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Topic Description



  • Background of the Study

Financial liberalization can be viewed as a set of operational reforms and policy measures designed to deregulate and transform the financial system and its structure with a view to achieve a liberalized market-oriented system within an appropriate regulatory framework (Johnston and Sundararajan, 1999).  Financial liberalization has been variously characterized in the literature but Niels and Robert (2005) observed that whatever characterization, financial liberalization usually include official government policies that focus on deregulating credit controls, deregulating interest rate controls, removing entry barriers for foreign financial institutions, privatizing financial institutions, and removing restrictions on foreign financial transactions. In other words, financial liberalization has both domestic and foreign dimension.  Moreover, it focuses on introducing or strengthening the price mechanism in the market, as well as improving the conditions for market competition.  As opposed to financial liberalization financial repression (the inverse of financial liberalization) is evidenced by ceilings on interest rates and credit expansion, selective credit policies, high reserve requirements, and restriction on entry into the banking industry (Ikhide and Alawode, 2001).

There has been a renewed interest on the role of financial liberalization in economic growth. This current focus has been heightened by two key factors.  First, the global financial crisis that has ravaged the economies of the world especially the western world and the apparent inability of the classical and neo-classical economic models to adequately address the crisis.  Second, the on-going government interventionists’ activities in the financial systems of various countries of the world have called to question the McKinnon-Shaw hypothesis of financial liberalization as a catalyst for economic growth and the Schumpeterian ‘creative destruction’ logic of free and liberalized economies.

According to Ogbu (2010), the current global financial and economic crises, the huge bailout of the financial and non-financial institutions across the world and the rather uncertain and timid response to these massive government interventions in the functioning of the market are altogether producing four-fold theoretical-conceptual outcomes.  One, the empirical scenario is re-defining or re-evaluating the capitalist market economy.  Two, it is exposing the limits of ‘creative destruction’ logic of Schumpeter (1911).  Three, it calls to question the adequacy of the current economic modeling and analytical tools.  Four, it is leading the way to the emergence of a ‘new market economy’.

Ogbu (2010) argued further “not since the great depression of the 1930s has the world experienced this kind of economic down-turn.  Now, unlike then, the effects have been widespread, global and faster and the amounts involved staggering.  Unfortunately, the lessons of the 1930s could not be relied upon to provide answers for the current economic crisis.  As each country tries on its own to deal with the problems, the governments are getting more involved with market activities outside the previously accepted limits for a functioning market economy especially in the financial system”.


Theoretically, it is widely accepted that liberalizing the financial system could play a vital role in economic development.  Since the original theoretical analysis which provided a rationale for financial sector liberalization as a means to promote economic development was given by McKinnon (1973) and Shaw (1973), a lot of theoretical and empirical research has been carried out examining the concept in different contexts, countries and time periods (see for example, Abel 1980; Romer 1994; Lucas 1982; Bandiera et al. 2000; Khan and Reinhart 1990; and King and Levine 1990, Demir, 2005).


According to Arestis (2005) a number of writers question the wisdom of financial repression, arguing that it has detrimental effects on the real economy. Goldsmith (1969) argued that the main impact of financial repression was the effect on the efficiency of capital. McKinnon (1973) and Shaw (1973) stressed two other channels: first, financial repression affects how efficiently savings are allocated to investment; and second, through its effect on the return to savings, it also affects the equilibrium level of savings and investment. In this framework, therefore, investment suffers not only in quantity but also in quality terms since bankers do not ration the available funds according to the marginal productivity of investment projects but according to their own discretion. Under these conditions the financial sector is likely to stagnate. The low return on bank deposits encourages savers to hold their savings in the form of unproductive assets such as land, rather than the potentially productive bank deposits. Similarly, high reserve requirements restrict the supply of bank loans even further whilst directed credit programmes distort the allocation of credit since political priorities are, in general, not determined by the marginal productivity of different types of capital.


Arestis (2005) remarked further “the policy implications of this analysis are quite straightforward: remove interest rate ceilings, reduce reserve requirements and abolish directed credit programmes”. In other words, liberalize financial markets and let the free market determine the allocation of credit, where it is assumed that there will be a ‘free market’ with just a few banks, thereby ignoring issues of oligopoly and, of course, of credit rationing problems (Stiglitz and Weiss, 1981). With the real rate of interest adjusting to its equilibrium level, at which savings and investment are assumed to be in balance, low yielding investment projects would be eliminated (Schumpeter’s ‘creative destruction’), so that the overall efficiency of investment would be enhanced. Also, as the real rate of interest increases, saving and the total real supply of credit increases, this in turn will induce a higher volume of investment. Economic growth would, therefore, be stimulated not only through the increased investment but also due to an increase in the average productivity of capital. Moreover, the effects of lower reserve requirements reinforce the effects of higher saving on the supply of bank loans, whilst the abolition of directed credit programmes would lead to an even more efficient allocation of credit thereby stimulating further the average productivity of capital.


In recent years, several papers have been published on the relationship between financial liberalization and growth. Some studies focus on the quantity effects of liberalization while others concentrate on the quality effects of liberalization.  These studies use firm-level as well as cross-country data (see Niels and Robert, 2005). Laeven (2003) quoting from Niels and Robert (2005), in a study finds evidence for the hypothesis that financial liberalization reduces financial constraints of firms.  His study was based on information from 13 developing countries.  Similarly, positive effects of liberalization on reducing financial constraints are found, among others, by Koo and Shin (2004) for Korea, Harris, Schiantarelli and Siregar (1994) for Indonesia, Guncavdi, Bleaney and McKay (1998) for Turkey and Gelos and Werner (2002) for Mexico.  At the same time, however, studies by Jaramillo, Schiantarelli and Weiss (1996) on Ecuador and Hermes and Lensink (1998) on Chile find much less supportive evidence for the positive effect of financial liberalization on reducing financial constraints and inducing investment.


Other studies have used cross-country panel data.  Nazmi (2005) uses data for five Latin American countries and finds evidence that deregulation of financial markets increases investment and growth.  Bekaert, Harvey and Lunblad (2005) for a large sample of countries looked at liberalization of the stock market in particular, opening them up to foreign participation and found support for the view that a type of liberalization spurs economic growth through reducing the cost of equity capital and increasing investment.  Other cross-country analyses are less positive about the quantity effect of financial liberalization.  For instance, Bonfiglioli (2005) using information for 93 countries shows that financial liberalization marginally affects capital accumulation and hence investment.    Moreover, Bandiera et al. (2000) reviewed the impact of financial liberalization on saving based on information from eight developing countries over a 25-year period and found that savings rates actually fall, rather than increase, after financial liberalization.


From the foregoing, it could be seen that findings from extant research on the impact of financial liberalization on investment and growth remains inconclusive.  Further studies, perhaps, at micro (firm)-level may shed greater light as observed by Carruth et al. (1998) “the apparent inconsistencies in the results reveal the crucial importance of disaggregation when attempting to identify the impact of financial liberalization on investment and also highlights the need for appropriate econometric techniques that can integrate both time-series and cross-section information.  Moreover, it is apparent that there is a high degree of heterogeneity across industries which may potentially bias the results from any aggregate-level study.  Given these conclusions, it is clear that the use of company-level panel data, with its even higher level of disaggregation coupled with its greater data variability, is likely to be advantageous…”


1.2       Statement of Research Problem

For more than two decades after independence, the Nigerian financial system was repressed, as evidenced by ceilings on interest rates and credit expansion, selective credit policies, high reserve requirements, and restriction on entry into the banking industry.  This situation, according to Ikhide (1996) inhibited the functioning of the financial system and especially constrained its ability to mobilize savings and facilitate productive investment.  To reverse this situation and in line with the orthodoxy of the time, Nigeria like other developing countries embraced financial liberalization as one of the major planks of Structural Adjustment Programme in 1986.


According to Ikhide (1996) attempts at liberalizing the financial sector in Nigeria have fallen under five main headings – reform of the financial structure, monetary policy reforms, foreign exchange reforms, liberalization of capital movement and capital market reforms.  Reform of the financial structure includes measures designed to increase competition, strengthen the supervisory role of the regulatory authorities and strengthen public sector relationship with the financial sector. In this direction, some measures undertaken include: enhancing bank efficiency through increased competition and management by granting licenses to more banks to operate. Conditions for the licensing of new banks were relaxed. In response, the number of banks increased dramatically from 40 in 1986 to 120 in 1992. A comparable increase in the number of non-bank financial institutions occurred. Strengthening banks supervision and increasing their viability through adequate regulations regarding minimum capital requirements, specifying the range of assets and liabilities they can acquire, introduction of uniform accounting standards for banks to ensure accuracy, reliability and comparability. Two banking laws were promulgated with effect from June 1991, the CBN Decree No. 24 of 1991 and the Banks and Other Financial Institutions Decree (BOFID), No. 25,1991 (CBN, 2004).


There was also monetary policy reforms designed mainly to stabilize the economy in the short run and to induce the emergence of a market-oriented financial sector. Such reforms included: rationalization of credit controls; although credit ceilings on banks were not completely removed, the sector specific credit distributions target were compressed from 18 in 1985 to 2 in 1987 – priority (agriculture and manufacturing) and non-priority (others). Other credit measures enacted were the elimination of exceptions within the ceiling on bank credit expansion, giving similar treatment to commercial and merchant banks in relation to required liquidity ratios and credit ceiling, the modification of cash reserve requirements which is now based on the total deposit (demand, savings, and time deposits), rather than on time deposits only, and the reintroduction of stabilization securities (CBN, 2004).


Interest rate liberalization was aimed at enhancing the ability of banks to charge market-based loans rates and also guarantee the efficient allocation of scarce resources. In 1989, banks were encouraged to pay interest on current account deposits. The rate paid was negotiated between banks and their customers. There was a shift from direct to indirect system of monetary control in June 1993 with the introduction of open-market operations (OMO). Under the scheme, OMO was to be conducted exclusively through licensed discount houses, which were supposed to constitute the open market for government securities. The introduction of OMO was meant to replace the use of direct controls for managing liquidity in the economy.


All these and other reform measures were aimed at removing distortions in efficient allocation of resources to productive investments especially in the private sector.  For according to Khan and Reinhart (1990), economic growth can only be efficient and sustainable if it is coming primarily from the private sector.    In spite of these measures however, theoretical evidence suggest that the impact of financial liberalization on private sector investment in Nigeria is at best marginal (see Busari, 2007; Akinlo and Akinlo, 2007, Ayadi et al, 2009, Uchendu, 1993 and Ndebibo, 2004).  Moreover, there are still few studies at the macro level that address the impact of financial liberalization on private investment in Nigeria (see Oyejide, 1998; Edo, 1995, Ogun 1986).  In two aggregate level studies, Busari (2007 and 2008) and Busari and Fashanu (2009) suggest that liberalization appears to have helped ease the previously binding constraints on private investment in Nigeria.  At a sectoral level of analysis, results from Nzotta and Okereke (2009); Samuel and Emeja (2009), Nwaogwugwu (2008); Ndekwu (1998); Nnanna and Dogo (1999), Emenuga (1996), Nzotta (2004) and Olofin and Afangideh (2008) suggest that liberalization had very little impact, if any, on the behaviour of sectoral investments in Nigeria.

However, many of these macro level studies did not incorporate firm-level data in their analysis and focus essentially on the structural change in the investment behaviour under liberalization using mainly money market indicators. As firms remained the main drivers of the economy, an empirical analysis of investment under financial liberalization that incorporates firm-level investment and macroeconomic data under Post Keynesian framework has become imperative.  In addition, at a time that most countries in the global economic community are re-examining their economic models and financial architecture in response to the economic down-turn, a work of this nature becomes not only imperative but compelling. Moreover, after over two decades of operating a liberalized economic and financial model, an empirical work that will chronicle the impact of liberalization on investment in Nigeria at firm level has become imperative for academic and policy purposes.  This work filled this important research gap.  This was achieved through a firm level and macroeconomic data extracted from the balance sheets and income statements of manufacturing companies quoted on the Nigerian Stock Exchange and published in the NSE Yearly Factbook and Central Bank of Nigeria Statistical Bulletin for the period 1990 to 2009.

1.3       Objectives of the Study

The study examined empirically the impact of financial liberalization on investment in Nigeria using firm level and macroeconomic data.  To achieve this objective, the study strived to:

  1. Investigate how financial liberalization has evolved over time in Nigeria and the bank development indicators that influenced such evolution.
  2. Identify the various financial liberalization indicators and how these indicators impacted on investment of manufacturing firms in Nigeria.
  3. Examine the impact of financial liberalization on aggregate assets as a determinant of investment decisions of manufacturing firms in Nigeria.
  4. Ascertain the impact of financial liberalization on macroeconomic measures of uncertainty as determinant of investment decisions of manufacturing firms in Nigeria.

1.4       Research Questions

The study essentially sought to answer the following questions:

  1. How did financial liberalization evolve over time in Nigeria and what are the bank development indicators that influenced such evolution?
  2. What are indicators of financial liberalization and how do these indicators impact on investment of manufacturing firms in Nigeria?
  3. What is the impact of financial liberalization on aggregate assets of firms as determinant of investment decisions of these firms in Nigeria?
  4. Does financial liberalization have any impact on macroeconomic measures of uncertainty as determinants of investment decisions of manufacturing firms in Nigeria?

1.5       Research Hypotheses

To achieve the above objectives, the following hypotheses were investigated in the study:

  1. Financial liberalization is not positively and significantly related with bank development indicators in Nigeria
  2. Financial liberalization is not positively and signficantly related with firm level investments in Nigeria.
  3. Financial liberalization is not positively and significantly associated with aggregate assets of firms as a determinant of firm level investments in Nigeria.
  4. Financial liberalization is not positively related with macroeconomic measures of uncertainty as determinants of firm level investments in Nigeria.

1.6       Scope of the Study

The study focused on the impact of financial liberalization on investment in Nigeria using firm level and macroeconomic data. In other words, only manufacturing firms quoted in the Nigeria Stock Exchange were covered in the study.  In line with previous studies with similar orientation and the dynamic nature of investment models, only firms which have remained in existence continuously for at least five years after the initial year (1990) were covered.  Moreover, only manufacturing firms were included in the data set because physical capital accumulation (investment) was the focus of the study. Financial and insurance firms are highly leveraged entities and their investment horizon is somewhat different from those in the real sectors.  The exclusion of diverse sectors such as commerce and agriculture helped keep firm heterogeneity in the sample under control.

Furthermore, only manufacturing firms with less than 50% government ownership were included in the sample.  State owned enterprises (SDEs) have been subject to different managerial procedures than privately owned ones.  Since these enterprises should be understood as a part of the country’s long-term development plans, their financing and investment decisions are not necessarily expected to follow the models of their private competitors.

1.7       Significance of the Study

Financial liberalization and the role of government in economic growth and development have once again occupied the front burner in national and international discourse because of the global financial and economic melt-down that is ravaging the world and the apparent inability of current financial and economic theoretical models