High Real Interest Rates Under Financial Liberalization
Is there a Problem?
Author: Vicente Galbis1
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Concerns were raised beginning in the 1980s about the possible detrimental effects of high positive real interest rates under financial liberalization. Using a sample of 28 countries that underwent financial liberalization since the 1970s, the paper examines the evidence about the emergence of high real interest rates and discusses the possible causes and likely effects. Some remedies--preferably preventive--are considered including macroeconormic stabilization, fiscal consolidation, improvements in prudential regulation and supervision of the financial sector, and introduction of an efficient management of indirect monetary policy instruments.

Abstract

Concerns were raised beginning in the 1980s about the possible detrimental effects of high positive real interest rates under financial liberalization. Using a sample of 28 countries that underwent financial liberalization since the 1970s, the paper examines the evidence about the emergence of high real interest rates and discusses the possible causes and likely effects. Some remedies--preferably preventive--are considered including macroeconormic stabilization, fiscal consolidation, improvements in prudential regulation and supervision of the financial sector, and introduction of an efficient management of indirect monetary policy instruments.

I. Introduction

In the 1980s, concerns about the inefficiency effects of financial repression policies leading to negative real interest rates gave way to opposite concerns about the possible detrimental effects of high real interest rates under financial liberalization (Diaz-Alejandro, 1985; Galbis, 1987). These new concerns gave rise to a new “Washington consensus” about the proper objective of financial sector policies--to achieve positive real interest rates that are as close as possible to a zero real level (Williamson, 1990a, 1990b). The new paradigm rests on evidence that, under some conditions, financial liberalization could be associated with excessively high real interest rates that could choke an already indebted corporate sector, sending a wave of bankruptcies throughout this sector and, in turn, throughout the financial sector, leading thereby to an economic crisis. Behind this, there is the idea that developing countries could be more vulnerable than developed ones to financial instability under financial liberalization because of the narrowness of their financial markets, their lack of effective, market-based monetary policy instruments, their difficulties in exercising a proper degree of supervision over the financial system, and other structural impediments. It was pointed out, in particular, that some combinations of stabilization and reform policies could--especially under high and variable inflation and under the difficult structural conditions of the developing countries--lead to high real interest rates and to the consequences thereof.

With the advantage of hindsight, now that a very significant number of countries have undertaken financial liberalization, it would seem appropriate to reexamine the evidence of past experiences and to add some of those that have taken place more recently. The first set of issues that arises is whether, in fact, the perceived problem of high real interest rates is a widespread one, and whether it is only temporarily associated with the transition to financial liberalization or is also associated with post-liberalization systems. Another important set of issues is that of the likely effects of high real interest rates. Are high real interest rates necessarily detrimental? There is also the related issue of whether the problem, when it arises, is avoidable by changing the sequence of stabilization and liberalization measures, for instance, delaying the implementation of interest rate freedom until the structural impediments can be overcome and market-based policy instruments can be developed. There is, finally, the issue of what remedial measures can be undertaken to ameliorate the problem once it has manifested itself in the interplay of the market, short of undoing financial liberalization. An answer to these questions could help not only the authorities of countries that are currently struggling with problems resulting from financial liberalization but also those contemplating financial liberalization in the future.

Section II discusses the transition toward financial liberalization in a sample of 28 countries since the 1970s, and it examines the evidence about the emergence of high real rates of interest, or the lack thereof. The possible causes for the emergence of high real interest rates in many of the sample countries during some periods are reviewed in Section III. An analytical distinction is made of cases of inflationary expectations, perception of exchange rate risk, the existence of a wrong mix of monetary and fiscal policies, and the oligopolistic behavior of the financial system and distress borrowing. Section IV discusses the possible effects from observed high real interest rates on reducing investment and the rate of economic growth, inducing corporate and financial sector distress, prompting destabilizing (excessive) capital inflows, and causing an explosion in the growth of domestic government debt. Some suggested remedies are considered in Section V, and a preference is expressed for adequate preventive measures over treatment, the latter becoming unfortunately necessary when it is too late. In general, these measures follow from the examination of the causes and effects of high interest rates in the previous sections. Finally, Section VI summarizes the main findings and conclusions.

II. The Record

Many countries have made the transition to a system of market-based interest rates, including not only virtually all the developed countries but also an increasing number of developing ones. It would be impossible to cover the complete experience of the world; this paper, therefore, focuses on a selected sample of 28 countries (Table 1). The choice of countries has been governed by several factors, the primary one being the desire to cover mainly the experience of developing countries, on the assumption that these countries are more likely to suffer from disequilibrium problems. Only two developed countries, Spain and the United States, have been included by way of comparison with the developing ones. Another factor in the choice of countries has been the hope to capture the most relevant experience not only of those countries that have made the transition to full interest rate freedom, but also of others that have made significant progress toward liberalization through progressive interest rate deregulation or through a more flexible, albeit direct management of interest rates. Consideration has also been given to selecting countries on a wide geographical basis and on the basis of very different initial economic conditions.

Table 1.

Interest Rate Liberalization in Selected Countries

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The Central Bank of West African States (BCEAO) of the West African Monetary Union (WAMU), to which Benin belongs, abolished its preferential discount rate in October 1989. However, bank interest rates continued to be subject to regulation by the BCEAO (see also Côte d’Ivoire).

The regulatory framework is one in which financial institutions can freely determine interest rates but it also allows for indexation of some financial instruments and for many subsidized loan interest rates. Changes to monetary correction formulae have often been used by the authorities as an instrument to affect the rates. In March 1975 interest rates on time deposits and bills of acceptance were freed.

In October 1990, the Central Bank of Central African States (BEAC) of the Central African Monetary Union, to which Cameroon belongs, eliminated the BEAC’s preferential lending rates, simplified the interest rate structure, and increased its power to determine interest rate policy with a view to inducing greater flexibility in interest rates.

In January 1980, interest rates on term deposits were freed; lending rates were also freed, except for those on directed credit, and those of savings and loan associations, which have indexed rates. The Colombian Government has tried from time to time to control interest rates, usually without success. Interest rates are mostly freely determined--with occasional intervention by the Government--by a loose but effective lenders’ cartel that operates through the banking association.

Interest rates were freed in August 1986, but there remained a limit of 10 percentage points on the spread between lending rates and the rate paid on six-month deposits. This percentage was reduced to nine in 1987 and later eliminated, when a restriction was introduced to the effect that the minimum lending rate should be equal to the six-month deposit rate.

Note 1 on Benin also applies here, as Côte d’Ivoire is another member of the WAMU.

On January 1, 1989, interest rates on household deposits became more flexible; deposit interest rates on maturities of over three years were freed; other household deposit rates remained subject to two general ceilings: 12 percent for deposits of less than one year, and 20 percent for those between one and three years. For enterprises, interest rates on deposits were freed in January 1987, and those on loans in July 1987.

Interest rates were free from Bank of Jamaica direction since the early 1970s, except for a minimum rate on savings deposits and a maximum rate on mortgage rates for housing. Interest rate policy became more active in October 1985, when Bank of Jamaica certificates of deposit were introduced to provide an additional instrument, besides Treasury bills, of open market operations and to influence market rates. The ceiling on mortgage rates was lifted in mid-1985. The floor on the savings deposit rate was abolished in October 1990.

Although the Korean financial system underwent substantial changes during the 1980s, moving away from the highly regulated framework of the 1970s, interest rates were not effectively freed; two attempts to free the rates, one in the early 1980s and the other in December 1988, were halted. A program for full liberalization was announced in August 1991 to begin in December 1991 and to be implemented through 1996.

Interest rates on deposits and loans of commercial banks were freed in October 1978. An interbank rate mechanism was introduced in late 1981, under which each individual bank announces its own base lending rate (BLR) in line with its costs of funds. Since November 1983, all lending rates of commercial banks became pegged to the BLR.

Interest rates were freed in November 1981, with the only remaining regulatory requirement being the announcement of a minimum interest rate on savings deposits. (This interest rate floor was removed in 1988.) Considerable moral suasion is employed to keep loan rates within certain limits.

In March 1985 interest rates payable on one- and three-month deposits increased by 7 to 8 percentage points, in connection with the beginning of the placement of monetary regulation deposits by the Bank of Mexico. Concerned about the rise in interest rates and in the aftermath of the earthquakes, the authorities tried to lower the rates by some administrative measures, including the change in the auction system. The attempt to administer interest rates failed and was followed by increasing reliance upon the market mechanism in determining interest rates. The system of auctions of securities that was suspended since November 1985 was reinstated in July 1986.

On May 29, 1986, the authorities introduced a reform of interest rates, which allowed banks freely to set deposit rates equal to or above minimum rates and freed all lending rates (except for a maximum lending rate of 15 percent for loans to priority sectors).

On July 31, 1987, the Central Bank removed controls on interest rates, and raised the rediscount and treasury bill rates by 4 percentage points, to 15 percent and 14 percent, respectively. In November 1989, an auction-based system for the issue of Federal Government treasury bills and treasury certificates was introduced, but the rate continued to be influenced by a reservation price set by the Central Bank.

Ceilings on all deposit rates were lifted in July 1981; those on medium- and long-term lending in October 1981. The ceiling on short-term lending rates was eliminated at the end of 1982.

On April 1, 1990, the Government increased interest rates on loans to economic units to a uniform level of 5 percent which was above the highest previous level. Interest rates on all enterprise deposits were raised to a uniform 3 percent. On April 1, 1991, the National Bank of Poland freed all interest rates.

The rigid system of fixed interest rates and fixed differentials that prevailed for decades was replaced by a single maximum lending rate of 31 percent on July 25, 1991.

In March 1990, the remaining interest rate ceilings on time deposits (those with a maturity of one year and below) were abolished. At the same time, the maximum interest rate for loans was raised from 15 percent to 16.5 percent.

As part of the 1980 stabilization program, interest rates on time deposits were substantially deregulated. Following this action, time deposit rates were determined through a “gentleman’s agreement” among commercial banks. However, in December 1983, the authorities retook control over interest rates. In July 1987, as an initial step toward interest rate liberalization, interest rates on 12-month deposits were freed; this lasted until early 1988 when controls were re-established. Other attempts at deregulation were made subsequently.

On July 1, 1988, the Government introduced an across-the-board increase of 10 percentage points in most interest rates as part of its new economic program for 1988/89.

The Government freed interest rates in August 1981, but a new government re-established administrative control of interest rates in 1984. Another government increased and freed the rates in February 1989, but one month later the Supreme Court forced the Central Bank to set limits on interest rates; the limits were set at high (probably non-binding) levels.

Many countries, especially those that have moved only recently to liberalize interest rates, have been excluded from this paper for lack of enough relevant experience, or because of the difficulty of obtaining adequate information, or simply because their experience was not too different from that of countries that are included. 1/ However, occasional reference is made, as appropriate, to these additional countries, particularly to those that have been covered in previous studies. 1/

1. Movement toward financial liberalization

In this paper, financial liberalization is not quite synonymous with market determination of interest rates; there is a difference between the two, which may be illustrated by the following examples. In some countries where interest rates are legally free to be determined by market participants, the rates may nevertheless be substantially sticky because of the existence of an inefficient market structure, or because of non-interest rate financial regulations or because of strong moral suasion. By contrast, in other countries interest rates may be comprehensively regulated, yet flexibly adjusted to approximate market conditions. Also, the existing interest rate regulations may be nonbinding, as in the case of legal interest rate ceilings that are well above any possible market-determined rates, or in the case of very low legal floors on interest rates.

More important, financial liberalization generally encompasses a range of policies that go well beyond the formal freedom of financial institutions to determine interest rates. These policies include arrangements to spur financial market competition, such as freedom of entry of new financial institutions, as well as orderly exit of failing institutions; the limitation of reserve liquidity and portfolio requirements to what is necessary for the proper conduct of monetary policy and prudential regulation and not, as it is frequently the case, to capture concessionary resources for the government; and the elimination of preferential credit by the central bank or official banks at concessionary interest rates. At the same time, financial liberalization needs to be accompanied by stronger prudential regulation and supervision of financial institution, increased market information, and better enforcement of consumer protection regulations; these policies are needed for an efficient and stable financial market within which interest rates may reflect market conditions. On the international side, financial liberalization is associated with the dismantling of capital controls to allow for market-determined financial transactions between residents and nonresidents. The removal of capital controls, and the opening up of the market to foreign financial institutions, can have a decisive influence on the behavior of domestic financial markets and, therefore, on the determination of domestic interest rates.

The sample of countries chosen for this paper permits analysis of the interactions between interest rate freedom and some of the broader features of financial liberalization. This is important because the sequence of interest rate measures in the overall financial liberalization program may significantly affect the success or failure of the program.

It is also important to see financial liberalization in the broader context of macroeconomic adjustment and structural reforms, because of the significance of other policies for the results of financial liberalization. The sequencing of financial liberalization within the overall program of stabilization and structural reforms in such other areas as prices, wages, and exchange and trade will significantly affect the prospect for success or failure.

The following discussion distinguishes the experience of countries which achieved full interest rate freedom from that of other countries that retained a degree of interest rate control within a liberal framework. Appendix I contains two statistical tables on the discount, deposit and lending rates for the sample of 28 countries. Appendix I, Table I shows the rates for the 1980s, whereas Table I.A shows the rates for the 1970s for those countries that liberalized their interest rates at some time during the decade or that favored a high interest rate policy by discretionary action (Korea), and for the United States. To facilitate the analysis, an asterisk is used for each country to mark the year in which interest rates were freed, as per the information in Table 1.

Full liberalization

The following 14 countries in the sample may be regarded as having achieved full interest rate freedom: Argentina, Bolivia, Brazil, Chile, Hungary, Jamaica, Mauritius, Mexico, the Philippines, Poland, Romania, Spain, United States, and Uruguay. Of these, seven countries switched relatively quickly from a state of financial repression to full interest rate freedom: Argentina, Bolivia, Chile, Hungary, Poland, Romania, and Uruguay. The others either staged the liberalization through a long program or did not suffer from chronic repression before the liberalization was undertaken.

The early and dramatic liberalizations in the Southern Cone countries are the examples more frequently examined in the literature: Chile (1975), Argentina (1977) and Uruguay (1979). To date, they remain probably the most controversial. Similar liberalizations, undertaken in an atmosphere of urgency, were those of Bolivia (1985), Poland (1990), and Romania (1991). In all these cases, a severe state of inflation and financial repression prevailed before the measures were taken to lift administrative controls on interest rates.

In Chile, interest rate liberalization was accomplished in one year from May 1974, in the midst of a severe inflation and an attempt at stabilization. First, all previous deposit interest rate ceilings on nonindexed instruments with a maturity of less than one year were replaced by an overall ceiling of 200 percent for commercial banks, and up to 50 percent more for investment banks, thereby ending the quasi-monopolistic position of the system of savings and loan associations (SINAP) in the attraction of funds by means of partially indexed rates. In November 1974, the interest rates on time deposits of all banks were freed, a measure that induced massive withdrawals from SINAP, which quickly became bankrupt. Despite this difficulty, the remaining 200 percent ceiling on the savings deposit rate was eliminated in April 1975, and this completed the liberalization of interest rates.

Argentina undertook an early experiment in partial interest rate liberalization in February 1971, which ended within a year when, under the prospect of rapid withdrawals from banks in favor of liberalized nonbank intermediaries, the Central Bank reimposed uniform ceilings on all financial intermediaries. In 1975, under a rapidly escalating inflation, the Central Bank of Argentina first increased all interest rate ceilings and then freed all rates, except for a 40 percent ceiling on banks’ savings deposits (raised to 55 percent in September 1976). However, this remaining ceiling was still quite constraining, given the prevailing rate of inflation. In June 1977, the ceiling was finally removed, resulting in a substantial increase in short-term interest rates.

The liberalization in Uruguay started in April 1976, at the same time that an effort was made to reduce inflation. All peso-denominated deposit rates were freed, and all graduated loan interest rate ceilings were replaced by a uniform ceiling of 62 percent, signaling the intention of the authorities to move toward complete liberalization. This was achieved de facto one year later when the authorities further raised the loan interest rate ceiling to 90 percent, whereas inflation continued to decline. The ceiling on interest rates, which was increased again in 1988, was not formally removed, however, until September 1979.

The “big-bang” liberalization of interest rates in Bolivia in August 1985 was undertaken in connection with the introduction of a comprehensive program of stabilization and structural reform, which was designed to stop a severe hyperinflation and to return the economy to positive economic growth (Sachs, 1986). All interest rates were simultaneously set free in the financial markets for transactions in both Bolivian pesos and foreign currency (Juan J. Cariaga, in Williamson 1990b, p.48). Nominal interest rates on peso deposits dropped sharply from the levels prevailing during the hyperinflationary period, staying initially at negative real levels. This situation changed beginning in 1987 when inflation fell further and nominal interest rates remained relatively high, thereby resulting in relatively high real interest rates on peso-denominated deposits and loans. Dollar-denominated instruments in the domestic market also had interest rates well above U.S. and Eurodollar interest rates. (Calvo and Guidotti, 1991.)

Hungary achieved interest rate liberalization during its more recent spate of reforms for transition to a market economy. For enterprises, interest rates on deposits were freed in January 1987, and those on loans in July 1987. For households, interest rates on deposits with maturities of over three years were freed in January 1989; other household deposit rates remained subject to two general ceilings: 12 percent for deposits of less than one year, and 20 percent for those between one and three years. In January 1990, interest rates on household sector deposits of more than six months were freed. Finally, on January 1, 1991 the remaining ceiling on the rates of household deposits of less than six months was eliminated (Boote and Somogyi, 1991).

At the beginning of 1990, Poland embarked on an ambitious program of stabilization and structural reform in connection with which the National Bank of Poland (NBP) began a policy of maintaining interest rates that were positive in real terms with reference to projected (core) inflation. The refinance rate, which became the benchmark for the structure of interest rates, was flexibly moved with projected inflation. Banks were permitted to set deposit and loan rates freely, but were influenced by strong moral suasion. When, beginning in February 1991, large spreads emerged between lending and deposit rates, the NBP began to “advise” the state banks to lower their spreads, but this policy was rescinded from November 1991.

Similarly, in Romania the authorities moved quickly to liberalize interest rates in connection with a program of stabilization and structural reform. In April 1990, the provisional government simplified the structure of interest rates and moderately increased their level. When this measure proved to be insufficient, and also partly for consistency with the new flexible exchange rate policy, the authorities freed all interest rates on deposits and lending in April 1991 (Demekas and Khan, 1991).

The transition to full interest rate freedom in the remaining countries was less dramatic and, in some cases, simply involved a formal recognition of the de facto situation that generally prevailed before the liberalization. The experience of Brazil is unique among these countries in that it involved a transition from widespread indexation to liberalization. Brazil was the Latin American champion of indexation policies from the time of their inception in 1965 until 1975, when interest rates on time deposits were freed (although indexation for many instruments remained freely negotiable). One of the reasons for abandoning mandatory indexation was the insufficient increase in interest rates under rapidly escalating inflation because of the lag in the indexation formula. Furthermore, liberalization was considered to be more consistent with a new monetary policy framework in which open market operations would play a larger role. The move to interest rate freedom was preceded by signals from the authorities about their desire to see interest rates rise by taking discretionary measures twice in 1974 to increase ceiling rates and to align the structure of rates to reflect market forces.

The two industrial countries included in this paper moved to full liberalization in a programmed fashion, which was particularly slow in the case of Spain. Liberalization of interest rates in Spain started in 1969, received a big impulse in 1974-77 for maturities of more than one year, and was completed in March 1987. Because Spain had occasional bouts of double digit inflation, ceiling rates at times effectively constrained interest rates to be negative in real terms. By contrast, in the United States, the timing of interest rate liberalization largely prevented interest rate ceilings from becoming effective constraints on the behavior of the financial system. Its formal liberalization of interest rates started on March 31, 1980 when the President signed into law the Depository Institutions Deregulation and Monetary Control Act, which, inter alia, provided for the elimination over a period of six years of all Regulation Q ceilings on interest payments on time and savings deposits. The period of lifting these regulations (1980-86) coincided with a substantial increase in nominal interest rates to double-digit levels, which was without precedence in the history of the country.

In Jamaica, interest rates were free since the early 1970s except for a minimum savings deposit rate (abolished in October 1990) and a ceiling on mortgage lending rates for building societies (removed in mid-1985). An important change in the conduct of interest rate policy occurred in October 1985, when the Bank of Jamaica introduced its own certificates of deposit, which, together with treasury bill operations, became a main instrument to influence market interest rates.

In Mauritius, interest rates were substantially liberalized in November 1981, with the only remaining regulation being the announcement of a minimum interest rate on savings deposits; this floor was abolished in 1988. Following liberalization the authorities employed considerable moral suasion to keep loan rates within certain limits, but with a view to maintaining generally positive loan and deposit rates in real terms. Another factor influencing the interest rate structure was the agreement among the member banks of the Mauritius Bankers Association to limit movements in the rates.

In Mexico, despite the existence of interest rate ceilings, interest rates were traditionally influenced by market forces, especially by interest rates in the United States, given the relative freedom of capital movements of the Mexican economy. This policy worked well until 1973 when the combination of a two-digit rate of domestic inflation and a diminishing confidence in the value of the Mexican peso tended to create a problem of capital outflows. The authorities reacted by increasing the ceiling rates and by liberalizing the right of residents to accept U.S. dollar -denominated deposits, which accentuated the dollarization of the Mexican economy. Further steps were taken in the 1980s to ensure that market forces would play a larger role than in the past in the determination of interest rates. In December 1984, the Bank of Mexico began to conduct open market operations with government securities (treasury bills). In March 1985, in connection with the beginning of the placement of monetary regulation deposits by the Bank of Mexico, interest rates on deposits were increased substantially and became primarily market - determined. Following a failed attempt to readminister interest rates in late 1985, the Bank of Mexico reinforced the policy of interest rate freedom, and in July 1986 resumed the auctions of government securities that had been suspended since November 1985.

In the Philippines, ceilings on all deposit rates were lifted in July 1981; those on medium-and long-term lending in October 1981. The remaining ceiling on short-term lending rates was eliminated at the end of 1982.

Flexible framework

The countries in this group varied widely in their approach to financial liberalization. In some cases, as in Korea, Turkey, and Venezuela, attempts formally to free the rates did not materialize, although in Korea the general direction of policy and the underlying regulatory framework favored flexible rates.

The three countries in the African French zone examined in this paper--Benin, Cameroon and Côte d’Ivoire--all had a similar experience, which also essentially applied to the other members of their respective monetary unions. The Central Bank of West African States (BCEAO) of the West African Monetary Union (WAMU), to which Benin and Côte d’Ivoire belong, further liberalized interest rates in October 1989 by abolishing its preferential discount rate. However, bank interest rates continued to be subject to regulation by the BCEAO. In regulating the rates, the BCEAO took into account, in particular, the special relationship of the WAMU to France. Similarly, in October 1990, the Central Bank of Central African States (BEAC) of the Central African Monetary Union, to which Cameroon belongs, eliminated its preferential lending rates, simplified the banks’ interest rate structure, and undertook to determine interest rate policy with a view to greater flexibility in the rates, especially taking into account the special relationship with France.

Nigeria activated interest rate policy in May 1986 by raising the existing ceiling on lending rates. The Central Bank prescribed new interest rates with effect from January 1, 1987, but it kept the maximum lending rate at 15 percent. On July 31, 1987, the Central Bank of Nigeria removed controls on interest rates and raised the rediscount and treasury bill rates by 4 percentage points, to 15 and 14 percent, respectively. In November 1989, an auction-based system for the issue of Federal Government treasury bills and treasury certificates was introduced, but the rates on these securities continued to be influenced by a reservation price set by the Central Bank.

Tanzania, and Uganda without formally freeing interest rates from central bank control, made significant moves to increase interest rate flexibility and allow interest rates to move to positive real levels. In Tanzania, in July 1991, the authorities replaced the rigid system of fixed interest rates and fixed differentials that had prevailed for decades by a single maximum lending rate of 31 percent. The government of Uganda introduced on July 1, 1988 an across-the-board increase of 10 percentage points in most interest rates as part of its new economic program for 1988/89.

Significant interest rate liberalization was undertaken by Colombia and Costa Rica in a framework of relatively good overall economic stability. In Colombia, in January 1980, interest rates on term deposits were freed; lending rates were also freed, except for those on directed credit, and those on savings and loan associations, which operated on the basis of indexed rates. The Colombian Government tried subsequently from time to time to dictate interest rates, usually without success. Interest rates were substantially influenced by a loose but effective lenders’ cartel that operated through the bankers association. In Costa Rica, the policy of controlled but relatively flexible interest rates was replaced by interest rate freedom in August 1986; there remained only a limit of 10 percentage points on the spread between lending rates and the rate paid on six-month deposits (reduced to 9 percent in 1987 and later eliminated). A remaining restriction was introduced, however, to the effect that the minimum lending rate should be equal to the six-month deposit rate.

In different periods, Malaysia, Nepal and Thailand formally moved to market-based interest rates, but institutional factors reportedly continued to have an influence on the flexibility of the rates. In Malaysia interest rates on deposits and nonpriority loans of commercial banks were formally freed in October 1978, but remained significantly influenced by the behavior of a few large banks. An interbank rate mechanism was introduced in late 1981, under which each individual bank announced its own base lending rate (BLR) in line with its cost of funds. From November 1983, all lending rates of commercial banks were pegged to the BLR, which applied to the banks’ prime customers. In Nepal, on May 29, 1986, the authorities allowed banks freely to set deposit rates at or above minimum rates, and freed lending rates (except for a maximum lending rate of 15 percent for loans to priority sectors). In Thailand, the authorities introduced significant financial market reforms designed to increase the flexibility of interest rates much before freeing the rates in March 1990. Since 1979 the repurchase market in government securities became the main channel for the Bank of Thailand’s open market operations. In 1987 the Bank of Thailand initiated sales of its own bonds to mop up bank liquidity. An initial step in interest rate liberalization was taken in June 1989 when the interest rate ceiling on time deposits with a maturity of more than one year was lifted. In March 1990 interest rate ceilings on time deposits with a maturity of one year and below were abolished. At the same time, the maximum interest rate for loans was raised from 15 percent to 16.5 percent (and to 19 percent in November 1990).

Korea, Turkey, and Venezuela made attempts at interest rate liberalization without achieving the ultimate goal of formally freeing the rates. Korea offers an important example of successful flexible adjustment of interest rates by discretionary action rather than by the free interplay of market forces. The highly regulated Korean financial system of the 1970s evolved in the 1980s into one in which market forces played a somewhat greater role. There was a gradual change in interest rate policies in an environment of restrained financial policies and effective controls on cross-border capital transactions. Two attempts at interest rate liberalization, one in the early 1980s and the other in December 1988, were halted in the face of developments that the authorities considered to be undesirable. Under a new program for full interest rate liberalization that was announced in August 1991, interest rate deregulation began in December 1991 and is to be completed by 1996.

In Turkey, as part of the 1980 stabilization program, interest rates on time deposits were deregulated. Following this action, time deposit rates were determined through a “gentlemen’s agreement” among commercial banks, although at times rates rose above those sanctioned in the “agreement”. In January 1983 the authorities intervened to modify the system by requiring that the nine largest banks would be bound by the agreed rates, whereas the others were allowed to pay a premium of up to 2.5 percent above the agreed rates. As time deposit rates rose to relatively high levels while lending rates lagged behind, in December 1983 the authorities began to fix the rates once again, this time with a view to adopting a more rational interest rate structure; lending rates remained free (except for preferential rates, which were raised significantly), but the Central Bank was empowered to review and to set deposit rates at least every three months, taking into account the rate of inflation and other relevant developments. In July 1987, interest rates on 12-month deposits were freed again. In early 1988, however, following substantial speculation against the Turkish lira in the foreign exchange market, the authorities reintroduced controls on one-year deposit rates and implemented substantial hikes in interest rates on time deposits. On October 14, 1988, following another foreign exchange crisis, the authorities partially liberalized deposit rates (although a ceiling of 85 percent was imposed shortly thereafter). In November 1988 banks were permitted to change deposit rates up to 1/2 percentage points every two days (prior submission to the Central Bank). In May 1989, the banks were allowed for the first time to offer long-term floating-rate deposits of two- to five-year maturity.

In Venezuela interest rates were traditionally subject to ceilings which at times of rising inflation became an effective impediment to the upward flexibility of the rates. In August 1981 the government largely freed interest rates, but controls were re-established in 1984. Once again, the government increased and freed the rates in February 1989, but one month later the Supreme Court declared the measure unconstitutional and forced the Central Bank to set limits on interest rates; the new limits were set at high (probably nonbinding) levels.

2. Incidence of high real interest rates

It is not possible in general to characterize interest rates as being low or high except in relation to the particular circumstances of the country under discussion. The main circumstances, but by no means the only ones, for judging the adequacy of interest rates are the rate of inflation and the relationship to foreign interest rates, given the rate of depreciation (or appreciation) of the domestic currency in relation to the foreign currency (or currencies) to which comparison is made. As a first approximation, for the purposes of this paper, interest rates are defined as being high if they are positive by three or more percentage points in real terms. 1/ The contemporaneous consumer price index for each country is used as the indicator of inflation, and interest rates on lending and deposits, and interest rate spreads, are deflated using this indicator (for details see footnote 1 to Table 2). The resulting real interest rates and spreads are recorded in Tables 2 and 2A. Table 2 shows the available real rates for all 28 countries in the sample for the period since 1980 to the present, whereas Table 2A shows the rates for some countries during the 1970s. These tables are constructed from the rates in Appendix I.

Table 2.

Real Interest Rates and Spreads, 1980-91

(In percent per annum) 1/

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Source: Based on data from IMF, International Financial Statistics, except where otherwise indicated below. An asterisk over the data indicates the year of liberalization of interest rates.

Calculated by application of the following formula for the real rate of interest: Rt = ((rt - Δp/p)) 100, where rt = per unit nominal rate of interest (for loans and deposits, respectively) and Δp/p = per unit change in the consumer price index. The real spread is calculated as the difference between the real loan rate and the real deposit rate, or in other words, St = ((r - rd)/(1 + Δp/p)) 100, where St = real spread, and r and rd are the per unit nominal lending and deposit rates, respectively.

No price index is available.

Data from 1986 onward taken from Beletin Estadistico. Central Bank of Bolivia (see Appendix I Table I).

No interest rate data are available.

Table 2A.

Real Interest Rates and Spreads, 1970-79

(In percent per annum) 1/

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Sources: IMF, International Financial Statistics; and Galbis, 1979, Table 5, p.357. An asterisk over the data indicates the year of liberalization of interest rates.

See Table 2, footnote 1, for calculation of real rates of interest.

End of series in Galbis, 1979. The Galbis series and those of IFS are not necessarily consistent.

The data show that, in general, the liberalization of interest rates allowed the rates to increase toward positive real levels, although not all countries reached this intended objective. In addition, Korea and Thailand, which did not formally free but managed the rates, maintained positive real rates during most of the years in the last two decades. 2/ As shown in Appendix II, real interest rates increased in 14 of the 16 countries for which reliable data are available before and after the liberalization. The exceptions were Turkey and Venezuela, which suffered reversals in the liberalization process.

The early and rapid liberalizations of the Southern Cone countries-Argentina, Chile, and Uruguay--and that of Brazil led to different outcomes with regard to real interest rates. In Chile and Brazil, interest rates rose to positive real levels from the beginning and stayed high in real terms for many years, whereas in Argentina and Uruguay negative real deposit rates continued to exist for several years after the liberalization. The spreads between lending and deposit rates appeared to have risen in all cases, with the result that real lending rates were positive--including in Argentina and Uruguay--and in some cases they became very high in real terms. These early experiences with financial liberalization in developing countries--especially after the subsequent financial crises in Argentina, Chile and Uruguay--gave rise to the fear that liberalization might lead to high real rates, financial sector instability, and economic difficulties.

In the United States, the phased removal of all ceilings on interest rates during the period 1980-86, coincided with an increase in the rates to high positive real levels--the highest since the Great Depression (World Bank, 1989, page 8). This occurred as nominal rates climbed to unprecedented double-digit figures, while the rate of inflation tended to fall from the peak of 13.5 percent reached in 1980. This behavior of interest rates in the United States had a significant effect on the Eurodollar rates, which tended to be closely aligned with interest rates in the United States. 1/ It also affected the rates in industrial countries with liberal financial markets. 2/ This was not, however, the case in other industrial countries, like Spain, that still retained ceilings on interest rates, coupled with capital outflow restrictions. In Spain, it was not until all rates were freed in 1987--after a very prolonged liberalization process--that they turned positive in real terms.

In Cameroon, Côte d’Ivoire, and Benin, and surely also in the other members of their two respective African monetary unions, real interest rates fluctuated widely as nominal rates stayed basically unchanged while the rates of inflation gyrated. In Cameroon, the real rates on deposits exceeded 5 percent in both 1985 and 1989, but they were negative in many other years. A similar experience is reported by Turtelboom, 1991, in regard to The Gambia (with interest rate liberalization in 1986), Ghana (1987), Kenya (1991), Malawi (1988), and Nigeria (1987). In all these countries, following their respective liberalizations, a tendency was observed toward a rather sticky behavior of deposit interest rates, and toward an increase in the spread between deposit and lending rates (except, perhaps, in Nigeria).

The liberalization of interest rates in Malaysia (1978) and the Philippines (1982), with more sophisticated financial systems than those of the African countries, generally drove deposit interest rates to positive real levels. In Malaysia, positive rates had prevailed even before the liberalization was undertaken, because of its history of relatively low inflation. By contrast, in the Philippines, where inflation was higher and more variable, and where real interest rates had been effectively repressed to negative levels before the liberalization, the freeing of the rates did not produce an equally smooth transition. In 1984, two years after the liberalization, real interest rates still were highly negative, largely because of a climbing inflation rate.

Turkey offers an interesting example of how attempts at interest rate liberalization could be marred by difficulties in the underlying oligopolistic structure of the financial sector and the ineffectiveness of market-based instruments of monetary control (Denizer, 1989). When the authorities first liberalized the rates in 1980, against a background of substantial inflation, there was little movement in the rates--which were determined by a “gentlemen’s agreement” among banks--until 1982. During 1982 and 1983, real deposit interest rates turned highly positive, but lending rates lagged behind so that a negative spread between lending and deposit rates appears to have developed in the market, endangering the stability of the financial sector. 1/ The authorities retook control of interest rates by end-1983 in a concerted effort to stabilize financial markets, although with a view to maintaining positive real interest rates. Under official guidance, the interest rate spread once again became positive, and the administered rates began to trace inflationary tendencies rather accurately. However, following the second experiment in interest rate freedom in 1987, real deposit rates turned negative and stayed negative for several years; the spread seems to have remained positive and large.

Colombia and Mexico formally freed interest rates in the 1980s but with different results. Colombia started a policy of substantial interest rate freedom in 1980 from a situation of relatively low inflation and high ceiling interest rates that in most years had become nonbinding. Furthermore, its savings and loan association system had grown substantially under a policy of indexed rates that were competitive with those of banks and other financial institutions. Following liberalization, the real rates of interest on deposits always stayed at positive levels. 2/ By contrast, in Mexico, because of a combination of highly variable inflation and relatively inflexible interest rates--despite its presumed openness to the U.S. financial market--real deposit rates turned out to be negative in many years both before and after the official liberalization in 1985.

Following Bolivia’s comprehensive stabilization and structural reform program in 1985-86, all interest rates both in pesos and in U.S. dollars moved to high real levels and stayed high thereafter (Calvo and Guidotti, 1991). During the preceding years interest rates had been, predictably, highly negative in real terms as the inflexibility in legal maximum rates contrasted with an accelerating rate of inflation culminating in the 1985 hyperinflation.

Costa Rica, Jamaica, and Mauritius were among the countries with a relatively small economy that moved to interest rate freedom in the 1980s. In Mauritius, the 1981 liberalization of interest rates succeeded in moving interest rates to positive real levels, within a relatively stable financial framework and moderate inflation. Similarly, the 1985 liberalization in Jamaica was successful in establishing positive real rates. In Costa Rica, by contrast, the 1986 liberalization of interest rates did not succeed in making the rates sufficiently flexible to match the rising rate of inflation and, as a result, interest rates in the following three years remained negative in real terms. In contrast to Mauritius and Jamaica, Costa Rica had not developed an effective system of indirect monetary policy instruments consistent with a system of market-based interest rates. In addition, the Costa Rican financial sector continued to be largely dominated by its four publicly-owned commercial banks, with relatively little competition in the financial markets.

In Nepal, Tanzania, Uganda, and Venezuela, interest rates were negative in real terms during most of the period of the 1980s because of insufficient liberalization and institutional problems. In Nepal, the 1986 liberalization did not fully succeed in eliminating financial repression, although rates tended to be closer to inflation after the liberalization and the spreads came down. Similarly, the liberalizations in Uganda (1988) and Venezuela (1989) did not fully succeed in eliminating the negative real rates that had prevailed before liberalization. The case of Venezuela’s financial repression is particularly difficult to explain in light of the substantial connections that are presumed to exist between the Venezuelan financial sector and the financial markets in the United States. The interest rate liberalization in Tanzania (1991) appears thus far to have resulted in an increase in deposit and lending rates to positive real levels.

The interest rate liberalizations in Hungary and Poland--completed in 1991 and 1990, respectively--quickly achieved positive real interest rates. 1/ 2/ By contrast, real rates in Romania continued to be negative, though less so than before the 1991 liberalization.

The rest of this paper retains for further analysis only those countries in the sample for which real interest rate data are available for at least one year after liberalization and which had a positive real deposit interest rate of 3 percent or higher in at least one year following interest rate liberalization. These criteria exclude 8 of the 28 countries as follows: Benin, Hungary, Nepal, Poland, Romania, Tanzania, Uganda, and Venezuela. The experience in some of these cases is too recent to judge the results. The remaining 20 countries, for which there is some evidence on the existence of high positive real interest rates, are examined further in the following sections.

III. Possible Causes

Under financial liberalization interest rates are determined by market forces that affect the supply and the demand for funds, and not by regulation. However, they may be influenced by the authorities through market intervention. In fact, to be consistent with the new policy of liberalization, the authorities will have to switch from direct to indirect monetary policy instruments, which can influence both the volume of credit and money and interest rates (Leite and Sundararajan, 1990; and Wong, 1991). Instead of credit ceilings on individual banks, control of credit and money will be exercised through the flexible operation of rediscounts and open market operations. Market interest rates will thus be influenced by the monetary authorities’ own rediscount rate and by purchases and sales of government securities (mainly treasury bills); in some countries also by issuing the authorities’ own stabilization bonds. The success or failure in the transition to interest rate liberalization will depend, inter alia, on the appropriate development of financial markets and indirect monetary policy instruments. For this reason, ideally the development of these instruments and markets should precede the liberalization of interest rates; otherwise financial liberalization could lead to serious difficulties and the need to reimpose interest rate controls. In all the sample countries that moved to interest rate freedom the authorities, although with greater or lesser success, made anticipatory or parallel efforts to develop market-based monetary policy instruments and to foster the markets and institutions necessary to make these instruments effective.

The success or failure of financial liberalization also may be significantly affected by the macroeconomic and financial conditions prevailing at the beginning of, and during, the liberalization (Villanueva and Mirakhor, 1990; Turtleboom, 1991). A stable macroeconomic environment, with positive economic growth, moderate or low inflation, a stable exchange rate and a sound balance of payments situation, will undoubtedly facilitate the transition to interest rate freedom. A competitive and sound financial sector, with adequate capitalization, good management and sound portfolios will also be essential, and this will be facilitated by a strong system of prudential regulation and bank supervision.

Because the initial macroeconomic conditions, the sequencing of liberalization measures, the degree of financial sector development, and the efficacy of bank supervision can vary from one country to another, the transition to interest rate liberalization can produce different results. Furthermore, the maintenance of appropriate market interest rates is a task that does not end with the liberalization, but that requires permanent vigilance on the part of the monetary and bank supervisory authorities and appropriate coordination of all macroeconomic policies.

There are many possible causes of high real interest rates in financial markets. The most frequently cited, because of their possible negative effects, are the persistence of high inflationary expectations following an attempt at price stabilization; the risk of rapid exchange rate depreciation that will tend to reduce the external value of domestic money balances; the implementation of a wrong mix of macroeconomic policies and, in particular, of fiscal expansion with monetary restraint, perhaps supported also with capital inflow restrictions; the oligopolistic behavior of financial institutions in a concentrated financial market characterized by predatory competition; “distress borrowing” by nonfinancial enterprises resulting in an interest inelastic demand for funds, particularly for working capital, caused by a situation of high leverage combined with uncertain repayment prospects, especially in a generalized economic downturn; and moral hazard resulting from the existence of explicit or implicit deposit insurance without adequate bank supervision.

Another possible cause of high real interest rates (and one that is often overlooked because it does not result in negative effects that need corrective action by policymakers), is a very high genuine demand for investment funds not caused by distressed borrowing. This can result from such factors associated with rapid economic growth as the introduction of new technologies, new productive opportunities made possible by successful changes in the regulatory environment--including the opening up of the economy to the outside world--and reduced pressures on the real cost of labor to enterprise.

These possible causes of high real interest rates are not mutually exclusive, but can be generally reinforcing. A combination of various causes and circumstances would be more likely to lead to high real rates than any single factor. For instance, a country striving to stabilize prices from a high level of inflation during an economic boom by relying exclusively on monetary instruments, and in a situation of financial sector difficulties not countered by appropriate bank supervision, would be likely to experience high real interest rates.

Before going into the examination of the possible causes of high real interest rates in the sample countries, it would be useful to note that temporary and unpredictable shocks can also be a factor in the observed behavior of interest rates. For instance, because of the unpredictability of inflation, particularly in cases of external exogenous shocks, one would expect to observe a market pattern of high real interest rates in years of low inflation, and low (or even negative) real interest rates in years of high inflation, under the assumption that the part of inflation that is not anticipated cannot be offset by movements in interest rates. Real interest rates could therefore be moderately positive on average in the long run, but following a random or unpredictable pattern about the average. Only a sequence of years of high real interest rates would, in general, make a pattern that would require close analysis and examination to see if there was a problem.

1. Inflationary expectations

In many countries, the need to free interest rates from traditional ceilings became particularly acute when inflationary pressures reached a peak, either as a result of domestic policy failure or because of such external factors as the two oil shocks. In these circumstances, the authorities faced the double challenge of reducing inflation by implementing a stabilization program and of liberalizing interest rates to prevent the inefficiencies associated with financial repression. This challenge was not without risk for the behavior of interest rates in the newly liberalized environment. Following liberalization, the tendency would be for interest rates to rise to high nominal levels to offset inflation and--in the absence of complete credibility of the stabilization program--to stay at high levels or to come down only gradually and trailing with a lag the declining rate of inflation. To examine the relevance of this backward-looking inflationary expectations hypothesis in some cases, Tables 3 and 3A show the real deposit rates and the annual inflation rates for the 20 countries of the reduced sample.

Table 3.

Inflation, Exchange Rate Depreciation, and Real Deposit Interest Rates, 1980-1991 1/

(In percent per annum)

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Sources: Based on data in IMF, International Financial Statistics. An asterisk over the data indicates the year of liberalization of interest rates.

Real deposit interest rates from Table 2 above. Rate of inflation based on the consumer price index. Rate of exchange rate depreciation (+) or appreciation (-) derived from end-of-year exchange rate in local currency per U.S. dollar.

On the basis of the U.S. dollar per SDR.