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Research Digest
[Research Preview] Financial Development and Economic Growth in Korea

April 21, 2020

 

By Sunjoo Hwang, Fellow at KDI


※ This article is part of KDI Journal of Economic Policy, February 2020

Does an expansion in financial resources always facilitate economic growth? At first glance, it seems that there is a positive relationship between financial development and economic growth, as additional financial resources can serve as a factor affecting production. However, recent financial crises have witnessed that too much finance can harm sustainable economic growth.

If the true relationship between finance and growth is revealed, one can draw on several important policy implications. If there is a positive relationship, more investment in the financial sector is always beneficial. If there is a negative relationship between finance and growth, existing public policies that aim to expand the financial sector must change.

There is a large body of work on the relationship between finance and growth but, interestingly, the literature draws on a general conclusion that there is an inverse Ushaped relationship between financial development and economic growth. That is, an expansion in financial resources is useful for accelerating economic growth if the degree of financial development is under a certain threshold; otherwise, this expansion is detrimental to growth.

There are a number of economic theories that explain why the nonlinear relationship between finance and growth arises. According to a first group of theories, as financial resources are being accumulated, these resources are distributed less likely to sectors with high growth potential, such as the corporate sector or the investment sector, instead being distributed more to sectors with low growth potential, such as the household sector or the consumption sector (Hung, 2009; Beck et al., 2012; Hoshi and Kashyap, 2004). According to a second group of theories, if the amount of debt in an economy is sufficiently large, the economy becomes vulnerable to outside shocks; therefore, it is highly likely to face a financial crisis that typically reduces growth rates for at least several years, if not a decade (Drechsler et al., 2016; Stiglitz, 2000; Levchenko et al., 2009). According to a third group of theories, as the financial sector expands, talented workers are more likely to work in the financial sector than in the real economy; accordingly, poor labor productivity in the real economy leads to a slowdown in growth (Tobin, 1984; Kneer, 2013).

However, there are several caveats to consider when interpreting the nonlinear relationship found in the literature. First, financing methods can be divided roughly into direct financing and indirect financing. Secondly, there are two different aspects of financial development: quantitative and qualitative. The extant literature finds that there is an inverse U-shaped relationship between growth and quantitative financial development with regard to indirect financing. Although this finding is general, more research should be conducted to examine the growth-finance relationship in the area of direct financing or to examine possible relationships between growth and qualitative financial development.

Nevertheless, the findings in the literature have several important policy implications, as follows. First, a majority of households and firms in most economies, including some advanced economies, rely on different types of indirect financing, such as loans, whereas they rarely use direct financing means such as bond or stock issuances when raising funds. Secondly, if there is an inverse U-shaped relationship between growth and finance, there is a certain threshold level of financial development. If the current status of financial development is below the threshold, financial policies that aim to expand available financial resources are justifiable. However, if the current status of financial development exceeds the threshold, policymakers should refrain from simply expanding the financial sector and instead should improve on its qualitative aspects.

However, the findings of recent studies cannot be applied directly to the Korean economy because almost every existing study uses country-panel data. Some papers consider the OECD or G20 countries together while others study groups of emerging markets. These papers find that there are inverse U-shaped relationships between economic growth and the ratio of private credit to GDP while also indicating that 100% is a plausible threshold. Nonetheless, because none of these papers focus on the Korean economy, despite the fact that there are a number of similarities between Korea and several other countries, one cannot be sure whether such a nonlinear relationship holds or whether the threshold level is 100% in the Korean economy as well.

This paper focuses on the Korean economy and, in this regard, examines Korean time-series data. Because non-stationary time-series variables typically lead to misleading regression results if they are not cointegrated, this paper examines whether there are cointegrating relationships between the variables of interest and, if they exist, estimates these cointegrating relationships.

The main result of this paper is as follows. First, there is an inverse U-shaped cointegrating relationship between the five-year average economic growth rate and the ratio of private credit to GDP. It is also demonstrated here that the threshold level of private credit to GDP is 171.5%. The ratio of private credit to GDP in Korea has ghrtincreased steadily over time, becoming as high as 193% by the end of 2016.

※ This paper is an extension of a working paper, “Economic Growth and the Quantitative Expansion of Financial Resources,” Policy Study 2019-02, Korea Development Institute, 2019 (in Korean).
 
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The Department of Macroeconomics is conducting researches on the macro economy and macroeconomic policy, particularly focusing on suggesting the analysis of macroeconomic trends and current status of the economy at home and abroad, the economic forecast, and the policy direction of the macro economy. The Department is also in charge of establishing, sustaining and maintaining various econometric models, based on which it analyses policy effects and develops a long-term economic forecast.

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