Financial liberalization and interest rate determination in Tanzania: a dynamic specification

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Date
1997
Journal Title
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Publisher
University of Dar es Salaam
Abstract
The study investigates the relationship between liberalization and reform of the financial system on the one hand and the determination of the rate of interest in Tanzania during the period covering 1993:01 to 1996:12 on the other. It is recognized that the effects of financial repression are one problem retarding economic growth and development in developing countries. The elimination of controls on interest rates and liberalization of the financial system as a solution to financial repression and accompanying effects has in recent times become yet another problem. Theory holds that liberalization of the domestic financial markets and subsequent deregulation of the domestic interest rates will lead to greater influence of both foreign economic factors and domestic factors on the behaviour of the domestic rate of interest. The study employed both qualitative and quantitative methods of analysis. The qualitative analysis was basically descriptive while the quantitative analysis involved both statistical and econometric techniques. In econometric analysis, a dynamic model was specified to study the influence of foreign economic factors or domestic factors or both on the behaviour of the domestic rate of interest. A single reduced form equation was fitted to data covering 1993:01-1996:12. It was demonstrated that the Tanzanian economy was neither fully open nor completely closed and that the behaviour of the domestic rate of interest was influenced by both domestic and foreign economic factors. It was also demonstrated that the degree of financial openness of the economy as well as the speed of adjustment of the domestic rate of interest increased as the pace of financial liberalization and reform got underway. The findings show that the degree of financial openness of the Tanzanian economy was substantially higher than would be warranted by the existing legal restrictions on capital flows. The estimated index of financial openness of 0.96 for the period covering 1995:01-1996:12 implies that the domestic rate of interest would adjust almost instantaneously to equilibrium. But, the estimated speed of adjustment of the domestic rate of interest was found to be = 0.174 for the period, arising to = 0.276 during the 1996:03-1996:12 period. On the basis of the findings, it is observed that the empirical speed of adjustment is not consistent with calculated index of financial openness of the economy. This implies that there are constraints to the interest rate mechanism hampering the free determination of the domestic rate of interest. The study therefore recommends that measures be taken to eliminate elements constraining the response of the domestic rate of interest to foreign economic factors and/or domestic monetary policy and domestic factors. Focus should be directed at eliminating non-performing loans and monopolistic inefficiencies in the financial system through further reforms and restructuring of the financial system with a view to promote competition and efficiency as well as to narrow the interest rate differentials. In addition to hastening of the financial sector liberalization and reform process, the study also recommends restructuring and reform of the real sector as a strategy to increase the efficacy of the interest rate at influencing the major macroeconomic variables including savings, investment, the balance of payments and growth. It is expected that this will also improve efficacy of the indirect monetary control by reducing lags on policy implementation. The model can be used as an indicator of the progress of financial liberalization and the reform process in Tanzania.
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Keywords
Tanzania, Interest rates, Fiscal policy
Citation
Tuni, A. A. (1997) Financial liberalization and interest rate determination in Tanzania: a dynamic specification, Masters’ dissertation, University of Dar es Salaam. Available at (http://41.86.178.3/internetserver3.1.2/detail.aspx)