1.1 BACKGROUND OF THE STUDY
The pioneering contributions of Schumpeter (1911), and later McKinnon (1973) and Shaw (1973) regarding the relationship between financial development and economic growth has remained an important issue of debate in developing economies. The theoretical argument for linking financial development to growth is that a well-developed financial system performs several critical functions to enhance the efficiency of intermediation by reducing information, transaction, and monitoring costs. A modern financial system promotes investment by identifying and funding good business opportunities, mobilizes savings, monitors the performance of managers, enables the trading, hedging, and diversification of risk, and facilitates the exchange of goods and services. These functions result in a more efficient allocation of resources, in a more rapid accumulation of physical and human capital, and in faster technological progress, which in turn feed economic growth [Creane, et al. (2004)].
Long-term sustainable economic growth depends on the ability to raise the rates of accumulation of physical and human capital, to use the resulting productive assets more efficiently and ensuring the access of the whole population to these assets. Financial intermediation supports this investment process by mobilizing household and foreign savings for investment by firms; ensuring that these funds are allocated to the most productive use, spreading risk and providing liquidity so that firms can operate the new capacity efficiently.
Financial development thus involves the establishment and expansion of institutions, instruments and markets that support this investment and growth process through improvements in quantity, quality and efficiency of these financial intermediary services.
However, economist still holds startling different opinions regarding the importance of the financial system for economic growth. While many economists have underlined the importance of financial sector development in the process of economic development others still think that its importance is over stressed.
McKinnon and Shaw argued that government repression of financial systems through interest rate ceilings and directed credit to preferential non-productive sectors, among other restrictive measures, impedes financial development which they claim is essential for economic growth. The endogenous growth literature as well stresses the significance of financial development for long-run economic growth through the impact of financial sector services on capital accumulation and technological innovation. These services include mobilizing savings, acquiring information about investments and allocating resources, monitoring managers and exerting corporate control, and facilitating risk amelioration (Greenwood and Jovanovic, 1990; Bencivenga and Smith, 1991).
On the other hand, influential economists such as Robinson (1952), Kuznets (1955), Jung (1986) Lucas (1988), and Ireland (1994) contend that the role of financial development is either overstated or that financial development follows expansion of the real economy. This would indicate, in contrast to McKinnon and Shaw and the endogenous growth theorists that causality, if it exists, runs from economic growth to financial development. Somewhere between these two views is also the one that claims a mutual impact of finance and growth otherwise known as “the bidirectional causality view”. Demetriades and Hussein (1996), Greenwood and Smith (1997) and Luintel and Khan (1999) are some of the studies that provide evidence of bi-directional causality
It is in the light of these conflicting views that this study aims at explaining the relationship between financial development and growth in Nigeria.
For Nigeria, studying the relationship between financial development and economic growth is a vital one considering the continuing progress/reforms in its financial sector. Considered as an integral part of macroeconomic policy the financial sector reforms are expected to bring about significant economic benefits particularly through a more effective mobilization of savings and a more efficient allocation of resources thus putting the economy on the path of sustainable economic growth and development.
Although it is common to consider cross-country regression to judge the growth effects of financial development, it is also important to study individual-country evidence at least at a simple level to see whether higher levels of financial development are significantly and robustly correlated with faster rates of economic growth, physical capital accumulation and economic efficiency improvements.
- STATEMENT OF THE PROBLEM
Economic development in Nigeria has been characterized by fits and starts. Several factors have hampered economic growth; one of such factors often associated with this unsatisfactory growth performance is shallow finance. This factor is critical in view of the general belief that scarcity of long term finance in developing countries is the major impediment to higher investment and output growth in these economies Nnanna etal (2004).
Thus, it is now well recognized that financial development is crucial for economic growth. This recognition dating back to Schumpeter (1911) who argued that the services provided by the financial intermediaries are important for innovation and development.
As this assertion may seem, there is also the argument that financial development contributes significantly to the economic development of developed countries while the developing countries have not fared well in this regard Singh (1997).
Hence, even though a growing body of work reflects the close relationship between financial development and economic growth, it is still possible to encounter especially empirical researches evidencing all possibilities as positive, negative, no association or negligible relationships. While Cross country and more recently, panel data studies show evidence of a positive impact of financial development on growth, Time series on the other hand, offer contradictory results. Furthermore, the direction of causality between financial development and economic growth is crucial because it has significantly different implications for development policy; however, this causal relationship remains unclear.
Nigeria on its part has made notable efforts over the past years to reform its financial system going from the deregulation and liberalization of the financial sector activities under SAP 1986, banking consolidation of 2004 and the recent financial system strategy (FSS) 2007 which hopes to make the country’s financial sector the growth catalyst that would ultimately engineer Nigeria’s evolution into an international financial center and a natural destination for financial products and services. Despite these great efforts Nigeria’s economic growth has been dwindling and has still remained fragile not strong enough to significantly reduce the prevailing level of poverty even though the various indicators used in measuring financial development has been increasing steadily over the years. See table 1 below: