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Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense
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Policy Rate, Lending Rate and Investment in Africa - A Phd proposal for defense

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  • 1. POLICY RATE, LENDING RATE AND INVESTMENT IN AFRICA A PHD PROPOSAL Submitted to DEPARTMENT OF FINANCE UNIVERSITY OF GHANA BUSINESS SCHOOL LEGON, ACCRA AGYEI, SAMUEL KWAKU Email: twoices2003@yahoo.co.uk (Tel: 027 765 51 61) 1
  • 2. 1.0 INTRODUCTIONMonetary policy is the process by which the monetary authority of a country controls the supplyof money, often targeting a rate of interest to attain a set of objectives oriented towards thegrowth and stability of the economy. It could be considered as a set of goals dealing withmacroeconomics. The main objectives include controlling interest rates, inflation and currencyvalues. It is also to ensure economic stability, foster economic growth and ensure lowunemployment.Monetary policy is largely considered as an important tool for controlling an economy. Mishkin(1996) cautions though, that in order to be successful in such an enterprise, the monetaryauthorities must have an accurate assessment of the timing and effect of their policies on theeconomy, thus requiring an understanding of the mechanisms though which monetary policyaffects the economy. The main channels of monetary policy transmission are the traditionalinterest rate channel, exchange rate channel, equity price channels, credit channels (which coversbank lending channel and balance sheet channels) and expectation channel. Even thoughresearchers do not generally agree on the best channel of monetary transmission, the interest ratechannel appears to be the most important. The role of interest rate pass-through is crucial since itrepresents a potentially important transmission channel and because other channels of themonetary transmission mechanism are related to its performance. The monetary authority setspolicy rate; these affect short-term money market rates, which in turn influence medium to long-term market rates, bank retail rates, etc. (Isakova,2008; and Samba and Yan, 2010). Animportant feature of the interest rate transmission mechanism is its emphasis on the real ratherthan the nominal interest rate as that which affects consumer and business decisions. In addition,it is often the real long-term interest rate and not the short-term interest rate that is viewed as 2
  • 3. having the major impact on spending. How is it that changes in the short-term nominal interestrate induced by a central bank result in a corresponding change in the real interest rate on bothshort –term bonds? Mishkin (1996). Taylor (1995) argued that there is strong empirical evidencefor substantial interest rate effects on consumer and investment spending, making the interest-rate monetary transmission mechanism strong even though some researchers like Bernanke andGertler (1995) disagree. They are of the view that empirical studies have had a great difficulty inidentifying significant effects of interest rates through the cost of capital.Perhaps what has created this controversy on the effect of policy rate on an economy is the factthat the transmission mechanism is mostly incomplete, if even it has ever been complete. Severalreasons have been assigned for this market imperfection. But what is worrying is the fact that agreater percentage of these studies have been concentrated on developed economies. In the caseof Africa, to the best of the researcher’s knowledge, only one bold attempt has been made to lookinto this all-important subject (that is, Samba and Yan, 2010). Even with this study, only one ofthe four (4) major economic blocs was looked at. The main thrust of this study therefore is toascertain the mechanism by which policy rate translate to lending rate and lending rate alsotranslate to borrowing cost in Africa. Specifically, the study hopes to unveil the maindeterminants of policy rate, lending rate and deposit rate, explore the inter-relationships (if any)and assess whether lending rate has any effect on investment in Africa. 3
  • 4. 1.2 LITERATURE REVIEWThe performance of any economy is based –at least in the short-run on the fiscal and monetarypolicies implemented by the administrators of the economy. Fiscal policies are the decision ruleson government taxes and expenditure. The direction of government taxes and expenditurepatterns can stimulate or contract economic growth (measured as the gross domestic product).Tax cuts and increase in government expenditure have the potential to free more money toindividuals and corporate institutions to be used for productive activities; thus stimulatingexpansion. In the same vein, increase in government expenditures also fuel economic activityespecially in economies which depend largely on government spending. On the other hand, taxincreases and reduction in government spending will most likely slow down economic activity.Monetary policy is decision guidelines set and implemented by the central bank with the aim ofregulating the cost of credit and amount of money supply in an economy. Interest rate cuts areaimed at expanding the economy whiles interest rate increases are generally meant to slow downthe speed of economic activity.The relative importance of these economic management policies depends on whether one holds aKeynesian view of a Monetarist view. According to Keynesian school of thought fiscal policy ismore effective than monetary policy. Keynesians believe that the effect of monetary policy onthe real economy is only indirect hence slow. They believe that the effectiveness of monetarypolicy is limited to a large extent by the behavior of banks on one hand and firms and householdson the other. For instance, they argue that an expansionary monetary that increases bank reservesmay not necessary lead to an increase in money supply because banks may simply not be willingto lend. Also firms and households demand for investment and consumption goods may bedependent on other factors other than lower interest thereby making a reduction interest rates 4
  • 5. aimed at increasing investment and consumption an exercise in futility (CliffsNotes.com. FiscalPolicy. 17 Jun 2012). Weeks (2008) argues that even in developing countries, the effectivenessof monetary policy (under some assumptions as flexible exchange rate regime with perfectlyelastic capital flows) is undermined because fiscal policy proves to be a better option. Hetherefore concludes that fiscal policy is more effective whether the exchange rate is fixed orflexible, upholding the standard Keynesian view.Classical economist and monetarist hold the view the importance of fiscal policies fade whensecondary effects (ignored by Keynesians) of fiscal policies are considered. They explain that ifthe government embarks on an expansionary fiscal policy by increasing its spending throughborrowings from the domestic credit mark, given a constant money supply, it puts pressure oninterest rates to rise. Consequently, the increase in interest rates lead “crowd out” investment andconsumer spending that are sensitive to interest rates. In the same vein, a contractionary fiscalpolicy intended to curb inflation suffers a crowing –in effect, when secondary effects areconsidered. Government’s decision to reduce spending may reduce demand for money for thecredit market which inturn may reduce interest rate. The resultant effect would be an increase ininvestment and household spending (which are sensitive to interest rates) which has the potentialof fueling inflation or reducing the desired outcome from that fiscal policy (CliffsNotes.com.Monetary Policy. 17 Jun 2012). In addition monetarists argue that under a flexible exchangerate regime with perfectly elastic capital flows monetary policy is effective and fiscal policy isnot Weeks (2008).Generally, monetary policy is good at slowing down an overheated economy while fiscal policyis good at expanding an economy during a recession. Together they work to ensure propereconomic management. This study is not about which of the two economic policies can better 5
  • 6. help control or stimulate economic growth. The study seeks to find out how monetary policyaffects the performance of the African economy.1.2.1 Channels of Monetary Policy TransmissionUndoubtedly, much has been written on the effects of monetary policy on the performance of thereal economy. Attention has been given particularly to the transmission mechanism of monetarypolicy to the real economy. It is generally expected that the type of monetary policy adoptedshould have the desired effect on the real economy in order for managers of the economy to beable to manage the major economic indicators and ultimately the performance of the realeconomy. Although several versions of the transmission mechanism exist, five main channels arediscussed: (1) interest rate channel; (2) credit channel; (3) exchange rate channel; (4) wealthchannel; and (5) expectations channel (Amarasekara, 2004).Depending on what economic policy makers seek to achieve the interest channel can be used tocause an expansion or contraction of the economy. In periods where expansionary objectives aresought policy rates could be reduced to cause a reduction in the cost of borrowing in theeconomy. This will cause households and corporate entities to increase their spending therebyfueling a demand and subsequently, employment. In another way, a fall in interest rate causes thedepreciation of the local currency which stimulates exports relative to imports. Indeed if theeconomy is operating at full capacity then there is the likelihood of the increase in demandcausing prices of goods and labour cost to go up and thereby triggering inflation. Nevertheless,where contractionary economic objectives are sought, an increase in interest rate will causeinvestment, employment and output to reduce. The value of the currency will strengthen causing 6
  • 7. exports to be expensive relative to important which may eventually lead to balance of paymentproblems. Additionally this makes investors prefer bonds to equity causing equity prices to fall.Credit channel of monetary transmission is caused by the information asymmetry in the creditmarket. When lenders have all the needed information about borrowers, market forces ensurethat credit is allocated efficiently. In order words, lending would lend money to borrowers basedon the best hierarchy of borrowers who are creditworthy while is taken from the most willinglenders. Information asymmetry hampers the efficient means of taking this decision in the sensethat not all relevant information about lenders and borrowers are available. Credit channel ofmonetary transmission are grouped into bank lending channel and balance sheet channel.Exchange Rate Channel (Mishkin, 1996) When domestic interst rate falls deposits in domesticcurrency falls. This leads to a decline in domestic deposits since they become less attractive toinvestors as domestic currency in foreign currency rises increasing the value value of foreigncurrency. This fall in domestic currency causes domestic goods to be cheaper than forign goodsdecreasing exports and increasing imports. Increase in exports cuases morer production whichenhances growth in employment . Consequently the exchange rate channel is also influenced bythe traditional interest channel.Equity Price Channels: 1) Increasing money supply increases spending. Spending at theexchange pushes equity prices due to rise in demand. 2) Reduction in interest rates makes bondsless attractive to equity pushing equity prices up.Even though proponents of credit channels (some researchers) do not consider interest ratechannel as so important when compared to credit channels, they accept that credit channelsoperate from changes in the interest rate. Mishkin (1996) offers three reasons for the credit 7
  • 8. channel importance to monetary policy transmission mechanism. First, there is a large body ofcross-section evidence that supports the view that credit market imperfections of the type crucialto credit channels do indeed affect firms employment and spending decisions. Second, there sevidence, such as that found in Gertler and Gilchrist (1994), showing that small firms,which aremore likely to be credit constrained, are hurt more by tight monetary policy than are large firms,which are unlikely to be credit constrained. Third, and may be most compelling, the asymmetricinformation view of credit market imperfections at the core of the credit channel analysis is atheoretical construct that has proved to be highly useful in explaining many other importantphenomena.The credit channel has two main conduits for operation: the bank lending channel and thebalance sheet channel. Bank lending is enhanced when expansionary monetary policies arepursued. Monetary policies like reduction in bank reserve requirements has the tendency ofincreasing the amount of loanable funds and the size of deposits available for lending.Consequently, corporate spending and consumer spending is increased which in turn have effecton ouput. This channel is likely to work more perfectly depending on the level of dependency onbank loans for financing projects especially by corporate entities. Thus in an economy wherecorporate institutions have easy access to stock market funding, the effect of this channel on thereal economy may not be that strong. Given the relatively young nature of the most ExchangeMarkets in Africa and coupled with the fact that most non-financial corporations rely heavily onbank lending (Abor, 2005) to finance their activities, this channel promises to be an importantone to the African economy. This notwithstanding, there is evidence to suggest that bankregulations in oother developed nations that sought to restrict banks ability to raise funds hasgone down and that there seems to be a world wide decline in the traditional bank lending 8
  • 9. business (Edwards and Mishkin, 1995). All these put a slur on the importance of the banklending channel.Adverse selection and moral harzard problems of lending are worsened when borrowersnetworth are low. Expansionary monetary policy reduces the severity of this problem. Wheninterest rates are cut, equity becomes more attractive to investors. The increase in demand forequity, all other things being equal, causes share prices to rise thereby improving the networth ofcompanies and increasing investment. On the other hand, a fall in the net worth of firms, as aresult of a contractionary monetary policy would lead to a fall in investment. This condition isexplained by the balance sheet channel. The balance sheet channel can also be explained by thecredit rationing phenomenon (Stiglitz and Weiss, 1981) and the effect of monetary policy on thegeneral price level (Fisher, 1933).Ramlogan (2007) contend that the money and credit channels are particularly important tocountries where financial markets is at relatively early stage of development and thisidentification has serious ramifications.During the development of the financial market the link between the financial and real sectors ofthe economy is likely to change hence it is important to determine which of the financialaggregates monetary policy impacts upon. Furthermore, an understanding of the transmissionmechanism assists policy makers in deciding which disturbances warrant changes in monetarypolicy and which do not. Finally, knowledge of the transmission mechanism may help promotehigher investment and a faster pace of economic growth if it leads to a better choice of targetvariables. 9
  • 10. In addition, the importance of credit channel is emphasized by the fact that finding other formsof credit for households and small businesses is difficult especially in developing economies.Also, the effect of policy changes has a direct effect on bank credit - either on the quantity ofcredit offered and rate at which credit is given. For instance, an expansionary monetary policythat relaxes interest rates would cause the cost of credit to reduce and would likely have anincrease on the quantity of credit available (Pandit, et al 2006).Pandit, et al (2006) conclude that there is strong evidence in support of the existence of thecredit channel of monetary policy in India. In addition, banks’ capital adequacy ratios, openingup of the economy and the ownership structure are found to be more reactive to policy shocks.Also they found evidence in support of information asymmetry as the responses of larger banksand smaller banks differed. Specifically large banks are better able to insulate themselves againstcontractionary monetary policy as compared to smaller banks.The wealth channel explains that apart from the interest rate, exchange rate and credit channels,asset prices like stock and real estate are also potent in transmitting monetary policy. Anexpansionary monetary policy makes stocks more attractive than bonds, because returns onbonds would be minimal. It also makes real estate prices to increase as finance for housingbecomes less expensive. This is subsequently manifested to the real economy through theinvestment effects, wealth effects and the balance sheet effects.Tobin’s q theory also offers another important channel through which investment effects passeson monetary policy to the real economy. The theory measures the market value of firms relativetheir replacement cost (the cost of replicating the firm’s assets and liabilities). When aneconomy wants to expand by reducing policy rate, the increase in equity prices makes issuingstocks as a source of funding for new projects attractive. Firms are able to raise more funds 10
  • 11. through stock issues relative to the cost of replicating assets and liabilities and this causesinvestments to rise. On the contrary, a rise in interest rate which causes stock prices to fall alsocauses q to fall thus leading to a fall in investment. If q is low it means that new plant andequipment are expensive relative to the market value of the firm. It therefore becomesexpensive to issue new shares to finance the purchase of new equipment leading to a fall ininvestment.The wealth effects channel emanates from the broader economics principle that consumption isa function of income. In other words, the amount of resources controlled by a nation, entity orindividual, to a larger extent, explains their ability to consume. Modigliani puts this view inperspective through his life cycle model which states that consumption is determined by thelifetime resources of consumers. Financial assets, mainly stocks and real estate are consideredas the main life cycle resources components. Consequently, a reduction in interest rates whicheventually leads to a rise in stock prices and real estate prices leads to an enhanced householdwealth. With a boost in consumer wealth, aggregate demand is increased which pushesproduction to also rise to meet demand.The balance sheets of firms and households are improved when an interest rate cut leads to asurge in real estate and stock prices. This increases the collateral capacity of firms andhouseholds which in turn enhances not just the quantity of loans that can be sourced but also thequality of loans advanced to them by banks and other financial institutions. This therefore leadsto a rise in demand and investment. The opposite effect is experienced when an economyembarks upon a contractionary monetary policy. 11
  • 12. When players of the economy believe that certain current economic conditions warrant a changein the policy rate it leads to expectations about the future actions of the central bank. Thebehaviour of players therefore changes to reflect their expectations. For instance, when anincrease (decrease) in the policy rate is expected, borrowings can increase (decrease) now whichhas the effect of increasing money supply, economic activity and inflation, all other things beingequal.The mode through which the above main channels operate have been presented in the diagramin figure 1.Figure 1: Channels of Monetary Transmission Mechanism Market Interest Rates Domestic Demand Asset Prices Domestic Pressure Net External Demand Policy Credit Availability Inflation Instrument and Output Expectations Exchange Import Rates PricesSource: Amarasekara, C. (2004). Interest Rate Pass through in Sri Lanka. Bank of Sri LankaStaff Staff Studies- Volume 35, numbers 1&2 pg 1-32. 12
  • 13. 1.2.2 Lags of Monetary Policy TransmissionMonetary policy responses are transmitted with different effects on different economies. Itappears that certain specific country factors and conditions seem to play a role in the effectiveimplementation of certain monetary policies than others. Consequently some policies work wellor help certain country managers to achieve their monetary targets than others. Iman Sharif ()concluded that a common monetary policy implemented by the European Central bank is likelyto have different effects on member countries. This is because after investigating in theimportance of the credit channel in indicating real economic activity, the results of Germanyand Italy were different from that of France and UK (see also Fountasa and Papagapitos, 2001) .This according to Amarasekara (2004) is probably the reason why there is lack of consensusamong economists on the existence of all the monetary policies discussed above and theirrespective of their importance. Even though researchers generally agree that the speed and sizeof the effect of each channel of monetary policy channel has different effect not only fordifferent countries but also for the same country at different time frames, they also do notdisagree that the effect of monetary policy on any economy is transmitted with certain lags.Indeed, Bonga-Bonga and Kabundi (2008) have documented that some critics even doubt thepotency of monetary policy in affecting the real economy through controlling inflation due tothe substantial lag of monetary policy changes to effectively affect the inflation level.Vaish (2000) has categorized these lags into inside lag intermediate lag and outside lags.According to Vaish (ibid), these lags in a way contribute to the inability of monetary policies tohave instantaneous effect on their final targets. The inside lag is the delay caused basically by 13
  • 14. monetary policy makers. It occurs within the framework of monetary policy administration. Itbegins with the time frame it takes policy makers to acknowledge the need to adjust policyinstruments (recognition lag) through the lag caused by administration procedures required totake that policy action (Administration lag) to when the action is actually taken. Whiles theintermediate lag recognizes the fact that it takes some time before interest rates and spendingconditions are adjusted to reflect any monetary policy action taken, the outside lag is groupedinto decision lag and production lag. The decision lag explains that it takes some time beforeadjusted interest rates and spending conditions are reflected in the decisions of spenders. Lastly,but in the same vein, the time lag between spending decisions and their effect on final targetslike prices, output and employment is known as the production lag. It could be inferred that thecontrol or responsibility of reducing these lags lies in the hands of all the major players in thefinancial sector of the economy. The inside lag, to a large extent, can be controlled by policymakers. On the other hand, the intermediate lag and the outside can be controlled by financialinstitutions and other deficit and surplus spending units. In order to control the lags effectively,information in the market should be readily available, accurate, timely and less expensive just asmarket players should constantly be in the search to benefit from them.Figure 1: Lags of Monetary Policy Transmission 14
  • 15. Inside Lag Intermediate Outside Lag Lag Recognition Administration Decision Production Lag or Action Lag Lag Lag Action Need Action Effect felt on Effect felt Effect felt on Needed Recognition Taken Interest Rates on Prices, Output and Credit Spending and Conditions Decision EmploymentSource: Vaish, M. C. (2000), Monetary Theory. New Delhi: Vikas Publishing House Pvt. Ltd.,15th EditionIn spite of these lags monetary policy is seen to affect the general economy through marketinterest rates, credit, asset prices, exchange rate and the expectations channels. Of all thesechannels, the interest rate channel appears to be the most influential through its direct effect onspending and production and indirect effect through other channels such as exchange ratechannel and equity price channels. Most of the channels (except interest rates) pick theirinfluence on the economy to a large extent from the interest rate channel. Also, Kovanen (2011)asserts that in developing and emerging market countries, where managers of the economy find itdifficult to achieve quantitative targets and financial markets are not only shallow but also lessdeveloped, the interest rate channel is of particular importance. Consequently, the importance of 15
  • 16. the interest rate channel coupled with the fact most firms and households fund their expendituresfrom bank borrowings (because of the limited sources of alternative funding) have necessitatedthe present study. This study seeks to find out: 1) what factor account for changes in policy rate,lending rates and deposit rates as well as their interrelationships; and 2) how these changes affectfirm and household investment.1.2.3 Interest Rate Channel, Pass-Through and StickinessThe interest rate channel is the mechanism by which the central bank influences the realeconomy through control of the amount of money supply in the economy by manipulating thecost of borrowing money. Most literature on the transmission mechanism of monetary policyimplicitly assumes that once a central bank’s policy rate is changed, short-term market and retailbanking rates will follow suit i.e. that there will be immediate and complete “pass-through” tocommercial bank rates (Amarasekara, 2004). But it is not uncommon for economies not towitness one for one change in lending rates whenever there is a change in the policy rate.Substantive empirical evidence confirms that changes in policy interest rate are transmitted to theoutput with a certain lag and that the pass-through of changes in policy rate to output or to otherelements of the transmission channel may be less than one for one. Incomplete and slow pass-through (or interest rate stickiness) of changes in policy interest rate to deposit rate and lendingrate is a kind of imperfection that constrains the effectiveness of monetary policy Khawaja andKhan (2008). Interest rate stickiness as used in this study relates to the second meaning given byCotttarelli and Kourelis (1994): 16
  • 17. First, it (interest rate stickiness) has been used to indicate that bank rates are relatively inelasticwith respect to shifts in the demand for bank loans and deposits. Second, it has been used toindicate that in the presence of a change of money market rates, bank rates change by a smalleramount in the short-run(short-run stickiness), and possible also in the long-run(long-runstickiness).Lowe and Rohling (1992) explain that agency cost (Stilglitz and weiss, 1981), adjustment cost(Cottareli and Kourelis, 1994 and Hofmann and Mizen, 2004)), Switching cost (Lowe andRohling, 1992), risk sharing (Friend and Howidd, 1980) and consumer irrationality (Ausbel,1991) are among the theories that explain interest rate stickiness. Other factors includecompetitiveness of the financial markets (Gropp, Sorensen, and Lichtenberger, 2007 anddifferences in financial structure of the banks (Schwarzbauer, 2006; Cottarelli and kourelis,1994) and information asymmetry (Kwapil and scharler (2006). Among the key factors that havebeen identified to account for interest rate stickiness are monetary policy regime, competitionamong banks competition from direct finance and the rigidity of bank cost (Mojon, 2000;Neumark and Sharpe, 1992; Enfrunand Cordier, 1994 and Kovana 2011). Some other factorsalso advanced by Cotarrelli and Kourelis (1994) in their pioneer work in this area are structuralfeatures of the financial system, such as existence of barrier to competition, the degree offinancial market development and the ownership structure of the banking system.This interest rate pass-through is reported severally by different researchers and depending onwhere the research took place. Moazzami (1999) examined the short-run and long-run impacts ofchanges in money market rates on lending rates in Canada and US and concluded that lendingrates in the US was stickier than that of Canada. 17
  • 18. Basing his findings on some Euro area, Mojon (2000) concluded that retail rates respondsluggishly to changes in the money market rate. Also he found that short term- rates generallyrespond faster than long-term rates, and that the presence of asymmetry in the degree of pass-through cannot be denied.In Sri Lanka, Amarasekara (2004) concluded that even though there is a rapid and almostcomplete pass-through from the Central Bank policy rates to call money market rates, the pass-through from call money market rates to commercial bank retail interest rates is not onlysluggish but also incomplete.Some prominent studies on interest rate on the African continent include Odhiambo (2009),Bonga-Bonga and Kabundi (2008), Samba and Yan (2010) and Kovana (2011). Odhiambo(2009) looked at how interest rate reforms influence economic growth through financialdeepening in Kenya. The study found strong support for the fact that interest rate liberalizationhas a strong positive impact on financial deepening (even though the strength and clarity of itsefficacy is sensitive to the level of dependency) and that this financial depth granger causeeconomic growth in Kenya (both in the long and short run).Bonga-Bonga and Kabundi (2008) considered the relationship between monetary policyinstrument and inflation in South Africa. They found that positive shocks to monetary policydecrease output but do not decrease credit demand and inflation in South AfricaIn a more recent study, Samba and Yan (2010) in their paper “Interest Rate Pass-through in theCentral African Economic and Monetary Community (CAEMC) Area: Evidence from an ADRLAnalysis” concluded that the immediate pass-through to the lending rate is quite two times theone in the deposit rate, consequently one can predict the magnitude of the long-term pass- 18
  • 19. through, which might be higher for the lending rate and lower for the deposit rate. They alsoindicated that while the long-run pass-through to the deposit rate is low and statistically differentfrom 1, thus incomplete, the lending rate rather exhibits an overshooting effect in reaction tochanges in the policy rate. Their results also confirm that there is evidence of asymmetry in thepass-through from the policy rate to both the lending and the deposit rate.In Ghana, Kovana (2011) concludes that the wholesale market responds gradually (with someasymmetries) to changes in policy rate changes while there is an incomplete and protracted pass-through to the retail market.Even though this study does not attempt to model the factors that account for interest ratestickiness, the presence of this stickiness seem to suggest that there are probably other factorsthat influence interest rates. This is one of the main objectives of this study.In the last five decades or so, Africa has witnessed a number of financial sector reforms aimedprimarily at ensuring economic stability, independence and growth. The results from theseeconomic reforms have been mixed. Several studies have subsequently been advanced in a bit tosearch for whether the policies themselves were defective or there are some marketimperfections which have hindered the transmission of good policies. This study is a modestattempt towards the search for a probable market imperfection which could deray the effectiveoperation of an economic policy.1.2 PROBLEM STATEMENT 19
  • 20. In theory, market participants take their cue from monetary authorities, so that increases in thepolicy interest rate would prompt a corresponding increase in market interest rates (Dakila Jr.and Claveria (2006). The mechanism by which monetary policy is transmitted into changes inoutput and inflation has received a good deal of attention from economists in recent years.Despite there being a voluminous literature on the topic there is no consensus about the natureand relative strength of the mechanisms that transmit monetary policy shocks to the real sector(Ramlogan, 2007). On policy rate in particular, very little is known about the transfer mechanismand the speed with which lending rates are adjusted to reflect changes in policy rates. In Africa,interest rate channel is perceived to be the most dominant channel for transmitting monetarypolicy probably because of the underdeveloped nature of our financial markets. Theunderdeveloped nature of the financial market of the African continent leaves a greaterpercentage of households, corporate institutions and government agencies with no other choicethan to use debt as their main source of financing.Meanwhile some central bank executives in Africa have complained about the fact thatborrowing costs do not fully reflect policy rates. Some of the reasons which have been giveninclude high default rate of borrowers, high operating cost, high cost of bank borrowings basedon previously high base rates etc. Unfortunately, however, none of these reasons has been testedempirically and scientifically. This notwithstanding Mishkin (1996) advises that a necessarycondition for monetary authority to achieve its intermediate targets and final objectives is a clearunderstanding of the outcomes a particular policy will have on the economy, which justifies thecreation of an appropriate model of monetary transmission mechanism (MTM). So the bigquestion which follows almost naturally is that if factually the African economy is not so sure 20
  • 21. what influences policy rate, lending rate and deposit rate and the transmission mechanism ofpolicy rate, then what justifies its continuous use or reliance?The main thrust of this study, therefore, is to ascertain the mechanism by which policy ratetranslate to lending rates and deposit rates and how these rates in turn influence the level ofinvestment in Africa. Specifically, the study hopes to: 1) unveil the main determinants of policyrate, lending rate and deposit rate as well as examine their inter-relationships; and 2) assess theeffect of lending rate on investment in Africa.1.3 OBJECTIVES OF THE STUDYThe general objective of the study is to ascertain the effect of policy on lending rate and depositrate in Africa and how lending rate influence investment in Africa.Specifically, the study hopes to achieve the following objectives: • Ascertain the nature of policy rates, lending rates and deposit rate in Africa; • Ascertain the determinants of policy rates, lending rates and deposit rate in Africa; • Examine the inter-relationships among policy rates, lending rates and borrowing cost; • Assess the speed with which lending rates are adjusted to reflect changes in policy rates; • Ascertain whether the different phases of the interest rate pass through exhibit an asymmetry and; • Examine the effect of lending rate on investment in Africa 21
  • 22. HYPOTHESESHA1: Policy rate is affected by inflation rate, previous policy rate, money supply and cost ofborrowing.HA2: Lending rate is influenced by policy rate, corporate governance, geographical location,degree of market concentration, operational efficiency, capital adequacy and risk behavior,average size of bank, economies of scale, noninterest revenue and economic growth.HA3: Deposit Rate in Africa is influenced by lending rate, Bank liquidity position, operationalefficiency, bank size and market concentration.HA4: One percent change in Policy rate results in the same change in lending rateHA5: A change in policy rate is reflected in lending rate immediately.HA5: Policy rate has a negative relationship with investment in Africa.1.4 METHODOLOGYThe proposed study area is captioned policy rate, lending rate and investment in Africa. Theresearcher shall use data from secondary sources. The data shall be gathered from theInternational Monetary fund Statistics (IFS) and Bank Scope Data.1.4.1 Conceptual frameworkIn order to assess the how policy rate influences lending rate and the effect of lending rate on thelevel of investment in Africa the above conceptual frame work is used. From the framework anumber of factors determine the policy rate of countries. These include the level of money 22
  • 23. supply in the economy, current inflation rate, prevailing lending rate and economic growth. It isexpected that the determined policy rate feed into the lending rate of banks. Credit riskcompetition, cost of operations, capital structure, geographical location and credit risk are amongthe key factors that influence the lending rate of banks, which in turn will influence the level ofinvestment in Africa. Apart from lending rate, infrastructural development, economicperformance and finance sector development are also postulated to have an effect on the level ofinvestment in Africa. The broken arrows linking policy rate and lending rate on one hand andlending rate and deposit rate on the other signify that the pass through may not be complete.Figure 3: Conceptual Framework Money Supply POLICY RATE Economic Growth Inflation Credit Risk Competition Cost of Operations Capital Structure LENDING RATE Geographical Location Credit Risk Liquidity Deposi Mkt Concentration t Rate Bank size Operational Eff. INVESTMENT: Infrastructural Dev’t Corporate and Economic Growth Financial Sector Dev’t Household Political Stability 23
  • 24. Source: Author’s Construct1.4.2 Study sampleIn all, the researcher intends to include a total of twenty (20) countries in the study over a studyperiod of Twenty (20) years (from 1990 to 2010). The mode of selection is to pick five (5)countries each from the four (4) major monetary blocs- Central African Economic and MonetaryCommunity (CAEMC), West African Economic and Monetary Union (UEMOA), West AfricanMonetary Zone (WAMZ) and Southern African Customs Union (SACU).1.4.2 The ModelsThe nature of the data required for objective 1 to 4 allows for the use of Panel data methodologyfor the analysis. Panel data methodology has the advantage of not only allowing researchers toundertake cross-sectional observations over several time periods, but also control for individualheterogeneity due to hidden factors, which, if neglected in time-series or cross-section estimationsleads to biased results (Baltagi, 1995). The general form of the panel data model can be specifiedas: Yit = a + ßXit + eit (1)Where the subscript i denotes the cross-sectional dimension and t represents the time-seriesdimension. Yit, represents the dependent variable in the model. X contains the set of explanatoryvariables in the estimation model. a is the constant and ß represents the coefficients. 24
  • 25. The researcher intends to use the following models to test the four (4) main hypotheses in thestudy, in their respective order. 1. Determinants of policy rates in Africa BRit = α +β1IfR it + β2BRt-1 it + β3M2 it + β4GDPr it + β5LnR it +ε it (2) Where: BR it (policy rate) is prime rate for country i in time t; IfR it is inflation rate for country i in time t; BRt-1 it is the lag of prime rate for country i in time t; M2 it is the amount of money supply in the economy of country i in time t; LnR it is the average bank base rate of all banks in country i in time t and; ε it is the error term. 2. Determinants of Lending Rate in Africa LnR it = α + β1BRit + β2LnRt-1 it + β3CGit + β4GLit + β5HHL it+ β6OEit + β7KAit+ β8RSKit + β9SZEit + β10NiRit + β11EGit + ε it (3) Where: LnR it is the base rate of bank i in t; BRit is the policy rate existing in the country of bank i in time t; LnRt-1 it is the lag of the base rate of bank i in time t; 25
  • 26. CGit is the ratio of non-executive directors to total directors of bank i in time t; GLit is the geographical location of bank i in time t; HHL it is the Hierschman Herfindahl Index of bank i in time t; OEit is the degree of operating cost to total cost of bank i in time t; KAit is the ratio of equity capital to total asset of bank i in time t; RSKit is the loan loss ratio of bank i in time t; NiRit is noninterest revenue total revenue of bank i in time t; EGit is the GDP growth rate of the country of bank i in time t and; ε it is the error term.3. Determinants of Bank deposit rate in Africa. DiR it = α + β1LnR it + β2HHIit + β3LIQ it + β4BSZE it + β5STKRTN it + β6MSh it + β7BNKCAP it + β7BNKEFF it + ε it (4) Where: DiR it is the deposit interest rate of country i in time t; LnR it is the lending interest rate of country i in time t; HHI it is the Hierschman Herfindahl Index of country i in time t; LIQ is the liquidity position of Banks in country i in time t; BSZE it is the the natural log of total assets of banks in country i in time t; 26
  • 27. STKRTNit is the average stock market return of country i in time t; MSh it is the market share of firm I in time t; BNKCAP it is bank capital BNKEFF it is bank operational efficiency of country I in time t; ε it is the error term.4. Effect of lending rate on investment in Africa Ic it = α +β1LnR it + β2IfD it + β3GDP it + β4FsD it + β5 PSdummy it + ε it (5) Where: Ic it is investment output ratio and is computed as real private investment divided by real GDP of country i in time t; LnR it is the average base rate of banks in country i in time t; IfD it is infrastructural development measured as telephone lines per 100 people (WDI by Word Bank) of country i in time t; FsD it is financial Sector development measured as Private credit to GDP ratios of country i in time t; PSdummy it is a dummy for political stability (measured as 1 if Economist Intelligence Unit scores country as either very high risk or high risk otherwise 0) of country i in time t;5. Policy rate pass-through in Africa 27
  • 28. The researcher intends to test the pass-through of policy rate to lending rate by using the methodology proposed by Crespo-Cuaresma et al. (2004) and adopted by Samba and Yan (2010). This methodology consist of representing the relationship between the policy rate and a given market rate as an autoregressive distributed lag (ARDL) model such as Where is the market interest rate, is the policy rate and is a white noise disturbance with a constant variance ). Equation (1) can be rewritten using the lag operator as (2)WhereThe long-run relationship implied by this parameterization is given by (3)The error correlation (EC) representation of (1) can be written as 28
  • 29. Where there is a one-to-one mapping between the parameters in (4) and in (1). The term inbrackets acts as an attractor, and represents the long run equilibrium (i.e. λ = ). In fact,λ shows by how much the retail rate changes in reaction to a change in the policy rate by 100basis points after all adjustments have taken place. Meanwhile, when estimating equation (4),one might also be interested in the immediate pass-through, which is given by K0. It gives thereaction of retail rates to a change in the policy rate within the same time period. Kapwil andScharler (2006) argue that a high long-run pass-through might be due to high direct effectspassed through from the policy rate to retail rates or a high persistence in the retail rates. If λ isequal to 1, the pass-through is said to be complete in the long run and changes in the policy rateare to the full extent transmitted to retail rates.All the data shall be subjected to the unit root test through the Augmented Dickey-Fullerprocedures. Several methods have been proposed in the literature to estimate the parameters in(4), starting with the seminal contributions by Engel and Granger (1987) and Johansen (1988,1995). Another approach, suggested by Wickens and Breusch (1988), implies obtainingestimates for the parameters in (4) directly from the OLS estimates of (1). This is the approachthat shall be adopted for this study. Crespo-Cauaresma et al. (2004) indicate that similar resultsare obtained if the Bewley (1979) transformation of (1) is used to retrieve the long run responsesof the market interest rates to the policy rate.1.5 SIGNIFICANCE OF THE STUDY 29
  • 30. This study is a modest attempt on the effect of policy rate on lending rate and borrowing cost inAfrica and also to understand the transmission mechanism of policy rate to borrowing cost. It ishoped that the study will provide empirical evidence on the major factors that influence thesetting of policy rate, .ending rate and borrowing cost in Africa. It is also expected that the studyshall reveal whether policy rate pass through in Africa is complete or not and what accounts forthe policy rate stickiness in Africa, if any. Thus the results of the study is expected to offerimmense contribution to the discussion on what causes policy rate stickiness and also offerpolicy direction to managers of the African economy.1.6 SCOPE AND LIMITATIONThe study shall be limited to one channel of monetary policy transmission mechanism, policyrate. Also the study shall only include countries in the continent with available data. As a resultfindings from the study may not be particularly useful to countries which are not included in thestudy and countries which do not rely too much on the interest rate channel of monetary policytransmission.1.7 CHAPTER DISPOSITIONChapter one shall discuss the background of the study. It shall include the statement of theproblem, purpose of study, significance of study, proposition, limitations, definition of terms andfinally the organization of chapters.Chapter two will focus on the review of relevant literature concerning the study. 30
  • 31. Chapter three shall be devoted towards the overview of the state of the African economy withparticular emphasis on the monetary policy transmission mechanisms used in Africa while“Methodology” will be discussed in chapter 4. Specifically, it is about how data will be collectedand analyzed using the various statistical tools.Chapter five shall cover “discussion of the findings”. This chapter shall discuss all empiricalresults in chapter four in detail in order to read meanings into the entire quantitative andqualitative analysis.Finally, chapter six will present a summary of the whole work. It will include conclusions andrecommendation on policy rate, lending rate and borrowing cost in Africa.REFERENCES 1. Ausubel (1991). “The Failure of Corporation in the Credit Card Market.” American Economic Review, 81, 50-81. 2. Bernanke, B. S., and Gertler, M. (1995). “Inside the Black Box: The Credit Channel of Monetary Policy Transmission.” Journal of Economic Perspectives, vol. 9, No.4 pp.27- 48. 3. Bewley, R. (1979). “The Direct Estimation of the Equilibrium Response in a Linear Dynamic Model.” Economics Letters, 3 357-361. 4. Cotarelli, C., and Kourelis, A. (1994). “Financial Structure, Bank Lending Rates, and the Transmission Mechanism of Monetary Policy”, IMF Staff Papers, 41(4), 587-623. 5. Crespo-Cauresma, J., Egert, B., AND Reininger, T. (2004). Interest Rate Pass-Through in New EU Member States: The case of the Czech Republic, Hungary and Poland. The 31
  • 32. William Davidson Institute Paper No. 671, the William Davidson Institute of the University of Michigan Business School.6. Dakila Jr., F. G. and Claveria, R. A. (2006). “The Impact of BSP Policy Interrest Rates on Market Interest Rates.” Bangko Sentral Review 1-6.7. Engel, R. F., and Granger, C.W.J. (1987). “Co-intregration and Error Correlation: Representation, Estimation and Testing.” Econometrica, 55, 251-276.8. Fried, J. and Howitt, P. (1980). “Credit Rationing and Implicit Conttract Theory.” Journal of Money, Credit and Banking 12, 471-487.9. Gropp, R., Sorensen, C.K. and Lichtenberger (2007). “The Dynamics of Bank Spreads and Financial Structure.” ECB Working Paper Series No. 714.10. Hofmann, B., and Mizen, P. (2004). “Interest Rate Pass-Through and Monetary Transmission: Evidence from Individual Financial Institutions’ Retail Rates.” Economica. 71, 99-123.11. Isakova, A. (2008). “Monetary Policy Efficiency in the Economies of Central Asia.” Czech Journal of Economics and Finance, 58, No. 11-12.12. Johansen, S. (1988). “Statistical Analysis of Cointegrating Vectors.” Journal of Economic Dynamics and Control, 12, 231-254.13. Johansen, S. (1995). Likelihood-Based Inference in Cointegrated Vector Autoregressive Models. Oxford: Oxford University Press. 32
  • 33. 14. Khawaja, M. I. and Khan, S. (2008). “Pass-through of Change in Policy Interest Rate to Market Rates.” The Pakistan Development Review 47; 4 Part II (winter) pp. 661-674.15. Kwapwil, C., and Scharler, J. (2006). “Limited Pass-through from Policy to Retail Interest Rates: empirical evidence and Macroeconomic Implications. OeNb”. Monetary Policy and the Economy.16. Lowe, P. and Rohling, T. (1992). “Loan Rate Stickiness: Theory and Evidence.” Research Discussion Paper, Reserve Bank of Australia.17. Mishkin, F.S. (1996). “The Channels of Monetary Transmission: Lessons from Monetary Policy.” NBER Working Paper, No. 546418. Samba, M.C. and Yan, Y. (2010). “Interest Rate Pass-Through in the Central African Economic and Monetary Community (CAEMC) Area: Evidence from an ADRL Analysis.” International Journal of Business and Management Vol. 5, No. 1 pp. 31-41.19. Schwarzbauer, W. (2006). “Financial Structure and its Impact on the Convergence of Interest Rate Pass-Through in Europe: A Time-varying Interest Rate Pass-Through Model.” Institute for Advanced Studies (Economics Series 191).20. Stilglitz, J.E., and Weiss, A. (1981). “Credit Rationing in Markets with Imperfect Information,” American Economic Review, 393-410.21. Taylor, J. B. (1995). “The Monetary Transmission Mechanism: An Empirical Framework.” Journal of Economic Perspectives 9, 11-26.22. Wickens, M. R., and Breusch, T. S. (1988). “Dynamic Specification, the Long Run and the Estimation of Transformed Regression Models.” Economic Journal, 98, 189-205. 33
  • 34. 23. Kovanen, A. (2011). “Monetary Policy Transmission in Ghana: Does the interest Rate Channel Work?” IMF Working Paper WP/11/275 24. Vink, H. G. H. (2010) “determinants of deposit Rates in the Dutch Retail Deposit Market” Financial Management Masters’ Thesis, No. 476424, Tilburg University. 25. Bonga – Bonga, L. and Kabundi, A (2008). “Monetary Policy Instrument and Inflation in South Africa: Structural Vector Error Correction Model Approach”. Presented at the African Econometric Society Conference, Pretoria, 2008.26. Odhiambo, N. M. (2009). “Interest Rate Reforms, Financial Deepening and Economic Growth in Kenya: An Empirical Investigation” The Journal of Developing Areas, Vol. 43 No. 1 pp. 295-313.27. Iman Sharif Does the credit channel of the monetary transmission mechanisms predict recessions. http://worldresearchpapers.com/article_details.php?article_id=280 1. CliffsNotes.com. Fiscal Policy. 17 Jun 2012 <http://www.cliffsnotes.com/study_guide/topicArticleId-9789,articleId-9749.html>. 2. CliffsNotes.com. Monetary Policy. 17 Jun 2012 <http://www.cliffsnotes.com/study_guide/topicArticleId-9789,articleId-9750.html>. 34

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