Financial Integration and Macroeconomic Volatility in Kenya

Abstract

Kenya has witnessed increased financial integration following financial liberalization in the late 1980s which led to increased foreign private capital flows. On one hand financial integration is considered to complement domestic investment, enhance economic growth and reduce macroeconomic volatility by promoting credit and risk sharing. However, on the other hand private capital can enhance macroeconomic volatility by exposing domestic market to external volatility. Kenya has experienced low and volatile economic growth in the past four decades even in the phase of increased private capital flows in the 2000s. It is therefore necessary to identify the effect of financial integration on macroeconomic volatility in Kenya. In order to address this issue this study estimated a VAR model using secondary time series data for the period 1970 to 2011 to identify the effect of financial integration on macroeconomic volatility using foreign private investment flows as a measure of financial integration and output, investment and private consumption volatility as measures of macroeconomic volatility. The study found that financial integration reduces investment volatility but has no effect on output and private consumption volatility. This shows that the country has not reaped the full benefits of financial integration with respect to reducing consumption and output volatility. It is therefore essential that policy makers formulate policies that enhance financial integration which in turn reduces macroeconomic volatility in Kenya.