• Background of the Study

Financial liberalization can be viewed as a set of operational reforms and policy measures designed to deregulate and transform the financial system and its structure with a view to achieve a liberalized market-oriented system within an appropriate regulatory framework (Johnston and Sundararajan, 1999).  Financial liberalization has been variously characterized in the literature but Niels and Robert (2005) observed that whatever characterization, financial liberalization usually include official government policies that focus on deregulating credit controls, deregulating interest rate controls, removing entry barriers for foreign financial institutions, privatizing financial institutions, and removing restrictions on foreign financial transactions. In other words, financial liberalization has both domestic and foreign dimension.  Moreover, it focuses on introducing or strengthening the price mechanism in the market, as well as improving the conditions for market competition.  As opposed to financial liberalization financial repression (the inverse of financial liberalization) is evidenced by ceilings on interest rates and credit expansion, selective credit policies, high reserve requirements, and restriction on entry into the banking industry (Ikhide and Alawode, 2001).

There has been a renewed interest on the role of financial liberalization in economic growth. This current focus has been heightened by two key factors.  First, the global financial crisis that has ravaged the economies of the world especially the western world and the apparent inability of the classical and neo-classical economic models to adequately address the crisis.  Second, the on-going government interventionists’ activities in the financial systems of various countries of the world have called to question the McKinnon-Shaw hypothesis of financial liberalization as a catalyst for economic growth and the Schumpeterian ‘creative destruction’ logic of free and liberalized economies.

According to Ogbu (2010), the current global financial and economic crises, the huge bailout of the financial and non-financial institutions across the world and the rather uncertain and timid response to these massive government interventions in the functioning of the market are altogether producing four-fold theoretical-conceptual outcomes.  One, the empirical scenario is re-defining or re-evaluating the capitalist market economy.  Two, it is exposing the limits of ‘creative destruction’ logic of Schumpeter (1911).  Three, it calls to question the adequacy of the current economic modeling and analytical tools.  Four, it is leading the way to the emergence of a ‘new market economy’.

Ogbu (2010) argued further “not since the great depression of the 1930s has the world experienced this kind of economic down-turn.  Now, unlike then, the effects have been widespread, global and faster and the amounts involved staggering.  Unfortunately, the lessons of the 1930s could not be relied upon to provide answers for the current economic crisis.  As each country tries on its own to deal with the problems, the governments are getting more involved with market activities outside the previously accepted limits for a functioning market economy especially in the financial system”.


Theoretically, it is widely accepted that liberalizing the financial system could play a vital role in economic development.  Since the original theoretical analysis which provided a rationale for financial sector liberalization as a means to promote economic development was given by McKinnon (1973) and Shaw (1973), a lot of theoretical and empirical research has been carried out examining the concept in different contexts, countries and time periods (see for example, Abel 1980; Romer 1994; Lucas 1982; Bandiera et al. 2000; Khan and Reinhart 1990; and King and Levine 1990, Demir, 2005).


According to Arestis (2005) a number of writers question the wisdom of financial repression, arguing that it has detrimental effects on the real economy. Goldsmith (1969) argued that the main impact of financial repression was the effect on the efficiency of capital. McKinnon (1973) and Shaw (1973) stressed two other channels: first, financial repression affects how efficiently savings are allocated to investment; and second, through its effect on the return to savings, it also affects the equilibrium level of savings and investment. In this framework, therefore, investment suffers not only in quantity but also in quality terms since bankers do not ration the available funds according to the marginal productivity of investment projects but according to their own discretion. Under these conditions the financial sector is likely to stagnate. The low return on bank deposits encourages savers to hold their savings in the form of unproductive assets such as land, rather than the potentially productive bank deposits. Similarly, high reserve requirements restrict the supply of bank loans even further whilst directed credit programmes distort the allocation of credit since political priorities are, in general, not determined by the marginal productivity of different types of capital.


Arestis (2005) remarked further “the policy implications of this analysis are quite straightforward: remove interest rate ceilings, reduce reserve requirements and abolish directed credit programmes”. In other words, liberalize financial markets and let the free market determine the allocation of credit, where it is assumed that there will be a ‘free market’ with just a few banks, thereby ignoring issues of oligopoly and, of course, of credit rationing problems (Stiglitz and Weiss, 1981). With the real rate of interest adjusting to its equilibrium level, at which savings and investment are assumed to be in balance, low yielding investment projects would be eliminated (Schumpeter’s ‘creative destruction’), so that the overall efficiency of investment would be enhanced. Also, as the real rate of interest increases, saving and the total real supply of credit increases, this in turn will induce a higher volume of investment. Economic growth would, therefore, be stimulated not only through the increased investment but also due to an increase in the average productivity of capital. Moreover, the effects of lower reserve requirements reinforce the effects of higher saving on the supply of bank loans, whilst the abolition of directed credit programmes would lead to an even more efficient allocation of credit thereby stimulating further the average productivity of capital.


In recent years, several papers have been published on the relationship between financial liberalization and growth. Some studies focus on the quantity effects of liberalization while others concentrate on the quality effects of liberalization.  These studies use firm-level as well as cross-country data (see Niels and Robert, 2005). Laeven (2003) quoting from Niels and Robert (2005), in a study finds evidence for the hypothesis that financial liberalization reduces financial constraints of firms.  His study was based on information from 13 developing countries.  Similarly, positive effects of liberalization on reducing financial constraints are found, among others, by Koo and Shin (2004) for Korea, Harris, Schiantarelli and Siregar (1994) for Indonesia, Guncavdi, Bleaney and McKay (1998) for Turkey and Gelos and Werner (2002) for Mexico.  At the same time, however, studies by Jaramillo, Schiantarelli and Weiss (1996) on Ecuador and Hermes and Lensink (1998) on Chile find much less supportive evidence for the positive effect of financial liberalization on reducing financial constraints and inducing investment.


Other studies have used cross-country panel data.  Nazmi (2005) uses data for five Latin American countries and finds evidence that deregulation of financial markets increases investment and growth.  Bekaert, Harvey and Lunblad (2005) for a large sample of countries looked at liberalization of the stock market in particular, opening them up to foreign participation and found support for the view that a type of liberalization spurs economic growth through reducing the cost of equity capital and increasing investment.  Other cross-country analyses are less positive about the quantity effect of financial liberalization.  For instance, Bonfiglioli (2005) using information for 93 countries shows that financial liberalization marginally affects capital accumulation and hence investment.    Moreover, Bandiera et al. (2000) reviewed the impact of financial liberalization on saving based on information from eight developing countries over a 25-year period and found that savings rates actually fall, rather than increase, after financial liberalization.


From the foregoing, it could be seen that findings from extant research on the impact of financial liberalization on investment and growth remains inconclusive.  Further studies, perhaps, at micro (firm)-level may shed greater light as observed by Carruth et al. (1998) “the apparent inconsistencies in the results reveal the crucial importance of disaggregation when attempting to identify the impact of financial liberalization on investment and also highlights the need for appropriate econometric techniques that can integrate both time-series and cross-section information.  Moreover, it is apparent that there is a high degree of heterogeneity across industries which may potentially bias the results from any aggregate-level study.  Given these conclusions, it is clear that the use of company-level panel data, with its even higher level of disaggregation coupled with its greater data variability, is likely to be advantageous…”


1.2       Statement of Research Problem

For more than two decades after independence, the Nigerian financial system was repressed, as evidenced by ceilings on interest rates and credit expansion, selective credit policies, high reserve requirements, and restriction on entry into the banking industry.  This situation, according to Ikhide (1996) inhibited the functioning of the financial system and especially constrained its ability to mobilize savings and facilitate productive investment.  To reverse this situation and in line with the orthodoxy of the time, Nigeria like other developing countries embraced financial liberalization as one of the major planks of Structural Adjustment Programme in 1986.


According to Ikhide (1996) attempts at liberalizing the financial sector in Nigeria have fallen under five main headings – reform of the financial structure, monetary policy reforms, foreign exchange reforms, liberalization of capital movement and capital market reforms.  Reform of the financial structure includes measures designed to increase competition, strengthen the supervisory role of the regulatory authorities and strengthen public sector relationship with the financial sector. In this direction, some measures undertaken include: enhancing bank efficiency through increased competition and management by granting licenses to more banks to operate. Conditions for the licensing of new banks were relaxed. In response, the number of banks increased dramatically from 40 in 1986 to 120 in 1992. A comparable increase in the number of non-bank financial institutions occurred. Strengthening banks supervision and increasing their viability through adequate regulations regarding minimum capital requirements, specifying the range of assets and liabilities they can acquire, introduction of uniform accounting standards for banks to ensure accuracy, reliability and comparability. Two banking laws were promulgated with effect from June 1991, the CBN Decree No. 24 of 1991 and the Banks and Other Financial Institutions Decree (BOFID), No. 25,1991 (CBN, 2004).


There was also monetary policy reforms designed mainly to stabilize the economy in the short run and to induce the emergence of a market-oriented financial sector. Such reforms included: rationalization of credit controls; although credit ceilings on banks were not completely removed, the sector specific credit distributions target were compressed from 18 in 1985 to 2 in 1987 – priority (agriculture and manufacturing) and non-priority (others). Other credit measures enacted were the elimination of exceptions within the ceiling on bank credit expansion, giving similar treatment to commercial and merchant banks in relation to required liquidity ratios and credit ceiling, the modification of cash reserve requirements which is now based on the total deposit (demand, savings, and time deposits), rather than on time deposits only, and the reintroduction of stabilization securities (CBN, 2004).


Interest rate liberalization was aimed at enhancing the ability of banks to charge market-based loans rates and also guarantee the efficient allocation of scarce resources. In 1989, banks were encouraged to pay interest on current account deposits. The rate paid was negotiated between banks and their customers. There was a shift from direct to indirect system of monetary control in June 1993 with the introduction of open-market operations (OMO). Under the scheme, OMO was to be conducted exclusively through licensed discount houses, which were supposed to constitute the open market for government securities. The introduction of OMO was meant to replace the use of direct controls for managing liquidity in the economy.


All these and other reform measures were aimed at removing distortions in efficient allocation of resources to productive investments especially in the private sector.  For according to Khan and Reinhart (1990), economic growth can only be efficient and sustainable if it is coming primarily from the private sector.    In spite of these measures however, theoretical evidence suggest that the impact of financial liberalization on private sector investment in Nigeria is at best marginal (see Busari, 2007; Akinlo and Akinlo, 2007, Ayadi et al, 2009, Uchendu, 1993 and Ndebibo, 2004).  Moreover, there are still few studies at the macro level that address the impact of financial liberalization on private investment in Nigeria (see Oyejide, 1998; Edo, 1995, Ogun 1986).  In two aggregate level studies, Busari (2007 and 2008) and Busari and Fashanu (2009) suggest that liberalization appears to have helped ease the previously binding constraints on private investment in Nigeria.  At a sectoral level of analysis, results from Nzotta and Okereke (2009); Samuel and Emeja (2009), Nwaogwugwu (2008); Ndekwu (1998); Nnanna and Dogo (1999), Emenuga (1996), Nzotta (2004) and Olofin and Afangideh (2008) suggest that liberalization had very little impact, if any, on the behaviour of sectoral investments in Nigeria.

However, many of these macro level studies did not incorporate firm-level data in their analysis and focus essentially on the structural change in the investment behaviour under liberalization using mainly money market indicators. As firms remained the main drivers of the economy, an empirical analysis of investment under financial liberalization that incorporates firm-level investment and macroeconomic data under Post Keynesian framework has become imperative.  In addition, at a time that most countries in the global economic community are re-examining their economic models and financial architecture in response to the economic down-turn, a work of this nature becomes not only imperative but compelling. Moreover, after over two decades of operating a liberalized economic and financial model, an empirical work that will chronicle the impact of liberalization on investment in Nigeria at firm level has become imperative for academic and policy purposes.  This work filled this important research gap.  This was achieved through a firm level and macroeconomic data extracted from the balance sheets and income statements of manufacturing companies quoted on the Nigerian Stock Exchange and published in the NSE Yearly Factbook and Central Bank of Nigeria Statistical Bulletin for the period 1990 to 2009.

1.3       Objectives of the Study

The study examined empirically the impact of financial liberalization on investment in Nigeria using firm level and macroeconomic data.  To achieve this objective, the study strived to:

  1. Investigate how financial liberalization has evolved over time in Nigeria and the bank development indicators that influenced such evolution.
  2. Identify the various financial liberalization indicators and how these indicators impacted on investment of manufacturing firms in Nigeria.
  3. Examine the impact of financial liberalization on aggregate assets as a determinant of investment decisions of manufacturing firms in Nigeria.
  4. Ascertain the impact of financial liberalization on macroeconomic measures of uncertainty as determinant of investment decisions of manufacturing firms in Nigeria.

1.4       Research Questions

The study essentially sought to answer the following questions:

  1. How did financial liberalization evolve over time in Nigeria and what are the bank development indicators that influenced such evolution?
  2. What are indicators of financial liberalization and how do these indicators impact on investment of manufacturing firms in Nigeria?
  3. What is the impact of financial liberalization on aggregate assets of firms as determinant of investment decisions of these firms in Nigeria?
  4. Does financial liberalization have any impact on macroeconomic measures of uncertainty as determinants of investment decisions of manufacturing firms in Nigeria?

1.5       Research Hypotheses

To achieve the above objectives, the following hypotheses were investigated in the study:

  1. Financial liberalization is not positively and significantly related with bank development indicators in Nigeria
  2. Financial liberalization is not positively and signficantly related with firm level investments in Nigeria.
  3. Financial liberalization is not positively and significantly associated with aggregate assets of firms as a determinant of firm level investments in Nigeria.
  4. Financial liberalization is not positively related with macroeconomic measures of uncertainty as determinants of firm level investments in Nigeria.

1.6       Scope of the Study

The study focused on the impact of financial liberalization on investment in Nigeria using firm level and macroeconomic data. In other words, only manufacturing firms quoted in the Nigeria Stock Exchange were covered in the study.  In line with previous studies with similar orientation and the dynamic nature of investment models, only firms which have remained in existence continuously for at least five years after the initial year (1990) were covered.  Moreover, only manufacturing firms were included in the data set because physical capital accumulation (investment) was the focus of the study. Financial and insurance firms are highly leveraged entities and their investment horizon is somewhat different from those in the real sectors.  The exclusion of diverse sectors such as commerce and agriculture helped keep firm heterogeneity in the sample under control.

Furthermore, only manufacturing firms with less than 50% government ownership were included in the sample.  State owned enterprises (SDEs) have been subject to different managerial procedures than privately owned ones.  Since these enterprises should be understood as a part of the country’s long-term development plans, their financing and investment decisions are not necessarily expected to follow the models of their private competitors.


1.7       Significance of the Study

Financial liberalization and the role of government in economic growth and development have once again occupied the front burner in national and international discourse because of the global financial and economic melt-down that is ravaging the world and the apparent inability of current financial and economic theoretical models to reverse the situation.  It must be stated that Nigeria is not immune from the global scourge.  Indeed, the country like many others is currently examining and re-joggling its economic models to find the best mix to achieve her economic aspirations.  Moreover, the country has operated a liberalized economy for over two decades but sadly enough, there are still few empirical works in this direction.  To this end, a study of this nature at this time will be of immense benefits for policy and academic purposes.  Specifically, the following stakeholders may find the result of this work useful:

  1. Manufacturing Firms

Existing theoretical evidence suggest that financial liberalization has impacted minimally on investment in Nigeria.  A major theoretical underpinning of financial liberalization in the literature is that financial liberalization will alleviate financial restrictions and allow market forces determine real interest rates which in turn will encourage savings and greater investment.  Greater investment then is expected to lead to economic growth and development. If this expectation is not the case in Nigeria as suggested by theoretical evidence, it will stand to reason that some institutional and structural factors may be responsible for this state of affairs.  Acquiring empirical evidence in this direction will be of strategic importance for manufacturing firms to enhance their performance.

  1. Policy Makers

This work will also be of importance to policy makers such as the Federal Government and its agencies in providing a platform for designing economic and financial models that will enable the government deliver on its mandate of providing appropriate policy framework for private enterprise to thrive in Nigeria.  At a time that traditional economic models and financial architecture appears unable to provide solutions to economic downturns, the result of this work may provide the missing link.

  1. Financial System Regulators

It used to be a long-held view of the orthodoxy of the 1970s and early 1980s that liberalizing the financial markets would encourage better savings mobilization and greater allocative efficiency of capital. The underlying belief in the efficiency of financial markets led many to assert that with the onset of deregulation, higher levels of investment and growth would be achieved.  The liberalization process was expected to eliminate inefficiencies in financial intermediation and result in greater depth of the financial system.  This line of thought motivated the Nigerian Government to pursue liberalization of the country’s financial sector as part of the major planks of the Structural Adjustment Programme (SAP) in 1986.  After over two decades, it is imperative that the impact of the liberalization be empirically evaluated at firm level.  This is at the backdrop that understanding the investment behaviour of firms forms the major step in designing appropriate macro-economic policies that will drive investment.  This is where the result of this work may be useful to regulatory authorities like the Ministry of Finance, Central Bank of Nigeria, Nigeria Deposit Insurance Corporation, Securities and Exchange Commission, etc.

  1. Academia and General Public

The literature on financial liberalization has a long pedigree.  The literature commenced with the seminal work of McKinnon and Shaw in 1973 which focused on what they termed ‘financial repression’ and the need for developing economies to allow real interest rates along with other financial indicators to be determined by market forces.  Since that time, over hundreds of empirical studies have been carried out examining the hypothesis in many different contexts.  Initially, the debate focused on the effects of so-called ‘financial repression’ – low or negative real interest rates on savings and investment levels in developing countries.  In more recent times, researchers have extended the debate to consider other effects of financial repression on economic growth, financial crises and poverty, etc.  Currently, significant research is being conducted on the potentially destabilizing effects of financial liberalization (the converse of financial repression) on global financial markets.  Empirical works along this line is still at rudimentary stages in Nigeria.  The result of this work may act as the spring board for other researchers to do more firm-level studies on the impact of financial liberalization on investment.  It may also add to the existing body of knowledge on the subject of financial liberalization, investment and economic growth. The general public may also find the result of the work invigorating and possibly extend the frontiers of knowledge on financial liberalization and investment nexus.

1.8       Limitations of the Study

Like every research work, the study had some constraints.  First, resources in terms of money and time were a major constraint.  Collecting data required from the relatively large number of manufacturing firms entailed a great deal of work and money. Getting the annual reports and statements of accounts from the sample firms posed a problem given the poor habit of data preservation in the country.

Moreover, as observed by Gezici (2007), the absence of Generally Accepted Accounting Principles in line with international standards posed a problem in the construction of data set.  Most manufacturing firms in developing countries do not follow international accounting standard in their financial statements especially in area of inflation accounting. The lack of full inflation accounting is likely to cause some measurement error in the variables.  Inflation adjusted accounting technique is still not very popular in Nigeria despite the fact that the country has been a highly inflationary environment.  For instance, if the figures for land were not revalued yearly this may introduce measurement error in the calculation of capital stock.  Moreover, since certain balance sheet categories that represent stock items are more prone to the price level changes than others, comparing these items might cause distortions in the analysis.  Even though accounting reports usually employ certain revaluation methods but only for tangible fixed assets, these revaluation rates might not closely follow the relevant inflation rates.  But as also observed by Gezici (2007) these issues are common to research using firm level accounting data from developing countries.

It must also be mentioned that there is still not enough local literature on the impact of financial liberalization especially at firm level in Nigeria.  That means that foreign theoretical and empirical perspectives constituted the bulk of the data used in the literature review.  The implication is that any observed local trend in the analysis of the impact of financial liberalization was without any local theoretical foundation. However, these limitations did not invalidate the result of the study.

1.9       Operational Definition of Terms

Some terms have been defined in context to make them more responsive for the usage of the study. These include:


Investment is the change in capital stock during a given period usually at the end of an accounting year, net of depreciation.  Consequently, unlike capital, investment is a flow term and not a stock term (Trygve, 1960).  The investment flow in period t (It) can be calculated in real terms as the difference between the capital stock at the end of the period and the capital stock at the beginning of the period excluding replacement capital or physical depreciation rate of capital.

Capital Stock

Capital stock refers to Tangible Fixed Assets on the balance sheets of manufacturing companies including accumulated depreciation.  Specifically, it is the sum of machinery, plants, equipment, buildings, land, property, other tangible assets, and construction-in-progress. Inventories are excluded from the calculations. Under the Nigerian Accounting Standard Rules, tangible assets are recorded at historical cost and revalued at the end of every fiscal year according to the revaluation rates provided by the Nigerian Accounting Standard Board.  Land however, will be an exception to this revaluation rule.  This is because land is usually not revalued.  Therefore, it will not be possible to exclude land from the calculation of capital stock.

Macroeconomic Uncertainty (U)

Uncertainty is the probability that expected outcome may not be realized due to movement in uncertainty variables. In the context of this study, macroeconomic measures of uncertainty include changes in exchange rate, inflation and interest rate.  Movements in these macroeconomic indicators can affect the realization of investment outcome.  Therefore, uncertainty is the probability that the future rewards from an investment may not be realized or partially realized. Within the realm of investment uncertainty cannot be fully forecasted or accurately determined beforehand.  Keynes himself best illustrates the point:  “By uncertainty, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject in this sense to uncertainty…Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that, in which the prospect of a European war is uncertain, or the price of copper and the rate of interest 20 years hence, or the obsolescence of a new invention or the position of private wealth owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatsoever – we simply do not know” (Keynes, 1936).

Financial Liberalization Variables (FIN)

These are measures (proxies) of financial liberalization. They represent essentially the depth of financial deepening and market development.  They are defined as follows:

  1. M2-to-GDP ratio: This is broad money aggregate and measures the depth of financial sector development and has inducement to saving-investment. It is calculated as the natural log of the ratio of M2 (comprising deposits, currency outside deposit money banks, quasi-money liabilities of these institutions) to real GDP.
  2. Private Sector Credit-GDP ratio: Private Credit equals the value of credits by financial intermediaries to the private sector divided by GDP. The measure isolates credit issued to the private sector and therefore excludes credit issued to governments, government agencies, and public enterprises. Also, it excludes credits issued by central bank. It is obtained as the natural log of the ratio of private sector credit to real GDP.
  3. Stock Market Capitalization-GDP ratio: This is a measure of stock market capital mobilization or stock market liquidity and risk diversification. This measure equals the total market value of listed shares divided by GDP. The assumption behind this measure is that overall market size is positively correlated with the ability to mobilize capital and diversity risk on an economy wide basis. It is obtained as natural log of the value of listed shares to real GDP.

Public Sector Credit-GDP ratio: This is a measure of total domestic credits that accrue to government and is indicative of whether crowding out effect has occurred or not.  It is obtained as the natural log of the ratio of public sector credit to real GDP