The Effect of Financial Development on Economic Growth: An Investigation of the Finance -growth Nexus and Institutions in Sub-Saharan Africa

Abstract

This thesis investigates the relationship between financial development and economic growth for SubSaharan Africa, to determine whether policy-makers of the region can use strengthening of the financial sector as an instrument for ensuring long-term economic growth. Further, it investigates whether colonial strategies applied during the countries’ colonization periods can affect the subsequent development of the financial system, and this way determine economic growth. An Autoregressive Distributed Lag Model and a Wald test for Granger causality is used to determine whether two proxies for financial development have predictive power over future values of GDP growth. A case analysis is then used to examine whether colonial strategies applied in Botswana and The Congo have affected the countries’ financial systems and growth patterns, in order to draw broader conclusions for Sub-Saharan Africa’s policy makers seeking to strengthen economic growth. The key finding from the regression analysis is that financial development Granger-causes economic growth in eight out of the ten sample countries. For the remaining two countries, Ethiopia and Kenya, there is no evidence of Granger causality. As such, there is evidence of the supply-leading hypothesis in the majority of the nations. This implies that policy-makers in the eight countries should focus on reforms and legislation that promote financial development, in order to support economic growth. Further analysis shows that even the countries with no immediate Granger-causality should not disregard the importance of financial development in obtaining long-term economic growth. The case study of the two countries revealed that colonial strategies applied have the ability to greatly alter the institutions in place in a country, and that the institutions instated during colonization will have a tendency to remain in the country in vicious or virtuous circles, depending on their nature. These institutions, in turn, greatly affect the incentives of leaders and governments to support and enhance financial development. As there is evidence of the supply-leading hypothesis, colonial strategies have the ability, through their influence on financial development, to affect economic growth. Specifically, inclusive institutions will foster greater financial and economic development, whereas extractive institutions will have the opposite effect. This means that countries, which are still suffering under post-colonial extractive institutions, will have to focus on how to reform and improve their institutions before financial development can be used as an instrument to promote economic growth.