Research studies

Financial Development and Economic Growth: Toda and Yamamoto causality test in ALGERIA


Prepared by the researcher  :  Taleb Dalila  Economic Sciences, Abou Baker Belkaid University of TLEMCEN, ALGERIA 

Democratic Arab Center

Journal of Afro-Asian Studies : Tenth Issue – August 2021

A Periodical International Journal published by the “Democratic Arab Center” Germany – Berlin

Nationales ISSN-Zentrum für Deutschland
ISSN  2628-6475
Journal of Afro-Asian Studies

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The main objective of this paper is to examine the relationship between financial development and economic growth with the emphasis on the transmission channels as far as the influence of the financial system on economic growth in Algeria. We employ a time series analyses approach as adopted by Toda and Yamamoto (1995) causality test. Here, three indicators are employed, that are, domestic credit to private sector to GDP, real GDP per capita ,and real Gross Fixed Capital Formation. Our main results find an existence of the causal relationship between financial development and economic growth, the evidence presented in this paper provides strong and robust support to the view that financial sector development is crucial for economic growth and the efficiency of the financial sector is potentially important for the long term growth performance of Algeria.

  1. Introduction

The current crisis is reminiscent of the magnitude of the impact one can have on the other. The analysis of the causal links between finance and economic growth could be traced back, at least, to Schumpeter (1911), but it has really experienced a revival of interest from the works of Gurley and Shaw (1955), Granger (1963), Patrick (1966), Goldsmith (1969), Hicks (1969) and McKinnon (1973) through the introduction of empirical tests. Theoretically, Patrick (1966) proposes three hypotheses of links between finance and growth. It is first of all the “Supply Leading” hypothesis where financial development is at the root of economic growth. Then, he proposes the inverse hypothesis called “Demand following” where the financial development is a consequence of the growth. Finally, the so-called “stage-of-development” hypothesis states that finance causes growth in less developed economies, but as economies develop, causality is reversed, with growth taking over finance. Subsequently, McKinnon (1973) undertook to test these hypotheses empirically and found that the causal link from financial development to growth is more decisive. These results have had a great influence on the policies of the International Monetary Fund (IMF) and the World Bank in developing countries, particularly with regard to financial system reforms in these countries. Several studies will eventually lead to the same results as McKinnon (1973), such as those of the World Bank (1989), King and Levine (1993a, b), Pagano (1993), Neusser and Kugler (1998), Levine et al. (2000) and Calderon and Liu (2003). Conversely, fewer studies confirm, empirically, the causality going from growth to finance. However, Robinson (1952) argued that the greater emphasis on finance tended to overlook this latter sense of causality. Given the importance of economic policy implications, research on the links between finance and growth is timely. The financial sector acts on growth through two channels: capital accumulation and productivity improvement..

There are many factors that can be treated as economic growth determinants. One of these factors is the financial system. The institutional frameworks of the financial system as well as its performance are no doubt important determinants of output growth. The theoretical structural model implies that the development and stability of the financial sector both have a positive impact on economic growth.

However, when verifying this hypothesis on the basis of empirical data for real economies, some questions appear. First, is the positive relationship between the development of the financial sector and economic growth unconditional, or are there some constraints? Also, can a too big financial system hamper the growth rate of GDP?

Second, what is exactly the stability of the financial system and how can it be measured on the basis of statistical data? The problems regarding the relationship between the financial sector and economic growth strengthened after the last global crisis and the crisis in the euro zone. It turns out that some disturbances observed in the financial sphere of the economy may exert very significant and long-term impact on the behavior of the real economy.

Depend on the endogenous growth theory that indicated and stressed on the role of financial

intermediaries in improving the productivity of capital( Greenwood & Jovanovic 1990, Bencivinga &Smith 1991, Pagano 1993) , through two main ways :(i), by Collecting information for evaluating alternative investment projects hence improving the allocation of resources,(ii) providing opportunities to investors to diversify and hedge risk thus ,inducing individuals to invest in riskier but more productive investment alternatives (Pagano ,1993).

The recent view associated between financial liberalization and endogenous growth theory (Ang,2008, De Gregorio & Guidotti, 1995, Benhabib &Spiegel, 2000, Beck et al, 2000, Levine & Zervos, 1998),that financial development contributes in economic growth through two complementarity channels: capital accumulation and productivity of capital.

Given the financial crisis experienced since 1986, Algeria , started to privatize its economy with 1990 as a key transitional year  (the transition from planned to an open market economy).Algeria implemented several reforms starting by the financial sector under the following objectives1 : reduction of the direct government intervention and strengthen the role of market forces in the allocation of financial resources, improvement of the financial institutions capacity to mobilize the domestic saving, enhancing the effectiveness of monetary policy instruments, promoting competition among banks, and strengthening their financial soundness. In April 1990, Algeria adopted the law on currency and credit (90-10) to grant greater independence to the central bank (Bank of Algeria since 1990) and strengthen its capacity for banking supervision.

Therefore, the purpose of this work is to investigate the empirical relationship between financial development and economic growth, and stressing on the transmission channels which financial development influence growth in Algerian economy, by addressing the following issue : Does financial development promote economic growth in Algeria ?,

The study employs Toda and Yamamoto (1995) for Granger non-causality procedure, during the period 1970-2016, using indicators such as: credit to private sector to GDP measures banking system development, Real Gross Fixed Capital Formation as an indicator of the investment and Real GDP per capita as proxy of economic growth rate.

The paper is organized as follows: The first section is the introduction. Section 2 discusses theoretical and empirical issues on the relationship between the financial development and economic growth( describes various literatures reviewed) .Section 3 explains the used data, methodology and econometric model, Section 4 reports empirical results. Finally, section 5 concludes the paper.

2-Literature Review

A growing body of theoretical and empirical work demonstrates a strong, positive link between financial development and economic growth and the theoretical underpinnings of this relationship can be traced back to the work of Schumpter (1912)[1] and more recently, to McKinnon (1973) and Shaw (1973). The main policy implication of the McKinnon-Shaw school is that government restrictions on banking systems hinder financial development, and ultimately reduce growth. A flourishing body of empirical work includes three approaches in order to examine this positive relationship. They are: Cross-country studies, individual country studies and firm industry level studies. In this section these three approaches will be reviewed with focus on benefits and limitations.

Arab-country studies

 The seminal work in this area is by Boulila & Trabelsi (2002) investigated the causal relationship between banking system development and economic growth in Tunisia, they found evidence of finance leading growth during the period 1963-1987 ( period of financial repression ) ,and bi-directional causality from 1962 to 1998 , they concluded that the weak evidence to support that financial system contributes in economic process in Tunisia . The study of Ben Naceur & Ghazouani (2007)  and AL-ZUBI, Khaled& al (2006) aimed to examine the effect of banking system and financial market development on economic growth in 11 countries from MENA region, using GMM approach with various indicators of financial development, they found a negative relationship between financial system development and growth, they linked this result to the underdevelopment financial systems that are characterized by the countries under study (in MENA region). Alaoui Moustain (2004) and Chatri & Maaruf (2013) are among studies that have tested the financial-led growth hypothesis on Morocco, using VAR and VECM, respectivey model with various indicators of banking system and stock market, they found that the result depended on the proxies chosen for financial development, these result indicates that Morocco should keep to promote financial development through more financial reforms to spur the real sector.

The studies of Bakhouche (2007),Lacheheb  & al (2013) and Medjahad & al (2015) attempted to determine and analyse the effect of financial development on real sector in Algeria (test of supply leading hypothesis), using the same approach is ARDL model .their finding is no significant effect from financial development on growth in Algeria, they related this result to less developed banking system and need to more financial reforms to accelerate economic growth in Algeria ,Mohieldin, Mahmoud; and Al (2019) examines empirically the relationship between the development of the financial sector and economic growth in Egypt between 1980 and 2016. It draws comparisons based on critical financial indicators between Egypt and selected emerging markets and developing economies, using a new data set of financial development indexes released by the International Monetary Fund. Econometric time-series modeling of bivariate regressions for real growth per capita and measures of financial development, to assess the relationship between financial development and economic growth in Egypt, yields three specific findings. First; there is a strong association between real growth per capita and financial development measured. Second; access to and the efficiency of banking services are not associated with real per capita income. Third, the Financial Markets Access Index—which compiles data on market capitalization outside the top 10 largest companies and the number of corporate issuers of debt—indicates that there is a robust association with real per capita gross domestic product. The main policy implications suggest that there should be a stronger focus on promoting a more proactive role for the financial services industry in Egypt.

Cross-country studies.

The seminal work in this area is by Goldsmith (1969). Using data from 35 countries from 1860 to 1963, Goldsmith found that a positive association could be observed between economic and financial development if periods of several decades are considered. However, his work has several weaknesses: (i) it involves limited observations on only 35 countries, (ii) it does not control for other factors influencing economic growth, (iii) the size of financial intermediaries may not accurately measure the functioning of the financial system and (vi) it does not identify the direction of causality. Recently, researchers have taken steps to address some of these weaknesses. King and Levine (1993a,b, c) provided evidence for 80 developing countries over the period 1960-1989. They control for other factors affecting long-run growth, and examine the productivity growth channels. Besides that, they use four measures of the level of financial development to more precisely measure the functioning of the financial system than Goldsmith’s size measure. Furthermore, King and Levine (1993 b) study whether the value of financial depth in 1960 predicts the rate of economic growth and productivity improvements over the next 30 years. The regressions indicate that financial depth in 1960 is significantly correlated with each of the growth indicators averaged over the period 1960-1989. Thus, results suggest that the initial level of financial development is a good predictor of subsequent rates of economic growth and economic efficiency improvements over the next 30 years even after controlling for income, education, political stability and measures of monetary and fiscal policy.

Individual-country studies.

 Country-case studies provide a rich complement to cross-country comparisons. The most influential work in this area is by McKinnon (1973). He studies the relationship between the financial system and economic development in Argentina, Brazil, Chile, Germany, Indonesia, Korea and Taiwan in the post-World War II period. He concluded that better functioning financial systems support faster growth. The proponents of this approach criticize empirical studies based on cross-country growth regressions. They argue that these studies do not explicitly confront the issue of causality. In particular, this approach involves averaging out variables over long time periods, and using them in cross section regressions aimed at explaining cross-country variables of growth rates. Therefore, these techniques cannot allow different countries to exhibit different patterns of causality. This means that the causality result is only valid on average. Furthermore, cross-country growth regressions suffer from a variety of errors: measurement errors, statistical errors and conceptual errors. Also, since various factors change during the time period of the study (policies, preferences and business cycles), hoping to capture all these changes by certain explanatory variables averaged over time is rather optimistic. Consequently, interpreting the coefficient derives from such studies is rather difficult. Recent empirical literature in country-case studies can be found in Demetriades and Luintel (1996) work. They examine the effects of various types of banking sector controls on the process of financial deepening using data from the Reserve Bank of India. They find that these controls, with the exception of a lending rate ceiling, influence financial deepening negatively, independently of the well-known effect of the real interest rate.Gelbard and Pereira Leite (1999) examine the case of sub-Saharan Africa. They find that some progress has been achieved in terms of modernising the financial sector since the mid 1980’s, but conclude that much remains to be done. They also show some empirical evidence supporting the positive relationship between financial depth and growth for sub-Saharan Africa[2]. The positive and significant relationship between financial depth and growth has also been found in studies using pure time series.

Firm-industry level studies.

This approach focuses on microeconomic aspects. For example, Rajan and Zingales (1996) analyse the relationship between industry-level growth performance across countries and financial development. They find that industries that rely heavily on external funding grow comparatively faster in countries with well-developed intermediaries and stock markets than they do in countries that start with relatively weak financial systems. Similarly, using firm-level data from 30 countries, Demirguc-Kunt and Maksimovic (1996) argue that firms with access to more developed stock markets grow at faster rates than without this access. Furthermore, Rajan and Zingales (1998) tested the financial-growth nexus by focusing on the importance of the differential cost of external finance for firms. The firm’s dependence on external finance is defined as the ratio of capital expenditures minus flow cash from operations divided by capital expenditures. The authors focused then on the details of a mechanism by which finance affects growth, providing by the same occasion another test of causality, since they found evidence for a channel through which finance theoretically influences growth. Thus using firm and industrial level data for a broad cross-section of countries present evidence consistent with the view that the level of financial development materially affects the rate and structure of economic development. On the other hand, many studies show that there is negative relationship between financial development and economic growth. For example, De Gregorio and Guidotti (1995), in their empirical study of the long run correlation between financial development and economic growth, using panel data regressions with random effects for Latin American countries during the period 1950-1985, also have found a strong negative correlation between financial development and economic growth. They explained the finding by the effects of experiments of extreme liberalization of financial markets in some Latin American countries followed by their subsequent collapse. Berthélemy and Varoudakis (1998) also found a negative

correlation between financial development and growth using panel data regressions based on a panel set of 82 countries for the period 1960-1990. They argued that this empirical result might be explained by the existence of “threshold effects”, which state that countries may need to reach a certain level of financial depth (a threshold) before there is a significant effect on growth- associated with the existence of multiple equilibria in the long run between financial development and growth. They assume that the interaction between financial and real sectors generates two stable equilibria: a low equilibrium with weak growth performance and an underdeveloped financial sector and a higher equilibrium with notable growth and normal development of the financial market. Between the two, there is an unstable equilibrium, which defines the threshold effect of the financial development on economic growth.

Besides these three approaches, recent empirical literature has also revisited the old debate on the relative merits of bank-based financial systems (such as Germany and Japan) versus market-based financial systems (such as U.K. and U.S.). Proponents of bank-based systems find that: (i) in highly liquid markets, information is quickly revealed to investors at large, creating a free-rider problem, (ii) small investors are unable to exert corporate control due to superior information of managers and the likely collusion between managers and a few powerful members of the board and (iii) liquid markets make it easy for concerned stockholders to simply sell their chares rather than coordinate pressure against management. Thus, Those proponents argue that the combination of all of these market failures leads to an inefficient allocation of the saving and banks mitigate these failures by their long-term relationships with particular firms.

On the other hand, proponents of market-based systems focus on the weaknesses of bank-based systems, arguing that: (i) large banks tend to encourage firms to undertake very conservative investment projects, and extract large rents from firms, leaving them with low profits and little incentive to engage in new and innovative projects and (ii) shareholders have little oversight over bank managers who control not only banks but also, indirectly through financing, the firms. Moreover, the advocates of this system claim that it provides a various set of financial instruments that allow greater customisation of risk management techniques than in a more standardised bank-based system (Khan and Sehhadji, 2000). Emerging evidence suggests that neither view is fully correct. Levine (1999), James, Caprio and Levine (2000) suggest that establishing a legal environment that strongly protects the right of investors is much more important than comparing between these two systems. Levine (1997) argues that the choice is not either banks or markets because both of them provide complementary financial services to the economy, with both having positive implications for economic growth.

3.Data and Methods

3.1 Empirical specification and Data

This part highlights the econometrics model used to study the relationship between financial development and economic growth in Algeria.

The data we have employed for Algeria economy are annual observations covering the period 1970–2016. The variables are measured as follows: The annually data on the economic growth is proxy by real GDP per capita, real gross fixed capital formation as a proxy of volume of investment (capital accumulation) that used from previous studies such as: Adul G et al (2013), Ghirmay (2006), Hatem Hatef Abdulkadhim Altaee&al (2014) among others.

In the literature the most common measures for financial development are the M2 to GDP ratio or the Domestic credit to private sector (% of GDP). In this study the second measure is used in the absence of the role of financial market in Algeria( bank-based) . this is one of the most widely used measures (proxies) of financial development ( De Gregorio & Guidotti 1995, Benhabib & Spiegel,2000 , Adul & al ,2013, Beck & al, 2003, levine and Zervos ,1998) Anwar et al (2011), Ogunyiola(2013).

This indicator measures the quality and quantity of the investment financed by the banking sector, Data for our variables obtained from the World Development Indicators (WDI), On-line, 2018 ( ). All the variables are expressed in natural logarithm for the usual statistical reasons.

To model the effect of financial development on economic growth we follow the standard literature in specifying a Solow Growth function pertaining to the economic model below:


GDPC denotes real gross domestic product per capita, FD denotes the domestic credit to private sector measure of financial development and  GFCF real gross fixed capital formation.

The regression in log forms is as follow:

  1. Empirical Results

This section present firstly, the econometric methodology adopted to achieve the objective of this paper and secondly, the empirical results.

The empirical results commences by testing the order of integration of the variables. The Augmented Dickey Fuller approach was employed.

4.1 The stationary of the time series

Each time series was examined to determine if it is stationary or non- stationary employing the unit roots test. If a time series is found to be non-stationary, subsequently the examination was undertaken to determine if its first difference is stationary. Using this procedure the order of integration of a time series is determined. Table 1 presents the results of Augmented Dickey-Fuller (ADF) test statistics for the log levels and the first differences of the logs of the annual time series data.

From table 1; it is evident that all-time series are compatible with the hypothesis that stationarity characterizes the variables in this study. Since, (the ADF absolute computed values, are greater than the absolute critical values, at the first difference for variables, where all the statistics are significant).

                   Table 1.Unit Root Test (Augmented Dickey Fuller)

Level 1 er difference
Log gdpc – 0.5979




Log fd -1.3211




Log gfcf 2.3712





Source: prepared by the researcher, depending on the program eviews 8

According to the results obtained by the time series of this function is stationary at 5% (in absolute value) this means that there is a co-integration between the variables and there is a long-term relationship.

4.2 The Optimal Lag Length Selection

The next step is to determine the optimum order of lag length. This is important since under parametrization would tend to bias the results and over-parametrization would diminish the power of tests. The optimal lag length of the lagged differences of the tested variable is determined by minimizing the Akaike Information Criteria (AIC) and Schwarz Bastian Criteria (SBIC). Table 03 shows the selected lag length by criteria, all the criteria (LR, FPF, AIC, SC and HQ) recommended a joint lag 2 according to the table 2.

Table 2. the Optimal Lag Length

0 -1564.292 NA  9.15e+27  72.89732  73.02020  72.94264
1 -1396.908  303.6276  5.79e+24  65.53061  66.02210  65.71186
2 -1378.603   30.65038*   3.78e+24*   65.09781*   65.95793*   65.41500*
3 -1373.310  8.123601  4.57e+24  65.27025  66.49899  65.72337
4 -1369.007  6.004073  5.88e+24  65.48872  67.08608  66.07778
 * indicates lag order selected by the criterion
 LR: sequential modified LR test statistic (each test at 5% level)
 FPE: Final prediction error
 AIC: Akaike information criterion
 SC: Schwarz information criterion
 HQ: Hannan-Quinn information criterion




4.3 Cointegration Test

As the econometric analysis suggests, when the concern of unit root has been addressed; the co-integration test can be applied to verify the existence of long run relationship. The theory of co-integration defines that even though the variables under consideration are non-stationary at individual level but the linear relationship among them may still be stationary. After confirming the stationarity of the variables at 1(1).

This technique observes the long run relationship among the non-stationary variables while showing number of cointegrating equations. The test is based on the comparison of H0 (r=0) against the alternative H1 (r≠0) where “r” represents the number of co integrating vectors.

Table 3. Johansen cointegration test

Unrestricted Cointegration Rank Test (Trace)
Hypothesized Trace 0.05
No. of CE(s) Eigenvalue Statistic Critical Value Prob.**
None *  0.420626  34.60841  29.79707  0.0129
At most 1  0.199781  10.04705  15.49471  0.2771
At most 2  0.000398  0.017894  3.841466  0.8935
 Trace test indicates 1 cointegrating eqn(s) at the 0.05 level

Evidence from the result we find that ltrace is greater than the critical values ​​at the level of 5% suggests that the null hypothesis of no co-integration (r =0) cannot be rejected that there is no cointegration between the variables models to be estimated, but at (r =1) we find that ltrace is smaller than the critical values ​​at the level of 5% and therefore accept the null hypothesis, Based on these results, we can find one cointegrating. This in effect suggests that the existence of long-run relationship between the variables employed in our study is confirmed.

4.4 Toda-Yamamoto Granger Causality Test

Having ascertained that a cointegrating relationship exist between financial development, Domestic credit to private sector and economic growth, the final step in this study is to verify if financial development Cause economic growth using the Toda and Yamamoto causality test.

The empirical results of Granger Causality test based on Toda and Yamamoto (1995) methodology is estimated through MWALD test and reported in Table 5. The estimates of MWALD test show that the test result follows the chi-square distribution with 2 degrees of freedom in accordance with the appropriate lag length along with their associated probability.

Table (5): Toda-Yamamoto Causality

Dependent variable: GDPC
Excluded Chi-sq df Prob.
GFCF  14.86405 2  0.0006
FD  13.38100 2  0.0012
All  42.22640 4  0.0000
Dependent variable: GFCF
Excluded Chi-sq df Prob.
GDPC  4.590666 2  0.1007
FD  0.619535 2  0.7336
All  5.774385 4  0.2166
Dependent variable: FD
Excluded Chi-sq df Prob.
GDPC  1.100031 2  0.5769
GFCF  4.855068 2  0.0883
All  4.926580 4  0.2949

It is clear, from Table 05 that there is a unidirectional causality between financial development, investment and growth, for the fact financial development affect economic growth through capital accumulation channel and productivity of capital,

  1. Conclusion

This paper offers a broad analysis of the effect of development financial sector on economic growth for Algeria. The evidence presented in this paper provides strong and robust support to the view that financial sector development is crucial for economic growth and the efficiency of the financial sector is potentially important for the long term growth performance of Algeria. Given this positive relation, the importance of financial sector development should not be underestimated and has to be one of the main strategies to achieve sustainable economic growth in the long term. Building sound and stable financial sectors requires; liberalization of the financial system, adoption of the internationally acceptable codes and standards, strengthening of prudential regulation and supervision and training of the staff to manage and regulate these institutions


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[1] Schumpter, argued that finance does matter for economic development because financial institutions, by searching for successful innovation projects, finish by encouraging enterprises to produce better and more.

[2] For additional country case studies see Park (1993), Patrick and Park (1994) and Fry (1995).

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المركز الديمقراطى العربى

المركز الديمقراطي العربي مؤسسة مستقلة تعمل فى اطار البحث العلمى والتحليلى فى القضايا الاستراتيجية والسياسية والاقتصادية، ويهدف بشكل اساسى الى دراسة القضايا العربية وانماط التفاعل بين الدول العربية حكومات وشعوبا ومنظمات غير حكومية.

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