Testing the inverted-U hypothesis on economies with different levels of financial development

Abstract

The study seeks to understand the role that financial development has had on economic growth by testing the inverted-U hypothesis on three different countries of different levels of financial development, namely, Germany, Chile and Kenya. South Africa is hailed as being one of the most financially developed economies. A stark contrast to a divided population, which is regarded as being one of the most unequal societies in the world. We test the inverted-U theory on countries with different levels of financial development to examine whether the theory of economic growth driven by financial development is applicable to South Africa. Using multivariate linear regression (MLR) and Vector Auto Regression (VAR), the research examines association and causality, if any, for a market-based (SMC) and a bank-based (PCE) induced growth. The study found that both SMC and PCE are highly correlated to the GDP, but that only SMC has a causal relationship to GDP, suggesting that financial markets are better conditioned to grow the economy than banks are, for all levels of economic development. This evidence suggests that economic growth is most likely innovation-driven and South Africa’s innovation barometer is sub-par. The lesson for South Africa is that the country must put more emphasis on innovation-based growth if it is to reduce poverty and increase growth.