Full Project - EFFECT OF FINANCIAL DEEPENING ON THE GROWTH OF NIGERIA ECONOMY

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Full Project – EFFECT OF FINANCIAL DEEPENING ON THE GROWTH OF NIGERIA ECONOMY

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CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY:

In recent years, many studies have examined the link between financial deepening and economic development as well as the link between financial development and poverty reduction via economic growth from both micro and macro perspectives, example, Levine (2004), Fitzgerald (2008), Nzotta and Okereke (2009), etc. In this study we depart from the finance-growth nexus, but still from the macro angle to see if there is a direct relationship between financial deepening and economic growth. We will look at how welfare is linked to financial sector deepening and the existing transmission mechanisms. Few will doubt that income growth through access to financial services leads to improvement in people‘s lives. Increased income allows people to enhance their living standards and escape from extreme poverty. From the works of Claessen and Feijen (2006), without a developed financial sector, for example, domestic savers and foreign investors would be more hesitant to part with their money to otherwise sound investments, resulting in lower economic output as measured by GDP and household welfare. They sressed that a well-developed financial system enables firms to expand production and provides households with the ability to obtain essential assets like a house, insure against income shocks, start a company, receive cheaper remittances, and enjoy a pension when they retire.

As such, the financial sector is an engine of economic growth and household welfare. Most literature confirmed that financial market plays a vital role in the process of economic growth and development by facilitating savings and channeling funds from savers to investors, Nzotta and Okereke (2009). Financial intermediation of growth leads to financial deepening, which refers to the greater financial resource mobilization in the formal financial sector and the ease in liquidity constraints of banks and enlargement of funds available to finance projects, Fisher (1933).

Direct measurement of how well the financial sector performs each of its functions is difficult. As Ndebbio (2004) observed, it is not possible to observe directly the quality and quantity of the monitoring services performed by a bank when it extends a loan, at least not for a large country like Nigeria. Hence, researchers use proxies to measure financial deepening. Typically used indicators of financial deepening are ratio of MS2 (money) to GDP, ratio of private credit extended by commercial banks to GDP, and other financial assets.

As Ndebbio (2004) observed, only countries with high per capita incomes can experience rapid growth in financial assets. Such countries are none other than the developed countries. But what is crucial here is what constitutes the financial assets that wealth-holders must have as a result of high per capita income. Only when we can identify those financial assets will we be able to approximate financial deepening adequately. In short, and for our purpose, we borrow a lift from Ndebbio (2004) in asserting that financial deepening simply means an increase in the supply of financial assets in the economy. Therefore, the sum of all the measures of financial assets gives us the approximate size of financial deepening. That means that the widest range of such assets as broad money, liabilities of non-bank financial intermediaries, treasury bills, value of shares in the stock market, money market funds, etc., will have to be included in the measure of financial deepening. To simply pick the ratio of private sector credit to gross domestic product (GDP), as done in this study, is because of lack of data on other measures of financial assets likely to adequately approximate financial deepening in most Sub-Saharan African countries.

In his study, Ndebbio (2004) noted that if the increase in the supply of financial assets is small, it means that financial deepening in the economy is most likely to be shallow; but if the ratio is big, it means that financial deepening is likely to be high. He further went on to stressed that developed economies are characterized by high financial deepening, meaning that the financial sector in such countries has had significant growth and improvement, which has, in turn, led to the growth and development of the entire economy.

One common problem affecting the growth of development economies is the issue of ―financial shallowness‖ which is seen by many economists as an outcome of the adoption of inappropriate financial policy. In the 1980‘s, Nigeria alongside other African countries experienced widespread financial liberalization, interest rate deregulation, the entry of new banks and the likes, with the intention to deepen the financial sector but ended up producing financial openness without much financial depth, Collier and Gunning (1999). They further stressed that the legacy of financial liberalization in these countries was the establishment of weak banking organizations that were unable to open up the opportunities created by liberalization. Reflecting this in Nigeria saw the country being relegated to having less financial depth than other developing areas. As a result, banks were vulnerable to systemic crisis and the systemic risks in the country high. Thus, the Nigerian banking system was evidently limited in its resources mobilization with an adverse effect on the economy which hit more on the poor since they are the most vulnerable and hence financial deepening.

This prompted the Central Bank of Nigeria (CBN) to come up with new banking reform policies in 2005 in a bid to strengthen and increase the financial assets of banks. Banking reforms are part of financial sector reforms, and financial sector reforms are propelled by the need to deepen the financial sector and reposition it for growth to become integrated into the global financial architecture and evolve a banking sector that is consistent with regional integration requirement, savings mobilization and international best practices, Nnanna et al (2004).The recent banking sector reforms which experienced consolidation of banking institutions affected the level of financial deepening in the country.

Consolidation of banks has been the major reform policy instrument being adopted recently in correcting deficiencies in the financial sector. It ushered in other reform policies that followed including the bail-out of eight deposit money banks with huge non-performing loans in 2009.

A review of the financial deepening indicators show that, the depth of the financial sector as measured by the ratio of MS2 to GDP even though has been fluctuating but has increased more than previous years. For the period of the study the ratio at the end of 2009 stood at 43.4 per cent and 38.9 per cent for 2010. Bank financing of the economy measured by the ratio of private sector credit to GDP stood at 33.2 per cent though lower than that 41.1 per cent of 2009. The intermediation efficiency indicator as measured by the ratio of currency outside banks to broad money supply was 9.4 per cent compared with 8.6 per cent at end of December, 2009. The size of the banking system relative to the size of the economy indicated by the ratio of deposit money banks assets to GDP, declined from 69.6 per cent at end of December 2009 to 58.8 per cent in 2010, (CBN 2010 annual report). Below is a chart showing the ratio of deposit banks assets to GDP and a graph showing the ratio of broad money (MS2) to GDP, private sector credit to GDP.

However, welfare concerns in Nigeria were primarily related to its general lack of development and the effects on the society of the economic stringency of the 1980s and 1990s. Given the steady population growth and the decline in incomes since 1980, it was difficult not to conclude that for the mass of the population at the lower income level, there was profound economic growth loss, Metz (2011). Studies have shown that household per capita expenditure can provide insight into economic welfare or the living conditions of the population, Akerele and Adewuyi (2011). The assessment of economic growth in the country becomes necessary as the financial sector deepens. Households are important players in the financial sector, both as savers and borrowers. Financial sector deepening ought to bring direct economic growth improvement in an economy by increasing returns on and reducing risks of the invested savings of the populace particularly low income earners, since savings enable poor households to smoothen their consumption. And by increasing consumption, the demand for goods and services increases, thus, stimulating more agricultural and industrial production leading to more jobs and higher economic growth.

It is incontrovertible, that one of the developmental challenges facing the country is how to reduce the high level of poverty prevailing among her population. Given the current rate of population and economic growth and the resultant fluctuations in private per capita consumption expenditure in the country, the preoccupation does not come by surprise. Indeed, the economy is expected to grow by a minimum of 7.0 per cent per annum, if the millennium development goal of reducing the level of poverty by half is to be achieved by 2015.

The poor in the country need to be empowered, for many Nigerians; access to even a small amount of credit can make a considerable difference in their ability to earn a self reliant income. Thus, as finance deepens in the country it is necessary to ascertain if the CBN and other financial regulators have maintained a good balancing between regulating the financial sector effectively for the determinants of financial deepening to work effectively at all levels of the economy and providing a good environment that will promote sufficient and widely accessible financial services with less systemic crises. Studies have shown that, several indicators of economic growth has fallen dramatically in the aftermath of a disappointing financial sector reforms, severely affecting the most vulnerable and poorest people and resulting in a substantial welfare loss, Honohan (2004b), Jalilian and Kirkpatrick (2001). Although, high and sustainable economic growth is central to improvement of economic growth, studies by Asenso-Okyere et al (1993) revealed that promotion of efficient, sufficient and widely accessible financial services (rural banking inclusive) is a key to achieving pro-poor growth and welfare gains.

Financial deepening can affect economic growth in various ways and in many outcomes. The three aspects of welfare which could be affected by financial deepening, include; vulnerability, investment and consumption smoothening, Gloede and Rungruxsirivorn (2010). Studies have shown that it is not obvious whether financial deepening reduces or increases vulnerability which is the probability to stay or fall below the poverty line. According to Gloede and Rungruxsirivorn (2010), a higher amount of credit increases also the risk of fallen which is well known from corporate finance under the leverage ratio. Especially in the presence of the current financial crisis one might be tempted to argue in such a way. In the other hand, there are channels where financial deepening can improve economic growth. These channels result from the intermediation function of the financial sector, but the most important channel through which financial sector deepening leads to direct economic growth improvement is increased access to financial services.

Access to financial services-such as savings- through bank branch distribution can help firms and households cope with economic shocks, Claessens and Feijen (2006). Most literature has shown that firms‘ and households‘ access to financial services rises with financial deepening, Beck et al (2006). A well functioning financial system creates strong incentives for investment in order to increase productivity. Foster trade and business-linkages in order to facilitate technology transfer and improved resources used. Provide broad access to assets and markets in order to build up the asset base of the poor as well as increase the returns to such assets. Remittances from abroad and domestic transfers are important source of income for the poor, thus, reducing vulnerability. Where financial sector deepening leads to lower costs, the poor will benefit from more secure and rapid transfers, and easier access to transferred funds. Also, they enable the poor to draw down accumulated savings and borrow to invest in income-enhancing assets and start micro enterprises, thus, wider access to financial services, generates employment which increase incomes and welfare gains. And enabling the poor to save in a secure place, the provision of bank accounts and insurance allows the poor to establish a buffer against shocks thus, reducing vulnerability and increase the ability of individual and households to access basic services like health and education and thus having a more direct welfare benefit impact, DFID (2004).

The transmission mechanism works through – the expansion of bank branches especially in rural areas which will in addition provide support services such as provision of training and capacity building.

But there are skeptical views on whether financial sector deepening can lead to a broadening of access to finance services with the resultant economic growth benefits. Most literature confirms that financial development policies do not serve the poor. Greenwood and Jovanovic (1990), show that improvement in the financial system may not automatically lead to improvement in income distribution. They argue that there is an inverted U-shaped relationship between income inequality and financial deepening. Thus, the study restricts its analysis of the link between financial deepening and economic growth using financial accessibility indicators such as, bank branch expansion, savings rate and cost of acquiring credit. Based on the foregoing discussion, the study is designed to answer this critical question; are there proportionate economic growth benefits for all income levels in an economy from financial reforms that strengthen the economy generally?

1.2 STATEMENT OF PROBLEM:

Although a large body of studies have pointed out that financial deepening produces faster average growth with welfare implications, Levine (1997, 2005) and Beck et al (2000), Honohan (2004a), (2004b), Jalilian and KirkPatrick (2005), Beck et al (2007), Odhiambo (2009) etc. Researchers have not yet determined whether the economic growth gains of financial deepening benefit the whole population equally or whether it disproportionally benefits the rich or the poor. If financial deepening intensifies income inequality, this income distribution effect will hamper the beneficial effects of financial deepening on the poor.

Thus, theory predicts conflicting predictions on the economic growth implications of financial deepening. Scholars like Mendoza et al (2007) and others are of the opinion that if financial reform policies that produce financial deepening are not accompanied with proper and adequate regulatory framework, sound fiscal and macroeconomic stability, then financial deepening can have sizeable consequences on the distribution of wealth and adverse welfare effects.

They stressed that developing countries financial regulators fail to strike an appropriate balance between regulating the sector effectively for the determinants of financial deepening to be effective and providing a good environment for financial sector deepening, Levine et al (2000), Holden and Prokopenko (2001), DFID (2004). In addition some other studies followed a similar reasoning that the indicators of financial deepening that worked for some developed and developing countries may not work for other countries. According to these studies while there are large benefits from a well functioning financial system, financial sector deepening also brings risk which may hit more on the poor, Banerjee (2009), Zingales (2009). In the opinion of Mendoza et al (2007), even though financial deepening leads to a significant increase in wealth inequality in most developed countries, the economic growth consequences are still positive for these countries. By contrast, in countries with growing financial markets, the economic growth consequences are negative and the distribution of wealth does not change much.

However, recent studies on finance deepening in Nigeria especially on recent deepening efforts have concentrated more on its impact on economic growth, Ndebbio (2004), Nnanna (2004) and Nzotta and Okereke (2009. These studies imply that once there is growth it could have an impact on the whole economy. But economists are of the view that the imperative of growth for welfare improvement does not mean that growth is all that matters, Fields (2001). Access to financial services is crucial for welfare improvement, Jalilian and Kirkpatrick (2001), Asenso-okere et al (1993).

Though it is true that in recent times, bank intermediation in formal banking has improved in terms of speed of response to customers‘ needs and quality of service rendered in Nigeria as a result of the efforts geared towards the deepening of the financial system, Sanusi (2011), the same is not available to people in the rural areas. Bank branch location is heavily biased towards the urban areas with good infrastructures that can fetch good returns.

In addition, despite the improvements in the banking industry, they are still punctuated with cases of under-performance of their role. A significant proportion of credit transactions in Nigeria still take place in the informal markets, despite governments efforts aimed at channeling credit to the productive sector through the deposit money banks, Nnanna (2004). According to Soludo (2008), banking services are available to about 40 percent of the population and more than 60 percent of the poor do not have access to formal finance and are forced to rely on a narrow range of some risky and expensive informal services which constraints their ability to participate fully in markets to increase their income and contribute to economic growth. The business information provider (Business Hallmark 6^th-12^th June,2011), revealed that two years after the CBN launched the last bank reforms with N620 billion injected into eight banks, N1.7 trillion toxic assets bought off, the economy is still prostrate, banks not lending and poverty ravaging the land.

Moreover, at the period of this research, banks are pegging the minimum cash balance for savings account at N2000 and N5000 in some cases and lending practices curtailed with emphasis on risk minimization. Moreover, there is still high cost of capital (high interest rates) and existing anomalies in lending for investment in agricultural production which is one of the sectors expected to act as a catalyst towards a general economic growth improvemnet, Aderibigbe (2005). These developments may continue to increase the lack of financial accessibility of the low income earners and confine them to low-return capital intensive activities, so that despite being more risk averse they are less diversify. Already, there have been profound fluctuations in the private consumption expenditure in Nigeria, Odior and Banuso (2011), implying that private per capita consumption expenditure, a measure of economic growth will follow the same pattern. There is then a concern issue that the recent banking sector reform-led financial deepening in Nigeria will have a similar effect with that of deregulation/financial liberalization period which made commercial bank accounts inaccessible to most Nigerians, Ayida, (2007), generating severe welfare implications, which manifest indirectly through their relation with macroeconomic policies, raising arguments whether financial sector deepening in Nigeria is having a disproportionate economic growth beneficial impact or broadening access to financial services.

Thus, it is not clear whether the recent financial deepening processes in Nigeria will have any economic growth improvement. In view of this, there is the need to empirically investigate the level of deepening that has occurred in Nigeria and the nature of the impact on the economic growth. As a result, the following research questions become imperative.

1.3 RESEARCH QUESTION

What is the level of financial deepening that has occurred in Nigeria from 2005 to 2010.
What are the determinants of financial deepening in Nigeria?
Does financial deepening leads to economic growth improvement in Nigeria?

1.4 OBJECTIVE OF THE STUDY: The main objective of this study is to answer one critical question; are there economic growth benefits from financial reform policies that strengthen the economy? More specifically, the study intends;

To investigate the structural changes in the pre and post-consolidation periods in Nigeria.
To analyze the factors determining the level of financial deepening in Nigeria.
To determine the nature of impact financial deepening has on economic growth in Nigeria.

1.5 HYPOTHESIS OF THE STUDY

Ho: There are no structural changes in the level of financial deepening in the Country after 2005.
Ho: Macro-economic variables do not determine the level of financial deepening in Nigeria.
Ho: Financial deepening has no direct impact on economic growth in Nigeria.

1.6 POLICY RELEVANCE:

The wake-up call for financial sector reform should be critically examined especially its impact in all levels of the economy. This study is important at this level of economic development when efforts are being made to reposition the financial sector to enable it play key roles in economic development at all levels of income. It will also help policy makers and government to know the structural changes that have taken place with the reform policies on ground in Nigeria. It will also provide useful information that will be relevance in formulating a more targeted financial reform policy that will be beneficial to the poor. More so, the study would further add to the existing literature on the link between finance and economic growth.

1.7 THE SCOPE OF THE STUDY:

This country-specific study covers the periods 1975 to 2010. The choice is based on data availability and to have enough observations for time series analysis.

1.8 SOURCE OF DATA AND ECONOMETRIC SOFTWARE:

The source of data will be from the CBN – statistical bulletin and the econometric softwares to be used are Stata-10 and e-view.

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Full Project – EFFECT OF FINANCIAL DEEPENING ON THE GROWTH OF NIGERIA ECONOMY

Full Project – EFFECT OF FINANCIAL DEEPENING ON THE GROWTH OF NIGERIA ECONOMY

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