WORKING PAPER NO.

2015-04

Financial System Development and Economic Growth in Transition

Economies: New Empirical Evidence from the CEE and CIS Countries
By

Laura Cojocaru, Evangelos M. Falaris, Saul D. Hoffman, and Jeffrey B. Miller

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 Financial System Development and Economic Growth in Transition Economies:

New Empirical Evidence from the CEE and CIS Countries

Laura Cojocaru*, Evangelos M. Falaris**, Saul D. Hoffman**, and Jeffrey B. Miller***

January, 2015

Abstract: We examine the role of financial development in economic growth in the former

Communist countries of Central and Eastern Europe and the Commonwealth of Independent

States during the first two decades since the beginning of transition. These countries, which had

undeveloped financial systems under Communism, provide an interesting test of the relationship

between financial development and growth. Our study is the broadest in terms of coverage and

time period. We find that measures of financial market efficiency and competitiveness are more

important than the size of the market in terms of promoting economic growth.

JEL Classification: O16, P27, P34

Keywords: transition economies, CEE, CIS, financial sector development, economic growth

* Bankable Frontier Associates, 259 Elm Street, Suite 200, Somerville, MA 02144, USA;

lcojocaru@bankablefrontier.com

** Department of Economics, University of Delaware, Newark, DE, 19716, USA;

falaris@udel.edu; hoffmans@udel.edu

*** Department of Business, Gallaudet University, 800 Florida Avenue, NE, Washington, DC
20002, USA; socsecan@gmail.com

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I. Introduction

When the economic transition began in Central and Eastern Europe and the former Soviet

Union, the development of viable financial sectors was perceived to be an especially challenging

task. Centrally-planned economies did not have financial systems designed to allocate credit to

their highest value use. Instead, the financial sector functioned primarily as an accounting

system for carrying out the economic plan. Creating a market-oriented financial system during

transition presented unique problems. Unlike the situation in a developing economy where

enterprises grow over time and expand their funding sources as they grow, transition economies

already had large enterprises in place that would suddenly be cut off from their previous sources

of funding if new financial systems did not function properly. In the more than two decades that

have passed since the transition began in 1990, much progress has been achieved in the

development of financial systems, but the process of creating and reforming these systems based

on capitalist principles still continues and the extent of reform varies widely across the countries.

A substantial body of empirical research has investigated the relationship between

financial development and economic growth. Following King and Levine (1993) and the

development of techniques that addressed endogeneity issues, this literature finds that

development of an efficient financial system is an important determinant of economic growth

(Beck, Levine and Loayza (2000)). We still know very little, however, about the relationship

between financial development and economic growth under the circumstances specific to

transition economies. To date, only one paper (Koivu 2002) has addressed this issue across the

full range of transition economies and it is limited to the first seven years after transition, a time

period too short to assess impacts or to use more appropriate econometric techniques. This paper

attempts to fill that knowledge gap.

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 In this paper, we re-examine the relationship between financial development and

economic growth in the transition economies of Central and Eastern Europe (CEE) and the

Commonwealth of Independent States (CIS). We use panel data for 1990-2008 to estimate this

relationship beyond the first post-transition decade. The longer time period allows us to account

for possible endogeneity, using the System Generalized Method of Moments estimation

introduced by Arrelano and Bond (1991) and further developed by Arrelano and Bover (1995).

We examine multiple measures of the financial system, including indicators of financial

efficiency as well as financial depth. Like most research in this area, we focus primarily on the

characteristics of the banking system as measures of financial development.

When we include measures of both the amount of private sector credit and of the

efficiency of the banking system, we find that efficiency is more important and statistically

significant, while the impact of private credit is quantitatively smaller and statistically

insignificant. We find particularly strong evidence for the role of interest rate spreads and bank

overhead costs on economic growth. Our results are consistent with the general findings on the

financial development-growth relationship in other countries. In the context of the CEE and CIS

countries and in light of the specific problems they encountered during the process of financial

development, these results suggest the importance of continued emphasis on financial sector

development in transition economies.

The rest of this paper is organized as follows. In Section 2, we present a selective

literature review of the financial development-economic growth relationship, including papers

concerned with various aspects of financial development during transition. We also offer an

overview of the financial development process in the CEE and CIS countries. In Section 3 we

present our data and methods. We discuss the statistical problems associated with estimating

3
growth models and then discuss our preferred econometric method -System GMM. Section 4

presents our findings Section 5 presents conclusions and we also suggest topics for future

investigation.

II. Background

Literature review

The study of the relationship between financial development and economic growth can be

traced back to Schumpeter (1912), who argued that banks facilitate financial intermediation and

promote economic growth by selecting those entrepreneurs with the most innovative and

productive projects. Several decades later, Robinson (1952), Gurley and Shaw (1955) and Lewis

(1955) raised questions about the direction of causality. The modern empirical literature in this

area developed in the 1990s, following King and Levine (1993), who find positive effects of

financial sector development on growth. To address some of the econometric problems

associated with cross-country growth analysis, including reverse causation and omitted variables

bias, Levine, Loayza, and Beck (2000) and Beck, Levine, and Loayza (2000) used the System

Generalized Method of Moments (GMM) for panel data. The results in these papers were very

similar to those obtained earlier in pure cross-sectional analyses.

Other studies generally found a positive effect of financial development on economic

growth, however often depending on the presence of certain economic conditions. For example,

Rousseau and Wachtel (2002) found that the effect is significantly positive only when inflation is

below 5-6 percent, with the largest effect taking place during periods of disinflation. Rioja and

Valev (2004a) suggested that the effects of financial development might be non-linear or

dependent on exceeding certain thresholds. In a later study, Rousseau and Wachtel (2011) found

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that the relationship between financial deepening and growth may be weaker for developing

countries and may have weakened more generally in the past decade.

Despite the very different institutional context in transition economies, very few papers

have examined the effects of larger and more efficient financial systems on these economies.

Only Koivu (2002) focuses on almost all CEE and CIS transition countries.1 Using data for the

period 1993-2000, she finds that the margin between lending and deposit interest rates negatively

and significantly affected growth, but the size of the financial sector had no effect. Because her

analysis covers only a relatively short post-transition time period, some of which was affected by

political turmoil, it may not capture effects that may take longer to appear. Fink, Haiss and

Vuksic (2009) find that total financial intermediation contributed to growth in nine EU accession

countries, including seven CEE countries, for the period 1996-2000; domestic credit was a

significant factor in promoting growth, but private credit and stock market capitalization were

not important. Again, the time period is quite short. Mehl, Vespro and Windler (2006) find that

financial deepening had no significant effects on the growth of the South-Eastern European

countries for the period 1993-2003. Moreover, they find a significant negative effect of financial

intermediation and monetization on growth and a positive and sometimes significant effect of the

foreign bank penetration ratio. Other relevant studies include Masten, Coricelli, and Masten

(2008), who focus on financial integration and economic growth in Europe between 1996 and

2004, and Eller, Haiss, and Steiner (2006), who examine the impact of financial sector foreign

direct investment (FSFDI) on economic growth for 11 Central and Eastern European countries

between 1996 and 2003.

1 Tajikistan, Turkmenistan and Uzbekistan are missing from some models.

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 No study to date examines the CEE and CIS countries over a longer time frame and with

attention to multiple measures of financial development and econometric issues. These countries

provide an excellent test of the effect of financial development on growth, because their financial

systems are relatively new and vary widely.

Financial development in the CEE/CIS countries

Since the 1990s, the CEE and CIS countries have made substantial progress in the

creation and reform of their financial markets and institutions which, under the prior Communist

regimes, were limited to allocating funds passively to firms according to a central plan. Although

the inherited structures of these countries shared many similarities, important differences did

exist. For example, enterprises in Hungary, Poland and the former Yugoslavia were given some

degree of independence in their decisions and there were even some private firms. Monetary

holdings and trade credit were also allowed. The situation was vastly different in countries such

as Bulgaria, Romania and the Soviet Union (Coricelli (2001)).

During the first years after the fall of the Communist regimes, state-owned banks were

freed from the influence of the Central Bank and a large fraction of their non-performing loans

was written off (Liebscher et al. (2007)). Later, these banks were restructured and privatized,

commercial banks were created, and new, foreign-owned banks started to emerge. High levels of

foreign bank ownership, in many of these countries, between 60 and 90 percent, are now a

striking feature of many Eastern European banking systems.2 Foreign ownership brought

technological and managerial improvements, economies of scale, and arm’s length relationships

2 Foreign bank ownership accelerated dramatically after 1998 and continued even after 2000,
although at a slower pace.

6
between the financial sector and industry. It also reduced the concentration of economic power in

banking markets (Liebscher et al. (2007)).

The liberalization of the banking system encountered a series of problems. Ineffective

bankruptcy or contracting laws and the lack of enforcement mechanisms and adequate collateral

guidelines often led to soft budget constraints for former state-owned firms and to moral hazard

problems on the managers’ part. Although bank privatization and foreign ownership can harden

budget constraints, some soft budget constraints continued even after the reform of the financial

sector (De Haas (2001)). Most transition economies in Europe experienced major bank

insolvencies in the 1990s. The government institutions of these countries were weak and

vulnerable to pressures from various interest groups, which in turn hampered banking sector

restructuring. The lack of adequate deposit insurance laws and auditing and accounting standards

for firms and the often low-skilled human capital in the banking sector created additional

problems.

Table 1 summarizes selected economic and financial development indicators in the CEE

and CIS countries in 1995 and in 2008: GDP per capita, domestic credit to the private sector as a

percentage of GDP, and market capitalization of listed companies. Also shown are the

corresponding measures for three Western European countries, the United States, and Japan.3 As

of 1995, domestic credit to the private sector in the CIS countries ranged from just 1.5 percent of

GDP in Ukraine to 12.5 percent in the Kyrgyz Republic, compared to 86 to 203 percent in the

more developed countries. The CEE countries had greater domestic credit than the CIS

3 Because some of the non-CEE, non-CIS comparison countries, like the UK, are international
finance centers, some of their financial measures are larger than might be expected based on the
size of their domestic economies. France and Germany are the lowest of the group shown. Both
had domestic credit percentages that are approximately twice the CEE and CIS average.

7
countries, but, except for the Czech Republic, none were above 40 percent. In 1995, the average

GDP per capita of the CEE and CIS countries was just under $2700, less than 10 percent of the

level in the developed countries. Only Slovenia had GDP per capita greater than $10,000.

By 2000, many of these transition countries, especially the EU members, had carried out

significant reforms of their legal and financial structures and institutions. At present, some

countries have levels of credit to the private sector comparable to those of some West European

countries, although others are still lagging behind. The average credit level in these countries

tripled to 54.8 percent in 2008. GDP per capita also increased substantially, yet important

disparities remain, both in terms of GDP per capita and of financial development. For example,

GDP per capita in 2008 in Slovenia was $26,779, whereas in the Kyrgyz Republic it was less

than $900 per capita. Furthermore, private credit in Latvia was 90 percent of GDP, while in

Armenia it was only 17 percent of GDP. This compares with private credit in the UK, which has

a large international financial sector, of over 213 percent of GDP. Market capitalization shows

even more dramatic differences. Armenia’s market capitalization in 2008 was only 1.5 percent of

GDP while in the Russian Federation market capitalization was more than 82 percent, almost

equal to the market capitalization in the US.

Given the wide variation in the financial development of the CEE and CIS countries and

the specific problems associated with the reform of their financial sectors, it is important to

examine if the financial development-economic growth relationship holds in transition

economies and to determine which components of the financial system play the most important

role for the growth of these countries.

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III. Data and Methods

Methods. We use a standard model of economic growth augmented with measures of

financial development and efficiency. We model economic growth (g) in country i over time

period t as a function of income at the beginning of the period (yit), its level of financial

development (FDit), other observable country characteristics (Xit), an unobserved country effect

(ηi) and time effects (γt):

(1) 𝑔𝑔𝑖𝑖𝑖𝑖 = 𝛾𝛾𝑡𝑡 + 𝛼𝛼𝑦𝑦𝑖𝑖𝑖𝑖 + 𝛽𝛽𝑋𝑋𝑖𝑖𝑖𝑖 + 𝜆𝜆𝐹𝐹𝐹𝐹𝑖𝑖𝑖𝑖 + 𝜂𝜂𝑖𝑖 + 𝑣𝑣𝑖𝑖𝑖𝑖 , for i=1…N and t=1…T.

The focus of the analysis is on λ, which measures the impact of financial sector

development on economic growth. In order to measure financial sector development, we use

multiple indicators of financial development and financial efficiency. These indicators are

discussed in more detail in the data section.

The estimation of growth equations has well-known statistical difficulties. These

include the dynamic nature of the data-generating process; endogenous regressors and the

difficulty of finding valid instruments for potential IV estimation; measurement error, omitted

variables, and a small number of time periods.

An econometric method that deals with these problems is the First-Differenced

Generalized Method of Moments Estimator (difference GMM) developed by Arrelano and Bond

(1991). The model is based on the idea that taking the first difference of equation (1) removes the

time-invariant country fixed effects. Assuming that the transient errors are serially uncorrelated

and that the initial conditions are predetermined, the model instruments the right-hand-side

variables with lags. This method controls for time-invariant omitted variables bias and provides

consistent estimates, even in the presence of endogeneity and measurement errors. However, the

difference GMM model has been found to have poor finite-sample properties and problems

9
related to weak instruments may arise when the time series are persistent and the time dimension

is small (Arrelano and Bover (1995); Blundell and Bond (1998)). Growth series indeed have

these properties, since output is often averaged over periods of five years and is relatively

persistent. In this case, the difference GMM estimator may perform poorly in terms of bias and

precision.

The System Generalized Method of Moments estimator introduced by Arrelano and

Bover (1995) and further developed by Blundell and Bond (1998) produces consistent estimators

even under these conditions and has been shown to have superior finite sample properties.4 It

makes the additional assumption that the log difference of per capita GDP is not correlated with

the country’s individual effects. This assumption does not imply that country-specific effects

play no role in output determination, but rather that output growth and country-specific effects

are uncorrelated in the absence of conditioning variables. This allows for the use of lagged first-

differences as instruments for equations in levels. Thus, system GMM combines the set of

equations in first differences with suitable lagged levels as instruments, and with an additional

set of equations in levels with suitably lagged first-differences as instruments. Including the

regression in levels reduces the biases associated with small samples, since it does not eliminate

cross-country variation and does not intensify measurement error. Moreover, regressions in

levels have stronger correlation with their instruments than the variables in differences. Our use

of the system GMM estimation procedure follows Beck, Levine, and Loayza (2000).

4 Blundell and Bond (1998) use Monte Carlo simulations and show that in the case of finite
samples, system GMM offers dramatic reduction of bias and improved precision over difference
GMM estimation. These findings are also shown to hold in models with lagged dependent
variables and additional right-hand-side variables, as typically encountered in estimations of
growth models.

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 For all models reported in this paper, we use two tests of model specification. First, we

use the Hansen test of over-identifying restrictions, which tests the overall validity of the

instruments in excess of the number of endogenous regressors. Second, we examine the

assumption of no serial correlation in the error terms.5 Robust two-step standard errors are

computed, using the methodology suggested by Windmeijer (2005) to correct for small sample

biases.

Data. Our broadest dataset includes ten CIS countries—Armenia, Belarus, Georgia,

Kazakhstan, Kyrgyz Republic, Moldova, the Russian Federation, Tajikistan, Turkmenistan, and

Ukraine—and 15 CEE countries—Bosnia and Herzegovina, Bulgaria, Croatia, Czech Republic,

Estonia, Hungary, Latvia, Lithuania, Macedonia FYR, Montenegro, Poland, Romania, Serbia,

the Slovak Republic, and Slovenia. We do not include Albania, Azerbaijan, or Uzbekistan,

because no reliable data on financial system statistics are available. All data are taken from the

World Development Indicators (World Bank (2009)) and cover the period 1990-2008, except for

bank concentration, which was extracted from a database originally presented in Beck,

Demirgüç-Kunt, and Levine (2000) and updated subsequently. In some models, we necessarily

use a subset of countries to facilitate the use of certain independent variables that are not

available for all countries.

Economic growth is measured by the annual growth of real gross domestic product per

capita based on constant local currency.6 Because financial development is a complex concept,

5In System GMM, the presence of second order serial correlation calls into question the validity
of the instruments and may lead to biased coefficient estimates. First order serial correlation may
be present and does not pose a problem.
6It should be noted that the population of many of these countries fell during this time period.
The growth in output per capita thus reflects, to some degree, the decline in population.

11
we use multiple alternative measures of the size of financial intermediation and of the efficiency

of the financial sector. The efficiency of the financial system is measured by three indicators

that reflect the extent of competition in banking and finance. The Interest Rate Spread is the

difference between the interest rate charged by banks on loans to prime customers and the

interest rate paid by commercial or similar banks for demand, time, or savings deposits.7 It

reflects the costs of intermediation that banks incur and their mark-up levels, reflecting their

efficiency and market competitiveness. Saunders and Schumacher (2000) point out that although

the ex-Communist countries have made progress, their interest rate spreads were still relatively

large when compared to Western European countries.8 Lower interest spreads could reflect more

competition in the banking sector, better contract enforcement, efficiency in the legal system and

a lack of corruption (Demirgüç-Kunt and Huizinga 1998). However, relatively large spreads

may insure a higher degree of stability for the financial system, adding to the profitability and

capital of banks and better protecting them against crises. The net effect is uncertain, although

we expect the positive effect of low spreads to dominate.

We also examine two other related measures of banking efficiency. Overhead Costs are

banks’ operating costs for salaries, motor vehicles, and fixed assets (excluding depreciation),

relative to total earning assets. We expect that high overhead costs, typically reflecting

operational inefficiency, would have a negative impact on growth. Bank concentration is the

percent of total commercial bank assets controlled by the three largest banks. Although their

7 During this time period, foreign currency lending varied considerably and the length of average
loans also grew; see Haiss and Rainer (2012). Addressing these issues is a possible area for
future research.
8Bonin, Hasan and Wachtel (2008) suggest that much of the decrease in interest rate spreads
observed since the beginning of transition may be due to a reduction in the risk in the
macroeconomic environment, rather than an increase in banking competitiveness.

12
experiences were not identical, all CEE and CIS countries inherited high concentration ratios that

persisted long into the transition process. A highly concentrated commercial banking sector

might result in lack of competitive pressure to attract savings and channel them efficiently to

investors. On the other hand, a highly fragmented market might be evidence of undercapitalized

banks. Beck, Demirgüç-Kunt and Levine (2006) find some evidence that favors concentration-

stability theories: higher bank concentration reduces the likelihood that a country will suffer a

systemic banking crisis.9 All measures of financial system efficiency are measured in natural log

units.

Size is measured by two variables: Private Credit and Liquid Liabilities. Both are

measured as a percentage of GDP and converted into natural log units. Private Credit, one of the

main measures of financial development used in recent empirical studies, includes financial

resources provided to the private sector through loans, purchases of non-equity securities, trade

credits and other accounts receivable that establish a claim for repayment. Because this measure

excludes credit issued to the public sector, it is especially relevant for the countries studied.

Domestic Credit includes all credit to various sectors, including the public sector, bills, bonds,

and securities, loans and advances.

To control for other factors affecting economic growth, we use variables regularly

employed in the empirical growth literature. Initial GDP per capita, measured at the beginning

of each period, controls for the growth convergence effect (Barro, (1991)). The standard

prediction of neoclassical growth models is that a country will grow faster, the further away it is

from its steady state. Thus, we expect this variable to have a negative effect. Secondary school

9 This hypothesis seems less credible in light of the financial crises of the past few years.

13
enrollment10 is a measure of human capital and is expected to have a positive effect. These

measures are entered in the models in natural log units.

To aggregate away short-run business cycle effects and to better proxy long-run

economic growth, we follow the standard practice in the empirical growth literature by averaging

data across five-year time periods in the estimation of the system GMM model. Because we

have a 19 year time period from 1990 to 2008, we use one four-year period (1990-1993) and

three five-year periods. All country characteristics are averages over the sub-periods. Time

dummies are included in many of the specifications to control for common time trends in

economic growth, such as common productivity changes. We do not include other country-

specific policy variables such as budget deficits, the inflation rate, and exchange rate changes,

because they are likely to be endogenous.

Table 2 presents summary statistics for the main variables in our analysis, while

Appendix Table 1 provides summary statistics of selected financial indicators and economic

growth separately by country. The sample included in Table 1 is the core of our analysis and

includes 78 country x time-period observations. As can be seen in Table 2, the countries in the

sample have substantial differences in economic growth, financial development and

macroeconomic stability. The mean average period growth rate is 2.39, but there is a 25

percentage point range. All the financial indicators vary substantially. Private credit and liquid

liabilities both have a substantial range and standard deviation, as does the interest rate spread.

Overhead costs and concentration have slightly less, but still substantial, variation.

10We measure this as total enrollment in secondary education, regardless of age, expressed as a
percentage of the population of official secondary education age. The enrollment rate can exceed
100% due to the inclusion of over-aged and under-aged students because of early or late school
entrance and grade repetition.

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IV. Results

Table 3 reports our basic results for each measure one at a time, along with the control

variables. Our analysis sample includes 23 CIS and CEE countries; Montenegro and

Turkmenistan are dropped because no information on secondary school enrollment is available.

Columns (1) - (3) present the financial efficiency results and columns (4) - (5) present the

financial depth estimates. In this table and also in the following table, we carried out standard

specification tests (Hansen test and Arellano-Bond test for AR(1) and AR(2)). The results of

these tests support the validity of the over-identifying restrictions and the absence of second

order serial correlation in all regressions. Thus these tests are supportive of the reliability of our

estimates.

We find a statistically significant and large, negative impact of the interest rate spread

and overhead costs on economic growth; see columns (1) and (2). This means that those

economies whose financial systems offered lower interest rate spreads and whose banks had

lower overhead costs experienced relatively faster economic growth. Bank concentration has a

negative effect, but it is not statistically significant. The effect of private credit is positive and

statistically significant, indicating that, controlling for endogeneity, financial deepening

positively influenced economic growth in the CIS and CEE countries. This finding contrasts with

Koivu (2002) who finds that private credit negatively affects economic growth in the first post

transition decade. Domestic credit has a negative effect that is very imprecisely estimated (t-

statistic of 0.35).

Taken as a whole, these estimates tentatively suggest two findings. First, financial

structure and competitiveness had important effects on economic growth in the CIS and CEE

countries. Second, credit extended to the private sector played a more important role in

15
promoting economic growth than domestic credit overall. For transition economies, this result is

not too surprising, in light of the soft budget constraints and the persistence of state-owned

enterprises, especially during the first years after 1990. Even with a largely privately-owned

banking system, these problems can severely distort the allocative role of financial

intermediaries.

Among the other variables included in the models, initial GDP/capita has the expected

negative effect on growth and is consistently statistically significant. Secondary school

enrollment has a positive effect in all equations but one, but it is not generally statistically

significant. This may be because secondary school is mandatory in many of these countries and

its quality varies widely across countries. Its estimated impact is much larger in the models that

include measures of financial efficiency and competitiveness than those that include financial

size.

In Table 4, we present regressions, each of which includes multiple measures of financial

efficiency and financial size on economic growth. To keep the analysis manageable, we drop

domestic credit and focus on the remaining variables. We present four specifications, combining

each of the three financial system efficiency measures with private credit and then one with all

measures included. The measures are reasonably highly correlated, so estimation of precise

effects is more challenging.

When private credit is included along with the interest rate spread, we find that the

impact of private credit is about one-third its previous magnitude and it is no longer statistically

significant. The estimated effect of the interest spread falls by about 15%, but it is still

substantial and remains statistically significant. The sample used in Table 4 is not the same as in

16
Table 3, because the financial efficiency measures are not available for all countries and that

raises the possibility that the change in the impact of private credit reflects the changed sample.

To test this, we re-estimated the model of Table 3 with private credit alone on the sample used in

Table 4, Column (1). With that sample, the estimated coefficient on private credit, which was

3.88 in Table 3, fell to 3.15 and its t-statistic fell to 1.5, probably due to the smaller sample.

Adding the interest rate spread further reduces the coefficient to 1.30 and its t-statistic to 0.76.

Thus, the substantial decrease in the estimated effect of private credit that we observe in Table 4

is due primarily to the inclusion of the interest rate spread rather than the change in the sample.

A similar result holds for overhead costs: the impact of private credit is smaller and not

statistically significant, while the effect of overhead costs remains large, negative, and

statistically significant. The sole exception to this pattern is for bank concentration, where the

efficiency measure is not statistically significant, but private credit is. When we attempt to

include all the measures in column (5), the inter-correlation of the measures and the smaller

sample size across which all the measures are available (N=64) prevents us from estimating any

effects with statistical reliability. Tentatively, and with full awareness of the data limitations, we

interpret the results as evidence of the greater importance of financial system structure,

especially interest rate margins and overhead costs, relative to financial system size.

Robustness checks. We estimated a set of alternative specifications. We summarize

them here; full estimates are available from the authors.

17
 Because the schooling variable is not available for all countries x time periods, its

inclusion affects sample size.11 No qualitative or quantitative estimates differ when secondary

school enrollment is dropped from the regressions. We also experimented with controls for the

openness of the economy and the size of government, even though these may well be

endogenous.12 The degree of openness of the economy is measured as the sum of imports and

exports as a percent of GDP. Size of government is measured by government expenditures as a

percent of GDP. When we included both the openness and the government expenditure

measures to our baseline specification. The extent of openness has a negative effect on growth

that is statistically significant at the 10 percent level, while the size of government has a very

small, negative and statistically insignificant effect. The negative effect of openness may reflect

a shift of consumer demand toward higher-quality imported goods in the years immediately after

the opening of trade. The inclusion of these variables does not, however, qualitatively alter the

results concerning the effect of private credit on economic growth: the estimated coefficient of

private credit is nearly the same as in the baseline model. We also confirmed the negative effects

of high interest rate spreads by adding the degree of openness and government expenditure. The

estimated effect of the interest rate spread was unchanged.

Finally, we examined possible differences in the effect of financial variables on the CIS

and CEE countries. Because of sample size issues, we were unable to test whether the

relationship between financial development and economic growth differed between the two

11 Eight observations are lost, one each from Armenia, Bosnia and Herzegovina, Macedonia, and
the Slovak Republic, and three from Turkmenistan.
12In principle, it is possible to control for this endogeneity using system GMM. In practice, our
data set is not large enough to estimate this model and yield precise estimates.

18
groups using the GMM method. We did test for a simple additive difference in growth rates

between CEE and CIS countries via a dummy variable and found no evidence that growth rates

differed in this way between the two sets of countries.

V. Conclusion

In this paper, we empirically investigated the effect of financial sector development on

economic growth in the former CEE and CIS Communist countries over the transition years from

1990 through 2008. These countries are a particularly interesting example of this relationship

because they entered the transition with very undeveloped financial systems and because there is

substantial variation among them in the pace of financial development. Furthermore, problems

specific to the transition period in these countries, such as soft budget constraints and low bank

competition, could have weakened the potential positive effects of financial development on

economic growth. Thus, we were particularly interested in identifying the elements of financial

development (increase in size, efficiency, market competition) that had the most important role

in stimulating economic growth. To this end, we used several alternative measures to proxy both

financial depth and financial efficiency. Because of the possible endogeneity of some of the

regressors, we use system GMM in our estimation, following an approach previously used by

Beck, Levine and Loayza (2000).

We find some evidence that financial system efficiency and competitiveness is more

important than the amount of private sector credit provided by the banking system. While credit

to the private sector and efficiency measures are quantitatively important and statistically

significant by themselves, when we consider them together, efficiency is more important and

19
statistically significant.13 We find particularly strong evidence for the role of interest rate spreads

and bank overhead costs.

Our findings for these transition economies are broadly consistent with the overall

positive findings in the financial development-economic growth literature. In this respect, our

findings on the role of financial credit in transition economies do not support the finding of

Koivu (2002) that private credit negatively affected economic growth in the CEE and CIS

countries. However, her results are based on a shorter and earlier post-transition time period and

a different econometric technique. In a specification similar to hers, we find a positive effect of

private credit on economic growth (Table 3, Column 4).

While our estimates are based on a longer time series than in previous research, future

research using additional data is needed to verify if the relationship between financial

development and economic growth will change as these economies continue to mature.

Moreover, especially in light of the 2008 financial crisis, additional research on the

consequences of financial crises on these economies would be valuable.

13 An area of possible future research would be to test whether rapid increases in private sector
lending are damaging. This could occur particularly in situations where high growth leads to an
increase in non-performing loans. Haiss and Ziegler (2011) find that there is considerable
variation across countries.

20
 Table 1. Financial Development and Macroeconomic Indicators, CEE, CIS and Selected
Developed Countries, 1995 and 2008
Domestic credit Market capitalization
to private sector of listed companies GDP per capita (current
(% of GDP) (% of GDP) US $)
1995 2008 2008 1995 2008
CIS Countries
Armenia 7.3 17.4 1.5 456 3,917
Belarus 6.1 28.8 -- 1,371 6,377
Georgia 6.1 33.3 2.6 569 2,920
Kazakhstan 7.1 50.1 23.5 1,288 8,514
Kyrgyz Republic 12.5 -- 1.8 364 966
Moldova 6.7 36.5 -- 477 1,696
Russian Federation 9.4 42 23.9 2,651 11,700
Tajikistan -- 19.9 -- 213 709
Turkmenistan 1.1 -- -- 593 3,919
Ukraine 1.5 73.7 13.5 936 3,899
CEE Countries
Bosnia and Herzegovina -- 67.2 -- 530 4,802
Bulgaria 39.9 74.5 17.1 1,555 6,798
Croatia 26.5 64.9 38.5 4,722 15,696
Czech Republic 70.8 52.5 21.7 5,596 21,627
Estonia 16.3 98.7 8.2 2,629 17,738
Hungary 22.6 69.6 12.0 4,411 15,365
Latvia 23.1 43.8 4.8 2,107 14,858
Lithuania 39.9 74.5 7.7 2,178 14,071
Macedonia, FYR 26.5 64.9 8.4 2,262 4,686
Montenegro -- 88.0 63.3 -- 7,306
Poland 16.9 49.9 17.0 3,603 13,866
Romania -- 38.0 9.7 1,564 9,498
Serbia -- -- 25.5 -- 6,498
Slovak Republic 36.4 44.7 5.2 4,710 18,109
Slovenia 25.2 85.6 21.6 10,524 27,015
CIS & CEE Average1 20.1 55.4 16.4 2,405 9,702
Developed Countries
France 86.0 107.9 52.7 26,403 43,998
Germany 100.4 107.8 30.6 30,888 44,132
Japan 203.9 163.5 66.4 42,522 37,972
United Kingdom 113.1 213.4 68.9 20,350 43,780
United States 135.5 190.5 79.7 28,782 48,407

21
 Dev. Country Average1 127.8 156.6 59.7 29,789 43,658
1
Unweighted Average
Note: Albania, Azerbaijan, Turkmenistan, and Uzbekistan are not included.
Source: World Bank (2009)

22
Table 2: Economic Growth and Financial System Characteristics, CIS and CEE countries, 1990-
2008

Variable Mean Std. Dev. Min. Max.

Annual Growth, GDP Per Capita 2.39 6.10 -14.28 11.50
Private Credit (% of GDP) 28.22 19.32 2.03 82.14
Liquid Liabilities/GDP (%) 35.11 17.98 7.08 76.63
Interest Rate Spread (%) 17.75 23.65 1.55 142.38
Overhead Costs/Total Assets (%) 5.79 2.47 1.39 11.55
Bank Concentration (%) 72.68 16.96 18.81 100.00
Initial GDP/Capita 3190.0 3063.4 178.2 16887.4
Secondary School Enrollment (%) 90.3 6.9 76.6 104.8

Source: World Development Indicators CD, World Bank.

Note: Unit of observation is country x time-period. Sample size equals 78, except for Interest
Rate Spread and Bank Concentration (N=71), Net Interest Margin (N=68), and Overhead Costs
(N=69).

23
Table 3 Financial Efficiency, Financial Depth, and Economic Growth, CEE and CIS Countries,
1990-2008

(1) (2) (3) (4) (6)

−2.53**
Interest Rate Spread (2.60)
−6.66**
Overhead Costs (3.85)
−1.50
Bank Concentration (1.26)
3.88**
Private Credit (2.88)
−0.641
Domestic Credit (0.35)
−1.57* −2.33** −1.08 −2.28** −2.22*
Initial GDP/Capita (1.78) (2.83) (2.42) (3.09) (1.90)
2.54 4.61** 1.75 −0.395 0.55
Secondary School Enrollment (1.19) (2.40) (1.15) (0.34) (0.26)
# obs. 72 72 74 78 79
# countries 22 23 23 23 23
Hansen Test (p-value) 0.15 0.47 0.37 0.56 0.29
AR(1) (p-value) 0.41 0.40 0.09 0.03 0.04
AR(2) (p-value) 0.64 0.26 0.59 0.56 0.77

Dependent variable is GDP per capita growth. All independent variables are in natural logs and,
except for GDP/Capita, are time-period averages; see text for details. Time period dummies are
included in all models. All models estimated by System GMM using robust, two-step method.
Absolute values of t-statistics in parentheses. * denotes statistical significance at the 10% level,
** at 5% or less.

24
Table 4. Multivariate Analysis of Effect of Financial Efficiency and Depth on Economic Growth,
CEE and CIS Countries, 1990-2008

(1) (2) (3) (4)

−2.18** −0.18
Interest Rate Spread (2.15) (0.10)
−7.53** −1.04
Overhead Costs (4.79) (0.54)
−1.33 −1.26
Bank Concentration (1.45) (0.15)
1.30 1.68 2.34** 2.10
Private Credit (0.76) (1.37) (3.08) (1.41)
−2.10** −3.70** −2.15** −3.53**
Initial GDP/Capita (2.32) (3.74) (3.26) (2.94)
2.41 6.10** 2.03 4.66*
Secondary School Enrollment (0.86) (3.40) (1.38) (1.87)
# obs. 71 69 71 64
# countries 22 22 22 21
Hansen Test (p-value) 0.37 0.95 0.97 0.22
AR(1) (p-value) 0.37 0.48 0.05 0.55
AR(2) (p-value) 0.88 0.16 0.76 0.09

Dependent variable is GDP per capita growth. All independent variables are in natural logs and,
except for GDP/Capita, are time-period averages; see text for details. Time period dummies are
included in all models. All estimates are System GMM, using robust, two-step method. Absolute
values of t-statistics in parentheses. ** denotes statistical significance at the 5% level or less.

25
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APPENDIX
Table A1: Economic Growth and Financial System Characteristics, CIS and CEE countries,
1990-2008, by country

Variable Mean Std. Dev. Min. Max.

Armenia Growth 2.27 14.56 -19.43 11.50
Private Credit 12.65 8.00 7.48 24.41
Bank Concentration 0.80 0.15 0.63 0.93
Interest Rate Spread 19.25 12.47 11.66 33.64
Belarus Growth 2.53 7.13 -6.28 10.33
Private Credit 13.70 6.14 9.45 20.74
Bank Concentration 0.84 0.11 0.75 0.96
Interest Rate Spread 15.95 16.33 1.55 38.37
Bosnia & Herzegovina Growth 5.04 1.47 4.00 6.08
Private Credit 47.66 11.83 35.44 59.06
Bank Concentration 0.61 0.16 0.49 0.79
Interest Rate Spread 12.65 8.46 4.81 21.62
Bulgaria Growth 1.52 5.73 -5.49 6.91
Private Credit 45.03 24.73 17.35 74.71
Bank Concentration 0.75 0.25 0.44 1.00
Interest Rate Spread 34.22 43.22 5.97 97.69
Croatia Growth 0.23 8.82 -12.89 6.14
Private Credit 43.25 12.24 29.47 58.01
Bank Concentration 0.62 0.03 0.61 0.66
Interest Rate Spread 203.37 385.62 8.36 781.79
Czech Republic Growth 1.48 3.80 -3.94 4.90
Private Credit 56.65 17.08 41.60 73.21
Bank Concentration 0.73 0.14 0.60 0.92
Interest Rate Spread 5.38 1.23 4.32 7.04
Estonia Growth 1.29 7.82 -9.41 7.96
Private Credit 44.56 26.02 23.45 82.14
Bank Concentration 0.92 0.07 0.83 0.98
Interest Rate Spread 5.31 3.26 2.68 8.96
Georgia Growth -1.62 16.83 -26.76 8.82
Private Credit 11.41 8.55 5.04 21.13
Bank Concentration 0.76 0.07 0.72 0.84
Interest Rate Spread 21.88 8.83 13.42 31.04
Hungary Growth 1.58 4.22 -4.66 4.68
Private Credit 37.77 13.77 23.93 56.70
Bank Concentration 0.70 0.13 0.61 0.89
Interest Rate Spread 4.54 2.60 2.06 6.82
Kazakhstan Growth 1.40 8.36 -8.46 9.25
Private Credit 29.65 19.74 10.31 49.30
Bank Concentration 0.70 0.06 0.66 0.77
Interest Rate Spread -- -- -- --
Kyrgyz Republic Growth -0.98 6.08 -8.97 4.20
Private Credit 7.37 2.90 4.41 10.20
29
 Bank Concentration 0.86 0.04 0.83 0.89
Interest Rate Spread 22.65 3.01 19.36 25.25
Latvia Growth 1.71 10.29 -13.61 7.94
Private Credit 33.56 29.63 11.91 77.06
Bank Concentration 0.59 0.13 0.48 0.78
Interest Rate Spread 19.28 22.06 4.33 51.57
Lithuania Growth 0.59 10.07 -14.28 7.59
Private Credit 24.01 16.42 14.06 48.55
Bank Concentration 0.82 0.08 0.75 0.93
Interest Rate Spread 5.18 2.71 2.35 8.25
Macedonia, FYR Growth -0.36 4.98 -7.30 4.48
Private Credit 34.37 17.54 18.54 59.34
Bank Concentration 0.86 0.11 0.76 1.00
Interest Rate Spread 10.91 6.66 5.72 18.42
Moldova Growth -1.79 9.76 -12.33 7.42
Private Credit 14.50 10.62 5.57 29.14
Bank Concentration 0.78 0.23 0.53 1.00
Interest Rate Spread 7.74 2.56 5.01 10.08
Poland Growth 3.55 2.93 -0.49 5.99
Private Credit 26.15 7.21 19.65 35.95
Bank Concentration 0.61 0.08 0.53 0.70
Interest Rate Spread 39.58 68.55 3.71 142.38
Romania Growth 1.62 5.73 -6.06 7.37
Private Credit 15.73 9.90 9.56 27.15
Bank Concentration 0.74 0.13 0.66 0.89
Interest Rate Spread 15.35 4.88 9.72 18.40
Russian Federation Growth 0.54 8.00 -7.94 7.69
Private Credit 18.00 10.04 11.23 32.67
Bank Concentration 0.48 0.28 0.19 0.85
Interest Rate Spread 36.40 44.50 6.41 87.53
Serbia Growth -1.52 12.19 -19.15 7.07
Private Credit 28.16 2.31 25.62 30.15
Bank Concentration -- -- -- --
Interest Rate Spread 29.48 20.72 10.88 51.81
Slovak Republic Growth 2.24 6.45 -7.04 7.30
Private Credit 45.74 7.60 38.24 56.14
Bank Concentration 0.83 0.10 0.76 0.98
Interest Rate Spread 5.32 0.86 4.38 6.39
Slovenia Growth 2.26 3.71 -3.29 4.52
Private Credit 39.42 19.11 26.23 67.00
Bank Concentration 0.68 0.12 0.59 0.85
Interest Rate Spread 20.82 30.55 3.80 66.57
Tajikistan Growth -2.86 11.33 -15.05 7.06
Private Credit 16.01 3.56 12.91 19.90
Bank Concentration 1.00 -- 1.00 1.00
Interest Rate Spread 24.80 18.65 13.45 46.33

30
 Ukraine Growth -1.27 9.58 -9.85 7.13
Private Credit 16.83 20.76 2.03 46.73
Bank Concentration 0.69 0.27 0.39 1.00
Interest Rate Spread 26.57 14.81 7.63 40.69
Notes: Figures are averages for five-year time periods. Albania, Azerbaijan, Montenegro, Turkmenistan, and
Uzbekistan are not included in table.
Source: World Bank (2009)

31