In the mid-1980s, concerns arose about the possible detrimental effects of high real interest rates under financial liberalization. Using a sample of 28 countries that have undergone financial liberalization since the mid-1970s, this paper examines the incidence of high real interest rates and finds that they emerge rather frequently following liberalization. In contrast, virtually all countries experienced highly negative real interest rates before undertaking financial liberalization. Numerically high real interest rates are not necessarily out of equilibrium, however, and adverse consequences will not inevitably follow. High real interest rates can be efficient if they are the result of a large demand for funds associated with a high propensity to invest in sound projects that is engendered by favorable macroeconomic conditions and technological innovations.
However, high real interest can be undesirable in some cases, as a result of many diverse and complex causes. Among them are unabating inflationary expectations, exchange rate risk perceptions that accompany stabilization efforts that are not fully credible, attempts to stabilize an economy with stringent monetary policies but with inadequate fiscal consolidation, and attempts by oligopolistic financial institutions to capture a larger market share of deposits. Other causes are the financing by banks of distressed borrowers in an attempt to avoid provisioning and write-offs for loan losses and the moral hazard resulting from explicit or implicit deposit insurance in the absence of appropriate prudential regulations and bank supervision.
The effects of high real interest rates are equally complex and diverse and will vary according to their origins and to each country’s circumstances. The paper finds much evidence for favorable effects of liberalization. However, unfavorable conditions may lead in some cases to lower investment and growth, corporate and financial sector distress, destabilizing capital inflows, and increases in budget deficits and government debt. Countries must understand the causes and effects of their high real rates before applying remedies, either preventive or curative. Countries that are still contemplating interest rate liberalization should take preventive measures to stabilize prices, achieve fiscal consolidation, improve indirect monetary policy instruments, and strengthen prudential regulation and supervision of the financial system before problems emerge.