Financial development, sectoral effects, and international trade in Africa: An application of pooled mean group (PMG) estimation approach

• Published date: 01 January 2019
• Date: 01 January 2019
• Author: Yakubu Awudu Sare,Anthony Q.Q. Aboagye,Lord Mensah
• DOI: http://doi.org/10.1002/ijfe.1665

RESEARCH ARTICLE

Financial development, sectoral effects, and international

trade in Africa: An application of pooled mean group (PMG)

estimation approach

Yakubu Awudu Sare

1

| Anthony Q.Q. Aboagye

2

| Lord Mensah

2

1

Department of Banking and Finance,

School of Business and Law, University

for Development Studies, Wa, Ghana

2

Department of Finance, University of

Ghana Business School, Legon, Ghana

Correspondence

Yakubu Awudu Sare, Department of

Banking and Finance, School of Business

and Law, University for Development

Studies, Wa, Upper West region, Ghana.

Email: sareawudu@uds.edu.gh

JEL Classification: F13; G21

Abstract

Existing studies on financial development–international trade nexus have

centred on the implications of finance for trade without investigating the trans-

mission channels of finance on trade. More importantly, how financial sector

development mediates the relationship between sectoral value additions and

trade remains an unexplored area. This study addresses these gaps in the liter-

ature relying on panel data from 46 countries in Africa spanning 1980–2016.

Our evidence based on the pooled mean group estimations suggest that, for

both the long and short run, although the impact of sectoral value additions

is contingent on the proxy of trade, financial sector development does not have

a significant effect on international trade. This holds irrespective of the mea-

sure of finance and international trade. However, after controlling for the

transmission channels, a coexistence of a negative long run substitutionarity

between finance and trade is found, and this is invariant of the indicator of

finance and trade. On the mediation role, we find that higher sectoral value

additions dampen the deleterious effect of finance on trade with huge impact

emanating from the service sector. We discuss some key implications for

policy.

KEYWORDS

exports, financial development, sectoral value additions, trade, trade openness

1|INTRODUCTION

Undoubtedly, the importance of domestic financial devel-

opment cannot be overemphasized. This importance is

largely evident on its impact on economic growth

(Alexiou, Vogiazas, & Nellis, 2018; Ibrahim & Alagidede,

2016; Ibrahim & Alagidede, 2017a; Swamy & Dharani,

2018), economic volatility (Dabla‐Norris & Srivisal,

2013; Ibrahim & Alagidede, 2017b), and sectoral value

additions (Kumi, Ibrahim, & Yeboah, 2017). More

recently, Gyeke‐Dako, Agbloyor, Turkson, and Baffour

(2018) observe that financial development lowers the

social costs of financial intermediation. Indeed, evidence

abound of the significant relationship between countries'

level of financial development and international trade

flows (see Beck, 2002; Hur, Raj, & Riyanto, 2006; Kim,

2011; Kim, Lin, & Suen, 2010; Svaleryd & Vlachos,

2005). However, the current studies on financial develop-

ment–international trade nexus have left much lacuna in

the literature necessitating further research efforts in at

least two areas: (a) re‐engaging the debate where trade

flows, sectoral value additions, and domestic financial

development are lower and (b) investigating the mediat-

ing role of finance in influencing sectoral growth for

Received: 10 January 2018 Revised: 13 July 2018 Accepted: 9 September 2018

DOI: 10.1002/ijfe.1665

328 © 2018 John Wiley & Sons, Ltd. Int J Fin Econ. 2019;24:328–347.wileyonlinelibrary.com/journal/ijfe

improved international trade flows. This study signifi-

cantly contributes to the existing finance–trade literature

in several avenues. First, although discussions on the

impact of finance on trade have received much attention,

sectoral contributions to trade flows have been under

studied. We re‐engage the literature by empirically exam-

ining how domestic levels of financial development and

sectoral value additions influence countries' level of inter-

national trade. Second, this study also examines the

mediating role of finance in sectoral value additions–

trade nexus. Through this, we are able to show whether

sectoral value additions magnify or dampen the impact

of finance on trade. Third, by explicitly distinguishing

between the long and short run effects, we are able to

empirically show which sector significantly contributes

to trade given the level of domestic financial sector at dif-

ferent time periods. To the best of our knowledge, this is

the first study in Africa to investigate such linkages. This

study, therefore, makes a case for introducing such cru-

cial linkages into the finance–trade literature that has

been hitherto neglected.

Indeed, the UNCTAD (2014) report argues that inter-

national trade facilitates the cross‐border flow of goods

and services and production factors with the conclusion

that trade spurs economic growth. In the case of Africa,

although the continent's shambolic growth performance

is often attributed to several factors, barriers to interna-

tional trade and financial sector underdevelopment are

the main factors perpetuating the low economic growth

(see, for instance, Beck, Maimbo, Faye, & Triki, 2011;

Ndulu, Chakraborti, Lijane, Ramachandran, & Wolgin,

2007). Even for the most part, rigorous financial reforms

in Africa and attempts at international market integra-

tion have not yielded the desired economic performance.

1

Realizing the importance of domestic financial develop-

ment for trade, developing countries initiated policies to

increase their levels of financial development (Demir &

Dahi, 2011). UNCTAD (2005, 2007), however, suggests

that limited level of financial systems exacerbates the

transaction costs as a trade barrier if none of the trading

partners are able to offer the trade financing. Sadly,

despite efforts at improving the continent's financial

sector development, the effect of this on international

trade has not yet been reaped. Meanwhile, a growing

number of studies have confirmed the trade‐enhancing

effect of finance (see Beck, 2002; Kim, Lin, & Suen, 2012).

By augmenting the Heckscher–Ohlin's model of factor

endowment, Kletzer and Bardhan (1987) theoretically

reveal that, relative to those with under‐developed finan-

cial sector, economies with higher domestic financial sys-

tem benefit from easier access to external financing,

hence specializing in industries that require more exter-

nal source of finance. This view is further supported by

Beck (2002) and Svaleryd and Vlachos (2005) where a

positive link between financial development and the spe-

cialization pattern of international trade and comparative

advantage is established. Evidence abound that industries

that are more dependent on external finance grow faster

in countries with better developed financial systems. Con-

sequently, those economies with under‐developed finan-

cial sector have lower export share in industries with

higher external finance dependence (Demirguc‐Kunt &

Maksimovic, 1998; Rajan & Zingales, 1998). Thus, finan-

cial development regulates the degree of credit availabil-

ity for enhanced trade.

Apart from financial development, cross‐border trade

has become an essential tool driving economic growth

and development. Indeed, several studies (see, for

instance, Rajan & Zingales, 2003; Braun & Raddatz,

2008; Do & Levchenko, 2007) have argued that interna-

tional trade is strongly related to countries' domestic level

of financial sector development. The reasoning is that, if

higher international trade spurs economies' exposure to

the vagaries of the world market, then well‐developed

domestic financial sector acts as a powerful insurance

instrument that dampens barriers to trade. Theoretically,

Feeney and Hillman (2004) establish how capital market

incompleteness affects trade. They argue that there is no

inducement for special interest groups to lobby for protec-

tion if risks can be fully diversified. Therefore, improve-

ment in financial sector in a way that eliminates

asymmetric information and rigidities could potentially

lead to higher trade flows between and among countries.

The contribution of Rajan and Zingales (2003) to the

literature is situated within a framework where countries

openness to international trade improves domestic finan-

cial development by waning the influence of economic

and political incumbencies that inhibit financial liberali-

zation. Kim et al. (2010) investigate the long and short

run relationships between financial development and

international trade using a panel data for 87 OECD and

non‐OECD countries over 1960–2005. The authors find

a positive (negative) long (short) run nexus between trade

and finance, suggesting that, in the long run, finance and

trade are complements. However, after bifurcating the

sample into OECD and non‐OECD countries, these find-

ings only hold for the non‐OECD countries where major-

ity of the African countries fall. For the OECD countries,

financial development has insignificant effects on trade.

Thus, the overall effect of finance on international trade

is country‐specific. Kim et al. (2012) find a positive impact

of financial development on trade, whereas the effect of

trade on domestic financial development is unclear for a

sample of 63 countries over the period 1960–2007.

Indeed, from the foregoing, empirical literature on

finance–trade nexus has centred on the impact of finance

SARE ET AL.329