INTRODUCTION/ Background of the Study

“Does finance make a difference . . .?” Raymond Goldsmith (1969, p. 408). “Do economies with higher levels of financial development experience more or less volatility in economic growth rate?” Thorsten Beck, Mattias Lundberg and Giovanni Majnoni (2000)

The impact of financial development on output volatility has been a hotly debated theoretical issue. Economists hold startlingly different opinions regarding the importance of the financial system for mitigating output volatility. While many economists have underlined the importance of financial sector development in the process of economic development others still think that its importance is over stressed. Bagehot W. (1873) and Hicks J. (1969) argue that it played a critical role in igniting industrialization in England by facilitating the mobilization of capital for “immense works.” Schumpeter J. (1912) contends that well-functioning banks spur technological innovation by identifying and funding those entrepreneurs with the best chances of successfully implementing innovative products and production processes. In contrast, Robinson J (1952, p. 86) declares that “where enterprise leads finance follows.” “Pioneers of development economics,” including three Nobel Laureates, does not mention finance (Meir, G and Seers, D. (1984)). Furthermore, Stern’s (1989) review of development economics does not discuss the financial system, even in a section that least omitted topics. In the light of these conflicting views, this project uses existing theory to organize an analytical framework of the finance-growth nexus and then assesses the quantitative importance of the financial system on output volatility. The notion that a negative relationship exists between financial development and output volatility has been recognized by a crop of development economists, and a large body of empirical literature supports that.  The role of financial market development in smoothing out output volatility cannot be over emphasized. Whether financial development influences output volatility is not just a matter of academic curiosity, it is a crucial policy issue as well.

The financial sector can be said to ‘develop’ for example: the efficiency and competitiveness of the sector may improve; the range of financial services that are available may increase; the diversity of institutions which operate in the financial sector may increase; the amount of money that is intermediated through the financial sector may increase; the extent to which capital is allocated by private sector financial institutions, to private sector enterprises, responding to market signals (rather than government directed lending by state owned banks), may increase; the regulation and stability of the financial sector may improve; particularly important from a poverty reduction perspective, more of the population may gain access to financial services. It involves the establishment and expansion of institutions, instruments and markets that support this investment and growth process through improvements in quality, quantity and efficiency of these financial intermediary services. Financial development is calculated by taking the ratio of private-sector credit to GDP. The ratio of private credit to GDP is a common measure of financial development (Levine, et al. 2000).


The concept of volatility is a crucial issue in developing countries, since not only are output fluctuations larger and more abrupt in these economies, but also the ability to hedge against fluctuations is particularly limited by the weakness of their financial infrastructure. What is meant by “volatility”? A look at dictionary definitions yields a range of connotations: “tending to vary often or widely,” “unstable,” “changing suddenly,” “characterized by or prone to sudden change,” “unpredictable,” and “fickle. Greater volatility in developing countries stem from three sources. First, developing countries receive bigger exogenous shocks .These may come from the financial markets taking the form of sudden stop of capital inflows. Or they may come from goods market, especially as abrupt and large changes in the international term of trade. Second, developing countries seem to experience more domestic shocks .These are generated by a combination of the intrinsic instability of development process and self-inflicted policy mistakes .Government often instigate macroeconomic volatility by conducting erratic fiscal policy and ,even worse sometimes financing it through similarly volatile inflationary monetary policy .Third, developing countries have weaker “shock absorbers,” so external fluctuations have larger effects on their macroeconomic volatility economists have traditionally identified shock absorbers with two elements: financial markets to diversify macroeconomic risk and stabilization policies to counteract aggregate shocks. Both are deficient in developing countries, financial markets are shallow, drying up in times of crisis when they would be most useful and failing to provide adequate instruments to diversify the risks posed by external shocks.

For Nigeria, studying the relationship between financial development and output volatility is a vital one considering the continuing progress and reforms in the financial sector. Considered as an integral part of macroeconomic policy the financial sector reforms are expected to bring about significant economic benefits particularly through a more effective mobilization of savings and a more efficient allocation of resources thus putting the economy on the path of stable and sustainable economic growth and development. Nigeria has made notable efforts over the past years to reform its financial system going from the deregulation and liberalization of the financial sector activities under SAP in 1986, banking consolidation of 2004 and the recent financial system strategy (FSS) 2007 which hopes to make the country’s financial sector the growth catalyst that would ultimately engineer Nigeria’s evolution into an international financial center and a natural destination for financial products and services. Despite these great efforts Nigeria’s economic growth has been dwindling and fluctuating not strong enough to significantly reduce the prevailing level of poverty even though the various indicators used in measuring financial development has been increasing steadily over the years.

By any measure, developing countries always have the most macroeconomic volatility. The connection between volatility and lack of development is undeniable, making volatility fundamental development concern. Output volatility in developing countries has particularly welfare costs .No less important, output volatility has adverse effects on output growth and thus on future consumption. This is worst in countries that are poor, unable to conduct countercyclical fiscal policies or institutionally and financially underdeveloped.


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