Econ Change Restruct (2010) 43:205–219

DOI 10.1007/s10644-010-9085-5

Finance-investment-growth nexus in South Africa:

an ARDL-bounds testing procedure

Nicholas M. Odhiambo

Received: 10 June 2009 / Accepted: 16 February 2010 / Published online: 2 March 2010
Ó Springer Science+Business Media, LLC. 2010

Abstract In this paper we examine the dynamic causal relationship between

financial development, investment and economic growth in South Africa—using the
newly developed ARDL-Bounds testing procedure. Unlike the majority of the
previous studies, we incorporate investment in the bivariate model between finan-
cial development and economic growth—thereby creating a simple trivariate cau-
sality model. In addition, we use three proxies of financial development, namely
M2/GDP, the ratio of private sector credit to GDP and the ratio of liquid liabilities to
GDP in order to test the robustness of the results. Our results show that, on the
whole, economic growth has a formidable influence on the financial sector devel-
opment. The study also finds that there is a distinct unidirectional causal flow from
economic growth to investment. Moreover, the study also finds that investment,
which results from growth, Granger-causes financial development. The study,
therefore, recommends that South Africa should intensify its pro-growth policies in
order to bolster investment and financial development.

Keywords Africa  South Africa  Financial deepening  Investment 

Economic growth

JEL Classification G20  E40  D90  C22

1 Introduction

The debate regarding the causal relationship between financial development and
economic growth has been ongoing since the nineteenth century. The thrust of this

N. M. Odhiambo (&)
Economics Department, University of South Africa (UNISA), P.O. Box 392, UNISA,
Pretoria 0003, South Africa
e-mail: nmbaya99@yahoo.com; odhianm@unisa.ac.za

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206 Econ Change Restruct (2010) 43:205–219

debate has been whether it is the growth of the financial sector that leads the growth
of the real sector in the dynamic process of economic development or whether it is
the growth of the real sector that drives the development of the financial sector.
Previous empirical studies in this area suffer from three major limitations. First, the
majority of the previous studies on this subject have concentrated mainly on the use
of a bivariate causality test and may, therefore, suffer from the omission-of-variable
bias. In other words, the introduction of a third variable affecting both financial
depth and economic growth in the bivariate causality system may not only alter the
direction of causality between financial depth and economic growth, but also the
magnitude of the estimates. Secondly, some of the previous studies have relied
mainly on the cross-sectional data to examine the causal relationship between
financial development and economic growth. Yet, it is now clear that the cross-
sectional method by lumping together countries that are at different stages of
financial and economic development, may not satisfactorily address the country-
specific effects. Finally, the majority of the previous studies have mainly used the
residual-based cointegration test associated with Engle and Granger (1987) and the
maximum likelihood test based on Johansen (1988) and Johansen and Juselius
(1990). However, it is now well known that these cointegration techniques may not
be appropriate when the sample size is too small (see also Narayan and Smyth
2005).
The current study, therefore, attempts to fill this lacuna by investigating the
dynamic linkage between financial development, investment and economic
growth—using the newly developed ARDL-Bounds testing procedure. The study
incorporates investment as an intermittent variable, affecting both financial
development and economic growth—thereby forming a simple trivariate model.
In addition, three proxies of financial development have been used, namely M2/
GDP, the ratio of private sector credit to GDP and the ratio of liquid liabilities to
GDP, against real GDP per capita—a proxy for economic growth. The choice of
investment as an intermittent variable in the trivariate causality framework has been
largely influenced by the theoretical links between investment and economic
growth, on the one hand, and investment and financial development on the other.
The remainder of the paper is organised as follows: Sect. 2 discusses the trends of
financial development and economic growth in South Africa. Section 3 presents the
literature review, while the estimation techniques and empirical results are
presented in Sect. 4. Section 5 concludes the study.

2 Financial sector development and economic growth in South Africa

South Africa has a well-developed and highly sophisticated financial sector—with a

wide range of financial institutions and instruments. At the apex of South African
financial institutions is the South African Reserve Bank, which is followed by a
number of commercial banks, life insurance companies, the Post Office Savings
Bank, Unit trusts and micro-lenders, among others. In addition, there are investment
firms that offer a broad array of financial services and a strong financial market (see
Odhiambo 2009b). Currently the country has about 47 banks, of which 15 are

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Econ Change Restruct (2010) 43:205–219 207

160.00

140.00

120.00

100.00
Per cent

80.00

60.00

40.00
M2 as a % of GDP
Total private credit as a % of GDP
20.00
Liquid liabilities as a % of GDP

0.00
80

82

84

86

88

90

92

94

96

98

00

02

04

06
19

19

19

19

19

19

19

19

19

19

20

20

20

20
Year

Fig. 1 Trends of financial development indicators in South Africa during the 1995–2006 as compared to
1980. Source South African Reserve Bank Bulletin; World Bank (2009)

branches of foreign banks. Although the financial sector in South Africa is relatively
deep when compared to those of other SSA countries, the market share of the South
African banking sector is mainly dominated by a few banks. For example, by the
mid 1990s, more than 95% of the total assets of banks were held by only four
banking groups, namely Amalgamated Bank of South Africa (ABSA), Standard
Bank, First National Bank and Nedbank. The remaining 5% of the banks assets
were, however, spread among some 27 local banks, 9 foreign-controlled banks, and
a few branches of foreign banks as well as some mutual banks. Figure 1 shows the
trends of the selected financial development proxies in South Africa during the
period 1995–2008, as compared to 1980.
Although South African financial depth has improved considerably since 1993,
economic growth has consistently shown a mixed trend since the 1980s. For
example, during the period 1975–1984, the average annual percentage growth in
GDP in South Africa was 2.4%, with the highest growth rate of about 9.2% being
recorded in 1980. However, this rate decreased dramatically to an average of about
1.4% during the period 1985–1989 (see African Development Indicators 2002). This
dramatic decline in economic growth was mainly attributed to trade and financial
sanctions, political unrest, and the debt crisis, which inhibited prospects for
substantial capital inflows. Between 1990 and 1992, the GDP growth rate remained

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negative and systematically declined to—2.1% in 1992. It was only in 1993 that the
downward slide in the South African economy was reversed. Between 1993 and
1996, the GDP growth rate maintained a more or less increasing trend (with the
exception of 1995). In 1994, the GDP growth rate significantly increased to about
3.2% from about 1.2% in 1993. Although the rate declined slightly to about 3.1% in
1995, the country recorded a record high GDP growth rate of 4.2% in 1996.
However, the rate later declined in 1997 and 1998 to 2.5 and 0.7% respectively.
Despite dwindling economic growth, which affected South Africa in the 1980s and
1990s, a modest recovery in economic growth was maintained in 1999 and 2000.
The rate later increased to 4.2% in 2000, decreased in 2003 to 2.8% and increased
again in 2004 to 4.5%. By 2005, the GDP growth rate was 5.0%, the highest rate
recorded since 1984.

3 Literature review

The direction of causality between financial development and economic growth has
recently received emphasis from numerous empirical works in many developing
countries. Patrick (1966) distinguishes between supply-leading and demand-
following responses. According to the demand-following phenomenon, lack of
financial growth is a manifestation of a lack of demand for financial services. In
other words, according to this view, it is the real sector of the economy that
determines the level of financial development. In the second view, called the
supply-leading phenomenon, the financial sector precedes and induces real growth
by channelling scarce resources from small savers to large investors according to the
relative rate of return (see also Jung 1986). However, for a very long time the
conventional wisdom has been in favour of the supply-leading response where the
development of the financial sector is expected to precede the development of the
real sector.
There are at least four possibilities in the literature regarding the causal
relationship between financial depth and economic growth. The first possibility is
that financial development and economic growth are not causally related at all
(Graff 1999). This implies that neither of the two has any significant effect on the
other, and that the empirically observed correlation between them is merely the
result of a historical peculiarity. In other words, even though economies grow as the
financial sector grows, the two sectors—financial development and economic
growth—follow their own paths (see Graff 1999). The second possibility is known
as a supply-leading response. In this case, financial development is considered as a
determinant of economic growth, and the line of causation runs from financial
development to economic growth. This view has recently been widely supported by
McKinnon (1973), Shaw (1973), and King and Levine (1993), among others. The
third possibility is known as a demand-following response. The third view maintains
that financial development follows economic growth. In other words, economic
growth causes financial institutions to change and develop. According to this
hypothesis, the development of the real sector induces the demand for financial
services, which are passively satisfied by the introduction of new financial

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Econ Change Restruct (2010) 43:205–219 209

institutions (financial development).1 The fourth possibility, however, maintains

that both financial development and economic growth Granger-cause each other, i.e.
that there is a bidirectional causality between financial development and economic
growth.
On the empirical front, a number of studies have been conducted on the
relationship between financial development and economic growth in developing
countries, but with mixed results. De Gregorio and Guidotti (1995), for example,
while examining the relationship between financial development and economic
growth, conclude that, by and large, financial development leads to improved
growth—although the effects vary across countries and over time. Rajan and
Zingales (1998) investigate whether financial development facilitates economic
growth by scrutinising the rationale that financial development reduces the costs of
external finance to firms. The authors find that that financial development has a
substantially supportive influence on the rate of economic growth. Choe and Moosa
(1999) examine the relationship between the development of financial systems and
economic growth in Korea. They conclude that financial development in general
leads to economic growth, and that financial intermediaries are more important than
capital markets in this relationship. Darrat (1999) also finds that financial deepening
is generally a necessary causal factor of economic growth; but the strength of the
evidence varies across countries and across the proxies used to measure financial
deepening. Hondroyiannis et al. (2005), while examining the relationship between
the development of the banking system and the stock market and economic
performance in Greece, using VAR models, find that there exists a bidirectional
causality between finance and growth in the long run. Other empirical studies,
whose findings are consistent with the finance-led growth hypothesis, include those
of Jung (1986), Spears (1992), King and Levine (1993), Odedokun (1996), Ahmed
and Ansari (1998), Ghali (1999), Xu (2000), Jalilian and Kirkpatrick (2002),
Calderon and Lin (2003), Bhattacharya and Sivasubramanian (2003), Suleiman and
Abu-Qaun (2008), and more recently, Habibullah and Eng (2006), amongst others.
The empirical studies, which contend that economic growth Granger-causes
financial development, on the other hand, include studies by Crichton and De Silva
(1989; Shan et al. 2001; Agbetsiafa 2003; Odhiambo 2003; Waqabaca 2004; Zang
and Kim 2007; Odhiambo 2008), amongst others. Crichton and De Silva (1989), for
example, while examining the progress of financial intermediation resulting from
economic growth in Trinidad and Tobago, find that there is a definite and positive
correlation between economic growth and financial development, at least during the
period 1973–1982. Shan et al. (2001), while examining the relationship between
financial development and economic growth in nine OECD countries and China,
find little support for the hypothesis that finance ‘‘leads’’ economic growth, and they
caution against drawing such a general conclusion. In the same vein, Odhiambo
(2003), while using three proxies of financial development against real GDP per
capita, a proxy for economic growth, finds the demand-following response to

1
See Robinson (1952), Patrick (1966), Demetriades and Hussein (1996), and Chuah and Thai (2004).

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dominate in South Africa. Waqabaca (2004), while using data from Fiji, finds a
positive relationship between financial development and economic growth—but
with the causation running from economic growth to financial development.
Agbetsiafa (2003), using a sample of eight (8) emerging economies in sub-
Saharan Africa (SSA), finds a unidirectional causality from growth to finance to
dominate in the Ivory Coast and Kenya. In a recent study Zang and Kim (2007)
examine the causal link between financial development and economic growth in
East Asian countries, using the Sims-Geweke causality test performed on the large
panel data set provided by Levine et al. (2000). In sharp contrast to Levine et al.
(2000), the authors find substantial evidence that economic growth precedes
financial development, and they conclude that Robinson and Lucas might, in fact,
be right.
Despite the arguments in favour of the supply-leading response and demand-
following response, the empirical results from a number of studies have shown that
financial development and economic growth can Granger-cause one another.
Odhiambo (2005), for example, finds that, on the whole, a bidirectional causality
response predominates in Tanzania. Chuah and Thai (2004), while investigating the
causal relationship between financial development and economic growth in six GCC
countries, find that there is evidence of bidirectional causality in five of the six study
countries. Calderon and Lin (2003), while using the Geweke-decomposition test on
the pooled data of 109 countries, also reported some evidence of bidirectional
Granger causality. Akinboade (1998) also finds evidence of a bidirectional causality
between financial development and per capita income in Botswana. Wood (1993),
while examining the causal relationship between financial development and
economic growth in Barbados—using Hsiao’s (1979) test procedure—finds a
bidirectional causal relationship between financial development and economic
growth. Other empirical findings that are consistent with the bidirectional causal
relationship include those of Demetriades and Hussein (1996), Luintel and Khan
(1999), and Al-Yousif (2002), amongst others.

4 Estimation techniques and empirical results

4.1 Cointegration: ARDL-bounds testing procedure

Distributed Lag (ARDL)-Bounds testing approach is used to examine the long-run

cointegration relationship between financial development, investment and economic
growth. The ARDL model can be expressed as follows:
Model A: FD 1 (M2/GDP), Investment and Economic Growth
X n Xn X
n
DInFD1t ¼ a0 þ a1i DInFD1ti þ a2i DInInvti þ a3i DInyti
i¼1 i¼0 i¼0
þ a4 InFD1t1 þ a5 InInvt1 þ a6 Inyt1 þ e1t ð1Þ

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Econ Change Restruct (2010) 43:205–219 211

X
n X
n X
n
DInInvt ¼ b0 þ b1i DInInvti þ b2i DInFD1ti þ b3i DInyti
i¼1 i¼0 i¼0
þ b4 InInvt1 þ b5 InFD1t1 þ b6 Inyt1 þ e2t ð2Þ
X
n X
n X
n
DInyt ¼ d0 þ d1i DInyti þ d2i DInFD1ti þ d3i DInInvti
i¼1 i¼0 i¼0
þ d4 Inyt1 þ d5 InFD1t1 þ d6 InInvt1 þ e3t ð3Þ
Model B: FD 2 (Private Credit/GDP), Investment and Economic Growth
Xn Xn X
n
DInFD2t ¼ u0 þ u1i DInFD2ti þ u2i DInInvti þ u3i DInyti
i¼1 i¼0 i¼0
þ u4 InFD2t1 þ u5 InInvt1 þ u6 Inyt1 þ e1t ð4Þ
X
n X
n X
n
DInInvt ¼ l0 þ l1i DInInvti þ l2i DInFD2ti þ l3i DInyti
i¼1 i¼0 i¼0
þ l4 InInvt1 þ l5 InFD2t1 þ l6 Inyt1 þ e2t ð5Þ
X
n X
n X
n
DInyt ¼ k0 þ k1i DInyti þ k2i DInFD2ti þ k3i DInInvti
i¼1 i¼0 i¼0
þ k4 Inyt1 þ k5 InFD2t1 þ k6 InInvt1 þ e3t ð6Þ
Model C: FD 3 (Liquid Liabilities/GDP), Investment and Economic Growth
Xn X n X
n
DInFD3t ¼ W0 þ W1i DInFD3ti þ W2i DInInvti þ W3i DInyti
i¼1 i¼0 i¼0
þ W4 InFD3t1 þ W5 InInvt1 þ W6 Inyt1 þ m1t ð7Þ
X
n X
n X
n
DInInvt ¼ X0 þ X1i DInInvti þ X2i DInFD3ti þ X3i DInyti
i¼1 i¼0 i¼0
þ X4 InInvt1 þ X5 InFD3t1 þ X6 Inyt1 þ m2t ð8Þ
X
n X
n X
n
DInyt ¼ q0 þ q1i DInyti þ q2i DInFD3ti þ q3i DInInvti
i¼1 i¼0 i¼0
þ q4 Inyt1 þ q5 InFD3t1 þ q6 InInvt1 þ m3t ð9Þ

where: InFD1 = log of the ratio of broad money supply to GDP, FD2 = log of the
ratio of the private sector credit to GDP, FD3 = log of the ratio of the ratio of liquid
liabilities to GDP, InInv = log of the ratio of investment to GDP, Iny = log of real
per capita GDP, et, et and vt = white noise error terms, D = first difference
operator.
The ARDL-modelling approach was originally introduced by Pesaran and Shin
(1999) and later extended by Pesaran et al. (2001). The ARDL-cointegration
approach has numerous advantages in comparison with other cointegration methods.
Unlike other cointegration techniques, the ARDL approach does not impose the

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restrictive assumption that all the variables under study must be integrated of the
same order. In other words, the ARDL approach can be applied, regardless of
whether the underlying regressors are integrated of order one [I(1)], order zero
[I(0)], or fractionally integrated. Secondly, while other cointegration techniques are
sensitive to the size of the sample, the ARDL test is suitable even if the sample size
is small. Thirdly, the ARDL technique generally provides unbiased estimates of the
long-run model and valid t-statistics, even when some of the regressors are
endogenous (see also Harris and Sollis 2003). The bounds-testing procedure is
based on the joint F-statistic (or Wald statistic) for cointegration analysis (see also
Odhiambo 2009a). The asymptotic distribution of the F-statistic is non-standard
under the null hypothesis of no cointegration between the examined variables.
Pesaran and Pesaran (1997) and Pesaran et al. (2001) report two sets of critical
values for a given significance level. One set of critical values assumes that all the
variables included in the ARDL model are I(0), while the other is calculated on the
assumption that the variables are I(1). If the computed test statistic exceeds the
upper critical bounds value, then the Ho hypothesis is rejected. If the F-statistic falls
within the bounds then the cointegration test becomes inconclusive. If the F-statistic
is lower than the lower bounds value, then the null hypothesis of no cointegration
cannot be rejected.

4.2 Granger non-causality test

Once the long-run relationships have been identified in Sect. 4.1, the next step is to
examine the short-run and long-run Granger-causality between financial develop-
ment, investment and economic growth using the following model (see also
Odhiambo 2009a; Narayan and Smyth 2008).
Xn Xn X n
DInFDt ¼ a0 þ a1i DInFDti þ a2i DInInvti þ a3i DInyti
i¼1 i¼0 i¼0
þ ECMt1 þ l1t ð10Þ
X
n X
n X
n
DInInvt ¼ b0 þ b1i DInInvti þ b2i DInFDti þ b3i DInyti
i¼1 i¼0 i¼0
þ ECMt1 þ l2t ð11Þ
X
n X
n
DInyt ¼ d0 þ d1i DInyti þ d2i DInFDti
i¼1 i¼0
X
n
þ d3i DInInvti þ ECMt1 þ l2t ð12Þ
i¼0

where ECMt-1 = the lagged error-correction term obtained from the long-run
equilibrium relationship, FD = proxies of financial development, namely FD1,
FD2 and FD3.
Although the existence of a long-run relationship between FD, Inv and y suggests
that there must be Granger-causality in at least one direction, it does not indicate the

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Econ Change Restruct (2010) 43:205–219 213

direction of temporal causality between the variables. The direction of the causality
in this case can only be determined by the F-statistic and the lagged error-correction
term. While the t statistic on the coefficient of the lagged error-correction term
represents the long-run causal relationship, the F-statistic on the explanatory
variables represents the short-run causal effect (see Odhiambo 2009a; Narayan and
Smyth 2006). It should, however, be noted that even though the error-correction
term has been incorporated in all the Eqs. 10–12, only equations where the null
hypothesis of no cointegration is rejected will be estimated with an error-correction
term (see also Narayan and Smyth 2006; Morley 2006; Odhiambo 2009a).

4.3 Data source

Annual time series data, which covers the 1969–2006 period, is utilised in this
study. The data used in the study are obtained from different sources, including
various issues of the South African Reserve Bank reports, International Financial
Statistics (IFS) Yearbooks published by the International Monetary Fund and World
Bank Statistical Yearbooks.

4.4 Definitions of variables

(1) FD1 = Broad money stock = M2/GDP

where:
M2 = broad money stock; and
GDP = gross domestic product.
(2) FD2 = Private credit by deposit money banks and other financial institutions
as a ratio of GDP.
(3) FD3 = the ratio of liquid liabilities to GDP
(4) Real GDP per capita
The real per capita GDP is computed as follows:
Real GDP per capita (y) = Real GDP/Total Population
(5) Investment rate (Inv)
Investment rate (Inv) is computed as the ratio of private investment to GDP.

4.5 Empirical analysis

4.5.1 Stationarity test

Although the ARDL-modelling approach does not require unit root tests, it is
important to conduct the unit root test, in order to ensure that no variable is
integrated of order 2 [I(2)] or higher. This is critical because the ARDL procedure
assumes that all variables are either I(0) or I(1). If a variable is found to be I(2), then
the computed F-statistics, as produced by Pesaran et al (2001) and Narayan (2005),
can no longer be valid. The most frequently used unit root test is based on the

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Table 1 Stationarity tests of

Variable No trend Trend
variables on first Difference—
Phillips-Perron (PP) Test
DLFD1 -5.25388a -5.166551a
a
DLFD2 -5.18549 -5.465002a
a
DLFD3 -6.43532 -6.216012a
a
DLInv -7.52504 -7.391883a
a
DLy -4.12250 -4.243545a
Stationarity tests of variables on first
Note: The truncation lag for the difference—Dickey-Fuller GLS Test
PP tests is based on Newey and DLFD1 -4.949507a -5.254273a
West (1987) bandwidth, Critical
values for Dickey-Fuller GLS DLFD2 -4.807926a -5.042497a
test are based on Elliot et al. DLFD3 -4.722159a -5.504416a
(1996, Table 1) DLInv -6.653240 a
-6.836228a
a
Denotes 1% level of DLy -3.486820 a
-3.854779a
significance

Augmented Dickey-Fuller test—a parametric approach originally proposed by

Dickey and Fuller (1979, 1981). Unfortunately, it has been proved, using Monte
Carlo simulations, that the power of the ADF test is very low. To overcome this
problem, the semi-parametric Philips-Perron test, as proposed by Phillips and Perron
(1988), and the Dickey-Fuller-GLS test developed by Elliot et al. (1996) have been
used in this study. The results of the stationarity tests at level (not presented here)
show that all variables are non-stationary at level. Having found that the variables
are not stationary at level, the next step is to difference the variables once in order to
perform stationary tests on differenced variables. The results of the stationarity tests
on differenced variables are presented in Table 1.
The results reported in Table 1 show that after differencing the variables once, all
the variables were confirmed to be stationary. The Phillips-Perron and DF-GLS tests
applied to the first difference of the data series reject the null hypothesis of non-
stationarity for all the variables used in this study. It is, therefore, worth concluding
that all the variables are integrated of order one.

4.5.2 Cointegration test

The cointegration relationship between the various proxies of financial develop-

ment, investment and economic growth is examined using the newly developed
ARDL bounds testing procedure. Two steps are used in this procedure in a stepwise
fashion. In the first step, the order of lags on the first differenced variables in
Eqs. 1–9 is obtained from the unrestricted models by using the Akaike Information
Criterion (AIC) and the Schwartz-Bayesian Criterion (SBC). The results of the AIC
and SBC tests (not reported here) show that, while in the case of Eqs. 1 and 2 the
optimal lag is lag 1, in Eqs. 3–9, the optimal lag is lag 3. In the second step, we
apply the bounds F-test to Eqs. 1–9 in order to establish whether there exists a long-
run relationship between the variables under study. The results of the bounds test are
reported in Table 2.

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Econ Change Restruct (2010) 43:205–219 215

Table 2 Bounds F-test for cointegration

Model A: FD 1 (M2/GDP), investment and economic growth
DInFD1t FD1(Inv, y) 6.260**
DInvt Inv(FD, y) 9.930***
DInyt y (FD, Inv) 2.258
Model B: FD 2 (Private Credit/GDP), investment and economic growth
DInFD2t FD2(Inv, y) 2.0531
DInvt Inv(FD2, y) 4.6280*
DInyt y (FD2, Inv) 5.0909*
Model C: FD 3 (Liquid Liabilities/GDP), investment and economic growth
DInFD3t FD3(Inv, y) 4.7054*
DInvt Inv(FD3, y) 8.1673***
DInyt y (FD3, Inv) 1.2343
Asymptotic critical values
1% 5% 10%
I(0) I(1) I(0) I(1) I(0) I(1)
Narayan and Smyth (2005, p. 1989), 6.328 7.408 4.433 5.245 3.698 4.420
Appendix: Case IV

Note: ***, ** and * denote statistical significance at the 1, 5 and 10% levels, respectively

The results reported in Table 2 show that for model A there is evidence of
cointegration when the variables FD1 and Inv are taken as dependent variables in
model A. However, when per capita GDP is taken as a dependent variable, the
results of the bounds-testing procedure show that there is no cointegrating
relationship. For model B the results show that there is evidence of cointegration in
the Inv and y equations, but not in FD2 equation. Finally, for model C, the
cointegration is found to prevail in equations FD3 and Inv., but not in equation y.
This implies that only FD and Inv equations in the case of model A, Inv and y
equations in the case of model B, and FD3 and Inv equations, in the case of model
C, will be estimated with an error-correction term.

4.5.3 Analysis of causality test based on the error-correction model

Having found that there is a long-run relationship between the various proxies of
financial development, Investment and economic growth, the next step is to test for
the causality between the variables under study. The causality in this case is
examined through the significance of the coefficient of the lagged error-correction
term and the joint significance of the lagged differences of the explanatory variables
using the Wald test. The results of these causality tests are reported in Table 3.
The empirical results reported in Table 3 show that: (1) When M2/GDP is used as
a proxy for financial development, both economic growth and investment Granger-
cause financial development. This applies irrespective of whether the causality is
estimated in the short run or in the long run. The results also show that economic
growth Granger-causes investment in the short run and in the long run. These
findings are supported by the F-statistics and the coefficients of the lagged error-

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Table 3 Results of short-run and long-run causality test

Model A: FD1 (M2/GDP), investment and economic growth
F-statistics [P-value] t-statistics
Dependent variable DInFD1t DInInvt DInyt ECMt-1
DInFD1t – 4.4117** 4.7018** -0.4607[-3.960]***
DInInvt 0.89088 – 6.2704*** -0.4823[-4.398]***
DInyt 0.4243 0.14031 – –
Model B: FD2 (Private Credit/GDP), investment and economic growth
F-statistics [P-value] t-statistics
Dependent variable DInFD2t DInInvt DInyt ECMt-1
DInFD2t – 1.8612 6.5718*** –
DInInvt 1.1445 – 5.9021*** -0.5095[-2.233]**
DInyt 0.51662 0.0068 – -0.8632[-1.643]
Model C: FD3 (Liquid Liabilities/GDP), investment and economic growth
F-statistics [P-value] t-statistics
Dependent variable DInFD3t DInInvt DInyt ECMt-1
DInFD3t – 9.0370*** 6.9240*** -0.9353[-3.049]***
DInInvt 1.7278 – 4.5911** -0.5961[-2.309]**
DInyt 2.2063 2.3224 – –

correction terms, which are statistically significant in the FD1 and Inv. equations; (2)
When the ratio of private credit to GDP is used as a proxy for financial development,
no causality from financial development to economic growth is detected, but a prima-
facie causal flow from economic growth to financial development is found to prevail.
The prima-facie causal flow from economic growth to financial development is
supported by the F-statistic in the financial development equation, which is found to
be statistically significant. In addition, the study finds a unidirectional causal flow
from economic growth to investment, as confirmed by the F-statistic and the lagged
error-correction term, which are both statistically significant—as expected; (3)
Finally, when the ratio of liquid liabilities to GDP is used, both economic growth
development and investment are found to Granger-cause financial development in
the short run and in the long run. The short-run causality is confirmed by the F-
statistics in the financial development equation, which are statistically significant.
The long-run causality, on the other hand, is confirmed by the coefficient of the error-
correction term in the financial development equation, which is negative and
statistically significant. The results also show a unidirectional causal flow from
economic growth to investment—as shown by the F-statistic and the lagged error-
correction term, which are both statistically significant.

5 Conclusion

In the current study attempts have been made to examine the dynamic causal
relationship between financial development, investment and economic growth in

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South Africa. The majority of the previous studies have mainly used either the
residual-based cointegration test associated with Engle and Granger (1987), or the
maximum-likelihood test based on Johansen (1988) and Johansen and Juselius
(1990), which may not be appropriate when the sample size is too small. Moreover,
some of these studies have over-relied on a bivariate causality test and may,
therefore, suffer from the omission-of-variable bias. In an attempt to address the
methodological weaknesses associated with the previous studies, the current study
employs the newly developed ARDL-Bounds testing approach to examine the
causal relationship between financial development, investment and economic
growth in South Africa. Specifically, the study incorporates investment as an
intermittent variable in the bivariate setting between financial development and
economic growth—thereby creating a simple trivariate equation. In addition, the
study has employed three proxies of financial development indicators, namely M2/
GDP, the ratio of the private credit to GDP and the ratio of liquid liabilities to GDP.
Contrary to the empirical findings in other previous studies, the results of the current
study show that there is a unidirectional causal flow from economic growth to
financial development without any feedback, when M2/GDP and the ratio of liquid
liabilities to GDP are used as proxies of financial development. However, when the
ratio of private credit to GDP is used, no causal flow from financial development to
economic growth is detected, but a prima-facie causal flow from economic growth
to financial development is found to exist. The results also show that economic
growth Granger-causes investment, and investment Granger-causes financial
development in South Africa. The results apply irrespective of whether the
causality is estimated in the short run or in the long run. The study, therefore,
recommends that South Africa should intensify its pro-growth policies in order to
bolster investment and financial development.

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