ABSTRACT
The existing controversy in literature surrounding
depreciation of exchange rate is whether it is contractionary or expansionary
to economic growth and also the fact that nonperforming loan is believed in
literature to contract growth necessitated this study as Africa is in tabulate
time. As currencies in Africa continue to depreciate against major currencies
and nonperforming loan is also on a high side. Therefore, this study was mainly
to examine empirically what effect does the interaction term (nonperforming
loan and exchange rate) has on economic growth. Using 15 countries in Africa
with data spanning from 2002-2014 with the aid system GMM estimator, the
following findings were drawn.
The results show that exchange rate, nonperforming loan and
the interaction term, all have contractionary impact on economic growth in
Africa. Also, the study reveals that exchange rate, inflation, economic growth,
and unemployment are significant factors that determine nonperforming loans in
Africa. The study proposes that in Africa exchange rate depreciation passes
through nonperforming loan to retard economic growth. Therefore, Africa
authorities (fiscal and monetary) should anchor policy around exchange rate
with precision, this will stabilize the economy and banking assets quality
shocks. In addition, in the implementation of Basel II or III requirements of
credit assessment process, this study suggests that banks should take into account
the level of economic activity (real GDP) when granting loans.
CHAPTER
ONE
INTRODUCTION
1.1 Background
of the Study
One of the significant
constituents in financial intermediation in every country is the banking sector
which makes essential contribution to the global economy. Thus, the failure of
financial intermediations or ineffectiveness in a country creates fundamental
problems that have strong economic implications on the whole economy.
Therefore, Rodriguez-Moreno and Pena (2013) advanced that interest groups
should pay close attention to the financial system and seek to ensure it
soundness and stability as it is critical to the survival of every economy. In
emerging countries, the increasing expansion of financial intermediation such
as banks was usually regarded as a sign of catching-up with the advance
countries just about a decade before the 2008 financial crisis and it eventual
global meltdown. An effective and efficient financial system works to ensure
and secure economic efficiency. The financial intermediaries in financial
system have a core responsibility to serve as transferring loanable funds as
well as economic resources into investment areas which are profitable. But, it
is always observed that, this perfect functioning of financial intermediaries
can’t always be guaranteed during fund transfers (İslamoğlu, 2015). Today,
there is a global dilemma that societies are concern of; the world is getting
itself into unsustainable credit growth or with financial deepening which led
to and will continue to lead to crisis.
Isarescu (2007) believes,
without other stabilizers, as income policy and fiscal policy stance as
pro-cyclical and the attitude of central bank was highlighted as the potential
vulnerability by supplementing the limited space to exercising monetary policy
with the adoption of a range of prudential measures. Georgescu (2010) argues
that these measures put in place over time have lost it relevance
(effectiveness) particularly financial integration given a strong demand for
loans. As Modigliani-Miller theory (1958) suggest efficiency of financial
markets, and no availability of information asymmetry; business cycle
development is neutral to credit market development where recent literatures
have shown evidence based clues to support the bi-directional nature of the
association between gross domestic product growth and credit.
The global
financial crisis, it has been observed that external funding sources can induce
macroeconomic variables instability. As a result, Ouhibi and Hammami, (2015)
have stated, the potential risk of financial system vulnerability in economy is
assessed on the basis of the levels of nonperforming loans(NPLs) and
off-balance sheet trade activities (derivatives) which create credit risk and
foreign exchange risk respectively in the banking sector. The banking activity
is constantly determined by several factors that root different kinds of risks.
Therefore, banks main concern is the risk management. There are two main
sources of risks-facing financial institutions: systematic (undiversifiable or
market) and non-systematic (diversifiable or specific) risk. The
undiversifiable risk factors are risks associated with activities that are
beyond the banks’ control for example exchange rate instability which continue
to be a major challenge in the banking sector as a result of international
business financing. The non-systematic are the risks of bank specific related
activities. Banks today are troubled with growing
non-performing loans (NPLs) which are attributed to bank specific and market
factors, such as macro-economic imbalances as in depreciation of currency,
growing inflation and risk management quality among others. Notwithstanding,
theories in economic suggest that commercial banks play the role of lending and
fund mobilizations as its core mandate. To support this argument, Joseph et al,
(2012) stated emphatically that the traditional role of commercial banks is
credit lending (loans).
If the financial sector is
properly functioning and efficient, it essentially leads to achieving and
sustaining economic growth in the short run and eventually lead to economic
development in the long run. Hence, high qualities of loan asset serve as the
healthy financial sector in the economy and high level of NPLs indicate
unhealthy financial sector within a country (high default rate with
multi-dimensional) in both advanced and emerging nations and retire economic
growth. According to Negera (2012), in theory there are several reasons why
loans fail to perform. Among them are inflation, credit orientation, risk
appetite, poor monitoring and among several of them. Therefore, NPLs are caused
by macro-economic conditions and bank specific conditions (Bercoff et al.,
2002). Nevertheless, two main major risks on a bank balance sheet today remain
the credit risk (NPLs) and exchange rate risk, without doubt that these risks
have excessive power on the path of economic growth.
1.2 Problem
Statement
Nonperforming Loans (NPLs) and
deteriorating exchange rate are two key variables that have gained growing
attention in recent economic policy debate since the global financial crisis.
The global economic crisis as it were, continue to contribute to deteriorating
banks’ assets significantly and affect
credit quality indicators (NPLs) due to adverse changes in macro-economic
variables in the world (Prasanna, 2014). Therefore, several studies have
focused on the impact of NPLs on economic growth, and exchange rate on economic
growth (e.g Ahlem and Bashir, 2013; Klein, 2013; Sheefeni, 2015; Osei-Assibey
and Asenso, 2015). However, an interesting observation reveals that existing
studies concentrate on direct impact without observing the transmission
mechanism (the mediating and moderating role) from exchange rate through to
NPLs to affect economic growth, because the banking sector is the anchor of
every economy. Therefore, following the nature of Africa economies, adverse
changes of exchange rate and NPLs risk do not operate in isolation in the
banking sector but happen concurrently or have some interdependence. Hence,
because Africa economies are import driven and couple with the fact the private
sector are the most beneficiary of credit facilities of the banking sector, any
adverse changes of exchange rate affect the responsiveness of the private
sector to honour their loan obligation leading to nonperforming loans. This is
because as the currency continuous to deteriorates, as the case have been in
Africa, its cost the private sector more local currency to import, since it
would be converted into international currency in order to trade in the global
market. Now, once import becomes expensive it feeds into pricing of the good
and service, and all things being equal demand for goods and services thereby
affecting revenue generation negatively. So, as enough revenue cannot be raised
to finance economic activities of the private sector and also honour their loan
obligation to the banks creates the problem of nonperforming loans. Again,
dollarization of loans in the banking sector is contributing to the growing
nonperforming loans since adverse changes of exchange rate affects the loan
repayment. In the case of Africa because the deteriorating of exchange increase
amount payable and since the private sector is challenged in revenue generation
because of high price, this may lead to increase in default of loan repayment
hence nonperforming loans.
Therefore, the potential role
of exchange rate increasing nonperforming loan through to adverse economic
growth cannot be underestimated. Hence, given the detrimental effect of adverse
changes of exchange rate beyond its equilibrium level may lead to increasing
NPL ratio of banks, makes it indispensable to examine how the transmission
mechanism affects economic growth in Africa. Because Africa economies are
import driven, whatever happens to the exchange rate, have direct and indirect
effects on growth through the banking sector. Again, the digression from the
direct estimation of impact of exchange rate on growth will be particularly
useful for understanding taken the choice regarding methodologies which have
been employed in the applied study.
1.3 Objectives
of the Study
1.3.1 General Objective
As Africa economies attempt to
continue to recover from shocks of global crisis, it is therefore prudent to
determine the potential impact of increasing levels NPL, and exchange rate
instability on economic growth over time as strong evidence of slowing the grow
of Africa economy. The general objective is to examine how nonperforming loans,
and exchange rate plays out in the growth agenda of Africa.
On
account of the general objective for the study, the following specific
objectives are posed;
1.
To examine the extent to which
nonperforming loans, and exchange rate impact on economic growth.
2.
To
examine the impact
of the interaction
effect of NPLs
and exchange rate
on
economic
growth .
3. To examine the impact of exchange rate on
Nonperforming Loan
1.4 Research
Hypotheses
In this study, the researcher
developed testable hypothesis to investigate the relationships between the
chosen variables. Hence, based on the related literature review, the researcher
developed hypotheses to estimate the sign relationship, since the hypotheses
are statements that are to be tested (Brooks, 2008). The following below are
the null hypotheses to be tested.
H1.
|
There
is negative relationship between NPLs and economic growth in Africa.
|
H2.
|
There
is positive relationship between exchange rate and economic growth in Africa.
|
H3.
|
There
is a negative relationship between the interaction term (nonperforming loans
|
and
exchange rate) and economic growth in Africa.
|
|
H4.
|
There
is direct relationship between nonperforming loans and exchange rate in Africa
|
1.5 Significance
of the Study
The economic recession in
several developed nations and spread over effect to emerging and developing
nations as a result of recent global financial crisis have caused continue increasing of firms and
household defaults in banks loans causing significant loses hence NPLs. This
has awaken financial sector regulators to consistently observing banks loan
quality, possibilities of prompt detection and warning system capable of notifying
them to warrant a sound financial system and prevent systemic crises. Managing
risk prudently with emphasis to credit risk and exchange rate risk is very
important since banks are too important to fail. Each one of these risk can
cause a potential havoc to banking sector of an economy.
This study will bring to
policymakers and regulatory authorities the need for special attention to
proper management of credit and exchange rate and improving loan assets quality
to avoid calamities befalling on the banking sector which can spread over to
the entire economy. To bring to bear how NPLs and exchange rate deteriorating
might potentially contribute negatively to projected economic growth that
nation is anticipating.
This study thus would help
Central Banks and the commercial banks understand on the significance of
improving loan asset qualities to their businesses and economy, to the extent
that it will help central banks to examine its banking supervision policy
pertaining to ensuring asset quality and exchange rate stability. In addition
to the above, the study contributes to literature concerning NPLs and exchange
rate by controlling for economic shocks and immunization of economic growth as
growth cannot go on indefinitely with cost which has not also been seen in
contemporary
1.6 Limitation
and Scope of the Study
The study adjusts to fit core
objectives in examining the interest variables in Africa within the limited
time space. The research focused on fifteen (15) Africa countries because of
non- availability of data for the
time period considered for this study, thus from 2001-2015 to analyze the
effect of NPL and exchange rate on economic growth and the impact due to the
peculiar situation in the in Africa. Again, this study considers only two key
macroeconomic variables and how they influence the banks performance as in loan
quality. And of course the study covers and limited to Africa continent.
1.7 Study
Organization
This research works is
organized into five (5) chapters. Chapter one presents the background of the
study, problem statement, objectives of the study, research hypothesis,
significance of the study and the limitation and scope of the study. The next
chapter considered related literature review for both theoretical and
empirical. The third chapter works on the methodology of the research. The
chapter with analysis of data and presentation of findings, while the final
chapter contains the conclusion out of the findings, recommendation of the
study and give future directions for further studies.
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