Dynamic Openness and Financial Development Nexus in Ethiopia Evidence from Autoregressive Distributed Lag Approach

Abstract

This research focused on exploring the dynamic openness and financial development nexus in Ethiopia. To achieve this, it used annual data from 1981 to 2021 and applied Autoregressive Distributed Lag approach. The regression results indicate that financial openness significantly enhanced financial activity (financial sector credit to private enterprises) both in the long and short run in Ethiopia, while its effect on financial depth was only beneficial in the long run. In contrast, trade openness affect financial activity and financial size (the sum of deposit banks and central banks assets to GDP) negatively and significantly in the short run, although it does significantly enhance financial depth in the short run but hamper in the long run. Among the control variables, economic growth enhanced financial depth significantly both in the long and short run, while domestic investment consistently promote all the three proxies of financial development in the short term. However, inflation emerged as a significant constraint to all three financial development indicators in the short run, also hindering financial depth and financial activity in the long run. Furthermore, foreign aid had a significant positive impact on financial depth both in the long and short run, contrasting with its notable negative impact on financial sector credit to private enterprises and the size of financial system. The post-estimation diagnostic and stability tests confirm the reliability and parameter stability of the Autoregressive Distributed Lag models. Consequently, this study underscores the importance of developing and implementing effective policies aimed at attracting substantial foreign investment, curbing inflation, enhancing the capacity of private investors, and diversifying exports to foster financial development in Ethiopia.