ASYMMETRIC ADJUSTMENT OF COMMERCIAL BANK INTEREST RATES IN THE EURO AREA: IMPLICATIONS FOR MONETARY POLICY

by Harald Sander and Stefanie Kleimeier

Abstract: This study provides an empirical analysis of asymmetries in the transmission of policy rate innovations on bank lending rates. Our study extends on the existing literature by conducting cointegration analyses that explicitly test for structural breaks and for asymmetric upward and downward adjustment in interest rates. Comparing the empirical results for 12 European countries reveals that the speed of adjustment of lending rates to policy rate changes differs widely within the EMU, implying that the ECB is still confronted with an asymmetric EMU that complicates the conduct of a single monetary policy.

JEL Classification:Numbers: Keywords:

E43, E52, E58, F36 Interest Rates, Monetary Policy, European Monetary Union, Asymmetric Adjustment, Cointegration Analysis, Structural Breaks

The authors are from the University of Applied Sciences Cologne and the Maastricht University, respectively. S. Kleimeier would like to acknowledge the financial support from METEOR.

All comments are welcome. Please contact: Prof. Dr. Harald Sander University of Applied Sciences Cologne Claudiusstr. 1 50678 Kln Germany Phone: ++49-208-853691 Fax: ++49-221-8275-3131 e-mail: gh.sander@t-online.de

Shooting at a moving target in the fog is no easy task. Dornbusch, Favero and Giavazzi (1998) The markets are asymmetric; we are not. Alan Greenspan (1999)

1. Introduction

Since January 1, 1999 the new European Central Bank has to conduct a one-size-fits-all monetary policy based on her assessment of the average economic conditions of the 11 member countries of the European Monetary Union (EMU). Next to the usual issues and controversies in monetary policy making this implies three new challenges: (1) determining the appropriate average monetary policy in case of diverging economic conditions in the Euro area, (2) dealing with possible asymmetric effects of that monetary policy in different member countries, i.e. a divergent monetary transmission mechanism which (3) is most likely subject to dramatic changes (convergence?) as financial market integration and restructuring alongside EMU evolves. While the first challenge has always been at the heart of the controversies about a common currency and attracted a lot of public attention in the first half of 1999 as the cyclical position of the Euro area member countries appeared to diverge1 , the second issue has only recently become an important topic in empirical research. While the latter development is to be welcomed, challenge #3 should remind us that judgements about the workings of the monetary mechanism that are based on past data could be profoundly misleading in the context of a regime change. Our paper focuses on the latter two challenges by providing evidence on symmetries, asymmetries, and changes in the monetary mechanism in EMU member countries with particular reference to the financial market side of the transmission process.

Since Franco Modigliani (1963) the monetary mechanism has been described to consist of two parts: the financial market reaction and the wage-price mechanism. While many recent studies have been examining the impact of monetary policies on the real economy (e.g. Ramaswany and Sloek 1997) our study concentrates on the financial market reaction. There are a number of good reasons to do so: First, while there is evidence that the wage-price process is different across Europe, the Lucas principle suggests that this very process may adopt to the European focus of the ECBs monetary policy (Dornbusch et.al. 1998). Financial markets, however, may be more resistant to convergence. E.g. Cecchetti (1999. p. 22) argues that ...differences in financial structure are the proximate cause for these national asymmetries in the monetary policy transmission mechanism, and adds that unless legal structures are harmonized across Europe, financial structures will remain diverse, and so will

the monetary transmission mechanism. Kleimeier and Sander (2000) show that the attempt to integrate the European financial markets by means of regulations (like the 2nd Banking Directive) alone has brought little convergence in lending conditions so far. Secondly, given the high proportion of bank finance in Europe relative to the US/UK - as shown in Table 1 - the lending channel is an important element in the monetary mechanism in Europe as has been suggested by the advocates of the credit view (e.g. Bernake and Gertler 1995, Kashyap and Stein 1994). If loans and bonds are imperfect substitutes in the balance sheets of banks and firms, and firms cannot simply access the capital markets but have to rely on bank finance, the transmission of monetary policy impulses is necessarily linked to bank behaviour. Third, if the structure of the financial system matters as a conveyer of monetary policy, these structural differences can lead to asymmetries in European financial markets reaction and thus monetary policy transmission. In Germany, for example, the close bank-firm relationship tends to weaken the policy-determined interest rate lending rate link, while in economies like the British the like is known to be much more direct.

- insert Table 1 here -

Our study provides an empirical analysis of asymmetries in European financial markets by means of examining how innovations in policy rates are passed onto lending rates as an important element for the speed of the monetary transmission process. Until recently, the literature has often neglected this issue. Exemptions are e.g. Cotarelli and Kourelis (1994), who focus on the role of lending rate stickiness and its structural determinants, Cotarelli, Ferri, and Generale (1995), BIS (1995) and IMF, World Economic Outlook October (1996). Dornbusch et. al. (1998) review this literature with respect to the financial market reaction in potential EMU member countries and find that the characteristics of the financial system ....go some way towards explaining the observed asymmetries in the transmission mechanism. Our study extends on this literature in four important aspects: 1. The link between policy rates and lending rates is analysed in a cointegration approach that tests and allows for structural breaks in order to examine the impact of changing conditions on financial market performance so far. 2. The speed of adjustment to monetary policy innovations are measured by country differences in the error correction terms of the cointegration regression.

In mid-1999 public discussions about increasingly diverging development in production and prices in the EMU member countries abound. The ECB examines this issue in its July 1999 monthly bulletin. 2

3.

Recent research has shifted toward analysing asymmetric adjustment in interest rates (see Enders and Granger, 1998; and Scholnick 1996). As adjustments to innovations in monetary policy may differ when the lending rate is above or below its long run equilibrium level we test also for asymmetric upward and downward adjustment.

4.

Finally we compare cross-country asymmetries in upward and downward adjustments.

In sum, the relationship between national policy interest rates and commercial bank prime lending rates of EMU member countries is analysed by employing cointegration methodology for the 10 EMU member countries plus the United Kingdom and Greece in the period of 1984 to 1998, allowing for endogenously determined structural breaks and asymmetric adjustment towards a long-run equilibrium. Our results will show that the speed of adjustment of lending rates to innovations in policy interest rates still differs widely across countries. In five countries we find either no cointegration (France, Germany, Ireland) or statically insignificant error correction processes (Finland, Spain). In the remaining seven countries adjustment processes are partly symmetric (UK, Portugal, Italy) and partly asymmetric (Belgium, Luxembourg, Netherlands, Greece). Provided the introduction of the common currency will not eliminate these differences in the transmission mechanisms over time, the ECB will be facing the difficult task of formulating and implementing a single monetary policy in a Euro area where the effects of this policy will remain different across member countries.

2. Data and Methodology

In order to analyse the relationship between central bank policy rates and commercial bank lending rates, monthly interest rates have been collected from the CD-ROM version of the IMF's International Financial Statistics (IFS) for the following European countries: Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, The Netherlands, Portugal, and Spain as EMU member states and Greece and the United Kingdom as non-EMU member states.2 As lending rates the rates listed in line 60p of the IFS have been used whereas the central bank discount rates listed in line 60 have been used as policy rates. Exceptions to this sampling procedure were the following: Due to changes in central bank policy, rates from line 60a were used for France as of July 1989 and for the Netherlands as of January 1994. For the United Kingdom, no policy rates were available and money market rates of line 60b have been used instead. For Luxembourg, the Luxembourg lending rates were

Austria, Denmark, and Sweden are not included in this study since monthly lending rates were not available from the IFS for the full period under investigation. 3

used but Belgian rates were used as policy rates due to the monetary union between Belgium and Luxembourg. Descriptive statistics for each interest series are presented in Table 2 for the full sample period of January 1985 to December 1998 and for the post-break period used in the cointegration analysis of January 1994 until December 1998. The time-series of the respective series are shown in Figure 1.

- insert Table 2 and Figure 1 here -

The cointegration analysis applied in this study proceeds in three steps as promoted by Engle and Grangers (1987) followed by an extension of Engle and Grangers basic error correction model, which allows differentiation between an upward and a downward adjustment of interest rates. Before cointegration analysis can proceed, it must be ensured that all interest rate time series have unit roots. As Kleimeier and Sander (2000) have shown, time series of European money market and lending rates exhibit structural breaks in the early 1990s which reflect the changes in the European banking market brought about by the Second Banking Directive. Such a structural break has two specific implications for cointegration analysis. First, if a structural break at an priori unknown point in time is present in a time series, the unit root tests proposed by Engle and Granger (1987) have very little power. Better specified test statistics as proposed by Banerjee, Lumsdaine, and Stock (1992) which are consistent even in the presence of structural breaks will therefore need to be employed. Second, a time period free of structural breaks in the cointegration relationship has to be identified otherwise the interpretation of the cointegration vector will result in misleading conclusions. As Quandt (1960), Andrews (1993), Diebold and Chen (1996), and Hansen (1992) show, a supremum F test allows the exact determination of the timing of such a structural break. Once the break has been determined, the complete cointegration analysis can then be conducted for the pre and post-break periods separately. In particular, our study will focus on the post-break period only.

More formally, our methodology can be described as follows: In order to establish whether interest rates or spreads are I(1), two sets of test statistics will be employed based on regressions on levels as well as first differences for each national interest rate series zt . The first set includes the t- and F-tests proposed by Engle and Granger. The second set includes tests particularly designed to provide reliable results in the presence of a structural break. The t- and F-tests are based on a level regression includes next to lagged observations of the interest rate in question zt-1 also a trend variable T and on the corresponding regression for first differences: (1) zt = + zt-1 + zt-1 + T + t

(1B) zt = + zt-1 + zt-1 + T + t

The null hypothesis stating that the series follow random walks corresponds to H0 : =0 for the t-statistic and to H0 : ==0 for the F-statistic.

In the presence of structural breaks at an -priory unknown point in time, the above two unit root tests have very little power. Better specified are the following test statistics proposed by Banerjee, Lumsdaine, and Stock (1992). Using equation (1A) and (1B), recursive minimum -statistics can be calculated in order to test the null-hypothesis of =0 3 . Furthermore, sequential unit root tests that distinguish between a shift in the mean or the trend of the series can be calculated based on the following regressions for levels and first differences:

(2) zt = + zt-1 + zt-1 + T + D + t

(2B) zt = + zt-1 + zt-1 + T + D+ t

2 2

where D indicates a dummy variable. For the mean-shift tests, D is coded as 1 if t > k and 0 otherwise. For the trend-shift tests, D is coded as t if t > k and 0 otherwise. Here, both minimum -tests regarding H0 : =0 and maximum F-tests regarding H0 : ==0 can be calculated and compared to the critical values 4 .

Once the I(1) characteristic has been established, cointegration testing can commence. First, it has to be established whether or not the cointegration vector is characterised by a structural break and if so, when this break takes place. This is important since in the presence of a structural break, the standard cointegration tests such as those proposed by Engle and Granger have low power, i.e. the rejection frequency of the ADF test is clearly reduced (e.g. Gregory et. al., 1996). The cointegration relationship is described by equation (3) using the

This unit root test is based on a series of sub-samples which span one quarter of the total sample each and comprise data from t = 1 to k, t = 2 to k+1, until t = n to T. The recursive min- is found as the smallest t(k/T) over all sub-samples. To reject the null-hypothesis, the calculated min -value which has to be smaller than the critical value. 4 In particular, a series of regressions is run on the full sample so that different k can be chosen in accordance with Banerjee et als suggestion to move k through the mid-70% of the total sample. Similar to the recursive test, a minimum -value is calculated as the smallest t(k/T) over all sub-samples. 5

lending rate y t for the individual country as the dependent variable and the policy rate x of the same country as t the independent variable:

(3) y t = 1 + 2 xt + u t

To test for structural breaks a supremum F (supF) test is calculated. This test was first proposed by Quandt (1960) and has recently been the focus of various studies (e.g. Andrews 1993, Diebold and Chen 1996, Hansen 1992). This test can be seen as a rolling Chow test and is more flexible than the standard Chow test because it allows simultaneously to test for the significance and the timing of a structural break in the cointegration relationship 5 . If a break is present, the cointegration analysis will proceed focussing on the post-break period only.

Following Engle and Granger (1987), Durbin-Watson (DW) statistics are obtained from equation (3), followed by Dickey-Fuller (DF) and augmented Dickey-Fuller (ADF) tests. The Dickey-Fuller tests are based on the residuals of the cointegration regression (4) u t = - u t-1 + t

where the t-statistic for the estimated coefficient provides an indication regarding the cointegration of the two series. The augmented Dickey-Fuller test is obtained from the regression

(5) u t = -0 u t-1 + i i u t -i + t

Once cointegration is established, the corresponding error correction model (ECM) will be estimated in order to investigate the speed of adjustment of lending rates to changes in policy rates. Here, both a symmetric ECM as well as an asymmetric ECM is estimated. This distinction allows us to investigate possible differences in adjustment when rates are above versus below their equilibrium level. To find the correct specification of the

In particular, a series of standard Chow tests are conducted for a series of different break points k, which move through the mid-70% of the sample. SupF equals the largest Chow F-statistic and is compared to critical values as reported by Hansen (1992). The sequence of F-statistics can give an indication about the timing of the break. 6

ECM, the procedure suggested by Engle and Granger (1987) is followed. First, an unrestricted vector autoregression (UVAR) is estimated based on the regression

(6) y t = 0 + 1 y t-1 + 2 xt-1 + i yi y t -i + i xi xt -i + t

with a maximum lag structure of i=12. From this regression, the significant lagged first differences of the exogenous and endogenous variables are identified and included in the final ECM in combination with any error correction terms ECT obtained from the estimated errors that were found significant in the cointegration regressions stated in equation (3). Note also that the same lag-structure is used for the symmetric as for the asymmetric ECM. The speed of adjustment in the symmetric ECM can now be found by regressing

(7) y t = 0 + 1 ECT t-1 + i yi y t -i + i xi xt -i + t

The estimated coefficient 1 of the ECT measures the speed of adjustment. For example an estimated 1 of -0.2 indicates that if there is a shock to the variable y t which changes its value relative to the equilibrium relationship to the cointegrated series xt , then one fifth of the divergence is eliminated in the following period.

In the asymmetric model, a distinction is being made to whether the interest rates are below or above their equilibrium levels 6 . The ECT from the cointegration regression is separated into two components such that

(8)

ECT +t ECT +t

= ECT t =0

if ECTt > mean(ECT) otherwise

and (9) ECT ECT

t

= ECT t =0

if ECTt < mean(ECT) otherwise

The speed of adjustment in the asymmetric ECM can now be found by regressing

A similar approach has been used by Scholnick (1996), who however focuses on short-run dynamics different to the ones used here is equation (6) and (7). 7

(9) y t = 0 + 1 ECT +t-1 + 2 ECT t-1 + i yi y t -i + i xi xt -i + t The estimated coefficient 1 of ECT + measures the speed of adjustment when rates are above their equilibrium level, whereas the estimated coefficient 2 of ECT measures the speed of adjustment when rates are below their equilibrium level. A result of 1 = -0.3 versus 2 =-0.6 would indicate that if a shock to variable y t which raises its value relative to the equilibrium relationship to the cointegrated series x , it takes only half as long for the t divergence to be eliminated than if a shock to variable y t decreases its value relative to the equilibrium relationship to the cointegrated series xt . Finally, an F-test regarding the null-hypothesis 1 = 2 indicates whether the speed of adjustment is significantly different for above- and below-equilibrium levels.
-

3. Results and conclusions

Table 3 provides an overview of the different unit root test statistics employed in this study to test whether or not the interest rate series under consideration fulfil the requirement of being I(1). Overall, we are confident that cointegration analysis can proceed for all national series with the exception of Ireland, where lending rates appear to be I(0). Thus, special care should be taken when interpreting the results for Ireland in the remainder of the paper. - insert Table 3 here -

Table 4 provides evidence for the presence of a structural break in the cointegration relationship in each country with the exception of France. For the other countries the break occurs between August 1987 and December 1993. These breaks are similar to those detected by Kleimeier and Sander (2000) and can be attributed to the changes in the national banking systems as brought about by the second banking directive. As it is the objective of this study to focus on the transmission mechanism as it was in place right at the introduction of the EMU, the cointegration analysis will only focus on the post-break period. Consequently, a sample period free of breaks and common to all countries will be selected which ranges from January 1994 until December 1998.

- insert Table 4 here -

The main results of our study are summarized in Table 5 and visualised in Figure 2. Looking first at the Durbin-Watson and the Dickey-Fuller test statistics reveals that on the broadest level, two groups of countries exist in Europe: Those for which cointegration could be established implying an existing lending channel for the transmission of monetary policy and those for which cointegration could not be established. France, Germany, and Ireland belong to the latter group, whereas the remaining countries belong to the former group. Note, however, whereas the evidence in favour of cointegration is strong for Belgium, Italy, the Netherlands, Portugal, and Spain, only marginal evidence could be found for Finland, Luxembourg, Greece, and the United Kingdom. For these nine countries for which some level of cointegration could be detected, the estimated coefficients of the error correction terms in the symmetric and asymmetric ECM reveal a further separation of countries into two groups: Those for which the adjustment of lending rates to a policy rate shock is symmetric and those for which the adjustment is asymmetric. For Finland, Italy, Portugal, Spain, and UK the F-test reported in the last column of Table 5 is not significant and therefore 1 , the coefficient of the symmetric ECT is relevant. In these five countries, the speed of adjustment differs widely. In Finland, Italy, and Spain the coefficient is insignificantly different from zero indicating that even if cointegration could statistically be found, the time of adjustment is infinitively long. For Portugal and the UK, the estimated coefficient of 0.121 and 0.166 respectively indicate that lending rates fully adjust to shocks in policy rates within 6 to 8 months. In Belgium, Luxembourg, the Netherlands, and Greece the adjustment of lending rates to policy rate changes is asymmetric in nature as the F-statistics in Table 5 indicates. For all countries in this group, the adjustment is faster if rates are above the equilibrium level as is indicated by the finding that 1 is smaller than 2 . It is interesting to note that the divisions between cointegrated versus non-cointegrated interest rates and between symmetrically versus asymmetrically adjusting interest rates do not correspond neither to the distinction into EMU members and nonmembers, nor to that of EMU-core and non-core members (see also Dornbusch et. al., 1998). Overall, our findings indicate the presence of cross-country differences in the adjustment processes of commercial bank interest rates to policy rate changes within and outside the Euro area.

In sum, our study confirms that monetary policy in the Euro area is still to be conducted under the conditions of an "asymmetric EMU" of which the differences in the way the different banking systems in Euro area countries work are arguably among the most important ones 7 . We found not only that the speed of adjustment is different across countries of actual and prospective EMU member countries, but also that this

For a most recent statement on the "asymmetric EMU" see Corsetti and Pesenti in their September 1999 paper presented at the Brookings panel. 9

speed differs in terms of an asymmetric upward and downward adjustment process. Such asymmetries are present in some but not all countries under investigation, suggesting the necessity to include asymmetric models in the analysis. While optimists hope that the elimination of currency risks may contribute to an institutional harmonization within EMU the evidence provided here suggests that for the nearer future asymmetries will continue to influence the monetary mechanism within the Euro area.

10

Bibliography

Andrews, D.W.K., 1993, Tests for parameter instability and structural change with an unknown change point, Econometrica 61, 821-856. Banerjee, A., R.L. Lumsdaine, and J.H. Stock, 1992, Recursive and sequential test of the unit-root and trendbreak hypotheses: Theory and international evidence, Journal of Business & Economic Statistics 10, 271287. Bank for International Settlements (BIS), 1995, Financial structure and the monetary transmission mechanism, Basle. Bernake, B.S. and M. Gertler, 1995, Inside the black box: the credit channel of monetary policy transmission, Journal of Economic Perspectives 9, Fall 1995, 27-48. Corsetti, G. and P. Pesenti 1999, Stability, asymmetry and discontinuity: the outset of the European Monetary Union, revised draft, September, forthcoming Brookings Papers on Economic Activity, December 1999 Cecchetti, S.G., 1999, Legal Structure, Financial Structure, and the Monetary Transmission Mechanism, Federal Reserve Bank of New York Economic Policy Review, July 1999. Cotarelli, C., G. Ferri and A. Generale, 1995, Bank lending rates and financial structure in Italy: A case study, IMF Working Paper 95/38. Cotarelli, C. and A. Kourelis, 1994, Financial structure, bank lending rates, and the transmission mechanism of monetary policy, IMF Staff Papers 41, No.4. Diebold, F.S. and C. Chen, 1996, Testing structural stability with endogenous breakpoint A size comparison of analytic and bootstrap procedures, Journal of Econometrics 70, 221-241. Doornik, J. and D. Hendry, 1994, PG-GIVE 8.0: An interactive econometric modelling system, International Thompson Publishing, London. Dornbusch, R., Favero, C.A. and F. Giavazzi, 1998, A red letter day?, CEPR Discussion Paper 1804, February 1998. Enders, W. and C.W.J. Granger, 1999, Unit root tests and asymmetric adjustment with an example using the term structure of interest rates, Journal of Business and Economic Statistics 16, no.3, July 1998, 304-11. Engle, R.F. and C.W.J. Granger, 1987, Cointegration and error correction: Representation, estimation, and testing, Econometrica 55, 251-276. European Central Bank, 2000, The Euro area one year after the introduction of the Euro: key characteristics and changes in the financial structure, Monthly Bulletin January.

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Gregory, A.W., J.M. Nason, and D.G. Watt, 1996, Testing for structural breaks in cointegrated relationships, Journal of Econometrics 71, 321-341. Hansen, B.E., 1992, Tests for parameter instability in regressions with I(1) processes, Journal of Business & Economic Statistics 10, 321-341. International Monetary Fund, 1996, World Economic Outlook, October 1996 Kashyap, A.N. and J.C. Stein, 1993, Monetary policy and bank lending, NBER Working Paper 4317, April 1993 Kleimeier, S. and H. Sander, 2000, Regionalisation versus globalisation in European financial market integration: Evidence from cointegration analyses, Journal of Banking and Finance (forthcoming). Modigliani, F., 1963, The monetary transmission mechanism and its interaction with real phenomena, Review of Economics and Statistics 45(1), 79-107. Ramaswany, R. and T. Sloek, 1997, The real effects of monetary policy in the European Union: What are the differences?, IMF Working Paper 97/160. Scholnick, B., 1996, Asymmetric adjustment of commercial bank interest rates: evidence from Malaysia and Singapore, Journal of International Money and Finance 15, 485-496. Quandt, R., 1960, Tests of the hypothesis that a linear regression system obeys two separate regimes, Journal of the American Statistical Association 55, 324-330.

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Table 1: The Relative Importance of Bank Finance in Europe Panel A: The Relative Importance of Bank Finance in Europe by Countries in 1996 Country Market Capitalization as a Corporate Debt as a Bank Loans as a Percentage Percentage of GDP Percentage of GDP of all forms of Finance EMU Members Austria 15 46 65 Belgium 45 60 49 Finland 50 34 39 France 38 49 49 Germany 29 58 55 Ireland 18 13 80 Italy 21 37 50 Netherlands 96 48 53 Portugal 23 19 62 Spain 42 11 58 Members of the EU not in EMU Denmark 41 105 25 Greece 20 3 48 Sweden 99 73 32 United Kingdom 150 45 37 Other Countries Japan 67 39 59 USA 111 64 21 Source: Stephen G. Cecchetti, Legal Structure, Financial Structure, and the Monetary Transmission Mechanism, Federal Reserve Bank of New York Economic Policy Review, July 1999, p.16 Panel B: The Relative Importance of Bank Finance in the Euro Area, USA and Japan in June 1999a (as percentage of GDP) Euro Area USA Japan Bank Loans 100.4 48.4 107.0 Outstanding domestic debt securities 88.8 164.6 126.5 - issues by corporates 3.3 29.0 14.6 - issued by financial institutions 31.0 45.4 18.8 - issued by the public sector 54.5 90.2 93.1 Stock Market Capitalization 71.1 163.3 137.7 Source: ECB Monthly Bulletin, January 2000, p.39, own calculations a All data are June 1999 except for stock market capitalization which are October 1999

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Table 2: Monthly Policy and Lending Rates for EMU Members and Non-Members COUNTRY Policy Rates Lending Rates Mean Standard Mean Standard Period Deviation Deviation Belgium 01:1985 12:1998 6.58 2.75 10.10 2.22 01:1994 12:1998 3.29 0.87 7.86 1.00 Finland 01:1985 12:1998 6.75 1.83 9.03 5.18 01:1994 12:1998 4.56 0.59 6.49 1.17 France 01:1985 12:1998 7.35 2.58 8.95 1.54 01:1994 12:1998 4.09 0.98 7.13 0.76 Germany 01:1985 12:1998 4.50 1.85 10.43 1.71 01:1994 12:1998 3.25 0.96 10.12 1.01 Greece 01:1985 12:1998 19.19 1.81 23.73 3.82 01:1994 12:1998 18.19 2.71 21.79 3.41 Ireland 01:1985 12:1998 9.06 2.44 9.25 3.10 01:1994 12:1998 6.50 0.54 6.27 0.62 Italy 01:1985 12:1998 10.60 3.03 13.31 2.61 01:1994 12:1998 7.15 1.53 10.68 1.78 Luxembourg 01:1985 12:1998 6.58 2.75 7.13 1.17 01:1994 12:1998 3.29 0.87 5.87 0.57 Netherlands 01:1985 12:1998 4.93 1.90 8.99 2.26 01:1994 12:1998 3.19 0.99 6.80 0.92 Portugal 01:1985 12:1998 13.40 5.66 17.45 5.67 01:1994 12:1998 7.25 2.33 11.39 2.97 Spain 01:1985 12:1998 10.74 3.56 11.87 3.69 01:1994 12:1998 6.70 1.80 7.72 1.96 United Kingdom 01:1985 12:1998 9.11 3.26 9.33 3.11 01:1994 12:1998 6.06 0.92 6.38 0.69

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Table 3: Unit Root Tests for Time Series of Monthly National Interest Rates from January 1985 until December 1998 Country Levels
t(b) F recursive min mean-shift min mean-shift max F trend-shift min trend-shift max F t(b) F

First Differences
recursive min mean-shift min mean-shift max F trend-shift min trend-shift max F

Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain United Kingdom Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain United Kingdom

-1.72 -1.35 -1.69 -0.66 -0.71 -1.97 -1.21 -1.72 -1.07 -2.78 -2.50 -1.56 -1.47 -1.63 -1.41 -0.23 -0.35 -3.93* -2.64 -1.41 -0.93 -1.37 -2.00 -1.72

1.50 1.08 2.21 0.81 1.16 3.11 1.13 1.50 0.68 3.89 3.70 1.29 1.10 1.34 1.01 1.02 3.68 7.72* 3.61 1.00 0.68 0.94 2.53 1.54

-1.72 -1.41 -1.69 -1.27 -1.43 -2.49 -1.69 -1.72 -1.16 -2.79 -2.57 -1.56 -1.49 -1.25 -1.47 -1.41 -1.05 -3.93* -3.03* -1.48 -1.27 -1.41 -2.00 -1.72

-1.89 -2.50 -3.18 -1.89 -2.13 -2.15 -1.53 -1.89 -1.87 -2.48 -2.39 -1.72 -2.50 -1.82 -2.14 -1.19 -2.24 -3.31 -2.90 -1.77 -1.87 -1.58 -1.96 -1.82

8.78 17.24 17.36 17.62 8.85 8.44 8.65 8.78 15.01 11.63 7.37 9.06 10.93 14.48 10.77 19.11* 9.90 26.47* 7.68 10.78 13.22 9.70 6.70 7.62

-1.98 -3.25* -3.87* -2.51* -2.26 -2.18 -1.62 -1.98 -2.38 -2.68 -2.40 -1.69 -2.77 -2.61* -2.52 -1.92* -2.62 -3.35* -2.96 -2.37 -2.30 -1.70 -2.24 -1.70

Policy Rates 9.04 -9.14 21.02* -7.40 22.13* -7.77 18.92* -8.39 8.83 -8.62 9.09 -7.43 10.37 -6.78 9.04 -9.14 15.98 -6.70 13.15 -14.13 7.22 -6.01 10.27 -9.64 Lending Rates 11.42 -8.70 16.74* -6.45 11.64 -9.23 22.55* -6.97 10.31 -8.36 24.16* -9.00 9.29 -5.91 13.32 -9.02 13.44 -8.83 13.51 -9.63 7.51 -7.00 10.59 -6.94

41.81 27.47 30.18 35.16 37.14 27.63 23.02 41.81 22.48 99.87 18.06 46.48 37.86 20.84 42.58 24.32 34.95 40.51 17.54 40.67 39.10 46.36 24.49 24.18

-9.14 -7.40 -7.77 -8.39 -8.62 -7.44 -6.95 -9.14 -6.70 -14.13 -6.01 -9.64 -8.70 -6.45 -9.23 -6.97 -8.36 -9.00 -5.92 -9.02 -8.83 -9.63 -7.00 -6.94

-7.77 -6.28 -6.78 -7.17 -7.37 -6.28 -5.79 -7.77 -5.88 -11.91 -5.06 -8.13 -7.38 -5.56 -7.86 -5.88 -7.09 -7.59 -5.12 -7.60 -7.64 -8.14 -5.90 -5.85

49.48 35.26 35.14 61.43 49.20 29.54 28.89 49.48 33.55 112.90 21.25 53.06 42.00 29.89 48.43 49.94 40.31 54.52 25.59 50.42 50.31 57.78 26.96 28.55

-7.82 -6.31 -6.82 -7.22 -7.42 -6.33 -5.82 -7.82 -5.91 -12.00 -5.10 -8.18 -7.43 -5.60 -7.91 -5.93 -7.13 -7.64 -5.13 -7.65 -7.68 -8.20 -5.94 -5.89

49.82 32.93 33.61 53.60 47.41 30.00 28.42 49.82 30.96 110.74 26.73 56.58 43.51 25.89 53.33 46.68 42.22 50.28 26.20 49.16 50.17 61.72 32.07 30.46

Note: t(b) and F give unit-root test-statistics which ignore the possible presence of a structural break. The remaining test statistics allow for the presence of a structural break of unknown timing. The critical values for 100 observations are as follows: -3.46 (1%), -2.88 (5%), -2.57 (10%) for the t(b) test; 8.73 (1%), 6.49 (5%), 5.47 (10%) for the F test; -4.62 (2.5%), -2.88 (5%), -2.57 (10%) for the recursive min test; -5.07 (2.5%), -4.80 (5%), 4.54 (10%) for the mean-shift min test; 20.83 (2.5%), 18.62 (5%), 16.20 (10%) for the mean-shift max F test; -4.76 (2.5%), -4.48 (5%), -4.20 (10%) for the trend-shift min test; and 16.30 (2.5%), 14.80 (5%), 13.64 (10%) for the trend-shift max F test. * indicates that based on the respective test statistics these series might be considered I(0) at the 5% level.

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Table 4: Structural Break Test in the National Cointegration Vector between Policy Rates and Lending Rates from January 1985 to December 1998

Country
Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain United Kingdom

supF
509.3 181.7 12.0 354.0 140.3 20.5 78.8 122.1 32.8 41.5 63.7 15.9

Break point
March 1991 January 1989 August 1994 February 1993 May 1993 September 1992 September 1992 March 1991 December 1993 May 1992 August 1987 September 1992

Note: Based on the critical values reported by Hansen (1992) the breaks for all countries except France are significant.

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Table 5: Cointegration of Lending Rates (LR) and Policy Rates (PR) in the Period between January 1994 until December 1998 Country Cointegration Regression DW ADF(k)1 1 1 (t-statistics) (t-statistic)1 (t-statistic)1 EMU member countries Belgium LR = 4.24 + 1.10 PR (31.62) (27.92) Finland LR = -2.43 + 1.95 PR (-14.55) (53.87) France LR = 4.20 + 0.72 PR (27.22) (19.57) Germany LR = 6.97 + 0.97 PR (39.79) (18.69) Ireland LR = -0.28 + 1.01 PR (-0.59) (13.73) Italy LR = 2.53 + 1.14 PR (13.14) (43.33) Luxembourg LR = 3.95 + 0.59 PR (30.79) (15.54) Netherlands LR = 3.91 + 0.91 PR (48.97) (38.03) Portugal LR = 3.29 + 1.12 PR (5.41) (14.08) Spain LR = 0.49 + 1.07 PR (3.74) (56.61) Non-EMU member countries Greece LR = 1.15 + 1.17 PR (1.15) (21.58) United Kingdom LR = 2.53 + 0.64 PR (7.91) (12.18)

2 (t-statistic)1

F-test for H0 : 1 = 2 (significance level)

1.364* 0.884* 0.196 0.219 0.320 1.311* 0.485** 0.723* 1.419* 0.730*

-6.332 (0)* -2.499 (0) -2.737 -1.367 -1.975 -1.577 -2.255 (0) (1,12) (0) (4) (0)

-5.116 (0)* -2.409 (0) -3.817 (0)** -5.543 (0)* -3.309 (0)*** -3.399 (5)**

-0.598 (-6.785) -0.073 (-0.906) -0.219 (-3.198) -0.076 (-2.214) 0.039 (0.268) 0.188 (2.985) -0.138 (-1.830) -0.042 (-0.358) -0.121 (-2.909) 0.084 (0.545)

-0.771 (-5.981) -0.106 (-0.672) -0.273 (-2.762) -0.092 (-1.462) -0.072 (-0.177) 0.309 (2.242) -0.359 (-2.902) -0.579 (-2.029) -0.153 (-2.779) 0.212 (0.907)

-0.361 (-2.292) -0.044 (-0.312) -0.152 (-1.361) -0.048 (-0.491) 0.099 (0.391) 0.108 (1.054) 0.132 (0.928) 0.376 (1.610) -0.011 (-0.084) -0.169 (-0.446)

3.254 (0.077) 0.060 (0.807) 0.584 (0.448) 0.094 (0.761) 0.085 (0.772) 0.978 (0.328) 4.888 (0.031) 4.209 (0.046) 0.769 (0.384) 0.535 (0.467)

0.326*** 0.387**

-1.947 -1.429 -2.612 -2.890

(0) (9,12) (0) (12)***

-0.043 (-0.528) -0.166 (-1.853)

-0.424 (-2.620) -0.102 (-0.900)

0.334 (2.083) -0.297 (-1.786)

7.130 (0.010) 0.875 (0.354)

Note: DW gives the Durbin-Watson statistics. The critical values for rejecting the null hypothesis of non-cointegration are 0.511 (1%), 0.386 (5%) and 0.322 (10%) for 100 observation. ADF (k) gives the t statistic for in the (augmented) Dickey Fuller regression. k, given in brackets, gives the lags used in augmented Dickey Fuller regression, so that k=0 represents the simple Dickey-Fuller regression. The critical values for 100 observations are 4.07 (1%), 3.37 (5%), and 3.03 (10%) for the Dickey Fuller regression, and 3.77 (1%), 3.17 (5%), and 2.84 (10%) for the augmented Dickey Fuller regression. The error correction term (ECT) is given in the last column for which also t-values are reported in brackets. 1 The lag structures for the ADF(k) test and the symmetric as well as the asymmetric ECM are determined using all significant lags from k=1 to 12. * indicates that cointegration can be assumed at 1% significance level. ** indicates that cointegration can be assumed at 5% significance level. *** indicates that cointegration can be assumed at 10% significance level.

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0.4 0.2 0.0 -0.2 -0.4 -0.6 Luxembourg Belgium Netherlands United Kingdom -0.8 Finland Germany Ireland Portugal Greece France Spain

Note: For each country, the left-hand-side bar represents the ECT associated with above equilibrium rates whereas the right-hand-side bar indicates the ECT associated with below-equilibrium rates. - Non-colored bars indicate that the ECT is not significantly different from zero or that cointegration could not be established.

Italy