The finance–growth nexus: Does risk premium matter?

• DOI: http://doi.org/10.1002/ijfe.1681
• Published date: 01 January 2019
• Date: 01 January 2019
• Author: Michael Adusei

RESEARCH ARTICLE

The finance–growth nexus: Does risk premium matter?

Michael Adusei

Department of Accounting and Finance,

KNUST School of Business, Kwame

Nkrumah University of Science and

Technology, Kumasi, Ghana

Correspondence

Michael Adusei, Department of

Accounting and Finance, KNUST School of

Business, Kwame Nkrumah University of

Science and Technology, Kumasi, Ghana.

Email: madusei10@yahoo.com

Abstract

The bounds testing approach to cointegration analysis is employed in this

paper to examine whether the risk premium demanded by the banking sector

moderates the finance–growth nexus with data (1970–2015) from South Africa.

To the extent that the interaction between risk premium and financial develop-

ment positively affects growth in the long run, we affirm that the risk premium

demanded by the banking sector represents a significant channel through

which financial development drives growth. The main policy implication of

this finding is that financial liberalization that removes interest rates

restrictions, allowing the banking sector to adequately price risk, is in the best

interest of the South African economy.

KEYWORDS

banking sector, South Africa, economic growth, financialdevelopment, risk premium

1|INTRODUCTION

Since the pioneering work by Goldsmith (1969), which

lends some credence to the theoretical postulation of

Schumpeter (1911) that finance has positive implications

for a country's growth trajectory, the growth literature

has been flooded with an avalanche of empirical investi-

gations into channels through which the dynamics of

financial variables influence capital accumulation and

growth (Adeniyi, Oyinlola, Omisakin, & Egwaikhide,

2015; Adusei, 2012, 2013; Aghion, Howitt, & Mayer‐

Foulkes, 2005; Alaabed & Masih, 2016; Chow & Fung,

2013; Deidda & Fattouh, 2002; Demirguc‐Kunt & Levine,

2008; Ibrahim & Alagidede, 2017; Jalil & Feridun, 2011;

King & Levine, 1993; Levine, Loayza, & Beck, 2000; Rioja

& Valev, 2004; Ruiz‐Vergara, 2017; Saint‐Paul, 1992; Sassi

& Goaied, 2013; Tran, 2008; Waqabaca, 2004). Unfortu-

nately, these investigations have produced inconclusive

results. The implication is that the enquiry into the

finance–growth nexus remains an unfinished business.

A search of the empirical literature reveals an emerging

body of studies that yields to the notion that the relation

between financial development and economic growth is

non‐linear. That notwithstanding, consensus is yet to be

reached on the effect of the former on the latter in these

non‐linear investigations. Whereas studies such as Ruiz‐

Vergara (2017), Rioja and Valev (2004), and Deidda and

Fattouh (2002) report that finance has a positive impact

on economic growth for values above the threshold, stud-

ies such as Arcand, Berkes, and Panizza (2015), Law and

Singh (2014), and Ergungor (2008) report opposite

impact. Recent evidence from 29 sub‐Saharan African

countries adduced by Ibrahim and Alagidede (2017) sug-

gests that levels of per capital income, human capital,

and financial development above the threshold mediate

the relation between financial development and eco-

nomic growth.

Apart from the studies that unearth the mediating

effects of some variables on the finance–growth nexus,

there are few studies that subscribe to the interaction

effects of some variables on the nexus (Demetriades &

Law, 2006; Gazdar & Cherif, 2015; Sassi & Goaied,

2013). This paper adopts the evolving contingency

approach to the finance–growth nexus interrogation by

Received: 23 April 2018 Revised: 29 June 2018 Accepted: 10 September 2018

DOI: 10.1002/ijfe.1681

588 © 2018 John Wiley & Sons, Ltd. Int J Fin Econ. 2019;24:588–603.wileyonlinelibrary.com/journal/ijfe

examining the role of risk premium demanded by the

banking sector in the nexus. As far as we know, the ques-

tion of whether risk premium has growth implications

has not featured in the finance–growth discourse. More

importantly, whether risk premium interacts with finan-

cial development to significantly influence economic

growth has not attracted any empirical attention. We con-

tend that untangling the role of risk premium in the

finance‐growth link is a researchable theme because the

ability of the banking sector to accurately price risk,

which leads to a commensurate compensation for each

level of risk assumed, resonates with the “better finance,

more growth”proposition (Demetriades & Law, 2006).

In sum, three questions are addressed in this paper: (a)

Is there any significant relation between financial devel-

opment and economic growth? (b) Does the risk pre-

mium demanded by the banking sector promote or

impair economic growth? (c) Does the risk premium

demanded by the banking sector moderate the finance‐

growth nexus? These three important questions are

addressed with annual data (1970–2015) from South Africa.

Risk premium in this paper is defined as the interest

rate charged by banks on loans to private sector cus-

tomers minus the “risk‐free”Treasury bill interest rate

at which short‐term government securities are issued or

traded in the market.

1

Its possible effect on the finance–

growth nexus is founded on three hypotheses/theories.

The filtering effect hypothesis of interest rates posits that

when interest rates are high, only entrepreneurs who are

sure of viable projects (positive net present value projects)

access funds from financial markets. Rational entrepre-

neurs who are not sure of success of their intended pro-

jects are likely to shy away from borrowing. Because

those projects that are potentially viable are funded, it is

predictable that the funding of such projects by the bank-

ing sector is likely to contribute to economic growth. It is,

therefore, reasonable to hypothesize that risk premium

should promote economic growth, and by extension, the

interaction between risk premium and financial develop-

ment should accelerate economic growth. However, it is

also possible to rely on information asymmetry hypothe-

sis to predict that a higher risk premium demanded by

the banking sector could lead to financial crisis with neg-

ative consequences for growth. This is because a higher

risk premium drives up interest rates in the banking sec-

tor. When this happens, borrowers who will not honour

their credit obligations will be willing and prepared to

accept credit at whatever level of interest rate. This may

result in banks having more non‐performing loans with

negative ramifications for growth. Loanable funds theory

also predicts a negative relation between risk premium

and economic growth. This is because a higher risk

premium demanded by the banking sector pushes

interest rate upwards, making cost of funds expensive

for entrepreneurs with viable investment projects. The

viable projects are abandoned because of high cost

involved in their prosecution. In the end, economic

growth suffers due to a fall in production, all things being

equal. Notwithstanding the above,we succumb to the fil-

tering hypothesis of interest rates and predict that risk

premium as well as the interaction between risk premium

and financial development should promote growth in

South Africa.

The decision to use data from South Africa to answer

the above questions is strategic. Besides her economic

success, South Africa's financial system is highly devel-

oped and rated among the top 10 financial sectors of the

globe with her banking regulations ranked outstanding

(Shahbaza, Tiwari, & Nasir, 2013). However, considering

the perceived high risks in Africa (Allen, Otchere, &

Senbet, 2011), it is interesting to know whether the risk

premium charged by the banking system in South Africa

has any significant growth ramifications. We justify our

decision to focus on a single country study instead of a

multi‐country study on the suggestion made by Al‐Yousif

(2002) that the relation between financial development

and economic growth cannot be generalized across coun-

tries because economic policies are country specific, and

their success hinges on the efficiency of the institutions

executing them.

Using bounds testing approach to cointegration, we

demonstrate in this paper that when risk premium inter-

acts with financial development economic growth is

enhanced in the long run. We conclude that appropriate

pricing of risk by the banking sector is one of the

channels through which financial development

significantly affects economic growth.

A number of reasons make this paper relevant. The

search for the nexus between finance and growth,

although has received a lot of empirical attention, yet

the discordant results that have attended it make it a sim-

mering research topic worth pursuing. Apart from adding

to the positive effect of finance on growth literature, the

paper contributes to the burgeoning literature on the con-

tingency approach to the finance–growth nexus discourse

by exploring whether the risk premium demanded by the

banking sector moderates the nexus. It is our view that

the finding that risk premium significantly interacts with

financial development to accelerate economic growth

comes across as a value addition to the growth literature

and reinforces the budding literature on the contingency

approach to the finance–growth nexus enquiry. Our evi-

dence suggests that an increase in interest rates

occasioned by effective risk pricing serves as a conduit

through which financial development drives long run

economic growth. Policy wise, this implies that financial

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