Financial Sector Development And The Nigeria Economy

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Get the Complete ProjectFINANCIAL SECTOR DEVELOPMENT AND THE NIGERIA ECONOMY

Abstract

The study examines the relationship between Financial Sector Development and Economic Growth in Nigeria. Time series data from 1990-2009 were fitted into the regression equation using various econometric techniques such as Augmented Dickey Fuller (ADF) test, Johansen Multivariate Co-integration Test, Ordinary Least Square Regression and Vector Error Correction Model (VEC). The result shows that development in financial sector variables viz: banking sector credits, total market capitalization and foreign direct investment positively affect economic growth variables – Real Gross Domestic Product. This result is consistent with a number of earlier studies reviewed in the literature that found financial sector variables to positively affect real gross domestic product.

1. Introduction

The link between financial sector and economic growth has been debated in financial and economic literatures. Many researchers are of the view that there still exists great dichotomy regarding the role of financial intermediaries in facilitating sustainable economic growth in the long term. Earlier studies by Schumpeter (1911), Gurley and Shaw (1955), attest to this claim. Later studies like Levine and Zervos (1996) argue that financial systems do not promote economic growth rather respond to real sector development in an economy.

According to the new growth theorists, a well-developed financial sector facilitates high and sustainable economic growth (Hicks, 1969). The Nigerian financial system comprises the money market, the capital market, and the institutions and channels that facilitate the smooth intermediation of financial transactions in the economy. The financial services sector is made up of the banking system, other financial institutions, and the securities, insurance and pension sub-sectors (CBN 2009). These institutions trade in financial instruments such as domestic currency, foreign currency, stocks, bonds and derivatives. The role of the financial sector in any economy is that of intermediation by mobilizing savings from the areas of surpluses to those of deficits. This means no profitable investment would be frustrated on account of lack of finance.

With the global financial crisis, most countries appear to have recognized the role of financial sector development in sustaining economic growth. Most affected economies had a fall in stocks and commodities prices with consequent decline in the total market capitalization. For example, according to CBN (2008), the Nigerian capital market index which grew from a value of 12,137 in 2002 to 57,990 in 2007 fell to 20,827 in 2009, while total Market capitalization of N13.29 trillion in 2007 fell to N7.03 trillion in 2009.

The global financial crisis which translated into economic meltdown of most nations led to several bail out of the financial sector (with public funds) by the governments of the affected countries with believe that once the financial sector is revived it will translate into reviving the economy and stimulate growth. This scenario however, will only be possible if there is positive relationship between the financial sector and the economic growth with causality running from the financial sector to economic growth. This provoked the need to investigate the relationship between the financial development and economic growth as public funds should not be used in bailing out the financial sector where such relationship does not exist or where the causal relationship runs from economic growth to financial development.

Within the study period (1990-2009), Nigeria has witnessed development in its financial sector affecting the key sub sectors especially the ones chosen for this study. The effect of the development however, will not be appreciated without relating it with economic growth.

There have been several studies on the financial sector development and economic growth. However, most of them consider one component of the financial sector in relation to economic growth. Many studies have been conducted on Capital market and economic growth, banking credit and economic growth and like wise foreign direct investment and economic growth. The use of one component of the financial sector like banking credit or capital market as a representative of the entire financial sector is inadequate and in appropriate, because the essence of the financial sector which is that of intermediation cannot be solely performed effectively by only one subsector of the financial system like banking or capital market neither can it be handled by foreign direct investment alone. An effective financial intermediation will require the collective contribution of the various subsectors of the financial system (like banks, capital market, etc) simultaneously.

Therefore, to summarize, the gaps that prompted this study are, first, the fact that most studies conducted previously in Nigeria on the financial sector and economic growth used only one component of the financial sector such as Capital market, FDI or Banking credits. Taking one component of the financial sector to represent the whole financial sector will not be an adequate sample of the entire financial sector. This is because for an effective intermediation function which is the key purpose of any financial sector to take place for both short and long term tenors, the collaboration of at least these three components selected for this study will be more appropriate. To fill the gap therefore, this study considered three components of the financial sector comprising banking credits, capital market and foreign direct investment to the financial sector together in relation to economic growth. Secondly, this research employed a combination of two models of data analysis as against the use of only one in previous studies. For example Osinubi (2002) employed ordinary least squares regression (OLS) in his studies of capital market and economic growth in Nigeria. Folorunso (2009) used Spearman’s rho in his studies of relationship between FDI and economic growth in Nigeria. This study however, used a combination of Vector Error Correction model and OLS. Thirdly, while other studies attempted to find the relationship between a component of the financial sector such as capital market and economic growth, this study went further to uncover the direction of causality in addition to the relationship. Assuming that a relationship exists between capital market, banking credit, FDI and economic growth, what is the direction of the relationship? Is it capital market that is causing economic growth or vice versa? Accordingly, is it inflow of FDI that is causing economic growth or economic growth causing inflow of FDI? Fourthly, there are divergent views as to the nature of the relationship between each of the component of the financial sector chosen for this study and the economic growth. While some studies found a positive relationship some discovered a negative relationship and others did not find any relationship between the financial sector and the economic growth.

The objectives of the study therefore are:

1. To examine the relationship between financial sector development and economic growth in Nigeria.

2. To determine the causal relationship between total Market capitalization, Banking sector credits, Foreign Direct Investment inflow to financial sector, and Real Gross Domestic Product in Nigeria.

The following hypotheses are formulated in line with the research objectives.

Hypothesis 1

H

o1

There is no significant relationship between financial sector development and economic growth in Nigeria.

H

A1

There is significant relationship between financial sector development and economic growth in Nigeria.

Hypothesis 2

H

o2.1

There is no causal relationship between total Market capitalization and Real Gross Domestic Product in Nigeria.

H

A2.1

There is causal relationship between total Market capitalization and Real Gross Domestic Product in Nigeria.

H

o2.2

There is no causal relationship between Banking sector credits and Real Gross Domestic Product in Nigeria.

H

A2.2

There is causal relationship between Banking sector credits and Real Gross Domestic Product in Nigeria

H

o2.3

There is no causal relationship between Foreign Direct Investment to financial sector and Real Gross Domestic Product in Nigeria.

H

A2.3

There is causal relationship between Foreign Direct Investment to financial sector and Real Gross Domestic Product in Nigeria

The remainder of this paper is structured as follows: the second part covers review of some related literature and theoretical framework while the methodology is provided in the third section. The empirical results and discussion is provided in section four. Finally, conclusion and recommendations are provided in section five.

2. Literature Review and Theoretical Framework

Financial system serves as the medium of the savings-investment process. One fundamental question is: will the development of financial system exert a positive effect on economic growth? A vast empirical literature on the issue exists with varying and often contradicting views. However, the review will begins with theoretical framework followed by empirical studies.

2.1. Theoretical Framework

Most literature focus on two main diverging theoretical paradigm namely the “supply leading hypothesis” and “demand following hypothesis” in line with Patrick (1966) which postulated a feed back relationship between economic growth and financial development. While, the ‘supply-leading’ hypothesis posits a unidirectional causation that runs from financial deepening to economic growth

implying that new functional financial markets and institutions will increase the supply of financial

 

services. This will definitely lead to high but sustainable real economic growth. This hypothesis

 

performs two roles namely to transfer resources from low growth sectors to high growth sectors and to

 

promote entrepreneurial response in the later sector.

Earlier scholars such as Schumpeter (1912), Goldsmith (1969), Shaw (1973) and McKinnon (1973), emphasized the importance of the financial system in economic growth. Hicks (1969) argued that the industrialization process in England was promoted by the development of the financial sector which increased the access of the government and people to funds that were used to finance capital projects which led to the development of the economy. This view was supported by King and Levine (1993), that financial development fosters economic growth. Moreover, Bensivenga (1995) concluded that well developed financial market induces long run economic growth. Other studies that supports the supply leading

 

hypothesis include (Calderon and Liu, 2002); Neusser and Kugler (1998) and

 

Levine, Beck and Loayza (2000).

The ‘demand-following’ hypothesis posits a unidirectional causation

 

from economic growth to financial development. This implies financial system passive response to

 

economic growth meaning that the increasing demand for financial services might lead to the

 

aggressive expansion of the financial system as the real sector of the economy grows.

Previous studies

 

that support this hypothesis include Gurley and Shaw (1955, 1967), Goldsmith (1969) and Jung (1986). Others are Guryay, Safakli and Tuze (2007) who empirically examined the relationship between financial development and economic growth. The study employed Ordinary Least Squares technique to show that there is significant positive effect of financial development on economic growth for Northern Cyprus. They posit that causality runs from growth to financial development without a feed back.

In addition, Patrick (1966) suggested a third hypothesis known as the “stage of development hypothesis” which posits that the supply-leading financial development can induce real investment in

 

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