Re-examining the finance-growth relationship for a developing economy: A time series analysis of post-reform India

The cross-country empirical literature on the finance-growth relationship has debated three propositions. These are (i) Financial deepening has a strong impact on the growth process (ii) Measures of financial “activity” rather than the “size” of the sector plays a more significant role in the growth process and (iii) Financial structure (bank-based versus stock market-based) has no impact on the growth process at all. The present study re-examines the validity of these propositions for a developing economy using the Vector Error Correction Model (VECM) methodology. In the context of the “size versus activity” debate, we also test whether these two aspects of the financial sector can impact growth rates independently. The results support the strong impact of financial deepening on growth but finds that the other propositions are not as robust.