The Relationship Between Exchange Rate Volatility And Banking Sector Development: Time-Series Evidence From Emerging Economies

A limited number of recent studies have tested the relationship between some of the macroeconomic indicators and banking sector development. Among them, there are only few single developing-country studies, which tried to examine the direct impact of exchange rate volatility on the banking sector with mixed results. This paper examines the relationship between exchange rate volatility and banking sector development in 16 emerging economies over the period of 1980-2011. In this study we employ Pessaran, et al. 2001 bounds testing approach to cointegratoin and developed the short-run and long-run models. Our findings indicate that banking sector development responds significantly to exchange rate volatility in the majority of emerging economies in which 9 out of 16 confirm the short-run effect and 10 out of 16 exhibit the long-run effect. A strongly negative link between exchange rate uncertainty and liquid liabilities is confirmed. We find that the short-run effect effects last into the long-run effect only in 7 emerging economies. Furthermore, assessing the real exchange rate changes in long run confirmed that appreciation impede the banking sector development and eventually financial market development in majority of emerging economies. Meanwhile, our estimated results show the evidence of the significant impact of real income on banking sector development in almost all countries, implying that higher economic growth leads to higher banking activities and more investment. Given several country-specific results, based on their different economic and financial structure, we suggest that it is very crucial to implement appropriate monetary policy for emerging economies to stabilize their economic growth through the banking sector development upon unexpected exchange rate shocks. Under any kind of uncertainty in a country's financial system, chances for enjoying a well-developed banking sector in emerging economies would fade. All negative effects of exchange rate volatility will reduce efficiency of financial market and long-term growth of economy. In order to achieve these economies' long-run economic growth goals, we suggest that, the banking sector development and eventually financial market development should be considered a long-term objective for all emerging economies. In this paper, possible rationales for contrary short-run and long-run effects are also discussed.