The impact of financial development on economic growth in sub-Saharan Africa. Does institutional quality matter?

ABSTRACT

It is hypothesized that a well-functioning financial market is necessary but not sufficient condition to achieve the expected economic growth. Therefore, policy instruments of government aimed at streamlining financial sector activity in sub-Saharan Africa (SSA) are imperative. As a result, this paper explores the effect of financial development on economic growth by allowing the link between the two far variables to be mediated by the quality of institutions for the period 2000–2019. Using Twenty-nine (29) countries and the System-Generalized Method of Moments (system-GMM) estimation method, it is found that financial development has a positive and significant effect on economic growth. In addition, it is found that, when rule of law, political stability, and regulatory quality are highly effective, the positive effect of financial development on economic growth is magnified.

KEYWORDS:

• Financial development
• institutional quality
• economic growth
• sub-Saharan Africa

1. Introduction

Financial development is widely acknowledged to be central to economic development (Levine 1999), and that inclusive financial systems are important for development (Yao and Yueh 2009; Park and Mercado 2015). However, the debate on whether financial development leads economic growth or it is economic growth that leads to financial development remains unresolved. Following the seminal paper by Schumpeter (1911) and King and Levine (1993), a body of literature (Levine 2005; Beck and Levine 2004; Odhiambo 2009; Ibrahim and Alagidede 2018; Abbas, Gul, and Ghulam 2022) have documented that financial development leads to economic growth through better capital allocation (supply-leading hypothesis). Whilst other scholars (Naceur and Ghazouani 2007; Hasan, Koetter, and Wedow 2009) have also indicated that financial development actually follows economic growth to supply financial need (demand-following hypothesis).

Contemporary empirical evidence suggests that an increase in financial development considerably augments economic growth in a monotonically manner, suggesting that the impact of financial development on economic growth depends on the structures and fundamentals of an economy (see Arestis, Demetriades, and Luintel 2001; Beck and Levine 2004; Beck, Levine, and Loayza 2000; Ibrahim and Alagidede 2018; Sohag et al. 2015). With this, it can be construed that financial development complements economic growth only if there are clear channels or linkages. As a result, Otchere, Senbet, and Simbanegavi (2017) demonstrate that in designing financial sector reforms, policies should be tilted towards functional perspective of financial systems and not just savings and capital mobilizations.

The IMF (2016) report on financial sector development reveals that sub-Saharan Africa have made a considerable progress towards its financial sector development over the years. The reports further indicate that the region’s median ratio of private sector credit to GDP has doubled from its 1995 level. The region has led the world in innovative financial services based on mobile telephony, especially in East Africa. The M-Pesa, M-Shwari, and M-Kopa in Kenya for example have helped to reduce transaction costs and have facilitated personal transactions. In addition, microfinance has also grown suddenly in SSA providing services to customers at lower cost, and the larger parts of the population in SSA now have access to financial services. The report further added that foreign banks (for example, Pan-African banks) now have a presence in most countries in SSA. Their expansion has filled the gaps left by European and US banks, and has promulgated greater economic integration, and has made the financial sector more competitive.

This notwithstanding, data from Africa Development Indicators database indicate that economic growth in SSA has witnessed a disappointing performance. The annual growth rate of GDP per capita for the past three decades, averaged, 2.39%, 0.90% and −0.96% for the periods 1961–1970, 1971–1980 and 1981–1990, respectively. In addition, the average annual growth rate of GDP per capita for 1991–2000 and 2001–2010 are shown to be −0.32% and 2.18%, accordingly. Notwithstanding to this, Fjose, Grünfeld, and Sqw (2010) had revealed that these growth values recorded in SSA were far below what was documented in Asia and Latin America for the same decades. In 2018, the SSA economy also contracted by approximately 0.33%, which marked about 0.23 percentage point lower than the values recorded in 1990s. In addition, growth rate also differs significantly among the SSA countries. While Angola, Ethiopia and Mozambique are on the growth verge, other economies like Burundi, Malawi and Zimbabwe are struggling severely (Kutan, Samargandi, and Sohag 2017). In the year 2012, as these countries¹ recorded GDP per capita growth of 4.71%, 5.62% and 4.35%, the economies of Burundi, Malawi and Zimbabwe grew at a lower rate of 1.12%, −0.99% and 0.19%, respectively (WDI, 2018).

It is worth mentioning that while some scholars (e.g. Carlin and Soskice 2009; Ezeoha and Cattaneo 2012; Cervellati, Fortunato, and Sunde 2009) attribute these poor growth performances in SSA economies to factors like poor education, health, high population growth rate, low life expectancy, poor human capital development and low level of investment, others (Aluko and Ibrahim 2020; Beck et al., 2005; Bordo and Rousseau 2006; Effiong 2015; Harper and McNulty 2008; Sghaier, 2018; Kutan, Samargandi, and Sohag 2017) also argue vehemently for poor institutional structures. This is because better institutions seek to specifies property right, enforce contract terms, protect the disadvantaged parties (investors), reduce corruption and shapes both macro and financial policies. These aforementioned factors tend to restore the financial markets’ credibility and boost the confidence level of both domestic and foreign investors. Arguably, Manasseh, Mathew, and Ogbuabor (2017) (cited in Mark and Nwaiwu (2015)) added that changes in government decisions or policies influence the degree to which economic entities achieve their business goals and objectives. As a result, although a well-functioning financial system is necessary for economic growth, it is not a sufficient condition to enhance growth. Therefore, policies of government aimed at improving the efficiency and operations of the financial system are deemed critical. According to Chinn and Ito (2006), in economies where the legal system does not clearly define property rights or ensure contract enforcement, the incentives for lending can be limited. This is due to the fact that lenders, as well as the creditors would be afraid of losing their funds. Hence, the effect of institutional quality in bridging the gap in the finance-growth nexus cannot be underestimated.

Given the insight from the above, it is relevant to investigate the role of institutional quality in the relationship between financial development and economic growth in SSA to argument the few studies in SSA (Opoku, Ibrahim, and Sare 2019; Aluko and Ibrahim 2020; An, Zou, and Kargbo 2020). Although, Aluko and Ibrahim (2020) has applied threshold regression analysis to assess the value at which institutions boost economic growth in SSA. However, this study fills a vacuum in the literature in several ways. First, this study applied three institutional quality variables which include rule of law, regulatory quality, and political stability for a more comprehensive and robust analysis in SSA. Second, this study determines the degree or threshold level at which both institutional quality variables and financial development boost economic growth in Sub-Saharan Africa by employing system Generalized Methods of Moments (GMM) to estimate the marginal effect of the interaction between institutional quality and financial development from 5th to 95th percentiles in order to determine the value at which institutional quality in SSA facilitates the potential effect of financial development on economic growth. According to Brambor, Clark, and Golder (2006), it is important to generate the marginal effect if there are interactions in the empirical model since the actual impact of the interaction term on economic growth could adequately be assessed through their marginal effect. Computing the marginal effect of the interaction between institutional quality and financial development using GMM from the 5th to 95th percentile will provide more robust and comprehensive results than threshold regression, which has been used in previous studies (Aluko and Ibrahim 2020; Law, Azman-Saini, and Ibrahim 2013). This is due to the fact that this analysis will exogenously predict the value at which institutional quality complements financial development to improve growth from the 5th (low institution) to the 95th (high institution) percentiles.

The rest of the paper is organized as follows. The following section presents a review of pertinent literature. Section three focuses on the methodological framework employed. The fourth section discusses the empirical findings, and the final section concludes.

2. Literature review

To understand the link between financial development and economic growth in developing economies, particularly in countries where poverty is high, it is relevant to review some theoretical and empirical literature. However, to help expound on these linkages, the study first reviews the current state of financial development in SSA.

2.1. Financial sector development in SSA

Financial sector is the set of markets and institutions that permit the transfer of credit between surplus and deficit units. With this in mind, financial sector development occurs when financial markets and institutions are able to ease the cost incurred in transaction and provide better intermediation in an economy. Because the financial sector helps mobilize savings and direct funds into productive uses, its development has become essential in most economies’ policy frameworks. Evidence points to the view that financial sector development is critical for economic development (Odhiambo 2009; Giedeman, 2010; Ibrahim and Alagidede 2018). This is because it enhances economic growth through efficient allocation of capital. Although, financial sector in SSA has grown significantly but has generally not caught up with that of other developing countries. The report released by IMF in 2016 reveals that SSA region’s median ratio of private sector credit to GDP has increased by almost 10 percentage points since 1995, to about 21 percent in 2021. Also, available data from Africa Development Database show that domestic credit to the private sector was 61.23 percent of GDP in 2000, and this increased dramatically to 65.58 percent in 2019. In addition, Sulemana and Dramani (2020) estimated the average growth of financial development in SSA using stock market capitalization and discovered it to be 24.66 percent for the period 1990–2018. According to the authors, this value was significantly higher than what was documented in MENA and ASEAN economies during the same time period.

Furthermore, most Pan African banks (Ecobank, Absa Bank, etc.) have branches in most SSA regions, increasing financial inclusion and lowering bank transaction costs in the region. Another encouraging trend is that the share of marketable instruments is increasing in comparison to non-marketable debt, allowing countries to set more liquid benchmarks for future corporate issuances. The average maturity of instruments has increased significantly, and debt instruments with maturities longer than 10 years have recently become common in a number of SSA countries (Benin, Burkina Faso, Kenya, Mali, Tanzania, and Zambia). Although several financial sector development measures have been adopted, this study proxies financial sector development with financial development index and domestic credit to the private sector by banks (as a percentage of GDP). (See, for example, Opoku, Ibrahim, and Sare 2019; Sulemana and Dramani 2020.)

2.2. Theoretical review

Theories that explain the relationship between institutional quality, financial development and economic growth can be tapped from demand-following hypothesis, supplying leading hypothesis, and law and finance theory. The first two theories propounded by Robinson (1952) and Patrick (1966) explain the relationship between financial development and economic growth whereas the latter theory explains the association between the three aforementioned variables.² The demand-following hypothesis predicts that financial development follows economic growth because as the economy expands, new demands for financial services emerge and an increase in demand for these services ensure further growth in an economy (Robinson 1952). In short, this theory proposes that financial development is basically the response to the greater demand for financial services as the real sector of the economy develops. From an empirical point of view, the studies by Naceur and Ghazouani (2007), Hasan, Koetter, and Wedow (2009) and Samargandi et al. (2014) have validated the demand-following hypothesis and have claimed that it is more effective in developing countries than in industrial economies.

Turning to the supply-leading hypothesis, financial development is viewed to enhance economic growth by supply growth-enhancing resources (Hsueh, Hu and Tu, 2013). Given this, Patrick (1966) has identified three significant channels through which financial development can influence economic growth. First, financial institutions facilitate the rate of capital accumulation by providing convenient and effective saving, transaction and investment platform that encourage individuals in an economy to save, invest and work more in order to ensure growth and development. Second, financial institutions also provide an alternate mechanism for transferring funds from less productive to more productive uses in order to improve investment and capital stock. The final issue-based channel emphasizes how intermediation among various asset holders help to effectively transfer tangible wealth by changing ownership and composition. These channels imply that the creation of financial institutions and services occur before growth can be induced (Levine 2005; Beck and Levine 2004; Odhiambo 2009; Giedeman, 2010; Ibrahim and Alagidede 2018).

In addition, it is also hypothesized that institutions play a substantial role in explaining finance-growth nexus and this can be captured in the law and finance theory. The law and finance theory argue that legal traditions vary in terms of the priority attached to the right of private property owners and the protection of outside investors that forms the basis of financial development. The theory pivots primarily on the role played by the institutions to redress pertinent issues in the financial sector so as to enhance financial development. The pioneers of this theory stressed vehemently on country’s laws that protect private property right (see: Easterly and Levine 1997; Porta et al., 1998). This is because private property right gives individuals the exclusive right to use their resource as they see fit. In line with this, Barth et al., (1998) demonstrated that better institutions stimulate economic growth by shaping financial systems. In addition, La Porta et al. (1997) asserted that better legal protection of the interests of shareholders and creditors promote the flow of investment and availability of external finance to firms. Furthermore, Hooper, Ah Boon, and Asfandyar (2009) also revealed that stock markets in better governed countries have high equity returns and lower associated risk, resulting in increasing investment.

2.3. Empirical literature review

2.3.1. Financial development and economic growth

Studies on the relationship between financial development and economic growth have revealed that the benefits of financial development on economic growth depends on the structures and fundamentals underlying the economy. For instance, Campos et al. (2012) employed a power ARCH estimate in Argentina for the period between 1896 and 2000 and revealed that financial innovation has a positive long-run effect on economic growth confirming supply-leading hypothesis. Further, it was identified in their study that financial development enhances growth and not growth volatility in Argentina. With this, the study concluded that Argentina is combined with centralized economic planning and government regulations dominants and therefore, there is robust and stronger financial sector penetration. Given these findings, many scholars have supported the supply-leading hypothesis elsewhere in the world. One can relate to the empirical evidence by Al-Moulani and Alexiou (2017); Sghaie (2018); Benczúr, Karagiannis, and Kvedaras (2019); and Afonso and Blanco-Arana (2022). Also, the study by Arayssi, Fakih, and Kassem (2019) indicated that there is a bidirectional causality between financial development and economic growth in Kenya. In addition, Odhiambo (2009) also revealed that economic growth granger causes financial development to reduce poverty in south Africa.

Arguably, the negative effect of financial development on economic growth has also been provided. Seven and Yetkiner (2016), for example, used panel data from 1991 to 2011 to investigate the role of financial development in accounting for economic growth in low, middle, and high-income countries. Their results revealed that financial development has a negative repercussion on economic growth in high-income countries. Given these conflicting findings, contemporary researchers have argued that the effect of financial development on economic growth is actually non-linear. For instance, Hung (2009) provided an empirical investigation on the non-linear effect of financial development on economic growth in China by developing a model that incorporates non-productive consumption loans with productive investment loans in a standard model of asymmetric information. The study revealed that financial development facilitates both investment loans and consumption loans. While investment loans benefit economic growth, consumption loans impede economic growth. As a result, the effect of financial development on economic growth depends on the relative magnitudes of these two distinct channels. In addition, Shahbaz et al. (2017) also examined the nonlinear relationship between financial development and economic growth in Indian economy. Applying nonlinear autoregressive distributed lag bounds testing approach on a quarterly data spanning from 1960Q1 to 2015Q4, the asymmetric causality results revealed from the study show that only negative shocks to financial development have impacts on economic growth. Furthermore, Botev, Égert, and Jawadi (2019) assessed the nonlinear relationship between financial development and economic growth in developing, emerging and advanced economies over a period 1990–2012. Employing a Dynamic OLS threshold regressions, the study found that domestic credit and private domestic credit to GDP ratios show a positive effect on output per capita.

2.3.2. Financial development, institutional quality and economic growth

Given that financial development has double-edged effect on economic growth across countries, plethora of studies have augmented institutional quality in the relationship between financial development and economic growth. With this, a study by Hasan, Wachtel and Zhou (2009) on the effect of institutional development and financial deepening on economic growth suggest that the development of financial markets and property right are associated with stronger economic growth in China. In MENA economies, Nabi and Suliman (2009) investigated the causal relationship between institutions, banking development and economic growth; and indicated that the causality which runs from banking development to economic growth is more intense in countries with more developed institutional environment. Similarly, employing a common correlated effect approach on annual data for the period 1980–2012, Kutan, Samargandi, and Sohag (2017) examine the role of institutional quality in the linkage of financial development and economic growth in 21 MENA countries. They found that not all measures of financial development promote economic growth in the absence of institutional quality, but they all augment growth in the presence of institutional quality.

Few studies that have interacted financial development with institutional quality also suggest that institutional quality argument financial development to impact positively on economic growth. For example, Aluko and Ibrahim (2020) assess the effect of financial development on economic growth in sub-Saharan Africa by allowing the link to be mediated by the level of institutions. Using a threshold regression analysis, they found that below the optimal level of institutional quality, financial development does not significantly promote economic growth. However, for countries with institutional quality above the threshold, higher finance is associated with growth. In addition, Sulemana and Dramani (2020) also conducted a comparative analysis on transmission of financial sector development through institutional quality on economic growth between Economic Community of West African States (ECOWAS) and Southern African Development Community (SADC). Applying Seemingly Unrelated regression technique on panel data from1980 to 2016, the study revealed a positive complementarity effect of financial development and institutional quality on growth. However, the effect turned to be significant in only ECOWAS regions.

In addition, Ehigiamusoe and Samsurijan (2021) analyzes the moderation role of institutions in the finance-growth nexus from both theoretical and empirical perspective. Their study demonstrated that the optimal level of financial and institutional development are necessary conditions for finance to accelerate growth. Hence, countries that want to promote economic growth through the financial sector should give adequate priority to institutional development. Furthermore, employing a balanced panel data for twenty-one (21) countries in SSA spanning from 1986 to 2010, Effiong (2015) revealed an insignificant interaction effect of both financial and institutional development on economic growth. Given these findings, the author highlighted that the current institutions in SSA do not support the finance-growth nexus. Therefore, he implored for an improved institution in SSA. Using an innovative threshold estimation technique, Law, Azman-Saini, and Ibrahim (2013) examine whether the growth effect of financial development in countries with distinct levels of institutional development differ. Sampling 85 countries from 1980 to 2008, the study found that the impact of financial development on economic growth is positive and significant only after a certain threshold level of institutional development has been attained. Contrary, evidence provided by Compton and Giedeman (2011) also indicated that the positive effect of banking development on growth decreases as the level of institutions increases.

It can be concluded that better institutions enhance financial development to impact on economic growth positively. However, the degree or threshold at which these institutions complement the positive impact of financial development on economic growth is missing in literature especially in SSA (see Sulemana and Dramani 2020; Aluko and Ibrahim 2020). As a result, it is imperative to find that threshold value at which institutions complement financial development to impact on growth in SSA. Given this, the current study deviates from the study by Aluko and Ibrahim (2020) and Law, Azman-Saini, and Ibrahim (2013) by employing generalized method of moment estimation technique to estimate the marginal effect of the interaction between institutional quality and financial development from 5th to 95th percentiles for more comprehensive policy direction.

3. Methodology and data

This section presents the methodological framework adopted to analyze the data set used in this study.

3.1. Model specification

This study augments a basic linear relationship model between financial development and economic growth, similar to that of Sulemana and Dramani (2020), Aluko and Ibrahim (2020), and Kutan, Samargandi, and Sohag (2017) to include institutional quality and its interaction with financial development. As a result, the study expresses the functional form of Equation (1). (1) $RGDP=f(FD,IQ,FD\ast IQ,INFL,DI,TO,FDI)$(1)

where RGDP, FD, IQ, INFL, DI, TO and FDI denote economic growth (measured by GDP per capita), financial development (proxied by financial development index), institutional quality (measured using rule of law (RL), regulatory $RGDP=f(FD,IQ,FD\ast IQ,INFL,DI,TO,FDI)$ quality (RQ), and political stability (PS)), inflation, domestic investment, trade openness and foreign direct investment, respectively. Also, FD*IQ captures the interaction between financial development and institutional quality. The study transforms Equation (1) into its panel estimable form as specified in Equation (2). The choice of the sampled variables was influenced by Sulemana and Dramani (2020), Nabi and Suliman (2009) and Sghaier (2018). (2) $RGD{P}_{it}={\theta }_0+{\gamma }_{1}F{D}_{it}+{\gamma }_{2}I{Q}_{it}+{\gamma }_3(FD\ast IQ{)}_{it}+{\gamma }_{4}lnINF{L}_{it}+{\gamma }_{5}lnD{I}_{it}+{\gamma }_{6}lnT{O}_{it}+{\gamma }_{7}FD{I}_{it}+{\delta }_i+{\epsilon }_{it}$(2) It must be noted that ${\theta }_0$ and ${\gamma }^{\mathrm{\prime }}s$ (1, 2, 3, … 7) indicate the constant term and the unknown parameters to be estimated. Here, $\epsilon$ is the disturbance error term assumed to be normally distributed with zero mean and constant variance $[{\epsilon }_{it}\sim N(0,1)]$. Also, ${\delta }_i$, $t$ and $i$ indicate the unobserved country-specific heterogeneity, time trend, and the cross-sectional countries, respectively. It is to be noted that Equation (2) is estimated three times, and are named as Model 1, 2, and 3. Model 1 estimates the effect of financial development on economic growth while Model 2 estimates the effect of the three institutional quality variables on economic growth. In addition, Model 3 estimates the interactive role of rule of law, regulatory quality, and political stability. It is noted that the coefficient of interest is ${\gamma }_3$, which captures the actual effect of financial development on economic growth through the marginal effects when institutional quality is improved.

3.2. Data source

This study uses a balanced panel data on twenty-nine (29) countries³ in SSA from 2000 to 2019. The choice of the study period and countries is based on the availability of data. Data used in this study are sourced from IMF’s International Financial Statistics (IFS), and World Development Indicators (WDI). Specifically, data on financial development is gleaned from IFS while the data on the remaining variables in the study are sourced from the WDI.

3.3. Estimation strategy

The two-step System Generalized Method of Moments (system-GMM) of Blundell and Bond (1998) is employed to examine the impact of financial development, institutional quality, and its mediating role between financial development on economic growth. The system-GMM estimation technique is chosen over other panel estimators like fixed effect, random effect, and panel-corrected standard error due to some advantages of the system-GMM. First, the system-GMM estimator can handle panel data with small time (T) and large cross-sectional units (N), such as $T=18$ and $N=29$ in this study. Furthermore, it employs the lags of the endogenous regressor as internal instruments to mitigate any potential endogeneity issues that may develop because of the introduction of the lag dependent variable as part of the regressors. Given this, the system-GMM specification of Equation (2) is expressed in Equation (3) as: (3) $RGD{P}_{it}={\theta }_0+\phi RGD{P}_{it-1}+{\rho }_{1}F{D}_{it}+{\rho }_{2}I{Q}_{it}+{\rho }_3(FD\ast IQ{)}_{it}+{\rho }_{4}ln{\mathit{Z}}_{it}+{\delta }_i+{\epsilon }_{it}$(3) where Z represents a vector of other control variables included in the previous equations. Arellano and Bond (1991) and Hansen and Singleton (1982) J-test are employed to check for the absence of second-order serial correlation and the validity of the instruments, respectively. The null hypothesis of these tests suggests no second-order serial correlation and validity of instruments. Hence, if the probability value is greater than the conventional 5% significance level, this study fails to reject the null hypothesis. As a result, there will be the conclusion that there is no serial correlation, and the instruments employed are also valid.

Following Brambor, Clark, and Golder (2006) and Duodu et al. (2021), the study further generates the marginal effects of the interaction between financial development and institutional quality in Equation (3). This is because the marginal effects of the interaction term clearly show the true impact of a unit change in the financial development on economic growth than the coefficient of the interaction term. Hence, the marginal effect of the interaction term is computed as given by Equation (4). (4) ${\displaystyle \frac{\mathrm{\partial }RGD{P}_{it}}{\mathrm{\partial }F{D}_{it}}={\rho }_1+{\rho }_{3}IQ}$(4)

4. Results and discussion

To investigate the impact of financial development and institutional quality on economic growth, this section presents and discusses the correlation among the variables, short-run results and their respective marginal effect estimates. It should be emphasized that in this study, three institutional quality variables are used. These include rule of law, regulatory quality, and political stability.

4.1. Correlation matrix

In Table 1, the results for the correlation among the sample variables employed in this study are reported. It is revealed in Table 1 that among the variables used in this study, rule of law, and regulatory quality show a positive relationship with economic growth. However, political stability is seen to have a negative association with economic growth. This finding suggests that people’s perception about political instability diverts economic growth in SSA. In addition, inflation and trade openness have a negative association with economic growth. The negative association detected among those variables point to the view that economic growth in SSA do not move in tandem with the aforementioned variables. However, it is observed that domestic investment and foreign investment have a positive correlation with economic growth in SSA. Generally, the results in Table 1 indicate that the variables for the empirical analysis are less likely to exhibit exact linear relationship since the correlation coefficients of all the variables are less than 0.70 (Kennedy 2008). Therefore, the study proceeds to estimate the unknown parameters in Equation (3) using the Two-Step System GMM.

Table 1. Correlation results.

Variables	RGDP	RL	RQ	PS	FD	INFL	DI	TO	FDI
RGDP	1
RL	0.04	1
RQ	0.16	0.49	1
PS	−0.04	0.78	0.34	1
FD	0.05	0.24	0.65	0.23	1
lnINFL	−0.05	0.03	0.09	0.07	0.17	1
lnDI	0.10	0.05	0.22	0.03	0.08	−0.09	1
lnTO	−0.008	0.02	0.1311	−0.0262	−0.0075	−0.1420	0.69	1
lnFDI	0.003	−0.001	−0.10	−0.01	−0.02	0.10	−0.24	−0.29	1

Notes: RGDP, FD, RL, RQ, PS, INFL, DI, TO, and FDI denote economic growth, financial development, rule of law, regulatory quality, political stability, inflation, domestic investment, trade openness, and foreign direct investment respectively. The Standard errors are in parentheses. *, **, and *** indicate 10%, 5%, and 1% significance level, respectively.

4.2. The effect of financial development and institutional quality on economic growth

This section reports three different estimation results on the effect of financial development and institutional quality on economic growth. Specifically, in Table 2, the results show the separate effects of financial development and institutional quality on economic growth. In Table 3, the results for the interaction between financial development and each of the institutional quality variables are presented. In addition, the results for the marginal effect between financial development and each of the institutional quality variables are displayed in Table 4. It must be noted that the model specifications that separately include rule of law, regulatory quality, and political stability are respectively represented by Model 1, Model 2, and Model 3 in both Tables 2 and 3.

Table 2. Results of the effects of financial development and institutional quality on economic growth.

Variables	Rule of Law	Regulatory Quality	Political Stability
$RGD{P}_{\mathrm{t}-1}$	0.1265*** (0.0195)	0.1028*** (0.0180)	0.1022*** (0.0207)
FD	0.6628*** (0.1647)	0.3927* (0.1955)	0.5031** (0.2313)
RL	−0.0457*** (0.0115)
RQ		0.0499* (0.0260)
PS			0.0290** (0.0133)
lnINFL	0.0053*** (0.0017)	−0.0005 (0.0035)	0.0057*** (0.0019)
lnDI	−0.0171*** (0.0044)	−0.0235*** (0.0060)	−0.0100** (0.0043)
lnTO	−0.0103*** (0.0034)	−0.0061 (0.0057)	−0.0147* (0.0085)
FDI	−0.0005** (0.0002)	0.0004 (0.0003)	−0.0002 (0.0002)
Constant	0.1292*** (0.0222)	0.1632*** (0.0436)	0.1044** (0.0390)
AR(2) P-value	0.099	0.128	0.102
Hansen P-value	0.577	0.792	0.552
No. Groups	28	28	28
No. Instruments	27	25	25

Notes: RGDP, FD, RL, RQ, PS, INFL, DI, TO, and FDI denote economic growth, financial development, rule of law, regulatory quality, political stability, inflation, domestic investment, trade openness, and foreign direct investment. The Standard errors are in parentheses. *, **, and *** indicate 10%, 5%, and 1% significance level, respectively.

Table 3. Results of the role of institutional quality (rule of law, regulatory quality, and political stability).

Variables	Rule of Law	Regulatory Quality	Political Stability
$RGD{P}_{\mathrm{t}-1}$	0.1276** (0.0521)	−0.1022*** (0.0356)	0.0874*** (0.0240)
FD	0.1941* (0.1039)	0.1690 (0.3201)	0.4379* (0.2554)
RL	−0.0371*** (0.0105)
RQ		0.0102 (0.0828)
PS			0.0055 (0.0202)
FD*RL	0.2124* (0.1134)
FD*RQ		1.6681* (0.9256)
FD*PS			0.3958*** (0.1035)
lnINFL	0.0005 (0.0019)	−0.0244** (0.0092)	0.0052* (0.0027)
lnDI	−0.0174*** (0.0032)	−0.0025 (0.0138)	−0.0131*** (0.0057)
lnTO	0.0109** (0.0042)	−0.1381*** (0.0229)	−0.0131** (0.0061)
FDI	−0.0003* (0.0001)	−0.0021*** (0.0007)	−0.0002 (0.0003)
Constant	0.0481 (0.0288)	0.8741*** (0.1370)	0.1215*** (0.0352)
AR(2) P-value	0.298	0.517	0.142
Hansen P-value	0.581	0.155	0.652
No. Groups	28	28	28
No. Instruments	28	23	26

Note: RGDP, FD, RL, RQ, PS, INFL, DI, TO, and FDI denote economic growth, financial development, rule of law, regulatory quality, political stability, inflation, domestic investment, trade openness and foreign direct investment. The Standard errors are in parentheses. *, **, and *** indicate 10%, 5%, and 1% significance level, respectively.

Table 4. Results of marginal effect of financial development on economic growth.

	Rule of Law		Regulatory Quality		Political Stability
Percentiles	Percentile Value	Coefficients	Percentile Value	Coefficients	Percentile Value	Coefficients
5%	−0.5330	0.0808 (0.0857)	−0.4985	−0.6625 (0.5536)	−0.5383	0.2248 (0.2630)
10%	−0.4828	0.0915 (0.0858)	−0.4176	−0.5276 (0.4944)	−0.4481	0.2605 (0.2608)
25%	−0.3348	0.1230 (0.0882)	−0.2603	−0.2653 (0.3949)	−0.2980	0.3199 (0.2581)
50%	0.0551	0.2058* (0.1076)	0.0016	0.1716 (0.3202)	0.0091	0.5631** (0.2566)
75%	0.2948	0.2567* (0.1259)	0.2532	0.5914 (0.4024)	0.3165	0.6121** (0.2576)
90%	0.4177	0.2828** (0.1365)	0.4399	0.9028* (0.5254)	0.4256	0.6063** (0.2579)
95%	0.4670	0.2933** (0.1409)	0.5015	1.0056* (0.5717)	0.4617	0.6206** (0.2585)
99%	0.4670	0.2933** (0.1409)	0.5015	1.0056* (0.5717)	0.4617	0.6206** (0.2585)

Beginning with the results in Table 2, it can be observed that the results under all the three models show that financial development has a positive and significant effect on economic growth. This finding implies that an improvement in the financial sector leads to an increased economic growth in SSA. The finding confirms the ones found by Sghaie (2018), Benczúr, Karagiannis, and Kvedaras (2019), and Afonso and Blanco-Arana (2022).

Turning to the institutional quality variables employed for these empirical investigations, it is discovered that rule of law has a negative and significant effect on economic growth. Specifically, an improvement in rule of law decreases economic growth on average by 0.05%. This restrictive effect of rule of law on economic growth in SSA could be attributed to the fact that the economic agents (households and firms) lack confidence in the legal system, specifically the quality of contract enforcement, property rights, the police, and the courts. Hence, improvement in the rule of law does not influence firm’s decisions to embark on extravagant investment to increase economic growth in the sub-region. This result is consistent with the study by Gazdar and Cherif (2015).

However, regulatory quality and political stability are found to impact positively on economic growth. In particular, it is found that improvement in regulatory quality and political stability increase economic growth in SSA by approximately 0.05% and 0.03%, respectively. These findings imply that in order to achieve high economic growth, a sound government policy and a stable political environment are necessary. This is because both domestic and foreign investors prefer a political environment that is stable and free of policy uncertainty and proper governments regulations. This evidence corroborates the findings by Lee, Olasehinde-Williams, and Olanipekun (2021).

With respect to the control variables, it can be seen that inflation has a significantly positive effect on economic growth (see Models 1 and 2). Furthermore, domestic investment, trade openness, and foreign direct investment were revealed to impact negatively on economic. Also, from Table 2, the AR(2) and Hansen tests show that the estimates are accurate and efficient. This is because the p-values of AR(2) in all the Models (1, 2, and 3) are 0.099, 0.128, and 0.102 indicating non-rejection of the null hypothesis of no second-order serial correlation. Furthermore, the Hansen test also shows that instruments validity exists since the p-value of 0.577, 0.792, and 0.552 in Models (1, 2, and 3), respectively, indicate non-rejection of the null hypothesis of instruments validity.

The results displayed in Table 3 are for the case where interactions between financial development and each of the institutional variables are incorporated into the model. Consistent with the results in Table 2, the results in Table 3 show that financial development impacts economic growth positively.

It is interesting to note that in Table 3, the variables of interest are the coefficients of the interaction between financial development and the institutional factors. Given this, it can be seen that rule of law, regulatory quality, and political stability complement financial development to have a positive and significant effect on economic growth. In particular, the coefficients of the interaction terms imply that an improvement in financial development in SSA will cause economic growth to increase by 0.21%, 1.67%, and 0.40% when rule of law, regulatory quality, and political stability are improved or become efficient. These findings support the empirical study revealed by Aluko and Ibrahim (2020), who applied threshold regression technique to assess the value at which institutions boost economic growth in SSA.

4.3. Marginal impact of financial development on economic growth

It can be noticed from the results in Table 3 that the interactions between financial development and each of the institutional quality variables, (rule of law, regulatory quality, and political stability) are positive and statistically significant. This imply that these institutional factors complement financial development to enhance growth in SSA. However, to ascertain the actual effect of financial development on economic growth in the sub-region, it is necessary to estimate the marginal effect (i.e. conditional impact). Given Equation (4), the actual impact of financial development on economic growth is realized through its marginal effect. The marginal effect results at different percentiles values of rule of law, regulatory quality, and political stability are presented in Table 4.

The results in Table 4 reveal that at the lower percentiles (5th to 25th) of rule of law, political stability, and regulatory quality, financial development has insignificant effect on economic growth. This finding implies that at the lower level of institutional development in SSA, the potential gains from financial development on economic growth is not reaped.

However, it can be seen from Table 4 that at the medium and higher (50th to 75th) percentiles of rule of law and political stability, financial development significantly enhances economic growth. The coefficients of the interaction between financial development and rule of law indicates that financial development increases economic growth on average by 0.21% and 0.26% at 50th and 75th percentiles of rule of law receptively. Similarity, the coefficients of the interaction between financial development and political stability suggests that financial development improves economic growth on average by 0.56% and 0.61% at 50th and 75th percentiles of political stability respectively. These findings suggest that if there is a strong rule of law in an economy that enforces contract terms and protects disadvantaged parties (investors), the credibility of financial markets will be restored, increasing the confidence level of both domestic and foreign investors to lend money to the private sector in order to increase their investment. In terms of the positive interactive effect of political stability and financial development, Radu (2015) opined that a stable political environment helps in building a coherent and continuous path for sustainable development. This is because both domestic and foreign investors prefer a stable political environment, with less policy uncertainty. Therefore, a stable political environment helps to shape both macro and financial policies and attracts enormous foreign direct investment in the economy. These findings confirmed the evidence of Sulemana and Dramani (2020), Duodu and Baidoo (2020), and Aluko and Ibrahim (2020). Interestingly, at the 50th and 75th percentile of regulatory quality, financial development was not shown to be an important contributor to economic growth in SSA. This finding implies that the potential benefits of financial development on economic growth cannot be realized in SSA economies with negligent government regulations.

Again, at the 90th to 99th percentiles of rule of law, regulatory quality, and political stability, financial development significantly increases economic growth in SSA. These results suggest that the development of the financial sector can help to achieve high economic growth when rule of law, regulatory quality, and political stability are improved. The results suggest that the marginal benefit of financial development can fully be realized when institutions (rule of law, regulatory quality and political stability) are highly effective in SSA. Given the above results, we conducted a robustness check of all these estimates using domestic credit to the private sector by banks (% of GDP) as another measure of financial sector development, and the results are displayed in Appendix 1 and Appendix 2. It can be seen that the results are generally similar to the ones discussed above.

5. Conclusion

Institutional quality is being argued to argument financial development to influence economic growth. Given this, previous studies have used threshold regression to estimate the level at which institutional quality influences financial development to impact on economic growth. However, the application of system-GMM to predict exogenously the percentile value at which institutional quality facilitates financial development to impact on economic is missing in literature especially in SSA. As a result, this study employs the system-GMM estimation technique to examine the linkages between financial development and economic growth in the face of rule of law, regulatory quality, and political stability for the period spanning from 2000 to 2019 in SSA. Using Twenty-nine (29) countries in SSA, it is found that financial development has a positive effect on economic growth.

Also, it is found that rule of law, regulatory quality, and political stability has a positive effect on economic growth. Further, the conditional results (marginal effects) show that financial development improves economic growth in SSA when all the institutional quality indicators (rule of law, regulatory quality, and political stability) develops, implying that the marginal benefit of financial development on economic growth is only realized when rule of law, regulatory quality, and political stability in SSA develops to a greater extent (90th to 99th percentiles). Given these results, the study concludes that institutional quality can complement financial development to improve economic growth in SSA economies when institutions are significantly efficient.

From a policy perspective, efforts to make institutions in SSA work better and to become stronger and efficient are necessary to allow the economies in the region to reap the full potential benefit of financial development in achieving higher growth. That is, considering that financial development increases economic growth when rule of law, regulatory quality, and political stability are improved, it is recommended that policy makers and governments in SSA institute policy measures geared toward improving effectiveness and performance of institutions in SSA.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Angola, Ethiopia, and Mozambique.

2 Institutional quality, financial development, and economic growth.

3 Angola, Benin, Botswana, Burkina Faso, Burundi, Cameroon, Chad, Comoros, Central African Republic, Congo Dem. Rep., Cote d'Ivoire, Gabon, Gambia, The, Ghana, Kenya, Liberia, Madagascar, Mali, Malawi, Mauritius, Niger, Nigeria, Rwanda, Senegal, Sierra Leone, South Africa, Tanzania, Togo, and Uganda.

Appendices

Appendix 1: Results of the effects of financial development and institutional quality on economic growth

Table

Variables	Rule of Law	Regulatory Quality	Political Stability
$RGD{P}_{\mathrm{t}-1}$	0.1090*** (0.0159)	0.0599** (0.0242)	0.1073*** (0.0124)
FD	0.0304* (0.01587)	−0.0108 (0.0226)	0.0128 (0.0092)
RL	−0.0615*** (0.0153)
RQ		0.0219 (0.0284)
PS			−0.0079 (0.0099)
FD*RL	0.1304* (0.0724)
FD*RQ		0.2117*** (0.0445)
FD*PS			0.0218 (0.0145)
lnINFL	0.0001 (0.0033)	−0.0045 (0.0039)	0.0053** (0.0020)
lnDI	−0.0080 (0.0087)	−0.0239*** (0.0066)	−0.0110** (0.0051)
lnTO	0.0115** (0.0053)	−0.0059 (0.0075)	−0.0022 (0.0037)
FDI	0.0001 (0.0003)	−0.0002 (0.0005)	−0.0001 (0.0009)
Constant	0.0009 (0.0537)	0.1870*** (0.0638)	0.0538 (0.0297)
AR(2) P- value	0.307	0.368	0.542
Hansen P- value	0.712	0.821	0.664
No. Groups	28	28	28
No. Instruments	26	26	26

Notes: RGDP, FD, RL, RQ, PS, INFL, DI, TO, and FDI denote economic growth, financial development, rule of law, regulatory quality, political stability, inflation, domestic investment, trade openness, and foreign direct investment. The Standard errors are in parentheses. *, **, and *** indicate 10%, 5%, and 1% significance level, respectively.

Appendix 2: Results of marginal effect of financial development on economic growth

Table

	Rule of Law		Regulatory Quality		Political Stability
Percentiles	Percentile Value	Coefficients	Percentile Value	Coefficients	Percentile Value	Coefficients
5%	−0.5330	−0.0325 (0.0350)	−0.4985	−0.1163*** (0.0387)	−0.5383	0.0010 (0.0150)
10%	−0.4828	−0.0132 (0.0258)	−0.4176	−0.0992** (0.0357)	−0.4481	0.0030 (0.0139)
25%	−0.3348	0.0376** (0.0166)	−0.2603	−0.0659** (0.0301)	−0.2980	0.0063 (0.0121)
50%	0.0551	0.0689** (0.0288)	0.0016	−0.0105 (0.0225)	0.0091	0.0130 (0.0092)
75%	0.2948	0.0849** (0.0367)	0.2532	0.0428*** (0.0195)	0.3165	0.0196** (0.0078)
90%	0.4177	0.0913** (0.0399)	0.4399	0.0824*** (0.0212)	0.4256	0.0220*** (0.0078)
95%	0.4670	0.0913** (0.0399)	0.5015	0.0954*** (0.0224)	0.4617	0.0228*** (0.0079)
99%	0.4670	0.0304* (0.0153)	0.5015	0.0954*** (0.0224)	0.4617	0.0228*** (0.0079)