Influence of Institutional Quality on the Financial Development and Economic Growth Nexus in Sub-Saharan African Countries

Abstract

In Sub Saharan Africa, the struggle for sustainable economic prosperity still is the challenge of converting financial expansion into sustainable economic prosperity. The banking sector has been expanded, with financial activity following suit, in many countries in the region, but the benefits of growth are not always realized because of poor governance, corruption and weak legal systems. The above implies that financial development is not an isolated process, but also involves the effectiveness of the institutional environment. This study's analysis was based on the augmented Mankiw-Romer-Weil model where the human capital and financial factors were added to the production function. The study employed a 2-step System Generalized Method of Moments (GMM) approach to overcome the endogeneity and unobserved heterogeneity issues faced by twenty Sub-Saharan African countries during the period 2007–2024. To examine the moderating role of institutional quality on finance-growth relationship, multiplicative interaction terms were included. The robust approach to estimating the inequalities was realized by using Random Effects and thorough diagnostic analysis (Bond and Hansen tests) and complex econometric packages were used to estimate the inequalities. The results showed mixed relationship between the variables and weak correlation between financial development indicators, namely FIA (−0.0838), FIE (0.1778) and FMD (−0.0915) with real GDP growth. The Bond (2002) test confirmed that the lagged dependent variable (LDV) had different FE (0.4279) and OLS (−0.6244) estimates, thus supporting the use of the System GMM estimator. The cross-sectional dependence tests were significant, with Pesaran FE and Friedman FE giving a p=0.0000 and 0.0000 respectively. The results of system GMM revealed that FIA had a negative effect on growth (−0.6329; p<0.05) and institutional quality and FIA had a positive effect on growth (0.2182; p<0.01). Model validation was done by diagnostic tests and was validated for model validity with AR(2) (0.074) and Hansen (0.165). The study found that development of financial services without an accompanying strengthening of governance does not seem to have any economic pay-off. Thus, a key priority for policy makers is to bring about institutional changes, particularly in the area of regulatory integrity and corruption control, to enable financial systems to play a role in effectively channeling capital into productive investments