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Interest rates and the developing world: How rates in developed countries affect LDCs

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1983
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Padma Gotur

In combination with the rise in oil prices and the international recession, the high interest rates of the past several years have had a marked impact on the economies of the non-oil developing countries. The oil price increases of 1979 led to an initial deterioration in these countries’ current accounts; this was then aggravated by the slowdown of economic activity in the developed countries and the shrinkage of world trade that, in turn, reduced developing country exports and caused a sharp decline in the prices of some of their major exports.

Meanwhile, the external liabilities of these countries had risen markedly, from $130 billion in 1973 to almost $400 billion by the end of the decade. This escalation reflected the resort to additional borrowing rather than adjustment in response to the large current account deficits of the mid-1970s—borrowing that had been facilitated by the ready availability of loans during the period, frequently at negative real rates of interest. Since 1978, however, real interest rates have turned sharply positive, reflecting tight monetary policies pursued by industrial countries to control inflationary pressures and expectations. As a result, the debt-servicing costs of developing countries increased sharply and commodity prices worsened, leading to a further deterioration of their terms of trade and forcing many countries to expand their external borrowing and increase their debt-service burden yet more. The effects of these increased payments, combined with the impact on their current accounts of the world recession, resulted in a sharp curtailment of growth of these countries’ output.

The surveys of international financial developments in the Fund’s World Economic Outlook and other studies indicate the relative importance of the different factors accounting for this deterioration in the developing countries’ balance of payments and illustrate the diversity of their experience. Of an increase of $66 billion in the aggregate current account deficit of non-oil developing countries between 1978 and 1981, the oil trade balance accounted for $18 billion; net interest payments accounted for $24 billion; and the cyclical element in the terms of trade accounted for $21 billion. The relative impact of these factors also differed across groups of developing countries. While all the non-oil exporting countries were severely affected by the rise in oil prices, the middle-income countries, particularly those of the Western Hemisphere, were seriously hurt by the increase in interest rates, because of their significant dependence on borrowing from the international banking system. For the low-income countries, on the other hand, the interest payments were generally less important as they relied to a larger extent on official sources of financing on concessionary terms. These countries, however, were seriously handicapped by the steep decline in the prices of commodities, which often constituted their only exports.

Further, some countries had a net asset position vis-à-vis the international banking system. The higher interest rates earned on such assets helped to compensate partly for the higher interest payments on their overall net debtor position, since it was with respect to banking obligations that interest rates rose to particularly high levels. Countries in this position in June 1982 were China, Egypt, Ethiopia, Ghana, India, Kenya, and Pakistan. However, in general, the non-oil developing countries had a net liability position and were therefore adversely affected by the rising real rates since the late 1970s.

Interest rates and debt

International interest rates have been highly volatile since the early 1970s and have reached postwar peaks over the past several years. As measured by Eurodollar interest rates—which, except for a country risk premium, are representative of the terms at which developing countries borrow from private international sources—nominal rates tripled from 1976 to 1981. Real rates of interest, defined here as nominal rates adjusted for concurrent increases in prices, have fluctuated even more. Adjusted for increases in the GNP deflators for the industrial countries, real rates of interest as perceived by lenders were negative during the mid-1970s and turned sharply positive toward the turn of the decade to average almost 6 percent for 1979–82—markedly above historical norms. Real rates of interest, as perceived by developing country borrowers—that is, adjusted for changes in these countries’ export unit values—have been even more volatile and reached extremely high levels (15–20 percent) in 1981–82 (Chart 1).

Chart 1The three-month Eurodollar interest rate, 1972–82

(In percent per annum)

Sources: IMF, International Financial Statistics, and Fund staff estimates.

1 Derived as nominal rate less the weighted average of the GDP deflator of all industrial countries.

2 Derived as nominal rate less the U.S. dollar based export unit value index for non-oil developing countries.

Non-oil developing countries: long- and short-term debt and debt service, 1973–821(Values in billions of U.S. dollars; ratios in percent)
1973197419751976197719781979198019811982
Total outstanding debt130.1160.8190.8228.0278.5336.3396.9474.0555.0612.4
Short-term debt18.422.727.333.242.549.758.885.5102.2112.7
Long-term debt111.8138.1163.5194.9235.9286.6338.1388.5452.8499.6
Ratio of external debt to exports of goods and services2115.4104.6122.4125.5126.4130.2119.2112.9124.9143.3
Ratio of external debt to GDP222.421.823.825.727.428.527.527.631.034.7
Value of debt-service payments17.922.125.127.834.750.365.076.294.7107.1
Interest payments6.99.310.510.913.619.428.040.455.159.2
Amortization311.112.814.616.821.130.936.935.839.747.9
Debt-service ratio415.914.416.115.315.419.019.017.620.423.9
Interest payments ratio6.16.16.76.06.07.38.29.311.913.2
Amortization ratio39.88.39.49.39.411.710.88.38.610.7
Source: World Economic Outlook, 1983.

For classification of countries in groups shown here, see the introduction to Appendix B of World Economic Outlook, 1983. Excludes the People’s Republic of China for the years prior to 1977.

Ratio of year-end debt to exports or GDP for year indicated.

On long-term debt only. Estimates for the period up to 1981 reflect actual amortization payments. The estimates for 1982 reflect scheduled payments, but are modified to take into account the rescheduling agreements of 1982.

Payments (interest, amortization, or both) as percentages of exports of goods and services.

Source: World Economic Outlook, 1983.

For classification of countries in groups shown here, see the introduction to Appendix B of World Economic Outlook, 1983. Excludes the People’s Republic of China for the years prior to 1977.

Ratio of year-end debt to exports or GDP for year indicated.

On long-term debt only. Estimates for the period up to 1981 reflect actual amortization payments. The estimates for 1982 reflect scheduled payments, but are modified to take into account the rescheduling agreements of 1982.

Payments (interest, amortization, or both) as percentages of exports of goods and services.

The average interest costs paid by the developing countries have not risen as steeply as international interest rates would suggest. For instance, whereas market rates roughly tripled from 1976 to 1981, average interest rates paid on the developing countries’ medium- and long-term debt rose from 5 to 9 percent (Chart 2). These markedly lower average rates reflect two principal factors. First, a significant part of the total debt (some 50 percent in 1981) consists of long-term fixed interest rate loans that, unlike the rates on new bank lending shown in Chart 1, reflect the much lower loan rates prevailing before the mid-1970s. Second, a fairly sizable fraction of the debt (about 31 percent in 1981) is from official creditors (including the multilateral institutions), who have generally continued to charge low concessional interest rates, despite small increases.

Chart 2Interest rates on medium and long-term debt of non oil LDCs, 1974–82

(In percent per annum)

Sources: World Bank, World Debt Tables, 1982–83; and Fund staff estimates.

Nevertheless, interest rates paid by developing countries have risen steeply over the past several years, reflecting in part changes in the sources and structure of the debt. Between 1973 and 1981, there was an increase from about 36 percent to about 44 percent in the proportion of commercial bank lending to the total debt of non-oil developing countries—such lending is typically linked to a variable interest rate base such as the LIBOR (London interbank offered rate), modified for an allowance to compensate for bank exposure and country creditworthiness. As it is this part of the total debt that carried the highest rates, this rise is significant, particularly when account is taken of the fact that the nominal value of total debt rose almost fourfold over the period. Meanwhile, the proportion of concessional loans in the total long-term debt declined from 43 percent in 1974 to 28 percent in 1981, while the proportion of variable interest rate loans increased from about 16 percent to about 37 percent during the same period. Besides raising average interest costs, these shifts also had the effect of reducing average maturities and grace periods, since maturities and grace periods on loans from private creditors are typically shorter than those from official creditors.

As a result of these changes in the structure of their external indebtedness, developing countries were exposed to the sharp rise in interest rates of 1979–82. The middle-income countries were especially affected because they borrowed proportionately more from private sources. For these countries, the increase in interest payments raised the debt-service burden, which in turn added to the risk premium on new loans and thereby led to a further rise in their interest payments. Countries with large floating rate obligations also faced complicated debt management problems, arising not only from the increase in the real cost of such obligations but also from the extreme volatility of interest rates as well as of exchange rates. (For a discussion of the impact of floating rates, see “Floating interest rates and developing countries” by Paolo Neuhaus in Finance & Development, December 1982.)

The rise in interest rates, the rapid growth in external indebtedness, and the changes in the composition of that debt led to a significant increase in the non-oil developing countries’ debt-service payments (Table 1). Interest payments accounted for the bulk of the rise. Taking account of the foreign exchange holdings of developing countries and on the basis of total net banking liabilities of over $200 billion, each percentage point increase in Eurodollar interest rates represents a rise of over $2 billion a year in their interest payments. For countries in the Western Hemisphere, debt-service payments amounted to over 50 percent of export earnings in 1982.

The implications of such increases in debt-service payments very much depend on parallel developments elsewhere in the economy. These are discussed later, but the key role of the inflation rate and of its relationship to interest rates deserves mention here. If interest rates are lower than inflation rates, as was the case in the mid-1970s, increases in interest payments, in fact, mask a net real transfer of resources to the debtor countries. The size of the transfer depends on the rate of inflation, the maturity of the loan, and the margin between the interest rate and the inflation rate. However, for any given relationship between interest and inflation rates, an acceleration of inflation, such as occurred in the late 1970s, entails, in effect, a faster amortization of the real loan. The shortening of the underlying average maturity depends on the original maturity of the loan and the pace of the rise in inflation (see G. Russell Kincaid, “Inflation and the external debt of developing countries” in Finance & Development, December 1981). Finally, if interest rates rise more than inflation, as has clearly been the case since 1978, the real debt-service burden rises commensurately. In such circumstances, borrowers are under pressure to refinance their payments and can be severely handicapped by fluctuations in export receipts or any dislocation in capital markets.

Effects on commodities

Aside from their effect on debt service, the high real interest rates of the past several years have significantly lowered the prices of non-fuel primary commodities exported by the developing countries. These commodities accounted for about half of their export earnings on trade other than oil in 1980. Although the increasing importance of manufactured exports has partly mitigated the effects of unstable commodity export earnings for some middle-income countries, the primary sector continues to play a major role in the determination of GNP and the generation of foreign exchange resources in many developing countries, particularly in those with low per capita incomes.

Theoretical and empirical analyses of commodity markets have shown that shifts in demand for commodity exports have been caused primarily by the business cycle and the changing pace of price inflation in the industrial countries. Since 1977, however, other factors have also been important—namely, changes in interest rates, in exchange rates, and in international liquidity.

Interest rate changes have a direct impact on the transactions, inventory, and speculative demands for primary commodities. The transactions demand for a commodity pertains to its use as a raw material in the production processes of intermediate and final goods in the consuming countries, or for other direct consumption purposes. An increase in the cost of inputs, resulting, for instance, from an increase in the real interest rate, raises the cost of production of the finished product. The consequent decrease in the quantity produced reduces the derived demand for all inputs used in the production process, including commodity inputs, unless the producer can fully pass on the higher cost to the consumer.

The inventory and speculative demands both depend on expected changes in the price of the commodity relative to the nominal interest rate, but the inventory demand is also affected by the expectations of price changes in the finished product. This demand stems from the role of raw material stocks as a buffer against uncertainties about their supply or fluctuations in sales of intermediate and finished products. Higher real interest rates reduce inventory demand by raising the opportunity cost of holding inventories and thus discouraging inventory replenishment and commodity purchases. Such interest rate-induced fluctuations in inventories tend to reinforce the effect of the business cycle on inventories held by firms.

The speculative demand for commodities arises from the expectation of capital gains or losses from changes in the market value of the commodity net of holding costs. Since the difference between the nominal interest rate and the expected rate of increase in the price of the commodity gives the expected real cost of holding the commodity, an increase in interest rates reduces the speculative as well as the inventory demand for the commodity.

Interest rates also have other, less direct effects on commodity prices. For instance, the unusually high real interest rates of the past several years are likely to have exacerbated the declines in industrial production and output in developed countries and hence reduced their demand for imports of industrial raw materials. Another channel of influence has been via exchange rates. The high level of international interest rates has largely reflected developments in U.S. interest rates, developments that have fostered large capital inflows into the United States and a marked appreciation of the U.S. dollar, which, in turn, tend to reduce the demand for dollar-priced primary commodities. Various analyses have suggested that, other things being equal, a 1 percentage point appreciation of the U.S. dollar vis-à-vis the currencies of other industrial countries typically leads to a ¼ percent decline in the dollar price of non-fuel primary commodities. Given the more than 30 percent effective appreciation of the U.S. dollar from 1980 to late 1982, a sizable decline in commodity prices is thus implied.

In sum, higher real interest rates have depressed commodity prices as a result of their demand-reducing effects. Admittedly, these interest rates have also raised the costs confronted by primary product exporters, but these supply-reducing effects have been swamped by the demand effects and the competitive nature of the markets in question. Empirical analyses have concluded that increases in interest rates have a statistically significant negative effect on real commodity prices, with the effect being strong for agricultural raw materials and metals. Further, it appears that interest rate movements have a stronger influence on commodity prices during periods of increased interest rate instability than in periods when rates are moving within a small band. However, even without the use of sophisticated estimation techniques it is clear that increases in nominal and real interest rates have depressed commodity prices in 1981–82 over and above the commodity price reduction attributable to the stagnation of industrial demand in consumer countries (Charts 3 and 4). The effects of lower commodity prices and the accompanying deterioration in the terms of trade on those developing countries that export commodities are serious for middle-income countries, but are particularly severe for the low-income group that is proportionately more dependent on primary commodities for export earnings.

Chart 3Nominal and real commodity prices, 1970–82

Sources IMF, Research Department, Commodities Division; and United Nations, UN Monthly Bulletin of Statistics.

1Refers to non-oil primary commodities comprising food and beverages, agricultural raw materials, and metals. Averages of percentage changes of component commodity prices are weighted by the U.S. dollar value of exports of each commodity from primary producing countries in 1968–70

2 Real prices are the nominal index deflated by the U.N. export unit value index for the manufactures of the developed countries.

Chart 4Changes in interest rates and commodity prices, 1976–82

(In percent)

Sources: IMF, Research Department, Commodities Division, and International Finangcial Statistics; and united Nations. UN Monthly Bulletin of Statistics.

1First difference in the real interest rate, which is derived as the three-month Eurodollar rate less the percentage change in the weighted average GNP deflator for all industrial countries.

2Adjusted prices are residuals obtained from regressing the percentage change in real commodity prices on the percentage change in the weighted average industrial production for all industrial countries. Since demand factors have the major impact on prices, removing their effect isolates the component (or residual) affected by changes in interest rates or any other noncyclical variable. This relationship is not clearly evident in the pre-1976 period, perhaps partly because of the much smaller fluctuations of interest rates in the early and mid 1970s.

Instability in commodity prices, rooted in part in fluctuating interest rates, also creates a problem because of its effects on the cost of borrowing. Changes in real interest rates, based on adjustment of nominal rates by movements in export unit value indices, make it difficult to forecast the real cost of borrowing. Real rates determined on this basis became highly volatile in the 1970s as export prices were subject to considerable variation, especially in those countries that exported only one or two primary commodities. This difficulty in predicting real borrowing costs, even on fixed rate debt, compounded the debt management problems faced by developing countries.

Effects on growth

During the mid-1970s, the relatively easy availability of private international bank credit at negative real interest rates encouraged a rapid growth of investment spending in developing countries. This growth was generally associated with significantly increased productivity, incomes, and export capacity in the developing world during the 1970s. The middle-income countries (the largest developing country borrowers) accelerated their real investment spending to about 8 percent per annum—half a percent above the average rate of the 1960s—at a time when the growth of investment in the mature industrial economies fell from about 6 to under 2 percent per annum. A Fund study of the experience of a sample of 20 of the higher-income developing countries suggested that the increases in external borrowing of the period generally helped finance investment outlays rather than spending for consumption. Nevertheless, the relatively easy availability of credit at negative real interest rates may have encouraged some countries to maintain ultimately unsustainable levels of imports and to avoid the reductions in consumption and investment—and therefore growth—rates that would otherwise have been called for. Moreover, the negative real interest rates of those years may have led to distortions in the allocation of foreign as well as domestic resources.

However, if the low real interest rates of the mid-1970s may have resulted in possibly undue rates of investment spending, the subsequent rise in real interest rates has had the opposite effect. It has contributed to the slowing of growth in the developing world and threatens these countries’ medium-term growth prospects as well. The steep rise in the real costs of borrowing has narrowed the range of economically attractive investment opportunities, as it has reduced the real rate of return (after allowance for the increased cost of borrowing) on all investments. Though this may force decisionmakers to be more selective in screening investment projects, it is a development that, if sustained, is likely to dampen investment, and hence overall growth, over the medium term. The impact is especially severe on past investments financed through floating rate debt. The economic viability of these investments has been undermined by the higher real internal rates of return required to match the increase in real interest costs. Further, regardless of whether they were financed using fixed- or floating-rate debt, rates of return on past investments depend on actual and projected revenues that in turn depend on the path of output in the developed world and on the prices of the developing world’s exports. But these elements have, in general, been adversely affected by the international recession, to the further detriment of the profitability of investment in the developing countries.

In the short term, this deterioration in profitability together with the sharply lowered levels of export earnings has significantly slowed spending and the process of income generation in these countries. The rise in interest payments to foreign creditors induced by increased rates has also amounted to an increase in the leakages from the spending stream, thus further weakening aggregate demand and output.

Further, following a host of developments related to the increase in real interest rates—the decline in the perceived profitability of both past and future investments, the sharply higher debt-servicing costs, and the worsened outlook for export earnings—there was a reassessment by financial markets of developing countries’ capacity to service external debt. As a result, commercial lending to these countries has been severely curtailed since 1982, forcing many of them to reduce imports and cut back growth. For the non-oil developing countries as a group, growth slowed continuously from some 5.5 percent in 1977–79 to about 1 percent in 1982. While much of this slowdown cannot be traced directly to the rise in interest rates, there is little doubt that the steep rise in those rates was a major contributory factor.

The debt-service problem differs in intensity among the different groups of developing countries according to the size, source, and terms of their indebtedness. The problem is particularly serious for several countries of the Western Hemisphere that have become heavily indebted to private creditors at relatively high real rates of interest. Several of these countries have had to substantially reduce their imports and to negotiate substantial reschedulings of their existing debt-service obligations. For these countries, outright declines in output were common in 1982.

Outlook

The outlook for economic recovery and resumption of growth in the developing world is dependent, principally, on the strength of the revival of economic activity in the industrial countries and the associated resumption of growth in international trade. Such a resurgence in industrial country demand for imports from developing countries should improve their prices, which would, in turn, help reduce the real cost of foreign borrowing for the exporters. Further, an increase in these exports would improve the current account positions of the developing countries, augment their foreign exchange reserves, and enable them to meet debt-service obligations better and to finance productive domestic investment. Nevertheless, the pace and durability of the economic recovery and the associated improvement in relative commodity prices depend critically upon the lowering of real interest rates, which remain very high. This is particularly important in the present recovery, which is being led by interest-sensitive components of demand—stock rebuilding, consumer durables, and residential construction—that will, it is hoped, be followed by an increase in fixed business investment in the industrial world.

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