The Finance – Growth Nexus in Lesotho: Causality

Revelations from Alternative Proxies #

Powell L. Mohapi ∗
Department of Economics
National University of Lesotho

Sephooko I. Motelle
Research Department
Central Bank of Lesotho

Abstract
The Central Bank of Lesotho in 2002 issued a decree that the financial system of the
country – in particular the process of intermediation – should be given a massive
facelift in order to further enhance economic growth. Given the conflicting
hypotheses in the finance – growth causality, that decree can be viewed as putting the
cart before the horse. This paper provides an empirical basis upon which such a
decree (or a different one) should have been issued. Causality between five
alternative proxies of financial intermediation on the one hand and real GDP growth
on the other is the subject of this paper. Time series properties of the variables –
from unit roots to cointegration – are studied in order to establish the appropriate
causality test to use between the conventional Granger causality test and the VECM-
based causality test. Four out of five financial intermediation proxies together with
the growth variable are non-stationary. However all these non-stationary proxies turn
out to be not cointegrated with growth. Only one proxy Granger causes growth while
for the rest there is no causality in either direction between them and growth. No-
cointegration coupled with non-causality robustly reveals that the finance – growth
nexus does not hold for the Lesotho economy.

Keywords: Financial Development, Economic Growth, Causality, Cointegration

JEL Classification: E44, O11, O16

#
This paper was prepared for the 11th African Econometric Society conference held in Dakar, Senegal on July
5 – 7, 2006.
∗
Corresponding Author: Mailing: P.O. Roma 180, Lesotho; Tel: +266-2221-3594; Fax: +266-2234-0000; E-
mail: pl.mohapi@nul.ls / plmohapi@yahoo.co.uk
1. Introduction
Indicators such as bank liquidity ratio, credit deposit ratio, interest rate spread coupled with
the structure and composition of the financial sector in Lesotho suggest that Lesotho’s
financial intermediation process is rudimentary. The workshop that was hosted by the Central
Bank of Lesotho, ignited by this state of affairs, concluded that ways to improve financial
intermediation should be explored so that in the final analysis economic activity can be
enhanced. Given the conflicting hypothesis on the finance – growth causality, the conclusion
of that workshop can be viewed as putting the cart before the horse. This paper provides an
empirical basis upon which such a conclusion (or a different one) should have been based.
The literature on economics is replete with the finance-growth nexus, and many studies link
financial sector development directly with economic growth

Lesotho is currently working towards facilitating a private-sector-led growth. The financial

sector is the pivotal to this strategy. On this position Schumpeter (1934/1961) once said:
“Bankers are the gatekeepers of capitalist economic development. Their strategic function is
to screen potential innovators and advance the necessary purchasing power to the most
promising.” This is because the financial institutions provide the much needed funds to
finance viable projects.

2. Financial Intermediation in Lesotho: Basic Indicators

Financial intermediation in Lesotho is generally considered to be at “low levels” or in “its
infancy”. A testimony to this is that the financial sector in Lesotho is dominated by banking
institutions. Concentration is such that there are only three banks operating in the economy-
the Standard Bank Group Lesotho, Nedbank, and First National Bank. Besides, all the banks
are subsidiaries of foreign banks, following the closure and privatization of two state banks,
the Lesotho Agricultural Development Bank (LADB) and Lesotho Bank, respectively.

At the end of the third quarter of 2004, commercial bank liquidity hovered at 60.7 percent.
This indicates that banks prefer to hold assets of a relatively shorter maturity, such as money
market instruments, to the detriment of credit extension, which is of a relatively longer
maturity. A second measure of financial depth is the credit to deposit ratio. At the end of the

1
same period this ratio stood at 25.3 percent, demonstrating that banks are still reluctant to
extend credit (Central Bank of Lesotho; 2004).

It is important to isolate credit extended to the private sector from that issued to government
agencies and public enterprises. The underlying assumption is that private sector credit
generates increases in investment and productivity to a much larger extent than public sector
credit. And private sector credit reflects the strict evaluation of project viability by
intermediaries, and this leads to improved quality of loans to this sector than to the public
sector. In Lesotho banks lend about 13.8 percent of total deposits to the private sector, and
this is a far cry from what occurs in comparable economies of Swaziland and Namibia with
about 70 and 95 percent respectively (Central Bank of Lesotho; 2004).

Another indicator pointing to the rudimentary financial intermediation process the spread
between the lending and deposit rates that is quite large. At the end of September 2004, it
stood at 8.5 percent. This is not desirable considering that the narrower the spread the more
effective financial intermediaries are in the economy. In addition, compared to the inflation
rate, the real deposit rates remained negative, and this is also worrying (Central Bank of
Lesotho; 2004).

3. Finance and Growth in the Literature

3.1 General Views
Growth has for many decades been perceived as a central topic in development economics,
being viewed as a necessary precondition for development. The emphasis of development
economics has been on planning and resource allocation mechanisms that were separate from
those advocated by mainstream market-oriented economics (Watchel 2003). Levine (1997)
notes a remarkable skepticism that development economists have about the role of finance in
the fact that in a collection of influential essays on the subject none of them mentions the role
of finance and in another survey of the subject finance doesn’t make the list of omitted
topics.

2
Schumpeter was probably the first to acknowledge the role of finance in innovation and
production process, however the discussions around financial intermediation found their root
in the seminal contributions of Gurley and Shaw (1955), Goldsmith (1969) and McKinnon
(1973). The role of the financial sector in any economy is to direct resources from saver to
investment projects. That is why on a theoretical level it is generally accepted that financial
intermediation promotes growth.1 Surveys in the subject describe four ways in which this
comes about (Levine, 1997; Pagano, 1993 and Wachtel, 2002, 2003). Firstly, the financial
sector improves the screening funds-seeking investors and then monitors the funds-receiving
investors which improves the allocation of resources. Thus financial intermediaries play the
roles of “gate-keepers” and ‘delegated monitors’ (Schumpeter, 1934/1961; Ncube and Senbet
1997 and Guinnane 2002). Secondly, the financial sector encourages the mobilization of
savings by providing diverse instruments that match the differing preference of savers. Third,
lowering of transaction costs, screening and monitoring costs through economies of scale.
Lastly, financial intermediaries provide for risk management and liquidity.

3.2 The Finance-Growth Nexus Debate

Despite the seemingly theoretical consensus on the role of financial intermediation in
economic growth there is still a debate that remains unsettled on these two issues. Robinson
(1962) and Stiglitz (1994), have questioned the importance of the financial system in
promoting economic growth. They proposed that economic growth creates additional
demands for financial services, which in turn may bring about more developed financial
sectors. This gives rise to three conflicting hypotheses about the causal relationship between
economic growth and financial intermediation. The debate is on whether financial
intermediation causes economic growth or economic growth causes financial intermediation.
The third possibility that cannot be ruled out is bidirectional causation between the two.

Studies that examine the causality between financial development and economic growth take
two broad econometrics approaches. Gelb (1989), Fry (1997) King and Levine (1993) Rajan
and Zingales (1998) and Levine and Zervos (1998) have used national cross-sectional data to

1
Several theoretical studies have lent support to this view. Examples are Greenwood and Jovanovic (1990),
Levine and Zervos (1998). A survey by Wachtel (2002) shows that there is consensus about the role of finance
in growth.

3
model the relationship between financial development and economic growth. These studies
tend to support the hypothesis that the causality runs from financial development to
economic growth. Country case studies that support this supply-leading hypothesis include
Bhattacharya and Sivasubramanian (2003) for India.

Accepting the generalization of finance leading growth is dangerous and cannot be

extrapolated to inform policy in any given country unless prior investigation has been carried
out. Demand-following hypothesis and bidirectional causation are also prevalent. Boulila
and Trabelsi (2004) results for the Middle East and North African countries reveal causality
running predominantly from growth to finance. Country case studies for Fiji and Malysia by
Waqabaca (2004) and Ang and McKibbin (2005) further support the demand-following
hypothesis. Demetriades and Hussein (1996:387) conduct a variety of causality tests between
financial intermediary development and real GDP for 16 developing countries and find that:
considerable evidence of bidirectional causation and some evidence of reverse causation’.
Neusser and Kugler (1996:645) carried out cointegration and causality tests for the 13 OECD
countries between 1960 and 1994 and found a feedback from manufacturing GDP to
financial intermediation activity and argue that: ‘It is hard to ascertain the originating
direction of causality once the feedback process is under way.

There is a further body of evidence that shows a weak or non-robust link between financial
intermediation and economic growth. Neusser and Kugler (1996) found that the causal link
between financial development and economic growth is weak, especially for the smaller
countries. Chang (2002) results for China supports neither the demand-following hypothesis
nor the supply-leading hypothesis. Shan and Morris (2002) reject the supply-leading
hypothesis but neither find support for the demand-following one in a cross-country study of
19 OECD countries. Dawson (2003) found the link between finance and growth to be
insignificant for 13 Central and Eastern Europe countries. Allen and Ndikumana (2000) also
found positive but insignificant effect of finance on growth from a sample of 11 SADC
countries. Turkish evidence is sensitive to the choice of proxies in that for some measures of
financial intermediation finance causes growth while for some measures growth causes
finance (Kar and Pentecost, 2000).

4
4. Framework of Analysis
4.1 Econometric Methodology
Given the conflicting hypothesis on the causality between financial intermediation and
economic activity, for any given country such causality is an empirical question. Causality
tests between alternative proxies of financial intermediation and real GDP growth are carried
out. The standard procedure of testing for causality is the Granger causality test specified as:

yt = µ1 + ω1 ( L) xt −i + ψ 1 ( L) yt −i + ε 1t
(1a)
xt = µ 2 + ω2 ( L) xt − i + ψ 2 ( L) yt − i + ε 2t

In this system xt Grange causes yt if ω1 ( L) is statistically not equal to zero. Similarly,

yt Granger causes xt when ψ 2 ( L) is statistically not equal to zero. If none of the two

scenarios is true then there is no causality between xt and yt . However if both are true

then there exists feedback or bidirectional causality between xt and yt .

This bivariate VAR can succinctly be written as

Xt = µ + Θ(L)Xt − i + ε t (1b)

y 
in which X =  t  . However, this conventional Granger causality test becomes valid only if
 xt 
the variables are stationary (Granger, 1988). In the event that the variables involved are non-
stationary then several options are open to the analyst depending on whether such variables
are cointegrated or not. If the non-stationary variables are not cointegrated, they enter (1a) in
differenced form.2 If on the other hand they are cointegrated then the alternative procedure is
the VECM representation of the VAR used in the conventional test. This approach has been
used in the finance – growth causality studies, among others, by Kar and Pentecost (2000)

2
An alternative to this would be to find a stationary instrumental variable and use it.

5
and Boulila and Trabelsi (2004) as well as in the causality between twin deficits by Kouassi,
Iyoha & Kymn (2005). The mathematical representation of the latter is:

∆yt = ς 1 + φ1 ( L)∆xt −i + ϕ1 ( L)∆yt −i + α1ECM t −1 + ε1t

(2a)
∆xt = ς 2 + φ2 ( L)∆xt − i + ϕ2 ( L)∆yt − i + α 2 ECM t −1 + ε 2t

In this specification ECM is the error correction term β T X in which β T = (β1 β 2 ) is the
cointegrating vector. Parameters α1 and α 2 are elements of the adjustment vector.3 In this
specification there are two sources of causality. System (2a) exhibits unidirectional causality
from xt to yt if ϕ 2 ( L) ≠ 0 and α 2 ≠ 0 in the statistical sense. Non causality in either

direction is defined by φ1 ( L) = 0, ϕ 2 ( L) = 0 and α1 = α 2 = 0 (Kouassi et. al. 2005). The

relevant testing procedure in both systems – (1a) and (2a) – is the Wald F – test.
Therefore the compact representation of system (2a) is:

∆Xt = ς + Γ(L)∆Xt −i + αβ T X t −1 + ε t (2b)

The critical distinction between the treatment of non-stationary, non-cointegrated variables

and non-stationary, cointegrated variables is the inclusion of the ECM
term ΠXt −1 = αβ T Xt −1 in the latter to take into account the equilibrium relationship of the
variables implied by the presence of cointegration.

Figure 1 below characterizes the modeling philosophy used in this investigation.

3
This is the adjustment vector α that combines with the cointegration vector β T to form the matrix of long-run
parameters Π = αβ T .

6
 Figure 1: Causality testing options

Causality Testing

X and Y are I(0) X is I(0) & Y is I(I) or X and Y are I(1)

Y is I(0) & X is I(1)

X & Y are not X & Y are

cointegrated cointegrated

Granger Granger Causality

Causality with I(0) variables in
with variables levels and I(1)
in levels variables in first
differences

Granger Causality VECM – based

with variables in Causality Test
first differences

4.2 The Variables

In finance – growth nexus studies growth is measured either by rate of change of real GDP,
rate of change of GDP per capita or the log of GDP. The Lesotho series of the first and the
last measures show similar behavior when graphed together both in levels and in first
differences such that choice between the two boils down to the researchers’ preferences
and/or convenience. Rate of change of GDP was adopted as the growth variable (GR) in this
investigation.

There are several indicators for measuring the degree of financial intermediation. They are
considered one at a time immediately below:

The ratio of broad money to gross GDP (FI1): This simple indicator measures the
degree of monetization in the economy. The monetization variable is designed to
show the real size of the financial sector of a growing economy in which money
provides valuable payment and saving services (Kar and Pentecost, 2000).

7

The ratio of bank deposit liabilities to GDP (FI2): In a sense, the degree to which
banks collect cash and create deposits represents the degree of financial
intermediation. In developing countries, a large component of the broad money stock
is currency held outside the banking system. Therefore in order to obtain a more
representative measure of financial development, currency in circulation should be
excluded from the broad money stock. One such proxy is the ratio of bank deposit
liabilities to income (Kar and Pentecost, 2000).

Credit-based measure of financial intermediation

o The ratio of domestic credit to GDP (FI3): This represents the domestic assets of
the financial sector.
o The ratio of private sector credit to GDP (FI4): It is natural to assume that credit
extended to the private sector generates increases in investment and productivity
to a much larger extent than credit to the public sector. It is also argued that loans
to the private sector are given more stringently and that the improved quality of
investment emanating from financial intermediaries’ evaluation of project
viability is more significant for private sector credits.
o The ratio of private sector credit to domestic credit (FI5): A financial system that
simply funnels credit to the government or state-owned enterprises may not be
evaluating managers, selecting investment projects, pooling risk and providing
financial services to the same degree as a financial system that allocates credit to
the private sector. Lynch (1996) argues that government credit from banks in
countries with a highly regulated financial system is frequently captive and that
banks have no control over its use. Consequently, the important credit allocation
role of banks is best represented by their lending to the private sector.

The advantage of using numerous indicators lies in the conclusiveness of inferences made,
provided that all the indicators tell more or less the same story. The call on reliability of each
arises if the results are mixed. The data used is from the International Financial Statistics.

8
5. Empirical Findings
5.1 Unit-Root Test Results
The starting point of the analyses is to test the unit root properties of all the variables.
Traditional unit root tests of Dickey and Fuller, the DF and the ADF tests have in recent
times been rendered unreliable guides due to their size and power problems. Alternative unit
root tests have been developed and some of these have been automated in the most recent
versions of “canned” econometric software. These alternatives include the Phillips and
Perron (1988) test which has been found to suffer from similar shortcomings as the ADF
tests. There is however a new generation of unit-root tests with reasonably low size
distortions and good power. They include the GLS transformed ADF test and the ERS Point
Optimal test (Elliot, Rothenberg & Stock 1996), the KPSS test (Kwiatkowski, Phillips,
Schmidt & Shin 1992), and the M-test (Perron & Ng 1996).

All the variables under consideration – real GDP growth (GR) and the five proxies of
financial intermediation (FIk, k = 1,…,5) are passed through several of the unit-root tests
mentioned above. All the test regressions included a drift while some of them include a trend
variable as well. The decision as to whether include drifts and trends was aided by visuals
from the series plots. Table 1 below summarizes the results of such tests.

Table 1: Unit-root tests results of variables in levels

Unit Root Tests
X ADF PP KPSS ERSPO ADF-GLS
Variables in Levels

GR 1.3899 -0.9401 0.1978 143.67* -1.1142

FI1 -2.1210 -1.9484 0.2974 12.125* -1.9890
FI2 -3.2397 -3.1021 0.1602 6.4497* -3.0660*
FI3 -1.3705 -1.5481 0.3293* 6.6088* -1.3586
FI4 -1.4747 -1.4747 1.0992 25.133* -0.7356
FI5 -9.8367* -9.8367* 0.0808* 0.5245 -9.8591*
* Null Hypothesis that X is non-stationary is rejected at 5% level of significance

The use of multiple tests for each variable is employed as a robustness check and the
conclusion of the unit root status of each variable is reached on a simple majority – that is if
at least three out of the five tests render a given variable having a unit-root then the
conclusion is that that given variable does have a unit root. The converse is true. Using this

9
line of reasoning it can be observed that five of the variables under consideration, GR and
four proxies of financial intermediation (FI1, …, FI4) have a unit-root. Only FI5 is
stationary.

The non-stationary variables are taken through the test machinery in first-differences in order
to establish the order of integration of such variables. Table 2 below is a summary of such
results.
Table 2: Unit-root tests results of variables in first differences
Unit Root Tests
ADF ∆X PP KPSS ERSPO ADF-GLS
Variables in First

GR -3.0212 -2.8998 0.2081 0.0624# -1.1873#

FI1 -11.045 -11.127 0.2233 0.8119# -11.094
Differences

#
FI2 -12.135 -12.132 0.0911 0.8717 -12.056
FI3 -9.8424 -9.8746 0.1256 0.5358# -9.7969
#
FI4 -10.222 -10.222 0.2199 0.5413 -10.209
#
Null Hypothesis that ∆X is stationary is rejected at 5% level of significance

Again using the majority decision rule all the non-stationary variables become stationary
after first differencing.

5.2 Cointegration Results

In the preceding sub-section four of the five proxies of financial intermediation came out as
non-stationary together with GDP growth rate. As a result there are four bi-variate VARs to
work with in testing for cointegration between each of the four proxies and growth. The
Johansen approach is used in this investigation. Inclusion or exclusion of deterministic
components in the form of intercepts and trends affect the distribution of the Johansen test. In
conducting the test therefore, care needs to be taken. Eviews allows the following five
possibilities:
1. No deterministic trends in the VAR and the ECM has no intercept.
2. No deterministic trends in the VAR and the ECM has intercept.
3. The VAR has linear trends and the ECM has intercept.
4. Both the VAR and the ECM have liner trends.
5. The VAR has a quadratic trend and the ECM has a trend.

10
In this investigation cases 1 and 5 were immediately ruled out as impractical because in the
former case the cointegrating vector often includes the intercept while for the latter case the
reasoning is that quadratic trends in the data are infrequent. Further, it is not common for a
cointegrating regression (or VAR) to contain a trend. Choice between cases 2 and 3 is on
whether the elements have linear trends or not. Graphing the elements is a useful guide in
this regard (see appendix A). In the final analysis option 3 was used for all the four pairs.

In conducting the tests each of the four VARs were first estimated in levels in order to select
the appropriate order and the Schwartz Information Criterion was used. This is because
relative to other common information criteria the SIC favors more parsimonious models
(Verbeek, 2000). Kouassi, Iyoha & Kymn (2005) provide a lucid comparison of these criteria
in terms of consistency and efficiency both asymptotically and in finite samples. Table 3
below is a summary of cointegration test results from the four pairs of variables:

Table 3: Cointegration between Growth and FI Proxies

VAR elements Order of VAR Cointegrating Rank
GR and FI1 2 0
GR and FI2 4 0
GR and FI3 2 0
GR and FI4 2 0

All the proxies of financial intermediation (including the I(0) FI5) are not cointegrated with
growth in the case of Lesotho. The long-run or equilibrium relationship between financial
development and economic growth predicted by economic theory does not hold for Lesotho.
Derived from the use of several alternative proxies, this is a fairly robust conclusion.

5.3 Causality Revelations

The relationship between causality and cointegration is such that if two variables are
cointegrated, then one can expect Granger causation in at least one direction (Granger

11
1988).4 The absence of cointegration between growth and all the five proxies of financial
intermediation spells the expectation of no causality between growth and these proxies. Table
4 summarizes the causality between the first differences of growth and the first differences of
financial intermediation proxies.

Table 4: Finance – Growth Causality Revelations

(see Appendix B for statistical details)
Pair (GR and FIs) Revelation
1. ∆GR and ∆FI1 No Granger causality in either direction
2. ∆GR and ∆FI2 No Granger causality in either direction
3. ∆GR and ∆FI3 No Granger causality in either direction
4. ∆GR and ∆FI4 No Granger causality in either direction
5. a) ∆GR and ∆FI5 Granger causality from ∆FI5 to ∆GR
b) ∆GR and FI5 Granger causality from FI5 to ∆GR

Financial intermediation proxies M2 to GDP, Bank Deposit Liabilities to GDP, Domestic

Credit to GDP and Private Sector Credit to GDP neither cause GDP growth nor are they
caused by it in the Granger sense. These revelations are reinforced by the absence of
cointegration between these proxies and GDP growth. It is only the ratio of Private Sector
Credit to Domestic Credit that Granger causes GDP growth. The causality is unidirectional
and supports the supply leading hypothesis5 in the finance – growth nexus debate. However
on the whole, four out of five proxies supports neither hypothesis. Again this is a fairly
robust revelation that in the case of Lesotho finance does not cause growth nor does growth
cause finance.

4
As a flip side to this, some people use Granger causality test as a precursor for cointegration test. However
given that the reliability of Granger causality test depends on the unit root properties of the variables involved
this wisdom may be misleading.
5
By way of reminder the other hypothesis is the demand following hypothesis. In this hypothesis growth is
supposed to cause finance.

12
6. Discussion and Observations
The findings of this investigation suggest that there exist no causality between finance and
growth in either direction. This is consistent with the findings of Chang (2002), Shan and
Morris (2002) and Dawson (2003) that exhibit no link between fiancé and growth. A
resounding conclusion that can be made from this is that a slowdown in or lack of growth in
Lesotho cannot be attributed to its under developed financial sector. Aggressive strategies
aimed at enhancing growth in Lesotho should be directed elsewhere other than to the
financial sector.

Aziakpono (2003) investigated finance and growth in the Southern African Customs Union
of which Lesotho is a member. Using a SURE methodology, Aziakpono (2003) found a
positive but insignificant effect of financial intermediation on growth for Lesotho. Several
factors that may account for this insignificant link as well as the non-causality found in this
investigation are taken up below:
a) Institutional Impediments: Currently, there is no leasing industry in Lesotho. This
situation complicates the collateralization of loans. Therefore, a leasing act, which will
indicate the rights, duties and obligations of participants, should be promulgated. This
will be useful in the adjudication of cases involving breaches of contract. Additionally,
the screening of bad from good loans is complicated by lack of information on the
public’s credit record. This coupled with the perceived loan non-repayment culture that
the banks associate with Basotho makes it all the more difficult for banks to part with
money in the form of loans.
b) Low Entrepreneurial Activity: Entrepreneurial capacity in Lesotho is very low. This is
manifested by the lack of know-how by entrepreneurs to prepare project proposals that
can attract funding by banks. Ultimately commercial banks do not find bankable
projects deserving of bank finance. This pretty much explains the high liquidity ratio
that was highlighted in earlier sections of the paper.
c) The Behavior of Commercial Banks: Commercial banks are characteristic of high levels
of risk aversion. Their reluctance to lend is manifested by the shift from lending
operations to commission income which is not their core business. This shift of focus

13
 may very much be an execution of a mandate from the parent companies in South
Africa.
Another key factor that influences the indifferent behavior of commercial banks
towards advancement of credit is the relative ease with which the banks can invest
funds in other Common Monetary Area countries (especially South Africa) where they
can earn higher returns on their investments. The CMA agreement, which permits free
flow of funds among member countries coupled with the fact that most banks are
branches of South African banks make the whole process very easy (Aziakpono, 2003).

These results do not in any way imply that the financial sector development is a futile
exercise in the case of Lesotho. Financial widening may contribute by creating new products
for enterprises to take advantage of. This may call for diluting the concentrated structure of
the banking industry through loosening of entry requirements. There is a tradeoff between
stability and efficiency involved here though.

7. Conclusion
This investigation has attempted to gauge the standing of the Lesotho economy in the
unsettled debate of the role of financial intermediation in economic growth. There is a
theoretical consensus that financial development impacts positively on economic growth.
However this theoretical consensus has not been able to withstand empirical inquiry with
robustness. An array of cross-country studies using OLS regressions, panel regressions and
causality tests as well as country case studies that predominantly employ time-series
techniques has yielded different results – some lending support to the theoretical consensus,
others completely the opposite.

These revelations suggest that the role of finance in any economy cannot be a foregone
theoretical prescription but rather is an empirical question. This investigation examined the
direction of causality between financial development and economic growth in Lesotho using
the time-series techniques of cointegration and causality. Five alternative proxies of financial
development were paired each with the growth variable in the cointegration and causality
tests. No cointegration was found between any of them with growth imply that there is no

14
long-run relationship between growth and finance as advanced by theory. Causality exists
between only one proxy – ratio of private sector credit to total credit – and growth and it runs
from finance to growth.

The overall picture however is that of no cointegration and no causality between finance and
growth in Lesotho. The implication of this revelation is that lack of growth in Lesotho can in
no way be attributed to the under-developed financial sector. Aggressive growth enhancing
strategies in the short to medium term should be directed elsewhere other than the financial
sector. One can expect with some probability that growth thus enhance may be the driving
force behind financial sector development – the emergence of demand-following hypothesis.

15
References

Allen D.S. and L. Ndikumana (2000), “Financial Intermediation and Economic Growth in
Southern Africa”, Journal of African Economies, 9, 132-159

Ang J.B. and W.J. McKibbin (2005) “Financial Liberalization, Financial Sector
Development and Growth: Evidence from Malaysia” CAMA wp 5/2005 Centre of
Applied Macroeconomic Analysis, ANU

Aziakpono, M.J. (2003) “Financial Intermediation and Economic Growth in Southern

Africa”, NUL Economics Department Working Paper

Bhattacharya P.C. and M.N. Sivasubramanian (2003) “Financial Development and Economic
Growth in India: 1970-71 to 1998-99” Applied Financial Economics, 13, 925-929

Boulila, G and M. Trabelsi (2004) “The Causality Issue in the Finance and Growth Nexus:
Empirical Evidence from Middle East and North African Countries”, mimeo

Central Bank of Lesotho, 2004, Quarterly Review, 23(3), September.

Chang, T. (2002) “Financial Development and Economic Growth in Mainland China: A Note
on Testing Demand-Following or Supply-Leading Hypothesis” Applied Economic
Letters, 9, 869-873

Dawson, P.J. (2003) “Financial Development and Growth in Economies in Transition”

Applied Economic Letters, 10, 833-836

Demetriades, P.O. and K.A. Hussein (1996) “Does Financial Development Cause Economic
Growth? Time-Series Evidence from Sixteen Countries”, Journal of Development
Economics, 51(2), 387–411.

Elliot G., T. Rothenberg and J. Stock (1996) “Efficient Tests for an Autoregressive Unit
Root”, Econometrica, 64, 813-836

Fry, M. J. (1997) “In Favour of Financial Liberalization”, Economic Journal, 107, 754–770.

Gelb, A. H. (1989) “Financial Policies, Growth and Efficiency”, World Bank Working Paper,
No. 202.

Goldsmith, R. (1969) Financial Structure and Development, New Haven, Yale University
Press

Granger, C.W.J. (1988) “Some Recent Developments in the Concept of Causality”, Journal
of Econometrics, 39, 199-211

16
Greenwood, J. and B. Jovanovic (1990) “Financial Development, Growth and the
Distribution of Income”. Journal of Political Economy, 98, 1076-1107.

Guinnane, T.W. (2002) “Delegated Monitors, Large and Small: Germany’s Banking System,
1800 – 1914” Journal of Economic Literature, 40, 73-124

Gurley, J. G. and E. S. Shaw, 1955, “Financial Aspects of Economic Development”.

American Economic Review. Vol.45, No. 4. Pp 515-538.

Kar, M. and E. Pentecost (2000) “Financial Development and Economic Growth in Turkey:
Further Evidence on the Causality Issue.” CIFER working paper 00/27
Loughborough University

King, R. G. and R. Levine (1993) “Finance and Growth: Schumpeter Might be Right”,
Quarterly Journal of Economics, 108, pp. 717–737.

Kouassi E., M. Iyoha and K.O. Kymn (2005) Lag Length Selection and Tests of Granger
Causality between the Twin Deficits”, mimeo

Kwiatkowski D., P. Phillips, P. Schmidt and Y. Shin (1992) “Testing the Null Hypothesis of
Stationarity against the Alternative of a Unit Root”, Journal of Econometrics, 54,
159-178

Levine, R. 1997, “Financial Development and Economic Growth: Views and Agenda”
Journal of Economic Literature, (35), 688 – 726

Levine, R. and S. Zervos (1998) “Stock Markets, Banks, and Economic Growth”, American
Economic Review, 88, 537–558.

McKinnon, R. 1973, Money and Capital in Economic Development. Washington: The

Brookings Institution.

Ncube, M. and L.W. Senbet, 1997, “Perspectives on Financial Regulation and Liberalization
in Africa under Incentive Problems and Asymmetric Information”, Journal of African
Economies, 16(1)

Neusser, K. and M. Kugler (1996) “Manufacturing Growth and Financial Development:

Evidence from OECD Countries”, Review of Economics and Statistics, 80(4), 638–
646.

Pagano, M. 1993, “Financial Markets and Growth: An Overview” European Economic

Review, 37, 613-622.

Perron P. and S. Ng (1996) “Useful Modifications to Unit Root Tests with Dependent Errors
and their Local Asymptotic Properties”, Review of Economic Studies, 63, 435-463

17
Phillips, P. and P. Perron (1988) “Testing for a Unit Root in Time Series Regression”,
Biometrika, 75, 335-346

Rajan, R. G. and L. Zingales (1998) “Financial Dependence and Growth”, American

Economic Review, 88, 559–586.

Robinson, J. (1962) Essays in the Theory of Economic Growth, London, Macmillan.

Schumpeter, J. (1934) The Theory of Economic Development, Reprinted by OUP, New York,
1961.

Shan, J. and A. Morris (2002) “Does Financial Development ‘Lead’ Economic Growth?”
International Review of Applied Economics, 16(2), 153-168

Stiglitz, J. E. (1994) “The Role of the State in Financial Markets”, Proceedings of the World
Bank Annual Conferences on Development Economics, Washington DC, World Bank
.
Verbeek, M. (2000) A Guide to Modern Econometrics, Wiley & Sons

Wachtel, P. (2002) “Growth and Finance: What Do we Know and How Do We Know It?”
International Finance, 5(1), 335-362

Wachtel, P. (2003) “How Much Do We Really Know about Growth and Finance?” Federal
Reserve Bank of Atlanta Economic Review, 1st Quarter, 33-47

Waqabaca, C. (2004) “Financial Development and Economic Growth in Fiji” Reserve Bank
of Fiji wp 2004/03

18
 Appendix A: Variable Visual Plots

GDP growth rate over time FI1 = Ratio of M2 to GDP

3.7 .6

.5
3.6

.4
3.5
.3

3.4
.2

3.3 .1

.0
3.2
82 84 86 88 90 92 94 96 98 00 02
82 84 86 88 90 92 94 96 98 00 02

FI2 = Ratio of Bank Deposit Liabilities to GDP

FI3 = Ratio of Domestic Credit to GDP
.5
.3

.4 .2

.3 .1

.0
.2

-.1
.1
-.2

.0
82 84 86 88 90 92 94 96 98 00 02 -.3
82 84 86 88 90 92 94 96 98 00 02

FI4 = Ratio of Private Sector Credit to GDP

.30 FI5 = Ratio of Private Sector to Domestic Credit
200
.25
150
.20
100
.15

50
.10

0
.05

.00 -50
82 84 86 88 90 92 94 96 98 00 02
82 84 86 88 90 92 94 96 98 00 02

19
 Appendix B: Pairwise Causality Results – GR & the FIs
(in First Differences)

Pairwise Granger Causality Tests

Date: 06/30/06 Time: 01:29
Sample: 1980Q4 2003Q4
Lags: 12

Null Hypothesis: Obs F-Statistic Probability

DFI1 does not Granger Cause DGR1 80 0.99692 0.46406

DGR1 does not Granger Cause DFI1 1.03046 0.43521

DFI2 does not Granger Cause DGR1 80 1.15357 0.33880

DGR1 does not Granger Cause DFI2 0.65514 0.78546

DFI3 does not Granger Cause DGR1 80 1.57694 0.12587

DGR1 does not Granger Cause DFI3 1.22310 0.29148

DFI4 does not Granger Cause DGR1 80 1.21570 0.29627

DGR1 does not Granger Cause DFI4 0.63864 0.80002

DFI5 does not Granger Cause DGR1 80 2.40383 0.01398

DGR1 does not Granger Cause DFI5 0.20469 0.99770

FI5 does not Granger Cause DGR1 80 2.21372 0.02347

DGR1 does not Granger Cause FI5 0.12907 0.99977

5% Critical Value = 1.936

20