Executive Summary

1      This paper analyses the relative importance of global interest rates and domestic money market conditions in determining the local interbank rate, the extent to which currency factors create the differential between domestic and US interest rates, and the transmission mechanism from the domestic interbank rate to the prime lending and fixed deposit rates of banks.

2      The market-clearing domestic money market interest rate may be conceptualised as a weighted average of the interest rate level determined through uncovered interest arbitrage, and the level that would be sufficient to equate domestic money demand with existing money supply when the money market is closed to international capital flows. In order to analyse the relative importance of external and domestic factors in determining the domestic interbank rate, we model it as the outcome of a portfolio choice between money, domestic and foreign bonds, and domestic real assets. The results of our estimation show that changes in money supply or factors affecting the demand for money have no effect on the domestic interbank rate. Only changes in US interest rates or market expectations of future movements in the exchange rate have a significant impact on the domestic interbank rate.

3      If the domestic economy is completely integrated with the global economy, then arbitrage dictates that the uncovered interest parity, purchasing power parity and real interest parity conditions must hold ex ante. Due to data limitations, the standard procedure for testing these hypotheses is to determine if deviations from the parity conditions are systematically related to all known variables ex post. Our results for the sub-sample excluding the Asian currency crisis period show that ex post deviations from uncovered interest parity do not differ significantly from zero, indicating little systematic exchange rate risk premia or forecast errors. However, real interest parity and purchasing power parity are rejected, due to the presence of systematic inflation forecast errors.

4      We next evaluate how the prime lending and fixed deposit rates of banks respond to changes in the domestic interbank rate. In the Monti-Klein model, a monopolistic bank will change its deposit or prime rate only if the existing deposit or loan rate diverges from the profit-maximising rate as a result of a given change in the money market rate. The incentive to change these rates would be greater the larger the interest elasticity of loan demand or deposit supply. As the monopolistic power of banks increases, these elasticities become smaller, and deposit and loan rate rigidity increase. Moreover, the exercise of monopolistic power often results in asymmetric adjustments in deposit and loan rates, so that the deposit rate tends to rise more slowly (quickly), and the prime lending rate tends to rise more quickly (slowly), when the money market rate rises (falls).

5      Using a specification that allows only for symmetric responses, our results show that the response of the fixed deposit rate is larger than the response of the prime lending rate for a given change in the domestic interbank rate, with the mean lag of adjustment at 5.6 and 6 months respectively. The longer adjustment lag of the prime lending rate implies that the prime-deposit spread widens temporarily following a decline in the money market rate, and narrows temporarily as the interbank rate rises.

6      We also allow for differential speeds of adjustment in the prime and deposit rates for a given change in the domestic interbank rate. Using this formulation, our estimates indicate that neither the fixed deposit rate nor the prime rate displays any asymmetric adjustment pattern in response to a change in the domestic interbank rate. This may be attributed to the highly competitive nature of the banking industry in Singapore and the openness of the domestic economy. Borrowers are also free to deposit their funds and source their borrowing in different foreign currencies. The development of the private debt securities market as an alternative to bank loans will also serve to increase the competitiveness of prime and deposit rate pricing.