Abstract

The bearing of interest rate policies on saving and investment decisions has been discussed in the previous section within the context of economic growth. Equally important is the effect of interest rate policies on macroeconomic stability. Although the primary impact of interest rates is on the financial sector, interest rates, like wages and exchange rates, also exert a substantial influence on aggregate output and employment, real investment, and other real economic aggregates.

The bearing of interest rate policies on saving and investment decisions has been discussed in the previous section within the context of economic growth. Equally important is the effect of interest rate policies on macroeconomic stability. Although the primary impact of interest rates is on the financial sector, interest rates, like wages and exchange rates, also exert a substantial influence on aggregate output and employment, real investment, and other real economic aggregates.

Government policies on interest rates thus have important implications for the conduct of demand management policies. The levels and structure of interest rates affect the ability of the central bank to maintain control over the rate of domestic credit expansion, influence public sector revenues and expenditures, and have a significant effect on the balance of payments. As a result, the interest rate policies chosen by the authorities determine to a considerable degree the appropriate stance of other demand management policies.

In this section, it is first argued that a major consequence of interest rate repression is the disruption of macroeconomic stability, and that, owing to the acceleration of the velocity of circulation, destabilizing forces tend to intensify over time if repressed interest rates are maintained. The effects of undertaking interest rate reform are examined next, with particular emphasis on the positive contribution of such a reform to the restoration of stability. Finally, there is a discussion of the short-run transitional problems that may arise as an immediate result of interest rate reform and policy measures that might be adopted to counter such problems.

Repressed Interest Rates and Economic Stability

Many developing countries have, at one time or another, experienced prolonged periods during which interest rates were well below the rate of inflation. Such periods are often characterized by an increasing gap between ex ante aggregate demand and aggregate supply, acute foreign exchange shortages, and an acceleration of inflation. The more rapid inflation tends in turn to exacerbate the interest rate repression. Paralleling these developments, the banking sector experiences a shortage of funds as the real value of domestic financial savings declines, thereby reducing the availability of credit, while the demand for credit is simultaneously increasing, owing to negative real interest rates. In response to the emerging credit shortage, the authorities introduce various regulations and tighten existing ones in order to allocate credit through nonprice mechanisms. Ultimately, the acceleration of inflation and the rigidities arising out of extensive regulations lead to significant resource misallocation and economic dislocations and therefore reduce the sustainable rate of economic-growth.

In a typical scenario, the process just sketched begins with an increase in the fiscal deficit, which is financed largely by monetary expansion and results in an excess of aggregate demand over supply. To the extent that there is widespread slack in the economy, there may initially be some positive supply response. Nevertheless, there is a strong tendency for inflationary pressures to increase. With nominal interest rates being fixed by the authorities, the increase in the actual and the expected rates of inflation results in a decline in real interest rates. On the one hand, this leads to a reduction in the public’s demand for domestic financial assets, both monetary and quasi-monetary; this process, which can also be observed as an increased velocity of circulation, has occurred in some of the countries cited in Section III, such as Argentina, Ghana. Jamaica, and Turkey. On the other hand, the reduction in interest rates stimulates the desire to invest, as projects that were previously unprofitable now become attractive. If potential investors are able to raise the funds they require, domestically or abroad, the increase in investment expenditure, together with the increase in the velocity of circulation, tends to enlarge the gap between demand and supply in the goods market and this enlarged disequilibrium generally leads to a further acceleration of inflation. Unless corrective policies are adopted, the economy thus moves toward a more acute state of interest rate repression.

The response of the authorities and the public to repressed interest rates may intensify the destabilizing forces in the economy. The reduction in the demand for financial assets, by lowering the real value of deposits held with domestic financial institutions, forces the latter to curtail their lending operations to the private sector of the economy. The resulting shortage of credit prompts the authorities to adopt policies of credit rationing and to regulate the allocation of credit by selective credit policies. Moreover, in such an economic environment, restraints on credit expansion tend to weaken. When the cost of credit is negative, a net transfer of real resources from savers to borrowers occurs, and the banking system, as well as the monetary authorities, comes under increasing pressure from politically powerful social groups and businesses to maintain a high rate of credit expansion. Similar pressures are also exerted by the bureaucracy in charge of public sector economic enterprises. To the extent that monetary authorities yield to such pressures, interest rate repression becomes a self-sustaining process.

The drop in the demand for domestic financial assets, in response to a reduction in real interest rates, also has important implications for the balance of payments. Clearly, in a small and relatively open economy, with some degree of freedom for capital movements, noncompetitive interest rates cannot be sustained for an extended period of time without curtailing that freedom. As the demand for domestic financial assets falls, there will be an increase in the demand for foreign assets leading to capital outflows, which may reach excessive levels, especially when the exchange rate is regarded as overvalued.27 This problem becomes especially acute when interest rates abroad are high. Large capital outflows, which compound the current account problems arising from reduced domestic savings, force the authorities either to increase the amount of their official borrowing or to draw down international reserves. Often the authorities respond to capital outflows by introducing severe restrictions on capital movements, thus insulating the domestic financial system. Nevertheless, capital flight continues through a variety of clandestine channels, such as overinvoicing imports and underinvoicing exports. In tandem with the development of unofficial domestic financial markets, parallel markets in foreign exchange may develop and flourish.

After a prolonged period of repressed interest rates, the prevailing economic environment tends to depress the level of economic activity and growth rates may even become negative. The lack of demand for domestic financial assets causes the banking sector to shrink in size relative to gross domestic product (GDP). In many cases, the rate of capital accumulation falls, owing to the shortage of credit, despite a high demand for investment. Much, if not most, of the investment that is undertaken is financed through unofficial markets or investors’ own funds. The gap between nominal domestic demand and available supply tends to widen as a result of increases in velocity and in the incentives to hoard goods. These problems may be complicated by firms being forced to reduce output owing to shortages of imported raw materials and intermediate goods. Prices rise rapidly as a result of the prevailing excess demand. Particularly under a regime of fixed exchange rates, the competitiveness of the foreign sector will decline, leading to large current account deficits, which, coupled with capital outflows, result in major foreign exchange shortages. It is in response to such an economic environment that stabilization-cum-liberalization policies are adopted.

Interest Rate Reform and Stabilization Policies

From an operational point of view, it is important to analyze the economic consequences of interest rate reform not in isolation but within the context of stabilization programs under which a number of policy measures are being introduced. It is also important to keep in mind that the contribution of interest rate reform to the success of stabilization programs varies, depending both on the circumstances that prevail at the initiation of the program and on the manner in which the various aspects of the stabilization program are coordinated with each other.28 For example, if a stabilization program is being adopted after a long period of severe interest rate repression, increases in real interest rates that are sufficient to stimulate financial savings may not be achievable in the short run solely by reducing inflation. Under such circumstances, adjustment of nominal interest rates is necessary, either by liberalization or by discretionary action by the authorities. In contrast, when real interest rates have been only slightly negative, the appropriateness of undertaking interest rate reform should be judged on the basis of its potential benefits compared with the potential short-run problems arising from its implementation. It should thus be stressed that the relative merits of interest rate reform, within a specific stabilization or structural adjustment program, can be evaluated only case by case through a careful evaluation of the social benefits, as well as the social costs that could result from its implementation. In this subsection, the focus is on the potential benefits. The potential short-run problems are discussed in the next subsection.

Interest rate reform and other stabilization policies, such as fiscal and monetary restraint, devaluation of the currency, and the readjustment of relative domestic commodity and factor prices, may, in some cases, be implemented concurrently or within a short period of time. The immediate objectives of these policies are (1) to bring inflation under control by reducing the growth of nominal domestic demand for goods and services; (2) to restore the external competitiveness of the economy and thus improve the balance of payments; and (3) to promote a more efficient allocation of productive resources. Because of the fact that a major stabilization program involves several policy actions, it is important to ensure that these policies are closely coordinated, and that the presence, or lack, of a specific policy measure does not neutralize the impact of others.29

The widening role of interest rates in stabilization programs is evidenced by the fact that interest rates were a factor associated with economic performance in 7 of the 13 countries with extended arrangements approved by the International Monetary Fund in the three years 1978–80. Similarly, interest rate policy action was specified in all of these programs, as well as in 11 of the 17 stand-by arrangements approved by the Fund in 1980.

Interest rate reform can be accomplished either by permitting nominal interest rates to be determined by market forces or by exercising administrative control over interest rates in a flexible manner responsive to market conditions. Experience indicates that the authorities of countries carrying out such reform have generally preferred the latter policy but, in some countries where financial markets are reasonably well developed, a strong case can be made for permitting interest rates to be determined in the market. This judgment may be a difficult one to make and depends on the particular circumstances of each country. Regardless of the method chosen to reform the interest rate structure, what is required for the success of stabilization efforts is an upward adjustment in interest rates so that after allowing for expected inflation they will provide adequate compensation to savers.

An increase in interest rates aids stabilization efforts primarily by increasing the demand for interest-bearing bank deposits and thereby reducing the velocity of circulation. A reduction in the rate of growth of nominal demand, which is necessary in order to reduce inflationary pressures, can be achieved either by slowing the rate of monetary expansion or by reducing the rate of increase in the velocity of circulation. Where there is accelerating inflation and repressed interest rates, it might even require an actual contraction of money supply to offset the increase in velocity that occurs as the demand for monetary and quasi-monetary deposits lessens. In contrast, following an interest rate reform, the resulting increase in the public’s willingness to hold time and savings deposits contributes to a reduction in the growth of nominal domestic demand. Therefore, to the extent that the interest rate reform succeeds in stimulating the demand for domestic financial assets, the need for the curtailment of domestic credit expansion will be reduced, thus facilitating a more orderly adjustment of the economy to new fiscal and monetary policies.

Recent experience in Turkey tends to confirm the role that positive real interest rates can play in stimulating savings and increasing the demand for domestic financial assets. After interest rates were liberalized in July 1980, the resulting rise in the real rates of interest, coupled with a flexible exchange rate policy, increased the demand for domestic financial assets sharply. During each of the six quarters following the liberalization, time and savings deposits increased by more than 25 percent each quarter. The concomitant decline in the velocity of circulation was instrumental in reducing the rate of inflation from over 100 percent per annum in the third quarter of 1980 to about 30 percent per annum by the last quarter of 1981.

It is sometimes argued that positive real interest rates would lead to increased public sector expenditures without increasing potential revenues, and would thereby raise inflationary pressures by a larger fiscal deficit. Although this argument does point to a potentially serious problem, it ignores some of the other effects of positive real interest rates upon the demand for financial assets and public sector finances.

  • (i) The financing of the public sector deficit will be inflationary only to the extent that the resulting rate of monetary expansion exceeds the rate at which the demand for financial assets is increasing. In most developing countries, the deflationary effect of the expansion in the demand for financial assets, caused by shifts from negative to positive real interest rates, may well be larger than the inflationary effect of an increased deficit arising from higher interest payments.

  • (ii) Positive financing costs, in real terms, induce public sector enterprises to rationalize their operations, forcing them to introduce measures such as inventory controls in order to economize on their use of finance. Realistic interest costs also induce a rationalization of capital expenditures; investment projects are more carefully selected with less duplication and waste.

  • (iii) The portfolio allocation, induced by positive real interest rates, away from inflation hedges and into financial savings could provide the authorities with a potential source of increased revenue, because it is easier to collect taxes on interest income—when taxes are withheld at the source—than those on capital gains or income from inflation hedges.

  • (iv) To the extent that positive real interest rates promote economic growth, the revenue base of the government increases, thus providing more revenue to compensate for the increased cost of the public debt. In addition, because of the higher demand for all types of financial assets, there is a larger base for financing the public debt through issues of government bonds, thereby permitting reform in government financing procedures that can have long-run anti-inflationary consequences.

Notwithstanding these possible improvements in public finances resulting from interest rate reform, when such reform is being undertaken, bringing the fiscal deficit under control usually remains the most difficult task of stabilization programs. In many developing countries the size of the financial markets is limited, and the government is the predominant participant in these markets. In these circumstances, the financing of government debt may lead to large-scale financial crowding out and a shortage of funds for investment in the private sector. Moreover, the tax-exempt status of interest income from public debt tends to aggravate the problem by forcing the interest rates on private debt even higher.

In addition to these monetary and fiscal policy issues, it is also important to consider the impact of interest rate reform upon the external sector. Most important, the introduction of positive real interest rates can substantially reduce capital outflows and, to the extent that the domestic interest rate corrected for anticipated depreciation of the domestic currency exceeds the interest rates that prevail in world markets, net private capital inflows may be realized. For many developing countries, net capital inflows are necessary to finance their development efforts, particularly when domestic savings are insufficient. Experiences of several member countries suggest that capital flows are highly responsive to variations in interest rates.30 Interest rate reforms often result in large capital inflows, which partly represent the portfolio reallocation induced by the increase in interest rates; expectations regarding future exchange rate adjustments are also crucial in this connection. In the longer run, as the interest rate differential is maintained, capital inflows decline toward the amount representing the share of new foreign savings being directed toward the home country.

The net impact of interest rate reform on the trade account and the overall current account is more ambiguous. On the one hand, a number of developments may take place that will improve the current account balance. For example, positive real interest rates, together with appropriate exchange rate policies, are likely to induce firms to lower idle inventories of imported raw materials and semifinished products. Moreover, they may induce expatriate workers to maintain a larger inflow of remittances. Both these developments lead to a once-for-all improvement in the current account, and, for workers’ remittances, stimulate larger continuing inflows. A further improvement in the current account can be realized if there is a positive supply response to the stabilization measures, particularly to the increased availability of credit induced by the interest rate reform. To the extent that capacity utilization is improved in the export sector, the current account balance will improve.

On the other hand, several developments may result in a deterioration of the current account balance. It was suggested that a major consequence of interest rate reform is an enhanced availability of credit and therefore an increase in investment and saving. As the composition of expenditure is shifted away from consumption toward investment, an increase in the demand for imports is likely, as investment in developing countries tends, in general, to be more import-intensive than consumption. This increased demand will result in a rise in actual imports if, as is often true, an increase in interest rates is accompanied by removal or liberalization of import controls.31

The improvement realized in the capital account because of positive real interest rates is likely to be larger and take place more rapidly than any possible adverse developments in the current account. The overall short-term result will thus be an increase in reserves. Nevertheless, if capital inflows are permitted to result in an overvaluation of the domestic currency, the consequences for both the current and capital accounts could be less favorable. If improved foreign exchange availability is used to bolster reserves and reduce short-term external debt (for example, arrears), such an effect need not occur.

Although the net impact of higher interest rates on the balance of payments cannot be determined with certainty, there is some indirect evidence that the impact is likely to be favorable. A negative correlation between the velocity of circulation and the balance of payments has been observed in Fund programs. To the extent that interest reform could lead to a reduction in velocity, it would be reasonable also to expect an improvement in the balance of payments.

The importance of interest rate policies as part of a package of stabilization policies differs among countries. For countries where financial markets are reasonably well developed and international capital movements are permitted to some degree, or cannot in practice be avoided, the success of the entire stabilization program may hinge on the ability of the authorities to devise the correct combination of interest rate and exchange rate policies needed to avoid the extremes of excessive capital inflows or outflows, which, in turn, may jeopardize the achievement of both domestic monetary and balance of payments objectives. For countries with a relatively undeveloped financial system and strict restrictions on international capital flows, the role of interest rates may be somewhat less crucial for short-run stabilization policy. It would nevertheless be prudent not to exaggerate this comparison, as even low-income countries with undeveloped capital markets and exchange controls have discovered in recent years that inappropriate interest rate and exchange rate policies can have a damaging economic impact through the operation of various parallel, unofficial, or illegal markets.

Short-Run Problems Arising from Interest Rate Reform

The problem of integrating interest rate policy into an overall stabilization program is especially acute in the early stages of such a program, when monetary and fiscal restraint, movement to a more realistic exchange rate, freeing or raising interest rates, and other types of liberalization often occur. The latter may include eliminating or reducing exchange restrictions (including controls over capital movements), removing or reducing import controls and tariffs, phasing out price controls for various domestically consumed goods, and easing direct controls over the allocation of credit by the financial system.

Because of the many different forms that stabilization-cum-liberalization programs might take, it would be impossible to offer a general assessment of the dynamic response of the economy during the period immediately following the introduction of stabilization programs where a change in interest rates is a major component. As a general rule, the short-run response of the economy to a stabilization program depends on the initial conditions prevailing at the time immediately prior to the initiation of the program and on the other policy measures contained in the program. In view of these considerations, what is offered here is in the nature of an enumeration of the short-run difficulties that the authorities have faced, or have feared that they might face, in countries undertaking or considering interest rate reform, together with some suggestions of what steps might be taken to deal with these difficulties.

  • (i) Following the liberalization of interest rates, there is a tendency for “overshooting” to occur with respect to interest rates on new bank credit. This is because banks and other financial institutions compete for deposits by raising deposit rates: the pressure on them to do so is more intense if the government has raised interest rates on its own debt instruments and made them available to the public, and also if there are lags in the supply of new funds to the banking system. Higher deposit rates, however, face the financial institutions with a severe profit squeeze, because of the assets yielding low returns still carried over from the period of repressed interest rates. The only way banks can avoid severe losses—short of receiving credit at lower interest rates from the monetary authorities—is to charge interest rates on new loans that are very high, relative both to deposit rates and the rate of inflation; as new loans gradually replace old loans in portfolios, lending rates will then tend to subside to their longer-run equilibrium levels. Conversely, a noncompetitive banking system may fail to raise deposit rates of interest to those comparable with the rate of inflation while simultaneously raising its profit margin by increasing the spread between lending and deposit rates. In this latter instance temporary floors for deposit rates and temporary ceilings for lending rates may be helpful.

  • (ii) Higher lending rates, whether or not subject to “overshooting,” lead in turn to higher operating costs for the productive sectors. To be sure, these costs are substantia) only for those activities that rely heavily on large amounts of borrowed funds. Those producers that are forced to absorb the cost increases, because of international competition or domestic regulations, may face losses or even bankruptcy. This tendency is reinforced by the burden of the higher interest loans used to roll over previous loans to finance projects whose nominal yields have not increased. To the extent that short-term borrowing was used to finance long-term projects during the period of interest rate repression, the average maturity of firms’ liabilities will be lower than that of their assets. This discrepancy between the maturities of assets and liabilities generally results in liquidity problems for the firms. On the one hand, those producers that are able to pass on their increased costs to their customers will do so. This increase in prices will be reflected in the price indices and, therefore, may mistakenly be perceived as an intensification of inflationary pressures at a time when anti-inflationary policies are just taking hold; this effect of higher interest rates is often cited by the authorities in member countries. On the other hand, losses lead to bankruptcies that tend to raise the proportion of bad loans in banks’ portfolios and. therefore, tend to increase the spread between the lending and deposit rates of interest.

  • (iii) The central bank, being the guardian of the financial system, may feel obliged to subsidize banks and other financial intermediaries on a long-term basis until their low-yielding assets are liquidated. There may also be a strong temptation for the authorities to maintain preferential interest rates for key sectors. The resulting monetary expansion could add to inflationary pressures and thereby nullify some of the positive effects expected from the change in interest rates. This effect, however, will not be serious if the increase in demand for domestic financial assets—induced by higher interest rates—is sufficient to absorb the monetary expansion or if the fiscal deficit is correspondingly reduced.

  • (iv) To the extent that there is overshooting of interest rates on new credits, borrowing for investment may be discouraged, especially if it is expected that interest rates will eventually fall. This possibility is particularly relevant when the credibility of stabilization efforts is in doubt, and the policy measures, specifically the interest rate reforms, are perceived as being transitory. With the expectation of renewed repression of interest rates over the medium term, businesses will be reluctant to undertake any new borrowing and will defer their investment plans, thereby exerting a contractionary impact on output that may be significant when interest rate reform is accompanied by demand-restrictive policies.

  • (v) High domestic interest rates are an incentive to borrow from abroad, provided that differentials between domestic and foreign interest rates remain in excess of the expected rate of depreciation of the domestic currency. Such borrowing may be carried out directly by firms or individuals or with the assistance and guarantees of local financial institutions. Alternatively, domestic banks themselves may borrow abroad and on-lend to their domestic customers. Adding to the resulting capital inflow is the often substantial repatriation of foreign assets owned by residents.32 To the extent that these forms of capital inflow occur, the initial rise in loan rates will be dampened. At the same time, however, such capital inflows may at times be excessive and thereby face the monetary authorities with the difficult choice of either permitting the exchange rate to appreciate, which complicates the task of structural adjustment, or purchasing foreign exchange from the public, which may interfere with their efforts to reduce the rate of monetary expansion. This danger is acute, however, only for countries where there is an initially severe degree of interest rate repression and residents are permitted to engage in foreign borrowing. Furthermore, a large part of the increase in capital inflows may be absorbed by the increase in demand for domestic financial assets caused by changes in interest rates and the monetary authorities may, to some extent, be able to sterilize the capital inflow. Nevertheless, the authorities may find it necessary in such circumstances to limit by guidelines or direct restrictions the volume of foreign borrowing.

In countries where comprehensive reform measures were adopted, some of these problems emerged in varying degrees of severity. For example, it is widely recognized that Chile experienced the overshooting problem and the associated developments, particularly excessive foreign borrowing, following the liberalization of interest rates. In 1977 and 1978 ex post real interest rates were very high. Although it could be argued that these rates were appropriate ex ante, owing to high inflationary expectations, the interest rate differential in favor of Chile far exceeded the rate of depreciation of the peso—which was being strictly limited in order to dampen inflationary expectations—and stimulated excessive foreign borrowing. In order to prevent such foreign borrowing from becoming a destabilizing force, the authorities were compelled to impose controls on capital inflows. In Argentina the increasing spread between the lending and deposit rates of interest following interest rate liberalization was of concern to the authorities. In an attempt to reduce the spread, the Central Bank undertook to pay interest on some of the required legal reserves. As a result of successful implementation of this policy, the spread was reduced significantly in a relatively short period.33

27

In practice, interest rate repression often coexists with highly protectionist trade policies and overvaluation of the domestic currency.

28

For a more formalistic analysis of the coordination of interest rate policies with other stabilization policies, see Mathieson (1980), where the optimal combination of stabilization policies and interest rate reform is discussed.

29

For an exposition of some of the issues involved, sec Kapur (1976). Using a model that incorporates financial markets, he argues that stabilization through an initial increase in nominal interest rates has more favorable output effects in the short run than stabilization through an initial tightening of monetary policy.

30

See, for instance, the estimates of Khan (1974) with respect to capital movements in Venezuela.

31

Although import liberalization is a purely discretionary action not directly related to interest rate policies, the shortages of foreign exchange, imported raw materials, and intermediate products, and the resulting unemployment usually preceding the initiation of an adjustment program almost always force the authorities to adopt policies of liberalizing imports as a necessary step to increasing investment.

32

It must be pointed out that at the onset of liberalised interest rate policies some of the large capital inflows that take place are the result of a portfolio reallocation. In the longer run, as the interest rale differential is maintained, capital inflows will decline toward a level representing the share of new savings being directed toward the home country.

33

Nevertheless, the Argentine authorities found it difficult to cope with the larger problems of coordinating exchange rate and interest rate policies; these problems are described in Appendix II.

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