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Keywords: Interest rate pass-through, retail interest rates, Turkish banking system, ECM JEL Classification Codes: E43, E52, G21
1. Introduction
This study deals with the relationship between a money market rate and banks retail rates in the banking system of Turkey by empirically examining the pass-through that is defined as the degree and the speed of adjustment of interest rates to money market rate. Most central banks use a short-term interest rate as their instrument of monetary policy. Changes to this short term interest rate are the first important stage in the transmission of monetary policy. The transmission mechanism is usually sluggish and incomplete in the short term but rather complete in the medium and long-term. Thus, changes in the local currency money market rate, induced by monetary policy decisions or by changing conditions in the money market, are transmitted to local currency bank retail rates but only with lags. The speed of response is usually associated to the effectiveness of monetary policy, so measuring the pass-through is crucial to improving the understanding of the whole process. The primary concern in this study is twofold: First, I want to investigate empirically the relationship between a money market rate and banks retail lending rates. Second, I would like to highlight one of the main factors that influence the price setting behavior of bank in a developing economics context. For this aim, a single equation error correction models (ECM) is used in order to quantify the degree and the speed of pass through and estimate symmetric and asymmetric dynamic adjustment of interest rates in the Turkish banking system both in long and short run.
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"The first version of this paper was prepared with Professor Ilyas Siklar and presented at Singapore Economic Review Conference 2007, (2-4 August 2007). The author is deeply indebted to Professor Ilyas Siklar for his superb advice and contribution regarding methodology and furnishing data. "
The remainder of the paper is organized as follows; the following part provides a brief review of related theoretical and empirical literature. Section three presents some relevant background on the Turkish economy. Section four discusses the methodological issues and presents empirical results that are obtained. Finally, in section four, includes some concluding remarks.
through of market conditions to retail bank interest rates in Hungary with a panel of bank deposit and loan rates. They find out a clear difference in the pricing of household and corporate instruments.
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NTL Billion Total assets Loans Securities portfolio Deposits Source: BRSA Annual Report 2006
The total amount of deposits of the sector as of the end of December 2006 was 307.6 billion NTL (approximately 219,28 billion USD). 186.3 billion NTL (approximately 133,07 billion USD) of these deposits are denominated in TL, and 121.4 NTL billion (approximately 86,71 billion USD) in FX. The fact that 87.3% of the total is held by the 10 large-scale deposit banks shows the high level of concentration in the sector. The maturities of most of the deposits are short-term. Deposits having maturities of less than three months constitute about 95.2% of total deposits. Since 2002, total assets of the Turkish banking system have been growing steadily. As of 2006 total assets reached 499.7 billion NTL (approximately 321,21 billion USD) (BRSA, 2006).
4. Methodological Issues
4.1. The Data The data set consist of three interest rate series, called money market rate, lending rate and deposit rate. Data were collected from the Electronic Data Dissemination System of the Central Bank of the Republic of Turkey for money market rate and deposit rate series and from Turkish Banking Association reports for lending rate series. Monthly data covering the period April 2001 up to June 2007 is used in the analysis. This period has been chosen for two reasons. First, it is this period when credit channel of Turkish Banking System (TBS) has started to work properly and total assets of TBS have been growing steadily. Second, prior to this period the CBRT was not independent. The time series of variables used in this study are shown in Figure 1.
Figure 1: Trends in Money Market, Lending and Deposit Rates
.9 .8 .7 .6 .5 .4 .3 .2 .1 2001 2002 2003 MMR 2004 LR 2005 2006 DR
4.2. Method of Estimation In order to analyze dynamic interest rate adjustment between the policy controlled interest rate and the interest rates on loans or deposits, symmetric error correction model (ECM) is used as a starting point.
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In this model, short run dynamics are linked to long run equilibrium. Our specification of the ECM takes the following form:
I i =1 J
rt = i rt i + j mmrt j + ectt 1 + t
j =0
(1)
where rt denotes deposit rate (dr) or lending rate (lr), mmr is the money market over-night interest rate, and ect is the error correction term estimated from the respective cointegration regressions and t is the error term assumed to be normally distributed and not serially correlated. The term ect is one period lagged deviation from the long run equilibrium. The speed of adjustment parameter is , which has a sensible economic interpretation if it has a positive value. The interpretation of speed of adjustment value follows this example. If estimated of -0.25, this indicates that in a case of a shock to the deposit or lending rate which changes its value relative to equilibrium value, the one forth of divergence is eliminate in the following period. Following Scholnic (1996) and Kleimeir and Sander (2000), asymmetric error correction model is also estimated in order to find out if interest rates adjust differently to the cases in which they are below or above their equilibrium levels. In this framework error correction terms from the cointegration regression is separated into two components (Kleimeir and Sander, 2000, pp.8), such that;
ectt+ = ectt if ect > mean (ect ) ectt+ = 0 otherwise
(2)
and
ectt = ectt if ect < mean (ect ) ectt = 0 otherwise
(3)
The positive errors ( ect t+ ) in equation (2) implies that if the deposit or lending rate is above its equilibrium value following a decline in the money market rate, then it will start falling in the next period. Similarly, the negative errors ( ectt ) in equation (3) means that if deposit or lending rate is below their equilibrium value following an increase in the money market rate, they will start increasing in the subsequent period. Now the specification of asymmetric short run dynamic equation takes the following form:
I i =1 J
(4)
The estimated coefficient of 1 measures the speed of adjustment in response to the previous period disequilibrium relationship between deposit or lending rates and money market rate when rates are above their equilibrium level whereas the estimated coefficient of 2 measures the speed of adjustment in response to the previous period disequilibrium relationship between variables when rates are below their equilibrium level. The test of whether retail interest rates adjust asymmetrically is whether 1 is significantly different from 2, and if, 1>2 for deposits, banks are quicker in adjusting deposit rates downwards than they are to adjust them upwards while 2>1 in the loan market implying that banks adjust lending rates upwards faster than they are to adjust them downward. 4.3. Empirical Results In the first stage, the order of integration is tested using the Augmented Dickey Fuller (ADF) unit root tests. Unit Root tests are conducted to verify the stationarity properties (absence of trend and long-run mean reversion) of the time series data so as to avoid spurious regressions. A series is said to be (weakly or covariance) stationary if the mean and autocovariances of the series do not depend on time. If a time series has a unit root, a widespread and convenient way to remove non-stationarity is by taking first differences of the relevant variable. A non-stationary series which by differencing d times transfers to a stationary one, is called integrated of order d and denoted as I(d) (Charemza and
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Deadman, 1997). In order to investigate the time series properties of the variables the sequential testing procedure suggested by Holden and Thompson (1992) is used. The main advantage of this procedure is that it takes into account the full data generating process with drift and trend terms and tests the null hypothesis of unit root sequentially.
Table 2:
Variable
Levels First Difference Lag Order Test Statistics Probability Lag Order Test Statistics Probability dr 1 -1.04 0.93 1 -5.87* 0.00 lr 4 -0.23 0.99 1 -5.81* 0.00 mmr 1 -0.57 0.98 0 -6.23* 0.00 Note:* Denote rejection of null hypothesis at the 5% and level. Number of lags were chosen in accordance with the Schwarz info criterion. Critical values are from McKinnon (1996).
The results of the test for all variables are presented in Table 1. The results show that each of the series is non-stationary when the variables are defined in terms of levels. First differencing the series removed the non stationary components in all series, concluding that all series are integrated of order one. Engel and Granger (1987) argue that, although a set of economic series are not stationary, there may exist some linear combination of the variables that is stationary. Now, we proceed to test for cointegration in the data series in order to test whether there is a long run relationship between the variables. The ADF test on the residuals based on the regression of money market rate and lending rate, and the money market rate and deposit rate, show that the residuals are indeed I(0), enabling us to conclude that both the deposit and lending rates are cointegrated with the money market rate. This study uses the Johansen (1988) approach to test for co-integration. The Johansen co integration procedure gives the results as reported in Table 3 for lending rate and money market rate relation and in Table 4 for deposit rate and money market rate relation. The maximum eigenvalue and trace statistics show that there are one cointegrating vector between lending rate and money market rate, and deposit rate and money market rate financial development proxies and economic growth at the 5 per cent level This confirms the existence of an underlying long-run stationary steady-state relationship between the bank interest rates and the developments in money market rates.
Table 3: Lending Rate Money Market Rate Equation
Null r=0 r 1 Alternative r =1 r=2
Maximun Eigen Value Statistic %5 Critical Value Probability 34.62 19.39* 0.00 10.08 12.52 0.12 Trace Test Statistics Null Alternative Statistic %5 Critical Value Probability r=0 r1 44.69 25.87* 0.00 r1 r=2 10.08 12.52 0.12 Note:* Denote rejection of null hypothesis at the 5% level. Critical values are from Mc Kinnon, Haug, Michelis (1999)
Table 4:
Maximun Eigen Value Statistic %5 Critical Value Probability 22.82 19.39* 0.02 7.62 12.52 0.28 Trace Test Statistics Null Alternative Statistic %5 Critical Value Probability r=0 r1 30.44 25.87* 0.03 r1 r=2 7.62 12.52 0.29 Note:* Denote rejection of null hypothesis at the 5% level. Critical values are from Mc Kinnon, Haug, Michelis (1999)
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The estimates of the normalized cointegrating vector (long run) which shows long run adjustments for lending rate-money market rate relation and deposit rate-money market rate relation is shown with following equations; Normalized cointegrating vector: lr 1.192(mmr) (5) (0.052) and Normalized cointegrating vector: dr 1.054(mmr) (6) (0.050) Based on equation (5) and (6), it can be said that the long run adjustment of lending rate and deposit rate with respect to 1 percent change in money market rate is 1,192 and 1,054, respectively which implies that in long run there is complete pass through from changes in money market rate to banks retail rates.
Table 5:
Variable Intercept lrt-1 drt-1 mmrt-1 ecmt-1
ecmt+1 ecmt1
Wald statistics 0.29 R2 0.33 0.29 0.21 DW 1.86 1.41 1.97 Note: First numbers are estimates for the coefficients and t-statistics are displayed in parentheses
After employing Enders (1995) and Hendrys (1986) General to Specific Paradigm 2 lags, a constant and a trend is included in to ECM model. A number of lags for each of the three variables have been included to capture the short-run dynamic relationship in the ECM system. Table 5 gives the results of the dynamic short run adjustments estimated for symmetric ECM model and asymmetric ECM model. In both the lending rate-money market rate relationship and the deposit rate-money market rate relationship, the coefficients on the error correction terms are significantly negative as required. The symmetric short run adjustment of the lending rate following a deviation from long run equilibrium in the previous period is 0.35 for lending rate and 0.12 for the deposit rate. As stated earlier, according to customer reaction hypothesis, one may expect greater rigidity in deposit rate decreases and in loan rate increases due to customers unfavorably reactions to unstable rates. Second, especially in concentrated markets, deposit rates may be more rigid upwards and lending rates may be more rigid downwards due to cost of the breaking collusive pricing arrangements of banks. The estimated coefficients of the asymmetric adjustments are in line with the common intuition, although they are both statistically insignificant at the 5% significance level. According to the estimated model, the lending rate adjusts downwards by 0.19 following a previous periods decline in the money market rate, compared with an upward adjustment of 0.50 and deposit rate adjusts downward by 0.10 and upward by 0.69 in response to disequilibrium in the money market. As a final step, a Wald test is used in order to test whether estimated asymmetric coefficients are significantly different from each other. As Scholnic (1996) states, if 1 is not significantly different from 2, this implies that there is no significant asymmetry where the retail rate is increasing as opposed to decreasing An important step in the analysis of asymmetric adjustment is to test whether
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the estimated asymmetric coefficients are equal. From the bottom part of table 5, one can see that the null hypothesis of equal adjustments cannot be rejected as the Wald statistics are significantly less than the critical value (2(1) = 1.94) at 5% level of significance. Therefore, lending and deposit rates adjust equally to a change in money market rate.
5. Conclusion
In this paper, we investigate the symmetric and asymmetric adjustments of retail interest rates to money market rate in Turkey for the period between April 2001 and December 2006. This process is important since the speed and the degree of response is usually associated to the effectiveness of monetary policy. The empirical results show that Turkish Banking System adjust completely their interest rates to changes in the market rates in the long run, while in the short run lending rate shows more flexibility relative to deposit rate. In addition, greater rigidity is find in deposit rate decreases which is in line with customers negative reactions hypothesis and greater rigidity in lending rate decreases which is in line with in collusive pricing arrangements of Turkish banks due to concentrated structure of the System. Finally, empirical results presented in this paper suggest that retail interest rates does not adjust asymmetrically to an increase or a decrease in money market rate in Turkey.
References
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