Effect of interest rate, capital inflow, inflation and degree of openness on economic growth in Kenya

Abstract

The general purpose of the study was to investigate the impact of financial liberalization on economic growth in Kenya. Financial liberalization refers to the deregulation of domestic financial markets and the liberalization of the capital account. According to Kaminsky and Schmukler (2002), financial liberalization often refers to: (i) domestic financial market deregulation such as decontrol of the interest rate; (ii) removal of restrictions on capital account transactions that will increase mobility of capital between countries; and (iii) opening of financial services industry to foreign competition While some studies suggest that financial liberalization raises savings and investment, improving efficiency of investment and spurring economic growth, others reveal that, it leads to financial instability and is often considered a cause for financial crises. These conflicting results logically lead to the need for further empirical research. The study specifically focused on the effect of: interest rate on economic growth, effect of capital inflow on economic growth, effect of inflation on economic growth and the relationship between degree of openness and economic growth. During the study, the secondary data was collected from World Bank information site for the period covering years 1980 to 2012, the period was chosen in order to cover different political regimes. The study adopted econometric techniques such an error correction model (ECM) to establish the degree of variables adjustment towards equilibrium. The ECM is preferred because in addition to capturing the adjustment process towards equilibrium, it also represents the short and long term dynamics of the problem. Johansen Co-integration test was also employed to test long run equilibrium relationship among the chosen variables. The study carried unit root test to establish that the time series data on all the variables are stationary, which is the pre-requisite for the Johansen Co-integration test. E-views statistical tool was used to analyze the data. Regression and correlation analysis was also done to test the relationship between the variables of the study. The analyzed data was presented in the form of tables and line graphs. The multiple regression models specify the endogenous variable (Gross Domestic Product) as a function of Capital Inflow, Interest rate, Inflation, and Degree of Openness representing the exogenous variables. The results obtained from the Co-integration test reveals the existence of a long-run equilibrium relationship among the variables and co-integrating equations at 5% significance level. Also, the ECM coefficient of adjustment had the correct negative sign and statistically significant at 5% level. The coefficient of multiple determinations (R2) in both the Over-parameterized Model (95%) and the Parsimonious Model (95%) reveal that the relevant variables highlighted jointly affect GDP significantly. The study therefore concludes that financial liberalization has a growth-stimulating effect on Kenyan economy. It recommends open economy with reasonable lending rate coupled with stable inflation in order to spur economic growth. The political economy should also be stable to encourage foreign direct investment. The government through monetary arm of CBK should also put strict prudential guidelines aimed at strengthening banking industry.