The Character of the State in Financial Development and Economic Growth

This article proposes a framework for conceptualizing the finance-growth theory in developing economies. The study investigates how the influence of the character of a state may inadvertently define the trajectory of financial development of the state and its resultant effect on economic growth. To analyze this assertion, a developing economy (Nigeria) which had experienced decades of autocratic military governance was studied using a vector co-integration analysis. A historical case review was conducted using secondary data. The historical review revealed evidence of three major characters while the econometric analysis revealed the presence of macroeconomic structures identifying at least five co-integrating vectors.


INTRODUCTION
"One of the most important problems in the field of Finance, if not the single most important one, almost everyone would agree, is the effect that financial structure and development have on economic growth" Goldsmith (1969:390).
Following Goldsmith (1969), this research focused on studying how the character of a state could define the pace and direction of financial development and economic growth. This study therefore focused on examining the financial and economic structures of the Nigerian economy which has a very different set of residual socio-economic and socio-political identity characters from developed economies, the characters of whom the theory is based upon. These broad characters include properly functioning democracies, free markets and largely mono ethnic societies. Numerous empirical and theoretical studies have shown that ethnicity does have a negative impact on economic growth (Montalvo and Reynal-Querol 2005, Collier, 2008and Baggio and Papyrakis, 2010. While It may be argued however that several studies have been carried out to demonstrate the existence of the impact of social and political instability on economic growth, most of all the studies such as Levine and Zervos (1996), Barro (1996) etc utilise cross-sectional data while Asteriou and Price (2001) utilise time series data but look at the effect of political uncertainty on investment growth and hence economic growth using Gross Domestic Product (GDP) as a proxy for economic growth in the United Kingdom and Collier (2008) shows precisely how political instabilities have contributed to African governments abdicating their responsibilities towards the provision of public goods for the benefit of their citizens. No known study has carried out an analysis of the impact of the character of the state leading to political instability and uncertainty on the causal relationship of financial development on economic growth in Nigeria. Asteriou and Price (2001) further indicate that in a 'polarised society', a change in the government may create political uncertainty with its attendant effect on economic growth; in the Nigerian context, polarity can be clearly seen by the deep stratification in ethnic groups from the North to the South and the vicious contest to control the Federal Government (Osaghae 1998). Asteriou and Price in their study of the UK economy give further insight as to why military takeovers of government in Nigeria was always welcome, they stress that if the current government was perceived to be untrustworthy, news of their ousting could lead to an increase in investment. However in the Nigerian case where there is a track record of the outcome of military governance, can this premise necessarily be true?
The result of this study proved otherwise. This study is further unique due to the fact that it studied a developing economy with a unique set of endogenous characters.
The Finance-Growth theory's main drive is that developments in the financial system help ameliorate inadequacies in information exchange between investors and providers of capital. Banks are thought to be in better control of information flow due to the personal contact they have with their clients while a different school of thought believes that markets are in place to counteract the rent seeking and monopoly prone attitude of banks thereby presenting a more investor friendly platform (Beck and Levine, 2004). This assumes that ceteris paribus the political economy of the country is in a state of tranquillity.
In Nigeria however and a large number of African countries, evidence from literature (Brown 1995, Collier 2008 suggests that this may not be the case as these countries in addition to experiencing a constant state of flux in their body polity are riddled with decadent infrastructure that could further foster information asymmetry such as poor road networks, poor communication systems and even huge threats to the movement of factors of production due largely to ethnic strife between competing politico-ethnic groups (Madiebo 1980, Osaghae 1998, Falola and Heaton 2008.

THEORETICAL PERSPECTIVES
A vast amount of literature exists relating financial development indicators to economic growth from two varied points of view. Some economists are of the view that financial development leads to economic growth while others are of the view that economic growth brings about financial development. Early pioneers of the literature like Bagehot (1873), Schumpeter (1911), Gurley and Shaw (1955) and Goldsmith (1969) strongly belief that the former is the case while more recent researchers like Robinson (1952) and Lucas (1988) queue behind the latter opinion, Lucas indicating that the entire dialogue has received far too much attention. McKinnon (1973) presents an economic development hypothesis that upholds the use of domestic capital markets as drivers of economic development in developing economies rather than inflow of foreign capital. His analysis details the need to use interest rates as an indicator of the actual volume of capital available in an economy for investment, implying an inverse relationship between interest rate and volume of capital. Levine (2004) further cites the views of other researchers such as Bagehot (1873), Gurley and Shaw (1955) and Goldsmith (1969) supportive of the fact that financial development leads to economic growth. Lucas (1988:41) clearly stands out in his position that different economies require different patterns of growth thereby implying that either of the two views above could be applicable to different economies. Greenwood and Smith (1997) are of the view that financial development spurs economic growth and economic growth leads to further financial development. Miller (1998) warns of the dangers inherent in depending on traditional bank loans to finance growth due to depositor's free will to draw on their bank balances; he cites the example of financial crisis in Southeast Asia as an under-dependence on financial markets to fund growth initiatives against a preference for bank funds. This view of Miller's incidentally constitutes another key division in the literature; some proponents strongly believe that a banking sector based financial system is superior to a financial market based system while others such as Alam and Hassan (2003) unequivocally uphold the reverse, arguing that stock market development granger causes growth in GDP (a proxy for economic growth). The United States and The United Kingdom due to properly dispersed and efficiently run financial markets it can be argued are able to manage pockets of financial crisis in their financial systems due to the alternative role markets play relative to traditional bank capital.
Advances in research skills and data such as are evidenced in Demirguc-Kunt and Levine (2001) has created contrary schools of thought as to which financial system drives economic growth and to what extent. The general view of the finance-growth literature (Demirguc-Kunt and Levine, 2001) suggests that economic growth is primarily driven by financial development and not necessarily by financial structure (bank or market based). Evidence of this view was drawn from the case of Germany and Japan, bank based systems versus the United States of America and the United Kingdom, market based systems. All four countries have experienced similar magnitude of long run growth in GDP. They further indicate that the size of the banking sector as well as the size and liquidity of the stock market exert a causal drive on economic growth using Gross Domestic Product per Capita as a proxy for economic growth. Goldsmith (1969) employed a three tier approach to investigate the relationship between financial structure and economic development.
Goldsmith's first case was to establish the potential of change in nature of financial instruments, markets and institutions in a country as the country experiences economic growth; evidence from his research demonstrates that banks had the tendency to grow much faster than other non-banking financial institutions and the stock market. Secondly Goldsmith attempted with limited success to show that financial development imposes a causal effect on economic growth. To demonstrate this relationship he employed a graphical method to show that the movement of indicators representing these two variables (using time series data from thirty five countries) were indeed positively correlated. Due to a lack of data, he was unable to draw a strong conclusion on his third case which was to establish how the nature of a country's financial structure affects the speed of economic growth; Goldsmith sought to use direct evidence from Germany and the United Kingdom, The United States and Japan to argue that increased financial development had a positive impact on the speed of economic growth. Loayza and Ranciere (2004) however argue that financial development has the tendency to impede economic growth by bringing with it the propensity for financial crisis. He draws his argument from existing literature such as Caprio and Klingebiel (2003) amongst others to show that financial development in the short term leads to negative consequences of volatility and crisis resulting in stunted and often negative growth but as the system further matures in terms of credit control and management, faster and more rapid economic growth may be experienced.
From the foregoing, the question of financial development leading to economic growth has long since been debated but perhaps not completely resolved (Spratt 2009). The intention of this section in general is not to prove that financial development definitely leads to economic growth but to highlight pockets of evidence as a framework to examine how the character of a state could possibly alter the relationship to a minor or significant degree.

Research Framework
This study adopted a historical case review of the Nigerian political economy from 1960 to 2007 in a bid to identify landmarks and themes that may be conglomerated into characters of the State under review. Data sources used were secondary (from existing literature). The purpose of adopting a historical case review was to unearth historic information relating to the determinants of the development of the financial system in Nigeria with a view to understanding the present situation as a leverage to predict or control future policy determinants suitable for development of the financial system. To achieve this aim, the research looked at the causes, effects and trends associated with these determinants. Of particular importance was country data on Nigeria relating to the long years under autocratic military governance. The qualitative data set was logically and critically analysed with a view to maintaining objectivity.

.2 Statement of Problem and Model Specification
Given the short run Error Correction Model (ECM) Y t = a 0 + a 1 Y t-1 + 0 X t + 1 X t-1 + e 0 ET + c 0 CV + m 0 MG+ u t (1) If a series of negative shocks occur in the economy represented by the character of the state (ethnicity, prebendalism, civil war and military intervention/governance) captured by the dummy variables ET, CV and MG then we may likely have a situation whereby Y t increases at a slower rate than its lagged value Y t-1 . In future periods, Y t-1 will therefore be located below its long-run steady-state growth path.
If we successfully eliminate these characteristic factors (ethnicity, prebendalism, civil war and military governance/intervention), how fast, or what will be the speed of adjustment of Y t back to its steady state long-run equilibrium.
If the analysis shows that characteristic factors represented by dummy variables slow down the increase of Y t then we can conclude that in the case of the Nigerian Economy, the causal relationship between financial development and economic growth is truncated by the character of the state.

.0 DATA AND EMPIRICAL FINDINGS
The study uses financial intermediary data from the International Financial Statistics (IFS) and financial market data from the Nigerian Stock Exchange.
The specified model was analyzed using cointegration analysis to investigate the degree of correlation between the dependent and independent variables under review. Cointegration analysis provides a basic framework for testing,

.1 The Augmented Dickey Fuller Test (ADF Test)
The Augmented Dickey Fuller Test was conducted to investigate the stationary properties of the time series data employed in this study. The test was formulated as shown below: X t = X t-1 + ß 1 X t-j + a + t +u t Where X j are the first differences of the series and t is the time. Stationarity is sought to ensure that the possibility of spurious regressions is eliminated and the entire series is of the same stationary order. The following results where obtained.

.2 The T est for Co-integration
This test was employed to explore the existence of a long-run relationship between the proxy for economic growth and proxies for financial development in the Nigerian economy given the effect of characters of the Nigerian State represented in the test equation by dummy variables. The reported critical value was obtained from Mackinnon (1991) (2008) is the impact ethnicity, civil unrest and military governance may have in effectively hindering this growth process from taking shape.

.3 The Error Correction Mechanism Test
The error correction model has the advantage that it can estimate the correction from a previous period state of disequilibrium in the variables under study as a means of determining the existence of a short run relationship between the variables under study (Asteriou and Hall, 2007). Error Correction Mechanisms (ECM's) further provide the advantage of enabling the researcher generate the best model that fits the data set or better still confirms how well the data set fits the model under estimation (Asteriou and Hall, 2007:310).
The ECM specification according to Asteriou and Hall (2007) for Y t and X t that are co-integrated is given by: Where u t = Y t -ß 1 -ß 2 X t (4) b 1 = the short run impact multiplier effect that a change in X t will have on Y t u t-1 = Y t-1 -ß 1 -ß 2 X t-1 p = the feedback/adjustment effect that measures the correction rate of the disequilibrium.
The test revealed that in the short run, successive readings did resemble each other as shown by the value of the DW statistics of 1.7192 significantly less than "2" implying that the characters of the state highlighted in the historical analysis do have an impact on the short run growth mechanism of the Nigerian economy. These results are further supported by an R 2 value of 0.86280.  (2000), Demirguc-Kunt and Levine (2001) and Levine (2002) who argue that financial structure is irrelevant, what is of importance is the development of intermediaries and markets.

ANALYSIS AND INTERPRETATION OF RESULTS
This section is divided into two parts; the first part discusses the results of the empirical analysis and interprets the findings while the second part discusses the relevance of these results explaining the linkages between financial market development and economic growth in Nigeria.

.1 Evaluation and Interpretation of Results
The Unit root test revealed that the data series for Real GDP Per Capita as well as those for size, efficiency and activity of financial markets and intermediaries were all stationary at first difference and therefore contained only one unit root.
When the ADF Co-integration test was carried out to determine the long run and 293 respectively with the long term effect of military government being the most significant long run relationship with economic growth. The good news here is that even though the most significant long run relationship, at a probability of 293 in 1000 samples, the long term impact of military governance on economic growth in Nigeria is seen to be relatively diminished.
The short run relationship of the variables was measured using the error correction mechanism employing lagged values of the variables. In this analysis it was revealed that the R-Squared was 86.280 (a strong fit), the DW-Statistic was 1.7192 (below the mid-value of 2) an indication of positive autocorrelation which implies that in the short-run, successive lag values will carry forward their error terms to the next period. This incidence of positive autocorrelation can be related to the Osaghae (1998) which demonstrated that in spite of the fact that Nigerians are quick to move from one situation to another speedily putting aside their differences for short run economic gains, they quickly return to their differences as soon as their initial economic desire is satisfied. As a result of this, we see that the political structure of the country has persistently remained skewed towards a politico-ethnic structure with political power highly centralized within the structure of the Federal Government. For the short run relationship between stock market development and economic growth, we observe that the size of the stock market is the most significant variable in relation to economic growth with a probability of 15 in 1000 followed by the efficiency of the stock market (14 in 1000) and activity of the stock market (10 in 1000). Looking at the short run impact of financial intermediaries on economic growth, the results obtained suggest that in the short run, the stock market is considered to be less significant in contribution to financial deepening, a finding which is consistent with existing literature. We observe from the long run relationship that even though the stock market increases its significance, financial intermediaries still remain comparatively significant as argued in Allen and Gale (2000)  Test revealed that at least five co-integrating vectors were in existence which enabled the rejection of the null hypothesis of no co-integrating vector using both the Eigenvalue statistics and the Trace statistics. The presence of an underlying macroeconomic structure lends credence to the validity of the finance-growth theory as evidenced in the literature review.

Relevance of Results
In sum, this analysis revealed the presence of long-run macroeconomic structures within the Nigerian financial system but suggested that GDP per  Schumpeter's (1911) analysis on funding of innovative thinking, it can be argued that a faster growing banking sector and financial market driven by higher and sustainable investments such as can only be driven by a government focused on a balanced national development agenda as opposed to a regional agenda will see the financial sector acting as the lead indicator in economic growth.

CONCLUSION AND POLICY IMPLICATIONS
The Borderline between Economics and Politics has been an area many researchers in Political Economics have frequently shied away from, most preferring to concentrate on Economics while others on Politics (Collier, inferences from both fields to analyse contemporary issues unique to both fields using the Nigerian Economic and Political platform as an empirical example. This study therefore compliments the vast body of literature in the field of financial development and economic growth by drawing inferences that may be useful for understanding the growth trajectory of developing economies and why Western oriented development policies often led by the World Bank and IMF typically fail to liberate these economies (Brown, 1995).
Being a major oil exporter, Nigeria has maintained a strong oil export capacity on the average of two million barrels per day giving the country a strong macroeconomic outlook built on decaying political structures. Collier (2008) argued that most resource rich under-developed countries tend to neglect the development of other sectors such as the financial sector as successive governments preferred to concentrate their efforts on exploitation of natural resource driven wealth. This argument supported by De Soto (2000), Moyo (2009) and further elaborated by the foregoing analysis demonstrates that the character of a state plays a key role in the development of its financial intermediaries and markets and therefore the views originated by Schumpeter (1911), developed by Goldsmith (1969) and given empirical evidence by a host of researchers such as Levine (2004) cannot hold as entirely true in Nigeria (a typical developing economy) without bringing into perspective the character of the state as an endogenous variable.