Financial sector development and economic growth in the East African Community: A panel data analysis

Abstract

This study investigates the relationship between financial sector development and economic growth for the East African community countries over the period 1990 to 2012. Annual macroeconomic data extracted from the World Development Indicators 2013 were utilized in empirical analysis. It utilizes the recently developed panel data unit root tests and cointegration techniques to investigate and estimate the long-run equilibrium relationship between economic growth and financial sector development. The results show that economic growth, financial development and the control variables have unit roots and are cointegrated. Furthermore, conditional on finding cointegration, the study extends the literature by estimating the long-run relationship between financial sector development and economic growth using DOLS. Results show a positive and statistically significant equilibrium relation between financial development and economic growth for all different financial indicators. After establishing that economic growth has a long-run relationship with financial sector development, the study examines the causality link between these two variables. The causality results from the panel VECM based on generalized method of moment estimation provide evidence in favour of a positive bi-directional causality in the long- run, giving credence to both the supply-leading and the demand-following hypothesis. Empirical findings imply that financial depth stimulates growth and, simultaneously, economic growth propels financial development. The expansion of the real sector can significantly influence development of the financial sector. This has a number of important policy implications. First, to gain sustainable economic growth, it is desirable to further undertake financial reforms. Second, to take advantage of the positive interaction between economic growth and financial development, there is need to liberalize the community (EAC) and the financial sector while improving the efficiency of these countries’ financial systems to stimulate saving/investment and, consequently, long-term economic growth. In other words, strategies that promote real sector development in the community (EAC) should also be emphasized. Third For the financial system to clearly promote economic growth, monetary authorities must ensure that banks provide necessary funds to the real sector of the economy. Monetary authorities therefore must ensure that financial intermediaries are properly linked to the real sector of the economy by pursuing appropriate policies that will increase the level of financial intermediation, achieve positive interest rate and increase the level of investment.