Determinants of interest rate spread in Uganda: 1980-2013

Abstract

Interest rate spread is too wide in Uganda, thus the purpose of this study is to examine the determinants of bank interest rate spread in Uganda and to provide policy options that would help to narrow the interest rate spread so as to enhance the efficiency of the Banking sector and hence economic growth and development of Uganda. The study focused on some banking industry-specific and macroeconomic determinants of interest rate spread. In particular, the study investigated the effect of inflation, GDP growth, official exchange rate, extent of government borrowing from commercial banks, credit to the private sector by commercial banks, Treasury bill rate and total deposits of commercial banks on interest rate spread in Uganda for the period 1980 to 2013. Ordinary Least Squares were used to estimate the linear regression model and Annual data obtained from the World Bank data bank and Bank of Uganda was used. To ensure that the model was adequate, consistent and unbiased, various diagnostic tests were conducted. The Dickey-Fuller Test was performed to determine if the variables were stationary and cointegration analysis using the Johansen test was also done to determine whether the variables are cointegrating. The Ramsey test was also conducted to ensure that the model was correctly specified. Finally, the error correction model was estimated to check the speed of adjustment of the variables towards equilibrium. The study then found the second lag of the interest rate spread to be important in explaining the variation in the interest rate spread in Uganda. The coefficient of the first lag of GDP growth rate was found to have a negative significant impact on the interest rate spread. Also the second lag of inflation was significant and positively associated with interest rate spread .The coefficient of first lag of credit to private sector by commercial banks was negative and statistically significant. Also the coefficient of the log of first lag of government borrowing was found to have a Positive impact on IRS. In addition, the second lag of Treasury bill rate was positively associated with interest rate spread together with the coefficient of the second lag of official exchange rate .The coefficient of the log of the second lag of total deposits of commercial banks was also found to be negative and statistically significant. The major policy recommendations to reduce interest rate spread according to the study include; increasing total deposits of commercial banks, increasing GDP growth rate, maintaining low exchange rate, pursuing interest rate policies such as reduction of interest rate on a 91-day Treasury bill rate together with policies to curb down inflation.