16 International Journal of Economics and Management Sciences Vol. 1, No. 12, 2012, pp. 16-28 MANAGEMENT JOURNALS managementjournals.org EFFECT OF FINANCIAL LIBERALIZATION ON ECONOMIC GROWTH IN DEVELOPING COUNTRIES: The Nigerian Experience SULAIMAN, L.A. 1* , Oke, M.O 2 and Azeez, B.A 3 *1 Corresponding Author: Banking and Finance Department, Faculty of Management Sciences,Ekiti State University, Ado Ekiti, Nigeria. E-mail: sulaimanluq01@gmail.com 2 Banking and Finance Department, Faculty of Management Sciences, Ekiti State University, Ado Ekiti, Nigeria. E-mail: Okemike2001@yahoo.com 3 Banking and Finance Department, Faculty of Management Sciences, Ekiti State University, Ado Ekiti, Nigeria. E-mail: aminahotulana@yahoo.com ABSTRACT Mckinnon-Shaw hypothesis asserts that financial liberalization is essential for economic growth. In view of this, the study critically investigates the effect of financial liberalization on the economic growth in developing nations with its assessment focusing on Nigeria. In an attempt to determine this effect, the study employs a model which proxy Gross Domestic Product as the dependent variable and the following macroeconomic variables; lending rate, exchange rate, inflation rate, financial deepening (M 2 /GDP) and degree of openness as its financial liberalization indices. Annual time series data on these variables were largely obtained from the Central Bank of Nigeria Statistical bulletin from 1987 to 2009. The empirical investigation is done using the Johansen Co-integration test and the Error Correction Mechanism (ECM). The results obtained from the Co- integration test reveals the existence of a long-run equilibrium relationship among the variables and co- integrating equations at 5% significance level. Also, the Error Correction Mechanism shows a very high coefficient of multiple determination (R 2 ) in both the Over-parameterized Model (95%) and the Parsimonious Model (91%). The study therefore concludes that financial liberalization has a growth-stimulating effect on Nigeria. It recommends that economic stability should either be maintained or pursued before implementing any form of financial liberalization measures and the regulatory and supervisory framework for the financial sector should be strengthened. Keywords: Financial Liberalization, Economic Growth, Developing Countries, Augmented Dickey-Fuller (ADF) Unit Root Test, Co-integration test, Error Correction Mechanism (ECM). 1. INTRODUCTION Prior to financial liberalization, the government of developing countries practiced financial repression thereby subjecting the administrative framework of the financial system to its whims and caprices, such that financial policies formulated and implemented suit its desires. Their developmental strategies were designed such that the government or its agencies were vested with the responsibility to make decisions regarding the allocation of resources thereby giving the market forces a less important role to play in economic development. Due to the widely spread benefits attainable from financial liberalization; many developing countries in order to achieve economic buoyancy have experienced the gradual but apparent liberalization of its financial sector. The state-dominated development paradigm has shifted towards a more market-determined strategy of development in the recent years due to the relatively low growth rate of incomes, industrial output and recurring balance of payment crises in the state-dominated paradigm and also influenced by the astonishing success of Japan and East Asian countries in accelerating growth through the market-determined strategy of development (Nair, 2004).