INFLUENCE OF MACROECONOMIC STABILITY ON FINANCIAL DEVELOPMENT

IN DEVELOPING ECONOMIES: EVIDENCE FROM WEST AFRICAN REGION

ABSTRACT

This paper examines the effects of macroeconomic stability on the financial development in
the West African region. Macroeconomic stability is measured based on the five variables of
the Maastricht Criteria (inflation rate, real exchange rate, government debt, fiscal deficit and
real interest rate). This study employs novel dynamic models on panel data. The results suggest
that macroeconomic stability has significant effects on financial development in the region.
Specifically, inflation rate, real exchange rate and fiscal deficit have negative effects. The
effects of government debt and real interest rate are positive. This study confirms that the five
macroeconomic stability variables are the determinants of financial development. Hence,
developing economies should strive to achieve macroeconomic stability in order to drive
financial development and to achieve sustainable economic development.

Keywords: Macroeconomic stability; financial development; economic growth; developing

economies

JEL Classification: O47, G21, G23

1
 I. INTRODUCTION

The nexus between financial development and economic growth has received considerable
attention in recent years. Although the majority of studies conclude that financial development
has the capacity to spur economic growth, but the degree of impact depends on the level of
financial development (Ehigiamusoe and Lean, 2018; Law and Singh, 2014; Rioja and Valev,
2004a; Samargandi et al., 2015). For instance, Henderson et al. (2013) reported that a low level
of financial development has no significant impact on economic growth, as demonstrated in
many cases in developing countries. But Arcand et al. (2015) documented that when credit to
private sector reaches 100% of GDP, the positive impact of financial development on economic
growth vanishes. In between these two extremes, the degree of the positive impact of financial
development on economic growth varies with the levels of financial development (Beck et al.,
2014; Rousseau and Wachtel, 2011).

In essence, variations in the level of financial development across countries could be due to
several factors, which include macroeconomic stability variables. Some empirical studies have
examined the determinants of financial development. For instance, income level, current and
capital account openness and financial openness have been identified as fundamental variables
that affect financial development (Baltagi et al., 2009; Chinn and Ito, 2006; Law and
Habibullah, 2009; Rajan and Zingales, 2003). But the impact of macroeconomic stability
variables (inflation rate, real exchange rate, government debt, fiscal deficit and real interest
rate) on the development of the financial system have not been thoroughly examined. It is
fundamental to investigate the relationship between macroeconomic stability variables and
financial development. There is theoretical evidence suggesting that poor macroeconomic
performance has some harmful effects on financial sector development. For instance, low and
stable inflation is a pre-condition to achieve an active and well-developed financial sector,
while a high and volatile inflation rate has deleterious effects on financial development
(Bittencourt, 2011). The dynamic relationship between real exchange rate and financial
development has also been stressed in theoretical literature (Aghion et al., 2009; Elbadawi et
al., 2012).

Furthermore, the theoretical link between public debt and financial development suggests that
the banking sector that lends principally to the public sector causes the financial system to
become inefficient and experience slow development. But, when the public debt held by banks
is at a moderate level, it can support financial market development through the provision of
collateral and benchmark of yield curve (Hauner, 2009; Ismihan and Ozkan, 2012). Moreover,
fiscal deficit and financial development are also theoretically related since inflationary pressure
of budget deficit is stronger in countries with undeveloped financial markets. In fact, public
debt and fiscal crisis, as well as the associated hike in interest rate, could lead to a subsequent
crisis in financial market (Ishaq and Mohsin, 2015; Neaime, 2015). Lastly, interest rate
influences decisions on saving and investment, as well as the demand for financial services,
instruments and intermediaries. High lending rate increase the cost of capital and discourage
investors from borrowing money for investments. Negative real interest rates (resulting from
financial repression1 and credit control) may also reduce the incentives to save (gross domestic

1
A term used to describe a situation where government policies or regulations (such as interest rate ceilings, credit
ceilings or restrictions, liquidity ratio requirements, capital controls, high bank reserve requirements, etc) hinder
the effective functioning of the financial intermediaries of a country. Arguably, financial repression inhibits
efficient capital allocation and weakens economic growth (see Ang and McKibbin, 2007; Luintel and Khan, 1999;
Naceur et al. 2008).

2
savings), thereby encouraging bank to take risk which could lead to a reduction in their
profitability (Ang and McKibbin, 2007; Aydemir and Ovenc, 2016; Luintel and Khan, 1999;
Naceur et al., 2008).
From the theoretical perspective, a study on the determinants of financial development is
deemed fundamental because of the pivotal role of the financial system in economic growth
and development. For instance, the theories of economic growth show that financial
development has the capacity to influence economic growth by promoting capital accumulation
and productivity growth (Beck et al., 2000; Rioja and Valev, 2004a). Moreover, the financial
Kuznets curve hypothesis2 stresses the vital role of the financial system in influencing income
inequality (Beck, et al., 2007; Greenwood and Jovanovic, 1990; Jalil and Feridun, 2011).
However, the ability of the financial sector to influence economic growth or development
depends on the level of its development, which is itself determined by some macroeconomic
variables.
Nevertheless, several developing countries have been facing severe macroeconomic instability
in recent decades due to a combination of output volatility, inflation variability, exchange rate
instability, severe government budget deficits, foreign payment deficits and growing foreign
debt obligations (Ehigiamusoe and Lean, 2017; Serven and Montiel, 2004; Todaro and Smith,
2009). In essence, Dabla-Norris and Srivisal (2013) posited that financial development and
macroeconomic volatility have a theoretical relationship. Dabla-Norris (2015) added that a
major priority of the International Monetary Fund (IMF) is to promote financial deepening,
economic growth and macroeconomic stability in developing countries. Consequently, a large
number of developing countries have adopted certain macroeconomic policies with a view to
ensuring macroeconomic stability. Therefore, it is important to examine the impact of
macroeconomic stability variables on different dimensions of the economy, and one of those
being financial system development. The findings of this study could be valuable in
formulating appropriate government policies that would enhance the performance of the
financial sector and macroeconomic variables, especially in developing countries.

This paper aims to address the gap in empirical study on the impact of macroeconomic stability
variables on financial development by using annual panel data for the West African region
from 1980 to 20143. Balanced panels data are used for all the models. The variables used in
this study are based on the Maastricht Criteria4 of measuring macroeconomic stability. The
region consists of 16 countries, namely Benin, Burkina Faso, Cape Verde, Cote D’Ivoire,
Gambia, Ghana, Guinea, Guinea-Bissau, Liberia, Mali, Mauritania, Niger, Nigeria, Senegal,
Sierra Leone and Togo.

The West African region was chosen for this study because, despite various financial reforms
and restructuring, the level of financial development is still low compared to other regions. For
instance, the average credit to private sector relative to GDP5 during 1980-2015 was 15.76%
compared to 35.97%, 36.92%, 50.11%, 123.37% and 142.45% in Latin America, MENA

2
A term used to describe the theoretical relationship between financial development and income inequality.
3
With exception of models of government debt and fiscal deficit between 1990 and 2014 due to unavailability of
data.
4
The choice of variables based on the Maastricht Criteria is justifiable because it is more comprehensive than the
ECOWAS Convergence Criteria variables, albeit similar. For instance, the five Maastricht Criteria variables are
inflation rate, national debt relative to GDP, fiscal deficit relative to GDP, currency fluctuations and real interest
rate. In comparison, the ECOWAS Convergence Criteria variables are inflation rate, fiscal deficit relative to GDP,
central bank deficit financing and gross external reserves.
5
World Development Indicators (2016) of World Bank.

3
region, Sub-Saharan Africa, OECD and East Asia respectively. Similarly, broad money supply
relative to GDP in the West African region was 25.77% compared to 36.81%, 41.12%, 60.15%,
101.73% and 156.86% in Sub-Saharan Africa, Latin America, MENA region, OECD and East
Asia respectively. These indicators suggest a much lower level of financial development in the
West African region compared to other regions.

Many West African countries have experienced severe levels of macroeconomic instability in
the past decades. For instance, in the 1980-2015 period, average inflation rates were
exceptionally high in Nigeria (19.44%), Guinea (18.56%), Guinea-Bissau (27.57%), Ghana
(27.86%) and Sierra Leone (34.53%). The average inflation rate for the entire region in the
period above was 11.66%, which was significantly higher compared to 8.65%, 8.57%, 5.11%,
4.63%, 4.22% in Latin America, Sub-Saharan Africa, MENA region, East Asia and OECD
respectively. The real exchange rate has also plummeted in recent years as the nominal
exchange rate has continued to experience severe depreciation across the countries.

Furthermore, the dwindling government revenue across West African countries has continued
to exacerbate the level of budget deficit, as the average fiscal deficit relative to GDP in the
region stood at -3.01% during the 1990-2014 period. For the same period, the following
countries had a greater fiscal deficit relative to GDP than the regional average: Gambia (-
3.24%), Cote D’Ivoire (-3.40%), Togo (-3.61%), Guinea (-3.78%), Sierra Leone (-4.40%),
Cape Verde (-5.97%), Ghana (-7.14%). In order to meet this deficit, most of the countries in
the West African region resorted to domestic and foreign borrowing thereby causing soaring
government debt. Consequently, the debt-GDP ratio in the region was 114.28% during this
period. The debt-GDP ratio was exceptionally high in Mali (85.48%), Gambia (88.03%),
Guinea (97.83%), Togo (102.66%), Sierra Leone (129.47%), Cote D’Ivoire (134.28%),
Mauritania (138.04%), Guinea-Bissau (209.19%) and Liberia (401.68%). Domestic borrowing
thusly aggravated the situation in the domestic money market by increasing the cost of capital
(real interest rate), thereby crowding out potentially more productive private sector investment.
During this period, the average real interest rate in the West African region was 6.72%.

The analysis of macroeconomic variables in the West African region indicates that the region
has experienced macroeconomic instability in recent decades, since most of the variables
exceeded the maximum values recommended by the Maastricht Criteria for macroeconomic
stability. According to the Maastricht Criteria6, the five indicators for macroeconomic stability
of a country are low and stable inflation rate (within 3%), low currency fluctuation (within
3%), low government debt relative to GDP (within 60%), low budget deficit relative to GDP
(within 3%), and low long-term interest rate (within 9%). Some studies have also shown
highlighted these variables to be key indicators of macroeconomic stability (e.g. Ehigiamusoe
and Lean, 2017; Serven and Montiel, 2004; Todaro and Smith, 2009).

The rest of the article is divided into five sections. Section 2 provides a critical review on the
current understanding of the determinants of financial development. Section 3 explains the
approach of using panel data in dynamic models. Section 4 is the reports of empirical results.
Section 5 offers key conclusions and policy options for designing reform programs for financial
systems.

6
See European Commission Convergence Report 2014.

4
 II. LITERATURE REVIEW
Several variables have been suggested in empirical literature as fundamental determinants of
financial system development. For instance, La Porta et al. (1997) reported that legal rules and
law enforcement quality (investor protection) affect the development of financial markets. In
essence, countries with poor investor protection have narrower or smaller financial markets.
This view was corroborated by Levine et al. (2000) who showed that legal and accounting
systems that promote contract enforcement, creditor rights and accounting practices have the
capacity to spur financial development and ultimately propel economic growth.

In addition, Chinn and Ito (2006) showed that a higher level of financial openness promotes
equity market development particularly when a certain threshold level of legal development
has been reached. They concluded that banking development and trade openness are
prerequisites for equity market development and capital account liberalization respectively.
Similarly, Baltagi et al. (2009) found that financial openness and/or trade openness have
beneficial effects on banking sector development. Unlike the Rajan and Zingales (2003)
hypothesis which documented that both financial and trade openness are prerequisites for
financial development, Baltagi et al. (2009) concluded that either one by itself would still be
beneficial to financial development.

Another key determinant is per capita real income. Evidence from the studies of Luintel and
Khan (1999) and Boyd et al. (2001) showed that per capita real income has a significant
positive impact on financial development. Ang and McKibbin (2007), Kim and Lin (2010) and
Bittencourt (2011) also provided evidence in support of a positive impact of real GDP per
capita. In contrast, Cherif and Dreger (2016) found that per capita income has insignificant
impact on financial development in MENA countries.

The role of institutions in the development of the financial system has also been emphasized in
empirical studies. Law and Habibullah (2009) examined the influence of institutional quality
on financial market development in twenty-seven countries, and reported that institutional
quality is a statistically significant determinant of both capital market and banking sector
development. Cherif and Dreger (2016) also investigated the institutional determinants of
financial development and reported that institutional conditions are fundamental for both
banking and stock market development after controlling for other economic determinants.
Fernandez and Tamayo (2017) posited that institutional arrangements influence financial
development by worsening or ameliorating transaction costs and information frictions – the
two key factors characterizing the development of the financial system.

This present study attempts to investigate whether a stable macroeconomic environment is a

sine qua non for the development of the financial market, and should therefore be considered
a key determinant too. The key macroeconomic stability variables according to the Maastricht
Criteria are inflation rate, government debt, fiscal deficit, real exchange rate and real interest
rate. There is sufficient theoretical and empirical support on the effects of these variables on
financial development, as expounded below.

Inflation rate has been investigated in numerous empirical studies but without conclusive
agreement on its effect. Some studies have demonstrated that low and stable inflation rates
stimulate financial development. For instance, Abbey (2012) concluded that inflation rate has
no long-run significant relationship with financial development in Ghana. This is corroborated
by Cherif and Dreger (2016) who studied MENA countries, but contradicted by English (1999)

5
who found a long-run positive relationship. As for short-run effect, Abbey (2012) and Kim and
Lin (2010) found evidence of a positive unidirectional causal relationship between inflation
rate and financial development.

In contrast to the above, other studies have demonstrated that high and volatile rates have
deleterious effects on financial development. Bittencourt (2011) showed that inflation rate has
a negative and significant impact on financial development. Naceur and Ghazouani (2005)
found that once inflation rate exceeds a certain threshold, it has a negative effect on financial
sector performance. Boyd et al. (2001) also found a non-linear inverse relation between
inflation rate and financial development. Kim and Lin (2010) found a long-run negative effect
of inflation rate on financial development. Moreover, Akosah (2013) found that inflation rate
has a long-run negative unidirectional causal relationship with financial development, while a
short-run negative bidirectional causality exists between them in Ghana. Odhiambo (2012)
corroborated the findings of the existence of a negative long-run relationship between inflation
rate and financial development in Zambia. In summary, some studies conclude that a high
inflation rate due to poor macroeconomic performance has a harmful effect on financial sector
development whereas other studies conclude that a low and stable inflation rate is a
precondition for achieving an active and strong financial sector.

Another variable with an inconclusive result is real interest rate. Luintel and Khan (1999) and
Ang (2008) showed that real interest rate has a significant positive impact on financial
development, contradicting a previous study (Ang and McKibbin, 2007) which found that real
interest rate and financial repression have a negative effect on financial development. A low
interest rate increases the risk of bank and its’ effect on risk assets diminishes particularly for
banks with a greater equity capital (Delis and Kouretas, 2011). Aydemir and Ovenc (2016) also
posited that short-term interest rate has a short-run negative effect on banking profitability.
Assefa et al. (2017) opined that interest rate has a significant negative impact on stock returns
in developed countries. Thus, interest rate influences saving and investment decisions as well
as the demand for financial services, products, instruments, and intermediaries. A high lending
rate increases the cost of capital and discourages investors from borrowing money for
investments. Similarly, a negative real interest rate occasioned by financial repression and
credit control may reduce the incentive to save, thereby reducing gross domestic savings (Ang
and McKibbin, 2007; Luintel and Khan, 1999; Naceur et al. 2008).

However, there is very limited empirical evidence on the effect of the rest of the three
macroeconomic stability variables on financial development. The theoretical link between
public debt and financial development has been emphasized in Hauner (2009) who posited that
if the banking sector lends mainly to the public sector, it becomes inefficient and experiences
slow development. However, when the public debt held by banks is at a moderate level, it can
support financial market development through the provision of collateral and benchmark. The
study also provided some evidence to support a detrimental relationship between public debt
and financial repression. Similarly, Ismihan and Ozkan (2012) also contended that public debt
could harm financial development in countries where government is the main recipient of bank
lending. They added that the adverse effects of public borrowing or debt on financial
development and macroeconomic outcomes are likely to be larger in countries with lower
financial depth than otherwise.

There is a potential relationship between real exchange rate and financial development. Aghion
et al. (2009) posited that the impact of real exchange rate volatility on productivity growth
depends on the development of the financial sector. Elbadawi et al. (2012) also argued that

6
financial development has the capacity to alleviate the negative effect of real exchange rate
overvaluation on growth.

Finally, Ishaq and Mohsin (2015) attempted to explain the relationship between fiscal deficit
and financial development when they contended that inflationary pressure of budget deficit is
stronger in countries with undeveloped financial markets, while Neaime (2015) argued that
debt and fiscal crises can lead to a subsequent banking crisis. Ball and Mankiw (1995) and
Rubin et al. (2004) argued that rising debt levels and/or fiscal deficit are correlated with
economic growth because of their influence on investors’ confidence on the ability of a nation
to settle debt service payments. Thus, higher returns in form of higher interest rate is needed to
persuade investors to keep financing the fiscal deficit. This hike in interest rate could lead to
financial market crisis and inhibit growth.

The above review shows that the impact of key variables on financial development have been
examined by previous studies. There are some empirical evidences to support significant
positive effects of legal protection, trade and financial openness, income level, and maturity of
national institutions on financial development, while the effect of inflation rate is inconclusive.
This study differs from previous empirical studies in that it focuses on examining the impact
of five macroeconomic stability variables (inflation rate, real exchange rate, government debt,
fiscal deficit and real interest rate) on financial development and to develop dynamic models
using data from the West African region. This is the first study that examines how these five
variables affect the financial sector within dynamic models. This study employs novel
empirical strategies that enable us to examine both the long-run and short-run impact of these
variables on financial development as well as account for possible endogeneity.

III. DATA AND METHODOLOGY

III.1 Model Specification

The dynamic linear models used in this study are consistent with the models used in Ang and
McKibbin (2007); Baltagi et al. (2009); Chinn and Ito (2006); Kim and Lin (2010); and Law
and Habibullah (2009). The models7 are given as follows:

FDi ,t = a INFi ,t + d ¢Z i ,t + hi + µt + e i ,t (1)

FDi ,t = b RERi ,t + d ¢Z i ,t + hi + µt + e i ,t (2)
FDi ,t = v DEBi ,t + d ¢Zi ,t + hi + µt + e i ,t (3)
FDi ,t = y DEFi ,t + d ¢Z i ,t + hi + µt + e i ,t (4)
FDi ,t = j INTi ,t + d ¢Zi ,t + hi + µt + e i ,t (5)

where FD = financial development (proxy by credit to private sector relative to GDP, and
alternatively by liquid liabilities relative to GDP for robustness checks); INF = inflation rate;
RER = real exchange rate; DEB = government debt relative to GDP; DEF = fiscal deficit
relative to GDP; INT = real interest rate; Z = set of control variables such as the lagged value
of financial development, level of per capita income, government consumption expenditure
relative to GDP and trade openness relative to GDP; i = 1, 2, …, N; t = 1, 2, …, T; η =

7
Due to the presence of multicollinearity among the regressors, we follow a similar procedure utilized in Law
and Habibullah (2009) to include one macroeconomic stability variable in the model at a time along with other
control variables.

7
unobserved country-specific effect; µ = time specific-effect; and ε = independent and
identically distributed normal error term8. Trade openness relative to GDP and government
consumption expenditure relative to GDP are included in the model to capture the degree of a
country’s openness and the effect of government policy respectively (Bittencourt, 2011; Kim
and Lin, 2010). Moreover, one-period lagged financial development is included in the model
as one of the independent variables in order to capture persistence since there is a considerable
level of persistence in financial development (Baltagi et al., 2009). All variables except
inflation rate, fiscal deficit and real interest rate are transformed into natural logarithm before
analysis.

III.2. Estimation Techniques

Since T>N in the panel, the estimation techniques employed in this study are Mean Group
(MG) and Pooled Mean Group (PMG). The PMG model (Pesaran et al., 1999) assumes
homogeneous long-run coefficients across countries but allows for variations in short-run
coefficients, speed of adjustment, and error variances. The MG model (Pesaran and Smith,
1995) allows both long-run and short-run coefficients to differ across countries, as well as the
speed of adjustment and the error variances. The Hausman test of homogeneity of long-run
coefficients is conducted to ascertain the preferred model between MG and PMG.
III.3 Data Sources
The annual data used in this study covers the sample period from 1980 to 2014. The data for
real GDP per capita, credit to private sector, government consumption expenditure, and trade
openness are from World Development Indicators (2016). The data for inflation rate is from
World Economic Outlook (2016). The data for government debt and fiscal deficit is from the
Central Bank of the West African states. The data for real exchange rate is computed from
nominal exchange rates and consumer price indices are obtained from World Development
Indicators (2016).
IV. EMPIRICAL RESULTS

IV.1 Descriptive statistics and correlation analysis

A summary of the descriptive statistics and correlation analysis of the variables in the model
are presented in Table 1. There are wide variations between the maximum and minimum values
of each of the variables during the period. For instance, the mean value of credit to private
sector relative to GDP was 15.43%, while the respective maximum and minimum values were
65.27% and 0.80%. The lower part of Table 1 shows the correlation analysis of the variables.
All the macroeconomic stability variables (with the exception of real interest rate) have
negative correlation with financial development indicators, while all the control variables
(income level, government expenditure and trade openness) are positively correlated with
financial development.
Insert Table 1 About Here

8
Institutional factors are not included in the models because of unavailability of data on institutional factors in
the West African region.

8
Figure 1 shows the trends of the average financial development (proxy by credit to private
sector relative to GDP and liquid liabilities relative to GDP), inflation rate and real interest rate
in the West African region during the 1980-2014 period. The graph demonstrates that financial
development performed better during the period with lower and stable inflation rate (1996-
2014) compared to the period with higher and unstable inflation rate (1980-1995). For instance,
when inflation rate was 23.5% in 1987, credit to private sector and liquid liabilities were 15.1%
and 21.5% respectively. But when inflation rate dropped to 5.38% in 2010, credit to private
sector and liquid liabilities were 18.5% and 34.3% respectively. This suggests that high
inflation impedes financial development in the region 9 . Conversely, financial development
indicators are higher during periods of higher real interest rates. For example, in 1995 when
real interest rate was 4.3%, credit to private sector and liquid liabilities were 11.5% and 21.1%
respectively, compared to 20.2% and 35.6% when real interest rate was 13.5% in 2012. Figure
2 shows that government debt reduced substantially while fiscal deficit rose marginally during
this period.

Insert Figure 1 About Here

Insert Figure 2 About Here

IV.2 Panel Unit Root Tests

Panel unit root tests are conducted to ascertain the order of integration of the variables using
the tests proposed by Maddala and Wu (1999), Levin et al. (2002), Im et al. (2003), and Pesaran
(2007). The results reported in Table 2 show that all the variables are integrated of order zero
except real GDP per capita, credit to private sector, liquid liabilities and government debt which
are [I(1)]. Since some of the variables in our model are integrated of order zero while the other
variables are integrated of order one, we employ MG and PMG estimators. These estimators
can be applied irrespective of the order of integration of the variables in the model because
they are based on Autoregressive Distributed Lag (ARDL) model in error correction form of
cointegration tests (see Pesaran and Smith, 1995; Pesaran, Smith and Shin, 1999; Demetriades
and Law, 2006; Ehigiamusoe and Lean, 2018). Specifically, Pesaran and Smith (1995) and
Pesaran, Smith and Shin (1999) posited that the MG and PMG estimators (approaches to
cointegration test), unlike other cointegration techniques, do not require all the variables in the
model to be stationary at the same level. They demonstrated that the dynamic panel ARDL can
be applied even with variables that have different orders of integration, irrespective of whether
they are I(0) or I(1) or a mixture of the two, which is a fundamental advantage of the ARDL
model (see Ehigiamusoe et al., 2018; Samargandi et al., 2015).
Insert Table 2 About Here

IV.3 PMG Estimation Results

9
The graphs should be interpreted with caution because they were plotted with the mean (average) values of all
the countries in the region. For instance, the inflation rate for 1980 is the average inflation rate of all the countries
for that year. One shortcoming of arithmetic mean is that it could be affected by extremely large or small values.
Hence, it is necessary to focus on the regression results to ascertain the true relationship between the variables.

9
Table 3 reports the results of PMG estimation of the impact of macroeconomic stability on
financial development in the West African region. It is shown that inflation rate has a
significant long-run negative effect on financial development, albeit with no short-run effect.
This suggests that an increase in inflation rate retards the development of the financial sector,
while a decrease in inflation rate is necessary to achieve a deeper and more active financial
sector. This is consistent with Kim and Lin (2010), Bittencourt (2011) and Haslag and Koo
(1999) who found that inflation rate and financial development are negatively related.

Financial sectors are less developed in countries with higher inflation rates because they are
associated with financial repression. Thus, high inflation rate reduces household sector’s
purchasing power, and decreases their saving capacity, thereby further reduces bank deposit
and increases bank’s default ratio. Moreover, high inflation rate is capable of promoting
hedging and raises outflow of capital as well as inhibits economic activities (Anwar et al.,
2017). Thus, Bittencourt (2011) noted that high inflation rate is capable of reducing the returns
on savings, which in turn decreases savings and savers. Thereby causing severe information
friction, reduce pool of borrowers, and leads to scarcer credit in the economy. Theoretical
models based on imperfect credit market opined that, in the presence of information-type credit
market friction with endogenous severity, high inflation rate causes greater credit rationing and
distorts information flow, thereby worsening credit market frictions (Kim and Lin, 2010).
Besides, high inflation rate could repress financial intermediation because it erodes the
usefulness of money assets, and result in policy decisions that could distort the financial
structure.

Insert Table 3 About Here

Real exchange rate is found to have a significant short-run negative effects on financial
development, albeit the long-run impact is tenuous. This implies that a depreciation in real
exchange rate will reduce financial development. The finding is consistent with Aghion et al.
(2009) who reported that financial development and real exchange rate have a dynamic
relationship. Fundamentally, real exchange rate uncertainty worsens the negative investment
effects of domestic credit market constraints. They contended that borrowing of credit constrain
firm and the appreciation of exchange rate reduce current earnings, leading to the decrease in
borrowing and product introduction. The opposite holds at the time of exchange rate
depreciation. Slavtcheva (2015) added that countries, with under-developed financial sectors,
have higher inflation rates under flexible exchange rate regime. And in these economies,
financial intermediaries tend to hold higher proportion of deposits as required reserves.
Consequently, both higher inflation rate and greater reserves impede productivity growth and
financial development.

The study also finds that government debt relative to GDP has a long-run positive effect on
financial development, albeit with no short-run effect. This result suggests that government
debt has no harmful effect on financial development in the region. This finding is consistent
with Hauner (2009) and Ismihan and Ozkan (2012) who documented that government debt is
only likely to cause harm to financial development in countries where government is the main
recipient of bank lending. Therefore, the positive impact of government debt on financial
development found in this study is not surprising. The impact could be positive or negative
depending on whether the banking sector mainly lend to the private or public sector, as well as
the degree of financial deepening of the banking sector (Hauner, 2009; Ismihan and Ozkan,
2012). Unlike the debt-growth nexus where the level of public debt determines the direction of

10
the relationship between public debt and economic growth (Reinhart and Rogoff 2010; Panizza
and Presbitero, 2014; Woo and Kumar, 2015), public debt is only deleterious to the financial
system in economies where government is the major recipient of bank lending (Hauner, 2009;
Ismihan and Ozkan, 2012). Specifically, Hauner (2009) argued that a banking sector that lends
principally to the public sector makes the financial system to become inefficient and experience
slow development. But when the public debt held by the banks is moderate, it can support
financial market development through the provision of collateral and benchmark. Moreover,
Ismihan and Ozkan (2012) posited that the adverse effect of government borrowing or debt on
financial development are only severe in countries with lower financial depth. Hence, the
positive impact of government debt on financial development found in this present study
suggests that the public sector is not the main recipient of banks' lending in the West African
region. It also implies that the various banking sector reforms embarked upon by several West
African countries in the last decades have improved the financial deepening of the sector. In
essence, theoretical literature stresses the supportive role of government debt on financial
development through the provision of collateral and benchmark (relatively safe asset).
However, government debt may be helpful to financial development up to a certain threshold
level. Beyond that level, it may turn harmful.

It is found that fiscal deficit relative to GDP has a significant long-run negative effect on
financial development, albeit with no short-run effect. This suggests that an increase in fiscal
deficit will adversely affect the development of the financial sector in the long-run. This is in
agreement with Ishaq and Mohsin (2015) who contended that inflationary pressure of budget
deficit is stronger in countries with undeveloped financial markets. Neaime (2015) also argued
that fiscal crisis can lead to banking crisis. Fundamentally, unless financed from external sources,
fiscal deficit usually compels the government to borrow from domestic financial markets through
the issuance of bonds. Thus, the increased government borrowing often restricts private sector
access to credit, thereby reducing the potentially more productive private sector investment. A
decrease in investment reduces the demand for financial services, products and intermediaries,
which have a negative effect on the development of financial sector.

Finally, real interest rate has a positive and significant effect on financial development,
suggesting that an increase in real interest rate would increase financial development in the
West African region. This is consistent with Luintel and Khan (1999) and Ang (2008).
Basically, theoretical literature based on McKinnon-Shaw type models and endogenous growth
posit that financial development is a positive function of real income and real interest rate. A
positive real interest rate enhances financial development by increasing the volume of financial
saving mobilization, as well as the volume and productivity of capital, thereby stimulating
economic growth (Law and Habibullah, 2009). Thus, higher real interest rates stimulate
average productivity of physical capital by discouraging investors from investing in low return
projects. Financial development literature (e.g. McKinnon, 1973; Shaw, 1973) argued that ill-
conceived government interventions such as interest rate ceilings, high reserve requirements
and direct credit programs are the major causes of under-developed financial sector. They
posited that interest rates ceiling, due to high inflation rates, causes negative real interest rates
that dampens saving and causes excess demand for investable funds. Thereby, it reduces the
volume of investment and productivity of capital, dampening the development of the financial
sector.

In all the models in this study, the convergence coefficients are negative and statistically
significant, suggesting the existence of long-run relationships between the independent
variables and financial development. Also, the Hausman test statistics suggest that the PMG

11
models are the appropriate models10. Furthermore, the results of the set of control variables are
consistent with Baltagi et al. (2009), Bittencourt (2011), and Kim and Lin (2010) who reported
a significant role of income level, trade openness and government expenditures in the
development of financial systems. According to Loayza et al. (2007), a high level of
macroeconomic instability in most developing nations is the result of a combination of volatile
macroeconomic policies, large external shocks, weak institutions, and microeconomic
rigidities. The three major sources of volatility are exogenous shocks (arising from financial or
good markets), domestic shocks (arising from self-inflicted policy mistakes or intrinsic
instability in the development process), and weak shock absorbers (arising from weak financial
markets which are supposed to diversify macroeconomic risks).

Mehran et al. (1998) observed that the financial system in many countries in the Sub-Sahara
Africa experienced some weaknesses and vulnerabilities in the 1980s and early 1990s primarily
because of the deterioration in macroeconomic conditions and a high level of political
interference in the operations of financial institutions as well as unwholesome interest rate
policies. They posited that macroeconomic instability exacerbated the challenges faced by the
financial system during that period. As the fiscal deficit was high and continued rising, most
governments resorted to borrowing from central banks (due to shallow financial markets) in
order to meet financial requirements. This led to a high inflation rate, more bad loans and asset
price bubbles, and further aggravation of asset portfolio of financial institutions.

IV.4 Robustness Checks

This study conducted some checks to ascertain the robustness of the estimation results. Firstly,
the study used alternative proxy of financial development namely liquid liabilities relative to
GDP. The use of liquid liabilities enables us to capture other aspects of financial development
other than private sector credit. Liquid liabilities (M3) is a measure of financial depth and the
overall size of the financial intermediary sector. It is more concerned with the capacity to
provide transaction services by financial system rather than the capacity to channel funds from
savers to borrowers (Khan and Senhadji, 2003). The PMG results presented in Table 4 are
consistent with the earlier results obtained when financial development is proxied by credit to
private sector. This result is consistent with Ehigiamusoe et al. (2017) who documented that
the proxies of financial development produce similar results in finance-growth nexus. This
view corroborated with Badeeb and Lean (2017) who utilized principal component analysis for
modeling financial development.

Insert Table 4 About Here

Secondly, the study used Mean Group (MG) to complement the PMG estimator since the
former allows for the long-run and short-run coefficients, the speed of adjustment and error
variances to be differed across countries (Pesaran and Smith, 1995). The MG results (available
upon request) are similar to the PMG results in terms of signs and significance of the
coefficients. Moreover, we also employed Generalized Method of Moments (GMM) as
proposed by Arellano and Bond (1991) to further ascertain the robustness of the regression
results. The use of GMM enables us to address the issue of endogeneity. The results of the
GMM estimation11 presented in Table 5 corroborated with the earlier results obtained with

10
Since the Hausman test statistic indicates that the PMG models are appropriate, the results of MG models are
not presented but are available upon request. Note that the lag order was chosen based on Schwarz Information
Criteria (SIC) subjected to a maximum lag of 2, resulting in ARDL (1,1,1,1,1,1) equation.
11
GMM estimation results should be interpreted with caution because GMM estimator is more suitable for a
panel data with N>T.

12
PMG estimator. There are evidences that inflation rate, real exchange rate and fiscal deficit
have a negative impact, while government debt and real interest rate have a positive impact on
financial development.

Insert Table 5 About Here

Finally, this study probed further to ascertain whether the relationship between financial
development and macroeconomic stability was accentuated by the presence of structural breaks
in the series. Therefore, this study conducted structural breaks test proposed by Bai and Perron
(2003) and found structural breaks in some of the countries. To address this phenomenon, the
study used dummy variable approach (where the years before the breaks take the value of 0,
and the years after the breaks take the value of 1) and included the appropriate dummy variables
in the regression models (see Wallack, 2003). The PMG results (available upon request) reveal
that the relationships between financial development and macroeconomic stability variables
are consistent with the earlier results in terms of the signs and significance of the coefficients
(albeit the size somewhat differ). Nevertheless, the structural break dummies included in the
regression are statistically insignificant, suggesting that structural breaks have no effect on
financial development during the study's period.

The negative impact of inflation on financial development found in this study agrees with some
previous empirical studies (e.g. Akosah, 2013; Bittencourt, 2011; Boyd et al., 2001; Kim and
Lin, 2010; Naceur and Ghazouani 2005; Odhiambo, 2012) which reported that inflation rate
has an adverse effect on the development of the financial sector. However, Abbey (2012)
reported an insignificant relationship between the two variables in Ghana, and similar results
were also documented in MENA region by Cherif and Dreger (2016). The differences in the
empirical findings could be due to various factors such as differences in the level of financial
development and inflation rates, differences in methodologies, data and periods covered by the
studies, as well as inability of the studies to account for some econometric issues (e.g.
heterogeneity, endogeneity, structural breaks). Similarly, the negative impact of real exchange
rate on financial development found in this study is consistent with Aghion et al. (2009),
Elbadawi et al. (2012) and Slavtcheva (2015), which demonstrates the dynamic relationship
between financial development and real exchange rate. Moreover, the finding of this study on
the relationship between financial development and real interest rate is consistent with Ang
(2008) and Luintel and Khan (1999), although Ang and McKibbin (2007) reported otherwise.
Essentially, some studies (e.g. McKinnon, 1973; Shaw, 1973) revealed that inappropriate
government interventions, such as interest rate ceilings and high reserve requirements, impede
the development of the financial system. There is also consistency between some empirical
studies (e.g. Ishaq and Mohsin, 2015; Neaime, 2015) and the findings of this study regarding
the impact of fiscal deficit on financial development. Finally, the empirical outcome of this
study on the link between government debt and financial development agrees with Hauner
(2009) and Ismihan and Ozkan (2012), who showed that government debt is only likely to harm
financial development in countries where government is the main recipient of bank lending.

V. CONCLUSION

In summary, the objective of this study is to determine the effects of macroeconomic stability
on the development of financial sector in the West African region. Evidence from the study
indicates that variations in these five macroeconomic stability variables (inflation rate, real
exchange rate, government debt, fiscal deficit and real interest rate) could explain variations in
financial development in the West African region. More precisely, inflation rate, real exchange

13
rate and fiscal deficit have negative effects on financial development while the effects of
government debt and real interest rate are positive. The results are robust to alternative proxy
of financial development and alternative estimation techniques.

The implication of this finding is that reductions in inflation rate, real exchange rate and fiscal
deficit have the capacity to accelerate financial development in the West African region. In
essence, poor macroeconomic environment is repugnant to financial development in the region.
Macroeconomic instability will affect the development of financial sector and hinder its
capacity to accelerate economic growth and development.

This study therefore proposes the following policy recommendations. Countries should ensure
macroeconomic stability if they wish to achieve a better financial development with a view to
sustainable economic development. Specifically, the West African countries should employ
the appropriate fiscal and monetary policies in order to lower and stabilize inflation rate. This
is particularly important because a high and unstable inflation rate could also have a deleterious
effect on other variables such as real exchange rate, real interest rate and economic growth rate.
Furthermore, efforts should be made to lower fiscal deficit within the recommendations of the
Maastricht Criteria. In this regard, the importance of effective Medium Term Expenditure
Framework (MTEF) in ensuring fiscal discipline cannot be overemphasized. In addition,
though government debt has yet to have any direct deleterious effect on financial development
in the region, it does not suggest that excessive debt is good. Government debt could have
indirect harmful effect on financial development through other variables (e.g. economic
growth). This study shows that economic growth has a significant positive impact on financial
development, and any variable that weakens economic growth could indirectly affect financial
development. Finally, the countries should prioritize policies that can prevent the depreciation
and fluctuations in real exchange rate in their development agenda.
This study has succeeded in unveiling the effects of macroeconomic stability on financial
sector development in the entire West African region. However, we attempted to include
governance and institutional variables (e.g. corruption, rule of law, bureaucracy, property
rights, corporate governance) as control variables in our models, but unavailability of time
series/long span panel data on these variables in West African countries limited us. Hence,
when the long span data on governance and institutional variables in West African countries
become readily available, future studies that include them as control variables in their models,
will be more robustness. Moreover, the impact of macroeconomic stability on financial
development could differ across the West African countries. Thus, as a further research
agenda, this study recommends an examination of the effects of macroeconomic stability on
financial development in the West African countries. This is fundamental because a greater
macroeconomic stability may suggest a higher level of financial development in some
countries, but not in others. Knowing where macroeconomic stability affects financial
development, and where it does not, is fundamental for policy making. Finally, as we have
shown the direct impact of government debt on financial development, future study should
investigate the indirect effect by using interaction models.

14
 REFERENCES

Abbey, E.N. (2012). ‘Inflation and financial development: Evidence’, American Journal of
Economics and Business Administration, 4(4), pp. 227-236.
Akosah, N.K. (2013). ‘Dynamics of inflation and financial development: Empirical evidence
from Ghana’, Journal of Economics and Sustainable Development, 4(15), pp. 20-37.
Aghion, P., Bacchetta, P., Ranciere, R. and Rogoff, K. (2009). ‘Exchange rate volatility and
productivity growth: The role of financial development’, Journal of Monetary
Economics, 56(4), pp. 494-513.
Ang, J.B. (2008). ‘What are the mechanisms linking financial development and economic
growth in Malaysia?’, Economic Modelling, 25(1), pp. 38-53.
Ang, J.B. and McKibbin, W.J. (2007). ‘Financial liberalization, financial sector development
and growth: evidence from Malaysia’, Journal of Development Economics, 84(1), pp.
215-233.
Anwar, S., Shahzadi, H. and Nasreen, S. (2017). ‘Determinants of Financial Development for
Selected SAARC Countries: A Panel Data Analysis’, Journal of. Applied
Environmental and Biological Sciences, 7(7), pp. 109-118.
Assefa, T.A., Esqueda, O.A. and Mollick, A.V. (2017). ‘Stock returns and interest rates around
the World: A panel data approach’, Journal of Economics and Business, 89, pp. 20-35.
Arcand, J.L., Berkes, E. and Panizza, U. (2015). ‘Too much finance?’, Journal of Economic
Growth, 20(2), pp. 105-148.
Arellano, M. and Bond, S. (1991). ‘Some tests of specification for panel data: Monte Carlo
evidence and an application to employment equations’, The Review of Economics
Studies, 58(2), pp.277-297.
Aydemir, R. and Ovenc, G. (2016). ‘Interest rates, the yield curve and bank profitability in an
emerging market economy’, Economic Systems, 40 (4), pp. 670-682.
Badeeb, R.A. and Lean, H.H. (2017). ‘The Determinants of Financial Development in the
Republic of Yemen: Evidence from the Principal Components Approach’, Capital
Market Review, 25(2), pp. 32-48.
Bai, J. and Perron, P. (2003). ‘Computation and analysis of multiple structural change models’.
Journal of Applied Econometrics, 18(1), pp. 1-22.
Ball, L. and Mankiw, N.G. (1995). ‘What do budget deficits do?’ National Bureau of Economic
Research. Working Paper (No. w5263), 1-35.
Baltagi, B.H., Demetriades, P.O. and Law, S.H. (2009). ‘Financial development and openness:
Evidence from panel data’, Journal of Development Economics, 89 (2), pp. 285-296.
Beck, T., Degryse, H. and Kneer, C. (2014). ‘Is more finance better? Disentangling
intermediation and size effects of financial systems’, Journal of Financial Stability, 10,
50-64.
Beck, T., Demirgüç-Kunt, A. and Levine, R. (2007). ‘Finance, Inequality and the Poor’,
Journal of Economic Growth, 12, 27-49.
Beck, T., Levine, R. and Loayza, N. (2000). ‘Finance and the Sources of Growth’, Journal of
Financial Economics, 58(1), 261-300.
Bittencourt, M. (2011). ‘Inflation and financial development: Evidence from Brazil’. Economic
Modelling, 28(1), pp. 91-99.
Boyd, J.H., Levine, R. and Smith, B.D. (2001). ‘The impact of inflation on financial sector
performance’, Journal of Monetary Economics, 47(2), pp. 221-248.
Cherif, M. and Dreger, C. (2016). ‘Institutional determinants of financial development in
MENA countries’, Review of Development Economics, 20(3), pp. 670-680.

15
Chinn, M.D. and Ito, H. (2006). ‘What matters for financial development? Capital controls,
institutions and interactions’. Journal of Development Economics, 81(1), pp. 163-192.
Dabla-Norris, E. (2015). ‘Financial Deepening for Macroeconomic Stability and Sustained
Growth’, Macro Research for Development: An IMF-DFID Collaboration Paper.
Dabla-Norris, M. E. and Srivisal, M.N. (2013). ‘Revisiting the link between finance and
macroeconomic volatility’, International Monetary Fund Working Paper No. 13-29.
Delis, M.D. and Kouretas, G.P. (2011). ‘Interest rates and bank risk-taking’, Journal of
Banking and Finance, 35(4), pp. 840-855.
Ehigiamusoe, K.U. and Lean, H.H. (2017). ‘Macroeconomic Variables, Investment and
Economic Development in Nigeria: A Prognosis’, Journal of Economic Cooperation
and Development, 38(3), 145-168.
Ehigiamusoe, K.U., Lean, H.H. and Badeeb, R.A. (2017). ‘Finance-Growth Nexus in Cote
D'Ivoire and Nigeria: Does the Proxy of Financial Development Matter?’ Pertanika
Journal of Social Science and Humanities, 25(1), pp. 401-415.
Ehigiamusoe, K.U. and Lean, H.H. (2018). ‘Finance-growth nexus: New insights from West
African Region’, Emerging Markets Finance and Trade, 54(11), 2596-2613.
Ehigiamusoe, K.U., Lean, H.H. and Lee, C.C. (2018). ‘Moderating effect of inflation on the
finance–growth nexus: insights from West African countries’, Empirical Economics,
1-24 (In-press).
Elbadawi, I.A., Kaltani, L. and Soto, R. (2012). ‘Aid, real exchange rate misalignment, and
economic growth in Sub-Saharan Africa’, World Development, 40(4), pp. 681-700.
English, W.B. (1999). ‘Inflation and financial sector size’, Journal of Monetary Economics,
44(3), pp. 379-400.
European Commission Convergence Report 2014. ‘European Economy 4|2014’. Published by
European Commission, Directorate-General for Economic and Financial Affairs, Unit
Communication, B-1049 Brussels, Belgium.
Fernandez, A. and Tamayo, C.E. (2017). ‘From institutions to financial development and
growth: What are the links?’, Journal of Economic Survey, 31(1), pp. 17-57.
Greenwood, J. and Jovanovic, B. (1990). ‘Financial development, growth, and the distribution
of income’, National Bureau of Economic Research, Working paper No. w3189.
Haslag, J. and Koo, J. (1999). ‘Financial repression, financial development and economic
growth”, Federal Reserve Bank of Dallas, Working Paper 99-02.
Hauner, D. (2009). ‘Public debt and financial development’, Journal of Development
Economics, 88(1), pp. 171-183.
Henderson, D.J., Papageorgiou, C. and Parmeter, C.F. (2013). ‘Who benefits from financial
development? New methods, new evidence’, European Economic Review, 63, pp. 47-
67.
Im, K.S., Pesaran, M.H. and Shin, Y. (2003). ‘Testing for unit roots in Heterogeneous Panels’,
Journal of Econometrics, 115(1), pp. 53-74.
Ishaq, T., and Mohsin, H.M. (2015). ‘Deficits and inflation; Are monetary and financial
institutions worthy to consider or not?’, Borsa Istanbul Review, 15(3), pp. 180-191.
Ismihan, M. and Ozkan, F.G. (2012). ‘Public debt and financial development: A theoretical
exploration’, Economics Letters, 115 (3), 348-351.
Jalil, A. and Feridun, M. (2011). ‘Long-run relationship between income inequality and
financial development in China’, Journal of the Asia Pacific Economy, 16, 202–214.
Khan, M.S. and Senhadji, A.S. (2003). ‘Financial development and economic growth: A review
and new evidence’, Journal of African Economies, 12(2), pp. 89-110.

16
Kim, D.H. and Lin, S.C. (2010). ‘Dynamic relationship between inflation and financial
development’, Monetary Dynamics, 14(3), pp. 343-364.
La Porta, R., Lopez-de-Silanes, F., Shleifer, A. and Vishny, R.W. (1997). ‘Legal determinants
of external finance’, Journal of Finance, 52(3), pp. 1131-1150.
Law, S.H. and Habibullah, M.S. (2009). ‘The determinants of financial development:
Institutions, openness and financial liberalisation’, South African Journal of
Economics, 77(1), pp. 45-58.
Law, S.H. and Singh, N. (2014). ‘Does too much finance harm economic growth?’, Journal of
Banking and Finance, 41, pp. 36-44.
Levin, A., Lin, C.F. and Chu, C.S. (2002). ‘Unit root tests in panel data: Asymptotic and finite-
sample properties’, Journal of Econometrics, 108(1), pp. 1-24.
Levine, R., Loayza, N. and Beck, T. (2000). ‘Financial intermediation and growth: Causality
and causes’, Journal of Monetary Economics, 46(1), pp. 31-77.
Loayza, N.V., Ranciere, R., Servén, L. and Ventura, J. (2007). ‘Macroeconomic volatility and
welfare in developing countries: An introduction’, The World Bank Economic Review,
21 (3), 343-357.
Luintel, K.B. and Khan, M. (1999). ‘A quantitative reassessment of the finance–growth nexus:
evidence from a multivariate VAR’, Journal of Development Economics, 60(2), pp.
381-405.
Maddala, G.S. and Wu, S. (1999). “A comparative study of unit root tests with panel data and
a new simple test’, Oxford Bulletin of Economics and Statistics, 61, pp. 631-652.
McKinnon, R.I. (1973). ‘Money and Capital in Economic Development’ Washington D.C. The
Bookings Institution.
Mehran, H., Ugolini, P., Briffaux, J., Iden, G., Lybek, T., Swaray, S. and Hayward, P. (1998).
‘Financial sector development in sub-Saharan African countries’. International
Monetary Fund Working Paper No. 169, 1-20.
Naceur, S.B. and Ghazouani, S. (2005). ‘Does inflation impact on financial sector performance
in the MENA region?’, Review of Middle East Economics and Finance, 3(3), pp. 219-
229.
Naceur, S.B. Ghazouani, S. and Omran, M. (2008). ‘Does stock market liberalization spur
financial and economic development in the MENA region?’, Journal of Comparative
Economics, 36(4), pp. 673-693.
Neaime, S. (2015). ‘Sustainability of budget deficits and public debts in selected European
Union countries’, The Journal of Economic Asymmetries, 12(1), pp. 1-21.
Odhiambo, N.M. (2012). ‘The impact of inflation on financial sector development: Experience
from Zambia’, Journal of Applied Business Research, 28(6), 1497-1508.
Panizza, U. and Presbitero, A.F. (2014). ‘Public Debt and Economic Growth: is there a causal
effect?’, Journal of Macroeconomics, 41, 21-41.
Patrick, H.T. (1966). ‘Financial development and economic growth: A new investigation’,
Journal of Economic Development, 38(1), pp. 27-46.
Pesaran, M.H. and Smith, R. (1995). ‘Estimating long-run relationships from dynamic
heterogeneous panels’, Journal of Econometrics, 68(1), pp. 79-113.
Pesaran, M.H., Shin, Y. and Smith, R.P. (1999). ‘Pooled mean group estimation of dynamic
heterogeneous panels’, Journal of the American Statistical Association, 94(446), pp.
621-634.
Pesaran, M.H. (2007). ‘A simple panel unit root test in the presence of cross-section
dependence’, Journal of Applied Econometrics, 22(2), pp. 265-312.
Rajan, R.G. and Zingales, L. (2003). ‘The great reversals: the politics of financial development
in the twentieth century’, Journal of Financial Economics, 69(1), pp. 5-50.

17
Reinhart, C.M. and Rogoff, K.S. (2010). ‘Growth in a Time of Debt’, American Economic
Review, 100(2), 573-578.
Rioja, F. and Valev, N. (2004a). ‘Finance and the Sources of Growth at Various Stages of
Economic Development’, Economic Inquiry, 42(1), 127-140.
Rioja, F. and Valev, N. (2004b). ‘Does one size fit all? A re-examination of the finance and
growth relationship’, Journal of Development Economics, 74, pp. 429-447.
Robinson, J. (1952). ‘The generalisation of the general theory’, The Rate of Interest and other
Essays, 2, 1-76.
Rousseau, P.L. and Wachtel, P. (2011). ‘What is happening to the impact of financial
deepening on economic growth?’, Economic Inquiry, 49(1), pp. 276-288.
Rubin, R.E., Orszag, P.R. and Sinai, A. (2004). ‘Sustained budget deficits: The risk of financial
and fiscal disarray’, Paper presented at the National Economic and Financial Policies
for Growth and Stability Forum, January 4, San Diego.
Samargandi, N., Fidrmuc, J. and Ghosh, S. (2015). ‘Is the relationship between financial
development and economic growth monotonic? Evidence from a sample of middle-
income countries’, World Development, 68, pp. 66-81.
Shaw, E. (1973). ‘Financial Deepening in Economic Development’ New York, Oxford
University press.
Slavtcheva, D. (2015). ‘Financial development, exchange rate regimes and productivity
growth: Theory and evidence’, Journal of Macroeconomics, 44, 109-123.
Serven, L. and Montiel, P. (2004). Macroeconomic Stability: the more the better? Economic
Growth in the 1990s: Learning from a Decade of Reforms. Available on:
http://www1.worldbank.org/prem/lessons1990s/Chap%204%20macroecon%20092104%20rw.pdf
Todaro, M.P and Smith. C.S (2009). ‘Economic Development’, 10th Edition. United
Kingdom. Addison-Wesley Pearson Education Limited.
Wallack, J.S. (2003). ‘Structural breaks in Indian macroeconomic data’, Economic and
Political Weekly, 38(41), pp. 4312-4315.
Woo, J. and Kumar, M.S. (2015). ‘Public Debt and Growth’, Economica, 82(328), 705-739.

18
 TABLE 1
Descriptive statistics and correlation analysis
CPS LLY INF RER DEB DEF INT Y GOV TOP
Mean 15.431 25.642 11.857 1144.3 114.28 -3.013 6.727 566.72 14.806 68.979
Maximum 65.277 83.026 178.700 88103.8 789.8 40.340 56.248 3766.11 54.515 321.631
Minimum 0.802 0.416 -35.525 0.004 7.450 -13.98 -51.62 64.810 3.541 6.320
Std. Dev. 10.774 12.758 19.030 5281.9 119.9 5.339 14.27 527.874 5.962 34.172
LLY 0723
INF -0.273 -0.308
RER -0.217 -0.187 0.073
DEB -0.139 -0.289 0.192 -0.104
DEF -0.186 -0.239 -0.006 -0.011 0.063
INT 0.043 0.134 -0.494 -0.042 -0.023 0.008
Y 0.711 0.725 -0.235 -0.108 -0.364 -0.094 -0.039
GOV 0.481 0.263 -0.279 -0.168 0.034 -0.098 0.082 0.158
TOP 0.170 0.169 -0.075 -0.185 0.340 0.026 -0.063 0.015 0.265
Notes: CPS=credit to private sector relative to GDP, LLY = liquid liabilities relative to GDP, INF=inflation rate,
RER=real exchange rate, DEB=government debt relative to GDP, DEF=fiscal deficit relative to GDP, INT=real
interest rate, Y= income level, GOV= government consumption expenditure relative to GDP and TOP= trade
openness relative to GDP.

TABLE 2
Panel unit root tests
Variables ADF-Fisher LLC IPS Pesaran
CPS 27.357 -1.109 -0.059 -0.541
LLY 33.193 0.317 0.215 -2.662***
INF 122.431*** -7.999*** -7.612*** -6.787***
RER 48.882** -4.376*** -2.224** -1.566**
DEB 16.405 -0.448 1.434 -0.427
DEF 101.654*** -5.489*** -6.398*** -4.519***
INT 53.970*** -4.557*** -2.128*** -1.337*
Y 12.068 2.203 3.183 -1.457
GOV 78.280*** -4.974*** -4.797*** -3.235***
TOP 54.206*** -1.511* -2.265** -1.496*
∆CPS 180.387*** -10.724*** -10.873*** -9.482***
∆LLY 184.236*** -11.242*** -11.267*** -10.573***
∆INF 350.181*** -16.868*** -19.922*** -16.733***
∆RER 169.106*** -8.619*** -10.494*** -7.581***
∆DEB 113.550*** -6.029*** -7.324*** -6.031***
∆DEF 201.995*** -8.908*** -12.702*** -12.732***
∆INT 204.713*** -11.703*** -10.928*** -11.595***
∆Y 179.439*** -9.498*** -11.005*** -11.030***
∆GOV 228.511*** -12.234*** -13.619*** -11.012***
∆TOP 213.345*** -10.752*** -12.801*** -10.175***
Notes: ***, ** and * indicates statistically significant at 1%, 5% and 10%, respectively, and a rejection of null
hypothesis of unit root. ∆= first differenced notation, LLC=Levin et al. (2002), IPS= Im et al. (2003), CPS=credit
to private sector relative to GDP, LLY = liquid liabilities relative to GDP, INF=inflation rate, RER=real
exchange rate, DEB=government debt relative to GDP, DEF=fiscal deficit relative to GDP, INT=real interest
rate, Y= income level, GOV= government consumption expenditure relative to GDP and TOP= trade openness
relative to GDP.

19
 TABLE 3
Results of PMG estimation
Variables (1) (2) (3) (4) (5)
Long-run coefficients
INF -0.049***
(0.011)
RER -0.021
(0.034)
DEB 0.154***
(0.038)
DEF -0.009***
(0.001)
INT 0.009**
(0.004)
Y 0.725*** 0.512*** 0.098** 0.197*** 0.190**
(0.151) (0.112) (0.058) (0.045) (0.108)
GOV 0.612** 0.004 0.573*** -0.038 0.138
(0.260) (0.127) (0.076) (0.077) (0.089)
TOP 2.010*** 0.495*** 0.319*** 0.014 -0.192
(0.303) (0.132) (0.110) (0.061) (0.109)
Convergence coefficient -0.104*** -0.214*** -0.362*** -0.354*** -0.136***
(0.021) (0.053) (0.074) (0.073) (0.045)
Constant -0.666** -1.054*** -3.747*** -1.764** -0.232
(0.294) (0.394) (0.974) (0.855) (0.318)
Short-run coefficients
∆INF -0.002
(0.002)
∆RER -0.159**
(0.086)
∆DEB -0.007
(0.062)
∆DEF -0.002
(0.004)
∆INT -0.001
(0.001)
DCPSt -1 -0.009 0.057 0.134** 0.105 0.049
(0.050) (0.052) (0.076) (0.066) (0.072)
DY -0.101 -0.277*** -0.095 -0.037 -0.088
(0.087) (0.100) (0.106) (0.081) (0.074)
∆GOV 0.103** 0.133** 0.099** 0.192*** 0.141**
(0.061) (0.057) (0.072) (0.065) (0.057)
∆TOP -0.088 -0.105** -0.137 -0.102 -0.094
(0.069) (0.051) (0.089) (0.091) (0.107)
Time Trend 0.001 0.002** 0.017*** 0.018*** 0.003
(0.069) (0.001) (0.004) (0.003) (0.001)
Countries 16 16 16 16 13
Observations 560 560 400 400 455
Hausman Test 11.76 2.89 3.30 3.97 0.88
Log likelihood 306.989 303.648 271.603 265.389 254.058
Notes: ***, ** and * indicates statistically significant at the 1%, 5% and 10% levels, respectively. Standard errors
in parenthesis. Dependent variable=credit to private sector relative to GDP, INF=inflation rate, RER=real
exchange rate, DEB=government debt relative to GDP, DEF=fiscal deficit relative to GDP, INT=real interest

20
rate, Y= income level, GOV= government consumption expenditure relative to GDP, TOP= trade openness
relative to GDP, CPSt -1 = one-period lagged credit to private sector relative to GDP.

TABLE 4
Results of PMG estimation (financial development is proxy by liquid liabilities/GDP)
Variables (1) (2) (3) (4) (5)
Long-run coefficients
INF -0.004***
(0.002)
RER -0.009
(0.031)
DEB 0.106***
(0.030)
DEF -0.001
(0.002)
INT 0.003***
(0.001)
Y 0.152*** 0.106** 0.266*** 0.159*** 0.106***
(0.037) (0.043) (0.055) (0.052) (0.033)
GOV -0.059 -0.145*** 0.166*** -0.059 -0.511***
(0.052) (0.050) (0.062) (0.067) (0.064)
TOP 0.188*** 0.283*** 0.255*** 0.321*** 0.193***
(0.048) (0.041) (0.036) (0.047) (0.038)
Convergence coefficient -0.437*** -0.432*** -0.474*** -0.471*** -0.421***
(0.072) (0.083) (0.085) (0.078) (0.131)
Constant -0.443 0.323 -2.036*** -1.041** -0.011
(0.559) (0.891) (0.579) (0.639) (0.999)
Short-run coefficients
∆INF 0.002
(0.001)
∆RER 0.001
(0.054)
∆DEB 0.049
(0.061)
∆DEF 0.002
(0.004)
∆INT 0.001
(0.001)
DLLYt -1 0,213*** 0.201*** 0.159*** 0.192*** 0.184**
(0.037) (0.049) (0.058) (0.066) (0.088)
DY -0.274** -0.294*** -0.208** -0.261** -0.181**
(0.108) (0.059) (0.109) (0.122) (0.076)
∆GOV 0.079** 0.084** 0.148*** 0.249*** 0.089*
(0.036) (0.036) (0.054) (0.060) (0.051)
∆TOP -0.106** -0.098* -0.144** -0.128** -0.088
(0.053) (0.054) (0.065) (0.060) (0.067)
Time Trend 0.004*** 0.003 0.008*** 0.007** 0.007**
(0.002) (0.003) (0.002) (0.003) (0.003)
Countries 16 16 16 16 13
Observations 560 560 400 400 455
Hausman Test 5.25 2.93 1.11 0.55 4.85
Log likelihood 535.068 557.861 400.646 404.304 410.208

21
Notes: ***, ** and * indicates statistically significant at the 1%, 5% and 10% levels, respectively. Standard errors in
parenthesis. The regression also included dummies variables to account for structural breaks. Dependent variable=credit to
private sector relative to GDP, INF=inflation rate, RER=real exchange rate, DEB=government debt relative to GDP,
DEF=fiscal deficit relative to GDP, INT=real interest rate, Y= income level, GOV= government consumption expenditure
relative to GDP, TOP= trade openness relative to GDP, DLLYt -1 = one-period lagged liquid liabilities relative to GDP.

TABLE 5
Robustness checks of the estimation results using GMM Estimation
Variables (1) (2) (3) (4) (5)
INF -0.002***
(0.001)
RER -0.066**
(0.032)
DEB 0.135***
(0.030)
DEF -0.004**
(0.002)
INT 0.003**
(0.001)
Y 0.151** 0.191** 0.434*** 0.207** 0.013
(0.071) (0.091) (0.109) (0.109) (0.109)
GOV 0.712*** 0.941*** 0.283 0.216 0.774**
(0.271) (0.342) (0.282) (0.299) (0.341)
TOP -0.099 -0.409 -0.146 -0.108 -0.105
(0.182) (0.261) (0.127) (0.165) (0.284)
CPS t -1 0.253*** 0.119*** 0.159** 0.239** 0.349**
(0.045) (0.058) (0.196) (0.174) (0.149)
Constant -0.538 0.550 -2.556* 0.473 0.252
(1.031) (1.113) (1.369) (1.189) (1.167)
Observations 560 560 400 400 455
Sargan Test (p-value) 13.40 9.203 12.529 12.956 4.818
(0.999) (1.000) (0.961) (0.953) (1.000)
First order serial correlation test -1.949 -1.690 0.169 -0.295 -1.8.836
(p-value) (0.051) (0.091) (0.861) (0.768) (0.066)
Second order serial correlation test -0.022 0.311 -0.239 -0.309 0.273
(p-value) (0.982) (0.756) (0.811) (0.758) (0.785)
Notes: ***, ** and * indicates statistically significant at 1%, 5% and 10%, respectively. The estimation method
is two-step GMM. Heteroscedasticity –corrected standard errors in parenthesis. Dependent variable=credit to
private sector relative to GDP, INF=inflation rate, RER=real exchange rate, DEB=government debt relative to
GDP, DEF=fiscal deficit relative to GDP, INT=real interest rate, Y= income level, GOV= government
consumption expenditure relative to GDP, TOP= trade openness relative to GDP, CPSt -1 = one-period lagged
credit to private sector relative to GDP.

22
Figure 1. Trends of financial development indicators, inflation rate and real interest rate in the
West African region

40

30

20
Percentage

10

0
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
-10

-20

credit to private sector/GDP liquid liabilities/GDP inflation rate real interest rate

Figure 2. Trends of financial development indicators, government debt and fiscal deficit in the
West African region

23
250

200

150

100

50

0
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
19
19
19
19
19
19
19
19
19
19
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
-50

credit to private sector/GDP liquid liabilities/GDP government debt/GDP fiscal deficit/GDP

24