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The relationship between stock market and economic growth is tested for Portugal (1993–2011), which is a small open economy dependent on bank financing. The relationship between economic growth and bank financing is also appraised. Using Vector Autoregressive (VAR) modeling, Granger causality, variance decomposition and impulse response function are discussed. The physical replacement of the currency, as a consequence of the integration in the European Monetary Union, proves to be an economic regime change. The effect of the subprime crisis was also proved. There is evidence of Granger bidirectional causality between the stock market and economic growth. Meanwhile, there was no evidence of causality running from bank financing to economic growth.

The relationship between economic growth and the financial system, whose components are stock markets and the banking system, has received considerable attention for decades (e.g. Beck and Levine, 2004, Capasso, 2008, Goldsmith, 1969, Keynes, 1973, Levine, 1991 and Schumpeter, 1982). Traditionally, Anglo-Saxon countries use mainly the capital market for corporate financing, while in non-Anglo-Saxon countries the banking system predominates (e.g. Marini, 2005 and Lee, 2012). The use of long series as well as the control of structural changes might be important in determining the relationship between the financial system and growth. Given that structural changes may have the strongest impacts on a small economy, we will focus on Portugal. This exercise will allow us to verify the interaction of variables during the 1990s and 2000s, a period full of both economic and political change. Considering that Portugal is a non-Anglo-Saxon country, the banking system is expected to play a more significant role in the economy than the stock market. The analysis of the relationship between stock market and economic growth was extended by using Vector Autoregressive (VAR) modeling, controlling for economic regime change experienced in the Portuguese economy. That change is a consequence of joining the European Economic and Monetary Union (EMU), and it is econometrically controlled by using an exogenous variable, namely a shift dummy. The main questions of this study are: (i) will the stock market play an important role in Portuguese economic growth? and (ii) will the banking system therefore be influential in Portuguese economic growth? Both stock market development and the banking system are expected to play a positive role in economic growth. Results suggest that the stock market Granger-causes economic growth. However, this Granger causality is not verified from banking system to economic growth. This study allows us to better understand how to act in terms of economic policy for the financial system, focusing on the stock market segment or banking segment. This paper evolves as follows. Section 2 covers the literature review. Section 3 presents the data and model used. The results shown in Section 4 are discussed in Section 5. Section 6 concludes.

The effect of the stock market development on economic growth in Portugal (1993–2011), which is a small economy subject to strong impacts caused by structural changes, is analyzed. A comparison of the effects of the two competing systems of financing the economy – stock market and bank financing – on economic growth is also provided. No cointegration relationship was detected. A VAR model, with exogenous both impulse and shift dummies, was estimated. The VAR model proved to be suitable for handling the analysis of the relative contributions of the stock market and bank financing on economic growth. However, this analysis requires the inspection and posterior inclusion of the Portuguese idiosyncrasies. The absence of these controls could mask relevant causal relationships among variables, leading to erroneous conclusions. Regarding the two components of the financial system, two behaviors are observed. On the one hand, a positive causal relationship between stock market development and economic growth was detected, and it is, in fact, bidirectional. On the other hand, it appears that the banking system is not driving economic growth, but is a net beneficiary of that growth. In view of this, economic policies ought to be aware that it is stock market development, and not bank financing, that promotes economic growth. The different nature of these two components of the financial system deserves to be the object of further research, including understanding the transmission channels through which financial markets and their segments interact with economic growth. The control variables enabled facts often associated with the Portuguese reality to be proved. On the one hand, investment did not produce significant multiplier effects. On the other hand, the loss of economic price competitiveness is notorious. Also considered were the Portuguese idiosyncrasies, namely: (i) the break in the GDP series in the third quarter of 2000; (ii) the physical change in currency, from the escudo to the euro, which constitutes an economic regime change; and (iii) the subprime crisis. These facts prove to be mandatory for a full understanding of the transmission channels from finance to the economy.