Does financial structure matter for economic growth in an open economy?

Financial structure is critical for economic growth. This paper examines the relationship between financial structure and economic growth in an open economy by developing an extended neoclassical growth model, which incorporates technological progress and foreign direct investment (FDI). The theoretical analysis demonstrates that an optimal financial structure exists at the steady-state growth rate, with technological progress serving as a key mechanism. Using cross-country panel data from 2003 to 2020, we find that the financial structure dominated by direct financing is more conducive to economic growth, particularly in developing countries. Further analysis indicates that the financial structure promotes economic growth through technological progress. In addition, the positive effect of direct financing follows an inverse U-shaped pattern. While an increasing proportion of direct financing fosters economic growth, exceeding the turning point of the inverse U-shaped curve inhibits growth. Developed countries reach this turning point earlier than developing countries. Moreover, the effect of financial structure evolves dynamically across different stages of economic development. It also exhibits distinct patterns across countries, following a U-shaped pattern in developing countries and declining steadily in developed countries. These findings provide policy insights on optimizing financial structure to promote economic growth in an open economy.