*2.2. Model Specification*

This study employs the finance-growth model in extant literature (e.g., Levine et al. 2000; Beck et al. 2000) as the baseline model to examine the impact of financial development on economic growth in the West African region given as follows:

$$Y\_{it} = \mathfrak{a}\_1 F D\_{it} + \delta' Z\_{it} + \eta\_i + \mu\_t + \varepsilon\_{it} \tag{1}$$

where *Y* = real GDP per capita, *FD* = financial development (proxy by credit to the private sector relative to GDP, and alternatively by liquid liabilities relative to GDP), *Z* = a set of control variables (namely governmen<sup>t</sup> consumption expenditure relative to GDP, trade openness relative to GDP, human capital, and inflation rate), *ηi* = unobserved country-specific effect; *μt* = time specific-effect, and *<sup>ε</sup>i*,*<sup>t</sup>* = independent and identically distributed error term. All the variables except inflation are transformed into natural logarithm before analysis.

Moreover, we augmen<sup>t</sup> the finance-growth model with real exchange rate (or its volatility) as well as the interaction term between financial development and real exchange rate or its volatility (see Aghion et al. 2009) given as follows:

$$Y\_{it} = a\_1 F D\_{it} + a\_2 RER\_{it} + a \chi \left( F D\_{it} \* RER\_{it} \right) + \delta' Z\_{it} + \eta\_i + \mu\_l + \varepsilon\_{it} \tag{2}$$

where RER = real exchange rate<sup>2</sup> (alternatively as real exchange rate volatility), and *FD* ∗ *RER* = interaction term between financial development and real exchange rate (alternatively as real exchange rate volatility).

The interaction term enables us to ascertain whether the growth effect of financial development varies with the levels of the real exchange rate or its volatility. Hence, the study seeks to test the hypothesis that financial development has a larger impact on economic growth in the environment of lower real exchange rate or its volatility compared to the environment of high real exchange rate or its volatility. The interaction term between the two variables captures the marginal effects via the partial derivatives of the economic growth equation (Equation (2)) with respect to financial development given as follows:

$$\frac{\partial Y\_{it}}{\partial F D\_{it}} = \kappa\_1 + \kappa\_3 RER\_{it} \tag{3}$$

Our conditional hypothesis focuses on the sign of the coefficients of *α*1 and *α*3. If *α*1 > 0 and *α*3 > 0, it implies that financial development has a positive impact on economic growth, and real exchange rate favourably influences that positive impact. If *α*1 > 0 and *α*3 < 0, it suggests that financial development has a positive impact on economic growth, and real exchange rate adversely influences that positive impact. If *α*1 < 0 and *α*3 > 0, it denotes that financial development has a negative impact on economic growth, and real exchange rate mitigates that negative impact. If *α*1 < 0 and *α*3 < 0, it implies that financial development has a negative impact on economic growth, and real exchange rate aggravates that negative impact. However, if the entire marginal effect (*<sup>α</sup>*1 + *<sup>α</sup>*3*RER*) is positive, it implies that more financial development and real exchange rate or its volatility enhance economic growth, but the opposite holds if the marginal effect is negative. To determine the statistical significance of the marginal effects, Brambor et al. (2006) suggested that the corresponding standard errors and t-statistics should be computed for inferences.

To compute the corresponding t-statistics of the marginal effects, we first employ the following formula to compute the variance from the coefficient covariance matrix:

$$
\sigma\_{\frac{\partial \mathbb{M}}{\partial \mathbb{D}}}^2 = \text{var}(\mathbb{A}\_1) + RER^2 \text{var}(\mathbb{A}\_3) + 2RER \text{cov}\left(\mathbb{A}\_1 \mathbb{A}\_3\right) \tag{4}
$$

The square root of the variance gives the standard error, and the marginal effect divided by the standard error gives the t-statistics. A large t-statistic suggests that the marginal effect is statistically significant.

#### *2.3. Justification of the Variables in the Model*

The model follows the finance-growth nexus but augmented with real exchange rate or its volatility. The dependent variable is economic growth (proxy by real GDP per capita) following some previous studies (e.g., Demetriades and Law 2006; Ehigiamusoe et al. 2018; Gries et al. 2009; Kar et al. 2011; Law et al. 2018). This study uses the preferred and commonly used proxy of financial development in the finance literature, namely domestic credit to the private sector as a ratio of GDP<sup>3</sup>

<sup>2</sup> The real exchange rate between West Africa currencies and the United States dollar is the product of the nominal exchange rate (the units of West Africa currencies given up for one United States dollar) and the ratio of consumer price index between West Africa and United States. The core equation is RER = eP\*/P, where e = the nominal West Africa currencies − US dollar exchange rate, P\* = the consumer price index in West Africa, and P = the consumer price index in the United States.

<sup>3</sup> We thank the anonymous reviewer for this comment. We are aware that, at a low level of financial development (proxy by credit to the private sector relative to GDP), an increase in credit to the private sector could sugges<sup>t</sup> a higher financial development and probably greater economic growth. However, at a high level of financial development, an increase in credit to the private sector (e.g., from 150% to 200% of GDP) may not indicate a positive development in the financial sector, rather it might probably sugges<sup>t</sup> that the financial sector could undermine economic growth (see Arcand et al. 2015; Law and Singh 2014; Samargandi et al. 2015; Law et al. 2018). Specifically, Arcand et al. (2015) showed that the impact of financial development on economic growth turns negative when financial development (proxy by credit to the private sector) reaches 100% of GDP. However, our study focuses on developing economies of the West African region with a

(see Arcand et al. 2015; Beck et al. 2000; Demetriades and Law 2006; Ehigiamusoe and Lean 2018; Ehigiamusoe et al. 2018; King and Levine 1993; Law and Singh 2014; Law et al. 2018; Levine et al. 2000; Rioja and Valev 2004; Samargandi et al. 2015). It measures the credits issued by the banking institutions to the private sector and excludes credits issued to governments, its agencies, public enterprises as well as credits issued by the central bank (Beck et al. 2000; Levine et al. 2000). In order to check the robustness of the results, liquid liabilities relative to GDP is used as alternative proxy of financial development (see Hassan et al. 2011; Loayza and Ranciere 2006). Liquid liabilities are commonly referred to as M3/GDP. It is a measure of financial depth and the overall size of the financial intermediary sector4. It is the addition of currency, demand and interest-bearing liabilities of both banks and non-bank financial institutions. It consists of broad money supply (M2) plus commercial paper, travelers' checks, foreign currency time deposits and shares of mutual funds or market funds held by residents as a ratio of GDP (see World Development Indicators 2016). It is a better measure of financial depth because M2 may be a poor proxy of financial development in countries with underdeveloped financial system. M3/GDP is more concerned with the capacity of the financial system to provide transaction services rather than the capacity to channel funds from savers to borrowers (see Khan and Senhadji 2003).

First, theoretical literature on the finance-growth nexus posited that financial development accelerates economic growth by enhancing the sources of growth such as capital accumulation and productivity growth (see King and Levine 1993; Levine and Zervos 1998; Beck et al. 2000; Rioja and Valev 2004). Specifically, Levine and Zervos (1998) noted that a financial system is considered as developed when it can efficiently and effectively perform the resource mobilization and allocation functions aimed at promoting capital accumulation, productivity improvement and, ultimately, economic growth. Beck et al. (2000) reported that financial development has a positive impact on productivity growth and physical capital growth, which feeds through to economic growth (albeit the impact of the latter is tenuous). Rioja and Valev (2004) also revealed that financial development has a positive impact on economic growth; and the channel is primarily through capital accumulation in developing countries but mainly through productivity growth in more developed countries. The capital accumulation channel suggests that an efficient financial system mobilizes savings and allocates resources to domestic and foreign capital investments thereby boosting capital accumulation. Through saving mobilization, the financial sector overcomes the indivisibilities' problems. Conversely, the productivity channel stresses the importance of innovative financial technologies, which decrease the problem of information asymmetry that hinders efficient allocation of financial resources and investment project monitoring (see King and Levine 1993). This channel suggests that a well-developed financial system provides efficient credit facilities and other financial services that promote the adoption of modern technology to boost knowledge- and technology-intensive industries.

Second, theoretical literature has also underscored the influence of the real exchange rate on economic growth. Accordingly, an increase in the real exchange rate could have a negative effect on economic growth, while a decrease in the real exchange rate could have a positive effect (Habib et al. 2017). This present study employs the level of the real exchange rate in line with extant literature (e.g., Gala 2008; Habib et al. 2017; Rautava 2004; Tang 2015), and real exchange rate volatility that is consistent with previous studies (e.g., Aghion et al. 2009; Bleaney and Greenaway 2001; Rapetti et al. 2012; Vieira et al. 2013). The level of the real exchange rate has the capacity to reduce both capital accumulation and productivity growth, thereby weakening the channels through which financial development enhances economic growth. It also affects saving, investment, private

relatively low level of financial development as indicated in Table 1. It shows that the average credit to the private sector relative to GDP was 15.4%, while liquid liabilities relative to GDP were 25.6% during the 1980–2014 period. Therefore, financial system development in the West African region has not reached the level of excessive financial development, which could undermine economic growth in the region.

<sup>4</sup> Although credit to the private sector relative to GDP and liquid liabilities relative to GDP are the two most commonly used proxies of financial development in the literature, but unavailability of data on other proxies (e.g., stock market indicators, commercial-central bank assets, etc.) in the West African region limited our choice of proxies.

consumption and trade balance. For instance, a high and volatile real exchange rate has the potential to diminish international trade, weaken macroeconomic stability, distort price transparency and inhibit international financial integration (see Bleaney and Greenaway 2001; Razmi et al. 2012; Rodriguez 2017). Thus, real shocks and financial shocks are related, since the latter are significantly amplified in countries with high exchange rate fluctuations. In turn, exchange rate fluctuation is the outcome of both real and financial aggregate shocks. It affects the growth performance of credit-constrained firms.

Third, extant literature has posited that financial development and real exchange rate have a dynamic relationship. For instance, Aghion et al. (2009) posited that the growth interaction between financial development and real exchange rate stems from the fact that an increase in exchange rate causes a reduction in the firms' current earnings, their ability to borrow in order to survive liquidity shocks, and long-term investments in innovation. They argued that although a decline in the real exchange rate has the opposite effect, but the existence of credit constraint suggests that the positive effects which a decline in the real exchange rate have on innovation may not be adequately compensated for by the negative effect of an increase in the real exchange rate. In other words, a greater anticipation of exchange rate fluctuation has the capacity to discourage investments in R&D, which ultimately decreases the level of financial development and economic growth. Hence, a high exchange rate fluctuation could dampen the positive impact of financial development on economic growth, especially in countries with a low level of financial development. From the foregoing discussion, therefore, this study seeks to test the hypothesis that financial development has a larger impact on economic growth in an environment of a lower real exchange rate (or its volatility) compared to an environment of a high real exchange rate (or its volatility).

The set of control variables included in the models is governmen<sup>t</sup> consumption expenditure relative to GDP (used as an indicator of governmen<sup>t</sup> policy), trade openness relative to GDP (captures the degree of a country's openness), human capital (proxy by average years of schooling), which accounts for the effect of human capital accumulation on growth, and inflation rate (captures macroeconomic instability). These control variables are generally used in finance literature (see Beck et al. 2000; Levine et al. 2000). They are expected to be positively related to economic growth except inflation rate.
