What Drives Interest Rate Spreads in Pacific Island Countries? An Empirical Investigation

Growth has been sluggish in Pacific island countries (PICs). High cost of credit is likelyone of the reasons. While the small scale, geographic dispersion, and vulnerability toshocks increase the cost and risk of credit in this country group, there is considerablevariability in interest rate spreads both across countries and over time. This paperexamines the determinants of lending rates and interest rate spreads in a panel of six PICs,extending the literature that was largely descriptive in nature or focused on a singlecountry. Our results are in line with economic theory. We find that the size of theeconomy is negatively correlated with spreads, confirming the importance of scale.Inflation appears to have only marginal impact on spreads. High loan loss provisions andnonperforming loans increase the cost of credit. So does banking system concentration.Higher institutional quality is associated with lower spreads.