3.2.2. Robustness Checks

This study conducts some checks to ascertain the robustness of the regression results. First, we use alternative estimation techniques, namely an Instrumental Variable (IV) approach based on Two Stage Least Squares (TSLS) to control for possible endogeneity. The results reported in Table 4 are consistent with the PMG results, with financial development positively related to economic growth, whereas the interaction term is negatively related. It also shows that the marginal effects of financial development on economic growth diminish as real exchange rate and its volatility increase.

<sup>5</sup> Hence, the results of the MG model are not presented to conserve space but available upon request.


**Table 4.** Robustness checks using Instrumental Variables (IV) regressions.

Notes: \*\*\*, \*\* and \* indicates statistically significant at 1%, 5% and 10%, respectively. Heteroscedasticity–corrected standard errors are in parenthesis. The instruments used are the legal origins of the countries as well as the initial values of financial development, governmen<sup>t</sup> expenditure, trade openness, human capita and inflation rate. Dependent variable = economic growth; CPS = credit to the private sector relative to GDP, RER = real exchange rate, CPS\*RER = interaction term between credit to the private sector and real exchange rate, RERV = real exchange rate volatility, LLY\*RERV = interaction term between liquid liabilities and real exchange rate volatility, GOV = governmen<sup>t</sup> consumption expenditure relative to GDP, TOP = trade openness relative to GDP, HCA = human capital, INF = inflation rate.

Second, we use an alternative proxy of financial development (namely, liquid liabilities relative to GDP) and redo the analysis. The results presented in Table 5 also provided evidence that real exchange rate volatility is deleterious to the finance-growth nexus in the West African region. It also shows that the inclusion of the real exchange rate and the interaction term in the model diminishes the positive impact of financial development on economic growth.


**Table 5.** Robustness checks using alternative proxy of financial development (liquid liabilities relative to GDP).

Notes: \*\*\*, \*\* and \* indicate statistically significant at 1%, 5% and 10%, respectively. Standard errors in parenthesis. Dependent variable = economic growth; LLY = liquid liabilities relative to GDP, RER = real exchange rate, LLY\*RER = interaction term between liquid liabilities and real exchange rate, RERV = real exchange rate volatility, LLY\*RERV = interaction term between liquid liabilities and real exchange rate volatility, GOV = governmen<sup>t</sup> consumption expenditure relative to GDP, TOP = trade openness relative to GDP, HCA = human capital, INF = inflation rate.

Thirdly, in order to account for structural breaks in the series, we conduct a structural break test using the test developed by Bai and Perron (2003), and found significant structural breaks in some countries. To account for the breaks, we include dummy variables that take the value of 1 from the years of the breaks and 0 otherwise in the model (see Wallack 2003), and redo the analysis. The estimation results<sup>6</sup> are similar to the earlier results in terms of the sign and significant of the coefficients (albeit the magnitude somewhat differ).

#### 3.2.3. SUR Estimation Results for Individual Country

Tables 6 and 7 show the SUR estimation results of the influence of the real exchange rate and its volatility on the finance-growth nexus in West African countries using disaggregated data. This is necessary to control for cross sectional dependence among the countries in the panel. In essence, the LM test statistic confirms the existence of cross-sectional dependence among the countries in the panel and the suitability of SUR estimator. In Table 6, the interaction term between financial development and real exchange rate enters with a negative coefficient in 12 countries suggesting that the impact of financial development on economic growth is adversely influenced by real exchange rate in these countries<sup>7</sup> (Benin, Burkina Faso, Cape Verde, Cote D'Ivoire, Gambia, Guinea, Mali, Mauritania, Niger, Senegal, Sierra Leone and Togo). The computed marginal effects diminish as real exchange rates increase in these countries. However, there is evidence that the real exchange rate is harmful to the finance-growth nexus in four countries (Ghana, Guinea Bissau, Liberia and Nigeria).

Similarly, Table 7 reveals that the interaction term between financial development and real exchange rate volatility enters with a negative coefficient in 13 countries (Benin, Burkina Faso, Cape Verde, Cote D'Ivoire, Ghana, Guinea, Liberia, Mauritania, Niger, Nigeria, Senegal, Sierra Leone and Togo), implying that real exchange rate volatility reduces the impact of financial development on economic growth. The computed marginal effects are lower at higher levels of volatility relative to lower levels in these West African countries.

<sup>6</sup> The results are not reported to conserve space, but available upon request.

<sup>7</sup> The results of the SUR model with the linear real exchange rate are not reported to conserve space, but available upon request. The results are similar to the ones presented in Table 6, as the interaction term enters with a negative coefficient in 12 countries.



sector relative to GDP, CPS\*RER = interaction term between credit to the private sector and real exchange rate, GOV = government consumption expenditure relative to GDP, TOP =

trade openness relative to GDP, HCA = human capital, INF = inflation rate.



consumption expenditure relative to GDP, TOP = trade openness relative to GDP, HCA = human capital, INF = inflation rate.

#### **4. Discussion and Policy Implications**

The findings of this study are summarized as follows: first, financial development enhances economic growth in the West African region. This implies that variations in financial development can explain variations in economic growth in the region. This is consistent with empirical literature, which opined that financial development enhances economic growth in developing countries by accelerating the sources of growth such as capital accumulation and productivity growth (see Ehigiamusoe and Lean 2018; Ehigiamusoe et al. 2018; Karimo and Ogbonna 2017; Ratsimalahelo and Barry 2010; Rioja and Valev 2004; Sanogo and Moussa 2017). This suggests that the financial system in the West African region is capable of mobilizing savings and allocating resources to domestic and foreign capital investments, which boost capital accumulation. In recent times, the financial system in many West African countries have embarked on innovative financial technologies which decrease the problem of information asymmetry (which hinders efficient allocation of financial resources and investment project monitoring), thereby facilitating economic growth.

Second, the findings on the link between real exchange rate and economic growth are consistent with Aghion et al. (2009), Elbadawi et al. (2012) and Vieira et al. (2013) who reported a negative impact of the real exchange rate on economic growth. Specifically, Aghion et al. (2009) reported that real exchange rate volatility has deleterious effects on economic variables such as productivity growth, investment and private consumption. They argued that uncertainty in the real exchange rate worsens the negative effect of domestic credit market constraints on investments. Jayashankar and Rath (2017) also posited that the relationship between the foreign exchange market and money market in emerging economies could make positive or negative shocks that affect one market to be quickly transmitted to another market via the contagious effect.

Apart from its direct adverse effect on economic growth, this study also reveals that real exchange rate weakens the impact of financial development on economic growth in the West African region. 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 consumption and trade balance (see Razmi et al. 2012; Rodriguez 2017).

Similarly, this study shows that real exchange rate volatility has a deleterious effect on the impact of financial development on economic growth in the West African region. This is consistent with the theoretical literature which contended that 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; Katusiime 2019; Razmi et al. 2012). 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.

Unlike previous studies, this present study shows that the impact of financial development on economic growth varies with the level of the real exchange rate and its volatility. In other words, besides their direct effects, real exchange rate and its volatility have indirect effects on economic growth through the financial sector. This study represents a novel idea by showing the marginal effects of financial development on economic growth at various levels of the real exchange rate (or its volatility), an issue that was not explored in previous literature. This is fundamental because the marginal effect enables us to determine the changes in economic growth caused by simultaneous changes in both financial development and real exchange rate (or its volatility), which is essential for policy formulation.

The implication of this study is that high real exchange rate and high volatility adversely affect the finance-growth nexus in the West African region. Hence, a reduction or stability in the real exchange rate is fundamental for financial development to enhance economic growth in West African countries. This suggests that the existing policies on real exchange rate have not been able to reduce the variable

to the level that it would have beneficial effects on the finance-growth nexus. Hence, West African countries need to re-evaluate the policies as well as formulate the necessary fiscal and monetary policies that would ensure reduction in the real exchange rate.
