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During the 1950s and
1960s, the government of developing countries controlled interest rates in
order to generate financial resources required to finance government budget
deficits and for stabilisation purposes (World Bank, 2005). However, by the
early 1970s, these so-called government interventions were largely criticised
by the neo-classical economists and proponents of the financial liberalisation
hypothesis who argued that developing countries should move away from financial
repression- a situation where the government controls lending and deposit
interest rates, towards financial liberalisation in order to boost their levels
of economic activity and growth. McKinnon (1973) and Shaw (1973) were the earliest
economists to propose theoretical arguments challenging financial repression,
independently. They both advocated the call for interest rate liberalisation
and the elimination of other financially repressive policies practiced by
governments such as discriminatory credit controls that slowed down the level
of economic activity and growth.

 

The relationship existing
between financial liberalisation policies, capital formation and economic
growth has long been a subject of debate in the financial liberalisation
literature. In the context of this, there seems to be contradictory evidence in
the theoretical and empirical relationship between financial liberalisation
policies and capital formation and between financial liberalisation policies
and economic growth. Since the seminal contribution of McKinnon (1973) and Shaw
(1973), the prevailing tradition in
economics posits that financial liberalisation is beneficial to developing
countries as the removal of interest rate controls would encourage financial
savings and lead to an increase in the quantity and quality of investment. The standard
policy recommendation emanating from this literature is that
through financial liberalisation, the quantity and the composition of financial
development variables promote economic growth by increasing the level of
financial savings thereby enhancing capital formation, efficient credit
allocation, and provision of access to foreign capital (McKinnon, 1973; Shaw,
1973; Fry, 1997; Fischer, 1998; and Summers, 2000). Importantly, this is the
prevailing view at the International Monetary Fund (IMF) and the World Bank.

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However, a competing
strand of the literature (Stiglitz and Weiss, 1981; Taylor, 1983;
Diaz-Alejandro, 1985; Krugman, 1993; Rodrik, 1998; Van Wijnbergen, 1983; and Stiglitz,
2000 amongst others) opposes the conventional prediction emanating from the
literature and their criticisms of the financial liberalisation policy have
developed from various lines of reasoning. For instance, the Keynesians such as
Burkett and Dutt (1991) claim that financial markets are not self-equilibrating
i.e., markets do not automatically clear while neo-structuralists such as
Taylor (1983) and Van Wijnbergen (1983) highlight the role of the informal
financial sector especially in developing countries. Also, Diaz-Alejandro
(1985) and Demirguc-Kunt and Detragaiche (1998, 1999) claim that financial
liberalisation may cause financial fragility while Stiglitz and Weiss (1981)
and Stiglitz (2000) assert that the presence of asymmetric information in
financial markets may cause market failures in the financial system. Up until
now, there exists no less than five theoretical arguments against the McKinnon
(1973) and Shaw (1973) financial liberalisation hypothesis. These schools of
thought oppose the conventional view by making use of various theoretical
models to argue against the efficacy of financial liberalisation. The
controversy centres on whether financial liberalisation, and specifically
interest rate liberalisation and capital market liberalisation are a safe and
influential road to capital formation and economic growth.

 

Ever since the McKinnon
(1973) and Shaw (1973) financial liberalisation hypothesis which criticised
financial repression as the cause of unsatisfactory levels of capital formation
and growth especially in developing countries, researchers have also focused
their attention on the liberalisation of debt and equity markets, also referred
to as capital market liberalisation. Bekaert et al (2003) define capital market
liberalisation as an act whereby the government of a country grants overseas
investors the freedom to trade in the domestic capital market without
restrictions, while granting domestic residents the freedom to participate in
the activities of foreign capital markets. 
The role of capital market liberalisation in encouraging capital
formation and growth is also highly debated in the financial liberalisation
literature.

 

Economists who are in
favour of capital market liberalisation (see for instance, Greenwood and Smith,
1997; Obstfeld, 1998;  and Henry,2000)
argue that liberalising a country’s capital market promotes effective and
efficient international resource allocation, reduces cost of equity capital, improves
the size and liquidity of the domestic capital market, increase availability of
financial resources for domestic investments and consequently improve economic
growth. However, economists who argue against capital market liberalisation (see
for instance, Devereux and Smith, 1994 and Stiglitz, 2000) maintain that investments
in the capital market are mainly short term and that it is less likely that
capital market liberalisation will promote capital formation or economic growth
because long term investments which are likely to produce higher returns and
benefits cannot take place on the basis of short term capital.

 

The standard policy recommendation given to developing
countries by neo-classical economists and the Internation Monetary Fund and
World Bank representatives is the liberalisation of deposit and lending
interest rates. Beginning from the mid-1980s, several countries
in Sub-Sahara Africa adopted structural adjustment programmes within the
framework of the IMF supported Structural Adjustment Facility/Enhanced
Structural Adjustment Facility and the World Bank’s Structural Adjustment
Credit/Loan programmes. One key feature of these programmes was the drive for
adaptation of measures that encouraged trade and financial liberalisation and
this was a precondition for obtaining loans for developmental purposes from the
World Bank and the IMF. Since the 1980s, several countries in the Sub-Saharan
African region have embarked on various degrees of liberalisation of the
financial sector in a bid to increase savings mobilisation and capital
formation in order to improve investment levels and consequently boost economic
growth but the effects of financial liberalisation on economic growth and
capital formation are ambiguous. This supports the view that financial
liberalisation may encourage both excessive risk taking and macroeconomic
instability with detrimental effects on the macroeconomic aggregates.

 

Research on the relationship between financial
liberalisation, capital formation and economic growth mainly focuses on Latin
America, Asia and the developed countries with very limited research devoted to
the African countries and, in particular, the Sub-Sahara African region.
Nevertheless, a few researchers have investigated the impact of different
financial reform policies on economic growth in the Sub-Sahara region. For
instance, Fowowe (2013) examines the effects of five financial reform policies
on growth in 19 Sub-Sahara African countries, using panel data for the period
1978 to 2000. In his investigation, he constructs two indexes that measure the
gradual progression and institutional changes involved in the financial sector
reforms. The reform policies tested are bank denationalization and
restructuring; interest rate liberalisation; prudential regulation; free entry
into banking as well as the abolition of sectoral credit guidelines. Ghazanchyan
and Stotsky (2013) also empirically examines the drivers of growth in
Sub-Sahara Africa by relating the recent growth experience to key determinants
of growth including current account liberalisation, private and public investment,
the exchange rate regime as well as government consumption in 42 countries for
the period 1999 to 2011. Furthermore, Misati and Nyamongo (2012) investigate
the dual role of financial liberalisation on growth using a bank crisis model
and a growth model similar to Ranciere et al (2006). Their study covers 34
Sub-Sahara African countries from 1983 to 2008, using panel data. The authors
place emphasis on capital market liberalisation in order to investigate the
linkage between financial liberalisation and financial fragility, and they examine
the dual effect of financial liberalisation on economic growth. Other studies
relating to the Sub-Sahara African region include Menyah et al (2014) who
investigate the causal relationship between financial development and economic
growth for 21 countries for the period 1965 to 2008 within a framework that
also accounts for international trade.

 

The above mentioned
research related to the Sub-Sahara African region investigate different
instruments of financial liberalisation but largely ignore capital market
liberalisation and the impact of financial liberalisation policies on capital
formation. Also, majority of the existing empirical studies (for instance,
Levine and Zervos (1998)), which include some developing countries from the
Sub-Saharan African region are cross sectional and their results have to be
interpreted with caution when considering developing countries as one cannot
completely rely on results from cross sectional studies due to individual
country differences. Developing countries especially those in Sub-Sahara Africa
have different underlying macroeconomic and structural characteristics, e.g.
the level of economic development, the size and structure of the financial
sector, population size and growth levels which should be explicitly
investigated and modeled.

 

This thesis aims at
filling a gap in the literature by providing empirical evidence on the effects
of the two principal financial liberalisation policies, namely capital market
liberalisation and interest rate liberalisation, on capital formation and
economic growth in a single econometric framework after considering country specific
heterogeneities. The thesis investigates the effects of interest rate
liberalisation and capital market liberalisation on capital formation and
economic growth using improved time series estimation techniques that allow for
the existence of structural breaks. The empirical investigation begins with
carrying out a Chow test within the framework of the ordinary least squares
(OLS) multiple linear regression in order to test for structural breaks.
Thereafter, test for stationarity (or non-stationarity) is carried out using
the Perron (1989) modified Dickey-Fuller unit root test which includes dummy
variables to account for one exogenous structural break as in Shretsha and
Chowdhury (2007).

 

Furthermore, the long run
relationship between interest rate liberalisation, capital market
liberalisation, capital formation and economic growth is examined using the
Johansen (2000) maximum likelihood cointegration procedure which allows for the
existence of structural breaks by analysing cointegration in a Gaussian vector autoregressive
(VAR) model with known breakpoint dates. Granger causality testing is also
performed as part of the time series estimations, in order to ascertain the
direction of causality among the variables of interest. The Granger causality
test procedure employed considers a single shift (i.e., one structural break)
in the mean of the time series and two endogenous variables and tests for
causality by estimating a VAR system with a dummy variable which is a function
of the structural breakpoint date (as in Bianchi, 1995).

 

The thesis also employs
panel estimation techniques to examine the relationship between the two financial
liberalisation policies on capital formation and economic growth. Initially, a
fixed effects model that includes year dummies as well as country dummies is
estimated to ascertain the relationship (as in Fowowe, 2008). Thereafter, a
random effects model within the framework of Mundlak (1978) is estimated in
order to decompose the effects of both policies on capital formation and
economic growth into transitory effects and permanent effects (as in Bender and
Theodossiou, 2015).

 

1.2.
Aims and Objectives of the Study

This research aims to
assemble, organise, analyse and synthesise available data from ten Sub-Sahara
African countries in order to provide empirical evidence in a comparative
framework on the efficacy of financial liberalisation policies and the relative
merits of contrasting approaches in enhancing economic growth and capital
formation, thus contributing to the theoretical and policy discourse. The
countries under investigation include Ghana, Ivory Coast, Kenya, Mauritius,
Nigeria, Sierra Leone, South Africa, Tanzania, Uganda and Zimbabwe. The
objectives of this thesis are to empirically investigate for the selected
Sub-Sahara African countries:

 

 

 

(1)   The
effect of interest rate liberalisation on capital formation.

 

(2)   The
effect of capital market liberalisation on capital formation.

 

(3)   The
effect of interest rate liberalisation on economic growth.

 

(4)   The
effect of capital market liberalisation on economic growth.

 

A review of the
literature on the impact of financial liberalisation on capital formation and
growth is used as a springboard for the empirical analysis.

 

1.3.
Significance of the Study

The purpose of this
research three fold. This includes a review of the literature on the rationale
for financial repression, to analyse both the theoretical and empirical
literature on the relationship between two main financial liberalisation
policies and capital formation and economic growth, and to empirically
investigate the effects of both financial liberalisation policies on capital
formation and on economic growth with specific reference to the Sub-Saharan
African region for the period from 1970 to 2014.

 

From the mid-1980s, many
countries in Sub-Sahara Africa adopted structural adjustment programs within
the framework of the IMF supported Structural Adjustment Facility/Enhanced
Structural Adjustment Facility and the World Bank’s Structural Adjustment
Credit/Loan programs. One key feature of these programmes was the drive for
adaptation of measures that encouraged financial liberalisation, and this condition
had to be fulfilled before the World Bank or the IMF granted loans to these Sub-Saharan
African countries. Hence, the period covered by the thesis covers the pre-
financial liberalisation era and the post-financial liberalisation era.

 

Furthermore, a vast
majority of studies in the financial liberalisation literature have
concentrated on developed countries as well as emerging countries especially in
East Asia and Latin America. There is very limited research devoted to African
countries in general and the Sub-Saharan African region in particular.
Moreover, the effects of financial liberalisation on capital formation have
been ignored largely in the financial liberalisation literature. Therefore,
this thesis redresses this imbalance by investigating and providing evidence
and insight into the relationship between the two main financial liberalisation
policies namely capital market liberalisation and interest rate liberalisation,
and their effects on capital formation and economic growth in the Sub-Sahara
African region. In addition, since
developing countries, especially those in Africa have different levels of
economic development, population size, poverty rates and income inequality it
is important that this inter-country
heterogeneity be explicitly incorporated in the statistical
methodology.

 

Essentially, this research aims at informing the theoretical
discourse on the consequences of financial liberalisation on capital formation
and economic growth as reflected in the empirical record. However, by
highlighting the relative success or failure of policy recommendations arising
from the two theoretical approaches, it provides evidence on the profound
economic and sociological consequences of such policies as these macroeconomic
aggregates affect the current and future wellbeing of entire populations. Hence, this research is a significant contribution to the economics literature
and theoretical controversy but also informs the broad social literature, and
ultimately development policy in Sub-Sahara Africa.

 

Initially, the study employs modified time series techniques
to investigate the impact of interest rate liberalisation and capital market
liberalisation in each country separately. The findings are compared across
countries to identify significant differences in the path and intensity of
capital formation and economic growth. Thereafter, fixed effects panel estimation
techniques are also employed to assess the impact of the two financial
liberalisation policies to all the ten Sub-Saharan African countries
collectively after controlling for inter-country heterogeneity. A major novelty
of this thesis is that the time series estimations allow for structural breaks.
Furthermore, this thesis utilizes a new random effects panel estimation
technique namely the so-called Mundlak
methodology that enables the decomposition of the effects of the financial
liberalisation policies on capital formation and growth into transitory effects
and permanent effects.

 

1.4.
Organisation of the Study

This thesis has been designed
to include into nine Chapters. Chapter one is the introductory chapter which
presents the background to the study, aims and objectives of the study as well
as the significance of the study. The financial liberalisation literature is
explored in two separate chapters. Chapter two presents a review of the
theoretical and empirical literature on the effects of interest rate
liberalisation on capital formation and on economic growth, while Chapter three
presents a review of the theoretical and empirical literature on the effects of
capital market liberalisation on capital formation and on economic growth.  The literature review is used as a springboard
for the empirical analysis. In Chapter four, the selected Sub-Saharan African
countries under investigation are examined in more detail. This comprises an
overview of the economy and financial system of each of the countries as well
as capital formation and economic growth trends for the pre-liberalisation and
post-liberalisation periods.

 

The empirical investigation
is presented in four chapters. In Chapter five, the thesis presents an overview
of the data, methodology and research design. The choice of the financial
liberalisation measures are also discussed and all the variables are defined. Chapter
six presents the time series empirical models and discusses the time series
estimation techniques while Chapter seven presents and discusses the time
series estimation results. In Chapter eight, the panel data models, methodology
and estimation results are presented and discussed. Finally, Chapter nine
presents the conclusions of the thesis. It comprises a rundown of the main
research findings, policy recommendations, limitations of the thesis as well as
suggestions for further research.

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