Financial Liberalization and Financial Deepening in Kenya

Abstract

Financial liberalization has been part of financial reform packages in many countries as stabilization for financial deepening tools of respective economies. One of these countries is Kenya which has been undergoing various financial sector reforms since 1980 to improve economy mainly on the ease of financial sector, equity market and capital account. This research was conducted to establish the effect of financial liberalization on financial deepening in Kenya in relation to various financial liberalization effects and measures adopted from 1990 to 2020. The study specifically investigated the impact of interest rate liberalization on financial deepening development in Kenya, determine the influence of capital account liberalization on financial deepening in Kenya, determine impact of equity market liberalization on financial deepening in Kenya, determine impact of privatization of financial institutions on financial deepening in Kenya and ascertain the moderating effect of market risk on the relationship between financial deepening and financial sector liberalization. The principal component analysis method was used in the calculation of the index required data for all the years since the liberalization process started in Kenya to calculate the financial liberalization index required for the study period. The was data from world bank and Central Bank of Kenya that covers e measures of independent variables (Interest rate liberalization, Privatization of financial institutions, Capital account liberalization and equity market liberalization), the moderating variable (market risk) and dependent variable (financial deepening) from 1990 to 2020. The Secondary data was sourced from Central Bank of Kenya reports and statistical bulletins. The model estimation followed the Auto-regressive Distributive Lag (ARDL) approach with the effect estimated in line with the Granger Causality analysis for hypothesis. The regression results indicate that interest rate liberalization does not significantly influence financial deepening in Kenya; however, capital account liberalization demonstrates a substantial positive impact, with a coefficient indicating that increased liberalization is associated with enhanced financial deepening, as foreign direct investment helps correct disequilibrium in broad money. Similarly, equity market liberalization also shows a significant positive effect on financial development in Kenya, highlighting its importance in facilitating financial deepening. Furthermore, the results suggest that the privatization of financial institutions plays a crucial role, as an increase in privatization corresponds to improvements in financial deepening. Additionally, findings from the hierarchical Bayes Error Correction Model reveal that market risk moderates the relationships between interest rate liberalization, capital account liberalization, and privatization, indicating that increased market risk may reduce the positive impacts of these liberalization efforts on financial deepening. Consequently, the study concludes that capital account liberalization, equity market liberalization, and privatization of financial institutions are key determinants of financial deepening in Kenya, and it is recommended that policymakers implement measures to manage market risks effectively while fostering these liberalization processes to enhance the overall financial landscape.