Assessing financial development in India and its relation with economic activity: An empirical analysis

It has been widely believed and empirically established that financial development and economic activity across the economies have strong inter-linkages. In the literature analyzing above relationship, the assessment of financial development has been challenging. Different indicators representing financial development in terms of financial intermediation, capital market development, debt market development etc. are widely used. A couple of studies have developed indices of financial development to use as a summary measure of overall financial development. In the Indian case also a couple of studies have used financial indices mainly covering financial intermediation and size of the financial markets. The present study attempts to develop a summary index for financial development in India by incorporating efficiency parameters of financial development to the above, using principal components analysis. Subsequently, using this index as a proxy for financial development, formal econometric tools such as co-integration and causality tests are applied to analyze the inter-linkages between financial development and economic activity in India. Our results based on Granger causality approach using VECM confirm the one way causality running from economic activity to financial development in India during the post-reform period, supporting demand following hypothesis of financial development