THE EFFECT OF B ANKING AND INSURANCE ON THE GROWTH OF CAPITAL AND OUTPUT

BY

IAN P. WEBB INTERNATIONAL INSURANCE F OUNDATION MARTIN F. GRACE GEORGIA STATE UNIVERSITY HAROLD D. SKIPPER GEORGIA STATE UNIVERSITY

March 2002

CENTER FOR RISK M ANAGEMENT AND INSURANCE WORKING PAPER 02-1 ROBINSON COLLEGE OF BUSINESS GEORGIA STATE UNIVERSITY PO BOX 4036 ATLANTA, GA 30302-4036

Contact author is: Ian P. Webb, Suite 202, 1233 20th St., NW, Washington, DC, 20036; Phone: 202 296-2424; email: webb@iifdc.org.

T HE EFFECT OF BANKING AND INSURANCE ON THE GROWTH OF CAPITAL AND OUTPUT

ABSTRACT Banks and insurers should contribute to economic growth by facilitating the efficient allocation of capital. To test their roles in growth, a Solow model with a set of productivity parameters is estimated. Identified endogeneity is controlled for using an iterated three stage least squares simultaneous estimation with exogenous instruments as key variables. The exogenous components of banking and life insurance penetration are found to be robustly predictive of increased productivity across 55 countries for the 1980-1996 period, after controlling for the impact of education, exports, government displacement of the private sector, and investment on growth. The results also suggest that higher levels of banking and insurance penetration jointly produce a greater effect on growth than would be indicated by the sum of their individual contributions.

INTRODUCTION Among emerging market economies, we observe countries that are rich in natural resources or blessed with high savings rates, yet with unimpressive economic growth rates. This fact points to the now widely accepted premise that capital itself is insufficient for economic growth. Institutions and environmental conditions that affect resource allocation appear also to be critical factors. If developing countries fail to create favorable conditions or to promote institutions that permit resources to flow to projects and industries promising the highest social return, their growth potential will be unrealized. Development theory, consequently, is today according greater attention to institutions that promote more efficient allocations of production factors.

Financial intermediaries are widely credited with improving resource allocation. Banks and insurers help mobilize and allocate savings, monitor investment projects and credit risk, and mitigate the negative consequences that random shocks can have on capital investment. The roles of these two types of financial intermediaries over different stages of growth, however, are poorly understood. The neoclassical Solow-Swan model has been a cornerstone of growth theory since its development in the 1950s [Solow (1956) and Solow (1957)]. Estimations using the models original specifications of capital, labor, and technology have consistently explained major components of growth across countries. These estimations, however, have also consistently left unexplained a residual that accounts for 20 to 40 percent of growth. 1 Variables for human capital, exports, and technology have been added to the Solow-Swan framework in an effort to explain this productivity residual, but with only partial success.2 The role of financial institutions has not yet been analyzed. This paper takes advantage of new cross-country data on insurance activity to explore the effects that banks and insurers separately and jointly have on economic growth. With the help of the Swiss Reinsurance Company's Economic Research and Consulting Department, a new data set was put together using official published statistics from national supervisory authorities over a 16 year period. The new data set extends significantly beyond previous cross-sectional and panel studies the coverage of countries and time periods studied. We introduce country-specific intermediary activity in the Solow-Swan framework, hypothesizing that is represents a measure of the efficiency with which capital is employed in

For one of the most comprehensive studies using this model, see Mankiw, Romer, and Weil (1992). They use an augmented Solow growth model incorporating human capital investment on a 98 country sample, increasing the power of the regression from 60% to 80%. 2 See Ram (1987), Hsing and Hsieh (1997), and Mankiw, Romer and Weil (1992).

economies. Growth dynamics within the model are explored, and predictions of the relationship between banking and insurance activity and growth rates of capital and output are generated. Classical linear models and simultaneous systems of equations are specified to test various hypotheses. We include economic and financial variables for 55 countries over the period 1980 through 1996. Other variables are included to control for omitted variable bias and to generate a better understanding of the entire growth equation. The robustness of these results is evaluated using control variables and alternative specifications of the model. We find that the exogenous components of banking and life insurance penetration are robustly predictive of increased productivity across the 55 countries. The results also suggest that higher levels of banking and insurance penetration produce greater benefits together than would be indicated by the sum of their individual contributions. The paper is organized as follows. We introduce background, including a literature review, on the financial intermediation process and resource allocation. We then explore the possible interaction between banks and insurers in contributing to economic growth. The Solow-Swan model is then introduced, followed by our revision of that model to account for financial activity of banks, life insurers, and property/liability insurers. Results for two models follow.

FINANCIAL INTERMEDIATION AND RESOURCE ALLOCATION Arrow (1974) summarized many of the contributions that financial institutions make to an economy. The idealized Arrow-Debreu economy has perfect competition (including perfect information and credible contract enforcement) as well as unrestricted lending and borrowing at appropriately risk-adjusted interest rates. Such ideal states do not exist in reality, because economic

agents cannot observe the true risks of investments or the behavior of contracted agents nor costlessly diversify their resources through a multitude of contracts. Financial institutions, therefore, are created to reduce transactions costs in meeting liquidity and risk preferences. By reducing frictions, financial markets and intermediaries allow agents and economies to more efficiently to allocate income between consumption and savings and to allocate savings across investments. If financial intermediaries can achieve these allocation goals, they increase the effective level of capital in an economy. They also enable entrepreneurs and individual savers to invest in riskier but potentially more productive technologies. The liquidity, risk pooling, and project monitoring provided by banks and insurers, consequently, may all contribute to more efficient capital allocation. Financial intermediaries provide economic agents with additional liquidity and risk preferences. Banks provide this liquidity to clients through interest-bearing deposits and loans, commercial paper, and letters of credit, among others.3 In short, by promising liquidity and return, banks alter the composition of savings from cash holdings, household and farm inventory, and jewelry and other physical property to more productive forms of investment.4 Banks also possess comparative advantages over individual savers in collecting information and monitoring investments. Funds are thereby channeled to a portfolio of investment projects offering the highest marginal returns for their risk profiles. Through pooling, entrepreneurs and individual savers can invest in riskier but potentially more productive technologies. The role of insurance companies in the allocation of resources has not been studied as extensively as that of banks. Skipper (1997) provides an overview of the various means by which

3 4

For a survey of the literature describing, see Levine (1996). It can be argued that the convenience of a payment system attracts deposits as much as the comb ination of liquidity and return on deposits.

insurers may contribute to economic growth. These include: 1) promoting financial stability, 2) facilitating trade and commerce, 3) mobilizing savings, 4) allowing risks to be managed more efficiently, 5) encouraging loss mitigation, and 6) fostering a more efficient allocation of capital. He notes that the liquidity guaranteed by insurance coverage promotes greater financial and legal stability. Distress costs and capital waste are minimized by insurance coverage that manages shocks to stocks of physical and human capital.5 Trade and commerce are facilitated when transportation, payment, and goods are insured. Life insurers, in particular, channel significant amounts of savings into capital markets. Life insurance reduces the demand for liquidity in the form of money and durable goods, and shifts the composition of individuals portfolios of savings to more productive assets. Life insurance may shift the demand for liquidity through relatively unproductive assets (such as cash and jewelry) to more productive forms. This effect mirrors that which banks have on the quality of investments, as discussed by Pagano (1993) and Bencivenga and Smith (1991). Among other benefits, property/liability insurers reduce the likelihood of distress liquidation of firms in the face of catastrophic losses. Mayers and Smith (1982) reason that risk-neutral shareholders have an interest in insuring against losses to avoid bankruptcy costs. These costs may collectively have measurable effects on an economy. With insufficient risk-financing choices in an economy, the potential for losses that destroy much of the built-up value of equity can affect initial and reinvestment decisions. Additionally, if insurers can lower the costs of risk financing, they boost the expected return on projects. Lower costs could result because insurers: 1) excel in offering risk-pooling services through the identification of standardized risks and simplification of contracts, 2) provide optimal investments
5

The idea of health as a stock of human capital was discussed by Grossman (1972). Health insurance may help 5

and asset-liability matching, 3) provide valuable and cost-effective administrative services related to risk management and claims payments, and 4) offer products that are tax-deductible business expenses in many markets.

INTERACTION OF BANKS AND INSURERS IN PROMOTING ECONOMIC GROWTH Banks and insurers arguably complement each other in their intermediation functions. Retail and investment banks excel in identifying and providing financing for investment-worthy small and large businesses, respectively. Life and property/liability insurers, on the other hand, typically invest in corporate and government bonds, commercial mortgages, and equity. Life insurers emphasize longterm investments; banks short-term. As a result, their affect on emerging market economies may have something to do with the relative importance of the type of financing they provide during different stages of development. A collection of empirical studies forms a patchwork of generally supportive evidence that banking, stock market, and financial sector activity all have a strong correlation with economic growth [see, e.g., Fritz (1984) and Jung (1986)]. The services of banks and insurers may be interdependent to some degree. Banks, for example, may more readily offer credit when insurance is present. Loans for residential purchase/construction and new cars may require insurance on the collateral. Insurance requires effective payment systems, so its growth may be facilitated by a strong banking sector. Banks and life insurers both intermediate personal savings, providing important sources for short- and long-term funds in an economy. Services offered to savers, however, differ enough to suggest that they may be distant rather than close substitutes. The immediate liquidity of banking

reduce waste arising by ensuring prompt attention and preventive medicine for illnesses and injuries. 6

deposits is uncharacteristic of endowment, whole life, and other savings-related insurance policies. Liquidity and payment system needs probably are prime motivators for bank deposits. Although banks offer fixed-term savings products, such as certificates of deposit, these often are of shorter duration than life investment products. Banks and property/liability insurers may be relatively close substitutes in very low- income countries. Poor individuals and firms may not be able to afford insurance and decide instead to rely on precautionary bank savings. The affordability of insurance is an objective matter in part because there is a minimum level of coverage that makes its economically sound in most lines. Low-income individuals needing low levels of coverage face comparatively higher unit insurance prices, because insurer overhead, marketing, and servicing costs are large in relation to the actuarially fair price. Affordability is also a function of risk aversion. The risk tolerance of individuals and firms may change as their personal wealth rises, as does the nature of loss exposures. How risk aversion changes with level of income/wealth is unsettled. If low-income individuals/firms have higher risk tolerances, their demand for insurance could be lower. This could help explain the lower insurance penetration in low-income countries. It is reasonable also to expect banks to be comparatively more attractive providers of liquidity in countries with inefficient insurance industries. These inefficiencies are more likely to exist in lowincome countries, many of which have a history of regulatory constraints, financial repression, and poor infrastructure.

THE SOLOW -SWAN MODEL

The Solow-Swan neoclassical model has enjoyed a resurgence in development economics. Several studies have reiterated its strengths in light of the challenges posed by endogenous growth models. For example, cross-country studies have estimated the value of broad capital (human and physical) to be quite different from that implied by endogenous growth [Romer (1987) and Englander and Mittelstadt (1988)]. Rather than an expected finding that the share of broad capital in empirical estimates is unity, these authors found it to fall between 0.4 and 0.6, closer to values consistently estimated with the neoclassical model. Explicit in the neoclassical model, moreover, is the notion of diminishing returns to physical capital, a premise widely accepted in the field and so desirable as a growth dynamic. Further, the neoclassical models convergence prediction is defensible if interpreted as implying conditional rather than absolute convergence. Conditional convergence requires augmenting the model to account for differences in productivity across countries and over time. One way to account for these differences is to measure country-specific differences in savings rates and/or institutional factors. These factors should be able to shift the production function outward and so explain increases in national output. Financial intermediation is a likely candidate to explain differences in investment as well as productivity. For this reason, we consider it a shift variable in our revision to the Solow-Swan framework. Under the Solow-Swan model, production is organized by firms that hire the services of workers and rent the services of capital. Households are endowed with units of labor that they inelastically supply to firms at the prevailing wage rate (w). All capital is owned by households and supplied to firms at the prevailing rental rate (r). The marginal products of labor and capital equal the

interest rate (r) and the wage rate. Factors receive their marginal products and, assuming a constant rate of substitution, capitals share in national income always will be and labors share will be (1- ). Savings rates and population growth are taken as exogenous. Output saved is available to augment the stock of capital owned by the household sector. Capital depreciates at a constant, exogenous rate ( ). Growth over time in the number of households and, equivalently, the supply of workers occurs at a constant, exogenous rate (n). Employment, therefore, is governed by L = nL , and so
L (t ) = L (0)e nt , n 0

(1)

Assuming a Cobb-Douglas linearly homogenous function, production is governed by

Y (t ) = A(t ) K (t ) L(t ) 1

0< <1

(2)

where Y(t) is production, K(t) is capital, and L(t) is labor at time t. A(t) explains changes in productivity of given levels of capital and labor due to technology, which grows at the constant, exogenous rate g, so
A(t ) = A(0) e gt

(3)

Improvements in technology have been cited as a primary explanation for the productivity differences between economies. Unfortunately, measures of technology stock are not available for cross-country studies over any substantial length of time. For this reason, it is appropriate for an empirical study to incorporate a slope coefficient that represents A(t) that affects all countries to the same extent. The coefficient picks up improvements in productivity due not only to technology but to any factor that affects all countries simultaneously. REVISED SOLOW -SWAN MODEL

In this revised model, Z(t) measures the aggregate of the weighted financial activities of three financial institutions: banks (B), property/liability insurers (PL), and life insurers (LF). Each financial activity is weighted by the size of its monetary measure relative to output. The aggregate of the three weighted financial activities makes up a productivity multiplicator in this revised model, as follows:
Z ( t ) = Z ( 0) exp( Bit + PLit + LFi t )

(4)

where subscripts refer to country i and time period t, and Y ( t ) = Z ( t ) A( t ) K ( t ) L( t ) 1 (5)

Z(t) is a multiplicative exponent that shifts the production function.6 When some institutional factor or other change in the economy shifts the production function outward, the economy produces more at any level of capital and labor. With the case of financial intermediation, this shift presumably occurs because capital is directed towards more productive ends.7 This model also assumes diminishing returns to capital and labor such that dY/dK > 0, dY/dL > 0, d2Y/K <0, d2Y/K <0,

and that the production function can also be written as, Y = Z ( t ) A( t ) K L1 = Z ( t ) A( t ) F[ K, L)] . (6)

The revised Solow-Swan model predicts that insurance and banking spur capital stock productivity, in turn driving the level of investment and output. It is generally agreed that productivity

In this model, financial intermediary activity is considered labor-augmenting, because it is thought that investments in new technology and/or organizational improvements increase output per labor unit. 7 The growth rates of banking, life insurance, and property/liability insurance are combined within Z(t) as they measure financial activity, not actual investment channeled. The economic impact of bank lending and life insurer financing of long-term capital projects is greater than the value of the amount financed, as this financing can facilitate an entire investment. Similarly, the economic significance of PL insurance is greater than the value of the losses indemnified by such insurance because some such indemnities avoid bankruptcy costs. 10

gains come from improvements in the quality of investment or capital stock and not just increases in the level of investment. Some authors [e.g., Eltis (1973)] argue that any new investment carries with it innovations in the organization of capital, as in the replacement of old capital stock with new and so more efficient/effective stock. Others argue that new investment in itself is insufficient evidence of improvement in quality of capital stock and that the nature of the investment needs to be examined. Eltis (1973) suggests that the rate of investment drives technical progress by creating an externality from learning by watching. Scott (1992) supports Eltiss emphasis on investment, arguing that the rate of inventions depends on the rate of investment, and so the rate of investment determines technical progress. According to this story, innovation builds upon innovation, providing the rest of the market with the opportunity to learn by watching. As other firms watch this process of innovation from new investment, positive externalities are generated. It does not seem plausible, however, that the level of gross investment itself drives improvement in capital stock quality. This hypothesis appears to echo the neoclassical stance that the level of capital stock itself is the fundamental determinant of growth. Consequently, it would be desirable if any study examining the role that financial intermediaries have on growth could distinguish their impact on the level from the quality of investment. The stances of Scott and Eltis, moreover, appear to be driven as much by data limitations as by the strength of their theoretical positions. Scott (1992) claims that a distinction between ordinary investment, which merely reduplicates existing assets, and investment on research or educational expenditures, which results in innovation, has not been made operational for a theory of economic growth. As a result, he concludes that gross investment, and not any particular types of investment

11

which differentiates between the productivity of human, R&D, or other capital, should be the appropriate measure for productivity. Distinguishing between the impact on level and quality of capital stock is particularly challenging. Measuring the value-added and so productivity of new investment arguably requires disaggregated data on quantity and type of investment, information that is not easily obtained for large cross-country samples. Due to these data issues, it is difficult to discern directly between the impact that banking and insurance have on the level and quality of investment. Differentiating between these two effects of financial intermediation is, however, important. This paper considers some indirect evidence that shows the degree to which banking and insurance appear to stimulate economic growth through levels of gross domestic investment. Exogenous Financial Intermediary Variables Studies employing the neoclassical model customarily construct a capital stock series or assume that gross domestic investment (GDI) approximates the change in this stock. Because of the inherent difficulties and resulting arbitrariness injected by methodological decisions that have to be made in the construction of such a series, this paper uses GDI as a proxy. Empirical studies employing the neoclassical framework commonly ignore the potentially endogenous relationship between capital stock and output in the estimations. In our Model 1, we assume that neither GDI nor financial variables are endogenous in the growth equation. To reduce the possibility that endogeneity is an issue, we construct variables in accordance with the method used in what might be coined the classic growth equation.8

The use of average levels of independent variables against average growth rates has long been common in growth 12

This approach takes average levels of financial intermediary activity and regresses them against average growth rates of economies. Theory suggests that economic growth induces growth in the TABLE 1 financial system, and thus one would expect growth rates of the real and financial sectors to be Specification of the Production Function Equation Assuming Exogeneity of Financial Intermediary Variables correlated. This has no implications, however, concerning the size of the financial system relative to Variable Variable Definition 0 slope coefficient 9 GDP. The financial variables used in this study measure this latter effect. LnRGDPc endperiod LnRGDPc begperiod y it = average growth rate of real per n Taking average levels of financial capita gross domestic product (RGDPc) intermediary activity and regressing them against average
growth rates of the economy, consequently, is a better test of the causality running from the financial to LnGDIcendperiod LnGDIcbegperiod k it = average growth rate of capital stock per n capita sector. It is also a better way to control for possible endogeneity between these two sectors in the real

Bit = average level of banking activity

BankCreditit growth equations, as any simultaneous determination nof real and financial sectors is more likely to t = 0 the GDPit n create highly correlated growth rates than correlation between average levels of financial penetration
10

and = average rate of the of property/ PLit the growthpenetrationeconomy. liability insurance activity

Property Liability Premiumit n= 0 t GDPit n Life Premiumit tn= 0 GDPit n

LFit = average penetration of life insurance

activity

EXGit = average level of exports as a share of GDP

Exportsit n= 0 t GDPit n Gov ' tExpendituresit n= 0 t GDPit n

GOVGit = average government expenditure as a share of GDP

EDU

% population over 25 who have completed primary school 9 GDPoGregorio and Guidotti (1996), p. 252, explain why this specification of the growth equationcapita natural log of initial real GDP per is commonly used to De (1980 value) measure causality.
equations and is stylized by Barro and Sala-I-Martin (1995) in their textbook on economic growth.
10

Penetration refers to size of financial activity relative to GDP. Thus, life insurance penetration is gross life premium divided by GDP.

13

Dividing equation 5 by L, yields the intensive form of the growth equation, y ( t ) = Z ( t ) A( t )k ( t ) . (5a)

An empirical specification is developed by taking natural logs and derivatives with respect to time. The addition of control variables results in yit = 0 + j L nZit + k it + j X it +it (7),
j =1 j= 4 3 8

where change in output intensity is y it = [the growth rate of real GDP per capita]. The change in

capital intensity is k it = [gross domestic investment]. The change in financial intermediary activity with respect to time is Ln Z = B + PL + LF , and the exogenous change in technology A is represented by the slope coefficient. The variables included to control for other influences on productivity are Xit = [education enrollment, government expenditure as share of GDP, and log of initial real GDP per capita]. Ln refers to the natural logarithm of a variable. Following common practice in economic growth studies, this paper takes period averages; 8 and 16 year averages in this case. Variable definitions are shown in Table 1. Average growth rates of GDP per capita and capital stock are measured as differences of logs divided by years in the period. This produces a rough compound rate of growth over the entire period. Our methodology dictates that average differences should be taken of the financial intermediary variables. A slight alteration of the model could dictate that growth rates be taken of the financial variables. Indeed, for financial (and all control) variables used in this study, either average differences or average growth rates produce higher correlations with average growth rates of GDP per capita.11

11

A yearly, pooled time-series also could be estimated with the models. However, by taking averages over a time period, the model can ignore a variety of other potential dynamics that might condition the relationship between 14

We adopt the practice common in growth studies of using average levels of explanatory variables of interest, because of it being a more rigorous assessment of the causal relationship with economic growth. The results using average levels, moreover, are just as strong as using average differences.12 Description of Control Variables Technology Growth A(t) represents worldwide improvement in productivity. If there is worldwide improvement in financial transaction capacity, represented perhaps by new payments system technology or some other innovation that can be transmitted to all countries, this term will pick up some of the impact that might otherwise be attributable to the efficacy of the financial sector. The slope coefficient is expected to be positive, reflecting a measurable level of productivity increase over time that is constant across countries. Banking Banking activity is an important medium of external finance for entrepreneurs and capital projects of all sizes. The measure of banking used in this study, following King and Levine (1993a), is the ratio of the claims on the nonfinancial private sector by deposit money banks to GDP (BankCredit, or as they name it, PRIVY). A financial system that simply funnels credit to the government or state-

these two in the short-run. These short-term influences include yearly macroeconomic shocks, any particular lagstructure that might exist between the real and financial sector, and shocks exclusively affecting the insurance or banking industries. By smoothing these out, a clearer picture is obtained about the long-term relationship between financial intermediary activity and economic growth. A time-series analysis with yearly observations would require some hypotheses as to how particular time regimes, regulatory regimes, and short and long-term economic shocks might affect the variables differently in the countries studied. An expanded dataset that includes information on such factors would be particularly useful for such further research. 12 Levine and Zervos (1998), pp. 543-4, discuss the practice of using averaged levels of growth indicators in crosscountry regressions. The average level of financial activity is the mean of financial penetration over the entire period; that is, the sum each years penetration divided by the number of years in the period. The average difference of financial activity is the mean increment of financial penetration; that is, the ending year level less the beginning year level, divided by number of years. The use of average differences of financial activity produced results that were almost identical to those using average levels of financial activity. This more stringent assessment of causality running from the financial to the real sector produces no substantial difference in the findings. 15

owned enterprises may not be evaluating managers, selecting investment projects, pooling risk, and providing financial services to the same degree of effectiveness as a private sector orientation. In many developing countries, government guarantees of loans to public sector projects have created moral hazard problems with poor repayment rates. In such cases, government intervention into the credit decisions of banks has interfered with their funneling funds to their most productive uses. Consequently, credit provided to the private sector is used in this banking measure as an indicator of that banking activity that is addressing the resource allocation needs of the economy. The coefficient on BankCredit is expected to be positive to the extent that private sector use of banking is closely related to growth of the gross domestic product. Life Insurance Life insurers mobilize funds through attractive medium and long-term savings products. Longterm finance provided by life insurers may have a particularly important role in economies that need such financing for infrastructure development. Long-term equity positions by life insurers also can have a beneficial impact on private sector capital projects. The coefficient on LF is expected to be positive. Property/Liability Insurance Property/liability insurers do not mobilize medium and long-term savings to the extent that life insurers do. Their products are characterized by a short- to medium-term intermediation of funds. As a result, they channel funds from individuals and firms into short- and medium-term capital projects. Property/liability insurers also can reduce costly interruption and even the entire liquidation of firms. Trade and commerce in activities with otherwise troublesome risks can be facilitated. The analysis of risks that accompanies an active insurance market, moreover, provides investors with information on

16

the probabilities of loss/failure that allows better resource allocation. The coefficient on PL is expected to be positive. Education Various authors have found that education is strongly related to economic growth.13 They have reasoned that value added to production can be a function of the education level of the workforce. High-technology industries have much to benefit from more educated workers. Small- and mediumsize entrepreneurs also can improve their productivity if they can educate themselves as to the latest technological advances as well as to the local and international market conditions affecting their products. The service industry, particularly, can ascribe much of its added value directly to the skills and education of its workforce. Education is measured in many ways, the most common being initial level of primary or secondary enrollment. This study uses educational data compiled by Barro and Lee (1994) to measure the percentage of the population over age 25 with primary educational attainment. The expected sign is positive. Government Consumption The degree to which the public sector dominates the economy is believed by many to be an indicator of the crowding out of the more efficient private sector. Private-sector investment is driven by profit concerns, while government investment is directed to social or political concerns. Government expenditure as a percent of GDP is expected to be negatively correlated with economic growth. Exports

13

For cross-country studies measuring the impact of education and other variables on growth, see Mankiw, Weil, and Romer (1992) and Barro and Sala-I-Martin (1995). 17

A vibrant export industry has been associated with faster economic development [McNab and Moore (1998), Balassa (1985), Feder (1983), and Barro (1991)]. Exports can increase capacity utilization, allow a country to take advantage of scale economies, and promote technical change. The measure used in this study is total exports to GDP. The expected sign is positive. Initial GDP Cross-country empirical studies regularly include a measure of initial GDP to control for the convergence effect of economies. Some low-income countries with initially low levels of capital stock experience high growth rates that generally are not characteristic of developed nations. We control for the initial level of income to reduce the possibility that the convergence effect biases the coefficients on other variables. The log of initial real GDP per capita is used, following the example of Barro and Sala-I-Martin (1995) and King and Levine (1993a). The expected sign is negative. Capital Stock Capital stock is the primary component of the production function in this model. Changes in the capital stock level are expected to account for most of output variation. Measuring capital stock is problematic, as comparable figures in national accounts do not exist. Rather than construct a capital stock series, this paper follows the common practice of using GDI as a proxy for change in capital stock. The expected sign is positive. Joint Banking/Insurance As suggested earlier, the coexistence of banking and insurance may create greater depth in the financial sector, allowing for a greater menu of financing options for entrepreneurs and public-sector projects and affecting an improved allocation of resources. If banking and insurance merely complement each other, interaction terms between property/liability and life insurance and banking

18

should have coefficients equal to zero. If these three intermediaries contribute to each other by creating financial sector synergy, the coefficients on banking/insurance interaction terms added to the model should be positive.

RESULTS The 55 countries included in our study are listed in Appendix I. These countries represent the great majority worldwide of both economic output and financial services production. Appendix II indicates the sources of our data.

Assuming Exogenous Financial Variables: Model 1 Model 1 assumes no endogenous relationship between financial intermediary, investment, and economic growth variables. Results using ordinary least squares are presented in Table 2

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TABLE 2
Model 1 Results: Regression Assuming Exogeneity of Financial Intermediary Variables, Dependant Variable is Growth Rate of Real GDP Per Capita. GDP a Population Intercept GDP 1980 Population 1980 GDI Population Bank Credit GDP Life Premium GDP PL Premium GDP % Pop 25+ Primary Education 1980 Exports GDP Govt Expenditure GDP Adj. R2 N
a

-0.490 (0.881) -0.000* b (0.000) 0.000 (0.000) 4.060** (1.35) 29.000 (23.331) -6.700 (45.074) 0.021 (0.018) -3037.203 (4578.001) 35230.278* (1799.289) 0.388 55

The GDP/Population variable is average growth rate of real GDP per capita over 1980-1996. All other variables represent averages of yearly levels over 1980-1996 or, if indicated, 1980 values. b Standard errors are in parentheses; and * and ** indicate significance at the 10 and 5 percent level, respectively.

Banking credit to the private sector, initial GDP per capita, and governments share in GDP are all significant. Initial GDP per capita has its expected negative sign. Exports, investment, the intercept, and the other financial intermediary variables do not enter significantly. Various authors have suggested no a priori way to know the direction of causality between financial activity and economic expansion. If causality does not run in one direction only, as Model 1 assumes, but rather in two directions, the models estimation may not produce reliable results. Endogenous variables could produce contemporaneous correlation between regressors and the disturbance term. This could lead to bias in the OLS estimator, even asymptotically.

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Endogeneity between Gross Domestic Product, Banking, and Life Insurance The fact that endogeneity may exist between financial variables and GDP growth complicates the specification of empirical growth models incorporating the role of the financial sector. Barro and Salai-I-Martin (1995) discuss the possibility that financial activity may be a product rather than a cause of economic growth. To examine whether banking and investment are causes or consequences of growth, they regress each separately against GDP per capita in non-structural growth regressions, using instrumental variables to control for endogeneity. They find no clear evidence indicating the direction of causation. King and Levine (1993a, 1993b, 1993c) also examine the relationship between financial activity and growth. They use GDP per capita and investment as dependent variables in separate estimations. Their approach is tailored to recognize the possibility that banking and investment might be endogenously related (as might occur if banking activity stimulated the level of investment). If this were true, the significance of banking could be obscured or distorted if investment were included with it as a regressor in the same equation. The disadvantage of this approach is that it risks producing an under-specified model by excluding investment from the growth equation. Gregorio and Guidotti (1996) presume that banking drives investment to some degree. They compare the coefficients on the banking variable when investment is first excluded then added as a regressor to a growth equation. By examining the resulting reduction in economic magnitude of the banking coefficient, they conclude that approximately one-quarter to one-third of bankings influence on output is due to its effect on the level of investment, the rest being due to its influence on productivity.

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Endogenous Variables and Simultaneous Equations: Model 2 Financial services may not be supply leading, as assumed in the specification of Model 1, but rather demand-following [Patrick (1966)]. This would imply that economic growth pulls along financial activity, making financial intermediation an accompaniment rather than a stimulant to growth. If this were true, the endogenous relationship between financial activity and GDP might bias the results of Model 1. There is also the possibility that investment is determined by economic growth. The precise relationship between investment and growth of GDP has not been defined in the growth literature. Barro and Sala-I-Martin (1995), for example, found a positive correlation between the investment ratio (GDI/GDP) and GDP in their expansive cross-country growth study. Their results, however, suggested that this correlation reflected a reverse causation from growth to investment, rather than from investment to growth. Finally, either banking or insurance might work directly through investment to affect output. In this case, stimulation of capital growth would not exhibit a lagged effect due to the positive impact on the productivity of capital itself, but rather an immediate impact as it would comprise a significant portion of increase in investment. If so, an endogenous relationship would exist between either banking or insurance and GDI. Following the example of McNab and Moore (1996) who use simultaneous equations to better address the issue of causality between export expansion and economic growth, Model 2 identifies exogenous variables that explain variations in banking and insurance activity. The following simultaneous equations recognize the bi-directional causality between financial activity and GDP using exogenous components of financial intermediary activity:

22

it = 0 + 1 Yit + 2 ENG + 3 FREN + 4 GERM + 5SCAND + it1 (8) PL IT = 0 + 1 Y it + 2 CORRUPT + 3 BUREAUQL + it 2

LFit = 0 + 1 Y it + 2 CATH + 3 MUSL + 4 PROTEST + it 3

(9)

(10) (11)

K it = 0 + 1UGDIGo + it 4
They are estimated simultaneously using 3SLS with equation (7), as, yit = 0 + j L nZit + k it + j X it +it
j =1 j= 4 3 8

(12)

This method estimates all identified structural equations together as a set. The specification of Model 2, which includes the measures used to describe the exogenous

TABLE 3
Model 2 Specification: Assuming Endogeneity of Financial Intermediary Variables

Variable
ENG FREN GERM SCAND SOC CATH MUSL PROTEST OTHDEN CORRUPT BUREAQL UGDIGo

Variable Definition
English Common Law French Commercial Code German Commercial Code Scandinavian Commercial Code Socialist/Communist Law % population Catholic % population Muslim % population Protestant % population other denomination Measure of corruption Measure of bureaucratic quality Initial value of GDI per capita GDP (1980 value)

components of financial and capital stock variables, is described in Table 3.

23

Not all measures of religious composition and legal origin are used simultaneously in the estimation, as this would produce singular matrices. Consequently, OTHDEN and SOC are omitted in the estimation of Model 2. Employing the above simultaneous system requires finding variables that account for significant exogenous components of the endogenous variables in question. Research suggests that differences in legal and accounting systems help explain differences in financial development.14 The theory here is that legal and regulatory systems that give high priority to creditors receiving the full value of their claims and to contract enforcement should have better functioning financial intermediaries than countries whose systems provide weaker support to creditors and contract holders. Issues of contract enforcement and creditor rights have direct relevance to the use of bank services. Consequently, the origin of a countrys legal code (LEG) is tested as an identifying restriction of banking activity. Property/liability insurance depends on the moral fabric of a society as well as the enforcement of property rights. If moral hazard problems, including fraud, are prevalent, the insurance mechanism can become prohibitively expensive for large population segments or even break down entirely. Adequate property rights enforcement ensures that those responsible for damage to anothers property are held accountable. Such rights are also fundamental to consumer confidence in the performance of insurance contracts. Enforcement of property rights can be measured by the quality of a nations justice system and efficiency of government. To measure these environmental factors influence on property/liability insurance markets, the International Country Risk Guide measures of

14

Thus, LaPorta, et al. (1997), in comparing 49 countries, show that legal rules of English, French, German, and Scandinavian origin each relate differentially to the size of national capital and debt markets. Levine, Loayza and Beck (1998) show that legal origin differences are associated with differences in financial intermediary activity. 24

corruption and bureaucratic quality are used as proxies for the social ethic and strength of enforcement of property rights. Previous studies have found that national religious composition can have a significant effect on life insurance demand (Browne and Kim: 1993). Many Muslims believe that the purchase of life insurance is inconsistent with the Koran. Protestant populations generally hold no such beliefs. Estimation of religious composition corroborates its suitability as an instrumental variable for life insurance. Identifying restrictions are found and tested for each financial intermediary variable and for GDI. An F-test for the joint significance of these restrictions in explaining the variation of each financial intermediary variable reveals all to be satisfactory (at the 5 percent level). Legal origin, religion, and corruption are found to be good instrumental variables for banking, life insurance, and property/liability insurance development, respectively. While these instrumental variables are interesting from a theoretical perspective, as they point to exogenous determinants of financial intermediary penetration, they are not used in the estimations. Initial values of the financial variables, which also serve as good instruments (all meet the 5 percent level of significance for model fit), do better at facilitating convergence of the simultaneous estimations. For this reason, they are selected over legal origin, religion, corruption, and bureaucratic quality. Initial values are commonly used as instruments to control for endogeneity [see Barro and Salai-I-Martin (1996) and Levine, Loayza and Beck (2000)]. Results are presented in Table 4.

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TABLE 4
Simultaneous Equations Results: Interrelationships between Financial Intermediary Penetration and Growth of GDP per Capita
Dependant Variables GDP a Population Independent Variables GDP Population 231.091**b (80.754) -359.820* (184.321) 0.022 (0.019) 0.067 (0.043) 0.004* (0.001) -0.004 (0.003) 0.001 (0.001) 0.004 (0.003) GDI Population Bank Credit GDP Life Premium GDP PL Premium GDP

-0.14 Intercept (0.925) GDP 1980 -0.000 Population 1980 (0.000) GDI 0.000 Population (0.000) Bank Credit 4.239* GDP (2.108) Life Premium 56.873** GDP (21.572) PL Premium -63.148 GDP (59.764) % Pop 25+ 0.023* Primary Education 1980 (0.014) Exports 996.439 GDP (3508.906) Govt Expenditure 54574.754 GDP (39433.930) GDI 1980 1.036** Population 1980 (0.034) Bank Credit 1980 0.921** GDP 1980 (0.091) Life Premium 1980 1.302** GDP 1980 (0.138) PL Premium 1980 0.641** GDP 1980 (0.083) System Weighted R2 = 0.847 N = 55 a GDP/Population is the average growth rate of real GDP per capita over 1980-1996. All other variables are average levels over 1980-1996; or, if indicated, 1980 values. The system weighted R2 is reported for the entire set of simultaneous

The use of cross-country as opposed to panel data precludes definite conclusions about

causality. Nevertheless, these results suggest that higher levels of banking and life insurance penetration predict higher growth rates across the sample of countries. This growth prediction holds even after controlling for the role of investment, education, exports, and government intrusion in the economy. Equally interesting, it is the exogenously determined components of banking and life insurance penetration that predict economic growth.
26

Table 4 shows a one-way relationship between banking penetration and GDP growth, and a two-way relationship between life insurance penetration and GDP growth The coefficient on the life insurance variable (first column in Table 4) suggests that a 2 percent increase in life insurance penetration will be accompanied by a 1.12 percent increase in average GDP per capita.15 Concerning the other direction of the relationship, the coefficient on the GDP variable (second column in Table 4) indicates that a 1 percent increase in average GDP per capita growth will be accompanied by a 0.4 percent increase in life insurance penetration. The coefficient on the banking variable (first column in Table 4) indicates that an increase of 10 percent in banking credit to the private sector as a share of GDP will be accompanied by a 0.42 percent increase in average GDP per capita growth. 16 GDP per capita does not predict growth in banking in this model. From the estimation of Model 2, it can also be seen that the investment variable does not explain GDP growth, but GDP does explain increases in investment. This finding corroborates that of Barro and Salai-I-Martin (1996) who suggest that one of the principal reasons for the association between growth and investment is the ability of growth to explain investment but not vice-versa. The education variable is significant, consistent with the findings of other studies. The government consumption variable is not significant. This result is not unexpected as two other studies [King and Levine (1993a) and Levine, Loayza, and Beck (2000)], showed similar results.

15

The average life penetration over 1980-1996 for the 55 countries ranges from 0 to 0.07. Consequently, a 2 percent increase would move a country along approximately one-third of the range from the lowest to the highest penetration. For example, if a countrys average life penetration over the 1980-1996 period is 2.5 percent and its average GDP per capita growth rate is 3 percent, the model predicts that an increase in average life penetration to 4.5 percent would be accompanied by an increase in average GDP per capita growth rate to 4.12 percent.
16

The average banking penetration over 1980-1996 for the 55 countries ranges from 0 to 1.0. Consequently, a 10 percent increase would move a country along approximately one-tenth of the entire range.

27

The export variable proves insignificant as a predictor of economic growth. Other studies [McNab and Moore (1998) and Balassa (1985)] have found exports to be a significant and robust indicator of economic growth. This discrepancy in results may be due to the use of different data sets or to variation across studies in the construction of the export variable. Each of the financial institution variables is significant when introduced into Model 2 individually. However, when added together, only life insurance and banking retain their significance, possibly due to multicollinearity.

Integrated versus Independent Contributions to Growth That property/liability insurance is robbed of its explanatory power by another financial institution hints at some possible overlap between their roles in the economy. To explore this possibility, we turn to factor analysis to determine whether banking, life insurance, and property/liability insurance have shared roles in economic growth. Banking, life insurers, and property/liability insurers offer distinct financial services. They spread risks over time and across people in somewhat different ways. They are similar, however, in that all are conduits for substantial amounts of investment. One factor, therefore, likely represents the impact of this financial intermediation on the economy. The factor thought to represent financial intermediation is labeled F[Bank_Life_PL] and is included in Model 2.17 The results of this estimation are shown in Table 5.

17

Estimated values of banking, life insurance, and property/liability insurance formed from instruments for these variables are used to calculate the single factor, F[Bank_Life_PL]. 28

TABLE 5
Simultaneous Equations (Model 2): Financial Intermediation Factor (F[Bank_Life_PL]) Extracted from Three Financial Intermediary Variables
GDPa Population GDP Population Intercept GDP 1980 Population 1980 GDI Population % Pop 25+ Primary Education 1980 Exports GDP Govt Expenditure GDP GDI 1980 Population 1980 GDI Population 196.342** (57.428) -335.112** (140.798)

1.782* (0.729) -0.000* (0.000) 0.001 (0.000) 0.024* (0.014) -1661.642 (3495.749) -24249.909* (13504.343)

1.031** (0.034)

1.358** F[Bank_Life_PL]c (0.369) System weighted R2 = 0.923, N = 55 a GDP/Population is the average growth rate of real GDP per capita over 1980-1996. All other variables are average levels over 1980-1996; or, if indicated, 1980 values. The system weighted R2 is reported for the entire set of simultaneous equations. b Standard errors are in parentheses; and * and ** indicate significance at the 10 and 5 percent level, respectively. c F[B_LF_PL] represents Factor 1 that was calculated for all three financial institution variables.

The financial intermediation factor accounts for 65 percent of these variables cumulative variance and is statistically significant. It captures the major part of these financial institutions contribution to economic growth. Synergies Financial institutions may both share some common role in stimulating economic growth and function better collectively than separately. Thus, the more efficient are banks payment systems, the lower are attendant insurer administrative costs. Property/liability insurance protects banks loan collateral. Also, the growth of one type of financial intermediary in a society can have positive spillover effects on the demand for the services offered by other financial intermediaries as consumer sophistication grows.
29

TABLE 6
Simultaneous Equations (Model 2): Interaction Terms among Financial Intermediary To Variablestest the hypothesis that synergies exist between the three financial intermediaries, interaction
Dependant Variables a GDPadded to the simultaneous model. 18 Life Premium presented in GDI Bank Credit terms between these intermediaries are Results are PL Premium Population Population GDP GDP GDP Independent Variables Table 6.19 The interaction terms between bank 218.773**and bank0.025 life are significant at the 10 and 5 and PL b and GDP 0.005** 0.002 Population (68.142) (0.017) (0.001) (0.001) Intercept -0.712 -338.598** 0.069 -0.005 0.005* percent levels, respectively. The strength of these interaction terms points to a mutually constructive (1.105) (166.112) (0.041) (0.003) (0.003) GDP 1980 -0.000 relationship between banking and insurance. Population 1980 (0.000) GDI -0.000 Populationclarity, the results of Model 2, with and without interaction terms, are presented in (0.000) For greater Bank Credit 2.455 GDP (1.946) Table 7. Banking and life insurance are significant in the absence of the interaction terms. When these Life Premium 17.442 GDP (29.500) terms are added, the interaction terms are seen to dominate the explanatory power of the individual PL Premium -12.031 GDP (65.893) % Pop 25+ 0.028** financial institution terms. Primary Education 1980 (0.014) TABLE 7 Exports -1970.909 GDP (3712.989) Simultaneous Equations (Model 2): Comparison of Results with and without Interaction Govt 16546.232 Terms Expenditure GDP (36589.934) Dependant Variables GDI 1980 GDPa 1.032** GDPa Population 1980 Population(0.034) Population Bank Credit Variables 0.904** Independant 1980 GDP 1980 (0.088) Intercept -0.141 -0.712 Life Premium 1980 (0.925) (1.106) 1.235** GDP 1980 GDP 1980 -0.000 -0.000 (0.146) (0.000) (0.000) PL Population 1980 Premium 1980 0.629** GDI 0.000 -0.000 GDP 1980 (0.081) Population (0.000) (0.000) Bank Credit * LifePremium 0.814** b 2.455 GDP Bank Credit GDP (0.277) 4.230* GDP (2.108) (1.946) Bank Credit * PLPremium 111.651* 17.442 GDP Life Premium GDP (63.067)56.870** GDP (21.572) (29.500) -12.031 PLPremiumPL*Premium LifePremium 0.043 -63.141 GDP GDP (59.769) (65.899) GDP (0.303) % Pop 25+ 0.023* 0.028** Primary Education 0.874 1980 (0.014) (0.014) 2 System weighted R = Exports 996.444 -1970.989 N = 55 GDP (3508.537) (3712.982) a GDP/Population is the average growth rate of real GDP per capita over 1980-1996. All other variables are average levels Govt Expenditure 1980 values. The system weighted R2 is16546.256 the entire set of simultaneous 54574.371 over 1980-1996; or, if indicated, reported for GDP (39433.936) (36589.959) equations. Bank Credit * LifePremium b Standard errors are in parentheses; and * and ** indicate significance at 0.814** 5 percent level, respectively. the 10 and GDP GDP (0.277) Bank Credit * PLPremium 111.653* GDP GDP (63.067) PL Premium * LifePremium 0.043 18 Interaction terms are also created by multiplying two financial intermediary terms taken from estimated values; that GDP GDP (0.303) is, they are the product of two estimated values calculated from instrumental variables. System weighted R2 = .834 = .879 19 Testing these interaction terms one at a time in Model 2 does not alter this finding. N = 55 = 55 a GDP/Population is the average growth rate of real GDP per capita over 1980-1996. All other variables are average levels 30 over 1980-1996; or, if indicated, 1980 values. The system weighted R2 is reported for the entire set of simultaneous equations.

An F-test is used to determine if the marginal effects of banking, life insurance, and PL insurance are statistically different from zero. None of these financial intermediary variables have statistically significant marginal effects when expressed as a function of both individual and interaction terms measured at the means. However, as is clear from Tables 6 and 7, the interaction terms themselves are statistically significant, and so are likely driving the model. In summary, results suggest that the joint development of banking and property/liability insurance and of banking and life insurance have more to do with economic expansion than the development of either banking or insurance individually.

CONCLUSIONS Using a Solow model, we examined whether banks, life insurers, and property/liability insurers individually and collectively contribute to economic growth by facilitating the efficient allocation of capital. Even controlling for the traditional variables believed to explain growth, we find that the exogenous components of banking and life insurance penetration are robustly predictive of increased productivity across our sample of 55 countries for the 1980-1996 period. We also find evidence of synergy between banks and insurers, thus producing greater benefits jointly than indicated by the sum of their individual contributions. These study findings are consistent with the traditional economic arguments that markets including financial markets that are permitted to develop under liberal conditions are more likely to lead to greater social welfare. Conversely, financial markets whose development is hindered by unnecessary government and other barriers to entry and anticompetitive policies deny their country additional economic growth potential and

31

development.

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BIBLIOGRAPHY Arrow, K. J., 1974, Essays in the Theory of Risk Bearing. Chicago: Markham Publishing Co. Balassa, Bela, 1985, Exports, Policy Choices, and Economic Growth: Further Evidence, Journal of Development Economics, 18(May-June): 23-35. Barro, Robert J., 1991, Economic Growth in a Cross Section of Countries, Quarterly Journal of Economics 106: 407-433. Barro, Robert J. and Jong-Wha Lee, 1994, Sources of Economic Growth, Carnegie-Rochester Conference Series on Public Policy. 40:1-46. Barro, Robert J. and Xavier Sala-I-Martin, 1995, Economic Growth. New York: McGraw-Hill, Inc. Bencivenga, Valerie, and Bruce D. Smith, 1991, Financial Intermediation and Endogenous Growth, Review of Economic Studies, 58(2): 195-209. Browne: Mark, and Kihin Kim, 1993, An International Analysis of Life Insurance Demand, Journal of Risk and Insurance 60(December): 616-34 Eltis, W.A., 1973, Growth and Distribution, United Kingdom: Macmillan Press Ltd. Englander, A. and A. Mittelstadt. 1988, Total Factor Productivity: Macroeconomic and Structural Aspects of the Slowdown OECD Economic Studies no 10. Feder, Gershon 1983, On Exports and Economic Growth, Journal of Development Economics 12 (February/April): 59-73. Fritz, R.G., 1984, Time Series Evidence on the Causal Relationship between Financial Deepening and Economic Development, Journal of Economic Development, (July): 91-112. Gregorio, Jose De and Pablo E. Guidotti, 1996, Financial Development and Economic Growth, in Road Maps to Prosperity: Essays on Growth and Development., ed. Andres Solimano, University of Michigan Press. Grossman, Michael, 1972, On the Concept of Health Capital and the Demand for Health. Journal of Political Economy, 80: 223-255. Hsing, Yu and Wen-Jen Hsieh, 1997, Testing the Augmented Solow Growth Model: The Case of Taiwan, RISEC, 44(3): 601-606. International Monetary Fund, Various Years, International Financial Statistics Washington: IMF.
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Jung, W. S. 1986, Financial Deepening and Economic Growth: International Evidence, Economic Development and Cultural Change (January): 333-346. Levine, Ross, 1996, Financial Development and Economic Growth: Views and Agenda, Washington, DC (September), World Bank Mimeo. Levine, Ross, Norman Loayza, and Thorsten Beck, 2000 Finance and the Sources of Growth, Journal of Financial Economics 58: 261-300. Levine, Ross and Sara Zervos, 1998, Stock Markets, Banks, and Economic Growth, American Economic Review (June): 537 - 558. King, Robert G. and Ross Levine,1993a, Finance and Growth: Schumpeter Might be Right, Quarterly Journal of Economics, 108(3): 717-738. King, Robert G. and Ross Levine, 1993b, Finance, Entrepreneurship and Growth: Theory and Evidence, Journal of Monetary Economics, 32(3): 513-42. King, Robert G. and Ross Levine, 1993c, Financial Intermediation and Economic Development, in Capital Markets and Financial Intermediation. eds. Colin Mayer and Xavier Vives. Cambridge: Cambridge University Press. La Porta, Rafael, Florencio Lopes-De-Silanes, Andrei Shleifer, and Robert Vishny. 1997. Legal Determinants of External Finance, The Journal of Finance, 52: 1131-1150. Mankiw, Gregory N., David Romer and David N. Weil, 1992, A Contribution to the Empirics of Economic Growth, The Quarterly Journal of Economics 107: 407-437. Mayers, D. and Clifford Smith, Jr. 1982, On the Corporate Demand for Insurance, Journal of Business, 55: 281-296. McNab, R. and R. E. Moore, 1998, Trade Policy, Export Expansion, Human Capital and Growth, The Journal of International Trade & Economic Development, 7(2): 237-256. Pagano, Marco, 1993, Financial Markets and Growth: An Overview, European Economic Review 37: 613-22. Patrick, Hugh, 1966, Financial Development and Economic Growth in Underdeveloped Countries. Economic Development and Cultural Change 14(2): 174-89. Ram, Rati. 1987, Exports and Economic Growth In Developing Countries: Evidence from TimeSeries and Cross-Section Data, Economic Development and Cultural Change 36:(1) 5173.

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APPENDIX I: Countries (55) used in the 1980-1996 estimations Algeria Chile Cyprus France Indonesia S. Korea Australia China Denmark Greece Ireland Luxembourg Austria Ivory Coast Dom. Rep Guatemala Israel Morocco Belgium Cameroon Ecuador H. Kong Italy Brazil Colombia Egypt Iceland Japan Canada Costa Rica Finland India Kenya Netherlands Philippines Sweden Venezuela Switzerland

Mexico Malaysia Peru

New Zealand Nigeria Norway Portugal Thailand Singapore Tunisia UK

Pakistan Spain

South Africa USA

W. Germany Zimbabwe

36

APPENDIX II: Sources of Data Income is measured as gross domestic product (GDP). GDP figures are taken from the International Financial Statistics (IFS) line 99b.a Data for capital stock do not exist in national accounts. GDI, commonly used as a measure of the yearly change in capital stock, is used as a proxy in this study. GDI figures are taken from the World Bank Development Indicators Database. Exports as a share of GDP is calculated from IFS, lines 90c and 99b. Government consumption as a share of GDP is calculated from IFS, lines 91F and 99b. The financial activity of deposit money banks is measured as the bank credit extended to the private sector, line 32D, as a share of GDP, line 99b. The financial activity of life and property/liability insurers is their corresponding insurance penetration, defined as gross premiums written as a percent of GDP. Gross premium data are extracted from various issues of Sigma, Swiss Reinsurance Company.
LFit measures change life insurer penetration and PLit measures change in property/liability insurance

penetration. These growth rates approximate the growth of services provided by these institutions. Actual investment channeled, especially by life insurers, is greater in most cases than premiums collected in one year would suggest, as insurers accumulate investments from earlier periods. Life insurer reserves would be a more accurate approximation of the investment function but these data are unavailable internationally.

Line numbers refer to entries in the International Financial Statistics, as compiled by the International Monetary Fund. 37

Data for legal origin and religious composition of the population are taken from La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998). The corruption and bureaucratic quality measures are taken from the International Country Risk Guide 1999.

38