Chapter

II Interest Rates and Interest Rate Policies: An Overview

Author(s):
International Monetary Fund
Published Date:
October 1983
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In any economy in which decisions by individual economic units play a major role, interest rates perform several important functions in which they influence a broad range of economic decisions and outcomes. In this respect, interest rates are similar in scope to the influence of other economywide prices, such as the exchange rate and the basic wage rate.2

  • (i) First of all, as the reward for accumulating financial assets and postponing current consumption, interest rates influence the willingness to save currently earned income.

  • (ii) As an element of the cost of capital, interest rates influence the demand for and allocation of borrowed funds.

  • (iii) As the return on domestic financial assets, domestic interest rates, together with the rate of return on foreign financial assets, expected changes in the exchange rate, and the expected rate of inflation, determine the allocation of the public’s wealth (accumulated savings) among domestic financial assets, foreign financial assets, and goods that are held as inflation hedges.3

Through the first two of these channels, interest rates directly affect the flows of saving and investment; through the latter channel, they influence the proportion of accumulated savings that are placed in financial assets denominated in domestic currency. For saving and borrowing decisions, the relevant interest rate is the real interest rate, i.e., the nominal interest rate corrected for the expected increase in goods prices.4 Similarly, the allocation of wealth between financial assets and goods involves a comparison of the nominal rate of return on financial assets—that is, the rate of interest—with the rates at which prices of goods are expected to increase. Consequently, for the allocation of wealth between financial assets and goods, the relevant magnitude to consider is also a real rate of interest.

In market-oriented economies, where most saving and investment decisions are taken separately, changes in interest rates and the general price level in response to disequilibria between saving and investment or between demands for and supplies of financial assets are instrumental in restoring equilibrium, provided that the institutional environment permits such changes. The equilibrium interest rate, corrected for the expected rate of inflation, is equal both to the marginal rate at which lenders are willing to exchange future for present consumption and to the real marginal rate of return expected on investment opportunities available to borrowers. If these rates are positive, it follows that the equilibrium interest rate must not be less than the expected rate of inflation.

In planned economies, where a large part of saving and investment decisions are made according to plan, rates of interest as such have no direct influence on these decisions. But planners, in order to allocate scarce resources efficiently, need to take into account both the rates of return on different investments and the social cost of funds used to finance them. Furthermore, even in planned economies there appears to be, in practice, a significant degree of separation between saving and investment decisions, and interest rates could, therefore, play a useful role in restoring or maintaining financial balance. To the extent that such decisions are left to individual households and enterprises, a wide divergence between actual interest rates and shadow rates would be likely to result in serious allocative inefficiencies.

The extent to which interest rates serve the equilibrating function just described depends upon the extent to which they are permitted to do so by government policies. In some countries, most interest rates are essentially market determined. In others, although some loan and deposit rates are market determined, interest rates for certain types of credit institutions are subject to regulation. In most developing countries, the interest rates of principal importance are determined administratively, typically through legally imposed ceilings or floors on lending and deposit rates. These rates are also indirectly affected by such measures as legal reserve requirements that specify minimum holdings of certain low-interest assets and, thereby, lead to an increase in the spread between loan and deposit rates offered to the public. In many countries, official control over interest rates is exercised simply by virtue of the fact that all banks, or the largest banks, are nationalized, and, even when such banks are formally regarded as autonomous entities, the influence of the government over the activities of these institutions is often powerful, whether exercised continually or only intermittently.5

A commonly cited reason why the authorities in developing countries choose to control interest rates is that, while market-determined interest rates tend to produce equilibrium in financial markets, in most developing countries (as well as in many industrial ones) these markets suffer from serious imperfections. Financial markets are often very thin because of the low income and limited degree of monetization of these economies. In many countries these markets are dominated by one or two banks that exercise monopolistic or oligopolistic control over interest rates and credit allocation. Even in countries with more developed financial markets there is a tendency for these markets to follow the leadership of a single dominant bank, often of a state-owned or quasi-public character. In some countries, too, banks are parts of conglomerates that include major industrial enterprises, whose financing needs are given special priority in the operations of these banks. All these institutional features may prevent the banking system from operating competitively and may, therefore, prevent interest rates from fully performing their potential role in guiding saving and investment.

Another important motive for controlling interest rates is related to the existence of an extensive set of other controls, notably over investment, production, prices, foreign exchange transactions, and foreign trade. While discussion of such controls is beyond the scope of this paper, it should be noted that these controls must be taken into account when interest rate policies are being formulated. For example, governments often set interest rates that diverge from their market values as a means of offsetting other distortions in the economy. While this type of “second-best” argument in favor of regulated interest rates may appear to justify the authorities’ response to specific problems as they arise, it may be questioned whether, as a general proposition, the undesirable effects of existing distortions should be dealt with by the creation of further distortions.

While the authorities in most developing countries choose to control and regulate interest rates closely, the manner in which these controls and regulations are exercised and, particularly, the level at which interest rates are set differ significantly among countries. In some countries interest rates are administered in a flexible manner in an attempt to maintain “market-related” rates that follow more or less closely the movements of those rates that would be produced by the forces of supply and demand. In many developing countries, however, the administration of interest rate policy lacks this flexibility, and, over time, large divergences between administered and market rates emerge.6 For a wide range of countries, available data suggests that real interest rates are often negative—sometimes by a substantial margin—although there are also a number of countries where this is not true (Table 1).7 In the following discussion, a policy of maintaining interest rates that are significantly lower than market-clearing rates will be called for the sake of brevity “interest rate repression,” and a policy of permitting interest rates to move closer to market-clearing rates will be called “interest rate reform.”

Table 1.Selected Developing Countries: Interest Rates and Inflation, June 1978–June 1981
June 1980 Interest Rate1June 1980-June 1981 Percentage Change in the Consumer Price IndexJune 1980 interest Rate Adjusted for Inflation2June 1979 Interest Rate Adjusted for Inflation3June 1978 Interest Rate Adjusted for Inflation3
Argentina4107.894.36.9–3.8–17.1
Bahrain9.06.12.71.27.6
Bangladesh8.214.2–5.2–3.6–5.3
Brazil573.2106.3–16.0–13.1–0.4
Burma68.0–3.712.15.43.7
Chile437.921.014.013.118.2
Colombia735.427.95.9–4.50.0
Ecuador12.018.0–5.10.40.3
Egypt9.011.9–2.6–14.10.5
Ghana13.0118.2–48.2–19.6–36.4
Greece16.023.3–5.9–11.8–3.6
India7.013.7–5.9–4.40.5
Indonesia9.09.00.0–7.9–12.4
Ivory Coast7.22.54.6–8.3–10.2
Jamaica9.011.52.2–15.9–15.1
Kenya6.311.8–4.9–7.1–1.7
Korea23.025.6–1.3–6.2–0.8
Kuwait89.26.82.2–2.11.5
Malaysia7.011.2–3.1–0.13.7
Mexico915.627.8–9.5–8.7–2.4
Morocco7.015.2–7.1–2.5–0.7
Nepal12.013.8–1.6–2.94.7
Nigeria6.324.214.4–4.21–3.110
Pakistan12.015.0–2.60.72.5
Peru35.581.5–25.3–13.8–27.9
Philippines12.011.10.8–6.0–8.6
Portugal21.017.62.93.72.6
Singapore910.38.71.5–3.42.4
South Africa7.514.5–6.1–6.1–3.5
Sri Lanka20.017.02.6–12.36.9
Syrian Arab Republic5.015.1–8.8–13.11.2
Thailand12.011.60.4–12.01.0
Turkey33.028.93.2–47.0–28.3
Uruguay1151.234.812.2–13.8–10.1
Venezuela12.017.7–4.8–8.8–2.2
Zaïre25.025.8–0.6–18.0–51.4
Zambia8.313.0–4.2–4.9–2.0
Source: Information collected by the Fund staff.

Unless otherwise indicated, the rate on one-year time deposits that would have been earned over the 12 months subsequent to June 1980.

Computed as 100[(1 + i)/(l + p) – 1], where i is the nominal interest rate, p is the change in the consumer price index over the previous 12 months, and both are expressed in decimal form.

Computed in the same way as the rate for June 1980.

The interest rate is the yield on one-month time deposits compounded over the relevant 12-month period. Longer-term rates are unimportant because of the dominance of shorter-term rates.

The interest rate is the yield on two-year treasury bonds acquired 12 months before the indicated month, including interest and monetary correction.

The interest rate on savings bank accounts is used because of the unimportance of time deposits.

For the 1980 interest rate, the rate on 90-day certificates of deposit is used, compounded over the appropriate period.

Data taken from International Reports Statistical Market Letter, various issues.

Data for June 1980 only taken from International Reports Statistical Market Letter, various issues.

Twelve-month time deposit rate in effect was 5.25 percent.

The interest rate is the yield on six-month time deposits compounded over the appropriate period.

Source: Information collected by the Fund staff.

Unless otherwise indicated, the rate on one-year time deposits that would have been earned over the 12 months subsequent to June 1980.

Computed as 100[(1 + i)/(l + p) – 1], where i is the nominal interest rate, p is the change in the consumer price index over the previous 12 months, and both are expressed in decimal form.

Computed in the same way as the rate for June 1980.

The interest rate is the yield on one-month time deposits compounded over the relevant 12-month period. Longer-term rates are unimportant because of the dominance of shorter-term rates.

The interest rate is the yield on two-year treasury bonds acquired 12 months before the indicated month, including interest and monetary correction.

The interest rate on savings bank accounts is used because of the unimportance of time deposits.

For the 1980 interest rate, the rate on 90-day certificates of deposit is used, compounded over the appropriate period.

Data taken from International Reports Statistical Market Letter, various issues.

Data for June 1980 only taken from International Reports Statistical Market Letter, various issues.

Twelve-month time deposit rate in effect was 5.25 percent.

The interest rate is the yield on six-month time deposits compounded over the appropriate period.

The reasons why the authorities in most developing countries, as well as in many developed ones, are inclined to follow a policy of interest rate repression will be taken up in more detail in later sections of the paper. Here, one might briefly mention some of the principal ones: the desire to keep down the cost of servicing the public sector’s debt; the suspicion that oligopolistic financial markets would set excessively high lending rates, especially for smaller borrowers, or excessively large spreads between deposit and lending rates; fears that higher interest rates damage disadvantaged sectors or groups; the belief that higher interest rates result in lower investment and growth; concerns about the adjustment costs faced by both financial institutions and nonfinancial enterprises; and worries that a rise in interest rates may be inflationary, either through the direct impact on costs or the indirect effect through expectations. In many instances, a policy of retaining low interest rates through administrative controls arises from a desire to avoid the consequences of other policies being pursued, such as maintaining a large fiscal deficit and limiting private credit expansion, on interest rates, investment, and growth.

The attempt to maintain interest rates below those consistent with the prevailing demand for and supply of financial resources8 is frequently associated with—indeed, may require—the allocation of available funds through selective credit policies, which channel credit to key industries and priority sectors at the expense of credit to other sectors. These policies are implemented through a variety of mechanisms. Financial institutions may be compensated for lending to priority sectors by preferential rediscount policies or lower reserve requirements; the asset portfolios of financial institutions may be regulated by imposing quantitative ceilings on nonpriority lending or floors on priority lending; specialized financial institutions may be established that direct their funds to priority sectors at low interest rates and receive preferential treatment from the monetary authority: the central bank may offer special rediscount facilities for specified purposes; and, less frequently, the differential between deposit and loan rates may be financed through budgetary allocations to financial institutions.

In most developing countries, either at present or at an earlier stage in their development, interest rate repression reinforces, and is reinforced by, the underdeveloped state of financial institutions, a setting that has been termed “financial repression.”9 Financial repression is characterized by a monopolistic or oligopolistic banking system serving the credit needs of well-established urban borrowers, with the financial needs of small urban borrowers and the population of the rural areas (where economic activity is still partially nonmonetized) being met principally by small-scale moneylenders. The activities of the latter are unregulated, if not illegal, and consequently result in far higher interest rates than those prevailing in the official, regulated financial markets. The limited scope and oligopolistic nature of the organized market induce the government to intervene through interest rate repression and credit controls; at the same time, the low interest rates tend to retard the growth of financial savings and thereby also discourage the spread of organized banking into the rural areas.

While both interest rate and financial repression have persisted for many years in a number of countries, the monetary authorities in some other countries have undertaken steps to eliminate such repression. These steps include “financial reform,” which consists of measures to integrate, and foster competition within, the financial sector, so as to extend efficient banking services to all segments of the community, as well as “interest rate reform.” The next section focuses on the impact of both interest rate repression and interest rate reform on the resources available for investment and on the volume and productivity of investment undertaken. Section IV then discusses the results of these two types of policy on the ability of the authorities to manage aggregate demand and the balance of payments.

A detailed exposition of the influence of interest rates over economic decisions can be found in Fisher (1930) and Keynes (1936). For practical aspects of interest rate policies in developing countries, sec Chandavarkar (1971) and Galbis (1977, 1981).

In what follows in this paper, it should be understood that interest rates, as fixed rates of return on capital, interact with actual and expected rates of return on equity participation in enterprises (domestic and foreign) to determine the allocation of holdings of wealth between equity and interest-bearing assets. In certain cases, governmental regulations constrain the freedom of financial organizations, such as insurance companies or pension funds, to invest in equity participations or certain types of private interest-bearing assets. In most developing countries, however, the rales of return on equity participation are of relatively minor importance, owing to the underdeveloped state of capital markets in these countries.

The definition of real interest rates given here and subsequently in the paper abstracts from differences in the rates of change in prices of different goods and services that may be relevant for the calculations of borrowers and lenders. Prices of consumer goods are especially relevant for household savers, whereas wholesale prices may be more important for borrowing firms.

Governments also influence the level and structure of interest rates by fiscal measures such as different tax treatment of interest income according to origin (domestic versus foreign) or according to economic sectors. For example, it is common practice to exempt interest payments on public liabilities from taxation.

The importance of flexibility is indicated in the following passage from Leff and Sato (1980): “Artificial inflexibility of the interest rate deprives developing countries of an instrument for controlling investment and perhaps also for eliciting more domestic saving...,” p. 178.

As mentioned earlier, what is relevant for economic decisions is the ex ante real interest rate—that is, the nominal interest rate corrected for the expected rate of inflation—and references to “real interest rate” in the rest of the paper arc to be understood in this sense. Because of the difficulty in measuring the expected rate of inflation, however, Table 1 shows the actual ex post real return experienced by depositors in financial institutions.

That is, the interest rates that equate the demand for and supply of different types of liquid funds, given the levels of official foreign borrowing and the public sector deficit.

This term, and the analysis of this paragraph, are based on the analysis of McKinnon (1973), See also Galbis (1979) for several extensions.

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