Exploring the relationship between development finance and growth 

This article is based on a journal article titled Financial development and economic growth in sub-Saharan Africa: A sectoral perspective which appeared in Cogent Economics & Finance. The aim of this shorter article is to highlight the researchers’ key findings on the impact of development finance on sectoral growth in sub-Saharan Africa.

The relationship between development finance and growth has been studied for years, usually based on aggregate GDP and on the presumption that each economic sector responds to financial development in the same way. The persistent interest may be due to the important role that finance plays in leveraging growth by mobilising excess liquidity in the system and allocating it to the most productive sectors of the economy in the most efficient manner. Yet, the relationship between finance and growth has always remained inconclusive. Moreover, the possibility that the impact of financial development on growth could vary across different sectors of the economy is not well researched.

The productivity of capital can vary across the sectors and the return on investible projects could dictate which sector receives more credit. The agricultural sector in sub-Saharan Africa is characterised by low productivity owing to low returns and the perpetual risk of harvest failure. This vulnerability is due to the sector’s heavy reliance on rain which could affect the outcome of any investment. 

In contrast, the service and industrial sectors may attract good projects. However, these sectors are capital intensive. This means more finance is needed to realise a positive effect on growth.

Examining the impact of finance on sectoral growth can therefore be more helpful than looking at aggregate growth as each sector has different financial demands and productivity levels. In addition, policies on growth are initiated at the sectoral level. Therefore, exploring the impact of financial development at the sectoral level could uncover valuable information for sector-specific policies.

What does the literature say?

A review of the literature was undertaken to understand the arguments, hypotheses, and theories pertaining to the relationship between financial development and economic growth. Findings from the theoretical literature review range from a positive relationship (the financing of innovative ideas could lead to growth; growth leads, finance follows) to an inconclusive one (the impact of finance on growth is negligible).

An empirical literature review was also done to examine the finance–growth relationship at country and cross-country levels. Earlier studies established a linear and positive relationship between financial development and growth. Later studies looked at the structure of the financial system, reporting the importance of the stock market in economic growth in countries that are market-based while the banking sector drives growth in bank-based countries. Also, the banking sector affects growth positively during the early stages of development, while the stock market takes over as the economy advances. According to another study, the banking sector drives growth across the three income groups (lower-, middle- and upper-income countries), while the stock market only drives growth in the middle- and upper-income countries.

It has now been suggested that the relationship between finance and growth could be non-linear. In an influential paper, Cecchetti and Kharroubi (2012) established that finance has a positive impact on growth only up to a point, beyond which the impact of finance on growth becomes negative. This is known as the too-much-finance hypothesis. The authors explained that the financial sector does not exist in isolation but rather competes with other sectors of the economy for scarce resources. Thus, as financial development increases, it begins to deprive other sectors of much-needed resources, resulting in the negative effect of finance on growth.

Differences between the agricultural, industrial and service sectors

The agricultural industry is associated with very specific risks. Financial institutions prefer to lend money to the non-agricultural sector as they perceive agricultural activities to be too risky. Also, the cost of extending credit to the agricultural sector is high as a result of multiple low-volume transactions.

According to the Alliance for a Green Revolution in Africa (2017), the share of total credit to agriculture in sub-Saharan Africa was less than 1%. Even in countries where agriculture’s contribution to GDP is over 50%, credit to the sector is skewed in favour of the trade sector. 

The situation is much the same across countries. This means credit allocation varies significantly across different sectors of the economy, with the agricultural sector being the most negatively affected despite the sector’s contribution to employment and livelihoods. 

Knowing how development finance impacts sectoral growth could help policymakers to shape sector-specific policies aimed at enhancing the growth of such sectors.

How was this study conducted?

This study examined the effect of financial development across sectors in sub-Saharan Africa over the period 1990 to 2018 using the Generalised Method of Moments (GMM). The study also employed the financial development index devised by Svirydzenka (2016) to assess the relationship between financial development and sectoral growth in the context of sub-Saharan Africa. The index is a comprehensive measure of financial development incorporating, among others, banking, stock market, insurance, mutual fund, and pension fund indicators. As the financial sector has evolved beyond banking and stock markets, Svirydzenka’s index better reflects the activities of financial intermediation in an economy relative to using a single measure. 

A sample of 44 sub-Saharan African countries was selected for the study, based on data availability covering the period 1990 to 2018. The year 1990 was chosen as the starting period because financial sector reforms in the region picked up afterwards.

The dependent variables were sectoral value additions in the service, industrial and agricultural sectors measured as a percentage of GDP. Financial development was the main variable of interest. As the main objective was to examine the impact of financial development on sectoral growth, the financial development index (FinDI – an integration of the financial institution index and financial market index) was used as a measure of overall financial development. 

What did the results show?

Overall, the evidence showed that financial development had a positive impact on service and agricultural growth, while the impact was negative for industrial growth. Key takeouts from the study include the following:

• Sector size: The service sector is the largest contributor to GDP in sub-Saharan Africa. The mean share of the services sector in GDP over the sampling period was 49% relative to agriculture and industry, whose shares were 25% and 26% respectively. 
• Low level of financial development: The region is characterised by a low level of financial development. In terms of financial structure, the mean value for financial institutions was higher compared to financial markets. This confirms that financial development was dominated by financial institutions, particularly banking.
• Labour, investment, consumption and trade-openness: The study controlled for variables known to affect growth, namely labour, investment, consumption and trade-openness. The mean value for labour was higher compared to that of investment as a percentage of GDP, suggesting that economic activities in the region were labour driven. Trade-openness as a share of GDP had a higher mean value of 63%, reflecting increasing trade within and outside the region. The statistics showed a great disparity between the minimum and maximum values of consumption as a percentage of GDP, depicting wider variations in government expenditure.
• Financial development and growth in the service and agricultural sectors: The results showed that financial development had a positive impact on growth in service and agriculture. An increase in financial development by 1% led to an increase of about 0.34% and 0.19% in service and agricultural growth, respectively. The thresholds were 47.2% and 31.7% for the service and agricultural sectors respectively. Above these thresholds, a percentage increase in financial development leads to a reduction in service and agricultural growth by 0.0036% and 0.0030% respectively. This confirms the too-much-finance hypothesis. Thus, when the financial system grows bigger relative to the size of the economy, the financial system may not contribute to the efficiency of investment, resulting in a negative effect. 
• Financial development and growth in the industrial sector: The impact of financial development on the industrial sector was clearly negative. An increase in financial development by 1% led to a 0.53% reduction in industry growth. However, above the threshold of 43.3%, an increase in financial development by 1% resulted in an increase in industrial growth by 0.006%. As the industrial sector is capital intensive, the level of financial development would have to rise to a certain level for finance to have a positive impact on the industry. There is also a correlation between the size of the financial system and industry growth. Investment in mining and manufacturing typically requires significant amounts of capital. An underdeveloped financial system may lack the capacity to channel large financial flows towards a growth-enhancing industry that requires a considerable investment.
• Financial institutions: It was found that financial institutions had a positive impact on service and agricultural growth. A percentage increase in the level of financial institutions resulted in a 0.28% and 0.50% increase in service and agricultural growth respectively. The estimated thresholds were 67% for the service sector and 39% for the agricultural sector, which are higher compared to financial development. This is to be expected given that financial intermediation in sub-Saharan Africa is bank-driven relative to the stock market. Above these thresholds, an increase in financial development by 1% led to an increase in service growth by 0.28% and 0.50% for the agricultural sector. Similarly, the impact of financial institutions on the industry was negative. An increase in the level of financial institutions reduced industry growth by 0.29%. This suggests that for financial institutions to have a positive impact on industrial growth, the figure must rise above a threshold of 52%. 
• Financial markets: The evidence for the financial markets was similar to that for financial institutions. Significantly, financial markets had a positive impact on the service and agricultural sectors. An increase in financial markets by 1% led to a 0.44% increase in service and 0.21% in agricultural growth. Above a threshold of 25%, a percentage increase in financial markets resulted in a decrease in service growth by 0.009%. The estimated threshold for the agricultural sector is 19%, above which, a percentage increase in financial markets led to a fall in agricultural growth by 0.01%. For financial markets to have a positive impact on industrial growth, the ratio must rise to 29%. The thresholds for the financial markets are lower than those for overall financial development and financial institutions, reflecting the underdeveloped nature of financial markets in the region.

How can this help with the formulation of policies?

The study examined whether the impact of financial development varies across economic sectors, with the results showing that financial sector development could spur the growth of the service and agricultural sectors but only up to thresholds of 47.2% and 31.7% respectively. Beyond these points, financial development could hamper the growth of these sectors.

The findings also showed that financial development could positively affect industrial growth but only after attaining a threshold of 43.3%. Thus, the study supports the too-much-finance hypothesis in the case of the service and agricultural sectors while too little finance was noted in the case of the industrial sector.

Another key finding is that financial structure matters in explaining sectoral value addition as the impact of financial institutions and markets vary across sectors. 

In short, the extent of credit use, as well as the productivity of credit, is not the same across all sectors. This has implications for policymakers in sub-Saharan Africa and developing countries with similar features. Policymakers should consider the optimal level of financial development when formulating sectoral growth policies. To maximise the benefits associated with industrialisation, there is a need to promote the development of the financial sector. The analysis further revealed that financial structure matters – hence there is a need for policies to develop both financial institutions and financial markets. 

With the industrial sector considered critical for economic transformation, the findings imply that policymakers in sub-Saharan Africa should continue to promote financial development to spur industrialisation.

• Find the original article here: Ustarz, Y. & Fanta, A.B. (2021). Financial development and economic growth in sub-Saharan Africa: A sectoral perspective. Cogent Economics & Finance. Volume 9. https://doi.org/10.1080/23322039.2021.1934976 
• Dr Ashenafi Beyene Fanta is a senior lecturer in Development Finance at Stellenbosch Business School.
• Mr Yazidu Ustarz is a PhD candidate at Stellenbosch Business School. He is also a lecturer at the University for Development Studies in Ghana. 
• Cecchetti, S., & Kharroubi, E. (2012). Reassessing the impact of finance on growth. BIS Working Paper No. 381, 1–21.
• Svirydzenka, K. (2016). Introducing a new broad-based index of financial development. IMF Working Papers. https://doi.org/10.5089/9781513583709.001