sustainability Article The Dynamics of Financial Development, Government Quality, and Economic Growth in Different Groups of Economies Shahid Iqbal 1,2,* , Abdul Qayyum Khan 1, Muhammad Yar Khan 1 and Lamya Al-Aali 3 1 Department of Management Sciences, COMSATS University Islamabad, Wah Campus 47040, Pakistan; [email protected] (A.Q.K.); [email protected] (M.Y.K.) 2 Department of Management Sciences, Riphah International University, Islamabad 44100, Pakistan 3 Saudi Central Bank (SAMA), Riyadh 11587, Saudi Arabia; [email protected] * Correspondence: [email protected] Abstract: This study examines the causal relationship between economic growth, financial devel- opment, and national governance. To analyze the three-way link of the stated variables, the Panel Vector Auto-Regressive (PVAR) model was applied to 115 economies between 1996 to 2018. The impact of each variable shock is explored through Impulse Response Function (IRF) and variance decomposition. The results indicate that the financial development and national governance shocks have a more persistent impact on economic growth in low-income economies than emerging and developed economies. In contrast, output shock influences long-term financial development in developed economies and affects national governance in a monotonic fashion in all three sets of economies. Moreover, national governance is explored as a critical factor for economic growth especially in low-income economies. Citation: Iqbal, S.; Khan, A.Q.; Khan, Keywords: economic growth; financial development; governance quality; PVAR M.Y.; Al-Aali, L. The Dynamics of Financial Development, Government Quality, and Economic Growth in Different Groups of Economies. 1. Introduction Sustainability 2021, 13, 7573. Increasing income inequalities and limited access to economic resource around the world https://doi.org/10.3390/su13147573 is nowadays a crucial global issue [1]. The top economies enjoy life standards of up to 58 times better than low-income nations, who hardly avail basic needs of life. For example, the World Academic Editors: Antonio Boggia Bank data shows that the GDP per capita of high-income countries remained $43,559 against and Luigi Aldieri an aggregate world GDP of $10,858, while low-income nations only generated $740 per capita in 2018. A glimpse of these differences can be seen in Figure1 , which plots GDP per capita Received: 3 June 2021 distribution (2010 constant) across the different income groups of the economy, i.e., high Accepted: 30 June 2021 Published: 7 July 2021 income, upper medium, lower medium, and low income from 1980 to 2018. The most important and challenging factor is to understand how some countries Publisher’s Note: MDPI stays neutral are so rich while others remain so poor [2] and to consider which type of economies with regard to jurisdictional claims in grow more rapidly. However, fundamental economic theories suggest that human capital, published maps and institutional affil- physical capital, and technology can significantly increase aggregate output [3,4]. However, iations. if these factors can cause such a difference in income across countries (up to fifty-fold), why do various nations fail to invest more in human resources and physical capital or improve their technologies? It is fair to conclude that there must be some other underlying reasons which may prevent many economies from investing enough in these proximate causes, i.e., technology, workforce, and physical capital. For example, a country with Copyright: © 2021 by the authors. Licensee MDPI, Basel, Switzerland. weak law and order situations, extreme corruption, and political instability creates hurdles This article is an open access article for the business community to contribute to economic growth [5–7]. While on the other distributed under the terms and side, a nation that provides opportunities and incentives for investment boosts business conditions of the Creative Commons activities and ultimately enhances the economy [8]. Therefore, it is important to consider Attribution (CC BY) license (https:// the fundamental causes along with proximate causes while examining income differences creativecommons.org/licenses/by/ across nations—reasons such as the role of institutions, geography, culture, and other 4.0/). exogenous factors. However, of those four primary fundamental causes (luck, geography, Sustainability 2021, 13, 7573. https://doi.org/10.3390/su13147573 https://www.mdpi.com/journal/sustainability Sustainability 2021, 13, x FOR PEER REVIEW 2 of 14 Sustainability 2021, 13, 7573 2 of 14 differences across nations—reasons such as the role of institutions, geography, culture, and other exogenous factors. However, of those four primary fundamental causes (luck, institutions,geography, andinstitutions, culture), and only culture), institutions only can institutions be potentially can reformedbe potentially for better reformed results, for makingbetter results, this factor making more this critical factor than more others. critical than others. FigureFigure 1. 1.The The graphgraph demonstrates the the income income difference difference of of different different economic economic groups groups in incomparison compar- to aggregate world income. HIC = high-income counties; LMC = lower-medium countries; UMC = ison to aggregate world income. HIC = high-income counties; LMC = lower-medium countries; upper-medium countries; LIC = low-income countries; WLD = world aggregate income. UMC = upper-medium countries; LIC = low-income countries; WLD = world aggregate income. TheThe institution institution was was defined defined as as the the rules rules of of the the game game for for society society by by North North [ 9[9].]. It It refers refers toto regulations, regulations, laws, laws, and and policies policies that that ensure ensure the the appropriate appropriate allocation allocation of of resources resources and and supportsupport for for businesses businesses and and individuals individuals with with less less economic economic resources. resources. Thus, Thus, it is it essential is essential to contextualizeto contextualize the qualitythe quality of institutions/national of institutions/national governance governance while investigating while investigating income differencesincome differences across nations. across Moreover,nations. Moreover recent financial, recentreforms financial and reforms technological and technological improve- mentsimprovements further enhance further theenhance importance the importance of government of government quality inquality securing in securing cross-border cross- financialborder financial contracts. contracts. As such, variousAs such, studies various have studies been initiatedhave been to incorporate initiated to institutional incorporate qualityinstitutional into growth quality models, into growth mainly models, categorized mainly into categorized three forms. into three forms. TheThe first first strand strand of theof the literature literature has mainlyhas mainly focused focused on the on governance–growth the governance–growth nexus. Fornexus. example, For example, Ref. [10] [10] constructed constructed a governance a governance index index to analyze to analyze public public capital capital effec- tivenesseffectiveness in economic in economic growth. growth. The constructed The constructed index’s governing index’s governing factors were factors telephone were faults,telephone electricity faults, losses,electricity road losses, conditions, road conditions, and diesel and locomotive diesel locomotive availability. availability. The study The concludedstudy concluded infrastructure infrastructure effectiveness effectiveness is the most is th criticale most factor critical in factor explaining in explaining cross-country cross- differencescountry differences in economic in economic growth. Similarly, growth. theSimila studiesrly, the of [studies11–13] alsoof [11–13] evaluated also that evaluated good governancethat good ensuresgovernance the allocation ensures ofthe public allocation expenditure of public to a productiveexpenditure outcome, to a productive which in turnoutcome, promotes which economic in turn growth.promotes Unfortunately, economic growth. developing Unfortunately, nationsmainly developing misallocate nations governmentmainly misallocate spending, government which causes spending, them to whic be unproductiveh causes them at to the be margin unproductive [2]. at the marginThe [2]. second strand of the literature states that governance basically enhances financial developmentThe second (FD) strand and thatof the improved literature FDstates further that governance contributes basically to economic enhances growth. financial For instance,development Refs. [(FD)5,14] and introduced that improved the investor FD furt protectionher contributes phenomenon to economic and concluded growth. that For financialinstance, effectiveness [5,14] introduced variation the around investor the protection world could phenomenon be traced to and differences concluded in their that legalfinancial rules effectiveness and enforcement variation quality. around They the evaluated world thatcould effective be traced laws to anddifferences their vigorous in their enforcementlegal rules and by enforcement the legal system quality. encourage They eval investorsuated that to finance effective businesses, laws and whichtheir vigorous in turn leadsenforcement to a better, by the more legal developed system encourage financial market.investors These to finance developed