FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH

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CHAPTER 2 THE FINANCE-GROWTH NEXUS: THEORY AND EVIDENCE

INTRODUCTION

The aim of this chapter is to discuss theoretical and empirical literature on finance, production and economic growth. It attempts to explain the factors of production in general and then focuses on the empirical evidence of the impact of credit on output.
Over the past several years, the role of financial development in economic growth has been a focus of attention and has attracted a large number of theoretical and empirical studies to investigate the relationship between the two (e.g. Demirgüç-Kunt
& Malsimovic, 1998; Goldsmith, 1969; King and Levine, 1993; McKinnon, 1973; Rajan and Zingales, 1998; Shaw, 1973). In addition to the growing body of literature on the determinants of economic growth, this chapter attempts to explore the following question: “Is finance a precondition for growth?” At a micro level, particularly in developing countries, some researchers, such as Rioja and Valev (2004), who studied low-income countries such as Cameroon, India, Philippines and Sudan; Odhiambo (2007), who studied Tanzania; and Wolde-Rufael (2009), who studied Kenya, argue that it is still not clear whether (1) finance plays a significant role as a factor of economic growth, or (2) whether it is economic growth that stimulates the growth of the financial sector. Accordingly, the finance-growth nexus still remains an inconclusive empirical issue. This chapter reviews literature on this debate.

FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH: THEORETICAL FRAMEWORK

It is generally accepted that financial markets and institutions channel savings of surplus units to deficit units, and in so doing foster investment activities. As to whether this function of financial markets and institutions can foster economic growth, remains an unresolved empirical question. The first hint that financial development can lead to economic growth was put forward by Schumpeter (1911), who observed that the financial system can be used to channel resources into the most productive use. However, a few decades later, Robinson (1952) argued that financial development does not lead to economic growth, but rather follows it. In other words, the demand for financial services increases as economies grow.
Economic theory predicts that finance promotes economic growth through four different channels or mechanisms. First, intermediaries ameliorate the information asymmetry problem (Blackburn, Bose and Capasso, 2005; Blackburn and Hung, 1998; Bose and Cothren, 1996; Diamond, 1984; Morales, 2003). Second, they increase the efficiency of investments (Greenwood and Jovanovic, 1990). Third, they enhance investment productivity (Saint-Paul, 1992) by providing liquidity, hence allowing capital accumulation (Bencivenga and Smith, 1991). Fourth, they allow human capital formation (De Gregorio and Kim, 2000).
Diamond (1984) emphasises the ability of financial intermediaries to monitor investment projects cost-effectively, thereby increasing entrepreneurs‟ access to funds. In the absence of financial intermediaries, monitoring costs would be too large as to discourage credit to entrepreneurs. Bose and Cothren (1996) demonstrate that this attribute of financial intermediaries promotes resources allocation that leads to economic growth.
Through the design of incentive-compatible loan contracts and post-loan monitoring activities, Blackburn and Hung (1998) demonstrate that financial intermediaries contribute to economic growth by managing the moral hazard problem. Morales (2003) observes that monitoring increases project productivity because entrepreneurs are forced to ensure the success of their projects so that they are able to pay back loans. There would be a loss of societal resources in the absence of monitoring by intermediaries (Blackburn et al., 2005).
Bencivenga and Smith (1991) model the finance-growth nexus by looking at a financial system dominated by intermediaries, where society owns either liquid or illiquid assets. They observe that although liquid assets could be less productive compared to illiquid assets, society prefers liquid assets in order to respond quickly to emergencies. Financial intermediaries resolve this liquidity mismatch because they attract deposits from a large number of depositors and create loans. These loans are used to finance long-term investment projects while at the same time allowing society access to liquid funds. It is this process that promotes capital formation, leading to economic growth.
According to Saint-Paul (1992), when entrepreneurs utilise a productive, specialised technology that poses more risk, they can diversify the risk through financial markets. Greenwood and Jovanovic (1990) and later Greenwood and Smith (1997) opined that financial intermediation promotes growth because it allows a higher rate of return to be earned on capital, and growth in turn provides the means to implement costly financial structures.
De Gregorio and Kim (2000) observe that financial intermediaries enhance human capital formation by allowing individuals to access credit to finance their education, which enables them to specialise in skills useful in economic development. Without intermediaries, individuals would prefer low-skill jobs, because they cannot afford tuition fees for high-skill education.
Notwithstanding general consensus on the role of finance in the economy, scholars differ on the causes of financial development. Some believe the financial system is exogenously developed by government (e.g. Bencivenga and Smith 1991), while others believe that it is endogenously developed. Hence, there are disagreements on the direction of causality between finance and economic growth.
There are at least four views in the literature regarding the relationship between financial development and economic growth. The four views are that (1) financial development causes economic growth (Adu, Marbuah and Mensah, 2013; Arestis, Demetriades and Luintel, 2001; Dawson, 2008), (2) economic growth leads to financial development (Blanco, 2009; Chakraborty, 2008; Lucas, 1988; Odhiambo, 2010), (3) economic growth and financial development are complimentary or bidirectional (De la Fuente and Marín, 1996; Greenwood and Jovanovic, 1990; Khan, 2001; Saint-Paul, 1992) and (4) there is no causality running between economic growth and financial development at all (Kar, Nazhoglu and Agir, 2011).
The first hypothesis, commonly known as „supply-leading‟, posits that financial development is a necessary precondition for economic growth (see King and Levine, 1993; Levine and Zevros, 1998; Patrick, 1966; Wolde-Rufael, 2009:1142). Therefore, following from this view, finance leads and causality flows from financial development to economic growth. In other words, in the supply-leading phenomenon, the financial sector precedes and induces real growth by channelling scarce resources from small savers to large investors according to the relative rate of return (Estrada, Park and Kamayandi, 2010:43; Odhiambo, 2010:208; Stammer, 1972:324; Yay & Oktayer, 2009:56). According to Patrick (1966:23), supply-leading finance is “the creation of financial institutions and instruments in advance of demand for them, in an effort to stimulate economic growth”.
The second hypothesis, referred to as the „demand-following‟ phenomenon, is that financial development follows economic growth. In other words, economic growth causes financial markets as well as credit markets to grow and develop. The term „demand-following‟ refers to the creation of modern financial institutions, financial assets and liabilities and related financial services in response to the demand for these services by investors and savers in the real economy (Patrick, 1966:23). In this case, financial development is seen as a consequence of economic development. Contrary to the first view, in this case, the development of the real sector is considered to be more important than the financial sector. According to the demand-following view, lack of financial growth indicates low demand for financial services. Using data for 74 economies over the period 1975–2005, Hartmann, Herwartz and Walle (2012) found that economic growth promotes financial development but not vice versa, ruling out the popular view that finance drives growth. Their finding is robust even after grouping samples into different income groups.
In the third hypothesis, the causal relationship between financial development and economic growth is bidirectional. Both financial development and economic development are seen to Granger-cause each other. Saint-Paul (1992) demonstrates that when innovation increases, so does the demand for financial services, which in turn leads to financial development. De la Fuente and Marín (1996) also make the same prediction that growth in the real sector increases demand for financial services, which in turn raises the return on information-processing activities by financial intermediaries, and eventually leads to growth of the financial sector. Greenwood and Jovanovic (1990) observe that growth boosts finance and finance accelerates growth. Khan (2001) observes that growth enhances financial development by raising borrowers‟ collateralisable net worth and finance promotes growth by increasing return on investment. Odeniran and Udeaja (2010:91) tested the competing finance-growth nexus hypothesis using Granger causality tests in a VAR framework over the period 1960–2009. Their empirical results confirmed bidirectional causality between some of the proxies of financial development and the economic growth variable. Specifically, they observed that in Nigeria the measures of financial development Granger-cause output. At the same time, net domestic credit was observed to be equally driven by growth in output, thus indicating bidirectional causality. These results confirmed earlier studies by Acaravci, Ozturk and Acaravci (2009:11), whose findings show that for the panels of 24 sub-Saharan African countries, there is a bidirectional causal relationship between real GDP per capita and the domestic credit provided by the banking sector.
The fourth hypothesis does not see a causal relationship between financial development and economic growth. In other words, financial development and economic growth each have factors peculiar to them that stimulate their growth. There is scant empirical evidence supporting this hypothesis. For instance, Mihalca‟s (2007:724) work in Romania showed that there is no relationship between financial development and economic growth. One of the reasons could be that the weakness of the financial development has encouraged the inefficient allocation of savings and led to a negative growth in the real GDP (inverse relationship).
In a cross-country study, Kar et al. (2011) demonstrated that there is no clear consensus on the direction of causality between finance and growth in the MENA countries. The results of the causal relationship differed according to country-specific characteristics. While in some MENA countries, finance was observed to cause growth (also supported by Aghion, Howitt and Mayer-Foulkes, 2005), for example in Israel and Morocco, none of the financial development indicators causes economic growth in Algeria, Egypt, Iran and Sudan. The authors concluded that an increase in income level leads to the supply of credit to the private sector, as the causality runs from economic growth to financial development in 9 out of 15 countries.

CHAPTER 1  INTRODUCTION AND BACKGROUND
1.1 INTRODUCTION
1.2 AN OVERVIEW OF THE AGRICULTURAL SECTOR IN SOUTH AFRICA3
1.3 SOME HISTORICAL FACTS ABOUT SOUTH AFRICAN AGRICULTURE 6
1.4 OVERVIEW OF THE FINANCIAL SECTOR IN SOUTH AFRICA
1.5 BACKGROUND TO THE RESEARCH PROBLEM
1.6 RESEARCH OBJECTIVES
1.7 JUSTIFICATION OF THE STUDY
CHAPTER 2  THE FINANCE-GROWTH NEXUS: THEORY AND EVIDENCE
2.1 INTRODUCTION
2.2 FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH: THEORETICAL FRAMEWORK
2.3 FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH: EMPIRICAL EVIDENCE
CHAPTER 3  BANK FINANCE AND AGRICULTURAL GROWTH: EMPIRICAL EVIDENCE
3.1 INTRODUCTION
3.2 FINANCE AND GROWTH IN THE AGRICULTURAL SECTOR
3.3 CREDIT AS A FACTOR OF PRODUCTION
3.4 NON-FINANCIAL FACTORS THAT AFFECT AGRICULTURAL OUTPUT
CHAPTER 4  METHODOLOGICAL ISSUES REVIEW
4.1 INTRODUCTION
4.2 CONCEPTUAL ISSUES IN MEASURING AGRICULTURAL OUTPUT
4.3 METHODOLOGICAL APPROACHES
4.4 DEFINITION OF VARIABLES
CHAPTER 5  RESEARCH DESIGN AND STATISTICAL METHODS
5.1 INTRODUCTION
5.2 RESEARCH DESIGN
5.3 DATA SOURCES AND COLLECTION METHODS
5.4 METHODOLOGICAL LIMITATIONS
5.5 METHODS OF SECONDARY DATA ANALYSIS s
5.6 ANALYSIS OF SURVEY DATA
CHAPTER 6  HYPOTHESIS TESTING AND EMPIRICAL RESULTS: SECONDARY DATA
6.1 INTRODUCTION
6.2 REVIEW OF CREDIT TRENDS
6.3 DESCRIPTIVE STATISTICS AND CORRELATION ANALYSIS
6.4 UNIT ROOT TESTS
6.5 ESTIMATION OF EMPIRICAL RESULTS: COINTEGRATION TEST
6.6 MODEL ESTIMATION FOR THE LONG-RUN RELATIONSHIP
6.7 THE ERROR CORRECTION MODEL (ECM)
6.8 GRANGER CAUSALITY TEST
6.9 VARIANCE DECOMPOSITION
6.10 IMPULSE RESPONSES
CHAPTER 7  HYPOTHESES TESTING AND EMPIRICAL RESULTS: SURVEY DATA
7.1 INTRODUCTION
7.2 VALIDITY AND RELIABILITY TESTS
7.3 INTERPRETATION OF FACTOR LOADINGS
7.4 RELIABILITY TEST: CRONBACH‟S ALPHA
7.5 DESCRIPTIVE STATISTICS
7.6 CORRELATION ANALYSIS
7.7 HYPOTHESES TESTING
7.8 TESTING HYPOTHESIS 2
7.9 TESTING HYPOTHESIS 3
7.10 TESTING HYPOTHESIS 4
7.11 STRUCTURAL EQUATION MODELLING
7.12 MODEL 2: DEMAND FOR CREDIT
7.13 MODEL 3: ACCESS TO CREDIT BY SMALLHOLDER FARMERS
7.14 MODEL 4: IMPACT OF CAPITAL STRUCTURE ON FARM PERFORMANCE
7.15 MODEL 5: PROPOSED MODEL FOR AGRICULTURAL OUTPUT
CHAPTER 8  DISCUSSION OF RESULTS, CONCLUSION AND RECOMMENDATIONS
8.1 INTRODUCTION
8.2 DISCUSSION OF EMPIRICAL RESULTS
8.3 SURVEY RESULTS
8.4 CONTRIBUTION OF THE STUDY
8.5 CONCLUSION
8.6 LIMITATIONS OF THE STUDY
8.7 RECOMMENDATIONS AND SUGGESTIONS FOR FURTHER STUDY
BIBLIOGRAPHY
LIST OF APPENDICES
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