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While the banking industry has been the backbone of the financial world for several decades, it may not be sufficient to meet the needs of entrepreneurs seeking financing. In Africa, in particular, the stock market is largely underutilized as a source of capital, a fact that seriously limits entrepreneurship and therefore employment opportunities, and is also responsible for lower levels of income and growth. In addition, Africa has a low level of foreign direct investments (FDI), even though, compared to other continents, it needs this financing the most. This is the dissertation example on financial development and economic growth which is the contribution of one of our writer who shared it freely. If you have any objection on its publication you may let us know. 

By contrast, Asian developing countries have more sophisticated financial structures and offer a wide range of financial services. For instance, the stock exchanges of Asia include more products, such as a wide variety of derivatives and exchange-traded funds which are comparable to products in developed countries. Asian financial markets also have a technological advantage over African financial markets. In addition, more companies are listed on Asian exchanges, including a large number of foreign corporations. As a result, Asian financial markets have earned a greater level of both domestic and foreign investor confidence than African countries and have become competitive with other global markets, including the United States.

The Objective of the dissertation

The objective of this study is to determine whether a well-developed financial sector, as reflected in an expansion of the bank and insurance industries as well as stock markets in their role as financial intermediaries, could address these issues and thereby enhance economic growth. To this end, this study compares how financial development has contributed to economic growth in African countries and Asian countries to examine whether African countries could benefit from expanding their financial sector as some Asian countries have done. In particular, the study investigates the efficiency of the African and Asian stock markets to determine whether these markets have the capacity to manage information asymmetry and stability and whether they can promote technological progress for an economy’s overall long run growth. Efficient markets imply better financial stability which, in turn, would attract more domestic and foreign investments, thus stimulating economic growth. Finally, based on the analysis carried out, the study makes policy recommendations that would enhance economic growth.

Scope of the Study

This study covers selected African and Asia countries: Bangladesh, Botswana, Egypt, Ghana, India, Kenya, Nigeria, Malaysia, Mauritius, Morocco, Pakistan, Philippines, South Africa, Singapore, Sri Lanka, and Thailand. The time period of the study is from 1988 to 2007.

Significance of the Study

A better understanding of the relationship between financial development and economic growth is of particular importance as it can help developing countries target their policies effectively to achieve economic growth. These policy recommendations need to be specifically suited to the situation of developing countries, since policies from developed countries are not easily applicable there. Asian and African developing countries share a number of similarities but also exhibit some differences and a comparison of the relationship between financial development and economic growth in these countries will therefore yield valuable insights into this investigation.

Limitations of the Study

Data availability is the most important limiting factor for this study. Most stock markets in Africa and Asia were formed in the late 1980s or early 1990s, but some were created even later. This significantly reduced the number of suitable countries for this study.

Another limitation is the fact that certain financial activities in developing countries have not been effectively captured by available statistical methods. For instance, informal methods of lending through friends and families as well as activities of informal credit unions or market organizations do not pass through conventional channels and are thus not measured.

Nevertheless, these obstacles have been overcome by using the variable “domestic credit to the private sector” which covers a wide range of the smaller savings and loan systems. Also, the research selects countries that have sufficient data within the study period.

Organization of the Study

The study is divided into 7 chapters. Chapter 1 introduces the concepts of Financial Development and Economic Growth. It also presents the scope and significance of the study. Chapter 2 discusses Global, African, and Asian financial markets. Chapter 3 reviews the existing literature on financial development and economic growth and presents the research questions that will be the focus of this study. Chapter 4 provides the theoretical framework, while Chapter 5 introduces the model specification, hypotheses, methodology, as well as the data sources. Chapter 6 presents the empirical analysis and results. Finally, Chapter 7 provides conclusions and policy recommendations.

Financial development


Global Financial Markets

This section presents an overview of the state of global financial markets. The key global players in the global financial markets are the countries of the G-7, including the United States, Japan, and the United Kingdom. In the past, the United States set the pace for financial mobilization. However, more recently, budget deficits, the declining dollar, the presence of a stronger European Union, and the introduction of the Euro currency, have challenged the leadership position of the United States (International Monetary Fund, 2007). China in particular is fast rising in its role as a global player and significant partner for both developing and developed nations alike (Soros, 2008).

The recent banking crises in 2008 and 2009, which originated from the housing crises in the United States, show that banks are unable to absorb losses indefinitely. During that period, banks had insufficient capital, and some small banks collapsed completely whereas larger banks were bailed out, arguably to avoid a possible breakdown of the economy. The recent crises is however different from other past economic crises because it had a wider impact on several sectors of the economy. For instance, the technological crisis of 2000 (dotcom bubble) did not have such a drastic impact on the overall economy and was limited to specific sectors. In addition, most banks then had sufficient capital to absorb losses. As a result, there were fewer bank failures, and banks were still able to function effectively as intermediaries (Soros, 2008).

Also, banks as financial intermediaries have drastically restricted their lending, and the resultant tight financial and monetary conditions around the world may lead to a further reduction in economic activity. In the U.S., for instance, reducing the credit supply to household borrowers may worsen the downturn in the housing market. In addition, falling equity prices could reduce consumer confidence and therefore consumer spending. Also, in the corporate sector, a higher cost of capital could reduce capital spending. Furthermore, disturbances in the credit and funding markets could reduce the overall provision and channeling of credit. A weaker aggregate domestic demand due to changes in financial risks, market conditions as well as increased global inflation could invariably lower the economy’s potential for growth, even more so, if foreign investors’ preferences for U.S. assets were to decrease. On the other hand, a slower growth of the U.S. economy and the depreciation of the dollar would help reduce the current U.S. budget deficit and thus reduce the amount of financing needed (International Monetary Fund, 2007).

Although global financial markets are currently facing serious challenges, it is important to remember that in the past, these markets have demonstrated the ability to recover and regain strength and momentum. From the Great Depression to the recessions experienced in the 1980s and 1990s, global economies in industrialized countries have never been permanently weakened by such decreases in economic activity. Business cycles, which are short-term fluctuations in output and employment, occur naturally in all economies and are characterized by periods of growth and recessions. The challenge lies in a nation’s ability to properly manage such business cycles and steer its economy quickly back to growth during a recession period.

During challenging economic times, stable national economic institutions, dedicated controls as well as corrective mechanisms have made it possible for certain countries to continue to forge ahead. For instance, the United States established the Federal Deposit Insurance Corporation after the great depression to reduce incidences of bank failures. In addition, the Federal Reserve Bank has been very vigilant in its monetary policies to avoid over-contracting the money supply, which – in the presence of deflation – would complicate a depression.

Similarly, the Japanese government passed large tax cuts to encourage consumer spending during the economic downturn in the1990s. “The Japanese government also expanded the money supply rapidly to increase expected inflation, lower real interest rate, and stimulate investment spending to enhance growth” (Mankiw, 2007).

Lessons From The Current Global Financial Crisis

The recent global financial downturn has made clear that it is important to re-examine the nature of financial development and economic growth. With stock prices decreasing and home values declining rapidly, governments and consumers alike are seeing their wealth diminish rapidly. The global economy is looking to governments across the globe to prevent the unsettling possibility of a global depression, and the concept of a free market system without government intervention needs to be questioned. When a market has proven to be incapable of correcting itself, due to the prevalence of players in the market system who distort the operating mechanism, it is necessary for the government as a regulator to intervene (International Monetary Fund, 2007).

The nature of the current global crises has also further called for an overall reassessment of the generally accepted theories or the ―fundamentals ―of the economies world- wide. Classical economists like Adam Smith propagated the ―Invisible Hands Theory‖ in which markets were viewed to be generally correct and tend towards equilibrium. Keynes challenged this view by proposing reasonable and timely government interventions to guide the economy appropriately.

However, since the 1970s nations have been tending towards the classical economists’ view of little intervention and implementing policies only after problems have occurred. Keynes further introduced the concept of “animal spirits” in which individuals do not make decisions based on rational economic motives. The notion of Animal spirits suggests that individuals in the market place will factor in their subjective opinions of confidence in the economy, fairness, corruption levels and money illusions into their decision making process, causing further distortions in the functioning of markets (Akerlof and Shiller, 2009).

Soros (2008) also introduced the concept of Reflexivity in financial markets as a new paradigm contrary to the belief that markets will always tend towards equilibrium. Reflexive processes involve lack of correspondence between the participants’ views and the actual state of affairs. As such, people are participants in the environments that they are trying to understand and thus cannot have perfect knowledge since they can manipulate whatever knowledge they acquire. Reflexivity thus introduces a high level of indeterminacy and uncertainty into financial markets (Soros, 2008). The conventional fiscal and monetary policies implemented by nations to guide the economies do not take these principles into consideration and thus results may not have their desired effects.

These issues are particularly crucial for African and Asian markets that seek to balance outright government control and effective regulation in an uncertain/unpredictable environment. In African countries, there is a significant level of distrust of governments who have been associated with corrupt practices and a lack of accountability and transparency. Also, many African countries have been affected by political instability, wars and civil unrest; this has made it difficult to apply consistent policies. By contrast, the political stability in Asian countries coupled with improved economic conditions, due to increased exports of manufactured goods, has provided an enabling environment for consistent monetary and fiscal policies that encourage innovation while providing adequate oversight.

The current financial crisis is a reminder not to take for granted that financial markets regulate the economy. Careful monitoring without over-regulation is essential to ensure a proper functioning of the financial systems. Financial markets around the world are interconnected and distortions in one area of the global economy will affect all financial markets. Asian and African nations who are still in their early developmental stages will be particularly affected by a global financial crisis and impaired financial market stability. These countries will have to strike a delicate balance between establishing financial markets as an avenue to foster growth and becoming over-dependent on this sector which, due to its susceptibility to reliance on foreign demand, can change the direction of the economy.

African Financial Markets

In this section, African financial markets are reviewed with a focus on their current state and on existing challenges. Financial markets in this region have opened up as a result of private sector companies seeking a yield in financial investments. Since the emerging markets are part of the global environment, private sector companies have the option of foreign financing.

A possible concern, however is that African financial markets rely heavily on foreign investment through multinational corporations and the employment opportunities they provide. This may lead growing indigenous industries that are unable to compete with these larger organizations to go out of business. Also, the countries lack solid infrastructures. In a country like Nigeria, power and water supply is limited and the general public relies on personal generators. This increases the cost of doing business and causes serious inefficiencies. During the past year, a number of multinational corporations have left Nigeria and moved to Ghana because of the erratic electricity supply in Nigeria. Ghana has also provided attractive tax breaks to encourage these companies to relocate their operations. Furthermore, transportation and communication structures are seriously lacking in most African countries which has led to increased prices and affected the overall economy negatively.

African countries initially had a higher level of economic stability when compared to the ASEAN2 member countries. In the 1970s, they had lower inflation rates, high international reserves, and low debt-to-GDP ratios. However, some central banks in Africa target only a reduction of inflation as opposed to attempting to meet the dual goal of achieving stable money and reducing inflation

In addition, most African and Asian countries gained independence between the 1940s and 1960s and also discovered and exploited natural resources around that time. Also, in the 1960s, the average levels of GDP in Southeast Asian countries like Indonesia, Malaysia, and Thailand were similar to the GDP in most African countries. In addition, to similarities in economic structures, African and Asian countries had similar social structures during this time period, in particular with respect to a lack of human resource potential. Finally, both groups of countries experienced similar post-independence ethnic conflicts and political instability (Court and Yanagihara, 1998).

In spite of these similarities, Africa has fallen behind in maintaining economic growth due to its inability to manage internal crises, wars, corruption, as well as its lack of infrastructure. African financial markets also lack the organization and stability necessary to make them more attractive to global investors. Since investors will switch their investments to areas or countries where they will benefit the most, African countries need to offer competitive interest rates and stabilize their exchange rates.

Elbadawi (1996) contended that macroeconomic stability in Africa has worsened since the mid 1970s. Most countries have a high fiscal deficit which further exposes their economies. Easterly (2006) questions the role of International Organizations like the World Bank and the IMF in implementing successful programs to achieve macroeconomic stability. Easterly (2006) pointed out that both the World Bank and IMF gave Cote D’Ivoire 26 structural adjustment loans in total between in the 1980s and the 1990s. However, per capita GDP in Cote D’Ivoire was drastically diminished during that period, resulting in a severe depression. Similarly other African countries who received structural adjustment loans from the IMF and the World Bank had negative or zero growth (Easterly, 2006).

Nellor also noted that Africa’s resource-rich countries have a weak record of long run macroeconomic performance, mostly because the governments tend to spend more than their economies can absorb. These countries have strong exchange rates when prices for commodities such as oil are high “causing a false higher growth rate” and these exchange rates then block their non-resource sectors. Eventually, when oil prices fall, the already stifled non-resource sectors are unable to perform adequately and the growth rate deteriorates the “resource curse”. Oil-producing nations like Nigeria and Angola are thus susceptible to oil shocks and fluctuating demand and currency prices which impact overall GDP levels.

Asian Financial Markets

This section provides an overview of Asian financial markets in the selected countries analyzed in this study. Thailand, Malaysia and Indonesia were running trade deficits in the early 1990s financed by capital inflows from the United States and Japan. A reduction in the inflow of capital followed by the reduction of foreign reserves led to the devaluation of the Thai Baht. This set off panic among investors to other Asian countries and further region-wide devaluations occurred (Krugman, 1999).

Stiglitz argued that the crisis was caused by a premature financial and capital market liberalization that did not have an effective regulatory framework. These countries also appeared to have reasonable banking regulations and supervision. In sum, they had, or appeared to have, strong macroeconomic fundamentals. In spite of all these favorable conditions, Asian countries experienced a financial crisis. Krugman (1999) indicated that a warning sign for potential problems is the fact that Asia overall achieved high rates of economic growth without corresponding increases in productivity. As such, Asia’s growth was due to resource mobilization rather than efficiency. Stiglitz thus advised against full liberalization which promotes instability and not growth. Due to differences between financial and capital markets on the one hand, and markets for ordinary goods and services on the other hand, policies which work well for the goods market may not necessarily apply to the financial markets (Goodhart, 2004).

State of African and Asian Markets in Comparison with Other Global Markets

The developing markets in Africa and Asia are not yet at par with other global markets, such as the ones in the United States, Europe, Japan, and Hong Kong, and there is still a higher level of risk associated with investing in these emerging markets. While industrialized nations enjoy the confidence consumers and investors have in their political and financial stability, the market buoyancy in the developing regions of the world is still wanting. Nevertheless, Asia has propelled itself ahead of Africa by establishing infrastructures and institutions which serve as the backbone of development (Court & Yanagihara, 1998). They have also reduced dependence on primary products and on oil revenues as the drivers of economic activity and are shifting to manufactured products and services, e.g., in India and the Philippines. Asian countries have expanded their financial markets to include banking, stock exchanges, and the insurance industry. As a result, Asian countries are more attractive to investors as they present lower risks.

In order to stimulate their economies through growth, it will be crucial for African countries to emphasize export-led growth in the non-resource sector, as evidenced by the experience of some Asian countries (Nellor, 2008). There is a possibility that the export-led model may not be sufficiently effective due to the prevalence of primary commodities in Africa that have high-demand elasticities and are very sensitive to foreign exchange fluctuations; also export-led growth has lower bargaining power compared to other regions. Yet, Nellor (2008) asserted that Africa still has a growth potential via import substitution, intraregional trade, and export markets.

financial market of africa 


The relationship between financial development and economic growth has been studied extensively and has been subject to much debate. This chapter reviews the literature on financial development and economic growth and discusses their causal relationship. It also discusses existing statistical analyses for the relationship between financial development and economic growth across and within countries. This review helps us in identifying gaps in research based on which the specific research questions for this study are developed.

The Relationship between Financial Development and Economic growth

The relationship between financial development and economic growth was examined initially by economists like Joseph Schumpeter (1911), who argues that “well-functioning banks stimulate technological innovation by identifying and funding entrepreneurs with the best chances of successfully implementing innovative products and production processes”. Joan Robinson (1952) believed that “finance follows the leadership of enterprise because economic development itself creates demand for particular types of financial arrangements to which the financial system responds automatically”.

Patrick (1966) contended that “financial development furthers economic growth in the early stages of development, but that this causality is reversed in the later stages”. Goldsmith conducted a seminal study in 1969 in which he examined the financial superstructure—which consists of both primary and secondary securities—of various countries over time. His findings help to understand the overall function of the financial system.

Goldsmith (1969) argued that “financial superstructure in the form of primary and secondary securities will accelerate economic growth and improve economic performance by facilitating the migration of funds to the best user, allowing the funds to yield the highest social return”. Goldsmith conceded that the impact of a financial superstructure will vary significantly from country to country and also change considerably over time. It will therefore be essential to perform a case-by-case study of the role of financial superstructures in economic development and to determine the causal direction of this relationship.

Shaw (1973) examined the roles played by financial deepening and financial liberalization in the economy of a nation. He suggested that financial deepening would enhance diversified menu of assets, increase financial stock, reduce the burden of taxation as well as the demand for foreign savings. Financial deepening also increases the size of the monetary system and produces opportunities for institutions other than the banking sector, including insurance companies. Financial liberalization on the other hand could influence growth and currency rate stability as well as equalization of income distribution in a nation.

Shaw (1973) also argued that Asian countries have progressed further along the path of financial deepening by offering a diversified range of financial assets than African countries. McKinnon (1973) also suggests that financial development is determined by legislation and government regulation which implies the degree of financial repression. Shaw and McKinnon (1973) stated that “government interventions like interest rate ceilings, high reserve requirements, and credit programs are the main sources of financial underdevelopment”. McKinnon and Shaw further suggested that deposit ceilings, or lending rates, and high inflation rates have usually resulted in negative real interest rates and discouraged savings, and have also created excess demand for funds for investment. As a result, the volume of investment and the productivity of capital decreased when real interest rates were too low. King and Levine (1993), expanding on Goldsmith’s analysis, studied 80 countries from 1960 until 1989 using cross country regressions to determine “whether the level of financial development predicts long run economic growth, capital accumulation, and productivity growth”.

Controlling for other factors that affect long run growth, they measured financial development using the following indicators: 1) “Depth: the size of financial intermediaries which is equal to the liabilities of the financial system; 2) Bank: degree to which a country’s central bank allocates credit, compared to commercial banks; 3) Private: the ratio of credit allocated to private enterprises to total domestic credit; 4) Privy: credit to private enterprises divided by GDP”.

King and Levine’s (1993b) underlying assumption was that “financial systems that allocate more credit to private firms research and mobilize savings more effectively”. Therefore, the ability of financial systems to allocate more credit to mobilize savings shows that the financial structure is more versatile. They concluded that “financial development is a good predictor of economic growth, physical capital accumulation, and economic efficiency improvements”. In effect, as countries get richer, they expand traditional savings and loan banks but also the use of other financial intermediaries such as insurance companies, investment banks, and stock markets (King and Levine, 1993b). However, their analysis which utilized cross-country regressions did not provide a robust analysis compared to time-series methodologies. Also, the research did not assess other areas of the financial superstructure such as the insurance and pension fund sectors.

In another cross-country study, Levine (1997) found that stock market liquidity also translates to higher level of per-capita GDP growth. There was also empirical evidence that showed that financial structure, which encompasses all financial intermediaries, varies across countries and changes as countries get richer or develop their financial intermediaries. For example, banks allocation of credit grows compared to the central bank’s allocation. In addition, non-financial institutions, insurance companies, investment banks become more important as the stock market grows. Levine (1997) indicated that financial markets mobilize and pool savings across diverse number of investors. If there is better savings mobilization, capital accumulation would be enhanced as well as resource allocation and technological innovation. Financial development also affects economic growth through its influence on technological progress by reallocating savings to different capital-producing technology or by changing the rate of technology innovation, or by identifying potentially successful entrepreneurs in this sector.

Levine (1997) argued that the reason stock markets affect economic growth is because their liquidity makes investments less risky. Similarly, Levine (1991) and Bencivenga and Smith (1991) indicated that trading financial assets in stock markets seems safer because these markets allow savers to change their portfolios to buy and sell quickly. In addition, companies have easy access to capital through the issue of equity.

Current research on the topic of financial development and economic growth, however, displays certain weaknesses. For example, Levine (1997) found that the structure of financial systems or the overall function of different financial systems is not sufficiently quantified. Also, “it is difficult to attribute differences in growth rate to certain differences in the financial sector”. Although in his cross-country studies, Levine (1997) provided “an insight into the relationship between financial development and economic growth, he recognized that it is difficult to compare financial structures across countries, as there are significant differences in legal systems and natural resource endowments which ultimately produce diverse political and institutional structures”. Levine also indicated that there are differences in cost and assumptions of models which make such an analysis difficult. It becomes clear that existing studies provide a thorough overview of the role of the financial sector and financial development; however, they contain little advice with regards to risk mitigation which would be especially relevant for developing countries.

With regard to the general question of the relationship between financial development and economic growth, it is important to consider the obstacles to financial development. Demetriades and Andrianova (2003) stated that these obstacles include government ownership of banks, legal hindrances, as well as political economy constraints. They also stated that in reality, households face borrowing constraints and have several interest rates as opposed to a single interest rate assumed by the neoclassical economists. In addition, the authors argued that an economy with a well-functioning financial system that addresses the issues of moral hazard and adverse selection effectively is likely to have high investment rates as well as a highly productive capital stock. Demetriades and Andrianova (2003) also indicate that since information about a transaction is a major factor in financial decision-making, the relationship between financial development and economic growth is likely to depend on how the financial system manages the information problems.

In light of the above, we note that developing countries, especially in Africa, have experienced difficulties maintaining macroeconomic stability. Villanueva and Mirakhor (1990) indicate that existing conditions such as large budget deficits and high inflation combined with moral hazards and insufficient bank supervision were at the root of the crisis in the 1980s and therefore need to be closely monitored. McKinnon (1991) argued that real sector reforms should precede financial liberalization, e.g., the privatization of state-owned businesses. He also contended that deficits and inflation should be reduced before reforms can be implemented to remove any inflation-related price distortions. Furthermore, McKinnon recommended an adequate regulatory system and supervision of the financial systems and advocates that domestic financial liberalization like interest-rate deregulation and reduction of the reserve requirements should be done prior to liberalizing capital flows; specifically he recommended that restrictions on long run flows like FDIs should be taken off first and restrictions on volatile short-term flows last.

When Demirguc-Kunt and Detragiache (1999) analyzed the 1996/97 banking crisis for 53 countries, they found, after controlling for other determinants, that financial liberalization had a statistically significant positive effect on the likelihood of a banking crisis. However, the increase in the likelihood is lower in developed countries or countries with better developed and functioning institutions, such as legal systems, bureaucracies, etc. Overall, the authors contended that there is no clear-cut evidence that financial liberalization promotes economic growth, but these findings point to the fact that countries should protect investors through enhanced mechanisms for contract enforcement as well as through a sufficiently developed insurance industry to mitigate risks. Levine, Loayza, and Beck (2000) have shown that “regulatory changes that strengthen creditor rights, contract enforcement, and accounting practices boost financial intermediary development and economic growth”.

The entire picture becomes even more complex when one takes into consideration studies that examine whether government ownership of banks promotes economic growth. La Porta, Lopez de Silanes, Shleifer and Vishny (2000) reported “a negative correlation between government ownership of banks, financial development, and economic growth”, while Demetriades and Andrianova (2003) concluded that privatization of state banks is unnecessary.

La Porta et al. (1997, 1998) also argued that civil law countries (France and former colonies) tend to offer less protection to their minority shareholders and creditors compared to common law countries (England and former colonies), which underlines the importance of monitoring the financial sector.

In sum, it is of essence for developing countries in Africa and Asia to address the obstacles to financial development stated in the preceding section, if they want to strengthen and grow their economies. Facing a number of institutional and socio-economic challenges, they are placed at a disadvantage, and a thorough assessment of their positions is needed in order to provide them with realistic and effective solutions.

Although cross-country studies are very helpful in order to understand the general aspects of financial development and economic growth, they have some deficiencies with respect to their quantitative analyses, which, according to Evans (1995), arise from the heterogeneity of slope coefficients across countries. For example, cross-country studies only estimate the average effects of financial development on economic growth across countries, but do not specify the individual country-specific result. Also, it is possible to have different causality patterns across countries (Arestis & Demetriades, 1997). These problems have led some researchers to implement time-series analysis. In their time series study, Arestis and Demetriades (1997) examined whether, how, and to what extent the financial system can have an impact on economic growth. Specifically, they assessed how financial deepening, investment, and capital efficiency in the financial system will influence this process.

Arestis and Demetriades (1997) also examined whether financial liberalization can stimulate investment and growth. The authors found “substantial variation across counties even with the same variables and estimation methods”. For example, they found important differences in the relationship between financial development and economic growth between the United States and Germany. They therefore recommended employing the time-series methods and taking individual country characteristics into account when approaching this subject. However, the authors only focused on two countries—the United States and Germany—and did not consider African and Asian countries, which are emerging economies, so their research results are not directly transferable. Another study by the same authors performed a year earlier examined data for several (twelve) countries and found that the “causal link between finance and growth is determined by the nature and operation of the financial institutions and economic policies of any given country” (Arestis & Demetriades, 1996).

Demetriades and Hussein (1996) as well as Odedokun (1996), used “time series analysis and found that the nature of the relationship between financial development and economic growth varies between countries”. Odedokun used an extensive sample of 71 countries and found that in about 85% of the countries, financial development contributes to economic growth. His research included a large number of African and Asian countries and therefore has special relevance for this study; however, one weakness of his study is that he only utilized banking sector indicators to assess the impact of financial development on economic growth.

Demetriades and Hussein (1996) performed causality tests for 16 developing countries and found that “the causal relationship between financial development and economic growth varies across countries”. Half of the countries show a bi-directional causality between the two factors, while the rest show an impact of economic growth on finance and not vice versa.

However, while Asian countries were well represented, South Africa and Mauritius were the only African countries that were included in this research, which therefore only has limited relevance for this study. In addition, Odedokun (1996), as well as Demetriades and Hussein only used banking sector indicators, thus omitting other important aspects of the financial superstructure on economic development.

Calderon and Liu (2001) also performed an econometric time series analysis of data from 109 countries, covering the time period from 1960 until 1994 and confirmed that there is a bidirectional causal relationship between financial development and economic growth. More importantly, they also discovered that in developing countries the impact of financial development on economic growth is more important than the impact of economic growth on financial development. This finding explains 84% of the overall relationship between financial development and economic growth over a 10-year period in developing countries. In addition, the authors found that the longer the period examined in developing countries, the more substantial was the impact of financial sector development on economic growth. Over long periods of time, the impact of economic growth on financial sector development becomes almost insignificant in both developed and developing countries.

Other factors that positively affect economic growth have been revealed by Zingales (2003) and include institutional characteristics, such as the legal structure, respect for property rights, a low degree of corruption, as well as the extent of financial sector development. Zingales acknowledged that all these factors are highly inter-correlated, which makes it difficult to determine the Demirguc-Kunt and Levine’s (1996) time series analysis confirmed that stock markets as financial intermediaries are important to economic growth. In addition, they indicated that the attention of developing countries has shifted from concentrating solely on the banking industry to expanding the stock market. World stock market capitalization grew from $4.7 to $15.2 trillion between the mid 1980s and mid 1990s (Demirguc-Kunt & Levine, 1996, p. 223). Levine and Zervos (1996) indicated that well-developed stock markets can offer different kinds of financial services than banking systems, providing a different avenue to investment and growth.

Utilizing cross-country regression studies for 47 countries, they showed that “increased stock market capitalization, measured either by the ratio of the stock market value to GDP or by the number of listed companies, could improve an economy’s ability to mobilize capital and diversify risk”.

According to Singh (1997), the success of stock markets hinges on whether stock prices actually reflect the expected future profitability of companies. Resources will go to the most efficient and productive companies that are able to carry out their investment strategies.

However, if stock prices are very volatile and subject to speculation, bubbles, and price manipulations, this limits the ability of stock markets to contribute to economic growth and can even affect it negatively. Furthermore, efficient stock markets—just like well-functioning banking systems—complement bank financing and also exercise corporate control via mergers and acquisitions. Therefore, stock markets have to be efficient in order to have an impact on economic growth.

Beck and Levine (2004) used “panel-data methods to determine the role of stock markets and banks for economic growth using data for 40 countries from 1975-98. They found that stock market liquidity, i.e., the total value of shares traded relatively to market capitalization, is positively related to GDP growth”. In addition, they found that, along with stock markets, a credit-based banking measure had a significantly positive influence on GDP growth (U.K. Department for International Development, 2004).

Stock markets, however, also underlie varying degrees of volatility; and high degrees of volatility will, according to Federer (1993) result in an inefficient allocation of resources and in higher interest rates which, in turn, infringes on the volume and productivity of investment and reduces growth (Arestis & Demetriades, 2001).

Current stock markets in Africa are challenged by low liquidity (Yartey & Adjasi, 2007), measured by the turnover ratio. Because of the low business volume in individual African countries, Yartey and Adjasi argued, “it will be hard to support a local market with its own trading system”. They utilized Arellano and Bond’s (1991) dynamic instrumental variable modeling approach of the difference generalized method of moments using “lagged values of the dependent variable (growth) and differences of the independent variables”.

Yartey and Adjasi found that stock market development (total value of shares traded relative to GDP-liquidity) along with investment and past growth levels plays a significant role in economic development.

Limitations of Existing Studies

While existing research has examined the issue of the impact of financial development on economic growth in developed countries, hardly any research has focused specifically on the situation of developing countries, especially in Africa and Asia; the research that has targeted these continents has only included a few countries or focused on just one of these continents at a time. Yet, a more concentrated and comprehensive analysis of African and Asian countries could yield interesting results, as some of the countries in these two continents were considered to be at similar stages of development and showed similar potential in the 1960s, but have since progressed differently.

In addition, much of the research focuses either on the banking industry or on the stock market, but not on both, with the notable exception of Levine and Zervos (1996) as well as Beck and Levine (2004). These authors, however, made little attempt to explain the specific impact of the stock market and the banking industry on economic growth in individual developing countries.

Furthermore, existing studies have not integrated the concept of market efficiency to determine the role it plays in financial market stability and consequently in economic development. Also, none of these studies examined the interplay between the insurance industry and financial sector development. In addition, as already mentioned, cross-country regressions were the most common methodology used, but this method does not consider changes over time.

Also, previous studies did not address the need to utilize panel data methods for data that are both cross-sectional and cover a period of time to study the significance of banking and stock market development in Africa and Asia.

Research Questions

The above review of the existing research indicates that the following questions have not been addressed. They will therefore serve as the focus for this study:

  1. Does financial development have an effect on economic growth, as measured by percapita growth, for the selected countries in the time period of 1988-2007?

  2. Does market efficiency promote economic growth and to what extent are the markets in the selected countries efficient?




Theoretical Frameworks

This chapter discusses the two theoretical frameworks for this study. King and Levine (1993a) provide the basic theoretical foundations for the two research questions, as they link the neoclassical economic theory with financial intermediaries and thus provide a starting point for further examining the role of financial development. However, in order to apply this theory to the research questions, further research as carried out by Odedokun (1996), Favara (2001) and Trew (2006) is utilized in this study for development of a composite framework. Specifically, the first research question investigating the relationship between financial development and percapita income growth utilizes a composite theory derived from Favara (2001) and Odedokun (1996), both of which, in turn, are based on King and Levine (1993). Economic growth, as in Favara (2001), is measured in terms of per-capita GDP growth, because it represents a better measure of income levels compared to GDP growth.

The theoretical framework for the second research question to examine the significance of market efficiency in relation to financial development and economic growth is based on the random walk theory as in Fama (1970); the linkage of market efficiency with financial development was first determined by King and Levine (1993a) and further examined by Trew (2006). The chapter opens with a discussion of King and Levine’s analysis, followed by a review of the relationship between financial intermediaries and market efficiency as proposed by Trew.

Next, a composite theoretical framework for an examination of the relationship between financial development and economic growth is presented that is based on King and Levine’s foundational concept as well as Favara (2000) and Odedokun (1996). The chapter concludes by elaborating on aspects of the random walk theory by Fama as they apply to the study of market efficiency.

Key Elements of the King-and-Levine Model

King and Levine (1993a) combined Schumpeter’s (1912) and Knight’s (1951) concepts of innovation and entrepreneurship and formed a model which describes how financial intermediaries arise from the need to finance the innovations or projects of the most suitable entrepreneur. In such a setting, financial intermediaries will rise endogenously as part of a market mechanism for the screening of entrepreneurs and for the financing of intangible, productivity-enhancing investment by credit-worthy entrepreneurs. In the model of King and Levine, countries with better-functioning financial systems will be more successful in evaluating innovations and entrepreneurs. They also will ceteris paribus allocate savings to more efficient and productive endeavors than countries with less-effective financial systems. More efficient resource allocation, in turn, translates into increased productivity and growth through physical capital accumulation, improvements in the types of intangible capital, as described previously, and human capital development.

Financial Intermediaries and Market Efficiency

Trew (2006) expanded on King and Levine’s analysis and proposed a model in which financial intermediaries are based on a firms’ demand for physical capital and human capital. Trew’s study also emphasized the importance of market efficiency for stimulating economic growth.

Composite Theoretical Framework

This section provides the composite theoretical framework for the investigation of the relationship between financial development and economic growth. The basis for estimating the impact of financial development on economic growth used in this study is the principle of conditional convergence as found in Favara (2003). Conditional convergence implies that “the lower the starting level of real per-capita GDP, relative to the long-term or steady-state position, the faster the growth rate”. Therefore, “the convergence is conditional because the steady-state levels of capital and output per worker depend on the savings rate, the population growth rate as well as the position of the production function, all of which are country-specific characteristics”.

Empirical results have also shown that cross-country differences like different government policies and initial stock of human capital are important (Barro R. & Salai-i-Martin X, 2001). Barro and Salai-i-Martin showed an illustration of countries in Africa and Asia that started out at similar stages of development and possessed about the same level of human and natural resources; however their movements to steady state levels were affected by country-specific characteristics.

In the neoclassical growth model, diminishing returns to factor accumulation imply that the economy’s growth rate Yit – Yit -1 decreases with the level of income represented by Yit -1. For a given Yit -1, a permanent increase in Xit or Finit initially raises the growth rate and over time the level of income per capita. Thus, in the long run, an increase in the amount of bank credit has an impact on the level of per-capita output, not on the growth rate of per capita output (Favara, 2003).

Specifically, this study uses the following variables in the vector Finit : Stktrd1 – value of stock traded; MktCap1 – Market Capitalization as a percentage of GDP; Liqli – Liquid Liabilities (M3 as a percentage of GDP) ; Domcred2 – Domestic Credit to private sector as a percentage of GDP and Ins1 – Insurance and Financial Services as a percentage of commercial exports.

The above discussions show that there are several country-specific effects which have to be taken into consideration when determining the impact of financial development on economic growth. Therefore, the panel-data approach used in this study controls for individual influences or effects of the countries including insurance, stock market, and banking development variables in the vector of financial development variables, Finit. These variables are representative of the overall financial superstructure and allow for a more complete description of the relationship between financial development and economic growth.

Theoretical Framework for Market Efficiency—The Random Walk Theory

Financial market efficiency is an important factor in the context of this study, because greater financial efficiency “reduces the disincentive to entrepreneurship and the accumulation of human capital, and therefore increases the rate of technological progress and ultimately the long run growth of a country’s economy”.

Based on Trew’s (2006) finding that confirmed the importance of financial intermediary efficiency in economic growth, this study also investigates financial market efficiency in selected countries, using the random walk theory, as presented by Fama (1970), which has been used extensively in several research studies to determine market efficiency.

The random walk theory states that in an efficient market, prices fully reflect available information. This implies that successive changes or returns are independent and identically distributed. There are three types of tests of market efficiency which include weak form tests, semistrong form tests as well as strong form tests. This study will apply weak form tests to determine if markets are efficient, as this study is based on historical information. Also, other forms of efficiency tests cannot be readily applied to the stock prices of developing countries which may limit the number of countries tested. Several studies including Khaled and Islam (2005) and Hassan and Sultan (2003) have successfully applied weak form tests in developing countries.

The random walk model is stated as F(rj, t+1)/φt) = F(rj, t+11). Where rj is the return on security J, φt is the set of information assumed to be fully reflect in the price at t . This means that the conditional and marginal probability distributions of an independent random variable are identical. Also, the density function f is the same for all t. Assuming the expected return on security J is constant over time, gives E(rj, t+1/φt) = E(rj, t+1). The mean of the distribution of rj, t+1 is independent of the information available at t, φt. The random walk model indicates that the entire distribution is independent of φ t. The serial covariances of a random walk are zero (Fama, 1970).




The Model

Based on the theoretical framework described in the previous chapter, this chapter specifies the model that will be used based on the theoretical foundations discussed previously; it also presents the hypotheses which will be tested in the empirical analysis. The second research question regarding the role of market efficiency in relation to financial development and economic growth does not require any model specification, because tests for efficiency based on the random walk theory are done in terms of Unit Root tests and Autocorrelation Function tests.

To answer the first research question, the following equation is estimated, based on Favara’s (2003) model and the work of Odedokun (1996), and King and Levine (1993a), as discussed earlier.

Yit – Yit -1 = αY1, t-1 +β1Xit + β2 Insit + β3Stit + β4Bnkit + Vit

Vit = μt + Vt + έit

Where Insit represents the insurance sector, Stit is a vector of stock market variables – which include Stktrd1 (value of stock traded) and Mktcap1 (market capitalization over GDP). Bnkit is a vector of banking sector variables – which include Liqli (Liquid Liabilities – M3 as a percentage of GDP) and Domcred2 (Domestic Credit to Private Sector) , Xit is a vector of control variables which include Prod – productivity measure of GDP/Labor force; Extdebt – External Debt; Open1 – Trade Openness ratio of imports and exports over GDP; Infl1 – Inflation; Grsfcap – Gross Fixed Capital Formation and Gov1 – Government Spending. and Yit is the logarithm of real per capita GDP growth.

However, the model used in this study is different from the models of Favara (2003), King and Levine (1993a) and Odedokun (1996) in the following manner: The financial development indicators represented by the vector Finit in Favara’s (2003) analysis included: 1) LLY (Liqli here), which is the “level of liquid liabilities to the banking system and which captures the overall size of the financial sector and its ability to provide broad transaction services”, and 2) PCY (Domcred2 here), which is “the amount of credit issued to the private sector by banks and other financial institutions”. According to Favara (and based on the International Finance Statistics opinion), it is a better indicator of financial development because it only accounts for credit granted to the private sector rather than the government and non-private sector. Therefore, Favara measured financial development using only banking sector indicators.

In this study, the banking system development is measured using Domcred2, the ratio of domestic credit to the private sector (the same as Favara’s PCY), and Liqli, the level of liquid liabilities (M3 as a percentage of GDP). Ins is added as a measure of the presence of the insurance industry for robustness. The insurance industry is a financial intermediary that manages the occurrence of unanticipated events, and its existence signifies a certain level of financial development. Including the insurance sector as a financial development indicator in the regression will determine if mitigating business risks will impact economic growth. Availability of several kinds of insurance products to pool inherent risks associated with entrepreneurship will mitigate disincentive to entrepreneurship. For instance, loss of business, capital goods, inventory as well as liability from worker or consumer injuries, lawsuits, fraud, natural disasters, or foreign government appropriation are examples of some major risks to entrepreneurs.

Testing market efficiency is necessary because, according to the growth theory, greater efficiency increases the rate of technological progress and as such long run growth. Market efficiency will be investigated using the random walk theory as a test for weak form efficiency in order to determine which of the developing countries are found to be efficient in this respect.


Hypothesis 1

The null hypothesis states that financial development has no effect on per-capita GDP growth.

The alternative hypothesis states that financial development has an effect on per-capita GDP growth.

Hypothesis 2a

The null hypothesis states that the effect of financial development on economic growth is lower in Asian countries with more advanced financial superstructures compared to African countries.

The alternative hypothesis states that the effect of financial development on economic growth is higher in Asian countries with more advanced financial superstructures compared to African countries.

Hypothesis 2b

The null hypothesis states that insurance as part of financial development has no impact on per-capita GDP growth.

The alternate hypothesis states that insurance as part of financial development has an impact on per-capita GDP growth.

Hypothesis 3

The null hypothesis states that the financial markets of developing countries are inefficient.

The alternate hypothesis states that the financial markets of developing countries are efficient.


The first research question about the relationship between financial development and economic growth is examined by using panel-data methods including generalized least squares (GLS), generalized method of moments (GMM), and vector auto regression. The GMM panel estimator is more precise than cross-section estimators because it directly controls for any potential distortion of data that could be caused by the exclusion of country-specific effects and the endogeneity of all regressors (Favara, 2003). The second research question about market efficiency is answered by conducting efficiency tests using Unit Root and Autocorrelation Function tests to determine if the variables follow a random walk and are thus efficient.

This analysis of the relationship between financial development and economic growth also includes an assessment of random and fixed effects, with “fixed” implying that the effect does not vary over time, not that it is non-stochastic. The assessment of fixed effects determines whether the unobserved individual effect contains elements that are correlated with the regressors in the model. This distinction is important because the unobserved effects (other variables apart from the financial development and economic growth indicators used in the regressions), which may not be captured because they cannot be measured, may actually either be correlated with the variables used or uncorrelated. If the uncaptured or unobserved variables are correlated with the variables used in the model, the results obtained by using the ordinary least squares method are biased. Regressions cannot capture all variables, thus uncaptured variables are included in the error term.

The main advantage of the random effects approach is that it can be estimated by the ordinary least squares method. Most uncaptured data are actually correlated with the variables used in the regression. For instance, this study does not capture factors such as the location of the financial intermediaries or number of employees in organizations which will be correlated with the financial variables used.

This study applies the Hausman Specification test to assess orthogonality of the random effects and regressors, which is critical, as the dummy-variable approach results in losing degrees of freedom. Hausman’s Specification test, developed in 1978, was based on the idea that “in the hypothesis of no correlation, both ordinary least squares (OLS) in the least squares dummy variable model and generalized least squares (GLS) are consistent, but OLS is inefficient”. Under the alternative, OLS is consistent, while GLS is not. Thus, under the null hypothesis, the two estimates would not be systematically different, and a test is derived from this minor difference.




This chapter presents the empirical analysis for the relationship between financial development and economic growth. The various estimations using Generalized Least Squares Methods (GLS), Generalized Methods of Moments (GMM) which is followed by a presentation of the results of the individual countries for causality, as well as tests for cointegration and efficiency.


Panel Generalized Least Squares Estimate

The first estimate used is a SUR GLS panel-data regression of 17 African and Asian countries for the time period between 1988 and 2007. The SUR GLS provides a better estimate of the panel data compared with the OLS. This is a departure from Favara’s analysis and other empirical work in the growth/financial development; the reason for this is that the panel data regression is estimated by GLS rather than the use of cross-section weights over time where each country has one observation. The measures of stock market development, insurance, and banking sector development enter the regressions separately at first and subsequently together.

The results obtained from estimating the impact of the value of stock traded on per capita GDP growth in the presence of controls like government spending, trade openness, gross fixed capital formation, external debt and inflation are in Table 1:

Table 1GLS Results for the Impact of Stock Markets on Economic Growth



p value














Gov 1






R Squared



Adjusted R2



Durbin Watson



F Statistic




As expected, government spending, trade openness, and investment in fixed capital are positively correlated with economic growth. Trade openness and fixed capital investment are significant. If a variable has a p value of less than 0.05, it is significant and has an impact on economic growth. If it has a positive sign in addition to being significant, then it means that it has a positive impact on economic growth. By contrast, if it is significant and has a negative sign, it has a negative impact on economic growth. Debt levels and inflation are expected to have a negative impact on economic growth. On the other hand, an insignificant variable has no impact on economic growth. Also, inflation and external debt levels are significant and negatively correlated with per-capita GDP growth. In this regression, stock market development stktrd1 is also positively correlated with per-capita GDP growth and significant. The R squared is high 0.819421, suggesting that the model fits the data.

The results obtained from estimating the impact of domestic credit (banking sector variable) on economic growth in the presence of trade openness are shown in the Table 2:

Table 2: GLS Results for the Impact of Domestic Credit to Private Sector on Economic Growth



p value









R Squared



Adjusted R2



Durbin Watson



F Statistic



Using Domcred2 as a proxy for financial development shows that domestic credit has a positive and significant effect on economic growth. The control variable trade openness has the expected positive coefficient and significant influence.

The results obtained from estimating the impact of stock value traded, liquid liability and insurance on economic growth in the presence of gross fixed capital, trade openness and external debt as controls, are shown in Table 3:

Table 3: GLS Results for the Impact of Stock Value Traded, Liquid Liability and Insurance on Economic Growth



p value




















R Squared



Adjusted R2



Durbin Watson



F Statistic




The results obtained from estimating the impact of stock value traded on economic growth in the presence of trade openness as a control in African countries only, are shown in Table 4:

Table 4: GLS Results for the Impact of Stock Value Traded on Economic Growth in Africa



p value








R Squared



Adjusted R2



Durbin Watson



F Statistic





The results obtained from estimating the impact of stock value traded and liquid liability on economic growth using gross fixed capital as a control in Asia, are shown in Table 5:

Table 5: GLS Results for the Impact of Stock Value Traded and Liquid Liability on Economic Growth in Asia



p value











R Squared



Adjusted R2



Durbin Watson



F Statistic




Generalized Method of Moments Estimate

As in Favara (2003), this study runs GMM estimates in panel data using lagged values of th variables as instruments. In a few aspects, however, this study departs from Favara’s methodology. This study focuses on Africa and Asian countries, while Favara used 85 countries from all over the world. Also Favara, uses financial development variables such as liquid liabilities of the financial system and value of loans made by deposit money banks only. In addition to these variables, this study uses stock market development variables, such as market capitalization and the value of stock traded. Furthermore, this study adds a measure for insurance services as a percentage of commercial service exports to determine if it has any significant effect on per-capita growth. Finally, while Favara uses period averages for both her crosscountry regressions and panel regressions, this study relies on the actual data from 1988-2007.

The results obtained from estimating the impact of market capitalization, liquid liability and insurance in the unbalanced panel data for African and Asian countries using trade openness as a control, are shown in Table 6:

Table 6: GMM Results for the Impact of Market Capitalization, Liquid Liability, and Insurance on Economic Growth



p value














R Squared



Adjusted R2



Durbin Watson



J Statistic




In the above unbalanced panel of African and Asia countries, the control variable trade openness is, as expected, positively correlated with per-capita GDP growth and significant. Liquid liability (measure of financial sector development), market capitalization, and insurance services as a percentage of commercial service exports are also positively correlated with percapita GDP growth and significant. A high R squared of 0.96564 suggests that the regression model fits the data.

Efficiency Tests in Selected Developing Countries

This section carries out efficiency tests of stock markets in selected developing countries using returns on dividend yields, price earnings, and stock indices. Fama (1970) defined weak form efficiency tests, in which future prices cannot be predicted from historical prices, have been most widely used for emerging markets. In the semi-strong form efficient markets, the prices adjust to public information quickly, which makes it impossible to obtain excess returns by trading based on this information. The strong form efficient markets prices reflect both private and public information so that it is not possible to earn excess returns.

The weak form efficiency tests applied here—the Autocorrelation Function test and the Unit Root test—are widely used in the research literature. The Autocorrelation Function test examines efficiency by looking at the level of autocorrelation in a time series, measuring the correlation between current and lagged values. If the autocorrelation coefficient is significant, the returns are predictable and the market is not efficient. If the Box Pierce Q Statistic is significant, the series is not stationary, and we can reject the null of the absence of autocorrelation, so the returns are auto-correlated and the market is efficient. The Q test determines if there is white noise in the series. A white noise process has a zero value mean and no serial correlation. The Unit Root test determines whether or not a series follows a random walk and is not stationary.




The current global financial crisis has demonstrated the need to free up credit markets in order to foster economic activity, and developing countries cannot afford to be left behind. This study investigated the role of financial development in this context and has shown that financial sector development, as measured by the banking industry, stock market, and insurance variables, plays a pivotal role for economic growth in developing countries. In particular, efficient allocation of resources and operation of markets are essential to maintain overall financial stability. Also, there has to be a balance between internal policies and external influence for emerging market economies which are not resilient enough to withstand large shocks from exposure to fluctuations or instability in global markets. The Asian financial crises showed the susceptibility of developing countries to market volatility.


The study assesses country specific effects by applying time series methods – Generalized Method of Moments and Generalized Least Squares and also by performing granger causality tests and cointegration tests in individual countries. The time series methods resolve the problem of heterogeneity of slope coefficients across countries. Further, this study has shown that the impact of the financial development differs according to the stage of development as noted in other empirical research and that in the Asian countries included here, financial development has an overall higher impact on economic growth than in the African countries included in this study. Also, the study shows that in Botswana, a higher middle income country, causation flows from economic growth to financial development only, while in most low income and lower middle income countries, there is bi-directional causality between financial development and economic growth. Also, cointegration tests in the individual countries reveal the presence of at least cointegrating vector in most of the countries studied here thus signifying the presence of a long – run relationship between financial development and economic growth in those countries.

Also, the study shows that most of the markets in both Africa and Asia are weak form efficient, namely; Egypt, Kenya, Ghana, Malaysia, Mauritius, Morocco, India, Nigeria, Pakistan, Philippines, South Africa, Singapore and Thailand based on at least one of the weak form efficiency tests – the autocorrelation function and unit root tests on dividend yields and stock prices. However, this was not consistent as only 8 countries were found to be weak form efficient using both dividend yields and stock prices – namely; Egypt, Kenya, Malaysia, Morocco, Nigeria, Pakistan, Singapore and Thailand. This fluctuation in efficiency has the implication of limiting technical progress and long run economic growth. As a result, when resources are not allocated efficiently, it reduces the impact of financial development on economic growth. Also, shocks in financial markets in developed countries are likely to negatively impact developing countries’ markets, if they are in a fragile state.

The global economy is an interdependent system where emerging markets serve as potential investment outlets for saturated domestic markets. It is essential that financial industries (banking, stock markets, insurance) of developing countries be assisted to improve to ensure the continuity of market outlet availability worldwide and therefore overall stability of the global economy. In addition, this study shows that the insurance industry which plays an important role in mitigating risks also facilitates economic growth. Hence, business efforts in developing countries should be geared towards improving the insurance industries in all its ramifications. A solid insurance industry, in turn, will support financial security and business transactions and therefore contribute to the overall objective of economic growth.

Since the study finds bi-directional causality between financial development and economic growth as in other empirical studies such as Demetriades and Hussein (1996), economic policies should be geared towards both improving the financial structure and promoting overall economic development.

Policy Recommendations

This study finds that financial development as represented by the banking sector, stock market, and insurance industry has an impact on economic growth. It also shows that the financial variables in Asian countries have a higher contribution to economic growth compared to African countries. The study further has demonstrated that it is important for financial markets to be efficient in order to be able to contribute to economic growth. These findings clearly show that Africa lags behind Asia and the rest of the world and thus has to take important steps in order to experience sustainable economic growth. Asia as well has to ensure that it maintains an environment that continues to foster economic growth.

The fact remains that Africa is still a relatively young continent; most countries achieved independence only about 50 years ago. Since development implies significant political, social, and economic changes, it requires time, and all developing countries need to go through various phases and steps of development before they can achieve economic stability and growth. In order for this to happen, the political, legal, and economic structures of a country need to be considered as they are all interconnected. The legal structure should facilitate contract enforcement for businesses, and provide security and law enforcement, while the political structure should provide an enabling environment with synergetic socio-economic and physical infrastructures necessary to implement economic policies. The development policies proposed and utilized in the Western world need to be adapted to the African context and institutions need to be in place to support these policies to position the continent as an investment magnet that is poised to make significant progress towards growth and development.

In order to stimulate the economy via investments, government policies should also encourage the development of technology and the utilization of the current pool of underemployed skilled labor in this process. This study has also shown that technological change/efficiency as measured by the Productivity variable has a positive and significant impact on economic growth in Africa and Asia. Technology is and has been the driving force of industrialization across the world and over the centuries, and developing countries cannot afford to ignore this fact. For instance, if foreign investors are unable to view market data and reports of developing countries on the internet due to inadequate technology, they are less likely to invest there. Although developing countries are relatively behind industrialized countries in this respect, they still stand a good chance to learn technological methods thereby expanding productivity to sustain their population and reduce poverty levels.

In addition, the environment itself has to be conducive to attaining and retaining economic growth. This implies the presence of incentives from the government of developing countries to foster growth and development which, in turn, will guarantee that the quest for economic growth in developing countries continues. To create such an environment in African and Asian countries, as this study has shown, the following policies should be pursued:

Expand the insurance sector to reduce business risk

This research study shows the importance of the insurance industry in facilitating economic growth. Insurance was found to have a positive and significant influence on economic growth in both Africa and Asia. Insurance institutions reduce business risk by indemnifying or making the insured party whole in the event of a loss which is particularly important in developing countries where businesses are exposed to a high level of potential political, legal, socioeconomic, environmental, and social hazards.

Examples of such risks include: political instability, which lends itself to the risk of expropriation of assets; lack of basic infrastructure, such as electricity and water supply; environmental hazards, such as famine, drought, pest infestation, pollution; social problems, including collective ownership and assertion of rights especially for land use and tribalism. The presence of a stable and effective insurance industry would serve to ameliorate these risks and encourage business development.

Ensure adequate financial market oversight and regulation to promote efficiency

This study shows that market efficiency is an important catalyst of economic growth. Lack of market efficiency enables speculative trading and leads to market volatility which has adverse macroeconomic effects. Market efficiency and confidence in the markets, in turn, are furthered by effective financial market oversight and regulation. Although stock markets and banking sectors in Africa and Asia have regulating bodies, the effectiveness of these agencies is in need of improvement. Confidence in the banking sector could be facilitated by monitoring banks and establishing prudent financial policies. In addition, the regulating bodies should monitor companies to ensure compliance with established rules, such as producing public annual reports and audited financial statements.

The legislative branch of governments provides an additional avenue for financial sector oversight and regulation. However, inadequate and inefficient legal infrastructure hinders investment in developing countries, as there is fear of violation of property rights. Developing countries also tend to have informal enterprise systems which lend themselves to loopholes and manipulation and contracts may therefore not be enforced appropriately. In addition, formalized processes and stable political institutions provide a great level of sophistication. By contrast, political instability, unrest, and war reduce the development of financial enterprises which is why investors have often shied away from Africa.

Expand financial markets in Africa

This study has shown that the contribution of financial development to economic growth is higher in Asian countries than in African countries, showing the need for African countries to expand their financial markets and offer more competitive products to attract investors. In addition, financial markets need to be expanded to support the new wave of industrialization. Inflation rates need to be monitored, and realistic interest rates need to be offered to the banking sector.

These requirements necessitate a re-engineering of the existing financial systems. There is a need for a reliable banking industry and for security markets to support initial public offerings and the buying and selling of stock, futures, forwards-commodities, and options. There is also a demand for expanded insurance markets. African and Asian developing countries should also aim to increase the number of companies in their stock markets to fuel development in these countries which have large populations.

The economies of the developing countries of Asia and Africa are still evolving although still largely influenced by the vagaries of development. Tremendous difficulties beset all developing economies alike including lack of finance, political instability and corruption. African and Asian countries have to understand the complexity of financial markets in order to introduce effective policies. There are indications that infusion of capital from stable economies are beginning to make a difference. This study sought to compare the developing Asian and African economies. Asia has a more robust economy backed by more stable commodity prices and relative stable political environment and macroeconomic policies. However, there is an ongoing consciousness in African countries as well as global institutions such as the World Bank and IMF on the need to implement change based on lessons learned from failed policies. Future studies should thus investigate the long term impact of these proposed policy changes on the African economy.




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