Financial Markets, Financial Institutions and International Trade: Examining the causal links for Indian Economy

TL;DR

This paper examines the causal relationships between financial development and international trade in India from 1980 to 2019, highlighting the significance of financial markets in promoting trade growth.

Contribution

It provides empirical evidence of long-term and short-term causal links between financial market development and trade openness in India, using multiple measures and advanced econometric models.

Findings

Long-run causality from financial development to trade openness

Cointegration between financial market development and trade openness

Trade openness promotes financial institutional development in the short run

Abstract

This study investigates whether a uni-directional or bi-directional causal relationship exists between financial development and international trade for Indian economy, during the time period from 1980 to 2019. The empirical analysis utilizes three measures of financial development created by IMF, namely, financial institutional development index, financial market development index and a composite index of financial development, encompassing dimensions of financial access, depth and efficiency. Johansen cointegration, vector error correction model and vector auto regressive model are estimated to examine the long run relationship and short run dynamics among the variables of interest. The econometric results indicate that there is indeed a long run causal relationship between the composite index of financial development and trade openness. Cointegration is also found to exist between trade openness and index of financial market development. However, there is no evidence of cointegration between financial institutional development and trade openness. Granger causality test results indicate the presence of uni-directional causality running from composite index of financial development to trade openness. Financial market development is also found to Granger cause trade openness. In contrast, trade openness is found to promote financial institutional development in the short run. Empirical evidence thus underlines the importance of formulating policies which recognize the role of well-developed financial markets in accelerating international trade of Indian economy.