Financial development and economic growth: The case of Rwanda

Abstract

The link between financial development and economic growth has been assessed by many studies on either groups of countries or individual countries which have come up with conclusions reflecting mainly four schools of thought linking the two: the supply-leading phenomenon; the demand-following phenomenon; bidirectional causation between the two; or no/negative association between the two. This study explores this literature and tries to analyze where Rwanda falls in these theories. It uses a recently constructed financial development measure (FD index) that combines many dimensions of financial system development; access, depth and efficiency of both financial intermediaries and financial markets, which is extensively broader than traditional indicators used in the majority of previous studies. The study has employed the augmented Granger non-causality test suggested by Toda and Yamamoto to assess the link between finance and growth, if any, for the years 1980 to 2018. The results suggest that, for Rwanda, the link is described by the demandfollowing theory, particularly driven by financial institutions. On the other hand, the financial markets and traditional indicators have a bi-directional relationship with economic growth. These findings are important for further research on financial institutions and highlight the importance of nurturing the financial markets so as to drive growth.