Financial development and economic growth: evidence from southern African development community countries

Abstract

This paper examines causality between financial development and economic growth for 10 Southern African Development Community (SADC) countries for the period 1994 to 2013. We employed the vector autoregression (VAR) approach to conduct Granger causality tests to determine the direction of causality relationship between financial development and economic growth. Before conducting Granger causality tests, we performed the following prerequisite tests: unit root tests to test for data stationarity, and cointegration tests to examine short-and long-run relationships between financial development and economic growth. Our results provide evidence of two of the three main views on the link between financial development and economic growth: the supply leading theory (financial development causes economic growth or positive causality); and the demand following response (economic growth causes financial development or reverse causality). Specifically, our empirical results suggest that when broad money (BM) and direct credit (DC) are used as measures of financial development, there is evidence of the demand following response for 50% and 60% of the sample, respectively. Results also showed that financial development caused economic growth in 20% and 30% of the sample when BM and DC are used to measure financial development, respectively. No evidence of causality was recorded for 30% and 10% of the countries when BM and DC were used to measure financial development, respectively. In light of the dominance of reverse causality and the presence of no causality for some countries, we conclude that financial liberalization failed to increase economic growth for 80% and 70% of the sample when broad money and domestic credit were used to measure financial development, respectively. The differences in the direction of causality across SADC countries could be due to a wide variation in the policies governing the financial sector, colonial origin and other institutional factors which shape the laws governing how banks and other financial institutions operate in different countries. Our findings suggest different policy routes for countries within the SADC region with regard to how they can grow their economies. Specifically, countries for which the reverse causality result holds should direct more resources towards stimulating economic growth through channels other than financial development in order to develop their financial sectors. On the other hand, we recommend that countries for which the financial development leading to economic growth result holds should channel more of their resources towards growing their financial sectors in order to drive economic growth.