Growing awareness of the harm that administered interest rates can cause has recently led many governments to give market forces a bigger say. The transition, however, requires a well-formulated strategy
It is widely accepted that interest rate policy plays an important role in achieving both internal and external balance and ensuring the efficient allocation of financial resources in an economy. Interest rates influence the demand and supply of investable resources and the decisions of economic agents to invest and consume. They are at the center of any policies that the monetary authorities may choose to undertake to influence business conditions and economic activity.
Many countries have chosen to administer interest rates at low or negative real levels, often unchanged for protracted periods. An administered interest rate policy, however, misallocates resources and hampers financial sector development that is essential for growth. While it is now generally recognized that this strategy has serious shortcomings, it is less clear how to achieve a smooth transition from repressed interest rates to market rates. If the level and structure of interest rates are found to be adequate on the basis of a range of indicators, and the macroeconomic environment has been generally stable, then rapid interest rate liberalization is unlikely to pose serious problems for the stability of the financial system. However, if interest rates are clearly out of line, the transition from rigid interest rates to a system of market-determined rates should be carefully planned in coordination with macro stabilization policies.
Macroeconomic stabilization is in general a prerequisite to successful structural adjustments, both in the financial and real sectors. At the same time, many structural reforms in the financial sector that permit greater flexibility and effectiveness of interest rate policies will become particularly urgent in a broader reform program in order to achieve stabilization and other structural objectives. In view of the close linkages between stabilization policies, financial sector reforms, and other structural reforms, it is necessary to have an appropriate pace and sequence of interest rate liberalization and the supporting financial sector reforms. Strategy for such a reform package is discussed below.
Interest rate liberalization is not synonymous with laissez-faire policies. It requires the replacement of the administratively set interest rates by indirect monetary management techniques that operate through the market. Such market-based techniques—adapted to reflect the state of financial market development—could be used to manage interest rates indirectly without recourse to administered rates. Through this indirect mechanism, the authorities could either target an interest rate level, or keep adjusting it to achieve a target for monetary and credit expansion. The choice of the targets will depend—as discussed later—on the macroeconomic circumstances. The feasibility and effectiveness of achieving such a transition in the interest rate regime will, however, require progress toward macro-economic stability as well as supporting reforms in the financial sector. These reforms should eliminate a number of weaknesses in the financial sector, including lack of competition, market segmentation, deficient monetary policy operating procedures, inadequate prudential regulations, and excessive government intervention in credit allocation. Without such reforms, interest rate liberalization could result in instability and distortions, and adversely affect macroeconomic performance. In particular, policymakers must give special attention to a number of questions when they start to liberalize, and depending upon the answers, a suitable transition strategy can be devised.
How can one ensure competition? Interest rate liberalization needs to be accompanied by a properly phased program to remove artificial obstacles to competition. Adequate competition is essential to avoid a rapid widening of spreads between deposit and lending rates, as well as excessive increases in lending rates, and to ensure an appropriate response of banks to changes in monetary policy. In particular, a regulatory environment that creates excessive market segmentation (e.g., highly differentiated reserve and liquid asset ratios), or encourages enterprises to deal with a limited group of financial institutions (e.g., due to enterprises owning banks and vice versa) has to be modified. In addition, banking policies need to be designed to facilitate licensing, mergers and divestitures, and opening of new branches. Selective credit policies based on below-market interest rates also have to be either given up or reduced in scope to prevent high borrowing costs to nonpreferential borrowers. Such measures have figured prominently in the financial sector reforms of countries like Ghana, Indonesia, Jamaica, Malaysia, Nepal, the Philippines, and Poland.
This article is based on a more comprehensive paper by the authors entitled “Issues in Interest Rate Management and Liberalization,” IMF Working Paper (WPI90I12), March 1990.
In some cases, adequate incentives for borrowers to respond to interest rate changes must be provided. One way is to limit the privileged access to the banking system by state-owned enterprises or firms closely linked to banks. Banks with a large volume of nonperforming loans are another obstacle to competition and interest rate flexibility. This is because higher interest rates due to competition will magnify the liquidity problems of such banks, leading to bank failures and a loss of fiscal and monetary control. Hence, financial restructuring of such banks, supported by strengthened prudential regulations, is an important step to increase competition in the banking system. Without a range of policy changes to improve competition, interest rate liberalization could produce significant distortions in the level, structure, and responsiveness of interest rates.
Are monetary policy instruments effective in influencing interest rates? Any move toward a more liberal interest rate regime should be associated with the development of appropriate monetary policy instruments—such as auctions of treasury or central bank bills, and reforms of rediscount operations—that influence interest rates indirectly, while supporting market development. The objective is to have a range of policy instruments to influence the marginal cost of funds to the banking system, in coordination with exchange rate policies. In this regard, the design and mix of monetary policy instruments becomes critical to ensure monetary control, while minimizing adverse short-term effects on growth and promoting further development of financial markets.
The development of market-based monetary policy instruments and the fostering of money markets are mutually supporting processes. Therefore, the introduction of such instruments should go hand in hand with measures to strengthen financial markets—such as reforms of financial sector laws, introduction of new money market instruments, and the development of market-making functions by financial institutions. Often, the clearing and settlement system for payment transactions has to be strengthened to support an active money market. In addition, central banks need to develop different levels of monetary programming to monitor liquidity in the interbank and money markets so that they can intervene at appropriate times at their own initiative to stabilize and influence money market rates.
Will the market-determined lending and deposit rates respond rapidly to monetary policy? The role of monetary policy in influencing interest rates depends upon the speed of response of interest rates to changes in monetary policy. In some countries (e.g., Indonesia, Jamaica, Malaysia, and the Philippines), the authorities introduced significant monetary reforms to develop money markets and strengthen monetary policy instruments following interest rate liberalization. As a result, they have achieved the technical ability to influence money market rates. Nevertheless, as seen in the case of Malaysia, the adjustment of lending and deposit rates in line with the money market rates was quite often delayed due to inadequate competition in money and deposit markets. This means that the impact of monetary policy may be limited to the money market and may not be easily transmitted to other financial transactions. In addition, interest rate spreads between deposit and lending rates may be larger than usual or lending rates may remain excessively high in the period just after liberalization, reflecting in part excessive risk-taking by banks and distress borrowing (e.g., Chile, Uruguay).
These problems are caused by a variety of factors, including inappropriate prudential limits on interbank borrowing, limitations on the range of instruments and participants in the money market, significant differences in the maturity structure of assets and liabilities, and central bank operating procedures causing excessive fluctuations in money market rates. The rigidity of credit demand in response to interest rate changes owing to a large share of nonperforming loans, highly leveraged borrowers, and weak banking supervision also contributes to the sluggish response of lending and deposit rates following liberalization. These are serious, but not unsurmountable, problems that can be addressed by the authorities as part of their financial reform efforts.
Is the bank supervision mechanism sufficiently sound? If many lending institutions are weak—with a large share of nonperforming loans and high operating costs following liberalization—unexpected failures of individual units can lead to systemic crises, as is well known in the cases of Argentina, Chile, and the Philippines. Moreover, a large share of nonperforming loans in the system can significantly hamper the responsiveness of interest rates to credit demand. If interest rates rise, nonperforming loans would tend to grow automatically as banks try to keep these loans current by capitalizing interest. The resulting increase in nonperforming loans may offset any decrease in demand for performing loans. These considerations suggest that an appropriate system of bank supervision is essential to ensure the sound functioning of the bank system and to make interest rate liberalization effective.
A delicate situation can result from “maturity transformation” by financial institutions in some countries. This circumstance, where institutions have lent long term at fixed rates, even when their funds are borrowed mostly short term, can adversely affect the liberalization process. As a result, an increase in interest rates will raise the cost of funds, while interest income will change much more gradually. This sequence of events can easily develop into a serious financial problem for banks and could lead to excessive risk-taking. To reduce exposure to interest rate risk, financial institutions that engage in maturity transformation should be encouraged to actively promote adjustable rate loan contracts, that is, contracts that permit interest rates to change at regular intervals. Capitalization of part of the interest payments, with some part explicitly borne by the budget, has been used extensively in Poland to moderate the debt-servicing burden on borrowers in the short run. In addition, appropriate prudential guidelines on maturity transformation—including liquid asset guidelines—should be developed as part of banking supervision.
Should the government try to influence interest rates directly? Government intervention poses special problems. Although some types of government intervention can improve the allocation of resources, other forms might be the dominant reason behind their misallocation. Even when interest rates are not directly set by the government, the rates are often affected through three main mechanisms: (1) the existence of preferential credit policies for selected sectors of the economy; (2) the financing of government deficits either through captive markets or at market-determined rates; and (3) open market policies directed at influencing trends in monetary and credit aggregates to achieve given economic targets. The first form of intervention is counterproductive; the second will depend on the level of the deficit to be financed; the third is a useful instrument to achieve the macroeconomic objectives of the authorities.
Selective credit policies are often used to influence the allocation of resources in the economy. They have, however, been ineffective in a majority of cases and have contributed to distorting prevailing interest rates. Recognizing this, many countries have moved to eliminate interest rate subsidies or special refinancing facilities that target special sectors of the economy.
Government budget deficits, financed in the market on equal terms with the private sector, will achieve an efficient allocation of resources. A misallocation is likely to arise when the central bank accommodates the government’s credit needs directly or when special incentives or regulations are used to sell government debt (i.e., tax incentives, use of government liabilities to fulfill liquidity requirements, and portfolio regulations on contractual savings institutions).
Open market operations can be conducted either in the primary market or in the secondary market. Many countries have used primary sales of some government securities—either central bank securities or treasury bills—as an instrument of monetary policy. Varying the timing and the volume of primary issues, and issuing them at market rates, has proved to be an attractive technique in influencing bank reserves and interest rates in the short run, particularly in the absence of active secondary markets in these securities. This has also served as a transitional device to foster the development of secondary markets.
Open market policies can be used to influence interest rates without having to resort to direct regulation of financial intermediaries. Such a strategy would imply allowing monetary and credit aggregates to find their own levels. But what criteria could guide the authorities’ choice between interest rate and monetary (or credit) aggregate targeting? The generally accepted view is that interest rates should be the preferred short-run and intermediate target when the dominant source of instability in the economic system is the financial sector (e.g., shifts in money demand due to financial innovations). The targeting of a monetary or credit aggregate should be selected when real sector disturbances are more important (e.g., shifts in terms of trade and fluctuations in real demand for goods and services).
In practice, of course, no simple rule of policy intervention can ensure economic and financial stability. In an economy that may be simultaneously subject to multiple disturbances of varying intensities, on which there is imperfect information, policymakers may prefer to adopt a policy of discretionary adaptation by continuously reviewing the settings of policy targets in the face of the most recent information. Although a choice would still be necessary between interest rate or money supply targets, this would be subsidiary to the crucial task of setting the consistent target levels for these variables. Thus, even in a liberalized interest rate regime, the authorities must constantly take a view of the appropriate level of the interest rate and strive to achieve it. Central banks, in general, must attempt to smooth out short-term fluctuations in interest rates around their “fundamental” trends, to ensure that changes in trends are not obscured by day-to-day volatility. Such “defensive” monetary policy operations would help speed the effects of monetary policy and enable financial markets to function smoothly.
The experience of developing countries that have addressed the above questions concerning interest rate liberalization suggests some lessons on transition strategy from underdeveloped financial markets to developed markets. Key monetary control reforms should be initiated early in the reform process owing to the support they provide to the stabilization process. Open market-type operations that rely on sales of government or central bank securities in the primary market could be introduced even in countries with no or limited financial markets, with the central bank serving initially as the major source of liquidity to such instruments through the discount window. This could be followed by reforms of discount windows to reduce the role of the central bank and increase the role of markets in providing liquidity to the instruments, measures to foster new institutions and instruments in the money market, and eventually new operating procedures to manage the flow of funds in the secondary markets. As the authorities begin to move toward greater interest rate flexibility within the above framework, a minimal program of reforms in prudential accounting regulations and bank portfolio restructuring should also be implemented.
Thus a critical mass of reforms in the financial sector is necessary at the outset of the interest rate liberalization process in many countries, simultaneously with a stabilization package. Policies that enhance competition (i.e., liberal licensing and branching) could be pursued in a subsequent phase of reform. The pace of interest rate liberalization will also be conditioned by the speed with which the complementary reforms can be accomplished, and the ability of the budget to handle the fiscal consequences of recapitalizing weak institutions and to offset any credit boom arising from a shift toward market-based monetary control instruments.
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