Financial Development and Economic Growth : A Case of Botswana 1980-2014

The study examines the long run and the short run relationship between bank and stock market developments and economic growth in Botswana using annual data over the period 1980-2014. Simple indices for bank development and for stock market development were constructed to proxy financial development in these sectors. The study used the ARDL approach is applied to test for the existence of the long run relationship. Granger causality was also used to test the direction of the relationship and E-views 8.0 to run the ARDL model. The results indicate the existence of a positive and statistically significant long run and the short run relationship between stock market development and growth which is consistent with other studies. On the other hand, bank developments were found to have a negative but statistically insignificant long-run relationship while in the short run the relationship remained negative but statistically significant. These results are interesting for a low income country like Botswana where banks are expected to have a sizable effect on growth than stock markets. The weak association between bank developments and growth may be a confirmation of inefficient credit allocation by the banks pointing to a poor regulatory environment and lack of supervision by the Central Bank. Investment and government expenditure was also found to contribute positively to economic growth while causality was found to be bidirectional. All in all, results seem to suggest that a stable economic environment coupled with strong institutions is critical for growth in Botswana Key terms: Financial Development (Bank development & Stock market Index), Economic Growth 1.0 Introduction The importance of financial development in promoting economic growth has been a major concern in development economics. Generally, there exists an overwhelming unanimity that well‐functioning financial intermediaries have played a significant role in economic growth (King and Levine, 1993a,b; Levine and Zervos, 1998; Levine et al., 2000a,b; Wachtel 2003, Seetanah, 2007 in Seetanah, Ramessur and Rojid, 2009). The critical role played by the financial sector is when it is able to effectively direct financial resources toward the sectors that demand those most. A developed financial sector promotes a better allocation of the financial resources into productive use and contributes positively to the economic growth (Grassa and Gazdar, 2013). The Nexus is also empirically investigated by identifying the causal relationship between financial development and economic development as done by several authors (King and Levine,1993a,b;Toda and Yamamoto,1995; Khan and Senhadji, 2000; Levine et al., 2000) and Giri (2015). The authors involved generally accepted that financial sector plays a critical role in expediting economic growth by mobilizing savings, facilitating payments, trading of goods and services and promoting the efficient allocation of resources. By mobilization of savings, financial intermediaries also increase the availability of funds in the market for lending for both large and small businesses which in tur n create employment for the citizens. It is also found that financial development reduces information asymmetry and price risk and it is crucial for economic growth (Murinde, 2012). According to Eita (2007), Botswana was initially an underdeveloped economy which used South African currencies before and after its independence. This is because the country was a member of the Rand Monetary Area (RMA) and this membership did not give the government any monetary independence because monetary policy was conducted by the South African Reserve Bank. Botswana terminated its membership of the RMA in 1976 and established its own central bank and currency, the Pula (Ahmed, 2006). There were only two commercial banks which were foreign-owned namely Standard Chartered and Barclays. These banks were incorporated locally after the establishment of the central bank, but they were free to make their own decisions. As Akinboade (1998) stated, the economy of Botswana recorded a high growth rate of more than 10 percent per year for most of the 1980s because of the increase in diamond revenue. This rapid increase in economic growth led to a rapid expansion of the financial system and the two commercial banks expanded to more than thirty branches or agencies. International Journal of Management Sciences and Business Research, April-2018 ISSN (2226-8235) Vol-7, Issue 4 http://www.ijmsbr. com Page 2 To accommodate other players in the market, the Botswana Stock Market (BSE) established in 1989 with the mandate to oversee portfolio investment institutions which were allowed to buy shares on generous terms. However, local institutions were subjected to exchange control regulations for investing up to 50 percent of their assets abroad. According to Ahmed (2006), the exchange control measures penalized local savers because foreign financial assets generally offer a higher real rate of return than those denominated in Pula. Local investors were denied the opportunity to increase their wealth and diversify their risks. Despite the fact that Botswana experienced rapid economic growth, financial institutions did not expand as expected. According to Jefferis (1995) and Ahmed (2006), since independence, the financial sector has been dominated by two major commercial banks which concentrated on short-term segments of the market. These banks did not offer much development to enhance long-term investment for a considerable period. Also, there was a limited range of financial instruments and capital market for equities and long-term, and short-term debt instruments did not exist before the establishment of the Botswana Stock Market. The government recognized that although excess liquidity existed, there was a demand for long-term financing which was not satisfied. This constituted a structural weakness in the financial system. Since then, the financial system of Botswana has grown by leaps and bounds. To investigate the backdrop of these investment activities, very few studies on bank and stock market developments and economic growth in Botswana have been carried out. Hence this prompted this research to establish the impact of this development on the rate of growth of the economy. 2.0 Theoretical literature review. 2.1. 1 Exogenous Growth theories In the traditional neoclassical growth models independently developed by Solow (1956) and Swan (1956), the output of an economy grows in response to larger inputs of physical capital and labor. Other economic variables such as human capital and financial institutions are excluded in these models. The standard Solow Cobb-Douglas production function is thus written as; Y = AK α L β , where Y is the output and depends on capital (K), Labour (L), as well as productivity (A); α and β are production elasticities with α + β =1. ( ) ( ) ( ( ) ( ) . (i) Where denotes time, is the elasticity of output with respect to capital, and ( ) represents total production, is capital and L is labour. refers to laboua r-augmenting technology or ―knowledge‖, thus represents total production. All factors of production are fully employed and initial values. ( ) ( ) and ( ) are given.The number of workers, ie labour as we,,ll as the level of technology grow exogenously at rates and , repectively. However, the Mankiw, Romer, and Weil (1992) model marked an important contribution to the debate on the nature of economic growth. In particular, it was argued that the observed empirical shortcomings of the neoclassical Solow growth model 1 in particular a large underestimate of the difference in incomes between advanced and developing countries unless capital is assumed to have a far larger impact on output than its income share implies were due to the omission of human capital. Effectively, Mankiw et al. (1992) argued that the traditional Cobb-Douglas formulation should include human capital variable and should be rephrased as; ( ) .