emmanuel kyei thesis

8/2/2019 Emmanuel Kyei Thesis

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TOPIC: ECONOMIC IMPACT OF FINANCIAL SECTOR LIBERALIZATION ON THE PERFORMANCE OF MICRO-

AND SMALL SCALE ENTERPRISES IN GHANA

CHAPTER ONE

INTRODUCTION

1.1 OVERVIEW

Financial sector of any modern economy plays a significant role in the growth and

development process of that country.

Firstly, the sector mobilises savings and then effectively allocates it across investment

projects. Secondly, the sector provides insurance to risk-averse savers and investors.

Thirdly, in an open economy it helps domestic lenders and borrowers to compete

effectively on the international capital market. Finally the sector as a whole creates new

jobs and career opportunities for individuals in the society. ( Caprio et al 1994).

However, the contribution of the financial sector to the development of micro and small-

scale enterprises depends upon the quality and quantity of its services and the efficiency

with which it provides them.

Financial sector in Sub- Sahara Africa countries (SSA), including Ghana had been

characterised by weak resource mobilisation, high credit loses, high intermediation costs

and excessive political interference. Stightz (1998) asserted that history does not offer

many examples of successful economies that did not accord the market a central role in the

allocation and monitoring of capital. Thus in a repressed financial sector, where policies

governing it is the preserve of the government; financial institutions hardly achieve success

under such repressive environments.

In the field of development finance, advocates for financial liberalisation generally argue

that liberal financial policies that remove constraints and controls tend to improve the

efficiency of financial resource allocation. According to Stiglitz, Provide there are no

externalities the competitive market price is efficient, and hence this theory can be applied1


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to financial markets in terms of the supply and demand for funds at the market clearing

interest rate. Theory states that financial sector should be fully liberalised in the same way

that governments are advised to stay off the product market.

The cases for financial sector liberalisation stems from the fact that liberalisation have so

many advantages healthy for a financial sector in particular and the growth and

development of a nation in general. It has been asserted that financial sector liberalisation

increases savings, improves the efficiency with which resources are allocated among

alternative investment projects and therefore raises the rate of economic growth.

Investment spending which is one of the major categories of expenditure entering into the

aggregate demand has become a significant element in the development of the economies

of nations. This proactive element in an industrial society, which involves the acquisition of

capital goods, is very significant because of its impact on the economys productive

capacity (Peterson 1998). Its function is to produce other goods and services. This means

that even though investment expenditure plays a key role in determining current levels of

income and employment their influence reach beyond the present because of their impact

upon capacity. Investment expenditures are thus vital factors in economic growth, which

depend to a great extent upon how rapidly productive capacity is being enlarged.

The predicament of governments of developing countries, including Ghana was their

inability to liberalise the financial sector. This has hindered entrepreneurs of micro, small

and medium scale enterprises to have more access to financial services for expansion.

Prior to 1983 Ghana operated a tightly regulated financial system. The impacts of the

tightly regulated policies on economic development were dismal. In April 1983 the

government of Ghana introduced a strict budget, which contained a programme of far

reaching economic reforms known as the Economic Recovery Programme (ERP, 1983 to

1986). This programme was followed by the Structural Adjustment Programme I (SAP I

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1987 to 88) and (SAP II 1989 to 90). These programmes have been aimed at both economic

stabilisation and structural adjustments. Included in the package of the ERP was the

financial sector liberalisation.

Financial sector liberalisation became necessary since the pre-liberalisation financial sector

policies of government in terms of control over financial markets, together with an acute

prolong economic crises and unorthodox measures, had severely damaged the financial

system leading to both financial shallowing and bank distress. (Gockel et al 1995)

The productive sector of any modern economy is made up of enterprises categorised into

micro, small, medium and large scale, depending on the size and extent of productive

capacity. For these enterprises to increase production of goods and services, increased flow

of financial services are very essential.

Basically the financial services that are available to these categories of enterprises in Ghana

are;

(i) Retained Earnings (internal cash flow of the firm).

(ii) Equity financing (selling of shares in the firm).

(iii) Borrowing (issuing of bonds and other forms of debt from the banks and non-bank

financial institutions)

(iv) Transfer financing (friends, relations etc.)

(v) Personal savings (self financing)

While some medium and almost all large scale enterprises that constitute a small

percentage to aggregate output and small proportion of the economy have access to

financial services in Ghana, the micro and small-scale enterprises that form a large

percentage in terms of aggregate output and size are limited to retained Earnings,

borrowing from the informal sources (money lenders, rotating savings, credit associations,

saving collection i.e. Susu), and a very limited access to formal sources (the commercial

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banks, saving banks, etc.) inspite of increasing demand for more financial services in order

to expand output of goods and services.

Micro and small-scale enterprises thus typically cite lack of access to finance as an

important constraint on their operations. This lack of access is often associated with

financial policies and bank practices that make it hard for banks to cover the high cost and

risks involved in lending to small firms.

1:2 STATEMENT OF THE PROBLEM

Many developing countries have experienced financial shocks through the introduction of

financial liberalisation.

Prior to the liberalisation of the financial sector, many economies in the developing world

had discarded the price mechanism by instituting controls on the interest rates, minimum

and maximum credits, credit allocation and exchange rates. Later on, most less developed

countries instituted measures to liberalise their financial sectors by allowing free entry into

the banking system. Fixing of interest rates were liberalised, credit controls were abolished,

and flexible exchange rates replaced the fixed exchange rate regime. Thus, financial

liberalisation became the dominant policy paradigm over the last two decades.

Ghana, like many other less developed country pursued the policy of controls over interest

rates and credit allocations. Thus prior to 1989 Ghana followed a policy of financial

repression which relied on fixing interest rate below market levels and controlling the

allocation of credit. The financial system thus remained under-developed, lending patterns

were inefficient and failed to achieve their distributional goals. Negative real interest rates

led to low savings and encouraged capital flight. Macro-economic performance also

deteriorated with its adverse impact on the growth of bank assets. Credit availability to the

micro and small-scale enterprises were also constrained.

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Extensive government intervention characterised the pre-liberalisation era. Public

ownership dominated the Banking system. The bank of Ghana determined the structure of

interest rates including minimum interest rates for deposits and maximum lending rates.

Priority sector such as agriculture received preferential lending rates and in most cases

these were lower than the minimum saving deposit rates. Sectoral credit guidelines based

on an annual credit plan drawn up by the Bank of Ghana were imposed on the Commercial

Banks to channel credit towards the priority sectors of agriculture, manufacturing and

exports.

Although the financial sector policies were aimed at supporting priority sectors through the

use of sectoral credit guidelines and preferential interest rates, the supply of credit to these

sectors declined in real terms. Credit to the whole of the non-government sectors amounted

to only 3.6 percent of GDP in 1985, having fallen from 9.8% of GDP in 1977 (World Bank

1986v).

In 1987, Ghana initiated the liberalisation of its financial sector by removing controls on

interest rates; and the sectoral composition of Bank lending and by introducing market

based instruments of monetary controls.

Liberalisation was expected to provide easy access to micro project credit facilities from

the banking system at affordable capital costs. The implication is that in Ghana micro and

small firms significantly contribute to economic growth and development so that with

access to bank loans these entrepreneurs could expand their businesses and thereby fulfil

the economic growth of Ghana.

However, there is the belief that financial sector liberalisation has led to the following

consequences on Ghanas economy including micro and small-scale enterprises.

First, there is the belief that some disadvantaged groups such as the micro and small-scale

enterprises and the poor have not enjoyed adequate attention of commercial banks in the

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post liberalisation period. It is felt that the liberalisation has led to the concentration of

financial assets in the hands of large firms. This situation might have led to many micro and

small-scale enterprises having to seek credit through non-formal means such as

moneylenders in order to survive.

The high interest rates and difficulties in meeting standard loan requirements due to the

liberalisation of the financial sector have prevented micro and small firms from borrowing.

Added to this, the liberalisation of the financial sector has tended to facilitate the search for

quick profits to the extent that resources are channelled away from productive sectors of the

economy such as micro and small-scale enterprises.

There is therefore the need for a detailed study of the financial sector liberalisation and its

impact on the performance of micro and small-scale enterprises in Ghana. Micro and small-

scale enterprises have a significant role to play in terms of their employment generation

capacity, quick production response and their adaptation to weak infrastructure and their

use of local resources as well as being the means of developing indigenous entrepreneurial

and managerial skills for sustained industrialisation. Micro and small-scale enterprises also

contribute to development. To ensure balanced growth and development the National Board

for Small-scale Industries (Act 434) was established in 1985 to oversee the growth of micro

and small-scale industries in Ghana.

However, the significant role that the micro and small-scale enterprises are expected to play

in Ghana has been constrained with a number of factors including accessing funds from the

formal financial institutions.

1:3 THE RESEARCH QUESTIONS

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The research questions that need attention in view of the perceived benefit that financial

sector liberalisation confer on the performance of micro and small-scale enterprises then

are:

(a) Are there any macro economic factors that help to explain the level of credit to the

private sector and hence to the micro and small-scale enterprises in Ghana?

(b) Is financial liberalisation a sufficient condition for credit availability to micro and small

scale enterprises or has financial liberalisation actually increased the supply of credit

from the formal financial sector to micro and small enterprises?

(c) If yes; how much has the micro and small-scale enterprises benefited? If no why?

Hypothesis to be tested based on the above research questions are presented in chapter

three.

1:4 OBJECTIVE OF THE STUDY

Financial sector liberalisation became an integral part of Ghanas Economic Recovery

Programme (ERP) in the late 1980s. It is felt that the pre-liberalisation policies of

government control over the financial market together with and acute and prolonged

economic crises had severely damaged the financial system.

The general purpose of this study is to:

(i) trace the impact of macro-economic factors on lending to the private sector.

(ii) empirically ascertain the extent to which the financial sector liberalisation has

facilitated credit availability to the micro and small-scale enterprises in Ghana.

(iii) ascertain other benefits derived by the micro and small-scale enterprises from

the financial sector liberalisation

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(iv) make suggestions that will strengthen the capacity of the financial sector in Ghana

in facilitating access of micro and small-scale enterprises to financial services which

will be of great help to the economy as a whole.

1:5 JUSTIFICATION FOR THE STUDY

The growth of commercial bank lending to the small-scale borrowers and start-up

enterprises following financial liberalisation has been somehow disappointing. However,

the role micro and small-scale enterprises play in an economy in terms of their contribution

to the private led-growth through employment and income earning opportunities, and by

quick response to changing policies incentives and market conditions cannot be

overemphasized.

In fulfilment of the mandate, the National Board for Small-scale Industries (NBSSI) has

developed a policy document, which provides a wide range of services, among which are

the micro and small enterprises financing. Strengthening the structure and operational

capabilities of micro and small-scale enterprises and also encouraging commercial Banks to

formulate MSE financing policy and loan desks are among the policy document of NBSSI.

However micro and small-scale enterprises often cite lack of access to finance as an

important constraint on their operations.

Aryeetey, Baah-Nuako et al (1994) studied the supply and demand for finance of small-

scale enterprises in Ghana. In their paper, they came out with certain findings about small-

scale enterprises finance under liberalisation in Ghana. However, the study was not meant

to establish the impact of financial sector liberalisation on the performance of micro and

small-scale enterprises.

This study intends to establish such impact quantitatively.

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1:6 DATA SOURCES AND COLLECTION TECHNIQUES

Basically the study depends on primary and secondary sources of data and information. The

main objective is to ascertain the extent to which the micro and small-scale enterprises use

the financial institutions. This is examined through survey of micro and small-scale

enterprises in the Ashanti Region particularly Kumasi Metropolis. The survey is to enable

the researcher assess the views of the micro and small-scale entrepreneurs on the research

topic.

Micro and small-scale entrepreneurs constitute the main source of primary data through

structured interviews. The collection of secondary data is through consulting secondary

sources both within and outside target groups. These secondary sources include reports,

journals, newspaper publications, bulletins, newsletters, and textbooks.

1:7 SCOPE OF THE STUDY

For in-depth study, the research covers micro and small-scale enterprises (MSEs) in

Ashanti Region, especially Kumasi metropolis. The centrality of the region, with Kumasi as

a second metropolis of Ghana, has drawn several MSEs to the region. Clusters of MSEs are

found in various areas of Kumasi such as Suame, Asafo, Adum etc. Such clustering

enhances such a study and reduces cost of research.

However, it is believed that the homogeneity nature of MSEs in Ghana permits some

generalisation.

The distribution of the respondents per city/town is as follows;

DISTRICT CITY/TOWN No of Respondents

Kumasi Metropolis Kumasi 250

Sekyere East Effiduasi 50

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Adansi West Obuasi 40

Afigya Sekyere Agona 35

Offinso Offinso 35

Ejura Sekyeredumasi Ejura 40

Sekyere West Mampong 50

Asante Akim North Konongo 35

Atwima Nkawie 25

Total 550

1.8 ORGANISATION OF THE STUDY

This work is divided into five (5) main chapters.

Chapter two (2) deals with the literature review, which is the review of previous work done

on the topic.

Chapter three (3) deals with the conceptual model of the topic.

Chapter four (4) deals with the survey findings and empirical results and discussions of the

results.

Chapter five (5) contains conclusion and suggestions.

CHAPTER TWO

2:0 LITERATURE REVIEW

2:1 FINANCIAL REPRESSION

According to NILLS (1989) financial system in Sub-Saharan African countries had

long been shackled with extensive imprudent regulations operated on inefficient grounds.

The economies of Sub-Saharan African countries were dominated by just few institutions10


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mainly commercial banks. Common to most of these systems were statutory interest rate

ceilings, the accommodation of government borrowing and the existence of informal

financing. The generally restricted financial systems had hindered the efficient mobilisation

and allocation of financial resources and impeded monetary control policy.

Most of these countries in Sub-Saharan Africa followed the Keynesian theory of

investment and growth. The Keynesian theory of investment and growth postulates a

negative relationship between interest rate and investment. Thus an artificially low interest

rates boost investment and savings and hence growth. The underlying reason for the

Keynesian theory of investment and growth is the belief that high borrowing costs (lending

rates) discourage private investment. The Keynesian doctrine of government intervention

was a popular policy prescription in the 1950s and 1960s.

The period of financial repression was characterised by;

(a) nominal interest rates set below market levels

(b) negative real interest rates

(c) direct credit and credit ceilings

(d) highly regulated and controlled financial system

(e) high reserve requirements

(f) foreign exchange rate distortion

As stated earlier, the rationale for financial repression was based on Keynesian theory of

investment that artificially low interest rates boost investment and savings and hence

growth. Also high cash reserve ratios and statutory liquidity ratio makes cheap funds

available to the government. Again interest rates below the market interest rates means cost

savings to government on public debt.

2:2 EFFECTS OF FINANCIAL REPRESSION

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There are many literatures on the effects of financial repression on the economies of

countries that adopted it. According to one literature on the effects of financial repression

issued by Kirkpatrick (2002), financial repression led to the following consequences on the

economies of most countries that adopted it;

Firstly, financial system remained under developed.

Secondly, lending patterns were inefficient and failed to achieve their distributional goals.

Thirdly, negative interest rates led to low savings and encouraged capital flight.

Fourthly, macroeconomic performance also deteriorated. Countries with large negative real

interest rates experienced lower allocation efficiency and growth rates.

Also in the state-owned banking sector, poor lending decisions (often politically

influenced) and low repayment rates led to banks insolvency and large budgetary bailouts

of depositors and creditors.

According to Todaro (1998), the concentration of development and commercial

bank loans to few large borrowers, together with the widespread existence of high inflation,

growing budget deficit, and negative real interest rates led to a serious credit crunch in

less developing countries. Todaro analysed the effect of being subjected to numerous

lending restrictions and mandatory interest rate ceilings at levels below market clearing

rates. Theoretically when there is an effective interest rate ceiling below equilibrium level,

the demand for loanable fund would greatly exceed the available supply. The excess

demand would lead to a need to ration the limited supply. This phenomenon is known as

financial repression since investment is limited or repressed by shortage of savings

resulting from administered real interest rate below the equilibrium level. According to

Todaro, in the absence of outright corruption in the allocation of the limited loanable funds,

most commercial banks choose to allocate the available credit to few larger borrowers. This

is to minimise the administrative overhead cost of lending. Thus, the net effect of

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government controls over lending rates means that even the fewer loans would be allocated

to few investors. Banks could only cover the additional administrative costs as well as the

added risks of smaller loans by charging higher interest rates. This would imply that

farmers and micro entrepreneurs would not have resource from banking system but seek

finance from the unorganised money market, even though they would be willing to borrow

at rates above market clearing level. One suggested solution to the problem according to

Todaro would be to liberate the financial sector by allowing nominal interest rates to rise to

market-clearing levels.

2:3 FINANCIAL LIBERALISATION

The failure of Keynesian economics to explain the drop in output simultaneously with

rising prices experienced in the early 1970s due to cost shocks prompted a debate on the

validity of government intervention policies.

McKinnon (1973) and Shaw (1973) argued that in the context of developing

countries, where the only organised financial system is the banking system, financial

repression retards economic growth. The McKinnon-Shaw views of financial liberalisation

soon became the mainstay of economic reform in developing countries (Athukorala and

Rajapathirona 1992).

In Sub-Saharan African countries also, financial liberalisation became a dominant policy

paradigm over the past two decades.

According to Fry (1995, 1997), McKinnon-Shaw school favours financial

liberalisation, and argues that financial repression in the form of ceilings on interest rates

which causes real rates to be negative distorts the economy in several way. A low level of

deposit interest rates;

(i) produce a bias in favour of current consumption against future

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consumption, thus they push savings and investment below their

socially optimum levels.

(ii) Potential depositors may engage in low-yielding direct investment.

(iii) Bank borrowers choose high capital-intensive projects.

(iv) Low interest rate ceilings discourage risk-taking on the part of financial

institutions.

(v) Low interest rate may shift funds to kerb markets.

(vi) International capital flight.

Shreft and Smith (1997) also argued that a low level of lending rates causes under

investment in the allocation of information about projects or borrowers. The government

can further distort the financial market by offering relatively high interest rates on

government bonds in order to borrow money from financial institutions. This government

borrowing crowds out private borrowing or investment.

According to Brownbridge and Harvey (1998) the argument on which the financial

liberalisation depended was that;

(i) Removing government control of interest rates would eliminate the ill effects

of negative real interest rates because market forces would raise nominal rates

above inflation.

(ii) Raising nominal interest rates would increase bank deposit, and make more

finance available and would improve the efficiency of bank lending.

(iii) Allowing interest rate to be independently determined by the market forces

would make bank lending possible to a wide range of borrowers including,

especially, the small-scale borrowers who were previously excluded from access to

banks credit, by allowing banks to match reward to risk.

(iv) Licensing new banks would, through increased competition increase the

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range and reduce the cost of bank lending.

(v) The macroeconomic objectives of monetary policy would be achieved

more effectively by relying on indirect instruments of direct controls

2:4 PREREQUISITE FOR FINANCIAL LIBERALISATION

In his paper in a book Instrument of Economic Policy in Africa, EL NIL (1989) outlines

the prerequisites for successful financial liberalisation. For financial sector liberalisation to

be effective in realising its broad objectives, some necessary conditions, mostly related to

its formulation and implementation, must prevail.

(i) POLITICAL COMMITMENT

There should be a commitment to the reform for a financial liberalisation to be carried out

successfully, there must be a political commitment to the liberalisation. Courage and

determination need to be accompanied by energetic effort to explain the benefits of the

liberalisation to the affected segments of the population at large and to economic operators

in particular. Since financial liberalisation involves difficult decisions regarding removal of

distortions affecting both the direction and cost of credit, political commitment is said to be

very important. The liberalisation needs to redress any existing imbalances in the

distribution of credit between sectors, regions, industries etc and to tackle distortions in the

cost at which credit is delivered. In addition the closure or rehabilitation of troubled

financial institutions would also result in some retrenchment of jobs. It is most certain that

pressure groups, which may lose their jobs during a reform, would lobby to obstruct or at

least delay the needed change. Also in the early stages of the reform, it is likely that the

budgetary problems would be aggravated due to the liberalisation of the financial sector,

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which would entail extra costs in the form of higher interest rate payments on domestic

debt. Also public sector share of domestic credit may be reduced.

In these circumstances additional external support may be indispensable in order to enable

the government to find alternative means of meeting its financial obligation.

(ii) MACROECONOMIC ENVIRONMENT

In addition to political commitment, there should be the existence of appropriate

macroeconomic environment. Such environment must be free of destabilising inflationary

pressures and other adverse macroeconomic features. The stability must encourage greater

mobilisation of domestic savings as well as their efficient allocation and should also assist

in the integration of fragmented informal credit market into the formal financial sector.

It should be noted however that statutory regulations in many African countries still impose

low and frequently negative real interest rates on bank deposits, which together with

policies that bred inflationary tendencies deflect financial savings away from the banking

system. Polak (1989) observed that these policies make for highly inefficient linkages

between the supply of savings and the demand for investment and consequently for low

growth.

(iii)LOGISTICAL FRAMEWORK

Another prerequisite for successful financial liberalisation is logistical framework. NILS

points out that the capacity for carrying out effective financial liberalisation also rests to a

large extent on the underlying regulatory framework and the quality of those entrusted with

its implementation. The regulatory framework consists of the Central Bank and the non-

bank financial intermediaries. Gelb and Honoban (1989) in their study of financial reforms

in adjustment programmes observed that these reforms seek to establish their supervisory

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and regulatory functions through the enforcement of information system. They pointed out

that there is the need for a thorough training of those who are charged to implement the

programme.

(iv)SPEED AND EXTENT OF REFORM

Another prerequisite for financial liberalisation is the speed and extent of reforms. A

sufficient time is required before financial liberalisation can fully work themselves out, and

succeed in establishing a deep liberal and efficient financial sector, conducive to the more

efficient conduct of monetary policy and the mobilisation and allocation of financial

resources. This according to NIL is due to rudimentary and repressed state of African

financial systems. Also due to narrow financial infrastructure in most African countries, it

is hardly possible to achieve competitive returns over a relatively short period. NIL

suggests that liberalisation should be carried out in phases or entire liberalisation over an

extended period of time.

(v) EXTERNAL SUPPORT

The external support is needed not only for carrying out meaningful financial liberalisation,

but also for other adjustment policies. The liberalisation, which involves management of

interest rate, extension of banking services to rural areas and other capacity building, entails

substantial costs. For example the partial freeing of interest rates will increase interest

payments on government domestic debt leading to aggravation in the fiscal position. The

higher interest rate would lead to a more efficient use of credit and hence external support

is thus needed to cushion the initial deterioration in the budget deficit. Although the cutting

down of government domestic credit is usually the required measure in a financial

liberalisation, the adoption of revenue enhancing and expenditure curbing measures to prop

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up the budget will be a slow process in most African countries. Adequate and orderly

external resources flow is crucial for countries that want to sustain the modest progress

achieved by liberalising their financial system.

In McKinnon (1973) and Shaw (1973) framework of interest rate restraints inhibits

financial development largely by depressing real interest rates, which in turn affect

economic growth. In the McKinnon-Shaw framework interest rate liberation, by increasing

the volume of bank assets and liabilities enhance the development of the banking system.

Others however, have suggested that in the presence of information asymmetries,

liberalisation of interest rates may not necessarily lead to financial deepening (Schiantarelli

et al 1994). Indeed the combination of asymmetric information with the provision of

deposit insurance can lead to excessively risky lending and substantial increases in bad

debts ( Caprio 1994).

Furthermore, intensive competition that usually follows financial liberalisation

lowers profits for banks, which in turn erode their franchise values. This situation increases

the premium for external finance and thus lowering bank incentives for making good

loans. (Caprio and Summers 1994, Gerther and Rose 1996, Hellman et al 1996b, 2000).

This exacerbates the problems in the banking system, thereby increasing the risk of

bank portfolios, which in turn may affect adversely the public perception of the soundness

of the banking system. Consequently prudent bank behaviour is undermined, with the

probability of financial crises being enhanced substantially (Hellman et al 2000, Akerlof

and Roma 1993).

According to Stiglitz (1994) some types of financial restraints, such as interest rate

ceilings on deposit rates, by keeping profit margins within certain limits can reduce the

problems of moral hazard and adverse selection. In this way, financial restraints may

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reduce the risk of bank portfolios by limiting bank incentives to invest in assets that

facilitate gambling.

Structuralists who hold contrary views to the McKinnon-Shaw school of financial

liberalisation argue that low level of real interest rates and credit towards priority sectors

would increase investment and economic growth (Stiglitz and Weiss 1981, 1992). They

also suggest raising government expenditure in order to increase effective demand,

investment and economic growth where inflation tax is easy source of government

revenues. Interest rate deregulation increases savings on the one hand and reduces effective

demand and profits on the other (Burkett and Dutt 1991, Gibson and Tsakolotos 1994). The

negative impact often dominates the positive one due to a pessimistic view regarding future

profits, which worsens the negative impacts causing a decline in savings, investment and

economic growth.

(i) Structuralists argue that an increase in the interest rates;

(ii) causes a real interest rate appreciation and exerts a negative impact on the

tradable sector by making export more expensive

(iii) incurs losses to a bank when it is lending long term and borrowing on a

short-term basis.

(iv) raises government budgetary strain since in developing countries significant

portion of deficits are financed by bank loans. Moreover a reduction in reserve

requirements and a relief from buying government bonds reduce tax revenues.

Structuralists again argue that financial institutions, maximising expected profits usually

charge interest rates lower than the equilibrium rates. The financial institutions thus decline

to supply funds to borrowers who are willing to pay equilibrium rates.

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According to Beckerman (1988), the neo-Keynesians also argue that a low level of

interest rates may be because;

(i) A low level of demand for investment caused by depressed expectations and high

levels of uncertainty about the future

(ii) Cash holding or liquidity preference or the accumulation of savings to make large

purchase when excess to credit market is limited. Consequently, savings take place

even when interest rates are negative. Any initiative to increase real interest rates

generates an oversupply of fund.

This damages the stability of the financial sector.

The Neo-Structuralists also using a portfolio framework for the allocation of household

asset also challenged the argument put up by McKinnon and Shaw. The neo-structuralists

led by Taylor (1983, 1988), Van Wijnberger (1983), Buffie (1984) and Dornbush and

Reynose (1990) criticised the McKinnon-Shaw prescription on the grounds that high

interest rates would probably reduce the rate of economic growth by reducing the real

supply of credit available to the private sector.

The argument of Neo-Structuralists is based on the idea that the organised financial

sector (the banking system) in developing countries is less efficient than the unorganised

money market (informal credit market) in intermediating financial resources. The neo-

structuralists uses Tobins general equilibrium approach to financial markets in developing

countries. They argue that higher bank interest rates may induce portfolio shifts to bank

deposits more from assets in informal credit markets than from currency or inflation

hedges. Therefore higher bank credits crowds private investment and hence depress the20


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growth of the economy in the short term (Van Wijnberger 1983). Thus the Tobins general

equilibrium approach to financial markets is based on the revelation that household tend to

diversify their asset portfolio rather than putting all their eggs in one basket (Incoom S. E

unpublished book).

According to Stiligtz (1994), contrary to the prediction of McKinnon-Shaw school, credit

rationing prevails even in the absence of ceilings on interest rates. In addition, information

and monitoring are public goods, which are very important for the financial markets and

under-supplied by competitive markets.

According to the McKinnon (1973) analysis of financial repression, economic

liberalisation and monetary stabilization are complementary concepts. When inflation is

high and uncertain, the full deregulation (liberalisation) of markets in goods, financial

capital or labour services cannot work well. Thus in determining how to bring domestic

inflation under control in the liberalised economy, government must attempt to keep

interest rates, exchange rates and wage rates properly aligned during the period of

disinflation.

Diaz-Alenjandro (1985) argues that this policy has proved difficult in a number of

countries. Accordingly, the general case favouring financial liberalisation has been called to

question by a series of bank panics and bankruptcies in the southern cone of Latin America.

According to Taylor (1983), different conclusions on the effect of financial liberalisation

come from different perceptions of the efficiency of banks and informal credit market in

intermediating financial resources. McKinnon and Shaw view the informal credit market as

rudimentary and fragmented. It does not efficiently intermediate household savings to

private investment when compared with organised banking system. In contrast neo-21


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structuralists view informal credit markets as very competitive and agile, while reserve

requirements deflect financial intermediation through commercial banks. For this reason,

banks cannot intermediate credit as efficiently as the informal market.

From country cases it is clear that macroeconomic stabilisation policies must

precede deregulation of banks and other financial institutions. Developing countries must

also avoid over-borrowing from abroad when liberalisation programme appears to be

successful.

2:5 EMPIRICAL EVIDENCE OF FINANCIAL LIBERALISATION

According to Rudiger, Dornbush and Reynose (1993), empirical evidence is ambiguous

regarding whether a rise in real deposit rates has a positive effect on saving ratios. A

number of empirical studies conclude that the net response of savings to interest rates is

small. The existence of informal kerb markets in developing countries may also limit the

influence of interest rates on savings.

According to Kirkpatrick (2002), the period of financial liberalisation coincided

with, or was soon followed by, heightened financial instability culminating in the dramatic

financial crises in East Asia in the second half of the 1990s. He states that financial

liberalisation has not led to a smooth transition to a stable and efficient financial system.

Quoting from Kirkpatricks (2002), the experience with financial liberalisation reveals a

strong correlation between financial liberalisation and financial crises. This he explains is

due partly to the exposure of existing inefficiencies and distortions in the financial

structure. And also partly by the failure to develop a strong regulatory and supervisory

framework, prior to financial liberalisation Kirkpatrick argues however that, it would be

wrong to jump to the easy, but shallow, conclusion that financial liberalisation has failed.

His argument is replicated;

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Firstly, the fact that the period of financial liberalisation coincides with a period of

increased systematic instability does not prove causality.

Secondly, no process of change comes cheap. A reason assessment of the costs and benefits

of the policy change is needed.

Thirdly, what would have been the outcome without the policy change?

Finally, the impact of financial liberalisation will differ between countries depending on

each countrys economic and institutional characteristics.

Kirkpatrick (2002) quoting Brownbridge states, the growth of commercial bank

lending to the private sector, particularly to small-scale borrowers and start-up enterprise in

Sub-Sahara Africa following financial liberalisation has been disappointing.

According to Kirkpatrick, much of the blame for financial crisis in the post-

financial liberalisation period lies with the scale and sequencing of financial liberalisation.

What is needed is a more gradual and considered approach to financial liberalisation.

Saprin Report (2001), on the impact of financial sector liberalisation in four

countries evidenced the following consequences:

(a) Financial assets have become more concentrated. Thus financial intermediaries have

directed financing towards large, mostly urban firms. This has hindered the

development of small and medium-size enterprises and rural economies due to lack of

access to finance.

(b) Important sectors of the economy and population groups have been unable to access

affordable credit. Small and medium-size firms, rural and indigenous producers, and

women have very limited access to the formal financial system. This situation is due to

high interest rates resulting from financial liberalisation and difficulties in meeting

standard loan requirements. Many small-scale enterprises have either gone bankruptcy

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or been forced to seek credit through non-formal means, such as moneylenders, in order

to survive.

(c) Financial liberalisation has strengthened small, private-interest groups that are not

prone to comply with state authority.

(d) Economic efficiency within the financial sector has not improved. The gap between

borrowing and savings rates of interest has increased in all the four countries the study

covered.

(e) Liberalisation of interest rates and capital accounts have contributed to economic

crises and increased vulnerability to external shocks.

Fry (1989), gives empirical evidence for McKinnon-Shaw thesis on financial liberalisation.

He uses real deposit rate as a proxy for financial liberalisation. He sampled twenty eight

(28) less developed countries over 1970-1985. His conclusion is that a 1% rise in real

deposit rate leads to 0.1% rise in national savings rate. Financial liberalisation seems to

have little impact on the quantum of savings.

According to Khan and Villaneuva (IMF WP No 91/28) financial liberalisation

seems to be strongly associated with higher growth. They contend that financial

liberalisation seems to operate by increasing the efficiency of investment rather than its

quantum.

According to Levin (1998), Fry (1995), a host of empirical studies have been

carried out and the general findings of them support the McKinnon-Shaw hypothesis that

financial liberalisation is associated with faster growth through investment.

2:6 FINANCIAL LIBERALISATION IN SUB-SAHARAN AFRICA

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According to Kirkpatrick (2002) most of Sub-Sahara African countries adopted

financial liberalisation under World Bank lending conditionalities. The key elements of the

conditionalities included;

(i) Privatisation of banks

(ii) Entry of new domestic and foreign entrants into the banking sector.

(iii) Banking restructuring and recapitalisation

(iv) Strengthening bank regulation and supervision institutions.

Financial liberalisation in Sub-Saharan Africa took place only very

recently (since the mid eighties).

Initially, the focus was on relaxation of controls on interest rates. The relaxation of

controls on the financial sector was often part of a more general policy shift towards

liberalisation of the domestic economy and opening up to the international economy.

Financial liberalisation soon broadened beyond interest rate liberalisation to include a wide

range of measures constituting a programme of financial sector liberalisation.

Financial liberalisation in some Sub-Sahara Africa countries outlined by Montiel

(1995) is replicated below.

(i) The Gambia (September 1985) ceiling on interest rates were

removed in September 1985, an auction

system for issuing Treasury bills was

introduced in July 1985, and quantitative

controls on credit were removed in

September 1990.

(ii) Nigeria (July 1987) - Directed credit restrictions were

relaxed over the period 1983-1987 by

increasing the sectoral aggregation of directed

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credit allocation. On July 31, 1987, the

Central Bank removed interest rate controls

and raised both the Treasury bill and

rediscount rate by 4% point to 15 and 14%. In

November 1989, an auction system was

instituted for treasury bills and certificates but

the Central Bank retained a reservation price

Ghana (September 1987) - ceilings on interest rates were removed,

while the removal of quantitative credit

controls was done in 1992.

Malawi (April 1988) - ceilings on interest rates were removed,

and quantitative credit ceilings were eliminated

in January 1991.

Uganda (July 1988) - in July 1, 1988, an increase of 10%

points were announced on most interest rates.

Benin & Cote dIvoire

(October 1990) - the BCEAO abolished its preferential

discount rate, but bank interest rates remained

subject to regulation. Cote dIvoire is also a

member of the BCEAO, so it was affected by

these liberalising measures.

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Cameroun (October 1990) - the BEAC eliminated its preferential

Lending rates, simplified its interest rate structure,

and increased its power to determine interest rate

policy with the intention to move toward greater

flexibility in rates.

Tanzania (July 1991) - the system of fixed interest rates and fixed

differentials were replaced by a single maximum

lending rate of 31% on July 25.

Kenya (July 1991) - Interest rate ceilings were removed.

Financial liberalisation in Sub-Sahara Africa has failed to significantly raise savings rate in

most cases so that Sub-Sahara Africa countries remain dependent on external finance for

investment funds. The impact of financial liberalisation on investment has also been

limited. Over the period 1989-91, the savings ratio was 12% over a group of Sub-Sahara

Africa countries, although with a considerable variation between them. This compares

unfavourably with Asian countries such as India, China and Indonesia where gross

domestic savings rate for 1988-92 are reported to be between 20-40% (Nissanke and

Aryeetey 1996, Citing Global Coalition for Africa 1993).

Karinki (1996), finds that in Kenya rises in real interest rate occurred with financial

liberalisation but did not result in either increase in savings, or investment lending to riskier

small and medium scale enterprises. Neither was a statistical significant relationship found

with the allocative efficiency of credit. This was attributed to the rising transaction costs of

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lending to small and medium enterprises, taxation and other operational constraints. The

conclusion may be that financial liberalisation focussing solely on interest rate

liberalisation is insufficient. Ademola Oyegile (1993) finds a contrast situation in Nigeria

where financial liberalisation was found to have a strong positive impact on the availability

of credit to small and medium enterprises. This was due largely to a shift in allocation from

other factors. Gibson and Tsakolatos (1994) find that cross country economic evidence on

the effect on interest rises on savings and investment is inconclusive.

2:7 PRE-FINANCIAL LIBERALISATION POLICIES IN GHANA

(i) Monetary Policy

The main instruments of monetary policy in Ghana had traditionally been quantitative

ceilings on the domestic asset creation of the banking system and reserve requirement.

Credit ceiling and sectoral credit controls had been one of the major instruments of

Bank of Ghanas financial policy between 1960-90. The credit ceilings were derived from

Bank of Ghanas macroeconomic ceilings on the banking systems met domestic assets set

according to monetary and inflationary projections. The ceiling was categorised into credit

to the rest of the economy and credit to the government and to cocoa financing. (Gockel et

al 1995)

(ii) Low Interest Rate Policies

With the low interest rates, Bank of Ghana set minimum rates for deposits and to place

ceilings in lending rates to serve as incentives to attain higher levels of investment. Thus,

Ghanas interest rate before liberalisation lacked flexibility with the results that at a

generally high rate of inflation, real interest rates became increasingly negative

i = r-p

i = real interest rate, productivity of capital

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r = nominal interest rate (lending or borrowing)

p = rate of inflation

r is kept low so that where p>r, i


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reserve requirements to hold large amounts of low or zero-yield assets, major distortions to

interest rates arise; where it is possible there will be increases in the margin between

deposit and lending rates. In Ghana, while both rates were largely controlled, the minimum

deposit rate tended also to become the maximum. Moreover, the banks resorted to high

service charges to borrowers.

(iv)Unorthodox Monetary Policies and Bad Legislation

Bank of Ghana carried out two major monetary policies in attempts to mop up excess

liquidity in the economy to halt inflation. The first exercise was the currency conversion

undertaken in 1979. This was followed by a demonetisations of the fifty (50) cedis notes

(the highest denomination of the Ghanaian currency at the time). There was also the

freezing of bank deposits in excess of 50,000 cedis, while bank loans for financing trade

inventories and businesses deals of more that 1,000 cedis were required to be conducted by

cheque.

The reason for the pre-reform policies were among other things

(i) The desire to increase the level of investment

(ii) To improve the allocation of investment among the various sectors of the economy.

(iii) The desire to keep financial costs down in order to avoid what was believed to be

the inflationary effects of liberalised market rates of interest

(iv) The desire to maintain low and stable interest rates to countervail the perceived

baneful effects of exorbitant rates in the informal markets.

(A. F Gockel 1995)

2:8 IMPACT OF PRE-FINANCIAL LIBERALISATION POLICIES ON BANKING

MARKET IN GHANA

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According to Brownbridge and Gockel (1995) the following were the impact of pre-reform

policies on banking markets in Ghana.

Firstly, the pre-reform policies led to severe financial shallowing in Ghana. The

broad money as a percentage of Gross Domestic Product (GDP), which was relatively

stable at around 20% from 1964 to 1974, rose briefly in the mid 1970s to a peak of 29% in

1976 and then collapsed to 12.5% in 1984. Banks deposits also became less attractive

relative to cash.

Aryeetey and Gockel (1990) in a study of the informal financial sector found that streeting

banking was increasing in contrast to formal sector intermediation.

Secondly, one of the pre-liberalisation policies was aimed to support priority sectors

through the use of sectoral credit guidelines and preferential interest rates. However, the

supply of credit to the priority sectors declined in real terms. Credit to the whole of the non-

government sector, including both priority and non priority sectors amounted to only 3.6%

of GDP in 1983, having fallen from 9.8% in 1977 (World Bank 1986 v). The figure

however excludes cocoa financing.

The main reasons for the decline in credit to the non-government sector were due to the

decline in financial depth, and also crowding out by the governments borrowing

requirement. In 1983, government took 87% of net domestic credit.

Thirdly, financial distress affected all the public sector banks in the 1980s. All the

banks were rendered insolvent by non-performing assets (NPAs) and had to be restructured

in 1989-91. A total of 62 billion of the NPAs was identified in the banking system and

was replaced by Bank of Ghana bonds or offset against liabilities of the banks to the Bank

of Ghana or the government. Most of the NPAs were transferred to the non-performing

Assets Recovery Trust (NPART) in 1991.

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The NPAs included non-performing loans, letters of credit and equity investments,

which yield no income.

2.9 F INANCIAL SECTOR LIBERALISATION PROCESS IN GHANA

In April 1983, the government of Ghana introduced a strict budget which contains a

programme of economic reform known as the Economic Recovery Programme (ERP,1983-

1986). This programme was followed by the Structural Adjustment Programme I (SAP I,

1987-88 and SAP II 1989-90). These programmes were aimed at both economic

stabilisation and structural adjustment. Included in the package of the ERP was the

financial sector liberalisation. According to Gockel et al (1995) financial liberalisation

became necessary since the pre-liberalisation policies of government in terms of control

over financial markets, together with an acute prolong economic crises and certain

unorthodox measures had severely damaged the financial system leading to both financial

shallowing and bank distress.

When the government of Ghana approached the World bank and the International Monetary

Fund (IMF) in early 1980s for assistance to put its economy into sound footing, financial

sector liberalisation became a conditionality of assistance. The government of Ghana and

the world bank agreed that a reform and restructuring of the financial sector was

indispensable for successful economic recovery programme.

A programme of financial sector reform was therefore implemented between 1988-90. The

programme became known as Financial Sector Reform Programme (FINSAP). There were

two components of FINSAP known as FINSAP I and FINSAP II.

FINSAP I was implemented between 1988-90 and FINSAP II begun 1990/91. The

objectives of FINSAP I programme were;

(i) to restructure banks that were distressed

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(ii) to improve saving mobilisation and enhance the efficiency of credit allocation.

(iii) to reform banking laws

(iv) to develop money and capital markets

(v) to restructure the regulatory framework and improve bank supervision

(vi) to establish a non-performing assets recovery trust.

Among the measures that were taken to restructure the then distressed banks were,

(a) reconstitution and strengthening of affected banks Board of Directors

(b) closure of unprofitable branches

(c) operating costs reduction through staff retrenchment

New Banking Law was inacted in 1989. The law defines the minimum capital requirements

for various types of banks and by bank ownership.

(a) The minimum paid-up capital for commercial banks with at least 60% Ghanaian

ownership was fixed at 200 million cedis.

(b) For foreign banks with Ghanaian ownership less than 60% the minimum paid-up

capital required is 500 million cedis.

(c) Development banks are required to maintain a minimum paid-up capital of one billion

cedis

(d) Each bank is required to maintain a minimum capital adequacy ratio of 6 percent

although Bank of Ghana has the discretion to increase it.

Also as part of the implementation of FINSAP I, non-performing assets of the distressed

banks were transferred to a newly created Non-Performing Assets Recovery Trust

(NPART) which was a government-owned agency. Table 2:1 below shows the non-

performing assets transferred to NPART by banks.

Table 2:1 Non-performing Assets Transferred to NPART by Banks (in million

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cedis)

Bank Amount of NPAs Transferred to NPART % of total NPAs

G.C.B

S.S.B

N.S.C.B

A.D.B

N.I.B

B.H.C

Barclays

S.C.B

M.B.G

14,321

12,585

725

1,293

6,623

12,853

689

462

881

28.4

25.0

1.4

2.6

13.1

25.5

1.4

0.9

1.7

Total 50,433 100

Source: NPART, Annual report 1991, pg 24 and 1994, pg 15

FINSAP II was begun in 1990/91 and the agenda for it were as follows

(i) to continue and complete the incomplete business under FINSAP I

(ii) to divest state-owned banks in accordance with financial liberalisation and

deregulation

(iii) reform the institutional structure of Bank of Ghana

(iv) promote and strengthen the non-bank financial institutions

2:10 DEFINITION OF MICRO AND SMALL-SCALE ENTERPRISES

According to Storey (1994), there is no single, uniformly acceptable definition of a micro

and small-scale firm.

Firms differ in their levels of capitalisation, sales and employment. Hence

definitions which employ measures of size (number of employees, turnovers, profitability,

net worth etc) when applied to one sector could lead to all firms being classified as micro34


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and small-scale while the same size definition when applied to a different sector could lead

to a different result. (Quartey et al 2000)

2:10:1 SOME INTERNATIONL DEFINITIONS

According to Quartey et al (2000) the first attempt to overcome the definition problem of

small and micro scale was by the Bolton Committee in 1971. Bolton Committee (1971)

formulated an economic and statistical definition.

The Bolton Committee economic and statistical definition is replicated below.

Under the economic definition, a firm is regarded as small if it meets the following criteria.

(i) It has a relatively small share of their market place

(ii) It is managed by owners or part owners in a personalised way, and not through the

medium of a formalised management structure.

(iii) It is independent, in the sense of not forming part of a large enterprise.

The statistical definition is based on three main areas;

(i) Quantifying the size of the small firm sector and its contribution to GDP,

employment exports etc.

(ii) Comparing the extent to which the small firm sectors economic contribution has

changed over time.

(iii) Applying the statistical definition in a cross country comparison of the small firms

economic contribution

According to Quartey et al (2000), there were a number of weaknesses in the Bolton

Committees economic and statistical definition, which led to the European

Commission coinage of the term small and medium enterprises (SME). The SME sector

is made up of three components. Firms with

(i) 1 to 9 employees micro enterprises

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(ii) 10 to 99 employees - small enterprises

(iii)100 to 499 employees - medium enterprises

Thus, the SME sector comprises enterprises (except agric, hunting, forestry and fishing),

which employ less than 500 workers. European Commissions definitions are based solely

on employment rather than a multiplicity of criteria.

Secondly, the use of 100 employees as the small firms upper limit is more

appropriate given the productivity over the last two decades (Storey 1994).

Alternative definition was given by United Nations Industrial Development

Organisation (UNIDO). Its definition for the developing countries is as follows

(i) firm with employees less than five (5) micro

(ii) firm with employees between 5 and 19 small

(iii) firm with employees between 20 and 99 medium

The UNIDO definition is also based solely on employment.

2:10:2 Ghanas Definition of Micro and Small-scale Enterprise

The most commonly used criterion in defining micro and small enterprises in Ghana is the

number of employees of the enterprise. The problem with the employee criterion is the

confusion arising out of it, in respect of the arbitrariness and the cut off points used by the

various official sources.

Other sources also use fixed assets in the enterprise as a criterion in defining small

and micro enterprises.

The National Board for Small-scale Industries (NBSSI) in Ghana applies both the

fixed asset and the number of employees criteria.

Osei et al (1993) in defining small-scale enterprises in Ghana uses an employment

cut off point of 30 employees to indicate small-scale enterprises. The small-scale

enterprises are broken down into3 categories as follow;

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(i) firm employing less than 6 people - micro

(ii) firm employing between 6 9 people - very small

(iii) firm employing between 10 29 people - small

This definition is also based solely on employment rather than multiplicity of criteria.

2:11 MICRO AND SMALL-SCALE ENTERPRISE RELATION WITH THE

FINANCIAL SERVICES IN GHANA

Lack of policy clarity and action specificity tended to exacerbate the marginalisation of

micro and small enterprises, thus affecting their relationships with financial services sector.

According to JAICA (1998), there is a large gap between micro and small-scale

enterprises and financial institutions. In Ghanas pre-liberalisation era, the foreign banks

and commercial banks had the majority of their branches concentrating their activities in

the cities. They had traditionally shunned rural areas and the micro and small enterprises.

According to Steel (1994), private firms access to bank credit has been restricted in

many developing countries because governments and public enterprises had been given

first claim on financial resources. The table below reveals the ratio of private lending to

total lending as well as ratio of private sector credit to G.D.P in percentages in four African

countries.

Table 2:2 Credit Allocation between Private and Public Sectors

Ratio of Private lending to Total lending

(%)

Ratio of Private sector Credit to GDP

(%)

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1986 1990 1993

Ghana 13.6 27.6 35.6

Malawi 39.5-52.5 40.4 14.6

Nigeria 47.2-63.5 44.9 17.4

Tanzania 7.2 14.6 27.1

1981 86

2.4

9.1

17.4

2.3

Source: The World Bank Economic Review, vol. 11 May 1997,No 2

The table above shows that, indeed private sector share of total lending is very low. This

low lending to the private sector affected the growth of micro and small enterprises.

Aryeetey et al (1994), analysing the impact of liberalised financial policies in

Ghana, established that liberalised financial policies positively affected incentives to lend.

However, other measures taken to stabilise the economy and strengthen the banking system

had a short-run negative impact on credit availability to small enterprises. They concluded

that tight monetary policies resulted in higher interest rates on government paper than on

loans to long-standing commercial clients. This led in turn to non-competitive higher rates

to new, smaller borrowers.

2:12 POLICIES FOR PROMOTING MSEs IN GHANA

The government of Ghana realising the potentials of MSEs for economic development has

put in place a number of technical, institutional and financial support to enable the sector

perform its effective role in the economy of Ghana.

Firstly, private sector Advisory Group was set up, and the abolition of the

Manufacturing Industries Act, 1971 (Act 356), which repealed a number of price control

laws.

Secondly, the investment code of 1985 (P.N.D.C Law 116), which promotes joint

ventures between foreign and local investors was enacted.

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Thirdly, a mutual credit Guarantee scheme was set up for entrepreneurs who do not

have adequate or no collateral and have limited access to bank credit.

Fourthly, Rural finance project aimed at providing long term credit to small-scale

farmers and artisan was set up.

The National Board for Small-scale Industries (NBSSI) has been established within

the ministry of Trade and Industry to oversee the growth of micro and small-scale

industries in Ghana. In 1987 the Ghana Appropriate Technology Industrial Service

(GRATIS) was established. GRATIS is to oversee the small-scale industrial concerns by

transferring appropriate Technology to small-scale enterprises.

Again, Intermediate Technical Transfer Units (ITTUs) have been established in

some Regional capitals to address the technical needs of small-scale enterprises.

Bank of Ghana in collaboration with the institutions has been providing financial

assistance to small enterprises. One such institution is the International Development

Association (IDA), which has established fund for small-scale enterprises. Under the

programme of Action to Mitigate the Social Cost of Adjustment (PAMSCAD), a revolving

fund has been established for SMEs.

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CHAPTER THREE

3:0 CONCEPTUAL FRAMEWORK AND METHOD OF STUDY

3:1 OVERVIEW

According to Montiel (1995) a large number of variables have been used as proxies for

financial development. These proxies are;

a) indicators of financial depth such as narrow money supply (M1) as a proportion of

Gross Domestic Product (GDP) or broad Money Supply (M2) as a proportion of

GDP. This proxy can be expressed as IFD = M1/GDP or M2/GDP

b) the share of financial intermediation done by Commercial Banks measured by the

ratio of deposit money, bank domestic assets to the domestic assets of deposit40


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money of commercial banks and the central bank together (King and Levine 1992,

1993).

c) the volume of lending to the private sector measured by ratio of flow of credit to the

private sector to GDP, (De Gregorio and Guidotti (1992)) OR the share of total

domestic banking system credit extended to the private sector as opposed to the

public sector. (King and Levine 1992, 1993)

d) direct indicators of financial repression such as the reserve ratio (Roubini and Sala-

i-Martin 1992a) or the ex post real interest rate Gelb, 1989). King and Levine

(1992).

The study adopts both the financial depth and the volume of lending to the private sector as

indicators of financial development.

3:2 FINANCIAL DEEPENING

One basic argument put forward by the McKinnon-Shaw hypothesis of financial sector

liberalisation is that it leads to financial Deepening. Thus financial sector liberalisation

accompanied by an increase in real interest rates encourages individuals to hold more

financial assets, which is associated with high levels of savings, investment and growth.

There are three indexes of measuring financial deepening. The three indexes of financial

deepening are used to measure the impact of financial liberalisation on the portfolio choices

of individual economic units.

The three indexes are

a) The narrow money supply (M1) as a proportion of Gross Domestic Product (GDP)

b) Broad money supply (M2) as a proportion of Gross Domestic Product (M2/GDP)

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c) The broad money supply (M2) plus private foreign denominated deposits,

government Treasury bills and government stocks (M2) as a proportion of GDP

(M3/GDP)

M1 is defined as currency plus demand deposits

M2 is defined as M1 plus savings and time deposits

M3 is defined as M2 plus foreign denominated deposits, government Treasury bills and

government stocks.

For the purpose of this study, financial deepening will be measured by the ratio of broad

money (M2) as a proportion of Gross Domestic Product (M2/GDP). This is because

M2/GDP has been the traditional measure of financial deepening. Also in Ghana like many

developing economies the most widely used financial assets are currency, demand deposit,

and time deposits unlike in developed economies where Treasury bills and other financial

assets are widely used. Hence the appropriate measure for financial deepening in Ghana is

M2/GDP.

3:3 EFFECT OF MACROECONOMIC VARIABLES ON CREDIT TO THE

PRIVATE SECTOR

The McKinnon-Shaw hypothesis argues further that financial deepening increases the

volume of institutional credit.

Mwadira and others (2002) in analysing the effect of macroeconomic variables on credit to

the private sector in Zimbabwe identified three important macroeconomic variables viz,

i) Lending interest rate

ii) Gross Domestic Product

iii) Bank financing of government budget deficit.

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In Ghana, like many countries, the financial environment in which lenders and borrowers

must operate can be altered by floating interest rates and changes in monetary policy.

Government budget deficits are generally financed through bearing on lending rates in

Ghana. Hence, the macroeconomic variables that affect credit to the private sector in

Zimbabwe are adopted to study the effect of macroeconomic variables on credit to the

private sector in Ghana.

An analytical framework can therefore be used to explain the effect of macroeconomic

factors on credit to the private sector. This is done by using a model, which links credit to

the private sector to the performance of the G.D.P, lending interest rates and bank financing

of government budget deficit.

(i) Lending Interest Rate (it) And Credit To The Private Sector (Ct)

Theoretically, it is expected that an inverse relationship would exist between lending

interest rate and credit advanced to the private sector. Macroeconomic environment affects

the performance of the banking sector, by influencing the ability to repay borrowed loans.

The demand for loans with unpredictable returns from investment and quality of collateral

determines the amount of premium charged and therefore the cost of borrowed funds to the

investors. An unstable macroeconomic environment and poor economic growth present an

uncertainty about investment return and these raise the lending rates as the level of non-

performing loans goes up. This squeezes the bank margin. As the level of non-performing

loan increases, banks have to charge high-risk premiums to cover their default risk. Low

lending rates do not allow banks sufficient profit margins to accommodate the increased

expenses associated with lending to small and new borrowers. At concessionary lending

interest rates, lenders (banks) may ration credit according to commercial creteria. Banks

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therefore lend to clients offering greater security and less risk. Therefore at a lower interest

rate, credit advanced to small-scale enterprises and new borrowers is limited since banks

consider them to be risky and lacked the needed collateral security.

(ii) Gross Domestic Product (GDPt) and Credit to the Private Sector (Ct)

Credit to the private sector is influenced by the Gross Domestic Product of a nation.

Theoretically, it is expected that a direct relationship would exist between GDP and amount

of credit advanced to the private sector. This is because if a nations GDP is high, the

private sector share of credit is likely to be higher and vice versa.

(iii) Bank financing of government budget deficit (BfGDt) and credit to the

Private Sector (Ct).

Fiscal deficit is caused by increased government expenditure in excess of its revenue. There

are several ways of financing government budget deficit. One way of financing the

government budget is by borrowing from the banking system. If the government budget

deficit is financed by the banks it affects credit expansion to the private sector through a

rise in lending interest rates. Government borrowing from the banking system thus reduces

supply of loanable funds to the private sector (crowding out effect).

An inverse relationship is expected to exist between the amount of credit advanced to the

private sector and bank financing of the government budget deficit. The higher the amount

of government budget deficit financed by the banking sector, the smaller the amount of

loanable funds available to the private sector, especially small-scale borrowers.

3:4 Estimation Of The Model Of Impact Of Macroeconomic Factors On Credit To

The Private Sector.

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In estimating the model of the impact of macroeconomic factors on credit to the private

sector in Ghana, the study adopted the model used by Mwadira et al in (2002) in estimating

the impact of macroeconomic factors on credit to the private sector in Zimbabwe. Thus the

impact of macroeconomic factor on private sector is analysed by estimating a linear

regression model as follows.

Ct = f (GDPt, BfGDt, It, D)

Ct = o + 1 GDPt + 2 BfGDt + 3 it + 4 D +

Where,

Ct = credit or loan to the private sector at time t

GDPt = Gross Domestic Product at market Price at time t

it = lending interest rate at time t

BfGDt = Bank financing of government budget deficit at time t

Dt = Dummy variable for the liberalisation period

= residual

The dummy variable is introduced into the model to capture response to

shocks during the liberalisation period.

3:5 METHOD OF STUDY

3:5:1 Stationarity Test

The first test to be conducted is the Stationarity Test to establish the stationarity of the

variables. The reason for this test is that most economic time series data tend to be

non-stationary. A non-stationarity series has no finite variance asymptotically and

therefore many of the standard theorems of asymptotic analysis will not be valid. If a

series is non-stationary, one is likely to finish up with a model showing promising

diagnostics test statistics even in the case where there is no sense in the regression

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analysis. It is therefore important to establish the stationarity of the variables before

any meaningful regression can be done.

The study uses the Augmented Dicky Fuller test (ADF) to test the stationarity of the

variables. The ADF test is superior to the Dicky Fuller (DF) test, since the DF test does not

consider the possibility of auto-correlation in the error term. The ADF is used to overcome

the auto-correction in the error term (Ngugi & Kabubo 1998)

3:5:2 Cointegration Test

After establishing the stationarity of the variables, the next test is the Cointegration Test.

Cointegration analysis is used to test the long run relationship between the variables in the

model. Variables are said to be cointegrated if a linear combination of these variables

assumes a lower order of integration. These variables must always be of the same order of

integration individually. That is, they are individually non-stationary, integrated of the same

order, but their linear combination is integrated of a lower order (Ndungu 2001).

The purpose of the cointegration test is that if two or more series are linked together to

form equilibrium relationship for a long run, the relationship between the variables returns

to the mean even though each individual series may not revert to the mean.

The study used the Johansen (1988) cointegration approach to test the cointegration

between the variables. The Johansen approach employs two test statistics; the trace

statistics and the maximum eigen values. The statistics are applied sequentially to

determine the number of cointegrating vectors in the system.

Gonzalo (1994) supports the superior properties of the Johansen Technique relative to the

others.

3:5:3 Error Correction Model (ECM)

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The short-run structure of the model is also important in terms of the information it conveys

which is associated with the short-run adjustment behaviour of economic variables.

Therefore in the second step, the study will estimate the short-run variation in error

correction form with uniquely identified cointegrating vector to obtain a parsimonious

version of the statistical model under consideration.

The study applies the Schwarz Bayesian Creterion (SBC) by using the conventional ECM

that takes into account the cointegrating relationship among the variables.

The data for the analysis is collected from the Bank of Ghana monthly as well as annual

reports and also from the Statistical Services of Ghana.

3:6 THE IMPACT OF THE FINANCIAL LIBERALISATION ON THE

PERFORMANCE OF MICRO AND SMALL-SCALE ENTERPRISES.

The impact of the financial liberalisation on the performance of micro and small enterprises

is examined through a survey of micro and small-scales enterprises in Ashanti Region

particularly Kumasi Metropolis. The survey is carried out to assess the views of micro and

small-scale entrepreneurs on very important issues, which are relevant to the research topic.

The most topical issues being the accessibility to bank loans and services by the micro and

small-scale operators, and how these services have improved their performances.

3:7 HYPOTHESES

The hypotheses to be tested based on the objective of the study are that;

(a) The monetary and fiscal policies implemented during the liberalisation period

has not led to in

emmanuel kyei thesis

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