Recession and financial development: An empirical analysis

This paper mainly examine the sensitivity level of economic recession to the financial sector development by ascertaining whether such relationship is linear and contingent on trade openness, GDP per capita, financial openness, institution, democracy and fuels. We employ annual data of 129 countries from all part of the world spanning 1990-2010 and invoke Ordinary Least Squares (OLS) estimation method; we applied Sasabuchi test to verify the inverse U-shape and estimate the extreme point. We also used semiparametric and regional exclusion based regression for robustness check. The nexus between recession and financial development assessment suggest that, the nonlinearity and thus U-shaped relationship is operational; additionally, when financial development increases, it is accompanied by a reduction in the depth of recessions; and this, up to a certain threshold. Beyond this brink, financial deepening correlates with deep recessions. Additionally, we found that trade openness have a positive on economic recession independently to the estimation method. For robustness check, estimations results first confirm the baseline findings in terms of magnitude and significance in the correlation coefficients; then, highlight sub-Saharan Africa (SSA), South Asia (SASIA) and Latin America and Caribbean (LAC) as the order of continental/regional importance in increasing magnitude. Finally, the semiparametric regression show that, the results of the parametric part converge with the previous results in general, and bear out with illustration the functional form of the nonlinear relation between recession and financial development. To the best of our knowledge, this is the first study examining this relationship using newly primary and hitherto almost unexploited “Rare macroeconomic disasters” data from Barro and Ursua (2012) which allow us to build a more specific proxy of the variable “economic recession”.