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Financial development and income in North Africa.

Article Excerpt
Abstract We explore the short-run dynamics and long-run relationship between income and financial development in Algeria, Egypt, and Morocco. We use co-integration and VECM models and four indicators of financial development. The empirical results indicate that there is a long-run relationship between income and each financial development indicator, except credit to the private sector in Algeria. On the other hand, Granger-causality test results indicate that the evidence on the direction of causality is mixed.

Keywords North Africa * Financial development * Economic growth * VECM * Arab countries

JEL E20 * G40 * G2

Introduction

Numerous studies have stressed the important role of the financial sector in economic growth. Emphasis on the effect of financial development can be traced back to the writings of Bagehot (1873) and Schumpeter (1912). The influential work of Gurley and Shaw (1955), Goldsmith (1969), Mckinnon (1973), and Shaw (1973) contributed significantly to the early literature. The topic was revived in more recent work, including Levine (1997), Beck et al. (2000), Benhabib and Spiegel (2000), and Levine et al. (2000). Yet, some scholars have maintained that finance may not be a significant determinant of economic growth and development (Robinson 1952; Lucas 1988; Stem 1989).

Recent empirical literature presents mixed findings. For example, King and Levine (1993a) show that the level of financial development is a predictor of productivity improvement and economic development. On the other hand, Demetriades and Hussein (1996) find little empirical evidence that finance causes growth. Moreover, some studies claim that financial development may have a negative influence on growth. Improved financial development, which leads to better resource allocation, increases returns and may lower saving (income effect); thus possibly causing growth to fall (Bencivenga and Smith 1991; King and Levine 1993b).

The goal of this paper is to explore the short-run dynamics and long-run relationship between income and financial development (banking sector development) in North Africa. We use four indicators of financial development and annual data from Algeria, Egypt, and Morocco, Morocco and Egypt have implemented important financial reforms in the past two decades, but the financial sector in Algeria remains controlled by the state and is relatively underdeveloped (see Creane et al. 2006).

We use a bivariate vector-autoregressive (VAR) model in order to be able to compare our results to those obtained by Demetriades and Hussein (1996) who employs similar methodology and has found mixed evidence on the direction of causality between growth and financial development. Interestingly, the empirical results we obtain indicate that the evidence on the direction of causality is mixed. Moreover, the relationship between financial development and income in both the long and the short run is, in many cases, negative. Only in the case of the ratio of liquid liabilities to GDP (the variable LIQ) do we find a positive long-run relationship between financial development and income in all three countries.

Brief Review of the Empirical Literature

It is widely argued in literature that the main effects of financial development on growth (or economic development) operates through enhancing the functions of the financial system. It is argued that financial development reduces risk. improves the allocation of resources, allows a better access to information about investments, improves monitoring, and increases saving mobilization (Levine 1997).

Recent empirical literature on the relationship between financial development and growth includes Bencivenga and Smith (1991), King and Levine (1993a, b), Demetriades and Hussein (1996), Beck et al. (2000), Baliamoune-Lutz (2003), and Calderon and Liu (2003). Interestingly, the empirical literature contains conflicting findings. Some studies report that finance causes growth (King and Levine 1993a), while others maintain that growth causes financial development (Baliamoune-Lutz 2003). Yet, other authors have found mixed results (Demetriades and Hussein 1996), or bi-directional causality (Luintel and Khan 1999; Calderon and Liu 2003). For example, Calderon and Liu (2003) use data from 109 developing and industrial countries from 1960 to 1994 and report that there is bi-direction causality between financial development and growth. The authors also show that financial deepening contributes more to the causality link between growth and financial development in developing countries than in industrial countries.

Overview of the Financial Sector in Algeria, Egypt and Morocco (1)

Similar to other developing countries, the governments of Morocco, Algeria and Egypt practiced high degrees of financial repression during most of the 1970s and the first half of the 1980s. Giovannini and de Melo (1993) use data on 24 developing countries...