EXCHANGE RATE, NON-PERFORMING LOANS AND ECONOMIC GROWTH IN AFRICA

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 (─░slamo─člu, 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.


1.3.2    Specific Objectives

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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Item Type: Ghanaian Project Material  |  Attribute: 94 pages  |  Chapters: 1-5
Format: MS Word  |  Price: GH50  |  Delivery: Within 30Mins.
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