Impact Of Financial Deepening On Economic Growth In Nigeria

Project and Seminar Material for Economics

Impact Of Financial Deepening On Economic Growth In Nigeria


Abstract


This study examined the impact of financial deepening on economic growth in Nigeria using annual time series between 1982 and 2019. Financial development was captured with financial deepening indicator measured as a ratio of credit to the private sector to gross domestic product (GDP). The data were obtained from the 2020 Central Bank of Nigeria statistical bulletin. The study employed an econometric approach by incorporating granger causality test, unit root test, Bounds test, and the error correction mechanism. Findings from the Granger causality test revealed that there exists a unidirectional causality that flows from financial development to economic development in Nigeria, implying that the supply-leading finance hypothesis was prevalent. Also, there exist both a shot-run and long-run positive and significant relationship between financial deepening (measured as a ratio of credit to private sector to GDP) and economic growth in Nigeria within the study period. It is in this light that the paper recommended that there is need for more financial market development that favours more credit to the private sector in order to stimulate economic growth. This can be achieved through strengthening the micro finance sector so as to make credits available and accessible to the micro entrepreneurs who are often deprived of credit by the conventional credit markets.

 


Table of Content


Chapter One

1.0 Introduction

  • 1.1 Background to the Study
  • 1.2 Statement of the Problem
  • 1.3 Objectives of the Study
  • 1.4 Research Question
  • 1.5 Research Hypothesis
  • 1.6 Significance of the Study
  • 1.7 Scope of Study
  • 1.8 Limitation of the Study
  • 1.9 Definition of Terms
  • 1.10 Organisation of the Study

Chapter Two

2.0 Literature Review

  • 2.1 Conceptual Framework
  • 2.2 Determinants of Financial Deepening
  • 2.3 Economic Growth
  • 2.4 Determinants of Economic Growth
  • 2.5 The Nigerian Financial Sector Before Sap
  • 2.6 The Nigerian Financial Sector During Sap
  • 2.7 Nigerian Financial Sector Reform
  • 2.8 Theoretical Framework
  • 2.9 Empirical Literature

Chapter Three

3.0 Research Methodology

  • 3.1 Research Design
  • 3.2 Data Source
  • 3.3 Model Specification
  • 3.4 Analytical Approach

Chapter Four

4.0 Results and Discussion

  • 4.1 Descriptive Statistics
  • 4.2 Correlation Matrix
  • 4.3 Static (Long-Run) Estimates
  • 4.4 Post-Diagnostic Test
  • 4.5 Stability Test
  • 4.6 Granger Causality Test
  • 4.7 Unit Root Test
  • 4.8 Bounds Test for Long-Run Relationship
  • 4.9 Error Correction Mechanism

Chapter Five

5.0 Summary, Conclusion and Recommendation

  • 5.1 Summary
  • 5.2 Conclusion
  • 5.3 Recommendation
  • References
  • Appendix

Chapter One


1.0 Introduction

1.1 Background to the Study

In the 1990s, several studies were conducted to examine the theory on the relationship between the financial deepening and the real sector of the economy. Such include the works of King and Levine (1993), and Levine (1997). Using correlation analysis, their studies revealed that the financial sector has a significant role to play in the development of the real sector of the economy. The role of the financial sector has also been described to include promoting savings (Bencivenga and Smith, 1991), providing vital information (Greenwood and Jovanovic, 1990), and affecting credit rationing (Boyd and Smith, 1997). The financial system has been described as an engine of growth in that as the financial sector extends credit to the productive sectors of the economy at affordable costs, the overall economy grows inclusively (Karimo and Ogbonna, 2017). As noted by Beck and Levine (2004), financial institutions (banking system and financial market) can only improve the output growth of an economy if there are functional industrial activities, free flow of information, low transaction cost and an optimal resource allocation.

Prior to 1986, the Nigerian financial system was under “financial repression” with an undesirable real interest rate, a high tax burden on financial earnings, high liquidity, possible financial misallocations, and a high reserve requirement ratios (CBN,2003). After 1986, the financial markets became an active part of the economy. The lifting of repressive controls on financial market instruments was realized gradually over 1986 and beyond as part of policy change. It was expected that the 1986 shift in policy stance in the form of Structural Adjustment Programme (SAP) would be a watershed in the life of the national economy (Karimo and Ogbonna, 2017).

There have been diverse views on the linkages between the financial sector development and the real sector development of the economy. In this regards, the supply-leading finance, demand-following finance, the feedback hypothesis, the neutral hypothesis, and the structuralist hypothesis have been on the point of discussion over time. The supply-leading finance was propounded by Schumpeter (1911) and developed further by scholars such as Gurley and Shaw (1967), McKinnon (1973), and King and Levine (1993). These finance-led proponents are of the opinion that it is financial development that can propel economic growth due to improvement in the efficiency of capital accumulation or an increase in the rate of savings as well as the rate of investment. The demand- following finance took their tool by defining the direction of causality to flow from the real sector to the financial sector. To them, it is the improvements in the economy that drive higher demand for the use of money, which consequently promotes financial development (see Robinson, 1952; Goldsmith, 1969; Jung 1986; Lucas, 1988; and Kar and Pentecost,
Using the Nigerian data, evidence shows that financial development (measured here as a ratio of credit to the private sector to GDP) exhibits a positive relationship. This is presented in the Figure 1

Figure 1: Trend of Financial Development index and economic growth.

The credit to private sector as a ratio of GDP (CPS/GDP) and the log of gross domestic product (ln GDP) maintained an upward movement over time, though with some fluctuations in the part of CPS/GDP. However, ln GDP has maintained a steady upward growth over time. The key issue that arises from this positive nature of their relationship could be the direction of causality. That is, is it development in the financial sector that causes development in the real sector or the other way round?

There have been series of conflicting results on the relationship between financial development and real sector growth. The recent studies of Christopoulos and Tsionas (2004), Odeniran and Udeaja (2012), Ebiringa and Duruibe (2015), and Karimo and Ogbonna (2017) revealed that it is development in the financial sector that causes growth in the real sector. On the contrary, Madichie, et al. (2014) established that it is the development in the real sector that causes the development in the financial sector, while Osuji and Chigbu (2009) established a bidirectional causality between financial development and economic growth. The absence of any form of causality between the financial sector and the real sector was also noticed (Adekunle, Salami and Adedipe, 2013). These mixed findings and contentions in the direction of causality between financial development and real sector development are the major propeller of this study. This study therefore aims at examining the nature of the relationship between financial development and real sector development as well as examining the existence of a long-run relationship between the two sectors of the Nigerian economy.


1.2 Statement of the Problem

Although a large body of studies have pointed out that financial deepening produces faster average growth with welfare implications, Levine (1997, 2005) and Beck et al (2000), Honohan (2004a), (2004b), Jalilian and Kirk Patrick (2005), Beck et al (2007), Odhiambo (2009) etc. Researchers have not yet determined whether the aggregate welfare gains of financial deepening benefit the whole population equally or whether it disproportionally benefits the rich or the poor. If financial deepening intensifies income inequality, this income distribution effect will hamper the beneficial effects of financial deepening on the poor.

Thus, theory predicts conflicting predictions on the aggregate welfare implications of financial deepening. Scholars like Mendoza et al (2007) and others are of the opinion that if financial reform policies that produce financial deepening are not accompanied with proper and adequate regulatory framework, sound fiscal and macroeconomic stability, then financial deepening can have sizeable consequences on the distribution of wealth and adverse welfare effects.

They stressed that developing countries financial regulators fail to strike an appropriate balance between regulating the sector effectively for the determinants of financial deepening to be effective and providing a good environment for financial sector deepening, Levine et al (2000), Holden and Prokopenko (2001), DFID (2004). In addition some other studies followed a similar reasoning that the indicators of financial deepening that worked for some developed and developing countries may not work for other countries. According to these studies while there are large benefits from a well functioning financial system, financial sector deepening also brings risk which may hit more on the poor, Banerjee (2009), Zingales (2009). In the opinion of Mendoza et al (2007), even though financial deepening leads to a significant increase in wealth inequality in most developed countries, the aggregate welfare consequences are still positive for these countries. By contrast, in countries with growing financial markets, the aggregate welfare consequences are negative and the distribution of wealth does not change much.

However, recent studies on finance deepening in Nigeria especially on recent deepening efforts have concentrated more on its impact on economic growth, Ndebbio (2004), Nnanna (2004) and Nzotta and Okereke (2009. These studies imply that once there is growth it could have an impact on the whole economy. But economists are of the view that the imperative of growth for welfare improvement does not mean that growth is all that matters, Fields (2001). Access to financial services is crucial for welfare improvement, Jalilian and Kirkpatrick (2001), Asenso-okere et al (1993).

Though it is true that in recent times, bank intermediation in formal banking has improved in terms of speed of response to customers’ needs and quality of service rendered in Nigeria as a result of the efforts geared towards the deepening of the financial system, Sanusi (2011), the same is not available to people in the rural areas. Bank branch location is heavily biased towards the urban areas with good infrastructures that can fetch good returns.
In addition, despite the improvements in the banking industry, they are still punctuated with cases of under-performance of their role. A significant proportion of credit transactions in Nigeria still take place in the informal markets, despite governments efforts aimed at channeling credit to the productive sector through the deposit money banks, Nnanna (2004). According to Soludo (2008), banking services are available to about 40 percent of the population and more than 60 percent of the poor do not have access to formal finance and are forced to rely on a narrow range of some risky and expensive informal services which constraints their ability to participate fully in markets to increase their income and contribute to economic growth. The business information provider (Business Hallmark 6th-12th June,2011), revealed that two years after the CBN launched the last bank reforms with N620 billion injected into eight banks, N1.7 trillion toxic assets bought off, the economy is still prostrate, banks not lending and poverty ravaging the land.

Moreover, at the period of this research, banks are pegging the minimum cash balance for savings account at N2000 and N5000 in some cases and lending practices curtailed with emphasis on risk minimization. Moreover, there is still high cost of capital (high interest rates) and existing anomalies in lending for investment in agricultural production which is one of the sectors expected to act as a catalyst towards a general aggregate welfare improvemnet, Aderibigbe (2005). These developments may continue to increase the lack of financial accessibility of the low income earners and confine them to low-return capital intensive activities, so that despite being more risk averse they are less diversify. Already, there have been profound fluctuations in the private consumption expenditure in Nigeria, Odior and Banuso (2011), implying that private per capita consumption expenditure, a measure of aggregate welfare will follow the same pattern. There is then a concern issue that the recent banking sector reform-led financial deepening in Nigeria will have a similar effect with that of deregulation/financial liberalization period which made commercial bank accounts inaccessible to most Nigerians, Ayida, (2007), generating severe welfare implications, which manifest indirectly through their relation with macroeconomic policies, raising arguments whether financial sector deepening in Nigeria is having a disproportionate aggregate welfare beneficial impact or broadening access to financial services.


1.3 Objectives of the Study

The aim of this study is to investigate the impact of financial deepening on economic growth in Nigeria. Specifically, the objectives of the study include to;

  1. To examine the nature of the causal relationship between financial deepening and economic growth in Nigeria
  2. To investigate the influence of financial deepening on economic development in Nigeria
  3. To determine the nature of a long-run relationship between financial deepening and economic growth in Nigeria

1.4 Research Question

The following research questions are formulated to guide this research:

  1. What is the nature of the causal relationship between financial deepening and economic growth in Nigeria?
  2. What is the influence of financial deepening on economic development in Nigeria?
  3. What is the nature of a long-run relationship between financial deepening and economic growth in Nigeria?

1.5 Research Hypothesis

  1. HO1 There is no significant impact of financial deepening on economic growth in Nigeria
  2. HO2 There is no significant influence of financial deepening on economic development in Nigeria

1.6 Significance of the Study

Financial system is seen as a vehicle for promoting economic growth. Financial institutions identify the most efficient investment ventures and channel resources from savers to investors. It also screens borrowers, manages risks and operates the payment and settlement system. Thus, development of an efficient and vibrant financial system is fundamental to macroeconomic stability. Existing literature has only discussed this relationship in theory.

This study is significant and unique because, it empirically investigate the causal relationship between financial deepening and economic growth, thereby filling the existing gap in the literature.

More so, this study will contribute to the existing literature by extending the study period and employ more sophistical and higher techniques of estimation in order to achieve reliable and consistent result. Ultimately, the findings of this study will serve as a policy guide to the government and captains of industries.

The study will also serve as a reference material for further studies on finance-growth nexus and other academic works.


1.7 Scope of Study

This study shall focus on the empirical relationship that exists between financial deepening and economic growth with particular reference to the Nigerian state. The empirical investigation is however restricted to the period between 1982 and 2019 to ascertain whether causality proceeds from financial deepening to economic growth or vice versa. The study also examined the degree or magnitude of the causal relationship between financial deepening and economic growth in Nigeria.


1.8 Limitation of the Study

The limitation of the study is that it only catered for the impact of financial deepening on economic growth in Nigeria using variables gross domestic product (lnGDP), financial deepening (FIND), exchange rate (EXC), log of total government expenditure (lnGEX), and prime lending rate (PLR) between 1982 and 2019.


1.9 Definition Of Terms

Impacts:

Refers to the influence (whether negative or positive) of financial deepening on economic growth in Nigeria

Financial Deepening:

Is a term used often by economic development experts. Financial deepening generally means an increased ratio of money supply to GDP or some price index. It refers to liquid money. The more liquid money is available in an economy, the more opportunities exist for continued growth.

Economic Growth:

Can be defined as the increase or improvement in the inflation-adjusted market value of the goods and services produced by an economy over time. Statisticians conventionally measure such growth as the percent rate of increase in the real gross domestic product, or real GDP.


1.10 Organisation of the Study

This study is organized into five chapters. Chapter one included the background of the study, research problem, research objectives and questions as well as limitation of the study. Chapter two contains the literature review. Chapter three includes the research methodology. Chapter Four contains the results and discussion of key findings of the study. Chapter Five finally looks at the summary, conclusions, and recommendations based on the findings.


Chapter Five


5.0 Summary, Conclusion and Recommendation

5.1 Summary

The study investigated the impact of financial deepening on economic growth in Nigeria. The major findings of this research work are:

  1. It is development in the financial sector that causes development in the real sector. The Granger causality test indicated that financial development Granger causes economic development hence, the findings lends support to the supply-following finance hypothesis. The implication here is that the financial system needs to play a pivotal role in the growth process of the country.
  2. Financial deepening positively and significantly influences economic growth both in the short-run and in the long-run. The implication here is that finance-led growth hypothesis is valid in Nigeria both in the short run and in the long-run.
  3. Prime lending rate positively influences economic growth in the short-run but negatively do so in the long-run. This implies that in the short-run, investors may not really be mindful of the rate of interest when their focus is to start up. However, in the long-run they may be very cautious since they can rely on their retained earnings for expansion.

5.2 Conclusion

This study investigated the influence of financial development on economic growth in Nigeria for the period 1982 to 2019. The role of the financial system is crucial for economic development of a country as it promote savings (Bencivenga and Smith, 1991), provide vital information (Greenwood and Jovanovic, 1990), and affect credit rationing (Boyd and Smith, 1997). The direction of causality between financial development and economic growth has been established on the basis of the supply-leading and demand-following finance hypotheses. Financial development has also been discussed to be a function of the level of economic development of a country based on the structuralist hypothesis. Findings from the study has established that the prevalent finance-growth hypothesis in Nigeria is supply-leading, implying that development in the financial sector is what propels growth in the real sector of the Nigerian economy. This indicates that, based on the structuralist hypothesis, Nigeria is still at her early stage of development and therefore needs supply of investment finance in order to stimulate growth in the real sector of the economy. Also, the study revealed that financial development posed a positive and significant effect on economic growth in Nigeria within the study period.


5.3 Recommendation

Based on the findings of this study, the following are recommended;

  1. Since it is observed that there is a causal relationship between financial development and economic growth in Nigeria, concerted efforts should be geared towards innovative financial system that will be able to stand the demands of the real sector in terms of investment finance.
  2. Also, since there is a positive and significant relationship between financial development and economic growth, there is need for more financial market development that favours more credit to the private sector in order to stimulate economic growth. This can be achieved through strengthening the micro finance sector so as to make credits available and accessible to the micro entrepreneurs who are often deprived of credit by the conventional credit markets.
  3. The government should encourage monetary authorities like the Central Bank of Nigeria to build a conducive and enabling environment for friendly interest rates so that prospective investors can increase their investment and raise the nation’s production capacity.

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