In our research paper, we conduct an empirical study on the direct causal relationship between foreign direct investment (hereafter FDI) and financial market development (hereafter FMD) in Africa, and their combined impact on economic growth. This study is even more relevant in the African context for a number of reasons. On the one hand, one can expect FDI to be an impetus for financial market reforms and serve as a mechanism to improve the transparency, liquidity and depth of financial markets in Africa. On the other hand, well-functioning financial markets on the continent can contribute to a more efficient allocation of foreign investments into productive sectors and create more value for foreign investors, hence foster more foreign investments. Therefore, we would expect FDI and FMD to simultaneouslyimpact positively on each other in the African context.

There are several theoretical rationales for expecting a causal relationship between FDI and FMD. First, an increase in FDI net inflows would contribute to the expansion of the economic activities and lead to an increase in funds available in the economy, which in turn would boost financial intermediation through available financial markets or the banking system. Besides, companies involved in FDI are also likely to be listed on local stock markets as they usually originate from industrialised countries where financing through stock market is a tradition and a must-do for any company that wants to enhance its image among investors. Second, using political economic analysis, one can argue that an increase in FDI would reduce the relative power of the elites in the economy and can prompt them to adopt market friendly regulations, thus strengthening the financial sector. Third, a relatively well functioning financial market can attract foreign investors as they will perceive it as a sign of vitality, openness from the countries authorities and market friendly environment, thus inducing them to invest more in the country. In addition, a relatively developed stock market increases the liquidity of listed companies and may eventually reduce the cost of capital, thus making the country attractive to foreign investors. Each of these arguments providesa theoretical rationale for a positive relationship between FDI and financial market development.

Furthermore, the literature on the relationship between FDI, FMD and economic growth has focused primarily on the relationship between FDI and economic growth and the role played by FMD in that linkage. The literature is almost silent on a possible direct causality between FDI and FMD. The few empirical papers that address this issue consider the role played by FMD in the channelling of FDI into economic production or focus on specific regions. Although, it is established that FDI contributes more to growth in countries with more developed financial market, it is not clear how FDI and FMD interact with each other, especially in Africa, where financial markets are still at the very developmental stage.

The extant literature has not clearly established, at least empirically, a direct link between FDI and FMD, especially for African countries where stock markets are at their embryonic stages and these countries rely strongly on foreign investments for economic development programs. The forgoing discussion relating to the link between FDI and FMD clearly suggests that the relationship between FDI and FMD is endogenously determined. We therefore use a system of simultaneous equations involving both FMD and FDI variables as dependent and independent variables in assessing this direct relationship between FDI and FMD, while controlling for other factors that affect the inflows of foreign direct investments and the development of financial markets.

Compared to previous studies, we use a multiple ofvariables to measure FDI and FMD, as suggested by the literature. For FDI, we use the ratio of FDI net inflows as a percentage of GDP and the ratio of FDI net inflows as percentage of gross capital formation (GCF). For FMD, we use stock market and as well as banking sector development variables; namely: (i) stock market capitalisation as a percentage of GDP, (ii) stock market turnover ratio, (iii) stock market value traded as a percentage of GDP, (iv) total credit by financial intermediaries to private sector over GDP, (v) liquid liabilities of the financial system divided by GDP and (vi) ratio of commercial bank assets to commercial bank andcentral bank assets. We also include in our regressions other variables found in the literature to be key determinants of FDI and FMD.

Based on Granger causality tests and multivariate analyses, we document a bidirectional positive relationship between FDI and FMD. We also find that FDI impacts positively and significantly on economic growth in Africa when we control for the simultaneous effects of both FDI and FMD.

Our work provides additional evidence that FMD facilitates the inflows of FDI and significantlycontributes to economic growth. More importantly, the statistical results also support the view that economic growth, FDI and FMD are interconnected. While the surge in private capital inflows in the 2000’s may be facilitated by the combined effects of worldwide excess liquidity and high commodity prices, it arguably reflects the progress made by a number of African countries in financial sector reforms. Yet, for most African countries, FMD is still in its infancy. Despite the policy measures adopted by some countries to make the business environment more attractive to FDI, the financial system remains bank-based rather than market-based. With the exception of a few stock exchanges such Johannesburg Stock Exchange, several African exchanges suffer from a lack of scale and the network economies needed to create the level of liquiditynecessary to make the markets effective channels to mobilize long-term capital resources in general and induce greater inflows of FDI in particular. The extent to which a consolidation of African stock exchanges and a greater integration of financial markets would induce greater inflows of FDI and foster higher economic growth could be an interesting subject for a future study.

Dr. Isaac Otchere is Associate Professor of Finance at Sprott School of Business at Carelton University in Ottawa, Canada. His research interests include valuation, mergers and acquisitions (M&A), and privatization. He taught MBA courses at Universities in Canada, Australia, Singapore and Ukraine, among others and has received a number of awards for excellence in teaching.

Dr. Pierre Yourougou is Clinical Associate Professor of Finance and Kiebach Fellow at Whitman School of Management at Syracuse University in New York, USA. His research interests include emerging markets, corporate finance, and financial markets and institutions.

Dr. Issouf Soumaré is Associate Professor of Finance and Managing Director of the Laboratory for Financial Engineering at Laval University in Canada. He is also responsible for the MBA & MSc Finance and MSc Financial Engineering programs at the same university. His research and teaching interests include risk management, financial engineering and numerical methods in finance. His theoretical and applied financial economic works have been published in leading international economics and finance journals.

(1) UNCTAD, 2009, World Investment Report 2009, Transnational Corporation, Agricultural Production and Development, United Nations, New York and Geneva.
(2) Beck, T., Fuchs, M., and M. Uy, 2009, Finance in Africa: Achievements and Challenges, World Bank Policy Research Working Paper 5020.

Most of the discussion on financial deepening and broadening focuses on financial institutions and markets and thus on the supply side.  And it is natural to start the analysis here, as that is where traditionally data have been. Similarly, regulators focus on financial institutions and markets as natural starting point. Looking at the big picture, however, we care about the users and beneficiaries of financial services.  We care about enterprises that need external financing for working capital and investment. We care about households that need access to payment and deposits services. We care about risk management services for both households and enterprises. Only in a second instance do we care about who provides these services.  In the recent Financing Africa flagship report, my co-authors and I therefore emphasize the need for increased focus on users, with important repercussions for both analysis and policy.  

This increased focus on users is supported by recent data collection exercises for both enterprises and individuals that have allowed a closer look at users and non-users of financial services, understanding both supply and demand-side barriers and the extent of use. However, it also requires a reorientation in regulatory approaches, as I will discuss in the following.   What does a closer focus on users imply? First, it implies an increased effort at financial literacy, i.e. knowledge about products and capability to make good financial decisions, both for households and enterprises. There is often a lack of awareness about available financial products, as well as a lack of capability to manage resources well, knowing to evaluate and compare different financial products and services, and demanding one’s rights if necessary. 

Specific activities in this area might include the design of graphic tables with comparative information on the full pricing of financial products, community and village road shows to explain major financial concepts, training on the delivery of financial education by retail officers, financial literacy messages in m-banking systems, campaigns on new pension systems, basic brochures on financial services, the inclusion of financial literacy in school curricula, campaigns on the management of debt and the avoidance of over indebtedness, and campaigns on the economics and the benefits of the insurance market. A lot has happened in this area in recent years, but significantly more research and analysis is needed to explore what kind of program targeted of which population group can be helpful.  

Second, there is a general trust issue. Overcoming households’ mistrust of financial institutions might be easier in the case of transaction services, where the inter temporal nature of financial services is reduced to a few minutes, especially in m-banking, especially in the case of mobile phone banking, in contrast to savings or credit services, where the result can only be seen after months if not years. The rapid success of m-banking services focusing on payment and remittance services in several African economies has shown the promise of using transaction services as entry point for the inclusion agenda.  

Third, an increased focus on users implies more tailor-made products for the bottom of the pyramid. Transaction accounts, often linked to the use of ATMs rather than shiny banking halls, might be more attractive and cheaper for large part of the currently unbanked population. Agency banking, i.e. financial service provision through non-financial institutions, such as supermarkets or gas stations – a success in Latin America - can help overcome geographic and cultural barriers. Linking with informal financial service providers and microcredit institutions can also help barriers between banks and users.  

Fourth, for enterprises, a focus on users refers mostly to the challenge of turning investment into bankable projects. Standard barriers include the lack of collateralizable assets and audited financial statements. To address the lack of collateral one has to look beyond the upgrade of property registries – part of the necessary infrastructure of any modern financial system, but a rather long-term goal; products tailored for SMEs such as leasing or factoring rely less on traditional collateral. Combining lending with extension services for entrepreneurs can be promising.  

Standard accounting rules are too much of a burden for most SMEs. There might a need for the development and implementation of simplified accounting standards for microenterprises and for SMEs.  

Fifth, it is important to stress that financing is only one of the many obstacles that African enterprises face in their operation and growth. African firms report greater obstacles than firms outside Africa in access to land, customs and trade regulations, transport, and, most strikingly, electricity. This points to the deteriorated physical infrastructure that African enterprises have to deal with, as well as the deficiencies in the broader regulatory environment, and thus a broader reform agenda than financial sector reforms.  

While a focus on users is important in the financial deepening and broadening agenda, it is as important in the financial stability agenda. We care about stability of financial systems not for the sake of bankers and stock market traders, but for the sake of users. 

This implies consumer protection, including (1) consumer disclosure that is clear, simple, easy to understand, and comparable; (2) prohibitions on business practices that are unfair, abusive, or deceptive and (3) efficient and easy-to-use recourse mechanisms.    

On a more general level, it might have to imply a rethinking of supervisory focus. The decision to extend regulation and supervision to non-bank segments of the financial system has to take into account the need for protection by different users. We therefore advocate a caveat emptor approach for segments of financial markets with mostly sophisticated users, such as equity funds and over-the-counter segments of capital markets, whereby the weight of the responsibility for monitoring lies on sophisticated investors rather than supervisors. For bottom-of-the pyramid segments, on the other hand, we advocate an increased supervisory focus, especially in the case of deposit-taking institutions. Experiences from low- and middle-income countries have shown the risk that pyramid schemes and their collapse can pose for socio-economic stability.  Beyond regulation and supervision of deposit-taking institutions and conduct of business regulations for non-deposit taking institutions, this implies increased consumer protection as outlined above.  

The increased focus on users is thus a broad agenda. As with the rest of the financial sector agenda, one size does not fit all. While South Africa has established a multi-tiered consumer protection framework, the institutional demands for such a framework might be too large for many small low-income countries, where simpler versions, maybe based on industry self-monitoring, might be necessary. Regulation and supervision of many small microfinance institutions can be costly in many African countries with limited supervisory resources, using apex structures can be helpful in this context.

Africa remains one of the least developed, and the most under-banked continent. This is not a coincidence, and reflects the importance of banking as an engine for economic development. Financial institutions stimulate growth, by promoting savings, by allocating capital efficiently and by helping risk diversification. But finance can also reduce poverty, by facilitating access to deposits and allowing individuals to take advantage of opportunities which require upfront costs. This could be in the form of allowing entrepreneurs who lack funding to launch their own businesses.

Conventional banking has shown some limitations in adapting to the low-income environment. Access to finance is limited as borrowers often lack collateral against which they can borrow. When collateral is available, the lack of an efficient judiciary and well-defined property rights may hinder conventional banking from recouping the collateral in case of a failed venture. In addition, from the poor’s point of view, a failure of a loan could lead to a poverty trap from which it may be difficult to rebound. In such circumstance, if borrowers have a high level of risk aversion that discourages risk-taking, lending may also not take place.

In such an environment, Islamic banking has the potential to accelerate financial development. It seeks to provide financial services compatible with Islamic teaching, by reducing some of the risk elements of borrowing. Interest payments are prohibited for instance. In addition, even when banks provide all the financing, both borrowers and lenders share the risk of failure and success, creating a shock-absorbing mechanism that is essential to encourage risk taking. As African countries tend to be undiversified, commodity producing countries subject to boom-bust cycles and the vagaries of nature, such a form of borrowing that takes into account the inability for individuals to take on too much risk might stimulate investment and growth more than traditional banking. The relative stability, and continued growth of Islamic banking during the global financial crisis attests to its resilience and potential. In addition, Islamic banking promotes increased financial intermediation, as it satisfies the needs of devout Muslims, encouraging savings.

Against this background, in our study (1) we have analyzed econometrically how Islamic banking has diffused throughout the World and drawn policy implications to accelerate its progress. With African home to one of the largest Islamic population, accounting for a little more than 40 percent of the population, Islamic banking could become a key engine for financial deepening. During the last decade, Islamic banking has grown from a niche market into a mainstream industry in many African countries. Within Africa,regional variations are visible, with Islamic banking having diffused more rapidly in Northern Africa—a region that is predominantly Muslim—than in the regions that have sparser Islamic populations such further south the continent. From Senegal to Kenya, and Mauritius, Islamic banks are being licensed across the continent, without major changes to existing banking regulations.

The study finds that the probability of increased Islamic banking in a given country rises with the share of Muslims in the population, income per capital, the price of oil and macroeconomic stability. Proximity to Malaysia and Bahrain, the two main Islamic financial centers, and trade integration with Middle-Eastern countries also make diffusion more likely. Interest rates negatively affect the diffusion of Islamic banking, reflecting the implicit benchmark they pose for Islamic banks.

Some results were more surprising. Islamic banks spread more rapidly in countries with established banking system. Islamic banks offer products not delivered by conventional banks and thus complement, rather and substitute for conventional banks. The quality of a country’s institutions, such as the rule of law or quality of bureaucracy was not found to statistically explain the diffusion of Islamic banking, unlike conventional banking. Because Islamic banking is guided by Shariah, it is largely immune to weak institutions: disputes can be settled within Islamic jurisprudence. Finally, contrary to conventional wisdom, the 9/11 attacks were not an important factor in the diffusion of Islamic banking. These events simply coincide with rising oil prices, which appear to the actual driver of Islamic banking diffusion (2).

The research findings imply that Islamic banking can help accelerate financial development and growth throughout the continent. With the Muslim population expected to reach about 650 million by 2030 (3) —a large share of which will be unbanked—combined with ongoing macroeconomic stability, a low interest rate environment andan institutional setting that needs to be strengthened, the African region has the potential to become a fertile ground for Islamic banking development. However, more needs to be done to raise per capita income through structural reforms and strengthen trade ties with Middle-Eastern countries.

Islamic banking diffusion could stimulate financial development and improve access to financial services, thereby spurring growth. However, it is nota panacea; developing Islamic banking is only part of an overall and well-coordinated policy package designed to achieve sustainable growth and poverty reduction.

Kangni Kpodar is an economist in the Fiscal Affairs Department at the IMF, with a PhD in economics from the CERDI (Clermont-Ferrand, France). His research interest focuses on financial development, growth and poverty issues.

Patrick Imam is an economist in the Monetary and Capital Markets Department at the IMF, with a PhD in economics from Cambridge University (Cambridge, UK). His research interest encompasses capital markets and financial stability.

(1) Patrick Imam and Kangni Kpodar, 2010,“Islamic Banking, How Has it Diffused”, IMF Working Paper No.195
(2) Although high oil prices are found to stimulate Islamic banking development, they are likely to hurt nonoil exporting countries in Africa, offsetting the potential benefits Islamic banking development may bring to economic growth.
(3) Pew Research Center (2011)