ASSESSING THE FINANCE- GROWTH

CHANNEL IN KENYA; A VAR ANALYSIS

LITERATURE REVIEW
By; Liz Njoki
K1O2/21443/2020
 A BRIEF OVERVIEW
The relationship between financial deepening and economic growth has been of interest since as early as 1873.
Patrick (1966) identified two patterns in this relationship; “supply leading” and “demand following”.
Various studies have shown a positive relationship between financial deepening and economic growth.
Studies for the Kenyan case showed a negative relationship suggesting a point of disconnect in the finance- growth
transmission channel.
Two reasons in previous research identified by the study as the source of disconnect ;
Diversion of funds to non-productive activities due to micro-economic inefficiencies in the market. This was
attributed to political interference, corruption in the banking system among others.
Widespread liberalization of financial markets that took place in the late 1980s-early 90s changing the basic structural
relationship between finance and growth. This would occur if the observed benefits of financial deepening led to
liberalization before the associated legal and regulatory institutions were sufficiently well developed. As a
consequence, the impact on growth would become smaller as no guidelines would be in place to guide the process
meaningfully.
 Objectives
 The study’s main objective was to establish main points of disconnect in the finance growth
transmission channel.
 The study also sought to offer policy suggestions and possible solutions.
 Methodology
The study used the relationship between capital stock and real output as put forward by earlier
studies.
FD R S K Y
Where,
FD- Financial deepening
R- Interest rate
S- Savings
K- Capital stock
Y- National output
 Methodology
The study used VAR( Vector Autoregressive) models to determine the interrelationship between the variables.
Two VAR models were used due to the presence of two measures of financial deepening in Kenya
i) Degree of financial intermediation (M2/GDP)
ii) Growth rate of per capita real money balances (M2)
 The VAR representation used in the study was;
A0 X t = B0 +B1 Xt-1 +… +Bp X t-p + et
Where ;
i)A0 is a matrix containing contemporaneous effects
ii) X t is a vector containing endogenous variables
iii)B0 is a column vector of intercepts
iv)B1 to Bp are matrices containing structural coefficients for variables lagged p times.
The above equation cannot be well estimated so the study used a standard reduced form VAR.
The study used annual time series data from 1972 to 2008. To reduce the possibility of multicollinearity, the data
was transformed into log form.
 Findings
 Stationarity

The data used was non- stationary. The study argued that the goal of VAR is to determine the interrelationships between
variables and not determining parameter estimates. Differencing when estimating a structural model may cause loss of
important information.
 Structural VAR model
Five relationships were identified.
Two lags optimal for model 1 and one lag optimal for model 2.
Residual serial correlation test- absence of serial correlation.
Residual heteroscedasticity test- absence of heteroskedasticity.
 Impulse response
For both models, R responded positively to FD in the long run.
A shock on R had a positive effect on financial savings.
Capital formation did not respond positively to innovation in financial savings.
National income did not respond positively to a shock in capital formation.
 Variance decomposition
Supported the findings in impulse response analysis.
 Interpretation
The study found that financial deepening in Kenya has a positive impact on deposit rates due to
Kenya’s financial system being well diversified and driven by modest competition practices.
Deepening enhances the competition for funds from surplus spending units, raising the deposit
rate. Deposit rates in turn have a positive impact on financial savings. A slight increase in returns
from bank deposits is taken positively by the saving community which has increased access to
banking services due to agency banking.
The study found that financial savings are not converted to investible funds. This implies that
banking institutions channel customer deposits to other uses rather than loaning these funds to
deficit spending units to finance their investment projects. The study suggested investments and
hedging while holding large amounts of foreign currency as some of the reasons.
The study found that capital formation does not lead to economic growth. This is due to lack of
proper risk assessment before undertaking projects, leading to low returns.
 Conclusion and policy recommendations
The study found that there exists a link between finance and economic growth but there are several
points of disconnect in the transmission channel. The study found that despite the fact that
financial deepening leads to increased interest rates in the long run which in turn leads to increased
savings mobilization, the mobilized savings are not converted to capital formation. Therefore,
expansion of capital formation does not have an impact on economic growth.
The study recommended that the government should come up with a policy that would require a
greater percentage of savings in financial institutions to be lent out to domestic investors and
discourage financial institutions from holding idle cash reserves.
The study also recommended that the government should ensure that capital formation contributes
to economic growth. This is by making sure Kenya is investor-friendly to encourage investment by
both local and foreign investors.
 Critique
Strengths
The study identified the point of disconnect in the finance- growth transmission channel in Kenya.
Weakness
Though the study justified the use of VAR while using data at levels, it failed to conduct
cointegration analysis. The study failed to carry out cointegration test to test the regression at level
since data used was non-stationary and if cointegration was present use the Vector Error Correction
Model instead of just using VAR. The justification for using VAR was not sufficient.
The study did not outline the contribution of the liberalization of financial markets to this
disconnect if any as suggested by earlier studies.
The study failed to acknowledge the role of corruption and political interference on the disconnect
in the finance- growth channel.