Economic development and domestic finance : An investigation into the McKinnon-Shaw hypotesis

This thesis provides an empirical investigation into the relationship between economic growth and the depth of a country's financial sector. We begin by identifying several economic and financial factors traditionally employed by development theorists to understand economic growth. We then summarise the McKinnon-Shaw hypothesis that ascribes considerable importance to the deepening of the domestic financial sector in low-income countries through free-market financial liberalisation in order to achieve superior economic growth. The hypothesis advocates that a domestic financial sector free to offer positive real rates of interest will encourage higher saving, and will in turn more efficiently mobilise and allocate savings to entrepreneurial investment spurring increased economic growth. We construct ten variables that reflect both traditional economic development theories and the McKinnon-Shaw hypothesis, and use these variables to test hypotheses developed from the economic and financial literature. Using the data of 52 low-income countries for the period 1980 to 1990 sourced from the Perm World Table an d the International Financial Statistics, we quantify and compare the statistical relationships between per capita economic growth and the ten variables. We then use a Sims-causality methodology in an attempt to determine the direction of the statistically significant relationships. We find a statistically and economically significant relationship between per capita economic growth and financial depth, but that this relationship is dominated by the investment rate and saving rate effects. Contrary to the McKinnon-Shaw hypothesis, we further find causality relationships demonstrating that economic growth in low-income countries leads to increased investment, saving, and financial depth, and not vice versa. We postulate that these causal relationships reflect (1) a "wait-and-see" attitude on the part of investors and creditors, and (2) an income effect on the part of savers.Business, Sauder School ofFinance, Division ofGraduat