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Determinants of financial development in

Ethiopia: ARDL approach

Teshager Mazengia Asratie |

To cite this article: Teshager Mazengia Asratie | (2021) Determinants of financial

development in Ethiopia: ARDL approach, Cogent Economics & Finance, 9:1, 1963063, DOI:
10.1080/23322039.2021.1963063

To link to this article: https://doi.org/10.1080/23322039.2021.1963063

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Asratie, Cogent Economics & Finance (2021), 9: 1963063
https://doi.org/10.1080/23322039.2021.1963063

FINANCIAL ECONOMICS | RESEARCH ARTICLE

Determinants of financial development in
Ethiopia: ARDL approach
Teshager Mazengia Asratie1*

Received: 07 March 2021

Abstract: Sustainable economic growth requires financial sector development.
Accepted: 28 July 2021 However, financial development is low in Ethiopia. Hence, the main objective of the
*Corresponding author: Teshager study was to examine determinants of financial development in Ethiopia. Annual
Mazengia Asratie, Economics, Debre data from 1980 to 2019 was used and examined by ARDL estimation technique.
Berhan University, Debre Berhan,
Ethiopia Private sector credit and money supply as percentage of GDP were used as depen­
E-mail: teshagerm2016@gmail.com
dent variables. Independent variables include external debt, reserve requirement,
Reviewing editor: real exchange rate, lending interest rate, inflation, political freedom index, trade
David McMillan, University Of Stirling,
Stirling, United Kingdom openness and economic growth. Broad money supply model is positively affected by
Additional information is available at
political freedom index, economic growth and trade openness both in the short run
the end of the article and long run. While it is negatively affected by interest rate and reserve require­
ment. However, real exchange rate has negative effect in the long run and insig­
nificant effect in the short run. On the other hand, credit to private sector model is
positively affected by inflation, and political freedom, economic growth and trade
openness. While it is negatively affected by external debt, reserve requirement and
lending interest rate. Error correction estimation result of credit to private sector
model shows the adjustment coefficient is −0.263 and statistically significant at 5%
level of significance, which means short run deviation from long run equilibrium is
adjusted at a rate of 26.3%. The adjustment coefficient for broad money supply
model is −0.254. The study recommends that the government needs to improve
trade and the quality of factors of production, reduce reserve requirement, reducing
interest rate on lending, political.

Subjects: Development Studies; Economics and Development; Economics; Finance

Keywords: finance; financial development; ARDL; Ethiopia

1. Introduction
Financial development has important ramifications for economic growth, because it channels funds
from surplus to deficient units to finance investment projects. However, in Ethiopia creation of

ABOUT THE AUTHOR PUBLIC INTEREST STATEMENT

Teshager Mazengia, the author of this article, is Financial development is essential for sustainable
MSc in economics holder from Addis Ababa development of the economy. However, financial
University with specialization of resource and development is low and at its infant age. Moreover,
environmental economics. Currently I am work­ the majority of credit from financial institutions,
ing for Debre Berhan University as lecturer. I am particularly from bank goes to public sectors, which
interested to conduct a study on financial sector lowers the amount of credit provided to the private
performance, renewable and non-renewable sector. Thus answering the question ”why financial
resource use efficiency, and valuation. development indicators (money supply and credit to
the private sector) is low?” may have many benefits
to Ethiopian economy.

© 2021 The Author(s). This open access article is distributed under a Creative Commons
Attribution (CC-BY) 4.0 license.

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appropriate regulatory framework and sound financial system is difficult particularly during the Derg
regime (1974 to 1991) were state enterprise received bank finance. After the overthrow of the socialist
regime in 1991, Ethiopia started market economy. Following this, new financial institutions have
emerged and private sector becomes active players in the financial system (Addison & Fole, 2001).

Banking in Ethiopia is dominated by government owned entity with two-third market shares. In
2019, there are 17 commercial banks (16 private and 1 public). The sector shows notable changes
from single state owned in 1990 to 7 banks in 2000. The total number of public and private bank
branches reaches 4,757 as of June 2018, which improves population to bank branch ratio from 1
branch to 126,000 in June 2008 to 20,000 in 2018. Also depositor numbers are increased from
4 million in 2010 to 33 million in 2018. For instance, commercial bank of Ethiopia served
18.8 million customers through 1,708 ATM Machines, 11,796 POS-machines and 1,375 branches.
On the other hand, private banks has a maximum of 380 branches and customers not more than
2 million per bank, and only around 300 ATM machines (CEPHEUS, 2019).

On the credit side, the majority of funds by banks (two thirds) have gone to the public sector. In
2011–2012, private credit to private sector was 36% of total credit, but in June 2018, it declines to
32%. Currently, private credit to private sector is only 11%, half lower than the average among the
20 largest African countries and in need of much improvement if a more private sector driven
economy is to take hold in the coming years. In addition to the limited credit provided to private
sectors in Ethiopia, the particular forms and lending features are not matched with the demand of
private business firms. Moreover, loans by bank provided to small and micro enterprises requires
stringent collateral or it is short-term maturities, which in turn holds back the potential user base
among Ethiopia’s large pool of small- and medium-sized enterprises (CEPHEUS, 2019).

Following change in government in 1991, Ethiopia made a reform on financial sector. However,
Ethiopia can’t improve the performance of financial sector as much as expected. Almost all financial
sectors are at their infant stage and the majority of the peoples, particularly living in rural areas of the
country, cannot easily access the financial sector either for formal credit or for saving purpose.
Particularly in the rural areas of the country, to get financial sectors households cross much many
kilometers with foot. Financial sectors have no modernized, automated and networked their services
(Yimer, 2011). Though both private banks and microfinance institutions are allowed to emerge, the
coverage and size of financial sectors are very low. In 2014, only 10% of households were accessed to
formal credit. Financial sector in Ethiopia heavily depends on banking sector, and insurance compa­
nies and microfinance institutions are the next best alternatives of getting money (NBE, 2015).

Since the economy is dominated by subsistent agriculture the degree of monetization and financial
sector development in Ethiopia are very low. Broad money supply (M2) as a proportion of GDP, which
is one measure of financial development was only 24% to 28% from the period 2008/09 to 2013/14.
Another measure of financial development, credit to private and public enterprise sectors to GDP ratio
stands at about 22% in 2013/14 (Gashayie & Singh, 2016). However, this is the lowest as compared to
other east African countries particularly south Africa and Kenya, which are countries having most
and second most developed financial sectors in east African countries (Ogola, 2016). Improving the
availability of financial facilities is one of the incentives that should be proposed for stimulating its
growth and the realization of its potential contribution to the Ethiopian economy. However, the need
for finance became higher and complicated when they grow and involve in high dynamic activities.
Despite this the level of financial development as compared to demand is very low. Therefore
identifying the determining factors of financial development has paramount importance. Hence,
this study tries to investigate the factors which hamper the development of financial sector in
Ethiopia using an auto-regressive distributed lag model.

The reminder of the paper is presented as follows. Section 2provides an overview of previous
theoretical and empirical literatures. Section 3 presents methodologies and data. The remaining
section 4 and 5 presents result and discussion and conclusion and recommendations, respectively.

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2. Literature review
Researchers grouped all endogenous and exogenous factors affecting financial development in to five
groups. These are the interference of the government, legal tradition, institutions, openness policy and
political economy factors (Voghouei et al., 2011). By comparing the level of price and quantities,
particularly the interest rate spread and stock-flow, one can determine the performance of financial
sector of a country. Many researchers used different indicators of financial development. For instance,
Arcand et.al. (2015), Scartascini (2012) and Huang (2005) used credit to private as a percentage of
gross domestic products. On the other hand, King and Levine (1993), Demetriades and Leuintel,
(1996) and Saci and Holden (2008) used liquid liability (M2) as a percentage of gross domestic
products.

Empirical study by Mbulawa (2015) show that strong evidence suggesting that financial develop­
ment (credit to the private sector % GDP) is explained by economic growth, trade openness and
institutional factors play a complementary role. Using 16 industrial countries Hofmann (2001)
analyzed the determinants of credit to the private non-bank sector. The author found that financial
development is negatively affected by real interest rate. According to Akinlo and Oni (2015), the prime
lending rate and reserve ratio cause a drop in private sector credit. Inflation raises private credit to
the private sector, but it tends to reduce real bank lending to the private sector. Using principal
component approach Badeb and Lean (2017) examined the main determinants of financial develop­
ment in the Republic of Yemen. They found economic growth and trade openness have a positive
impact on the pace of financial development. The natural resource dependence has a negative
impact.

Takyi and Obeng (2013) also found the influencing variables of Ghana’s financial development
using an auto-regressive distributed lag model. The model estimation found that income per capita
and trade openness had a positive significant effect on a country’s financial progress. While inflation
and interest rates have a positive statistically significant influence in the short and long run, reserve
requirements for commercial banks have a negative statistically significant influence in both the short
and long run. Borrowing by the government, on the other hand, has no effect. Benya (2010)
discovered that financial development and trade openness have a considerable beneficial link.
According to Huang (2005), political liberalization has a positive impact on financial development,
especially in the short run. From 1978/79 to 2010/11, Assefa (2014) evaluated the short and long-run
influence of bank-specific, monetary policy, and macroeconomic variables on bank loan to the private
sector in Ethiopia using a supply-side methodology. The author discovered that the requirement has
no effect on commercial banks’ loan to the private sector in the long or short run.

Bist and Read (2018a) investigated the long-run relationship between financial development and
economic growth using panel co-integration analysis in 16 selected low-income countries by
employing annual time series data from 1995 to 2014. Dynamic OLS estimation result shows
that financial development has positive significant effect of economic growth. Ellahi (Ellahi et al.,
2021) examined institutional factors affecting financial industry of South Asian Association of
Regional Cooperation (SAARC) region. The author employed generalized method of moment and
found that trade openness; institutional factors, legal origin, and real gross domestic product have
statistically positive significant effect on financial depth. On the other hand, inflation has negative
significant effect. Recent studies discussed various factors, which positively or negatively affect the
finance-growth relation. Ehigiamusoe et al. (2019) explored the impact of inflation on the relation­
ship between finance and economic growth in the West African region. They found a negative
interaction term of the inflation rate and financial development. A novel outcome is finding the
threshold level of inflation, which was 5.6% above, which could harm the relationship. Significant
findings suggested that instead of increasing both financial development and inflation, it is worth
to improve financial development and reduce the inflation rate. A similar analysis by Ehigiamusoe
et al. (2019) discussed that macroeconomic stability is an essential determinant of financial
development. The West African region study found that macroeconomic stability is an important
factor, particularly for financial sector development.

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3. Methodology and data

This study is used secondary data mainly drawn from World Development Indicators (WDI), freedom
house survey (FHS), national bank of Ethiopia (NBE) and International monetary fund (IMF). In
Ethiopia for the dependent variables (credit to private sector as a percentage of GDP and broad
money supply as a percentage of GDP) there is no compiled data from 1980 backwards. Due to this
this study covers covers a period of 40 years from the period (1980–2019). The dependent variables
used in this are broad money supply as % of gross domestic product and credit to private sector as %
gross domestic product. The independent variables are external debt, reserve requirement, real
exchange rate, lending interest rate, inflation rate, political freedom index, trade openness, and
GDP = gross domestic product. Summary statistics of both dependent and independent variables is
reported in Table 1, and the trend of dependents variables were discussed below in Figure 1.

For the study sample broad money supply as a percentage of GDP has a mean value of 31.194%
with minimum and maximum values of 16.081 and 45.353% respectively. since the stanard error is
higher it represents higher variation from its mean, which indicates in Ethiopia there is no stable
growth of money supply proportional to growth of real gross domestic product. Growth of liquid
liability as % of GDP has no constant trend. This financial development indicator remained low for
most of the Derg period. Between 1981/82 and 1985/86, the ratio of M2/GDP increased from 15%
to 20% and further to 22% by 1989/90. During the last two years of the Derg regime, M2 further
expanded due to the growth in the net claims of banks on the central government. After the
economic reform, efforts have been made to make growth of broad money supply in line with
nominal GDP growth. A relatively faster growth in broad money has been witnessed from 1994/95
to 2005 since the beginning of the reform averaging 23% in 1994/1995 and 45% in 2005.

On the other hand, credit to private sector as percentage of real gross domestic product is lower,
which is on average 16.188% with maximum and minimum values of 35.45 and 6.11 respectively.
Domestic credit issued to the private sector refers to the financial resources provided to the private
sector, such as through loans, purchase of non-equity securities and trade credit and other
account receivables, that establish a claim for repayment. For some countries, these claims include
credit to public enterprises. Bank credit to the private sector grew slowly because of the restriction
imposed on the economic activities of the private sector. After the economic reform however, bank
claims on government grew on average by 3.2% while non-government borrowers increased by
20% per annum due to the increasing participation of the private sector. Credit disbursed to non-
government borrowers accounted for 51% of the total domestic credit up from 30% in 1991/92.
Unlike the Derg period, bank credit to the private sector became a major determinant for the
expansion of the monetary base. For example, the ratio of private credit as percent of GDP in 2004
was 19.1 the second highest in East Africa (Kiyota et al., 2007). However, this does not necessarily
mean that intermediation is stronger because Ethiopia’s GDP is relatively low. After 2010 domestic
credit to private sector as % of GDP increase.

The average value of lending interest rate in Ethiopia from the period 1980 to 2019 is 10.964%.
The minimum and the maximum value of this variable is 6.8% and 15.5% respectively with lower
variations of 2.556%. The mean value of the inflation rate in the country is 9.798% for the period
1980 to 2019. The minimum and the maximum value of this variable are −7.764% and 39.27%,
respectively. The variation from the mean for inflation rate is 10.336%. This highest variation from
the mean is an indication of macro-economic instability in the region through overall price
increasing, which affects economic activities. during the study period Ethiopia’s real exchange
rate growth ranges from 2.987 to 20.356% with mean values and standard deviation of 10.793
and 5.191, respectively. In standard theory, depreciation will raise exports in the foreign market
this will improve investment and in the contrary depreciation will decrease import this will
discourage investment through increasing investment inputs imported from the rest of the
world. In Ethiopia case the later one is mostly happen because, Ethiopian investors they import
more capital goods than they export.

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Table 1. Summary statistics of variables

Variables Observation Mean Std. Dev. MIN MAX
M2%GDP 40 31.194 8.762 16.081 45.353
CPS%GDP 40 16.188 5.56 6.107 35.451
Interest rate 40 10.964 2.556 6.8 15.5
Freedom 40 5.688 .889 4 7
index(FI)
Trade openess 40 0.365 0.248 0.011 .412
Inflation(CPI) 40 9.798 10.336 −7.764 39.265
External debt 40 12.29 26.36 −64.04 88.31
growth
Real exchange 40 10.793 5.191 2.987 20.356
rate
Reserve 40 24.19 11.22 9.76 48.56
requirment
Real gross 40 5.978 6.425 −11.144 13.859
domestic
product growth

The measurement of political freedom incorporates two broad sub-groups: political right (PR)
and civil liberties ratings (CL). Political right includes sub groups such as process of election, level of
participation and political pluralism and government functioning. While civil liberties includes level
of freedom of expression and belief, rights associated with freedom to join and leave existing
groups of organization, rule of law, protection of individual right and personal freedom. Both
evaluated in the range of 1 to 7. If the index ranges between 1 and 2.5 a country is considered
as free, 3 to 5 partially free and 5.5 to 7 is considered as not free. The average values of 5.688 with
standard deviation of 0.889. The minimum and maximum values are 4 and 7, respectively. The
mean value shows that in Ethiopia there is political freedom. From 1980 to 2019 the average
growth of external debt stock in the country remains high averaging 12.29% with standard
deviation of 26.26. The minimum level of growth of external debt stock is negative 64.04% whilst
the maximum value recorded at 88.31%. This is an indication that countries in the region heavily
dependent on the external financial source to fill their financial gaps.

For the study sample the mean growth of reserve requirement is 24.19% and the minimum and
maximum growth are 9.76 and 48.56%, respectively. The other variable is trade openness (export +
import/RGDP) with a mean value of 0.365 or 36.5% with minimum and maximum of 1.1 and 41.2%,
respectively. Finally, the mean growth of real gross domestic product is 5.978 with minimum and
maximum growth of negative 11.144 and 13.859%, respectively.

3.1. Empirical model specification

The linkage between financial development and independent variables were tested by ARDL
estimation technique. Estimation method to test the long run relationship between dependent
variable and independent variable, the study applies Autoregressive Distributed Lag (ARDL) Model,
which is first developed by (Pesaran et al., 1997; 1999). ARDL approach is preferred over Johansen
maximum Likelihood because the former avoids the problem of order of integration, suitable for
small sample size, provides consistent results.

According to Johansen and Juselius (1990), Pesaran and Shin (1995), and Pesaran et al. (1996)
the general ARDL model is specified as follows.

The ARDL (p, q1, q2, q3 . . . . . . . . . .qk) model specification is given as follows.

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Figure 1. Trend of money sup­

28

45
ply and credit to private sector
as a percentage of gross

26
domestic product.

40
24

Broad money supply as a%age of RGDP

22

35
20
18

30
16
14

25
12
10

20
8

15
6
1980
1982
1984
1986
1988
1990
1992
1994
1996
2098
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
20

1980
1982
1984
1986
1988
1990
1992
1994
1996
2098
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
20
19

19
year year

k
ΦðL; pÞyt ¼ ∑ Bi ðL; qi Þxit þ δwt þ ut (3:1)
i

Where,ΦðL; pÞ ¼ 1 Φ1 L Φ2 L2 . . . . . . . . . . . . . . . :: ΦP LP

�
BðL; qÞ ¼ 1 β1 L β2 L2 . . . . . . . . . . . . : βq Lq , for i = 1, 2, and 3 . . . . . . .k, ut ,iid 0; δ2 and L is the
lag operator. Based on the above equation 3.1 The ARDL model specifications:

ΦðLÞyt ¼ φ þ θðLÞxt þ ut (3:2)

With ΦðLÞ ¼ 1 Φ1 L . . . . . . :: Φ p Lp ;

θð L Þ ¼ β 0 β1 L ......... βq Lq

Hence, the general ARDL (p, q1, q2, q3 . . . qk) model;

ΦðLÞyt ¼ φ þ θ1 ðLÞx1t þ θ2 ðLÞx2t þ θk ðLÞxkt þ ut (3:3)

Using the lag operators L applied to each component of vector, Lky = yt-k, is convenient to define
the lag polynomial Δ and the vector polynomial BðL; qÞ. As long as the error term Ut assumed to be,
white noise process, or more generally, independent with xt, xt-1 . . . and yt, yt-1 . . ., the ARDL model
consistently estimated using ordinary least squares. To explain the determinants of financial
development this study adopted the empirical model specification by Chinn and Ito (2002).
However, I utilize more updated data and incorporate new and additional variables. This include
freedom house survey index.

Generally, the mathematical form of the study is formed as:

M2/GDP = f (debt, RR, RER, R, INF, FI, RGDP and TOP)

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CPSGDP = f ((debt, RR, RER, R, INF, FI, RGDP and TOP)

Where M2/GDP = broad money supply as % of gross domestic product, CPSGDP = credit to private
sector as % gross domestic product, debt = external debt, RR = reserve requirement, RER = real
exchange rate, R = lending interest rate, INF = inflation rate, FI = political freedom index, TOP = trade
openness, and GDP = gross domestic product. Based on the above equation of determinants factor of
financial development, ARDL model in mathematical form is formed as follows

Q J L M
CPSGDPt ¼ C0 þ ∑ αi CPSGDPt 1 þ ∑ βj DEBTt j þ ∑ γl RRt l þ ∑ δm RERt mþ
i¼1 j¼0 l¼0 m¼0
S P N R Z
∑ πs Rt s þ ∑ ηp INFt p þ ∑ ζn FIt n þ ∑ γr TOPt r þ ∑ ρz RGDPt Z þ
s¼0 p¼0 n¼0 r¼0 z¼0

εt ðModel1Þ

M2 Q M2 J L M S
¼ C0 þ ∑ αi þ ∑ βj DEBTt j þ ∑ γl RRt l þ ∑ δm RERt m þ ∑ πs Rt s
GDPt i¼1 GDPt 1 j¼0 l¼0 m¼0 s¼0
P N R Z
þ ∑ ηp INFt p þ ∑ ζn FIt n þ ∑ γr TOPt r þ ∑ ρz RGDPt Z
p¼0 n¼0 r¼0 z¼0

þ εt ðModel2Þ

Where cpsgdp and m2/gdp refers to credit to private sector and liquid liabilities to the share
of GDP respectively.C0 is the drift parameter, Q,J, L, M, S, P, N,R, Y and Z denotes the lag
lengths. α; β; γ; δ; η; θ; ζ; ρandπ Are the coefficients to be estimated, i, j, l, m, s, p, n, r, y and
z denotes the time trend, and εt is the error term. Since it is necessary to understand the long
run and short run dynamics of the determinants of financial development, specification of the
long run and short run ARDL models is specified after checking the co integration of variables.
Therefore, the short run model is specified as the error correction model as shown in the
following Equation.

q q q q
ΔCPSGDPt ¼ C0 þ ∑ β1 ΔCPSGDPt i þ ∑ β2 ΔDEBTt i þ ∑ β3 ΔRRt i þ ∑ β4 ΔRERt i
i¼1 i¼1 i¼1 i¼1
q q q q
þ ∑ β5 ΔRt i þ ∑ β6 ΔINFt i þ ∑ β7 ΔFIt i þ ∑ β8 ΔTOPt i
i¼1 i¼1 i¼1 i¼1
q
þ ∑ β9 ΔGRGDPt i þ θECMt i þ εt ðModel3Þ
i¼1

M2 q q q q q
Δ ¼ C0 þ ∑ β1 ΔCPSGDPt i þ ∑ β2 ΔDEBTt i þ ∑ β3 ΔRRt i þ ∑ β4 ΔRERt i þ ∑ β5 ΔRt i
GDPtt i¼1 i¼1 i¼1 i¼1 i¼1
q q q q
þ ∑ β6 ΔINFt i þ ∑ β7 ΔFIt i þ ∑ β8 ΔTOPt i þ ∑ β9 ΔGRGDPt i þ θECMt i
i¼1 i¼1 i¼1 i¼1
þ εt ðModel4Þ

To test long run co- integration between variables ARDL bound test is used based on Null hypoth­
esis (HO): no long run relationship and alternative hypothesis (H1): there exists long run relation­
ship. The decision is accept if F < critical value for I (0) independent variables or reject if F > critical
value for I (1).

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Table 2. Stationary test of variables

Variables t-statistics at level t-statistics at 1st stationary
difference
M2%GDP −1.425 −4.666 I(1)***
CPS%GDP −1.136 −4.777 I(1)***
IR −5.568 −10.518 I(0)***
FI −6.165 −9.706 I(0)***
TOP −6.418 −11.941 I(0)***
INF −2.965 −8.415 I(0)**
Debt −1.385 −7.229 I(1)***
RER −0.958 −4.435 I(1)***
RR −1.629 −7.63 I(1)***
Real gross domestic −4.363 −7.793 I(0)***
product

4. Empirical findings

4.1. Results of unit root test

In this study, Augmented Dickey–Fuller (ADF) unit-root test developed by Dickey and Fuller (1979)
was used. Hamilton (1994) describes the four possible ways (with trend and drift; without trend
and drift; with drift but without trend; with trend but without drift) of conducting ADF test. Deciding
to choose among these four options involves many theories and the nature of the data. For
instance, if the data has non-zero mean ADF test including trend but avoiding drift is the best
way. As a result the author in this study used this test statistics and the result for both level and
first difference reported in Table 2 confirms that M2/GDP, CPS/GDP, external debt, real exchange
rate and reserve requirement are stationary at first difference. While lending interest rate, political
freedom index, trade openness, inflation and economic growth are stationary at level.

4.2. Results of bounds test of co-integration

In this study, the presence of co-integration in the long run is tested by bound test. The value of F-
statistics is used as identifying the existence of long-run relationship between dependent and inde­
pendent variables. ARDL-bound test is based on Null hypothesis (HO): no long-run relationship and
alternative hypothesis (H1): there exists long run relationship. The computed F-statistic can be com­
pared with the critical values provided by Pesaran et al. (2001) or Narayan (2005). However, the critical
value computed by Pesaran et al. (2001) is not suitable for small sample, which necessitates the use of
Narayan’s (2005) critical values. The decision is accept Ho if F < critical value for I (0) independent
variables or reject if F > critical value for I (1). The results of bound test for long run co-integration of
model 1 reported in Table 3 show that F- statistics value of the test is 8.099, which is greater than
critical value (4.10) of upper bounds at 1% level of significance. While for model 2 reported in Table 4
below, the F- statistics value are 7.508, which is also greater than critical value (4.10) at 1% level of
significance. Hence, in both models null hypothesis of no co- integration is rejected.

Table 3. Bound test for model 1

Critical value 90% Critical value 95% Critical Critical value 99%
value97.5%
K I(0) I(1) I(0) I(1) I(0) I(1) I(0) I(1)
8 1.95 3.06 2.22 3.39 2.48 3.70 2.79 4.10
F- statistics for model 1 = 8.099

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Table 4. Bound test for model 2

Critical value 90% Critical value 95% Critical Critical value 99%
value97.5%
K I(0) I(1) I(0) I(1) I(0) I(1) I(0) I(1)
8 1.95 3.06 2.22 3.39 2.48 3.70 2.79 4.10
F- statistics for model 2 = 7.508

4.3. Results of long- and shortrun relationship

4.3.1. Long- and shortrun estimation of model 1 (credit to private sector as %of GDP) as
dependent variable
ARDL estimation of long and short run regression result is reported in Table 5. In both long- and short-
run external debt has statistically significant negative effect on financial development, measured as
credit to private sector as a percentage of GDP. When debt and debt-servicing of a country increase,
private investment falls as investors are discouraged because of the expectation that future corporate
taxes would increase to pay off the outstanding debt. Also, when government resorts to domestic
borrowing, interest rate rises and investment falls. Estimation result of ARDL model revealed that
national bank’s reserve requirement has negative significant effect on financial development at 5 and
10% significance level in long and short run, respectively. Giorgio (1999) found similar results, and it is
in line with the proposition by McKinnon-Shaw, which believes that an increase in reserve requirement
retards the performance of financial sector. The empirical study conducted by Ang (2008) is similar
with this result. When reserve requirement increases the amount of excess reserve (Vault cash)
declines, which in turn may reduce the availability of credit to the private sector.

Over the study period, interest rate has an adverse significant effect on financial development
of Ethiopia. This is because the prime rate of interest that financial institutions charged widens
interest rate spread of banks, which implies low saving interest rate discourages potential savers
and in turn the availability of resources in the financial institution, and the amount of credit to the
private sector. The use of prime rate by the financial institution as a monetary policy signal
reduces the response of lending rates to changes in market rates, which reduces the flexibility of
banks performing their financial activities. The coefficient of inflation has positive significant

Table 5. Long run ARDL estimation result for model 1

ARDL(1, 0, 1,1,2,1,0,2,2) Dependent variable: CPS%GDP

Independent coefficient Standard error T-ratio P- value

variable
CPSGDP(−1) 0.738 0.121 6.11 0.000 ***
Gdebt −0.075 0.018 −4.07 0.001***
RR(−1) −0.014 0.0053 −2.14 0.048**
RER(−1) 0.102 0.345 0.29 0.772
R(−2) −0.687 0.237 −2.9 0.010**
INF(−1) 0.145 0.052 2.8 0.013**
Freedom −1.39 0.658 −2.12 0.050**
GTOP(−2) 0.328 0.044 2.31 0.035**
GDP growth (−2) 0.193 0.066 2.94 0.010**
Constant −8.38 5.576 −1.50 0.152

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effect. It has positive effect in the short run and is statistically significant at 5% significance level
for both long run and short run. When the general price level increases to increase profit through
an increase in price investors or firms may be highly willing to invest, which increases demand for
investment. Thus, other things constant the values of credit to private sector increase. Moreover,
according to classical school of macroeconomics inflationary environment may improve financial
development by increasing the money supply money and increasing financial resources for
investment projects.

The regression indicates the Freedom Index to be significant at 5% significance level in both
long run and short run regression coefficients. The negative sing of the coefficient comes from the
Freedom Index specification. Since 1 is highest evaluation of freedom and democracy and 7 for
the lowest scale, negative sign is in line with our suggestion that more freedom and democracy
enhances financial development. The result is in line with predicted sign. However, the study is
contrary to the research work conducted by Yang (2011) who pointed out that the level of
democracy affects financial development depth if and only if cross sectional data is employed.
The other variable examined is trade openness and the result shows there is a positive relation­
ship between financial development and trade openness in both short and long run estimation
result at 5% level of precision. This means that increases in trade openness has the potential of
stimulating financial development in Ethiopia at the aggregate level over the study period. This
positive relationship is supported by the study of Rajan and Zingales (2003) which claim that
greater openness is linked with adjustment is the structure of the sector which will in turn boost
demand for external finance. Finally, in both short and long run trade openness and economic
growth have positive significant effect on financial development. As income increases the
demand for goods increases and to fulfill the increased demand higher investment and produc­
tion is required; higher investment can be financed by borrowing, which in turn increases credit to
private sector (financial development).

After estimating long run co-integrating model, estimating the short run dynamic relationship
between variables with in ARDL model is the next step. To do so, a linear combination denoted by
error-correction term, ECMt-1 is retained in the ARDL model. On below Table 6 estimation of the
model selected based on AIC selection criteria is reported. From the above table the coefficient of
the error correction model (ECM) of the selected ARDL (1, 0, 1, 1, 2, 1, 0, 2 and 2) is negative and
highly significant at 5% level. The ECM stands for the rate of adjustment to restore equilibrium in
the dynamic model following a disturbance. The coefficient of the ECM is around −0.263 and this
signifies that a deviation from the long-run equilibrium subsequent to a short-run shock is
corrected by about 26.3% at the end of each year.

4.3.2. Long- and short-run estimation of Model 2 (Money supply as percentage of GDP) as
dependent variable
Long-run ARDL estimation result for model 2 (money supply as a percentage of GDP) is reported
in Table 7. In both long- and short-run external debt has insignificant effect. In both long- and short-
run reserve requirement has statistically negative significant effect on financial development. this is
because when central bank (national bank of Ethiopia) increases reserve requirement, the amount of
money (deposit) at commercial banks (micro finances) decreases, which in turn results decrease in
the amount of loans to investors. In addition to reserve requirement in the long run, real exchange
rate has negative significant effect on financial development, but in the short run it has insignificant
effect. Moreover, in the long run, inflation has positive significant impact. This confirms quantity
theory of money, which states money supply and inflation have positive relationship. While in the
short run it has insignificant effect. Political freedom index freedom has also positive significant effect
on financial development of Ethiopia in both long and short run. It is concerned about whether the
institutional development of one’s country depends on democracy and rules of law i.e. the involve­
ment of the population in the decision making process). In estimating the level of freedom, freedom
house survey control for cultural difference and provides generalized estimation built on worldwide
standards of political and civil rights such as universal declaration of human rights. The coefficient of

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Table 6. Short run (ECM_1) ARDL estimation result for model 1

ARDL(1,0, 1,1,2,1,0,2,2) Dependent variable: ΔCPS%GDP

Independent coefficient Standard error T-ratio P- value

variable
Δdebt −0.075 0.018 −4.07 0.001***
ΔRR(−1) −0.387 0.089 −4.35 0.007***
ΔRER(−1) 0.091 0.331 0.28 0.786
ΔR(−1) −0.879 0.248 −3.54 0.003***
ΔINF(−1) .096 0.0501 1.93 0.072*
ΔFreedom −1.395 0.658 −2.12 0.050**
ΔTOP(−2) 0.087 0.043 2.00 0.060*
ΔGDP Growth (−1) 0.193 0.066 2.94 0.010***
Constant −8.38 5.576 −1.50 0.152
ECM(−1) −0.263 0.121 −2.17 0.045**

freedom index on Table 7 is negative, which means as the values of freedom index increases political
and civic liberties are violated i.e. the country is not free, which in turn deters financial development.
Coefficient of trade openness is statistically significant at 5% significance level in both long and short
run. This means that increases in trade openness has the potential of stimulating financial develop­
ment in Ethiopia at the aggregate level over the study period. Finally, economic growth has positive
significant effect on financial development for long and short run period confirming the quality for
standard of living are deemed imperative in determining financial development. The result is similar
to the findings of Jaffee and Levonian (2001).

Like long run effect in the short run also reserve requirement and real exchange rate have
negative significant effect on financial development performance of Ethiopia. On the other hand,
inflation, political freedom index, and trade openness have positive significant effect. From Table 8
below the coefficient of the error correction model (ECM) of the selected ARDL (1, 1, 0, 1, 1, 4, 1, 0,
and 2) is negative and highly significant at 5% level. The ECM stands for the rate of adjustment to
restore equilibrium in the dynamic model following a disturbance. The coefficient of the ECM is
around −0.254 and this signifies that a deviation from the long-run equilibrium subsequent to
a short-run shock is corrected by about 25.4% at the end of each year.

5. Conclusion and recommendation

To make the growth of the economy sustainable and maximize social welfare improving the perfor­
mance of financial sector is essential. However, in Ethiopia financial development is very low and
unevenly distributed. So identifying determinant factors of financial development has paramount
importance. Therefore, the main objective of this study was to examine determinant factors of
Ethiopia’s financial sector development. To achieve this objective annual time series data from the
period 1980 to 2019 was used. Auto-regressive distributed lag estimation technique is applied in this
study. Error correction estimation results of credit to private sector as % GDP model shows the
adjustment coefficient is negative (−0.263) and statistically significant at 5% level of significance,
which means short run deviation from long run equilibrium is adjusted at a rate of 26.3%. The
adjustment coefficient for liquid liability as % GDP is −0.254.

Both in the long and short run the two financial development indicators (credit to private sector
as % GDP and broad money supply M2 as % GDP) are positively affected by political freedom index,
trade openness, and economic growth. While the long and short run estimation result of ARDL
model revealed that reserve requirement and lending interest rate have negative significant effect

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Table 7. Long run estimation result of ARDL for model 2

ARDL(1, 1, 0,1,1,4,1,0,2) Dependent variable: m2gdp

Independent coefficient Standard error T-ratio P- value

variable
m2gdp(−1) 0.746 0.073 10.23 0.000***
debt(−1) −0.023 0.015 −1.49 0.149
RR −0.174 0.0772 −2.25 0.033**
RER(−1) −0.68 0.293 −2.32 0.028**
R(−1) −0.692 0.239 −2.90 0.008***
INF(−4) 0.132 0.039 3.35 0.002***
Freedom(−1) −1.47 0.677 −2.17 0.039**
TOP 1.158 0.354 3.27 0.003***
GDP growth (−2) 0.153 0.064 2.38 0.025**
Constant 9.069 6.603 1.37 0.181

on both financial development indicators. On the other hand, in the long run real exchange rate
has negative effect on financial development measured by money supply as a percentage of GDP,
but it has insignificant effect in the short run. Contrary to these both in the long run, real exchange
rate has insignificant effect on credit to private sector. In addition to this, in both long and short
run external debt has negative significant effect on credit to private sector, but in both long and
short run it has insignificant effect on broad money supply M2 as % GDP. Inflation rate has positive
significant effect on credit to private sector as % GDP, but it has positive significant effect in the
long run and insignificant effect in short run on broad money supply M2 as % GDP. Based on the
results revealed the author of this article recommends the following policy directions:

● The government and national bank of Ethiopia can adjust both saving and lending interest
rate policies. Increasing interest rate on saving will increase deposit in the financial institution,
which will make financial institutions to have enough deposit to lend in the form of loan. To
equilibrate demand and supply of loanable fund the concerning authority would reduce
lending interest rate.

Table 8. Short run (ECM_1) estimation result of ARDL for model 2

ARDL(1, 1, 0,1,1,4,1,0,2) Dependent variable: Δm2gdp

Independent coefficient Standard error T-ratio P- value

variable
Δdebt(−1) 0.023 0.0153 1.49 0.149
ΔRR −0.174 0.0772 −2.25 0.033**
ΔRER(−1) −0.468 0.329 −1.42 0.167
ΔIR(−1) −0.692 0.239 −2.90 0.008***
ΔINF(−3) 0.027 0.0396 0.68 0.505
ΔFI(−1) 1.47 0.677 2.17 0.039**
ΔTOP 1.158 0.354 3.27 0.003***
ΔGDP Growth (−1) 0.153 0.0644 −2.38 0.025**
Constant 9.069 6.603 1.37 0.181
ECM(−1) −0.254 0.335 −1.80 0.083*

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● To allow high and sustainable development of the financial sector performance in Ethiopia
efforts should be made to allow more trade openness through reducing trade barriers and
simplify procedures and controls. But for least developing countries like Ethiopia highly depen­
dent on foreign trade may have detrimental for the growth of the economy, because accord­
ing to the law of the Prebisch–Singer terms of trade declines. Thus, trade openness measured
as the sum of export and import divided by GDP can be boosted by providing sufficient loan to
export industries that diversifies and facilitates the shift towards the export of semi-finished
and manufactured goods and in turn financial development.
● There is internal conflicts and violation of democratic and human rights are violated. The
government should respect political rights and civil liberties; an increase in reserve require­
ment reduces deposits of financial institutions available for loan, which in turn negatively
affects financial development. Hence, reducing reserve requirement will boost financial devel­
opment in the country. National bank of Ethiopia may.
● Finally, real exchange rate has negative effect on financial development. Thus one way of
reducing real exchange rate to increase financial development is not to devalue domestic
currency. The government and other concerning bodies in the country should implement
policies which brings economic growth. These are improving the quality of both physical and
human capital, reducing the bureaucracy for getting license for investment, stabilizing price.

Funding groups and government capabilities. Journal of

The author received no direct funding for this research. Banking & Finance, 36(3), 626–643
Benyah, F. (2010). Determinants of financial develop­
Author details ment: A focus on African countries. Thesis submitted
Teshager Mazengia Asratie1 in partial fulfilment of a master’s degree: Jonkoping
E-mail: teshagerm2016@gmail.com University. http://hj.diva-portal.org/smash/get/
1
Department of Economics, Debre Berhan University, diva2:337616/FULLTEXT01
Debre Berhan, Ethiopia. Bist, J. P., & Read, R. (2018a). Financial development and
economic growth: Evidence from a panel of 16
Citation information African and non-African low-income countries.
Cite this article as: Determinants of financial development Cogent Economics & Finance, 6(1), 1449780. https://
in Ethiopia: ARDL approach, Teshager Mazengia Asratie, doi.org/10.1080/23322039.2018.1449780
Cogent Economics & Finance (2021), 9: 1963063. Bist, J. P., & Read, R. (2018b). Financial development and
economic growth: Evidence from a panel of 16
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