Specification of the Theoretical Mode!

In this section, the Pagano endogenous growth model adopted by (Ghatak and Siddiki, 1997) in the study of financial liberalization and èndogenous growth in Bangladesh is applied. The model incorporates human capital (HC) since financial liberalization increases the quality of HC by financing education to financially constrained households (Gregorio 1996). Endogenous growth theory (NGT) predicts that HC is one of the main engin es of economie growth- a common feature in LDCs. The Pagano model predicts that FL increases: (i) savings and investment, (ii) the proportion of saving that goes to investment and (iii) the efficiency of investment by improving competitiveness, availability of information regarding the investment projects. Using the AK version of endogenous growth model, Pagano postulates that the above three factors in turn increase the rate of economie growth. The extended model predicts that there is an additional efficiency gained caused by the accumulation of HC resulting from FL. To explain the model, it is assumed that aggregate output is a linear function of the aggregate capital stock:

Yt = AKt ⁽¹⁾ Where Yt is aggregate output, A represents the marginal productivity of capital, K¹ is the aggregate capital stock and t is time. This production function represents a competitive economy with the presence of externality or spillover effects. Bach firm faces constant retum to scale, but the economy as a whole shows increasing retums to scale with respect to Kt. Suppose the population is stationary and the economy produces a single good which can be consumed or invested. Also assuming that the rate of depreciation of investment is zero and gross investments:

It = Kt+I-Kt ⁽²⁾

Kt+I=lt+Kt

This is a one-sector economy with no government and external sectors. Assume that financial institutions channel a proportion f of saving,

S~o

to investment,

I~o

i.e. the proportion (1-f) of saving that is lost in the process of intermediation. Therefore the capital market equilibrium condition is:

jSt= It ⁽³⁾

Using equations (1) and (2), the growth rate at time t+l can be written as follows:

Yt + ₁ _ Yt = AK.t + 1 - AK.t = Kt + 1 -Kt = Kt + 1 _ 1

gt+l = Yt AK.t Kt Kt

lt+Kt lt Ait gt ⁺ 1

=

- - - 1 = -

=

-Kt Kt AKt

(4)

Where gt+I is the growth rate ofincome at time t+I Define the steady state as.

a period where A remain constant . In this case, there will be a state in which output and capital per worker are no longer changing, known as a steady state, we set:

Substituting equation (3) and (4):

g=A-=Afs lt Yt

from equation (S),the steady growth rate (g) can be written as follows:

lng =ln A+ lns + lnf

(5)

(6) for g to be positive it follows that A> 0

where g

=

Afs. Taking the logarithms of equation (6) distinguishes three channels: f, s, and "A", through which Financial liberalization could influence growth. The transmission mechanisms are explained below.

a) CHANNELING SAVING TO INVESTMENT

Financial institutions collect private savings and direct them into investment. Fis cannot generally transform all savings into investment since transaction costs and profits absorb sorne of the funds. A portion (I-f) ofsaving remains out ofinvestment. FLin the form of the expansion of bank branches and licencing of new banks, as well as a reduction in reserve requirements boost competition among Fis, which reduces their commissions and fees, the difference between lending and borrowing rates and hence there is a rise in f.

The structural equation for f can be written as follows:

(7) Infi

= f

o + jtlnFDR +ut

where FDrt represents a vector of government financial policies which help or hinder financial development and competition. The variable ft represents factor which enhances financial development. Such outcomes are positive when policies reduce reserve requirements, restrictions on new banks or branches and hence boost the financial markets, vice versa.

b) IMPROVING THE ALLOCATION ON INVESTMENT

The Fis plays a second role by improving the efficiency of funds by channeling them towards more productive projects and by promoting education and training. The Fis increase the efficiency of investment in the following ways: firstly, Fis provide information on more productive opportunities. Secondly, Fis help in channeling funds towards more risky but productive projects by risk sharing and portfolio diversification Paul (1992). The Fis also help in providing funds towards long run and productive projects and reduce premature liquidation by fulfilling unexpected future liquidity demands Diamonds and Dybvig (1983). Finally, Fis can facilitate education and training of financially constrained young agents by providing study loan. Renee the second equation can be written as follows:

InA= Ao + A1In(!::::. y)+ .fuinHC +Ut, with A1. fu > 0

!:::.K

(8)

where the difference operators Y!::::./ !:::.K is the ratio of incrementai capital (GDP) to output ratio (ICOR), u

1 is an identical and independently distributed error term, HC is human capital. FL improves the efficiency of investment, which is reflected in the IOCR. FL improves the quality of HC. Both effects increase "A". According to the financial liberalization paradigm as postulated by Mckim10n (1973) and Shaw (1973), a more liberalized financial system will induce an increase in investment and therefore promote economie growth. The endogenous growth model predicts that there is an additional efficiency gained caused by the accumulation of human capital (HC) resulting from financialliberalization.

C) EFFECTS ON THE RATE OF SAVING

As predicted by the Mckinnon and Shaw hypothesis, FL in the form of an increase in real deposit rates to induce savings in financial assets instead of investing in inflation hedges. Thus, FL increases private savings, i.e. bank deposits will in turn increase credit allocation, investment and economie growth. The behavioural equation for the saving ratio can be as follows:

In s

=

S

0+ S1 In DRst+Ut,with S1 >0

(9)

Where So and S1 are initial and marginal savings, DR51 represents real deposit rates.

The policy prescription by Mckinnon and Shaw for financially repressed economy is to raise institutional interest rates orto reduce the rate of inflation. The concept of financial liberalization emphasizes the removal of ceiling on interest rates and other contrais on financial intermediaries, so that real deposit rates are kept positive to attract more savmgs.

Substituting equations ( 7, 8, and 9) we have the equation below.

t.,.Y

In g = ao +at ln(-)+ a2ln HC + ŒJln FD + a4DR + u;

t.,.k

we obtain the following reduced form equation:

(10)

where u

1 is an identical and independent distributed error term, with other variables as defined above. Equation (1 0) predicts that economie growth is positive! y affected by the incrementai capital-output ratios ([.,.y ) represented by investment (INV), human capital

f'.,.K

(HC), real deposit rates (DR) and a policy vector which boosts or deters financial deepening (FD).

In the madel we include private sector credit and current account balance to determine the effects of these variables in the Nigerian economy.

PCGR

=

f(INVGDP, FINDEPGDP,PSCRGDP, REALDEP, CUABGDP, HCAP)

Incrementai capital /output ratio ( !'::.y ) represented by investment i'::.K

Broad money (M2/GDP) as financial deepening is an indicator which measures the impact of financialliberalization

Private sector credit as a percentage of GDP captures the share of credit channeled to the private sector

Real deposit rate (d-r{ where d= nomina112 months deposit rate and 1te = expected inflation)

Current account balance by GDP (measures foreign savings) Human capital measured by the gross secondary school enrolment ratio

The above relation can be rewritten in a logarithmic formas follows:

lnPCGRt = a

0+ a

11n(INVGDP)t +

a2ln(FJNDEP~DP)t

+a31n(PSCRGDP)t + a which is presurned to satisfy the least square assumptions of homoscedasticity, serial independence and normal distribution.

1

Il,

4.2.2 Expia nation of Variables

THE PER CAPITA GDP (PCGR)

A host of empirical studies have been carried out and the general findings support the Mckinnon and Shaw hypothesis that a more liberalized financial regimes are associated with faster economie growth (see Levine 1997, Fry, 1995). Modem economie growth is associated with arise in the rate of per capita incarne due primarily to improvement in the quality of input which led to greater efficiency or increase in the productivity per unit of input. The level of real incarne per capita is used as a measure of the standard of living and the relative level of development of a country. The use of GDP per capita 1s convenient because it is a measurable quantity and the required data are in existence.

INVESTMENT

The public sector has been the major engine of growth of the economy until recently when it divested in sorne major industrial and commercial concem. Given the wide different indicators faced by private and public agents, there is an emerging appreciation that private investment is in general more efficient and more productive than public investment. As a result, there has been an incre.ased recognition that private and public plays different role in the growth process. According to the financial liberalization paradigm as postulated by Mckinnon and Shaw, a more liberalized financial system will induce an increase in saving and investment and therefore promote economie growth.

Private investment in Nigeria has been marred by high lending rates and difficult operating environment coupled with poor infrastructural facilities such as electricity, telecommunication, poor road network, social insecurity and the lack of commitment by the policy makers to fashion out an enduring industrial blue print for the country. The indigenous entrepreneurs must initiate industrial action to attract foreign investors.

PRIV ATE SECTOR CREDIT (PSCR)

The ratio of the private sector credit to GDP can be used as another proxy for financial development (Odedokun, 1989). It is expected to increase in response to improved priee

signaling, represented primarily by the establishment of positive real interest rates. It is assumed that credit provided to the private sector generates increases in investment and productivity to a rouch larger extent than do credit to the public sector. Liberalization would also channel funds towards financing the more productive projects. According to this view, an increase in real interest rates following Iiberalization should encourage saving and expand the supply of credit available to domestic investors, thereby increasing economie growth.

FINDEP (M2/GDP)

Financial deepening, the growth of financial assets faster than the growth of non financial assets, involves the monetization of an economy by increasing use of financial intermediation by savers and investors, and the rise of specialized financial institutions.

Formai institutions gradually absorbed or displace informai finance. Savings are increasingly held in financial forms rather than in non financial assets. According to the World Bank (1989:27), financial deepening can be viewed as an increase in the stock of financial assets. Implicitly in the Gauley-Shaw-Mckinnon model, there must be capital accumulation for financial deepening to subsist. The M2/GDP ratio captures the overall size of the formai financial intermediary sector. This is a typical indicator of financial depth (King and Levine 1993a). There is none the Iess sorne positive interrelationship between financial resources mobilization and financial deepening on one hand and between financial deepening and the growth and development of the economy.

The paucity of financial instrument in the Nigerian economy has contributed to the underdeveloped money and capital markets. Secondly, Nigeria as a cash economy; non financial asset grows faster than financial asset. However, with the introduction of the long term Bonds and Savings certificates the financial market will rebound. The broad money as a measure of financial deepening increased to 32.3 percent in 1986; however, it declined in the subsequent years. The fall may not be unconnected with the financial sector distress which resulted in a temporal Joss of confidence by the depositors. When

compared with the pre-reform period (1970-1985), money supply increased from 21.9 percent to 22.4 percent during the liberalization period.

REAL DEPOSIT RATE (REALDEP)

According to the Mckinnon - Shaw hypothesis the real interest rate must be positive to induce savings and the beneficiai effects of financial liberalization. The real interest rate '

captures the effects of financial reform and deepening. It is measured as nominal interest rate on time deposits less the rate of inflation. In Nigeria, the real deposit rate has been negative in most part of the study period. The indication is that the economy is still repressed. The margin between the real deposit and lending rates continued to widen which is an antithesis to the financialliberalization paradigm. (Fig.4)

FIGURE 4: REAL DEPOSIT AND LENDING RATES

REAL INTEREST RATE IN THE NIGERIAN ECONOMY (1970-2002)

YEAR

i--+-

REAL DEPOSIT RA TE __,_REAL LENDING RA TEl

The graph shows that the Nigerian economy for most part was repressed. In a financially repressed economy the real deposit and lending rates are negative. This development is

noticed in the early liberalization period (1986), however, the margin widened in the mid and later period of the programme. This trend is an indication of po licy misalignment and contrary to the expected decline in the cost of intermediation due to competition and positive real interest rates.

CURRENT ACCOUNT BALANCE (FOREIGN SAVINGS)

The current account balance surplus implies that a country 1s accumulating net international assets. Conversely, a current account deficit implies that it is running down its foreign assets or accumulating liabilities Seck and EL NIL (1993). The extemal current account balance is defined as export of goods and services minus import of goods and services plus net factor income from abroad plus net current transfer from abroad.

This can be expressed thus: (Saving- Investment gap = current account balance = foreign saving). The current account balance as a ratio ofGDP has been in deficit for most of the study periods. It declined from 22.5 in 1986 to 5.7 in 1994 and recorded a marginal increase of 1.4 in 1999. The implication of this occurrence is a perpetuation of capital flight in the economy.

HUMAN CAPITAL (HCAP)

Endogenous growth theory (NGT) predicts that human capital (HC) is one of the main engines of economie growth - a common feature in LDCs. The extended model predicts that there is an additional efficiency gained caused by the accumulation of HC resulting from financial liberalization. From our data, the gross secondary school enrolment ratio as a measure of human capital increased marginally by 4.4 percentage points during the reformed period. However, despite this achievement the country still suffers from human capital underdevelopment when compared with the level of illiteracy rate. This could be attributable to high cost of education, worsening unemployment, high demands by the school authorities which most parents can ill afford.

4.3 ESTIMATION PROCEDURES

4.3.1 Unit Root Test

The study will establish the arder of integration between the variables in the madel and by verifying whether each series has a unit root using the Phillips Perron test (PP). The different tests are achieved assuming the presence of a unit root.

Ho : Unit Root (non stationary) H1 : No Unit Root (stationary)

If the Phillips Perron statistic is greater than McKinnon's critical values then we do not reject Ho and we consider the variable as non stationary, if not it is stationary.

\

Consequently, the co integration test is undertaken to establish the long run relationship between financial variables and economie growth. It is worthy to note that even if a set of variable is non-stationary, there exists a linear combination of the set that is stationary.

There is co integration when although a set of variable might vary with time, they rn ove together over time and require the same level of differencing to achieve stationarity.

In a bivariate case, there is co integration when the ordinary !east square (OLS) estimator yields an estimate of the slope coefficient which is consistent estimator of the long-run relationship between levels in the two variables with no need to resort to either lagging or differencing. In the case of a multivariate variable, co integration theory as demonstrated in Johansen (1985), it is not necessary that all the variables in a multivariate regression to have the same arder of integrability to achieve cointegration. Such a regression equation would then form a co integrating equation and valid inference about the long-run can be drawn from its estimation (Worrell and Scantlebury-Maynard 1997, pp Q33).

Leon (1987) has found that in the multivariate context, cointegration is attainable though the original series have different arder of integrability.

4.3.2 The Cointegration Technique

This technique postulates a long-run relationship among a group of time series variables.

Variables are said to be cointegrated if they are affected by the same long-run influences. Non-stationary variables may drift in the short- run though eventually converged towards equilibrium in the long-run. Cointegration is an econometrie technique which allows the econometrician to separate long-run equilibrium relationship put forward by economie theory in general from short run dynamics.

The adoption of this procedure was in response to difficulties encountered by many researchers many of whom assumed previously that time series data were all stationary.

This was however proved otherwise. Prior to the global economie recession of the earl y 1970s, the world economie conditions in both developed and developing countries was stable. The inflation rate was 1ow while income growth, savings, investment fluctuated marginally. In such a stable environment, it was possible to treat non-stationary series as if they were stationary. The aftermath of the economie crises of the mid 1970s made it clear that the economie world was not as stationary as researchers thought and this found expression in large deviations in economie aggregates. Thus the need for appropriate time series became manifest.

It was for this reason that most well founded econometrie relationships began to show defective signs to the disappointment and bewilderment of most researchers. The estimated models failed to predict outcome with maximum precision. In response to this problem, a more comprehensive treatment of the time-series characteristics in the econometrie model was found- the notion of COINTERGATION (Hendry, 1986) and Granger (1986). The above explains why non-stationarity has been a major phenomenon of the 1980s and 1990s. Consequent! y, any time-series econometrie study which fails to take into account the cointegration test will suffer a set back. Time series are said to be stationary when they have a constant mean, constant variance and covariance which are independent oftime. This can be established by a unit root test.

4.3.4 Stability Test

In order to determine the stability of the model, we adopt the CUSUM and CUSUM of squares tests. The stability of the coefficient of a model plays an important role when we try to understand the economie phenomenon and to make forecast. If a model is unstable it will result in an unreliable estimate. The E-view econometrie package will be used to determine the stability of the model. If the curve does not eut the corridor, the ECM model is deemed structurally stable. The limit of the boundary is the stability zone. If there is intersection between the curves outside the corridor, we have instability.

All the equations in the study were run using Ordinary Least Squares (OLS). For each of the functions, we estimated four equations as follows: One for unit root using the Philips-Perron test, another for co integration model using Johansen test, the error correction model is estimated to determine the short and the long run dynamic of the model while the Granger Causality test would be applied to test for causality between economie growth and financialliberalization.

The Engle-Granger representation theo rem establishes that if a set of variables is

cointegrated, it will have an error correction mechanism that will ensure an adjustment process in which the error in the long-run relationship does not grow over time. Thus, meaning that the short-run dynamics relationship will converge with the long-run dynamics through an error correction mechanism.

4.4 SOURCES AND LIMITATIONS OF THE DATA

This study covers the period from 1970 - 2002 using secondary data from the World

This study covers the period from 1970 - 2002 using secondary data from the World

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