Abstract

(1) Interest rates are an important element in determining the demand for domestic financial assets, the levels of domestic saving and investment, and the current and capital accounts in the balance of payments. Their importance varies among developing countries, however, because of differences in the degree of development of financial markets, the degree of separation of saving and investment decisions, and the extent of freedom permitted to inward and outward capital movements.

  • (1) Interest rates are an important element in determining the demand for domestic financial assets, the levels of domestic saving and investment, and the current and capital accounts in the balance of payments. Their importance varies among developing countries, however, because of differences in the degree of development of financial markets, the degree of separation of saving and investment decisions, and the extent of freedom permitted to inward and outward capital movements.

  • (2) There is widespread reluctance among the authorities of developing countries to permit interest rates to be determined in the market. This reluctance is only partially explained by imperfections in financial markets or the fact that in some countries major financial institutions are state controlled. To a great extent, it may derive from the view that interest rates ought to serve various policy objectives rather than bringing the underlying demand for funds into equilibrium with their supply. For this reason, there has been a tendency for the administered interest rates in developing countries to be lower than current rates of inflation, even when interest rates in international financial markets are strongly positive in real terms. The excess demand for credit generated by these relatively low interest rates is dealt with by a variety of measures to allocate credit by administrative means.

  • (3) Repression of interest rates produces lower rates of saving, of investment, and, hence, of economic growth than would result from equilibrium interest rates, chiefly because domestic financial savings are discouraged in favor of either the accumulation of goods or of foreign assets. The experience of a number of countries confirms the dependence of domestic financial saving on interest rates. Subequilibrium interest rates also encourage businesses to undertake investments with low rates of social return, such as the accumulation of inventories, rather than using their resources to build new plant and equipment. Various selective credit arrangements that accompany subequilibrium interest rates are not likely to improve the overall quality and productivity of investment.

  • (4) Real interest rates that are substantially negative over a protracted period also exert a destabilizing influence over the entire economy. The increase in the velocity of circulation brought about by the reduction in real interest rates tends to increase the excess demand for goods and services and to intensify inflationary pressures, while simultaneously reducing the availability of the credit necessary to Finance investment and sustain economic growth. Repression of interest rates renders the implementation of demand management policies difficult and in some cases impossible. In order to restore economic stability and to attain a sustainable rate of economic growth, interest rates must be raised to positive levels in real terms.

  • (5) When undertaking an interest rate reform under a regime of administered interest rates, the level to which interest rates should be raised is a difficult issue. Although prevailing circumstances may warrant a sharp increase in interest rates, at the same time, care must be taken to avoid excessive increases. Interest rates that are too high tend to lower economic growth by reducing investment demand, even though funds to finance investments may then be available. This consideration is particularly relevant when the interest rate reform is being adopted as part of a comprehensive set of policies of structural adjustment and stabilization. Under these circumstances, it may be advisable to gear interest rates not to the current rate of inflation but to the rate of inflation that is expected to prevail as the new policies take hold. While such a policy might entail real interest rates that are negative for temporary periods, its chances for success would not be jeopardized as long as the degree of negativity was minimal and the negative rates were not maintained for an extended period. For this to be successful, the public should view the authorities as carrying out a program based on realistic objectives, steadfastly adhered to, while sufficient flexibility is maintained to counteract unforeseen difficulties.

  • (6) In the transitional period following the interest rate reform, when the economy adjusts to higher interest rates, a number of short-run problems may emerge that affect both the financial and the real sectors of the economy. These problems are not insurmountable, however, provided that the policies to counter them are adopted rapidly. In any event, the existence of the potential for these problems to emerge should not be viewed as justification for maintaining repressed interest rates.

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