Research: The Nexus between Financial Inclusion, Economic Growth and Income — Evidence from Nigeria

There is a considerable amount of data and research on the demand-side dynamics of digital financial services (DFS) in Africa.

This piqued our interest and spurred us to head in the other direction, exploring the supply-side dynamics of DFS in Nigeria. Our last few articles have been covering the research we did in this area.

One particular area of interest is the overall macro-economic perspective of financial inclusion. Yes, we know it benefits consumers and financial institutions, but how about the economy in general? How do we translate these micro-level impacts to the macro-economic space? How does financial inclusion benefit Nigeria as a whole?

To answer these questions, Doyin Salami, Ikechukwu Kilekume, Victor Alex and Olalekan David, our resident researchers at the SIDFS initiative, conducted a study to investigate the relationship between financial inclusion, economic growth and income. They set out to test the supply-side hypothesis that, improvements in financial inclusion have positive effects on real sector variables (economic growth and income). In other words, access to and use of formal financial services should stimulate increased capital accumulation, which in turn leads to higher economic activity and thus growth.

The primary objective was to determine the extent of the impact, if any, that changes to financial inclusion exerts on economic growth and income.

DEFINITIONS AND VARIABLES

A. Economic Growth: measures the relative change in a country’s output over time. The Gross domestic product (GDP) is the most widely used metric of national economic output.

B. Income: Refers to the national disposable income (NDI). It is the aggregation of domestic factor income, external income, business taxes and other transfers from the rest of the world that are similar to output growth.

C. Formal Financial Inclusion (FFI): refers to the number of adult Nigerians categorised as either banked or having access to formal financial services.

D. Informal Formal Financial Inclusion (INFI): A measure of the proportion of adults using informal financial services like “Ajo”, “Esusu”, piggy bank, and so on.

The aim of our study was to determine the kind of relationship between our four variables: Formal Financial Inclusion (FFI), Informal Financial Inclusion (INFI), Economic growth (GDP) and Income (NDI).

We collated national data on the four variables between the periods 2008–2016, spliced and analysed them to determine the direction and level of causality.

Supply-side hypothesis: relationship between financial inclusion, economic growth and income

The framework above illustrates the supposed relationship between our variables. It follows that through heightened financial literacy, improvements in financial inclusion lead to economic growth and higher income. The underlying framework suggests improvements in the provision and use of financial services enables the mobilisation of loanable funds, improves access to credit and may lower the cost of credit. In turn, these developments increase investment and capital accumulation efficiency. Likewise, higher investment increases employment, income, savings and transactions. These, in turn, increase the use of financial services.

FINDINGS

From our research, we were able to conclude the following:,

1. The direction of relationships between formal financial inclusion, economic growth and real income is unidirectional i.e. increased formal financial inclusion leads to real economic growth and then increase in real income.
2. On the other hand, informal financial inclusion has a unidirectional causal relationship with formal financial inclusion i.e. INFI leads to FFI; while the direction of causality between informal financial inclusion and economic growth is bidirectional i.e. changes in informal financial inclusion cause changes in GDP, and changes in GDP also leads to changes in informal financial inclusion.
3. We also discovered that, changes in formal financial inclusion cause changes in economic growth and income but not the other way around. That is, the more we are able to onboard excluded people into the formal financial services ecosystem, the more the needle shifts positively on the economic growth and income scale. Nevertheless, increases in economic growth and income have little, if any, effect on the rate of inclusion into the formal financial sector.
4. There is causality between formal financial inclusion and economic growth. The theoretical assumptions of this study lie in explaining the supply- and demand-side arguments that being financially included spurs growth in economic activities and income. The result of our empirical analyses confirms this theory. The result also suggests that informal financial inclusion plays a vital role in the expansion of formal financial inclusion since informal sector activities contribute significantly to gross output.
5. Improvements in real economic activities come from increased financial inclusion. There is sufficient evidence to say that, irrespective of the use of formal or informal providers of financial services, greater access to and use of these services enables even more economic participation thereby raising economic growth and ‘real’ income.
6. However, the absence of a causal relationship between ‘real’ income and formal financial inclusion remains puzzling and requires further investigation. This gap stems from the hypothesis that as formal financial inclusion elevates real economic activities, ‘real’ income should rise. This phenomenon ought to be the case with the generation of higher income from economic activities; it should serve to improve access to and use of formal financial services and products.
7. Finally, rising real economic activities leads to increased informal financial inclusion but not formal financial inclusion. This also requires further investigation.

WHY DOES THIS MATTER?

The existence of a positive, substantial and lasting relationship between the access to and use of financial services and economic growth would present a strong case for concentrating on increasing financial inclusion as a critical pillar of policy development aimed at restoring vitality to Nigeria’s economy and sustaining it.

Also, establishing the direction of causality helps us identify the dependent and independent variables in the relationships under consideration. With the causal question settled, emphasis will shift to determine the response time with which the dependent variables (economic growth and income) will respond to changes in the other explanatory variable (financial inclusion). Furthermore, our study also indicates that any policy intervention will take at least two quarters (6 months) before effecting the policy targets.

This helps stakeholders nurse realistic expectations.

POLICY RECOMMENDATIONS
The policy proposals emanating from a better understanding of the relationship between financial inclusion, economic growth and income require:
i. Building inclusive financial systems that facilitate financial access and use.
ii. Expanding the portfolio of financial services available in the mainstream beyond banking and payments.
iii. Incorporating informal financial institutions into the financial services ecosystem.
iv. Correcting dwindling real income by normalising and stabilising price levels to facilitate automatic adjustment.

CONCLUSION

The outcome of our study proved the supply-side hypothesis true — that financial inclusion has spillover effects on economic activities and income.

Our findings were presented at a closed roundtable in Abuja to a room full of policy makers, influencers and international experts in the financial services industry. We expect that this paper will form an evidence base for the necessary reforms in the sector that will create the change we need.

Download and read the paper here.