Interest Rate Reforms, Financial Deepening and Economic Growth in Kenya: An Empirical Investigation

By Odhiambo, Nicholas M. | The Journal of Developing Areas, Fall 2009 | Go to article overview

Interest Rate Reforms, Financial Deepening and Economic Growth in Kenya: An Empirical Investigation


Odhiambo, Nicholas M., The Journal of Developing Areas


ABSTRACT

This paper examines the impact of interest rate reforms on financial deepening and economic growth in Kenya, using two models: the financial deepening model and the dynamic Granger causality model. The study attempts to answer two critical questions: Does interest rate liberalization in Kenya have any positive influence on financial deepening? Does the financial depth which results from interest rate liberalization lead to economic growth? Using cointegration and error-correction models, the study finds strong support for the positive impact of interest rate liberalization on financial deepening in Kenya - although the strength and clarity of its efficacy is sensitive to the level of the dependency ratio. The study also finds financial depth to Granger cause economic growth in Kenya. The study, therefore, concludes that the interest rate liberalization in Kenya has succeeded in increasing economic growth through its influence on financial depth. This applies irrespective of whether the models are estimated in a static long-run formulation (cointegration model) or in the dynamic formulation (error-correction model).

JEL Classifications: G20, E40, D90, C22

Keywords: Africa, Kenya, interest rate liberalization, financial deepening, economic growth

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

Since the re-invention of the financial liberalization concept in the 1970s by Ronald McKinnon and Edward Shaw, many developing countries have implemented far-reaching financial reforms. Specifically, many countries have made attempts to deregulate interest rates, eliminate or reduce credit controls, allow free entry into the banking sector, give autonomy to commercial banks, allow for private ownership of banks and liberalize international capital flows. However, of these six dimensions of financial liberalization, interest rate liberalization has been the main center of attention. Unfortunately, the experience of these countries with regard to interest rate liberalization has been mixed. Whether interest rate liberalization does indeed impact positively on financial deepening and economic growth, as postulated by the proponents of interest rate liberalization, remains an issue of empirical investigation.

Previous empirical studies on this topic have concentrated mainly on Asia and Latin America, affording sub-Saharan African (SSA) countries either very little coverage or none at all. Even where such studies have been undertaken, findings on the role played by high interest rates and their effect on financial deepening and economic growth are at best inconclusive. For instance, several studies have found little evidence for the positive role of interest rate on economic growth because of its ambiguous impact on savings. Yet, there has been enormous support for the position that even though interest rates might not significantly affect the savings rate, they do influence economic growth through their effect on financial deepening. In addition, the inconclusive nature of the previous empirical studies on the efficacy of financial liberalization in many developing countries has led to a renewed interest in the finance-growth nexus debate, i.e. whether it is the growth of the financial sector that leads the real sector in the dynamic process of economic development or it is the growth of the real sector that drives the development of the financial sector.

The current study, therefore, attempts to investigate the linkage between interest rate liberalization, financial deepening and economic growth using data from Kenya. Unlike the majority of the previous studies, this study uses a two-step method to examine this linkage. In the first step the study examines the role of interest rate liberalization on financial deepening using a dynamic specification model. In the second step the study examines the direction of inter-temporal causality between financial depth and economic growth. …

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