Full Project – THE IMPACT OF FINANCIAL DEVELOPMENT ON ECONOMIC GROWTH IN NIGERIA

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ABSTRACT

The study examined the impact of financial development in the economic growth of Nigeria. Financial development is not simply a result of economic growth; it is also the driver of economic growth. Financial development (FI), a feature of financial development, is a process that marks improvement in quantity, quality, and efficiency of financial intermediary services. It generates local savings, which increase productive investments in local businesses. This paper investigated the impact of FI on economic growth in Nigeria. It aimed to highlight the determinants of FI and its impact on economic growth. Secondary data were sourced from world development indicators and ordinary least square regression model was used to analyze the data. The result shows that FI is a signifi cant determinant of the total factor of production, as well as capital per worker, which invariably determines the fi nal level of output in the economy. This study recommends that natural and economic resources should be adequately harnessed, as alternative means of revitalization and diversification of Nigeria’s oil-dependent monocultural economy. Four different measures of financial development are used to capture the different channels through which finance can affect growth. The empirical findings provide evidence that there is a stable positive long run relationship between financial development and economic growth. The result further showed that in Nigeria the direction of causality between financial development and economic growth is sensitive to the choice of proxy used for financial development. Financial development cause economic growth when private sector credit is used as proxy but when money to income ratio, bank deposits and domestic credit ratios are alternatively used as proxies, growth is found to cause financial development.

CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

Financial development has increasingly become a crucial topic among researchers, stakeholders and policymakers especially in developing nations. However, 65% of adults in the poorest developing nations still lack access to a transaction account and only 20% save through a formal financial institution (Pazarbasioglu et al., 2020). According to the Global Findex report in 2017, only 33% of the adult population own a bank account at a formal financial institution in sub-Saharan Africa (SSA), which is less than any other region in the world (Demirguc-Kunt et al., 2018). Primarily, financial development begins with adults owning a transaction account which can be used to save money, send and receive payments (Demirgüç-Kunt et al., 2017). For low-income individuals and households, owning formal bank accounts involve inconveniences and high transaction costs (Beck & Demirgüç-Kunt, 2008; Karlan et al., 2016; Soumaré et al., 2016) but the availability of mobile telephony has helped to reduce the constraints, especially, in rural areas (Andrianaivo & Kpodar, 2011; Pazarbasioglu et al., 2020).

The pioneering contributions of Schumpeter (1911), and later McKinnon (1973) and Shaw (1973) regarding the relationship between financial development and economic growth has remained an important issue of debate in developing economies. The theoretical argument for linking financial development to growth is that a well-developed financial system performs several critical functions to enhance the efficiency of intermediation by reducing information, transaction, and monitoring costs. A modern financial system promotes investment by identifying and funding good business opportunities, mobilizes savings, monitors the performance of managers, enables the trading, hedging, and diversification of risk, and facilitates the exchange of goods and services. These functions result in a more efficient allocation of resources, in a more rapid accumulation of physical and human capital, and in faster technological progress, which in turn feed economic growth [Creane, et al. (2004)].

Long-term sustainable economic growth depends on the ability to raise the rates of accumulation of physical and human capital, to use the resulting productive assets more efficiently and ensuring the access of the whole population to these assets. 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, 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 through improvements in quantity, quality and efficiency of these financial intermediary services.

However, economist still holds startling different opinions regarding the importance of the financial system for economic growth. While many economists have underlined the importance of financial sector development in the process of economic development others still think that its importance is over stressed.

For Nigeria, studying the relationship between financial development and economic growth is a vital one considering the continuing progress/reforms in its financial sector. Considered as an integral part of macroeconomic policy the financial sector reforms are expected to bring about significant economic benefits particularly through a more effective mobilization of savings and a more efficient allocation of resources thus putting the economy on the path of sustainable economic growth and development.

Although it is common to consider cross-country regression to judge the growth effects of financial development, it is also important to study individual-country evidence at least at a simple level to see whether higher levels of financial development are significantly and robustly correlated with faster rates of economic growth, physical capital accumulation and economic efficiency improvements.

1.2 STATEMENT OF THE PROBLEM

Economic growth in Nigeria has been characterized by fits and starts. Several factors have hampered economic growth; one of such factors often associated with this unsatisfactory growth performance is shallow finance. This factor is critical in view of the general belief that scarcity of long term finance in developing countries is the major impediment to higher investment and output growth in these economies Nnanna etal (2004).

Thus, it is now well recognized that financial development is crucial for economic growth. This recognition dating back to Schumpeter (1911) who argued that the services provided by the financial intermediaries are important for innovation and development.

As this assertion may seem, there is also the argument that financial development contributes significantly to the economic development of developed countries while the developing countries have not fared well in this regard Singh (1997).

Hence, even though a growing body of work reflects the close relationship between financial development and economic growth, it is still possible to encounter especially empirical researches evidencing all possibilities as positive, negative, no association or negligible relationships. While Cross country and more recently, panel data studies show evidence of a positive impact of financial development on growth, Time series on the other hand, offer contradictory results. Furthermore, the direction of causality between financial development and economic growth is crucial because it has significantly different implications for development policy; however, this causal relationship remains unclear.

Nigeria on its part has made notable efforts over the past years to reform its financial system going from the deregulation and liberalization of the financial sector activities under SAP 1986, banking consolidation of 2004 and the recent financial system strategy (FSS) 2007 which hopes to make the country’s financial sector the growth catalyst that would ultimately engineer Nigeria’s evolution into an international financial center and a natural destination for financial products and services. Despite these great efforts Nigeria’s economic growth has been dwindling and has still remained fragile not strong enough to significantly reduce the prevailing level of poverty even though the various indicators used in measuring financial development has been increasing steadily over the years. See table 1 below:

Table 1

Where CPS = Credit to Private Sector; M2 = Money Supply Source CBN Statistical Bulletin 2008

From the table above, one would ask; what is the relationship between the growth in these financial development indicators and Nigeria’s economic growth over the years? Secondly, considering the fact that correlation does not imply causation in any way; can changes in Nigeria’s growth rate be attributed to improvements and innovations in its financial sector? Does this financial growth promote economic development in Nigeria?

Referring to earlier studies done on this area especially the works of Aigbokan (1995), Odedokun (1995) and Ndebbio (2004) as it pertains to Nigeria, their studies in testing for causality failed to employ multivariate co integration and vector error correction model (VECM) thus failed in making a clear distinction between long run and short run causality.

This distinction is very important since as Darrat (1999) states “most of the benefits of higher levels of financial development could be realized in the short run while in the long run as the economy grows and becomes mature these effects slowly disappear”.

Moreso, the time span of some of the studies were too brief to capture the long run relationship between financial development and economic growth as the number of observations did not exceed 25 years.

The work of Ndebbio (2004) was based on a cross country regression approach and generally there has been a growing concern about cross country empirical approach and its use for causal inference in particular. The studies based on cross country suffer from potential biases induced by simultaneity, omitted variables and unobserved country specific effect on the finance – growth nexus. This was acknowledged by Levine (1997) and Luintel and Khan (1999) who further explained that aggregation blurs important events and differences across countries.

Similarly, the studies were based on financial measures that may not capture the mechanism through which financial development cause economic growth.

Accordingly, it is appropriate and timely to empirically re-examine the financial development and economic growth relationship in Nigeria, utilizing larger sample size, introducing alternative indicators of financial development and testing for causality in a multivariate co integration framework. This forms the bedrock of this research effort. In essence the study will seek to answer the following research questions:

• What is the relationship between the impact of financial development in the economic growth of Nigeria?
• What are the direction of causality between the impact of financial development in the economic growth of Nigeria?
• Finally, what are the policy implications of these relationships?

1.3 OBJECTIVE OF THE STUDY

The study will address the following objectives:

1. To examine the relationship between the impact of financial development in the economic growth of Nigeria.

2. To determine the direction of causality between financial development and economic growth.

1.4 STATEMENT OF HYPOTHESES

To assess the nature of the finance-growth relationship, the following hypotheses have been suggested:

1. Financial development has no positive significant relationship with economic growth in Nigeria.

2. There is no direction of causality between the impact of financial development in the economic growth of Nigeria.

1.5 SIGNIFICANCE OF THE STUDY

Whether financial development influences economic growth is not just a matter of intellectual curiosity, it is a crucial policy issue as research that clarifies our understanding about the role of finance in economic growth will have policy implications and shape policy oriented research.

Thus, the importance of this study lies in the fact that it will provide an insight as to whether financial sector development is a necessary and sufficient condition for higher growth rates in Nigerian economy.

Information about the impact of finance on economic growth will influence the priority that policy makers and advisers attach to reforming financial sector policies. Furthermore, convincing evidence that the financial system influences long-run economic growth will advertise the urgent need for research on the political, legal, regulating and policy determinants of financial development.

In contrast, if a sufficiently abundant quantity of research indicates that the operation of the financial sector merely responds to economic development, then this will almost certainly mitigate the intensity of research on the determinants and evolution of financial systems.

1.6 SCOPE OF THE STUDY

The study examined the study examined the impact of financial development in the economic growth of Nigeria. To assess the current state of knowledge on the finance-growth nexus in Nigeria, a time series data will be employed. The study will cover the period 1960 to 2008.

Definition of Terms

Financial Development: Financial sector development in developing countries and emerging markets is part of the private sector development strategy to stimulate economic growth and reduce poverty.

Economic 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 in a financial year.

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Full Project – THE IMPACT OF FINANCIAL DEVELOPMENT ON ECONOMIC GROWTH IN NIGERIA