Thesis

FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH: THE MALAWIAN STOCK MARKET AND BANKS

PERSPECTIVE

BY

MWAWI TITUS MSUKU

This paper was submitted in partial fulfillment of the requirements for the award

of ESAMI/MSM Degree,

Masters in Business Administration (MBA)

Awarded by

ESAMI MSM Eastern & Southern Africa and Maastricht School Management Institute of Management P.O. Box 3030, P.O. Box 1203 Arusha, 6201 BE Maastricht TANZANIA THE NETHERLANDS

October 24th 2009

DECLARATION

I, Mwawi Titus Msuku, declare that I am the sole author of this dissertation, that during the

period of registered study I have not been registered for other academic award or qualification,

nor has any of the material been submitted wholly or partly for any other award. This dissertation

is a result of my own research work, and where other people’s research was used, they have been

dully acknowledged.

Date …………………………….. Signature ...………………………………..

CANDIDATE

Date …………………………….. Name ...………………………………..

SUPERVISOR

Signature ...………………………………..

SUPERVISOR

ii

ABSTRACT

Using quarterly time series data from 2001:1 to 2009:2, this study investigated whether measures

of financial development (stock market development and banking development) predict future

rates of economic growth in Malawi and also tested whether financial development is supply-

leading or demand-following.

The study found that financial development as measured by stock market liquidity and bank

credit to the private sector is positively and significantly correlated with future rates of economic

growth, even after controlling for other factors associated with long-run economic performance.

The study also found that financial development is supply-leading in the sense that there was a

strong causal flow from financial development to economic growth. These results are consistent

with the view that stock markets and banks facilitate more efficient resource allocation and long-

run economic growth.

iii

TABLE OF CONTENTS

CHAPTER 1: INTRODUCTION............................................................................................. 1

1.1 BRIEF BACKGROUND .............................................................................................1

1.2 OVERVIEW OF THE FINANCIAL SECTOR IN MALAWI.......................................2

1.2.1 Bank and Non-Bank Financial Sector ......................................................................2

1.2.2 Capital Market.........................................................................................................3

1.2.3 Money Market..........................................................................................................3

1.2.4 The National Payment System ..................................................................................3

1.2.5 Characteristics and Performance of the Financial Sector in Malawi ........................4

1.2.6 Financial Sector Reforms in Malawi ........................................................................7

1.3 PROBLEM STATEMENT ........................................................................................10

1.4 PURPOSE OF THE STUDY......................................................................................10

1.5 RESEARCH OBJECTIVES.......................................................................................11

1.6 RESEARCH HYPOTHESIS......................................................................................11

1.7 RESEARCH QUESTIONS........................................................................................13

1.8 SIGNIFICANCE OF THE STUDY............................................................................14

CHAPTER 2: LITERATURE REVIEW ................................................................................15

2.1 FINANCIAL SYSTEM .............................................................................................15

2.1.1 Financial Institutions .............................................................................................15

2.1.2 Financial Markets..................................................................................................16

2.1.2.1 Capital Markets..............................................................................................16

2.1.2.1.1 Primary Capital Market ..............................................................................17

2.1.2.1.2 Secondary Capital Market ..........................................................................17

2.1.2.1.3 Capital Market Instruments ........................................................................18

2.1.2.1.4 Role of Capital Markets..............................................................................18

2.1.2.2 Money Markets ..............................................................................................20

2.1.2.2.1 Money Market Instruments.........................................................................21

iv

2.2 FINANCIAL DEVELOPMENT ................................................................................22

2.3 ECONOMIC GROWTH............................................................................................23

2.3.1 Stock Markets and Economic Growth.....................................................................23

2.3.2 Banks and Economic Growth .................................................................................27

2.4 EMPIRICAL STUDIES.............................................................................................28

CHAPTER 3: THEORETICAL FRAMEWORK ..................................................................30

3.1 THEORY ..................................................................................................................30

CHAPTER 4: RESEARCH DESIGN AND METHODOLOGY ...........................................34

4.1 RESEARCH DESIGN ...............................................................................................34

4.2 METHODOLOGY ....................................................................................................34

4.2.1 Model ....................................................................................................................35

4.2.2 Data.......................................................................................................................38

4.2.3 Data Analysis.........................................................................................................39

4.2.3.1 The Phillip-Perron Unit Root Test ..................................................................39

4.2.3.2 The Serial Correlation LM Test ......................................................................39

4.2.3.3 The Breusch-Pagan-Godfrey Test...................................................................40

4.2.3.4 The Ramsey RESET Test ...............................................................................40

4.2.3.5 The Granger Causality Test ............................................................................40

CHAPTER 5: FINDINGS AND ANALYSIS..........................................................................41

5.1 RESULTS .................................................................................................................41

CHAPTER 6: CONCLUSION ................................................................................................44

6.1 CONCLUSIONS .......................................................................................................44

6.2 RECOMMENDATIONS...........................................................................................44

6.3 SUGGESTIONS FOR FUTURE RESEARCH ...........................................................46

REFERENCES........................................................................................................................47

APPENDIX..............................................................................................................................52

v

LIST OF TABLES

Table 1: Descriptive Statistics ...................................................................................................52

Table 2: Correlations.................................................................................................................52

Table 3: Unit Root Test Results.................................................................................................52

Table 4: OLS Regression Results I ............................................................................................54

Table 5: OLS Regression Results II...........................................................................................55

Table 6: Granger Causality Test Results ....................................................................................56

Table 7: Study Data...................................................................................................................57

LIST OF FIGURES

Figure 1: The Link between Finance and Growth ......................................................................32

1

CHAPTER 1: INTRODUCTION

1.1 BRIEF BACKGROUND

Mobilization of resources for national development has long been the central focus of

development economics. As a result of this, centrality of savings and investment in economic

growth has been given considerable attention in the literature (Rostow, 1960; Malivaud, 1979;

Soyode, 1990; Aigbokan, 1995; Samuel, 1996; Demirguc-Kunt and Levine, 1996). For

sustainable growth and development, funds must be effectively mobilized and allocated to enable

businesses and the economies harness their human, material and management resources for

optimal output. The stock markets and banks are economic institutions that promote efficiency in

capital formulation and allocation.

According to McKinnon (1973), liberalization of financial markets allows financial deepening

which reflects an increasing use of financial intermediation by savers and investors and the

monetization of the economy and allows efficient flow of resources among people and

institutions over time. This encourages savings and reduces constraint on capital accumulation

and improves allocative efficiency of investment by transferring capital from less productive to

more productive sectors. Regulations such as deposit interest rate ceilings, minimum/maximum

lending rates, quantity restrictions on lending, etc. cause real interest rates to be negative and

unstable especially in the presence of high inflation in an economy. Regulation does lead to

negative impact on the amount of domestic savings and thus capital formation, which retards

economic growth and development.

While economists have generally reached a consensus on the impact of financial development on

economic growth, pointing to causation running from financial development, Patrick (1966)

argues that causation is bi-directional. That is, financial development is both supply-leading and

demand-following. The supply-leading hypothesis claims a causal relationship from financial

development to economic growth by saying that intentional creation and development of

financial institutions and markets would increase the supply of financial services and thus lead to

economic growth while the demand-following hypothesis claims that it is growth of the economy

2

which causes increased demand for financial services which in turn leads to development of

financial institutions and markets.

This study is organized as follows: Chapter 1 gives an introduction to the study, Chapter 2

reviews the literature, Chapter 3 presents the theoretical framework, and Chapter 4 spells out the

research design and methodology. While Chapter 5 is the findings and analysis, Chapter 6 has

the research’s conclusion.

1.2 OVERVIEW OF THE FINANCIAL SECTOR IN MALAWI

The Reserve Bank of Malawi is the core of the financial system responsible for ensuring the

financial system’s soundness. The Reserve Bank of Malawi regulates and supervises the

activities of financial institutions under the 1989 Banking Act, and is responsible for licensing

and registering banks. The commercial banking system is the most vital component of the

financial sector, responsible for accepting deposits and granting short-term credit to productive

entities. In addition to banking institutions, the financial sector also includes a range of other

institutions including savings banks, insurance companies, pension funds, investment banks

(long-term credit) and a securities market.

1.2.1 Bank and Non-Bank Financial Sector

The financial system in Malawi is dominated by the banking sector, which consists of 10

commercial banks and the Reserve Bank of Malawi, the country’s central bank. New banking

institutions have begun to enter the market, including numerous specialized banks catering for

specific industries. Non-bank financial institutions in Malawi are represented by 2 discount

houses, 2 leasing companies, 11 insurance brokers, 12 insurance companies, 1 reinsurance

company, 23 foreign exchange bureaus, 2 money transmitters, one investment company, one

investment trust and eight fund/portfolio managers.

3

1.2.2 Capital Market

The Malawi Stock Exchange has been in existence since 1994 but equity trading had not started

until November 1996 when it first listed the National Insurance Company Limited. Prior to this

first listing, the major activities undertaken were the provision of a facility for secondary market

trading in Government of Malawi’s capital market securities, namely Treasury Bills and Local

Registered Stocks.

The exchange operates in terms of the Capital Markets Development Act of 1990 and the Capital

Market Development Regulations of 1992. Trading occurs on Monday to Friday, between 09h00

and 12h00 local time, using a single price auction system. Equities and government securities are

traded. Clearing occurs by transaction, and settlement occurs on a T + 7 basis. There is no

depository and capital gains tax at marginal rate is applied if shares are sold within a year of

purchase (MK10,000 of revenue from sale is, however, exempt from tax).

Currently Malawi's capital market has five stockbrokers namely Stockbrokers Malawi Limited

(SML), FDH Stockbrokers Ltd, Trust Securities, CDH Stockbrokers Ltd and African Alliance,

which became Malawi's fifth stock broking firm and opened for business January 2009.

1.2.3 Money Market

The Reserve Bank of Malawi acts as an agent of the Malawi Government in the issuance of

Treasury Bills with maturities of 91, 182 and 273 days. Reserve Bank of Malawi bills are also

auctioned to the general public. The day count basis convention for Treasury securities is

actual/365.

1.2.4 The National Payment System

The Malawi Switch Center (MALSWITCH), implemented by the Reserve Bank of Malawi in

2002, forms the basis of Malawi’s National Payment System. This payment system links all the

banks and allows daily electronic cheque clearing and “real-time” settlements between banks and

4

can improve banks’ ability to manage liquidity. Banks know at any time how much money they

have and Reserve Bank of Malawi has better information on liquidity and money supply.

Apart from settlement and clearing functions, MALSWITCH may be a promising platform for a

range of electronic payment, funds transfer and banking products that serve a broad client base.

The use of the MALSWITCH network to support funds transfer services however has been

reportedly low as only a limited number of banks have installed electronic interfaces with

MALSWITCH that enable smart card users to use any ATM machine, regardless of bank branch

or location.

1.2.5 Characteristics and Performance of the Financial Sector in Malawi

Private sector involvement in the financial sector, including the entry of new players has

increased with financial liberalization measures. In 2006, two banks, National Bank of Malawi

and Standard Bank, dominated the sector with 58% of the sector’s assets and 59% of its deposits

(KPMG, Banking Survey Africa 2004). The first foreign shareholders entered the market in 1994

following banking sector reforms. Standard Bank, formerly Commercial Bank of Malawi and

formerly government controlled, is now 60% owned by Standard Bank of South Africa. Majority

foreign controlled banks owned over 46% of total assets in the sector in 2006, with most foreign

owned investors entering the market through investments in new companies (KPMG, Banking

Survey Africa 2004). In recent years other private firms including Leasing and Financing

Company and National Finance Company have expanded operations.

Despite increase in the involvement of the private sector, National Bank of Malawi, Malawi’s

largest commercial bank, is dominated by owners that include companies with significant

government shareholdings. Additionally, the government remains a dominant player in the

ownership structures and boards of major financial institutions, including Malawi Rural Finance

Corporation (MRFC) and Malawi Savings Bank (MSB). The strong role of government in

lending operations has tended to reduce the overall efficiency and performance of institutions

5

and compromised overall sector performance.1 The government however has stated its intention

to privatize and/or restructure parastatals.

In March 2009, the total amount of commercial banks private sector deposits was MWK 118.1

billion; about 4/5 represented domestic deposits and 1/5 foreign currency deposits. Commercial

banks’ net credit to the government (primarily through Treasury Bills subscriptions) totaled

MWK 30.5 billion. Including credit from commercial banks and monetary authorities, credit to

government totaled MWK 96.5 billion. Net credit extended to the private sector totaled MWK

72.7 billion and total net domestic credit was 173.8 billion with MWK 4.6 billion net credit

extended to statutory bodies in the same month in 2009 (Reserve Bank of Malawi, March 2009).

Credit to the private sector as a percentage of total domestic debt has reduced steadily over the

years. At 78% of total credit, for example, in 2000, private sector credit was only 39% in 2004,

34% in 2008 and 42% in March 2009. Claims on the state and central bank (Treasury Bills and

other advances) are far greater than private sector loans and are rising, claiming an even greater

share of resources that might be otherwise available to drive sustainable economic growth.

Central government debt which was dangerously high at about 28% of GDP in 2004, funded

primarily by private sector holdings, decreased to around 10% of GDP in 2008 (Reserve Bank of

Malawi, March 2009).

As of end June 2009, total market capitalization for the domestic stock market was MWK 835.73

billion (or US$ 5.94 billion), with a mere 15 companies publicly traded; the banking system has

a virtual monopoly on sources of financing for businesses.

The banking sector in Malawi appears profitable, largely due to high levels of investments in

government Treasury Bills that offer high real rates of return to encourage their purchase. While

nominal and real rates of return have fallen steadily in recent years, continued high real returns

on T-bills maintain incentives for high levels of investment in T-bills and discourage lending to

the private sector. Banking sector profitability is highly vulnerable to changes on the rates of T-

1Institutions have in some cases politicized lending decisions

6

bills, for example, for the fiscal year ending September 2002, Malawi Rural Finance Company

(MRFC) investment in government securities contributed about 42% to MRFC’s total revenues

for the year. The loan portfolio contributed about 40% (USAID AMAP, 2004).

In addition to fiscal and monetary policies, lack of competition in the banking sector has

contributed to wide spreads between lending and borrowing rates upwards of 20% between 1999

and 2003. Real interest rates averaged 28% between 2000 and 2002. In June 2003, minimum and

maximum nominal lending rates of the two largest banks varied from 46% to 52% while the

average nominal savings rate was 26%, representing a spread of 20 to 26 points. By October

2003, while nominal lending rates had fallen to 40.5% from 46.5%, savings rates decreased to

18.5% increasing the spread to between 22 and 28 points. By June 2004, rising inflation and

macroeconomic uncertainty resulted in a hike once again in lending rates to between 46% and

52%, with savings rate at 22%. Given inflation rates of 11.6% in June 2004, real interest rates

varied from 34% to 40%, higher than the average rates for the preceding five years (1999 –

2003). While new players have entered the market and created more competition, a recent study

indicated that given the dominance of the two main players, interest rate spreads are not likely to

decline in the near future (Chirwa and Mlachila, 2002). Inflation has since dropped from 15.5%

in 2005 to 13.9% in 2006 to 7.9% in 2007 and up to 8.3% in 2008 while from December 2007 to

March 2009, the minimum and maximum nominal lending rates have varied from 19.5% to 27%

with an average nominal savings rate of 2.75%, representing a spread of 16.75% to 24.25%.

Reserve Bank of Malawi has adopted a number of policies to stimulate lending and reduce

spreads including a reduction in their lending rate to commercial banks. The bank rate was cut

from 25% to 20% in November 2006 then to 17.5% in August 2007 and again to 15% in

November 2007 from as high as 45% in mid-2004. The short-term interbank rate was cut by five

points to 35% at the end of 2003, compared to an estimated average of 47.1% in 2003. The

interbank rate was maintained at 25% for the majority of 2004 and was 13.1% in March 2009.

Reserve Bank of Malawi had agreed to reduce commercial banks’ reserve requirement from 30%

to 10% by end 2004, but later decided to delay reserve requirement cuts, now resting at 15.5%.

Reserve Bank of Malawi fears that extra liquidity in the financial system will drive inflation rates

7

up and the absence of good productive opportunities in the domestic economy will drive up

imports and draw on dangerously low foreign exchange reserves.

1.2.6 Financial Sector Reforms in Malawi

In an attempt to improve economic performance, Malawi, like many other developing countries

adopted the structural adjustment programs since the mid-1980s. Financial reforms have been a

major component of structural adjustment programs in developing countries. Following the

McKinnon (1973) - Shaw (1973) hypothesis, the conventional wisdom is that flexibility and

efficiency of the financial system are critical to the growth and development of a market

economy. The McKinnon-Shaw hypothesis suggests that government control and intervention in

the financial system, which limit the operation of market mechanisms lead to financial repression

and retards economic growth and development.

In Malawi, financial reforms typically involved not only decontrolling interest rates and

eliminating credit limits; they also entailed considerable institutional reforms, including new

laws and regulations governing the financial sector, the restructuring and privatization of banks

and the adoption of indirect instruments of monetary policy (Mehran et al., 1998). These

financial reforms are naturally expected to improve financial intermediation and lead to more

investment, productivity and economic growth (McKinnon, 1991).

Financial sector reforms in Malawi began in 1987 when commercial banks were given the

freedom to set their own lending interest rates. In 1988 deposit rates were deregulated and

preferential interest rates to the agricultural sector were abolished. By 1990 all interest rates were

fully liberalized.

Despite the commencement of reforms in 1987, there was relatively little systematic analysis and

a serious financial reform agenda until 1989 when the legal framework for the financial sector

was overhauled. Both the Reserve Bank of Malawi (Reserve Bank of Malawi) Act and the

Banking Act were significantly revised in order to give more powers to the central bank to

supervise and regulate the financial sector, to introduce indirect monetary instruments and to

8

regulate entry of new banks into the financial system. Bank supervision was significantly

enhanced in order not only to more effectively supervise existing institutions but also to

adequately and effectively assess applicants for entry by new institutions, a process that had

hitherto been ad hoc and non-transparent.

Prior to completion of financial sector reforms, the financial system only had two commercial

banks, two leasing finance institutions, one savings bank and one building society (Chirwa,

2001). The changes in the legal framework resulted in restructuring of existing institutions and

entry of new institutions in commercial banking activities. Three existing non-bank institutions

(two in leasing and one in trade finance) were granted corporate banking licenses and two more

(one in leasing and corporate finance and another in trade finance) were licensed in corporate

banking by 1991 (Mlachila and Chirwa, 2002).

Since 1994, the number of commercial banks in the financial system has increased to ten. The

postal savings bank, hitherto a moribund part of the postal and telecommunications

administration, was corporatized and converted into the Malawi Savings Bank and was

incorporated as a merchant bank in 1995 (Mlachila and Chirwa, 2002). The new commercial

bank entrants compete in the same markets as the two already established commercial banks,

offering demand, savings and time deposit accounts to the public. Nonetheless, the two well-

established commercial banks still remain dominant with first mover advantages and an

established branch network across the country. The new entrants have a few branches and mostly

only operate in the two main commercial centers of Lilongwe and Blantyre.

In the monetary policy area, the central bank introduced indirect instruments to deal with excess

liquidity, namely central bank bills and later, treasury bills for open market operations. However,

due to lack of confidence and the perceived high cost of monetary policy, the central bank had

maintained the use of relatively high liquidity reserve requirements as an important lever of

monetary policy. Changes in the reserve requirement were the main monetary policy instrument

during the period 1990-92, with 6 adjustments, 4 of which occurred in 1990. The reserve

requirement was introduced in 1989 at 10% and increased to 35% in 1994 and then decreased to

30% in 2000. The penalty for noncompliance was introduced in 1992 at 18%, with the reserve

9

requirement at 20% and reached a peak of 60% in 1995 until it dropped to 43% in 1997. Initially,

liquidity reserves deposited with the central bank earned interest but this ceased at the end of

1990. The central bank reintroduced interest on liquidity reserves in 1997 although this was

short-lived with liquidity reserves with the central bank ceasing to earn interest in August 1998

(Mlachila and Chirwa, 2002).

Open market operations have became the most active monetary policy instrument, with the

introduction of Reserve Bank of Malawi bills and treasury bills to mop up excess liquidity in the

economy. In addition, the first discount house was established in 1997 and led to the

intensification of operations within the inter-bank market. The inter-bank market is now playing

an important role in financing the short-term liquidity needs of financial institutions and a

cheaper source of finance compared to the cost of borrowing from the discount window at the

central bank.

Following the 1990 Capital Market Development Act, the Malawi Government continued to

introduce measures to broaden the capital market and improve the mobilization of domestic

financial resources. The Malawi Stock Exchange was established in 1994, the same year

Stockbrokers Malawi Limited was established to deal in listed company shares and act as a

broker in government and other securities approved by Reserve Bank of Malawi.

As a step towards market determination of the exchange rate, Malawi Government authorities

created a foreign exchange market administered by the central bank where weekly auctions of

foreign exchange would take place. Together with the exchange rate liberalization in February

1994, all foreign exchange transactions were liberalized except for the capital account which

remained under exchange control regulations.

During the same reform process, the Government of Malawi also undertook the privatization of

public enterprises through the enactment of the Privatization Act passed in 1995. This was aimed

at improving efficiency, fostering competition and establishing a wider base of share ownership.

10

1.3 PROBLEM STATEMENT

Financial sector reforms in Malawi began in 1987 with the liberalization of lending rates and

then the deregulation of deposit rates in 1988, following earlier periodic adjustments in interest

rates and exchange rates. While this was done in the context of IMF supported programs, there

was relatively little systematic analysis and a serious financial reform agenda until 1989. The

World Bank (1989) in the analysis of the industrial sector in Malawi identified financial sector

underdevelopment as a key impediment to economic growth and development. Following several

financial sector studies and initiatives, the Government of Malawi undertook a systematic

program of financial sector reforms (World Bank, 1991).

Again, in 1999 Gelbard and Leite completed a survey-based comprehensive index of financial

development in Africa based on six aspects of financial development. Overall the financial

system in Malawi improved from being underdeveloped with an index of 24 in 1987 to being

minimally developed with an index of 47 in 1997 representing 95.8% improvement.2

It was against this background that this research aimed at empirically answering the question: has

the effort by the Government of Malawi to develop the financial sector led to economic growth?

1.4 PURPOSE OF THE STUDY

The purpose of this research specifically was to empirically evaluate whether financial sector

development indicators are robustly correlated with future rates of economic growth and to

investigate the direction of causality between financial development and economic growth in

Malawi using time series data.

2 The rankings in Gelbard and Leite are relative to other African countries, they should not be interpreted as indicators of financial development from a worldwide perspective. Only Egypt, South Africa and Morocco which are classified among “emerging markets” can be considered as relatively developed from an international standard.

11

1.5 RESEARCH OBJECTIVES

The research aimed at evaluating the characteristics of the financial sector in Malawi that are of

paramount importance to economic growth and that can be developed to steer economic growth

in the country. The objectives of this study were:

1. To evaluate whether stock market development as measured by stock market liquidity –

proxied by the value of stock trading relative to the size of market is significantly

correlated with economic growth in Malawi.

2. To evaluate whether stock market development as measured by stock market liquidity –

proxied by value of trading relative to the size of the economy is significantly correlated

with economic growth.

3. To evaluate whether banking development as measured by bank loans to the private

sector is significantly correlated to economic growth.

4. To investigate whether financial development is supply-leading or demand-following.

1.6 RESEARCH HYPOTHESIS

The stock market is expected to accelerate economic growth by providing a boost to domestic

savings and increasing the quantity and quality of investment (Singh, 1997). The stock market is

expected to encourage savings by providing individuals with an additional financial instrument

that may better meet their risk preferences and liquidity needs. Better savings mobilization may

increase the savings rate (Levine and Zervo, 1998). Stock markets also provide an avenue for

growing companies to raise capital at lower cost. In addition, companies in countries with

developed stock markets are less dependent on bank financing, which can reduce the risk of a

credit crunch. Stock markets therefore are able to positively influence economic growth through

encouraging savings amongst individuals and providing avenues for firm financing.

12

The stock market is expected to ensure through the takeover mechanism that past investments are

also most efficiently used. Theoretically, the threat of takeover is expected to provide

management with an incentive to maximize firm value. The presumption is that, if management

does not maximize firm value another economic agent may take control of the firm, replace

management and reap the gains from the more efficient firm. Thus, a free market in corporate

control, by providing financial discipline, is expected to provide the best guarantee of efficiency

in the use of assets. Similarly, the ability to effect changes in the management of listed

companies is expected to ensure that managerial resources are used efficiently (Kumar, 1984).

Efficient stock markets are expected to reduce costs of information. They may do so through the

generation and dissemination of firm specific information that efficient stock prices reveal. Stock

markets are efficient if prices incorporate all available information. Reducing the cost of

acquiring information is expected to facilitate and improve the acquisition of information about

investment opportunities and thereby improves resource allocation. Stock prices determined in

exchanges and other publicly available information may help investors make better investment

decisions and thereby ensure better allocation of funds among corporations and as a result a

higher rate of economic growth.

Stock market liquidity is expected to reduce the downside of risk and costs of investing in

projects that do not pay off for a long time. With a liquid market, the initial investors do not lose

access to their savings for the duration of the investment project because they can easily, quickly

and cheaply sell their stake in the company (Bencivenga and Smith, 1991). Thus, more liquid

stock markets could ease investment in long-term, potentially more profitable projects, thereby

improving the allocation of capital and enhancing prospects for long-term growth.

Banks are expected to facilitate pooling and trading of risk. Without financial intermediaries,

lenders facing liquidity shocks are forced to withdraw funds invested in long-term investment

projects. Early withdrawal reduces economic growth. Banks can improve upon the situation by

giving savers (lenders) immediate access to their funds while simultaneously offering borrowers

a long-term supply of capital. At the aggregate level, the liquidity risk that individual lenders

face is perfectly diversified (Diamond and Dybvig, 1983; Greenwood and Smith, 1997;

13

Bencivenga and Smith, 1991). By facilitating diversification, banks allow the economy to invest

relatively more in productive technology. This spurs economic growth (Obstfeld, 1994).

Banks are expected to improve on the allocation of funds over investment projects by acquiring

information ex-ante. Information asymmetries generate a need for perspective research: firms

with productive investment projects but no funding have an informational advantage about the

quality of their investment. It is difficult and costly for individual lenders to screen projects and

their managers. Information acquisition costs create incentives for intermediaries to arise: the

economy avoids duplication of the screening cost.

Banks are expected to mobilize savings in an efficient way. Banks establish a marketplace where

lenders feel comfortable to relinquish control of their savings. Because it is possible to save in

differing sums of money, a larger fraction of the population can participate in banking.

Accordingly, the study tested the following hypotheses:

1. H0: Stock market development does not lead to economic growth

H1: Stock market development leads to economic growth

2. H0: Banking development does not lead to economic growth

H1: Banking development leads to economic growth

1.7 RESEARCH QUESTIONS

The study aimed at answering the following questions:

1. Does stock market development lead to economic growth in Malawi?

2. Does banking development lead to economic growth in Malawi?

14

1.8 SIGNIFICANCE OF THE STUDY

Many studies have concentrated on cross-section regressions which as pointed by Levine and

Renelt (1992) among others should be view with caution. In the literature, it is accepted that time

series studies of economic growth offer important advantages as compared to cross-country

growth regressions, see for example Jones (1995) and Kocherlakota and Yi (1997). According to

Levine and Zervos (1996), cross-country growth regressions suffer from measurement, statistical

and conceptual problems.

In terms of measurement problems, country officials sometimes define, collect and measure

variables inconsistently across countries. Further, people with detailed country knowledge

frequently find discrepancies between published data and what they know happened.

In terms of statistical problems, regression analysis assumes that the observations are drawn from

the same population, yet vastly different countries appear in cross-country regressions. Many

countries may be sufficiently different such that they warrant separate analyses.

Conceptually, the coefficients from cross-country regressions should be interpreted cautiously.

When averaging over long periods, many changes are occurring simultaneously: countries

change policies, economies experience business cycles and governments rise and fall.

Thus, aggregation may blur important events and differences across countries. The cross-

sectional approach in this way limits the potential robustness of findings with respect to country

specific effects and time related effects. This study, by using time series data from Malawi

provides robust findings pertaining to Malawi by taking into consideration country specific

effects and time related effects and therefore avoiding the measurement, statistical and

conceptual problems suffered by the cross-country growth regressions.

15

CHAPTER 2: LITERATURE REVIEW

2.1 FINANCIAL SYSTEM

A financial system consists of institutional units and markets that interact, typically in a complex

manner, for the purpose of mobilizing funds for investment, and providing facilities, including

payment systems, for the financing of commercial activity (IMF, 2004).

Financial systems deepen when financial assets grow faster than a country’s income growth; this

is measured by the growth in liquid assets (composed primarily of currency and deposits in the

central bank, demand, fixed and term deposits and commercial paper like bonds) as a percentage

of a country’s GDP. This measure provides an indication of the banking system’s ability to

increase lending.

A smooth functioning financial system is the glue that binds a strong performing economy and it

is characterized by:

An efficient payment system

A stable convertible currency

Intermediation of savings and loans

The management, spreading and transfer of risk

A smooth functioning financial system enables an efficient allocation of resources and stable

consumption that lead to higher growth rates and lower rates of poverty (Gonzalez-Vega, 2003).

2.1.1 Financial Institutions

The role of financial institutions within the system is primarily to intermediate between those

that provide funds and those that need funds, and typically involves transforming and managing

risk. Particularly for a deposit-taker, this risk arises from its role in maturity transformation,

where liabilities are typically short term, (e.g., demand deposits), while its assets have a longer

16

maturity and are often illiquid (e.g., loans) (IMF, 2004). Broadly speaking, there are three major

types of financial institutions:

1. deposit-taking institutions that accept and manage deposits and make loans (these include

banks, credit unions, trust companies and mortgage loan companies)

2. insurance companies and pension funds

3. brokers, underwriters and investment funds

2.1.2 Financial Markets

Financial markets provide a forum within which financial claims can be traded under established

rules of conduct, and can facilitate the management and transformation of risk. They also play an

important role in identifying market prices (“price discovery”) (IMF, 2004).

2.1.2.1 Capital Markets

The capital market is where individuals, companies, governments, and other organizations trade

in financial securities. The stock market and the bond market are two examples of sections in the

capital market.

The primal role of the capital market is to channelize investments from investors who have

surplus funds to the ones who are running a deficit. Certain organizations in both the private and

public sectors will sell securities on the capital market in order to raise funds for business or

other ventures. For instance, a company may conduct an initial public offering (IPO) in order to

reach out to the investing public and receive capital to use in its business. A government may

issue bonds, for instance, treasury bonds, in order to receive funds.

The capital market is divided into two different markets. These are the primary capital market

and secondary capital market.

17

2.1.2.1.1 Primary Capital Market

The primary capital market is concerned with the new securities which are traded in this market.

This market is used by the companies, corporations and the national governments to generate

funds for different purposes like setting up new businesses, expanding existing businesses or

modernization of businesses.

The primary capital market is also called the New Issue Market or NIM. The securities which are

introduced in the market are sold for first time to the general public in this market and it is called

the Initial Public Offering (IPO). The process of offering new issues of existing stocks to the

purchasers is known as underwriting. The act of selling new issues in the primary capital market

follows a particular process. This process requires the involvement of a syndicate of the

securities dealers. The dealers who are running the process get a certain amount as commission

which is included in the price of the security offered in the primary capital market.

There are three ways of offering new issues in the primary capital market. These are:

Initial Public Offering

Preferential Issue.

Rights Issue (for existing companies)

2.1.2.1.2 Secondary Capital Market

The secondary capital market, otherwise known as the aftermarket, involves the resale of

existing securities. This typically occurs on an exchange, although that is not necessarily always

the case. Individual investors often buy, sell, and trade amongst each other, although

organizations may also be involved.

18

2.1.2.1.3 Capital Market Instruments

The financial instruments that have long maturity periods are dealt in the capital market. The

different types of financial instruments that are traded in the capital markets are equity

instruments, credit market instruments, insurance instruments, foreign exchange instruments,

hybrid instruments and derivative instruments.

One example of these uniform instruments is a fixed rate bond. A fixed rate bond allows a

company/government to borrow money for a fixed period of time while paying a fixed interest

rate on that borrowed money. In the capital markets, the uniformity of fixed rate bonds facilitate

the transfer of capital from lender to borrower. Other examples of capital market instruments

include equity, floating rate bonds, convertible bonds, asset backed securities, mortgage backed

securities, and interest rate swaps.

There are a number of capital market instruments used for market trade, including stocks, bonds,

debentures, treasury bills, foreign exchange, fixed deposits, and others. These are used by the

investors to make a profit out of their respective markets. All of these are called capital market

instruments because these are responsible for generating funds for companies, corporations, and

sometimes national governments.

While all capital market instruments are designed to provide a return on investment, the risk

factors are different for each and the selection of the instrument depends on the choice of the

investor. The risk tolerance factor and the expected returns from the investment play a decisive

role in the selection by an investor of a capital market instrument.

2.1.2.1.4 Role of Capital Markets

The potential role of financial markets in economic growth has been well documented. Capital

markets are mechanisms for raising and trading long-term capital and thus represent the long end

of the maturity spectrum of financial instruments. In general, financial markets provide four

important economic functions. The first is that markets determine the prices of assets traded

19

through the interaction of buyers and sellers. This is the process of price discovery. Second,

financial markets provide a mechanism for an investor to sell a financial asset. Thus, markets

offer liquidity or the ability to convert a financial asset into cash. Thirdly, financial markets

reduce the cost of financial transactions. By bringing sellers and buyers of financial assets

together, explicit search costs, such as the cost that would be spent to identify a seller or buyer of

an asset are eliminated. Information costs, which are incurred in assessing the investment merits

of a financial asset, are also reduced because specialized institutions emerge to produce

information more efficiently. Finally, financial markets provide facilities for transferring risk. In

so doing, they ensure that risks are borne by those most willing to bear them. In performing all

these functions, financial markets serve to mobilize savings from the public and channel them to

firms undertaking productive investments, generating even more savings and investment in a

virtuous growth cycle. Inactive markets are weak in terms of liquidity production and

information production. An inefficient market becomes a barrier to raising capital in the primary

market, and reduces the volume of trading in secondary markets.

Capital market institutions, such as stock exchanges, stockbrokerage and investment banking

firms, deliver several secondary economic benefits. Capital markets facilitate corporate

governance and serve as markets for corporate control. Inefficient management is typically

thrown out of office through takeovers, which allow unfriendly raiders to accumulate shares in

the open market and take control of the firm. The very threat of such takeovers is actually a

powerful mechanism for disciplining management. The stock market also serves as a

thermometer for corporate performance. Management gets signals from the stock price behavior

to judge performance and take corrective action. In short, the stock market votes on corporate

performance.

Within the capital market, securities firms (also called investment banking and/or stockbrokerage

firms) work within a stock exchange framework to fulfill the economic role of financial markets

through a set of distinct activities. The key activities of securities firms cover the broker, dealer

and advisory and research functions.

Broker Function: Brokers earn a commission or fee by bringing buyers and sellers together.

They do not take an ownership position in an asset and, therefore, do not accept the risk of

20

fluctuating asset prices. As brokers, securities firms are the channels through which individuals,

businesses and governments may purchase or sell bonds, shares and other types of securities.

While direct purchases and sale of securities are possible between consenting parties, such

transactions are time-consuming and costly because of the amount of time it takes a buyer to find

a seller (i.e., high search costs). The broker, on the other hand, has a well-developed set of

relationships for trading securities and is able to arrange transactions for a fee and at a lower

overall cost.

Dealer Function: Dealers take an ownership position with the intent of immediately disposing of

the asset or holding it for a more extended period. Dealers serve as market makers. In this

capacity, they hold an inventory of securities and are prepared to sell the securities at the offer

price and buy at the bid price, earning a spread equal to the difference. When instruments are

traded over the counter, the existence of a secondary market depends on the function of the

dealer as a market maker.

Advisory and Research Function: In addition to the broker and dealer functions, the securities

industry offers many other services. These include advisory services, research and mergers and

acquisitions (finding a buyer and a seller). The research functions are important for the efficiency

of financial markets. An efficient financial market is defined as a market in which securities

prices fully reflect all available information. By researching extensively on various securities and

by using such information to make trades, securities firms provide a transmission mechanism for

the flow of information into securities prices.

2.1.2.2 Money Markets

The money market is the market where liquid and short-term borrowing and lending take place.

The lending of funds in this market constitutes short-term investments. In a certain sense all bank

notes, current accounts, etc. belong to the money market.

In financial market terms, the money market exists for the purpose of issuing and trading of

short-term instruments, that is, instruments where the term remaining from the date when trading

takes place to the date of redemption of the loan represented by die instrument (commonly

referred to as the "term to maturity"), is of a short-term nature. In theory, this term for

21

classification as a money market instrument is given as one year. In practice, however,

instruments with a term to maturity of three years or less are normally classified as money

market instruments although this is not a hard and fast rule.

The need for a money market arises because receipts of economic units do not coincide with

their expenditures. These units can hold money balances to insure that planned expenditures can

be maintained independently of cash receipts (that is, transactions balances in the form of

currency or demand deposits). There is however, a cost in the form of foregone interest involved,

by holding these balances. To enable the economic units to minimize this cost, they usually seek

to hold the minimum money balances required for day-to-day transactions. They supplement

these balances with holdings of money market instruments. The advantages of money market

instruments are: that they can be converted to cash quickly and at a relatively low cost, and they

have low price risk due to their short maturities. Economic units can also meet their short-term

cash demands by maintaining access to the money market and raising funds there when required.

2.1.2.2.1 Money Market Instruments

The financial instruments that have short or medium term maturity periods are dealt in the

money market.

Types of Money Market Instruments

Treasury Bills: The Treasury bills are short-term money market instrument that mature in a

year or less than that. The purchase price is less than the face value. At maturity the

government pays the Treasury Bill holder the full face value. The Treasury Bills are

marketable, affordable and risk free. The security attached to the treasury bills comes at the

cost of very low returns.

Certificate of Deposit: The certificates of deposit are basically time deposits that are issued

by the commercial banks with maturity periods ranging from 3 months to five years. The

return on the certificate of deposit is higher than the Treasury Bills because it assumes a

higher level of risk.

22

Commercial Paper: Commercial Paper is short-term loan that is issued by a corporation use

for financing accounts receivable and inventories. Commercial Papers have higher

denominations as compared to the Treasury Bills and the Certificate of Deposit. The maturity

period of Commercial Papers are a maximum of 9 months. They are very safe since the

financial situation of the corporation can be anticipated over a few months.

Banker's Acceptance: It is a short-term credit investment. It is guaranteed by a bank to make

payments. The Banker's Acceptance is traded in the Secondary market. The banker's

acceptance is mostly used to finance exports, imports and other transactions in goods. The

banker's acceptance need not be held till the maturity date but the holder has the option to sell

it off in the secondary market whenever he finds it suitable.

Repos: The Repo or the repurchase agreement is used by the government security holder

when he sells the security to a lender and promises to repurchase from him overnight. Hence

the Repos have terms raging from 1 night to 30 days. They are very safe due to government

backing.

2.2 FINANCIAL DEVELOPMENT

Financial development refers to measures that affect the growth, efficiency, standards and

diversification of the financial system. Financial development focuses on initiatives to encourage

the growth of savings and the development of money and capital markets. It aims to grow the

financial system by mobilizing savings, promoting competition and efficiency and facilitating the

allocation of resources among different uses, both productive and consumptive. In addition, it

aims to establish a well functioning and efficiency payment system that enables the clearing and

transfer of funds among financial institutions.

In short, financial development involves improvements in:

1. producing information about possible investments and allocating capital,

23

2. monitoring firms and exerting corporate governance,

3. trading, diversification and management of risk,

4. mobilization and pooling of saving,

5. easing the exchange of goods and services.

These financial functions influence savings and investment decisions, and technological

innovations and hence economic growth.

2.3 ECONOMIC GROWTH

Economic growth is an increase in the level of production of goods and services by a country

over a certain period of time. Economic growth refers only to the quantity of goods and services

produced; it says nothing about the way in which they are produced. In recent years, the idea of

'sustainable development' has brought in additional factors such as environmentally sound

processes that must be taken into account in growing an economy. Thus, economic development,

a related term, refers to the change in the way goods and services are produced; positive

economic development involves the introduction of more efficient or "productive" technologies

or forms of social organization. Nominal growth is defined as economic growth including

inflation, while real growth is nominal growth minus inflation.

Increases in the capital stock, advances in technology, and improvements in the quality and level

of literacy are considered to be the principal causes of economic growth.

2.3.1 Stock Markets and Economic Growth

In recent times there was a growing concern on the role of the stock market in economic growth

(Levine and Zervos, 1996; Demirguc-Kunt and Levine, 1996; Oyejide, 1994; Nyong, 1997). The

stock market is in the focus of the economist and policy makers because of the perceived benefits

it provides for the economy. The stock market provides the fulcrum for capital market activities

and it is often cited as a barometer of business direction. An active stock market may be relied

24

upon to measure changes in the general economic activities using the stock market index

(Obadan, 1998).

The most efficient allocation of capital is achieved by liberalizing financial markets and letting

the market allocate the capital. But if the financial market is composed of banks only, the market

will fail to achieve efficient allocation of capital because of the shortcoming of debt finance in

the presence of asymmetric information.3 Thus, the development of stock markets is necessary to

achieve full efficiency of capital allocation if the government is to liberalize the financial system.

While banks finance only well-established, safe borrowers, stock markets can finance risky,

productive and innovative investment projects (Caporale, Howells and Soliman, 2004).

Stock markets contribute to economic growth through the specific services it performs either

directly or indirectly. Notable among the functions of the stock market are mobilization of

savings, creation of liquidity, risk diversification, improved dissemination and acquisition of

information and enhance incentive for corporate control. Improving the efficiency and

effectiveness of these functions, through prompt delivery of their services can augment the rate

of economic growth.

The stock market is viewed as a complex institution imbued with inherent mechanism through

which long-term funds of the major sectors of the economy comprising households, firms and

government are mobilized, harnessed and made available to various sectors of the economy

(Nyong, 1997). The development of the capital market and apparently the stock market provides

opportunities for greater funds mobilization, improved efficiency in resource allocation and

provision of relevant information for appraisal (Inanga and Emenuga, 1997).

The stock market enables governments and industries to raise long-term capital for financing

new projects and expanding and modernizing industrial/commercial concerns. For instance,

companies would need to build new factories, expand existing ones, or buy new machinery.

Government would also require funds for the provision of infrastructures. All these activities

require long-term capital, which is provided by a well functioning stock market (Osinubi, 2004).

3 Relevant information which is known to some but not all parties involved.

25

If capital resources are not provided to those economic areas, especially industries where demand

is growing and which are capable of increasing production and productivity, the rate of economic

expansion often suffers. A unique benefit of the stock market to corporate entities is the

provision of long-term, non-debt financial capital. Through the issuance of equity securities,

companies acquire perpetual capital for development. Through the provision of equity capital,

the market also enables companies to avoid over-reliance on debt-financing, thus improving

corporate debt-to-equity ratio.

Stock markets may also affect economic activities through the creation of liquidity. Liquid equity

markets make available savings for profitable investments that require long-term commitment of

capital. Hitherto, investors are often reluctant to relinquish control of their savings for long

periods. As asserted by Bencivenga, Smith and Starr (1996), without liquid capital markets there

would be no industrial revolution. This is because savers would be less willing to invest in large,

long-term projects that characterized the early phase of industrial revolution.

Closely related to liquidity is the function of risk diversification. Stock markets can affect

economic growth when they are internationally integrated. This enables greater economic risk

sharing because high return projects also tend to be comparatively risky. Stock markets that

facilitate risk diversification encourage a shift to higher return projects (Obstfeld, 1994). The

resultant effect is a boost in the economy leading to growth through the shifting of society’s

savings to higher return investments.

Accelerated economic growth may also result from acquiring information about firms; rewards

often come to an investor who is able to trade on information obtained by effective monitoring of

firms for profit. Thus, improved information will improve resource allocation and promote

economic growth.

The nature and economic significance of the relationship between stock market development and

economic growth vary according to a country’s level of economic development, with a larger

impact in less developed economies (Filer, Hanousek and Campos, 1999). The proponents of

positive relationships between stock market development and economic growth hinge their

26

argument on the fact that the stock market aids economic growth and development through the

mobilization and allocation of savings, risk diversification, liquidity creating ability and

corporate governance among others. Nyong (1997) reported that as far back as 1969, Goldsmith

Raymond observed that the emergence of equity markets and its rapid development indicate the

level of economic growth and development.

Using the liquidity argument, Bencivenga, Smith and Starr (1996) reasoned that the level of

economic activities is affected by the stock market through it liquidity creating ability. The logic

of this reasoning is that profitable investments require long-term capital commitment; often

investors are not willing or are reluctant to trade their savings for a long gestation period. With

liquid equity markets, risks associated with investment are reduced, making it more attractive to

investors. Thus, the easy transfer of capital ownership facilitates firm’s permanent access to

capital raised through equity issues. Therefore, as liquid markets improve the allocation of

capital, the prospects for long-term economic growth are enhanced. Also, savings and investment

are increased due to reduction in the risk worthiness of investment facilitated by stock market

liquidity.

An alternative view on stock market and long-term economic growth by Demirguc-Kunt and

Levine (1996), however, observed that there are some channels through which liquidity can deter

growth. Firstly, savings rate may be reduced, this happens when there is increasing returns on

investment through income and substitution effect. As savings rate falls and with the existence of

externality attached to capital accumulation, greater stock market liquidity could slow down

economic growth. Secondly, reducing uncertainty associated with investment may impact on

savings rate, but the extent and direction remain ambiguous. This is because it is a function of

the degree of risk-averseness of economic agents. Thirdly, effective corporate governance often

touted as an advantage of liquid stock markets may be adversely affected. The ease with which

equity can be disposed of may weaken investors’ commitment and serves as a disincentive to

corporate control and vigilance on the part of investors thereby negating their role of monitoring

firms’ performance. This often culminates in stalling economic growth.

27

2.3.2 Banks and Economic Growth

Banks facilitate the transfer of resources from savers to firms, in this way overcoming the

imperfections which are present in the real world and are absent in a theoretical world without

frictions in which savers directly finance firms. The presence of asymmetric information which

hinders the direct financing of firms by savers justifies the existence of banks whose aim is to

reduce information costs. The banks gather information, in this way eliminating the problems

connected with the presence of asymmetric information. The banks’ activities permit the real

world, characterized by imperfections, to obtain those optimal results that characterize an

economy without imperfections in which the mechanism of the interest rate ensures the efficient

allocation of the savings. In a world without information asymmetries the mechanism that allows

saved resources to be efficiently allocated is the interest rate, through this mechanism productive

resources are given to those who are able to obtain the highest return, the presence of

information asymmetries prevents this mechanism from working.

Financial intermediaries may lower the costs of gathering and processing information and

thereby improve the allocation of resources (Boyd and Prescott, 1986). Such information

improvement on all economic agents can boost economic growth. Besides, banks may also spur

the rate of technological innovation by selecting those entrepreneurs with the greatest chances of

launching successful ventures (King and Levine, 1993b). Bencivenga and Smith (1993) show

that banks that alleviate the corporate governance problem by lowering monitoring costs will

reduce credit rationing and thereby spur economic growth. Financial intermediaries provide

vehicles for trading, pooling and diversifying risk. Thus, they allow agents to hold a diversified

portfolio of risky projects that will induce society to shift towards projects with higher expected

returns with positive incidence on economic growth (Gurley and Shaw, 1955; Greenwood and

Javonovic, 1990).

Bencivenga and Smith (1991) show that, by eliminating liquidity risk, banks can increase

allocation of resources to high return, illiquid asset and accelerate growth. Financial

intermediaries that encourage the mobilization of savings by providing attractive instruments and

saving vehicles can profoundly affect economic development. Acemoglu and Zilibotti (1997)

28

noted that, with large, indivisible projects, financial arrangements that collect resources from

disparate savers and invest it in a diversified portfolio of risky projects make it more easier to

reallocate investment toward higher return activities with positive implications on economic

growth.

The effect of better financial intermediaries on savings, however, is theoretically ambiguous.

Higher returns ambiguously affect savings rate, due to well-known income and substitution

effects. Also, greater risk diversification opportunities have an ambiguous impact on savings rate

(Levhari and Srinivasan, 1969). Moreover, in a closed economy, a drop in savings rates may

have a negative impact on growth. Indeed, if these savings and externality effects are sufficiently

large, an improvement in financial intermediary development could lower growth (Bencivenga

and Smith, 1991).

2.4 EMPIRICAL STUDIES

Some earlier studies have examined the relationship between growth and stock markets, and the

banking sector, using either cross-country or panel methods. However, their empirical approach

typically suffers from serious econometric weaknesses. For instance, the Ordinary Least Squares

(OLS) regressions estimated by Levine and Zervos (1998) are potentially affected by

simultaneity bias, and do not control for country fixed effects. Beck, Levine and Loayza (2000)

tried to control for simultaneity bias by using instrumental variable procedures, but did not

include a measure of stock market development in their analysis, as this was available only for a

much smaller group of countries than the ones they considered. Rousseau and Wachtel (2000)

improved upon earlier contributions by using the difference panel estimator introduced by

Arellano and Bond (1991), which removes both the bias resulting from unobserved country

effects and simultaneity bias. However, as shown by Alonso-Borrego and Arellano (1999), this

estimator suffers from finite sample bias and is not very accurate asymptotically. The latest

contribution to this type of literature is due to Beck and Levine (2004), who apply more recent

generalized-method-of-moments techniques for dynamic panels in an attempt to resolve the

statistical weaknesses of previous studies. Specifically, they construct five-year averages to filter

cyclical fluctuations, and use three different versions of the system panel estimator developed by

29

Arellano and Bover (1995), that has been shown to have a superior performance in terms of both

consistency and efficiency. All three variants, though, still give rise to some problems. In

particular, the one-step estimator requires the errors to be homoscedastic, which is not an

empirically supported assumption; the two-step estimator is based on heteroskedasticity-

consistent standard errors, but its finite sample performance is likely to be affected by over-

fitting, with the empirical critical values of the corresponding test statistic being very different

from the asymptotic ones; finally, the modified estimator introduced by Calderon, Chong and

Loayza (2000) attenuates the over- fitting problem, but implies the loss of an observation. It is

not entirely surprising, therefore, that the empirical results produced by these estimators are not

always consistent. Consequently, Beck and Levine (2004) are not able to identify independent

contributions of stock markets and banks to economic growth, although their analysis does

suggest that financial development as a whole is beneficial to growth.

Finally, Bekaert, Harvey and Lundblad (2003) use an instrumental variable estimator which

reduces to pooled OLS under simplifying assumptions on the weighting matrix. They focus on

financial liberalization, arguing that this is not just another aspect of more general financial

(banking and stock market) development, and conclude that equity market liberalization leads to

a one percent increase in annual real economic growth over a five-year period in a broad cross-

section of developed and emerging countries. However, once again there are some econometric

difficulties arising from their panel approach. For instance, the results depend to some extent on

the weighting matrix, whose appropriate definition is not the same if one assumes

heteroskedasticity across countries and time, group-wise heteroskedasticity, overlapping

observations etc. Also, the choice of interval, and more generally omitted variable bias (see

Mankiw (1995)) can affect their results. Even more importantly, this type of regression, despite

being predictive, is informative about association, rather than causality.

30

CHAPTER 3: THEORETICAL FRAMEWORK

3.1 THEORY

Theory stipulates that economic growth may come from the following two channels: growth in

the amount of factors of production or increases in the efficiency with which those factors are

used. In other words, growth is induced by the increase in investment (accumulation of capital)

and the efficiency of investment (technological innovation) (De Gregorio, 1996).

In an economy higher national savings would encourage investment (capital accumulation) and

this is why savings is viewed as an important vehicle to increase growth. The efficiency of

investment, in turn, includes not only total factor productivity growth, but also the accumulation

of other factors not included in physical capital, and hence, not included in standard measures of

investment such as human capital, organizational capital, information, etc. Financial

development has a dual effect on economic growth. On the one hand, the development of

domestic financial markets may enhance the efficiency of capital accumulation. On the other

hand, financial intermediation may contribute to raising the savings rate and, thus, the investment

rate.

Significant information and transaction frictions prevent savers from easily entrusting their

savings to entrepreneurs and firms. First, acquiring and processing information on firms and

prospective investment projects is not only costly for individual investors, but would also result

in duplication of effort. Second, individual investors face high costs of monitoring and

controlling borrowers once money has changed hands. In this context, it should also be noted

that small investors have incentives to free-ride on large investors who have greater incentives to

pay the cost of screening, assessing, monitoring and controlling firms. Third, investors are

reluctant to give up control over their savings over a longer time period (liquidity risk). Many

investments, however, require the long-term commitment of resources. Fourth, investors face

idiosyncratic risk of individual investments. In the absence of tools to diversify these risks,

investors again might be reluctant to give up control over their savings.

31

The costs of acquiring information and making transactions thus create incentives for the

emergence of financial markets and institutions. Put differently, financial markets and

institutions may arise to ameliorate the problems created by information and transactions

frictions. Different types and combinations of information and transaction costs motivate distinct

financial contracts, markets, and institutions.

In arising to ameliorate transaction and information costs, financial systems serve one primary

function: they facilitate the allocation of resources, across space and time, in an uncertain

environment (Merton and Bodie 1995, p. 12). To organize the vast literature on financial and

economic activity, Levine (1997) breaks this primary function into five basic functions.

Specifically, financial systems:

Facilitate the trading, hedging, diversifying and pooling of risk,

Allocate resources,

Monitor managers and exert corporate control,

Mobilize savings and

Facilitate the exchange of goods and services.

Levine (1997) stipulates that each financial function may affect economic growth through two

channels: capital accumulation and technological innovation. On capital accumulation, one class

of growth models uses either capital externalities or capital goods produced using constant

returns to scale but without the use of non-reproducible factors to generate steady-state per capita

growth (Romer, 1986; Lucas, 1988; Rebelo, 1991). In these models, the functions performed by

the financial system affect steady-state growth by influencing the rate of capital formation. The

financial system affects capital accumulation either by altering the savings rate or by reallocating

savings among different capital producing technologies. On technological innovation, a second

class of growth models focuses on the invention of new production processes and goods (Romer,

1990; Grossman and Helpman, 1991; Aghion and Howitt, 1992). In these models, the functions

performed by the financial system affect steady-state growth by altering the rate of technological

innovation.

32

Schematically, Levine (1997) portrays the link between finance and growth as follows:

Figure 1: The Link between Finance and Growth

Figure 1 outlines how specific market frictions motivate the emergence of financial contracts,

markets and intermediaries and how these financial arrangements provide the five functions that

affect saving and allocation decisions in ways that influence economic growth.

33

1. Mobilisation of savings: savings facilities allow households to save their money in a

secure place, which can then be combined into usefully large amounts and lent on to

individuals and firms to finance investment.

2. Risk management: by combining many households’ savings, financial intermediaries can

ensure any individual household can get its money back whenever it wants. And by

investing in lots of projects on behalf of savers, they facilitate risk diversification, which

increases returns and encourages more savings.

3. Acquiring information about investment opportunities: financial intermediaries can

reduce information costs by acquiring and comparing information about many competing

investment opportunities on behalf of all their savers, thus ensuring that capital is

allocated efficiently, to the best projects.

4. Monitoring borrowers and exerting corporate control: financial intermediaries monitor

the performance of enterprises on behalf of many investors, and thus incentivize

managers of borrowing enterprises to perform well.

5. Facilitating the exchange of goods and services: by reducing information and

transactions costs in the economy, the financial sector enables more transactions to take

place, which allows greater specialization and productivity.

By performing these functions, the financial sector serves to increase savings and investment,

encourage foreign inflows, and ensure finance is allocated to the best (i.e. most productive)

projects. This means that financial sector development boosts long-run growth by increasing the

amount of capital in the economy (including human as well as physical capital, through

investment in education and health, as well as in machinery and tools), and through its impacts

on the rate of technological progress.

34

CHAPTER 4: RESEARCH DESIGN AND METHODOLOGY

4.1 RESEARCH DESIGN

Many studies, as pointed out earlier, have concentrated on cross-sectional regressions which

according to Levine and Renelt (1992), among others, should be viewed with caution. The use of

the cross-sectional approach limits the potential robustness of their findings with respect to

country specific effects and time related effects. This study, thus, used a case study approach to

evaluate the relationship and causality between stock market and bank development and

economic growth in Malawi.

4.2 METHODOLOGY

Since the theory that was being evaluated focuses on the long-run (as opposed to higher

frequency) relationships between stock markets, banks and economic growth, this study followed

Beck and Levine (2004) and averaged economic growth data over five quarters to abstract from

business cycle influences and focus on economic growth.4

The study used E-Views 6.0 software package and in particular the Ordinary Least Squares

(OLS) regression technique to estimate the relationship between stock market development and

economic growth and banking development and economic growth. According to Oluwatoyin and

Gbadebo (2009), the technique possesses the unique property of Best Linear Unbiased Estimator

(BLUE) when compared to other estimating techniques. The OLS estimator also possesses the

desirable qualities of unbiasness, consistency, and efficiency:

1. The parameter estimates obtained by OLS have optimal properties.

2. The computation procedure of the OLS is fairly simple compared to other econometric

techniques of estimation. 4 Loayza and Ranciere (2002) found that short-run surges in Bank Credit are good predictors of banking crises and slow growth, while high levels of Bank Credit over the long-run are associated with economic growth. These results emphasize the significance of using sufficiently low-frequency data to abstract from crises and business cycles and focus on economic growth.

35

3. OLS is used by most researchers.

4. They always have a fairly statistical result.

The Phillips-Perron unit root test (Phillips, 1987 and Perron, 1988) was used in order to

determine if the time series property of the dependent and independent variables have unit roots

because when they have unit roots, the traditional estimation method, using observations on

levels of those variables would likely find a statistically significant relationship even when

meaningful “economic” linkage is absent (Akinlo and Odusola, 2000).

The Serial Correlation LM Test was utilized to test for serial correlation in the residuals (error

terms) in order to determine if residuals from different (usually adjacent) time periods were

correlated.

The Breusch-Pagan-Godfrey Heteroskedasticity Test was used to check if residuals in the

regression had non-constant variances.

The Ramsey RESET Test was also employed to ensure that the model was correctly specified.

Lastly, the Granger Causality test was carried out to find out the direction of causality between

financial development and economic growth.

4.2.1 Model

In examining the linkage between financial development (stock market and banking

development) and economic growth in Malawi, this study used an eclectic model that was

inspired by Beck and Levine (2004).

To measure bank development, the study followed Beck and Levine (2004) and used bank credit

(BANK), which equals bank claims on the private sector by deposit money banks divided by

GDP. Although BANK does not directly measure the degree to which banks ease information

and transaction costs, BANK improves upon alternative measures. First, unlike many studies of

36

finance and growth that use the ratio of M3 to GDP as an empirical proxy of financial

development, the BANK variable isolates bank credit to the private sector and therefore excludes

credits by development banks and loans to the government and public enterprises.

To measure stock market development, the study also followed Beck and Levine (2004) and

used the Turnover Ratio (TOR) measure of market liquidity, which equals the value of the trades

of shares on domestic exchanges divided by total value of listed shares. It indicates the trading

volume of the stock market relative to its size. Some models predict countries with illiquid

markets will create disincentives to long-run investments because it is comparatively difficult to

sell one's stake in the firm. In contrast, more liquid stock markets reduce disincentives to long-

run investment, since liquid markets provide a ready exit-option for investors. This can foster

more efficient resource allocation and faster growth (Levine, 1991; Bencivenga, Smith, and

Starr, 1995).

The study also experimented with the other measures of stock market development that were

used by Levine and Zervos (1998) and Rousseau and Wachtel (2000). Value Traded Ratio

(VTR) equals the value of the trades of domestic shares on domestic exchanges divided by GDP

has two potential pitfalls. First, it does not measure the liquidity of the market, that is, it does not

directly measure the trading costs or the uncertainty associated with trading and settling equity

transactions. It measures trading relative to the size of the economy that is how agents can

cheaply, quickly and confidently trade ownership claims of a large percentage of the economy’s

productive technologies (Levine and Zervos, 1998). Second, since markets are forward looking,

they will anticipate higher economic growth by higher share prices. Since Value Traded is the

product of quantity and price, this indicator can rise without an increase in the number of

transactions. Turnover Ratio does not suffer from this shortcoming since both numerator and

denominator contain the price. The study also considered Market Capitalization Ratio (MCR),

which equals the value of listed shares divided by GDP. Its main shortcoming is that theory does

not suggest the mere listing of shares will influence resource allocation and growth. Furthermore,

Levine and Zervos (1998) show that Market Capitalization is not a good predictor of economic

growth.

37

To measure economic growth the study followed Arestis, Demetriades and Luintel (2001) and

used real GDP (RGDP) which is a measure of national output and an economic growth indicator

(World Bank, WDI 2005).

To assess the strength of the independent link between both stock markets and growth and bank

development and economic growth, the study controlled for other potential determinants of

economic growth in the regressions. These included the initial real per capita income (RPCI) to

control for convergence, the ratio of government expenditure to GDP (GOVT), the share of

exports and imports to GDP (TRADE) and the inflation rate (INFL)5.

Accordingly, this study used the following log-log regression model:

Y = + X + φF + (1)

where Y represents real GDP, represents exogenous factors, X represents the set of

conditioning information to control for other factors associated with economic growth (i.e. initial

per capita income, initial share of exports and imports to GDP, initial ratio of government

expenditures to GDP and initial inflation rate), F is either initial bank credit, initial turnover ratio

or initial value traded ratio, and φ are vectors of coefficients on the variables in X and F

respectively and is an error term.

Regarding the a priori expectations for equation (1):

φ Y / F > 0, where F is BANK

This says that there is a positive relationship between banking development and economic

growth. Banking development will lead to economic growth.

φ Y / F > 0, where F is either TOR or VTR

5 Other recent empirical papers on the role of financial development in economic growth have used the same control variables, see among others Beck, Levine and Loayza (2000) and Beck and Levine (2004)

38

This says that there is a positive relationship between stock market development and economic

growth. Stock market development will lead to economic growth.

= Y / X > 0, where X is either RPCI or TRADE

This says that there is a positive relationship between per capita income or trade and economic

growth. Improvements in either per capita income or trade will lead to economic growth.

Y / X < 0, where X is either GOVT or INFL

This says that there is a negative relationship between government expenditure or inflation and

economic growth. Increases in government expenditure or inflation will thwart economic

growth.

4.2.2 Data

In realizing a country case study for Malawi, this study used quarterly time series data for the

period 2001:1 – 2009:2 to identify the existence of a correlation between the stock market

development and economic growth and between banking development and economic growth.

The study used a sample of 30 observations with data collected from the following secondary

sources:

1. Reserve Bank of Malawi

2. Malawi Stock Exchange

3. National Statistics Office

The choice of these sources was based on their authenticity and reliability. The data was obtained

from the institutions quarterly reports (Reserve Bank of Malawi’s Financial and Economic

Reviews, Malawi Stock Exchange’s Market Reports and National Statistics Office’s Statistical

Bulletins) as well as from their websites.

39

The study used a five-quarter moving average to average real GDP data and each observation

contained a five-quarter average real GDP value and initial values (values at the beginning of

each moving average) of RPCI, BANK, TOR, VTR, GOVT, TRADE and INFL.

4.2.3 Data Analysis

4.2.3.1 The Phillip-Perron Unit Root Test

A time series is said to be stationary if its mean, variance and covariances remain constant over

time. When carrying out time series analysis it is crucial to check for stationarity as regression

with non-stationary data may lead to spurious results. Granger and Newbold (1974) coined the

term “spurious regression” to describe regression results, involving time series that have t-values

that suggest that there is a significant relationship between two variables when in fact there is no

significant relationship between the variables, hence their use of the word “spurious”.

In their own words, they said: “In our opinion the econometrician can no longer ignore the time

series properties of the variables which he or she is concerned – except at their own peril. The

fact that many economic [and financial] ‘levels’ are random walks [or behave as if they are

random walks] means that considerable care has to be taken in studying economic and financial

variables”.

To test for stationarity in the variables, the Phillip-Perron unit root test was used. The results are

reported in Table 3. As it can be seen the variables are either I(0) i.e. stationary in level or I(1)

i.e. stationary in first difference. Since it was ascertained that the variables were I(0) or I(1), the

long-run equation could be estimated.

4.2.3.2 The Serial Correlation LM Test

Serial correlation does not affect the unbiasedness or consistency of OLS estimators but it does

affect their efficiency. This can lead to the conclusion that the parameter estimates are more

40

precise than they really are. There will be a tendency to reject the null hypothesis when it should

not be rejected. The serial correlation tests results are presented in Table 4 and Table 5.

4.2.3.3 The Breusch-Pagan-Godfrey Test

Heteroskedasticity does not cause OLS coefficient estimates to be biased nor inconsistent but it

can cause the variance (thus standard errors) of coefficients to be underestimated. This may lead

you to judge that a relationship is statistically significant when it is actually too weak to be

confidently distinguished from zero. Results for the heteroskedasticity tests are reported in

Tables 4 and 5.

4.2.3.4 The Ramsey RESET Test

This test is designed to detect omitted variables and incorrect functional form. In other words, it

checks a model to see if it has not omitted significant variables or included extraneous ones. The

results for test are contained in Tables 4 and 5.

4.2.3.5 The Granger Causality Test

Traditionally, Granger (1969) causality is employed to test for the causal relationship between

two variables. This test states that, if past values of a variable y significantly contribute to

forecast the future value of another variable x then y is said to Granger cause x. Conversely, if

past values of x statistically improve the prediction of y, then we can conclude that x Granger

causes y. The results of the Granger causality test are presented in Table 6.

41

CHAPTER 5: FINDINGS AND ANALYSIS

5.1 RESULTS

The results in Table 4 show that (i) development of stock markets and banks have both a

statistically and economically large impact on economic growth, and (ii) the results are not due

to simultaneity bias or omitted variables.

Bank credit enters the regressions significantly at 1% and with a positive coefficient, both jointly

with either turnover ratio (regression 4) or value traded ratio (regression 5) and individually

(regression 1).

Turnover ratio enters the regression significantly at 10% and with a positive coefficient, both

jointly with bank credit (regression 4) and individually (regression 2). However, when turnover

ratio enters the regression individually there is evidence of serial correlation and model

misspecification as indicated by p-values of 0.0121 and 0.0101 respectively.

Value traded ratio enters the regressions significantly at 1% and with a positive coefficient, both

jointly with bank credit (regression 5) and individually (regression 3). However, just like

turnover ratio when value traded ratio enters the regression individually there is evidence of

model misspecification as indicated by a p-value of 0.0261.

Whenever turnover ratio or value traded ratio enter the regressions individually there is evidence

of model misspecification, this suggests that some significant variable is omitted and that

variable is bank credit because whenever bank credit is included in the regressions there is no

evidence of model misspecification.

To further test if bank credit is that significant omitted variable market capitalization ratio is

included in the regression analysis. The results are shown in Table 5.

42

Market capitalization ratio enters with a positive coefficient and significantly at 1% in all

regressions except one (at 2%). Turnover ratio enters the regressions with a positive coefficient

and significantly at 1% (regression 3) and at 2% (regression 4). Value traded ratio enters all the

regressions significantly at 1% and with a positive coefficient.

Bank credit has a negative coefficient in all regressions against expectation and is insignificant in

all regressions except one in which it enters significantly at 10%. In all the regressions (with

market capitalization ratio) included there is evidence of model misspecification as shown by the

p-values of the Ramsey RESET test. These results show that market capitalization is not a good

predictor of economic growth, concurring with Levine and Zervos (1998).

The forward looking nature of stock prices – the “price effect” – is not driving the strong link

between stock market liquidity and economic growth. This can be verified from two results

according to Levine and Zervos (1998). First, the price effect does not influence the turnover

ratio, and turnover is robustly linked with future rates of economic growth. Second, when market

capitalization and value traded ratio are included together in the same regression (Table 5,

regressions 4 and 6) to test whether the price-effect is producing the strong empirical links

between the value traded ratio and economic growth,6 value traded ratio remains significantly

correlated with economic growth (with little changes in the estimated coefficients). If the price-

effect did drive the empirical link between the value traded ratio and economic growth then

value traded ratio should not have remained significantly correlated with economic growth.

Thus, the evidence is inconsistent with the view that expectations of future growth, which are

reflected in current stock prices, are driving the strong empirical relationship between stock

market liquidity and economic growth. The evidence is consistent with the view that the ability

to trade ownership of an economy’s productive technologies easily promotes more efficient

allocation of resources and faster growth.

The other explanatory variables generally enter the regressions as expected. Initial income enters

significantly at 1% with a positive coefficient in all regressions. Government expenditure enters

all regressions with an unexpected positive coefficient but is insignificant in all but one. Trade

6 The price-effect influences both market capitalization ratio and value traded ratio.

43

enters all the regressions with an expected positive coefficient but is significant in some and

insignificant in others. Inflation enters all regression significantly at 1% with an expected

negative coefficient.

The results in Table 6 suggest that there is uni-directional causality between bank credit and real

GDP running from bank credit at 1% significance level. There is also uni-directional causality

between turnover ratio and real GDP running from turnover ratio at 10% significance level.

Further, there is bi-directional causality between value traded ratio and real GDP running from

value traded ratio at 1% significance level and running from real GDP at 5% significance level.

Thus, uni-directional causality runs from financial development (stock market development and

banking development) to economic growth.

Following the results in Table 4 and Table 6, we therefore reject the null hypotheses that:

1. Stock market development does not lead to economic growth in Malawi.

2. Banking development does not lead to economic growth in Malawi.

44

CHAPTER 6: CONCLUSION

6.1 CONCLUSIONS

This study sought to explore the relationship between financial development and economic

growth. It empirically examined the effects of stock market and banking development indicators

on economic growth. In sum, the results strongly reject the notion that financial development is

unimportant or harmful in Malawi. It is found that, even after controlling for other factors

associated with economic growth, stock market and banking development are both positively and

robustly correlated with future rates of economic growth. Furthermore, since measures of stock

market development and banking development both enter the growth regression significantly, the

findings suggest that banks provide different financial services from those provided by stock

markets. The study also finds that causality between financial development and economic growth

runs from financial development, that is, it is supply-leading. The strong, positive link between

financial development and economic growth and the Granger causality test results suggest that

financial factors are an integral part of the growth process. Therefore, for significant growth, the

focus of policy should be on measures to promote growth in the financial sector in order to

facilitate investment and thus, lead to economic growth.

6.2 RECOMMENDATIONS

First, the macroeconomic environment should be stabilized in order to foster the development of

the financial sector. Macroeconomic volatility worsens the problem of informational

asymmetries and becomes a source of vulnerability to the financial system. Low and predictable

rates of inflation are more likely to contribute to financial development and economic growth.

Both domestic and foreign investors will be unwilling to invest in a financial sector where there

are expectations of high inflation. It is therefore necessary that the environment should be

enabling in order to realize its full potential.

Institution quality should be improved. Institution quality is important for financial development

because efficient and accountable institutions tend to broaden appeal and confidence in

45

investment. Investment thus becomes gradually more attractive as political risk is resolved over

time. Therefore, the development of good quality institutions can affect the attractiveness of

investment and lead to financial development. Yartey (2007) finds that good quality institutions

such as law and order, democratic accountability and bureaucratic quality as important

determinants of stock market development in Africa because they reduce political risk and

enhance the viability of external finance.

Regulation and supervision of the financial system should be strengthened as it plays a great role

in determining both its stability and the extent of services provided. This helps in making optimal

decisions, increasing access to external finance and resulting in productive investment. There is

the need for a well structured and clear rule of law within an efficient judicial system, which

allows for contract repudiation and expropriation in this regard.

Finally, increasing public knowledge about the functioning of the stock market could promote

the development of the stock market in Malawi. Knowledge about stock market activity can be

improved through regular and intensive education programs. Educating the public about the role

of the stock market can help increase the investor base and improve the liquidity of the stock

market. There is very little education on the role of the stock market in Malawi. Education about

the stock market must be at the firm and individual level. At firm level it is important to allay the

fears of firms by educating them strongly and regularly on the benefits of listing. At the

individual level, Malawi could tap into potentially large amounts of financial wealth which exists

outside the financial system, by pursuing vigorous and consistent educational campaigns about

the stock market at various levels of society. Such educational drives are already in existence in a

number of stock markets in Africa. In South Africa, the JSE/Liberty Life Investment Challenge

which introduces the youth to dynamic games in economics and finance and its applications to

investing and trading on the JSE has been running for three decades now.

46

6.3 SUGGESTIONS FOR FUTURE RESEARCH

Further research could be conducted on the following areas to enhance the knowledge and

literature on financial development and economic growth in Malawi:

The impact of financial development on per capita capital stock, productivity and

savings.

The impact of the development of other financial institutions such insurance, mutual

funds etc on economic growth.

The importance of frequency of data on the study of the relationship between financial

development and economic growth.

47

REFERENCES

1. Acemoglu, D. and Zilibotti, F. 1997. “Was Prometheus Unbound by Chance? Risk,

Diversification and Growth. Journal of Political Economy August Vol. 105 pp. 709-751.

2. Aigbokan, B. 1995. “Financial Development and Economic Growth: A Test of Hypothesis

on Supply-Leading and Demand-Following Finance, with Evidence on Nigeria”. Nigerian

Economic and Financial Review (N.E.F.R) December Vol. 1(2) pp. 1-10.

3. Alonso-Borrego, C. and Arellano, M. 1999. “Symmetrically Normalized Instrumental

Variable Estimation Using Panel Data”. Journal of Business and Economic Statistics Vol. 17

pp. 36-49.

4. Arellano, M. and Bond, S. 1991. “Some Tests of Specification for Panel Data: Monte Carlo

Evidence and an Application to Employment Equations”. Review of Economic Studies Vol.

58 pp. 277-297.

5. Arellano, M. and Bover, S. 1995. “Another Look at the Instrumental-Variable Estimation of

Error-Components Models”. Journal of Econometrics Vol. 68 pp. 29-52.

6. Bagehot, W. 1873. “Lombard Street, a Description of the Money Market”. Homewood, IL:

Irwin.

7. Beck, T., Levine, R. and Loayza, N. 2000. “Finance and the Sources of Growth”. Journal of

Financial Economics Vol. 58 pp.261-300.

8. Beck, T. and Levine, R. 2004. “Stock Markets, Banks and Growth: Panel Evidence”. Journal

of Banking and Finance Vol. 28(3) pp. 423-442.

9. Bekaert, G., Harvey, C. and Lundblad, C. 2003. “Does Financial Liberalization Spur

Growth?” Working Paper, Fuqua School of Business, Duke University Durham, NC, USA.

10. Bencinvenga, V. and Smith, B. 1991. “Financial Intermediation and Endogenous Growth”.

Review of Economic Studies April Vol. 58(2) pp. 195-209.

11. Bencivenga, V. and Smith, D. 1993. “Some Consequences of Credit Rationing in an

Endogenous Growth Model”. Journal of Economic Dynamics and Control January – March

Vol. 17 pp. 97-122.

12. Bencivenga, V. et al. 1995. “Transactions Costs, Technological Choice and Endogenous

Growth”. Journal of Economic Theory October Vol. 67(1) pp. 53-177.

48

13. Bencivenga, V., Smith B. and Starr, R. 1996. “Equity Markets, Transition Governments and

Capital Accumulations: An Illustration”. The World Bank Review Vol. 10(2) 241-265.

14. Bhide, A. 1993. “The Hidden Costs of Stock Market Liquidity”. Journal of Financial

Economics August Vol. 34(2) pp. 31-51.

15. Boyd, J. and Prescott, E. 1986. Financial Intermediary-Coalitions”. Journal of Economics

Theory April Vol. 38(2) pp. 211-232.

16. Calderon, C., Chong, A. and Loayza, N. 2000. “Determinants of Current Account Deficits in

Developing Countries”. World Bank Research Policy Working Paper 2398.

17. Caporale, G., Howells, P. and Soliman, A. 2004. “Stock Market Development and Economic

Growth: The Causal Linkage”. Journal of Economic Development June Vol. 29(1) pp. 33-50.

18. De Gregorio, J. 1996. “Financial Integration, Financial Development and Economic

Growth”. Unpublished.

19. Demirguc-Kunt, A. and Levine, R. 1996. “Stork Market, Corporate Finance and Economic

Growth: An Overview”. The World Bank Review Vol. 10 2: 233-239.

20. Devereux, M. and Smith, G. 1994. “International Risk Sharing and Economic Growth”.

International Economic Review August Vol. 35(4) pp. 535-550.

21. Diamond, D. and Dybvig, P. 1983. “Bank Runs, Deposit Insurance and Liquidity”. Journal of

Political Economy June Vol. 91(3) pp. 401-419.

22. Filer, R., Hanousek, J. and Campos, N. 1999. “Do Stock Markets Promote Economic

Growth?” The William Davidson Institute (University of Michigan Business School)

September Working Paper Series No. 267.

23. Goldsmith, R. 1969. “Financial Structure and Development. New Haven: Yale University

Press.

24. Gonzalez-Vega, C. 2003. “Deepening Rural Financial Markets: Macroeconomic, Policy and

Political Dimensions”. Supported by USAID. Available online:

www.basis.wisc.edu/rfc/documents/theme_macro.pdf

25. Greenwood, J. and Jovanovic, B. 1990. “Financial Development, Growth and the

Distribution of Income. Journal of Political Economy October Pt. 1 Vol. 98(5) pp. 1076-

1107.

49

26. Greenwood, J. and Smith, B. 1997. “Financial Markets in Development and Development of

Financial Markets”. Journal of Economic Dynamics and Control January Vol. 21(1) pp. 145-

181.

27. Gurley, J. and Shaw, E. 1955. “Financial Aspects of Economic Development”. American

Economic Review September Vol. 45(4) pp. 515-538.

28. Jones, C. 1995. “Time Series Tests of Endogenous Growth Models”. Quarterly Journal of

Economics Vol. 110 pp. 495-525.

29. Inanga, I. and Emenuga, C. 1997. “Institutional, Traditional and Asset Pricing Characteristics

of the Nigerian Stock Exchange”. African Economic Research Consortium March Research

Paper No. 60.

30. King, R. and Levine, R. 1993a. “Financial and Intermediation and Economic Development”,

in Financial Intermediation in the Construction of Europe. Eds.: Colin Mayer and Xavier

Vives, pp. 156-89. London: Centre for Economic Policy Research.

31. King, R. and Levine, R. 1993b. “Finance and Growth: Schumpeter Might Be Right”.

Quarterly Journal of Economics August Vol. 108(3) pp. 717-738.

32. King, R. and Levine, R. 1993c. “Finance, Entrepreneurship and Growth: Theory and

Evidence”. Journal of Monetary Economics December Vol. 32(3) pp. 513-542.

33. Kocherlakota, N. and Yi, K. 1997. “Is There Endogenous Long-Run Growth: Evidence From

the United States and United Kingdom”. Journal of Money and Banking Vol. 29 pp. 235-260.

34. Kumar, M. 1984. “Growth, Acquisition and Investment”. Cambridge: Cambridge University

Press.

35. Levhari, D. and Srinivasan, T. 1969. “Optimal Savings under Uncertainty”. Review of

Economic Studies Vol. 35 pp. 153-163.

36. Levine, R. 1991. “Stock Markets, Growth and Tax Policy”. Journal of Finance September

Vol. 46(4) pp. 1445-1465.

37. Levine, R. and Renelt, D. 1992. “A Sensitivity Analysis of Cross-Country Growth

Regression”. America Economic Review Vol. 82 pp. 942-963.

38. Levine, R. and Zervos, S. 1996. “Stock Market Development and Long-Run Growth”. The

World Bank Review Vol. 10(2).

39. Levine, R. and Zervos, S. 1998. “Stock Markets, Banks and Economic Growth”. The

American Economic Review June Vol. 88(3) pp. 537-558.

50

40. Lucas, R. 1988. “On the Mechanics of Economic Development”. Journal of Monetary

Economics July Vol. 22(1) pp. 3-42.

41. Malawi Stock Exchange. Market Report (various issues).

42. Malivaud, E. 1997. “Economic Growth and Resources Vol. 1: The Major Issues”.

Proceedings of the 5th World Congress of the International Economic Association held in

Tokyo, Japan 1977. London: Macmillan Press Limited.

43. Mankiw, N. 1995. “The Growth of Nations”. Brookings Papers on Economic Activity Vol.1

pp. 275-310.

44. McKinnon, R. 1973. “Money and Capital in Economic Development”. Washington D.C.:

Brookings Institution.

45. Mlachila, M and Chirwa, E. 2002. “Financial Reforms and Interest Rate Spreads in the

Commercial Banking System in Malawi”. IMF Working Paper No. 02/06, January.

46. National Statistics Office. Statistical Bulletin (various issues).

47. Nowbutsing, B. and Odit, M. 2009. “Stock Market Development and Economic Growth:

TheCase of Mauritius”. International Business and Economic Research Journal February

Vol. 8(2) pp. 77-88.

48. Nyong, M. 1997. “Capital Market Development and Long-Run Economic Growth: Theory,

Evidence and Analysis”. First Bank Review December pp. 13-38.

49. Obadan, M. 1998. “Capital Market and Nigeria’s Economic Development”. Presidential

Address presented at Nigeria Economic Society’s one day seminar at the Institute of

International Affairs, Lagos, 21st January.

50. Obstfeld, M. 1994. “Risk-Taking, Global Diversification and Growth”. American Economic

Review December Vol. 84(5) pp. 1310-1329.

51. Osinubi, T. 2004. “Does Stock Market Promote Growth in Nigeria?” The ICFAI Journal of

Applied Finance Vol. 10(3) pp. 17-35.

52. Oyejide, T. 1994. “The Financial System and Economic Growth in the Context of Political

Transition”. Central Bank of Nigeria Economic and Financial Review Vol. 32(3) pp. 260-

267.

53. Reserve Bank of Malawi. Financial and Economic Review (various issues).

54. Robinson, J. 1952. “The Generalization of the General Theory”. The Rate of Interest and

Other Essays, pp. 67-146. London: Macmillan.

51

55. Rostow, W. 1960. “The Process of Economic Growth”. 2nd ed. London: Oxford University

Press.

56. Rousseau, P. and Wachtel, P. 2000. “Equity Markets and Growth: Cross-country Evidence

on Timing and Outcomes, 1980-1995”. Journal of Banking and Finance Vol. 24 pp. 1933-

1957.

57. Samuel, C. 1996. “Stock Market and Investment: The Governance Role of the Market”. The

World Bank Review Vol. 10(2).

58. Schumpeter, J. 1912. “The Theory of Economic Development”. Translated, Cambridge,

Massachusetts: Havard University Press, 1934.

59. Shleifer, A. and Vishny, R. 1986. “Large Shareholders and Corporate Control”. Journal of

Political Economy June Vol. 96(3) pp. 461-488.

60. Singh, A. 1997. “Financial Liberalization, Stock Markets and Economic Development”. The

Economic Journal Vol. 107 pp. 771-782.

61. Soyode, A. 1990. “The Role of Capital in Economic Development”. Security Market Journal

Nigeria Vol. 6.

62. Yartey, C. 2007. “The Institutional and Macroeconomic Determinants of Stock Market

Development in Africa,” in Okpara, John, ed. Management and Economic Development in

Sub-Saharan Africa: Theoretical and Applied Perspectives. London: Adonis and Abbey.

63. Yartey, C. and Adjasi, C. 2007. “Stock Market Development in Sub-Saharan Africa: Critical

Issues and Challenges”. IMF Working Paper No. 209.

52

APPENDIX

Table 1: Descriptive Statistics

Descriptive Statistics Economic Growth Bank Credit Turnover Ratio Value Traded Ratio

Mean 64.15 6.98 2.35 0.45 Median 57.65 6.36 1.73 0.19

Maximum 107.49 11.68 13.82 1.92 Minimum 51.62 4.42 0.19 0.01 Std. Dev. 16.36 2.06 2.78 0.55

Observations 30 30 30 30

Table 2: Correlations

Correlations Economic

Growth Bank Credit Turnover Ratio Value Traded

Ratio Economic Growth 1

Bank Credit 0.58 1 Turnover Ratio 0.08 0.14 1

Value Traded Ratio 0.64 0.68 0.62 1

Table 3: Unit Root Test Results

Phillips-Perron Unit Root Test Variable PP-Statistic Variable PP-Statistic Decision RGDP1 -30.96211 DRGDP I(0) RPCI1 -2.319918 DRPCI -7.756459 I(1)

GOVT1 -3.718484 DGOVT -7.135910 I(1) TRADE2 -5.841406 DTRADE I(0)

INFL2 -2.121166 DINFL -4.684262 I(1) BANK1 -3.894459 DBANK -10.09494 I(1) TOR1 -3.862102 DTOR -6.195149 I(1) VTR1 -3.954254 DVTR -7000284 I(1)

Critical Values 1%: -4.323979; 5%: -3.580623; 10%: -3.225334 1In the test this variable is included as log(variable) 2In the test this variable is included as log(1+variable)

53

54

Table 4: OLS Regression Results I

OLS Regression Coefficients Regressors 1 2 3 4 5

Constant 4.384 3.507 3.659 4.378 4.202 (0.0000) (0.0000) (0.0000) (0.0000) (0.0000)

RPCI1 0.784 1.000 0.873 0.787 0.779 (0.0000) (0.0000) (0.0000) (0.0000) (0.0000)

GOVT1 0.094 0.275 0.149 0.072 0.070 (0.3573) (0.0610) (0.1975) (0.5018) (0.4726)

TRADE2 1.684 0.551 0.598 1.564 1.326 (0.0263) (0.5189) (0.3519) (0.0357) (0.0609)

INFL2 -1.368 -1.628 -1.542 -1.328 -1.384 (0.0004) (0.0054) (0.0003) (0.0003) (0.0001)

BANK1 0.386 0.374 0.265 (0.0001) (0.0002) (0.0058)

TOR1 0.030 0.022 (0.0661) (0.0713)

VTR1 0.060 0.033 (0.0001) (0.0097)

R2 0.88 0.78 0.87 0.89 0.90 Adjusted R2 0.86 0.73 0.84 0.86 0.88

Serial Correlation LM Test (p-value) 0.2861 0.0121 0.6566 0.4910 0.4939

Heteroskedasticity Test: Breusch-Pagan-Godfrey

(p-value)

0.4866 0.4490 0.2638 0.5010 0.5369

Ramsey RESET Test (p-value) 0.1238 0.0101 0.0261 0.3162 0.2524

Observations 30 30 30 30 30

* Heteroskedasticity-consistent p-values are in parentheses 1In the regression this variable is included as log(variable) 2In the regression this variable is included as log(1+variable)

55

Table 5: OLS Regression Results II

OLS Regression Coefficients With Market Capitalization Ratio Included Regressors 1 2 3 4 5 6

Constant 3.761 3.728 3.780 3.798 3.534 3.385 (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000)

RPCI1 0.676 0.674 0.668 0.677 0.648 0.648 (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000)

GOVT1 0.083 0.084 0.039 0.044 0.046 0.054 (0.2132) (0.1986) (0.5135) (0.4539) (0.3835) (0.2647)

TRADE2 0.726 0.678 0.698 0.673 0.198 0.054 (0.1978) (0.3940) (0.2456) (0.1795) (0.7577) (0.9301)

INFL2 -1.741 -1.759 -1.668 -1.645 -1.803 -1.850 (0.0000) (0.0002) (0.0000) (0.0000) (0.0000) (0.0000)

BANK1 -0.019 -0.153 -0.241 (0.9079) (0.2931) (0.0823)

TOR1 0.032 0.036 (0.0051) (0.0142)

VTR1 0.033 0.041 (0.0004) (0.0009)

MCR1 0.136 0.142 0.138 0.106 0.182 0.168 (0.0000) (0.0120) (0.0000) (0.0001) (0.0006) (0.0001)

R2 0.91 0.91 0.93 0.94 0.94 0.94 Adjusted R2 0.89 0.89 0.91 0.92 0.91 0.92

Serial Correlation LM Test (p-value) 0.4703 0.5017 0.7307 0.7905 0.5180 0..7515

Heteroskedasticity Test: Breusch-Pagan-Godfrey

(p-value)

0.5682 0.6242 0.8902 0.9223 0.9354 0.9587

Ramsey RESET Test (p-value) 0.0034 0.0014 0.0367 0.0453 0.0029 0.0021

Observations 30 30 30 30 30 30

* Heteroskedasticity-consistent p-values are in parentheses 1In the regression this variable is included as log(variable) 2In the regression this variable is included as log(1+variable)

56

Table 6: Granger Causality Test Results

Null Hypothesis F-Statistic Probability

BANK does not Granger Cause RGDP 13.8959 0.0001

RGDP does not Granger Cause BANK 0.37051 0.6944

TOR does not Granger Cause RGDP 2.76459 0.0840

RGDP does not Granger Cause TOR 0.69974 0.5070

VTR does not Granger Cause RGDP 8.09806 0.0022

RGDP does not Granger Cause VTR 5.64292 0.0101

57

Table 7: Study Data

BANK MCR VTR TOR INFL GOVT TRADE RPCI RGDP 0.048204 0.119480 0.001084 0.009074 0.2870 0.067207 0.011088 7.007500 59.78400 0.046238 0.120100 0.000450 0.003740 0.2480 0.061491 -0.019311 5.876700 56.05290 0.053130 0.122220 0.002310 0.018870 0.2990 0.080771 -0.031653 4.917600 54.01870 0.066644 0.108600 0.015000 0.138200 0.2330 0.105202 -0.030658 4.362900 53.63440 0.051139 0.089300 0.000999 0.011185 0.1800 0.067039 -0.016982 5.514300 53.95470 0.049967 0.085700 0.000160 0.001871 0.1710 0.061338 -0.043326 5.124400 52.99930 0.050542 0.079700 0.000416 0.005224 0.1670 0.080376 -0.056347 4.793300 52.56890 0.053211 0.072800 0.001900 0.025700 0.1344 0.111854 -0.046557 4.607600 52.61250 0.055104 0.069460 0.001410 0.020240 0.1050 0.103185 -0.054731 4.265800 55.91150 0.059091 0.055520 0.002445 0.044043 0.0900 0.091767 -0.016618 4.941200 56.62420 0.054340 0.057520 0.000969 0.016840 0.0900 0.103031 -0.041916 4.793200 59.79390 0.059518 0.062320 0.004900 0.078700 0.0960 0.118815 -0.055799 4.679800 60.33940 0.044227 0.049510 0.000875 0.017668 0.1020 0.090850 -0.087548 5.768300 62.55970 0.060650 0.061950 0.001446 0.023336 0.1130 0.118910 -0.028911 4.452900 61.41750 0.048395 0.069700 0.000356 0.005106 0.1130 0.068717 -0.072077 6.161200 62.87430 0.068494 0.090110 0.003300 0.001897 0.1280 0.108934 -0.056144 4.894100 58.22620 0.055994 0.092760 0.000102 0.006400 0.1420 0.107728 -0.084946 5.348500 57.73430 0.069897 0.110060 0.000230 0.002090 0.1550 0.094677 -0.065605 5.133400 55.45310 0.076590 0.117890 0.001986 0.016840 0.1540 0.100922 -0.107835 4.936000 53.41400 0.086069 0.147160 0.004500 0.030700 0.1650 0.191117 -0.075312 4.056300 51.62010 0.069434 0.155750 0.001440 0.009220 0.1710 0.092151 -0.085809 4.428000 54.47110 0.088900 0.285280 0.002310 0.008084 0.1530 0.127209 -0.034007 4.277400 55.92250 0.094868 0.324880 0.002230 0.006860 0.1200 0.156054 -0.105386 4.166200 57.56610 0.116762 0.354730 0.008300 0.023300 0.1050 0.161816 -0.041131 4.073500 62.09070 0.088711 0.327990 0.015330 0.046750 0.0860 0.141723 -0.075947 4.956800 73.95870 0.097269 0.475370 0.010550 0.022190 0.0790 0.088801 -0.016782 4.876600 82.96160 0.098359 0.526910 0.013690 0.026060 0.0720 0.169627 -0.044866 4.805800 91.79640 0.091146 0.486460 0.013900 0.028500 0.0740 0.129989 -0.055827 5.831300 100.4326 0.085553 0.335330 0.001811 0.005400 0.0820 0.084655 -0.060467 8.393400 106.1119 0.106878 0.372420 0.019200 0.051570 0.0790 0.059421 -0.075733 8.265600 107.4861