Interest rate liberalization, domestic savings mobilization and money demand in the Gambia

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NATIONS UNIES UNITED NATIONS

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INSTITUT AFRICAIN DE DEVELOPPEMENT ECONOMIQUE ET DE PLANIFICATION AFRICAN INSTITUTE FOR ECONOMIC DEVELOPMENT AND PLANNING ·-

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Alieu O. Ceesay . .

· Submitted in Partiai=".tuifillment of the Requirements f~r the ~ward of the Degree

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of Master of Arts in Economie Policy and Management at the At:rican lnstitute for Economie Development and Planning (IDEP), bas been read ànd approved by

Chief Supervisor

Thesis Committee Members

Mr. Racine.Kane . .. :

Extemal Examiner · ·• D r . m· . . Ndiaye ... ~ . . ... .

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·':.• DEDICATION

This thesis is dedicated to my brother Ali CEESA Y who died in Ghana while on an official mission

and

Bukary A. M. Gaye (Buks) who died in August 1998. They have always been very supportive but due to the indomitable forces of Providence, they could not live to witness this day. May

their souls rest in etemal peace.

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• Acknowledgements

The successful completion of this thesis has resulted from assistance rendered by a number of individuals, organizations and institutions; it is therefore very difficult to have an exhaustive list of all these. All the same, I cannot fail to single out certain individuals and institutions.

I must seize this golden opportunity to thank most sincerely, the Director ofiDEP, Dr. Jeggan C.

Senghor who has always stepped in to solve my problems during difficult times. His was a fatherly role. Through him I would also like to thank all the staff of the Institute, all of whom have contributed in their own small ways toward the completion of this thesis. I cannot fail to thank Prof. Philip K. Quarcoo who acted as my chief supervisor and meticulously guided me throughout the research despite his busy schedule. Without his valuable inputs, both as my econometrie applications tutor and chief supervisor, this thesis would not have seen the light of day. I am also very grateful for the helpful comments made on an earlier draft by Dr. Amath Ndiaye, my ext~mal examiner. I also acknowledge with gratitude the valuable comments made by Dr. Birahim Bouna Niang and Mr. Racine Kane, members of my thesis committee. Special thanks also go to Dr. Birahim B. Niang for making valuable documents available. The valuable efforts put in by IDEP interpreters are most commendable, particularly the consolations from Mr.

Amoako were indeed much-needed source of inspiration throughout the study. The staffs at the library, administration and finance office also contributed toward the successful completion of not only the thesis but even the studies leading to the thesis-writing phase.

Back home, I must thank the govemment of The Gambia through the Economie Management

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on record the efforts of Mr. Dodou Bami Jagne, Permanent Secretary, Department of State for Finance and Economie Affairs and Mr. A.S.M. Ndow, Director of Central Statistics. I acknowledge with special thanks the assistance given by Mr. Ousman Dibba, Baboucar Daffeh and Aja Maimuna Baya (Aji Mai).

The staff of the Central Bank of The Gambia have also been very helpful. In this regard, I would like to thank Mr. Modou Ceesay, Director ofResearch, Mr. Herbert Carr, Mr. Abdoulie Jarra and all the staff at the library, for their valuable assistance during the course of the research leading to this thesis.

Members of my family and friends have also accorded meaningful contributions that warrant special attention. I would be doing them injustice if I fail to acknowledge this. My father Omar Ceesay, mother (Rohey F.Gaye), Omar J. Mbye, Layin B.S. Gaye, Alhajie Ali Ceesay, Jawara Gaye (Sir), Mad Secka, Nuha Ceesay and last but by no means the least, Mr. Ebrima M. Jobe. I thank them all for their love and support. I would also like to put on record the valuable assistance rendered by Fatumata and Mahawa.

In as much as the final product of this thesis has been the result of the numero us types of support received and cross-fertilization of ideas between colleagues and lecturers, I alone assume full responsibility for any shortcomings or inadequacies contained herein.

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[ 3::

^studycovers the period 1973 to 1997 and investigates the impact of the interest rate liberalisation policy on domestic savings mobilization and money demand in The Gambia, using a cointegration approach.

The main hypothesis tested was that interest rate liberalization positively affected domestic savings mobilization. The analysis showed that the impact of the real interest rate on domestic savings mobilization was positive and significant at the 5% level in Iine with the Financial Liberalization thesis. On the other hand, the impact of the real interest rate on the demand for real money balances was negative in line with Keynesian theoretical expectations but contrary to the postulates of the Financial Liberalization hypothesis. For domestic savings mobilization, the dependency ratio, although not a policy variable as such, was found to exert a significant and negative impact.

A secondary hypothesis tested was that the economie reform measures may have destabilized the money demand function, but the analysis showed that the demand for money function was found to be stable over the period of the study. In order for this to be maintained, it was recommended that the slow (graduai) speed of the financial sector reform should be adhered to, as haste would destabi1ize this function and frustrate monetary po1icy execution in The

Garn9

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INTRODUCTION

Background and Statement of the Problem

A controversial conditionality of structural adjustment programmes is interest rate liberalization.

The controversy surrounds the effects of interest rate liberalization on savings and the demand for money. The issue has remained controversial and has been aggravated by diametrically opposing views of Keynesian and monetarist schools of thought on the desirability of conscious interest rate liberalization programmes. This controversy leaves policy-makers, especially in developing countries like The Gambia, with no clear-cut rule on the utilization of this policy instrument in their efforts to redirect their economies from the vicious cycle of stagnation to the virtuous cycle of economie growth and development. It must be said, though, that prior to the adoption of the structural adjustment programmes in developing countries, interest rate policies were, in most cases and places, characterized by control measures to the extent that sorne were in fact negative in real terms.

The earlier interest rate theories of the monetarist and Keynesian schools of thought were first challenged in the seminal works of Ronald I. Mckinnon and Edward S. Shaw (1973). The authors did not stop there but went further to offer an alternative proposition in the name of a

« Financial Liberalization Hypothesis ». The hypothesis contends that financial repression is inimical to sayings, investment, financial development and growth and that for these macroeconomie variables to move in their desired directions, interest rate reforms would have to be undertaken. This meant that market forces would have to be given more priority at the

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detriment of direct government intervention in the determination of interest rates. The thinking was that these reforms would give rise to positive real interest rates which would be accompanied by increased financial savings, financial deepening, more productive use of existing capital and economie growth as an inevitable concomitant.

Their arguments were so forceful and intellectually appealing that by the beginning of the 1980s,

most African countries that undertook structural adjustment programmes had interest rate liberalization ranking very high in their macroeconomie policy agenda. Thus it came as no surprise that in 1985 interest rates were to sorne extent liberalized in The Gambia for the first time in the country' s economie his tory.

The introduction of interest rate liberalization as a component of the financial sector reform is believed to have sorne negative implications for monetary policy as a demand management tool.

This phenomenon was properly addressed by Ndungu's (1996) submission in an AERC senior policy seminar held in June 1996. In his presentation, he was able to show that in Kenya and U ganda, movements in the money multiplier have been fairly stable prior to the 1990s, oscillating around the mean of zero. In the 1990s, however, this pattern changed and movements around the mean became more pronounced. These extreme movements in the money multiplier point to the central banks' inability to control money supply. These results show that it is unlikely to have a stable money demand function, where the money multiplier and possibly velocity of money have been unstable. He concluded in the following words « the effectiveness of monetary policy depends on the assumption that there is a stable and predictable money

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demand function and velocity ... and thus more research is required to show wh ether there are effects on the stability of the money demand function during liberalisation periods. » ¹

It must be noted that even though the policy was adopted in The Gambia, the controversy was far from resolved, neither were the other negative implications of the policy addressed. After almost a decade of adopting this policy, one may now ask the relevant question : Where has

interest rate liberalization taken us ? Is interest rate liberalization in The Gambia worthwhile ? What has been the impact of interest rate liberalization on the stability of the demand for money function and hence the efficacy of monetary po licy as a demand management tool ? The study covers the period 1973 to 1997 and would attempt to supply answers and give sorne insights into these pertinent questions.

Objective

The main objective of this study is to investigate the impact of interest rate liberalization on financial savings and to highlight the impact of the po licy on the stability of the money demand function in The Gambia.

Hypothesis

A working hypothesis of this study is that interest rate liberalization in The Gambia has impacted positively on domestic savings mobilization but the policy and the accompanying measures have also destabilized the money demand function.

1 AERC- African Development Review, Vol.9, No.!, June 1997

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Justification of the Study

After almost a decade of adopting the interest rate policy, no research of the sort being conceived has been conducted in The Gambia to investi gate the possible impact of the po licy on the macroeconomie variables/aggregates in question. Sorne studies were conducted in Kenya, Nigeria, Latin America, South East Asia, among others, but the findings seem to demonstrate that the issue of interest rate liberalization is country-specifie and does not lend itself to hasty generalizations. Since the interest rate is a tool that is often widely used and its relationship with savings, is far Îrom clear, a study that attempts to investigate the relationship between these variables in a developing economy like The Gambia is a worthwhile venture.

Again, quantitative formulation of monetary policy typically assumes the existence of a relatively stable money demand function. This statement is sometimes interpreted wrongly as implying that incarne velocity must be constant. What is required is simply that the demand for money, or velocity, be a predictable function of sorne variables. Financial sector reforms, and in particular interest rate liberalisation, that affects the determinants of the demand for money, namely incarne, interest rates, exchange rates and so on may lead to significant changes, and possibly instability, in the demand for money function. Such changes , particularly if they are unpredictable, would obviously make it difficult, if not impossible, to ascertain the liquidity needs of the economy, inevitably creating greater uncertainty in the amount of money and credit to be supplied to achieve the policymaker's ultimate objectives.This therefore provides enough motivation for a study of this nature to better understand the intricacies associated with financial sector reform especially as it impacts on monetary policy. Thus the study would fill a major gap, given the fact that research in this area has been largely lacking in The Gambia.

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Most of the studies cited used the ordinary least squares (OLS) technique but did not conduct more reliable techniques such as cointegration and stationarity tests. Non-stationarity is extremely common in macroeconomie time-series such as income, consumption, money, priees etc. and as data samples get longer, the phenomenon becomes more and more pronounced.

Failure to appropriately deal with this would have serious implications particularly as non- stationarity has been a phenomenon of the 1980s and 1990s. The study, in order to surmount this major defect, would employ cointegration and stationarity tests after which the parameters would be estimated using the Ordinary least Squares technique.

Organization of the Study

The Study is organized into four chapters. It begins with an introduction, comprising basically a statement of the research problem and objectives to be attained. In Chapter one the Economie Recovery Programme of which interest rate liberalisation was a component, was introduced and elaborated upon. Chapter two contains the theoretical background and empiricalliterature review in order to investigate how thought/thinking over the issues of savings and money demand estimation have evolved over time. In chapter three, we presented a description of the methodology and the model specifications. The models in the study were estimated, diagnosed, and interpreted in Chapter four. The summary, policy implications and recommendations arising from the models built end the study in a final section.

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CHAPTERONE

BACKGROUND TO THE GAMBIAN ECONOMY

1.0 Introduction

This chapter takes a look at background information on the demographie and economie characteristics of The Gambia. This is followed by an evaluation of the stabilization and structural adjustment programme, and the position of financial sector reform in the overall programme.

1.1 Background

The Gambia is a small country in the Western region of Africa with an alarming population growth rate of 4.2% per annum (1993 Census) which shows that the population will double in or about 2009. In 1965, after independence from colonial domination, The Gambia maintained a sound and stable macroeconomie framework: modest economie growth, 4.7% growth in per capita incarnes, 3. 7% of annual inflation rate and a foreign debt of only US $ 5 million.

However, in the 1970s both economie and non-economie factors affected economie performance considerably. These factors can also be classified as internai and external. Paramount among these were the first and second oil priee shocks, droughts, worsening terms of trade ( classified as external factors) exacerbated the balance of payments (BOP) position of The Gambia. The internai factors included inappropriate govemment policies such as swelling of the civil service, govemment intervention in productive and distributive activities through the establishment of

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These were financed by printing money (monetary accommodation), domestic and external borrowing with. high inflation rates, crowding out of the private sector investment and heavy- indebtedness as inevitable concomitants. The budget deficit, which was only 3% of GDP during 1965-75, deteriorated sharply to 15% of GDP over the 1980-85 period. Deficit financing was frequent in addition to controls of priees and interest rates to an extent that real interest rates became negative and this made private investment to drop. This was reflected in the decline of private sector investment from 8.7% of GDP in 1975 to less than 3% of GDP in 1985. This largely contributed to a decline in economie activities and reduced growth in average per capita income to only 0.2% a year.

By 1985, it was becoming increasingly clear that The Gambia had run into serious economie difficulties to such an extent that reforms were inevitable. Between 1980 and 1985, real per capita income dropped from US $ 320 to US $ 227. The fiscal deficit in 1985 was 17% of GDP and the current account deficit of the balance of payments was 21% of GDP. External debt was about US $ 245 million and gross international reserves were equivalent to only two weeks of import cover. Debt service arrears amounted to 64% of GDP and this eroded the creditworthiness of The Gambia in the eyes of international financial institutions particularly the IMF and the WorldBank.

In reaction to these unfavourable macroeconomie indicators, a task force drawn from the ministries of Finance & Trade, Economie Planning, the Central Bank and National Investment Board was assembled in June 1985 to look into the situation and give policy recommendations.

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This task force recommended an adjustment programme, which was immediately adopted by the then governmell:t in August of the same year in arder to arrest the situation.

1.2 The Economie Recovery Programme

Launched in August 1985, the economie recovery programme had two broad objectives:

(a) to reverse the over-extension of government in the economie life of the country; and

(b) to create a favourable climate for private productive investment through elimination of exchange rate and priee distortions.

The following policies were recommended for timely implementation in arder to achieve the above broad objectives:

(i) exchange rate liberalization

(ii) financial sector reforms ( interest rate liberalization) (iii) reduction of the public sector (and its deficit) (iv) removal of subsidies

(v) deregulation: divestiture and privatization of State-owned Enterprises (SOEs) (vi) priee decontrol

In principle, thê government accepted that a realistic exchange rate was a strong pre-requisite in creating a conducive climate for the long-term growth of The Gambian economy. It thus introduced an inter-bank foreign exchange market on 20¹^hJanuary 1986, and adopted a managed floating exchange rate regime. Import licensing, exchange control and all restrictions on payments and transfers for current international transactions were abolished.

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To further support the floating exchange rate regime, interest rate liberalization and prudent credit policies were subsequently put in place. Interest rate liberalization was also believed to be capable ofleading to positive real interest rates, which in turn would help boost domestic savings mobilization in accordance with the Financial Liberalization Hypothesis. In particular, net credits from the Central Bank to the government and bank credits to the Gambia Produce Marketing Board (GPMB) were to be drastically reduced.²

To encourage participants in the new exchange rate regime to hold local currency (Dalasi)- denominated assets, the government removed ceilings on deposit and lending rates; raised commercial bank reserve ratios substantially, related the minimum deposit rates to the market rate of interest, which was then determined by a bi-weekly treasury bills auction.

Steps were also taken to strengthen the Gambia Commercial and Development Bank through improved loan appraisal, credit supervision and improved accounting procedures. The Agricultural Development Bank was wound up, sorne public enterprises liquidated, and others subjected to Performance and Management Contracts. A moratorium on government guaranteed loans was put in place.

The government was determined more than ev er be fore to reduce its budget deficits ( excluding foreign grants) from 12.4% of GDP in 1984/85 to 6.4% in 1985/86. Even though total revenue and grants were estimated to increase by 17% during 1985/86, total recurrent expenditure was estimated to increase by only 6% over the same period. About 2300 casual and lower grade

2 The Gambia Produce Marketing Board was later divested

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workers were retrenched and increases in public sector salaries were frozen until 1989. In addition, following the report of a consultant that reviewed the whole civil service a further

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1200 employees were retrenched and more than 800 vacant posts suppressed, all in a bid to reduce the budget deficit.

An element of direct cost recovery was introduced in health, higher education and municipal services in order to mobilize government revenues to be able to strengthen and maintain these services. Major recommendations of the Tax Reform Committee established in 1984 were adopted in order to increase efficiency and equity of the tax system.

The government also revised its public investment programme by redesigning on-going projects in order to reflect new priorities and effect cost savings. As a result of this, sorne projects were modified and others regarded as white elephants postponed or cancelled altogether. In identification of new projects, it was decided that utmost priority be given to those that addressed rehabilitation and maintenance of public assets, export generation and import substitution. New projects were only adopted if the terms were concessionary i.e. with a high percentage of grant element, soft interest payments, long grace and maturity periods. During the 1990s and beyond, the government would neither contract nor guarantee any new non-concessional extemal loans (that is, loans not entailing a grant element of at least 35 percent). Similarly, the government would neither contract nor guarantee any extemal loans with maturities of less than one year, with the exception of normal import credits. In addition to this, any loan contracted or guaranteed by the government would be subjected to prior approval from the Department of

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State for Finance and Economie Affairs (DOSFEA); it would also ensure that the recommendations in the World Bank consultant's report on the debt-reporting system were implemented to ·the letter.

As noted above, the mass retrenchments conducted were in a bid to shift expenditures from salaries to supplies and materials. A social safety net was also put in place in the form of Job- and-Skills Retraining Programme in order to prepare retrenched workers to move to the private formai and informai sectors.

The poor performance of State-Owned Enterprises, most of which were loss-making, was also a

severe strain on the whole financial system of the country. Most of these enterprises were indebted heavily to the Gambia Commercial and Development Bank (GCDP), which negatively impacted on the health of the banking sector. In order to arrest the situation, government adopted the following two strategies during the Economie Recovery Programme (ERP): (1) rationalization of public sector · activities and a moratorium on the creation of new public enterprises, and (2) systematic efforts to improve the sector's performance through use of Performance Contracts, technical assistance, and seUlement ofinterlocking arrears. The National Investment Board's capacity to monitor these enterprises was strengthened through legislation.

However the National Investment Board was dissolved and subsequently replaced by the National Investment Power Authority (NIPA) in 1994.

The total extemal debt of The Gambia, as noted above, amounted to SDR 208 million in 1985 or approximately 206% of GDP. The servicing of the debt and the attempt to eliminate arrears

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became a major drain on the limited resources of the nation. An extemal debt management policy was adopted in a bid to improve the debt maturity profile, secure official development assistance in the form of grants and highly concessionary loans and also to curtail non- concessionary borrowing. A package consisting of debt relief, rescheduling and bridge financing was successfully negotiated. The programme ended in 1989 and was to be replaced by the Programme for Sustained Development to consolidate the gains already made and avoid obstacles/ pitfalls.

1.3 The Programme for Sustained Development

In 1989, a sister programme, the Programme for Sustained Development replaced the Economie Recovery Programme in order to consolidate the gains already made and at the same time address policy mistakes, shortcomings and the negative impact of the Economie Recovery Programme especially on the most vulnerable. In principle, the Programme for Sustained Development was established to increase supply response and also incorporate to a large extent the social dimensions of the Economie Recovery Programme and thus a departure from the orthodox form of the adjustment programmes as recommended by the Bretton Woods Institutions. In other words the govemment wanted to go beyond the quantitative macroeconomie aggregates and indicators to see what was actually happening at the grassroots level and also to foster grassroots participation. From this perspective, the Programme for Sustained Development can be said to have been a step further in the bottom-up approach to development planning and included attributes that better qualifies it to be termed, a Structural Adjustment Programme. However, there are striking similarities with the ERP as would be shown below and in that regard much still remained to be desired as far as the human dimension

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1.3.1 Exchange Rate and Monetary Policy

In the managed floating exchange rate regime adopted in 1986, the rate of exchange was to a large extent de~ermined by market forces i.e. demand for and supply of foreign exchange.

Commercial banks and foreign exchange bureaus participated in an inter-bank market at which the value of the local currency (Dalasi) relative to sterling and other major currencies was freely set. This was also to be the basis of exchange rate policy throughout the Programme for Sustained Development in arder to improve the country's extemal competitiveness vis-à-vis her trading partners. During this programme, it was a major objective of public policy that the inflation rate be reduced to below 5% from around 10% by 1995 and this goal presupposes a stable exchange rate, supported by adequate international reserves.

The removal of exchange control in 1986 meant that savers in The Gambia were free to move their funds abroad with the implication that local banks would have to compete with those overseas for deposit mobilization. Thus the rate of interest obtainable abroad was the opportunity cast of funds in The Gambia. Given the strong trade links that exist between Gambia and the United Kingdom (U.K.), short-term interest rates in London would continue to exert a meaningful impact on interest rates in The Gambia. The three-month rate in London was 15%

during the inception of the Programme for Sustained Development or more than 6 percentage points above the UK inflation rate. It has been realized that the rate of interest on treasury bills in The Gambia had been significantly higher than the London inter-bank offer rate (LIBOR) since the introduction of the ERP. This was partly attributable to the lack of confidence by savers on the stability of the Dalasi (the local currency) vis-à-vis the Sterling and the undeveloped financial market. However, the premium dropped from more than 10 percentage points in

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1987/88 due to prudent domestic monetary and fiscal poli ci es and during the inception of the Programme for Sustained Development.

The Gambian treasury bill rate was only 5 percentage points above the LIBOR. It was a basic principle of The Gambia to monitor, over the Programme for Sustained Development, the level of interest rates on treasury bills in light of overall performance of the economy and developments in the U.K. and other European money markets.

It was a maJor government policy to continue to g1ve priority to market forces in the determination of interest rates in all sectors including agriculture, distributive trade and parastatals during the PSD. The government was also determined to reduce the 12% spread between lending rates of 20% and deposit rates of 8%. The spread is an indicator of efficiency of the financial system: the lower the spread, the more efficient the financial system and vice versa and government was determined to reduce this over the PSD in order to boost productive investment. Further steps in the liberalization of the financial sector and promotion of increased competition may bring the spread down. However, this is yet to be achieved and perhaps improved banking supervision, proper accounting procedures and more user-friendly information in the banking system would help locate the anomaly.

Up to the end ofthe financial year 1989/90, the Central Bank of The Gambia controlled the level of credit mainly through the imposition of direct credit ceilings on commercial banks. This has partly explained the high lending rate by banks in order to ration credit but excessively high lending rates are capable of discouraging creditworthy and 'safe' borrowers - the adverse

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selection problem. Thus over the period ofthe PSD, it was government po licy to shift from direct to indirect instruments of monetary control which would enhance greater competition and efficiency. Whether this would cause instability in the money demand function is an empirically unresolved issue that can only be established by a country-specifie research su ch as ours. ³

Over the Economie Recovery Programme, it was also realized that a large composition of the commercial banks' portfolios was composed ofshort-term deposits at the detriment oflong-term

deposits and it was to be addressed during the Programme for Sustained Development. In principle, it also aimed at decentralizing fmancial institutions to rural areas to enhance savings mobilization and access to credit by this segment of society.

1.3.2 Macroeconomie Management and the Public Finances

A key compomint of the overall economie strategy adopted under the ERP and continued in the

Programme for Sustained Development was the reduction of public sector deficit to a level where it could be financed comfortably from available resources without tending to crowd out

private sector investment. Considerable progress was made toward attainment of this during the ERP. The deficit (excluding foreign loans and grants and exceptional items) declined from 22%

of GDP in 1987/88 to 10.9% in 1989/90 and was estimated at 4.6% in 1990/91. A further reduction in the deficit was another major pre-occupation of the PSD.

3 A stable money demand function is a sine qua non for the efficacy of monetary po licy and if this shift can be shown to create instability in the function it would further complicate monetary policy execution in The Gambia.

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1.4 Monetary Policy and Financial Sector Reform Beyond the PSD

The main objective ofmonetary policy was to be the containment of annual inflation at about 3%

while maintaining an adequate level of gross official reserves. The exchange rate was to continue to float freely, and the central bank was to limit its interventions to smoothing out seasonal fluctuations and to meeting its extemal reserve objective. The monetary programme aimed at keeping broad money growth in line with nominal GDP. Accordingly, the rate of growth of broad money was proj ected to decline from sorne 22 percent in 1997 to less than 8 percent in 1998-2000. The demand for credit to the private sector was expected to expand at rates exceeding the growth rate of broad money, as the targeted reduction in the domestic indebtedness of the govemment was expected to lead to a graduai decline in interest rates.

The monetary authorities were to follow closely the excess reserves of the banking system and continue to rely" on indirect instruments, in particular, auctions of treasury and central bank bills.

To enable the central bank to sterilize excess reserves more effectively, more reliance was to be gradually placed on the issuance of central bank bills for monetary policy purposes. Liquidity management would aim at ensuring that short-term domestic interest rates remained positive in real terms, with appropriate differentiais vis-à-vis interest rates abroad. The central bank would also aim to substantially improve the functioning of primary and secondary markets. Regarding the primary market, more frequent auctions of wider maturities of the eligible paper would be held, the current, paper-based book-entry system would be computerized to lower the cost of secondary trading.

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To develop secondary markets, the central bank would limit the period open for the rediscounting of treasury bills, start signaling changes in money market conditions by adjusting its rediscount rate between auctions, and initiate the establishment of a formai secondary market in treasury bills, inter-bank deposits, and foreign exchange. The monetary authorities would refrain, however, from acting as a market maker. Moreover, after sufficient preparation and the strengthening of the liquidity management framework, the central bank was to gradually shift the trust of its liquidity operations from primary auctions to short-term repurchase agreements with commercial banks. In the area of secondary market development, the authorities would request technical assistance from the Fund.

To increase the efficiency of financial markets further and spur the development of secondary markets, and in line with the 1994 Fund technical assistance report on improving financial markets and monetary policy implementation, reserve requirements would be unified, liquidity requirements gradually reduced, and compliance with both regulations would be required on an average biweekly, rather than daily, basis. In addition, inter-bank deposits would be excluded from the deposit base used for reserve calculation. Financial market transparency would be promoted through timely publication of interest and ex change rates, and of commercial banks' fees and charges. Finally, the central bank would allow commercial banks to accept foreign currency deposits, conditional on their final financial situation and the observance of the related supervisory requirements and foreign exchange exposure limits, which would replace the current ceilings on foreign ex change holdings by commercial banks in earl y 1999.

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The Gambian "financial sector has remained highly concentrated in recent years and the government views an expansion in the number of financial institutions, including banks, as essential to enhancing competition within the sector and stimulating financial intermediation.

The failed Meridien Bank, control of which was assumed by the central bank in 1995, was restructured and recapitalized as the Trust Bank, and was to be offered for sale during 1998. The

monetary authorities recognize the importance of leasing companies, as well as of informai loan and savings schemes (such as the Village Savings and Credit Associations (VISACAs)). Of the twenty three VISACAs currently operating, six are registered with the central bank, which will continue to offer assistance by disseminating recommended operating rules and organizing education campaigns.

1.5 Evolution of Monetary and other Macroeconomie Aggregates

The evolution of real broad and narrow money before and beyond the ERP was also examined.

From this table calculations were also made to determine the difference _9etween narrow money balances (M ₁₎ and broad mo ney balances (M₂₎ which is a good proxy for financial saving through the banking sector. The growth in this proxy for financial saving in the banking sector fluctuated greatly from 1974 to 1989. However, from 1990 to 1997 there was steady growth in real terms thus suggesting that the financial sector reforms now beginning to take effect, would very likely increase savings in the banking sector. This is also in line with the postulates of the financialliberalisation thesis. The following tabl~ (table 1.4.1 on page 19) sheds more light on the evolution of real money balances in The Gambia before the adoption of the ERP (1974-1984) and after its implementation (1985-1997).

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year 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 : 1984 1985 1 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

To evaluate "financial repression" and the impact of financialliberalisation on the real interest rate (deposit rate), the trends of the real deposit rate (nominal deposit rate less the rate· of inflation) were also presented in table 1.4.1. From the period 1973 to 1987, the real deposit rate was negative and this represented the period of financial repression in The Gambia. From the period 1988 to 1997, the real interest rate became positive and this also lends sorne support to the view that financialliberalisation can lead to positive real interest rates. Prima facie, the positive real interest rate was expected to impact positively on savings mobilization in The Gambia.

Table 1.4.1: Evolution of basic macroeconomie aggregates in The Gambia, 1973-1997

Inflation Deposit Rate M2 Ml M2-Ml FIR RGDP NGDP (M2-M1)/gdp

6.9 -3.6 ^311.3 ^257.7 ^53.6 ^0.34 ^610.3 ^119.7 ^0.05

9.2 -3.5 ^313.3 ^245.0 ^68.3 ^0.28 ^731.3 ^180.7 0.05

25.9 -4.0 ²⁸²^.3 ^220.0 ^62.2 ^0.26 ^685.6 ^203.5 0.05

17.0 -3.2 ^352.0 ^248.8 ^103.2 ^0.29 ^724.3 ^245.2 ^0.08

12.4 -2.1 ^275.3 ^178.3 ^97.0 ^0.22 ^733.3 ³⁰⁸^.5 ^0.07

8.9 -3.9 ^369.0 ^237.8 ^131.3 ^0.32 ^706.0 ^314.9 ^0.10

6.1 -1.1 ³¹⁸^.7 ^224.0 ^94.6 ^0.24 ^819.1 ^359.5 ^0.07

6.8 -1.8 ^329.2 ^222.4 ^106.8 ^0.22 ^776.0 ^367.3 ^0.08

5.9 2.6 ^375.8 ^263.8 ¹¹²^.0 ^0.29 ^848.1 ^407.8 ^0.08

10.9 -2.4 ^392.6 ^269.6 ^123.0 ^0.27 ⁹⁵⁵^.5 ^461.6 ^0.09

10.6 -2.1 ⁴⁴⁹^.7 ^280.3 ^169.4 ^0.33 ^897.1 ^520.9 ^0.12

22.1 -13.1 ^388.5 ^227.9 ^160.6 ^0.28 ^926.3 ^576.3 ^0.12

18.3 -8.5 ^496.9 ^313.5 ^183.4 ^0.35 ^914.5 ⁷¹⁷^.6 ^0.13

56.6 -40.5 ^340.5 ^205.7 ^134.8 ^0.25 ^991.6 ^911.6 ^0.12

23.5 -7.7 ^343.5 ^197.8 ^145.7 ^0.24 ^1040.5 ^1040.5 ^0.14

11.7 3.3 ^352.9 ^191.2 ^161.8 ^0.22 ^1052.1 ^11161.5 ^0.16

8.3 4.6 ^393.8 ^215.2 ^178.5 ^0.23 ^1125.7 ^1439.0 ^0.15

12.2 -0.9 ^380.2 ^218.2 ^162.0 ^0.22 ¹¹⁴³^.5 ^1764.4 ^0.12

8.6 4.1 ^440.2 ^267.1 ^173.1 ^0.22 ¹¹^79.0 ^1819.1 ^0.14

9.5 4.3 ^457.6 ^269.7 ^187.9 ^0.24 ^1219.0 ^1881.0 ^0.16

6.5 6.5 ^512.9 ^284.3 ^228.7 ^0.26 ^1255.6 ^1937.4 ^0.19

1.7 10.9 ^474.4 ^241.3 ^233.1 ^0.24 ^1258.1 ^1941.2 ^0.20

7.0 5.5 ^517.2 ^266.5 ^250.7 ^0.26 ^1269.4 ^1958.7 ^0.22

1.1 11.4 ^535.9 ^251.1 ^284.8 ^0.26 ^1297.4 ^2001.8 ^0.26

2.8 9.7 ^645.7 ^338.9 ^306.8 ^0.30 ^1367.4 ^2109.9 ^0.27

Source: Adapted by the author from IFS and world tables (various publications). The calculation ofproxy for financial saving in the banking sector is the author's own.

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A financial deepening indicator also known as the financial intermediation ratio (FIR), measured in this study as the ratio of real broad money to real GNP (M2/GNP), was also calculated and presented in the same table to shed light on the relationship (if any) between financial liberalisation and development of the fmancial sector in The Gambia. The indicator tends to suggest that financial liberalization has not been accompanied by financial development. The limitations of this traditional indicator aside, one might conclude that since the ratio did not rise beyond 30% from 1986 to 1997 whereas prior to the adjustment programme, the value reached a peak of 35%, the ratio is not responsive (at least positively) to the financialliberalization policy.

On the other hand, the ratio of financial savings in the banking sector as a proportion of GDP increased over the period of the study especially after financial liberalisation period as can be seen on the relevant table.

1.6 Conclusion

The role of the donor community, in the form of foreign assistance, in order to continue the programmes and policies begun under the ERP to build up foreign reserves and to raise the living standards of The Garn bian people at a faster rate than achieved during the ERP, was also central in the PSD. The Donor Conference was to serve as a forum to discuss the nature of development

assistance needed in support of the PSD. The PSD, as noted above, reinforced the ERP policies and the social services benefited greatly in terms of a major revision and redirection of public expenditure programs. The share ofhealth and education in current expenditures increased again and reached about 35% in 1992/93. Success was also recorded in the decentralization process and involving the population to partake in national development issues during this programme.

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CHAPTERTWO

LITERA TURE REVIEW

2.1 Theoretical Background on Interest Rate Liberalization

Up to the earl y part of the 1970s, there were two sets of opposing theories as far as interest rate policies were concemed. These were classified as the classical-neoclassical theories of growth and the Keynesian counter arguments. The classical-neoclassical thesis postulates that high interest rates have a positive, significant and a direct impact on savings and hence investment.

The Keynesians, however, postulated that low interest rates help to boost investment and income resulting in higher savings mobilized. It can be construed, therefore, that in the classical- neoclassical position, saving is tak:en as the dominant determinant of growth and development whereas Keynes and his disciples consider investment as the dominant determinant. Even though their policy prescriptions differ, the important role of the interest rate is recognized in both theses. As a result of this, interest rate policies differed from countries depending on whether they are adherents to the Keynesian or classical-neoclassical policy prescriptions.

In 1973, Mckinnon and Shaw criticized both ofthese earlier theories. The two authors introduced the notion of « Financial deepening » ⁴which is a measure of the efficiency of capital allocation by diverting more resources to where there are better investment opportunities. In his submission, Mckinnon stated that domestic capital markets in developing countries and their

4 This is measured as the ratio ofbroad money to GNP (or GDP)

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modus operanda are affected by monetary and fiscal policies. The prevalent theories of monetarism and financial processes whether of Keynesian or Monetarist leanings, he went on, could not exp lain the predominant role/ paramouncy of real money balances in the operation of capital markets in developing countries.

He dismissed the Keynesian madel on the grounds that it was « purely short-term oriented » such that as soon as available savings are used up in current investment, the madel did not clearly state how new savings would be generated to meet further investment requirements. He contended that the theory is also irrelevant to developing countries where savings, and not investment, are considered to be the major constraint on the development equation.

On the neoclassical monetary theory, Mckinnon(1973) attacked and dismissed it for positing a competitive relationship between real money balances and capital accumulation. He asserted that the competitive relationship presented in the madel would imply that an increase in say, real money balances, following high real interest rates, would lead to a reduction in investment (Mckinnon, (1973), pp. 42-50).

This brings us to his complementarity hypothesis which states that real money balances and physical capital are complementary and not substitute items. This complementarity means that large and fast-g;rowing real cash balances promote rapid growth in investment and aggregate output. It was argued in this madel that low and negative reallending and deposit interest rates reduce real cash balances, and hence measures to eliminate financial repression will increase real cash balances and enhance savings and investment, and thus growth.

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The above arguments were represented diagramatically by Maxwell J. Fry (Fry 1988, p.16) in order to throw more light on the theoretical underpinnings why financialliberalization should be desired and adopted as a public interest rate policy prescription compared to financial repression.

The figure as adapted by the author from Fry (1988) is presented in the next page.

Savings and investment are on the horizontal axis while the real interest rate is on the vertical axis. The diagram depicts the theoretical postulates of a positive relationship between the real interest rate and savings on the one hand, and the inverse relationship between investment and the real interest rate, on the other. According to the authors (Mckinnon and Shaw), administratively determined nominal interest rates which characterized most developing countries at the time, holds the real interest rate far below its equilibrium level. In the diagram, given initial investment function (I) and savings function (S0 ) financial repression is represented by line RR, which amongst other things, consists of administratively determined nominal interest rate po licy that, as a matter of fact, holds the real interest rate far below its market clearing leve!

at z.

23

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Fig 1 : Savings, investment and the real interest rate

Real interest rate

r 3

r 1

r 0

Jo 1

1

1 2

Savings and Investment

R

This po licy holds the real interest rate at r0. Actual investment achievable with this rate of interest is Io, which is the arnount of saving mobilized at the real interest rate of r0. Also ceilings are put on lending rates, i.e. if r₃that would bring about equilibrium is not allowed, then non-priee rationing of excess demand for limited loanable funds would arise equal to VK

In such a case, credit allocation becomes less sensitive to transactions costs and perceived risk of default, and becomes more likely to be subjected to such other considerations as the quality of collateral, political pressures, loan size and covert benefits to loan officers. Consequently savings are likely to remain at low levels, and hence investment, since savings is the primary factor theorized to determine the real supply of credit. A second and equally important consequense is that investible funds are inefficiently allocated by means of non-priee criteria as a result of which

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funding is likely to take place for a good number of low-yielding investments. This would negatively impact on output growth and hence employment in the overall economy.

Development of the financial sector and economie performance are seriously impaired by these two features.

On the other h~d, relaxation of the degree to which the financial system is repressed is expected to have positive effects on savings. Considera higher nominal interest rate corresponding to the lineR¹R¹with a real interest rate such as r1. This policy change will reduce the number of low- yielding investments previously funded at RR, thus increasing the average efficiency of investment. This increases the economie growth rate and shifts the saving rate function to S₁as shown in the diagram. The increase in the saving rate arises because increase in average efficiency of investment means increased productivity of investment which yields higher economie growth . This will consequently increase the level of economie activity, and all things being equal, output will also increase. Since savings is a positive function of output, it is also expected to respond positively by this theory.

Actual investment will also be higher at this rate of interest because of the increase in savings.

Thus the real interest rate as the return to savers, is very central to any policy that aims at increasing the lev el of investment. This increase in both quantity and quality of investment has a strong positive effect on economie growth. Growth in the financially repressed economy is therefore considered to be constrained by savings rather than investment opportunities (Mckinnon, 1973, pp. 59-61; Shaw, 1973, p.81).

25

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The policy recommendation arising herefrom requires that, a financial liberalization process, which will eventually liberalize interest rate ceilings be implemented in those countries whose financial systems are repressed. This, Mckinnon and Shaw hypothesized, will not only result in increased savings and loanable funds but also in a more efficient allocation of these funds both of which contribute in their own small ways to higher economie growth rates. The equilibrium condition as shown in the diagram, would give rise to a real interest rate of r2 and savings and investment equâl to h. The market for loanable funds equilibrates by the interaction of the forces of demand for and supply of funds.

The works of Mckinnon(1973) and Shaw(1973) gave rise to the financialliberalization theory which states that liberalization of the financial sector from interest rate ceilings and other restrictions promote economie development and growth because higher rates of interest make for increased savings and greater efficiency in capital allocation. ⁵Is this submission true as far as The Gambia is concemed ? It must be noted that it was amidst such controversy as will be demonstrated in the literature that will follow that this policy was recommmended for financ.ially repressed economies. The responsiveness of savings to interest rate changes was characterized by mixed results and conclusions even in countries like the United States.This controversy aside, the implications of the policy on demand for money and its stability did not also attract much attention at the time. These are the issues that our study intends to investigate.

2.2 Theoretical Background on the Demand for Money

The money demand function is not of theoretical interest by itself but it is because it pla ys a key role in monetary targeting. It is for this reason that the money demand function has been more

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subjected to the rigours of regression estimation, scrutiny and monitoring, than any other behavioural function from macroeconomie theory. But the specification of a stable money demand function with good predictive properties eludes researchers even today.

Since Goldfield's discovery of missing money (1976) soon after his revisit to money demand (1973), several problems have cropped up in the theoretical expositions of the money demand function. A who le spectrum of attempts has ensued, since then, to improve the predictive powers of the money demand function. These attempts have included use of sophisticated estimation techniques, flexible lag structures, flexible functional forms, stochastic parameter models, new additional variables such as the own rate on money, expected rate of inflation, non-human wealth and so on into the money demand function (Cuttbertson, 1985). There is no doubt that these efforts have proved successful but there is always scope for further improvement.

The standard single equation log-linear money macroeconomie demand function supposedly derived from ut~lity maximization is given by:

where

Mt*= desired real money balances

y = real national incarne for the scale variable r = real rate of interest.

The partial adjustment framework assumes that nominal money holdings adjust according to the following formula:

LnMt- lnMt-1 =à( lnMt* -lnMt-1) +Ut ... (2)

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Substituting (1) into (2) and rearranging yields

Ln Mt= à(ao + a1lnyt + a2lnr) + (1-à)ln(Mt-IIP) +Ut ... (3)

The above equation (equation 3) is the partial adjustment version of the short-mn real money demand function. From this theoretical basis, a number of empirical studies have been carried out in order to estimate the money demand function and sorne in fact went further to test it for stability.

Our study intends to review recent empirical findings on the determinants of this important function and test it for stability as far as Gambian data is concemed.

2.3 Empirical Literature Review on Savings

The Shaw and Mckinnon hypothesis as highlighted above has sparked a number of studies geared primarily towards investigating empirically, the proposition with regard to savings, investment, growth and financial development/deepening. For the purpose of this paper, the impact of the policy on domestic savings and money demand , as highlighted above would be examined.

Fry in 1978 undertook a study of seven Asian countries using pooled time series analysis on annual observations. He estimated a domestic savings function by two-stage least squares with country dummy variables method (TSLSDV). The savings rate was regressed on the real growth rate, real per capita income, foreign savings as a ratio of GNP, the real interest rate and the domestic savmgs rate lagged one period. His main emphasis here was on the relationship

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between the domestic savings rate and the real interest rate. The impact of the real interest rate was positive and significant and he concluded that positive real interest rates do indeed matter for domestic savings mobilization for investment. However, Fry did not subject the variables used to stationarity and cointegration tests, which we think would have improved his important findings. Again the demographie factor was not taken into account and our study intends to fill this gap.

In 1984, Yusuf and Peters did a similar study on Korea but estimated the aggregate savings function using Ordinary Least Squares (OLS) technique. They regressed aggregate savings on current income, permanent income, growth rate of income, rate of inflation, foreign savings and the real interest on time deposits.

Their regression results indicated that all the estimated equations performed well in terms of standard error of regressions, which ranged from 0.06 to 0.087. They concluded that a 10%

increase in the real interest rate on time deposits would raise gross savings⁶by 11.57% and gross domestic savin~s by 5.03%. The policy implication is similar to that of Fry's that financial conditions (high interest rates) impact positively on aggregate savings performance.

In their study of six West African countries Leite and Makonnen (1986) estimated a private savings function by the weighted least squares method, using normalized variables which were corrected for heteroscedasticity. Their private savings function was regressed on disposable income, real interest rate, exports as a proportion of GDP and the lagged dependent variable.

6 Gross Savings = Gross domestic Savings + Foreign grants and Private transfers 29