1. Arnaud Mehl and Adalbert Winkler
The finance-growth nexus and financial sector environment: new evidence from Southeast Europe
Arnaud Mehl and Adalbert Winkler
Directorate General International and European Relations European Central Bank
Dubrovnik, 27 June 2003

2. Scope and motivations of the paper
Give evidence on the finance-growth relation since the early 1990s in Southeast Europe (SEE):
- Bulgaria, Romania + Moldova
- Albania, Bosnia & Herzegovina, Croatia, FYR Macedonia,
Serbia & Montenegro
Motivations:
- Few empirical studies on finance-growth nexus in transition
- SEE countries under-researched (=/= CEE countries)
- Substantial change in financial sector environment
- Countries moving closer to the EU, with some implications on banking reform
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3. => Real start now of financial development?
Main results
No evidence of growth-supportive effects of financial depth in SEE since the early 1990s
Contrasts with conventional wisdom on finance-growth nexus
Interpretation: reflection of banking sectors’ poor environment in the largest part of the last decade
Financial sector environment has improved in recent years
=> Real start now of financial development?
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4. The finance-growth nexus in the literature: brief overview
Positive (and causal) relation between finance and (future) growth
Standard econometric specification:
Real GDP per capita growth
= Control variables + Financial depth indicator
Finance’s contribution to growth is through productivity improvement
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5. Applying the standard empirical framework to SEE
Specific challenges to transition economies:
1 - The standard set of controls may not apply
2 - Short time series
3 - Instability in earlier years of transition & war
Modelling framework:
1 - Data for the 8 SEE countries over
2 - Financial depth: monetisation & intermediation
3 - Controls: inflation & private sector to GDP
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6. Empirical evidence
Financial depth is not significantly correlated with real GDP per capita growth in SEE
Results insensitive to:
1 - Endogeneity (IV estimation)
2 - Initial conditions (country fixed-effects)
3 - Set of control variables
4 - Robust estimation
5 - War dummy
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7. A conceptual framework to interpret the evidence
Financial development: quantity and quality
FINANCIAL DEPTH
Shallow
Deep
Socialist financial system
Non-developed financial sector
Poor
Financial sector prone to inflation and crises
ENVIRONMENT QUALITY
Stable financial sector but not actively growth-supportive
Developed and growth supportive financial sector
Good
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8. Applying this framework to SEE countries’ experience (1)
Up to the late 1990s - Deep financial sector, poor environment:
1 - Insufficient restructuring of state-owned banks and poor governance
2 - Lax regulation on licensing new private banks and connected lending
3 - Lack of human capital and credit technology
4 - Inadequate banking supervision
5 - Poor institutional and legal environment
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9. Applying this framework to SEE countries’ experience (2)
The crises years - Shallower financial sector, persistently poor environment:
1 - Outbreak of financial crises
2 - Shrinking of financial depth
3 - Output losses
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10. Applying this framework to SEE countries’ experience (3)
The late 1990s - Improved environment:
1 - Hardening of budget constraints
2 - Tightening of banking supervision and regulation
3 - Banking sector consolidation and opening to foreign investors
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11. Today, financial sectors in SEE are liquid...
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12. …but intermediation, crucial to growth, remains overall low...
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13. …due to a number of factors:
Cautious lending behaviour
Characteristics of non-financial private sector
Time required to adjust to the new environment
Room for improvement in the legal framework
Short maturity of deposits and potential of currency mismatch
High demand for liquid and risk-free assets
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14. although, in some countries, credit has recently been more dynamic
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15. Conclusion (1): Interpreting SEE countries’ experience
FINANCIAL DEPTH
Shallow
Deep
Socialist financial system
Non-developed financial sector
Poor
Financial sector prone to inflation and crises
ENVIRONMENT QUALITY
Stable financial sector but not actively growth-supportive
Developed and growth supportive financial sector ?
Good
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16. Conclusion (2): implications
No growth-effects of finance due to financial sectors’ specific evolution
However in some countries financial development may have started
Address bottlenecks to financial intermediation in most countries
Monitor rapid credit growth in some countries
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