Regional Financial Integration and Economic Activity in Africa Akpan Ekpo and Chuku Chuku 4 Integrate Africa n° 291 September 2017 Working Paper Series African Development Bank Group Working Paper No 291 Abstract Unlike in Asia and Europe, it is not clear what the regionalization. Second, using carefully specified pattern and impact of financial integration have been parametric and nonparametric regression analyses, in Africa. This paper addresses three main issues: we find that higher levels of financial integration is the progress and experience towards financial associated with higher levels of growth and integration in Africa, the degree and timing of the investment, but not necessarily total factor integration process in selected African stock productivity. The relationships become even clearer markets, and the effect of financial integration on when we zoom in on the nonparametric iso-growth economic activity. First, using time-varying surface plots, which show that there is a threshold parameters from a state-space model, we assess the level of financial development that is consistent with degree and timing of financial integration in Africa growth in a financially segmented economy. Finally, and find results that indicate contemporary patterns some policy implications are gleaned from the toward increasing financial globalisation relative to results and the experiences in Asia and Europe. This paper is the product of the Vice-Presidency for Economic Governance and Knowledge Management. It is part of a larger effort by the African Development Bank to promote knowledge and learning, share ideas, provide open access to its research, and make a contribution to development policy. The papers featured in the Working Paper Series (WPS) are those considered to have a bearing on the mission of AfDB, its strategic objectives of Inclusive and Green Growth, and its High-5 priority areas—to Power Africa, Feed Africa, Industrialize Africa, Integrate Africa and Improve Living Conditions of Africans. The authors may be contacted at [email protected]. Rights and Permissions All rights reserved. The text and data in this publication may be reproduced as long as the source is cited. Reproduction for commercial purposes is forbidden. The WPS disseminates the findings of work in progress, preliminary research results, and development experience and lessons, to encourage the exchange of ideas and innovative thinking among researchers, development practitioners, policy makers, and donors. 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Regional Financial Integration and Economic Activity in Africa 1 Akpan Ekpo and Chuku Chuku JEL Codes: F36, E44, C23, C14 Keywords: Financial integration, State-space model, Nonparametric regression, Economic activity, Africa 1 Professor Akpan Ekpo is a member of the Presidential Economic Management Team in Nigeria and the Director General of the West African Institute for Financial and Economic Management (WAIFEM). Email: [email protected] or [email protected]; Chuku Chuku is with the Department of Economics, University of Uyo, Nigeria; and a member of the Macroeconomic Modelling Team at the African Development Bank, Cote d’Ivoire. Email: [email protected] or [email protected]. The authors are grateful for the funding for this project provided by the African Economic Research Consortium (AERC) with Grant No. RC 13537. They also benefited from review comments by Lemma Senbet, Isaac Otchere, Robert Lensink, Kalu Ojah, Peter Quartly, and participants at the Plenary Session of the June 2016 AERC Biannual Workshop and various collaborative workshops. They would also like to thank Manuel Arellano and participants at the 2015 Econometric Society Conference in Zambia for useful comments on earlier versions. The paper is forthcoming in the Journal of African Economies. 1 1 Introduction Financial development and integration became the prominent reform tools for most devel- oping countries in the early 1980s when it became obvious that the lack of well-developed financial systems was inhibiting progress in these countries. To fix ideas early, regional financial integration refers to a market or institutionally driven process of broadening and deepening the financial interrelationships within a region; whereas, financial development refers to the process by which financial institutions and markets increase in size and influence on the rest of the economy (Senbet, 1998; Wakeman-Linn & Wagh, 2008). This process of financial regionalization involves several activities, the fundamental ones being: the elimination of cross-country investment barriers; equitable treatment of foreign and domestic investors; harmonization of national policies, laws, and institutions; synchronization of operational structures like technology and information systems; and very importantly, the convergence of prices, returns, and risk assessments. Our aim in this study is threefold: first, to trace the progress and experience towards financial integration in Africa, benchmarking the progress made so far on ex ante targets; second, to determine the degree and timing of financial integration in selected sub-Saharan African stock markets, using an unobserved latent variable; and finally, to understand the effect of regional financial integration on economic activity in Africa, using both linear parametric and nonlinear (nonparametric) estimation techniques. But why should markets, especially those in Africa, be regionally integrated? Many authorities in the field have endeavoured to answer this question by showing descriptively, and sometimes theoretically, how this could be a strategic approach for Africa's accelerated development and structural transformation.1 Overall, it is expected that financial regionalization would enable the participating regional economies to take advantage of the \systemic scale economies" that accrue to larger financial systems. These scale effects emanate from several angles, including the expansion of the spectrum of opportunities for financial intermediation; the creation of larger markets, which makes it more cost effective to improve financial infrastructure; the efficiency effects that arise from the increase in the number of financial sector participants, which promotes diversification and healthy competition, and thus, eventually results in lower prices for services; and lastly, the increased capacity to withstand financial crisis (see Wakeman-Linn & Wagh, 2008; Senbet & Otchere, 2006; Ag´enor, 2003). Moreover, financial integration generally improves macroeconomic and financial discipline. Although there is historical evidence that greater financial integration could also have adverse effects on the economy|for example, through the higher risk of cross-border financial contagion, which was recently observed in the global financial crisis of 2007/08 and the 1Some examples include Senbet(1998); Ekpo(1994); Ali and Imai(2015); Senbet(2009); Ogunkola(2002); Chuku(2012); Senbet and Otchere(2006); Obadan(2006); Wakeman-Linn and Wagh(2008) and Ekpo and Afangide(2010) 2 Asian financial crisis of the late 1990s|there is a more stable relationship between financial integration and economic growth (see Edison, Levine, Ricci, & Sløk, 2002). Other potential costs of financial integration include uneven distribution of the flow of funds, which is often skewed in favour of countries with larger markets; inadequate domestic allocation of the flow of funds, which could hamper growth effects and exacerbate domestic distortions; loss of macroeconomic stability; and the risks associated with the penetration of foreign financial institutions (see Ag´enor, 2003; Park & Lee, 2011). The problem, however, is that despite the highlighted benefits of financial integration to participating economies|a fact that has been established for other regions using stylized information and empirical analysis (see, for examples, Ag´enor(2003); Fung, Tam, and Yu(2008); Edison et al.(2002); Baele, Ferrando, H¨ordahl,Krylova, and Monnet(2004), and Adjaout´eand Danthine(2004))|it is not obvious that this is also the case for Africa, especially because of the peculiar idiosyncrasies of the existing regional financial architecture, and the fact that there are hardly any studies that examine this relationship beyond a correlation and descriptive statistics based framework. Hence, it is important to rigorously investigate whether or not the extent of regional financial integration achieved so far has helped to improve the level of aggregate economic activity in Africa. Insights from such an investigation will provide an objective assessment of the growth impact of financial regional- ization, and serve as a basis for rationalising any proposals for reforms and intensification of the financial integration process in Africa. This study contributes to the literature in at least three different ways. First, from a methodological point of view, this is the first study we are aware of that uses nonpara- metric