Analyzing the Dynamic Relationships between Physical Infrastructure, Financial Development and Economic Growth in India

• DOI: http://doi.org/10.1111/asej.12190
• Author: N. R. Bhanumurthy,Ranjan K. Mohanty
• Date: 01 December 2019
• Published date: 01 December 2019

Analyzing the Dynamic Relationships between

Physical Infrastructure, Financial Development

and Economic Growth in India*

Ranjan K. Mohanty and N. R. Bhanumurthy

Received 29 August 2018; Accepted 15 December 2019

This paper investigates the dynamic relationships between physical infrastructure,

financial development and economic growth in the case of India, using the auto-

regressive distributed lag and the Toda–Yamamoto causality approach for the

period 1980 to 2016. A physical infrastructure index and a financial development

index are constructed using the principal component analysis. The empirical

results suggest that physical infrastructure has a positive effect on economic

growth both in the long run and short run, whereas financial development,

although significant, has a weak impact on economic growth. The causality test

supports a bidirectional causal relationship between infrastructure development

and economic growth, while it finds unidirectional causation running from eco-

nomic growth to financial development. As India is aiming for higher growth for

a sustained period, our results suggest that there is a need for government inter-

vention in expanding the physical infrastructure and this, in turn, could lead to

economic growth as well as financial sector development.

Keywords: infrastructure index, financial development index, economic growth,

ARDL approach, India.

JEL classification codes: H40, C43, O40, C32.

doi: 10.1111/asej.12190

I. Introduction

Infrastructure and the financial sector are two crucial factors for the economic

progress of any country. A well-developed financial system and better infrastruc-

ture are expected to boost growth and inclusiveness. In the case of India, which

is one of the fastest-growing large economies in the world, while both the infra-

structure and the financial sector have been expanding, large gaps still exist. To

sustain the high growth momentum and to make such growth inclusive, there is

*Mohanty and Bhanumurthy (corresponding authors): National Institute of Public Finance and

Policy, New Delhi 110067, India. Email: ranjanmohanty85@gmail.com, nrbmurthy@gmail.com. An

earlier version of the paper was presented at the 16th International Convention of the East Asian

Economic Association hosted by the National Taiwan University, Taipei on 27–28 October 2018.

The authors would like to thank all the conference participants, the anonymous referees and the Edi-

tor of this journal for their valuable suggestions to improve the quality of the paper.

© 2020 East Asian Economic Association and John Wiley & Sons Australia, Ltd

Asian Economic Journal 2019, Vol.33 No. 4, 381–403 381

a need to understand the role and the extent of infrastructure as well as financial

development. Therefore, in this paper, an attempt is made to examine the impact

of physical infrastructure and financial development along with other control

variables on economic growth in India.

There are two types of infrastructure: physical and social. Physical infrastruc-

ture development is an essential driving force for achieving rapid economic

growth. Higher investment in physical infrastructure reduces transaction costs as

well as other input costs, fosters trade and investment, opens up new markets,

improves competitiveness, creates employment opportunities, raises productivity,

and stimulates economic activities. Provision of social infrastructure such as

education and health services endows the economy with skilled and productive

human capital, which could also lead to an increase in productivity and growth

but mostly in the long run. All these facilities are expected to have both direct

and indirect roles in the development by increasing the factor productivity of

land, labor and capital in the production process. Recently, the Indian Govern-

ment estimated that there is a need for nearly $4.5tn to reduce the physical infra-

structure deficit in the country.

1

There are a number of studies in the existing literature that look at links

between infrastructure and economic growth by using cross-sectional, time-

series and panel data analysis. Previous literature has clearly emphasized the role

of infrastructure development on economic growth (e.g. Wang, 2002; Esfahani

and Ramirez, 2003; Zhang and Fan, 2004; Fedderke et al., 2006; Luoto, 2011).

Many studies have also found that there is unidirectional/bidirectional causality

between infrastructure and economic growth (Canning and Pedroni, 2008; Singh

and Bhanumurthy, 2014; Pradhan et al., 2016). Some regional studies in India

(e.g. Fan et al., 2000; Lall, 2007) suggest that physical infrastructure such as

transportation, communication, power and telephones promote efficiency and,

hence, economic growth. Most of these studies conclude that infrastructure

development has a positive and significant effect on economic growth.

In addition to infrastructure, another factor that could affect growth positively,

and is widely identified in the literature, is the extent of financial development.

The emergence of endogenous growth literature has generated renewed interest

in the positive role of financial development in driving economic growth

(Greenwood and Jovanovic, 1990; Bencivenga and Smith, 1991; King and

Levine, 1993). Developed financial systems promote economic growth by mobi-

lizing savings, allocating resources to the most productive investments, reducing

information, transaction and monitoring costs, diversifying risks, and encourag-

ing innovation. Thus, they eventually lead to economic growth because of more

efficient resource allocation, accumulation of physical and human capital, and

faster technological progress. The positive relationship between financial devel-

opment and economic growth is supported in the literature (Gurley and Shaw,

1 See: https://www.thehindubusinessline.com/economy/piyush-goyal-capital-cost-for-45-trillion-

infra-investment-a-challenge/article24251518.ece

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