Financial Development and Growth December 2017

1. 1
Does Financial Development
Cause Economic Growth in
Egypt?
Mahmoud Mohieldin, Khaled Hussein and Ahmed
Rostom
DECEMBER 25 | 2017
The findings, interpretations, and conclusions expressed in this presentation are entirely those of the authors. They do not represent the views of the World Bank Group and its
affiliated organizations nor those of the Executive Directors of the World Bank or the governments they represent. It does not also represent the views of The United Nations
Economic Commission for Africa and should only be attributed to Authors in their personal research capacities.

2. 2
Agenda
Introduction
Financial
Development and
Economic
Growth in Egypt
Review of
Literature
Data and
Model
Description
Results,
Discussion
& Conclusion
Trends of
Financial
Development

3. 3
Introduction
The origin of the "financial development" concept goes back to the early work of J.
Gurley and E. Shaw (1955, 1956, 1960, 1967). They investigate evolution of the
financial structure during economic growth, and argue that financial development is a
positive function of real wealth.
A powerful and influential school of thought, pioneered by R. McKinnon (1973) and E.
Shaw (1973), introduces financial development as a process and strategy to achieve
faster economic growth.
Both McKinnon (1973) and Shaw (1973) claim that liberalisation from restrictions such
as interest rate ceilings, high reserve requirements, and selective credit programmes,
facilitates economic development. This is because when the interest rate is below
equilibrium, higher rates of interest will increase savings and lead to a greater efficiency
of capital allocation.
During economic development,
as their incomes per capita
increases, countries usually
experience more rapid growth in
financial assets than in national
wealth or national product.
Financial growth in excess of real
growth is apparently a common
phenomenon around the
world...... over time, for any one
country as its income per capita
increases, financial assets rise
relative to national real wealth.
(1967, pp. 257-258).

4. 4
Introduction
 The McKinnon/Shaw hypothesis was influenced to a large extent by the poor development record of many developing countries in the 1960s which were characterised
by intensive government intervention. The financial liberalisation perspective exerted an increasing influence on international organisations such as the IMF and the
World Bank. Consequently, the implementation of financial liberalisation policies have become popular reforms in many developing countries during the last twenty five
years. The results of these reforms have been mixed.
 Egypt may be considered as an ideal case study to examine the relationship between finance and economic growth. The Egyptian economy came under the influence of
socialism between 1959 and 1972 but has been moving towards capitalism since 1973. These changes have directly affected the structure and the policies of the
financial sector in Egypt over the last four decades.
 The Egyptian financial sector over the period 1960- 90 was heavily repressed in the sense that the government intervened and distorted its market mechanisms. The
government set ceilings on deposit and lending nominal interest rates, imposed a relatively high ratio of required reserves, determined the allocation of credit to
particular projects and intervened in the portfolio composition of banks. In January 1991, Egypt started, in accordance with the IMF and the World Bank, an economic
reform programme with financial liberalisation policy.
 The aim of the paper is to examine the empirical relationships between financial development and economic growth in Egypt over the time period 1980-2015. The rest of
the paper is organised as follows: Section 2 presents an overview to the analytical literature on ‘finance and growth’. Section 3 provides an overview of the Egyptian
financial sector over the last three decades. Section 4 discusses the model specifications. Section 5 explains the measurement of the variables and data sources.
Section 6 presents the empirical results and Section 7 concludes.

5. 5
Literature Review
Hussein
(2002)
Roija and
Valev(2004)
Rufael (2009)
Walle and
Herwartz, 2014
Chowdhury
2016
Chavula et al
2017

6. 6
Financial Development & Economic Growth in Egypt
The Egyptian economy has witnessed several
distinct periods of economic management
 The period of British occupation before early 1950s
 a period of socialism (the wave of nationalization)
from 1959 to 1972/73
 A period known as the Open Door Inftah from 1973
to 1980/81
 The economic reform period from 1981 to present
(Bolbol et al, 2005).
Under British occupation, the Egyptian banking sector was
dominated by foreign banks.
This changed during the waves of nationalization which began in
1959/60 that ensured full ownership of the banks by government
The number of banks reduced to five (5) commercial banks, and
three (3) specialized banks and the Central Bank of Egypt (CBE).
This followed the implementation of the first five-year economic plan
aimed at achieving economic development. Massive investments in
long-maturing projects took place.
Commercial banks had to bring credit policies in line with the
national plan.

7. 7
Financial Development & Economic Growth in Egypt
 The “open-door” policy was introduced in 1973/74 which
led to establishment of private and joint venture banks,
foreign bank branches, and offshore institutions.
 Several changes were introduced to encourage private
banks to operate on equal footing with state banks.
 Moreover, tax concessions and unrestricted repatriation
of profits were granted for foreign investors.
 Stock market laws tried to increase the number of joint
stock and limited liability companies.
 Interest rates payable on deposits were market based and
followed the trend in international financial markets.
 In contrast, interest rates on domestic currency deposits
were still regulated by the central bank.
As a result, the investments in the financial sector increased during
the period, with the number of operating banks increased to 39
commercial banks and 31 investment banks.
As a result, the investments in the financial sector increased during
the period, with the number of operating banks increased to 39
commercial banks and 31 investment banks.
Over the same period, lending to the private sector rose gradually
from an annual average of 19 per cent to 28 per cent.
However, the relatively large network of branches of public sector
banks enabled them to dominate the banking sector, making it
highly segmented and lacking in both competition and innovation,
hence less improvement in financial services. (Bolbol, et al., 2005).

8. 8
Financial Development & Economic Growth in Egypt
 The economic reform program adopted in 1990/1991 included major banking reforms as well. The financial sector
changes included elimination of the repressive measures, leading to liberalization of the bank lending and deposit
rates; removal of ceilings on bank-lending to the private sector.
 This resulted in rise in lending to the private sector from an annual average of 28 per cent of GDP during the period
between 1975 and 1990 to 42 per cent of GDP between 1991 and 2002.
 Transparency also improved as banks were required to publish their financial reports in line with international
accounting standards. The government also undertook privatization program in the banking industry with the aim of
enhancing competition and reducing market concentration.
 The government also undertook privatization program in the banking industry with the aim of enhancing competition
and reducing market concentration.
 Capital market development is considered an important component of financial development, and can also play a key
role in the process of economic growth. The Egyptian Stock Market is among the oldest in the world.

9. 9
Financial Development & Economic Growth in Egypt
 The Egyptian stock market is made up of the stock markets of Cairo and Alexandria which until the 1997 were
separate stock markets: the Cairo stock exchange founded in the 1903 and the Alexandria stock exchange founded in
1883.
 Egypt’s capital markets were revitalized following the 1991 national economic reform program. This resulted in a surge
in market activities, which further pushed for more modern market policies, regulations and institutional support.
 The reforms were followed by the establishment of the Egypt Capital Markets Development Project (CMD) in the late
1990s which aim at: improving efficiency, transparency and stability; strengthening institutional capabilities of both
public and private capital market institutions; strengthening regulatory environment; and developing secondary trading
in new financial instruments.
 CMD led to many developments in the capital market, including: automation of trading, clearing and settlement; better
dissemination of market information through internet and electronic data; greater self-regulation and better disclosure;
modernization of market institutions, systems and procedures; and market diversity and flexibility.
 Trading at the Egyptian Exchange has increased several folds with six stock indices, and an average 9 billion securities
traded and a total trade value of about USD 2 billion on monthly basis.

10. 10
Financial Development & Economic Growth in Egypt
 In February 2014, a new set of listing rules were introduced, aiming at
facilitating the procedures of new offering for companies as well as
improving market transparency and minority protection rights.
 The new rules addressed, among other things, the capital increases
resulting from mergers, the necessary disclosure regarding the use of
proceeds of the capital increase, the board of directors' independence as
well as the related party transactions.
 Overall, The financial development has continued to improve in Egypt, as
reflected by various indicators shown in figures 1 - 4. It is however no
doubt that the political and economic circumstances that Egypt faced
during the recent years have affected the overall economy and the
performance of the financial sector.
 A healthy and stable financial system, underpinned by sound
macroeconomic management and prudential regulations, is essential for
sustained growth.

11. 11
Trend Of Financial Development
Financial institutions (FI) and Financial markets (FM) play an important role in financial development in an
economy depending on the level of political freedom, the rule of law and property rights protection in the country
(Aghion and Howiit, 2009) (Adu, Marbuah and Mensah, 2013).
International Monetary Fund (IMF) recently developed several indices that can be used to measure financial
development in an economy (please see Annex I for details).
 Similarly, financial market indices (FMEI - Financial Markets Efficiency Index; FMDI - Financial Markets Depth
Index and FMAI - Financial Markets Access Index) also measure the level and progress of development in the
financial markets along the same parameters.

12. 12
Key Indices In
Egypt Financial Institution Indices
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
FINANCIALDEVELOPMENTINDICES
TIME (YEARS)
FD FIA FID FIE FII
Source: Based on IMF (2017)
FD - Financial Development Index; FII - Financial Institutions Index; FIE - Financial Institutions
Efficiency Index; FID - Financial Institutions Depth Index; FIA - Financial Institutions Access
Index
Figure 1

13. 13
Key Indices In
Egypt Financial Market Indices
Source: Based on IMF (2017)
FD - Financial Development Index; FMI - Financial Markets Index; FMEI - Financial Markets
Efficiency Index; FMDI - Financial Markets Depth Index; FMAI - Financial Markets Access Index.
Figure 2
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
FinancialDevelopmentIndices
Time (Year)
FD FMAI FMDI FMEI FMI

14. 14
Indicators Of Financial Development In
Egypt & Other Selected Comparable
CountriesTable 1.1: Financial Depth, efficiency and competitiveness indicators (2015/2016)
Country
Private Bank
Credit/ GDP
M2 / GDP Credit / Deposit Liquid Liability / GDP Lending Rate Less Deposit Rate
Egypt 34.15 0.98 40.59 72.87 5.74
Malaysia 65.32 0.90 111.00 42.21 1.52
Morocco 123.94 1.33 130.37 42.84 -
South
Africa
66.94 0.60 73.86 108.64 3.11
Thailand 114.88 - 96.57 132.51 3.17
Turkey 66.19 0.54 98.68 109.29 -
Source: Based on IMF, IFS & WDI (2017)

15. 15
1. Private Bank Credit – GDP Ratio
0
20
40
60
80
100
120
140
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
PrivateBankCredit-GDPratio
Time (Years)
Egypt
Morocco
Malaysia
South Africa
Turkey
Thailand
Source: Based on IMF, IFS & WDI (2017)
Private Bank Credit – GDP Ratio (2000 – 2016)
Figure 3

16. 16
2. M2 / GDP Ratio
Similarly, the trend of FD as measured by M2-GDP ratio is different across the 6 countries over the last two decades. Malaysia has the highest and generally
increasing ratio throughout the period with few fluctuations, while Turkey has the lowest, but also increasing over the period. Egypt’s FD begins to decline in 2007
with the lowest score of 0.70 in 2012 before beginning to pick up in 2015
-
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
M2-GDPRatio
Time (Years)
Egypt
Morocco
Malaysia
South Africa
Turkey
Thailand
Source: Based on IMF, IFS & WDI (2017)
Figure 4
M2-GDP Ratio (1965 – 2016)

17. 17
3. Loans/ Deposits
Ratio
Figure 5
 The Loans to deposits ratio is a measure of
liquidity of the financial institutions as well as the
ability of the banking sector to utilize available
resources.
 The ratio is the highest in South Africa for most of
the periods and remains relatively constant, while
it is very low and declining in Egypt.
 It has risen consistently in Turkey over the period
from 37.12 in 2002 to about 130.37 in 2015.
Source: Based on Financial Structure Database (2017)
0.00 20.00 40.00 60.00 80.00 100.00 120.00 140.00 160.00
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Credit-Deposits Ratio
Time(Year)
Thailand
Malaysia
Morocco
Turkey
South Africa
Egypts
Credit/Deposit Ratio (2000 – 2015)

18. 18
4. Liquid Liabilities/ GDP
Ratio
Figure 6
Liquid Liabilities/GDP Ratio (2000 – 2015)
0.00
20.00
40.00
60.00
80.00
100.00
120.00
140.00
160.00
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Liability-GDPRatio
Time (Year)
Egypts
South Africa
Turkey
Morocco
Malaysia
Thailand
Source: Based on Financial Structure Database (2017)

19. 19
5. Competitiveness in the Egyptian Banking sector
Figure 7
Source: Based IFS (2017)
Figure 5 shows the trend Egyptian banking sector competitiveness as measured by the difference between lending rate and deposit rate over the period 1976 -
2015. The spread has fluctuated around 5 per cent for the last 4 decades, peaking at 8.33 per cent in 1992 and the lowest rate of 3.65 per cent in 1998. This implies
that despite the reforms and the liberalization of the banking sector in Egypt over the years, the sector’s competiveness has remained relatively unchanged.
Interest Rates (Lending and Deposit – 1976 - 2016)
0.00
5.00
10.00
15.00
20.00
25.00
InterestRates(%)
Time (Years)
Deposit Int. Rate Lendinf Int. Rate Lending Int. Rate - Deposit Int. Rate

20. 20
6. Economic Growth in Egypt
Figure 8
The Egyptian economic growth fluctuated over the years, but fell drastically from about 7 per cent in 2008 to around 1.8 per cent in 2011, before beginning to
recover thereafter. The fall in growth could be attributed to the global financial crisis, among other factors. The recovery is expected to continue as recent investment
and industrial licensing laws are likely to boost investment. However, security concerns and political situation could slowdown growth. According to focus economics
analysts, the economy is expected to expand by 4.3 per cent in 2018, and 4.7 in 2019. On the other hand, GDP per capita has risen consistently over the last three
decades from about USD 1,192 in 1980 to about USD 2,724 in 2016, with an average of USD 1906 (see figure 8).
GDP per capita 1981-2015
0
500
1000
1500
2000
2500
3000
GDPpercapita(USD)
Time (Years)

21. 21
Econometric Methodology and Modeling Strategy
Auto Regressive Distributed Lag Model (ARDL):
yt = β0 + β1yt-1 + .......+ βpyt-p + α0xt + α1xt-1 + α2xt-2 + ......... + αqxt-q + εt
yt= Dependent Variable
yt-p= Lagged Values of yt
xt-q = Successive lags of X Explanatory Variables
εt = Random Disturbance Term

22. 22
Hypothesis
We estimate the following unrestricted ECM for the financial savings function:
∆𝐿𝑅𝐺𝐷𝑃𝑃𝐶𝑡
= ∅𝑜 + ∅1,𝑖 𝐿𝑅𝐺𝐷𝑃𝑃𝐶𝑡−𝑖 + ∅2,𝑗 𝐹𝐷𝐼𝑛𝑑𝑒𝑥𝑡−𝑗 +
𝑡=1
𝑘
𝜃 𝑘∆𝐿𝑅𝐺𝐷𝑃𝑃𝐶𝑡−𝑘 +
𝑡=1
𝑛
𝜃 𝑛∆𝐹𝐷𝐼𝑛𝑑𝑒𝑥𝑡−𝑛 + 𝜀𝑡
𝐿𝐺𝐷𝑃𝑃𝐶 : log of real GDP per capita
FD Index: Financial Development Index relating to m2togdp, Financial Markets Index (FMI) and Financial
Markets Access Index (FMAI) (both indices defined in Annex I).

23. 23
LRGDPPC and m2GDP Variable Plot

24. 24
M2 to GDP Equations
Error Correction Equation for m2 to GDP:
ECM = LRGDPPC - 9.09552 - 0.172701*m2gdp - 0.0236099*Trend;
WALD test: Chi^2(5) = 1484.49 [0.0000] **
ARDL for m2 to GDP:
DLRGDPPC = + 3.21 - 0.353*LRGDPPC_3 + 0.0746*m2gdp_2 + 0.00847*Trend
(SE) (0.559) (0.062) (0.0232) (0.00147)

25. 25
Stability of ARDL for LRGDPPC and m2gdp
LRGDPPC_3 ´ +/-2SE
1995 2000 2005 2010 2015
-1.0
-0.5
0.0
0.5
LRGDPPC_3 ´ +/-2SE m2gdp_2 ´ +/-2SE
1995 2000 2005 2010 2015
-0.2
0.0
0.2
0.4
m2gdp_2 ´ +/-2SE
1up CHOWs 1%
1995 2000 2005 2010 2015
0.5
1.0
1up CHOWs 1% Ndn CHOWs 1%
1995 2000 2005 2010 2015
0.5
1.0
Ndn CHOWs 1%
Nup CHOWs 1%
1995 2000 2005 2010 2015
0.5
1.0
Nup CHOWs 1%

26. 26
LRGDPPC and FMI Variable Plot

27. 27
FMI Equations
Error Correction Equation for FMI:
ECM = DLRGDPPC - 0.821779 + 0.0867412*LRGDPPC - 0.136949*FMI +
0.03141*dumm1986
+ 0.0300578*dumm1987 + 0.0342097*dumm1991;
WALD test: Chi^2(5) = 84.5788 [0.0000] **
ARDL for FMI:
ECM = DLRGDPPC = + 0.822 - 0.0867*LRGDPPC_2 + 0.137*FMI_1 - 0.0314*dumm1986
(SE) (0.111) (0.0121) (0.0211) (0.00938)
- 0.0301*dumm1987 - 0.0342*dumm1991
(0.00933) (0.00934)

28. 28
Stability of ARDL for LRGDPPC and FMI

29. 29
LRGDPPC and FMAI Variable Plot

30. 30
FMI Equations
Error Correction Equation for FMAI:
ECM = DLRGDPPC - 0.720434 + 0.0780651*LRGDPPC - 0.157068*FMAI;
WALD test: Chi^2(2) = 7.07392 [0.0291] *
ARDL for FMAI:
DLRGDPPC = + 0.72 + 0.249*LRGDPPC_1 - 0.327*LRGDPPC_2 +
0.157*FMAI_2
(SE) (0.28) (0.151) (0.137) (0.0591)

31. 31
Stability of ARDL for LRGDPPC and FMAI

32. 32
Conclusion
 In this paper, we investigated the association between financial development and economic growth in Egypt. We analyzed the trends in
and developments in financial sector development in Egypt during 1980 – 2016. The paper deployed the new data set on financial
sector development indices introduced by Svirydzenka (2016). The empirical modeling of bivariate regressions for real growth per capita
with the broadly used measure for financial development in the literature – M2 to GDP – provided strong support for the association
between real income growth and financial development at large.
 We further investigate the existence of time series dynamics between real income growth and indices relating to financial institutions and
banking. These regressions didn’t provide statistically significant results in terms of presence of time series dynamics and error
correction. This can be attributed to the low credit growth to private sector and the strong dominance and foot print for government in the
banking sector.
 However, the financial markets index of Svirydzenka (2016) provided strong association with real growth. This index is an aggregate
index of three sub-indices: financial markets (i) depth, (ii) efficiency and (iii) access. Further bivariate modeling for real growth with the
three sub-indices confirms that financial markets access index which compiles data on percent of market capitalization outside of top 10
largest companies and total number of issuers of debt (domestic and external, nonfinancial and financial corporations) per 100,000
adults – is associated with real income growth. Capital markets developments since 1980 provides statistically significant results for an
association to economic growth. These results provide a strong motivation for further efforts in this area. We will deploy bound testing
and further robust causality tests to check robustness of our results. We will also assess the capital markets structure and composition
of firms that were able to raise debt and equity through the market which might merit further investigation at the micro - firm level.

33. 33