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Financial Sector Reforms and Economic Growth in Ghana: A Dynamic ARDL Model

This paper examines the relationship between financial sector reforms and sustainable economic growth in Ghana. Employing the autoregressive distributed lag (ARDL) bounds testing approach and using GDP per capita as a growth indicator, this paper establishes a long-run relationship between economic growth and financial reforms, which is represented by an index calculated using principal component analysis (PCA). The paper finds that in the long run, financial sector reforms have an insignificant impact on economic growth in Ghana. This supports numerous past studies that have reported mixed or inconclusive results on the effects of financial reforms on economic growth. The paper concludes that increase in capital stock, not financial sector policy reforms, affects economic growth in Ghana. This paper therefore recommends an increase and modernization of capital stock in order to promote real sector growth in Ghana.


Introduction
The purpose of this paper is to empirically investigate and provide insight into the impact of financial liberalization on sustainable economic growth in Ghana  (Caprio et al., 2001;Laeven, 2003).
In addition, most recent studies published on financial reforms and economic growth are based on evidence mainly from South American and the East Asian countries, with little or no attention devoted to African countries, especially countries in the ECOW-AS region. The potential weakness of this paper is that the application of the findings to any other country should come with a proviso. Additionally, we did not apply Bartlett's test for sphericity to the financial liberalization index, and we did not obtained its Kaiser-Mayer-Olkin (KMO) coefficient. We therefore recommend that future studies apply this test to see if they reach the same conclusion. This paper is divided into six sections, including the introduction. In section two, the paper reviews financial sector reforms in Ghana. This is followed in section three by the literature review, both theoretical and empirical. In section four, the paper looks at the methodology and the empirical analysis. The conclusion is elaborated in section five, followed by the references.

An overview of financial Sector Reforms in Ghana
From its independence in 1957 to the year 1983, Ghana pursued a growth strategy policy, which can only be described as a policy based on inward-oriented trade, led by the public sector, and aimed at the achievement of social welfare objectives (Aryeetey, 1994). As a result, the budgetary pressures and the fast-depleting external reserves that led to shortages in the Ghanaian economy in the 1960s forced the introduction of price-control policies for the administrative allocation of scarce goods and services.
These policies extended to the financial services as well. By the mid-1960s, the price control regime became official with the establishment of a Price and Income Board. In the financial sector, banks were forced to provide credit on the basis of social and political considerations, and they were obliged to make sure that these credits were channeled into priority sectors, such as agriculture. In order to cope with the cost of credit, exchange rates and interest rates were fixed by the government.
The price-control regime instigated distortions in the market that led to the misallocation of resources.
Economic growth rates declined as a result of price distortions, which affected the production of the real sector in the economy. The control of the foreign exchange market led to the over-valuation of the domestic currency and therefore weakened the export sector at the expense of an increased appetite for foreign goods, which worsened the balance of payments.
According to Sowa and Acquaye (1999), the control of interest rates together with the high rate of inflation brought about a system of financial repression, which weakened the development of the financial sector and subjected the allocation of credit to political patronage.
An integral part of this inward-oriented policy strategy was the control that the government had over the financial sector. There were interest rate ceilings -both on deposits and credits -and there was no stock market. Government policies favored the mobilization of savings and the allocation of credits through government-owned financial institutions (Bank of Ghana, 2009

Theoretical issues
Financial repression is defined rather widely in the literature. An economy is described as financially repressed if it has a broad range of characteristics. According to McKinnon (1989), an economy is finan-cially repressed, when tax and other issues distort the domestic capital market. These taxes and distortions, he argues, take two general forms: interest rate controls and direct credit-allocation programs. According to Eschenbach (2004), financial repression can also be the combination of indiscriminate nominal interest rate ceilings and high and accelerating inflation. A high reserve requirement can also play a role.
Financial repression is based on the theory of liquidity preference, as propagated by Keynes (1936). He argued that the full employment equilibrium level of the real interest rate tends to be lower than that generated by liquidity preference. Therefore, interest rates had to be lowered in order to avoid a decrease in income. Tobin (1965) also suggested a model whereby small household producers allocate their wealth among money and productive capital. He argued that financial repression reduces the demand for money in favor of productive capital, thereby increasing the capital/labor ratio and accelerating economic growth. McKinnon (1973) and Shaw (1973) were the first to formalize the theory of interest rate liberalization. deposits are substitutes for cash or gold, rather than loans extended to the informal sector. Stiglitz (1989) also criticized the policy of financial liberalization on the theoretical ground of market failures in financial markets. Neo-structuralists argued that high interest rates increase inflation in the short run through cost-push effects and decelerate economic growth as a result of the reduced real credit volume.
These theoretical considerations are, however, complemented by policy requirements in developing countries where, if the government is unable to collect sufficient tax revenue, it imposes financial repressive measures as an implicit tax on the financial sector (Fry, 1995). Fry (1995) stated that financial repression is a severe and unintended form of financial restriction, which he considered to be a second-best policy for governments with low tax-raising powers. Reserve requirements, obligatory holdings of government bonds, or interest rate ceilings help authorities to divert savings to the public sector at low or zero costs.

Empirical Evidence
Research findings based on the McKinnon-Shaw hypothesis have rather mixed results. Additionally, available evidence shows that in addition to macroeconomic stabilization, sound and proven regulation of the financial sector seems to play a significant and important role in the successful implementation of interest rate reform policy in developing countries. Berthélemy and Varoudakis (1995) explored the relationship between financial liberalization and economic growth. They based their analysis on convergence club tests, which help to check for any potential poverty traps. They used sample data from 91 countries in the 1960-1985 period. They concluded that educational attainment is a priority factor with respect to economic development but that financial factors such as interest rate liberalization could lead to high or low economic growth outcomes.
In other words, convergence groups with similar long-run economic growth rates have the same impact as financial liberalization. These authors also showed that inadequate financial conditions may severely limit economic growth in countries that already have a sufficient stock of human capital to begin the process of economic development. They concluded that this indicates the existence of poverty traps.
In another study, Levine and Zervos (1998) used cross-sectional data from 47 countries for the period from 1976 to 1993 in order to investigate the impact of stock market activity on economic growth, capital stock growth, productivity growth, and the private savings rate. They reported a strong positive relationship between stock market liquidity (as measured by initial value traded as a ratio of GDP plus the initial turnover ratio -i.e., value traded as a ratio of average market capitalization), real GDP growth, capital stock growth and productivity growth.
They also found that other financial variables, such as stock market size, volatility and integration into international capital markets were not necessarily strongly linked to economic growth. Furthermore, using stock market liquidity and financial deepening

Methodology
According to the McKinnon and Shaw hypothesis and neo-classical economists, financial liberalization is expected to ultimately lead to an increase in economic growth. Based on this assumption, this paper specifies a model designed to evaluate the impact of financial liberalization on the macro-economic developments. This paper uses Beck et al. (2000) and specifies a modified model for real GDP per capita, a measure of economic growth, as a function of government expenditure, inflation and the financial liberalization index, as well as variables for labor and capital formation as To improve the efficiency of capital requires human effort. This paper has accounted for this by including capital stock (K) and a labor factor (L) in equation (1). Furthermore, inflation (INFL) has been included as a macro-economic indicator because it can be viewed as an indicator of poor macroeconomic policies that are likely to make a country prone to crises and, hence, to negatively affect growth (Fischer, 2005).
According to Fischer (2005), inflation is detrimental to economic growth. Additionally, De Gregorio (1995) noted that higher inflation has the effect of reducing labor supply; hence, it reduces economic growth. To minimize the effect of some outlier rates, this paper uses the natural log of one plus the rate of inflation.
As mentioned in the introduction, the combined financial sector reform index (FLBL) is determined by using PCA. This index has been included in the model in order to show the effects of various policy changes on the process of implementing the financial liberalization policy. The coefficient of FLBL is expected to be positive and statistically significant. According to Shrestha and Chowdhury (2006), in order to derive the financial liberalization indices, some arbitrary value must be assigned to each of the financial liberalization policy variables.
Each policy variable could take a value between 0 and 1, depending on the implementation status (Caprio et al., 2001;Laeven, 2003). Thus, when a particular sector is fully liberalized, the corresponding policy variable takes a value of 1, and when that sector and then calculating the associated error correction model in order to establish the adjustment coefficients of the error correction term (Masih et al., 2008). The short-run effects are therefore captured by the coefficients of the first-differenced variables in the UECM model. According to Bahmani-Oskooee and Brooks (1999), the existence of a long-term relationship is established from Equation (1), but this does not necessarily mean that the estimated coefficients are stable.
There is, however, the need to perform a series of test diagnoses on the model established. This involves testing the residuals (i.e., homoscedasticity, non-serial correlation, etc.), as well as stability tests to ensure that the estimated model is statistically robust.

Unit root tests for variables
As indicated in section one, the results of the Dickey-

Co-integration Analysis: ARDL bounds Test
The results of the co-integration test based on the ARDL bounds testing approach are reported in Table 3.
Thus, the null hypothesis of the non-existence of co-integration among the variables is rejected. This implies that there is a long-run co-integration relationship among the variables when the model is normalized on real GDP per capita (InRGDP) in Ghana. The long-run results of the selected model are reported in Table 4 below.
The results reported in Table 4 show that the coefficient of the real government expenditure (InGEXP) is statistically insignificant and has an unexpected a priori sign. The coefficient of inflation (InINFL) is statistically significant at the 5% level, and it has the expected negative sign. Furthermore, the coefficient of the combined financial Sector Reform index (FLBL), which serves as the proxy for the changes and implementation of the policy, has the expected sign but is statistically insignificant. Thus, financial sector reforms in Ghana have insignificant impact on economic growth in the long run.
However, capital accumulation (InK) has the expected sign and is statistically significant at the 5% level. Thus, a 1% increase in capital accumulation leads to an increase of approximately 0.9% in economic growth in the long run. The short-run dynamics of the model are shown in Table 5.
The coefficients of ∆InRGDP -1, ∆InK, ∆LnK -1 and ∆InINFL are all statistically significant at the 10% level. However, the coefficients of ∆InL, ∆InGEXP and ∆FLBL are all statistically insignificant. The coefficient of ECM(-1) is found to be statistically significant at the 5% level, with the expected negative sign.
This confirms the existence of a long-run relationship between the variables. The coefficient of the ECM (-1) term is -0.22, which suggests a relatively slow rate of adjustment.
The magnitude of the coefficient of the ECM(-1) term implies that the disequilibrium occurring due to a shock is totally corrected in approximately 4 years and 7 months at a rate of 22% per annum. Note: *, ** and *** denote the rejection of the null hypothesis at 10%, 5% and 1% significance levels, respectively. S = Stationary and N = Non-stationary. In is the natural log operator. The log of one plus the rate of inflation was used to diminish the impact of some outlier observations. Note: *, **and *** denote the rejection of the null hypothesis at 10%, 5% and 1% significance levels, respectively. S = Stationary and N = Non-stationary. In is the natural log operator. The log of one plus the rate of inflation was used to diminish the impact of some outlier observations.  Note: S = Stationary and N = Non-stationary. ∆ is the difference operator, and In is the natural log operator. *, **and *** denote the rejection of the null hypothesis at 10%, 5% and 1% significance levels, respectively.    The straight lines represent critical bounds at 5% significance level The straight lines represent critical bounds at 5% significance level

Conclusion
The main objective of this paper was to empirically examine and investigate the impact of financial sector reforms on sustainable economic growth in Ghana. This paper employed the ARDL bounds testing approach, the unrestricted error correction model (UECM) and the co-integration analysis popularized by Pesaran, Shin and Smith (2001) to establish the long-run relationship between the relevant time series variables. It also applied a multi-dimensional financial sector reform index constructed from a number of financial liberalization policy measures implemented as a result of the financial sector reforms in Ghana. A proviso that should be taken into consideration is that it has been recognized by many economists that co-integration techniques may not be appropriate when the sample size is too small (Narayan and Smyth, 2005).
The unit root tests employed suggest that all the variables were found to be either I(0) or I(1) stationary. Additionally, all the dependent variables were found to be co-integrated with the independent variables. This means that long-run relationships between the variables of interest were established. The empirical findings show that the impact of financial sector reforms on economic growth in Ghana is positive but insignificant in the long run, as well as in the short run. The findings therefore do not lend support to the neo-classical theory that financial liberalization leads to economic growth. A similar conclusion was reached by Hye and Wizarat (2011) in the case of Pakistan. This paper, however, finds that the increase in capital stock leads to economic growth in Ghana. To this end, we recommend that future studies apply Bartlett's test for sphericity to the financial liberalization index and obtain its Kaiser-Mayer-Olkin (KMO) coefficient to see if they reach the same conclusion.