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2. Financial Development, Growth, and Volatility

Author(s):
Montfort Mlachila, Ahmat Jidoud, Monique Newiak, Bozena Radzewicz-Bak, and Misa Takebe
Published Date:
September 2016
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Empirical estimates suggest that financial development has supported growth and reduced its volatility in sub-Saharan Africa. It has facilitated other economic policies in enhancing growth and stabilizing the economy. However, further financial development could yield additional gains for the region: raising the median financial development index to its benchmark value, as discussed in the last chapter, would be associated with an increase in growth by about 1.5 percentage points and lower its volatility further. The results thus confirm the salutary impact of financial development on reducing the volatility of growth and other macroeconomic variables. However, countries need to be vigilant about the emerging macro-financial risks in order to effectively manage the risks in financial development.

Financial development affects growth through several channels that are important for sub-Saharan Africa. First, it mobilizes savings from domestic and foreign sources, supports efficient allocations of capital (Acemoglu and Zilibotti 1997;Rajan and Zingales 1998), and increases total factor productivity (King and Levine 1993). Second, it eases the exchange of goods and services (Greenwood and Smith 1996). Third, it supports better risk management (Obstfeld 1994). Fourth, it facilitates information and enhances corporate governance (Grossman and Hart 1980; Shleifer and Vishny 1997). Financial development reduces information asymmetries, transaction and monitoring costs and allows risk diversification while improving the allocation of resources across different investment projects (Levine 1997). In addition, it increases the resilience of the economy by providing a variety of instruments that households and firms can employ to withstand adverse shocks. Sound financial systems can also strengthen the transmission mechanism of monetary and fiscal policies, through more information sharing and diversification of instruments. Finally, an important aspect of financial development—financial inclusion—reduces inequality of opportunity and mitigates the adverse effects of inequality on the level and durability of growth (Ostry, Berg, and Tsangarides 2014; World Bank 2014a; IMF 2015b). In particular, microeconomic and sociological studies show that women’s financial inclusion helps produce better welfare results in society.

Confirming the above arguments, the empirical evidence in the literature indeed suggests that financial development supports growth, especially at lower levels of financial development, although the effect on volatility is more mixed. Many studies find a positive impact, but suggest the existence of a threshold beyond which financial development is detrimental to growth (Arcand, Berkes, and Panizza 2012; Ceccheti and Kharoubi 2015; Sahay and others 2015b). This threshold effect is not relevant for sub-Saharan Africa, as all countries in the region are well below the threshold for exhibiting adverse growth effects.2 The literature has also shown that financial development helps dampen the impact of adverse shocks by alleviating firms’ and households’ borrowing constraints (Caballero and Krishnamurty 2001), and promoting diversification and management of risk (Acemoglu and Zilibotti 1997). However, the financial accelerator mechanism may propagate and amplify the impact of real shocks in an environment with credit market imperfections (Bernanke, Gertler, and Gilchrist 1999).

Building on this theoretical and empirical evidence, this chapter shows that deeper financial development is indeed associated with higher growth in sub-Saharan African countries, with the size of the effect varying across countries. In particular, this chapter assesses the impact of financial development on growth3 in sub-Saharan Africa following Sahay and others (2015b), and includes factors specific to the region, such as the effect of aid flows and of the share of the agricultural sector as a proxy for the primary and informal sectors. 4 As the results show a positive impact (Table 1), there is further scope for financial deepening in the region to better support growth, given that most sub-Saharan African countries are well below the inflection point for potential adverse effects.5 In particular, raising the median financial development index to its benchmark value is associated with an increase in growth by about 1.5 percentage points.

Table 1.Sub-Saharan Africa: GMM Estimation Results of Impact of Financial Development on Growth
Model 1Model 2
Financial development index27.00 **

(11.6)
Financial development index−33.83 *
(squared)(19.9)
Financial institution index9.956 ***

(3.51)
Financial market index0.794

(19.19)
Financial institution index * financial−19.590
market index(24.82)
Observations216216
Number of countries3939
Source: IMF staff estimates.Note: Robust standard errors in parentheses; *** p < 0.01, ** p < 0.05, * p < 0.1. Dependent variable is real GDP growth, averaged over non-overlapping five-year periods. Data cover over all sub-Saharan African countries (SSA), but availability varies by variables. Following Sahay and others (2015b), additional control variables include initial per capita GDP, education enrollment, and share of government consumption in GDP. The share of agriculture in GDP is added to better reflect its significance in SSA. Given the weak coefficient on the square terms, and that most SSA countries are at the relatively low level of financial development below the threshold to exhibit negative growth impact as discussed in the text, the model on the component index is run in level only in favor of parsimony. Model 1 represents the overall effect of financial development; model 2 represents the effect of dimensions of financial development. GMM = general method of moments.
Source: IMF staff estimates.Note: Robust standard errors in parentheses; *** p < 0.01, ** p < 0.05, * p < 0.1. Dependent variable is real GDP growth, averaged over non-overlapping five-year periods. Data cover over all sub-Saharan African countries (SSA), but availability varies by variables. Following Sahay and others (2015b), additional control variables include initial per capita GDP, education enrollment, and share of government consumption in GDP. The share of agriculture in GDP is added to better reflect its significance in SSA. Given the weak coefficient on the square terms, and that most SSA countries are at the relatively low level of financial development below the threshold to exhibit negative growth impact as discussed in the text, the model on the component index is run in level only in favor of parsimony. Model 1 represents the overall effect of financial development; model 2 represents the effect of dimensions of financial development. GMM = general method of moments.

We find that the impact on growth tends to be stronger for countries at a lower level of financial development. For low-income countries, with larger estimated gaps to the benchmark, the potential boost to growth is about 1.9 percentage points, while the growth boost for oil producers is at about 0.5 percentage point. For instance, raising the financial development index of Niger (0.08) to the level of Kenya (0.18) generates a positive growth impact of 1.9 percentage points, while a further increase to the level of Namibia (0.28) adds 1 percentage point.6 The results also show that for a median sub-Saharan African country, most of the growth effect is from the support of financial institutions, while that from financial markets is positive but not significant, likely undermined by the lack of financial infrastructure and competition. The results are illustrative and should be taken with caution, given that data are available for only about 40 sub-Saharan African countries. Moreover, the financial market index has little dispersion given the short history of financial market development outside of the banking sector among most of these countries.

The findings of recent micro-founded studies corroborate the salutary growth impact of relaxing structural financial constraints. IMF (2015b) summarizes the benefits of removing the most binding constraints to financial inclusion on GDP, total factor productivity (TFP), and inequality in a set of countries (Kenya, Mozambique, Nigeria, Uganda, Zambia) and two monetary unions using the general equilibrium framework by Dabla-Norris and others (2015). The study identified borrowing constraints—limited enforcement of contracts and asymmetric information that results in high collateral and smaller leverage ratios—as the most relevant hurdles to firms’ access to finance. Relaxing these borrowing constraints could increase GDP levels by 8 to 20 percent through a substantial improvement in TFP over the long term (Figure 6). Lowering participation costs—factors limiting access to credit such as distance to banks or ATMs, documentation required to apply for a loan—could also modestly contribute to growth.

Figure 6.Long-Term Impact on GDP of Relaxing Financial Constraints

Sources: Dabla-Norris and others 2015; IMF country staff reports; and IMF staff calculations.

Note: CEMAC = Economic and Monetary Community of Central Africa; WAEMU = West African Economic and Monetary Union.

The relationship between financial development and growth volatility appears to be nonlinear in the vast majority of countries in the region. Following Sahay and others (2015b) and including region-specific control variables, we find that the relationship between financial development and volatility is nonlinear in sub-Saharan African countries (Table 2), similar to findings in other regions. Financial development initially smoothens growth volatility by relaxing credit constraints on firms and households, and providing them with a variety of instruments to withstand adverse shocks. However, as the financial sector deepens, its contribution in reducing volatility declines because a deeper financial sector increases the propagation and amplification of shocks. However, this nonlinearity does not imply that further financial development exacerbates volatility in the region: as seen in Figure 7, sub-Saharan African economies are below the threshold (estimated at about 0.4) beyond which financial development starts increasing growth volatility. In other words, our empirical analysis suggests that—under the current institutional setting and structural characteristics—this threshold is lower for sub-Saharan Africa than for other countries.

Figure 7.Sub-Saharan Africa: Impact of Financial Development on Growth Volatility

Source: IMF staff calculations.

Note: Based on the regression coefficients, this chart illustrates the simulated marginal impact on the standard deviation of the real GDP growth rate (five-year rolling standard deviation) of a 10 percent increase of a country’s financial development index. The U-shaped trend line shows that the reduction on volatility is stronger for countries with lower index levels and still favorable but less strong for countries with already comparatively higher level of financial development (green-shaded area). Beyond a certain financial development threshold level, further increase in the index would increase growth volatility (red-shaded area).

This presumably reflects the insufficiency of the region’s legal and institutional frameworks required to fully reap the benefits of deeper financial systems. Moreover, shocks that this region is subject to—especially those related to international commodity prices—are more frequent and of greater magnitude than others.

We also extended the analysis to examine the effect of financial development on investment volatility, including by using different components of financial development. The results suggest that financial development reduces overall growth volatility but only up to a certain point for sub-Saharan African countries, although it deepens investment fluctuations in other regions of the world (Table 2). The pronounced reduction of investment volatility may be attributed to the greater access to credit for large firms, which account for the bulk of investment in developing countries. Both financial institutions and financial markets are found to dampen growth volatility, but financial institutions are found to play a prominent role, consistent with their level of development in sub-Saharan African countries (Chapter 1).

Table 2.Sub-Saharan Africa: Estimation Results of Impact of Financial Development on Growth Volatility
Dependent: variable: volafility ofGDP growthInvestment-to-GDP growth
Financial development index−7.589 ***157.1***
(1.118)(2.741)
Financial development index3.739 ***−280.1***
(squared term)(1.318)(3.519)
Financial institution index−5.236 ***−24.67 ***
(0.664)(0.768)
Financial institution index5.03 ***
(squared term)(0.910)
Financial market Index−2.967 *

(1.529)
−38.80

*** (1.024)
Financial market Index−0.106
(squared term)(1.688)
SSA* financial development−9.706 ***−246.3 ***
(1.963)(10.06)
SSA* financial development16.31***404.6***
(squared term)(2.679)(51.59)
SSA* financial Inistitution index−4.592 ***−9.052 ***
(1.265)(3.253)
SSA* financial Institution index7.187 ***
(squared term)(1.970)
SSA* financial market index−2.290

(4.228)
32.65***

(3.731)
SSA* financial market index2.373
(squared term)(7.077)
Observations1,1731,1731,0331,033
Number of countries65658989
Sources: Sahay and others 2015b; and IMF staff estimates.Note: Robust standard errors in parentheses; *** p < 0.01, ** p < 0.05, * p < 0.1.Dependent variable: five-year rolling standard deviation of real GDP growth and growth of investment-to-GDP ratio. Additional control variables: five-year lags of GDP per capita, trade and financial openness, energy exports (percent of GDP), volatility of foreign growth, gross capital inflows in the region excluding country in question, terms-of-trade changes, polity index, growth in GDP per capita, government balance, and aid to GDP growth volatility for 1995–2013. The high magnitude of financial development variables’ coefficients on investment volatility could be explained by the substantial volatility of investment across countries and over time. In addition, although the aggregate coefficient is positive for the global sample, the financial development coefficient for sub-Saharan African countries (FD + FDxSSA) is statistically significant and negative while the coefficient on the square term is statistically significant and positive at the 5 percent level.1
Sources: Sahay and others 2015b; and IMF staff estimates.Note: Robust standard errors in parentheses; *** p < 0.01, ** p < 0.05, * p < 0.1.Dependent variable: five-year rolling standard deviation of real GDP growth and growth of investment-to-GDP ratio. Additional control variables: five-year lags of GDP per capita, trade and financial openness, energy exports (percent of GDP), volatility of foreign growth, gross capital inflows in the region excluding country in question, terms-of-trade changes, polity index, growth in GDP per capita, government balance, and aid to GDP growth volatility for 1995–2013. The high magnitude of financial development variables’ coefficients on investment volatility could be explained by the substantial volatility of investment across countries and over time. In addition, although the aggregate coefficient is positive for the global sample, the financial development coefficient for sub-Saharan African countries (FD + FDxSSA) is statistically significant and negative while the coefficient on the square term is statistically significant and positive at the 5 percent level.1

More Vigilance against Macro-financial Risks

The previous sections highlighted that further financial sector development in sub-Saharan Africa could yield significant macroeconomic gains. However, such development promotes a sector that, if excessive risks are taken, could pose a risk of substantial spillovers to the economy, highlighting the need to be vigilant about macro-financial risks.

Recent country studies on sub-Saharan African economies underscore a number of emerging macro-financial risks.

  • In the WAEMU, a combination of widening fiscal imbalances and accommodative monetary policy by the regional central bank (BCEAO) has allowed banks to significantly increase holdings of government securities to take advantage of the interest rate margin of government bonds over the low BCEAO refinancing rate, raising the sovereign financial risk (IMF 2015g).7
  • In Malawi, insufficient fiscal adjustment led to the accumulation of domestic payment arrears and more recourse to domestic financing, resulting in increased nonperforming loans and elevated financial sector exposure to government risks and thus heightened economic uncertainty (IMF 2015d).
  • In Namibia, a booming housing market has been posing a great risk to banks and could potentially lead to a fiscal risk.
  • In the CEMAC, Namibia, and Uganda, banks’ credit growth has been accompanied by significant concentration risks (IMF 2015c, 2015e, 2015f). Moreover, in Uganda, high dollarization in loans and deposits poses potential credit risks due to possible currency mismatches in borrowers’ balance sheets.

These developments could initiate bank and sovereign risk feedback loops. When such a risk materializes, it could be easily exacerbated, given the lack of enforcement of prudential rules, the weak judiciary system, and weak crisis resolution frameworks in the region.

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