CAUSALITY BETWEEN FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN NIGERIA

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ABSTRACT

This study provided an empirical analysis of causality between financial development and economic growth in Nigeria. Time series data from 1981 to 2019 relevant to the study were collected from the Central Bank of Nigeria statistical bulletin, Volume 30. The ordinary least squares (OLS) method of multivariate regression was utilized in analyzing the semi-log model. The Augmented Dickey-Fuller unit root test was employed to establish the stationarity of the variables while the Autoregressive Distributed Lag (ARDL) model was used for testing for the existence of long-run and short-run equilibrium conditions while the Granger causality test was applied to ascertain the direction of influence between financial development indicators and economic growth in Nigeria. Financial development indicators used in the study were financial depth (measured by broad money supply to GDP ratio), private sector credit to GDP ratio, stock market development (measured by market capitalization to GDP ratio), banking sector development (measured by total banks assets to GDP ratio), savings rate (proxied by national savings to GDP ratio) and informal finance which was proxied by the ratio of currency outside the banks (measured by M1 to M2 ratio). On the other hand, economic growth was measured by real gross domestic product. In consonance with the demand following hypothesis, the results of the Granger causality test revealed a causal relationship from real gross domestic product to financial depth, private sector credit ratio, market capitalization ratio and banking sector ratio. The ARDL bounds test indicated that a long-run cointegrating relationship existed between financial development indicators and economic growth in Nigeria. From the ARDL estimates, it was found that financial depth had a negative and significant influence on economic growth in the short run with positive but insignificant influence in the long run. Also, the private sector credit ratio had a negative influence on economic growth in both the long-run and short-run, but it was only significant in the short-run. In the long-run and short-run, the market capitalization ratio had a positive and significant influence on economic growth. Again, savings rate and informal finance (measured by the rate of currency outside the banks) were found to exert a negative and significant influence on economic growth in both the long-run and short-run. It is therefore recommended that government carry out subsequent efforts towards developing the financial sector in conformation with global standards. As such, factors that could hinder the growth of the flow of financial resources to economically productive sectors should be mitigated and controlled.







TABLE OF CONTENTS

 

Title Page                    .                       .                       .                       .                        i

Certification               .                       .                       .                       .                        ii

Declaration                 .                       .                       .                       .                        iii

Dedication                  .                       .                       .                       .                        iv

Acknowledgements    .                       .                       .                       .                        v

List of Tables              .                       .                       .                       .                        viii

List of Figures             .                       .                       .                       .                        ix

Abstract                      .                       .                       .                       .                        x

 

CHAPTER 1: INTRODUCTION

1.1       Background to the Study                                                                                1

1.2       Statement of the Problem                                                                               3

1.3       Objectives of the Study                                                                                  6

1.4       Research Questions                                                                                        6

1.5       Research Hypotheses                                                                                      7

1.6       Scope of the Study                                                                                          8

1.7       Significance of the Study                                                                               8

1.8       Limitations of the Study                                                                                 9

1.9       Operational Definition of Terms                                                                    9

 

CHAPTER 2: LITERATURE REVIEW

2.1       Conceptual Framework                                                                                  11

2.1.1    Concept of financial development                                                                 13

2.1.2    The functional role of financial system                                                          17

2.1.3    Concept of economic growth                                                                         18

2.1.4    Linkages between financial development and economic growth                        19

2.1.5    Financial development and economic performance in Nigeria                        21

2.1.6    Financial reforms of the consolidation era; its implication for

financial sector development in Nigeria                                             22

2.1.7    Capital market based financial development and economic growth                        23

2.1.8    Financial integration: an aid to financial development                                  24

2.2       Theoretical Framework                                                                                  25

2.2.1    Demand following and supply-leading hypotheses                                        25

2.2.2    The feedback mechanism                                                                               27

2.2.3    Goldsmith theory                                                                                            28

2.2.4    Mckinnon's complementarity hypothesis                                                       29

2.2.5    Shaw’s hypothesis                                                                                          30

2.2.6    Neo-classical growth theory                                                                          32

2.3       Empirical Framework                                                                                     33

2.4       Summary of Literature                                                                                   58

2.5       Gap in Literature                                                                                            65

 

CHAPTER 3: METHODOLOGY

3.1       Research Design                                                                                             68

3.2       Nature and Sources of Data                                                                            68

3.3       Method of Data Analysis                                                                                68

3.4       Model Specification                                                                                       69

3.5       Description of Model Variables                                                                     70

3.6       Techniques of Data Analysis                                                                          72

 

CHAPTER 4: PRESENTATION OF DATA, ANALYSIS AND DISCUSSIONS

4.1       Presentation of Data                                                                                       75

4.2       Descriptive Statistic                                                                                       83

4.3       Empirical Analysis and Discussion of Findings                                             84

4.3.1    Augmented Dickey-Fuller (ADF) test for unit root                                       84

4.3.2    Granger causality test                                                                                     85

4.3.3    ARDL bounds testing for cointegration                                                         87

4.3.4    Error correction model (ECM)                                                                       89

4.3.5    Diagnostic test                                                                                                91

4.3.6    Test of hypotheses                                                                                          94

4.3.7    Discussion of findings                                                                                    96

 

CHAPTER 5: SUMMARY, CONCLUSION AND RECOMMENDATIONS

5.1       Summary                                                                                                        100

5.2       Conclusion                                                                                                      101

5.3       Recommendations                                                                                          102

5.4       Contribution to Knowledge                                                                            103

 

REFERENCES

APPENDIXES

 

 

  

 

 

 

 

LIST OF TABLES

2.1       Summary of empirical literature                                                                    59

3.1       Description of model variables and a priori expectation                               71

4.1       Annual time series data used for the study                                                     75

4.2       Descriptive statistic                                                                                        83

4.3       ADF unit root test results                                                                               85

4.4       Granger causality test                                                                                     86

4.5       Bounds test results                                                                              87

4.6       Long-run coefficient estimates                                                                       87

4.7       Error correction model                                                                                   90

4.8       Diagnostic test                                                                                                92

 

 

 

 

 

 

 

 

LIST OF FIGURES


1.1       Trend of market capitalization                                                                       5

2.1       Conceptual framework                                                                                   13

4.1       Trend of real gross domestic product                                                             76

4.2       Trend of broad money supply to GDP ratio                                                   77

4.3       Trend of private sector credit to GDP ratio                                                    78

4.4       Trend of market capitalization to GDP ratio                                                  79

4.5       Trend of banking sector assets to GDP ratio                                                  80

4.6       Trend of savings to GDP ratio                                                                        81

4.7       Trend of currency outside bank to M2                                                           82

4.8       CUSUM test                                                                                                   93

4.9       CUSUM sum of squares                                                                                 93

 

 

 

 

 

 

 

CHAPTER 1

INTRODUCTION


             1.1           BACKGROUND TO THE STUDY

Globally, economic growth which manifests as positive changes in the value of goods and services remains an important phenomenon. However, diverse economic factors and their interaction with each other play critical roles in stimulating growth. Based on this premise, the economic theory postulates that factors of production such as labour, capital and land are fundamental drivers of growth. Furthermore, growth theories added that technological changes are prominent sources of change in the production function (Tyson, 2021). Nevertheless, over time, the significance of a viable financial system was also recognized as a core driver of economic prosperity which led to the introduction of financial sector reforms of developing countries to facilitate economic growth through financial system development. Hence, a lot of research efforts have been made towards analyzing and understanding the connection between financial sector development and economic growth.

Financial development entails the capacity of financial institutions to effectively and efficiently attract and mobilize financial savings for investment activities towards sustainable economic growth. Based on the perceived causality between finance and growth, every nations’ economy requires a sophisticated and viable financial system to succeed. According to Haan, Pleninger and Sturm (2021), financial development is crucial to economic growth because it connotes the establishment and expansion of institutions, instruments and markets that facilitate investments and growth. Hence, a developed financial system speeds up the trade of goods and services, savings mobilization, resource allocation, and aids risk diversification. Based on this premise, many developing countries, Nigeria inclusive, have embraced strategic development plans that prioritize revamping and modernization of their financial sectors. For instance, since the mid-1980s, Nigeria has implemented reforms and policies within the context of the Structural Adjustment Programme (SAP) proposed by the Bretton Woods institutions in 1986. The essence of initiating these reforms is to create a more efficient and stable financial sector, which would drive optimum performance in the economy (Osisanwo, 2017; Soludo, 2007).

The causality between financial development and economic growth is tagged as the supply-leading and demand-following hypotheses (Karimo and Ogbonna, 2017). The standpoint of the supply-leading hypothesis is that the development of the financial system facilitates economic growth, implying that the development of financial institutions and markets stimulates economic growth. Numerous theoretical and empirical literature on the subject has shown that financial development is important and causes economic growth (Bassey, Okoi and Imoh, 2021; Sambo, Sulong and Sambo 2021; Olaniyi, 2020). Conversely, the demand-following hypothesis advances that economic growth stimulates financial development based on the notion that an increase in demand for financial services might prompt a rapid expansion in the financial sector as economic prosperity is enhanced (Mittal, 2017; Puatwoe, 2017; Adusei, 2013).

Contemporary finance researchers have extensively investigated the link between financial liberalization and other macroeconomics variables, but the role of financial development is not universally accepted. One of the oldest findings on the relationship between financial development and economic growth is based on Schumpeter (1912) who asserts that, the services provided by the financial intermediaries are important for innovation and development. According to Bagehot (1873) and Hicks (1969), development in the financial system played a critical role in industrialising England through the facilitation of capital mobilisation. Schumpeter (1912) harnesses the importance of the banking system in economic growth; financial institutions support innovation and creativity and thus enhance future growth by identifying and funding productive investments. Therefore, it facilitates the creation of wealth, trade and the formation of capital (Ahmed 2006). A further step taken by Fry (1978, 1980) and Galbis (1977) suggested that, interventions to impose restrictions on the banking system such as credit ceilings and high reserve requirements have a negative impact on the development of the financial sector, which ultimately reduces economic growth. In addition, (Levine 1997) suggested that aiding risk management, improving liquidity and reducing transaction costs leads to financial system development and thus encourages investments.

In Nigeria, the financial system reforms characterized by the the1986 deregulation influenced the extent of finance-driven economic growth (Nnanna, 2004). Nevertheless, the deregulation of the financial system of Nigeria, coupled with rapid financial markets globalization and the accelerated level of cross-border financial activities in Nigeria has generated interest regarding the level of financial development in the country. These have manifested in the level of growth in the financial outlet, accelerate activities in the capital and money market, increased bank branches, rapid use of credit and debit cards, increasing use of payment technologies like ATMs (Automatic Teller Machine Technology) and electronic transfer of deposits, expanding internet banking services, e-banking, and increase in total deposits, (Okereke, 2011). In this regard, financial development is expected to translate into economic growth, because persistent growth of the financial sector would make funds available for investments.

Intuitively, a well-developed financial system could drive efficiency with which a greater amount of capital accumulation is facilitated and a greater amount of funds are allocated to profitable investments. However, the controversy still exists in the literature as to whether the development of the financial system has driven the expected economic growth in Nigeria.  Based on the foregoing discussions, the study is designed to ascertain the causal relationship between financial development and the economic growth of Nigeria.


             1.2           STATEMENT OF THE PROBLEM

Since the Structural Adjusted Programme in 1986, Nigerian monetary authorities have embraced measures aimed at developing the financial system and decelerating the incidence of financial repression. These reforms have brought changes in Nigeria's financial sector to encourage competition, strengthen the supervisory and regulatory framework, and streamline public involvement in the financial system. Many new financial instruments/assets and techniques have been developed and existing ones have been modified, the financial markets have been adapted to meet new demands and new circumstances. All these have been aimed at developing the financial system. Unfortunately, the positivity expected from financial development and economic growth nexus is yet to be seen in Nigeria. Figure 1.1 shows the trend of market capitalization from 2007 to 2019.


Figure 1.1: Trend of market capitalization (2007-2019)

Source: Central Bank of Nigeria (CBN) Statistical Bulletin, Vol. 30, 2019.

In addition, notwithstanding the improvements in the Nigerian banking sector, they are still plagued with cases of the dismal performance of their role. For instance, a large proportion of credit transactions in Nigeria still take place in the informal markets, notwithstanding the government's efforts towards channelling credit to the productive sector through the commercial banks. According to Michael (2016), the underperformance of the banking sector was such that banking services are available to about 40% of the population and more than 60% of the poor do not gain access to formal finance and are propelled to depend on a narrow range of some risky and expensive informal services which hinder their ability to partake fully in financial markets to accelerate their income and contribute to economic growth. Hence, the economy is still prostrate, banks lack efficiency and effectiveness in lending.

These developments in the financial system might continue to spur the lack of financial accessibility and restrict economic units to low-return capital intensive activities. Already, there have been profound fluctuations in total savings and investments in Nigeria, implying that domestic production, a measure of economic growth will follow the same pattern. Again, literature is faced with the puzzle as to whether financial development influences economic growth or vice versa. For instance, prior empirical works such as Haan, Pleninger and Sturm (2021); Rehman and Hysa (2021); Karimo and Ogbonna (2017); Bidemi and Abidemi (2014); Matei (2020) found a one-way causal flow from components of financial development to economic growth, while studies like Nwakoby, Oleka and Ananwude (2019); Madichie, Maduka, Oguanobi and Ekesiobi (2014); Hamdi, Hakimi and Sbia (2013) found a one-way causal flow emanating from economic growth to financial development. Similarly, empirical studies such as Fuinhas, Filipe, Belucio and Marques (2019); Mittal (2017); Adusei (2013) and Odhiambo (2009) found evidence of a bidirectional relationship between components of financial development and economic growth while Bassey, Okoi and Imoh (2021) found no causal flow between the two variables. Furthermore, Kapaya (2020); Etale and Edoumiekumo (2020) and Iheonu, Asongu, Odo and Ojiem (2020) explained that the actual causal flow between financial development and economic growth is dependent on the measure of financial development. Based on these problems, there is a need to trace the direction of influence between financial development and economic growth in Nigeria. 


             1.3           OBJECTIVES OF THE STUDY

The core objective of this study is to ascertain the causality between financial development and economic growth in Nigeria. The specific objectives are to:

1.         investigate the causal effect of financial depth (measured by broad money supply to GDP ratio) on real gross domestic product in Nigeria.

2.         ascertain the direction of influence between private sector credit to GDP ratio and real gross domestic product in Nigeria.

3.         analyse the causal effect of stock market development (proxied by market capitalization to GDP ratio) and real gross domestic product in Nigeria.

4.         investigate the nature of causality between banking sector development (proxied by total bank assets to GDP ratio) and real gross domestic product in Nigeria.

5.         ascertain the causal effect between savings rate (measured by total national savings to GDP ratio) and real gross domestic product in Nigeria.

6.         determine the direction of causality between informal finance measured by currency outside bank (M1 to M2 ratio) and real gross domestic product in Nigeria and vice versa.

1.4       RESEARCH QUESTIONS

The study sought to answer the following research questions:

1.         What is the direction of causality between financial depth (measured by broad money supply to GDP ratio) and real gross domestic product in Nigeria?

2.         How does private sector credit/GDP ratio influence real gross domestic product of Nigeria and vice versa?

3.         What influence does market stock market development (measured by capitalization to GDP ratio) have on real gross domestic product in Nigeria?

4.         In what ways does banking sector development (proxied by bank assets to GDP ratio) influence real gross domestic product of Nigeria?

5.         How does savings rate (proxied by total national savings to GDP ratio) influence real gross domestic product of Nigeria?

6.         To what degree does ratio of informal finance measured by currency outside bank (M1 to M2 ratio) influence real gross domestic product in Nigeria and vice versa?

1.5       RESEARCH HYPOTHESES

The following hypotheses stated in null form were tested:

Ho1:  There is no significant causal relationship between financial depth (measured by broad money supply to GDP ratio) and real gross domestic product of Nigeria.

Ho2:  There is no significant causal relationship between private sector credit to GDP ratio and real gross domestic product in Nigeria.

Ho3:  Stock market development (measured by market capitalization to GDP ratio) has no significant causal influence on real gross domestic product of Nigeria.

Ho4:  Banking sector development (proxied by total bank assets to GDP ratio) has no significant causal influence on real gross domestic product of Nigeria.

Ho5:  Savings rate (measured by gross savings to GDP ratio has no significant influence on real gross domestic product of Nigeria.

Ho6:  Informal finance measured by currency outside bank (M1 to M2 ratio) has no significant causal influence on real gross domestic product of Nigeria.

1.6       SCOPE OF THE STUDY

The study investigated the causal relationship between financial development and economic growth in Nigeria from 1981 – 2019.  The choice of the period is justified because it covers both the pre and post-deregulation era of the Nigerian financial system. Also, it covered years (1981, 1982, 1983, 1984, 1991 and 2016) when the Nigerian economy recorded a negative real GDP growth rate (recession). On the other hand, the indicators of financial development considered for this study such as private sector credit to GDP ratio, broad money supply to GDP ratio, bank assets to GDP ratio, market capitalization to GDP, gross national savings to GDP ratio and informal finance covered key subsectors of the financial system and these indicators have significant shocks especially aftermath the financial liberalization in 1986 coupled with the global financial downturn of 2008 and economic recession witnessed in 2016.


1.7       SIGNIFICANCE OF THE STUDY

The need to empirically investigate the relationship that exists between financial development and economic growth is very critical. Hence, the significance of this study has been highlighted below as follows:

1.         Monetary Authority: This study is relevant at this level of economic development (characterized by the recession) when efforts are being geared towards repositioning the financial system to enable it to play key roles in economic growth. Hence, the monetary authority would understand the area of financial policy development that would aid to curb the current economic crisis witnessed in Nigeria. It will also aid policymakers and the government to understand the structural changes that have taken place with the reform policies on the ground in Nigeria.

2.         Investors: Both domestic and foreign investors are interested in the functionality of the economy. Hence, efforts towards developing the financial system for economic growth would influence investment decisions across the country. As such, this study will provide relevant information to investors to enhance investment induced economic growth in Nigeria. 

3.         Academia: It will also provide required information that will be critical in formulating a more targeted financial reform policy that will be of great benefit to Nigeria. More so, the study would be an addition to the literature on the linkages between finance and growth.

1.8       LIMITATIONS OF THE STUDY

The limitations that were encountered during this study were time factors and lack of funds. These two factors are economic resources and it is a clear fact that economic resources are limited and scarce. However, the researcher applied the principle of opportunity cost, the scale of preference and prudent utilization of available resources to accomplish the study.


1.9       OPERATIONAL DEFINITION OF TERMS

The terms listed below occurred frequently in this study. Therefore, explanations are provided as to the intended meaning of these terms.

1.           Financial development: Financial development is the capacity of financial institutions to effectively and efficiently attract and mobilize financial savings for investment activities towards sustainable economic growth.

2.           Formal finance: Formal finance refers to borrowings from recognized financial institutions such as banks and non-bank financial institutions.

3.           Informal finance: Informal financial institutions are financing activities that are mostly. Legal but their activities are often unrecorded, unregistered and unregulated by the government. Informal finance is often measured by currency outside the bank.

 

 

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