Short and long-term impact of trade openness on financial development in Sub-Saharan Africa

Abstract

The finance–openness debate has remained a complex one to date. Some studies argue that trade and capital account openness may promote financial development by enhancing foreign direct and portfolio investments. Other studies argue that financial development may improve trade policy and openness. Yet, one challenge faced by researchers in their quest to unravel the finance–openness debate is the lack of measures of trade openness that take a country's global interaction and interconnectedness into account. Our study addresses this challenge by extending a recently proposed index of trade openness to a panel data setting, and by examining the short- and long-term impact of trade openness on financial development for a panel of 43 sub-Saharan African (SSA) countries over the period 1996 to 2014. We test the performance of the pooled mean group (PMG) estimator against the dynamic fixed-effects (DFE) and the mean group (MG) estimators using the standard Hausman test, in order to ensure that the most appropriate estimator is used to estimate our dynamic, distributed lag model. We use the new measure of openness for the SSA countries to measure their interaction and interconnectedness with each other and find that openness is associated with significant financial development in the long term. In the short term, the effect of openness on financial development is not clear, but the results suggest that it may be negative. We then divide the sample into low- and middle-income countries and find that openness enhances financial development in the low-income countries. By contrast, openness is detrimental to financial development in the middle-income countries. This finding suggests a non-linear relationship between financial development and openness. We take the analysis a step further by examining the role of governance, human capital development, and infrastructural development, as these are major issues in SSA countries. We find that governance, human capital development, and infrastructure development are critical to financial development, particularly in the long term. In other words, these factors help to better explain the openness–finance relationship. Besides, they are important factors that policymakers should take into account when pursuing openness, financial development and a growth agenda.