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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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Regression results show that the effect of financial openness on market capitalization is positive for values of political risk greater than 4.27 in logarithm, corresponding to 71.5. It is therefore appropriate to undertake further analysis to identify the threshold level of real GDP per capita under which capital account liberalization has a negative effect on the stock market development.

We considered two plausible threshold variables: income level and political risk using two methods of simulations: rolling and recursive simulations. We observed how the coefficient of financial openness changes with the addition of higher values of the threshold variable in the sample. We used a window starting with the median of the threshold variables until it reaches the value of the 95th percentile of the entire sample. We also undertake simulations introducing interaction effect between financial openness and the threshold variable.

Simulation results show that there is indeed an interaction effect between income level and financial openness and that financial openness has a positive effect on stock market development for higher values of GDP per capita. For regressions with political risk as the threshold variable, we find that the negative effect of financial openness on stock market development decreases with higher values of risk (low political risk).

The components were selected because of their importance in past results. Yartey (2008a), for instance, found that law and order, bureaucratic quality, and democratic accountability are all important for stock market development in emerging market countries.

The evidence in the paper suggests that banking sector development, domestic savings, GDP per capita, and stock market liquidity are important determinants of stock market development in Africa. 28 Institutional development is also positive, especially government stability and law and order, because they tend to reduce political risk, enhance regulatory capacity, and support the viability of external finance. We find no conclusive evidence that macro economic stability has an impact. Finally, capital account liberalization has a positive impact on stock market development only in higher-income and low political risk countries.


This study uses panel data techniques to investigate the determinants of financial markets development in Africa. Using a dynamic panel estimator, we find that creditor rights protection, income level, trade openness, financial repression, and political risk are the most important determinants of banking sector development. Better protection of creditor rights, sound economic and trade policies, and economic growth stimulate the demand for cheaper credit. Good-quality institutions also lead to efficient supply of external finance; inefficient institutions form structural impediments to the supply of external finance (Huang, 2008). On the other hand, macroeconomic mismanagement and financial repression tend to discourage the demand for external finance, thereby derailing development of the banking system.

As for stock markets, domestic savings, stock market liquidity, and bank credit are shown to be important determinants of stock market development. Institutional quality is also found to be a robust and statistically significant determinant, which supports the case made by La Porta et al. (1997, 1999). Well-established institutions reduce political risk, a factor in investment decisions.

We do not, however, find any positive and robust relationship between capital account liberalization and stock market development. Further analysis showed the existence of threshold levels of real GDP per capita and political risk below which the effect of capital liberalization on stock market capitalization is negative. Simulation results suggest that the overall marginal effect of capital account liberalization on stock market capitalization is positive in high-income and low-political risk countries. This finding is in agreement with recent studies showing that the impact of capital account liberalization on a country’s financial development depends on its level of income and the quality of its domestic institutions. We also confirm that the relationship between banking sector and stock market development in Africa is positive, indicating that financial intermediaries and stock markets are complements, not substitutes.

Another likely determinant of stock market development in Africa is the degree of privatization. However, since data on privatization are difficult to find, we do not analyze it. Similarly, pension reforms and the creation of pension funds are likely to have had an impact on stock market development in some African countries.

The results that political risk, economic stability, and creditor rights protection are all important for banking sector development have significant implications for financial markets in developing Africa. Their significance implies that further efforts by African policy makers to reduce political risk and improve institutions, implement more open trade and sound macroeconomic policies, and better protect improve creditor rights can promote banking sector development. Similarly, policies to increase stock market liquidity, promote domestic savings, and build the financial intermediary sector can stimulate stock market development.

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Is South Africa Different?” IMF Working Paper 08/32 (Washington: International Monetary Fund).

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Critical Issues and Challenges,” IMF Working Paper 07/209 (Washington:

International Monetary Fund).

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Notes: All regressions include a constant and time effects. Standard errors are in parentheses. *, **, and *** means significant at 10, 5, and 1 percent level of significance.

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Notes: All regressions include a constant and time effects. Standard errors are in parentheses. *, **, and *** means significant at 10, 5, and 1 percent level of significance.

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Notes: All regressions include a constant and time effects. Robust standard errors in parentheses. *, **, and *** means significant at 10, 5, and 1 percent level of significance. FE and RE are fixed and random effects respectively.

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