Nonlinearities in Financial Development–Economic Growth Nexus: Evidence from sub–Saharan Africa (SSA)

21 August 2018
Publication Type: Policy Brief

The impact of financial development on economic growth has received much attention in the recent literature. The general conclusion is that development of the financial sector is positively related to the level of growth. However, theoretical studies have espoused discontinuities in the relationship. More importantly, the relationship between finance and economic activity is well mediated by the level of initial per capita income, human capital and existing financial development. While this is well documented at the theoretical front, empirical literature is silent on the nonlinearities in finance–growth nexus caused by the threshold variables. Beyond examining the impact of financial development on economic growth for 29 SSA countries over the period 1980–2014, in this study, we further investigate whether the impact of finance on growth is conditioned on the initial levels of countries’ income, human capital and financial sector development. Our overall finding is that, financial development is positively and significantly associated with economic growth. However, the growth–enhancing effect of finance is higher when measured with private relative to domestic credit. We re–examine the threshold effect of finance in the face of the threshold variables. Our evidence suggests that, in almost all cases, financial sector development is positively related to growth albeit insignificantly below the estimated thresholds. The only exception is the impact of private credit on growth below the income threshold where the impact is slightly significant. Similar trend is also noticed when domestic credit mediates the finance–growth nexus.

While financial development promotes growth, the initial level of finance significantly matter in mediating the impact of finance on economic activity. In other words, below a certain threshold, the intrinsic drive of the financial sector insignificantly affects growth. An underdeveloped financial sector may be associated with high transaction cost, rigidities and sub-optimal resource allocation with consequential effect on overall growth. However, as the financial sector continue to develop above a threshold, growth increases suggesting that countries with relatively high financial sector development enjoy higher growth. A key implication is that the link between economic growth and finance is contemporaneous and financial development importantly impact on economic activity. Thus, within this framework, policies that alter the efficiency of financial intermediation invariably provide a first order stimulus on overall level of growth. At the policy level, countries in SSA need to design strategies to enhance credit allocation, competition and regulations in order to make it possible for the financial development to stimulate economic growth as these appear to be necessary condition for long run growth.

We also found that, below the threshold level of per capita income, human capital and the level of finance, economic growth is largely insensitive to financial development. The main conclusion drawn is that higher level of finance is a necessary condition in long run growth and so are the overall level of income and countries’ human capital.

Our results are of crucial importance to policymakers with regard to the optimisation of the level of income, human capital and financial development that needs to be vigorously improved to ensure higher potential benefits for the economy through the financial sector. The evidence presented here reveals that predetermined components of countries’ structural characteristics are a good predictor of long run economic growth and that the level of countries’ income, human capital development and finance shape the ability of financial sector development in ameliorating information asymmetry, diversifying risk and efficiency with which resources are allocated.

Series title: Research Brief 154
1 August 2018
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