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SAVINGS AND INTEREST RATE: THE CASE OF KENYA / PARGNE ET TAUX D'INTRT: LE CAS DU KENYA Author(s): Jean-Paul Azam Reviewed work(s): Source: Savings and Development, Vol. 20, No. 1 (1996), pp. 33-44 Published by: Giordano Dell-Amore Foundation Stable URL: http://www.jstor.org/stable/25830565 . Accessed: 24/10/2012 07:43
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SAVINGSAND INTEREST RATE:THE CASE OF KENYA*

Jean-Paul Azam CERDI, Universite d'Auvergne

1. Introduction The part that the interest rate should play in the economic policies of developing countries is stilla hotlydebated issue, from both a theoretical and an empirical point of view. Among the reasons for disagreement between the researchers is the fact that the government only controls, ifat all, the rate of interest in the formalmarket. Many economists argue that thisofficialratedoes notmatter, because itis the informal curb) (or market thatdetermines the relevant (marginal) rate of interest.Fry (1988) and Montiel, Agenor and Haque (1993) have recentlyprovided useful surveys of this issue,while Calvo (1992) has raised sceptically the relatively new issue of its role in fighting inflation. Nevertheless, there isa widespread consensus that interestrates should be liberalized, if only because of their impacton the quality of investment (Collier and Mayer, 1989). However, the debate over the impact of the real interest rate on savings behaviour in as developing countries seems to have ledmany authors to dismiss this link empirically can only improve The implication thisview isthat interestrate liberalization of unimportant. the quality of investment, but notmuch its quantity inthe long run.Fry (1988) discusses some of the empirical results in thisarea, and defends the view that there isa critically positive impacton savings, forthe case of various Asian countries. In the case of Kenya, Mwega, Ngola and Mwangi (1990) and Oshikoya (1992) have tested the impact the real interestrateon totalor private domestic savings, with negative of and non significant results. The case of Kenya is particularly importantforat least two reasons. First, itiscertainly the country Africa with themost developed financialsector in (Grosh, 1990, Killickand Mwega, 1990, Azam and Daubree, 1995). It is thus the country most important macroeconomic where a priori financial variables should potentiallyplay the role in Africa. Hence, it isespecially interestingto see what contribution thissector can make to the determination of savings and growth, inorder to evaluate the potential for otherAfricancountries. Second, this boosting thedevelopment of such a financialsector in aftera prolonged period of financial countryadopted a program of financial liberalization, on repression. The real rateof interest bank deposits became positive inthemid-1980s,
* This paper is a falloutof a study done with Cecile Daubree for theO.E.C.D. Development Centre (Azam and Daubree, 1995) within a program directed by Jean-Claude Berthelemy. Iwish to thank them both, without Development centre, implicating.The views expressed herein do not necessarily reflect those of the O.E.C.D. I wish also to thank IbrahimElbadawi, JeffreyFine, Njuguna whose financial support is gratefullyaknowledged. Nairobi, as well as thewhole A.E.R.C. Mwangi, Francis Mwega, Benno Ndulu, and Cameron Short fortheirhelp in network.

33

SAVINGS AND DEVELOPMENT -No. 1 - 1996 -XX

afterhaving been negative ever since 1971. The real rateof interestis represented below at figure2, forthe period 1967-1990. Hence, we want to knowwhether such a move has an impacton savings and growth. The present paper presents econometric equations with the opposite result to those on described above, showing a positive and significant impactof the real rate of interest We argue that the impactof the interest rate on savings cannot be captured savings. unless due account is taken of the role that financial repression plays inshaping the relationshipbetween them.This isprobablywhat the previous studies cited above failed to do. The theoretical discussion of thispoint ispresented insection 2 below, while the econometric results are described insection 3. 2. Financial Repression and the Impact of the Interest Rate on Savings

The main drawback of theprevious studies devoted to the link between the interestrate and savings behaviour in account the regime switches Kenya is thatthey failed to take into entailed by the succession of periods of financial repression and financial liberalization. During the former,the real interest rate paid on deposits is appearently negative, and sometimes verymuch so. Then, basic principles suggest thattheobserved rateof interest thatbanks serve on deposits should not be interpreted face value, as itis not the only at benefit that households derive fromholding such bank deposits. Otherwise, theywould assets like just have to cash in theirdeposits and invest insome kind of inflation-proof storable goods to be better off.Hence, bank deposits serve some other purpose, that households view as valuable to such a point that theyaccept willingly to hold thiskind of asset, which pays a negative real rate of interest. This issue is not foreignto the question ofwhy households hold non interest bearing money, which afterall pays an even more negative rate of interestthan bank deposits in timesof financial repression. The usual answer to thispuzzle bymonetary theorists is that on services, which are in factan implicitinterest holding money provides some liquidity them. For example, Levhari and Patinkin (1968) discuss how the implicit flowof income derived from holding cash balances is related to the interestrateon alternative assets. One can imagine various aspects of the implicit interestpaid by banks on deposits. For example, holding positive deposits with a bank might be an investment ingoodwill by banks provide more easily consumption loans to their usual depositors than households, if to anybody else. Then, holding deposits with the bank may be a way of keeping an entitlement to a loan, and plays the part of some kind of insurance contract. Moreover, banks may provide various other services like legal advice or information gathering on 34

J. P. AZAM -SAVINGS AND INTEREST RATE INKENYA

investment opportunities, that theyonly deliver freeof charge to theirregularcustomers. One may thusassume thatthe implicit interest paid on deposits plays a more important part in inducingthe household to deposit themarginal shillingat the bank when the real rate of interest is negative thatwhen it is positive. In the latter case, households may some money with theirbank just because it a positive interest, without the pays deposit other services playing any part at themargin. Inotherwords, one may view the relevant as rateof interest the sum of theexplicit interestrate, which is measured by the published rate of interest, which is usually notmeasured by any rate of interest, and of the implicit rate isproportionatelymuch more important when number.We assume that the implicit the real rate of explicit interest is negative thanwhen it ispositive. Moreover, bank deposits are not the only store of value thathouseholds can hold for storable goods, buildings, wealth. They can hold various physical assets, like keeping their market to some cattle, etc. They can also lend money in the informal granaries, entrepreneurs of their relatives, etc. Hence, when analysing the impact of the rate of on on interest saving, one should infact take into account, beside the rateof interest bank the rates of returnof some other assets that households may hold in their deposits, portfolios.For the sake of parsimony, the normalway toget around thisproblem is to look on some representative rateof return theentire portfolio held by the household. Unless for theasset market isdramatically distorted,we can safely assume that the various rates of are linkedtogether by the households portfoliobehaviour. Hence, inequilibrium, return one may assume that the composite rate of intereston deposits described above, comprized of the explicit and the implicitinterest, isequal to representative rate of return on the household's entire portfolio. Otherwise, theywould either give up completely the was below the representative rate,or put the holding of deposits, if composite interestrate all theircapital inbank deposits, inthe reverse case. Hence, the assumption thatwe are testing below is that (i) savings depend on the on representative rateof return household assets, and (ii) this rateof returnis linkedto the more on We can write this rateof interest bank deposits via theasset market equilibrium. assume thatsavings S isa function the real of as a two-equation model. We first formally on rateof return the household portfolior, along with various other arguments likethe level of income V, etc.:
S = S(r, Y,...).

(+)(+) (1) on rate Denote /the real rateof interest bank deposits, and (3(R) the implicit of interest. 35

SAVINGS AND DEVELOPMENT -No. 1 - 1996 -XX

The functionalnotation B (R) is meant to capture the idea that the size of thispremium is an increasing functionof the degree of financial repression, denoted R. Then, portfolio equilibrium implies: / 8(R) = r. +

(+)

(2)

where 8~1(-) is the inverse function of Hence, by inverting we can write R = B'1(r-i), (2), B (-).This corresponds simply to the intuitive idea thattheabsolute value of a negative real rateof interestisa natural indicator the intensity financial repression. Intheempirical of of application performed insection 3 below, we simply assume that r = 0. Assuming any constant value forr would essentially yield the same result. Substituting (2) into(1) yields: S = S(i+B(R), Y,...) (3) S

Figure 1: The Non Linear Relationship 36

J. P. AZAM -SAVINGS AND INTEREST RATE IN KENYA

> Figure 1 represents a simple case of (3), where B(R) is constant when /' 0, and with R otherwise. The indicator financial repression R is inturn of assumed to increasing be higher, the lower is the rateof interestinthe negative quadrant. This diagram captures we estimate below. the essence of the non-linear relationship that Beside the rate of interest and the levelof income, one should also take into account theeffectof the windfall gains resultingfrom external shocks, as argued by Bevan, Collier and Gunning (1991). In most African countries, exports are limitedto a small number of primarycommodities, sold on very volatile markets. Typically, theworld prices of these commodities are fluctuating widely, with occasional positive shocks of a largeamplitude. Inthecase of Kenya, thecoffee boom of 1976-79 is themost spectacular example of such an external shock. Bevan, Collier and Gunning (1992) have shown how farmers,among others, have had an extremely largemarginal propensity to save windfall income. This proves how agents correctly foresaw the temporarynature of these positive shocks, and adopted the type of consumption-smoothing behaviour thatmost modern theories of consumption behaviour would predict. Inparticular, such a behaviour fits verywell within a theoretical framework based on the permanent income hypothesis (Bevan, Collier and Gunning, 1992). Consequently, we include the growth rate of the terms of trade as an below. argument inour estimated savings function
3. Econometric Results

We take the national savings rate, i.e. the ratioof national savings to national income, as the dependent variable in the econometric equations presented in this section. It is more satisfactory than thedomestic savings rateanalysed inthepapers noted S/Y. This is we the ratioof domestic saving toGDP. The main difference is that referredtoabove, /'.e. take international transfers into account, so thatnational incomecomes closer tocapturing the purchasing power of the households thanGDP does. We denote gtot thegrowth rateof the termsof trade,gtot(-l) its lagged value, and /' the on real rateof interest deposits. We simply compute the latter subtracting the ex post by to to observed rate of inflation the rate of interest, instead of trying compute any type of some series. Inso doing, we accept the riskof introducing expected real rate of interest measurement error, which might bias downwards the estimated coefficient.Hence, this as a potential downward bias reinforcesour case, insofar we find positive effectof the real 2 represents a plot of the national savings rateand the real rateof rateof interest. Figure with different scales. The savings ratecan be read offthe left-hand scale, and the interest, 37

SAVINGS AND DEVELOPMENT -No. 1 - 1996 -XX

scale. The horizontal dotted linecorresponds to the real rateof interest the right-hand off zero value of the real rate of interest.

1 I 1 I

88 70 72 74 78 78 80 82 84 88 88 90
Rate and Real Interest Rate (%)

! '

1 I

1 I 1 I '

1 I

1 I

1 !

1 I

1 f"

Figure 2: Savings

of Lastly,we use an indicator the degree of financial repression, that isoriginallydue toRoubini and Sala-y-Martin (1992). It isa variable that takes the value 1,when the real rate of interest ispositive; ittakes the value 2, when the real rateof interest lies between 0 and -5%, and ittakes the value 3, when itfallsbelow -5%. It isdenoted R. As will be seen shortly, we can best capture the regime switch analysed at figure 1 by entering the real rate of interest ina non linear way, as the interactionterm iR. As a benchmark, letus first analyse the resultswhen the real rateof interest isentered linearly inthe equation: 38

J. P. AZAM -SAVINGS AND INTEREST RATE INKENYA

S/Y = 13.35 + 0.09 gtot+0A2gtot(-1)

+ 3.01 fi+0.54/".

(4.90) (2.10)

(2.63)

(1.81) (2.22)
2.20,

(4)

N = 24, R2 = 0.42, F(5,19)= 3.46, D. W. =2.14, LM.F(6,18) = 0.13, ARCH.F(6,18)= = 2.72, ChowF(4,20)= 0.52. WhiteF(9,13)

The numbers in parentheses below theestimated coefficientsare the usual tratios.N is the number of observations, corresponding to the period 1967-1990. R2 is the usual coefficientof determination. It is not very high, but quite acceptable fora savings rate equation. F(5,19) is the standard F-test of equation (4) against theassumption that itsfour zero. D. W. is theDurbin and Watson testof serial independence of coefficientsare jointly the residuals. It does not detect any autocorrelation, and this isconfirmedby theLM. test, which is theF-version of the Lagrange multipliertest.The ARCHXesX isalso used tocheck White thatno auto-regressive conditional heteroscedasticity ispresent. White F(-) is the testof homoscedasticity. Lastly,Chowis theChow-forecast testof parameter constancy. As none of these tests signal any econometric problem,we can go on with the economic comments of the results. As expected, the termsof trade shocks have a positive impacton thesavings rate,and we we finda short lag polynomial of the first order. More importantly, findthat the two The coefficientof the real rateof interestispositive and financialvariables are significant. an increase inthe real rateof interest 1percentage point would by significant. Itimpliesthat raise the national savings rate by about halfa point. This isnot a negligible contribution. could play an importantrole ina policy aiming at Itfollows that the real rate of interest reducing foreign indebteness and enhancing growth.The degree of financial repression has a positive impact,given the real rate of interest. Inotherwords, when the real rate of becomes largelynegative, savers get some compensation by an increase inthe interest so with themeasured real rate. rate comformably implicit of interest, thatsavings do not fall When the real rate ispositive, the Roubini-Sala-y-Martin R variable isequal to one, and we get a straightforward positive impactof the real rate. bit We have managed to improvea little on equation (4), by entering the real rate of we enter an interaction term iR.This yields: a interestin non linear way. As a first attempt, S/Y= 14.47 + 0.11 gtot+0A2 gtot(-1) + 2.66 fi+0.19 iR. (5)

(6.80) (2.57)

(2.83)

(1.93) (2.48)

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SAVINGS AND DEVELOPMENT -No. 1 - 1996 -XX

N = 24, R2 = 0.45, F(5,19)= 3.89, D. W. = 1.92, L.M.F(6,18) = 0.02, ARCH.F(6,18)= = 2.98, ChowF(4,20)= 0.64. WhiteF(9,13)

1.87,

The presentation of the results follows thesame principles as for equation (4). No more econometric problem seems toarise with (5) as it with (4). The goodness of fitisslightly did betterwith (5), as can be seen from comparing either theR2s or theF(-)s, as the number seems that the non linear of variables involved is the same inthe twoequations. Hence, it specification of the interestrateeffect is marginally better.Notice that it onlymatters when the rateof interestisnegative, as R = 1 when the real rateof interestispositive. This result leads to a qualification of the comments made above about the potential of an active interestrate policy. Now, it appears that the impactof a 1 point increase inthe real rate, while the rate isalready positive,would only increase the national savings rate by 1/5of a point. However, the impact ispotentially we more powerful if start from positionwhere a the real rate is initially This is the typicalscenario of a liberalizationepisode, like negative. the one that took place in Kenya inthemid-1980s. We have obtained stillanother slight improvement,by dropping the Roubini-Sala-y Martin R variable, and entering the real interestrate to the power 3. The reason forthis substitution is that (i)2may be regarded a smoothed version of R when the real rate is negative, within the relevant range, so that (i)3 is related to iR. This is preferable to the stepwise behaviour of theRoubini-Sala-y-Martin R inthe range of negative real rates, but So, impliessome undesirable properties for high positive values of /'. provided we keep in mind that thevalidityof thisequation must be restrictedtoa range of values of the real rate of interest that excludes high positive values, and this is the realistic range, the best econometric performance isgiven by: S/Y= 18.43 + 0.08 gtot +0.11 gtot(-1) + 0.0017 (i)3. (6)

(31.55) (2.14)

(2.70)

(2.70)

N = 24, R2 = 0.46, F(4,20)= 5.64, D. W. = 1.88, L.M.F(6,18) = 0.02, ARCH.F(6,18)= = 0.98, WhiteF(9,13) ChowF(4,20)= 0.54.

1.52,

more parsimonious. It This equation has a better fit than (5), and is does not raise any econometric problem. What it implies for the interpretation the interest rate policy of 40

J. P. AZAM -SAVINGS AND INTEREST RATE INKENYA

pursued in Kenya over our period of analysis can be best analysed with the help of figure 3. Itrepresents the contributionof the real rateof interestto the national savings rate that can be derived fromequation (6), defined as 0.0017 (i)3. Hence, we observe that the interestratemade only a positive contribution to the savings rate in 1986, when it had a high real value. On the other hand, we can clearly see the cost of the financial repression would policy,which was pursued between 1972 and 1983. For example, the savings rate have been about 5 points higher in 1975 had the real rate of interest been simply zero instead of being as negative as it was, below -10%.

88 70 73 74 76 78 80 83 84 86 88 90
Figure 3: Contribution of (if to the Savings Rate 41

i '

1 i

1 i1 1 r 11 i

1 i

1 i

1 i

1 i 1 f

SAVINGS AND DEVELOPMENT -No. 1 - 1996 -XX

4. Conclusion Inthisshort paper, we have broughtout a significantpositive relationshipbetween the we had to real rate of interest and the national savings rate inKenya. Inorder to do this, control forexternal shocks, on the one hand, and for financial repression, on the other hand. The degree of financial repression can either be represented by the proxy used by Roubini and Sala-y-Martin, or by the square of the real interest rate,when the latter is and themost negative. This is infact marginally a bettersolution,which provides thebest fit parsimonious equation of the three equations presented. was The most strikingimplication this result is thatthe financial repression policy that of between 1972 and 1983, with some relapse afterwords, had a pursued consistently sizeable cost. According toour estimate, thiscost intermsof foregone savings could have been as high as about 5% ofGNP in 1975, theworst year inthis respect. Applying some kind of standard Harrod-Domar formula, with a capital-output ratiocalibrated at 2.5, such a figure implies thatthegrowth ratecould have been about 2 percentage points higher that year had the interestrate simply been zero. and could However, we have emphasized thatour resultsshould notbe pushed too far, not be used to simulate the type of savings rate that could be reached by raising real interestrates sky high.Within thewhole sample, we only had one pointwhen the real interestratewas above 5%, so thatnothing should be inferred rates at or above this for level.Nevertheless, thisexercise was worthwhile as an indicationof the cost of financial repression interms of savings and growth foregone inKenya inthe 1970s and 1980s.

42

J. P. AZAM -SAVINGS AND INTEREST RATE INKENYA

References
Azam, J. P. and C. Daubree (1995): Contourner I'Etat:Lacroissanceeconomiqueau Development Centre: Paris. Kenya(1964-1990), O.E.C.D.

V. W. Bevan, D., P. Collier and J. Gunning (1991): "TheMacroeconomics of External Shocks", in N. Balasubramanyam and S. Lall (eds.): Current Issues inDevelopment Economics, 91-117, Macmillan: London. W. Gunning (1992): "Anatomy of a Temporary Trade Shock: The Kenyan Coffee Boom Bevan, D., P. Collier and J. of 1976-9", Journal of African Economies, 1,271-305. Some Skeptical Notes", World Calvo, G.A. (1992): "Are High InterestRates Effective inStopping High Inflation? Bank Economic Review, 6, 55-69. Collier, P. and C. Mayer (1989): "The Assesment: Financial Liberalization, Financial Systems, and Economic Growth", Oxford Review of Economic Policy, 5, 1-12. Fry,M. J. (1988): Money, Interestand Banking inEconomic Development, Johns Hopkins: Baltimore.

Grosh, B. (1990): "Parastatal-Led Development: The Financial Sector Review, 2, 27-48. Killick, T. and F. M. Mwega (1990): Monetary Policy Development Institute:London. Levhari, D. and D. Patinkin (1968): "The Role of Money LVIII, 713-753. Montiel, P.J., P.-R. AgenorandN. Oxford. U. Haque(1993): in Kenya,

in Kenya, 1971 -1987", African Development

1967-88, ODI Working Paper 39, Overseas

ina Simple Growth Model", American Economic Review,

Financial Markets in Informal Developing Countries, Blackwells:

Mobilization of Private Savings Mwega,F. M., S. M. Ngola and N. Mwangi (1990): Real InterestRates and the Publishers: Nairobi. Africa, A.E.R.C. Research Paper 2, Initiative Oshikoya, T.W. (1992): "InterestRate Liberalization, Savings, and Development, XVI, 305-320. Investmentand Growth: The Case ofKenya", Savings

in

Roubini, N. and X. Sala-y-Martin (1992): "Financial Repression Economics, 39, 5-30.

and Economic Growth", Journal of Development

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SAVINGS AND DEVELOPMENT -No. 1 - 1996 -XX

Abstract This paper presents an empirical savings functionfor positive Kenya witha significant impactof the real interestrate, aftercontrolling fortermsof trade effects and theeffectof of financial repression on the functionalform thisequation. Previous studies failed to find this impact because theydid not pay due attention to this lattereffect. The theoretical model stress the role of the implicitinterest thatbanks have topay underpinnings of this on deposits when the (explicit) real interestrate is negative. This explains why deposits do not fall tozero insuch a case. The model shows that the savings rate in Kenya could was in the 1970s, had the real interestratebeen simplyzero have been much higher than it instead of being negative.

EPARGNE Resume

ET TAUX D'INTERET:

LE CAS DU KENYA

Cet article presente une fonctiond'epargne estimee econometriquement pour le du Kenya, avec un effetpositifet significatif tauxd'interet reel, apres avoir contrdle pour I 'influence des termesde I'echange etpourl'impactde la repression financieresurla forme fonctionnellede cette equation. Les etudes precedentes n'ont pas saisi cet effetparce qu'elles n'ont pas pris cet impact en compte. Les fondements theoriques de ce modele que les banques doivent payer sur les depots soulignent le role du tauxd'interet implicite quand le taux d'interet reel (explicite) est negatif. Ceci explique pourquoi les depots ne tombentpas a zero dans un telcas. Le modele montre que le tauxd'epargne au Kenya auraitpu etre beaucoup plus eleve dans les annees 1970 si le tauxd'interet reel avait ete nul au lieud'etre negatif.

44