Financial Development and Economic Growth in India: A Pre and Post Liberalization Financial Cycle Determination

Abstract

This thesis examines the role of financial development in influencing economic growth from 1980 to 2021, focusing on bank credit—measured through non-food gross bank credit (NFGBC), commercial bank credit, and agricultural credit—broad money supply (M3), stock market capitalization (BSE and NSE), and productive investments captured through gross fixed capital formation (GFCF). The study aims to examine both linear and nonlinear relationships between financial variables and macroeconomic indicators, while also identifying the presence of financial cycles in India and their interaction with business cycles. Annual data are mainly used for macroeconomic analysis, while monthly data are employed for the stock market and economic growth. In doing so, the study addresses a significant gap in the existing literature by jointly examining linear and nonlinear finance-growth relationships, financial cycles, structural relationships, and regional heterogeneity. To achieve these objectives, the study employs various econometric methodologies, including the Autoregressive Distributed Lag (ARDL) model to examine short-run and long-run dynamics, Threshold regression to capture nonlinear effects, and Structural Vector Autoregression (SVAR) to identify structural relationships among variables. Financial and business cycles are extracted using the Hodrick-Prescott Filter, with lead-lag relationships also examined to analyze whether financial cycles lead business cycles over time. The empirical results confirm a stable long-run relationship between financial development and economic growth. Bank credit and broad money supply exert positive and significant influences on GDP, indicating the importance of liquidity and credit availability in supporting economic activity. The study captures heterogeneity across states in terms of financial development and economic performance. The regional results indicate a significant role of banking credit in influencing economic growth, despite differences in financial depth. Moreover, despite periods of slowdown and economic shocks, the positive relationship between financial variables and growth remains intact. Stock market development has a significant influence on real economic activity, supporting the supply-leading hypothesis. Threshold regression results reveal a nonlinear relationship between stock market development and growth, with effects varying across market size and different phases of expansion and contraction. These findings highlight the importance of considering regime-dependent behavior when evaluating the finance-growth nexus in emerging economies. The cyclical analysis further confirms the presence of financial cycles in India, which are highly synchronized with business cycles, with credit and investment leading economic activity. The SVAR results show that shocks to NFGBC and GFCF play a significant role in output dynamics, underscoring the central role of credit and investment in driving economic fluctuations. Overall, the findings underscore the critical role of financial markets and productive investment in promoting sustainable growth in India and emphasize the importance of well-coordinated financial and economic policies. Policymakers should adopt a macro-financial approach that ensures stable credit provision, supports productive investments, and strengthens capital markets to smooth financial cycles and sustain long-term economic growth. Future research may extend this study by incorporating sectoral analysis and a cross-country panel framework with emerging economies, using higher-frequency data and advanced time-varying nonlinear econometric methods.