Financial sector development and economic growth in Rwanda.

Abstract

There is a widespread consensus in the literature that financial sector development plays a significant role in economic growth. Several studies have also shown that economic growth is associated with an efficient banking sector with low ratios of Non-Performing Loans (NPLs). Against this background, the government of Rwanda holds the view that developing the financial sector can lead to the country’s economic growth. However, there is no agreement in the literature on whether or not individuals and companies increase borrowing in response to financial sector development. In the case of Rwanda, no study that the researcher is aware of has established the directional influence between borrowing and financial sector development, and its links to economic growth. Similarly, no assessment has been made of the country’s financial sector efficiency and the causes of NPLs. Therefore, the main objective of this study is to assess the mechanism that relates financial sector development to economic growth in Rwanda. The study is made of three inter-related papers corresponding to the three specific objectives that together contribute to the achievement of the general objective of understanding how finance relates to economic growth in Rwanda. The first paper sets to investigate the relationship between financial intermediation and economic growth in Rwanda. Using a Cointegrated Structural Vector Autoregressive model on quarterly data for the period 1996:1 to 2010:4, the study finds the existence of a cointegrating relationship between financial intermediation and economic growth. It also observes that domestic credit to private sector shock accounts for the largest proportion of fluctuations in real output growth, followed by potential liquidity available, supporting the supply-leading hypothesis in the intermediation link between financial sector development and economic growth in Rwanda. The second paper aims at assessing the efficiency of commercial banks in Rwanda. Using a stochastic frontier analysis for the period 2007 to 2013, the study finds that the commercial banking sector has a mean cost efficiency score of 88.56 percent, suggesting that in order to enhance their efficiency, banks can reduce their input composition by 11.44 percent. Finally, the third paper investigates the microeconomic factors that influence NPLs in the Rwandan banking sector. Applying a multivariate logistic model, the study finds a negative relationship between repayment period and NPLs, indicating that an extension of the repayment period up to four years can lead to decreases in NPLs. Thus, for Rwanda to attract businesses that can easily make use of current financial services, it should reinforce incentives regarding the legal framework to conduct business. The country should also continue to promote the adoption and use of modern technology as well as sensitizing financial intermediaries to extend the repayment period. Combined, these measures could boost the financial sector’s efficiency, hence stimulating economic growth.