This
research study utilises annual data for ten Sub-Saharan African countries covering
the period 1970 to 2014 to analyse the effects of two very important financial
liberalisation policies namely interest rate liberalisation and capital market
liberalisation, on capital formation and on economic growth. The choice of the
period under investigation and the number of countries in the sample was
determined by the availability of data for the country variables included in
the empirical models. The period under investigation is of particular interest
because it covers the period before financial liberalisation as well as the
period after the implementation of the financial liberalisation policies,
thereby enabling a comparison of the trends in capital formation and economic growth
in the pre and post-financial liberalisation periods1. The
data employed in this research study have been derived from a variety of
sources. However, the main source of data is the World Bank’s World Development
Indicators (2016). Arguably, obtaining accurate and relevant information is
vital to good research. The World Bank’s database provides annual time-series
data on key macroeconomic, financial sector, education and trade indicators
such as GDP, inflation, government expenditure, savings, interest rates, and
capital market indicators by country from as early as 1960 and up to 2014.  The quality of data on macroeconomic and
financial indicators is a concern for some African countries characterised by
weak data collection mechanisms. However, data contained in the World Bank’s
dataset contains the most complete and reliable time series for macroeconomic
and financial indicators for Sub-Saharan African countries that are currently
available. The empirical analysis is carried out using data from the World
Bank, knowing fully well that it is the most reliable dataset for analysing the
impact of financial liberalisation policies, which is an issue of key policy
relevance. Some data have also been obtained from the IMF’s International
Financial Statistics as a basis for comparison and for missing years in the
World Bank’s dataset.

 

 

According to the financial liberalisation hypothesis
proposed by McKinnon (1973) and Shaw (1973), removing restrictions on interest
rates will bring about an increase in real interest rates, which will cause an
improvement in financial savings and encourage capital formation, leading to
improved economic growth levels. The financial liberalisation hypothesis
suggests that when real interest rates rise due to liberalisation, individuals,
households and firms will be encouraged to save more as the reward for
financial savings increases and this increase in financial savings means that
there will be more finance for capital formation. Warman and Thirwall (1994)
maintain that capital formation may be affected by real interest rates in two
opposite directions. On one hand, interest rates may have a positive effect on
capital formation through its effect on financial savings and on availability
of credit supply to the private sector. On the other hand, real interest rates
may have a negative effect on capital formation (assuming the credit supply is
held constant) if the interest rate is used as the indicator for the price of
credit.

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In the financial liberalisation literature, it is quite
common to find that various researchers have used different indicators as
proxies for financial liberalisation. For instance, some studies use a
financial liberalisation index that captures the change in several financial
liberalisation policies including interest rate liberalisation and is
constructed using principal components analysis as an indicator of financial
liberalisation (see for instance, Bandiera et al 2000; Achy 2005; and Owusu and
Odhiambo, 2014). However, a problem with this approach is that the effect of
the interest rate liberalisation policy alone is difficult to ascertain since the
index captures the change in other financial liberalisation policies as well. Some
other studies have used real interest rates as well as a dummy variable to
allow for structural breaks due to interest rate liberalisation as the interest
rate liberalisation indicators. For instance, some studies (see for instance Shrestha
and Chowdhury, 2007) use the real deposit interest rate and an interest rate
liberalisation dummy variable as an indicator of the policy when investigating
the effect of interest rate liberalisation on savings; and use the real lending
interest rate and an interest rate liberalisation dummy variable as an
indicator of the policy while investigating the effect of interest rate
liberalisation on capital formation. Furthermore, some studies (see Oshikoya,
1992; Fry, 1997; and Odhiambo, 2009) use the real deposit rate of interest,
which is the rate of interest minus inflation rate, compounded continuously as
an indicator of interest rate liberalisation while investigating the effect of
interest rate liberalisation on savings. The authors assert that the channel
for this effect is that higher real deposit interest rates increase the
availability of domestic credit to finance investment (capital formation) which
will consequently improve economic growth levels.

 

On the other hand, some other studies (see for instance
Eregha, 2010; Frimpong and Marbuah, 2010; and Attefah and Enning, 2016) use the
real lending interest rate, i.e., the user cost of capital or price of credit
as an indicator for interest rate liberalisation while analysing the effects of
the policy on investment. In relation to using the real lending interest rate
as an indicator of capital market liberalisation, Warman and Thirwall (1994)
maintain that although, the inverse association between real lending rates and
capital formation may appear inexplicable when considering the channel through
which real interest rates affect capital formation as explained by the
financial liberalisation hypothesis, this negative relationship between real
lending interest rate and capital formation can be reconciled with theory. The
authors assert that in the absence of highly fluctuating spreads between real
lending and deposit interest rates, the real deposit interest rate can be
considered a reasonable proxy for real lending interest rates in a regression
model. However, this does not hold true for the countries being examined in
this research thesis due to the high and unstable spread between deposit
interest rates and lending interest rates.

 

For
the purpose of this research, interest rate liberalisation is measured by real
interest rates. For investigating the effect of interest rate liberalisation on
capital formation, the real lending interest rate is used as the indicator of
interest rate liberalisation in line with Shrestha and Chowdhury (2007); and
Eregha (2010). The idea is that real lending interest rates may have a negative
effect on capital formation if it is used as an indicator for the price of
credit. On the other hand, for investigating the effects of interest rate
liberalisation on economic growth, the real deposit interest rate is used as an
indicator of interest rate liberalisation in line with Oshikoya (1992); Seck
and El Nil (1993); Fry (1997); and Odhiambo (2009). Deposit interest rate is
defined as the rate of return to savers paid by deposit-taking financial
institutions. The real deposit rate of interest is the deposit interest rate
adjusted for inflation, continuously compounded. McKinnon (1973) and Shaw
(1973) argue that positive real deposit rates encourage financial savings
mobilisation. Higher savings encourages capital formation, which in turn
promotes economic growth.

 

In
order to ascertain whether capital market liberalisation is beneficial to an
economy, the effects of the policy on economic growth should be examined.
Capital market liberalisation impacts on the development of the capital market
and on capital formation and these seem to be the two interrelated channels
through which capital market liberalisation improves economic growth. Capital
market development through liberalisation may improve capital formation.
Consequently, an increase in capital market development and capital formation
should improve the growth rate of the economy. To provide a better
understanding of the mechanism behind the effect of capital market
liberalisation, the focus of this thesis is on capital market development,
which is the key channel through which capital market liberalisation can boost
capital formation and economic growth.

 

In
the financial liberalisation literature, several indicators have been used to
measure capital market development due to liberalisation. For instance, Levine
and Zervos (1998) use measures of capital market size, liquidity, volatility
and integration with world capital markets in their investigation on the impact
of capital markets and banks on economic growth. The authors use the ratio of
market capitalization to GDP as a measure of the size of the capital market. To
measure capital market liquidity, the authors use two indicators- the turnover ratio,
which is the value of the trades of domestic shares on domestic exchanges
divided by the market capitalization; and the value traded which equals the
value of trades of domestic shares on domestic exchanges divided by GDP. Beck
et al (1999) also outline three important capital market indicators that
measure the size (market capitalisation), level of activity (value traded) and
efficiency (stock turnover) of capital markets. Furthermore, Beck and Levine
(2004) use the turnover ratio measurement of capital market liquidity, which
equals the value of the trades of shares on domestic exchanges divided by the
total value of listed shares. According to the authors, this indicator measures
the trading volume of the capital market relative to its size.

 

The
measures suggested by Beck et al (1999) are adopted for the purpose of this
research. Market capitalisation of listed companies (percentage of GDP, denoted
by SMC) is used as an indicator of
the size of the capital market in line with Levine and Zervos (1998a, b),
Naceur et al (2007), and Kinuthia and Etyang (2014). The market capitalisation
measure is one of the most widely used quantitative measures of capital market
development and is defined as the share price multiplied by the number of
shares outstanding (World Bank, 2016). Theory suggests that the size of the
capital market is positively correlated with risk diversification and capital
formation.

 

To
measure capital market liquidity, total value of stocks traded (percentage of
GDP, denoted by STOCK) is used in
line with Levine and Zervos (1998a, b) and Beck et al (1999). The variable is
defined as the total value of
shares traded during the period relative to GDP (World Bank, 2016). Levine and
Zervos (1998) point out that since capital markets are forward looking; the total
value of stocks variable has a shortcoming. If capital markets foresee enormous
corporate profits, the prices of stocks will rise in the present time. This
price increase would lead to a rise in the value of stock transactions and
therefore raise the STOCK. In such
case, the liquidity indicator would rise without a rise in the number of
transactions or a fall in transaction costs undoubtedly. However, this price
effect would affect the market capitalization to GDP ratio as well. According
to the authors, one way to measure the impact of the price effect is to include
both market capitalisation and value of stocks traded variables in the
regression model. The World Bank (2015) supports this assertion by stating that
the value of stocks traded variable complements the market capitalisation variable
by showing whether the size of the market corresponds to the level of trading
activities. If the value of stocks traded variable remains significantly
correlated with the dependent variable while controlling for market
capitalisation of listed companies, then the price effect is not dominating the
relationship between value of stocks traded and the dependent variable. Theory
suggests that liquidity in the capital market acts as an incentive to invest
and provides more efficient allocation of resources (Levine, 1991). Both the market
capitalisation and value of stocks traded variables are expected to have a
positive relationship with the dependent variables as theory suggests that more
efficient capital markets can foster better resource allocation and improve
economic growth levels.

 

 

In this thesis, capital formation is measured by Gross Capital Formation (%
of GDP), denoted by CF. According to
the World Bank (2017), Gross capital formation (formerly gross domestic
investment) consists of outlays on additions to the fixed assets of the economy
plus net changes in the level of inventories. Fixed assets include land
improvements (fences, ditches, drains, and so on); plant, machinery, and
equipment purchases; and the construction of roads, railways, and the like,
including schools, offices, hospitals, private residential dwellings, and
commercial and industrial buildings. Inventories are stocks of goods held by
firms to meet temporary or unexpected fluctuations in production or sales, and
“work in progress.” Gross capital formation has been used extensively
in the financial liberalisation literature as a measure of capital formation
(see Kraay, 1998; Fowowe, 2008; Chaudhry et al, 2012 and Misati and Nyamongo,
2012).

 

Economic Growth (GDPCAP):

Real GDP per capita is the
measure of economic growth in this research study. The World Bank (2017)
defines GDP per capita as gross domestic product divided by the mid-year
population. Gross domestic product is the sum of gross value added by all
domestic producers in the economy plus any product taxes and less any subsidies
not included in the product value. The real GDP per capita is a measure of the
total economic output of an economy divided by the population and adjusted for
inflation. It is calculated
without making deductions for depreciation of fabricated assets or for
depletion and degradation of natural resources. The data are in
current US dollars. Real GDP per capita has been used extensively in the
financial liberalisation literature as an indicator of economic growth (see for
instance Rosseau and Wachtel, 1998; Klein, 2005; La Porta et al, 2006; N’Zue
(2006); Naceur et al, 2007; Shahbaz et al, 2008; Kinuthia and Etyang, 2014).

 

 

 

 

5.5.2 The Explanatory Variables

Real Deposit Interest Rate (RDR):

The real deposit rate is used as an indicator of interest rate
liberalisation in this research and this measure has been
used extensively in the financial liberalisation literature (see for instance,
Seck and El Nil, 1993; Fry, 1997; and and Odhiambo, 2011). Deposit interest
rate is defined as the rate of return to savers paid by deposit-taking
financial institutions. The real deposit rate of interest is the deposit
interest rate adjusted for inflation as measured by the GDP deflator (World
Bank, 2017). Advocates of financial liberalisation maintain that positive real
deposit rates encourage financial savings mobilisation, which in turn
encourages capital formation and ultimately improves economic growth.

 

 

Real Lending Interest
Rate
(RLR)

Real lending rate,
denoted by RLR represents the cost of borrowing or the price of credit and is a
measure of interest rate liberalisation in this research. Economic theory
posits that capital formation is inversely related to the cost of borrowing.
The main explanation for the inverse relationship between capital formation and
lending interest rates is that as lending interest rates rise, the opportunity
cost of investment or capital formation also rises. This means that an increase
in lending interest rates may cause an increase in the return on funds
deposited in an account which is interest bearing, or from making a loan, which
reduces the attractiveness of investment relative to lending. Jorgenson (1963)
asserts that higher lending rates will lead to reduction in capital formation
through increased capital costs. Eregha (2010) also shows that fluctuations in
lending interest rates as well as high lending interest rates have a negative
impact on capital formation. According to the World Bank (2015), real interest rate is the lending interest rate adjusted
for inflation as measured by the GDP deflator. In line with
Shrestha and Chowdhury (2007), real lending rate, denoted by RLR is the real cost of funds to the
borrower i.e., the investor or the real yield to the lender.

 

Gross
Domestic Savings
(GDS)

Household and corporate
savings provide a flow of funds into the financial sector, which means that
funds are available for investment. Gross domestic savings (% of GDP), denoted
by GDS captures the level of savings
in the economy and is included in the capital econometric models in line with
Garcia and Lin (1999).  According to the
World Bank (2017), gross domestic
savings are calculated as GDP less final consumption expenditure (total
consumption).

 

Domestic Credit to the Private Sector (FDEV):

Domestic credit to private sector (percentage of GDP) according to the
World Bank (2017) refers to financial resources provided to the private sector
by financial corporations, such as through loans, purchases of non-equity
securities, and trade credits and other accounts receivable, that establish a
claim for repayment. The financial corporations include monetary authorities
and deposit money banks, as well as other financial corporations where data are
available (including corporations that do not accept transferable deposits but
do incur such liabilities as time and savings deposits). Examples of other
financial corporations are finance and leasing companies, money lenders,
insurance corporations, pension funds, and foreign exchange companies. FDEV has been used extensively in the
literature as a traditional measure of a country’s level of financial
development or depth (see Levine and Zervos (1998); Laoyza et al (2000);
Bonfiglioli (2004); Fowowe (2008); and Chaudhry et al (2012)).

 

Trade Liberalisation (TRADE)

The World Bank (2017)
defines trade liberalisation as the
sum of exports and imports of goods and services measured as a share of gross
domestic product. The TRADE variable is included in the regression models to
control for the potential effects of trade liberalisation on growth in line
with Bonfiglioli (2005), Haung and Temple (2005), and Chaudhry et al (2012);
who argue that trade may affect the efficiency of an economy through several
channels such as specialisation according to comparative advantage, access to
larger markets with more product variety and increased competition and provide
evidence that trade liberalisation or openness is a very important determinant
of economic growth.

 

General Government Final Consumption Expenditure (GOV)

General government final consumption expenditure (formerly general
government consumption) to GDP ratio includes all government current
expenditures for purchases of goods and services (including compensation of
employees). It also includes most expenditures on national defense and
security, but excludes government military expenditures that are part of
government capital formation (World Bank, 2017). GOV is included as one of the explanatory variables for the reason
that in developing countries where the government plays an important role in
the economy, the general government consumption expenditure, if directed
efficiently and effectively, could be a driving force for other productive
activities. Several studies in the financial liberalisation literature have
also included this variable in their empirical models to control for potential
effects of government consumption expenditure (see for instance De Gregorio and
Guidotti, 1995; Quinn, 1997; Beck and Levine, 2004; Bonfiglioli, 2004; Bekaert
et al, 2005; and Naceur et al, 2007).

 

Market Capitalization of Listed Companies (SMC)

To measure the size of
the capital market, this thesis uses Market Capitalization of listed companies
(percentage of GDP), represented by SMC.
Market capitalisation of listed companies (percentage of GDP) is one of the
most widely used quantitative measures of capital market development (see for
instance Levine and Zervos, 1998; Beck et al, 1999; Arestis et al, 2001; Edison
et al, 2002; Achy, 2003; and Chaudhry et al, 2012).  It is defined as the share price multiplied by
the number of shares outstanding. It is assumed that the ability of a country’s
capital market to mobilise capital and to diversify financial risks is
associated with the relative size of the capital market. In other words, theory
suggests that the size of the stock market is positively correlated with risk
diversification and capital formation.

 

Total Value of Stocks
Traded (STOCK).

Total Value of Stocks
Traded (percentage of GDP) is used in this research to measure capital market
liquidity in line with Levine and Zervos (1998), Achy (2003) and Naceur et al
(2007). According to the World Bank (2017), STOCK refers to the total value of shares traded during the
period relative to GDP. Levine and Zervos (1998) point out that since capital
markets are forward looking; the STOCK
variable has a shortcoming. If capital markets foresee enormous corporate
profits, the prices of stocks will rise in the present time, according to
Levine and Zervos (1998). This price increase would lead to a rise in the value
of stock transactions and therefore raise the STOCK. In such case, the liquidity indicator would rise without a
rise in the number of transactions or a fall in transaction costs undoubtedly.
However, this price effect would affect the market capitalization to GDP ratio
as well. According to the authors, one way to measure the impact of the price
effect is to include both market capitalisation of listed companies (SMC) and the value of stocks traded (STOCK) in the regression model. The
World Bank (2017) supports this assertion by stating that the STOCK variable complements the SMC variable by showing whether the size
of the market is matched by trading. If the STOCK
variable remains significantly correlated with the dependent variable while
controlling for SMC, then the price
effect is not dominating the relationship between STOCK and the dependent variable. Theory suggests that liquidity in
the capital market acts as an incentive to invest and provides more efficient
allocation of resources (Levine, 1991; and Naceur et al, 2007).

 

Inflation Rate (INFL)

According to the World
Bank (2017), inflation as measured
by the consumer price index reflects the annual percentage change in the cost
to the average consumer of acquiring a basket of goods and services that may be
fixed or changed at specified intervals, such as yearly. INFL is included in the regression to control for the effect of
macroeconomic stability in line with Boyd et al (2001), Bonfiglioli (2005) and
Naceur et al (2007). Both theoretical and empirical evidence have shown that
unstable or high inflation rates could lead to uncertainty about the future
profitability of investment projects. Hence, high and unstable inflation rate
has detrimental effects on capital formation and economic growth. De Gregorio
(1993) highlights the fact that higher inflation rates impacts negatively on
labour supply and consequently reduces economic growth. Bittencourt (2006)
agrees with De Gregorio’s assertion and states that “high rates of inflation
reduce investment spending and a substitution from labour supply to leisure,
which directly and negatively affects growth and capital accumulation. Where
there are missing values in the CPI inflation rate, the GDP deflator (annual
percentage) which is inflation as measured by the annual growth rate of the GDP
implicit deflator is used.