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Financial development and economic growth in Rwanda

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par Deogratias MR. DUSHIMUMUKIZA
University of Mauritius - Masters Degree in Economics 2010

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2.1.2 Proxy for financial sophisticatio

If we consider the definition provided by Koðar (1995), that financial sophistication is brought about by financial innovations and affects the nature and composition of monetary aggregates, it is reasonable to measure it by the ratio of M2 to M1. This is because financial sophistication will be characterized by introduction of credit cards, e-banking, more use of checking accounts and all these are embodied in M2. Liu et al (1994) noted that as the ratio of M2 to M1 increases, the more the technological improvements in banking system.

2.1.3 Other measures of financial development

Putting aside the distinction between financial depth and sophistication, other indicators have been added as candidate to represent the level of financial development within a country:

Levine (1997) included three extra proxies, namely: BANK, PRIVATE, and PRIVY, defined as follows:


BANK: It is the ratio of bank credit divided by bank credit plus central bank domestic assets and measures the degree to which the central bank versus commercial banks are allocating credit.

> PRIVATE: It is the ratio of credit allocated to private enterprises to total domestic credit (excluding credit to banks) and measures the level of financial services.

> PRIVY: It equals credit to private enterprises divided by GDP.

PRIVATE and PRIVY were chosen to correct weaknesses of BANK measure because not only financial intermediaries provide financial functions and the volume of credit given by banks may be flowing to public institutions which does not indicate the level of financial penetration. Unfortunately, PRIVATE and PRIVY could not correct for the weakness of considering only financial functions delivered by financial institutions.

Other indicators used are: Gross domestic saving to GDP (Hassan and JungSuk, 2007), some indicators of stock market development like stock market capitalization, turnover ratio and the number of listed companies (Yongfu, 2005). Fry (1989) identifies three quantitative measures of financial conditions specific to developing countries, based on McKinnon (1973) and Shaw (1973) theories of financial liberalization. These are: the real deposit rate of interest, population per bank branch and a financial intermediation ratio. He added investment as percentage of GDP and change in GDP to investment ratio as proxies of investment efficiency and net saving ratio respectively.

2.2 Relationship between financial development and economic growth

This section goes through the theoretical and empirical relationship between financial development and economic growth as identified by scholars.

2.2.1 Theoretical link between financial development and economic growth

Views on the link between financial development and economic growth can be divided into three hypotheses: The supply leading, demand leading and no link hypotheses.

Financial Development and Economic Growth in Rwanda Supply leading hypothesis

According to this view, the financial sector deepening leads to economic growth. The explanation is that, according to Levine (1997), financial development has five financial functions through which it affects economic growth. These functions, shared by Bodie et al (2008), are:

· Producing cheaper information about possible investment and allocating capital;

· Monitoring firms and exerting corporate governance;

· Trading, diversification and management of risk;

· Mobilizing and pulling of savings;

· Easing exchange of goods and services

The effect of financial innovations on economic growth is presented by Tufano (2002) in three functions:

· Financial innovations mitigate the lack of free movement of funds across time and space in incomplete markets and allow risk sharing among individuals.

· Innovations address agency concerns and information asymmetry with invention of new contracts like common stock which provides some mechanisms to squeeze information from firms, a warranty offered by a seller and income bonds linked to the availability of accounting information.

· They minimize searching and marketing cost: This is the role of ATMs, smart cards, ACH technologies and many other new businesses.

These financial functions influence savings, investment decisions, technological innovations and hence economic growth. Better functioning financial systems ease the external financing constraints that impede firm and industrial expansion. This implies that the creation of financial institutions and their services occurs in advance of demand for them. Thus, the availability of financial services stimulates the demand for these services by the entrepreneurs in the modern, growth-inducing sectors.

This hypothesis has received a great number of supporters: Schumpeter (1911)
argued that the financial sector deepening leads to economic growth through

productively making out and funding economically efficient projects. He put emphasis on banking sector which performs the function of intermediation between possessors of productive means and those who wish to use them and this is a key determinant in understanding capital formation.

McKinnon (1973) and Shaw (1973) developed a robust model of financial development appropriate to LDCs, through which financial development affects positively economic growth. Known as complementarity hypothesis, the McKinnon (1973) and Shaw (1973) model is based on the positive relationship between real deposit rate of interest and investment, contrary to previous thought where this link was negative. The model stresses the negative effects of financial repression on economic growth, characterizing developing economies.

In fact, they argue that financial repression through interest rate ceilings, directed credit, exchange rate controls, control on the source of finance of banking institutions and other forms of financial repression result in negative real deposit rate of interest. This reduces the supply of loanable funds and force banking institutions to apply credit rationing in front of excess demand of loanable funds. The outcome is the allocation of funds not based on the productivity of investment rather on other factors like transaction costs and apparent risk of default. This scenario leads to economy being allocating credit to non productive investments which decreases investment productivity and efficiency, thus slowing down economic growth.

Financial liberalization was proposed as a model of financial development which leads to economic growth through increase in real deposit rate of interest, raising the saving mobilization and the financing of the economy both from internal and external source, as a result of capital liberalization. This model has been a central point for analysing effect of financial development on economic growth, where most studies compare before and post financial liberalization periods. They include Jankee (2006) in Mauritius, Abebe (1990) in African LDCs, Demetriades and Luintel (1996) in India, Margaret (2004) in USA and many others.

In the same idea of financial liberalization, Fry (1997) explained the DiamondDybving financial intermediation in an overlapping-generations model developed by Bencivenga, Smith, Greenwood and Smith, and Levine. With banks acting as intermediaries between savers and borrowers, avoiding uncertainty which leads to resource misallocation and offering liquidity to savers, they produce higher capital/labour ratios and higher rates of economic growth.

Levine and Zervos (1996) recognise that liquid stock markets and growth banking sector lead to economic growth through increase in capital accumulation and production.

According to Greenwood and Jovanovic (1990), financial sector development will direct funds to higher yielding projects with the great involvement of information: the financial intermediaries produce better information, improve resource allocation and hence foster growth. Basically, the role of financial sector in easing access to information and leading to efficient financial market raises the quality of investment, leading to technological innovation and consequently to economic growth.

Cameron (1961) confirmed the supply leading hypothesis after his study in France where he found a positive impact of financial development on economic development through mortgage. Demand leading hypothesis

The supply leading hypothesis has not received unanimity among economists. Some influential economists such as Robinson (1952), and Friedman and Schwartz (1963) argued that the development of the financial sector is induced by economic growth such that it comes as a result of higher demand of financial services. Robinson supports that economic growth creates supply for financial services which would cause a financial development. Levine (2001) argued that economic growth may reduce the fixed cost of joining financial intermediaries and the more people join, hence financial sector may be caused by improvement in economic growth.

Kuznets (1955) supports this idea by saying that finance does not exert a significant impact on economic growth but rather when the economy grows, more financial institutions, financial products (financial innovation) and services come into the market in response to higher demand of financial services. For Thanvegelu (2004), enterprise guides then finance follows. No link or negative effect hypothesis

This hypothesis may be regarded as the criticism of the views above about the link between financial development and economic growth. The footstep of this theory may be drawn for the statement of Lucas (1988), who noted that economists have a tendency to overemphasize the role of financial factors in the process of economic growth. It is possible that the development of the financial sector markets may result as an impediment to growth when it induces volatility and discourages risk unenthusiastic investors from investing. Singh (1997) and Mauro (1995) noted that financial innovation allows risk reduction and may lower the precautionary savings and investments, thus slowing down economic growth.

A radical criticism of the role of financial development to economic growth mainly through financial liberalization comes from neo-structuralists. They refuted the model of financial deregulation developed by McKinnon (1973) and Shaw (1973) by attacking the assumption of competitive market in banking institutions embodied in the model. The point is that in most developing countries, the financial industry operates in oligopolistic or collusive model without an apparent competition as assumed by McKinnon-Shaw's theory.

Stiglitz (1994) argued that financial liberalization leads to market failures rooted from costly information which leads to externalities like a generalized bank crisis following a bankruptcy in one or two banks. He supports some measures of financial regulation like keeping interest rates below their market equilibrium, as corrective measures which will in addition improve the efficiency of capital allocation. In addition, financial repression was not the only source of credit rationing.

Again Stiglitz and Andrew (1981) demonstrated that other credit rationing may exist in equilibrium situation, as a result of other factors outside interest rate ceilings, like asymmetry information, collusion in banking sector which set deposit rate below the market equilibrium, consideration of transaction costs, anticipated risk of default, quality of collateral and pressure from bank managers.

This view has been supported by many researchers like Buffie (1989) who stated that if we give permission to reactions in markets, then financial liberalization will be a dangerous enterprise. Diaz-Alejandro (1985) summarized the effects of financial liberalization as «Good-bye financial repression, hello financial crash» because in most developing countries, financial crisis followed financial liberalization policies undertaken by governments and the results were worse.

Fry (1989) lists a group of neo-structuralists who questioned the validity of McKinnon-Shaw hypothesis and demonstrated that banks cannot intermediate as efficiently as curb markets between savers and lenders because reserve requirements constitute a leakage in the process of financial intermediation through commercial banks. The group includes Taylor Lance, Sweder Van Wijnbergen, Akira Kohsaka among others.

According to them, in practice, financial liberalization is likely to reduce the rate of economic growth by reducing total real supply of credit available to business firms. In short, the opponents of financial liberalization base their facts on various failures observed in many countries after liberalization, which led to financial distress and crisis. The list of countries is long but Argentina, Chile, Uruguay, Turkey and Philippines come on the top.

2.2.2 Empirical literature review o n the link between financial development and economic growth

The evidence on the link between financial development and economic growth covers a variety of studies using time series analysis, cross-country growth regressions, panel studies, etc.

Financial Development and Economic Growth in Rwanda Cross=cou ntry cases

The cross-country case studies have been carried out by many researchers: Levine and King (1993) and Levine and Zervos (1996) found that higher levels of financial development are positively correlated with economic development. Their findings suggest that the legal environment facing banks can have a significant impact on economic growth through its effect on bank behavior.

Michael and Giovanni (2001) examined whether there is evidence of a causal link from capital account liberalization to financial deepening and, through this channel, to overall economic growth on cross-section of developed and developing countries, over the period 1986 to 1995, as well as over the period 1976 to 1995. With regard to the link between financial development and GDP growth, they noted a statistically significant and economically relevant positive effect of open capital accounts on financial depth and economic growth. However, this effect seems to be concentrated among industrial countries, whereas a little evidence was found in developing countries for financial depth brought about by capital account liberalization to affect positively economic growth.

In Africa, Douglas (2003) investigated evidence of the finance growth nexus in a sample of emerging Sub-Saharan African countries using cointegration and a vector error-correction model. He found that financial development and economic growth are linked in the long-run in seven of eight countries and causality test revealed unidirectional causality from finance to growth in Ghana, Nigeria, Senegal, South Africa, Togo and Zambia. For Ivory Coast and Kenya, the causality run from growth to finance, confirming the demand leading hypothesis in the two countries. Panel data cases

Starting by Africa, Kesseven et al (2007) brought new evidence of finance-growth relationship from developing countries by analyzing a sample of 44 African countries from 1979 to 2002. They used both static and dynamic panel analysis and random effect and found that the financial development has been contributing to the level of output though the contribution was not at the same

level across countries. However, the contribution of financial development was observed to be on the lesser extent as compared to the other explanatory variables.

Karim and Holden (2001) conducted a panel of 30 developing countries to test the supply leading hypothesis. Using the alternative measures of bank development and stock market development, they found a strong positive link between stock market development and economic growth. However, contrary to the findings of Levine et al (2000), they found a negative association between credit allocation and economic growth. The reasons were the failure of financial deregulation due to absence of prerequisites for successful deregulation.

Fry (1989) examined over 15 years saving behavior in 14 Asian developing countries and 28 developing countries heavily indebted to the World Bank. It was found that a 1 percent rise in real deposit rate of interest raises national saving ratio by about 0.1 percent. On the effect of financial liberalization on investment productivity, Fry found positive and significant relationship between the incremental output/capital ratio and the real deposit rate of interest and also the real deposit rate of interest and economic growth in those Asian developing countries. Country case=studies

Spears (1991) examined the causal relationship between financial intermediation and economic growth in a sample of five Sub-Saharan African countries (Burkina Fasso, Cameroon, Ivory Cost, Kenya and Malawi), using Granger causality and two-distributed-lag regressions. He used two measures of the financial development: the ratio of money supply to real per capita GDP and the ratio of quasi-money to money supply. He found no causality between the later and economic growth and these results may be attributable to wrong measure used rather than absence of causality between financial development and economic growth. But the causality from financial development to economic growth was found when the ratio of money supply to GDP was used.

Team (2002) used a VECM in 13 Sub-Saharan African countries and found from the cointegration analysis that there exists a long-run relationship between financial development and economic growth in twelve out of thirteen countries and the causality run from finance to growth in eight of the countries taken in the sample. Six countries provided evidence of bi-directional causality.

Demetriades and Luintel (1996) found a bi-directional causality between financial deepening and economic growth in India and a negative impact of banking sector control on economic growth, in the model linking financial depth and banking deregulation to economic growth using Error Correction Model. Zhang (2007) examined if regional productivity growth is accounted for by the deepening process of financial development in China, using provincial panel data, and found that after controlling for other variables, the depth of financial intermediation exerts significantly positive influence on productivity growth in China during 1987-2001. The financial intermediation-growth nexus in post reform China was strongly supported. Industry and firm level case studies

Demirgüç-Kunt and Maksimovic (1998), in a firm level data, showed that larger banking systems and more liquid stock markets allow firms to grow faster than it would be had been internal resources used to finance their investments. Using industry level data across countries, Rajan and Zingales (1998) found that external finance benefits more to their users and allows firm to grow faster than firms which only resort to domestic financial markets.

A different approach was taken by Beck et al (2006) by examining the effect of the size of the industry in financial development-economic nexus. Using industry data, they concluded that economies dominated by small firms grow faster in developed financial system than large firm-based economies.

Raymond and Love (2004) used data of 37 industries in 43 countries over the period 1980-1990, to analyze the link between financial development and interindustry resource allocation in the short and long-run, and found that in the short-run, financial institutions allocate resources to any industry that has experienced a positive shock to growth opportunities irrespective of his source

of financing, whereas in the long-run, in countries with well developed financial institutions, industries which rely heavily on external financing (Debt-finance instead of equity-finance) will have a comparative advantage and will capture a larger share of total production in the economy.

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