J Econ Finan

https://doi.org/10.1007/s12197-017-9422-x

The impact of interest rate volatility on financial market

inclusion: evidence from emerging markets

Massomeh Hajilee 1 & Farhang Niroomand 1

# Springer Science+Business Media, LLC, part of Springer Nature 2017

Abstract Interest rate uncertainty adversely affects financial market performance and,
eventually, economic growth. This study investigates the relationship between interest
rate volatility and financial market inclusion for five selected emerging economies over
the period 1980–2015. To do this, we assess the long-run and short-run relationship
using Pesaran et al. (J Appl Econ 16:289–326, 2001) bounds testing approach to
cointegration and error-correction modeling and Shin et al. (2014) nonlinear
cointegration estimation method (NARDAL). The latter method incorporates
nonlinearity into the model and enables us to check the asymmetric effects of
interest rate variability on financial market inclusion. The findings of our linear
models indicate that short-run symmetric effects lead to long-run symmetric
effects in four countries (Turkey is the exception) and there is a long-run
symmetric effect for the other four countries. On the other hand, estimation
of nonlinear models shows the short-run existence of asymmetric effects for all
five emerging economies. We found that the long-run effect of interest rate
volatility is asymmetric in all countries except for Mexico. We suggest that this
group of countries should cautiously pay attention to laws and regulations
related to their financial market and interest rate policies. Our estimation results
show that interest rate uncertainty significantly affects financial market inclu-
sion and has an important role in financial market development and eventually
achieving higher economic growth.

Keywords Interest rate volatility . Nonlinear approach to ARDL . Asymmetric effect .

Financial market inclusion . Emerging economies

JEL classification E43 . G28 . O16

* Farhang Niroomand
niroomandf@uhv.edu

1
School of Business Administration, University of Houston-Victoria, Victoria, TX, USA
 J Econ Finan

1 Introduction

Emphasizing macroeconomic stability has been a major concern for economic policy
makers over the past few decades. Macroeconomic stability is said to be an important
shock absorber in the face of economic fluctuations for any nation, particularly for
emerging economies, due to their important role in promoting global economic growth.
Since the financial sector is the core of macroeconomic stability, a well-developed and
progressive financial market could enhance capital formation, more efficient resource
allocation, a higher level of investment and, in time, higher positive economic growth.
Over the last few years, the literature on financial market inclusion and related issues
has been growing rapidly. There have been several different definitions for financial
market inclusion, but all agree that financial market inclusion is easy access to financial
tools for everybody in a country. Following Mehrotra and Yetman (2015) and World
Bank (2012), financial market inclusion can be defined as available and affordable
financial services, broader credit accessibility and savings instruments to the public.
They found that with a more advanced financial market inclusion system, a country will
be able to enjoy a more stable monetary and financial system, poverty reduction and,
eventually, higher long-run economic growth. Meanwhile, Mbutor and Uba (2013)
argued that in countries like Nigeria, some improvement in financial accessibility, like
opening more banks, in practice did not positively affect the monetary sector. There-
fore, they argued that there are several other measures and determinants which all are
important in enhancing financial market inclusion. This argument has been supported
by Sahay et al. (2015) as well.
In this article our main goal is to assess the impact of interest rate volatility on
financial market inclusion. Interest rate is certainly one of the major factors that affect
banking sector performance significantly and eventually economic activity. The liter-
ature provides a broad range of studies related to interest rate changes and their effect
on different macroeconomic variables. For example, the relationship between interest
rates and some of the major economic variables like stock prices or banks’ stock returns
has been widely examined by Merton (1973), Long (1974), Stone (1974), Benink and
Wolff (2000), Kasman et al. (2011), Alam and Uddin (2009), Joseph and Vezos (2006),
Ballester et al. (2011), Jawaid and Ul Haq (2012) and Tripathi and Ghosh (2012). All of
these economists tried to examine the impact of interest rate volatility on
banks’ stock returns. Meanwhile, the findings of Tripathi and Ghosh (2012)
emphasize a significant relationship between interest rate volatility and most
banks’ returns in India. On the micro level, Papadamou and Siriopoulos (2014)
assessed both short-run and long-run relationships between interest rate volatil-
ity on both banks and insurance companies for the UK over the period 1989 to
2012 and found a significant relationship between these variables.
Regarding the existing literature on financial market inclusion, it is worth mention-
ing that several studies (Mehrotra and Yetman 2015; Mbutor and Uba 2013; Aduda and
Kalunda 2012 and Sahay et al. 2015 have tried to address financial market inclusion
and its role on the economic performance for various economies, especially in countries
where there is a large shadow economy. Other studies have been also conducted on the
shadow economy’s relationship to economic growth and development (Berrittella
2015; Elgin and Schneider 2016; Markellos et al. 2016). Previous studies on financial
market inclusion attempted to measure the effect of several variables like shadow
J Econ Finan

economy, human capital, trade openness and many other important variables on
financial market inclusion and their impact on economic development. For example,
Hanson (2012) argued about the role of emerging economies’ potential in improving
global trade relations, enhancing global living standards and increasing global eco-
nomic growth. In his study he focused on emerging economies’ efforts to improve
financial market inclusion to their citizens and higher integration into the international
financial system. Furthermore, Acemoglu et al. (2005) and Acemoglu and Robinson
(2010, 2012), showed that unfair allocation of resources like labor, capital and tech-
nology in some countries adversely affects economic growth. Therefore, obtaining a
higher level of financial market inclusion will be possible only for those countries that
have stronger financial institutions (Dell’Anno 2016).
After considering the large number of empirical studies related to either financial
market inclusion or its determinant and the impact of interest rate volatility on different
economic variables, to the best of our knowledge no empirical study has been done
related to the impact of interest rate volatility on financial market inclusion, especially
for emerging economies. We believe that this research positively contributes to the
existing literature related to both financial market inclusion and interest rate volatility.
Understanding this relationship is crucial for financial market development, especially
in emerging economies, and is worthy of examination. In this study, we examine the
impact of interest rate volatility on financial market inclusion for five emerging
economies over the period 1980–2015.1
Perhaps this study is the first to empirically investigate the impact of interest rate
uncertainty on financial market inclusion. In addition to linear estimation of the short
run and long term, we believe that using nonlinear and asymmetric
cointegration methodology provides more insight into and gives better under-
standing of the impact of interest rate uncertainty on financial market inclusion,
especially for these emerging economies.
The main goal of the current study is to investigate the asymmetric impacts of
interest rate uncertainty on financial market inclusion of the five selected emerging
economies. These countries are selected based on the availability of data. This article is
organized as follows: Section 2 will describe the model and estimation method. Results
are presented in Section 3, and conclusions are summarized in Section 4. Data
definition and sources are in the Appendix.

2 Model and estimation method

In this part of the research, we provide a brief explanation of the variables and
estimation method. We examine both short-run and long-run effects of the shadow
economy, interest rate volatility and economic growth on financial market inclusion for
five selected emerging economies over the period 1980–2015. According to the
standard definition, financial market inclusion is considered to be obtainable and
approachable, non-risky standard financial services for the public in every nation. Since
this study is attempting to investigate the effects of a group of variables – like economic
growth, shadow economy and interest rate variability (as our main interest) – on

1
Brazil, China, India, Mexico and Turkey, based on the availability of long-run time series data
 J Econ Finan

financial market inclusion, we provide a brief discussion on how to measure each of

these variables. To measure economic growth, we use real GDP per capita (Y). In order
to determine and measure financial market inclusion, we follow common procedure in
the literature and use the ratio of M3 to GDP.2 Shadow economy is another independent
variable in our model. In general, the existence of a shadow economy, which is usually
an economy’s unregistered activities, leads to a lower GDP growth rate. In other words,
shadow economy impedes economic growth. Determining shadow economy has been a
controversial and important issue for several economists and research institutions for
the last few decades. Several methods have been introduced to measure the size of the
shadow economy for a country. In 2010, Schneider, Buehn and Montenegro introduced
money market, labor market and the relative positon of the formal economy as
three different approaches to specify the level of shadow economy. Some other
economists view it quite differently, considering their related advantages and
disadvantages. Ahumada et al. (2009) introduced different methods of measure-
ment like income discrepancies, tax/regulatory surveys, resources utilized and
currency requirements. Another criterion of measuring shadow economy is
offered by Restrepo-Echavarria (2015), who argued that shadow economy
measurement can be divided into direct and indirect approaches, and, as they
argued, both methods require some auditing procedure.
As one of the important variables in our estimation models, we might define the
shadow economy as lack of formal financial tools and services and perhaps a lower
standard of living for all citizens. Obviously, with a higher level of financial market
inclusion, the savings rate is higher and, therefore, more funds and financial resources
are available for investment by both citizens and firms. On the other hand, the presence
of a shadow economy would negatively affect the financial system and eventually
economic growth. Dabla-Norris et al. (2015) showed existence and the size of the
shadow economy have a negative impact on accessibility and quality of financial
services in emerging economies. In this research, we follow the methodology of
Schneider et al. (2010) to determine the size of the shadow economy, and use the labor
force participation rate, measured as the total number of economically active
population between the ages of 15 to 64. Finally, in order to measure our main
variable of interest in this study, interest rate volatility, we use the real interest
rate (R) in order to construct a measure of real interest rate volatility (VR). The
volatility measure of real interest rate is defined as the standard deviation of 12
monthly real interest rates (R) within each year.
To construct the financial market inclusion model, we follow Hajilee et al. (2017).
The long-run specification of the financial inclusion model in this section follows the
literature reviewed in the previous section as in Eq. (1):

Ln FI t ¼ a þ b Ln Y t þ c Ln SEt þ d Ln Rt þ e Ln VRt þ εt ; ð1Þ

where FIt is a measure of financial market inclusion for each country i defined as the
ratio of M3 (liquid liabilities) to GDP. Yt is GDP per capita, SEt is the Shadow Economy
measured as labor force participation rate represented by the percentage of

2
By definition, this includes currency held outside the banking system and demand and interest-bearing
liabilities of banks and non-bank financial intermediaries.
J Econ Finan

economically active total population between the ages of 15 and 64, Rt is real interest
rate and VRtis a measure of variability of interest rate (R).
Since higher economic activity and economic growth create a better and more
positive economic environment for investors, we expect a positive estimate of the Y
coefficient (b). Following the idea that the existence of hidden and shady economic
activity negatively affects the financial market system and its growth, we expect the
estimate of SE coefficient(c) to be negative. Referring to the classic relationship in
literature, we argue that in the long run any investment decision is affected by major
macrocosmic variables like interest rate.3 Investor’s perspective is directly affected by
interest rate changes. Interest rate has a major role in financial market development and
financial market inclusion. Therefore, we expect the estimated coefficient of d to be
negative. Following this reasoning, we are expecting to have a negative estimated
coefficient for volatility measure (e).
The estimated coefficients of Eq. (1) illustrate the long-run effect. In order to
determine the short-run impacts of exogenous variables defined in model (1), we
transform Eq. (1) into an error-correction model (2) as:

n1 n2 n3 n4
Δ Ln FI t ¼ a þ ∑ β i Δ Ln FI t−i þ ∑ δi Δ Ln Y t−i þ ∑ ηi Δ Ln SEt−i þ ∑ λi Δ Ln Rt−i
n5
i¼1 i¼0 i¼0 i¼0
ð2Þ
þ ∑ λi Δ Ln VRt−i þ θ0 LnFI t−1 þ θ1 Ln Y t−1 þ θ2 Ln SEt−1 þ θ3 Ln Rt−1 þ θ4 Ln VRt−1 þ εt
i¼0

Formulation of Eq. (2) follows the Pesaran et al. (2001) study. As Eq. (2) shows, we
have included a linear combination of lagged level variables instead of a lagged error
correction term from the first equation. Following them, we apply the F test in order to
build the joint significance of lagged level variables to exhibit cointegration relation-
ship. The new F value employed in this methodology considers the integration orders
of the variables, whereas the upper-bound critical value is applicable for variables with
both integrated of order one or I(1) and integrated of order zero or I(0). Considering the
fact that most of the macro variables are either I(1) or I(0), they argued that it won’t be
necessary to conduct the unit-root testing before we run the models. This is the main
advantage of this estimation method. As is known, in all of the other cointegation
methods, pre unit-root testing is an important condition. Estimating both the short-run
and long-run effects at the same time is another superior facet of this estimation
method. To estimate short-run and long-run estimations in only one step, first of all
we are required to apply the ordinary least squares (OLS) estimation method to our
above outlined model (2). Inclusion of first differenced variables’ coefficients in Eq. (2)
exhibits the short-run effects. Meanwhile, the long-run effects are attainable by nor-
malized θ1 − θ4 on θ0.4
It is important to mention that in Eq. (2), the existence of symmetric effect is one of
the main hypotheses. However, in reality this might not be true, because there is always
a possibility of huge changes in the public and/or investors’ expectations over time,
especially the presence of interest rate volatility, money and financial market uncer-
tainty or the existence of a shadow economy. It is worth noting that not considering this
asymmetry due to the presence of interest rate uncertainty and shadow economy may
3
For more details, see Mishkin 1977, Mishkin 2007).
4
We follow Bahmani-Oskooee and Fariditavana (2016)
 J Econ Finan

lead to wrong and unwanted results. To overcome this shortfall, we are following
Bahmani-Oskooee and Fariditavana (2016) and introduce asymmetry adjustment of
interest rate volatility. First of all we need to build ΔLnVR, which basically relates to
positive changes and negative changes. Second, we arrange two different time series
variables. These two new series are the partial sum of positive changes (POS) and the
partial sum of negative changes (NEG):

Positive Changes ðPOS Þt ¼ ΔDLnVR ¼ ∑maxðDLnVRj; 0Þ;

ð3Þ
Negative Changes ðNEGÞt ¼ ΔDLnVR ¼ ∑maxðDLnVRj; ; 0Þ

For the next step, we need to return to the error-correction model outlined by Eq. (2)
and substitute the LnVR variable with POS and NEG variables. These are the partial
sum of positive and negative changes in LnVR. The new model is as follows:

n n n
ΔDLn FI ;t ¼ βo þ ∑ β1;k ΔLn FI t − k þ ∑ β2;k ΔLnY t − k þ ∑ β3;k ΔLnSEt − k
i i i
n n
þ ∑ β4;k ΔPOS t − k þ ∑ β5;k ΔN EGt − k þ λ1Ln Fl t − 1
i i

þ λ2LnY t1 þ λ3LnSEt − 1 þ λ4POS τ − 1 þ λ5N EGτ − 1 þ εt ð4Þ

Shin et al. (2014) emphasized building the partial sum variables and including them in
Eq. (4), and calling it a Nonlinear Autoregressive Distributed Lag model (NLARDL).
Their 2014 estimation method is based on the Pesaran et al. (2001) bounds testing
approach, and critical values used in their method are the same. After estimation of
model (4), we test the null hypothesis of no cointegration (i.e. λ1 = λ2 = λ3 = λ4 = 0) by
employing the F test. After establishing the long-run relationship, we need to determine
the long-run and short-run asymmetric effect. To do so, after estimating Eq. (4), we
need to test some other hypotheses. For the short-run asymmetry, we can look at two
criteria. First of all, if the sign of estimated coefficient of ΔPOS is different from the
estimated coefficient of ΔNEG at the equal lag level, there is a short-run asymmetric
effect (applying the Wald test also shows this). Second, different lag order of ΔPOS
and ΔNEG are additional signs of short-run adjustment asymmetry. In case of different
results, effects are asymmetric in the long term.

3 Results

In this section we review the results of estimation for both linear and nonlinear ARDL
models for each of these five selected emerging economies. We are using annual data
over the period 1980–2015 for the five selected emerging economies of Brazil, China,
India, Mexico and Turkey to assess the impact of interest rate changes on financial
market inclusion. Detailed information of the variable and data sources is presented in
the Appendix.
The estimation of the linear ARDL model specified in model (2) follows Hajilee
et al. (2017). Because our data are annual data, we implement a maximum of four lags
on each first differenced variable. In order to choose the optimum level of lags, or, on
J Econ Finan

the other hand, choosing the optimum models, we use Akaike’s information criterion
(AIC). The estimated results for all five countries are reported in Tables 1, 2, 3, 4, 5, 6,
7, 8, 9, and 10 for both linear and nonlinear models. We report the estimated results of
linear models in Tables 1, 3, 5, 7 and 9. Tables 2, 4, 6, 8 and 10 present the estimated
results of nonlinear models. The estimated short-run results are presented in Panel A;
long-run estimation results are presented in panel B; and selected diagnostic statistics
are reported for each optimum model in panel C of each table.
Starting with the results of linear models for interest rate volatility (VR), the short-
run estimated results from panel A show that for the emerging economies, except for
Mexico, there is at least one estimated significant coefficient for interest rate volatility
(at 5%), explaining that interest rate uncertainty (VR) has a short-run effect on financial
market inclusion. Furthermore, again except for Mexico, we find a short-run effect of
shadow economy (SE) on financial market inclusion. As expected, our estimated results
for the impact of economic growth (Y) is significant for all countries in the sample in
the short run.
Panel B reports the estimated results of long-run coefficients. Except for Turkey, the
estimated coefficient for interest rate volatility (VR) is significantly negative for the
countries in our sample (Brazil, China, India and Mexico). This result might be
explained by the fact that despite similar characteristics of all countries being emerging
economies, each country’s specific economic and financial structure, political charac-
teristics, international relation, and banking sector regulations might lead to an unex-
pected and different estimation result.

Table 1 Impact of interest rate volatility on financial market inclusion results for Brazil 1980–2015

Panel A: Short-run coefficient estimates for linear model

Lag order
0 1 2 3 4
Δ Ln SE −5.762 12.294 13.711
(1.973) (2.984) (3.249)
Δ Ln Y 0.337 0.162 −2.455
(0.258) (0.099) (1.786)
Δ LnR 0.052 0.005 0.004 −0.045
(1.019) (2.215) (0.114) (1.984)
Δ LnVR −0.126 0.005 0.004 −0.046
(2.407) (0.092) (0.114) (1.984)
Panel B: Long-run coefficient estimates for linear model
Constant Ln Y Ln SE LnR LnVR
−16.349 3.997 −3.227 −0.468 −0.397
(0.847) (1.991) (2.386) (1.705) (2.071)
Panel C: Diagnostic statistics
F ECMt-1 LM RESET Normality CUSUM CUSUM SQ Adj. R2
6.468 −0.541 0.039 5.016 1.080 S S 0.807
(6.73)

Numbers inside parentheses are absolute value of t-ratios

 J Econ Finan

Table 2 Impact of interest rate volatility on financial market inclusion results for Brazil 1980–2015 (nonlinear
model)

Panel A: Short-run coefficient estimates for nonlinear model

Lag order
0 1 2 3 4
Δ Ln SE −8.726
(6.771)
Δ Ln Y 2.106 0.546 2.269
(5.055) (1.833) (5.061)
Δ POS 0.856 −0.159 −0.140
(13.221) (1.508) (1.512)
Δ NEG 0.331 0.195 0.182 0.111
(6.511) (6.210) (6.953) (4.099)
Panel B: Long-run coefficient estimates for nonlinear model
Constant Ln Y Ln SE Ln POS Ln NEG
15.658 2.054 −6.662 0.654 −0.056
(5.009) (13.049) (8.257) (15.065) (1.982)
Panel C: Diagnostic statistics
F ECMt-1 LM RESET Normality CUSUM CUSUM SQ Wald-S Wald –L Adj.R2
7.281 −1.570 0.523 9.057 0.143 S S 1.238 0.014 0.987
(8.553)

Numbers inside parentheses are absolute value of t-ratios

Table 3 Impact of interest rate volatility on Financial Market Inclusion Results for Mexico 1980–2015

Panel A: Short-run coefficient estimates for linear model

Lag order
0 1 2 3 4
Δ Ln SE 0.066
(0.056)
Δ Ln Y 0.620 1.665 0.250 1.203
(0.744) (2.898) (0.426) (0.426)
Δ Ln R −0.036
(2.485)
Δ Ln VR 0.025
(0.808)
Panel B: Long-run coefficient estimates for linear model
Constant Ln Y Ln SE LR LVR
0.121 0.221 −0.266 −0.147 −0.101
(0.007) (2.086) (7.055) (2.387) (7.937)
Panel C: Diagnostic statistics
F ECMt-1 LM RESET Normality CUSUM CUSUM SQ Adj. R2
1.699 −0.245 0.739 3.112 1.296 S S 0.537
(3.209)

Numbers inside parentheses are absolute value of t-ratios

J Econ Finan

Table 4 Impact of interest rate volatility on financial market inclusion results for Mexico 1980–2015
(nonlinear model)

Panel A: Short-run coefficient estimates for nonlinear model

Lag order
0 1 2 3 4
Δ Ln SE 1.104
(0.597)
Δ Ln Y 0.194 1.769 0.365 1.166
(0.316) (3.123) (0.624) (2.019)
ΔPOS −0.019
(0.542)
Δ NEG −0.075
(2.216)
Panel B: Long-run coefficient estimates for nonlinear model
Constant Ln Y Ln SE Ln POS Ln NEG
−14.227 1.412 - 7.377 −0.126 −0.501
(0.215) (4.372) (2.419) (0.401) (0.901)
Panel C: Diagnostic statistics
F ECMt-1 LM RESET Normality CUSUM CUSUM SQ Wald-S Wald –L Adj. R2
10.810 −0.175 3.281 3.109 0.502 US US 0.498 0.127 0.493
(1.345)

Numbers inside parentheses are absolute value of t-ratios

Table 5 Impact of interest rate volatility on financial market inclusion results for Turkey 1980–2015

Panel A: Short-run coefficient estimates for linear model

Lag order
0 1 2 3 4
Δ Ln SE 0.526 2.696 −1.181 −1.888
(0.696) (2.409) (0.689) (1.379)
Δ Ln Y −1.238 −0.327 1.007
(2.506) (0.794) (2.106)
Δ Ln R −0.086 0.974 −0.107 0.0679
(2.542) (1.479) (2.937) (2.436)
Δ Ln VR 0.066 0.042 −0.031
(1.486) (1.115) (2.347)
Panel B: Long-run coefficient estimates for linear model
Constant Ln Y Ln SE LR LVR
−21.934 1.596 - 2.620 - 0.378 0.028
(2.496) (3.968) (2.031) (2.696) (0.335)
Panel C: Diagnostic statistics
F ECMt-1 LM RESET Normality CUSUM CUSUM SQ Adj. R2
4.471 −0.609 1.409 0.060 1.403 S S 0.649
(4.22)

Numbers inside parentheses are absolute value of t-ratios

 J Econ Finan

Table 6 Impact of interest rate volatility on financial market inclusion results for Turkey 1980–2015(non-
linear model)

Panel A: Short-run coefficient estimates for nonlinear model

Lag order
0 1 2 3 4
Δ Ln SE 1.535 3.319 0.939 −1.052
(2.770) (4.221) (1.007) (1.990)
Δ Ln Y −1.293 1.030 1.032 0.773
(4.413) (3.767) (4.105) (3.535)
Δ POS - 0.047 −0.123 −0.124
(0.729) (2.042) (2.413)
Δ NEG −0.124 0.464 0.363 0.051
(0.767) (0.007) (7.803) (1.835)
Panel B: Long-run coefficient estimates for nonlinear model
Constant Ln Y Ln SE Ln POS Ln NEG
35.289 2.839 −2.134 0.144 −0.231
(4.130) (4.499) (1.593) (5.377) (3.416)
Panel C: Diagnostic statistics
F ECMt-1 LM RESET Normality CUSUM CUSUM SQ Wald-S Wald –L Adj.R2
12.191 0.774 1.535 0.023 3.605 S S 11.294 13.806 0.845
(3.491)

Numbers inside parentheses are absolute value of t-ratios

Table 7 Impact of interest rate volatility on financial market inclusion results for China 1980–2015

Panel A: Short-run coefficient estimates for linear model

Lag order
0 1 2 3 4
Δ Ln SE −0.003 −11.601 −6.972
(2.410) (0.010) (3.631)
Δ Ln Y 2.221 −2.191 −0.812
(4.799) (4.429) (1.276)
Δ Ln R 0.010
(0.249)
Δ Ln VR −0.011 - 0.044 0.039 0.036
(0.393) (2.295) (2.159) (1.193)
Panel B: Long-run coefficient estimates for linear model
Constant Ln Y Ln SE LR LVR
−24.243 0.737 −5.423 - 0.006 −0.055
(16.889) (72.013) (17.338) (5.252) (2.532)
Panel C: Diagnostic statistics
F ECMt-1 LM RESET Normality CUSUM CUSUM SQ Adj R2
4.648 −0.755 5.578 22.623 12,667S S S 0.551
(3.516)

Numbers inside parentheses are absolute value of t-ratios

J Econ Finan

Table 8 Impact of interest rate volatility on financial market inclusion results for China 1980–2015(nonlinear
model)

Panel A: Short-run coefficient estimates for nonlinear model

Lag order
0 1 2 3 4
Δ Ln SE −0.390 −8.051 −6.345
(2.224) (2.713) (2.360)
Δ Ln Y 0.941 −1.718 −1.622 −0.926
(1.730) (3.996) (2.425) (1.626)
Δ POS 0.148 −0.145 −0.089 −0.174
(1.701) (1.524) (0.999) (3.205)
Δ NEG 0.026 0.005 - 0.052
(0.943) (0.255) (1.994)
Panel B: Long-run coefficient estimates for nonlinear model
Constant Ln Y Ln SE Ln POS Ln NEG
−16.957 0.667 - 3.892 0.075 - 0.049
(2.087) (4.234) (3.892) (1.251) (2.409)
Panel C: Diagnostic statistics
F ECMt-1 LM RESET Normality CUSUM CUSUM SQ Wald-S Wald –L Adj.R2
54.175 −1.443 3.356 1.006 2.455 S S 9.195 1.152 0.933
(7.306)

Numbers inside parentheses are absolute value of t-ratios

Table 9 Impact of interest rate volatility on financial market inclusion results for India 1980–2015

Panel A: Short-run coefficient estimates for linear model

Lag Order
0 1 2 3 4
Δ Ln SE −1.576 −0.212 1.036 2.898
(2.329) (0.252) (0.976) (2.902)
Δ Ln Y −0.474 −0.848
(1.923) (2.160)
Δ Ln R 0.004
(0.029)
Δ Ln VR −0.123
(1.829)
Panel B: Long-run coefficient estimates for linear model
Constant Ln Y Ln SE LR LVR
5.984 0.486 −1.119 −0.419 - 0.201
(3.782) (15.276) (3.039) (1.867) (4.902)
Panel C: Diagnostic statistics
F ECMt-1 LM RESET Normality CUSUM CUSUM SQ Adj. R2
3.156 −0.455 0.014 6.276 0.647 US S 0.424
(3.596)

Numbers inside parentheses are absolute value of t-ratios

 J Econ Finan

Table 10 Impact of interest rate volatility on financial market inclusion results for India 1980–2015
(nonlinear model)

Panel A: Short-run coefficient estimates for nonlinear model

Lag order
0 1 2 3 4
Δ Ln SE −0.638 −1.152 0.575 −2.013
(1.589) (2.428) (0.632) (2.518)
Δ Ln Y −0.707 −0.541 −1.503 −0.311
(4.498) (1.932) (5.398) (1.614)
Δ POS −0.045 −0.340 0.024 0.199
(0.602) (2.569) (0.331) (3.274)
Δ NEG 0.05
(2.012)
Panel B: Long-run coefficient estimates for nonlinear model
Constant Ln Y Ln SE POS NEG
6.351 0.305 −0.869 - 0.408 0.122
(4.325) (2.037) (5.067) (3.633) (4.307)
Panel C: Diagnostic statistics
F ECMt-1 LM RESET Normality CUSUM CUSUM SQ Wald-S Wald –L Adj.R2
1.674 −0.319 0.452 0.336 2.078 S S 8.571 2.941 0.667
(3.397)

Numbers inside parentheses are absolute value of t-ratios

In line with our expectation, long-run estimation of real income per capita (Y) is
significantly positive for all five sample countries, implying that a higher growth rate of
economy has a significant positive impact on financial market inclusion. This might be
due to stronger business opportunities, smoother investment procedure and a better
investment environment. Greater economic growth is an important factor in enhancing
financial market inclusion in all countries. The estimated results of long-run linear
models reported in panel B show that the effect of real interest (R) on financial market
inclusion is significantly negative for all five countries. Furthermore, the estimated
coefficient for shadow economy (SE) reported in panel B is significant and negative for
all five countries of Brazil, China, India, Mexico and Turkey. This indicates that the
presence of shadow economy or unfiled economy might lead to a serious negative
impact on financial market inclusion in the long run.
To confirm the long-run relationship between these variables, we check two param-
eters in Panel C. In each table, Panel C represents the results of diagnostic statistics. In
order to check the existence of long-run relationship or cointegration, we need to look
at the two criteria of either F-test value or ECMt-t-1’s sign and level of significance. As
the results show, the F statistic for all countries in our sample except for Mexico is
greater than its upper-bound critical value for this estimation (3.77).5 In addition to F
test, we might check the sign and significance of ECMt-1 as the second criterion of
cointegration. The reported estimated results for all models show a negative significant

5
Pesaran et al. (2001, Table CI, Case III, p. 300).
J Econ Finan

coefficient for all countries, confirming a long-run relationship between all variables.
Obtaining a significantly negative coefficient estimate of ECMt-1 implies the adjustment
of variables toward their long-run values, or cointegration in all five emerging econo-
mies. In other words, absolute value of the estimated coefficient shows adjustment
speed. For example, the estimated coefficient of ECMt-1 for Turkey (−0.609) is negative
and highly significant, and it shows that 6% of the adjustment toward long-run value
takes place in one year.
A few other additional diagnostics statistics are presented in panel C. For example,
the Lagrangian Multiplier is another criterion to test the existence of first-order
autocorrelation, and the Ramsey test or RESET assesses model misspecification. These
tests have χ2 distribution, with one degree of freedom. Comparing both values with the
critical value of 3.84, we conclude that neither statistic is significant in most of
the models, implying autocorrelation-free residuals and also correctly specified
equations. To show the stability of our short-run and long-run models, we
applied CUSUM and CUSUM SQ stability tests. In panel C, we use the
notation BS^ for Stable models and BUS^ for unstable models. Eventually, the
adjusted R2 shows each model’s goodness of fit.
Before we report the results of nonlinear estimation results, it is necessary to
mention a few points related to the concepts of nonlinearity and asymmetry.
Following Shin et al. (2014), if in estimated linear models we find insignificant
estimated coefficient for our variable of interest (interest rate volatility in this
case) in one or two or more countries, but in nonlinear models the estimated
coefficient for either POS or NEG variable is significant, we conclude that
nonlinearity is present for those one or two countries. Furthermore, it is worth
noting that checking the asymmetric effect in either the short run or long run
requires paying attention to size, sign and number of lags on POS and NEG
variables. Shin et al. (2014) have suggested applying Wald test in order to
determine asymmetry. They have identified three types of asymmetry; adjust-
ment asymmetry, impact asymmetry of the short-run estimates and long-run
asymmetry. Following their recommendation, we apply Wald test, denoted by
Wald-S, to establish short-run cumulative or impact asymmetry. We also apply
Wald test, denoted by Wald-L to verify long-run asymmetry to see if the
coefficient estimate of POS variable is significantly different from the estimate
of NEG variable.6 In the short run, if the lags attached to ΔPOS are different
from ΔNEG, this confirms adjustment asymmetry. For example, if at N number
of lags, either the sign or size of estimated coefficients of ΔPOS are different
from the estimated coefficients of ΔNEG, the short-run effects are asymmetric.
The estimated results of the nonlinear models are presented in Tables 2, 4, 6, 8
and 10. As in the linear model report formatting, Panel A shows the short-run
estimates of all variables including the partial sum of interest rate changes
(POS and NEG), and panel B presents the estimation results of long-run
coefficients. Short-run results of estimated coefficient of interest rate volatility
in nonlinear models show that only in the case of Mexico does the interest rate
volatility have no significant short-run effects in the linear model (Table 1
panel A), but either POS or NEG is significant in the nonlinear model (Table 6

6
See Shin et al. (2014) for more details.
 J Econ Finan

panel A), therefore evidencing nonlinearity. Meanwhile, the size, sign and
number of lags on POS and NEG variables would determine the existence of
asymmetric effects. Panel B of Tables 4, 6, 8 and 10 presents the estimated
results for long-run nonlinear coefficients. To check the presence of asymmetry,
we consider either the sign or size of the long-run coefficient estimate corre-
sponding to the POS and NEG variables. Since these have a different estimated
coefficient sign in NEG and POS variables, we conclude that the long-run
estimate of interest rate volatility is asymmetric; this is evident in all countries
except for Mexico.
Furthermore, the level of economic activity has a major significant impact on
financial market inclusion in the selected five emerging economies in the
nonlinear long-run models. As expected, the estimated coefficient is positive
and significant in all five countries. This variable has a positive significant
effect on financial market inclusion in the linear model. To check the validity
of our long-run estimate, similar to linear models we try to confirm the long-
run relationship or cointegration in the nonlinear model as well. Again, we use
two criteria of F test or ECMt-1 to check the long-run relationship. Panel C
provides the results of the F test, ECMt-1 and other diagnostic characteristic
statistics. First, we check the F statistic in panel C and compare it with the
upper bound critical value, using the same critical value of 3.77.
From F-test value, cointegration is obviously confirmed in all countries
except for India. Second, checking the ECMt-1 illustrates a highly negative
significance in all models, which is another way of confirming the convergence
of the variables toward their long-run equilibrium values or cointegration.
Referring to panel C, the LM and RESET tests are not significant for most
counties, and we confirm the stability of our estimated models by the CUSUM
and CUSUMSQ test results. Finally, the reported results of adjusted R2
confirm that all models enjoy goodness of fit. Two additional statistics are
employed to show the symmetry versus asymmetry effects of interest rate
volatility. The first one is adjustment asymmetry or adjustment path (in short
run), which is checking the duration (or number of lags) of short-run multi-
pliers related with ΔPOS and ΔNEG variables in panel C. As our estimated
results show, these paths are different in all five countries, which confirms
adjustment asymmetry. The second way to check the existence of asymmetry is
to check the size and sign of short-run estimates of ΔPOS and ΔNEG
variables. As our estimated results show, we find that short-run estimates differ
in size, sign and significance in all models. The third way to check the
presence of asymmetry is to check the results of the Wald test in order to
clarify whether the sum of short-run multipliers related to ΔPOS is different
from the one related to ΔNEG.
The estimated results of nonlinear short-run Wald test (Wald–S) are reported
in panel C of Tables 4, 6 and 8. 7 By comparing their estimated values with
their critical value at 10% (5%), the significance level is 2.70 (3.84), indicating
that it is significant in three of the five countries (Brazil and Mexico are the
exceptions), confirming an asymmetry effect. The reported results of Wald-L

7
Wald tests has χ`2distribution with one degree of freedom. Critical value at 5% confidence
J Econ Finan

(nonlinear long-run estimate) confirms that long-run asymmetry is observed

only in two countries, India and China.

4 Conclusions

The effect of interest rate uncertainty on financial market development is

inevitable and significant. 8 Financial market inclusion as an important player
in the financial market development process is directly affected by interest rate
uncertainty. Over the past few decades, the majority of emerging economies
employed several criteria to improve their financial market and eventually
strengthen their economic structure. To the best of our knowledge, there has
been a lack of attention to the impact of monetary policy, especially the impact
of interest rate volatility on financial market inclusion in emerging economies.
Perhaps this article is the first study attempting to determine the impact of
interest rate volatility on financial market development for a group of selected
emerging economies. This study examines the relationship between interest rate
volatility and financial market development in five emerging economies over
the period 1980–2015 and simultaneously applies the bounds testing approach
to cointegration method and asymmetry cointegration approach to nonlinearity.
According to our estimation methodology, examining the asymmetric impacts
significantly depends on nonlinear models estimation. Based on our estimation
and our results, interest rate volatility has significant short-run asymmetric
effects on financial market inclusion in almost all countries in our study. It is
also illustrated that nonlinear asymmetry cointegration exists.
The results of our study show that, both in the short run and the long run,
interest rate volatility has significant impact on financial market inclusion both
in a symmetric and an asymmetric manner in all five emerging economies. The
results obtained suggest a strong link between interest rate volatility and
financial market inclusion both in the short run and the long run. We found
that in this group of emerging economies, interest rate volatility or uncertainty
significantly affects financial market inclusion, which is an important part of
their financial system. It is crucial to remember that any kind of uncertainty
and asymmetry effects in a financial system has a negative impact on the
financial system and would lead to malfunctioning financial market develop-
ment and eventually negatively impact economic growth. We suggest that
emerging economies minimize any kind of economic uncertainties, especially
interest rate. These countries need to implement financial market reform, facil-
itate access to financial services and products, revise rules and regulations and
provide adequate financial services to the public. We believe that implementa-
tion of these measures by economic policy makers leads to higher financial
market inclusion, stronger financial market development and eventually greater
economic growth in emerging countries. We suggest that this group of countries
should be careful in observance of law and order related to their financial
market and interest rate policies.

8
See Hajilee et al. (2015).
 J Econ Finan

Appendix

Data definition and sources

Sources

All data used in the study are annual over the 1980–2015 period and come from the
following sources:
a. World Development Indicator (WDI), published by the World Bank (2016)
b. Global Financial Development Database (GFDD), published by the World Bank
(2017)
c. IMF International Financial Statistics (IFS) (2017)

Variables

R = Real interest rate is the lending interest rate adjusted for inflation
VR = Volatility measure of real interest rate (R). It is defined as the standard
deviation of 12 monthly real interest rates (R) within that year
FI = Liquid liabilities to GDP (%) or monetary aggregates (M3) to GDP (%)
Bank deposits to GDP (%): The total value of demand, time, and saving deposits at
domestic deposit money banks as a share of GDP
SE = The size of the shadow economy. This measure is computed as the labor force
participation rate measured by the proportion of the population ages 15–64 that is
economically active
Y = GDP per capita is gross domestic product divided by population, 2005=100

References

Acemoglu D, Robinson J (2010) The role of institutions in growth and development. Review of Economics
and Institutions 1(2):1–33. https://doi.org/10.5202/rei.v1i2.1
Acemoglu D, Robinson JA (2012) The 2012 index. Foreign Policy 194:85–91
Acemoglu D, Johnson S, Robinson JA (2005) Institutions as a fundamental cause of long-run growth.
Handbook of Economic Growth 1:385–472
Aduda J, Kalunda E (2012) Financial inclusion and financial sector stability with reference to Kenya: a review
of literature. Journal of Applied Finance and Banking 2(6):95–120
Ahumada H, Alvaredo F, Canavese A (2009) The monetary method to measure the size of the shadow
economy: a critical examination of its use. Revue économique 60:1069–1078. https://doi.org/10.3917
/reco.605.1069
Alam M, Uddin GS (2009) Relationship between interest rate and stock price: empirical evidence from
developed and developing countries. International Journal of Business and Management 4:43–51.
https://doi.org/10.5539/ijbm.v4n3p43
Bahmani-Oskooee M, Fariditavana H (2016) Nonlinear ARDL approach and the J-curve phenomenon. Open
Econ Rev 27:51–70
Ballester L, Ferrer R, González C (2011) Linear and nonlinear interest rate sensitivity of Spanish banks.
Spanish Rev Financ Econ 9:35–48
Benink H, Wolff C (2000) Survey data and the interest rate sensitivity of US bank stock returns. Economic
Notes 29:201–213
Berrittella M (2015) The effect of public education expenditure on shadow economy: a cross-country analysis.
Int Econ J 29(4):527–546
J Econ Finan

Dabla-Norris E, Ji Y, Townsend R, Unsal FD (2015) Identifying constraints to financial inclusion and their
impact on GDP and inequality: a structural framework for policy. IMF working paper: WP/15/22
Dell’Anno R (2016) Analyzing the determinants of the shadow economy with a Bseparate approach^: an
application of the relationship between inequality and the shadow economy. World Dev 84:342–356.
https://doi.org/10.1016/j.worlddev.2015.08.026
Elgin C, Schneider F (2016) Shadow economies in OECD countries: DGE vs. MIMIC approaches. Bogazici
Journal: Review of Social, Economic & Administrative Studies 30(1):1–32
Hajilee M, Al-Nasser OM, Perez GH (2015) Banking sector development and interest rate volatility in
emerging economies. Appl Econ 47:1739–1747. https://doi.org/10.1080/00036846.2014.1000520
Hajilee M, Stringer YD, Metghalchi M (2017) Financial market inclusion, shadow economy and economic
growth: new evidence from emerging economies. Q Rev Econ Finance. https://doi.org/10.1016/j.
qref.2017.07.015
Hanson GH (2012) The rise of middle kingdoms: emerging economies in global trade. J Econ Perspect 26(2):
41–63
Jawaid S, Ul Haq A (2012) Effects of interest rate, exchange rate and their volatilities on stock prices: evidence
from banking industry of Pakistan. Theoret Appl Econ 8:153–166
Joseph NA, Vezos P (2006) The sensitivity of US banks’ stock returns to interest rate and exchange rate
changes. Manag Financ 32:182–199
Kasman S, Vardar G, Tunç G (2011) The impact of interest rate and exchange rate volatility on banks' stock
returns and volatility: evidence from Turkey. Econ Model 28:1328–1334
Long J (1974) Stock prices, inflation and the term structure of interest rates. J Financ Econ 1:131–170
Markellos RN, Psychoyios D, Schneider F (2016) Sovereign debt markets in light of the shadow economy.
Eur J Oper Res 252(1):220–231. https://doi.org/10.1016/j.ejor.2015.12.039
Mbutor MO, Uba IA (2013) The impact of financial inclusion on monetary policy in Nigeria. Journal of
Economics and International Finance 5(8):318–326. https://doi.org/10.5897/JEIF2013.0541
Mehrotra A, Yetman J (2015) Financial inclusion – issues for central banks. BIS Quarterly Review
March 2015:83–96
Merton R (1973) An intertemporal capital asset pricing model. Econometrica 41:867–887
Mishkin F (1977) What depressed the consumer? The household balance sheet and the 1973-1975 recession.
Brook Pap Econ Act 1:123–164
Mishkin F (2007) Monetary Policy Strategy. MIT Press
Papadamou S, Siriopoulos C (2014) Interest rate risk and the creation of the monetary policy committee:
evidence from banks’ and life insurance companies’ stocks in the UK. J Econ Bus 71:45–67
Pesaran MH, Shin Y, Smith RJ (2001) Bounds testing approaches to the analysis of level relationships. J Appl
Econ 16:289–326
Restrepo-Echavarria P (2015) Measuring underground economy can be done, but it is difficult. The Regional
Economist 1(2015):10–11 www.stlouisfed.org
Sahay R, Čihák M, N’Diaye P, Barajas A, Mitra S, Kyobe A, Mooi Y, Yousefi S (2015) Financial inclusion:
can it meet multiple macroeconomic goals? IMF staff discussion note 15/17. International Monetary
Fund, Washington
Schneider F, Buehn A, Montenegro CE (2010) Shadow economies all over the world: new estimates for 162
countries from 1999 to 2007. The World Bank development research group poverty and Inequality Team
& Europe and Central Asia region human development economics unit July 2010. Policy research
working paper 5356
Shin Y, Yu B, Greenwood-Nimmo MJ (2014) Modelling asymmetric cointegration and dynamic multipliers in
a nonlinear ARDL framework. In W. C
Stone B (1974) Systematic interest–rate risk in a two–index model of returns. J Financ Quant Anal 9:709–721
Tripathi V, Ghosh R (2012) Interest rate sensitivity of banking stock returns in India. International Journal of
Financial Management 2:10–20
World Bank (2012) Financial inclusion strategies reference framework. In: Prepared for the G20 Mexico
presidency. World Bank, Washington, DC
World Bank (2016) World Development Indicator (WDI) 2016 Maps
World Bank (2017) Global financial development report: Financial inclusion. World Bank, Washington, DC