CHAPTER ONE

1.1 BACKGROUND TO THE STUDY:

Over the last two decades the determinants of economic growth have attracted increasing attention in both theoretical and applied research. Yet, the process underling economic performance is inadequately conceptualised and poorly understood, something which can be partly attributed to the lack of a generalized or unifying theory and the myopic way conventional economics approach the issue (Artelaris et al, 2007).

Economic growth in a developing economy rest on an efficient financial sector that pools domestic saving and mobilizes foreign capital for productive investments. In the developing countries, industries need more funds to increase their investment so that they can meet globalization constraint.

Hicks (1969) argues that in the nineteenth century, many private investment projects were so large that they could no longer be financed by individuals or from retained projects. The stock market then serves as an important tool in the mobilization and allocation of savings among competing uses which are critical to the growth and efficiency of the economy (Alile, 1984).

Recent theoretical literature on financial development and economic growth identifies three fundamental channels through which capital markets and other financial market and economic growth may be linked (Pagano, 1993): First, capital market development increases the proportion of savings that is channelled to investments; Second, capital market development may change the savings rate and hence, affect investments; Third, capital market development increases the efficiency of capital allocation.

It is well known that stock market and other financial market institutions play a major role in the economy through enhancing the efficiency in capital formation and allocation. They enable both corporations and the government to raise long-term and short term capital which enables them to finance new projects and expand other operations, In this regard, it is observed that the performance of the economy is boosted when capital is supplied to productive economic units. Furthermore, as economies continue to develop, additional funds are therefore needed to meet the rapid expansion and the stock market therefore serves as an appropriate avenue for the mobilization and allocation of resources among competing uses which are critical to the growth and efficiency of the economy.

In another study by Alile (1997), he argued that the determination of the overall growth of an economy depends on how efficiently the stock market performs its allocative functions of capital. Stock markets are a vital component for economic development as they provide listed companies with a platform to raise long-term capital and also provide investors with a forum for investing their surplus funds. As economies develop, more funds are needed to meet the rapid development and the stock markets and banks serve as an important source in the mobilization and allocation of savings among competing uses which are critical to the growth and efficiency of the economy. Stock markets fuel economic growth through diversification, mobilizing and pooling of savings from different investors and availing them to companies for optimal utilization.

The causality relationship between financial development with particular emphasis on stock market, banks and economic growth issue has stirred debates in academic circles and the controversy has arisen from the fact that the relationship between the two variables is dynamic in nature.

Theoretical literature has offered conflicting predictions on the role of financial development and economic growth. Schumpeter (1911), Gurley and Shaw (1955), Goldsmith (1969), McKinnon (1973) And Shaw (1973) all argue that financial repression which characterised the Less Developed Countries (LDCs) tend to retard economic growth. The causality relationship between economic growth and financial development is a controversial issue. Basically, the debate has been centred on whether it is the financial development that leads the economic growth or economic growth leads to financial development. This “financial development economic growth puzzle” is complicated by another view that the relationship is dynamic in nature. most of the related researches done in the past three decades mostly focused on the role of financial development in stimulating economic growth, and most work are cross country research none in the recent years focuses specifically on Nigeria.

It is particularly true that in the emerging economies, such as Nigeria, the evolution of stock market has great impact on the operation of banking institutions (Levine and Zervos, 1998; Khan and Senhadji,2000). Thus, domestic stock market development is expected to have significant relationship with economic growth. A wide theoretical debate is concerned with the fundamental relationship between financial development and economic growth.

Recent studies shed some light on the simultaneous effect of banks and stock market development on growth rather than a separate impact, Theory gives contradictory predictions about the incidence of financial development on economic growth, and about the separate impact of banks on growth and financial markets on growth. Boyd and Prescott (1986) argue that banks ease information frictions and therefore resource allocation while Stiglitz (1985) and Bhide (1993) defend the idea that banks are more efficient than equity markets in improving resource allocation and corporate governance. Some theories argue that banks and stock markets contribute together to economic growth by improving information dissemination and reducing transaction costs.

A growing body of work demonstrate a strong positive link between financial development and economic growth and there is evidence that the level of financial development is a good predictor of future economic development, it is also believed that a well functioning financial system is vitally linked to economic growth in countries with larger banks and more active stock market grow faster. A growing body of works as shown that the development of financial market and institutions is a critical part of the growth process and far from the opinion that the financial system is responding passively to economic growth and industrialization.

In contrast, Robinson (1952) argues that banks respond passively to economic growth and Lucas (1988) states that economists "badly over-stress" the role of the financial development. Empirically, King and Levine (1993a) show that the level of financial inter-mediation is a good predictor of long-run rates of economic growth, capital accumulation, and productivity improvements. Although all the existing evidence suggests that well developed financial intermediaries assist economic development, there is little evidence on the role of stock market and banks in economic growth in Nigeria. This empirical gap is notable because the data suggest that stock market is an integral part of financial development. Thus to have a comprehensive view of the tie between financial and economic development in Nigeria, there must be a conceptual and empirical exploration of the relationship between the functioning of the equity market, bank and economic growth using Nigeria as a case of study.

1.2 STATEMENT OF PROBLEM:

Before independence, the establishment of the national bank of Nigeria in 1933 represented the successful effort of Nigerians to establish a commercial bank that caters for their business interest. With the success recorded other five banks namely: the farmer’s bank (1947), the African continental bank (1948), pan African bank (1951), the standard bank of Nigeria (1954), and wema bank (1954), were established. Apart from these five indigenous banks, there were over twenty other banks established but collapsed before the end of 1954, But since then, there has been a tremendous growth in the commercial banking sector of the financial system since 1950. From five commercial banks in 1950 to 120 by 1992 consisting of 66 commercial banks and 54 merchant banks to 126 commercial banks by 1996. However following difficulties, in the banking system the numbers of banks plummeted to 89 in 2003. The number also fell to 25 banks by 2006 as a result of bank consolidation and recapitalization.

The banks through modern technology and branch networks source surplus funds and channel these into the most productive sector of the economy. The deposit of these banks represents the reservoir from which financial needs of business are supplied. At the same time the capital market has also undergone a number of changes, the stock market was created in 1960 to foster capital market development in order to facilitate cooperation among various segment of the economy and to direct efforts towards economic growth and development, the exchange which commenced operation in 1961 with only 19 securities traded on its floor and by 1996 there were 189 companies listed. As at the end of 1999 there were six branches at Kaduna, Port Harcourt, Kano, Onitsha, Ibadan and Lagos, which also serves as the head office of the exchange, each of the branches is with a trading floor, in 1981 the market capitalization of the Nigerian stock exchange was five (5) billion naira, by 1990 market capitalization was 16.3 billion naira and by1999 it was 300 billion naira, five years later the market capitalization rose to 2,112.5 billion naira and by 2007 it hit an all time high of13,294.6 billion naira before the Market capitalization nose-dived from its all time high of N13.5 trillion in March 2008 to close at N9,918.2 billion by the second week of January 2009. At a time, banks were financing about 65% of the Nigerian capital market through margin facilities granted to investors and stock broking firms. Many banks abandoned or sidelined their core operation of providing credit to the real sector in favour of "playing" the capital market for short-term speculative activities that seemed to pay off up to March 2008 before the cancer that afflicted the market set in. It is estimated that the total exposure of banks to the capital market in terms of trapped funds is in excess of N1 trillion. Thus, the capital market place became overheated with so much speculative activities of banks that by the time the market caved in, it became difficult for them to exit through the narrow door as there were no mega investors to "check them out". The Nigerian capital market was no longer seen as a market for long-term funds, but that of a short one. It could be noted that between 2005-2008, the banks embarked on unguarded short term treasure hunting spree from the capital market as their speculative activities soon overheated the capital market. There have been questions agitating minds about the sudden turn of events concerning the financial market, why is it that the growth was drastic and not gradual? Why is the crash so sharp and has become difficult for the financial market to rebound along with other market around the world?

It can assumed that this year on year performance of the financial market in terms of the market growth before the meltdown is due to the improvement in the economy, also the ability of the banks to be able to raise such huge amount of capital from the public is dependent on the buoyancy of the real sector of the economy, but it is not known if the happenings in the financial sector is commensurate with the real sector and how does this play on the economy at large or is it the economy that is responsible for the events in financial market. It is expected that the various development on the financial market have some input on economic growth.

The Nigeria economy is one of the largest in Africa, but theoretical and empirical research have given little emphasis on the nature of financial development and economic growth bearing in mind the recent downturn in the financial market and how it affects the real sector of the economy and this have generated a lot of controversies and further research needs to be carried out on the nature of relationship between the financial sector and economic growth in order to ascertain the link between financial development and economic growth. The major question is that does the level of economic growth experienced over the years commensurate with level of development in the financial sector, vice a vice the stock market and banking industries, what is the nature of the relationship between financial development and economic growth and the direction of causality relationship which still remains unresolved. This study therefore sought to examine the presence of causal linkage if any, between financial development and economic growth in Nigeria.

​1.3. OBJECTIVES OF THE STUDY:

The principal objective of this study is thus to re-examine the financial development-economic growth puzzle from the perspective of bank performance and stock market development using Nigeria as a case study. This study also intend to assess the individual impact of both on economic growth in Nigeria as a case study bearing in mind the recent reforms that has occurred in the financial sector of the country. The objectives are aligned as follows.

• To re-examine the financial development and economic growth puzzle.

• To assess the individual impact of stock market and bank performance on economic growth.

• To examine whether the level of development in the economy reflect in the financial market development and vice versa.
• To make recommendations as to how the operations of the market could be improve to boost economic growth and development of Nigeria.

1.4. RESEARCH QUESTION:

• Is there a dynamic linkage between financial development and economic growth?

• Is the impact of stock market and banks deepening on economic growth statistically significant?
• Does the level of development in the economic reflect in the financial market and vice versa?

1.5. RESEARCH HYPOTHESIS:

• There is no dynamic linkage between financial development and economic growth.

• There is insignificant individual and combined impact of stock market and bank deepening on economic growth.

• The level of economic growth is not reflected in financial market development.

• There is no causal relationship between stock market, bank performance and economic growth.

• There is no bi-directional causality between financial development and economic growth.

1.6 SIGNIFICANCE OF THE STUDY:

This study is a good source of information for researchers, as the results that emerge from this study will inform debates on this subject. This research further contributes to empirical literature on economic activity and financial market growth in Nigeria. The study is also a valuable source of information for policy formulation.

1.7 SCOPE AND DELIMITATION OF THE STUDY:

This research work only looked at a particular part of the economy (the financial sector). This work did not cover all the facets that make up the financial sector, but focus only on the capital market and its activities as it impacts on the Nigerian economic growth. The empirical investigation of the impact of the capital market on the economic growth in Nigeria was restricted to the period between 1980 and 2010 due to the non-availability of some important data.

1.8 ORGANIZATION OF THE STUDY:

The study is divided into five (5) chapters and organized as follows: Chapter one form the introduction part, this is where the main theme of the research is given. It comprises of the statement of the problem, objectives of the study, research questions and hypotheses, significance of the study, scope and delimitation of the study and organization of the study.

Chapter two is the literature review of the impact of financial market on the economic growth of Nigeria. Chapter three forms the research methodology which includes sources of data, method of data analysis and model specification. Chapter four is the data analysis while chapter five includes the summary, conclusion and recommendations.