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FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN NIGERIA

Fidelis O. Ogwumike and Afees A. Salisu

Abstract

This paper examines the short run, long run and the causal relationship between

financial development and economic growth in Nigeria from 1975 to 2008. Using the

Bound test approach, this study finds a positive long run relationship between financial

development and economic growth in Nigeria. Financial intermediation- credit to

private sector, stock market and financial reforms exert significant positive impact on

economic growth. Further, analysis of the short run dynamics reveals that about 40%

of the resulting disequilibrium is captured each period indicating minimal deviations

from the equilibrium. In addition, the result of the VAR-Granger causality test lends

support to the supply-leading hypothesis. Therefore, appropriate regulatory and

macroeconomic policies that will foster the expansion and development of the Nigerian

financial institutions should be pursued by the relevant authority.

JEL Classification Codes: C21, C61, I32

Keywords: Financial reform, economic growth, bound-test, causality,

INTRODUCTION

The pursuit of economic growth and sustainable development is one of the core

macroeconomic goals in every nation. Economic growth is usually anchored on the

financial development of a country. This is underscored by the fact that an effective

financial system, in addition to the economic transformation role, provides the

possibility of better savings mobilisation and allocation of same for development

purpose (Levine, 1997). This can be achieved through increasing the level of

investment in general as well as in human resources in particular to induce and sustain

economic growth and development. The goal of financial development is to achieve

efficiency in the financial sector and engender financial deepening and economic

growth. Thus, in the present paper, we attempt to quantify the extent to which financial

development in Nigeria has enhanced economic growth.

Ogwumike and Salisu are both lecturers in the Department of Economics University of Ibadan.

Corresponding Author’s Email: [email protected]

Vol. 12, No.2 Journal of Monetary and Economic Integration

92

The question of the relationship between financial development and economic growth

has been widely addressed by economic literature. Notably,taking into consideration

the role of economic growth in fostering financial development and the role of financial

development in enhancing economic growth. In addition to the demand-following and

the supply-leading hypotheses, there is a third strand of arguments in the literature

which submits that there is a feedback relationship between financial development and

economic growth.2 In this paper, we also evaluate these hypotheses using appropriate

methodology in order to ascertain the one that reasonably captures the financial

development-growth nexus in Nigeria.

The extensive financial reforms initiated in Nigeria in 1987 as part of the Structural

Adjustment Porgramme (SAP) include the deregulation of foreign exchange market,

interest rates, rationalisation of credit controls, licensing of new banks and, institutional

and regulatory changes (Ikhide and Alawode, 2002). Further, since the return to

democracy in 1999, more far-reaching financial reforms have been initiated including

the pension fund, 2004; bank consolidation policy, 2005; insurance, 2007; and capital

market reform. These financial reforms were expected to foster an efficient financial

system that would encourage domestic savings and investment and hence engender

economic growth and development.

The concern in Nigeria is that financial institutions (mostly banks) have not performed

to expectations in terms of mobilising savings for financing long-term development

projects in the real sector (Adeoye and Adewuyi, 2005). Further, there is no apparent

and appreciable contribution of financial deepening to economic growth in the post-

SAP era (Ayadi, Adegbite and Ayadi, 2008 and Ayadi, 2009). However, as noted by

Nzotta and Okereke (2009), some studies on financial development and economic

growth in Nigeria relied on money market indicators (see Ogun, 1986; Oyejide, 1986;

Edo, 1995; Ndebbio, 2004; and Akinlo and Akinlo, 2007) and they established a

positive and significant relationship between financial development and economic

growth. Further, some of these studies have employed either theories and

methodologies that omit some of the direct (credit supply and real interest rate) and

indirect (stock market) channel(s), or models that ignore the short run effects.

Against this background, this study seeks to answer the following questions:

To what extent has financial development enhanced economic growth in

Nigeria?

What is the direction of causality between financial development and

economic growth in Nigeria?

2 Each relationship will be discussed in the literature review section with empirical evidence

provided.

Vol. 12, No.1 Fidelis O. Ogwumike and Afees A. Salisu

93

The primary objectives of this study are to re-examine the finance development-

economic growth puzzle by including non-money market indicators; and consequently,

the causality framework is extended to account for these indicators in testing for the

probable existence of demand-following or supply-leading hypothesis or the feedback

in Nigeria. Essentially, the Bounds test approach (developed by Persaran et al, 2001

and suitable for small sample size study) is employed to answer the first research

question. The multivariate causality however often referred to as VAR-Granger

causality test is used to attend to the second. The latter method helps to circumvent

probable biased and inconsistent inferences arising from restricting endogenous

variables in the pairwise causality test.

The rest of the paper is organised as follows: The next section discusses financial

systems and economic performance in Nigeria. This is followed by a review of the

theoretical and empirical evidences. The next section discusses the methodology.

Results and interpretations are presented just before the conclusion.

THE FINANCIAL SYSTEM AND ECONOMIC PERFORMANCE IN

NIGERIA

The Nigeria financial system has experienced intensive restructuring and rapid market-

oriented transformations since the adoption of the SAP in 1986. Prior to this time, the

financial system was regulated as evidenced by ceiling on interest rates and credit

expansion, high reserve requirements, selective credit policies and restriction of entry

into the banking industry. Following deregulation, the bank and non-bank financial

institutions witnessed unprecedented increase due to the incentives provided for growth

and expansion of financial institutions. For example, the number of banks rose from 41

in 1986 to 115 in 1997. Further, the number of bank branches rose from 1,323 in 1986

to 2,551 in 1997. Similarly, the number of community banks (microfinance banks)

increased from 169 in 1990 to 695 in 2009; and the number of specialised non-bank

financial institutions3 increased from 84 in 1990 to 242 in 2008.

This deregulation spurred competition in the industry, forcing many banks to adopt

various strategies required to consolidate their existence. Inefficiency in banking

operations, poor management and misallocation of resources as well as political

3These include 80 insurance companies, National Economic and Reconstruction Fund

(NERFUND), Nigeria Social Insurance Trust Fund (NSITF), National Deposit Insurance

company (NDIC), and Nigerian Stock Exchange (NSE) in 1990. The 242 non-bank financial

institutions in 2008 include 75 Finance Houses, 75 insurance companies, 5 discount houses, 81

primary mortgage institutions, NERFUND, NSITF, NDIC, NSE, NAICON, and PENCOM (see

CBN Statistical Bulletin, 2008).


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interference resulted in bank distress which further weakened the capacity of the

financial system in resource mobilisation. Hence, by 1991, government came up with

the policy of guided deregulation which resulted in pegging of lending and deposit

rates, placement of embargo on further licensing of banks, among other measures.

Following the adoption of universal banking in Nigeria in 2000, commercial and

merchant banks were merged and they became Deposit Money Banks (DMBs)4.The

Debt Management Office (DMO) established in 2000 also spurred investment in

Federal Government bonds. In 2005, banks consolidation policy was put in place,

which increased the minimum paid-up capital for commercial banks to N25b; and the

total number of banks fell from 85 to 25. The effect of the consolidation was to foster

the creation of larger banks having better access to fund market.

Deregulation of banking operations allowed entry and competition in the financial

system. For example, the share of commercial banks in savings mobilized fell gradually

from 99% in 1960 to 84% in 1985 and further to 70% in 1994. This trend indicates a

more diversified financial system in which other institutions such as microfinance or

community banks and merchant banks played major roles in deposit mobilisation and

investment financing. The average growth of saving between 1985 and 2000 was 26%

while the average before deregulation era (1975-1985) was 20%.This clearly indicates

a greater mobilisation during deregulation.

Another important direction of change in the financial environment is the development

of new financial instruments and increases in the number of equity traded in the capital

market. Banks and other financial market participants were able to raise funds from a

wide array of financial instruments. Although capital market reforms started as far back

as 1988 with the creation of second tier securities market, it was not until 1993 that

further deregulatory measures were taken by replacing pricing and other direct controls

with indirect controls. However, the 1999 reforms brought changes in the Securities

and Exchange Commission and enhanced listing disclosure and check insider trading.

Similarly, the foreign exchange market reform started in 1986 when a second-tier

foreign exchange market was established and since then, the market has continued to

witness several policy reversals and modifications to date. In 2000, reforms in the area

of foreign exchange deposit took place, allowing the public to receive foreign currency

4Banks were now allowed to complement their primary banking services with securities and

insurance businesses, that is, banks were empowered to carry out all banking and non-banking

services (such as issuing house business, underwriting, capital issue and participating in

clearing house activities).


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in a domiciliary account so as to ensure that such remittances were retained in savings

within the banking system.

In all, the capital market deregulation coupled with the banking sector reforms (in

particular, recapitalisation), foreign exchange and pension reforms ushered in an era of

rapid growth in the capital market (Ogwumike and Afangideh, 2008). For example,

market capitalisation rose from N6.8 billion in 1986 to N9,563.0 billion in 2008; and

the value of shares traded rose from N497.9 million in 1986 to N1.68 trillion in 2008.

What effects did financial development in Nigeria have on economic growth?

Evidences show that prior to SAP, the government through its low interest rate policy

tried to spur investments and growth of the economy. This era of low interest rate led

to negative real rates of interest on deposits as well as loans and hindered the proper

functioning of the financial system due to inability to mobilise savings and facilitate

investment5. The consequence was a serious economic disruption which resulted in

currency depreciation and external debt repayment problems as well as adverse

consequence on the volume and productivity of investment.

Figure 1 shows that over the period, the real deposit rate was predominantly negative

and lowest during the period of deregulation/guided deregulation (1987 to 1996).

Similarly, the real GDP growth rate was negative (at its lowest point) during the pre-

reform era until 1985 when a positive real GDP growth rate of 9.5% was achieved.

Interestingly, the period after financial reform was introduced in 1987 ushered in a

positive change in real GDP growth rate. The real GDP growth rate again worsened

during the period of guided deregulation starting from 1991. It attained the peak in

2002; and declined thereafter.

5For example, low lending rates encouraged less productive investments and discouraged savers

from holding domestic financial assets. Directed credits to priority sectors often resulted in

deliberate defaults given that serious action could not be taken against defaulters. In fact, such

loans are often seen as part of recipients’ share of the national cake.


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Figure 1: Selected Financial development indicators and real GDP growth rate

in Nigeria

Source: Graphed from data computed from Central Bank of Nigeria (2008) Statistical bulletin

Credit to the private sector as a percentage of GDP only attained its pre-reform level

around 1990/1991 and after 2005. In fact, this development could be attributed partly

to the divergence between deposit and lending rates. For example, the average interest

rate spread (i.e, average lending rate minus average deposit rate) worsened during the

period of deregulation. It rose from 1.0% in 1986 to 14.1% in 2005. The implications

of high lending rates and low deposit rates are obvious: low incentive to save as savings

are discouraged which negatively affect banks’ ability to mobilise funds. This in turn

affects investment which maintained a downward trend throughout the period except

between 2007 and 2008; and consequently retarded economic growth. Generally, the

Rat

es

in P

erc

en

tage

(%

)

Credit of Private Sector/GDP (%)

Real Deposit Rate (%)

GFCF/GDP (%)

Stock Market Capitalization/GDP (%)

GDP Growth Rate (%)

Bank Deposit Liability = M2 - Currency in Circulation/GDP (%)


97

wide interest rate spread between deposit and lending rates encouraged speculation in

financial transactions. Financial reform through interest rates liberalisation was

expected to bring about a positive real deposit rates that would enable banks mobilise

funds for investment. However, real deposit rates in Nigeria have been predominantly

negative even after financial reform and banks have engaged in speculative activities

at the expense of lending to the real sectors of the economy.

Stock market capitalization as a ratio of GDP, gross fixed capital formation as a ratio

of GDP, and bank deposit liability as a ratio of GDP equally revealed mixed

performance over the period under consideration. Some of the indicators only had

marginal changes in their trends between the two periods. However, most of them

except real GDP growth rate witnessed significant improvements since 2005.

REVIEW OF THEORETICAL AND EMPIRICAL LITERATURE

Review of Theoretical Literature

The pioneering work of Schumpeter (1912) on finance-growth nexus argues that

financial development will induce economic growth, through efficient allocation of

funded resources to the productive sectors of the economy. Robinson (1952) however,

challenges this view on the premise that it is the necessity from high economic growth

that creates the need and demand for financial sector. Thus, in this view, it is the

improvements in the economy that drive higher demands for the use of money which

consequently promote financial development. In other words, financial markets

develop and progress as an aftermath of increased demand for their services from the

growing real sector. These two views were later formalized by Patrick (1966) who

identified two possible causal relationships between financial development and

economic growth, namely the "supply-leading" (i.e. finance-led growth) hypothesis

and the "demand-following" (growth-led finance) hypothesis. The former encapsulates

the views of Schumpeter (1912) and the later represents that of Robinson (1952).

Both the Keynesian monetary growth models and the Mackinnon and Shaw models

support the supply-leading hypothesis. However, they differ markedly in the role of

government and interest rates in the financial market. Keynes affirmed that there is a

historical and natural tendency for real interest rates to rise above its full employment

equilibrium level and that this should necessitate government intervention to reduce it

and stimulate growth. Tobin (1965) in the model of money and economic growth

supports the growth-enhancing implication of low and regulated interest rates. He noted

that since households have two assets - money and productive capital, the higher is the

return on capital relative to money, the more capital households will hold relative to

money. This produces a higher capital/labour ratio, a higher labour productivity and


98

hence higher economic growth. Therefore, reducing interest rate, which is the return

on money, increases the pace of economic growth.

On the other hand, financial repression- controlled interest rate and high reserve

requirements are the main focus of McKinnon Shaw School. They argue that the policy

is harmful to long-run growth because it reduces the volume of fund available for

investment (Eschenbach, 2004).

Both McKinnon (1973) and Shaw (1973) contend that controlled lending and deposit

rates lead to non-price rationing of credit, which results into repressed financial system

and slow growth. They affirmed that financial reforms that liberalize the financial

market will lead to greater financial development. Also, that a financial liberalization

would not only propel financial allocation efficiency of credit from the unproductive

sectors to the productive sectors, but would deepen the financial sector savings

(deposits liabilities) role through a positive real interest rate. They termed this the

complementarity hypothesis between real money balance and investment. Essentially,

under this hypothesis, exogenous liberalization reforms will cause interest rate to be

positive, which in turn increases savings liabilities, and credit allocation efficiency that

eventually transform to real investments and increase output and economic growth.

The endogenous growth literature have reached similar conclusion that financial

intermediation has a positive effect on the steady-state growth (Greenwood and

Jovanovic 1990; Becivenga and Smith 1991; Pagano 1993); and that government

intervention in the financial system has a negative effect on the growth rate. In addition,

the endogenous growth theory predicts a positive relationship between real income,

financial depth and real interest rate (see also King and Levine, 1993).

As argued in the literature, financial intermediaries through debt intermediation

promote investment, which in turn, raises the level of output (Shaw, 1973; and Luintel

and Khan, 1999). Similarly, Levine and Zervos (1996) state that, stock market

promotes investment through the provision of long- term (working) capital which in

turn, raises output and growth. Likewise, Khan and Senhadji (2000) advocate the non-

exclusion of stock market contribution to economic growth, prior to which, the Levine

model (1991) contends that investment will be discouraged when market participants

(i.e. investors, accumulated idle saving) are risk averse with no capital/stock market to

look/invest in. Similarly, studies such as Atje and Jovanovich (1993), Greenwood and

Smith (1997), Levine and Zervos (1998), among others, suggest that stock market

liquidity is a catalyst for long-run growth in developing countries. Without a liquid

stock market, many profitable long-term investments would not be undertaken as

savers would be reluctant to tie up their investments for long periods of time.


99

The view that financial development is an outcome of the growth in the real economy

was originally put forward by Robinson (1952) who stated that "where enterprise leads

finance follows". Interestingly, support for this view can also be found in the works of

Friedman and Schwartz (1963, cited in Demetriades and Hussein, 1996) on the demand

for money. They conclude that the causation would run from real GDP to financial

development, through the demand for money. The work of Patrick (1966) popularized

the “demand-following" hypothesis or the "growth-led finance” relationship. He

contends that the creation of modern financial institutions, their financial assets and

liabilities as well as services are in response to the demand for these services by

investors and savers in the real economy. In essence, economic growth depends on the

accumulation of input factors in the production process and technical progress; and

finance is one of this input factor, which affects both production and technical progress.

Patrick (1966) argues that the causation between financial development and economic

growth varies according to the stages of development process. He advocates that the

supply-leading pattern dominates the early stages of economic development, while the

demand-following dominates the later stages. With the possibility of a cyclical causal

relationship-feedback hypothesis, a two-way causal relationship between financial

development and economic performance may exist. In this hypothesis, it is asserted

that a country with a well-developed financial system could promote high economic

expansion just as Schumpeter (1912) suggest, through technological changes, product

and services innovation. This in turn creates higher demand on the financial

arrangements and services as noted by Levine (1997). Hence, the exact transmission

channels from finance to economic growth and in particular any estimate of their

quantitative impacts is still subject to considerable uncertainty.

Review of Empirical Literature

A number of empirical studies have attempted to test these hypotheses and their

findings have been mixed. Some of these studies have validated the supply-leading

hypothesis (see for example, King and Levine 1993; Levine and Zervos, 1996; Levine,

1997; Arestis et al., 2002; Christopoulos and Tsionas, 2004; and Acaravci et al., 2007).

Similarly, Akinlo and Egbetunde (2010) examine the long-run causal relationship

between financial development and economic growth in ten Sub-Saharan African

countries. The results show that financial development causes economic growth in four

countries, while growth Granger causes financial development in one country. The

results of the rest of the five countries support bi-directional causality. Similarly, Esso

(2010) in a study using ECOWAS countries found supply-leading relationship in three

countries, while growth causes financial development in one; and bi-directional

causality in two countries. Kargbo and Adamu (2009) in a study on the relationship

between financial development and economic growth in Sierra Leone the result

supports the supply-leading hypothesis. Shittu (2012) finds a positive relationship


100

between financial intermediation and economic growth. While some others provide

evidence in favour of the demand-following hypothesis (see for example Lucas, 1988;

Stern, 1989; Chandavarkar, 1992; Gurgay et al., 2007 and Shahnoushi et al., 2008;

among others).

The feedback hypothesis has been supported by such empirical works by Levine

(1997), Luintel and Khan (1999) and Demetriades and Andrianova (2003). Odeniran

and Udeaja (2010) test the competing finance-growth nexus hypotheses using Granger

causality tests in a VAR framework. The results suggest bidirectional causality between

financial development and economic growth. Kolapo and Adaramola (2011) examined

the impact of capital market on economic growth in Nigeria. The evidence from this

study reveals that the activities in the capital market tend to drive economic growth.

The causality test results suggest a bi-directional causation between economic growth

and the value of transactions in the stock market and a unidirectional causality from

market capitalisation to economic growth. Osuji and Chigbu (2012) employ the

Granger Causality test, Co-integration and Error Correction Method (ECM) to

investigate the impact of financial development on economic growth Nigeria. The

Granger tests indicate a bi-causality between Money Supply (MS) and Economic

Growth (GDP).

Thus, the debate on finance-growth relationship is still on-going and therefore offers a

vacuum for future research. In addition to the consideration of both long-run and short-

run dynamics and the causal linkage between financial development and economic

growth in Nigeria, the present paper also captures both the direct effect (which works

through the price and quantity channel) and the indirect effect (through stock market

channel). Essentially, the Bounds test approach (developed by Persaran et al, 2001 and

suitable for small sample size study) and the multivariate causality however often

referred to as VAR-Granger causality test are employed to answer the research

questions.

METHODOLOGY

Model Specification

In line with the extant literature, we use financial depth, financial intermediation and

stock market capitalization to proxy financial development. Financial depth is

conceived to be positively related to real income and real interest rate as postulated in

the theoretical literature particularly in the McKinnon-Shaw models and the

endogenous growth literature (see Luintel and Khan, 1999). The complementarity

between money and capital supports the positive relationship between the level of

output and financial depth (McKinnon, 1973). As argued in the literature, financial


101

intermediaries through debt intermediation promote investment, which in turn, raises

the level of output (see Shaw, 1973; and Luintel and Khan, 1999).

Similarly, Levine and Zervos (1996) state that, stock market promotes investment

through the provision of long- term (working) capital which in turn, raises output and

growth. Also, a positive real interest rate, increases financial depth through increased

volume of financial savings mobilization and by extension promotes growth through

increasing the volume and productivity of capital. A higher real interest rate exerts a

positive effect on the average productivity of physical capital by discouraging investors

from investing in low return projects. In addition, the endogenous growth theory

predicts a positive relationship between real income, financial depth and real interest

rate (see also King and Levine, 1993).

Based on the foregoing, and following Khan et al. (2005), the relationship between

growth and financial development can be specified as:

, , , , t tf BDL CPS RDR INVRGDP SMC (1)

Where:

RGDP = Real Gross Domestic Product

BDL = Bank Deposit Liability

CPS = Credit to the Private Sector

RDR = Real Discount Rate

INV = Investment

SMC = Stock Market Capitalisation

In this study, the effect of financial sector reform through the introduction of structural

adjustment programme in 1986 is examined. Thus, equation (1) is modified to include

a dummy variable as specified below:

, , , , ,t tf BDL CPS RDR INV SRGD MCP DUM (2)

To estimate equation (2), we take the natural logs of both sides which will result in the

following equation (3)

0 1 2 3 4 5 6 t t t t t t t tlnRGDP lnBDL lnCPS RDR lnINV lnSMC DUM u (3)

0, 0, 0, 0 0 lnBDL lnCPS RDR lnINV and lnSMC


102

The dummy variable accounts for financial sector reform shifts in Nigeria. DUM = 0

from 1975 to 1985 and 1 from 1986 to 2008. Where tu denotes the white noise error

term, 0 is a constant parameter while 1 to 6 are parameter coefficients. Except

real deposit rate and the dummy, all the variables are expressed in logarithmic form.

Also, all coefficients are expected to be positive.

Banks deposit liabilities (BDL), our measure of financial depth, is calculated by taking

the difference between total liquid liabilities and currency in circulation divided by

nominal GDP. A higher ratio implies a greater financial intermediary development. The

standard measure of financial depth in the literature is the ratio of broad money to GDP

(i.e. M2/GDP). However, as stressed by Demetriades and Luintel (1996) and Luintel

and Khan (1999), this ratio measures the extent of monetisation rather than of financial

depth. They argue that in the developing countries, monetisation can be increasing

without financial development occurring. In line with this argument, we regard

M2/GDP as not an entirely satisfactory indicator of financial depth. We, therefore,

include an alternative financial depth as a ratio of total bank deposit liabilities to

nominal GDP (i.e. deducting currency in circulation from M2).

The use of CPS as an indicator of financial intermediary has some advantages. More

importantly,it excludes credit to the public sector as well as credit issued by the central

bank. Thus, it represents more accurately the role of financial intermediaries in

channelling fund to private market participants. De Gregorio and Guidotti (1995) argue

that CPS has a clear advantage over other measures of monetary aggregate such as M1,

M2 and/or M3 in that it reasonably captures the actual volume of funds channelled to

the private sector. This financial indicator (CPS) has been previously used in

investigating the relationship between financial development and economic growth in

Nigeria (see Olomola, 1994; and Nzotta and Okereke, 2009). We interpret higher

CPS/GDP as an indicator of more financial services and, therefore, greater financial

intermediation.

Real deposit rate (RDR) is calculated by taking the difference between the nominal

deposit rate and inflation rate. Investment (INV) is seen as the expenditure on fixed

assets (buildings, plant and machinery, vehicles, etc.), either for replacement or adding

to the stock of existing fixed assets. It is measured as the ratio of gross capital formation

to GDP. SMC is the ratio of stock market capitalization to GDP. The size of the stock

market is positively correlated with the ability to mobilise capital and diversify risk6 .

6 Other complementary measures of stock market size are the stock market liquidity and risk

diversification (Levine and Zervos, 1996). But, we have chosen market capitalization as a ratio


103

Estimation Technique

Autoregressive Distributed (ARDL) Bounds Test Approach

This study employs the autoregressive distributed (ARDL) bounds test approach

proposed by Pesaran et al. (2001), based on unrestricted error correction model.

Compared to other cointegration procedures such as Engle and Granger (1987) and

Johansen and Juselius (1990), the bounds test approach appears to have gained

popularity in recent times for a number of reasons. First, the endogeneity problems and

inability to test hypotheses on the limited coefficients in the long run associated with

Engle-Granger method are avoided, that is, it has superior statistical properties on small

samples as it is relatively more efficient in small sample data sizes evident in most

developing countries. Second, the long run and short run parameters of the model are

estimated simultaneously. Third, all the variables are assumed to be endogenous.

Fourth, it does not require unit root testing usually employed to determine the order of

integration of variables. Lastly, whereas all the other methods require that the variables

in a time series regression are integrated of order one, I(1), only that of Pesaran et al.

(2001) could be used regardless of whether the underlying variables are I(0), I(1) or

fractionally integrated.

Nonetheless, to apply the bounds test, it is important to ensure that the variables under

consideration are not integrated at an order higher than one. In the presence of I(2)

variables, the critical values provided by Pesaran et al.(2001) are no longer valid. The

following ARDL representation of equation (3) will be estimated in order to test the

existence of long run relationship between economic growth and financial

development:

0 1 2 3 4 5

1 1 1 1 1

6 1 1 17 8 9 1 1 1

1

0 1 1

k k k k ki i i i i

t t i t i t i t i t i

i i i i i

ki

t i t t t t t

i

lnRGDP lnBDL lnCPS RDR lnINV lnSMC

lnRGDP lnBDL lnCPS RDR lnINV lnSMC

112 13 (4 )t t tlnRGDP DUM u

To determine the optimal lag length for the ARDL model in equation (4), lag selection

criteria such as the Schwarz Information Criteria (SIC) and Akaike Information

of GDP as it reflects the size of the market more than the liquidity or risk diversification

measures.


104

Criterion (AIC) are employed and the lag combination that minimises these criteria is

the optimal lag for the model.

Investigating the presence of a long run relationship amongst the variables in equation

(4) given the chosen lag requires the use of the Wald test (or F-test) in which the joint

significance of the coefficients for lagged one variable is tested with F-statistics

calculated under the null. We perform a joint significance test, where the null

hypothesis (H0: β7 = β8 = β9 = β10 = β11 = β12 = β13 =0) against the alternative, (H1: at

least one of the parameters is not equal to zero).

Consequently, the computed F-statistic is then compared with the non-standard critical

bounds values reported by the Pesaran et al. (2001). If the computed F-statistic exceeds

the upper critical bounds value, then H0 is rejected. If the F-statistic lies below both the

upper and the lower critical bounds value, it implies that the null hypothesis of no

cointegration is not rejected. However, when the computed F-statistic falls or lies

between the critical lower and upper bounds values, then the test becomes inconclusive.

Once the cointegrating relationship is established, the short run dynamics is also

analyzed. The error correction model representation of the ARDL model is specified in

equation (5) below:

0 1 2 3 4

1 1 1 1

5 6 1

1 1

(5)

k k k ki i i i

t t i t i t i t i

i i i i

k ki i

t i t i t t

i i

lnRGDP lnRGDP lnBDL lnCPS RDR

lnINV lnSMC ECM

Where λ is the speed of adjustment parameter, ECM is the residual obtained from the

long run estimation and t is a white noise error term. In addition, we perform the

CUSUM and CUSUMSQ test for parameter stability.

Causality

To complement this study, we conduct a causality test to establish the direction of

causality between financial development (and hence the various measures of financial

development) and economic growth. Essentially, this test is employed to determine

whether the link between financial development and economic growth follows the

supply-leading hypothesis or demand leading hypothesis or both.

According to Granger (1968), a variable say y is said to granger cause another variable

say x if past and present values of y help to predict x. This is the traditional Granger-

Causality (based on a bi-variate relationship). However, this has its own limitations: a

two-variable granger causality test without considering the effect of other variables is


105

subject to possible specification bias, as pointed out by Gujarati (1995), “...a causality

test is sensitive to model specification and the number of lags”. Therefore, the empirical

evidence of two-variable Granger causality may be biased when the number of

endogenous variables is more than two due to restriction of other endogenous variables

in the model. To this note, we consider the VAR Granger Causality test that allows for

several endogenous variables. The VAR Granger specification is given as:

1 2 3 4 5 6 1

1 1 1 1 1 1

1 2 3 4 5 6

1 1 1 1 1

(6)p p p p p p

t j t j j t j j t j j t j j t j j t j t

j j j j j j

p p p p p

t j t j j t j j t j j t j j t j j t j

j j j j j

bdl bdl rgdp cps rdr inv smc

rgdp rgdp bdl cps rdr inv smc

2

1

1 2 3 4 5 6 3

1 1 1 1 1 1

1 2 3 4 5

1 1 1 1

(7)

(8)

p

t

j

p p p p p p


j j j j j j

p p p p

t j t j j t j j t j j t j j t j

j j j j

cps cps rgdp bdl rdr inv smc

rdr rdr rgdp bdl cps inv

6 4

1 1

1 2 3 4 5 6 5

1 1 1 1 1 1

1 2 3 4

1 1

(9)

(10)

p p

j t j t

j j

p p p p p p


j j j j j j

p p

t j t j j t j j t j j t j

j j j

smc

inv inv rgdp bdl cps rdr smc

smc smc rgdp bdl cps

5 6 6

1 1 1 1

(11)p p p p

j t j j t j t

j j j

rdr inv

This multivariate causality test requires as a precondition, the estimation of a

corresponding VAR model as specified in equations 6 –11.

Data Sources

The study is based on annual data sourced from Central Bank of Nigeria (CBN)

Statistical Bulletin and Annual Report and Financial Statement (various years). Data

on stock market capitalisation was sourced from the Nigerian Stock Exchange Fact

Book (various years).

ESTIMATION RESULTS AND DISCUSSION

Although the ARDL approach to cointegration does not require the pre-testing of the

variables included in the model for unit root, the ADF unit root test is however

considered as this is necessary for VAR Granger causality test. The results are

presented in Appendix 1. Virtually all the variables in the model are stationary at first

difference and thus integrated of order 1 (i.e. I(1) series). Test of cointegration shows

that the computed F-statistic of 5.55 exceeds the lower and upper bounds critical values


106

of 3.15 and 4.43, respectively at the 1 per cent significance level, using Pesaran et al

(2001). Thus, the null hypothesis of no cointegration is rejected, implying long run

relationship among rgdp, bdl, cps, rdr, inv, and smc7.

Table 1: Bounds Tests for the Existence of Cointegration

Dependent variable Critical

value

F-statistic = 5.55

Lower bound Upper bound

Frgdp(rgdp│bdl, cps,

rdr, inv, smc, dum)

1%

5%

10%

3.15

2.45

2.12

4.43

3.61

3.23

Notes: Asymptotic critical value bounds are obtained from Table CI (iii) case III: unrestricted

intercept and no trend for k = 6 (Pesaran et al, 2001).

Long and Short Run Dynamics

The long run coefficients are presented in Table 2. As shown, the estimates of bank

CPS, SMC and financial reform/deregulation (DUM) have the expected signs while the

BDL, INV and the RDR do not conform to the theoretical expectation. Four of the

variables are statistically significant at the one per cent while financial reform DUM is

significant at 5 per cent level. The RDR and BDL do not seem to impact significantly

on long run growth in Nigeria.

Observably, financial intermediation proxied by bank CPS is an important factor

contributing to economic growth in the Nigerian economy and is highly significant at

one per cent. The coefficient of financial intermediation indicates that in the long run,

a one per cent increase in financial intermediation increases real output by 0.90 per

cent. The results are contrary to the findings of Osuji and Chigbu (2012) for Nigeria.

Also, a one per cent rise in SMC increases real output growth by 0.57 per cent. The

coefficient of the RDR contributes an insignificant negative effect. This suggests that

RDR does not appear to have any significant contribution on aggregate output in the

country. Thus, it is logical to conclude that the low interest rate on deposits is not

encouraging to stimulate the required level of savings to boost investment and

economic growth in Nigeria.

7The test for cointegration was also carried out using Johanson cointegration test. A long run

relationship exists. While the trace test indicates three cointegrating equations at 1% level, the

max-eigenvalue test also indicates three cointegrating equations. With two cointegrating

equation(s) at 5% and one cointegrating equation at 1%.


107

Table 2: Estimates of the Long Run Coefficients ARDL (1, 0, 0, 1, 1)

Dependent Variable: RGDP

Coefficient p-value

Const 10.5583 0.00001***

BDL -0.104503 0.67363

CPS 0.902922 0.00974***

RDR -0.00259726 0.57172

INV -0.957859 0.00009***

SMC 0.565489 0.00026***

DUM 0.58097 0.02275**

*** (**) critical values at 1% (5%). All variables are significant at 5% level

R-squared 0.889678

Adjusted R-squared 0.865162

F-statistic 36.28970 (0.000)

Durbin-Watson stat 1.445337 Source: Authors’ analysis

Although highly significant, the coefficient of investment, measured as Gross Fixed

Capital Formation to GDP has a negative value of – 0.96 per cent, indicating that

investment has not promoted economic growth in Nigeria. Notably, from existing

growth literature, investment share is mostly a robust variable explaining economic

growth. Previous studies have attributed this negative coefficient of investment in

relation to real output in the case of Nigeria to the following factors: (i) most public

sector infrastructure investments are not worthwhile; (ii) government implemented

public projects that turned out to be money-draining projects; (iii) government

contracts were awarded at inflated prices or completely abandoned after mobilisation

fees have been paid; (iv) there was looting of public funds which are central to savings

and investment; (v) low per capita income in Nigeria resulting in low private domestic

saving and thus may not be a major source of investment; (vi) frequent regime changes

and its attendant poor policy implementation, leading to lower long run investment;

(vii) public and private corrupt practices which divert scarce resources from productive

activities to unproductive activities arresting economic growth; and (viii) the frequent

use of deposits by Nigerian banks to trade in foreign exchange and government treasury

bills, among others, rather than channelling mobilized funds to the real sector of the

economy (see Soludo, 2004; Onwiodukokit and Adamu, 2005; Guseh and Oritsejafor,

2007; and Obamuyi, 2009).

Given the insignificant negative RDR, the estimated coefficient of financial depth

(BDL) is also negative (-0.11). Previous studies on Nigeria have also found this


108

negative relationship between financial depth and the level of real output growth. For

example, Adeoye and Adewuyi (2005) show that financial depth measured by M2/GDP

lags behind the tempo of economic activities and may not have been the source of real

GDP growth in Nigeria. Adeoye and Adewuyi (op. cit) attributed this poor

performance of financial depth in Nigeria to three factors: (i) Macroeconomic

instability due to high inflation rates; (ii) removal of foreign exchange control without

appropriate measures to avoid rapid exchange rate depreciation; and (iii) the

introduction of treasury bill (TB) auctions which made TB rates more attractive to

larger depositors who opted for TBs at the expense of time deposits.

Finally, the coefficient of financial reform dummy though relatively small is significant

and positive (0.58). Financial reforms which ensued healthy competition and therefore

improved service delivery by the financial institutions in Nigeria appear to be growth-

oriented Nonetheless, concerted efforts geared towards improving the management of

the liberalisation process through effective monitoring and regulatory framework may

drive a higher impact of financial reforms on growth. .

Short Run Dynamics

Premised on the tenet that financial development reforms especially in developing

countries lack credibility and continuity, a short run analysis becomes unavoidable. The

results obtained from the short run dynamic are presented in Table 3.

The results show that the estimated lagged error correction term (ECMt-1) is negative

and highly significant. This supports the co integration among the variables represented

by equation (1). The feedback coefficient is -0.41, which suggests a fairly high speed

of adjustment to equilibrium after a shock. Approximately, 41 per cent of the

disequilibria from the previous year’s shock converge or adjust back to the long run

equilibrium in the current year. Also, at least one of the representations of each variable

in the error correction model is statistically significant although at different levels of

significance. For example, while ∆invt-1 and Δrgdpt-1 representing change in investment

and economic growth respectively are statistically significant at 5% and 1%, ∆rdrt-1,

∆cpst-1 and ,∆smct-1 denoting change in real deposit rate, credit to private sector and

stock market capitalization respectively are all significant at 10%. This suggests that

the impact of financial development on the real sector has lag effects.

Although, the short-run response of current RDR is positive, its contribution is small

and insignificant. This is justifiable in Nigeria because low deposit interest rate makes

savings unattractive as a sizeable proportion of income is spent on “consumer goods”.

Further, the changes in real output respond positively to the changes in SMC in the

short run. Therefore, increased access to long term financing may enhance the growth

process in Nigeria. However, changes in real output respond negatively to changes in


109

BDL; thus, suggesting inefficient and weak financial intermediaries in the mobilization

of funds for productive activities.

Table 3: Error Correction Representation of ARDL Model (1, 0, 0, 1, 1, 1) selected

on the basis of AIC

Coefficient Std. Error t-ratio p-value

Const 0.0542039 0.0416698 1.3008 0.20742

ΔRGDPt-1 0.54113 0.161936 3.3416 0.00309***

ΔBDLt -0.0787969 0.14095 -0.5590 0.58205

ΔCPSt 0.347677 0.193879 1.7933 0.08735*

ΔRDRt 0.000717117 0.00214902 0.3337 0.74192

ΔRDRt-1 -0.0039473 0.00223683 -1.7647 0.09216*

ΔINVt -0.157638 0.179651 -0.8775 0.39016

ΔINVt-1 0.339038 0.160764 2.1089 0.04713**

ΔSMCt 0.0925685 0.16848 0.5494 0.58850

ΔSMCt-1 -0.297369 0.16564 -1.7953 0.08702*

ECMt-1 -0.412019 0.124025 -3.3221 0.00324***

Note: ***, ** and * represent level of significance at 1%, 5% and 10% respectively.

R-squared 0.561392 Adjusted R-squared 0.352531

F(10, 21) 2.687874 P-value(F) 0.027006

Log-likelihood 15.72400 Akaike criterion -9.448008

Schwarz criterion 6.675087 Durbin's Watson 0.168738

Stability Tests

We also performed CUSUM and CUSUMSQ stability test for estimated error

correction model. This is important in order to investigate whether the above long and

short run relationships found are stable for the entire period of study. The methodology

used is based on the Cumulative Sum (CUSUM) and the Cumulative Sum of Squares

(CUSUMSQ) tests proposed by Brown et al. (1975). Unlike the Chow test that requires

break point(s) to be specified, the CUSUM tests can be used even if we do not know

the structural break point. The CUSUM test uses the CUSUM of recursive residuals

based on the first n observations and is updated recursively and plotted against the


110

break point. The CUSUMSQ makes use of the squared recursive residuals and follows

the same procedure.

Figure 2 shows that the plots of CUSUM and CUSUMSQ are within the five per cent

critical bound, thus providing evidence that the parameters of the model do not suffer

from any structural instability over the period of study. In other words, all the

coefficients in the error correction model are stable.

Fig. 2: CUSUM and CUSUMSQ Plots for Stability Tests


111

Granger Causality Test Result:

The comprehensive report of the VAR granger causality is presented in the appendix.

Extract of the result is however shown in table 4 below for easy reference:

At 5 per cent level of significance, the VAR Granger causality test reveals that all the

financial development variables in the model jointly have a causal effect on economic

growth but not always individually (as “bdl, and cps” do not granger cause “rgdp”

individually). However, economic growth (rgdp) does not appear to granger cause

financial development. Overall, the causality result appears to support the view that

causality runs from financial development to economic growth and therefore, the

"supply-leading" hypothesis seems evident in Nigeria. This is in line with the findings

of Adelakun (2010) for Nigeria using the traditional bi-variate granger causality. The

results are contrary to the findings of Osuji and Chigbu (2012) and Samson and Elias

(2010) for Nigeria, who found a bi-directional causal relationship between economic

growth and financial development.

Table 4: Multivariate VAR Granger Causality Test Result

Equation

Variable

Equtn 6 Equtn 7 Equtn 8 Equtn 9 Equtn 10 Equtn 11

DUM BDL RGDP CPS RDR INV SMC

BDL D.V

(0.826)

{0.661}

(3.514)

{0.172}

(0.128)

{0.937}

(1.769)

{0.016}**

(2.623)

{0.269}

(2.136)

{0.343}

RGDP (0.6598)

{0.719} D.V (0.1227)

{0.9405}

(1.057)

{0.589}

(8.197)

{0.016}**

(0.134)

{0.854}

(0.026)

{0.986}

CPS (1.9338)

{0.380}

(3.4539)

{0.1779} D.V (0.111)

{0.945}

(1.8425)

{0.398}

(1.347)

{0.509}

(0.089)

{0.956}

RDR (3.9814)

{0.136}

(5.4172)

{0.066}*

(8.6548)

{0.013}** D.V (3.593)

{0.165}

(1.792)

{0.408}

(2.460)

{0.292}

INV (1.4452)

{0.485}

(9.808)

{0.00}***

(2.4424)

{0.2949}

(4.029)

{0.133} D.V

(0.014)

{0.992}

(6.550)

{0.037}

SMC (7.3328)

{0.025}**

(5.034)

{0.080}*

(3.7076)

{0.1566}

(0.375)

{0.829}

(5.3167)

{0.070}** D.V (1.974)

{0.372}

DUM (2.2686)

{0.321}

(1.507)

{0.470}

(0.3901)

{0.8228}

(2.913)

{0.233}

(0.9476)

{0.6226}

(0.445)

{0.800} D.V

ALL (26.608)

{0.008}***

(21.75)

{0.04}**

(31.774)

{0.001}***

(9.572)

{0.653}

(20.742)

{0.054}**

(8.769)

{0.722}

(22.19)

{0.03}**

NOTE: ( ) = Chi-Sq, { } = Prob, and D.V = Dependent Variable. ***, **, and * indicate

significance at 1, 5 and 10% respectively. Source: Authors’ Analysis.


112

CONCLUSION AND POLICY IMPLICATIONS

This study examined the empirical relationship between financial development and

economic growth in Nigeria from 1975 to 2008, using Bound test Autoregressive

Distributed Lag (ARDL) approach. The results show that there exists a unique long run

relationship between financial development and economic growth. Thus, financial

development is an important determinant of economic growth in Nigeria. In the long

run, financial reform (though small), credit to private sector and stock market exerted

positive impact on economic growth. While financial depth- bank deposit liability and

real deposit rate (although insignificant) and investment showed a negative impact on

real income. However, in the short run, most of the variables were statistically

significant; thus, justifying evidence of lag effect between financial development and

economic growth. Also, we find a stable long run relationship between financial

development and economic growth, as indicated by the CUSUM and CUSUMSQ

stability tests.

Five interesting results are obtained from this study. First, financial development

enhances economic growth in Nigeria. In particular, credit to private sector and stock

markets in Nigeria have yielded positive and significant results. Second, we find

evidence of unidirectional causality running from financial development (particularly

stock market) to growth. This implies that the development of the Nigeria stock market

can significantly influence economic growth. Hence, capital market-based financial

system causes growth in Nigeria. Third, financial depth does not contribute to growth

in the reform era. Fourth, all financial development indicators have lag effects in the

short run. This suggests that the impact of financial development on the real sector is

not instantaneous. Finally, financial reform in Nigeria though with a positive impact in

the long run, may still require further improvements.

Based on the above findings, the following policy implications are conceived:

i. The role of deposit money banks in contributing to growth will remain an

illusion if banks continue to pursue trade in foreign exchange, invest in

government treasury bills and directly fund the importation of goods

(Onwioduokit and Adamu, 2005) at the expense of promoting viable and

efficient investment in the real sector of the economy. It is therefore

recommended that effective means of improving credit channels and

liquidity to private firms by banks should be encouraged by CBN.

ii. The long run relationship between financial development and economic

growth shows that the former is significant in promoting real income. Hence,


113

policies should be directed towards promoting a more competitive

environment that enhances service delivery among financial institutions.

iii. Poor performance of financial reforms has been attributed to improper

sequencing of the reform agenda coupled with frequent policy reversals and

reintroduction (Ikhide and Alawode, (2002). Government should therefore

implement reforms that will enhance financial intermediation through stable

and sustainable real positive interest rates followed by sound

macroeconomic, monetary and fiscal policies targeted at low and sustainable

inflation rates.

iv. Equity market in Nigeria is not yet well-developed. Nonetheless, flow from

our causality results shows that stock market facilitates growth in Nigeria. In

order to spur a mature stock market in Nigeria and hence a higher level of

growth, we recommend policies geared towards the expansion and

development of the Nigerian stock market. For example, promoting a more

liberalised capital market will increase the efficiency of the stock market.

This will also ensure that stock prices truly reflect their fundamental worth

(values) or the expected future profitability of companies. Therefore,

resources can be effectively channeled to the most efficient and productive

companies, which will be better positioned to implement their investment

plans and hence, stimulate economic growth.


114

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117

APPENDIX

Appendix 1: Augmented Dickey Fuller Test of Unit Roots

Variables Level (first

difference)

ADF critical 1% (5%) Order of

integration

Stationary

Rgdp -1.766151

(-5.77383)

-3.64342 (-2.954021)

-3.64342 (-2.954021)

I(1)

Non-stationary

Stationary

Bdl -1.306175

(-5.617117)

-3.64342 (-2.954021)

-3.64342 (-2.954021)

I(1) Non-stationary

Stationary

Cps -2.366272

(-5.373915)

-3.64342 (-2.954021)

-3.64342 (-2.954021)

I(1) Non-stationary

Stationary

Rdr -4.092583 -3.64342 (-2.954021)

I(0) Stationary

Inv -1.680999

(-4.8207)

-3.64342 (-2.954021)

-3.64342 (-2.954021)

I(1) Non-stationary

Stationary

Smc -0.254409

(-6.306457)

-3.661661 (-2.960441)

-3.653730 (-2.957110)

I(1) Non-stationary

Stationary Source: Computed by the authors

VAR Granger Causality Specification:

1 2 3 4 5 6 1

1 1 1 1 1 1

1 2 3 4 5 6

1 1 1 1 1

(1)p p p p p p


j j j j j j

p p p p p

t j t j j t j j t j j t j j t j j t j

j j j j j

bdl bdl rgdp cps rdr inv smc

rgdp rgdp bdl cps rdr inv smc

2

1

1 2 3 4 5 6 3

1 1 1 1 1 1

1 2 3 4 5

1 1 1

(2)

(3)

p

t

j

p p p p p p


j j j j j j

p p p

t j t j j t j j t j j t j j t j

j j j j

cps cps rgdp bdl rdr inv smc

rdr rdr rgdp bdl cps inv

6 4

1 1 1

1 2 3 4 5 6 5

1 1 1 1 1 1

1 2 3 4

1 1

(4)

(5)

p p p

j t j t

j j

p p p p p p


j j j j j j

p p

t j t j j t j j t j j t

j j

smc

inv inv rgdp bdl cps rdr smc

smc smc rgdp bdl cps

5 6 6

1 1 1 1

(6)p p p p

j j t j j t j t

j j j j

rdr inv


118

APPENDIX 2:

VAR Granger Causality Test Result

VAR Granger Causality/Block Exogeneity Wald Tests

Sample: 1975 2008

Included observations: 32

Dependent variable: RGDP

Excluded Chi-sq df Prob.

BDL 0.826737 2 0.6614

CPS 3.453877 2 0.1778

RDR 5.417169 2 0.0666

INV 9.808842 2 0.0074

SMC 5.034929 2 0.0807

DUM 1.507184 2 0.4707

All 21.75883 12 0.0403

Dependent variable: BDL


RGDP 0.659779 2 0.7190

CPS 1.933760 2 0.3803

RDR 3.981442 2 0.1366

INV 1.445193 2 0.4855

SMC 7.332820 2 0.0256

DUM 2.268625 2 0.3216

All 26.60874 12 0.0088

Dependent variable: CPS


RGDP 0.122673 2 0.9405

BDL 3.514217 2 0.1725

RDR 8.654840 2 0.0132

INV 2.442379 2 0.2949

SMC 3.707630 2 0.1566

DUM 0.390087 2 0.8228

All 31.77493 12 0.0015

Dependent variable: RDR


RGDP 1.057740 2 0.5893

BDL 0.128899 2 0.9376

CPS 0.111617 2 0.9457

INV 4.029493 2 0.1334

SMC 0.375164 2 0.8290


119

DUM 2.913223 2 0.2330

All 9.572549 12 0.6534

Dependent variable: INV


RGDP 8.197907 2 0.0166

BDL 1.769129 2 0.4129

CPS 1.842458 2 0.3980

RDR 3.593599 2 0.1658

SMC 5.316692 2 0.0701

DUM 0.947564 2 0.6226

All 20.74233 12 0.0543

Dependent variable: SMC


RGDP 0.314066 2 0.8547

BDL 2.623620 2 0.2693

CPS 1.346975 2 0.5099

RDR 1.792863 2 0.4080

INV 0.014759 2 0.9926

DUM 0.445504 2 0.8003

All 8.769080 12 0.7225

n 3 is column 2 multiplied by 148 to convert current US dollar to Naira

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