Binesh Seetanah Paper Bfc2010

Banking Sector Controls and Financial Development

GOOROOCHURUN K, SEETANAH B ^*, SANNASEE V*AND SEETANAH B**
*Faculty of Law and Management, University of Mauritius
** RMIT, Melbourne, Australia
^Corresponding author: b.seetanah@uom.ac.mu

Electronic copy available at: http://ssrn.com/abstract=1594866


ABSTRACT
Financial development has received considerable attention in past literature. This study brings to
light financial deepening in an all new angle by introducing banking sector controls as its possible
determinants and that, to be considered for the Mauritian experience. A VECM is initially
formulated to capture the long run effect of the different banking policies used, followed by a
dynamic ordinary least squares (DOLS) estimation to cater for unknown small sample properties of
a VECM. Causality tests are applied to highlight the appropriateness of the different policies
imposed following results of their direction of causality. The outcome of the different techniques
used point out towards a positive and significant relationship of the different policies, formulated as
an index by way of principal component analysis (PCA). Based on the DOLS estimator, the
evidence on interest rate restraints points out to ambiguous long run effects on the different
indicators for financial development. Cash reserve requirement proves to deepen the financial
system while statutory liquidity requirement and directed credit programmes show a negative
interaction with financial development. Mostly one-way short run causality seems to run from the
individual controls to financial development but there is some evidence of reciprocity.
INTRODUCTION
The banking sector is one of the pillars of the financial system of an economy. In many
developed and even under-developed countries, the banking sector not only accounts for a large
proportion of its financial industry, but also provides for the good functioning of a well capitalised
economy. The financial ‘world’, if it may be allowed, revolves around banking institutions, which
play an important role in bringing the surplus unit and the deficit unit together. The central bank,
the regulator of the banking industry, is also the policy-maker. It imposes an authoritarian impulse
on commercial banks for acting in the best interest of their clients, in other words, the general
population, but more consequently, to the best of the economy. As a matter of factly, decisions
pertaining to banking institutions can have repercussions going to as far as the whole economy is
concerned and to an extent, the whole world if the economy in question is a global player. The
infamous ‘subprime crisis’ of 2007 and the later known ‘financial crisis’ in late 2008 should remind
us of the highly centralised role that banking institutions, and more precisely central banks, as
policy-makers, play in an economy.

I. Introduction

It may be argued that the development of a financial system is directed by banks and mostly
policies regarding banking institutions. Surely, the banking sector is losing ground as financial
markets make their entry on the global playground transacting billions’ worth of financial
instruments. However, banking sector policies have a direct impact on macroeconomic variables
and undoubtedly, on economic growth. There is a spectrum of policies or controls that banking
institutions are imposed with and the most common of them is interest rates.
Indeed, interest rate was one of the main policies used by Governments in the 1970s and
1980s to increase financial saving through increases in the rate of interest. However, the financial
liberalisation thesis of McKinnon (1973) and Shaw (1973) caused Governments to review their
policies, the thesis forecasting a deepening in financial sector development brought about by
interest rate market liberalisation. According to their findings, the poor performance of developing
countries was principally due to the repressive nature of the policies adopted to the likes of credit
rationing and high cash reserve requirements. This has specifically been the case for Mauritius
during that time frame1. The financial liberalisation standpoint was no exception to critics. It was
associated to bank fragility by Demirguc-Kunt and Detragiache (1998) which in turn caused a
depression (decrease in) of financial development.
Other repressionist policies involve restraints on interest rates, liquidity requirements and
directed credited credit programmes. All of these policies thus have an effect on financial
development and should be considered thoroughly before their imposition. Most studies have
looked into the causal relationship between financial development and economic growth but merely
a few have considered the individual repressionist controls and their effects on the level of
development of a country. As noted above, relaxing the different policies may also have a negative
interaction with financial development. It is, therefore, of crucial importance to navigate the paths
of these policies to bring to light their relationships with financial deepening.
Having a perception of banking sector policies on financial development ferrets out many
policy implications relating to central banks and their roles in financial system stabilisation. The
ascertainment of the influence of the banking policies imposed by the central bank on financial
development puts forth their reliability as policy-makers. The recent ‘financial crisis’ has
profoundly questioned the role of central banks as well as its ability in providing for stability
measures. It is sought that the analysis of the impact of the different banking sector policies on

1
Refer to chapter 3 for a perspective of the repressive policies adopted on the level of financial
development

2


I. Introduction

financial development will provide for the adaptability of the policies imposed to the financial
system of Mauritius.
The increasing number of multinationals today gives rise for concern to host countries as to
their share of benefits derived from multinationals’ market penetration. Indeed, the level of
financial development of a country is directly related to the bargaining power of the host country. In
consequence, the more developed a host country is, the more bargaining power it has. With
multinationals trying to penetrate more and more markets, host countries find themselves in a
position of ‘no say’ with foreign exchange being repatriated to the multinationals’ home country2.
Mauritius, in view of the different multinationals bound to be implanted in a near future, has got to
consider carefully the impact of the different banking sector controls on the level of financial
development if it would want to keep ahead of them.
This study brings to light financial deepening and introduces banking sector controls as its
possible determinants and that, to be considered for the Mauritian experience. It should be noted
that the majority of related studies has been concentrated to developed country cases with an
overwhelmingly few studies focusing on African states. A VECM is initially formulated to capture
the long run effect of the different banking policies used, followed by a dynamic ordinary least
squares (DOLS) estimation to cater for unknown small sample properties of a VECM. Causality
tests are applied to highlight the appropriateness of the different policies imposed following results
of their direction of causality
The study is organised as follows. Section 2 reviews the theoretical and empirical literature.
Section 3 describes the objectives and model specification as well as provides for the techniques for
estimation of the model and brings forth the econometric results and interpretation. Section 3 puts
forward the main conclusions on the findings.

2
The disadvantages are not restricted to the above‐mentioned; most of the host countries multinationals
choose to penetrate are often less developed in order to derive much more benefits. But this is due to
much criticisms.

3


LITERATURE REVIEW
The effect of banking sector policies on financial development has been a quite empirically
restrained evidenced subject in past literature. The few studies have linked financial intermediation
to growth tending towards a positive relationship (Bencivenga and Smith, 1991; Greenwood and
Jovanovic, 1990), most attesting financial intermediation as the spinal cord behind economic
development and thus growth. In this respect, financial intermediation and economic growth can
thus be linked with the Goldsmith-McKinnon-Shaw view on economic development (Greenwood
and Jovanovic, 1990). However, Arestis and Demetriades (2002) empirically brought forth the
ambiguity in asserting the effects of banking sector controls on the process of financial deepening.
The theoretical foundation as to the role of banking sector policies in financial development
or growth lies in the traditional approach (Demetriades & Luintel, 1996) of McKinnon (1973) and
Shaw (1973). Both postulated that government intervention in the pricing and allocation of loanable
funds constrains financial development in that it depresses real interest rates (Kapur, 1976;
Mathieson, 1980; Fry, 1995). McKinnon & Shaw focused on interest rate controls, particularly
interest rate ceilings, sometimes used interchangeably with ‘lifetime interest rate cap’, which may
distort the economy in several ways, including hostility towards risk-taking. Ang (2009) explained
three consequences: entrepreneurs may be discouraged from investing in high risk but potentially
high-yielding investment projects; financial intermediaries may choose to offer preferential lending
to established borrowers; and borrowers who obtain their funds at relatively low cost may prefer to
invest only in capital intensive projects. Thus, McKinnon & Shaw argued towards liberalising the
financial sectors through removing interest rate controls and allowing the market to determine its
own credit allocation in order to deepen the financial system.
The McKinnon/Shaw proposal of the interest rate effect thereby guides the avenues for
answering to a more developed financial system. However, interest rate restrictions and other
banking policies may have effects on financial development which surpass the interest rate controls
of McKinnon and Shaw (Demetriades and Luintel, 1996; Hachicha, 2005). As a matter-of-factly,
this hypothesis bases itself on the works of Courakis (1984) and Stiglitz (1994). Courakis argued
that the credit market structure (official and unofficial credit markets) influences the way in which
banking policies affect financial deepening, while Stiglitz postulated that asymmetric information
between borrowers and lenders increases adverse selection and moral hazards in credit markets.
Stiglitz (1994) thus affirmed that the perfectly competitive models of banking argued by McKinnon
(1973) and Shaw (1973) are inappropriate for assessing the effects of financial policies. In this
VI. Conclusion

respect, the McKinnon & Shaw (1973) approach was challenged to prove the inconsistency of their
proposal. The different ‘financial repression’ controls that were sought to retard financial
development in fact corroborate the deepening of the financial sector.
The ‘financial repression’ controls of McKinnon & Shaw (1973) proved to hinder financial
development. However, Ang (2009) argued that financial liberalisation, on its side, may not
necessarily lead to the strengthening of financial development. Wijnbergen (1982) and Taylor
(1983) advanced that one liberalisation policy in the form of lower taxation may be a disincentive
for financial intermediating activities, with the demand for credit by the private sector which is
reduced. Reserve requirements on banks are also a leakage in the intermediation process and in this
respect, both argued that curb (unorganised) markets are more efficient in intermediating savers and
investors. Another such policy may involve a rise in bank deposits rate. With curb markets being
the more efficient in the intermediation process, there will be a fall in the supply of loanable funds
as households (savers) are induced towards banking deposits. Wijnbergen (1982) and Taylor (1983)
thus concluded that removing interest rate restraints is a disincentive to private sector lending,
thereby retarding financial development.
McKinnon (1973) & Shaw (1973) claimed that interest rate controls hinder financial
development and that they should be removed in order to deepen the financial system. Stiglitz
(1994), however, argued that interest rate restraints may also bring about an increase in financial
saving, but given the presence of good governance in the financial system. Indeed, if the restrictions
are viewed as “policies aimed at enhancing the stability of the financial system”, there might be an
increase in the depth of the financial system as depositors agree to deposit their savings in banks.
But Hellman et al. (1996) demonstrated that banks are discouraged from “attracting new customers
and deepening market penetration”, given their zero profit margin on deposits due to intense
competition. Indeed, Stiglitz (1994) advanced the inappropriateness to assess the effects of financial
policies in a competitive equilibrium. This is why, if, for instance, a ceiling on deposit rate is
imposed, banks may be encountering positive returns and may thus be driven to attracting
depositors as long as the market is not fully penetrated. The rationale behind this, as Hellman et al.
(1996) viewed it, is that interest rate controls “can induce banks to spend more resources on
deepening the financial system.
In contrast to the arguments of McKinnon (1973) and Shaw (1973), Courakis (1984) found
that higher reserve requirements may cause profit-maximisation deposit rate to increase, should the
demand for loanable funds not be perfectly inelastic. This may be translated into a financial

50

VI. Conclusion

liberalisation policy that will undeniably increase the volume of loanable funds, thereby increasing
investment and hence, causing financial development. A higher reserve requirement is also
desirable in situations of accruing government deficits. As ascertained by the general equilibrium
model of Bencivenga and Smith (1992), “the optimal degree of financial repression depends on the
size of government deficits.” However, as noted from Wijnbergen (1982) and Taylor (1983), curb
(unorganised) markets are more efficient in the intermediation process. This is notably because curb
markets are not required to hold reserves and thus, the volume of loanable funds following savings
will turn into a higher investment than that of banks.
The perfect credit allocation for banks would be to target borrowers with a low risk profile
along with high return prospects. Banks are profit maximisers after all. Financial theory, however,
depicts the inability to achieve what banks would want to gain because only higher risks will bring
a higher return. Banks would therefore prefer to provide for loans to high risk borrowers, but only if
they are ready to pay a high enough rate of interest to compensate for the risk (Miller, 2002). A
country’s resources and priority sectors may, at times, provide for returns lower than that into which
banks would prefer to venture. Ang (2009) quoted India’s case, with its priority sectors ranging
from mainly agriculture to small-scale industries and housing, which are doubtlessly activities with
low returns. As a result, there is the need for government intervention to implement directed credit
programmes in order to allocate loans to priority sectors. However, with the implementation of
directed credit programmes, many potentially high return-yielding projects are overseen, hindering
financial development in a way (Ang, 2009). McKinnon (1973) and Shaw (1973) rightly advocated
the removal of directed credit programmes.
This financial liberalisation policy is, however, unlikely to result in allocative efficiency
(Stiglitz and Weiss, 1981). Indeed, with the rise in the demand for loans, Stiglitz and Weiss (1981)
found out that banks will practise credit rationing, which, in fact, implies an excess demand for
loans. In other words, banks will be limiting the supply of loans despite the availability of loanable
funds. This is partly due to information asymmetry present in the market for loans, which may drag
along situations of adverse selection & the so-called incentive effect. As stated above, banks are
concerned with the return on the loans provided, that is the interest rate charged, as well as the
riskiness of the loan. However, due to asymmetric information, the evaluation of loan applications
may be corrupt, so that the interest rate charged by the bank may itself affect the riskiness of the
loan through the sorting of potential borrowers (the adverse selection effect) or by affecting the
actions of borrowers (the incentive effect).

51

VI. Conclusion

Stiglitz and Weiss (1981) showed in their analysis that adverse selection usually occurs
when different borrowers have different probabilities of repayment. For banks to maximise their
payoffs, they should be able to identify those Expected
borrowers who have a greater probability to Return to
the bank
repay their respective loans. One of the
‘screening devices’ that banks may use to
identify the good borrowers is the rate of
interest. In truth, those borrowers who are r* Interest Rate
less likely to repay their loans in full will be Figure I Interest Rate and Banks’
Expected Return
more than willing to be charged a high rate
of interest. This is because they “perceive their probability of repayment to be low.” According to
Stiglitz and Weiss (1981), the average riskiness of a borrower increases as interest rate rises, and
that to the detriment of the bank’s payoff. From Figure I, it can be seen that as long as the rate of
interest rises up to a rate equal to r*, the expected return of the bank increases. Beyond r*, the
bank’s profits start to decline. The rate of interest r* can be described as the ‘optimal interest rate’
at which the bank can derive a profit from an allocated loan at that rate. The higher interest rate a
borrower is willing to pay, the riskier he is perceived.
It can be seen that removing directed credit programmes as suggested by McKinnon and
Shaw (1973) may not bring banks to make a proper evaluation of loan applications because of
asymmetric information on the market. This creates adverse selection to the extent that banks may
select those applications which provide a high rate of interest for which financial theory guarantees
a high payoff. But Stiglitz and Weiss (1981) demonstrated that beyond an optimal interest rate r*, a
bank’s return may fall and this is because it is borrowers with a lower probability to loan repayment
who are willing to pay a high rate of interest.
In contrast to the above, the implementation of directed credit programmes may as well
help in boosting financial development and achieving growth. This may only be achieved if certain
conditions are met after implementation. Schwarz (1992) analysed the effectiveness of directed
credit policies in the United States and provided for four necessary conditions that should occur in
the targeted priority sectors in order for a directed credit policy to achieve its objective.3 Firstly, the

3
Some directed credit policies are not only aimed at achieving development and growth, but rather at
smoothing decline. In the Japanese and German contexts, these programmes are designed in easing
resources out of an industry. Other objectives may be oriented towards an equitable distribution of
resources. Robert B. Reich, “Making Industrial Policy,” Foreign Affairs (60), Spring 1982, pp. 852‐81.

52

VI. Conclusion

directed credit should lead to increased financial intermediation, that is, borrowings must rise;
secondly, the credit programme should bring about an increase in investment; thirdly, the increased
investment achieved should be productive and a helping hand in increasing output; and lastly,
growth achieved in the targeted sector should lead to the overall growth of the economy. The first
step remains the most crucial condition, regardless of the ultimate aim of the directed credit policy.
If borrowing does not increase in the targeted sector, the credit programme will be regarded as
merely a subsidy to the targeted sector.
Evidence addressing all four conditions for the effectiveness of directed credit policies is
scarce. The parsimonious evidence that does exist all point out to the fulfillment of at least one of
the conditions for the policy to achieve its aim (Schwarz, 1992). Directed credit programmes in
developing countries are often the result of biased assessments and even, corruption, which result in
a lower degree of success of the programme (Emran and Stiglitz, 2009). The ambiguity in assessing
the real impact of the different financial repression controls is directed towards the empirical
evidence of the subject for a clearer view. On the empirical side, a number of countries have been
subject to this field of research, more particularly developing economies such as India, Thailand,
Nepal, the Philippines, and the Republic of Korea. The effect of banking sector controls on financial
development differed for each country (Hachicha, 2005). However, studies relating specifically to
the effects of the various banking sector policies on financial development remains lacking.
Demetriades and Luintel (1996) examined the effects of various types of banking sector
controls (interest rate control index, reserve requirements, minimum liquidity requirements and
directed credit programmes) for India, to find a significant negative impact on the process of
financial deepening. A conditional error correction model for financial deepening was estimated
and all controls, formulated as an index using a principal component analysis, evidenced a negative
interaction of -0.0465 on financial deepening. The individual controls also showed a negative
implication, with interest rate policies standing at -0.0154, while the rest of the policies taken into
account exhibited a significance of -0.0083. Demetriades and Luintel (1996) concluded in a “bi-
directional causality between financial deepening and economic growth”, implying that policies
affecting financial deepening in all likelihood will tend to have an effect on economic growth and
vice-versa.
Hachicha (2005) undertook an empirical investigation of the effect of the same controls as
Demetriades and Luintel’s (1996) analysis for India (interest rate, reserve and liquidity
requirements and directed credit programmes), on financial deepening for the case of Tunisia. The

53

VI. Conclusion

resulting evidence points towards a consistency with traditional literature on financial liberalisation.
Hachicha followed Eriksson’s (1995) structural error correction model and the estimated controls
altogether showed a significance of -0.0310. The individual significance of interest rate controls and
the rest of the policies investigated into stood at -0.0527 and -0.0524 respectively. The main finding
of Hachicha brings to light the negative significance of the direct long and short run effects of
financial repression during the near 40-year period of 1961 to 2000. Though it contrasts with the
prevalence of market imperfections on the financial forefront, the finding remains consistent to
most literature on the subject.
Hachicha (2005) summarised the findings of Demetriades and Luintel (1996b)4 findings
who also investigated the impact of banking sector policies on the level of financial deepening for
Nepal again in 1996. The results actually turned out to be the contrary of their study for India.
Indeed, they showed that banking sector controls have a positive impact on financial deepening
with a significance of 0.0216. A total of seven banking policies were introduced as variables.
Interest rate controls were seen to positively impact financial deepening with an average
significance of 0.0436, while non-interest rate controls had a negative effect of -0.007 on average.
Demetriades and Luintel (2001)5 also estimated a long-term financial deepening equation closely
linked to the ‘Korean Banking model’. Their result also showed, in contrast to their previous studies
for India, a positive impact on the volume of bank loans, but the financial repression index
exhibited a higher level of influence on financial deepening. A significance of 0.15 was noted.
Ang (2009) also undertook an empirical investigation of the impact of the various banking
sector controls on the level of financial development and eventually tested their significance in
explaining financial liberalization. Differing effects cash reserve requirement were noted on the
different indicators to financial development that were introduced. The substance of his findings
point out towards a positive effect of interest rate policies, liquidity requirements and directed credit
programmes. Credit programmes were noted to have the highest influence on the financial system
in the long run with a significance of 0.139. In addition, Ang (2009) conducted causal relationships
and found that economic growth has a positive and uni-directional causality on financial deepening
both in the short and long run.

4
See DEMETRIADES, P.O AND LUINTEL, L.B., 1996b. Banking sector policies and financial development in
Nepal. Oxford Bulletin of Economics and Statistics, 58 (2), 355‐372.
5
See DEMETRIADES, P.O AND LUINTEL, L.B., 2001. Financial restraints in the South Korean Miracle. Journal
of Development Studies, 64 (2), 459‐479.

54

VI. Conclusion

Demetriades and Luintel (1997) complemented their empirical analysis of financial
repression and development on India. The evidence point out towards the same conclusion of
Demetriades and Luintel (1996) in that the different repressionist policies have a negative influence
on the Indian financial system. They, however, caution against generalising the outcome of their
findings and provide that the resulting effect of the repressionist policies is largely dependent on the
institution being imposed with implementing the policies. Studies on the subject remain very few
but more and more researchers are being driven for consideration to the matter due to its high level
of policy implications today.
RESEARCH METHODOLOGY
In undertaking this research topic, the aim was to develop an assessment of the effects of the
different banking policies, adopted by the Central Bank of Mauritius, on the development of the
financial system. This will help in determining whether the financial controls used by the Bank of
Mauritius are parallel to the objective of the Government for a more liberalised economy. The main
hypothesis involving the positive influence of the ‘repressionist’ policies on financial deepening in
Mauritius is tested.
The long run impact of the banking policies will be taken into consideration in order to
allow for the evaluation of the effectiveness of the different policies imposed at the present and the
resulting outcome in the future. Within this process, an estimation of the relative influence of each
policy on financial deepening will be made. Furthermore, causality issues in both the short and long
run will be addressed (which has been much overlooked in past literature) to understand if the
different banking policies are causing a growth in financial development or on the contrary, whether
the level of financial deepening in Mauritius is constraining the BOM to allow for such policies. In
short, the direction of causality will help in determining related policies to be adopted.
The study also highlights the key role played by the Central Bank of Mauritius as a
craftsman of the eventual depth of the financial system. All decisions relating to the ‘repressionist’
school are directed by the Bank of Mauritius which is the regulator for the banking sector. The
model specified will allow for evaluating the relative influence of the BOM and the policies used on
financial deepening. Moreover, estimating an approximately accurate indicator for financial
development is of crucial importance in order to analyse the true impact of the banking policies. As

55

VI. Conclusion

such, an evaluation of the best possible proxy for financial deepening in Mauritius will be
estimated.
The above objectives flaunt or might as well brandish the critical importance of the subject
at hand. Such a study comprises many policy implications and for the Mauritian case, it will allow
for the evaluation of whether the different policies are judiciously imposed.
Model Specification & Data
The investigation goes back to nearly a decade after the independence of Mauritius in 1968,
for a time period of 34 years from 1976 to 2009. Banking sector controls, including interest rate
controls (IRC), cash reserve requirement (CRR), statutory liquidity requirement (SLR) and directed
credit programmes (DCP) are individually collected directly from Annual Reports of the BOM. The
specification includes an income variable, real per capita GDP6 (PCGDP), following Robinson
(1952) who stipulates that higher per capita income due to increased demand for financial services
may cause an expansion of the financial system. Interest rate (IR) adds to the econometric model to
allow for an analysis of the true influence of the banking controls independently of the well-known
interest rate effect. IR represents the bank rate, the rate at which the BOM lends to commercial
banks.
The ratio of bank branches to population, branch density (BD), is introduced following
Hachicha (2005). In order to give a true and fair perception of the effect of the different banking
policies on financial development, the ratios of foreign direct investment to GDP (FDIY) and gross
domestic fixed capital formation to GDP (GDFCFY), which are two of the determinants of financial
deepening, are integrated into the equation. Annual data covering the set time frame7 are obtained or
otherwise compiled from the IMF’s International Financial Statistics (IFS), the Central Statistics
Office of Mauritius (CSO) and Annual Reports of the BOM. The model used to test for the set
hypothesis calls for the specification of a financial deepening equation and estimating the effects of
the different banking policies independently. The model, which bases itself on the literature8, takes
the following functional form:

6
Constant at 2005 prices; GDP deflator is available in IFS; GDP is at market prices;
; such that
7
Note that data for 2009 are estimates and run through September of the said year
8
See Demetriades and Luintel (1996), Ang (2009), Hachicha (2005)

56

VI. Conclusion

(1)
To measure financial development, King and Levine’s (1993) widely used indicators are
used. Having an accurate proxy for financial deepening is a tedious task and the use of only one
proxy will be quite improper causing estimates to be biased. Thus, three different proxies for
financial deepening, as advocated by King and Levine (1993), will direct our specification – the
ratios of liquid liabilities to GDP (LLY), claims on the non-financial private sector to total domestic
credit (PCDC) and claims on the non-financial private sector to GDP (PCY). As stated by King and
Levine (1993), the first measure, LLY, gives the overall size of the formal financial intermediary
system, that is, banks and liquid liabilities consists of “currency held outside the banking system
plus demand and interest-bearing liabilities of banks and non-bank financial intermediaries.”9 The
two other measures, PCDC and PCY, measure domestic asset distribution. PCDC relates to the
proportion of credit that is allocated to private enterprises by the financial system. Despite being
fraught with problems, the three indicators give a clearer view as to the evolution and trend of
financial deepening. Data on the indicators are compiled from Annual Reports of the BOM and IFS.
The individual controls, cash reserve requirement (CRR) and statutory liquidity
requirement (SLR), are measured in percentages. Four interest rate controls (IRC) are allowed10,
namely a fixed deposit rate ceiling (fdc), a fixed deposit rate floor (fdf), a fixed lending rate ceiling
(flc) and a fixed lending rate floor (flf). To represent the various interest rate controls, dummy
variables are introduced, which take the value of 1 when a policy measure is present and 0 when no
restraint is noted. The dummy variables are represented by fdcd for a fixed deposit rate ceiling, fdfd
for a fixed deposit rate floor, flcd for a fixed lending rate ceiling and flfd for a fixed lending rate
floor. The extent of directed credit programmes takes the values 1, 2 and 3, when the programme
covers 0% up to 20%, 20-40%, and over 40% of total bank lending respectively. The extent of
directed credit programme (DCP) in Mauritius has always been high (over 40% except for 6 years),
with the Government prioritising many sectors including the sugar industry and other agriculture,
and more recently tourism.11

9
This measure equal to M2 for Mauritius (see King and Levine, 1993); financial stock are measured at end of
period while GDP flow over the period. To overcome this, an average of financial stock values at time t
and t‐1 is used, so that LLY in 1976 equals the average of LLY in 1975 and 1976 divided by GDP in 1976.
10
In contrast to literature; the use of a fixed deposit or lending rate would have resulted in the variables
being dropped due to zero variance
11
As from 1998, no data is available specifically on directed credit programmes; they were assumed to be
sectors being provided with lower relative lending rate, available from Annual Reports of the BOM

57

VI. Conclusion

All variables are measured in natural logarithms, denoted by L, except IRC, which is a
summary measure of interest rate controls (see section IV.II.I). Our model, thus, takes on a log-
linear econometric equation as follows:
(2)
where LFDt is represented either by LLLYt, LPCDCt and LPCYt. The three proxies to financial
deepening can be integrated into our specification such that three different models (B, D and F
respectively)12 may be specified as follows:
(B)
(D)
(F)
Principal Component Analysis
To capture the effects of restraints in interest rates on the Mauritian financial system, an
index of interest rate controls (IRC) is constructed using factor analysis and more precisely,
principal component analysis (PCA). PCA is mostly used for the purpose of data reduction, usually
in cases of a large set of correlated variables to one small set of uncorrelated variables. The use of
PCA has been a requirement since the different interest rate policies have a high degree of
multicollinearity amongst themselves. Table I lists the results of the PCA for interest rate controls
(IRC).
The eigenvalues capture the amount of variance that each factor extracts and the proportion
of total variance that the factor captures is made available. For instance, factor 1 explains 58.0% of

12
The rationale behind such a denomination for the models is to facilitate data analysis (see sub‐section
IV.II.I below)

58

VI. Conclusion

the total variance, 28.0% for factor 2 and so on. PCA is about data reduction, that is, a method for
reducing the number of variables. Now that the factors have been created, how many of them
should be retained (extracted)? Even though various commonly-used guidelines have been
proposed, choosing the number of factors to be retained remains an arbitrary decision. However,
they seem to yield the best results in practice.
One of the most commonly used criterion for selecting the number of factors to be extracted
is Kaiser’s (1960) proposal. He suggested retaining only factors with eigenvalues greater than 1. In
other words, only those factors which explain the total variance in a fair
Table I. Principal Component Factor Analysis (IRC)
Factor Analysis (pcf)*

Factors
1 2 3 4
Eigenvalues 2.318 1.119 0.491 0.072
% of variance 0.580 0.280 0.123 0.018
Cumulative % 0.580 0.859 0.982 1.000
Factor Loadings
1 2
fdcd 0.512 0.821
fdfd 0.716 -0.658
flcd 0.951 -0.036
flfd 0.799 0.107
* Principal component factor
amount should be retained. Catelli (1966) also proposed a selection criterion, a graphical method
known as the ‘scree’ test. This is done by plotting the eigenvalues of the different factors in a
simple line plot. Since component 3 explains not more than 12.3% of the total variance, only 2
factors are retained. Same is noted for Kaiser’s criterion, where only 2 factors give an eigenvalue of
more than 1. Once the factor analysis has been performed, a ‘rotation’ is done in order to make the
output of the analysis more understandable, followed by the generating of the variable IRC. Figure
II illustrates the interest rate controls index for Mauritius.

59

VI. Conclusion

80
70
60
50
40
30
20
10
Year
Figure II. Index of Interest Rate Controls
Figure above corroborates perfectly with the interest rate system in place in Mauritius. The
graph shows that as from 1984, no controls, in other words, no fixed deposit rate ceiling and floor
or fixed lending rate ceiling and floor were imposed. This depicts the liberalisation policy of interest
rates for more than two decades ago. From 1976 to 1984, several controls were imposed and it is
noted that through the end of the 70s, the most number of restraints were placed on interest rates.
This has been due to the very difficult economic situation that has been prevailing in Mauritius at
that time. For instance, in 1978, a ceiling on fixed deposit rate had to be imposed to limit
consumption in order to keep down the rate of inflation. A ceiling on lending rate was to reduce the
rate of expansion of bank credit as well as slow down the pace of imports and help conserving
foreign exchange. A fixed lending rate floor is also noted and guaranteed a minimum income from
lending activities to banks. All in all, the main objective of the Government at that time was to curb
down excessive monetary expansion and thereby ease the pressure on foreign exchange reserves
and restore equilibrium in the balance of payments.
In order to provide for multicollinearity issues relating to the individual banking policies, a
financial repression index (FRI)13, encapsulating each banking sector control under study (IRC,

13
See chapter III for an elaboration and a graphical view of the financial repression index; IRC and FRI are
not measured in natural logarithms since they will generate missing values due to their negative signs

60

VI. Conclusion

CRR, SLR and DCP), is constructed by way of principal component analysis. Nonetheless, models
B, D and F, comprising of the individual controls independently, will also be estimated to find
whether the use of the index generates more or less similar estimates as to when using the
individual controls. Also, models B, D and F, though expectant to a high degree of
multicollinearity, is of crucial importance since they will give the impact of the each individual
control on financial deepening independently. Thus, three more models, A, C and E, adds to our
previous set of models as follows14:
(A)
(C)
(E)
The use of the different models specified will allow for a thorough analysis of the
relationship between banking sector policies and financial deepening. Furthermore, the different
indicators for financial development will bring to light the most appropriate specification for the
case of Mauritius.
Estimation Techniques
The objective of this study is to derive an assessment of the long run impact of the various banking
sector policies on financial deepening. The causal relationship between the underlying variables
leads us to assume that the procedural assessment consist of a vector autoregressive (VAR) at
levels. Before going through the VAR method of estimation, some preliminary tests should be
performed.

14
For each indicator of FD, two models, the first comprising of the individual controls whilst the second with
the financial repression index (FRI), will be estimated together; thus, model A & B relate to LLY, model C &
D to PCDC and model E & F to PCY

61

VI. Conclusion

As a first step to the analysis process, traditional unit root tests are applied for an
integration analysis, the Augmented Dickey-Fuller (ADF) test and the Philips-Perron (PP) test. A
cointegration test, more precisely the Johansen procedure, will follow to determine whether there
are any cointegrating relationship between the variables and should it be the case, the long run
relationship will be estimated via a vector error-correction model (VECM). A cointegration test will
determine whether a long term relationship exists between the different variables and financial
deepening. A VECM can thus be formulated to capture the long run estimates, relating the influence
of the variables on financial deepening. A VECM applied on our specification will result in
equation (8) 15 below:
(8)
where
. is the constant representing a linear trend and contains the error correction term derived
from the long run cointegrating relationship via the Johansen test.
The resulting beta coefficient estimates of the error correction term in the VECM give out
the cointegrating vector which may be interpreted as the long run equation for our specification.
Specifically, the cointegrating vector provides for an estimate of the long run interaction of the
various independent variables on the dependent variable. However, as Bewley et al. (1994) pointed
out, the small sample properties of the VECM16 remain unknown. One way of bypassing this
situation might be to obtain the long run estimates of the specification through an alternative
approach. Two approaches which may be considered involve the fully-modified unrestricted error-
correction model (FM-UECM) and the dynamic ordinary least squares (DOLS) estimator. In our

15
Note that is representative of , , ; the Financial Repression Index ( ) is
also used for ease of interpretation to the reader. It is understandable that the second equation for each
FD indicator shall comprise of , , and
16
This remains a concern for econometricians for tests on long run coefficients of cointegrated system; see
also Omtzigt et al. (2002)

62

VI. Conclusion

case, we choose Stock and Watson’s (1993) DOLS estimator for the estimation of the long run
coefficients. Nonetheless, we provide for the cointegrating vector of the VECM in order to better
assess the sensitivity of the parameter estimates to the different procedures.
Stock and Watson’s procedure is a robust single equation approach which corrects for
regressor endogeneity and as Masih and Masih (2000) notes, it involves regressing I(1) variables on
other I(1) variables, any I(0) variables and leads and lags of the first difference of I(1) variables.
The DOLS procedure is regarded as being equivalent to the maximum likelihood estimator of
Johansen (1988). However, the DOLS estimator performs better in finite samples and also copes
with small sample and dynamic sources of bias. Dynamics is also introduced in the specification of
a model. The dynamic ordinary least squares regression17, where is a vector of k determinants of
, is shown as follows:
(9)
Beyond asserting a long term relationship, cointegration imparts causality between the
variables in at least one direction18. In other words, cointegration implicitly concludes there is a
long run causal relation between the variables. It has been proposed by Engle and Granger (1987)
that an error correction model may be used to test for Granger causality. The test is often labeled as
the short-run Granger non-causality test, determining, as the name suggests, the short run causal
relationship using the Wald test statistic to test for the significance of the lagged dynamic terms.
The weak exogeneity test may also be conducted to establish causality of the individual variables in
the long term, since it may be regarded as a long run non-causality test (Ang, 2009). The weak
exogeneity test follows a likelihood ratio test. However, the test itself does not explicitly
differentiate the direction of the long run causality running from one variable to the other. The
determination of causality will allow the evaluation of the different policies imposed and their
correctness.
The error correction term with lagged parameters (ECMt-1) provides for the speed of
adjustment. It is, in fact, as Amiruddin et al. (2007) puts it, a measure for the short run dispersal

17
See Kao et al. (2000) for an elaboration
18
See Granger (1988) for further reading

63

VI. Conclusion

from the long run equilibrium since variables may deviate from each other in the short term,
causing a disequilibrium in the system. Statistically significant coefficient on ECMt-1 proves that the
error correction mechanism in place drives the variables back to their long-run relationship. It will
be derived following Engle and Granger’s approach, the small sample properties remaining
unknown in the VECM. A cointegrating regression using OLS will be estimated followed by
another OLS regression of the differenced variables along with lags of the residuals. Throughout
this process, a derivation of the short run impact of the various variables will be allowed. The
coefficient.
ANALYSIS
Integration and Cointegration Analyses
As a first step to the estimation of the long run equation for financial deepening, unit root
tests are applied in order to determine the properties of the time-series and to evaluate the order of
integration of all the variables employed. Two widely used tests are applied, the Augmented
Dickey-Fuller19 (ADF) test and the Phillips-Perron20 (PP) test for unit root. The tests are applied on
both the level and first-difference of all variables to see whether they are stationary. The results,
reported in Table II, indicate that the hypothesis of non-stationarity cannot be rejected at level, but
is rejected at first difference (PP test).
The lag length selection for the ADF test is based on the Akaike’s Information Criterion
(AIC) and the Final Prediction Error (FPE), except for the first-differenced variable IRC, where the
Shwarz Bayesian Information Criterion (SBIC) is used. Liew’s (2004) study on the best lag length
selection criteria relates to the superiority of AIC and FPE over other criteria, including the Hannan-
Quinn Information Criteria (HQIC), in the case of small sample size of 60 observations and below.
The author explains that the use of AIC and FPE for choosing the optimal lag length reduces the
risk of under estimation but also maximises the chance of retrieving the true lag length. In the case
of the PP test, the Newey-West lag method is used to find the optimal lag length. Unless otherwise
stated, all variables are found to be significant at the 5% level.
The dominance of either one test through their relative power can be a matter for argument.
Maddala and Kim (2002 cited DeJong et al. 1992, p.100) note that both tests suffer from size
distortion problems, with “the presence of negatively correlated MA errors” for the ADF test and

19
See Dickey and Fuller, 1979 and 1981
20
See Phillips and Perron, 1988

64

VI. Conclusion

“plausibly correlated MA or AR error structures” for the PP test. According to them, the PP test has
a relatively lower power to the ADF test against “trend-stationary alternatives” and thus, the latter
should be considered in practice. This, however, remains dependent on the circumstances. In
contrast, the PP test may be considered more useful as it allows for heteroscedastic error terms
(Hamilton, 1994) and Banerjee et al. (1993, p.113) brought forth the higher power of the PP test
through a Monte Carlo Study. This is why, based on the PP test’s resulting outcome, it is concluded
that all variables are integrated of order 1 at the 5% significance level.
Having established that all variables are I(1), a cointegration test follows in order to detect
any long run relationship among two or more variables. Cointegrated variables not only express
long run equilibrium relationships, hence sharing common trends, but also confirm that estimated
relationships are not spurious (Engle and Granger, 1987). Though Engle and Granger’s two-step
approach cointegration test is the most commonly used, the Johansen cointegration testing
procedure21 is adopted. This is mainly because Johansen’s test for cointegration assumes all
variables to be endogeneous, unlike Engle and Granger’s approach whereby variables are treated
asymmetrically, specifying one as dependent and the other as independent. Also, Engle and
Granger’s approach does not allow for testing any hypothesis about the actual cointegrating
relationship (unlike Johansen’s test) but rather assumes the existence of at most a single
cointegrating vector.
Results from the Johansen’s cointegration test with the trace test statistic and the maximum
eigenvalue test statistic reported in panels A and B respectively. For most of the models the number
of cointegrating vector differs for each test statistic, but both lead to the rejection of the null
hypothesis of no cointegrating relationships. Parallel to Banerjee et al. (1993), the maximum
eigenvalue statistic is preferred due to its higher power over the trace statistic, thus discarding the
latter. However, conflicting evidence on the number of cointegrating vectors at the 1% and 5%
significance level, lead us to adopt a more conservative position at the 1% level. It is concluded that
with LLY as indicator for financial deepening, models A and B give out 4 and 5 cointegrating
vectors respectively; with PCDC, 4 and 5 cointegrating vectors are also noted for model C and D
respectively; and lastly with PCY, models E and F result in 3 and 5 cointegrating vectors
respectively. This provides evidence of a long term relationship between the variables and financial
deepening.

21
See Johansen (1988) and Johansen and Juselius (1990) for further reading

65

VI. Conclusion

Interaction with Financial Development
Long run Estimates
The evidence of cointegration in our specification is consistent with literature in that there
exists a long run equilibrium relationship between banking sector controls and financial deepening.
The presence of cointegrating vectors lead us to specify a VECM to measure the long run effect of
the various banking sector policies on financial development. For each indicator of financial
deepening, two VECMs are estimated, the first one comprising of the financial repression index
(FRI) and the other with the individual controls. The results are reported in Table IV.A.
All the variables are seen to have a significant long run relationship with financial
deepening. The long run effect of FRI is seen to be positive, though small (0.003 and 0.004), on
financial deepening with PCDC and PCY as indicators, while the contrary is noted with LLY. This
implies that the policies adopted by the BOM deepen the financial system. With LLY and PCDC as
FD, the individual controls tend towards a positive relationship for the index of interest rate controls
and statutory liquidity requirement, while a negative relationship is noted for cash reserve
requirement and directed credit programmes. The opposite is reported for PCY as indicator. The
first two indicators of FD seem to be consistent with the policies imposed. CRR is still prevalent in
Mauritius and has a negative impact on FD in that these amounts, instead of being left idle with the
Central Bank, could be used for loan allocation in investment settings. There are currently no
controls imposed on interest rates and SLR is 0% and these reflect a positive effect on FD. The
effect of DCP on FD implies that high return-yielding projects are being substituted for less
profitable sectors.
As to the other variables, the rate of interest has a positive interaction with financial
deepening with LLY and PCY as indicators. Branch density is positively related with FD in four
models and same is noted for the ratio of foreign direct investment to GDP. The ratio of gross
domestic fixed capital formation to GDP and real per capita GDP seem to produce arbitrary
outcomes in their relationship with FD. They are both expected to have a positive impact on
financial deepening but the contrary is reported. Only model C and E report a positive effect on
PCGDP on FD.
Though some of the results corroborate, nonetheless, as we have noted previously, the small
sample properties of a VECM are still unknown. The outcomes of the long run estimates may allow
a fair view of the real impact of the various variables on financial deepening. This is why another

66

VI. Conclusion

long run coefficient estimator is introduced, the dynamic ordinary least squares (DOLS). The results
(listed in Table IV.B) are not perfectly similar to that of the VECM but they cater for the negative
effect of PCGDP and GDFCFY on FD. Indeed, the DOLS estimator produce a positive and
significant long run relationship of real per capita GDP and the ratio of gross domestic fixed capital
formation to GDP in all six models. Model E, with PCY as FD, reports the highest impact of
PCGDP on FD (0.865) while model C, with PCDC as indicator of FD, gives the least effect. This is
consistent with theoretical literature on finance and growth. However, not all parameters are noted
to be significant in explaining financial deepening in the long run.
Table IV. Long run Effect on Financial Deepening22
IV.A: Estimation of Coefficients through VECM
Long run Interaction on FD

VECM
FD = LLLY FD = LPCDC FD = LPCY
Model A Model B Model C Model D Model E Model F
LPCGDP -0.911 -0.530 0.152 -0.758 0.457 -0.812

(0.000)* (0.000)* (0.051)*** (0.000)* (0.000)* (0.000)*
LIR 0.046 0.075 -0.365 -0.131 0.577 0.365
(0.000)* (0.000)* (0.000)* (0.000)* (0.000)* (0.000)*
FRI -0.001 _ 0.003 _ 0.005 _
(0.000)* (0.000)* (0.000)*
IRC _ 0.001 _ 0.002 _ -0.002
(0.000)* (0.000)* (0.000)*
LCRR _ -0.074 _ -0.679 _ 0.459
(0.000)* (0.000)* (0.000)*
LSLR _ 0.021 _ 0.059 _ -0.055
(0.000)* (0.000)* (0.000)*
LDCP _ -0.128 _ -0.103 _ 0.540
(0.000)* (0.000)* (0.000)*
LBD -0.046 0.340 0.648 -0.167 1.696 0.377
(0.011)** (0.000)* (0.000)* (0.000)* (0.000)* (0.000)*
LFDIY 0.071 0.026 -0.073 -0.070 0.103 0.024
(0.000)* (0.000)* (0.000)* (0.000)* (0.000)* (0.000)*
LGDFCFY -0.037 -0.317 -1.129 -0.706 -0.177 -0.304

22
The DOLS estimator (due to its accuracy) and banking sector controls are given priority over interpretation
of results

67

VI. Conclusion

(0.000)* (0.000)* (0.000)* (0.000)* (0.000)* (0.000)*
* significant at the 1% level; ** significant at the 5% level; *** significant at the 10% level; p-values are reported in
parentheses; refer to list of abbreviations for interpretation of variables
IV.B: Estimation of Coefficients through DOLS Estimator
Long run Interaction on FD

DOLS
FD=LLLY FD=LPCDC FD=LPCY
LPCGDP 0.672 0.710 0.366 0.687 0.865 0.780

(0.000)* (0.000)* (0.016)** (0.000)* (0.000)* (0.000)*
LIR -0.037 -0.002 0.069 0.133 -0.097 -0.076
(0.140) (0.916) (0.232) (0.002)* (0.140) (0.216)
FRI -0.0002 _ -0.001 _ -0.001 _
(0.223) (0.023)** (0.000)*
IRC _ -0.0001 _ -0.002 _ 0.002
(0.841) (0.000)* (0.100)***
LCRR _ 0.160 _ 0.538 _ -0.204
(0.017)** (0.000)* (0.162)
LSLR _ -0.020 _ -0.047 _ -0.002
(0.000)* (0.001)* (0.851)
LDCP _ 0.043 _ -0.054 _ -0.249
(0.140) (0.496) (0.003)*
LBD -0.122 -0.223 0.131 0.071 -0.118 -0.364
(0.028)** (0.000)* (0.408) (0.600) (0.178) (0.005)*
LFDIY -0.023 -0.014 0.005 0.041 -0.015 -0.018
(0.003)* (0.108) (0.793) (0.003)* (0.356) (0.034)**
LGDFCFY 0.217 0.186 0.694 0.512 0.230 0.261
(0.000)* (0.000)* (0.000)* (0.000)* (0.028)** (0.014)**
* significant at the 1% level; ** significant at the 5% level; *** significant at the 10% level; p-values are
reported in parentheses; refer to list of abbreviations for interpretation of variables
Interest rate is found to be significant in model E only, with PCDC as indicator of FD. A
positive impact is noted and the long run elasticity of FD with respect to IR is 0.133. This finding is
in accordance with Hachicha (2005) who also found a positive effect of interest rate on financial

68

VI. Conclusion

deepening for Tunisia. The financial repression index is found to be significant with PCDC and
PCY as FD. A negative long run impact is noted on financial development which confirms
traditional literature on financial liberalisation and empirical literature again carried out by
Hachicha (2005) for Tunisia. The long run elasticity of financial deepening with respect to financial
repression is found to be 0.001 across both models C and E.
The index of interest rate restraints seem to give contradicting effects in models D and F for
which it is significant. The former is reporting a negative influence while the latter a positive
relationship, but both with the same elasticities but different levels of significance. Ang’s (2009)
findings point towards a positive impact of interest rate controls on financial deepening in India.
The theoretical underpinnings also point towards a positive impact of interest rate controls. These
are inconsistent with the coefficient estimated at the 1% level, which allows for the best estimation
of IRC’s influence on FD. Models B and D report significant but positive and negative effects of
cash reserve requirement and statutory liquidity requirement on financial deepening respectively.
Ang (2009) pointed out the ambiguity of the effects of CRR on FD, finding both positive and
negative influence of CRR for the Indian financial system. However, it is by far contradictory to
conventional literature which notes a negative impact of CRR (Kim and Santomero, 1988).
The negative long run elasticity of financial deepening with respect to SLR follows the
empirical findings of Demetriades and Luintel (1996) but is in contrast to Ang’s (2009) findings. As
Ang (2009) points out, the imposition of an adequate liquidity ratio is important for a well-
functioning economy. Furthermore our findings are inconsistent with theoretical literature23. The
extent of directed credit programmes brings to light its negative impact on financial deepening. This
is against Schwarz (1992) empirical work. However, the extent of DCPs is based on assumptions24,
though the subsidies allocated to priority sectors is still high. The long run elasticity of FD on
branch density is found to be significant but negative in all three models A, B and F. This is in
contrast to the empirical findings of both Hachicha (2005) and Demetriades and Luintel (1996). The
ratio of foreign direct investment to GDP is found to have a negative impact on financial deepening
in two out of three significant models. Models A and F appropriate a negative elasticity of 0.023
and 0.018 respectively. However, the effect is very limited. Model D estimated a positive impact of
FDIY on FD.

23
See Courakis (1984)
24
Refer to section IV.II for the assumptions on directed credit programmes

69

VI. Conclusion

In short, the coefficients provide a clearer and more accurate perception of the different
banking sector policies on financial deepening, despite being contrary to empirical literature.
However, the yielded results concord with the policies in place in Mauritius. No interest rate
controls, a very low cash reserve requirement, a quasi-nil liquidity requirement and a high degree of
credit programme to priority sectors, provide for the necessary explanations for the signs of the
coefficients.
Short run Estimates
The short run impact of the different variables is derived through Engle and Granger’s
approach and listed in Table V. In contrast with the long run influence on financial development, all
of the banking controls do not show a short run effect. Indeed, only cash reserve requirement and
statutory liquidity requirement are seen to influence the level of financial development in the short
term. SLR is found to negatively impact financial development in both the short and long run while,
it is noted that cash reserve requirement interacts positively with FD in two of the three indicators
in again the short as well as long run. This shows the relative importance of CRR as policy measure
in impacting favourably financial development.
Table V. Short run Effect on Financial Deepening
Short run Interaction on FD

Engle and Granger’s Approach
LPCGDP 0.254 0.242 0.908 0.734 0.429 0.640

(0.155) (0.118) (0.015)** (0.012)** (0.218) (0.062)***
LIR -0.008 0.005 0.020 0.087 -0.049 -0.068
(0.769) (0.845) (0.711) (0.056)*** (0.357) (0.202)
FRI 0.000 _ -0.001 _ -0.001 _
(0.930) (0.016)** (0.002)*
IRC _ 0.000 _ -0.001 _ 0.001
(0.443) (0.244) (0.538)
LCRR _ 0.017 _ 0.388 _ -0.273
(0.774) (0.008)* (0.061)***
LSLR _ -0.005 _ -0.065 _ -0.013

70

VI. Conclusion

(0.452) (0.000)* (0.377)
LDCP _ 0.027 _ 0.168 _ -0.056
(0.679) (0.164) (0.699)
LBD 0.069 0.079 0.053 0.006 0.255 -0.243
(0.459) (0.347) (0.770) (0.965) (0.164) (0.186)
LFDIY -0.008 -0.007 0.014 0.027 0.005 -0.004
(0.307) (0.278) (0.408) (0.034)** (0.729) (0.777)
LGDFCFY 0.156 0.152 0.328 0.505 0.050 0.144
(0.008)* (0.003)* (0.024)** (0.000)* (0.641) (0.182)
* significant at the 1% level; ** significant at the 5% level; *** significant at the 10% level; p-values are reported in
parentheses; refer to list of abbreviations for interpretation of variables
V.IV Error Correction Term
The error correction term is computed via the Engle and Granger’s approach. It relates the
convergence of short run deviations to the equilibrium. An excerpt of the parameters for all three
indicators of financial development as dependent variables is provided in Table VIII below.
Table VIII. Error Correction Term25
Short run Adjustment Parameters

ECM t-1 -1.037 -1.192 -0.527 -1.314 -0.615 -0.840

(0.000)* (0.000)* (0.016)** (0.000)* (0.001)* (0.001)*
* and ** indicate significance at the 1% and 5% level; p-values are reported in parentheses; refer to list of
abbreviations for interpretation of variables
All models provide for significant error correction terms with the correct sign. This
confirms any cointegrating relationships existent between the various independent variables and any
of the indicators of FD. All deviations in the short run due to any shock in the system converge
back to equilibrium. For instance, the resulting ECMt-1 for PCY Model E implies that nearly 61.5%
of the short run disequilibrium is wiped out or corrected during one year. In contrast, LLLY‘s Model
A provides for a faster adjustment to equilibrium at 103.7%.

25
Parameters for these models only are derived due to their relative importance

71

VI. Conclusion

CONCLUSION
This study assessed the effects of the various repressionist policies on financial
development. Using a multivariate time series framework, annual data relating to restraints on
interest rates, cash reserve requirements, statutory liquidity requirements and directed credit
programmes are collected. King and Levine’s (1993) indicators of financial development are
implemented so that three indicators formulate three different models as a sensitivity analysis. Each
indicator provides for two specifications, one consisting of the individual controls to capture their
relative influence on financial development, and the other consisting of the financial repression
index which is computed via the principal component analysis. A PCA is also constructed for the
different interest rate controls due to multicollinearity issues. Other determinants of FD are included
to cater for any sample bias.
Two estimation techniques are allowed, the VECM and the DOLS estimator (Stock and
Watson, 1993), to account for the long run interactions of the different variables on financial
deepening. Johansen’s cointegration test provides for a clear view on the perspective of an existing
long run relationship between FD and the different variables. The DOLS estimator evidences a
positive influence of cash reserve requirements on the financial system (around 4%). Liquidity
requirements (0%) and directed credit programmes have a negative effect on FD. Interest rate
controls seem to have ambiguous relationship with FD. Short run influence shows CRR as the
leading effect policy. Causality issues show that liquidity requirements have a bi-directional short
run causality with the ratio of liquid liabilities to GDP as indicator to FD. The long run causality
test provided gives only a notion of the extent to which the different controls impact on financial
deepening. No evidence of direction can be derived. Again, cash reserve requirement shows a
higher causal relationship with FD.
It is brought forth that the ratio of private claims on the non-financial private sector to total
domestic credit does not level to an appropriate indicator to FD. Though the other two indicators
provide quite similar statistics, the ratio of liquid liabilities to GDP is preferred to best indicate
financial development in Mauritius. The financial repression index and the bank rate show a high
causal relationship with FD. These policies, formulated by the BOM, thus have profound
implications on the financial system. This shows the much centralised role played by the BOM in
the definition of the Mauritian financial system.

72

VI. Conclusion

The policy measure which best seems to cause financial deepening is cash reserve
requirement. Indeed, both long and short run estimates provide for a favourable interaction with the
level of financial development. Causality tests also show a short run causal relationship running
from cash reserve requirement to FD while the extent of long run causality seems to be highest for
CRR. Standing at approximately 4% in Mauritius, CRR has come down to its lowest level today.
This shows the relative reliability of the BOM in taking appropriate policy measures for the
Mauritian economy. Though CRR holds a drawback as to the extent of loanable funds available to
banks, this measure remains very much compelling and satisfactory.
This study provides for a quite captivating and ‘intriguing’ relationship between banking
sector controls and financial development, in that policies of a repressive nature tend to deepen the
financial system. This supports the findings of Stiglitz (1994) and Ang (2009). Evidence points out
that some forms of restraints on interest rates and the imposition of liquidity requirements in
Mauritius, but only to a certain extent, could lead up to financial deepening. Above a certain level
of repressionist measures imposed, financial development tends to depress.

73


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55

Appendix 3

APPENDICES
Panel : Model B with LLY as Indicator for Financial Deepening
Short run Granger Non-Causality Test [FD = LLY]
∆FD ∆LPCGDP ∆LIR ∆LBD ∆LFDIY ∆LGDFCFY

∆IRC ∆LCRR ∆LSLR ∆LDCP
∆FD _ 13.28 0.47 0.08 5.91 4.33 0.02 1.21 1.39 0.46
[LLLY] (0.0003)* (0.4948) (0.7733) (0.0150)** (0.0375)** (0.8789) (0.2706) (0.2391) (0.4962)
∆LPCGDP 1.95 _ 0.19 2.95 0.03 0.01 0.02 0.31 1.36 0.68
(0.1627) (0.6608) (0.0860)*** (0.8581) (0.9120) (0.8928) (0.5804) (0.2436) (0.4099)
∆LIR 0.30 0.13 _ 0.00 1.64 0.04 0.40 0.12 0.03 0.07
(0.5849) (0.7200) (0.9933) (0.2009) (0.8485) (0.5288) (0.7245) (0.8702) (0.7958)
∆IRC 1.03 0.77 0.26 _ 2.32 2.61 0.03 0.31 1.02 2.14
(0.3099) (0.3805) (0.6100) (0.1274) (0.1059) (0.8721) (0.5802) (0.3129) (0.1439)
∆LCRR 0.05 0.03 0.72 0.45 _ 0.04 0.01 0.11 0.38 0.67
(0.8312) (0.8659) (0.3974) (0.5033) (0.8406) (0.9107) (0.7436) (0.5355) (0.4135)
∆LSLR 3.84 1.73 0.03 0.50 7.87 _ 0.08 3.00 1.37 3.33
(0.0501)*** (0.1886) (0.8686) (0.4790) (0.0050)* (0.7716) (0.0831)*** (0.2425) (0.0680)***
∆LDCP 14.12 5.04 1.93 0.93 19.76 7.62 _ 10.96 21.97 19.19
(0.0002)* (0.0248)** (0.1649) (0.3350) (0.0000)* (0.0058)* (0.0009)* (0.0000)* (0.0000)*
∆LBD 3.89 0.02 0.25 1.84 0.81 0.62 0.46 _ 1.07 0.03
(0.0484)** (0.8900) (0.6196) (0.1745) (0.3670) (0.4321) (0.4989) (0.3000) (0.8623)
∆LFDIY 0.01 0.38 0.94 0.26 0.05 1.60 0.52 0.08 _ 0.02
(0.9247) (0.5393) (0.3330) (0.6077) (0.8269) (0.2065) (0.4717) (0.7720) (0.8895)
∆LGDFCFY 0.70 4.77 0.52 0.53 0.40 3.02 0.25 1.27 0.86 _
(0.4026) (0.0290)** (0.4699) (0.4647) (0.5245) (0.0824)*** (0.6147) (0.2599) (0.3547)
* significant at the 1% level; ** significant at the 5% level; *** significant at the 10% level; p-values are reported in parentheses; refer to list of abbreviations for
interpretation of variables

62

Appendix 3

Panel : Model C with PCDC as Indicator for Financial Deepening
Short run Granger Non-Causality Test [FD = PCDC]
∆FD ∆LPCGDP ∆LIR ∆FRI ∆LBD ∆LFDIY ∆LGDFCFY
∆FD _ 4.36 4.45 0.14 0.36 1.45 0.03

[LPCDC] (0.1130) (10.79) (0.9315) (0.8357) (0.4850) (0.9828)
∆LPCGDP 1.96 _ 1.03 2.77 1.72 0.75 0.50
(0.3754) (0.5976) (0.2497) (0.4234) (0.6883) (0.7788)
∆LIR 1.99 0.13 _ 3.08 1.13 2.04 1.55
(0.3696) (0.9360) (0.2143) (0.5678) (0.3602) (0.4614)
∆FRI 4.04 1.81 0.06 _ 0.76 2.91 1.05
(0.1324) (0.4054) (0.9680) (0.6822) (0.2336) (0.5927)
∆LBD 0.01 0.11 0.85 0.04 _ 1.94 1.73
(0.9965) (0.9461) (0.6545) (0.9792) (0.3787) (0.4205)
∆LFDIY 0.36 1.81 7.28 11.83 0.47 _ 4.63
(0.8365) (0.4054) (0.0262)** (0.0027)* (0.7915) (0.0985)***
∆LGDFCFY 8.11 5.96 5.87 3.09 6.21 1.62 _
(0.0173)** (0.0508)** (0.0530)** (0.2132) (0.0448)** (0.4450)
* significant at the 1% level; ** significant at the 5% level; *** significant at the 10% level; p-values are reported in parentheses; refer to list of

63

Appendix 3

Panel : Model D with PCDC as Indicator for Financial Deepening
Short run Granger Non-Causality Test [FD = PCDC]

∆FD _ 0.03 0.49 0.00 0.26 0.03 0.04 0.00 0.02 0.00
[LPCDC] (0.8609) (0.4831) (0.9946) (0.6085) (0.8542) (0.8450) (0.9958) (0.8907) (0.9466)
∆LPCGDP 0.03 _ 1.07 6.12 0.44 0.35 0.29 1.28 2.17 2.34
(0.8531) (0.3012) (0.0133)** (0.5062) (0.5557) (0.5930) (0.2570) (0.1410) (0.1259)
∆LIR 1.49 0.12 _ 0.05 6.43 0.00 0.03 0.19 1.24 2.63
(0.2229) (0.7257) (0.8205) (0.0112)** (0.9732) (0.8633) (0.6624) (0.2654) (0.1047)
∆IRC 6.92 5.78 3.21 _ 0.00 2.92 0.75 2.09 0.49 0.03
(0.0085)* (0.0162)** (0.0734)*** (0.9603) (0.0874)*** (0.3869) (0.1481) (0.4853) (0.8596)
∆LCRR 1.45 0.63 0.81 0.24 _ 0.41 0.00 0.04 0.91 0.03
(0.2290) (0.4277) (0.3671) (0.6241) (0.5228) (0.9559) (0.8322) (0.3399) (0.8570)
∆LSLR 0.00 0.00 0.65 0.15 0.55 _ 0.20 0.11 0.23 0.06
(0.9825) (0.9505) (0.4184) (0.6967) (0.4580) (0.6563) (0.7442) (0.6290) (0.8098)
∆LDCP 0.16 0.00 1.32 0.00 1.58 0.00 _ 1.05 2.19 0.66
(0.6864) (0.9544) (0.2501) (0.9850) (0.2094) (0.9493) (0.3060) (0.1392) (0.4182)
∆LBD 1.49 0.18 0.55 0.27 0.19 0.07 0.04 _ 4.97 1.90
(0.2307) (0.6689) (0.4573) (0.6062) (0.6607) (0.7915) (0.8339) (0.0257)** (0.1677)
∆LFDIY 1.44 0.07 2.67 0.41 1.94 2.68 0.00 1.38 _ 2.01
(0.2307) (0.7876) (0.1021) (0.5225) (0.1631) (0.1014) (0.9707) (0.2402) (0.1564)
∆LGDFCFY 4.75 0.02 0.02 0.13 0.10 0.00 0.24 0.24 1.10 _
(0.0293)** (0.8820) (0.8979) (0.7199) (0.7551) (0.9994) (0.6245) (0.6251) (0.2941)

64

Appendix 3

Panel : Model E with PCY as Indicator for Financial Deepening
Short run Granger Non-Causality Test [FD = PCY]
∆FD ∆LPCGDP ∆LIR ∆FRI ∆LBD ∆LFDIY ∆LGDFCFY
∆FD [LPCY] _ 14.50 11.41 6.22 3.61 4.03 2.72

(0.0007)* (0.0033)* (0.0446)** (0.1642) (0.1333) (0.2562)
∆LPCGDP 0.67 _ 1.08 2.72 1.38 0.85 0.99
(0.7155) (0.5838) (0.2564) (0.5026) (0.6533) (0.6104)
∆LIR 3.41 2.80 _ 3.38 0.42 4.63 0.54
(0.1816) (0.2461) (0.1843) (0.8108) (0.0989)*** (0.7638)
∆FRI 3.80 2.00 1.89 _ 1.85 2.45 0.31
(0.1495) (0.3675) (0.3892) (0.3974) (0.2942) (0.8546)
∆LBD 2.93 3.83 5.71 2.93 _ 3.26 1.41
(0.2315) (0.1471) (0.0575)*** (0.2310) (0.1960) (0.4940)
∆LFDIY 0.05 1.68 2.02 1.68 0.86 _ 5.14
(0.9766) (0.4314) (0.3647) (0.4308) (0.6505) (0.0763)***
∆LGDFCFY 3.00 5.16 1.10 0.95 0.82 1.54 _
(0.2233) (0.0757)*** (0.5770) (0.6204) (0.6623) (0.4624)
* significant at the 1% level; ** significant at the 5% level; *** significant at the 10% level; p-values are reported in parentheses; refer to list of

65

Appendix 3

Panel : Model F with PCY as Indicator for Financial Deepening
Short run Granger Non-Causality Test [FD = PCY]

∆FD _ 0.16 7.41 0.00 3.30 4.63 4.19 2.73 2.22 0.00
[LPCY] (0.6855) (0.0065)* (0.9914) (0.0694)*** (0.0314)** (0.0407)** (0.0982)*** (0.1359) (0.9638)
∆LPCGDP 0.56 _ 0.12 4.85 0.00 0.07 0.02 0.93 1.64 1.45
(0.4532) (0.7274) (0.0276)** (0.9839) (0.7848) (0.8970) (0.3360) (0.2005) (0.2291)
∆LIR 1.78 0.02 _ 0.17 0.16 0.10 0.22 0.22 0.01 0.81
(0.1817) (0.9003) (0.6837) (0.6861) (0.7484) (0.6378) (0.6382) (0.9150) (0.3674)
∆IRC 3.53 2.48 0.03 _ 6.64 3.34 0.31 2.82 1.14 2.92
(0.0602)** (0.1156) (0.8619) (0.0100)* (0.0676)** (0.5796) (0.0932)*** (0.2858) (0.0873)***
∆LCRR 0.02 0.03 5.99 0.05 _ 2.93 3.15 1.14 1.80 2.61
(0.8918) (0.8548) (0.0144)** (0.8211) (0.0868)*** (0.0758)** (0.2856) (0.1801) (0.1060)
∆LSLR 0.36 0.28 0.28 0.01 0.76 _ 2.75 0.68 1.02 0.89
(0.5465) (0.5954) (0.5994) (0.9337) (0.3842) (0.0971)*** (0.4104) (0.3119) (0.3443)
∆LDCP 0.29 0.00 0.32 0.22 0.46 2.30 _ 0.00 8.81 2.50
(0.5911) (0.9870) (0.5740) (0.6389) (0.4991) (0.1290) (0.9636) (0.0030)* (0.1140)
∆LBD 0.25 0.27 0.01 0.26 0.63 0.12 0.21 _ 1.76 0.00
(0.6156) (0.6059) (0.9214) (0.6113) (0.4275) (0.7329) (0.6491) (0.1846) (0.9811)
∆LFDIY 0.02 0.22 0.65 0.42 0.09 2.73 0.39 0.60 _ 0.15
(0.8791) (0.6356) (0.4186) (0.5185) (0.7641) (0.0982)*** (0.5308) (0.4387) (0.6953)
∆LGDFCFY 3.37 0.34 0.25 0.01 0.46 0.34 0.36 0.58 0.02 _
(0.0663)** (0.5605) (0.6151) (0.9053) (0.4960) (0.5625) (0.5499) (0.4466) (0.8842)

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Banking Sector Controls and Financial Development

^Corresponding author: b.seetanah@uom.ac.mu

Electronic copy available at: http://ssrn.com/abstract=1594866

Electronic copy available at: http://ssrn.com/abstract=1594866

Electronic copy available at: http://ssrn.com/abstract=1594866

Model Specification & Data

Principal Component Analysis

Table I. Principal Component Factor Analysis (IRC)

Factor Analysis (pcf)*

* Principal component factor

Figure II. Index of Interest Rate Controls

Integration and Cointegration Analyses

Long run Estimates

Table IV. Long run Effect on Financial Deepening22

IV.A: Estimation of Coefficients through VECM

Long run Interaction on FD

LPCGDP -0.911 -0.530 0.152 -0.758 0.457 -0.812

IV.B: Estimation of Coefficients through DOLS Estimator

Long run Interaction on FD

LPCGDP 0.672 0.710 0.366 0.687 0.865 0.780

Short run Estimates

Table V. Short run Effect on Financial Deepening

Short run Interaction on FD

LPCGDP 0.254 0.242 0.908 0.734 0.429 0.640

V.IV Error Correction Term

Table VIII. Error Correction Term25

Short run Adjustment Parameters

ECM t-1 -1.037 -1.192 -0.527 -1.314 -0.615 -0.840

DEMIRGUC-KUNT, A. AND DETRAGIACHE, E., 1998. The determinants of banking crises in

GRANGER, C.W.J., 1988. Some recent developments in a concept of causality. Journal of

MACKINNON, R.I., 1973. Money and Capital in Economic Development [online].

MASIH, R. AND MASIH, A.M.M., 2000. A reassessment of long-run elasticities of Japanese

VAN WIJNBERGEN, S., 1982. Stagflationary effects of monetary stabilization policies: a

Panel : Model B with LLY as Indicator for Financial Deepening

Short run Granger Non-Causality Test [FD = LLY]

∆FD ∆LPCGDP ∆LIR ∆LBD ∆LFDIY ∆LGDFCFY

Panel : Model C with PCDC as Indicator for Financial Deepening

Short run Granger Non-Causality Test [FD = PCDC]

∆FD ∆LPCGDP ∆LIR ∆FRI ∆LBD ∆LFDIY ∆LGDFCFY

∆FD _ 4.36 4.45 0.14 0.36 1.45 0.03

Short run Granger Non-Causality Test [FD = PCDC]

∆FD ∆LPCGDP ∆LIR ∆LBD ∆LFDIY ∆LGDFCFY

Panel : Model E with PCY as Indicator for Financial Deepening

Short run Granger Non-Causality Test [FD = PCY]

∆FD ∆LPCGDP ∆LIR ∆FRI ∆LBD ∆LFDIY ∆LGDFCFY

∆FD [LPCY] _ 14.50 11.41 6.22 3.61 4.03 2.72

Short run Granger Non-Causality Test [FD = PCY]

∆FD ∆LPCGDP ∆LIR ∆LBD ∆LFDIY ∆LGDFCFY

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