The relationship between the financial sector and economic growth in South Africa

Abstract

This study investigates the dynamic causal relationship that exists between financial development, economic growth and investment in South Africa. In order to achieve this objective, the study employs various financial sector indicators to proxy financial development. For the banking sector, the following indicators are used, namely the ratio of broad money stock to GDP, the ratio of broad money stock minus currency to GDP, the ratio of private sector credit to GDP, the ratio of non-financial private credit to total credit, and the ratio of liquid liabilities to GDP. In order to proxy financial development through stock market development, the following indicators are used, namely the ratio of market capitalisation to GDP, the ratio of total value of shares traded to GDP, the turnover ratio, and the stock market volatility calculated over a four quarter moving standard deviation, as well as an equally weighted stock market development index which combines the four former indicators. In both cases, the recently developed ARDL-Bounds testing procedure is applied to test for the presence of long-run cointegration. In addition, the VECM-Granger approach and Innovative Accounting Approach are applied to generate both in-sample and forecast causality results. In contrast to the majority of previous studies, this study also incorporates investment to develop a simple tri-variate causality model to limit the risk of misspecification bias. Employing time–series data covering the period 1969 to 2013, the in-sample empirical findings, when using banking sector indicators, provide evidence of a short-run bi-directional relationship between financial development and economic growth and a demand-following relationship in the long run. The forecast results provide support for a possible changing long-run relationship, with evidence of bi-directionality being found between financial development and economic growth. The results are less conclusive when using stock market development indicators, with the causal relationship being very sensitive to the proxy used. Nevertheless, these results identified that the causal relationship in question does change when using stock market development indicators, rather than banking sector proxies.