THE IMPACT OF FINANCIAL DEEPING ON ECONOMIC GROWTH OF NIGERIA

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THE IMPACT OF FINANCIAL DEEPING ON ECONOMIC GROWTH OF NIGERIA

ABSTRACT

The paper aimed at empirically investigating the impact of financial deepening on the growth of an economy, with particular emphasis on Nigeria over the period 1981–2010. Financial deepening was segregated to capture both bank and non-bank financial variables, because both are imperative to economic activities. The study therefore combined a proxy of banking sector development with stock market development to capture the influence of financial deepening on growth. The analysis is based on the bound testing approach to cointegration. The empirical results confirm cointegrated relationship between economic growth and financial deepening. The study also showed that, in the period of study, while there is bidirectional causality between bank financial deepening and economic growth, causality runs from economic growth to non-bank financial deepening. The results of the investigation are in favour of the finance-growth cum growth-finance hypothesis. For the period under study, Nigeria’s economic growth is sensitive to changes in financial deepening, past level of growth and the openness of the economy. It is therefore imperative that policies which seek to deliberately increase financial depth be vigorously pursued, in order to stimulate growth and consequently further deepen the financial sector of the economy. Although the finance-growth relationship is now firmly entrenched in the empirical literature, we show that it is not as strong in more recent data as it was in the original studies with data for the period from 1960 to 1989. We consider several explanations. First, we find that the incidence of financial crises is related to the dampening of the effect of financial deepening on growth. Excessive financial deepening or too rapid growth of credit may have led to both inflation and weakened banking systems which in turn gave rise to growth-inhibiting financial crises. Excessive financial deepening may also be a result of widespread financial liberalizations in the late 1980s and early 1990s in countries that lacked the legal or regulatory infrastructure to exploit financial development successfully. However, we find little indication that liberalizations played an important direct in reducing the effect of finance. Similarly, there is little evidence that the growth of equity markets in recent years has substituted for debt financing and led to a reduced role of financial deepening on growth.

CHAPTER ONE

1.0 INTRODUCTION

1.1 BACKGROUND OF THE STUDY

Long-term sustainable economic growth depends on the ability to raise the rates of accumulation of physical and human capital (Adelakun, 2011), to use the resulting productive assets more efficiently, and to ensure the access of the whole population to these assets (Birdsall and Londono, 1997). Financial intermediation supports this investment process by mobilizing household and foreign savings for investment by firms; ensuring that these funds are allocated to the most productive use; and spreading risk and providing liquidity so that firms can operate the new capacity efficiently. Financial development thus involves the establishment and expansion of institutions, instruments and markets that support this investment and growth process. Historically the role of banks and non-bank financial intermediaries ranging from pension funds to stock markets, has been to translate household savings into enterprise investment, monitor investments and allocate funds, and to price and spread risk. Financial development starts with the banking system and depends on the diffusion of scriptural money, which the banking system provides. As countries become highly developed, the share of the banking system in the assets of the financial sector declines, while that of newer and more specialized institutions – such as building societies, life insurance companies, retirement funds and finance assets of the banking system are of lesser value than the financial assets held by all other financial institutions, whereas the reverse is true in economically underdeveloped countries. The debate on the role of the financial sector in economic growth and development has been going on for over a century now and, there are two main schools of thought. The first one asserts that financial development plays a limited role in accompanying the development of real activity (Robinson, 1952; Lucas, 1988). This school considers that when the economy develops, the financial system develops. Robinson (1952), asserts that “where enterprises lead, finance follows” and, according to Lucas (1988), economists “badly over-stress” the role of financial factors in economic growth. Rajan and Zingales (1998) and Cameron (1967) opine that, although financial development is essential for growth, it is only “a lubricant but not a substitute for the machine”. The second school of thought accords a crucial role to financial development in boosting the processes of growth, innovation and economic development (Bagehot, 1873, Schumpeter, 1911, MacKinnon 1973, Levine 1996). These authors are of the opinion that causality proceeds from financial to economic development; it is only at a later stage that financial development leads on to growth. Haber, North and Weingast, (2008) assert that “countries do not have large banking systems and securities markets because they are wealthy; they are wealthy because they have large banking systems and securities markets”. Similarly, King and Levine (1993) argue that finance does not merely follow in the wake of economic activity. They affirm that the significant robust relationship between the degree of financial development and the rate of economic growth indicates much more than a positive association between contemporaneous shocks and financial/economic development. For Levine (1996), there is even evidence according to which the level of financial development is a good predictor of future rates of growth, of capital accumulation and of technological change. In Nigeria, there has been an underdevelopment of the real sector and it has been envisaged that the reason for this is the lack of funds from the financial sector to this sector. This ought not be so because over long periods, there has been in most countries a rough but unmistakable parallel between economic growth and financial development. According to the statistics gleaned from Goldsmith (1969), there is clearly a positive correlation between levels of economic development and financial development.

1.2 STATEMENT OF THE PROBLEM

The fundamental question in economic growth that has preoccupied researchers is why countries grow at different rates. The empirical growth literature has come with numerous explanations of cross-country differences in growth, including factor accumulation, resource endowments, the degree of macroeconomic stability, educational attainment, institutional development, legal system effectiveness, international trade and ethnic and religious diversity. The list of possible factors continues to expand, apparently without limit.

One critical factor that has begun to receive considerable attention more recently is the role of financial development in the growth process especially in the wake of the recent global economic and financial meltdown. The positive link between the financial depth and economic growth is in one sense fairly obvious. That is, more developed countries, without exception, have more developed financial markets. Therefore, it would seem that policies to develop the financial sector would be to raise economic growth. Indeed, the role of financial development is considered by many to be the key to economic development and growth.

While economists have generally reached a consensus on the central role of financial development in economic development theoretically; empirical works supporting this concept are conflicting. One school of thought asserts that financial development plays a limited role in accompanying the development of real activity; the second school of thought accords a crucial role to financial development in boosting the processes of growth, innovation and economic development; while for another group of scholars, the financial market promotes growth, with growth, in turn, comes market formation (Nicet-Chenaf, 2012). This study intends to bridge the existing gap in the literature by empirically investigating the role of financial development in the economic growth of Nigeria.

1.3 OBJECTIVES OF THE STUDY

The main purpose of this study is to provide an empirical investigation of the theoretical concept that financial development often leads to economic growth and development. Specifically, the study intends:

1. Investigate the role of financial development in the economic growth of Nigeria;

2. To examine the role of financial development in the economic development of Nigeria.

3. To assess the extent to which the financial sector has developed in Nigeria.

4. To examine the effect of interest rate reforms on financial deepening in Nigeria.

1.4 RESEARCH QUESTIONS

The following research questions shall be examined in the course of this study.

(i) Does financial development actually lead to economic growth?

(ii) Does financial development bring about economic development?

(iii) To what extent has the Nigerian financial market developed?

1.5 RESEARCH HYPOTHESES

The research hypotheses to be tested in this study are stated below:

Ho : That there is no significant positive relationship between financial development and economic growth in Nigeria.

H1: That there is significant positive relationship between financial development and economic growth in Nigeria.

HYPOTHESIS II

Ho : That there is no significant positive relationship between financial development and economic development in Nigeria.

H1: That there is significant positive relationship between financial development and economic development in Nigeria.

Where H0 represent null hypothesis and H1, the alternative hypothesis.

1.6 SIGNIFICANCE OF THE STUDY

Financial system is seen as vehicle for promoting economic growth. Financial institution identifies the most efficient investment ventures and channel resources from savers into 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 investigates the relationship between financial development/deepening and economic growth and development thereby filling the existing gap in the literature as it relates to the subject matter especially as it relates to Nigeria.

1.7 SCOPE OF THE STUDY

This study shall focus the empirical relationship that exists between the financial development/deepening and economic growth and development. The study shall also examine the extent of financial development in Nigeria. The empirical investigation shall be restricted to the period between 1970 to 2011.

1.8 PLAN OF THE STUDY

This study shall be divided into five chapters. The first chapter provides the background of the subject matter justifying the need for the study. Chapter two presents related literature concerning financial development and economic growth and development. The research methodology, which includes the research design, sources of data, model formulation, estimation techniques etc are stated in chapter three while data presentation and analysis were made in chapter four. Concluding comments in chapter five reflects on the summary, conclusion, recommendations and suggestion for further studies based on the findings of the study.

1.9 DEFINITION OF TERMS

Financial deepening : 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. It can also play an important role in reducing risk and vulnerability for disadvantaged groups, and increasing the ability of individuals and households to access basic services like health and education, thus having a more direct impact on poverty reduction.

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