Financial deepening, investment, and growth in frontier economies

Abstract

Few studies on finance-growth relationship have attempted to explicate the channel(s) by which financial deepening influences growth, particularly in (SSA). In this study, I report two of those channels; investment in the real sector and financial stability. The study adopts a two-step bi-model approach. In the first step, I estimate the investment model to establish the multiplicative effect of financial depth and financial stability on the real sector. In the second step, I import the investment real sector (investment) variable into the growth function to measure its interactive value with financial deepening on growth of gross domestic product (GDP). The combined approach of interacting financial deepening, investment, and financial stability accords the study a fresh analytical mileage over previous studies on the finance-growth nexus by assuming a high frequency growth value of explanatory variable multiplicative effects. Using institutional and macro-economic variables from 8 frontier markets of SSA countries from 2001-2011, I run panel unobserved effects model to report robust results and policy implications. In the absence of interaction term, the findings do not support the finance-led growth narrative. However, when interacted with real sector activity, the combined multiplicative effect is positive and significant. Similarly, there is strong evidence of the interactive role of financial system soundness and financial deepening in fostering real sector investment. The hypothesis that financial deepening confers growth benefits via real sector investment is affirmed when adjusted margins prediction is conducted. The policy implication of these findings suggests a need to coalesce financial resources into the real economy in an environment of tailored macroprudential policy.