Interest rate pdf

A short summary of this paper. Download Download PDF. Translate PDF. The methodology adopted for the study includes cointegration and vector error correction models VECM to determine the long and short run dynamics of the model. The paper examines time series data from to The results indicate that there exists a long run relationship between financial deepening and interest rates. We also find that interest rate reform has a positive and significant effect on financial deepening in Nigeria. Interest rate reform, as a policy under financial sector liberalization, has occupied a central position in the liberalization process.

The goal of interest rate reform is to achieve efficiency in the financial sector and engendering financial deepening. Nnanna and Dogo viewed financial deepening as a financial system which is largely free from financial repression.

Under such a liberalized system, the market should determine the behavior of lenders and borrowers. Odhiambo and Akinboade defined financial deepening as the increase in relative size and role of the financial system in an economy. In Nigeria, financial sector reforms began with the deregulation of interest rates in August Ikhide and Alawode, Prior to this period, the financial system operated under financial regulation, and interest rates were repressed.

According to McKinnon and Shaw , financial repression arises mostly when a country imposes ceilings on deposit and lending rates at a low level relative to inflation. The resulting low or negative interest rates spreads discourage saving mobilization and channelling of mobilized savings through the financial system. This has a negative impact on the quantity and quality of investment and hence economic growth.

The main argument of McKinnon- Shaw was that an increase in the real interest rate may induce savers to save, which generates more investment. Therefore, the expectation of interest rate reform was to encourage domestic savings and make loanable funds available in the banking system. The critical questions, therefore, are: Does interest rate reform has any positive effect on economic growth in Nigeria?

Will deregulation of the financial system speed up capital accumulation and economic growth in the country?

The study tests whether there is any significant relationship between interest rate reforms and financial deepening in Nigeria. The paper is relevant in view of the pivotal role played by interest rates in the saving-investment and growth relationship, as well as the need to provide capital for the private sector. The private sector is a catalyst in the development process.

The motivation for this study is to provide both theoretical and empirical evidence on the relationship between interest rate reforms and financial deepening in Nigeria. The findings will provoke financial policies that will promote economic growth in the country.

The paper is organized as follows. Section 2 discusses the literature on the link between interest rate reforms and financial deepening. Section 3 presents the data and methodology used in the study. Section 4 is presents the results of the analysis, and Section 5 provides concluding comments.

McKinnon-Shaw argued that financial repression reduces the real rate of growth of the economy. Financial repression refers to government fixing interest rates and its adverse consequences on the financial sector and economy. One of the basic arguments of the McKinnon-Shaw model is an investment function that responds negatively to the effective real rate of interest and positively to the growth rate.

The McKinnon-Shaw school of thought is financial liberalization exerts a positive effect on the rate of economic growth in both the short and medium term. This implies that interest rate reforms resulting from financial liberalization, as opposed to financial repression, increase savings into the banking system and investment through credit availability Agenor and Montiel, As Ucer argues , positive real interest rates resulting from financial liberalization lead to financial deepening, or a higher level of intermediation, as demand for money, defined as savings and term deposits as well as checking accounts and other currency increases as the proportion to national income, which in turn, promotes growth.

According to Ucer , the important role played by interest rates in savings, investment and economic growth makes the removal of interest rate controls a centrepiece of the liberalization process. Interest rates policy in Nigeria is discussed along the dividing period of pre-reform and post- reform periods. In order to compare the structure of interest rates between the sub-periods, Table 1 showed savings rate, maximum lending rate, savings-lending rate spread and the minimum rediscount rate to demonstrate the relationship among these four rates as the reform process progresses.

The period before was a period of financial repression, characterized by a highly regulated monetary policy environment in which policies of directed credits, interest rate ceiling and restrictive monetary expansion were the rule rather than the exception Soyibo and Olayiwola, Although interest rate policy instruments remained fixed there were marginal increases.

For the reform period, savings and maximum lending rates were determined by market forces. During this time interest rates increased as envisaged. For instance, following the reform, the nominal savings and maximum lending rates rose from 9. By , the savings and maximum lending rates have rose to This process gives rise to competitive interest rates, which are higher than pre-liberalization interest rate.

Lending Rate Redis-count Rate 3. Redis-count Rate This will in turn affect the amount of funds available for investment with a retarded influence on economic growth. On the other hand high lending rates are detrimental to productive investment and hence economic growth. As Soyibo and Olayiwola observe, borrowers with worthwhile investments may be discouraged from seeking loans and the quality of applicants could change adversely.

Again, high lending interest rates could create a moral hazard where loan seekers borrow to escape bankruptcy rather than invest or finance working capital. Generally, behavior of the interest rate structure is such that there is a wide margin between savings and maximum lending rates, which may encourage speculative financial transactions.

As Edirisuriya suggested, a commonly used measure to evaluate benefit from financial sector reforms is the interest spread or interest margin of banking institutions. The interest spread is the difference between interest income and interest expenditure.

Theoretically, interest margins decline with competition among banks. Figure 1 reveals the interest margin of Nigerian banks, which marginally declined in , then increased until , before nose-diving to very low level of 1.

The major reason for the decline in was competition among banks in the country. The number of banks in the country increased from a low level of 40 in to about by Implication of the situation depicted by the interest rate spread is that interest rate reform has not improved bank efficiency.

This is because the efficiency of a financial system is gauged by how quickly and cheaply the financial system is able to channel funds from surplus economic agents to the deficit agents for productive investments, while ensuring reasonable returns for the financial intermediaries. Figure 1: Savings-Lending Rate in Nigeria, 30 25 20 Percentage 15 10 Interest Spread 5 0 Year Interest margin of Nigerian banks, which marginally declined in , then increased until , before nose-diving to very low level of 1.

Outreville reported that the readily available traditional measures of financial deepening in developing countries are quantity indicators based on monetary and credit aggregates. For instance, Outreville, observes that savings deposits increase as the financial system expands. As Nanna and Dogo argue, freeing the financial system from repression through interest rate reforms, contributes to financial deepening, which Odhiambo and Akinboade postulate will increase the relative size and role of the financial system in the economy.

Figure 2 reveals that financial deepening and interest rates exhibited downward trends, especially between and as a result of the government policy of guided deregulation. This policy of financial repression has the tendency to discourage savings and inhibit financial development in a country. However, a full implementation of the liberalization policy thereafter led to rising deposit rates and increasing financial deepening in the country. This implies that interest rate reform has contributed to financial deepening, which in turn, contributed to economic growth by improving the productivity of investment.

From the foregoing literature review we deduce that financial reform leads to financial deepening, which encourages competitive interest rates and economic growth. This goal of this study is to investigate empirically this relationship, using most recent data in Nigeria.

Data were obtained mainly from publications of the Central Bank of Nigeria, the Statistical Bulletin, Annual Reports and Financial Statements, Banking Supervision and Annual Reports, and supplemented with data from other secondary sources.

The panel cointegration methodology has two main advantages over the fixed effects panel data model. First, we allow sovereign interest rates to deviate temporarily from their long-run equilibrium levels. We can assess the speed of adjustment towards long-run equilibrium levels.

Second, the methodology allows for country-specific short-run effects and common long-run effects. This assumption is in line with theoretical predictions and our methodology allows to test whether these predictions hold in practice. The contribution of our paper to Poghosyan is fourfold. First, we include a variable to assess the impact of demographics on interest rates. Second, we exclude the outlier countries Greece and Japan from the sample. Third, we correct an incorrectly implemented dummy variable in the data files of Poghosyan Finally, our data sample ends with data in rather than The remainder of the paper is organized as follows.

Section 2 reviews the existing literature. Section 3 describes the employed methodology and the data. Section 4 presents and discusses the empirical findings. Conclusions are in the final section. The first group of literature considers the so-called equilibrium interest rate that corresponds to an equilibrium in some theoretical market.

This rate anchors the empirically observed interest rates. The literature in this group explains the dynamics in the interest rate without focusing on a specific determinant. In contrast, the second group focuses on specific determinants of the interest rates.

This literature tends to have an empirical focus. The third group 1 The public sector purchase programme of the ECB buys bonds in the secondary market. The purchased bonds have a weighted remaining maturity below though close to 10 years.

The mixed results from Perotti in IMF should be replaced by the updated mixed results in Perotti While this paper uses the same sample as its predecessor, the spread in results has decreased. This literature includes latent factors as determinants of the term structure, which we do not consider here as it lacks a direct connection with economic fundamentals. An alternative definition of the equilibrium rate follows from the classical IS-LM framework.

The equilibrium interest rate tends to abstract from temporary deviations, but also from more sophisticated concepts such as term preference, risk perception, expectations, etc.

Still, movements in the equilibrium interest rate anchor movements in the empirically observed interest rates, for short-term rates as well as long-term rates. In the VoxEU eBook on secular stagnation Teulings and Baldwin, , most contributions argue that equilibrium real rates of interest will remain low for the next decades. In a related paper, Summers lists six explanations for the low real interest rates. Establishing a new firm requires less investments than before, particularly because new firms tend to be tech-firms P b.

Enhanced supervision on financial intermediation P c. The build-off of excessive leverage in the financial industry T d. This is reinforced when considering the quality-adjusted labor force P or prolonged T. The first paper reviews term structure models from a finance perspective.

The second one focuses on the interaction between macroeconomics and monetary policy. This is related to i. In total, the estimated effects explain basis points bp of the bp drop in real rates since the s. Around bp of this drop follows from the deterioration in the outlook for trend growth, another bp is due to a change in preferences. For instance, Rachel and Smith do not evaluate the effect of a a lower demand for private investments due to the decline in capital intensity of production, b the tax-effect vi from Summers , and, more temporary, c the effect of deleveraging in i from Summers The quantitative results are characterized by wide bands of uncertainty.

This makes real rates hard to predict in the long-run. For instance, the 17th CEPR-ICMB Geneva Report on the World Economy Bean, Broda, Ito and Kroszner, consider shifts in savings, associated especially with demographics as well as Chinese financial integration, as the dominant factor for the decline in interest rates, particularly in the decade or so before the financial crisis.

After the crisis, a decline in the propensity to invest and shifts in asset supply and demand are likely to have played some role too. Bean et al. The latter is in line with Rachel and Smith The uncertainty around the equilibrium rate is large, and its relationship with GDP trend growth is much more tenuous than widely believed. While their data sample starts already in the 19th century, they do not control for factors that are significant in previous studies such as demographics and inequality in the distribution of income.

While long-run predictions vary, the consensus is that interest rates will stay low in the medium-run. This medium-run period is not without any danger for the long-run.

For instance, BIS argues that the short-run benefit of a low interest rate regime persistently biases monetary policy towards a low interest rate regime. In the long-run, this results in asset price bubbles, macro-economic instability and chronic weakness, in line with Bean et al.

In the words of BIS , short-term gain risks being bought at the cost of long-term pain. We identify the following three main determinants from section 2. The empirical papers differ with respect to i nominal yields or real yields, 4 ii spreads or levels, iii current rates or forward rates, and iv a specific maturity or the whole term structure.

Demographics Decisions on investment and savings are age dependent. Young individuals tend to borrow for housing investments, while individuals getting close to the pension age prefer to accumulate wealth anticipating a decline in income and higher expenditures for health care and leisure.

An extensive literature review on ageing is in Poterba who concludes that over the last 70 years the correlation between asset returns on stocks, bonds, or bills, and the age structure of the U.

He notes that a problem with the empirical data is the relatively short time span for the slowly varying ageing effect, and the difficulty to control for other factors. As a consequence, policy makers should rely on theoretical models to assess the effects of ageing. Particularly during crisis periods, swap rates might differ from sovereign bond yields see e.

ECB, Nonetheless, the low level of sovereign bond yields is related to the low level of swap rates. Geanakoplos, Magill, and Quinzii develop a theoretical model where agents have perfect foresight.

The population composition alternates from favorable large working age size to unfavorable small working age size. Under several robustness checks they find an alternation of the real interest rate of several percentage points between the two different states. Unfortunately, the implications of the theoretical models are not easily translated to the real world economy.

Besides, some theoretical results rely heavily on seemingly small features. We give two examples. Firstly, the simulation in Krueger and Ludwig indicates a decline in the return to capital of 86bp between and In a more recent model, Ludwig, Schelkle and Vogel include the accumulation of human capital and find that the decline in returns is halved. Secondly, Fehr, Jokisch and Kotlikoff find a huge increase in the risk free rate of basis points in by imposing a strong home bias in investment flows.

A more recent literature survey on the effects of population age structure on savings and asset prices is in Hassan, Salim and Bloch In line with the discussion above, they conclude that both the empirical and the theoretical literature are inconclusive on the effect of age structure on the performance of financial markets.

Some papers find no evidence of such an effect or mixed results, whilst other papers do find a significant effect.

Lee states that existing simulation studies find a downward effect of ageing on rates of return, between 0. Unfortunately, references to specific literature and simulation horizons are missing in this study. In addition, some of this literature could be driven by spurious regressions on non-stationary variables. Ichiue and Shimizu control for such effects by using time dummies. Their model suggests that a one percent increase in the working age population ratio growth rate 6—10 years ahead increases the annualized 5-toyear forward real interest rate by 0.

It should be noted that time dummies may conceal omitted variables. As such, a higher debt rate or deficit of a country should be associated with higher bond yields for such a country.

Gale and Orzag , Baldacci and Kumar and Greenlaw, Hamilton, Hooper, and Mishkin provide surveys on the effect of debt and deficits on sovereign interest rates. State-of-the-art data series and econometric techniques are in Laubach and Poghosyan , respectively.

Ichiue and Shimizu find that domestic borrowing 0. It is doubtful whether the estimates in this paper also apply to members of a monetary union. Apart from credit risk, demand and supply of a sovereign bond determine its price and thus its yield. Warnock and Warnock estimate that the year Treasury yield would be 80 basis points higher without the substantial foreign inflows into the U.

They control for reductions in long-term inflation expectations, the volatility of long-term rates and various other factors. The preferred habitat hypothesis states that different bond investors prefer one maturity length over another and are only willing to buy bonds outside of their maturity preference if a risk premium for the maturity range is present.

Some papers investigate this hypothesis to explain irregularities in the term structure. Recent papers focusing on the bond supply of specific maturities include Krishnamurthy and Vissing-Jorgensen and Greenwood and Vayanos Both papers find that a larger supply of government debt decreases bond prices and thereby raises bond yields.

In response to the credit crisis, the Fed lowered interest rates by implementing quantitative easing QE. Figure 2. The reductions in interest rates primarily reflect lower risk premiums, including term premiums, rather than lower expectations of future short-term interest rates.

Notably, no macro factor other than QE is included in their model. The literature review in Jarow and Li suggests that the QE operations until lowered interest rates by 50 to bp. Table 2. The asset purchases under QE have led to a higher demand for bonds, limited re-usability of high quality collateral and reduced market liquidity. Valiante argues that the fragmentation of the sovereign bond markets in the euro area makes these markets inherently less liquid compared to the US sovereign bond market.

This amplifies the adverse effects of QE on liquidity. Their results indicate that the asset purchase programs in — reduced the sovereign bond spreads versus Germany and raised covered bond prices.

The quantitative effects of the programs are modest in magnitude though significant. European debt crisis A related strand of literature considers sovereign yield spreads between Germany and other euro area countries.

This literature has developed a consensus that the European debt crisis made investors more sensitive to fiscal balances. The specific determinants differ by country and over time. The sharp spikes in government bond yield spreads during the debt crisis cannot purely be attributed to changes in macroeconomic fundamentals. The general pricing of risk has changed over time as well. Thus, the relationship between variables indicating default and liquidity risk and government bond yield spreads may be time- varying.

Bernoth and Erdogan aim to capture this time-variation by estimating time varying coefficients using kernel regressions. The latter effect is the focus of analysis by De Grauwe and Ji who consider the debt crisis as a bad equilibrium.

By allowing for one structural break in a fixed effects model, they find evidence that a significant part of the surge in the spreads of the peripheral euro area countries was disconnected from underlying increases in fiscal variables. Investors became increasingly worried about debt levels in the euro area, and reacted by raising the spreads.

As a consequence, the crisis was associated with negative self-fulfilling market sentiments. Such behavior is not observed in countries outside the euro area. Rather than time variation in risk perception, Favero uses time-varying differences in fiscal fundamentals between countries. More specifically, a country- specific factor based on cross-country differences captures currency devaluation risk, i.

The dynamics of this factor are more similar for two countries if the debt rate and fiscal balance are more similar for both countries. The factor improves the model on out-of-sample forecasts for the period — Still, the model cannot predict the large spreads observed during the debt crisis.

Cross-country variation in determinants may also play a role. Particularly, sovereign yields of countries in Southern Europe may respond in a different way compared to countries in Northern Europe.

By adopting a general-to-specific selection procedure for regressors, Afonso, Arghyrou, Bagdatoglou and Kontonikas find a significant heterogeneity in determinants of spreads across groups of countries both in terms of the risk factors determining spreads over time and in terms of the magnitude of their impact on spreads. The set of financial and macro spreads' determinants in the euro area is rather unstable, but generally became richer.

The significance of the determinants increased as the crisis evolved. Still, other shocks such as liquidity and political uncertainty also played a role in the sovereign debt crisis. Income inequality The literature finds a mixed effect of income inequality on interest rates.

The empirical findings in Alesina and Perotti suggest that more income inequality leads to more social-political instability which in turn leads to less investment. However, their inequality measure is static and based on data. This is meant to tackle the endogeneity problem, but has a high price given the dynamics in income inequality throughout the sample that ends in In a later study, Barro finds that the investment ratio does not depend significantly on inequality, as measured by the Gini coefficient.

In our empirical setting, we do not attempt to quantify the effect of inequality on interest rates for three reasons. First, there is an inherent endogeneity problem. If lower interest rates induce more investment, the possible increase in capital income is for capital owners who are mostly in the highest income percentiles.

At the same time, a higher inequality in income or wealth leads to a higher propensity to save at a macro level and thus a lower interest rate. Hence, the causal relationship between income inequality and interest rate is unclear. Second, it is not clear-cut whether a lower demand for investment in some small open economy leads to lower sovereign yields for that specific country.

Obviously, globalization trends exclude cross-country arbitrage on sovereign debt. Third, data on income and particularly on wealth has serious measurement issues. Ideally, data collection methods should be identical over time and across countries. Though interesting, tackling these three important aspects on inequality is a study on its own. Other determinants The considered studies control for the impact of several other variables. For instance, GDP growth has an estimated effect on the nominal interest rate of roughly 15bp to 35bp, the effect of the inflation rate ranges between 14bp and 65bp.

Some studies test implicitly on the effect of the short-term interest rate on the long-term interest rate. An effect between 35bp and 75bp is reported. We are skeptical on including a short-term rate since other determinants may simultaneously affect short-term and long-term rates by shifting the whole term structure. The cross-sectional setup of panel data enables us to obtain more efficient estimates than using single country data. In addition to the determinants analysed by Poghosyan , we tested for other variables, for example alternative indicators for fiscal policy government debt and budget balance and demographic variables.

Most of the literature estimates a static regression or a VAR to determine the main determinants of the interest rate. An error correction model is used by only a few papers including Orr et al. Our choice of the panel cointegration model is motivated by the non-stationarity of some variables Appendix Table A.

We expect that similar variables determine the yields of developed countries, thus we consider a panel of 20 OECD countries. The estimator for 1 , the so-called pooled mean group PMG estimator, was introduced by Pesaran et al.

This means that the long-run equation is identical for each country, while cross- country heterogeneity in the short-run is allowed.