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How will the drivers of financial sector development in Africa play-out in post-COVID-19?

May 26, 2021
Muazu Ibrahim , Research Officer, Making Finance Work for Africa (MFW4A)

Undoubtedly, the development of the financial sector is central to countries in Africa. This is because, well-developed financial sector enhances overall economic growth, reduces poverty and ultimately inequality. In this case, improved financial sector is critical to achieving the Sustainable Development Goals (SDGs) and African Union Agenda 2063.

Given the importance of the financial sector, examining the factors that influence countries’ financial sector development has been a major issue in policy discourse especially at the macroeconomic level. Indeed, existing efforts have unearthed a number of factors. For instance, I led a study in 2018 on the determinants of financial sector – proxied by private and domestic credits (% of GDP) – in Africa relying on data from 46 countries. We find that, human capital, trade openness, real GDP per capita and gross fixed capital formation positively affect financial development. Specifically, accumulation of the human capital stock spurs financial market. This is because higher human capital accumulation through improved education increases people’s awareness of risk analysis hence increasing their risk taking capacity. Well-informed agents may also demand for improved financial services thus stimulating more banking patronage and intermediation. Beyond human capital, higher trade openness also enhances financial sector development in Africa. It is argued that the more opened a country is, the higher it is exposed to external demand shocks. Higher integration of countries to international markets therefore generates new demand for external finance particularly for the private sector. By being more opened to trade, firms are able to overcome financing bottlenecks through their ability to source external finance leading to higher financial sector development. In the case of Africa, the empirical finding suggests that the impact of trade openness is particularly more important than human capital given the sample evidence.

A critical dimension in trade openness-human capital-financial development relationships was also unearthed. Countries that are less integrated with the international markets stand to benefit more with regard to their domestic financial development if they either increase their current level of openness or build their present level of human capital. In this endeavour, even though the effect of trade openness is greater, it can be substituted with human capital accumulation especially when policy makers are keenly pursuing policies to improve financial development in Africa. However, the simultaneous opening to trade and improved human capital stock is exceedingly relevant in developing financial sectors rather than pursuing one of them. Therefore, the role of the interaction between trade openness and human capital accumulation in supporting the quantitative mechanisms of domestic financial sector development process in Africa promises to turn the continent’s bourgeoning financial sector towards the trajectory of growth.

Countries’ level of real GDP per capita is also crucial in influencing financial sector development. What is observed is that, rising incomes spurs demand for better financial services and intermediation as financial institutions are normally pushed to innovate in producing quality products to support the increased income. However, inflation negatively affects financial development. Economies with higher episodes of inflation undermine financial development relative to countries with generally lower inflation. Evidence abound that, higher inflation is associated with severe macroeconomic instability and therefore dampens financial institutions appetite to provide credit to the private sector. At the household level, increases in inflation constraints savings as households’ consumption expenditure increases following the increases in general price levels leaving lower income for savings. Given that the financial sector in Africa is largely bank-based, higher level of inflation will severely inhibit the development of the financial institutions. Remarkably, since the above factors matter for financial development, it pre-supposes that, exogenous forces that affect those factors will also result in changes to financial development given the relationships.

COVID-19 as an exogenous shock: Implications for financial development

The ramifications of the outbreak of COVID-19 pandemic have been well documented even though the full extent of the effect is yet to be determined. The heavy burden of the pandemic has significantly disturbed a wide range of the economic relationships. Immediate fall-outs of the pandemic involved the weakening of trade linkages given its effects on global supply chain, the lower income levels given its effect on employment and productivity. At the firm level, the COVID-19 effect is highly synchronized affecting firms across board and at the same time. The widespread lockdowns occasioned by the pandemic also led to the closure of schools with a consequential effect on learning outcomes and attendant long term impact on human capital stock. The UN estimates that the closures of schools impacted over 90% of the world’s student population with 99% coming from the low and lower-middle income countries. The learning losses also threaten to extend beyond this generation and erase decades of progress made in the human capital accumulated so far. Given the positive relationship of human capital and financial development, the negative shock to human capital will by far inhibit financial development. And to the extent that the continent’s human capital is already, the knock-on effect on financial markets will be dire.

In addition, the pandemic undoubtedly constrained trade flows as border closures heavily impacted on both imports and exports. To the extent that trade openness is computed as a ratio of the sum of imports and exports to GDP, the lower imports and exports also meant lower trade openness and less integration with the international markets. Already, Africa is less integrated with the global market given its share in global total trade. Given that trade openness matters more financial sector development than human capital, the outbreak of the pandemic will severely shrink the progress made in the financial sector with significant impact stemming from trade openness.

At the height of the pandemic in Africa, the containment phase, disruptions to supply chains due to the lockdown and hoarding resulting from panic buying potentially drove-up general prices of critical goods as food prices soared occasioned by the pent-up demand during the containment period. The general increases in the price levels pushed-up inflation thus heightening macroeconomic instability with implications for the financial sector. On one hand, financial sector development and availability of formal saving opportunities can affect the extent of pent-up demand. For instance, given the low financial inclusion in Africa, the rebound in demand may be infinitesimal as many people are less able to save. On the other hand, the uptake of digital finance and the increasing space of mobile money as a saving vehicle and payment platform may also improve the rebound in demand. In this case, the overall effect on financial development will be conditioned on the net effect of lower account ownership as measured by the low financial inclusion the proliferation of digital finance tools.

Furthermore, the exogenous systemic shock also restricted real GDP per capita income growth with concomitant effect on financial sectors. Given the importance of higher GDP per capita not only for poverty reduction and inequality, but also for the financial sector, the attendant impact will have a counteracting effect on policies that seek to spur financial development in Africa. Remarkably, if such shocks emanate from the financial sector, policy antidote would involve formulating prescriptions to contain such shocks from spilling over to other real sectors of the economy while shielding the overall financial sector from collapsing.

What is unique about the current shock is its exogenous nature emanating from outside the financial sector. In this case, the solution is considerably more challenging as they are intertwined involving several actors outside the financial sector. Until a universal vaccine coverage is achieved in a way that allows countries to be able to fully return to at least the pre-COVID-19 levels, current policy formulation should be able to address the channels through which the crisis affects the financial sector. Indeed, such channels are the factors that drive the financial sector development. Improving trade openness, real GDP per capita, deepening human capital while reducing the macroeconomic instability are essential in spurring financial sector development.

Because the shocks of the pandemic have already manifested in the financial sector like all other sectors in the economy, it is also important to institute policies that directly target the financial sector. Given the crucial role of the financial sector in financial intermediation by efficiently reallocating productive resources, failure to also directly intervene in the financial sector will aggravate the already narrow financial intermediation and threaten the gains chalked in the past decades. A well-functioning financial sector can help countries build forward better and for that matter, preserving and building resilient financial sectors can support countries to dampen the damages and come out of the crisis, stronger than before.


About the author

Muazu Ibrahim is the Research Officer of MFW4A. He is a numerate resource person with experience in development finance and economics, policy analysis, strategic planning and evidence-based research. Prior to joining MFW4A, he worked with the United Nations Economic Commission for Africa (UNECA) in Ethiopia. He has contributed to notable flagship reports including the Economic Report on Africa (ERA) and the Economic Governance Report (EGR). Muazu was a Lecturer with the School of Business and Law (SBL), University for Development Studies (UDS), Wa campus, Ghana, where he taught courses in development finance, international trade and finance, financial markets, financial crisis and bank regulation. Muazu obtained a PhD in Economics and Finance from Wits Business School, University of the Witwatersrand, South Africa where his research examined critical themes in financial sector development–economic growth nexus in sub-Saharan Africa.

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