Financial Development and Economic Growth Nexus: Evidence from Ethiopia (Johnson Approach to Co-Integration)

The main objective of the study was to examine empirically the nexus between banking sector development proxy by interest rate margin and economic growth in Ethiopia over the period 1975-2011. The Johnson approach to Co-integration and Error Correction Model are employed to investigate the long run and short run impact of financial development on economic growth. The test for Co-integration showed a linear long run relationship between real GDP per capita, interest rate margin, education (human capital), physical capital stock, and labor force. The estimated long run model revealed interest rate margin, physical capital stock, and labor growth remained significant variables. Moreover, net interstate margin is positively related to economic growth. This implies that economic growth becomes slow when transaction costs higher and a small share of savings is flow in to investment due to the inefficiency of the bank sector development. The short run, coefficient of error correction term is -0.2461 signifying about 24.61 percent annual adjustment towards long run equilibrium which is guaranteed the occurrence of a stable long run relationship among the variables. Moreover, the estimated short-run model confirmed that interest rate margin is significantly and negatively related to economic growth. This finding is consistent with theory, which advocates that economic growth will get faster when transaction costs get lower and a large share of savings is flowed in to investment. The above results have an important policy implication since most of the earlier studies measured the financial sector development using financial depth (size) which is not necessarily represent the development of financial sector due to its correlation with economic growth. The measurement of bank sector development by interest rate margin exposed Ethiopian bank sector needs further improvements to convey efficiency and competition among commercial banks. Hence, policy makers require reviewing the legal and institutional frameworks which creates financial repression and hinder financial sector efficiency.