed Lag (ARDL) model, LM serial correlation test, CUSUM test and Johansen Cointegration test to capture the nature of relation amongst these sectors in Indian context. We find that while market capitalization granger causes GDP, domestic credit does not granger cause GDP. We find no causality from the real economy (GDP) to financial sector (BSE Capitalization and Domestic Credit). ARDL and Johansen Cointegration Test results reveal that GDP is significantly explained by its own past values (both short and long run) as well as long run values of domestic credit and thus points towards the existence of long term cointegrating association between GDP and domestic credit while the absence of same between GDP and BSE capitalization.These results have significant inferences for economists, regulators and policy makers. So, even though Stock market reforms are a prerequisite for building investor confidence and accelerating real economic growth in short term, banking sector reforms is the key for sustaining it in the long term. We find evidence of supply leading hypothesis whereby economic growth is lead and caused by financial sector in short run (through stock market) and in long run (through banking sector)