Quantity and Quality Measures of Financial Development: Implications for Macroeconomic Performance

Financial development is often measured by financial depth such as the stock of private credit and market capitalization as a share of GDP. Such a measure focuses on the quantity aspect of financial development. In this paper, we propose measures that capture both the quantity and quality aspects of financial market development. For quantity measures, we construct a composite index with multiple variables which gauge the size and depth of the banking, equity, bond, and insurance markets. For quality measures, we create a composite index that reflects the degree of financial market diversity, liquidity and efficiency, and the institutional environment. The last factor captures the development of legal systems and institutions, human capital, and information and telecommunications infrastructure. We find that the quantity and quality measures are highly correlated with each another for advanced economies and Asian emerging market economies, but not for other economies. The disaggregated components of the quality measures suggest that it is the level of legal and institutional development that differentiates advanced economies from emerging and developing economies in terms of the quality measures. Compared to advanced economies, emerging and developing economies tend to have low levels of market diversity, liquidity, and efficiency. Our simple regression analysis shows that the quality measure of financial development has a positive effect on output growth and negative effects on output volatility and inflation for the sample of emerging and developing economies with relatively high-quality financial development. We also observe that a higher level of financial development, particularly in terms of quality, tends to lead to greater financial openness, and that greater financial openness tends to be associated with low growth, high growth volatility and high inflation for emerging and developing economies with low quality measures of financial development, while such undesirable impacts of financial openness can be mitigated by raising the quality of financial development.