1

Islamic Economics and Finance Research Group,

Universiti Kebangsaan Malaysia, Bangi 43600, Selangor, Malaysia Fax: 603-89215789 http://www.ukm.my/ekonis E-mail: ekonis@pkrisc.cc.ukm.my

Working Paper in Islamic Economics and Finance No. 0501

Credit Channels and Consumption Abdul Ghafar Ismail 1 Islamic Economics and Finance Research Group School of Economics Universiti Kebangsaan Malaysia Bangi, 43600 Selangor D.E., Malaysia and Wahyu Ario Pratomo 2 Universitas Sumatera Utara Medan Sumatera, Indonesia Tel: 603-8921 5760 Fax: 603-8921 5789 e-mail: agibab1986@yahoo.co.uk

This draft, October 2005 Paper to be presented at the International Conference on A Universal Paradigm of Socio-Scientific Reasoning, Asian University Bangladesh, Dhaka, December 17-18, 2005 Abstract The consumption of household generally depends on the excess sensitivity of current income, which is called liquidity constraint. As the consumption theory developed, the transmission of monetary policy on interest rate may affect the external finance premium, which in return make a change in consumption. This paper examines the relevant of credit channels on private consumption. Using data from 15 Islamic Banks in Malaysia during 1994-2004, we find that there is a weak tendency of Malaysian to correspondence with Islamic Banks in order to increase their consumption. The Malaysian tends to be liquidity constraint in consuming goods and services.
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Professor of banking and financial economics, Universiti Kebangsaan Malaysia Lecturer of financial economics, Universitas Sumatera Utara

2 Moreover, consumption is quite sensitive to the movement of real interest rate. An increase of real interest rate attracts Malaysian to save more

JEL Classification numbers: C33; D91; E21; Keywords: inter-temporal consumer choice; consumption; transmission channel; monetary policy; panel data

1.

Introduction

The prohibition of interest in Islam encourages banks to offer products that are based on al-bay and profit-sharing basis. The same basis was propagated by al-ghazali. Here, the consumer credit, which is offered through al-bay contract, allow the consumers to deal with not only personal or family emergencies and needs, but also to assist them in acquiring consumption goods. From here, many economists try to reveal the relationship between consumption and credit consumption. The macroeconomics literatures show that monetary policy influences the interest rates and hence, the cost of capital. Later, both affect the aggregate demand variables such as fixed investment, housing inventories and consumption for durable goods. In turn, changes in aggregate demand affect the level of production. The relationship between consumption and credit consumption as suggested by De Bond (1999) can be seen from the consumers balance sheets. He suggest that the consumption credit seems to be held for households since there is lack of access than other forms of credits. His empirical study focuses on the excess sensitivity of consumption to current income, which is called liquidity constraint. The higher excess sensitivity means consumers borrow less. In addition, Japelli and Pagano (1989) propose that this low level of consumer debt might also be due to either from capital market imperfection or from a low demand for loans. But, according to credit channel view, the direct effects of monetary policy on interest rate can be seen through the changes in the external finance premium (EFP), i.e., the difference in cost between funds raised externally (by issuing equity or debt) and funds generated internally (by retained earning). According to the credit view, when open market interest rate tends to increase, then EPF also goes up, vice versa. On the supply side, credit channel imposed EFP to capture the variation in credit condition. Any shocks to EFP will shock the demand side, the overall price of funds that borrowers face. Therefore, liquidity constraint ruins the real consumption decision regardless of whether there is credit rationing or not. The credit channel theory resumes that the balance sheet channel may be asymmetric over the business cycle. There would be more informational friction, which leads to the weaker credit for households. Therefore, the objective of this paper is to examine the relevant of credit channels of monetary policy on private consumption. The model is inspired from De Bondts model (1999), a consumption model incorporates credit channels by

3 assuming that individual does not only depend on current income but also external finance, which availability depends on EFP. This paper also will impose the impact of the business cycle to individual consumption. However, the model that is created in this paper focuses on the banks credit channel to individual consumption. The reason is to find out the bank performance as the agent of financial intermediation. There are 15 banks in Malaysia employed in this paper. The impact of EFP on consumption will be examined as predicted by the credit channel theory. The remaining discussion will be organized as follows. Section 2 reviews the literature on the consumption and credit channel. Section 3 proposes the model of consumption and credit channel. Section 4 explains the collecting data and the proxy of the EFP. Section 5 discusses the estimation results and economic intuition. Finally, Section 6 recommends some policy implications and conclusions. 2. Prior Studies

Keynes consumption function regarded as the first consumption function ever. However it was too simple and contrast with Kuznets (1946) specifically finding, that saving were a reasonably constant with the income, whilst Keynes predicted that as income rose, saving would take an ever-greater share of it. This finding supported by Duesenberry (1949) that argued people easily increase consumption when income rises but have a problem reduced it symmetrically when income falls. Individual consumption was influenced by the highest pervious income. In other way, consumer behavior is ratcheted up as income rises above previous peak. Then, Modigliani and Brumberg (1954) decided to propose Life Cycle Hypothesis (LCH) and similar idea was proposed by Friedman (1957) in his Permanent Income Hypothesis (PIH). The most important implication of the LC-PIH is that individual consumption depends on the resources available over his life time. In the LCH model, rational forward-looking consumers try to maximize his life time utility subject to intertemporal budget constraint. In PIH, the result is the same. The planned consumption path arises from information about future income. This view has been challenged by several empirical results. Some economists (Japelli and Pagano, 1989; and Campbell and Mankiw, 1991) find the excess sensitivity of consumption to current income and Shea (1995) finds the asymmetric behavior of excess sensitivity. Inspiring from previous researches about consumption theory, Bernanke and Gertler (1995) attempt to capture monetary policy transmissions in credit channel. They proposed that the central bank have any effect on the external finance premium in credit market. There are two possible linkages. Firstly, balance sheet channel, which stresses the potential impact of changes in monetary policy on borrowers balance sheets and income statements, including borrowers net worth, cash flow, and liquid assets. In particular, the greater is the borrowers net worth, the lower the external finance premium should be. Secondly, the bank-lending channel focuses more on the possible effect of monetary policy on supply of loans particularly by commercial banks. If supply of loans is disrupted, the borrowers may not be literally shut off from credit, but they are virtually certain to incur costs associated with finding a new lender, establishing a credit relationship. Therefore, a reduction in the supply of bank credit is likely to increase the external finance premium and to reduce the real activity.

However, obtaining the direct measure of EFP is quite difficult. Many researchers try to make a proxy to calculate it. Several consumption studies have already investigated a borrowing-lending wedge as a proxy for EFP. King (1986) introduces a model in which information asymmetries between borrowers and lenders lead to an endogenously determined wedge between borrowing and lending rates. He finds a significant impact of EFP on the consumption of British. Whilst, Jappeli and Pagano (1989) reveal that in Sweden, United States and UK aggregate consumption displays low sensitivity to current income and consumers liabilities are relatively high. The opposite appears in Italy, Japan, and Spain. However, they find that excess sensitivity may no originate from liquidity constraint; it is more from desire to borrow by the household rather than capital market imperfection. They suggest that there is no relationship between the estimated excess sensitivity of consumption to current income and the EFP in Italy, and the United Kingdom. Bacchetta and Gerlach (1997) find that FEP is also unsuccessful in predicting the consumption changes in France and United Kingdom. 3. The Model

The model of credit channel and consumption in this paper follows several authors who write the related topic. Winder and Palm (1989), Campbell and Mankiw (1991), Sarno and Taylor (1998) and De Bondt (1999) suggest that the consumption life cycle model formulated below implies that consumption follows a random walk with drift, given the real interest rate (r) is constant, and the intertemporal elasticity of substitution () is zero. Et 1 ct = * +Et 1 rt 1 (1)

where is a constant, ct represents real per capita consumption at time t, rt is the real interest rate at time t (so rt-1 denotes the real interest rate in period t-1). It represents consumer can borrow or lend. An increase in the real interest rate in previous time or period t-1 (rt-1) reduces consumption in previous time or period t-1 relative to current consumption. How much is transferred to the present depends directly on the coefficient of intertemporal elasticity of substitution (>0). The literature shows there are two groups of consumers, as suggested by Keynesian rule of thumb model of Campbell and Mankiw (1991). One group consists of consumers with liquidity constraint (). They will have the consumption function as a constant fraction of current income, whilst the other group (1-) is assumed to behave according to equation (1). The extension model of equation (1) by putting the group of consumers with liquidity constraint is as follows: Et 1 ct = (1 )[ + Et 1 rt 1 ] + Et 1 y t (2)

where denotes as the parameter of consumers with a constant fraction of income, and (1-) denotes as the parameter of consumers with a fraction of permanent income (PI). The coefficient yt is per capita real disposable income. Winder and Palm (1989)

5 show that the excess sensitivity of consumption to current income (or liquidity constraint) is related to a finite planning time horizon. Of the assumption required by LC-PIH, the postulate of perfect credit market has been almost naturally accused for the empirical failure of the theory. If a consumer cannot borrow and lend at the same level of interest rate to carry out this optimal consumption at some stage his desired consumption will subject to his disposable income, financial assets and the available supply of external finance. Using De Bondts model (1999), we assume that there are two groups of liquidity-constraint consumers. One is assumed to consume a constant fraction of current income (1) and the other group to consume a constant fraction of current income and the availability supply of external finance (2). Moreover, shifts in this availability supply of external finance are assumed to depend on the change in the EFP one period lagged because it takes some time to obtain the external finance sources for consumption expenditure after a change in the EFP. In addition, the impact of the EFP on external finance (credit supply) varies over the business cycle along with credit market imperfection. Meanwhile, the liquidity-unconstrained group has the parameter (1-1- 2). This leads to a modified -model with financial accelerator effect becomes
E t 1 c t = (1 1 2 )[ + E t 1 rt 1 ] + 1 [ E t 1 y t ] + 2 [ E t 1 y t + E t 1 cs t ]

(3)

we divide equation (3) with Et-1 then we get

c t = (1 1 2 )[ + rt 1 ] + 1 [y t ] + 2 [y t + cs t ]

(4)

where cst denotes credit supply with

* * + 1 EFP cst = 0 t 1 * +2 EFP t 1 bc t 1

(5)

or equivalently
* * * c t = (1 1 2 )[ + rt 1 ] + 1 [y t ] + 2 [y t + 0 + 1 EFPt 1 + 2 EFPt 1bc t 1 ]

(6)

* * c t = (1 1 2 ) + 2 0 + (1 1 2 )rt 1 + (1 + 2 )y t + 2 1 EFPt 1 + 2 2 EFPt 1bc t 1 ] (7)

then we get
c t = + rt 1 + y t + 1 EFPt 1 + 2 EFPt 1bc t 1 + t

(8)

* where bct denotes the business cycle in period t, = (1-1-2) + 2 0 ; = (1-1* 2); =1 + 2; 1 = 2 1* ; 2 = 2 2 and the error term, t is orthogonal to all variables known at time t-1 or earlier.

Based on equation (8), three consumption models are estimated. First, we estimate the credit channel model with liquidity-constrained consumers, where consumers use only current income. The second estimated model is a modified model without financial accelerator effect, which is the impact of the EFP, does not

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* vary over the business cycle ( 2 = 0 ). The third and last model is the modified model with financial accelerator effect with no parameter restrictions.

4.

Data and Estimation Method

The dependent variable in this study is consumption per capita (ct). We respectively measure this variable using consumption divided by population. The explanatory variables are Islamic inter-bank rate (rt), income per capita (yt), external finance premium (EFPt), and business cycle (bct). The income per capita uses GDP at constant price of 1997 divided by population, while credit channel is developed from all of consumption credit that given by 15 Islamic Banks in Malaysia. In order to find out the influence of business cycle to credit channel, we use dummy variable for crisis economy appearance. All of data are obtained from Banks Annual Report from 1994 until 2004 and International Financial Statistics. Basically, the estimated model is
c t = + rt 1 + y t + 1 EFPt 1 + 2 EFPt 1bc t 1 + t

(9)

where ct is consumption per capita, rt is real interest rate, yt is income per capita, EFPt is external financial premium, and bct is business cycle. Before, equation (9) can be estimated, firstly, we try to check the stationary of data by using unit root test. Granger and Newbold (1974) suggested that in the presence of nonstationary variables, there might be a spurious regression. A spurious regression has a high R2 and t-statistics that appear to be significant, but the results are without any economic meaning. The time series of c, y, r, and EFP are in fact nonstationary time series, that is generated by random process and can be written as follow: Z t = Z t 1 + t (10)

where t is the stochastic error term that follows the classical assumptions, which means, it has zero mean, constant variance and is nonautocorrelated (such an error term is also known as white noise error term) and Z is the time series. As the data used in this paper is panel data, so we used Levin, Lin and Chu and Im, Pesaran and Shim W test to check the level of stationary. Secondly, we will reveal the estimated regression without business cycle and including business cycles variable to find out the effect of crisis on the demand of credit in Malaysias Islamic Banks. The estimated regression will be construct in ordinary least square, fixed effect and random effect. To choose the appropriate model, we use Hausman Test. A central assumption in random effects estimation is the assumption that the random effects are uncorrelated with the explanatory variables. One common method for testing this assumption is to employ a Hausman (1978) test to compare the fixed and random effects estimates of coefficients.

4.

Empirical Results

Table 1 presents the results of all variables unit root test. Most of variables are fails to reject the null hypothesis at the 10% level by using Levin, Lin & Chu test except EFP. Similarly, the Im, Pesaran & Shin-W test also fails to reject the null hypothesis for all variables except r. Since all variables are not stationary at level, then the test extend to the first difference stationary test. The result shows that all variables are stationary at 1% level, therefore it is an I(1) stochastic process. Table 1. Levin, Lin & Chu and Im, Pesaran & Shin-W Statistics for credit channel and consumption Level I(0) First Difference I(1) Variables Levin, Lin & Im, Pesaran & Levin, Lin & Im, Pesaran & Chu t* Shin-W Stat Chu t* Shin-W Stat Con -1.510 5.323 -8.128* -3.900* Y 1.420 5.087 -8.255* -4.176* R -1.632 -4.092* -19.438* -12.413* EFP -4.335* -1.020 -3.999* -2.945* Note: The LL&C and IPS statistics were generated by model with individual intercept. * denote rejection of the null at 1% level The estimated regression of credit channel and consumption in this paper is revealed into three-estimated regression using ordinary least square, fixed effect and random effect are as follows: a. Ordinary Least Square Table 2: Credit Channel using OLS Method Model 1 Model 2 -28.847** 0.354* 7.69E-05 0.667 0.655

Variable Constant rt-1 10.676 0.380* yt EFPt-1 EFPt-1*bct R2 0.659 2 R (adj) 0.657 * denotes significant at level 1% ** denotes significant at level 5% *** denotes significant at level 10%

Model 2 -28.810* 0.357* 8.38E-05 0.002* 0.727 0.712

b.

Fixed Effect Method Table 3: Credit Channel using Fixed Effect Method Model 1 Model 2

Variable

Model 2

8 Constant -22.866 rt-1 10.371 0.395* yt EFPt-1 EFPt-1*bct R2 R2(adj) * denotes significant at level 1% ** denotes significant at level 5% *** denotes significant at level 10% 122.411* -25.286* 0.283*** -7.35E-05 0.771 0.690 87.740* -26.883** 0.303* -6.13E-05 0.002** 0.803 0.724

c.

Random Effect Method Table 4: Credit Channel using Random Effect Method

Variable Model 1 Constant -22.86 rt-1 10.371 0.395* yt EFPt-1 EFPt-1*bct R2 0.661 2 R (adj) 0.656 * denotes significant at level 1% ** denotes significant at level 5% *** denotes significant at level 10%

Model 2 124.160* -27.556* 0.280** 6.97E-05 0.746 0.732

Model 2 99.398* -26.787** 0.297* -0.0001 0.001** 0.772 0.754

Gujarati (2003) states that Random Effect Model is assumed that the intercept of an individual unit is a random drawing from a much larger population with a constant mean value. This implication of this statement is that we use Random Effect Model when the sample is so large and we select the data randomly to represent our analysis. As this research uses all of Islamic Banks in Malaysia data, therefore we prefer to choose Fixed Effect Model as a representative model. As a matter of fact, to strengthen the result, we analyses the result of estimated regression using Hausman Test. The results shown in Table 5 reveals that Hausman test is not significant. The thesis underlying is that the Fixed Effect and Random Effect estimators do not differ substantially. Implementing Gujarati (2003) recommendation, we use Fixed Effect Model as the representative model of credit channel. Table 5: Result of Hausman Test Chi-Square Stat 1.677 Df 4 Prob 0.7949

Cross Section Random

9 The estimated regression reveals that real interest rate, income and economic shocks will influence household consumption. In case of Malaysia, in average household tends to liquidity constraint. When their income increases they would like to save more and less to consume. There is a less motive to ask consumption credit from banks. It can be seen by the insignificant of parameter EFP. However, when the economic shocks occur, household tends to increase credit consumption. The sign is negative shows that an increase in EFP will reduce the motive of household to demand credit from banks. 5. Conclusions

This study shows that there is a weak tendency of Malaysian to correspondence with Islamic Banks in order to increase their consumption. The Malaysian tends to be liquidity constraint in consuming goods and services. Therefore, for monetary authorities possibly the most relevant conclusion is that credit channel in Malaysias Islamic Banks need more propagation mechanism. The insignificant of EFP might indicate that credit channel has not been popular yet among household in Malaysia. Another implication for monetary policy, consumption is quite sensitive to the movement of real interest rate. An increase of real interest rate attracts Malaysian to save more. The estimated result shows an increase of 1% real interest rate will decrease average per capita consumption about 27 Ringgit. The intertemporal consumption behavior clearly found among the household. References Bacchetta, P. and S. Gerlach, 1997, Consumption and Credit Constraints: Some International Evidence, Journal of Monetary Economics 40, 207-238. Bernanke, B.S. and M. Gertler, 1995, Inside the Black Box: the Credit Channel of Monetary Policy Transmission, Journal of Economic Perspectives 9, 1, 27-48. Campbell, J.Y and N.G. Mankiw, 1991, The Response of Consumption to Income: A Crosscountry Investigation, European Economic Review 35, 715-721. Crane, R. D., 1981, "Islamic Commercial Law in Comtemporary Economics," Embassy Handbook (Washington, DC: U.S. Department of State). De Bondt, 1999, Credit Channels and Consumption in Europe: Empirical Evidence, BIS Working Paper 69 Duessenbery, James and R. Brumberg 1954, Utility Analysis and the Consumption Function: An interpretation of cross section data, Post Keynesian Economics. Gujarati, Damodar N., 2003, Basic Econometrics, Mc Graw Hill, Singapore. Hausman, J. A.. 1978.. "Specification tests in econometrics.." Econometrica. 46: 1251-1271. Jappelli, T. and M. Pagano, 1989, Consumption and Capital Market Imperfections: An International Comparison, American Economic Review 79, 1088-1105. King, M.A., 1986, Capital Market Imperfections and the Consumption Function, Scandinavian Journal of Economics 88, 59-80. Kuznets, Simon, 1946, National Income: A Summary Finding, New York: NBER Milton Friedman, 1957, A Theory of the Consumption Function, Princeton: Princeton University Press Modigliani, F. & Brumberg, R., 1954, Utility analysis and the consumption function: An interpretation of cross-section data. In: Kurihara, K.K (ed.): PostKeynesian Economics. New Brunswick, NJ: Rutgers University Press

10 Sarno, L. and M.P. Taylor, 1998, Real Interest rates, Liquidity Constraints and Financial Deregulation: Private Consumption Behavior in the UK, Journal of Macroeconomics 20, 2, 221-242. Shea, J., 1995, Myopia, Liquidity Constraints, and Aggregate Consumption: a Simple Test, Journal of Money, Credit, and Banking 27, 3, 798-805. Winder, C.C.A. and F.C. Palm, 1989, Intertemporal Consumer Behaviour under Structural Changes in Income, Econometric Reviews 8, 1, 1-87.