Effect of Financial Depth on Economic Growth in Kenya

Abstract

A well-developed financial sector is critical for economic growth in Kenya. This is achieved through increased savings, which expand investments, enhance capital accumulation, and enable the efficient allocation of resources. Although there have been advancements in Kenya’s financial sector, the relationship between financial depth and economic growth continues to be unclear in empirical studies. Therefore, a better understanding of the effect of financial depth on economic growth is required to guide formulation of impactful policies that will elevate financial depth and stimulate economic growth. This will hasten the attainment of Kenya Vision 2030 and raise the GDP to the 10% level as envisioned. Thus, this study determined the effect of financial depth on economic growth in Kenya, specifically establishing the effects of private sector credit, broad money supply, stock market capitalization on economic growth. This research was anchored on financial intermediation theory by Gurley and Shaw (1955), which links financial development to economic expansion through efficient capital allocation. Additionally, it was supported by the exogenous economic growth theory by Solow-Swan (1956), endogenous economic growth theory by Paul Romer (1986), and Keynesian theory by John Maynard Keynes (1936). This study was guided by a positivist philosophical underpinning. A correlational research design was adopted. The research focused on all indicators of financial depth and economic growth for Kenya from 1980 to 2024, as compiled by the World Bank. Specifically, the researcher collected annual time series data for Kenya on private sector credit, broad money supply, stock market capitalization, and GDP per capita growth, resulting to a sample covering the years 1980 to 2024. An SVAR model was employed to analyze data using descriptive statistics, trend, correlational, causality, IRFs, and FEVD analyses. The research findings established that the effects of PSC, BMS, and SMC on Economic growth in Kenya were significant in the short run. However, the effects were insignificant in the long run. This showed that the targeted financial depth variables did not strongly explain changes in GDP. These results are crucial in guiding the development of effective policies that elevate both financial depth and economic growth. To ensure PSC, BMS, and SMC strongly boost economic growth, it will be essential for Kenya to create credit guarantee programs for encouraging long-term loans in productive sectors, improve tools for managing liquidity, such as reverse repos and standing for better market rates control, proper coordination of fiscal and monetary activities to match credit support with public investment projects, simplification of the requirements for SMEs to list on the market by reducing fees for early-stage, and improve corporate governance to increase market activities and investors trust.