Financial development and the innovation-economic growth nexus in developing countries

Document Type : Research Paper

Authors

1 M. A. of Economic, Faculty of Economics, Management and Administrative Sciences, Semnan University, Semnan, Iran

2 Assistant Professor of Economics, Semnan University, Semnan, Iran

Abstract

Purpose: The expansion of the financial sector has raised the concern of “brain drain” among industries. There are also concerns that too many financial activities may misallocate resources, both physical and human capital, from production sector to less productive ones. Financial development may make it easier for less efficient firms to stay in the market and prevent more efficient innovators from entering the market, which may harm innovation and growth. In this regard, the main purpose of this study is to investigate the role of financial development in the relationship between innovation and economic growth in developing countries.
Methodology: In order to meet the research goal, a regression model is specified to describe economic growth as a function of the first-order lag of economic growth, innovation and the product of innovation and financial development. Moreover, economy openness (the ratio of exports plus imports to GDP) and the ratio of the net flow of foreign direct investment to GDP are included in the model as control variables. In this model, one of the regressors is the first-order lag of the dependent variable. The regression equation is estimated using the Generalized Method of Moment (GMM) and the data for the period of 2000-2019.
In this study, the multidimensional index of financial development of the International Monetary Fund has been used as a relative ranking of countries on the depth, access, and efficiency of their financial institutions and financial markets. The Financial Institutions (FI) index is an aggregate of the Financial Institutions Depth (FID) index, which compiles the data on bank credits to the private sector in a percent of GDP, pension fund assets to GDP, mutual fund assets to GDP, and insurance premiums, life and non-life to GDP, Financial Institutions Access (FIA) index, which compiles the data on bank branches per 100,000 adults and ATMs per 1000,000 adults and Financial Institutions Efficiency (FIE) index, which compiles the data on banking sector net interest margin, lendind-deposits spread, non-interest income to total income, overhead costs to total assets, return on assets, and return on equity. Also, Financial Markets (FM) index is an aggregate of Financial Markets Depth (FMD) index, which compiles the data on stock market capitalization to Gdp, stocks traded to GDP, international debt securities of government to GDP, total debt securities of financial and nonfinancial corporations to GDP, Financial Markets Access (FMA) index, which compiles the data on a percent of market capitalization outside the top 10 largest companies, total number of issuers of debt (domestic and external, nonfinancial and financial corporations) per 100,000 adults, and Financial Markets Efficiency (FME) index, which compiles the data on stock market turnover ratio (stocks traded to capitalization). In addition, the number of the patents registered is considered as an index of innovation, and the real GDP per capita is considered as an index of economic growth.
Findings and discussion: The results of Generalized Method of Moment (GMM) show that the effect of innovation on economic growth is positive and statistically significant. Furthermore, the effect of the interaction between financial development and innovation on economic growth is negative and statistically significant, which suggests that the effect of innovation on economic growth is not independent of the level of financial development. According to the results, the threshold level of financial development is 0.76466. According to the results of descriptive statistics, the average financial development index for the selected developing countries is 0.378945, which is significantly lower than the threshold level. Therefore, if the level of financial development becomes lower than this threshold level, the higher the level of financial development, the smaller the positive effect of innovation on economic growth. In other words, when the level of financial development increases, the positive relationship between innovation and economic growth weakens.
Conclusions and policy implications: Based on the results, the financial development level increases the positive relationship between innovation and economic growth. Therefore, financial development weakens the positive growth effects of innovation. In other words, with a higher the level of financial development, a unit of increase in innovation leads to a smaller increase in economic growth. As empirical results indicate, trade openness and the ratio of foreign direct investment to GDP have a positive and significant effect on economic growth. It is suggested that, in parallel with the financial development, a serious solution should be provided regarding the optimal allocation of human and physical resources. The markets with low productivity should be identified, and their continuity of attendance should be prevented in order to provide the ground for the entry of new innovators and entrepreneurs. This is possible by making amendments in laws and regulations and increasing the quality of administrative systems.

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References

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The Journal of Economic Policy
Volume 16, Issue 32
March 2025
Pages 93-116

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