The Growth Effects of Financial Development Over Economic Cycle in South Africa

The Growth Effects of Financial Development Over Economic Cycle in South Africa

Naser Yenus Nuru, Hayelom Yrgaw Gereziher
DOI: 10.4018/978-1-7998-4817-2.ch007
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This study examines the effects of financial development, proxied by domestic credit, on growth for South Africa across the states of the economy over the sample period 1970Q1-2019Q3. To address this point, the authors use Jorda's local projection method to generate impulse response functions for this small developing open economy. The shocks, however, are identified by applying short-run contemporaneous restrictions in a vector autoregressive model based on Cholesky identification scheme. The states of the economy are determined by a threshold variable, namely output growth. The results indicate that one standard deviation shock in domestic credit leads to a significant increment in output in this economy. This effect, though, is a bit pronounced in recession than the expansion state. One standard deviation shock in domestic credit leads to around 0.8 and 0.5% increment in output in recession and expansion states at the fourth quarter and on impact, respectively. The results are also robust to an alternative proxy variable of financial development.
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The unanswered intuition behind the long-run sustainable economic growth and reasons for cross country growth differences between countries has always attracted considerable attention in the literature. Since the economic performance of a country determines the welfare of a country substantially researchers and economists are striving to determine the source of economic growth to implement accurate economic policies (Betül, 2014).

In the literature of economic growth, so many explanations and empirical investigations are stated about the sources of economic growth and development. The financial crisis that has happened in the 1970s marked the fall of the Keynesian view and rise of the neoclassical (Brian and Odhiambo, 2018). As a result, according to the neoclassical theory, countries transformed their policies towards trade liberalization after the 1980s. Hence, an interaction between the financial sector and the real sector is observed recently and considerable attention is given in the finance-growth literature. The financial crisis of 2008 made economists interested in reexamining the effect of financial development on the real economy. Prior to the financial crisis, there was a strong belief that financial development leads every economy to growth and development since information asymmetry and transaction costs are minimal in financially advanced systems (Ebru, 2016).

According to Demirgüç-Kunt and Levine (2008), the overall functions of the financial system is to reduce information and transaction costs impeding economic activity. It has five core functions played by the financial system (i) financial systems produce information and allocate capita, (ii) financial systems monitor firm behavior and exert corporate governance, (iii) financial instruments, intermediaries, and markets can facilitate the trading, (iv) financial systems pool or mobilize savings from different savers for investment, and (v) at a more fundamental level, financial instruments, intermediaries, and markets can stimulate specialization, innovation, and growth by reducing transactions costs. On the other hand, Beck, et al. (2014) argued that an oversized financial system leads to instability, imperfect competition, wastage of resources, rent extraction, negative externalities from auxiliary financial services and implicit insurances due to bailouts. Such externalities from auxiliary financial services, for example, can be useful for some clients but not for the whole society as it may lead the financial sector to grow too large relative to its social optimum. Hence, there could be limits to the financial benefits.

Therefore, the growth effects of financial development cannot be generalized for all countries. The differences across countries lead to the unique transmission mechanism of financial development on economic growth (José, et al. 2019; Al-Yousif, 2002). Another explanation for the puzzling results of previous studies is that the empirical results of the growth impact of financial development are sensitive to the choice of financial development indicator (Adu et al., 2013). Furthermore, previous studies, at least for South Africa, ignore the effects of economic cycles on the finance-growth nexus. According to the finance constraint theory, the economic cycle has inconsistent impacts on agents depending on their exposure to agency problem and asymmetric information. Hence, agents may respond to shocks in a financial sector differently across different cycles of the economy. This gap is going to be addressed in this paper by using the case of South Africa.

Similar to other developing countries, South Africa faced the effects of the 2008 global financial crisis, which disrupted – and in some cases reverse – the achievement of Millennium Development Goals, including decent work for all. This is of particular concern given that, even in the pre-crisis period, growth patterns in certain regions, notably in Africa, led to only negligible reductions in poverty. Decent living and working conditions still remain out of reach for large numbers of people. Importantly, the crisis spread throughout the real economy by important mutually-reinforcing transmission channels including limited availability of credit for working capital and many countries attempted financial–rescue measures to restore credit liquidity (Khatiwada, 2009). Hence, it is quite essential to see how growth can be affected by financial development during such slump times in economies like South Africa.

Key Terms in this Chapter

Vector Autoregression: Is a stochastic process model used to capture the linear interdependencies among multiple time series.

Impulse Response Functions: Are used to describe how the economy reacts over time to exogenous impulses, which economists usually call shocks, and are often modeled in the context of a vector autoregression.

Financial Development: Is about overcoming “costs” incurred in the financial system. This process of reducing the costs of acquiring information, enforcing contracts, and making transactions resulted in the emergence of financial contracts, markets, and intermediaries.

Economic Growth: Is an increase in the production of economic goods and services, compared from one period of time to another.

Economic Cycle: Is the fluctuation of the economy between periods of expansion (growth) and contraction (recession).

Small Open Economy: Is an economy that participates in international trade, but is small enough compared to its trading partners that its policies do not alter world prices, interest rates, or incomes, e.g., South Africa.

Cholesky Decomposition: In linear algebra, the Cholesky decomposition or Cholesky factorization is a decomposition of a Hermitian, positive-definite matrix into the product of a lower triangular matrix and its conjugate transpose, which is useful for efficient numerical solutions, e.g., Monte Carlo simulations.

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