Private Capital Inflow, Financial Development and Economic Growth in Kenya

Abstract

Private capital inflows have become an increasingly significant source of investment in developing countries, especially in Sub-Saharan Africa indicating the high degree to which the countries have become integrated into the global economy. This study sought to investigate the impact of private capital inflow and financial development on economic growth in Kenya, using a panel data analysis between 1970 to 2014. Specifically the study sought to investigate the causality between foreign direct investment, portfolio investment and cross-border interbank borrowing on economic growth; to analyze the effects of foreign direct investment, portfolio investment and cross-border interbank borrowing on economic growth; to examine the effects of financial development on economic growth and to examine the effects of macroeconomic variables on economic growth. The study was based on the Auerback-Kotlikoff (AK) dynamic life-cycle simulation model. The analysis was undertaken by employing Johansen cointegration test, vector error correction modeling approach and Granger Causality technique to investigate the causality between foreign direct investment, portfolio investment and cross-border interbank borrowing and economic growth. The ordinary least squares estimation was used to determine the effect of foreign direct investment, portfolio investment, cross-border interbank borrowing and financial development on economic growth. The study found that there was a unidirectional causality from foreign direct investment to economic growth and from economic growth to cross-border interbank borrowing. The standardized regression coefficient (β) value of the computed scores of foreign direct investment was (0.077276) with a t-test of 1.530526 and was statistically significant at 5 percent level with a (p-value=.0134).Though the coefficient of the log of portfolio investment as a ratio of gross domestic product was positive (β=0.015372, p-value=0.6405), but statistically insignificant. On the other hand the coefficient of log of cross-border interbank borrowing as a ratio of gross domestic product was positive (β=0.059199, p-value=0.4456) but statistically insignificant. The coefficient of gross domestic capital formation as a ratio of GDP which was the proxy for financial development was negative and statistically significant (β=-0.382785, p-value=0.0031).The coefficient of government expenditure on goods and services as a ratio of GDP was positive and statistically significant (β=0.086873, p-value=0.0042). The coefficient of secondary and tertiary institutions enrolment as a ratio of the total population which was used as a proxy for human capital was negative and statistically significant (β=-0.513306, p-value=0.0039).The coefficient of inflation which was used as a proxy for macroeconomic stability was negative and statistically significant (β=-.077303, p-value=0.0419).The coefficient of sum of total exports and total imports as a ratio of GDP which was used as a proxy for openness was positive and statistically significant (β=.151853, p-value=0.0042).This study found evidence that capital inflows foster higher economic growth, above and beyond any effects on the investment rate, but only for economies where financial sector has reached a certain level of development. The results thus suggest that the domestic financial sector plays a pivotal role in ensuring that international capital flows does indeed promote economic growth in Kenya. Future research should also conduct longitudinal studies that would provide definite information about cause-and-effect relationships as well as the changes in study variables over time. The findings of this study will form a basis for the formulation of policies relating to private capital inflows through the adoption of sound monetary and fiscal policies as well as market- oriented reforms that will include trade and capital market liberalization. It will also contribute to the existing body of knowledge in the field of private capital inflows and economic growth in developing countries.

Keywords: Private Capital Flow, Auerback-Kotlikoff (AK) model, Cross-Border Interbank Borrowing and Economic Growth