Digital financial inclusion, economic freedom, financial development, and growth: Implications from a panel data analysis

Rekha, G.; Rajamani, K.; Resmi, G. Working Paper Digital financial inclusion, economic freedom, financial development, and growth: Implications from a panel data analysis ADBI Working Paper Series, No. 1244 Provided in Cooperation with: Asian Development Bank Institute (ADBI), Tokyo Suggested Citation: Rekha, G.; Rajamani, K.; Resmi, G. (2021) : Digital financial inclusion, economic freedom, financial development, and growth: Implications from a panel data analysis, ADBI Working Paper Series, No. 1244, Asian Development Bank Institute (ADBI), Tokyo This Version is available at: https://hdl.handle.net/10419/238601 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Resmi No. 1244 March 2021 Asian Development Bank Institute The Working Paper series is a continuation of the formerly named Discussion Paper series; the numbering of the papers continued without interruption or change. ADBI’s working papers reflect initial ideas on a topic and are posted online for discussion. Some working papers may develop into other forms of publication. Suggested citation: Rekha, G., K. Rajamani, and G. Resmi. 2021. Digital Financial Inclusion, Economic Freedom, Financial Development, and Growth: Implications from a Panel Data Analysis. ADBI Working Paper 1244. Tokyo: Asian Development Bank Institute. Available: https://www.adb.org/publications/digital-financial-inclusion-economic-freedom-financial- development-growth Please contact the authors for information about this paper. Email: [email protected] G. Rekha is a Research Scientist and K. Rajamani is a Postdoctoral Research Fellow, both at the State Bank of India, Kolkata, India. G. Resmi Is an Assistant Professor of Christ (Deemed to be University), Bangalore, India. The views expressed in this paper are the views of the author and do not necessarily reflect the views or policies of ADBI, ADB, its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms. Working papers are subject to formal revision and correction before they are finalized and considered published. Asian Development Bank Institute Kasumigaseki Building, 8th Floor 3-2-5 Kasumigaseki, Chiyoda-ku Tokyo 100-6008, Japan Tel: +81-3-3593-5500 Fax: +81-3-3593-5571 URL: www.adbi.org E-mail: [email protected] © 2021 Asian Development Bank Institute ADBI Working Paper 1244 Rekha, Rajamani, and Resmi Abstract An all-inclusive financial system is one of the channels through which information and communication technology (ICT) affects economic growth. Digital financial inclusion is an evolving phenomenon that enhances the ease of access to and availability of formal financial services. Further, economic freedom is one of the significant factors affecting financial development and growth. Hence, there is a strong rationale for examining the effect of economic freedom on financial inclusion. However, there is no empirical evidence on the linkages between these variables in the literature. Accordingly, we examined these relationships. The results of a panel data analysis that we performed on a dataset pertaining to emerging economies show that the nexus of ICT diffusion–economic freedom–financial development has a positive impact on financial inclusion in the long run, highlighting the importance of creating an economic environment that is conducive to sustained economic growth. The findings of this study have significant implications from an economic policy standpoint and call for a more holistic approach. Keywords: financial inclusion, ICT, economic freedom, financial development, emerging economies, VECM JEL Classification: G20, G21, G28 ADBI Working Paper 1244 Rekha, Rajamani, and Resmi Contents 1. BACKGROUND ............................................................................................................. 1 2. BRIEF REVIEW OF THE LITERATURE ....................................................................... 2 3. METHODOLOGY ........................................................................................................... 3 3.1 Data and Sources .............................................................................................. 3 3.2 Model.................................................................................................................. 5 4. RESULTS ....................................................................................................................... 5 4.1 Panel Unit Root Tests ........................................................................................ 5 4.2 Co-integration among Variables ........................................................................ 5 4.3 Panel VECM....................................................................................................... 6 5. DISCUSSION AND IMPLICATIONS ............................................................................. 7 6. CONCLUSION ............................................................................................................... 8 REFERENCES .......................................................................................................................... 9 ADBI Working Paper 1244 Rekha, Rajamani, and Resmi 1 1. BACKGROUND Research has considered financial inclusion (FI) as a significant catalyst for economic development (Claessens 2006). FI refers to the availability of formal financial services to everyone, including deprived households and micro-enterprises (ADB 2000). Although an inclusive financial system has several merits, according to the Global Findex Database (2017), of the total global adult population, 50% (around 2 billion people) does not have access to formal financial services. As the World Bank reported, more than 50 countries are actively developing plans and policies for achieving FI to achieve universal financial access. Though FI is a global socioeconomic challenge, its impact will be greater for less-developed countries than for developed countries since research has determined that FI is fundamental for growth and poverty alleviation (Kim 2016). The experience of emerging nations, like India, is unique and severe, and the growth has been non-inclusive, one of the key reasons being the failure to achieve greater financial inclusion (Shafi and Medabesh 2012). Since the situation in emerging economies is different, it is imperative to study the dynamics in that context. Two critical types of factors that the literature has identified as driving FI across countries are structural factors and policy-related factors. While structural factors primarily decide the cost of delivering financial services to the population, policy-related factors are essential in creating a facilitating environment for financial inclusion. One of the primary structural factors is the information and communication technology (ICT) infrastructure. The diffusion of ICT has caused an intensive transformation of the world and allowed more access to finance. Technological innovation plays a vital role in economic growth. ICT reduces income disparities by formalizing the financial sector, and the literature has argued that FI is one of the ways in which ICT facilitates economic growth (Kpodar and Andrianaivo 2011; Tchamyou, Erreygers, and Cassimon 2019). Digital financial inclusion refers to leveraging ICT to enhance financial inclusion meaningfully. It is an evolving phenomenon, and understanding its associations with financial inclusion has many policy implications. Economic models indicate that economic freedom can influence production and resource efficiency. Countries with a low level of regulations will have more economic freedom than countries with more regulations—the greater the economic freedom, the greater the income and growth of a society. Economic researchers have reported that free choices and a supply of resources, rivalries between enterprises, and the trade and safety of private liberties are crucial to economic progress (North and Thomas 1973). In economically free societies, governments permit free mobility of labor, capital, and other resources and refrain from imposing constraints on liberty beyond a degree that is necessary to defend and preserve democracy itself (Heritage Foundation 2019). The Economic Freedom Index indicates that a total of 90 countries (50%) offer organizational conditions in which private firms enjoy at least a reasonable degree of economic freedom to achieve greater wealth and accomplishments. Furthermore, economic freedom is one of the significant factors affecting financial development and growth. Hence, there is a strong rationale for examining the effect of economic freedom on financial inclusion. However, there is no empirical evidence on the linkages between economic freedom and financial inclusion. ADBI Working Paper 1244 Rekha, Rajamani, and Resmi 2 The critical question facing practitioners and researchers regarding how to achieve an all‐inclusive financial system remains unanswered. In this context, this paper aims to explore the linkages among ICT diffusion, economic freedom, financial development, and financial inclusion by empirically examining a panel dataset pertaining to 22 emerging economies. The organization of the rest of the paper is as follows. Section 2 contains a brief review of the relevant conceptual and empirical literature on financial inclusion, ICT diffusion, economic freedom, and financial development. Section 3 discusses the data, sources, and empirical model that this study uses. Section 4 presents the empirical procedure and the results. Section 5 provides a discussion and policy implications. Section 6 presents the concluding remarks. 2. BRIEF REVIEW OF THE LITERATURE Both theoretical and empirical studies have observed that economies with higher degrees of financial inclusion have higher rates of GDP growth as well as lower income disparities (King and Levine 1993; Clark et al. 2006; Beck et al. 2007; Demirgüç-Kunt and Levine 2009; Demirgüç-Kunt, Klapper, and Singer 2017). Studies have presented empirical evidence on the FI–economic development nexus. Financial inclusion in developed economies primarily focuses on awareness of equal and affordable financial services, whereas, in developing economies, both access to financial services and financial literacy are involved. Financial exclusion focuses primarily on issues related to access, in particular the availability of banking outlets (Leyshon and Thrift 1995). Neaime and Gaysset (2018) observed that financial inclusion exerts a positive impact on financial stability and reduces income disparities in MENA countries. The numbers of loans/savings accounts and ATMs have unidirectional causation effects on the growth of the economy (Sharma 2016). Kim, Yu, and Hassan (2018) investigated the link between FI and economic growth in 57 companies through a panel regression analysis. They argued that financial inclusion has a positive impact on economic growth. Sarma and Pais (2011) examined the relationship between financial inclusion and development using country-specific factors related to FI. They proposed that variables such as income, discrimination, literacy, urbanization, communication networks, and knowledge play a significant part in financial inclusion. Sethi and Sethy (2019) confirmed that FI positively influences economic growth by analyzing both the demand and the supply side of financial services. The study also indicated that improving FI makes economic growth possible in the long run. Kumar (2013) investigated the availability of financial inclusion indicators in 29 Indian states using fixed effects and the generalized method of moments. The study suggested that the branch network is an important indicator of FI in India. Anarfo et al. (2019) examined the triadic connection between FI, financial sector development, and economic growth pertaining to sub-Saharan Africa, employing a VAR estimation method. It is evident from the study that FI is a critical factor in financial sector development. Further, evidence from the literature has suggested that FI supports economic growth through ICT. ICT in financial inclusion facilitates digital access to the use of formal financial services for excluded and underserved populations. Joia and dos Santos (2017) determined that e-government ventures fulfill the population’s need to access financial products and services. Another study suggested that the government could create central information repositories to provide the general public with general information about financial service providers to facilitate financial inclusion (Bongomin, Ntayi, and Munene 2016). Andrianaivo and Kpodar (2012) investigated the impact of ADBI Working Paper 1244 Rekha, Rajamani, and Resmi 3 ICT, especially that of mobile and fixed telephone penetration, on growth on a panel of African countries using the generalized method of moments (GMM) estimator. Mihasonirina and Kangni’s (2011) similar study also confirmed the importance of communication technologies for FI. Tchamyou, Erreygers, and Cassimon (2019) investigated the effect of ICT on economic disparity through the dimensions of depth, efficiency, activity, and size of the financial sector in African countries. The result showed that ICT lessens income disparity by formalizing the financial services sector. Another work based on the MENA region suggested that a high degree of ICT diffusion influences financial development favorably and enhances economic growth (Sassi and Goaied 2013). Falahaty and Jusoh (2013) also highlighted the significance of ICT in the financial growth of MENA countries. Earlier research has considered financial intermediaries as critical catalysts for innovation and economic growth. Schumpeter (1911) and Robinson (1952) argued that finance has no causal effect on development. Instead, financial development follows economic development as a consequence of the increased need for financial services. In the context of the increasing demand for financial services, more financial institutions, financial goods, and services arise in the markets. Ang and McKibbin (2007) investigated the impact of financial development on growth by analyzing Malaysian data in the period 1960 to 2001. The result indicated that financial liberalization has a significant influence on financial sector development. Many theoretical and empirical studies have supported the causal linkage between financial development and economic growth, indicating that established financial institutions and markets improve service availability, leading to economic development (King and Levine 1993; Neusser and Kugler 1998; Levine, Loayza, and Beck 2000), whereas some of the empirical research has also supported the hypothesis of a causal relationship between economic growth and financial development. Here, the growing demand for financial services could cause financial sector development as the real economy grows. Here, the need for financial services could contribute to the development of the financial sector when the overall economy develops (Goldsmith 1969; Jung 1986). In an economically free society, there will be freedom to work, produce, consume, and invest in any manner. Hafer (2013) argued that research has identified a substantial link between economic and financial development and economic freedom. The study further revealed that countries with greater economic freedom exhibit a higher degree of development in financial intermediaries, resulting in rapid economic growth. The findings from this research partly justify the association between economic freedom and growth. Carlson and Lundström (2002) suggested that economic freedom has a strong association with development. Financial freedom, which is one of the factors of economic freedom, has a significant long-run relationship with financial inclusion (Rekha, Rajamani, and Resmi 2020). However, there are no empirical studies in the literature on the linkages between economic freedom and financial inclusion. 3. METHODOLOGY 3.1 Data and Sources The study used annual data covering the period 2004–2017 pertaining to 22 emerging economies, which the availability of data dictated. We developed an index of financial inclusion (IFI) with three dimensions—namely penetration, availability, and usage—following a method similar to the one that Sarma and Pais (2011) explained, using World Bank data. The ICT Development Index, which measures the digital divide ADBI Working Paper 1244 Rekha, Rajamani, and Resmi 4 and enables the comparison of ICT performance across countries, comes from the United Nations International Telecommunication Union (UNITU 2017). The Index uses 11 information and communication technology (ICT) metrics (Table 1) in three subindices, namely ICT access, ICT use, and ICT skills, and aggregates the weighted values. The normalized and averaged indicators provide the sub-index values. Table 1: Indicators for the ICT Index Weights (Indicators) Weights (Sub-indices) ICT access 0.40 Fixed-telephone subscriptions per 100 inhabitants 0.20 Mobile-cellular telephone subscriptions per 100 inhabitants 0.20 International Internet bandwidth per internet user 0.20 Percentage of households with a computer 0.20 Percentage of households with internet access 0.20 ICT use 0.40 Percentage of individuals using the internet 0.33 Fixed-broadband Internet subscriptions per 100 inhabitants 0.33 Active mobile-broadband subscriptions per 100 inhabitants 0.33 ICT skills 0.20 Mean years of schooling 0.33 Secondary gross enrollment ratio 0.33 Tertiary gross enrollment ratio 0.33 Source: ITU. The Heritage Foundation (2019) provided the Economic Freedom Index, which measures the economic freedom in a country. The index covers 12 freedoms, from property rights to financial freedom (Table 2). Table 2: Economic Freedom Factors SL Category Factors 1 Rule of Law Property rights, government integrity, judicial effectiveness 2 Government Size Government spending, tax burden, fiscal health 3 Regulatory Efficiency Business freedom, labor freedom, monetary freedom 4 Open Markets Trade freedom, investment freedom, financial freedom Source: Heritage Foundation. We obtained the Financial Development Index, an aggregate of the Financial Institutions Index and the Financial Markets Index, based on depth, access, and efficiency, from the International Monetary Fund (IMF) database (IMF 2019). We employed the gross domestic product converted into international dollars using purchasing power parity rates (GDP PPP) as a proxy for economic development (World Bank 2018). ADBI Working Paper 1244 Rekha, Rajamani, and Resmi 11 Rekha, A. G., K. Rajamani, and A. G. Resmi. 2020. “Financial Divide, E-Governance and Financial Freedom: Empirical Evidence from Emerging Economies.” Finance India 34 (2): 563–72. Robinson, J. 1952. “The Generalization of the General Theory.” In The Rate of Interest and Other Essays. London: MacMillan. 67–146. Sarma, M., and J. Pais. 2011. “Financial Inclusion and Development.” Journal of International Development 23 (5): 613–28. Sassi, S., and M. Goaied. 2013. “Financial Development, ICT Diffusion and Economic Growth: Lessons from MENA Region.” Telecommunications Policy 37 (4–5): 252–61. Schumpeter, J. A. 1911. The Theory of Economic Development. Cambridge, MA: Harvard University Press. Sethi, D., and S. K. Sethy. 2019. “Financial Inclusion Matters for Economic Growth in India: Some Evidence from Cointegration Analysis.” International Journal of Social Economics 46 (1): 132–51. Shafi, M., and A. H. Medabesh. 2012. “Financial Inclusion in Developing Countries: Evidences from an Indian State.” International Business Research 5 (8): 116. Sharma, D. 2016. “Nexus between Financial Inclusion and Economic Growth: Evidence from the Emerging Indian Economy.” Journal of Financial Economic Policy 8 (1): 13–36. Tchamyou, V. S., G. Erreygers, and D. Cassimon. 2019. “Inequality, ICT and Financial Access in Africa.” Technological Forecasting and Social Change 139: 169–84. United Nations International Telecommunication Union (UNITU). 2017. “ICT Development Index.” https://www.itu.int/en/ITU-D/Statistics/Pages/ stat/default.aspx. World Bank. 2018. “PPP GDP.” https://data.worldbank.org/indicator/NY.GDP. PCAP.PP.CD.