FINANCIAL DEVELOPMENT – ECONOMIC GROWTH NEXUS IN THE EAST AFRICAN COMMUNITY: DOES LONG-RUN COINTEGRATION WITH STRUCTURAL BREAKS EXIST?

Abstract

The East African Community (EAC) countries including Burundi, Kenya, Rwanda and Uganda, have implemented financial sector reforms leading to financial development. This is expected to cause structural breaks in its long run equilibrium with economic growth. A new equilibrium may be established but is not guaranteed.  This paper investigated this issue using standard model and structural break specifications; and the Engle- Granger two step and the Gregory-Hansen-Quandt-Andrews-Muwanga cointegration procedures. The study established that: at least one structural break existed based on the SUP F test, and at least one other instability test for all the four countries; detection of cointegration with structural breaks is test statistic/model specification sensitive, thus the need to use more than one test statistic, with test being superior to all others; failure to capture regime shifts may lead to false rejection of cointegration; the statistic obtained from structural equations with breaks identified  using the Quandt-Andrew procedure can be used to test for cointegration with structural break(s) using the standard ADF tables (desirable) or the Gregory-Hansen critical values (with caution); and  that cointegration between economic growth and financial development exists but with structural breaks corresponding to key political developments in the four countries studied.