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«WP/09/182 Understanding the Growth of African Financial Markets Mihasonirina Andrianaivo and Charles Amo Yartey © 2009 International Monetary Fund ...»

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Understanding the Growth of African

Financial Markets

Mihasonirina Andrianaivo and Charles Amo Yartey

© 2009 International Monetary Fund WP/09/182

IMF Working Paper

African Department

Understanding the Growth of African Financial Markets

Prepared by Mihasonirina Andrianaivo and Charles Amo Yartey 1

Authorized for distribution by Peter Allum

August 2009


This Working Paper should not be reported as representing the views of the IMF.

The views expressed in this Working Paper are those of the authors and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the authors and are published to elicit comments and to further debate.

This paper examines empirically the determinants of financial market development in Africa with an emphasis on banking systems and stock markets. The results show that income level, creditor rights protection, financial repression, and political risk are the main determinants of banking sector development in Africa, and that stock market liquidity, domestic savings, banking sector development, and political risk are the main determinants of stock market development. We also find that liberalizing the capital account promotes financial market development only in countries with high incomes, well- developed institutions, or both. The powerful impacts of political risk on both banking sector and stock market development suggest that resolution of political risk may be important to the development of African financial markets.

JEL Classification Numbers: G20 G28 055 Keywords: Banks, Stock Markets, Political Risk, Africa Authors’ Email: Cyartey@imf.org; Mandrian@univ-rennes1.fr Mihasonirina Andrianaivo is a PhD candidate at L’Universite de Rennes I (CREM-UMR CNRS 62-11). She was a summer intern in the African Department when this paper was written. We would like to thank participants in the African department’s financial sector network seminar series for comments and suggestions.

The paper has also benefited from useful suggestions from Norbert Funke, Patrick Imam and Roland Kpodar.

The usual caveat for responsibility applies.

Contents Page I. Introduction

II. The Growth of African Financial Markets

A. Banking in Africa

B. Stock Markets in Africa

C. The Private Equity Market

D. The Bond Market in Africa

III.The Literature on Determinants of Financial Market Development

IV. Methodology

A. Modeling Banking Sector Development

B. Modelling the Determinants of Stock Market Development

V. Empirical Results

A. Banking Sector Development

B. Determinants of Stock Market Development

VI. Summary and Conclusion



Tables 1a.Explanatory Variables used for Banking Sector Regression

1b.Explanatory Variables used for Stock Market Regression

2. Determinants for Banking Sector Development (System GMM Estimation/Credit).........31

3. Determinants of Banking Sector Development (System GMM Estimation/Bank Assets).32

4. Determinants of Stock Markets Development (Panel Data Estimation)

5. Determinants of Stock Markets Development (GMM Estimation)


1. Africa: Banking Sector Development

2. The Growth of African Stock Markets

3. Private Equity Fundraising

4. Bond Markets in Africa


This paper studies the determinants of financial market development in Africa, especially banking systems and stock markets. Over the past few decades, world capital markets have surged, with significant contributions from emerging markets. In Africa, the financial landscape has changed with the growth of stock and bond markets as well as the private equity market. The number of stock markets in Africa has risen from 5 in 1990 to 18 currently. In the banking system, credit to the private sector and bank assets—both indicators of banking sector development—have increased significantly since 1990.

With extensive empirical evidence supporting the assertion that the financial development promotes growth (see Levine and Zervos, 1998, for instance), research is now shifting toward explaining the most important policy question: What explains cross-country differences in financial development? Why have some economies developed well- functioning financial systems while others have not? Understanding the determinants of financial development is important because financial development is expected to promote savings and investment, thereby facilitating economic growth.

This paper studies the determinants of financial market development in Africa using a panel of 53 countries for the period 1990 to 2006. Specifically, it examines the impact of income level, macroeconomic stability, financial liberalization and institutional quality on both banking sector and stock market development. Demirguc-Kunt and Levine (1996) have found that most stock market indicators are highly correlated with banking sector development. Countries with well-developed banking sectors also tend to have welldeveloped stock markets. We investigate if this positive relationship between banking sector and stock market development is observable in Africa.

Due to differences in the underlying theoretical foundation, our approach is to model banking sector and stock market development separately to identify both market-specific factors and general economic and institutional factors that can explain financial market development. 1 We model the determinants of banking sector development using the Mckinnon–Shaw hypothesis—financial repression hinders financial development and economic growth—as the baseline. Specifically, we regress two important indicators of banking sector development—credit to the private sector relative to GDP and commercial bank assets relative to total financial assets of the banking sector—on measures of economic stability, income level, institutional quality, and financial liberalization and trade openness. We model stock market development using the Calderon Rossell model—stock market development is a function of income level and stock market liquidity—as the baseline. We regress stock market capitalization relative to GDP on measures of stock market liquidity, income level, We use a panel of 18 countries for the stock market regression and 53 countries for the banking sector development regression.

capital account liberalization, and macroeconomic and institutional environment. Our general approach allows us to test the importance of competing theories (for instance, the financial repression hypothesis) in explaining financial market development.

We use annual data from 1990 to 2006 in order to maximize sample size and identify parameters of interest more precisely. In the banking sector regression, by including a lagged dependent variable as one of the explanatory variables we allow for dynamics in the behavior of the dependent variable to capture the possibility of partial adjustment toward the steady state. Our preferred method of estimating is the system generalized method of moments (GMM), but in the stock market regression, we used fixed effects and instrumental variable techniques because the system GMM was not designed for a small number of cross-section units (maximum 18 in the stock market regression).

Income level, creditor rights protection, financial repression, and political risk are shown to be the main determinants of banking sector development in Africa. Stock market liquidity, domestic savings, banking sector development, and political risk are shown to be the main determinants of stock market development. The powerful impact of political risk on both banking sector and stock market development suggest that resolution of political risk may be important for the development of African financial markets. Another interesting result is that liberalization of the capital account promotes financial market development only in countries with high-income levels, well-developed institutions, or both.

The findings on political risk, macroeconomic stability and creditor rights protection all being important for financial market development have significant implications for developing African financial markets. Their significance implies that any efforts by African governments to reduce political risk and improve institutions, implement more open trade and sound economic policies, and protect creditor rights can stimulate banking sector development. Similarly, policies to increase stock market liquidity, promote domestic savings, promote financial intermediaries, and reduce political risk can stimulate stock market development.

In what follows, Section II documents developments in Africa’s financial markets over the last few decades. Section III reviews the literature on the determinants of financial market development. Section IV discusses the data and methodology of the paper. Section V presents the empirical results, and Section VI presents our conclusions.


The financial systems of most African countries have undergone substantial changes over the last few decades. Most countries traditionally depended on the banking system, but in recent times (until the outbreak of the global financial crisis); capital markets have gained a prominent role.

A. Banking in Africa

It is difficult to generalize about banking system development because African countries are so diverse in terms of financial development and access to financial services. Nevertheless, we can identify a number of common trends. For African countries, credit to the private sector relative to GDP and bank assets relative to GDP are now higher than 10 years ago.

However, despite the rapid growth of African banking systems, indicators of financial depth in Africa are the lowest in the world. On average bank credit to the private sector represents no more than 15 percent of GDP in Africa; in developed economies, it is more than 100 percent.

Compared with their counterparts in emerging markets, African banks have a limited role in the economy. Banking services penetration is as low as 5 percent, and access in most countries is limited to the urban centers. The fact that the ratio of M1 to M2 is the highest in the world means that cash is still the dominant financial instrument. Financial intermediation is hampered by the slow execution of due process as manifested in slow court proceedings, the absence of credit assessment information, and little protection for property rights.

–  –  –

Despite its small size compared to other economies, banking systems in Africa are reasonably sound (Gulde et al., 2006). Better macroeconomic conditions and less government intervention seem to have diminished the ratio of nonperforming loans, even though the characteristics of a specific country, such as current or past conflicts and the implication for the government, can cause differences between countries. The capital adequacy ratio, which is respected, averages 16 percent of risk-weighted assets.

Banks are profitable even though they are less efficient than in other countries. Overhead costs and net interest rate margins are better than in other low-income countries (Beck and Honohan, 2007). The banking system is generally very concentrated; perhaps because the size of the market is small (the number of banks does increase with the size of the country because institutions need to reach economies of scale). Furthermore, banking systems are often dominated by foreign banks.

The legal environment tends to be less conducive to developing the sector. It is difficult to enforce a contract, property rights are less well defined, and the systems are too complex— all of which reinforce the attraction of the informal sector. Regulatory requirements are usually met, but regulators have less power to demand corrective action because they lack both independence and resources (Gulde et al., 2006).

–  –  –

Starting from about 5 in 1989, there are now 18 stock exchanges in Africa, and assets and listings have grown considerably (see Figure 2). Total market capitalization increased by 113 percent between 1995 and 2005.

–  –  –

African stock markets are still small compared to stock markets in other emerging markets.

They are dominated by a few large firms that represent a high proportion of total market capitalization. The number of listed companies is also small, except in South Africa, Egypt, and to some extent Nigeria. The Johannesburg stock exchange in South Africa dominates the region in terms of market capitalization, but the Cairo and Alexandria Stock Exchange (CASE) have recently been growing rapidly. Together South Africa and Egypt account for more than 50 percent of all listed companies in the entire continent. Institutional investors and governments with minority stockholdings are not active traders in secondary markets and lack of experience and resources for issuing shares prevent effective use of exchanges.

African stock markets are illiquid. Shares are rarely traded and there are large gaps between buy and sell orders. Usually, trading occurs in only a few stocks, those that represent the majority of market capitalization (Yartey and Adjasi, 2007). Turnover ratios are as little as

0.04 percent in Swaziland compared with about 31 percent in Mexico. Low liquidity implies more difficulty in supporting a local market with its own trading systems, market analysis, and brokers because business volume is too low.

Africa: Indicators of Stock Market Development, 2007

–  –  –

African stock markets suffer from infrastructural bottlenecks. Trading, clearing, and settlement systems are so slow it can take months to execute a single transaction (Senbet, 2008), and most of the exchanges still operate manual systems. That slows information production, hampers activity and turnover, and renders financial integration difficult.

Similarly, most markets do not have central depository systems, and some restrict foreign participation. Such bottlenecks induce inactivity (Yartey and Adjasi, 2007).

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