Academic journal article Contemporary Economic Policy

Financial Development and Income in African Countries

Academic journal article Contemporary Economic Policy

Financial Development and Income in African Countries

Article excerpt

I. INTRODUCTION

Patrick (1966) referred to the causality from financial development to economic growth and the causality from growth to financial development as the supply-leading hypothesis and demand-following hypothesis, respectively. Numerous studies have tried to test the validity of these hypotheses and the results, in general, point to different conclusions. For example, King and Levine (1993a) argue that "finance seems importantly to lead economic growth." The authors show that the level of financial development is a predictor of productivity improvement and economic development. On the other hand, Demetriades and Hussein (1996) find little empirical evidence that finance causes growth, while Luintel and Khan (1999) and Calderon and Liu (2003) show that there is bidirectional causality between growth and financial development. Moreover, some studies argue that financial development may have a nega-five influence on growth. Improved financial development that leads to better resource allocation increases returns and may lower saving (income effect) and thus may cause growth to fall (Bencivenga and Smith 1991; King and Levine 1993b).

This paper addresses an important empirical question in the context of sub-Saharan (SSA) economies. We estimate bivariate vector autore-gressive (VAR) equations and perform Granger-causality tests to explore the nature of the relationship between economic development (income per capita) and financial development (banking sector development), using two indicators of financial development. We perform bivariate (instead of multivariate) VAR estimations primarily to be consistent with Demetriades and Hussein's study, to which we compare our results. The goal of this study is not the study of the determinants of income. Rather, we explore whether there exists a long-run stable relationship between two time series (financial development and income), and we examine Granger causality (whether financial development Granger causes income or vice versa) between them. Granger-causality tests provide evidence on weak exogeneity, which is a necessary (but not sufficient) condition for strong exogeneity.

Our interest in African countries is motivated mainly by the following considerations. First, some recent empirical studies have found that the relationship between financial development and growth (or income) in African countries (using panel data) is negative or non-existent (Assane and Malamud 2010; Baliamoune-Lutz and Ndikumana 2007). Second, some African countries have somewhat liberalized the financial sector, while others still maintain financial repression. It would thus be useful to examine the differences in the finance-income nexus in countries at different levels of financial liberalization. Third, the institutional environment that is relevant to a good functioning of the financial system is at various levels of quality, with South Africa, Gabon, and Mauritius having a strong institutional environment, and the remaining countries having between very weak to somewhat good institutional environment. Given these considerations, a significant contribution of this paper is to shed additional light on the finance-growth relationship by focusing on a sample of African countries that offer a broader range of stages of financial development as well as a broader range (in terms of quality) of financial system supporting institutions.

First, we perform Zivot-Andrews tests to examine the presence of unit root with unknown structural break. Second, to test for cointegration between the variables we use the Gregory-Hansen cointegration test which is a more appropriate test when there is structural change in the data. The Gregory-Hansen test results suggest that there is no cointegration between income and financial development in any of the 18 countries. Finally, we estimate VAR models and test for the direction of causality between financial development and income and comment on the results. …

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