Financial development and economic growth in Rwanda

UNIVERSITY OF MAURITIUS

FACULTY OF SOCIAL SCIENCES AND

HUMANITIES

DEPARTMENT OF ECONOMICS AND STATISTICS

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by DUSHIMUMUKIZA Deogratias

I n partial fulfillment of the requirements of the degree of

Master of Arts in Economics

Project Supervisor: Assoc. Prof. JANKEE Kheswar

FEBRUARY 2010

Financial Development and Economic Growth in Rwanda

DEDICATION

This dissertation is dedicated to my beloved wife Louise MUKESHIMANA, my beloved daughter Ariane IRASUBIZA, my parents Marthe NIYONSABA, Samuel BUGINGO and my grand parents Abel SHAMURENZI and Berne NYIRAHUKU and to all other relatives.

Financial Development and Economic Growth in Rwanda

DECLARATION

UNIVERSITY OF MAURITIUS

PROJECT/DISSERTATION SUBMISSION FORM

Name: DUSHIMUMUKIZA DEOGRATIAS
Student ID:0826399
Programme of Studies:SH 540
Module Code/Name: MA ECONOMICS
Title of Project/Dissertation: FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH: THE CASE OF RWANDA
Name of Supervisor(s): Assoc.Prof. JANKEE KHESWAR
Declaration: In accordance with the appropriate regulations, I hereby submit the above dissertation for examination and I declare that: (i) I have read and understood the sections on Plagiarism and Fabrication and Falsification of Results found in the University's «General Information to Students» Handbook (2009/2010) and certify that the dissertation embodies the results of my own work. (ii) I have adhered to the `Harvard system of referencing' or a system acceptable as per «The University of Mauritius Referencing Guide» for referencing, quotations and citations in my dissertation. Each contribution to, and quotation in my dissertation from the work of other people has been attributed, and has been cited and referenced. (iii) I have not allowed and will not allow, anyone to copy my work with the intention of passing it off as his or her own work. (iv) I am aware that I may have to forfeit the certificate/diploma/degree in the event that plagiarism has been detected after the award. (v) Notwithstanding the supervision provided to me by the University of Mauritius, I warrant that any alleged act(s) of plagiarism during my stay as registered student of the University of Mauritius is entirely my own responsibility and the University of Mauritius and/or its employees shall under no circumstances whatsoever be under any liability of any kind in respect of the aforesaid act(s) of plagiarism.
	Date:05/02/2010
Signature:

ABSTRACT

The study was intended to test the impact of financial development on economic growth for Rwanda over the period 1964 to 2005. Four measures of financial development are used including measures of financial deepening and financial sophistication. We found out a significant positive effect of financial deepening on economic growth, a bi-directional negative relationship between financial sophistication and economic growth and no significant evidence of the ratio of credit of banking institutions to total domestic credit, and the ratio of credit to private sector to total domestic credit, in promoting economic growth.

The observed failure of credit to private sector in promoting economic growth suggests important policy implication on credit allocation among private sector, and the failure of financial sophistication to affect positively economic growth needs a further research on best proxies of financial innovation in Rwanda.

Financial Development and Economic Growth in Rwanda

ACKNOWLEDGEMENT

Various persons deserve a vote of thanks in as far as the accomplishment of this study is concerned. I have a pleasure to mention some of them: I am heavily indebted to Assoc. Prof. Jankee Kheswar for his professional guidance and advices that made this work a success.

While at the University of Mauritius, I received a lot of assistance from staff in the Department of Statistics and Economics. These include the Dean of the Faculty, Professor Sobhee Sanjeev, former Head of Department of Economics and Statistics Dr. Ancharaz Vinaye and Mrs. Parveen Salamut, the Administrative Officer. I would like to extend my heartfelt gratitude to my lecturers in the programme, namely: Dr. V. Tendrayen-Ragoobur and Dr. Nowbutsing M. Baboo for their invaluable knowledge they delivered without any reserve. The same acknowledgements extend to all Lecturers of JFE. My special thanks go to AERC and its staff for invaluable assistance on both financial and academic side, without them this study would not exist.

I am gratefully to my colleagues, Mohamed Alie Bangura, from the University of Botswana for the academic materials he provided whose added value to this study can not be estimated and Marie Amanda Guimbeau from the University of Mauritius for her kind assistance which was invaluable for someone in a foreign country. Indeed I cannot forget to mention my colleagues Wilson Ngyendo, Wilson K. Karuhanga, and Mustapha J. for their immeasurable comments.

My thanks are extended to all my family members in large and specifically my parents Marthe Niyonsaba, Samuel Bugingo, Abel Shamurenzi, Berne Nyirahuku, my in-laws family Gaspard Munyanzira and Annonciata Nyirabaziga for moral support they extended during my stay in a foreign country.

I owe most profound thanks and recognition to my beloved wife Louise Mukeshimana for the sacrifice she made by accepting our separation for two years after one year of wedding. Without her consent, I would not have gone for this course. May this achievement reflect the cost of her sacrifice.

In spite of all these numerous assistance from various persons, the errors, shortcomings and opinions expressed in this study are entirely mine.

TABLE OF CONTENTS

DEDICATION ii

DECLARATION iii

ABSTRACT iv

ACKNOWLEDGEMENT v

LIST OF TABLES AND FIGURES ix

LIST OF APPENDICES x

LIST OF ACCRONYMS xi

CHAPTER 1 1

INTRODUCTION 1

1.0 Introduction 1

1.1 Statement of the problem 1

1.2 Research questions 2

1.3 Research objectives 2

1.3.1 General Objective 2

1.3.2 Specific objectives 2

1.4 Research hypotheses 3

1.5 Significance of the study 3

1.6 Scope of the study 3

1.7 Organization of the study 3

CHAPTER 2 4

REVIEW OF LITERATURE ON FINANCIAL DEVELOPMENT AND ECONOMIC

GROWTH 4

2.0 Introduction 4

2.1. Measuring financial development 4

2.1.1 Proxies of financial depth 5

2.1.2 Proxy for financial sophistication 6

2.1.3 Other measures of financial development 6

2.2 Relationship between financial development and economic growth 7

2.2.1 Theoretical link between financial development and economic growth 7

2.2.2 Empirical literature review on the link between financial development and

economic growth 12

Financial Development and Economic Growth in Rwanda

2.3 Conclusion 16

CHAPTER 3 17

OVERVIEW OF THE RWANDAN FINANCIAL SECTOR 17

3.0 Introduction 17

3.1. Overview over the Rwandan economy 17

3.2 The Rwandan financial sector 19

3.2.1 Banking sector 20

3.2.2 Microfinance institutions 21

3.2.3 Insurance and pension funds 22

3.2.4 Financial markets 22

3.2.5 Financial liberalization in Rwanda 22

3.2.6 Monetary policy in Rwanda 23

3.3 Comparison of financial development within EAC 25

3.3.1 Ratio of Liquid liabilities (M3) to GDP 25

3.3.2 Claims on private sector to GDP ratio 26

3.3.3 Domestic credit to GDP ratio 26

3.4 Conclusion 27

CHAPTER 4 28

METHODOLOGY 28

4.0 Introduction 28

4.1 Meaning and rationale of the model used 28

4.2 Model specification and rationale of variables 28

4.3. Model estimation 29

4.3.1 Stationarity and cointegration 29

4.3.2 Granger causality tests 30

4.3.3. Variance decomposition and Impulse response 30

4.4. The data source and measurement 30

4.5 Conclusion 30

CHAPTER 5 31

MODEL ESTIMATION AND FINDINGS 31

5.0 Introduction 31

5.1 Test for stationarity 31

Financial Development and Economic Growth in Rwanda

5.2 Test for cointegration 32

5.3 Vector Error Correction Model (VECM) 34

5.4 The Engle-Granger test 36

5.5 Impulse responses and variance decompositions 37

5.5.1 Variance decomposition 37

5.5.2 Impulse response models 41

5.6 Discussion of findings 41

5.7 Conclusion 43

CHAPTER 6 44

CONCLUSIONS AND RECOMMENDATIONS 44

6.0 Introduction 44

6.1 Summary of findings 44

6.2 Policy recommendations 45

6.3 Areas for further research 46

REFERENCES 47

APPENDICES 52

Financial Development and Economic Growth in Rwanda

LIST OF TABLES AND FIGURES

TABLES

TABLE1: TRENDS IN AVERAGE OF PER CAPITA GDP 18

TABLE 2: ADF TEST STATISTICS IN LEVELS 31

TABLE 3: ADF TEST STATISTICS WITH FIRST DIFFERENCE 32

TABLE 4: NUMBER OF COINTEGRATING RELATIONS BY MODEL, AT 5% LEVEL* 33

TABLE 5: UNRESTRICTED COINTEGRATING RANK TEST (TRACE) 34

TABLE 6: SIGNIFICANT VECTOR ERROR CORRECTION ESTIMATES 35

TABLE 7: F-STATISTICS FOR VECM 35

TABLE 8: MARGINAL SIGNIFICANCE LEVELS ASSOCIATED WITH JOINT F-TEST 37

TABLE 9: VARIANCE DECOMPOSITION OF GRATE 38

TABLE 10: VARIANCE DECOMPOSITION OF DEPTH 38

TABLE 11: VARIANCE DECOMPOSITION OF SOPHT 39

TABLE 12: VARIANCE DECOMPOSITION OF BANK 40

TABLE 13: VARIANCE DECOMPOSITION OF PRIVATE 40

FIGURES

FIGURE 1: EVOLUTION IN RATION OF LIQUID LIABILITIES IN EAC 25

FIGURE 2: EVOLUTION IN AVERAGE OF CLAIMS ON PRIVATE SECTOR TO GDP IN EAC 26
FIGURE 3: EVOLUTION IN AVERAGE RATIO OF DOMESTIC CREDIT TO GDP IN EAC 27

LIST OF APPENDICES

Appendix A: Comparison of financial development in EAC Table A.1: Average ratio of liquid liabilities to GDP in EAC

Table A.2: Average ratio of claims on private sector to GDP in EAC Table A.3: Average domestic credit to GDP ratio in EAC

Appendix B: Granger causality test

Appendix C: Vector Error Correction Estimates, model 4 in Eviews Appendix D: Impulse responses

Table D.1: Response of GRATE

Table D.2: Response of DEPTH

Table D.3: Response of SOPHT

Table D.4: Response of BANK

Table E.5: Response of PRIVATE

Appendix E: Data used in regression

Financial Development and Economic Growth in Rwanda

LIST OF ACCRONYMS

ACH: Automated Clearing House

ADF: Augmented Dickey-Fuller

AERC: African Economic Research Consortium

AIC: Akaike Information Criteria

AR: Auto Regressive Models

ATMs: Automatic Teller Machines

BACAR: Banque Continentale Africaine au Rwanda

BCDI: Banque de Commerce et du Développement Industriel (now ECOBANK) BCR: Banque Commerciale du Rwanda

BK: Banque de Kigali

BPR S.A: Banque Populaire du Rwanda, Société Anonyme CIA: Central Intelligence Agency

CMAC: Capital Market Advisory Council

COGEAR: Compagnie Générale d'Assurance et de Réasurance COOPECS: Coopérative d'Epargne et de Crédit

CORAR: Compagnie Rwandaise d'Assurance et de Réasurance DF: Dickey-Fuller

DRC: The Democratic Republic of Congo (Former ZaÏre) DSA: Development Studies Association

EAC: East African Community

EDPRS: Economic Development and Poverty Reduction Strategy GDP: Gross Domestic Product

GNP: Gross National Product

H0: Nil hypothesis

H1: The alternative hypothesis

HQ: Hannan-Quinn criterion

I(0): Integrated of order 0 (stationary)

I(1): Integrated of order 1

IAER: Institute of Advanced Engineering and Research IFAD: International Fund for Agricultural Development IFS: International Financial Statistics

IMF: International Monetary Fund

KCB: Kenya Commercial Bank LDCs: Least Developed Countries

LR: Sequential modified LR test statistic

M1: Narrow money

M2: Broad money, money supply

M3: Liquid liabilities

MFIs: Microfinance Institutions MMI: Military Medical Insurance NBR: National Bank of Rwanda OLS: Ordinary Least Squares OTC: Over- the- Counter

RAMA: La Rwandaise d'Assurance Maladie

RWF: Rwandan Franc

SACCOs: Savings and Credit Cooperatives

SIMTEL: Société Interbancaire de Monétique et de Télécompensation SONARWA: Société Nationale d'Assurance au Rwanda

SORAS: Société Rwandaise d'Assurance

SSFR: Social Security Fund for Rwanda.

UBPR: Union des Banques Populaires du Rwanda (Cooperative Bank)

UNDP: United Nations Development Program

US$: United State Dollar

VAR: Vector Autoregression Model VECM: Vector Error Correction Model

Financial Development and Economic Growth in Rwanda

CHAPTER 1

INTRODUCTION

1.0 I ntroductio

Since the views of Schumpeter (1911) on the role of financial development on economic growth, strengthened by empirical works of McKinnon (1973) and Shaw (1973), and invaluable contribution of Levine (1997) who portrayed the functions through which financial development may affect economic growth, a bulk of studies have been conducted across regions and countries to provide further evidence on the link between financial development and economic growth. It is in this spirit we have undertaken this study to determine whether there is evidence of relationship between financial development and economic growth in Rwanda.

This chapter presents the knowledge gap to be filled, research questions and objectives alongside the hypotheses of the study. Moreover, the chapter shows at what extend the study is relevant for Rwanda, highlights the scope and the organization of the study.

1.1 Statement of the problem

The economic growth has been a major concern of the government of Rwanda by putting a lot of effort to sustain Rwandan economy and to improve social welfare. Even though Rwandan economy has recovered considerably since the 1994 genocide; the GDP per capita is still low, around 460 US$, and over 56 percent of the population live under the poverty line. The agricultural sector, employing more than two-third of the population is underdeveloped and its contribution to GDP is small, accounting less than 35 percent. The industry sector too seems not to be in a good position to be an alternative measure since it remained on infant stage and its contribution to GDP has never reached 20 percent.

Apparently, the alternative way to speed up economic development is through a
developed financial system. However, Rwandan financial system remains
shallow and financial depth is below the Sub-Saharan and East African

averages. The financial sophistication is impaired by a low level of financial innovation though the country is being known as having above average growth in information technology in the region. Moreover, Rwanda does not have a developed supply of capital market-based long-term debt instruments.

With undeveloped financial sector, it is unlikely for Rwanda to attain a sustainable development. The purpose of this study is to find out how the level of financial development is linked to the economic growth so as to bring to the light, emphasis and pinpoint the crucial, critical and paramount importance of financial development to the economic development process of Rwanda.