Sebastian Edwards and Mohsin S. Khan
During the last decade or so economists have emphasized the critical role that interest rate policies play in the development process. The growing literature on financial reform and financial liberalization in developing countries has dealt with many aspects of this topic, such as the relation between financial intermediation and economic growth, the sensitivity of savings to changes in real interest rates, and the relation between investment and interest rates. The empirical evidence indicates that, in general, there is indeed a positive association between the degree of development of the financial sector, in particular freer interest rates, and general economic performance in developing countries. (See, for instance, “The importance of interest rates in developing countries” by Anthony Lanyi and Rüşdü Saracoglu, Finance & Development, June 1983.) This finding has undoubtedly encouraged a number of countries to remove controls on interest rates, and to allow market forces to play a greater role in their determination.
With the process of financial liberalization well under way, economists and policymakers are now faced with a different set of issues. The focus of attention has begun to shift from the effects of freeing interest rates to how interest rates are in fact determined once the domestic financial market has been liberalized. Two factors have increased the importance of this particular issue: first, the recent experiences of the Southern Cone countries (Argentina, Chile, and Uruguay) where domestic interest rates rose to extraordinarily high levels following the implementation of financial reform policies, and, second, the evidence suggesting that the high and volatile interest rates of recent years in industrial countries were at least partially transmitted to developing countries. Both these factors have been a cause of concern to policymakers and have raised basic questions about the behavior of interest rates in developing countries, in particular as to what should be expected when controls on interest rates are eliminated. At present, however, there are relatively few studies dealing with the subject of interest rate determination, and even fewer specifically examining the respective roles of foreign factors and domestic monetary conditions in affecting interest rates in developing countries.
A fuller version of this paper appears in the IMF Staff Papers, June 1985.
Broadly speaking, the process of determination of interest rates is significantly affected by the degree of freedom of capital movements. For example, under fully free capital movements, some form of interest “arbitrage” will take place, with domestic interest rates depending on world interest rates, expected devaluation, and perhaps some risk factors. (Arbitrage refers to the flows of funds that take place because of the opportunity for profit provided by the difference between the interest rate in the domestic market and those in other financial centers, discounted for exchange and other risks. On the other hand, in the case of countries with a completely closed economy (including no capital movements), the nominal interest rate will be determined by conditions prevailing in the domestic money market, and by expected inflation. Most developing countries fall between these extreme categories, so that interest rates will generally depend on domestic money market conditions, as well as on the expected rate of devaluation and world interest rates.
From a policy perspective it is important to determine the way in which these factors actually affect interest rates. For example, an understanding of the effect of a devaluation or a change in domestic monetary conditions on interest rates is important for assessing the significance of the mechanisms through which stabilization policies affect aggregate demand. Typically, stabilization programs involve both exchange rate adjustments and tighter credit and monetary policies. If these policies generate an increase in the domestic (real) interest rate, there will be an additional channel through which aggregate demand will be affected, one that has generally not been considered in the analysis of stabilization policies because of the paucity of experience with liberalized capital markets.
The conceptual framework
From an analytical perspective, a model designed to study interest rate behavior in developing countries should explicitly take into account the fact that typically these countries are neither fully open to the rest of the world nor completely closed to foreign influences. As such, models of interest rate determination should be general enough to incorporate the intermediate case of a “semi-open economy,” where both domestic and foreign factors play a role. In order to construct such a model it is useful first to describe the two extreme cases of interest rate behavior in the fully open and completely closed economies. These extreme cases can then be combined into a general model that is considered to be the most relevant for developing countries.
Standard theory indicates that in a country that is completely closed to the rest of the world (that is, there is neither trade nor capital movements), the nominal interest rate would be given by the sum of the real interest rate and expected inflation. The real interest rate, in turn, will depend on the liquidity conditions of the money market. In this setting, increases in the real quantity of money, with other things given, will tend to result in a decline in the real interest rate in the short run. If it is further assumed that expected inflation does not change, the nominal interest rate—as stated above, the sum of the real interest rate and expected inflation—will also decrease, again in the short run. Conversely, a higher demand for liquidity will tend to generate higher interest rates. In this extreme case, where the economy in question is assumed to be closed and completely isolated from the rest of the world, there is obviously no role for foreign factors, such as foreign interest rates, in the determination of interest rates.
The other extreme case is that of a fully open economy with no restrictions on goods and capital movements. In equilibrium, through arbitrage, the domestic nominal interest rates will equal world interest rates (for financial instruments with the same characteristics) plus the expected rate of devaluation of the domestic currency and a risk premium. Under these conditions of completely free capital mobility, if the domestic interest rate exceeds the world interest rate (corrected by expected devaluation), capital will flow into the country in order to take advantage of the higher rate of return. This capital inflow, in turn, will increase the domestic level of liquidity and will depress the domestic rate of interest until it equals the world rate plus expected devaluation and the risk premium. When this equality is achieved, capital flows will cease and equilibrium will once again be reached.
The two extreme cases of a fully open or completely closed economy are, in fact, seldom observed in the real world, and it is more realistic to consider the case of an economy that, while not closed, nevertheless has some controls on capital movements. For such an economy it is likely that, at least in the short run, both open-and closed-economy factors will affect the movements in domestic interest rates. In essence, this would involve combining the two extremes into a general model in which the domestic nominal interest rate would depend on (1) conditions related to the level of liquidity in the domestic economy, (2) expected domestic inflation, (3) foreign interest rates, and (4) the expected rate of change in the exchange rate (and any risk premia).
Factors (1) and (2), of course, are related to the closed-economy model described above, whereas factors (3) and (4) are related to the fully open economy model. The relative importance of these factors in the process of determining interest rates in developing countries will depend on the degree of financial openness of the economy in question, which describes the conditions under which capital movements actually take place. If the economy is financially very open, domestic interest rates will be much more strongly influenced by world interest rates and expected devaluation than by domestic factors. On the other hand, if the economy is quite closed, financially, the conditions related to domestic liquidity and expected inflation will be the dominant ones. In fact, in this general model the two extremes discussed above are special cases that arise when financial openness is either complete or when it is absent. An important property of the model is that the degree of financial openness can actually be statistically estimated from the data as a “parameter” of the model. This estimated parameter will provide information on the actual degree of integration of the domestic capital market to the world financial market.
To assess its ability to describe the process of interest rate determination in developing countries, the general model was estimated using quarterly data for Colombia and Singapore. Since these two countries are quite different, both in terms of the development of their domestic financial markets as well as in the degree of controls over capital flows, they should provide a fair test of the basic model.
Since 1967 Colombia basically has followed a growth strategy based on export promotion. During the last 15 years a crawling-peg exchange rate system has been in effect, and at least in a segment of the capital market, interest rates have been allowed to fluctuate freely. Over this period the domestic capital market was slowly liberalized, but a number of restrictions to capital movements were maintained. For example, there were restrictions on the minimum maturity of loans obtained from abroad (usually five years); the movement of capital in and out of the country required formal approval from a number of government agencies, including the Exchange Office, the Ministry of Finance, and the National Planning Department; and a 95 percent advance deposit was required on all payments abroad, including capital outflows. While there was some capital mobility, the existence of such legal restrictions makes it best for practical purposes to characterize Colombia as a semi-open economy, rather than as fully open. As such, in terms of the conceptual framework presented above, one would expect interest rates to be determined in accordance with the intermediate case of the general model.
The Singapore economy, on the other hand, can be regarded as highly open, with virtually no restrictions on trade and capital flows. For example, imports are mostly unrestricted, with a very small number subject to tariffs, and all payments can be made freely. The last elements of exchange control on capital movements were eliminated in June 1978, and there are no hindrances to the movement of capital. After being pegged to sterling, the Singapore dollar floated from June 1973 to late 1975. Since then the currency has been pegged to a trade-weighted basket of the currencies of its major trading partners. In general, the progressive freeing of financial transactions, the exchange rate policy, and direct encouragement by the Government through its financial development program have combined to make Singapore into an important financial center with close links to other major financial markets. The foreign exchange market has also developed fairly rapidly, and although the volume of transactions is not as large as in the major financial centers, the Singapore market has over the years become among the largest in developing countries. There is a very active forward market, covering transactions of various maturities, with quotations being given on a daily basis by participating banks. These institutional factors would lead one to expect that, given the openness of the Singapore economy, domestic interest rates would respond rapidly to foreign developments.
Using quarterly data (for Colombia from the third quarter of 1968 to the fourth quarter of 1982, and for Singapore from the third quarter of 1976 to the fourth quarter of 1983), the following results were obtained. In the case of Colombia the general model performed as expected, clearly indicating that the nominal interest rate in Colombia has been sensitive to both foreign and domestic influences, and that ignoring either of these factors—as is the case when more traditional approaches to interest rate determination are used—would leave out important elements of the story. The results further indicated that the Colombian financial sector has, in practice, been more integrated with the rest of the world than might appear from an analysis of the nature and extent of capital controls during this period. According to estimates of the analysis, a 10 percentage point increase in the world interest rate, for example, will be translated into an increase of the domestic interest rate of over 8 percentage points in the long run. However, the average lag in adjustment of the nominal interest rate to a change in either the foreign interest rate or the exchange rate is between 3 and 4 quarters.
The results for Singapore are quite different from those for Colombia, with foreign factors playing the clearly dominant role in the determination of the domestic interest rate. Domestic monetary developments have no direct effect on the interest rate (although it is possible that they still could have an indirect impact through their influence on the forward premium). Also, with the extreme openness of the Singapore economy, implying that the adjustment of the domestic interest rate is instantaneous and interest parity is maintained continuously, the question of the lag in adjustment of the domestic interest rate in response to a change in the foreign interest rate does not arise.
The framework presented here has its limitations and can obviously be expanded in several directions. Four possible extensions are discussed in this section. The list is by no means exhaustive, and specifically does not incorporate various econometric issues that could arise in estimating a model of interest rate determination.
• Real interest rates in developing countries. Recently, some empirical studies have analyzed the behavior of real interest rates in industrial countries, placing special emphasis on whether these rates have tended to be equalized across countries. From a theoretical perspective, even if there are no exchange controls and the capital account is fully open, and, further, the nominal arbitrage condition holds, real interest rates can still differ across countries. For example, an expectation of a real depreciation would result in a country having a higher real interest rate than the rest of the world.
The framework discussed in this paper can be easily extended to analyze the process of determination of (ex post and ex ante) real interest rates. Since the ex post real interest rate is defined as the nominal rate minus the actual rate of inflation, a simple way of doing this is explicitly to incorporate inflation into the model. The resulting model could then be used to determine simultaneously the nominal interest rates and the rate of inflation, and the ex post real interest rates could then be directly obtained from these two equations. Furthermore, if the inflation equation is used to determine the expected rate of inflation, then one could calculate the ex ante real rate of interest.
To keep within the spirit of the model outlined here, the inflation equation specified should be general enough to allow both closed and open economy factors to play a role. In the extreme case of a fully open economy, domestic monetary conditions will have no direct effect, and the inflation rate will depend solely on world inflation and the (actual) rate of devaluation. If, in addition, it is assumed that the expected real exchange rate will remain constant, the model will predict the equality of domestic and foreign real interest rates. By contrast, if the economy is completely closed, the domestic rate of inflation, as well as the nominal and real interest rates, will have no relation to their world counterparts.
• Interest rates and liberalization. One of the limitations of the model presented in this paper is that it assumes a constant degree of openness of the financial sector in the country under study. A number of developing countries, however, have recently relaxed or removed controls on capital. To the extent that liberalization results in a higher degree of integration of the domestic and the world capital markets, the assumption of openness as constant over time is clearly inappropriate.
There are several possible ways to proceed if the degree of openness is changing through time. The simplest way would be to make openness a function of time, namely, to assume that the level and intensity of capital controls vary smoothly and gradually over the period of study. This simple approach would obviously break down if the changes in capital controls were abrupt or erratic, and it would be necessary to consider other methods formally to capture the liberalization process.
• Expected devaluation and interest rates. Throughout this article no mention has been made of how the expected rate of devaluation or the forward exchange premium is determined. In the present exercise these factors were assumed to be exogenous. This is quite a restrictive assumption; more realistic analysis would have to recognize that the expected exchange rate change is likely to be affected by movements in domestic interest rates and, more generally, by domestic monetary conditions. However, recognizing this issue and actually doing something about it are two quite different things, since in practice the formal modeling of the expected rate of devaluation or the forward premium has generally proved to be exceedingly difficult.
The way to proceed will depend on the exchange rate system of the country in question. If the country has a floating exchange rate, standard modern theories of exchange rate behavior can perhaps be used. Even so, this is no easy task since these models have not been particularly successful in predicting exchange rate movements. Under fixed rates the problem becomes even more complicated since the probability of an exchange rate crisis has then to be modeled explicitly. Some initial attempts have been made in this direction, but the modeling of exchange rate crises is still in its infancy. By and large it seems that the present “state of the art” of exchange rate modeling would preclude paying anything more than lip service to this particular issue.
• The role of currency substitution. In formulating the interest rate model for an open economy, attention has to be paid to the possibility of substitution between domestic and foreign money, defined generally as “currency substitution.” The assumption that domestic residents only substitute between domestic money, domestic bonds, and goods is obviously inappropriate, if individuals can also hold foreign money. Consequently, in an open economy the rate of return on foreign money is another factor that can directly affect domestic demand for money, and thus the domestic interest rate.
While currency substitution is a factor that should be explicitly taken into account in any realistic analysis, it is not clear how to model its effects. The general consensus is that the principal determinant of currency substitution is the expected change in the exchange rate, although there is a great deal of controversy on how this ought to be measured. Other things equal, an expected depreciation of the domestic currency, for whatever reason, would cause residents to switch out of domestic money into foreign money, and vice versa. Once, however, the difficult problems associated with the choice of an appropriate empirical proxy for exchange rate expectations are surmounted, the rest becomes relatively straightforward.
As more developing countries proceed to liberalize their domestic financial system and remove restrictions on capital flows, the issue of interest rate determination becomes increasingly important. In particular, how interest rates can be expected to behave in the changed environment, and how they will respond to foreign influences and domestic policies, are questions policymakers in developing countries have to consider. Only when interest rate behavior is well understood will it be really possible to predict the effects of interest rate changes on key macroeconomic variables such as savings, investment, the balance of payments, and economic growth, which are presumably the purposes for which the liberalization policies were originally designed.
This article has presented a framework for analyzing the process of interest rate determination in those developing countries that have undertaken financial reforms. Although the model is fairly simple, it is nevertheless able to incorporate the principal determinants of interest rates, such as foreign interest rates, expected changes in exchange rates, and domestic monetary developments. It may be applied to a variety of developing countries that differ widely in financial openness. For illustrative purposes the model was applied to two countries that differ quite significantly in terms of financial development and openness (Colombia and Singapore), and was found to yield quite sensible results. Indeed it was possible to determine empirically the degree of financial openness, defined both as the extent to which domestic interest rates are linked to foreign interest rates, as well as the speed with which they respond to changes in the latter, from the data for the countries. In conclusion, while due care should be taken in generalizing from the results of only two countries, this approach appears to have considerable potential and can serve as a useful starting point for studying the behavior of interest rates in developing countries.
Robert S. McNamara Fellowships Update
The World Bank is pleased to announce the fourth annual Robert S. McNamara Fellowships in honor of its former president.
A limited number of fellowships will be awarded for the 1986 academic year for full-time postgraduate work or research in fields related to economic development and institution building. Fellowships are offered for individual as well as group awards. A group proposal may include up to a maximum of five persons working at the same institution. The innovative or imaginative character of the work to be undertaken will be an important factor in selection. In addition, group proposals will be judged on how such a group activity would strengthen the institution to which the group is attached. The Fellowships Program is not intended to support work leading to an advanced degree. Candidates normally must be not more than 35 years of age, hold a master’s degree or equivalent, and carry out their work in a country other than their own. Fellowships include stipend for subsistence, accommodation, and travel and an allowance for books and the cost of research. Applications must reach the Fellowships Office by December 1,1985.
For further information about criteria and application procedures please contact J. Price Gittinger, Coordinator, McNamara Fellowships Program, Economic Development Institute, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A.