Financial liberalization and economic growth in Kenya: a var analysis

Abstract

This paper traces the impact of financial liberalisation on financial deepening and growth through the increment in credit channel to the private sector following financial deregulation. Based on the evidence of the sample period 1991-2002, it was found that the growth of the financial sector and the real sector moved interdependently in the period of financial liberalization (reverse-causation) in Kenya. Deepened financial institutions makes it possible for credit availability and capital (including the foreign finance element) that would otherwise either be unavailable in the absence of financial institutions or would be expensive to borrow under a system of financial repression. Economic growth on the other hand is expected to raise income levels and hence savings mobilisation through the interest rate channel. Consequently, the efforts in liberalization and reforms that are designed to improve efficiency of financial intermediaries will lead to economic growth by increasing demand and supply of credit to the productive private sector enterprises. Economic growth on the other hand could contribute to the growth of the financial sector if the demand for financial services increases. The results show that financial reforms undertaken in Kenya impacted positively on economic performance. There was an improvement in financial deepening but deeper financial liberalisation still needs to be undertaken. Credit to the private sector continued to rise. It appears that the outcome of the process of financial liberalization is better than the period of financial repression since access to credit rose following liberalization and other financial services have been developed (financial innovation). Therefore, further liberalization of the sector would be beneficial to growth.