Posted by: waleolusi | June 2, 2013


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The McKinnon-Shaw Hypothesis has been subjected to several empirical studies, each examining the hypothesis in different contexts. This paper employed empirical approach to reappraise the impact of financial liberalization (as hypothesized by McKinnon and Shaw) and its inherent financial crisis on economic growth in Nigeria between 1980 and 2010. A review of works show that the finance-growth nexus is positive in several economies, but inconclusive and at times negative in some developing economies, while financial crisis has a negative impact on output growth and tends to penalize the economy for adopting the liberalization policies. In this work, Error Correction Model is adopted to empirically verify the Nigerian case using data from CBN statistical bulletin. The regression result reveal that financial development indices show positive but insignificant impact on output growth (except the coefficient of investment which is positive and significant), an indication that shows the shallowness of the financial system, while the financial crisis index shows that, financial crisis has both negative and significant impact on economic growth in Nigeria.   


Generally, economic  literature has implied that a more efficient financial system will provide “better” financial services that would impact positively on the real growth rate of the economy (Akpan 2004), this notion have been supported by the controversial  McKinnon (1973) and Shaw (1973) hypothesis. The McKinnon-Shaw hypothesis argues that suppressive regulations in the financial markets lead to financial repression, distorting incentives of savers and investors in an economy. Regulations such as deposit interest rate ceiling, minimum/maximum lending rates, quantity restrictions on lending, etc. cause real interest rates to be negative and unstable especially in the presence of high inflation in an economy.

Eggoh (2008) posit that, although King and Levine (1993), Beck et al. (2000), then Levine et al. (2000) confirm the endogenous growth models results and show a positive association between financial development and economic growth, however, some authors assert that the relationship between the two variables would not be existent or even negative. One of arguments advanced by these authors is that the instability linked to financial development penalizes economic growth and destroy the positive effects associated to financial development.

According to Barry (2004), countries without financial markets cannot have financial crisis, one conceivable response to the problem of financial instability is to suppress domestic financial markets and transactions, thereby eliminating the problem of banking and financial crises, and international financial markets and transactions, thereby eliminating the problem of currency and exchange rate crises. Banks that are not permitted to borrow and lend will not fail; more generally, if banks are very tightly regulated the scope for risk taking by their managers will be limited. Similarly, if strict capital and exchange controls limit purchases and sales of foreign exchange, then there will be limited scope for speculating against a currency.

In contrast to the above however, evidence abound in economic literature that regulation does lead to negative impact on the amount of domestic savings and thus capital formation, which retards economic growth and development (financial repression). McKinnon (1973) and  Shaw (1973) advocates for the removal of many of these restrictions, that is, financial liberalization to, among others, establish positive real rates on deposits and loans as a growth promoting policy in the third world.  hence, the popular but also controversial  McKinnon-Shaw hypothesis therefore establish a positive link between financial depth, defined broadly as the level of development of financial markets, and economic growth, which  is in one sense fairly obvious. (McKinnon, 1973; Shaw, 1973).

However, the extent to which liberalization policies can induce growth does not come without its own cost in form of seasonal, cyclical or random financial crisis, which penalizes economic growth and destroy the positive effects associated to financial development (Eggoh, 2008), Kaminsky and Reinhart (1998) and Demirgüc-kunt and Detragiache (1988) confirm this assertion insofar as they found that financial instability would be positively associated with financial development, in Eggoh (2008), the works of Guillaumont and Kpodar (2004), and Loayza and Rancière (2004) take into account financial instability in the analysis of financial development and economic growth relationship. Economic literature establish with evidence, positive relation between finance and growth, but with a negative impact of the inherent financial crisis on growth.  This paper therefore aims at reappraising the financial liberalization hypothesis and its growth inducing capacity in the light of financial crisis which tends to rear its ugly head at the peak of the positive impact of liberalization policies using data and evidence from Nigeria between the periods from 1980 to 2010.

 2.     Literature Review

A huge body of theoretical and empirical literature on financial liberalization and capital flows has evolve over time, Arestis, Nissank and Stein (2005) traced the theories of financial liberalization to original text published before the works of McKinnon and Shaw. In their work they traced this to Patrick [1966], published the seminal work on the relationship between financial development and economic growth. He hypothesized two possible relationships, a “demand-following” approach, in which financial development arises as the economy develops, and a “supply-leading” phenomenon, in which the widespread expansion of financial institutions leads to economic growth. Prior to Patrick (1966) there had been a great deal of debate on the issue, with contributors ranging from Bagehot (1873) and Schumpeter (1912), who posited that Financial services are necessary for the advancement of economic growth in so far as they improve productivity by encouraging technological innovation and help to identify entrepreneurs who have the best chance of success in innovation process.

Eggoh (2008), reviewed empirical literature on the finance-growth relationship and stated that works on the relationship has greatly expanded since the work of King and Levine (1992, 1993). According to Eggoh, the first study establishing the empirical link between financial development and economic growth date back to Goldsmith (1969), the inaugural papers of King and Levine (1992, 1993) confirm the endogenous growth models of Bencivenga and Smith (1991), Saint-Paul (1992), Greenwood and Jovanovic (1990) and Pagano (1993). Eggoh in work classify empirical works on the finance growth nexus as follows:  firstly, findings that related to positive relationship between finance and growth; then controversy prompted by this literature is then examined and finally, an assessment of the literature taking into account the financial crisis in the analysis of the relationship between the two variables.

2.1. The Cost of Financial Liberalization

According to Barry (2004), a foundation of recent research on financial liberalization is the observation that the policy has both benefits and costs. The benefits of well developed, freely functioning financial markets are familiar if difficult to quantify. Some of which include, more generally achieving faster growth, greater returns on investment, and higher incomes. The costs take the form of volatility in markets that respond sharply to new information volatility with which the affected economies can find it difficult to cope.

It is therefore important to emphasize that volatility or financial crisis is intrinsic to financial markets. Crisis can be defined as a sharp change in asset prices that leads to distress among financial markets participants (Barry, 2004) hence will bring about short fall in the level capital available for investment in the economy, thereby bring about fall in output growth.

According to Eggoh (2008), many arguments referring to the source and the nature of financial instability have been advanced to prove the weak link or the negative impact of financial development on economic growth. Indeed, some studies have established the undeniable link between financial development and financial instability (Demirgüç-kunt & Detragiache, 1999 and Kaminsky & Reinhart, 1999); since banking and currency crisis slowdown growth, we can easily conclude, given the positive link between financial instability and financial development, that the latter would penalize growth. In Guillaumont and Kpodar (2004), who include financial instability in the analysis of the finance-growth relationship. They show that the positive effect of financial development on economic growth is lowered by 58% because of the increase of financial instability.

Finally, in Eggoh (2008) Rancière, Tornell and Westermann (2006) decompose the effects of financial liberalization in two parts: a direct effect on growth (which is positive) and an indirect effect through crises (negative effect). The empirical estimations carried out by the authors show that the direct effects of …financial liberalization on growth outweigh the indirect effects related to the strong propensity of crises. According to Rancière et al. (2006), there are two opposite views of financial liberalization: first, financial liberalization strengthens financial development and contributes to the long-term economic growth and, secondly, it leads to more frequent crises. the basic point to note here is empirical evidence abound even as they support theory that financial liberalization has a cost, and this comes in form of financial crisis which impact on growth negatively, however, the conclusion reached by scholar in economic literature is that the net benefit of financial liberalization policies still far out weights the cost, hence, there is no justification so to say for even developing economies who tends to be most badly affected by the economic cost of the finance-growth nexus, due their shallow financial system, to adopt suppressive policies in a bid to avoid to this cost. The rest of this paper therefore will attempt to reappraise the economic consequence of the financial liberalization policy in Nigeria the period from 1980 to 2010.

3. Model Specification

Following the works of Eggoh (2008), where financial instability indicator is the standard deviation of the cyclical component of the financial variable, and financial deepening, investment  and private sector credit were determinants of Real GDP, we specify the our model and Using ECM we estimate the following model.


4. Empirical Evidence

From our analysis, we establish  the presence of a positive nexus between financial development index and growth in Nigeria, though this connection does have significant indications for us to conclude that evident from Nigeria support the position of the McKinnon-Shaw hypothesis, the statement above is drawn from the fact that though the coefficient of FINDEP(-2) and PSCR show the expected apriori expectation of 0.000822 0.008467, implying that a proportionate change in these indices will lead to a change of 0.000822 and 0.008467 respectively in real GDP. But the test of significance measure does not give reasons to accept this connection. however, the index of investment (INVS) show a positive and significant coefficient of 0.380475, implying that a proportionate change in investment level that result from the increase in capital made available by financial liberalization policies bring about an increase of 0.380475 percent in real GDP, this somehow give this analysis some reasons to support the finance-growth nexus hypothesis in Nigeria. much more interestingly however, is the index of financial crisis (SFIN) which indicate the expected negative and significant connection between Crisis period of financial development and income growth, from regression result, a proportionate change in the index of financial crisis show that Real GDP will fall to the tune of -0.054466 percent, supporting the evidence that financial crisis penalizes the economy for adopting liberalization policies, the result also reveal the shallow nature of the Nigerian financial system as seen in the insignificant positive coefficient of financial development index and how financial crisis can negatively impact on growth significantly due to this shallow nature in Nigeria.

The result above also indicate that are potentials of a strong impact of the financial sector in the determination of the growth of the Nigeria economy however, the analysis also give strong indication that this positive finance-growth nexus does come without its cost, in terms of financial crisis, no matter how much benefit this nexus portends.

5.  Conclusion

In this study, the relationship between financial development and economic growth in light of financial crisis has been empirically estimated with data covering periods between 1980- 2010. Error correction model has been employed to test the existence of relationship among variables. phillip perron’s unit root test show that all variable are stationary at first difference, while using the DF or ADF unit root test on the residuals estimated, it was established that there is a long-run relationship among variables to be estimated (i.e. variables are cointegrated). Our OLS regression result show the presence of a positive but not significant impact of financial development variables on growth, the coefficient of the level of investment in the economy however compensated the insignificance of the financial development index as it shows a positive and very significant impact on growth, however, the coefficient of the index of financial crisis reveal that the impact of financial instability is negative and significant in Nigeria. In the light of this result therefore this paper will conclude that the level of the development of the Nigerian financial system is shallow as reveal by the insignificant coefficients of the financial deepening index which measures the depth of the financial system, but the finance-growth nexus in Nigeria is positive, however implicit in the benefit of this positive nexus is financial crisis, and from the result above, this can impact on the economy adversely and significantly.

This paper therefore will recommend that policy makers follow the position of Stiglitz (1994) who argued that while government intervention (beyond financial sector regulation) could not guarantee a more productive and efficient financial sector, a partially repressed financial sector clearly had the capacity to outperform more liberalized finance. It should therefore not be assumed a priori that liberalization will bring a net improvement in financial sector or real sector performance, most especially in developing and highly turbulent economy like Nigeria. According to Guillaumont & Kpodar (2004), the policy implications here are straightforward. As the beneficial impact of financial development on poverty reduction is dampened or even cancelled by financial instability, however, it is important to note, that policies of financial repression would not be justified by the fear of financial instability and financial crises which follow it (Eggoh, 2008) but the policy package must take the risk of financial instability into account.



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