Chapter 2 Literature Review
2.12 Financial Deepening, Economic Stability And Growth
2.12.4 Foreign Capital Flows And Financial Deepening
International financial flows are needed for the growth and development of underdeveloped markets. The SADC region is dominated by low-income financial markets that require external funding to promote financial development and in turn spur economic growth. Recently, many African countries have recorded unprecedented levels of global financial flows partly due to a
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surge in commodity prices (Dahou et al., 2009). African exports between 2000 and 2006 are estimated to have grown from USD159 billion to USD290 billion. Over the same period, portfolio equity and debt registered a fivefold increase to exceed USD60 billion while foreign remittance flows reached a peak of USD22 billion in 2006.
Although the issue of whether or not financial market development drives economic growth has generated considerable academic and policy debate (Dahou, Omar, and Pfister, 2009), based on our understanding, no study has investigated the directional or causal relations among financial deepening, foreign capital flow variability and the performance of stock markets, particularly in low-income countries. Excluding South Africa, the level of financial development in the SADC region is still very low (Andrianaivo and Yartey, 2010). Markets are characterized by limited access to debt and bond markets, and there is a small banking sector, low levels of deposits and loans, high levels of non-performing loans and general capital inadequacy among most financial institutions (Hearn and Piesse, 2008, Andrianaivo and Yartey, 2010). Because of the rapid growth in stock markets in African economies, recent years have been characterized by the adoption of international accounting and auditing standards (Ntim, 2012).
At the beginning of the 1990s, many countries in Southern Africa began the process of trade and financial liberalization, bank regulation, establishing central bank credibility and creating monetary policy. The dominance of government-owned financial institutions was reduced and new and innovative financial products were introduced. At global level, cross border mobility of capital flows increased and in the SADC region, considerable interest has been expressed in monetary integration; a single currency could be in place by 2018. Despite these significant developments, the financial system is still regarded as small in both absolute and relative terms. For example, Andrianaivo and Yartey (2010) show that in the developed financial markets bank credit to the private sector almost reached 100% while that in sub-Saharan African markets hardly exceeded 15%. Aregbeshola (2016) shows that financial development is a more significant driver of growth in developing economies than it is in industrialized countries, but points to the need for rapid economic growth as a prerequisite for financial market deepening. This raises the question of the widely debated causality relationship between financial deepening and growth. Arguably, financial deepening is at its lowest in Southern Africa. Given the above developments and changes in the financial landscape ,
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careful study of the directional financial linkages among foreign capital flow mobility, financial deepening and the performance of financial markets will add to or extend the existing theoretical and empirical literature, particularly on low-income countries. Although low-income SADC countries are receiving rapidly growing portfolio and remittance flows, they have not as yet experienced a significant shift in the size and sophistication of their financial markets to reap the benefits of large-scale economies (Beck et al., 2014b).
Regardless of the problems related to size, lack of depth and liquidity, some African capital markets do well in terms of return on investment. For instance, the Ghana Stock Exchange was regarded as the best performer in the world at the end of 2004, providing investors with an annual gain of 144% in US dollars compared to the 30% gain offered by Morgan Stanley Capital International Global Index (Databank Group, 2004).
The overall conclusion that an economy with advanced financial markets is exposed to highly unstable foreign financial flows and more risks (Broner and Ventura, 2016) is not confirmed by Sole Pagliari and Ahmed (2017). However, it is consistent with the findings of Lagoarde-Segot (2009) and Umutlu, Akdeniz, and Altay-Salih (2010), who found that a considerable relationship is displayed between the variability of capital flows and that this correlation is more powerful in more advanced markets. Hence, it can be deduced that an economy with advanced financial markets is more subjected to shocks emanating from the global financial market.
The North Atlantic financial crisis created considerable policy challenges and raised the need for more research on financial systems development and the mobility of international financial flows (Griffith-Jones et al., 2014). This is further motivation for the need to identify a desirable financial sector structure and size (Griffith-Jones et al., 2014). The crisis posed challenges to conventional wisdom that advanced economies’ financial systems and their regulation should be replicated by developing economies, given that these financial systems have been so problematic and badly regulated. Financial markets in African low-income countries are generally at an early stage of development and are shallow and narrow although they are experiencing moderately rapid deepening. Decision makers are, however, concerned that rapid growth combined with existing vulnerabilities to global shocks and regulatory lapses might pose major risks to financial market stability. Given this, it is difficult to apply the lessons learnt from crises in advanced financial markets to low-income African financial markets. According to Griffith-Jones et al. (2014), low-
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income financial markets are developing quite rapidly and are also exposing themselves to the risks of financial instability.
In general, foreign banks are expected to play a critical role in the financial deepening and stability of African markets; however, existing evidence is somewhat ambiguous, calling for further research (Beck et al., 2014a). For instance, foreign banks should bring critical experience from developed financial economies and should assist in attaining economies of scale in developing countries. However, they are less inclined to lend and their loans are more volatile than loans from domestic banks. In addition, foreign banks rely on ‘hard’ information about borrowers (Detragiache, Tressel, and Gupta, 2008). Fuchs et al. (2012a) argue that most foreign banks exist as subsidiaries that fund themselves and do not rely on parent banks, thus limiting their impact on national savings. In terms of financial deepening and stability, low-income African markets have the advantage of being latecomers to financial development and can learn from the positive and negative lessons of other economies’ experiences. Moreover, governments of low-income countries have more space and flexibility to shape the financial systems of smaller markets.