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)
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2. 1.0 INTRODUCTION
Monetary policy is the process by which the monetary authority of a country controls the supply
of money, often targeting a rate of interest to attain a set of objectives oriented towards the
growth and stability of the economy. It could be considered as a set of goals dealing with
macroeconomics. The main objectives include controlling interest rates, inflation and currency
values. It is also to ensure economic stability, foster economic growth and ensure low
unemployment.
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 monetary
authorities must have an accurate assessment of the timing and effect of their policies on the
economy, thus requiring an understanding of the mechanisms though which monetary policy
affects the economy. The main channels of monetary policy transmission are the traditional
interest rate channel, exchange rate channel, equity price channels, credit channels (which covers
bank lending channel and balance sheet channels) and expectation channel. Even though
researchers do not generally agree on the best channel of monetary transmission, the interest rate
channel appears to be the most important. The role of interest rate pass-through is crucial since it
represents a potentially important transmission channel and because other channels of the
monetary transmission mechanism are related to its performance. The monetary authority sets
policy 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). An
important feature of the interest rate transmission mechanism is its emphasis on the real rather
than 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
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3. having the major impact on spending. How is it that changes in the short-term nominal interest
rate induced by a central bank result in a corresponding change in the real interest rate on both
short –term bonds? Mishkin (1996). Taylor (1995) argued that there is strong empirical evidence
for substantial interest rate effects on consumer and investment spending, making the interest-
rate monetary transmission mechanism strong even though some researchers like Bernanke and
Gertler (1995) disagree. They are of the view that empirical studies have had a great difficulty in
identifying 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 fact
that the transmission mechanism is mostly incomplete, if even it has ever been complete. Several
reasons have been assigned for this market imperfection. But what is worrying is the fact that a
greater percentage of these studies have been concentrated on developed economies. In the case
of Africa, to the best of the researcher’s knowledge, only one bold attempt has been made to look
into this all-important subject (that is, Samba and Yan, 2010). Even with this study, only one of
the four (4) major economic blocs was looked at. The main thrust of this study therefore is to
ascertain the mechanism by which policy rate translate to lending rate and lending rate also
translate to borrowing cost in Africa. Specifically, the study hopes to unveil the main
determinants 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.
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4. 1.2 LITERATURE REVIEW
The performance of any economy is based –at least in the short-run on the fiscal and monetary
policies implemented by the administrators of the economy. Fiscal policies are the decision rules
on government taxes and expenditure. The direction of government taxes and expenditure
patterns 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 to
individuals and corporate institutions to be used for productive activities; thus stimulating
expansion. In the same vein, increase in government expenditures also fuel economic activity
especially in economies which depend largely on government spending. On the other hand, tax
increases 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 of
regulating the cost of credit and amount of money supply in an economy. Interest rate cuts are
aimed at expanding the economy whiles interest rate increases are generally meant to slow down
the speed of economic activity.
The relative importance of these economic management policies depends on whether one holds a
Keynesian view of a Monetarist view. According to Keynesian school of thought fiscal policy is
more effective than monetary policy. Keynesians believe that the effect of monetary policy on
the real economy is only indirect hence slow. They believe that the effectiveness of monetary
policy is limited to a large extent by the behavior of banks on one hand and firms and households
on the other. For instance, they argue that an expansionary monetary that increases bank reserves
may not necessary lead to an increase in money supply because banks may simply not be willing
to lend. Also firms and households demand for investment and consumption goods may be
dependent on other factors other than lower interest thereby making a reduction interest rates
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5. aimed at increasing investment and consumption an exercise in futility (CliffsNotes.com. Fiscal
Policy. 17 Jun 2012). Weeks (2008) argues that even in developing countries, the effectiveness
of monetary policy (under some assumptions as flexible exchange rate regime with perfectly
elastic capital flows) is undermined because fiscal policy proves to be a better option. He
therefore concludes that fiscal policy is more effective whether the exchange rate is fixed or
flexible, upholding the standard Keynesian view.
Classical economist and monetarist hold the view the importance of fiscal policies fade when
secondary effects (ignored by Keynesians) of fiscal policies are considered. They explain that if
the government embarks on an expansionary fiscal policy by increasing its spending through
borrowings from the domestic credit mark, given a constant money supply, it puts pressure on
interest rates to rise. Consequently, the increase in interest rates lead “crowd out” investment and
consumer spending that are sensitive to interest rates. In the same vein, a contractionary fiscal
policy intended to curb inflation suffers a crowing –in effect, when secondary effects are
considered. Government’s decision to reduce spending may reduce demand for money for the
credit market which inturn may reduce interest rate. The resultant effect would be an increase in
investment and household spending (which are sensitive to interest rates) which has the potential
of 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 exchange
rate regime with perfectly elastic capital flows monetary policy is effective and fiscal policy is
not Weeks (2008).
Generally, monetary policy is good at slowing down an overheated economy while fiscal policy
is good at expanding an economy during a recession. Together they work to ensure proper
economic management. This study is not about which of the two economic policies can better
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6. help control or stimulate economic growth. The study seeks to find out how monetary policy
affects the performance of the African economy.
1.2.1 Channels of Monetary Policy Transmission
Undoubtedly, much has been written on the effects of monetary policy on the performance of the
real economy. Attention has been given particularly to the transmission mechanism of monetary
policy to the real economy. It is generally expected that the type of monetary policy adopted
should have the desired effect on the real economy in order for managers of the economy to be
able to manage the major economic indicators and ultimately the performance of the real
economy. Although several versions of the transmission mechanism exist, five main channels are
discussed: (1) interest rate channel; (2) credit channel; (3) exchange rate channel; (4) wealth
channel; and (5) expectations channel (Amarasekara, 2004).
Depending on what economic policy makers seek to achieve the interest channel can be used to
cause an expansion or contraction of the economy. In periods where expansionary objectives are
sought policy rates could be reduced to cause a reduction in the cost of borrowing in the
economy. This will cause households and corporate entities to increase their spending thereby
fueling a demand and subsequently, employment. In another way, a fall in interest rate causes the
depreciation of the local currency which stimulates exports relative to imports. Indeed if the
economy is operating at full capacity then there is the likelihood of the increase in demand
causing 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 cause
investment, employment and output to reduce. The value of the currency will strengthen causing
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7. exports to be expensive relative to important which may eventually lead to balance of payment
problems. 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 credit
market. When lenders have all the needed information about borrowers, market forces ensure
that credit is allocated efficiently. In order words, lending would lend money to borrowers based
on the best hierarchy of borrowers who are creditworthy while is taken from the most willing
lenders. Information asymmetry hampers the efficient means of taking this decision in the sense
that not all relevant information about lenders and borrowers are available. Credit channel of
monetary transmission are grouped into bank lending channel and balance sheet channel.
Exchange Rate Channel (Mishkin, 1996) When domestic interst rate falls deposits in domestic
currency falls. This leads to a decline in domestic deposits since they become less attractive to
investors as domestic currency in foreign currency rises increasing the value value of foreign
currency. This fall in domestic currency causes domestic goods to be cheaper than forign goods
decreasing exports and increasing imports. Increase in exports cuases morer production which
enhances growth in employment . Consequently the exchange rate channel is also influenced by
the traditional interest channel.
Equity Price Channels: 1) Increasing money supply increases spending. Spending at the
exchange pushes equity prices due to rise in demand. 2) Reduction in interest rates makes bonds
less attractive to equity pushing equity prices up.
Even though proponents of credit channels (some researchers) do not consider interest rate
channel as so important when compared to credit channels, they accept that credit channels
operate from changes in the interest rate. Mishkin (1996) offers three reasons for the credit
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8. channel importance to monetary policy transmission mechanism. First, there is a large body of
cross-section evidence that supports the view that credit market imperfections of the type crucial
to credit channels do indeed affect firms' employment and spending decisions. Second, there s
evidence, such as that found in Gertler and Gilchrist (1994), showing that small firms,which are
more 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 asymmetric
information view of credit market imperfections at the core of the credit channel analysis is a
theoretical construct that has proved to be highly useful in explaining many other important
phenomena.
The credit channel has two main conduits for operation: the bank lending channel and the
balance sheet channel. Bank lending is enhanced when expansionary monetary policies are
pursued. Monetary policies like reduction in bank reserve requirements has the tendency of
increasing 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 effect
on ouput. This channel is likely to work more perfectly depending on the level of dependency on
bank loans for financing projects especially by corporate entities. Thus in an economy where
corporate institutions have easy access to stock market funding, the effect of this channel on the
real economy may not be that strong. Given the relatively young nature of the most Exchange
Markets in Africa and coupled with the fact that most non-financial corporations rely heavily on
bank lending (Abor, 2005) to finance their activities, this channel promises to be an important
one to the African economy. This notwithstanding, there is evidence to suggest that bank
regulations in oother developed nations that sought to restrict banks ability to raise funds has
gone down and that there seems to be a world wide decline in the traditional bank lending
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9. business (Edwards and Mishkin, 1995). All these put a slur on the importance of the bank
lending channel.
Adverse selection and moral harzard problems of lending are worsened when borrowers
networth are low. Expansionary monetary policy reduces the severity of this problem. When
interest rates are cut, equity becomes more attractive to investors. The increase in demand for
equity, all other things being equal, causes share prices to rise thereby improving the networth of
companies and increasing investment. On the other hand, a fall in the net worth of firms, as a
result of a contractionary monetary policy would lead to a fall in investment. This condition is
explained by the balance sheet channel. The balance sheet channel can also be explained by the
credit rationing phenomenon (Stiglitz and Weiss, 1981) and the effect of monetary policy on the
general price level (Fisher, 1933).
Ramlogan (2007) contend that the money and credit channels are particularly important to
countries where financial markets is at relatively early stage of development and this
identification has serious ramifications.
During the development of the financial market the link between the financial and real sectors of
the economy is likely to change hence it is important to determine which of the financial
aggregates monetary policy impacts upon. Furthermore, an understanding of the transmission
mechanism assists policy makers in deciding which disturbances warrant changes in monetary
policy and which do not. Finally, knowledge of the transmission mechanism may help promote
higher investment and a faster pace of economic growth if it leads to a better choice of target
variables.
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10. In addition, the importance of credit channel is emphasized by the fact that finding other forms
of 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 of
credit offered and rate at which credit is given. For instance, an expansionary monetary policy
that relaxes interest rates would cause the cost of credit to reduce and would likely have an
increase 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 the
credit channel of monetary policy in India. In addition, banks’ capital adequacy ratios, opening
up 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 banks
and smaller banks differed. Specifically large banks are better able to insulate themselves against
contractionary 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. An
expansionary monetary policy makes stocks more attractive than bonds, because returns on
bonds would be minimal. It also makes real estate prices to increase as finance for housing
becomes less expensive. This is subsequently manifested to the real economy through the
investment effects, wealth effects and the balance sheet effects.
Tobin’s q theory also offers another important channel through which investment effects passes
on monetary policy to the real economy. The theory measures the market value of firms relative
their replacement cost (the cost of replicating the firm’s assets and liabilities). When an
economy wants to expand by reducing policy rate, the increase in equity prices makes issuing
stocks as a source of funding for new projects attractive. Firms are able to raise more funds
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11. through stock issues relative to the cost of replicating assets and liabilities and this causes
investments to rise. On the contrary, a rise in interest rate which causes stock prices to fall also
causes q to fall thus leading to a fall in investment. If q is low it means that new plant and
equipment are expensive relative to the market value of the firm. It therefore becomes
expensive to issue new shares to finance the purchase of new equipment leading to a fall in
investment.
The wealth effects channel emanates from the broader economics principle that consumption is
a function of income. In other words, the amount of resources controlled by a nation, entity or
individual, to a larger extent, explains their ability to consume. Modigliani puts this view in
perspective through his life cycle model which states that consumption is determined by the
lifetime resources of consumers. Financial assets, mainly stocks and real estate are considered
as the main life cycle resources components. Consequently, a reduction in interest rates which
eventually leads to a rise in stock prices and real estate prices leads to an enhanced household
wealth. With a boost in consumer wealth, aggregate demand is increased which pushes
production to also rise to meet demand.
The balance sheets of firms and households are improved when an interest rate cut leads to a
surge in real estate and stock prices. This increases the collateral capacity of firms and
households which in turn enhances not just the quantity of loans that can be sourced but also the
quality of loans advanced to them by banks and other financial institutions. This therefore leads
to a rise in demand and investment. The opposite effect is experienced when an economy
embarks upon a contractionary monetary policy.
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12. When players of the economy believe that certain current economic conditions warrant a change
in the policy rate it leads to expectations about the future actions of the central bank. The
behaviour of players therefore changes to reflect their expectations. For instance, when an
increase (decrease) in the policy rate is expected, borrowings can increase (decrease) now which
has the effect of increasing money supply, economic activity and inflation, all other things being
equal.
The mode through which the above main channels operate have been presented in the diagram
in 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 Prices
Source: Amarasekara, C. (2004). Interest Rate Pass through in Sri Lanka. Bank of Sri Lanka
Staff Staff Studies- Volume 35, numbers 1&2 pg 1-32.
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13. 1.2.2 Lags of Monetary Policy Transmission
Monetary policy responses are transmitted with different effects on different economies. It
appears that certain specific country factors and conditions seem to play a role in the effective
implementation of certain monetary policies than others. Consequently some policies work well
or 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 likely
to have different effects on member countries. This is because after investigating in the
importance of the credit channel in indicating real economic activity, the results of Germany
and 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 consensus
among economists on the existence of all the monetary policies discussed above and their
respective of their importance. Even though researchers generally agree that the speed and size
of the effect of each channel of monetary policy channel has different effect not only for
different countries but also for the same country at different time frames, they also do not
disagree 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 the
potency of monetary policy in affecting the real economy through controlling inflation due to
the 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 to
have instantaneous effect on their final targets. The inside lag is the delay caused basically by
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14. monetary policy makers. It occurs within the framework of monetary policy administration. It
begins with the time frame it takes policy makers to acknowledge the need to adjust policy
instruments (recognition lag) through the lag caused by administration procedures required to
take that policy action (Administration lag) to when the action is actually taken. Whiles the
intermediate lag recognizes the fact that it takes some time before interest rates and spending
conditions are adjusted to reflect any monetary policy action taken, the outside lag is grouped
into decision lag and production lag. The decision lag explains that it takes some time before
adjusted 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 targets
like prices, output and employment is known as the production lag. It could be inferred that the
control or responsibility of reducing these lags lies in the hands of all the major players in the
financial sector of the economy. The inside lag, to a large extent, can be controlled by policy
makers. On the other hand, the intermediate lag and the outside can be controlled by financial
institutions 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 as
market players should constantly be in the search to benefit from them.
Figure 1: Lags of Monetary Policy Transmission
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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 Employment
Source: Vaish, M. C. (2000), Monetary Theory. New Delhi: Vikas Publishing House Pvt. Ltd.,
15th Edition
In spite of these lags monetary policy is seen to affect the general economy through market
interest rates, credit, asset prices, exchange rate and the expectations channels. Of all these
channels, the interest rate channel appears to be the most influential through its direct effect on
spending and production and indirect effect through other channels such as exchange rate
channel and equity price channels. Most of the channels (except interest rates) pick their
influence 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 it
difficult to achieve quantitative targets and financial markets are not only shallow but also less
developed, the interest rate channel is of particular importance. Consequently, the importance of
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16. the interest rate channel coupled with the fact most firms and households fund their expenditures
from bank borrowings (because of the limited sources of alternative funding) have necessitated
the 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 affect
firm and household investment.
1.2.3 Interest Rate Channel, Pass-Through and Stickiness
The interest rate channel is the mechanism by which the central bank influences the real
economy through control of the amount of money supply in the economy by manipulating the
cost of borrowing money. Most literature on the transmission mechanism of monetary policy
implicitly assumes that once a central bank’s policy rate is changed, short-term market and retail
banking rates will follow suit i.e. that there will be immediate and complete “pass-through” to
commercial bank rates (Amarasekara, 2004). But it is not uncommon for economies not to
witness 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 the
output with a certain lag and that the pass-through of changes in policy rate to output or to other
elements 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 lending
rate is a kind of imperfection that constrains the effectiveness of monetary policy Khawaja and
Khan (2008). Interest rate stickiness as used in this study relates to the second meaning given by
Cotttarelli and Kourelis (1994):
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17. First, it (interest rate stickiness) has been used to indicate that bank rates are relatively inelastic
with respect to shifts in the demand for bank loans and deposits. Second, it has been used to
indicate that in the presence of a change of money market rates, bank rates change by a smaller
amount in the short-run(short-run stickiness), and possible also in the long-run(long-run
stickiness).
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 and
Rohling, 1992), risk sharing (Friend and Howidd, 1980) and consumer irrationality (Ausbel,
1991) are among the theories that explain interest rate stickiness. Other factors include
competitiveness of the financial markets (Gropp, Sorensen, and Lichtenberger, 2007 and
differences in financial structure of the banks (Schwarzbauer, 2006; Cottarelli and kourelis,
1994) and information asymmetry (Kwapil and scharler (2006). Among the key factors that have
been identified to account for interest rate stickiness are monetary policy regime, competition
among 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 factors
also advanced by Cotarrelli and Kourelis (1994) in their pioneer work in this area are structural
features of the financial system, such as existence of barrier to competition, the degree of
financial market development and the ownership structure of the banking system.
This interest rate pass-through is reported severally by different researchers and depending on
where the research took place. Moazzami (1999) examined the short-run and long-run impacts of
changes in money market rates on lending rates in Canada and US and concluded that lending
rates in the US was stickier than that of Canada.
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18. Basing his findings on some Euro area, Mojon (2000) concluded that retail rates respond
sluggishly to changes in the money market rate. Also he found that short term- rates generally
respond 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 almost
complete 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 only
sluggish 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 financial
deepening in Kenya. The study found strong support for the fact that interest rate liberalization
has a strong positive impact on financial deepening (even though the strength and clarity of its
efficacy is sensitive to the level of dependency) and that this financial depth granger cause
economic growth in Kenya (both in the long and short run).
Bonga-Bonga and Kabundi (2008) considered the relationship between monetary policy
instrument and inflation in South Africa. They found that positive shocks to monetary policy
decrease output but do not decrease credit demand and inflation in South Africa
In a more recent study, Samba and Yan (2010) in their paper “Interest Rate Pass-through in the
Central African Economic and Monetary Community (CAEMC) Area: Evidence from an ADRL
Analysis” concluded that the immediate pass-through to the lending rate is quite two times the
one in the deposit rate, consequently one can predict the magnitude of the long-term pass-
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19. through, which might be higher for the lending rate and lower for the deposit rate. They also
indicated that while the long-run pass-through to the deposit rate is low and statistically different
from 1, thus incomplete, the lending rate rather exhibits an overshooting effect in reaction to
changes in the policy rate. Their results also confirm that there is evidence of asymmetry in the
pass-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 some
asymmetries) 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 rate
stickiness, the presence of this stickiness seem to suggest that there are probably other factors
that 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 aimed
primarily at ensuring economic stability, independence and growth. The results from these
economic reforms have been mixed. Several studies have subsequently been advanced in a bit to
search for whether the policies themselves were defective or there are some market
imperfections which have hindered the transmission of good policies. This study is a modest
attempt towards the search for a probable market imperfection which could deray the effective
operation of an economic policy.
1.2 PROBLEM STATEMENT
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20. In theory, market participants take their cue from monetary authorities, so that increases in the
policy 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 in
output 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 nature
and 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 mechanism
and 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 monetary
policy probably because of the underdeveloped nature of our financial markets. The
underdeveloped nature of the financial market of the African continent leaves a greater
percentage of households, corporate institutions and government agencies with no other choice
than to use debt as their main source of financing.
Meanwhile some central bank executives in Africa have complained about the fact that
borrowing costs do not fully reflect policy rates. Some of the reasons which have been given
include high default rate of borrowers, high operating cost, high cost of bank borrowings based
on previously high base rates etc. Unfortunately, however, none of these reasons has been tested
empirically and scientifically. This notwithstanding Mishkin (1996) advises that a necessary
condition for monetary authority to achieve its intermediate targets and final objectives is a clear
understanding of the outcomes a particular policy will have on the economy, which justifies the
creation of an appropriate model of monetary transmission mechanism (MTM). So the big
question which follows almost naturally is that if factually the African economy is not so sure
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21. what influences policy rate, lending rate and deposit rate and the transmission mechanism of
policy rate, then what justifies its continuous use or reliance?
The main thrust of this study, therefore, is to ascertain the mechanism by which policy rate
translate to lending rates and deposit rates and how these rates in turn influence the level of
investment in Africa. Specifically, the study hopes to: 1) unveil the main determinants of policy
rate, lending rate and deposit rate as well as examine their inter-relationships; and 2) assess the
effect of lending rate on investment in Africa.
1.3 OBJECTIVES OF THE STUDY
The general objective of the study is to ascertain the effect of policy on lending rate and deposit
rate 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
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22. HYPOTHESES
HA1: Policy rate is affected by inflation rate, previous policy rate, money supply and cost of
borrowing.
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, operational
efficiency, bank size and market concentration.
HA4: One percent change in Policy rate results in the same change in lending rate
HA5: A change in policy rate is reflected in lending rate immediately.
HA5: Policy rate has a negative relationship with investment in Africa.
1.4 METHODOLOGY
The proposed study area is captioned policy rate, lending rate and investment in Africa. The
researcher shall use data from secondary sources. The data shall be gathered from the
International Monetary fund Statistics (IFS) and Bank Scope Data.
1.4.1 Conceptual framework
In order to assess the how policy rate influences lending rate and the effect of lending rate on the
level of investment in Africa the above conceptual frame work is used. From the framework a
number of factors determine the policy rate of countries. These include the level of money
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23. supply in the economy, current inflation rate, prevailing lending rate and economic growth. It is
expected that the determined policy rate feed into the lending rate of banks. Credit risk
competition, cost of operations, capital structure, geographical location and credit risk are among
the key factors that influence the lending rate of banks, which in turn will influence the level of
investment in Africa. Apart from lending rate, infrastructural development, economic
performance and finance sector development are also postulated to have an effect on the level of
investment in Africa. The broken arrows linking policy rate and lending rate on one hand and
lending 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
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24. Source: Author’s Construct
1.4.2 Study sample
In all, the researcher intends to include a total of twenty (20) countries in the study over a study
period 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 Monetary
Community (CAEMC), West African Economic and Monetary Union (UEMOA), West African
Monetary Zone (WAMZ) and Southern African Customs Union (SACU).
1.4.2 The Models
The nature of the data required for objective 1 to 4 allows for the use of Panel data methodology
for the analysis. Panel data methodology has the advantage of not only allowing researchers to
undertake cross-sectional observations over several time periods, but also control for individual
heterogeneity due to hidden factors, which, if neglected in time-series or cross-section estimations
leads to biased results (Baltagi, 1995). The general form of the panel data model can be specified
as:
Yit = a + ßXit + eit (1)
Where the subscript i denotes the cross-sectional dimension and t represents the time-series
dimension. Yit, represents the dependent variable in the model. X contains the set of explanatory
variables in the estimation model. a is the constant and ß represents the coefficients.
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25. The researcher intends to use the following models to test the four (4) main hypotheses in the
study, 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;
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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;
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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
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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)
Where
The 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 in
brackets 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 100
basis 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 the
reaction of retail rates to a change in the policy rate within the same time period. Kapwil and
Scharler (2006) argue that a high long-run pass-through might be due to high direct effects
passed through from the policy rate to retail rates or a high persistence in the retail rates. If λ is
equal to 1, the pass-through is said to be complete in the long run and changes in the policy rate
are to the full extent transmitted to retail rates.
All the data shall be subjected to the unit root test through the Augmented Dickey-Fuller
procedures. 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 obtaining
estimates for the parameters in (4) directly from the OLS estimates of (1). This is the approach
that shall be adopted for this study. Crespo-Cauaresma et al. (2004) indicate that similar results
are obtained if the Bewley (1979) transformation of (1) is used to retrieve the long run responses
of 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 in
Africa and also to understand the transmission mechanism of policy rate to borrowing cost. It is
hoped that the study will provide empirical evidence on the major factors that influence the
setting of policy rate, .ending rate and borrowing cost in Africa. It is also expected that the study
shall reveal whether policy rate pass through in Africa is complete or not and what accounts for
the policy rate stickiness in Africa, if any. Thus the results of the study is expected to offer
immense contribution to the discussion on what causes policy rate stickiness and also offer
policy direction to managers of the African economy.
1.6 SCOPE AND LIMITATION
The study shall be limited to one channel of monetary policy transmission mechanism, policy
rate. Also the study shall only include countries in the continent with available data. As a result
findings from the study may not be particularly useful to countries which are not included in the
study and countries which do not rely too much on the interest rate channel of monetary policy
transmission.
1.7 CHAPTER DISPOSITION
Chapter one shall discuss the background of the study. It shall include the statement of the
problem, purpose of study, significance of study, proposition, limitations, definition of terms and
finally the organization of chapters.
Chapter two will focus on the review of relevant literature concerning the study.
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31. Chapter three shall be devoted towards the overview of the state of the African economy with
particular 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 collected
and analyzed using the various statistical tools.
Chapter five shall cover “discussion of the findings”. This chapter shall discuss all empirical
results in chapter four in detail in order to read meanings into the entire quantitative and
qualitative analysis.
Finally, chapter six will present a summary of the whole work. It will include conclusions and
recommendation on policy rate, lending rate and borrowing cost in Africa.
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