Impact of commercial banking sector development on economic growth in small Pacific countries: a case study of the Vanuatu economy

Abstract

Apart from the positive and significant correlation between bank credit and development (King & Levine, 1993b), earlier studies by McKinnon (1973) and Shaw (1973) also documented the role of financial sectors in developing economies and identified struggling economies with least developed financial sectors which exhibit less minimization of asymmetric information and high transaction costs. A number of extensive literatures have highlighted the positive impact of financial development in developed countries on growth; however very little has been documented for small Pacific Island Countries with underdeveloped financial systems. An empirical analysis using time-series data from 1983 to 2013 is used in this study to investigate the impact of financial development through commercial banking on economic growth in Vanuatu. The model estimation includes unit root tests, checks for cointegration using the Johansen cointegration procedure, checks for Granger non-causality tests and investigating the short-run and long-run relationships using a Vector-Error-Correction Model (VECM). The results show that financial development has a positive and significant relationship (lagged by a two year period) with growth, reflecting the weak monetary policy transmission in under-developed money markets and financial systems. The causality test results show that a positive and significant short run relationship runs from financial intermediation to economic growth, and a long-run relationship exists between private sector credit and growth. In addition, the implementation of the Comprehensive Reform Program in 1997 has had little impact on growth as a result of the persisting hurdles to growth in small Island countries. This study offers opportunities for future reforms that will address sustainable financial development policies supporting growth.