Anand G. Chandavarkar
One of the basic problems facing the less developed countries is the scarcity of domestic capital relative to the size of investment required to achieve high and self-sustaining rates of growth of national and per capita incomes. Although the accumu-lation of capital by itself is no longer regarded by economists as a uniquely important source of economic growth, its role as a necessary condition of economic development is well recognized.
In view of its crucial role, the price of capital as measured by rates of interest may indeed be expected to assume an important role in the economic systems and policies of the less developed countries. But, paradoxically, purposive interest rate policies have been conspicuously lacking in most developing economies apart from a few exceptions, notably China (Taiwan) and the Republic of Korea. The general emphasis in the literature as well as in actual policies has been largely on the role of interest rates (i.e., loan rates) as a means of regulating the cost and availability of credit. But interest rates can also be viewed as instruments for more effective mobilization of domestic savings (i.e., as deposit rates) through the offer of realistic rates on monetary savings such as time and savings deposits, government securities, and claims on financial institutions.
Since capital is scarce, it follows that there should be an incentive for saving as well as a device for its efficient allocation among alternative uses. These twin functions are discharged, although with varying efficiency, through the interest rate mechanism. But the market for capital, especially in the less developed countries, is imperfect, so that the structure and levels of interest rates established by the free play of demand and supply do not always reflect the true economic cost of capital to the economy.
Although interest rate policy has many aspects, each one of which is relevant for particular phases or objectives of monetary and fiscal policies or development planning, we are concerned here primarily with its role in the organized sector as a means of increasing voluntary private saving through the banking system in the less developed countries, taking into account the experience of China and Korea where such policies have been successfully implemented. This aspect of interest rates merits much closer attention not only on account of its intrinsic importance but also because of the general skepticism regarding the efficacy of interest rates in mobilizing savings, which derives from the lack of a determinate causal link between rates of interest and aggregate real saving in the national accounts sense or even between interest rates and financial saving.
In respect of financial savings, the econometric evidence, while by no means conclusive, indicates that factors such as the level and the rate of growth of disposal income and wealth, price expectations, and institutional facilities for savings are more influential in explaining observed variations in the volume of saving than changes in rates of interest. All this reflects the complexity of the motives and incentives underlying savings decisions of persons and households. It is in fact even debatable how far the act of saving, which is really a residual reflecting the difference between income and consumption, partakes of the nature of deliberate and purposive behavior.
All this, however, need not be construed as arguing for the irrelevance of interest rate policies in the savings strategies of developing countries. The experience of China and Korea is particularly instructive on this aspect and suggests that the efficacy of a positive interest rate policy is by no means limited to conditions of high or rapid inflation such as prevailed in China and Korea. In fact even countries with little or no inflation may find that by maintaining interest rates at unrealistic or inappropriate levels, they are denying themselves the use of a potent instrument to mobilize adequate savings for desired levels of growth. Also, the imposition of statutory or informal ceilings on loan and deposit rates of interest in developed and developing countries alike, whether in the form of usury laws or interbank agreements, also suggests that interest rates are far more important than economists or monetary authorities are perhaps willing to concede. If interest rates were in fact inconsequential, there would scarcely be any need to impose ceilings or otherwise regulate them, much less any justification for the prodigious academic discussion provoked by interest rate policies!
Why an Interest Rate Policy for Developing Countries?
One of the characteristic features of less developed countries is the prevalence of very high rates of interest ranging, typically, from 24 per cent per annum to even 50 per cent and above, in the unorganized sector, where credit is supplied by money lenders and nonin-stitutional bankers. This sector often finances the major portion of total credit, whereas the organized sector, with interest rates generally about 12 per cent or lower, meets only the remaining requirements. The question may therefore reasonably be raised: what is the role of interest rate policy in countries where nominal rates of interest (i.e., rates expressed in terms of money) for the most part are high enough to reward the effort of saving and where the problem therefore is to reduce the cost of credit so as to stimulate greater investment and economic growth? In fact the existence of usury laws in many developing countries points to the need to reduce the high average rates of interest on loans by eliminating the high-risk premiums and monopolistic profits in the money lending business. But the paradox presented by these facts is more apparent than real. For one thing, the high rates of interest in rural areas are exclusively lenders’ rates that are applicable only to loan transactions and not to deposit transactions. Money lenders do not usually accept deposits and in the event of acceptance the rates are far below those for loans. Their customers are almost exclusively borrowers whose incomes are too low and fluctuating to enable them to save and hold their savings in the form of deposits for any length of time. The high rates of interest charged by lenders have little influence on the propensity to save of the rural sector. Therefore from this point of view an appropriate interest rate policy for the unorganized sector should aim at reducing rates to more economic levels through multiplication and diversification of sources of credit and a broad-based program of improved production and marketing in order to enhance the creditworthiness of the rural borrower.
On the other hand, interest rates in the organized sector, comprising joint stock commercial banks and other financial institutions, in most less developed countries are substantially below those in the unorganized sector, even allowing for monopoly profit and the greater element of risk in the latter. They are at about the same or lower levels compared with similar rates in the developed countries where savings are much higher, and even where the rates are slightly higher than in the developed countries, it is arguable that the gap does not fully reflect the relative scarcity of capital.
The low rates of interest in the organized sector may lead to uneconomical use of credit by individuals and firms that have easy access to credit at established rates. This is an issue of vital importance for developing countries, since the organized sector, although small in relation to the total economy, accounts for the major share of new investment under development plans. To the extent that deposit rates are not adjusted when domestic prices rise, the real rate of return (i.e., the nominal or money rate adjusted for price changes) on savings may fall to zero or even become negative. Inadequate or negative real rates of interest tend to discourage savings in monetary forms, and may also have a negative effect on the level of aggregate real savings (i.e., in terms of national accounts). Besides, unrealistic rates of interest impede the growth of the organized money and capital market by discouraging the development of financial intermediaries, which are unable to compete with the unorganized sector on the basis of existing rates of interest. Such intermediaries could play a vital role in matching efficiently the flow of current savings with the investment intentions of entrepreneurs. For all these reasons a policy of ensuring positive real rates of interest is desirable in the less developed countries. This, however, raises the question whether such policies are feasible, given the institutional and psychological barriers.
The Bias Toward Low and Stable Rates of Interest
The prevailing bias in favor of comparatively low and stable average rates of interest in most of the less developed countries is the cumulative effect of various factors—historical, institutional, and psychological. Although it is difficult to indicate their relative importance or historical sequence, it is possible to identify some of the important operative influences.
Thus, one of the major obstacles to the adoption of bolder interest rate policies in less developed countries is the notion that a given historical level of interest rates in the organized sector, say, in the range of 3-5 per cent, is in some sense “normal.” In some of the less developed countries, one of the major assumptions of policy, even if not always well articulated, seems to be that it is both possible and desirable to finance long-term development on the basis of low and stable rates of interest. The notion of a normal level of interest rates may well be a survival from the period of war finance (1939-45), when it was both necessary and desirable to finance the war effort with a stable basic rate like 3 per cent. It would have been obviously impracticable to float government loans on the basis of rising rates of interest, since such a policy, besides adding to the costs of war finance, would have undermined the borrowing program by encouraging investors to withhold subscriptions in anticipation of better terms.
The belief in the inefficiency of interest rate changes in influencing savings and investment also derives from the fact that the historical range of variation of rates of interest in the organized sector in most developing countries has been comparatively narrow. It may be that within this narrow range interest rates have had negligible effects. This, however, does not disprove the possibility that a wider range of variation, say, 10-20 per cent, may decisively affect investment and savings. The notion of a low normal range of interest rates is, moreover, inappropriate in a dynamic economy where relative prices, including the rate of interest, have constantly to reflect the changing relative scarcities of commodities and factors of production.
The tendency to regard interest rate policy as irrelevant or at best only of minor significance also derives its strength from the economic doctrine that investment, through rising incomes, creates its own saving; therefore savings are a function of the level and distribution of income rather than of interest rates. The belief that savings are largely insensitive to changes in the rate of interest also tends to be reinforced by the growing importance, even in the less developed countries, of “contractual” savings such as life insurance and social security funds and of financial institutions that either by law or due to the nature of their operations must invest a minimum proportion of their assets in government securities. Since contractual and trustee saving takes place irrespective of the prevailing rate of interest, an increase in their share and size means an enlargement of the “captive market” for private savings. But the existence of a captive market for private savings is not a decisive argument against establishment of more realistic rates of interest. To continue to offer unattractive rates of interest to one class of savers, when effective rates of interest in the rest of the economy are much higher, amounts to subsidizing one class of borrowers (public sector) merely because the lenders (private savers) have no alternative. This argument is based not merely on grounds of equity to the saver but, even more, on criteria of economic efficiency in allocation of scarce investable funds which are clearly violated by permitting excessive diversion of funds to the public sector through the captive market. To the extent these conditions prevail, the economic rationale of low and stable rates of interest in the less developed countries is not well-founded.
Chinese and Korean Experience
The experience of China since 1949 and of Korea since 1964-65 is specially instructive in demonstrating the potentialities of a realistic interest rate policy as a means of mobilizing voluntary private saving through the banking system as an integral part of a comprehensive program of stabilization and development.
One of the major economic problems facing the Chinese authorities in the late 1940’s and early 1950’s was to counter an acute inflation in the wake of civil war and to prevent a flight of money into goods by encouraging the public to hold financial assets. Given the high rate of inflation with prices rising at about 85per cent a year and the inherent difficulties of additional taxation and compulsory borrowing in the prevailing situation, the most feasible alternative for the authorities was to offer sufficiently high rates of interest on bank deposits to induce the public to save. They also recognized that under highly inflationary conditions the public could not be expected to hold financial assets with long maturities. Therefore a strategy of high interest rates was initiated in March 1950 through the offer of “preferential deposits” with banks of one-month and three-month maturities at 7 per cent and 9 per cent a month, respectively. This evoked a favorable response, and time deposits rose from NT$2 million early in 1950 to NT$37 million by August 1950. Thereafter the authorities, while maintaining nominal rates of interest high enough to offer a positive real rate, adopted a policy of lowering them progressively with the gradual improvement in public confidence in the value of money; they also began extending the maturities of deposits to six months and one year.
Commercial banks were given the option of placing the excess of “preferential” deposits, which they could not profitably lend or invest, with the Bank of Taiwan (a commercial bank that during the 1950’s performed central banking functions for the Government). These redeposits earned interest at rates equal to or above those paid by the banks to their depositors. The successful experience of preferential bank deposits also encouraged the Government to issue high interest rate bonds of its own in maturities of 12 months to 30 months at rates ranging from 9 to 18 per cent per annum (tax exempt), the latter being sold exclusively to the nonbank public. Altogether the policy of maintaining realistic rates of interest in China, as evidenced by the rise in financial saving as well as aggregate saving, has been highly successful.
A pineapple cannery at Kaohsiung, Taiwan built with the assistance of World Bank funds: a remarkable export success has been achieved with this crop.
|Central Bank||Money Market||Government|
|Discount Rates||Rates||Bond Yields|
|Less Developed Countries|
|Interest Rate for One-Year||Ratio of Private|
|Time and Savings||Time and Savings Deposits||Savings to Gross|
|Deposits||(Per cent per annum at||National Product|
|(Billion NT$)||end of year)||(Per cent)|
|(adjusted for change in index|
|of wholesale prices)|
|1969||(Apr.)||28.9||9.72||11.83||(Dec. 1968-Apr. 1969)||…|
Korea, too, experienced inflation, though not to the same extent as China, for nearly two decades after the division of the country in 1945. Following the reforms in the foreign exchange system in May 1964 and March 1965 and the adoption of a comprehensive stabilization program, the Korean authorities also embarked upon a drastic reform of the interest rate structure so as to provide an adequate “real” interest rate to depositors, to attract funds from the unorganized sector, and generally to facilitate a more effective credit policy. The Interest Restriction Law was amended in September 1965 to enable imposition of higher legally permissible rates of interest. The standard loan rate of banks was raised from 14 per cent to 26 per cent per annum and the rates on time and savings deposits were raised to 1.5 per cent, 2.0 per cent, 2.2 per cent, and 2.5 per cent a month on maturities of 3 months, 6 months, 12 months, and 18 months (and above), respectively.
The rise in deposit rates evoked a spectacular increase of 47 per cent in time and savings deposits in the first quarter after the interest rate reform. Thereafter an annual rate of increase of over 100 per cent in time and savings deposits has been maintained, which is impressive even allowing for the inclusion of accrued interest in the figures of deposits. The application of the standard loan rate of 26 per cent per annum was, however, modified by a system of preferential rates, mostly for export finance or for the import of raw materials by export industries. In order to alleviate the strain on the profit position of banks as a result of the narrowed differential between loan and deposit rates, the central bank paid interest at 5 per cent on the special deposits that commercial banks were required to keep with it and at 10 per cent on central bank stabilization bonds. The resultant improvement in monetary savings enabled the Korean authorities to simplify and lower the structure of deposit rates in April 1968 without, however, reducing loan rates and then, in October 1968, to reduce marginally both deposit and loan rates. There was another downward revision of interest rates, effective June 2, 1969, which was the third since the interest rate reform of 1965. This time the annual interest rate on general purpose loans was also reduced from 25.2 per cent to 24 per cent, and the commercial bill discount rate from 26 per cent to 24.6 per cent. These measures may be regarded as part of a long-term process of financial “normalization.” It is noteworthy that the ratio of domestic savings to gross national product rose from 2.2 per cent in 1962 to 15.1 per cent in 1968.
Admittedly, in both China and Korea interest rate reforms were only one of the elements in the stabilization program, since there were other and perhaps more significant elements such as exchange reforms, appropriate monetary and fiscal policies, and foreign aid, etc. Nevertheless, their contribution to the success of the programs was certainly substantial even allowing for the limitations of the evidence presented in this article.
|Time and||Deposit Rates||on 12-Month|
|Savings||Time Deposits||Time Deposits|
|(In billions||3||6||12||term||change in|
|of won)||Date of change||Months||Months||Months||savings||consumer prices)|
|(In per cent per annum)|
|1966||87.3||Sept. 30, 1965||9.0||12.0||15.0||3.65||9.6|
|1967||160.8||Sept. 30, 1965|
|1968||311.5||Apr. 1, 1968||15.6||20.4||26.4||5.00||16.5|
|Oct. 1, 1968||14.4||19.2||25.2||5.00|
|June 2, 1969||12.0||16.8||22.8||5.00|
It may also be conceded that the use of extremely high money rates of interest in both countries occurred under very special circumstances of high and rising inflation which both justified the use of and brought success to the interest rate policies implemented. The success of interest rate policies in China and Korea has, however, many pertinent lessons for other less developed countries, not least because these countries also rank high in the “growth league” as well as in point of export performance. It underscores both the desirability and feasibility of maintaining realistic rates of interest on monetary savings which also help to improve the climate for aggregate real savings and thereby to promote stability as well as development. Above all, it suggests that there is a critical range within which monetary savings may respond positively to increases in rates of interest. Equally, the fact that policies in both countries have been sufficiently flexible to permit a downward adjustment in interest rates with a progressive increase in monetary savings also implies that the emphasis in developing countries should be on realistic and flexible interest rates rather than on stable average rates whether at a high or a low level. Perhaps the greatest single barrier to realistic interest rates is the tendency to concentrate on the money rate rather than on the real rate of return and also the psychological resistance to raising nominal rates to very high levels.
But, equally, countries like Malaysia and Singapore which have enjoyed a relatively high degree of price stability have been thereby able to ensure a positive real return to savers even though nominal rates of interest have remained relatively stable at conventional levels. This indicates that the objective of an adequate positive rate of return to savers can be achieved either through manipulation of money rates of interest or through stable prices. An appropriate over-all interest rate policy for a less developed country will, however, have to be based on a delicate balancing of the requirements of rates realistic enough to stimulate saving but not too high to inhibit investment in desired channels.