Financial development and economic growth in Kenya

Abstract

The relationship between financial development and economic growth is a crucial issue for both developing and developed countries. The importance of this issue depends on the financial intermediation functions and their effects on the economic growth process. In this sense, many economists have made theoretical and empirical studies on the relationship between financial development and economic growth and the direction of this study in recent years. Therefore this study seeks to empirically explore the causal link between the level of financial development and economic growth in Kenya for the period 1967 to 2006. To achieve the objectives, both Granger-causality analysis and Error Correction Model (ECM) were applied based on the theory of cointegration. The results of the cointegration analysis provide evidence of a stable long run relationship between economic growth and financial development in Kenya. This implies that whenever there is a shock to the system, short run adjustments occur to re-establish long run equilibrium. With respect to the direction of long run causality, the granger-causality analysis indicated that there is a bidirectional relationship running from financial development to economic growth and vice versa. Thus an increase in the level of financial development would raise real GDP while improved economic growth would trigger higher financial development. In policy terms, the findings imply that Kenya can accelerate economic growth by improving the financial sector since financial development can be an engine of growth in this country. Financial deepening and further institutional reforms should constitute a successful strategy towards enhancing Kenya's economic performance.