Sectoral allocations of domestic credit and their effects on economic growth in Ethiopia

The optimal allocation of financial resources by well-established financial systems is crucial for fostering economic growth. Nevertheless, due to imperfections in real-world settings, financial systems inadvertently distribute credit to unproductive sectors, resulting in inefficiencies in economic performance. Thus, this study aims to investigate the sectoral allocations of credit and how, in turn, such credit allocations affect the performance of each economic sector, from 1991 to 2022. To this effect, it employed the Cross-Section Augmented Error Correction (CS-ECM) model, and this model has a PMG estimation technique; hence, heterogeneous (short-run) and homogeneous (long-run) coefficients are computed as a result. The descriptive results show that domestic credits that are allocated to agriculture, industry, services, and the private and public sectors are not only small but also misallocated to inefficient sectors. Similarly, the econometrics results indicate that credits given to the public and industry sectors have a negative effect on output growth in the short term, while credits distributed to the agricultural, service, and private sectors have a small but positive effect on growth. Besides, the long-term results show that the overall credit allocation to the economy has negative effects on growth, indicating credit misallocation has unfavorable long-term effects compared to short-term effects. Financial policies and strategies should therefore be designed to welcome foreign banks as well as capacitate the existing domestic financial institutions so that substantial financial resources can be mobilized, both from the external and internal economies, and distributed in such a way as to 'give more credit to an efficient sector'.