The effect of budget deficit on interest rates in the countries of sub-Saharan Africa: A panel VAR approach

Abstract

The 2007-2008 global economic crisis and the recent effects of declining global oil prices has led most countries in sub-Saharan Africa to respond by borrowing massively from both domestic and international market to fund the day to day running of the home country. The effects of borrowing and increased deficit financing raises the age old question of the linkage between government deficits financing, rising domestic interest rates and contracting investment. Notable amongst the issue raised by increasing deficit financing is the issue of government borrowing crowding out private sector investment which manifest in the form of a short fall in private sector’s purchase of government bond below the anticipated raise in government deficit financing resulting in more borrowing on the part of government and less money available for financing private projects. Theories abound in the literature that tried to establish the linkage between budget deficit and interest rate, however, there is no consensus on the relationship between them and on the magnitude of the deficit financing that will ultimately trigger a rise in domestic interest rates. This study, therefore, examines the effect of government deficit financing on interest rates. The study applied panel Vector Auto regression techniques (PVAR) on dataset collected from 18 countries across Sub-Saharan Africa (SSA) over the period 2000 to 2014. The result obtained analyzing the impulse function (IRF), the variance decomposition (VDC) and the VAR causality show the response of interest rate to rising government fiscal deficits to be slow initially negating the conventional Keynesian proposition which states that rising government deficit reduces the stock of loanable funds and consequently crowds out private sector investment. Subsequently, the result shows interest rate response to government fiscal deficit to be neutral or insensitive. These findings lend credence to the Ricardian Equivalence theory, which emphasizes the neutrality of budget deficit on interest rate. In addition, interest rate responded positively to exchange rate, inflation, and money supply. The empirical evidence suggest that Sub-Saharan African economies need not bother about the effects of rising government borrowing on interest rates provided they stay within the accepted limit of debt sustainability ratio.