THE EFFECT OF FINANCIAL DEVELOPMENT AND INSTITUTIONAL QUALITY ON ECONOMIC GROWTH: A STUDY ON OIC COUNTRIES USING SEEMINGLY UNRELATED REGRESSION.

Abstract

This paper examines how financial development (FD), institutional quality (IQ), and economic growth are related in the selected OIC countries using the Seemingly Unrelated Regression (SUR) method. The findings show that the countries are highly heterogeneous. In Malaysia, FD and IQ make significant and positive contributions to growth, and, by implication, are complementary. Indonesia adheres to the FD-driven growth but there is a high negative level of IQ influence that indicates institutional weaknesses. In the case of Turkey and Saudi Arabia, FD shows a highly significant impact on growth but, in the case of IQ there is no significant impact whereas, in the case of Pakistan, FD and IQ do not have significant impact on growth. Total-effect estimations further show that complementarities between FD and IQ are the most pronounced where institutional frameworks are also favourable except for Indonesia where the negative effect of IQ is offset by the positive effect of interaction term. These results indicate the way in which financial deepening is not enough without the solidification of institutions. Policy implications point out that reforms of both financial sector efficiency and quality of governance are needed simultaneously and only integrated strategies can lead to long-range sustainable and inclusive growth.