FINANCIAL DEVELOPMENT IN DEVELOPING COUNTRIES

Abstract

What are the economic, political, institutional, socio-cultural, and geographical determinants of financial development in developing countries? This paper uses the two-way fixed effects (with clustered standard errors) and annual panel data from 1980 to 2018 for 69 developing countries in sub-Saharan Africa, Middle East and North Africa, East and South Asia, Latin America, and the Caribbean to address this question. The principal component analysis is employed to construct a financial development index based on three financial development indicators. This study builds on the previous studies by introducing new potential determinants of financial development such as the perception of corruption, and by exploring important quadratic and interaction effects. The results show that national income, trade openness, indices of political stability and Polity2 (a democracy score), perception of corruption, the predominant religion in the countries, and geographical factors such as territorial access to the sea explain the differences in the levels of financial development across countries and regions. A rise in national income leads to a higher level of financial development and countries with a high perceived level of corruption have a lower level of financial development. There is strong evidence of threshold effects as trade openness has a diminishing marginal effect on financial development while the auxiliary growth regressions show that financial development has an increasing marginal effect on national income. Of the five regions studied, East and South Asia and sub-Saharan Africa have the highest and lowest levels of financial development, respectively. Also, fuel-exporting countries, least developed countries, and landlocked countries tend to have lower levels of financial development. These results have relevant policy implications for developing countries in their continued efforts to achieve better financial development and ultimately, sustainable economic development.