79452 AUTHOR ACCEPTED MANUSCRIPT FINAL PUBLICATION INFORMATION Why Don't Banks Lend to Egypt's Private Sector? The definitive version of the text was subsequently published in Economic Modelling, 33, 2013-04-09 Published by Elsevier THE FINAL PUBLISHED VERSION OF THIS ARTICLE IS AVAILABLE ON THE PUBLISHER’S PLATFORM This Author Accepted Manuscript is copyrighted by the World Bank and published by Elsevier. It is posted here by agreement between them. Changes resulting from the publishing process—such as editing, corrections, structural formatting, and other quality control mechanisms—may not be reflected in this version of the text. You may download, copy, and distribute this Author Accepted Manuscript for noncommercial purposes. Your license is limited by the following restrictions: (1) You may use this Author Accepted Manuscript for noncommercial purposes only under a CC BY-NC-ND 3.0 Unported license http://creativecommons.org/licenses/by-nc-nd/3.0/. (2) The integrity of the work and identification of the author, copyright owner, and publisher must be preserved in any copy. (3) You must attribute this Author Accepted Manuscript in the following format: This is an Author Accepted Manuscript of an Article by Herrera, Santiago; Hurlin, Christophe; Zaki, Chahir Why Don't Banks Lend to Egypt's Private Sector? © World Bank, published in the Economic Modelling33 2013-04-09 http:// creativecommons.org/licenses/by-nc-nd/3.0/ © 2013 The World Bank Why Don’t Banks Lend to Egypt’s Private Sector? 1 Santiago Herrera 2 Christophe Hurlin 3 Chahir Zaki 4 Abstract Bank credit to Egypt’s private sector decreased over the last decade, despite a recapitalized banking system and high rates of economic growth. Recent macro-economic turmoil has reinforced the trend. This paper explains the decrease based on credit supply and demand considerations by 1) presenting stylized facts regarding the evolution of the banks’ sources and fund use in 2005 to 2011, noting two different cycles of external capital flows, and 2) estimating private credit supply and demand equations using quarterly data from 1998 to 2011. The system of simultaneous equations is estimated both assuming continuous market clearing and allowing for transitory price rigidity entailing market disequilibrium. The main results are robust to the market clearing assumption. During the global financial crisis, a significant capital outflow stalled bank deposit growth, which in turn affected the private sector’s credit supply. At the same time, the banking sector increased credit to the government. Both factors reduced the private sector’s credit supply during the period under study. After the trough of the global crisis, capital flowed back into Egypt and deposit growth stopped being a drag on the supply side, but bank credit to the government continued to drive the decrease in the private sector’s credit supply. Beginning in the final quarter of 2010, capital flows reversed in tandem with global capital markets, and in January 2011 the popular uprising that ousted President Hosni Mubarak added an Egypt-specific shock that accentuated the outflow. Lending capacity dragged again, accounting for 10 percent of the estimated fall in private credit. Credit to the government continued to drain resources, accounting for 70 - 80 percent of the estimated total decline. Reduced economic activity contributed around 15 percent of the total fall in credit. The relative importance of these factors contrasts with that of the preceding capital inflow period, when credit to the government accounted for 54 percent of the estimated fall, while demand factors accounted for a similar percentage. Keywords: Private credit, Egypt, Supply and Demand System, Disequilibrium model. J.E.L Classification : D50, E42, C32, P00 1 This paper is a product of the MNSED Unit, MNSPR Department/Network, sector Borad: EPOL. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at sherrera@worldbank.org. The authors thank Adolfo Barajas for detailed comments on a previous draft of the paper. The paper is individually authored, and does not necessarily represent the views neither of The World Bank nor of its Executive Directors. 2 Santiago Herrera, Lead Economist, World Bank, Cairo, Egypt. Email: sherrera@worldbank.org 3 Christophe Hurlin, Orleans University, Orleans, France. christophe.hurlin@univ-orleans.fr 4 Chahir Zaki, Assistant Professor, Cairo University, Cairo, Egypt. Email: chahir.zaki@feps.edu.eg 1. Introduction Since 2000, banking credit to the private sector has declined in real terms and as a share of Egypt’s GDP. During the past decade the banking system witnessed recapitalization of public banks and two different cycles of external capital flows. Capital flowed in until mid-2008 when the global financial crisis erupted, and flowed out until mid-2009. As global risk appetite recovered, capital flowed back in until the last quarter of 2010, when global capital markets tightened again and the January 2011 uprising accentuated the capital outflow. Aside from the capital flows’ stop-go cycles, public finance deficits and financing needs created an expansion-contraction-expansion cycle that affected bank credit to the private sector. Output fluctuations with episodes of high growth as well as output contractions affected the private sector’s demand for credit. This paper describes how these factors interact to produce a decline in credit to the private sector. The paper first examines the stylized facts of bank credit to the private sector in an international context, benchmarking the expected amount of private sector credit for a country with Egypt’s characteristics (using FINSTAT, a benchmarking tool developed by the World Bank). It also explores the evolution of banking sector sources and uses, based on its aggregate balance sheet and similar exercises performed for Latin America and the MENA regions (Barajas et al., 2002; 2010). The central objective of the paper is to estimate credit supply and demand equations in line with the abundant empirical literature on the topic. Some studies examine the issue assuming that prices are flexible enough to clear the market by equalizing supply and demand. Others assume that prices are not perfectly flexible and estimate demand and supply equations using the short-side rule (i.e. that observed credit quantities can occur on the demand or supply schedules, whichever is smallest, at a given interest rate). Assuming an excess supply or demand at a given point, the researcher infers the likelihood of the observed quantity being on the supply or demand regimes. Empirical studies based on aggregate time series data and applied to business loans include Laffont and Garcia (1977) for the Canadian market, Sealey (1979) and King (1986) for the US market. Pazarbasioglu (1997) and Kim (1999) investigate whether there was a credit crunch, respectively in Finland following the banking crisis of 1991- 92, in Korea following the financial crisis in December 1997. In Latin America, Catao (1997) and Braun and Levy-Yeyati (2000) assessed credit contraction for Argentina, Berrospide and Dorich (2001) for Peru, Carrasquilla, Galindo and Vasquez (2000) and Barajas, Lopez and Oliveros (2001) for Colombia, Barajas and Steiner (2002) for Colombia, Peru and Mexico, and Hurlin and Kierzenkowski (2007) for Poland. The rest of the paper is organized as follows. Section Two describes some stylized facts for the credit market in Egypt and compares the case with peer countries. It also discusses the evolution of the banking sector’s main sources and uses of funds. Section Three describes the methodology of credit demand and supply estimation and presents the data sources. Section Four reports and interprets the empirical results within the macroeconomic context. Section Five concludes. 2. Stylized Facts 2.1 Banking Reform in Egypt The Central Bank of Egypt in 2004 adopted a reform program that aims at building solid infrastructure and more efficient and sound banking sector. Although the global financial crisis led to many negative repercussions on several world economies, the Egyptian banking sector weathered the negative repercussions due to the successful reform program that have launched in 2004. Indeed, as it was mentioned by the World Bank (2009) “the Egyptian financial sector is the most far reaching, substantive and comprehensive drive toward financial sector strengthening so far in Egypt - and indeed in any other country of the Middle East and North Africa region”. This reform has been implemented in two phases. The first phase had three main pillars: first, strengthening the legal, regulatory and supervisory framework; second, consolidating the banking sector and increasing private participation within banking assets and finally the financial, operational and institutional restructuring of public-sector banks. Those reforms led to a robust, solid and well capitalized banks (see Table 1), as banks decreased from 57 to 39; assets increased by 88% to reach EGP 1.1 billion in 2008 up from EGP 0.57 billion in 2003; total deposits increased by 85% over the same period; capital adequacy ratio increased from 12.2% to reach 15.1%. In addition, the flow of new capital through mergers and acquisitions in the banking system reached EGP 24.24 billion in 2008. At the banking sector level, as it is shown in Table 2, the banking reform plan reduced the number of operating banks in Egypt from 61 banks to 39 while increasing the number of branches by 25% to reach 3502 branches (up from 2783). This was mainly due to the significant decrease in the number of private and foreign banks that ended their business. Furthermore, banking density has slightly decreased from 24.9 to 22.3 thanks to this increase in the total number of branches. [Tables 1 and 2 about here] Others aspects have also improved since the ratio of nonperforming loans to total gross loans has decreased from 26 percent in 2005 to 11 percent in 2011 and the interest rate spread declined from 5.9 percent to 4.8 percent. Finally, it is important to note that the bank liquid reserves to bank assets ratio has been increasing after the reform until 2007 to reach 45 percent up from 33.4 percent in 2005. However, the ration started to decrease due to the financial crisis in 2008/2009 reaching 34.2 percent. The deterioration has been more pronounced due to the popular uprising in January 2011 since the bank liquid reserves to bank assets ratio reached 16.3 percent as shown in Table 3. This means that the banking system liquidity has significantly decreased implying that adverse macroeconomic conditions should be more likely to lead to banking and financial crises. [Table 3 about here] The second phase of the banking sector reform program that started in 2009 aims at deepening the Egyptian banking sector and enhancing its efficiency and competitiveness through enhancing access to financial services, continuing the strengthening of the regulatory and supervisory framework through the implementation of Basel II/III and enhancing the implementation of Corporate Governance rules and regulations. Those reforms increased the loans-deposits ratio reaching 54%, average loans-GDP ratio reaching 49.4% and average deposits-GDP ratio reaching 90%. Those figures are much higher than the world average in 2008. Having said that, the implications of the financial turmoil would have been much more severe on the banking sector and on the rate of credit to GDP haven't this reform have happened. Therefore, the impact of the banking sector reform program on the banks ability to extend credit cannot be missed. 2.2 Private Credit in Egypt in an International Context In comparing Egypt to other countries, two trends emerge. First, while private credit to GDP declined continuously since 2000 in Egypt, it increased in Morocco, Tunisia, India and Turkey (see Figure 1). Second, in 2009, Egypt was performing below the MENA countries’ average (40 percent), the middle income countries average (41.6 percent) and its peer group average (49.9 percent) (see Figure 2 and Table 4). It is quite alarming given that the private sector was the main source of investment (70% of total investments came from the private sector) and hence the driving force behind employment opportunities and economic growth. [Figures 1 and 2 about here] [Table 4 about here] Having examined the international context for evolution of private credit in Egypt and expected levels based on this sample of countries, we turn now to the domestic context. 2.2 Sources and Uses of Funds of the Banking Sector Total bank credit as a share of GDP has been falling since 2006, except in 2011, when credit to the government jumped by six percentage points of GDP (see Table 5). 5 The banking sector’s claims on the government (Figure 3) and on the business sector (Figure 4) show divergent trends. [Table 5 about here] 5 This section and the remainder of the paper uses Central Bank of Egypt (CBE) data on credit aggregates. Section I used the FINSTATS database for all variables to ensure comparability across countries. [Figures 3 and 4 about here] To explain private sector lending we will examine the sources and uses of banking funds during this period using the methodology of an existing study of bank credit contraction in Latin America (IMF Staff papers Barajas-Steiner, 2002), to facilitate comparison. The banking sector’s fund sources are deposits (Dt); net foreign liabilities (NFLt), and bank capital (Kt). Uses include lending to the private sector (CPSt), lending to the government (GOVt), changing its net credit position with the CBE (CBt), and cash holdings or other assets (OTHt). Hence, credit to private sector can be defined as follows: CPSt = Dt + NFLt + Kt - GOVt - CBt - OTHt Private sector credit growth (and change) can be decomposed into changes in these other balance sheet items that either contribute to or offset the decline: ∆CPSt/CPSt-1 = ∆Dt/CPSt-1 + ∆NFLt/CPSt-1 + ∆Kt/CPSt-1 - ∆GOVt /CPSt-1 - ∆CBt/CPSt-1 - ∆OTHt/CPSt-1 Table 6 shows the changes in sources and uses of funds for the period 2005 to 2011. Real deposits are the main force behind the changes, exhibiting high growth rates during the boom years of 2007 and 2008, a time when real net foreign liabilities were falling. The 2009 data reflects the impact of the global crisis (data corresponds to fiscal years, ending in June), when the banking sector’s net foreign liabilities increased, compensating the decrease in the deposits as a source of funding. The general trend in the uses of funds shows that the real credit position with the CBE was the main alternative use of funds until 2009 when real credit to the government began taking over as the main use of banking sector funds. In 2011, against a background of political unrest, real credit to the private sector decreased by 8.5 percent, as a result of contraction of sources by 17 percent and of alternative uses by 8.5 percent. The banking sector’s adjustment to capital outflow consisted of compensating the contraction of net foreign liabilities with a reduction in the net credit position with the CBE by a similar magnitude. [Table 6 about here] During the capital inflow period 2006 to 2008, the Egyptian banking sector did not fund credit operations expanding its net foreign liabilities. In fact, during the capital inflow years the banking sector’s liabilities with the rest of the world became instead a contractive factor. In 2009, when capital flowed out in response to the global crisis, banks used their external liabilities as a funding source, playing a counter-cyclical role. Only in 2011, during the capital outflow related to the January uprising, were the net foreign liabilities pro-cyclical (see Table 7). [Table 7 about here] The role of Egypt’s central bank (CBE) helps explain this puzzling behavior. During the capital inflow period, the CBE intervened to prevent the domestic currency’s appreciation. CBE’s foreign currency assets increased from USD 23 billion in June 2006 to USD 48 billion in June 2008. To compensate for this expansion, the banks had to increase their net credit position with the CBE, especially in 2007 and 2008. During the capital outflow periods 2009 and 2011, the banking sector reduced its net credit position with the CBE. Table 6 also shows a significant expansion of credit to government in FY2009 (30 percent), accompanied by a change in the banking sector’s net credit position with the CBE. This may reflect a countercyclical monetary policy by the CBE who provided liquidity to the banking system to accommodate the government’s higher demand for credit. Figures 5 and 6 show the evolution of bank deposits. Until 2008 they grew at a significantly higher rate than the uses of funds. As of mid-2008 they stagnated and growth rates in Figure 6 show a close synchronicity with capital flows. [Figures 5 and 6 about here] From the demand for credit side, two factors typically affect credit expansion and/or contraction, i.e. the level of economic activity and the availability of alternative funding sources. Egypt’s economic activity measured by the real industrial production index was clearly expanding, especially in the period 2002-2008, but then began contracting (see Figure 7).6 [Figure 7 about here] The availability of alternative funding sources for firms (captured by the evolution of the stock market index, EGX 30) expanded significantly in the boom period 2004 to 2008. During the 2008 global crisis it fell precipitously, recovering again during the renewed capital inflow, and falling again in the recent macroeconomic turmoil (Figure 8). [Figure 8 about here] 3 Methodology Given the stylized facts regarding credit demand and supply determinants, we can verify the statistical validity of expected relationships and quantify the impact of different factors. 6 Quarterly GDP data is only available starting in 2002, while the industrial production index is available since 1998. The larger degrees of freedom for the econometric estimation explains the choice of this variable. Following Laffont and Garcia (1977) and others, this section estimates aggregate demand and supply functions of bank credit to Egypt’s private sector using two assumptions: an equilibrium approach and a disequilibrium one. The first assumes that prices are flexible and clear the market continuously, and estimates the system of simultaneous equations using traditional methods. The second method relaxes the market clearing assumption, allowing for transitory excess supply or demand situations, and estimates the system of equations using the Maddala and Nelson (1974) disequilibrium technique. 3.1 Equilibrium Hypothesis In the specification of the supply and demand functions, the identification of the model requires that one or more variables included in one function be excluded from the other. Following Barajas and Steiner (2002), our identification variables in the demand equation capture the macroeconomic environment that affects credit demand: real industrial production (RIP) and the stock market index (EGX30). The former reflects the business environment and has a positive effect on credit demand; the latter represents an alternative form of financing for Egyptian firms, and should therefore have a negative impact on credit demand. Real lending rate (RLEN) is added to determine the impact of credit prices on credit demand. The variables introduced in the supply function measure the banks’ ability to supply loanable funds. We constructed an exogenous “lending capacity” (LEND.CAP.) variable which consists of real total deposits minus banks’ real reserves. The higher the total deposits, the more the bank will supply credit. By contrast, the higher the reserves, the lower the available loanable funds. Therefore, we expect a positive effect of the lending capacity variable on credit to private sector. To capture the trade-off that banks face when lending to the government, we introduced the real T-bill rates (RTBILL) in the supply function. This variable is mostly exogenous to the banking system but affect banks’ willingness to lend to the government. The higher the T-bill rates, the more funds banks provide to government and hence the less they can lend to private firms. Therefore, it has a negative impact on credit supply to the private sector. Finally, lending rates (RLEN) were introduced to determine the impact of credit prices on credit supply7. Our dependent variable is real credit to the private sector (RCRPV). The system of equations is: Supply function: ln(RCRPV)t=β0 + β1 (RLEN)t + β2 ln(RTBILL)t + β3ln(LEND.CAP)t-1 + єt (1) Demand function: ln(RCRPV)t =α0 + α1 (RLEN)t + α2 ln(RIP)t-1 + α3 ln(EGX30)t-1 + εt (2) with єt and εt the respective disturbance terms. We ran the regression using different techniques. First, using a seemingly unrelated regression, we estimated the supply and demand system assuming that the disturbances across 7 Real rates were computed using the Fisher’s relation (1+i) = (1+r)(1+π) where i is the nominal rate, r the real rate and π the inflation rate. Therefore, r = (1+i)/(1+π) – 1. equations are contemporaneously correlated (Zellner, 1962). Next, we ran it using a multivariate regression. Finally, we used OLS and 2SLS regressions. 3.2 Disequilibrium Hypothesis Since Fair and Jaffee (1972) extensive literature has adressed the econometric problems associated with estimating demand and supply schedules in disequilibrium markets. The main approach consists in using maximum likelihood ( ML ) methods. In a seminal paper, Maddala and Nelson (1974) derived the general likelihood function for different disequilibrium models and proposed the appropriate ML estimating procedures. Their model is as follows: t β1 + ε 1,t (3) ' d t = x1, st = x'2,t β 2 + ε 2,t (4) qt = min (d t , st ) (5) where dt denotes the unobservable quantity demanded during period t; st the unobservable quantity supplied during period t; ' x1, ( (1) (1) 1 ) ' (1) t = x1,t x2,t ...x K ,t is a vector of K1 explanatory variables that influence dt; ( (2) (2) x'2,t = x1, 2 )(2)' t x2,t ...x K ,t is a vector of K2, explanatory variables that influence st; β1 and β2 are respectively (K1,1) and (K2,1) vectors of parameters. We assume that dt and st are unobservable at date t, whereas x1,t and x2,t are observable. The variable qt denotes the actual quantity observed at time t. The equation (5) is the crucial disequilibrium hypothesis, which allows for the possibility that the price of the exchanged good is not perfectly flexible and rationing occurs. More generally, equation (5) indicates that any disequilibrium that occurs (i.e. any divergence between the quantity supplied and demanded) results from an incomplete price adjustment. Therefore, on the basis of voluntary exchange the ‘short side’ of the market prevails. With equation (5), the model indicates the probabilities of each observation belonging to either supplied or demanded quantities. Next, we present the model’s theoretical underpinnings. In a first version, following Maddala and Nelson (1974), we assume that both residuals ε1,t and ε2,t are stationary processes, independently and normally distributed with variance σ21 and σ22 respectively. Under these regularity assumptions, the transformed variable ε1,t - ε2,t is normally distributed with a variance equal to σ2 = σ21+σ22. Hence, the reduced variable (ε1,t - ε2,t)/σ follows a N(0,1). The probability that the observation qt belongs to the demand regime, denoted πt(d), can then be computed as the corresponding N(0,1) fractile: x2 − π t = P(Dt < St ) = Φ(ht ) = (d ) 1 ht 2π ∫ −∞ e 2 dx (6) ( where ht = x'2,t β 2 − x1, ' ) t β1 /σ , and Φ ( x ) denotes the cumulative distribution function of the N(0,1). Symmetrically, the probability of obtaining the supply regime, denoted πt(s), is defined by P(St < Dt ) = 1 − Φ (ht ) 8 3.3 Data The quarterly dataset from 1998 to 2011 was compiled from different sources. Data regarding credit to private sector came from the banking survey published in CBE’s monthly report. Total deposits, banks’ reserves with the CBE (that were used to construct the lending capacity) and bank lending rates also come from the same source. Industrial production comes from the Central Agency for Public Mobilization and Statistics (CAPMAS) deflated by the CPI; and the stock market index (EGX30) as reported by the Egyptian Stock Market. EGX 30 Index is a market capitalization-weighted index. Finally, lending rates were taken from CBE reports while T-Bill rates were gathered from Ministry of Finance reports9. All nominal variables were deflated by the consumer price index. To partially control for endogeneity bias, the models use the lagged values for industrial production, bank deposits, bank reserves and the stock market index. 8 For further details, see appendix 1-4 9 To check whether our series are stationary or not, we ran the Augmented Dickey-Fuller test and found they all suffer from a unit root problem. After taking the first difference and running the ADF, we found our variables stationary. Finally, we conducted the Johansen’s test to determine whether our series are co-integrated or not. We found that they form a co- integrated vector, allowing us to estimate the model in levels. 4 Empirical Results 4.1 Results of the Equilibrium Hypothesis Table 8 presents the regression results using different techniques, all of which yield similar results. In the demand equation, real industrial production has the expected positive sign while the stock market index has a negative impact on the demand for credit, reflecting its role as a substitute for bank credit. The real lending rate turns out with an unexpected positive sign and statistically significant coefficient. [Table 8 about here] Concerning the supply function, we found lending capacity to be positively and statistically significant related to credit supply. The trade-off between government and private sector seems to be an important factor in explaining Egypt’s credit contraction. The more the banks provide loans to the government, the less they can lend to private firms. Consequently, the coefficient associated to the real T-bill interest rate is negative and statistically significant. Finally, in a supply function we expect a positive impact of credit prices on credit quantities. The real lending rate in fact has a positive and statistically significant impact on credit supply at 1 percent. 4.2 Results of the Disequilibrium Hypothesis Table 9 summarizes the results using the disequilibrium model, with the same specifications as in the previous section. We use the two-step OLS parameters of the previous section as the initial values for the maximization process (see appendix for more details). We checked the results’ robustness using various initial conditions for the algorithm of ML maximization and various methods to optimize the ML (i.e. by finding the zero of the gradient; by minimizing with or without condition on the parameter; with a numerical/analytical gradient, etc.). The results (available upon request) show that the ML estimated parameters are robust to these changes. Figure 9 shows each regime’s estimated probabilities for the best model in terms of the log-likelihood statistics and information criteria. It is conventional to assume an excess of supply (respectively demand) when the estimated probability of the supply regime (respectively demand) is higher than 0.5. These estimated probabilities of supply and demand regimes clearly indicate that the probabilities of regimes are often larger than 0.8 or less than 0.2. We can identify two main periods: for 2001-2003, there was excess demand of credit that progressively decreased and switched to an excess of supply situation until 2011. After the global crisis (in 2008) both the demand and supply of credit to the private sector diminished, and while the fall in the supply is estimated to be greater, the excess supply still persists. [Table 9 about here] [Figure 9 about here] The disequilibrium econometrics approach based on the short-side rule is consistent with the theory of equilibrium credit rationing derived from asymmetric information models. Because of moral hazard and adverse selection problems, an excess demand in the loan market may exist, since a rise in the loan interest rate can reduce the banks’ expected return. If each bank attracts only the least profitable customers, each may have an excess supply of loanable funds, but none will accept to reduce its interest rate. Consequently, there may be an excess credit supply in the banking sector, without a fall in the interest rate to clear the loan market. This excess of supply can be observed in Figure 10, illustrating the estimated demand and supply for the private sector’s real claims. [Figures 10 and 11 about here] 4.3 Decomposing the Predicted Changes in Credit The models presented in Tables 8 and 9 allow us to determine the relative importance of demand and supply factors in the evolution of credit to the private sector during five sub- periods. These are categorized based on external capital flows: inflow periods (July 2001-June 2004, July 2004-June 2008, July 2009-September 2010) or outflow periods (July 2008-June 2009, and October 2010-June 2011). Predicted change is calculated by multiplying the coefficients obtained in the previous section by the change in the explanatory variable throughout a given sub-period. Changes brought about as a result of adjustments in interest rates show a movement along supply and demand curves. By contrast, changes in the other explanatory variables show the predicted shifts in the curves. Tables 10 and 11 present the results for different sub-periods using the equilibrium and disequilibrium models respectively. The two models yield similar results even when the absolute numbers differ. The disequilibrium model offers more volatile predictions, given the greater elasticity of the credit supply to changes in the real T-bill rates (2.19 in the disequilibrium model versus 1.89 in the equilibrium model) and the larger elasticity of the demand for credit to changes in alternative funding sources (-.11 in the disequilibrium model versus -.08 in the equilibrium one). General trends persist despite the differences. Until 2008, lending capacity growth is the single most important credit supply factor, whereas after 2009 it is credit to the government (captured by the real T-bill rate). From the demand perspective, both the level of activity and the alternative funding sources switch dominant roles. During the period July 2004 to June 2008, from the demand side, the availability of substitute funding sources was partially dampened by the positive impact of economic expansion. From the bank credit supply side, moderate growth in credit to the government compensated the equally moderate lending capacity. During the global crisis (July 2008 to June 2009) a significant capital outflow led to a negative impact of lending capacity, which in turn affected the private sector’s credit supply. Additionally, the banking sector gave credit to the government. Both made the supply effect dominant during the period. From the demand side, the contraction of economic activity mitigated credit demand but the lack of alternative funding sources led to higher demand for credit from the banking sector. After the June 2009 trough of the global crisis, capital flowed back into the country. Lending capacity growth stopped being a drag on the supply side, and availability of alternative funding sources released pressure from the demand side (Tables 10 and 11). Now credit to the government was behind the fall in credit to the private sector. [Tables 10 and 11 about here] From the last quarter of 2010 (October) capital started flowing out of Egypt, in tandem with global capital markets, and the January 2011 uprising added an Egypt-specific shock that accentuated the outflow. Capacity of lending declines dragged again and credit to the government continued to drain resources. During this period, credit to the government accounts for between 70 and 80 percent of the predicted total decline in credit, and the fall in deposits accounts for almost 10 percent of the predicted fall in private credit. The slowdown in economic activity accounts for about 15 percent of the predicted total fall in credit. Table 12 summarizes these findings by presenting 1) how supply is higher or lower than demand shifts for each period 2) whether the shifts are in the same direction or operate in opposite ways, and 3) the main determinant of supply and demand shifts. [Table 12 about here] 5 Conclusions The paper explained the credit contraction to the private sector based on the banking sector’s sources and uses of funds, as well as estimating econometrically a system of supply and demand for private credit. An analysis of the banking sector’s sources and uses of funds reveals a close association of bank credit to the private sector with external capital flows but mostly through the deposit growth rate, which was the main determinant of the sources of funds. The banking sector’s net external liabilities were countercyclical, i.e. they contracted during the capital inflow period and expanded during the capital outflow. In this sense, the sector played a stabilizing role. Only during the last cycle of capital outflow since the Revolution the net foreign liabilities have been pro-cyclical. The banks’ net credit position with the CBE fell during the capital outflow episodes of 2009 and 2011 and increased during the capital inflow episodes, which may be interpreted as an effective countercyclical monetary policy. The system of simultaneous equations was estimated both assuming continuous market clearing and allowing for transitory price rigidity entailing market disequilibrium. The main results are robust to the market clearing assumption. Up to the global financial crisis, the main elements driving bank credit were from the demand side, though in opposing directions: vigorous industrial activity implied growing demand for bank credit, but available alternative sources of financing implied lower demand for bank credit. After the global financial crisis, the banking sector’s credit to the government played the dominant role from the supply side, while subdued economic activity operated in the same direction from the demand side. Starting in the last quarter of 2010 capital flows reversed, in tandem with global capital markets, and the events of January 2011 accentuated the outflow. The slowdown in economic activity accounted for between 15 and 20 percent of the predicted total fall in credit, while the expansion of the credit to the government accounts for the remaining fall in the observed credit to the private sector. The relative importance of these factors contrasts with that of the preceding capital inflow period during which credit to the government accounted for about 50 percent of the estimated fall, while demand factors accounted for a similar amount. References Barajas, A. E. Lopez and H. Oliveros (2001) “Porque en Colombia el credito al sector privado es tan reducido?” Borradores de Economia No. 185. Banco de la Republica. Barajas and Steiner (2002) “Why don’t they lend? Credit Stagnation in Latin America”, IMF Staff Papers. vol. 49. Special issue. Barajas, A. R. Chami, R. Espinoza, and H. 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Pazarabasioglu, C. (1997) “A Credit Crunch: Finland in the Aftermath of the Banking Crisis”, IMF Staff Papers, Vol. 44, No. 3, pp. 315-327. Quandt R. (1988) The Econometrics of Disequilibrium, Blackwell. Sealey, C (1979) “Credit Rationning in the Commercial Loan Market. Estimates of a Structural Model under Conditions of Disequilibrium”, Journal of Finance, Vol. 34, pp. 689- 702. Zellner, (1962) “An Efficient Method of Estimating Seemingly Unrelated Regressions and Tests for Aggregation Bias,” Journal of the American Statistical Association, vol. 57, pp. 348– 368. Tables Table 1: Banking Aggregates before and after 2004 Reform LE million (End of June) 2003 2008 % change Total Assets (in EGP) 577,938 1,083,311 87.70% Total Deposits (in EGP) 403,144 747,199 85.30% Loans & Discounts (in EGP) 284,722 401,425 41.20% Capital & Reserves (in EGP) 29,960 53,436 82.70% Capital adequacy ratio 12.20% 15.10% 2.90% Source: Central Bank of Egypt. Table 2: Number of Banks and Banking Density End of June 2004+ 2005 2006 2007 2008 2009 2010 Total Number of Banks Operating in Egypt 61 52** 43*** 41*** 40*** 39*** 39 Total Number of Branches 2783 2841 2944 3056 3297 3443 3502 Banking Density+ 24.9 24.8 24.5 24.2 22.9 22.3 22.3 Number of Public Sector Banks 7 7 7 6 6 5 5 Number of Branches of Public Sector Banks 2153 2185 2222 2074 2089 2088 2080 Number of Private Sector Banks 35 34 29 28 27 27 27 Number of Branches of Private Sector Banks 571 607 674 930 1145 1270 1329 Number of Private and Joint venture (JV) Banks 19 11 7 7 7 7 7 Number of Branches of Private and JV Banks 59 49 48 52 63 85 93 *Population in thousand / Banking unit. + Egyptian banks abroad are not included , also two banks established under private laws and are not registered with CBE: the Arab International Bank, and Nasser Social Bank *** The decrease was because seven branches of foreign banks ended their business. Table 3: Financial and Banking Variables in Egypt 2005 2006 2007 2008 2009 2010 2011 Bank capital to assets ratio (%) 6.1 4.9 4.8 5.6 5.5 6.2 6.3 Bank liquid reserves to bank assets ratio (%) 33.4 34.0 44.9 36.5 34.2 33.3 16.8 Bank nonperforming loans to total gross loans (%) 26.5 18.2 19.3 14.8 13.4 11.0 - Deposit interest rate (%) 7.2 6.0 6.1 6.6 6.5 6.2 6.2 Lending interest rate (%) 13.1 12.6 12.5 12.3 12.0 11.0 11.0 Interest rate spread (lending minus deposit rate, %) 5.9 6.6 6.4 5.7 5.5 4.8 4.8 Source: Central Bank of Egypt. Table 4: Private Credit/GDP (percent) Regional Comparison S01IFS0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Egypt, Arab Rep. 52.0 54.9 54.7 53.9 54.0 51.2 49.3 45.5 42.8 36.2 MENA Average 37.7 38.0 37.0 36.1 36.3 37.1 38.1 39.5 39.5 40.3 MENA Median 34.4 28.4 26.2 25.6 27.7 28.2 30.9 34.3 31.2 33.8 LMC Average 29.5 29.2 29.1 29.7 31.1 33.5 35.0 38.1 39.9 41.6 LMC Median 27.1 23.9 21.1 24.4 25.5 27.3 29.1 30.3 32.2 33.6 HIC OECD Median 81.1 92.8 94.4 97.7 98.4 102.2 104.1 105.0 108.2 111.5 Peer Group Average 42.6 40.3 41.1 40.8 41.6 42.8 43.9 45.7 48.5 49.9 Expected median 19.0 19.2 19.4 21.1 22.8 23.8 25.7 28.3 31.1 31.6 Number of countries used for the regional and income group benchmarks (not the OECD benchmark) S03FSI0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Regional benchmarks 11 11 11 11 11 11 11 11 11 11 Income group benchmarks 47 47 48 48 48 48 48 48 48 47 Source: Finstat (2011) Table 5: Credit as Share of GDP credit of banking sector in local currency ( as % of GDP) 2006 2007 2008 2009 2010 2011 total credit 0.789 0.662 0.568 0.623 0.596 0.631 gov 0.387 0.309 0.249 0.325 0.322 0.382 pub bus 0.043 0.025 0.022 0.023 0.018 0.018 priv bus 0.278 0.254 0.219 0.200 0.182 0.161 household 0.081 0.074 0.078 0.076 0.075 0.070 Source: Central Bank of Egypt (CBE) monthly reports Table 6: Change in sources and uses of funds of the banking sector (for fiscal years ending in June) as a ratio to real credit to the private sector 2005 2006 2007 2008 2009 2010 2011 Change in credit to the private sector -0.044 0.009 -0.015 0.017 -0.078 -0.029 -0.085 Change in sources 0.062 0.035 -0.026 0.116 -0.038 0.024 -0.170 Change in deposits 0.066 0.086 0.115 0.047 -0.171 -0.031 -0.044 Local currency 0.055 0.098 0.023 0.083 -0.072 0.030 -0.048 Foreign currency -0.002 -0.013 0.030 -0.028 -0.053 -0.054 -0.020 Other 0.013 0.000 0.061 -0.008 -0.045 -0.008 0.024 Change in foreign liabilities -0.010 -0.072 -0.121 0.046 0.146 0.060 -0.077 Change in capital 0.006 0.022 -0.019 0.023 -0.014 -0.005 -0.049 Change in alternative uses 0.106 0.026 -0.010 0.100 0.040 0.052 -0.085 Change in credit government 0.065 0.050 -0.108 0.013 0.210 0.072 0.044 Change in net credit to CBE 0.026 -0.020 0.066 0.074 -0.142 -0.025 -0.144 Change in other assets & cash 0.015 -0.004 0.033 0.013 -0.028 0.006 0.014 Source: Central Bank of Egypt Note: Real figures of all aggregates were obtained by deflating nominal figures by the CPI index from CAPMAS. Table 7 – Change in CBE foreign currency assets (in Billion US$) Int. Res. Change & For. in CBE Current Capital Assets1 IR & FA2 Account3 Account4 Mar 17.6 2.6 1.0 1.6 Jun 19.2 1.6 0.1 1.5 2005 Sept 22.0 2.8 0.2 2.6 Dec 23.4 1.4 0.8 0.6 Mar 23.7 0.3 0.9 -0.6 Jun 23.2 -0.5 -0.1 -0.4 2006 Sept 25.9 2.7 1.3 1.4 Dec 32.0 6.1 0.4 5.7 Mar 36.4 4.4 1.1 3.3 Jun 38.5 2.1 -0.6 2.7 2007 Sept 38.9 0.4 -0.1 0.5 Dec 43.2 4.3 -0.2 4.5 Mar 47.5 4.3 0.7 3.6 Jun 48.5 1.0 0.5 0.5 2008 Sept 41.9 -6.6 -1.0 -5.6 Dec 34.9 -7.0 -1.5 -5.5 Mar 32.1 -2.8 -0.9 -1.9 Jun 31.7 -0.4 -1.0 0.6 2009 Sept 35.6 3.9 -0.5 4.4 Dec 36.0 0.4 -0.8 1.2 Mar 39.3 3.3 -1.3 4.6 Jun 40.7 1.4 -1.7 3.1 2010 Sept 45.7 5.0 -0.8 5.8 Dec 43.5 -2.2 -0.6 -1.6 Mar 30.5 -13.0 -1.0 -12.0 Jun 26.5 -4.0 -0.4 -3.6 2011 Sept 24.5 -2.0 -2.2 0.2 Dec 18.5 -6.0 -1.8 -4.2 Source: Authors’ calculations based on CBE monthly reports. Notes: 1. International reserves + foreign assets of the CBE. 2. Change in (1) 3. Current account from the CBE monthly reports 4. (2) – (3) Table 8: Demand and Supply of Private Credit (Equilibrium Estimation) SURE MVREG Ln(Claim. Priv.) Ln(Claim. Priv.) Supply Demand Supply Demand Real Lending Rate 1.721*** 0.892*** 1.721*** 0.892*** (0.327) (0.212) (0.343) (0.222) Real T-bill Rate -0.958*** -0.958*** (0.335) (0.351) Ln(Lagged Lending Cap.) 0.198*** 0.198*** (0.0584) (0.0612) Ln(Lagged Industrial Prod.) 0.249*** 0.249*** (0.0523) (0.0548) Ln(Lagged EGX 30) -0.0397*** -0.0397*** (0.0121) (0.0126) Constant 6.165*** 6.566*** 6.165*** 6.566*** (0.497) (0.285) (0.521) (0.299) Observations 45 45 45 45 R-squared 0.458 0.491 0.458 0.491 OLS 2SLS Ln(Claim. Priv.) Ln(Claim. Priv.) Supply Demand Supply Demand Real Lending Rate 2.509*** 0.788*** 2.509*** 0.788*** (0.391) (0.235) (0.391) (0.235) Real T-bill Rate -1.892*** -1.892*** (0.431) (0.431) Ln(Lagged Lending Cap.) 0.241*** 0.241*** (0.0658) (0.0658) Ln(Lagged Industrial Prod.) 0.378*** 0.378*** (0.0622) (0.0622) Ln(Lagged EGX 30) -0.0785*** -0.0785*** (0.0155) (0.0155) Constant 5.776*** 6.044*** 5.776*** 6.044*** (0.560) (0.328) (0.560) (0.328) Observations 45 45 45 45 R-squared 0.517 0.560 0.517 0.560 Standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1 Table 9: Demand and Supply of Private Credit (Disequilibrium estimation) Equations Estimates Supply equation Constant 6.6444*** (7.2737) Real lending rate 2.7062*** (4.5826) Real T-bill rates -2.1912*** (-3.8632) Ln(Lagged lending capacity) 0.1387* (1.2887) Variance of residuals 0.0564*** (48.308) Demand equation Constant 4.7733*** (9.5659) Real lending rate 0.7455 (1.1246) Ln(Lagged real industrial production) 0.6378*** (9.7747) Ln(Lagged stock market index) -0.1127*** (-8.4481) Variance of residuals 0.0066*** (187.20) Log-likelihood -84.0863 Adjusted R² 0.4750 Frequency of supply regimes (FS) 22.22% Frequency of demand regimes (FD) 77.78% Akaïke Information criteria -252.41 Schwarz Information Criteria -234.34 Notes: 1) Asymptotic t-statistics are in parentheses. 2) FD (FS) denotes the frequency of demand (supply) regimes given that a period or regime occurs when the corresponding probability is higher than 0.5. Table 10: Decomposition of Predicted Change in Real Credit (Equilibrium Hypothesis) Supply Coeff Growth Multiplication Jul.01- Jul.04- Jul.08- Jul.09- Oct.10- Jul.01- Jul.04- Jul.08- Jul.09- Oct.10- Jun.04 Jun.08 Jun.09 Sep.10 Jun.11 Jun.04 Jun.08 Jun.09 Sep.10 Jun.11 Real Lending rate 2.509 -1.5% -1.1% -4.1% 2.1% 0.6% -3.76% -2.66% -10.35% 5.18% 1.50% Real Tbill rate -1.892 -1.3% -0.8% -4.2% 2.9% 3.6% 2.40% 1.43% 7.99% -5.56% -6.78% Ln(Lend. Cap.) 0.241 11.5% 5.3% -5.9% -1.6% -2.6% 2.78% 1.27% -1.42% -0.39% -0.63% 1 Shifts in the curve 5.18% 2.70% 6.56% -5.95% -7.41% 2 Total changes in Supply 1.42% 0.04% -3.79% -0.78% -5.91% Demand Coeff Growth Multiplication Jul.01- Jul.04- Jul.08- Jul.09- Oct.10- Jul.01- Jul.04- Jul.08- Jul.09- Oct.10- Jun.04 Jun.08 Jun.09 Sep.10 Jun.11 Jun.04 Jun.08 Jun.09 Sep.10 Jun.11 Real Lending rate 0.788 -1.5% -1.1% -4.1% 2.1% 0.6% -1.18% -0.84% -3.25% 1.63% 0.47% Ln(Industrial Prod.) 0.378 12.9% 10.1% -4.2% -7.0% -3.2% 4.86% 3.81% -1.60% -2.64% -1.21% Ln(EGX 30) -0.079 21.5% 81.3% -40% 21.7% -7.5% -1.69% -6.38% 3.13% -1.71% 0.59% 3 Shifts in the curve 3.18% -2.57% 1.53% -4.35% -0.62% 4 Total changes in Demand 1.99% -3.41% -1.72% -2.72% -0.15% 5 Estimated Total shifts in Supply and Demand 8.35% 0.13% 8.10% -10.30% -8.03% 6 Estimated Total changes Private credit 3.41% -3.37% -5.51% -3.50% -6.06% 7 Observed Total changes Private credit 4.16% -0.29% -5.70% -6.13% -7.13% Source: Constructed by the authors using the regressions results. Notes: 1= change in real T-bill rates + change in lending capacity. 2= 1 + change in lending rate 3= change in industrial production and stock market index 4= 3+ change in lending rate + change in T-bill rate 5=1+3 6= 2+4 7= observed change in claims on private sector. Table 11: Decomposition of Predicted Change in Real Credit (Disequilibrium Hypothesis) Supply Coeff Growth Multiplication Jul.01- Jul.04- Jul.08- Jul.09- Oct.10- Jul.01- Jul.04- Jul.08- Jul.09- Oct.10- Jun.04 Jun.08 Jun.09 Sep.10 Jun.11 Jun.04 Jun.08 Jun.09 Sep.10 Jun.11 Real Lending rate 2.706 -1.5% -1.1% -4.1% 2.1% 0.6% -4.06% -2.87% -11.16% 5.58% 1.62% Real T-bill rate -2.191 -1.3% -0.8% -4.2% 2.9% 3.6% 2.78% 1.65% 9.25% -6.44% -7.85% Ln(Lend. Cap.) 0.139 11.5% 5.3% -5.9% -1.6% -2.6% 1.60% 0.73% -0.82% -0.22% -0.36% Shifts in the curve 4.38% 2.39% 8.43% -6.67% -8.22% Total changes in Supply 0.32% -0.48% -2.74% -1.09% -6.60% Demand Coeff Growth Multiplication Jul.01- Jul.04- Jul.08- Jul.09- Oct.10 Jul.01- Jul.04- Jul.08- Jul.09- Oct.10 Jun.04 Jun.08 Jun.09 Sep.10 Jun.11 Jun.04 Jun.08 Jun.09 Sep.10 Jun.11 Real Lending rate 0.746 -1.5% -1.1% -4.1% 2.1% 0.6% -1.12% -0.79% -3.08% 1.54% 0.45% Ln(Industrial Prod.) 0.638 12.9% 10.1% -4.2% -7.0% -3.2% 8.21% 6.42% -2.70% -4.46% -2.04% Ln(EGX 30) -0.113 21.5% 81.3% -39.9% 21.7% -7.5% -2.42% -9.16% 4.50% -2.45% 0.85% Shifts in the curve 5.78% -2.74% 1.80% -6.91% -1.19% Total changes in Demand 4.67% -3.53% -1.27% -5.37% -0.75% Estimated Total shifts in Supply and Demand 10.2% -0.35% 10.23% -13.57% -9.41% Estimated Total changes Private credit 4.98% -4.01% -4.01% -6.45% -7.34% Observed Total changes Private credit 4.16% -0.29% -5.70% -6.13% -7.13% Source: Constructed by the authors using the regressions results. Notes: 1= change in real T-bill rates + change in lending capacity. 2= 1 + change in lending rate 3= change in industrial production and stock market index 4= 3+ change in lending rate + change in T-bill rate 5=1+3 6= 2+4 7= observed change in claims on private sector. Table 12: Summary of the Decomposition Results Equilibrium Disequilibrium Shifts Direction Determinants Shifts Direction Determinants Supply Demand Supply Demand Jul.01-Jun.04 SD Same T-Bill rate Alternative Fin. S>D Same T-Bill rate Alternative Fin. Jul.09-Sep.10 SD Same T-Bill rate. Industry S>D Same T-Bill rate Industry Figures Figure 1: Private Credit/GDP (percent) in Selected Peer Economies 120.0 EGY GTM 100.0 IND 80.0 MAR_ 60.0 MEX PHL 40.0 THA 20.0 TUN TUR 0.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: Finstat (2011) Figure 2: Private Credit/GDP (percent) - Regional Comparison Private Credit / GDP (%) 60.0 40.0 20.0 0.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Value Observed Regional Median Income Group Median Expected median Peer Group Average Source: Finstat (2011) Figure 3: Real Claims on Government vs. Private Sector 3500 3000 2500 2000 1500 1000 500 0 Q1-98 Q4-98 Q3-99 Q2-00 Q1-01 Q4-01 Q3-02 Q2-03 Q1-04 Q4-04 Q3-05 Q2-06 Q1-07 Q4-07 Q3-08 Q2-09 Q1-10 Q4-10 Q3-11 Net Claims Gov Claim Priv. Sector Source: The Central Bank of Egypt Note: Real figures of claims on government and private sector were obtained by deflating nominal figures by the CPI index Figure 4: Growth Rates of Claims on Gov. and Private Sector 50% 40% 30% 20% 10% 0% -10% -20% -30% Net Claims Gov Claim Priv. Sector Source: Central Bank of Egypt Figure 5 Real Deposits in Local and Foreign Currency (in constant EGP) 7000 6000 5000 4000 3000 2000 1000 0 May-01 May-08 Dec-01 Dec-08 Apr-04 Apr-11 Mar-00 Oct-00 Jun-05 Jan-06 Aug-06 Mar-07 Oct-07 Nov-04 Jul-02 Feb-03 Sep-03 Jul-09 Feb-10 Sep-10 Total Local Foreign Source: Central Bank of Egypt Figure 6: Real Deposits in Local and Foreign Currency (growth rates in percent) 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% May-02 May-09 Dec-02 Dec-09 Apr-05 Mar-01 Oct-01 Jun-06 Jan-07 Aug-07 Mar-08 Oct-08 Nov-05 Jul-03 Feb-04 Sep-04 Jul-10 Feb-11 -10.0% -20.0% Total Local Foreign Source: Central Bank of Egypt Figure 7: Real Industrial Production 1000 900 800 700 600 500 400 300 200 100 0 Source: CAPMAS. Note: Real industrial production obtained by deflating nominal figures by the CPI index. Figure 8: Stock Market Index - EGX30 12000 10000 8000 6000 4000 2000 0 Q1-98 Q4-98 Q3-99 Q2-00 Q1-01 Q4-01 Q3-02 Q2-03 Q1-04 Q4-04 Q3-05 Q2-06 Q1-07 Q4-07 Q3-08 Q2-09 Q1-10 Q4-10 Q3-11 Source: The Egyptian Stock Market. Figure 9: Unconditional Probability of the Regime S or D 1 0.9 0.8 0.7 0.6 Probability of supply regime 0.5 Probability of demand regime 0.4 0.3 0.2 0.1 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Constructed by the authors. Figure 10: Estimated Demand and Supply 8.2 Supply equation 8.15 Demand equation 8.1 8.05 8 7.95 7.9 7.85 7.8 7.75 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Constructed by the authors. Figure 11: Adjustment on quantities 8 7.95 7.9 7.85 7.8 Historical quantities Fitted quantities 7.75 7.7 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Constructed by the authors. Appendix 1: The log-likelihood function Let θ denote the vector of structural parameters θ = (β1 β 2 σ 1σ 2 )' . To compute the marginal density, f Q (qt ) , of the observable variable qt , we consider the joint density of d t and t st , denoted g D , S (d t , st ) . Given the definition of the disequilibrium, we know that: t t f Q (qt ) = f Q (qt ) + f Q (qt ) (A.1) t t Dt < St t St < Dt Next, we obtain the corresponding marginal density of qt on the two subsets (cf. Appendix 2): ∞ fQ (qt ) = ∫q = d g Dt ,St (d t , z )dz (A.2) t Dt < St t t ∞ fQ (qt ) = ∫q = s g Dt ,St (z, st )dz (A.3) t St < Dt t t Finally, we obtain the unconditional density function of Qt : ∞ ∞ f Q (qt ) = f Q (qt , θ ) = ∫ g D , S (qt , z )dz + ∫ g D , S ( z , qt )dz (A.4) t t qt t t qt t t Conditional to a structural parameters set θ and a sample of observable variables qt , x1,t and x2,t observed on T periods, the log-likelihood function of the model is then defined by: [ ] T L(θ ) = ∑ log f Q (qt , θ ) (A.5) t t =1 If we assume that both residuals ε 1 and ε 2 are independent, the unconditional density function of Qt can be expressed as follows: 1  β −q   x'2,t β 2 − qt  ' x1, f Q (qt ) = φ  t 1 t  Φ      t σ1  σ1   σ2   x'2,t β 2 − qt   x1, 1 ' β −q  + φ  Φ  t 1 t     (A.6) σ2  σ2   σ1  where φ(.) denotes the normal N(0,1) density function. Appendix 2 provides the proof. In this case, the first and second order derivatives of L(θ) can be computed analytically (Maddala and Nelson, 1974) or numerically. We can use an iterative procedure such as the Newton-Raphson to obtain the ML estimates of the structural parameters θ. Given the parameters’ estimated values, we can assess the probability that the (d ) (s ) ^ ^ observation qt belongs either to the demand or the supply regime, π t and π t . Appendix 2: Marginal densities of Qt in a stable disequilibrium model Let g D , S (d t , st ) denote the joint density of Dt and St . We know that the corresponding t t marginal densities of the unobservable variables Dt and St are defined by: ∞ ∞ f D (d t ) = ∫ g D , S (d t , z )dz f S (st ) = ∫ g D , S ( z , st )dz t −∞ t t t −∞ t t (A.7) We compute the marginal density of Qt on the two subset Qt = Dt , with Dt < St and Qt = St , with St < Dt . When Dt < St , for a given realization d t of Dt , the marginal density of Qt , is given by the area defined by the joint density g D , S (d t , z ) , for values z of St superior to d t . t t Assuming that Dt < St , the marginal density of Qt is then given by: ∞ fQ D