Does Financial Development Cause Economic Growth? Micro Evidence from Indonesia

The recent empirical findings show the positive role of financial development on economic growth. However, the causal flow on the relationship between them differs among these studies either uni-directional relationship or bi-directional relationship. Consequently, this study aims to investigate the role of financial development especially banking sector on economic growth of Indonesia and to examine the causal relationship between them by using a dynamic Granger causality test and Granger causality test based on error correction model (ECM). This study employs data from period 1970-2006. Within this period, Indonesia has many experiences in the financial development starting from financial reforms, financial liberalization, and restructuring of financial sector. The results reveal that the relationship between financial development and economic growth in Indonesia is uni-directional from economic growth to financial development. Economic development in Indonesia creates demands for financial services and financial sector responds to these demands or demand-following approach. It can be said that the financial liberalization in 1988 has increased the role of financial sector especially banking sector on economic growth of Indonesia through intermediary function. This study, therefore, informs that any argument on the view of “finance leads growth” should be stated very carefully. In case of Indonesia, there is not enough evidence to support that financial development leads to economic growth.