Financial System Development and Democracy: a Panel Smooth Transition Regression Approach for Developing Countries

There is evidence for mixed effects of democracy on the development of the financial sector. Part of the literature explains theses controversies by assuming that democracy’s effect on development is non-linear. This paper tries to bring new insights into this debate by examining non-linearities by the way of a new method of analysis, i.e., a panel smooth transition regression model. We use a sample of 90 developing countries over the period 1984–2007 and rely on panel smooth threshold regression, fixed effects, and system GMM models. Findings confirm the fact that the relationship between democracy and financial development is indeed non-linear. Furthermore, results demonstrate that the level of democracy and financial system development are correlated in a U-shaped manner. Hence, there are two extreme regimes where democracy’s impact on the financial system is different depending on the democracy level. Particularly, there is a threshold level of democracy, estimated at 5, beyond which more democracy enhances the financial sector development and below which democracy hinders the development of the financial system.