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The role of local financial market on economic growth: A sample of three

African economic groupings

Article in African Journal of Economic and Management Studies · June 2016

DOI: 10.1108/AJEMS-06-2014-0048

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 African Journal of Economic and Management Studies
The role of local financial market on economic growth – a sample of three African economic groupings
Rafiu Adewale Aregbeshola
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 Introduction

Most of the previous investigation on the determinants of economic growth has established

strong linkage with the efficiency of local financial market (Schumpeter 1934; Beck &

Levine 2002; Lee & Chang 2009). While this relationship appears to be significant across

geophysics, it has been significantly stronger in low and middle-income economies (De

Gregorio & Guidotti 1995; Rousseau & Wachtel 2000; Antràs, Desai & Foley 2008), which

suggests that the development of local financial markets place an important impulse on
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economic growth. By order of economic classification, most of the countries in Africa belong

to this category of economic grouping.

Research indicates that economic growth is catalysed by the activities of the local financial

markets, essentially by improving the access to and cost of capital of resident corporations

(Levine & Renelt 1992; Asiedu 2002). For a multinational corporation, the principal roles

played by the local financial market as regards operational considerations are the efficient

transfer, allocation and repatriation of financial resources. These roles are achievable only in

well-functioning and efficiently supervised capital markets (Ito 1999; Lee & Chang 2009). In

addition, because of the high risks of market failures, multinational corporations tend to

minimise their offshore financial commitments in developing countries by adopting various

portfolio-management strategies, especially by listing on the host capital market (Froot &

Stein 1991).

The rationale for this financial strategy may be premised on Modigliani and Miller’s theory

of capital structure (the capital structure “relevance” principle), which suggests that firms will

seek a capital structure that minimises the weighted average cost of capital (Modigliani &

Miller 1958). According to this theory, debt financing is less costly compared to equity, given

that interest expenses are largely tax deductible. However, there is always the need to balance
 the organisational capital structure in a way that leverages the positive effects of both debt

and equity financing (Robb & Robinson 2010). This form of portfolio-management strategy

has increased the need for the development of domestic financial markets as a possible means

of filling the capital gap, especially in the developing countries (Binswanger 1999; Azman-

Saini, Law & Ahmad 2010).

Research also finds that developed local financial markets are capable of accelerating

economic growth, as they enhance efficient resource allocation (Rousseau & Wachtel 2000).
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In particular, healthy local financial markets are capable of enabling investors to rebalance

their portfolios quickly and cheaply (Bencivenga, Smith & Starr 1996). Therefore, as

financial market development mobilises investible capital, it also reduces portfolio risks.

Along this line, empirical evidence suggests that a financial market with a certain threshold

of development is capable of catalysing home-grown entrepreneurial development, stimulates

innovation and attract inflow of foreign direct investment – all that culminate in economic

growth (Levine & Zervos 1998; Rajan & Zingales 2003; Antràs, Desai & Foley 2008).

One of the reasons attributed to the unattractiveness of Africa, other less developed and

developing economies to attracting capital inflow that is capable of boosting economic

growth is risk aversion (Allen & Ndikumana 2000; Lamont & Polk 2002). More specifically,

the political economy of most African countries remain shaky, while the local financial

markets are generally regarded as fledgling and lacking the requisite supporting

infrastructures that could aid their viability (Alfaro et al 2004). Further, most capital markets

in the developing countries are characterised by market inefficiency and weak supervision,

thereby increasing their susceptibility to failure (Lamont 1997; Fauver, Houston & Naranj

2003).

2
 Although, a number of studies have been conducted on the role of local financial market on

economic growth in emerging economies (Naceur, Ghazouani & Omran 2007); advanced

economies (Atje & Jovanovic 1993; Rajan & Zingales 2003) as well as in Africa (Alfaro et al

2004; Adam & Tweneboah 2009; Adjasi, Abor, Osei & Nyavor-Foli 2009), this study differs

from the previous work in methodology and focus. In specific, in the documented studies that

cover Africa, the effects of resource endowment were largely ignored and the studies are

either country-specific or positioned within a single region. Further, none of the studies

incorporated regional comparison in their estimations. This study covers, amongst others,
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those identified academic lacuna.

Importance of financial markets to local economy

Various authors (such as Ashegian 2004; Bayoumi & Melander 2008) have established strong

linkage in the growth and finance nexus. However, the issue of causality between local

financial market development and economic growth remains largely inconclusive. While

some studies have found financial market to have enhanced economic growth (Atje &

Jovanovic 1993; Allen & Ndikumana 2000), others have found the evidence in support of this

hypothesis to be weak (Bencivenga & Smith 1991; Ghirmay 2004).

Notwithstanding this inconclusiveness, early economists such as Schumpeter (1934) pointed

to a significant role of banks, one of the major components of financial market, as enhancing

technological capacity through their intermediation role in the economy. Schumpeter (1934)

observed that technological diffusion is achieved through efficient allocation of savings by

identifying and funding entrepreneurial initiatives with high potential of success in

implementing innovative ideas and improving production processes. Various empirical

studies (McKinnon 1973; Fry 1988) have been conducted since this early research by

3
 Schumpeter (1934) to ascertain the validity his postulation. The results of these investigations

have been in the affirmative.

In addition, local financial markets have been found to promote public-private sector

partnerships by encouraging participation of the private sector in productive investments. In

pursuit of economic efficiency, shifting production resources from the public to the private

sector to enhance economic productivity has become inevitable as exhaustible national

financial resources are continuously overstretched (Allen & Ndikumana 2000).

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Evidence provided by Schumpeter (1934) and buttressed by Madura (2001) suggest that some

of the components of the financial market (especially banks), “facilitates the flow of long-

term funds from surplus units to deficit units” (Madura 2001:3) within the economy. Owing

to limited savings and inadequate depth of local financial markets in the developing world

(Ojah & Pillay 2009), improved capital inflow generally allow a country to run current

account deficit without depleting the national foreign reserves (Ito 1999).

This capability to run current account deficit is achieved as the capital market mobilises long-

term investible capital and channels it to possible growth-stimulating economic activities.

The viability and efficiency of the local financial market, therefore, influences the level of

capital that could be generated within the local economy to finance long-term projects. A

broad source of capital with diversified terms is capable of fostering competition in the

market; and a competitive financial market normally attracts lower cost of capital (Townsend

1979; Ojah & Pillay 2009).

Furthermore, Patrick (1966) investigates the roles played by local financial markets through

causal lenses. The author suggests that the direction of causality between financial markets

and economic growth is an indication of the importance of the interaction of these variables

4
 in shaping the market mechanism. For example, using “supply-leading” and “demand-

following” hypotheses within the context of dominant relative activity between the real

economy and the national financial market, “supply-leading” hypothesis holds when the

causality runs from the financial market to economic growth. Whereas, the “demand-

following” hypothesis holds when the demand from consumers create the need for more

funding through the financial market; i.e. when the causality runs from economic growth to

financial market. Expectantly, some scholars are of the opinion that causality can run in both

directions simultaneously instead of being unidirectional at different stages of the economy

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(Demetriades & Hussein 1996; Shan & Jianhong 2006).

To investigate the relationship between financial market development and economic growth

in the three African economic groupings, it is considered essential to lay a synoptic basis for

the economic demography of these groupings. As a whole, Africa is home to roughly 1.1

billion indigenous people (United Nations Conference on Trade and Investment 2013) and

this is expected to increase to 2.2 billion by 2050. The continent accounts for about 15% of

the world population and it boasts 17% of the world export trade and 20% of world import

(WTO 2012:22). However, resources accounts for the major part of the exports.

Looking at each of the regions, the North African grouping experienced stable political and

economic environment for decades, until the recent incidence of Arab spring. This explains

why the region boasts a significant proportion of the continent’s GDP, coupled with being the

second most developed grouping (save for southern Africa).

Before the advent of the Arab spring that began on the 14th January 2011 in Tunisia, North

Africa accounted for about 44 per cent of Africa’s GDP with barely 20 per cent of the

continent’s population (UNCTAD 2013). However, adequate record on the group’s economic

performance in recent years have been difficult to compute as a result of fragmentation in

5
 resource control, political and economic instability, violent protests, lost workdays,

vandalism, and political thuggery. However, the 2013/14 Global Competitiveness Index and

World Investment Reports suggest that the economic environment of the largest economies in

North Africa (Egypt, Morocco and Tunisia) has been significantly affected since 2012 and

the future of those economies remain bleak.

The Southern African region (with South Africa as its economic hub) claims the second

largest portion of the total gross domestic product (GDP) on the African continent, and thus
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the second largest economic grouping. This economic group comprises of barely five per cent

of the total African population but accounts for about 22 per cent of its GDP. The West

African group is one of the least developed on the continent, claiming barely 15 per cent of

the total GDP of the continent, while it accounts for roughly 30 per cent of the continent’s

population.

The statistics cited above suggests that improvement is required, especially in the

macroeconomic fundamentals in these economic groupings in order to achieve the most-

desired economic growth. To that extent, this study intends to uncover the possible impact of

local financial markets on economic growth.

Research methodology

This study investigates the possible relationship between local financial market and economic

growth in a panel environment. Two countries are chosen from each of the three regions. The

sampled countries are the largest economies in each of the groupings. For instance, South

Africa and Botswana that are chosen from southern Africa region account for more than 95

per cent of southern Africa’s economy in 2013 – a trend that has subsisted over the past

decade (United Nations Conference on Trade and Development 2014).

6
 According to the same source, the same can be said about Nigeria and Ghana that are chosen

in West Africa as these countries account for more than 75 per cent of the region’s GDP in

2013. Egypt and Morocco are chosen to represent North Africa in this study. Egypt is

included in the study being the clear economic leader in the region. Although, the economies

of Algeria and Libya are far bigger than that of Morocco that is chosen as the second proxy

nation, the wave of strikes and civil unrest that has pervaded these countries makes it illogical

to include them in this study. Further, the North African economies are fragmented and there

is very little difference in the economic performance of the five leading countries, namely
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Algeria, Libya, Morocco and Tunisia, save for Egypt. The two chosen countries (Egypt and

Morocco) account for slightly more than 20 per cent of the total GDP of the region in 2013.

Focusing on macroeconomic variables, the study uses aggregate data covering the period

between 1980 and 2012. The dataset is generated from the Africa Development Indicators

database – an arm of the World Bank as well as the United Nations Conference on Trade and

Development (UNCTAD) statistical database for validation purposes. It must be pointed out

that the dataset was unbalanced. To avoid econometric estimation errors that may arise if the

dependent variables exhibit high missing values, five years moving average

backward/forward was used to balance the panel. In addition, various diagnostic techniques

were performed. For example, given that estimating variables like currency value of stock

traded and inflation figures in the same equation may trigger significant level of skewness,

most of the variables in the series are transformed through the diagnostic techniques that are

discussed in the paragraphs that follow.

Before estimating the equation, stepwise regression analysis was performed to determine the

explanatory power of the variables in the series. Before conducting GMM estimation, the

Hausman test was conducted to determine the appropriate series dummy for the estimation

7
 (either the fixed or random effect). To ascertain causality, Granger causality test is performed

after the GMM. The process followed in these diagnostics and estimations will be explained

in the paragraphs that follow.

Empirical analysis

Previous studies that investigate the relationship between local financial market and

economic growth (such as Alfaro et al, 2004; Adjasi & Biekpe 2006; Caves 2007; Revia

2013) measured growth through real GDP as proxy. In this study, similar proxy of real GDP
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will be used (GDP per capita) at constant prices (2000 base year), especially because the

variable is adjudged the best measure of real economic growth. In addition, various other

measures of financial market development were applied. For instance, Alfaro et al (2004)

incorporated the banking sector as the dominant measure of financial market efficiency.

Caves (2007) emphasised the importance of local banking system in his study, while Adjasi

and Biekpe (2006) uncover the impact of stock turnover as a dominant measure.

The component of financial market used in this study include (1) bank deposit, which depicts

the importance of bank finances (BANK), (2) the percentage of credit allocated to private

firms (PRIVY), (3) equity market capitalisation (EQCAP), (4) the ratio of total claims on the

nonfinancial private sector to GDP (NONFIN) and (5) stock turnover rate (TURNOVER).

This study adopts Levine and Zervos (1998) finance-growth linkage model, which has been

adjudged by authors (such as Khan & Senhadji 2000) as the most efficient basic model in this

study area.

The model is depicted as follows:

LogYit = α1 + α2CMTit + α3Xit + eit

From the model above:

8
 Yit is economic growth measured as the log of: (GDPCt/GDPCt−1) in country i and at time t.

CMTit is the capital market indicators for country i at time t;

Xit contains control variables and eit is the error term.

As suggested by literature, various estimation techniques have been proposed for this model

(Levine & Zervos 1998; Khan & Senhadji 2000). The major concern in estimating any

growth equation is the likelihood of problems of biases and inconsistent estimation results.

These errors and biases occur as a result of the need to estimate the equation in a way that is
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dynamic enough to accommodate variations in economic fundamentals that are country-

specific and/or time-related. Evidence (Kiviet 1995; Allen & Ndikumana 2000; Alfaro et al

2004) suggest that the Arellano and Bond (1991) Generalized Method of Moments (GMM) is

the most suitable estimation technique because the technique makes it possible to adopt

dynamic instrumental variables in the estimation.

Using this technique, the model is estimated in an environment where the lagged value of

dependent variable (economic growth) and differences of the independent variables (CMT –

using orthogonal deviation) are used as valid instruments to control for these biases and

errors. The use of these instruments is necessary in dynamic panel because the lagged

dependent variable [yit − yit_1] will be correlated with the lagged error terms [eit − eit_1],

thereby generating endogeneity. However, the use of suitable instruments (which are

restricted to one in this estimation) as validated by the Sargan test also helps to rest possible

endogeneity biases.

It is also considered important to test for the order of correlation of the residuals. To do this,

the Autoregressive (AR) test is applied (not reported). As indicated at the bottom of each

table, the model is estimated in a heteroscedastic consistent standard error robust

9
 environment. This method is applied given that the Hausman test indicates the significance of

cross-section dynamics, which further justifies the use of orthogonal deviation technique.

Data Analysis

The results of the various estimations are presented in this section. The analyses are preceded

by descriptive statistics, then a unit root test. For the unit root test, it is customary to use the

Augmented Dickey Fuller (ADF) technique in simple time series estimations. The ADF

technique is mostly applied in econometric estimations to determine the stationarity of

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datasets, especially when dealing with large sample size. For small sample size, the Dickey-

Fuller Generalised Least Square (DF-GLS) test, which is also referred to as a de-trending test

and developed by Elliot, Rothenberg and Stock (1996), is preferable. However, these

diagnostic techniques are largely unsuitable for panel data (Pesaran 2007; Baltagi 2008). To

that extent, the Lindeberg–Levy central limit theorem (LLC) (Levin, Lin & Chu 2002) unit

root estimation technique is used.

The unit root test generally helps to determine which variable to use in form and which ones

to transform, either through natural logging or by differencing. The introduction of time trend

or intercept term also help to determine the effects of cross-sectional and time-related

disturbances in the series. As stated earlier, the result of the descriptive statistics will be

presented in Table 1:

Table 1: Descriptive Statistics for Pooled Data (1980 – 2012)

GROWTH BANK EQCAP NONFIN PRIVY TURNOVER
Mean 1569.871 27.71448 40.61303 12.54586 37.59902 9.473384
Median 1240.031 20.64000 14.31500 8.230000 21.68050 0.720000
Maximum 4377.556 78.33000 265.6200 72.91000 167.5360 142.6300

10
 Minimum 188.1487 1.390000 1.170000 0.070000 1.542268 0.020000
Std. Dev. 1224.399 20.57326 57.51566 14.15023 38.76432 23.06035
Skewness 0.644066 0.798259 2.055645 1.499018 1.716346 3.634797
Kurtosis 2.134282 2.434749 6.643225 5.110299 5.130414 17.11832
Jarque-Bera 19.87219 23.66410 248.9503 110.8931 134.6568 2080.436
Probability 0.000048 0.000007 0.000000 0.000000 0.000000 0.000000
Sum 310834.4 5487.468 8041.380 2484.080 7444.605 1875.730
Sum Sq. 2.95E+08 83382.03 651686.0 39445.13 296026.4 104760.6
Dev.
Observations 198 198 198 198 198 198

According to Table 1, growth exhibits the highest level of variation. This is an indication that

economic growth in the sampled African countries has been volatile over the period covered.
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However, the skewness of the data is the lowest, suggesting that the volatility is occasioned

by a few outlier observations in 2011 Egypt, 2011 Morocco, in South Africa between 2005

and 2011, Nigeria between 2010 and 2011 and Ghana between 2008 and 2011. Apart from

growth, the standard deviation of equity capitalisation (EQCAP) is also moderately high

(second to growth). Unlike in the case of growth, the skewness of this variable is higher than

the rest others, save for equity turnover rate (TURNOVER). This result indicates that the

variable does not only exhibit one of the highest levels of volatility, but the volatility cuts

across a wide range of time among the sampled countries.

The other measures of financial market development exhibit moderate volatility with credit

directed to nonfinancial private sector (NONFIN) showing the lowest level of volatility. It

must be pointed out that the volatility of private sector funding (PRIVY – 38.8) is lower than

that of BANK (20.6), NONFIN (14.2) and TURNOVER (23.1). Further, the skewness is lower

than those of EQCAP and TURNOVER. This result suggests that the distribution of the

dataset for this variable is more ‘even’. In conclusion, the p-values of all the variables suggest

that fear of abnormal distribution of data are allayed, given that all the datasets are

statistically significant at one per cent error level.

11
 Having conducted the normality test for the data distribution, we now proceed to the test of

unit root. The result for the test is presented in Table 2:

Table 2: Unit Root Test for Pooled Data (1980 – 2012)

Newey-West Automatic Bandwidth Selection and Bartlett Kernel
I II III
Variables Levin, Lin & Chu (Individual Intercept Levin, Lin & Chu Levin, Lin & Chu
and Trends) (individual effects) (none)
At level In first diff. At level In first diff. At level In first diff.
Growth -0.60305 -2.33370*** 0.39074 -4.44742*** 0.39074 -6.13987***

Observation 186 184 186 184 186 182

Order of integration
I(1) I(1) (I(1)
BANK -1.78246** -4.16687*** 0.13306 -5.79642*** 4.09529 -9.12014***
Observation 183 180 191 181 184 185
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Order of integration
I(0) I(1) I(1)
EQCAP 4.14761 -1.22614** 4.66007 -3.73614*** 1.76736 -9.32272***
Observation 172 167 180 176 181 178
Order of integration
I(1) I(1) I(1)
NONFIN -2.48890*** -6.86024*** -1.24535 -7.59801*** -2.81050*** -9.58512***
Observation 186 184 188 184 189 184
Order of integration
I(0) I(1) I(0)
PRIVY -0.90783 -6.16418*** 0.89497 -5.59075*** 1.81227 -10.2064***
Observation 182 184 188 180 185 180
Order of integration
I(1) I(1) I(1)
TURNOVER 4.90046 7.89233 3.81204 7.16029 -0.85959 -3.44040***
Observation 175 169 171 167 169 164

Order of integration
- - I(1)
Using the Levin, Lin & Chu (2002) test, probabilities are computed assuming asympotic normality
***; **; * This indicates that we reject the null hypothesis of unit root at 1%, 5% and 10%.
Automatic selection of maximum lags; Automatic lag length selection based on SIC: 0 to 5
All variables except for BANK and NONFIN are stationary in first difference and significant at minimum of 5%.

In Table 2, column I of the table tests for unit root in individual intercept and trend (both at

level and in first difference), while columns II and III test for unit root in individual effects

and no effects respectively. According to Table 2, only BANK and NONFIN are stationary at

level, suggesting that all other variables need transformation before estimation. In specific,

TURNOVER only became stationary when the trends and individual effects are wiped and the

data is transformed. This suggests that cross-sectional effects and time are of important

considerations.

The regression analyses (Table 3) now follows the unit root tests:

Table 3: The Regional GMM Panel Regression for the Sampled Countries (1980-2012)

12
 Capital Market development on Growth (Dependent Variable – Growth)
Variables I II III
BANK -8.387390 0.694386 1.113633
(2.98970)*** (20.4022) (1.71081)
EQCAP 1.681708 5.682974 -0.338732
(1.861244) (3.33570)* (0.50451)*
NONFIN -4.135215 -57.62297 0.424948
(1.874798)** (74.90496) (0.24930)**
PRIVY 5.783860 -33.47160 -1.360633
(2.937595)** (6.9381)*** (1.50853)
TURNOVER 2.514717 -3.902332 7.997009
(2.403084) (2.490123) (2.7291)***
Sargan Test (Prob >chi2) 0.348 0.119 0.49
Observation 64 64 64
Number of countries 2 2 2

Robust standard errors are in parentheses. *** p<0.01, ** p<0.05, * p<0.1. Cross-section weights instrument weighting matrix and
Convergence was achieved after 1 weight iterations. Cross-section weights (PCSE) standard errors & covariance (no d.f. correction).
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Maximum lags of dependent and predetermined variables for use as instruments are limited to 1. Period fixed (dummy variables) applied in
the estimation.

The model specified in this study is estimated in an orthogonal deviation environment, as

contained in Table 3. Orthogonal deviation is found to be superior to differencing in dynamic

panel estimations (Baltagi 2008). In Table 1, columns I, II and III show the output for each of

the regions under consideration, namely north, southern and west Africa respectively. In each

of the estimations, the Sargan test of over-identifying is statistically insignificant, suggesting

that there is no autocorrelation between the instruments and the model residuals, thereby

validating the appropriateness of the instruments.

Looking at individual variables for each region (starting with north Africa), three of the five

explanatory variables are statistically significant, of which two of the variables (BANK and

NONFIN) bear negative coefficients, suggesting that these two variables have significantly

strong negative effects on economic growth in north Africa. This observation is essentially

true because, the two variables are statistically significant at one and five per cent error levels

respectively and their coefficients (-8.4 and -4.1 respectively) are statistically explosive.

This form of relationship suggests that economic growth can be enhanced in North Africa if

institutional and operational interventions are initiated towards improving the negative

impacts of these variables. Arguably, the financial market in the region is weakly supervised

13
 and ill-controlled because a well-supervised banking sector (BANK) is expected to contribute

to economic growth through robust financial intermediation (as in Caves, 2007). The same

argument can be advanced for NONFIN.

The other variable of interest that is also statistically significant is the percentage of credit

allocated to private firms (PRIVY). This variable is statistically significant at five per cent

error level and it bears an explosive positive coefficient with the dependent variable (5.8),

suggesting that economic growth could be stimulated if more credit is directed to the private
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sector. This finding corroborates the postulation of Schumpeter (1934). The last two variables

in the estimation (TURNOVER and EQCAP) are not statistically significant in the estimation,

thereby negating the possibility of their contribution to economic growth in North Africa.

However, the situation in southern Africa is quite different. For instance, equity capitalisation

(EQCAP) is statistically significant at 10 per cent error level and it bears a strong positive

coefficient with the dependent variable (70 per cent). This suggests that economic growth in

the region can be enthused by improving the efficiency of the stock market, especially the

stock market capitalisation.

Unlike in the case of North Africa, credit directed to the private sector (PRIVY) is statistically

significant but it bears an explosive negative coefficient with the dependent variable (-33.5).

This result seems to suggest imperfections in the disbursement process of this fund, thereby

requiring consorted efforts towards improving the efficiency of the intermediation process.

The possibility of poor supervisory and inadequately spanned intermediation in the financial

market might have contributed to the alleged inefficiency.

The last column (column III) contains the analysis for west Africa. According to that column,

the two measures of equity market i.e. stock market capitalisation (EQCAP) and stock

14
 turnover rate (TURNOVER) are statistically significant at 10 and one per cent error levels

respectively. Although, equity market capitalisation bears a relatively weak negative

coefficient with the dependent variable, the strength of its statistical significance also

downplays its importance. This finding implies that more trading on the stock exchange

platform should be encouraged in order to grow the economy of the region.

The fact that stock market capitalisation does not contribute positively to economic growth

may be an indication that buy-and-hold system is still a reality in the region. Still on column
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III, the credit directed to nonfinancial private sector (NONFIN) relates positively to growth

and it is statistically significant at five per cent error level. This suggests that more credit

needs to be directed to the nonfinancial private sector in order to grow the economy.

Before conducting the causality test, it is considered important to pool the regional datasets in

order to uncover the dynamics across the regions. Although, the analysis presented above

reveals the regional effects of the financial market and growth nexus, the cross-regional effect

is also appropriate in order to generalise the findings. The result of the pooled analysis is

presented in the paragraphs that follow, following the same diagnostic procedures and

estimation techniques.

Table 4: The Pooled Analysis for the Sampled Countries

(1980-2012) (Dependent Variable – Growth)
Variables Statistics
BANK 5.047373

15
 ( 5.317133)

EQCAP 4.290960
( 2.420439)**
NONFIN 5.751655
( 3.561758)*
PRIVY -13.96508
( 3.955799)***
TURNOVER -1.022449
( 2.843577)
Sargan Test (Prob >chi2) 0.987
Observation 192
Number of countries 6
Orthogonal Deviation Yes

Robust standard errors are in parentheses. *** p<0.01, ** p<0.05, * p<0.1. Cross-section weights instrument weighting matrix and
Convergence was achieved after 1 weight iterations. Cross-section weights (PCSE) standard errors & covariance (no d.f. correction).
Maximum lags of dependent and predetermined variables for use as instruments are limited to 1. Period fixed (dummy variables) applied in
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the estimation

The estimation presented in Table 4 passes the basic goodness of fit test with the Sargan test

being statistically insignificant. In addition, the robust standard error of the estimation is

reasonable (366.6806) and the standard deviation of the independent variables is also

acceptable (376.5010), especially considering the number of observation in the estimation.

Looking at individual variables in Table 4, three of the five capital market variables (EQCAP

NONFIN and PRIVY) are statistically significant at five per cent, 10 per cent and one per cent

error levels respectively. While two of the variables bear explosive positive coefficients

(EQCAP – 4.3, and NONFIN – 5.8), credit directed to the private sector (PRIVY) has an

inverse relationship with the dependent variable, and the coefficient is also explosive.

However, the remaining two capital market development indicators (BANK and TURNOVER)

are statistically insignificant in the estimation.

This finding points to the possibility that an increase in market capitalisation of the equity

market would enhance economic growth in the sampled African countries. The same could be

said about an increase in credit directed to nonfinancial private sector of the economy.

Conversely, there is an indication to suggest that credit directed to the private sector is not

16
 utilised efficiently enough to positively affect growth. Again, this finding corroborates the

argument of inefficient intermediation system and weak supervisory regime.

Having found some level of relationship between economic growth and some of the

measurable indicators of financial market development, it is considered important to uncover

the kind of causal relationship that subsists among the variables. The result of the causality

tests are presented in Table 5.

Table 5: Granger Causality Tests for the Sampled Regions (1980-2012)

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I II III
Granger Causality Granger Causality Granger Causality
Variables Statistics Statistics Statistics
( 3.12723)*
BANK Growth 1.19294 1.27529
( 3.83809)** (4.49623)** (7.22253)***
Growth BANK
(4.52319)*
EQCAP Growth 2.35311 1.26059
(10.8488)*** (5.47687)***
Growth EQCAP 0.18114

NONFIN Growth 1.31582 1.88569 0.42321

Growth NONFIN 0.38266 0.51926 1.46892

PRIVY Growth 1.67871 0.54107 1.51854

(3.08881)*** (7.32786)***
Growth PRIVY 0.25989
(8.2170)*
TURNOVER Growth 0.06807 2.13432
(13.7408)*** (7.54277)***
Growth TURNOVER 0.07461
Observation 62 62 62
Number of countries 2 2 2

F-Statistics are in parentheses. *** p<0.01, ** p<0.05, * p<0.1. The Granger Causality test is conducted with a lag of 2.

In Table 5, columns I, II and III show the Granger causality output for each of the regions

under consideration, namely north, southern and west Africa respectively. From column I,

three of the five capital market variables exhibit bi-directional causality. However, the causal

relationship is stronger from economic growth to each of the capital market development

variables. It must be recalled that we controlled for endogeneity bias in the dynamic panel

regression. According to the causality test for the North Africa region (column I), economic

17
 growth enhances the volume of credit provided by the banking sector. However, there is a

weak reverse causal effect from BANK to economic growth. The same kind of relationship

subsists between economic growth and explanatory variables such as equity market

capitalisation (EQCAP) and stock turnover rate (TURNOVER). While there is no causal

relationship between growth and credit directed to nonfinancial private sector of the

economy, the unidirectional causal relationship between growth and credit directed to the

private sector (PRIVY) flows strongly from growth to PRIVY.

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From the analysis in column II, there is only one causal relationship – flowing from economic

growth to BANK. According to this result, one can reasonably suggest that economic growth

enhances financial market development and not the other way round. More importantly, the

impact of economic growth on the efficiency/functionality of the banking sector is seen to be

significantly high.

According to the analysis contained in column III, all the capital market variables exhibit

causal relationship with economic growth (save for NONFIN). Just as in the previous results

for the other two regions, all these unidirectional causalities run strongly from economic

growth to capital market development indicators. This result further buttresses the assumption

that economic growth is the driving force of financial market development on the African

continent, converse to the postulation that capital market development motivates economic

growth.

To further establish the causal hypothesis between financial market and growth, we conduct

pooled causality test for all the sampled regions. The essence of pooled estimation is not to

treat all the sampled countries as a single entity, but rather to uncover the possible dynamics

of this nexus throughout the leading economies on the continent. The result of the analysis is

presented in Table 6.

18
 Table 6: The Pooled Causality Tests for the Sampled Regions (1980-2012)
Variables Causality
BANK Growth (1.13357)
Growth BANK (4.58289)**

EQCAP Growth 0.30809

Growth EQCAP (7.02849)***

NONFIN Growth
0.16465
Growth NONFIN
1.65727
PRIVY Growth
1.95910
Growth PRIVY
0.17886
TURNOVER Growth
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0.81835
Growth TURNOVER
0.97006
Observation 186
Number of countries 6
F-Statistics are in parentheses. *** p<0.01, ** p<0.05, * p<0.1

According to Table 6, only two of the five measures of financial market development

variables (BANK and EQCAP) exhibit causal relationship with growth and these causalities

are unidirectional. In both instances, causality runs strongly from growth to BANK and also to

EQCAP. This result further buttresses the fact that the financial markets of the sampled

African countries are more likely to develop as the economy grows. Although, evidence from

the regional analyses indicate that financial market development also influences economic

growth (albeit weakly), the overarching causal effect tilts more strongly towards the effects of

economic growth on the development of Africa’s leading financial markets. To that extent,

the “demand-following” hypothesis of Patrick (1966), which was situated within the context

of dominant relative activity holds true in this study.

Discussion of findings and conclusion

This study investigates the possible relationship between economic growth and the efficiency

of local financial market in the leading Africa financial markets. Most of the previous studies

suggest strong relationship between economic growth and efficient local financial markets,

19
 and the strength of this relationship is determined by the level of the economy’s advancement

with the effect being stronger in less developed countries. It must be pointed out, however,

that a few of the studies were inconclusive in their findings. Further, the studies were largely

either country-specific or with specific regional bias.

In this study, we divided the focal areas into two, namely the regional analyses and the

pooled analyses. Within the context of the regional analysis, this study finds that financial

market plays some roles on economic growth, whereas the effects are lower in some regions.
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However, the effects of financial market development on economic growth are stronger in

north and west Africa than in southern Africa. Given that southern Africa financial market is

more developed than the other two regions, this finding may buttress the fact that financial

market development is significantly more important as growth driver in less developed

countries than in developed ones. An argument can also be advanced that the effect of

financial market on economic growth is lesser in southern Africa because the southern

Africa’s economy as a whole is relatively more developed compared to the other two regions.

Further, this study was able to demonstrate the importance of various components of financial

market as they apply to the regions under consideration. For example, the study found that

the credit directed to nonfinancial private sector (NONFIN) is largely a potential growth-

driver in both north and West Africa regions. It was also uncovered that while equity market

efficiency may enhance growth in West Africa, the North African region would have to

develop its banking sector to potentially stimulate economic growth. Although, the financial

market in the southern Africa region is deemed relatively more developed, the region still

needs to ensure efficient allocation of resources to the private sector. It is observed that the

southern Africa region will potentially be more developed if a better financial deepening

mechanism is initiated, given that PRIVY was statistically significant in the estimation.

20
 Expectedly in the pooled estimation, we observed a combination of both stock market and the

banking sector playing important roles on economic growth. In specific, EQCAP, NONFIN

and more importantly, PRIVY, play statistically significant roles on economic growth on the

sampled countries as a collective.

In addition, one of the most important contributions of this study was its postulation of the

direction of causality between local financial market development and economic growth in

africa, not only on regional economic basis but on a pooled platform as well. Contrary to the
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findings in some of the earlier studies (Atje & Jovanovic 1993; Beck & Levine 2002; Rajan

& Zingales 2003; Lee & Chang 2009) that financial market development stimulates economic

growth, this study observes that reverse is the case in the sampled regions. However, the

contradiction of the findings of this study to the earlier ones may be premised on the

postulation that level of economic development is an important consideration (De Gregorio &

Guidotti 1995; Allen & Ndikumana 2000). Asiedu (2002) also suggested that Africa exhibits

different traits to the rest of the world in various dimensions.

From the on-going, it could be concluded that the continent needs to grow its economy in

order to achieve financial market development. The fact that financial market development

may also precipitate economic growth alludes to the application of both of Patricks’ (1966)

“supply-leading” and “demand-following” hypotheses. In conclusion, the significance of

economic growth is once again manifested as the possible catalyst not only to alleviate

poverty as observed by some authors (Ashegian 2004; Hill 2013) but also as catalyst for

financial market development, which will ultimately further economic growth.

21
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