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The purpose of this study is to examine empirically the relationship between economic growth and financial sector development in GCC countries. In particular, the main objective of this study is to econometrically investigate the direction of the causal relationships between real economic growth and certain measures of financial sector performance and their policy implications for financial sector reform. Granger causality tests have been carried out in the context of cointegration and vector correction techniques for 1975-2003 time period. For the most part, the empirical results gave some support for financial deepening as an engine for economic growth in GCC countries. Equally important, the empirical results also indicated different inferences depending on the measure of financial development used and the results are also sensitive to the short versus long run causality process. Furthermore, no clear support for the supply-leading hypothesis is obtained for Bahrain neither in long run nor in short run. That is, financial deepening, defined either in terms of claims of private sector or Time and saving deposits of its financial system, unidirectional cause economic growth. This result is not surprising and actually intuitive as Bahrain’s financial sector is mainly catered to international financial markets and so it is dominated by offshore banking outlets. The same analogy goes to UAE as Dubai, in recent years, has become a major trade and international financial center in the Middle East. In contrast, for Saudi Arabia, the evidence was clear that expansion in the size of the financial system stimulates economic growth both in the short and the long run. Moreover, the causality runs in both directions: “finance causes growth” and “growth leads finance”. As the feedback process from the financial sector to economic growth and from economic growth to the financial sector are both present. The case of Saudi Arabia is particularly interesting as the Saudi financial sector is the biggest among GCC and the Arab economies and its stock market is also the largest in the Arab world in term of market capitalization. Therefore, while sophistication in the financial system ultimately induces higher economic growth, economic development itself would feedback and induces further sophistication in the financial system. Yet empirical results of this study indicated that financial systems do contribute to economic development but favorable effect requires fairly long time to be noticeable but equally important, policies aiming to promote economic and financial development in GCC countries should be persistent over a somewhat longed period of time.
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