The importance of interest rates in developing economies: and how they affect economic performance

Contributor Notes

Experience suggests that holding down interest rates to stimulate growth is a counterproductive policy.

This paper discusses quantitative indicators that measure such macroeconomic variables as the growth of national product, inflation. The importance of considering several indicators in a dynamic context becomes particularly relevant during periods when needed economic and financial adjustment measures are undertaken. Rationales given for maintaining negative real interest rates in developing countries range from keeping down the cost of servicing the public sector’s debt, or of investment, to avoiding the consequences of other policies.


This paper discusses quantitative indicators that measure such macroeconomic variables as the growth of national product, inflation. The importance of considering several indicators in a dynamic context becomes particularly relevant during periods when needed economic and financial adjustment measures are undertaken. Rationales given for maintaining negative real interest rates in developing countries range from keeping down the cost of servicing the public sector’s debt, or of investment, to avoiding the consequences of other policies.

Anthony Lanyi and Rüşdü Saracoglu

In any economy where the market plays a significant role, interest rates exercise a pervasive influence over economic decisions and performance. On the one hand, they influence the willingness to save; on the other, they influence the demand for and allocation of borrowed funds. Finally—together with foreign interest rates, expected changes in the exchange rate, and the expected rate of inflation—they determine the allocation of accumulated savings among domestic and foreign financial assets and physical assets.

The importance of interest rates for economic decisionmaking varies among developing countries, however, because of differences in the development of their financial markets, the degree of separation of saving and investment decisions, and the freedom permitted to capital movements in and out of the country. For example, interest rates play a less crucial role in countries with large nonmonetized sectors than in highly monetized economies, and have less direct impact in centrally planned than in market-oriented economies. In market-oriented economies, where most saving and investment decisions are taken separately, changes in interest rates (like those in wages and exchange rates) are instrumental in restoring and maintaining balance between demand and supply in goods and money markets, provided that the institutional environment permits such changes. But even in planned economies, or countries with less developed financial markets, the authorities, in order to allocate scarce resources efficiently, still need to take into account both the rates of return on different investments and the social cost of funds used to finance them.

Other factors, such as religious orientation, also affect the role of interest rates. In Islamic countries, for instance, the use of fixed charges on borrowed funds runs counter to strongly held religious beliefs, and in some of these countries forms of financial intermediation based on the sharing of profits and losses between lenders and borrower are being established.

In most developing countries, the interest rates of principal importance are determined administratively, typically through legally imposed limits on lending and deposit rates. (In many, official control is exercised simply through state ownership of some or all of the principal banks.) One reason for controlling rates in these countries is concern over the effects on interest rates of the domination of financial markets by one or two banks. Another may be to offset the effects of other distortions on investment, production, prices, foreign exchange transactions, and foreign trade. In some developing countries, especially in Asia and Latin America, administered interest rates generally follow the movements of rates that would be produced by the forces of supply and demand. In a number of others, however, real interest rates—nominal interest rates corrected for expected price increases—are often negative, sometimes by a substantial margin. (See table, where real interest rates are calculated on the basis of actual inflation rates, because of difficulties in measuring expected rates of inflation.) Negative real deposit rates signify that, in general, physical assets earn a higher rate of return than do savings accounts, and negative real loan rates mean that it is profitable to borrow even when there is a very low rate of return on the uses to which the borrowed funds are put.

Rationales given for maintaining negative real interest rates in developing countries range from keeping down the cost of servicing the public sector’s debt, or of investment, to avoiding the consequences of other policies—such as maintaining a large fiscal deficit and limiting private credit expansion—on interest rates, investment, and growth, and to subsidizing disadvantaged economic groups or regions. The excess demand for credit generated by these low real rates is frequently associated with—indeed, may require—selective credit policies to channel available funds to key industries and sectors.

Rates of interest and inflation in selected developing countries

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Source: Fund staff estimates, unless otherwise noted.

Unless otherwise indicated, the rate on one-year time deposits.

Computed as 100[(1 +l)/(1 +ρ)-1], where i is the nominal interest rate, p is the percentage change in the Consumer Price Index, and both are expressed in decimal form.

The interest rate is the yield on one-month time deposits compounded over the relevant 12-month period. Longer-term rates are unimportant because of the dominance of the shorter term.

The interest rate is the annualized yield on two-year treasury bonds, including interest and monetary correction.

Data, for July 1980 to June 1981 only, taken from International Reports Statistical Market Letter, various issues.

Influence on savings

A development strategy that relies on financial saving as a major source of investment finance requires price and nonprice incentives to stimulate such saving. There is, however, considerable disagreement over the influence exerted by interest rates on the volume of saving. This influence may be dampened by institutional factors, such as the substantial volume of contractual saving in some middle-income developing countries and the fact that in many developing countries large segments of the population have little or no access to financial institutions. Furthermore, in low-income countries there may be little scope for additional long-term private saving. Nevertheless, the available empirical evidence, based largely on the experience of Asian and Latin American countries, suggests that saving is likely to increase with interest rates, especially when rates become positive in real terms after having been maintained by administrative action at substantially negative real levels.

The form in which accumulated savings are held is also of crucial importance in many developing countries. Highly negative real interest rates encourage the public to hold a large proportion of their wealth and place an even larger proportion of their saving out of current income in inflation hedges such as real estate, consumer durables, and foreign currency holdings rather than in the form of domestic financial assets. This preference not only reduces the financial savings available for investment but it also either puts upward pressure on prices (if hedges are domestic goods) or weakens the home currency position in foreign exchange markets (if hedges are foreign goods and assets).

A substantial increase in interest rates to positive levels in real terms, following a protracted period of negative real rates, can be expected to have both short-run and long-run effects. In the short run, an increase in interest rates could cause an immediate once-and-for-all rise in the demand for domestic interest-bearing financial assets and an accompanying fall in the demand for inflation hedges. When a large change in interest rates is involved, this re-allocation of the public’s wealth may result in a substantial rise in the resources available for investment in the short run. Moreover, if the new rates are higher than those abroad—taking expected exchange rates into account—capital inflows will take place and permit the government to liberalize imports, removing a previous barrier to investment. In the long run, the average rate of return on savings will rise and may result in a continuing increase in the ratio of saving to income—provided, of course, that incentives for saving are maintained. The same factors also tend to increase the proportion of new saving allocated to domestic financial assets rather than to consumer goods and foreign financial assets.

There is evidence—for example, from Argentina, Brazil, Ghana, Jamaica, the Republic of Korea, Malaysia, and Turkey during the late 1970s—that the volume of financial savings (measured by broad money) is highly sensitive to the real return on deposits, and that there is some association between an increase in financial savings and satisfactory growth performance. In Ghana, for instance, between 1976 and 1980, interest rates never exceeded 13 per cent, while inflation was at or near the triple-digit range. These strongly negative real rates caused a precipitous flight from banking deposits and a decline in real financial savings. This trend was interrupted only in 1979, when time deposits actually grew slightly in real terms as the rate of inflation fell, causing real returns to rise.

In Argentina, too, in 1976 when real interest rates were strongly negative, time and savings deposits in real terms had practically disappeared, declining by over 70 per cent in 1975. Over the next few years, rates were allowed to rise above inflation, and deposits rose rapidly, more than doubling in real terms in 1977. Meanwhile Malaysia, between 1975-80, had positive real rates, experienced double-digit growth in real time and savings deposits, and maintained a high rate of economic growth.

For a number of years, Brazil and Korea have, on the whole, followed policies of maintaining interest rates in line with inflation—in Brazil, this has been achieved in part by indexation of certain financial assets—although temporary departures from these policies have led to sharp declines in financial savings. Jamaica and Turkey are examples of countries where a recent turnaround in real interest rates, from sharply negative to positive, has had dramatic effects on financial savings.

Influence on investment

As already mentioned, a principal motive for holding interest rates down in developing countries is to stimulate investment. How far does it do this? The answer needs to take into account the impact of interest rates on (1) the volume and (2) the productivity of investment. The discussion of the first issue focuses on investment in plant and equipment rather than inventories. In some situations, it is true, the ability of the economy to operate at full capacity may be limited by a shortage of working capital to finance minimum inventories. Such a situation, however, is not likely to prevail after a protracted period of negative real interest rates, since the latter will already have induced high inventory levels. Moreover, long-run growth depends crucially on the quantity and productivity of fixed investment.

It is often argued that low interest rates in developing countries stimulate the level of desired investment by keeping financing costs low. But at the same time low interest rates tend to discourage financial saving and therefore reduce the funds available for lending, so that desired investment is higher than the realized investment. A rise in interest rates may thus lead to a higher level of actual investment, even if it somewhat reduces desired investment. Moreover, desired investment may be buoyed as expected rates of return improve with the attractiveness of the general economic environment, which is adversely affected by the capital outflows, foreign exchange shortages, and low expected returns to investment projects that frequently coexist with low interest rates.

In addition, low interest rates in an inflationary environment may encourage firms to borrow for inflation hedges; this borrowing is typically incorporated into the demand for working capital and tends to crowd out investment financing. While a change in the rate of inflation generally leaves the relative profitabilities of inflation hedges and fixed investment unaltered, an increase in interest rates is likely to reduce borrowing for hedges and increase that for fixed investment; interest rates on credit for working capital are often liberalized to a greater degree than lending rates for plant and equipment, and the expansion of credit for working capital is likely to be subject to stricter official limits than that for fixed investment.

The argument that lower interest rates for investment finance raise the rate of investment also assumes that additional funds to finance the additional investment would be available; however, when the market mechanism is prevented from functioning by extensive regulation of interest rates, the necessary real credit expansion will not be forthcoming, credit rationing schemes will be needed, and the case is yet to be made that low interest rates thereby actually increase realized investment over a sustained period of time.

These effects may be somewhat dampened, however, by the evolution of alternative sources of funds when market channels become inoperative. For instance, “forced” saving might be generated as inflation redistributes income from low to high savers—in particular from wage earners to recipients of profits. Artificially low interest rates and credit rationing also tend to increase reliance on self-financing of investment and to stimulate the growth of unofficial credit markets, in which interest rates are higher than the official ones. Although these markets perform less efficiently as financial intermediaries than the official banking system—because of their smaller scale and higher risk premia—their operation nevertheless tends to offset and conceal the detrimental effects of interest rate repression. Countries with access to international capital markets, too, can raise additional financing from foreign borrowing—though foreign credits tend to have high interest costs and to be limited in their uses. Finally, higher demand for investment can be financed through increasing government saving, achieved by reducing noninvestment expenditures and by raising both taxes and the prices of goods and services provided by the public sector.

It is thus possible to finance additional investment demand without an increase in interest rates, but this may either require an increased fiscal effort or be accomplished in ways that diminish the efficiency of financial intermediation. If additional real saving is not forthcoming through any of these channels, a portion of the desired investment will simply not occur.

Growth depends not only on the volume but also on the quality of investment. For a variety of reasons, productivity is difficult to measure; here it will be represented by the rate of economic growth realized from a given volume of investment.

In market-oriented economies, private rates of return generally guide a large part of investment decisions. Because they may diverge widely from social rates of return, the authorities frequently administer interest rates and credit allocation to offset this divergence—typically, as has been seen, through low interest rates accompanied by selective credit arrangements. The success of these policies depends crucially on the ability of policymakers to identify important sectors correctly and to control the use of their funds. Neither of these tasks, however, is accomplished easily. Key sectors are hard to identify. There is a lack of reliable data on many important economic activities; the existing price structure is frequently highly distorted by regulations and controls; forecasts are uncertain; and economic judgments are, in practice, often subordinated to social and political pressures—for instance, the frequent inclusion of all public sector activities in the priority category, whether or not justifiable on economic grounds.

Even when economically important projects with high returns are correctly identified, selective credit policies still tend, over time, to lower the overall rate of economic growth, because they bias the allocation of funds toward all projects in certain sectors, even those with low social rates of return. This is not to say, however, that if the allocation of credit were left entirely in the hands of the banking system, efficient allocation of credit would be ensured. Distortions would arise as well-established firms enjoying personal connections with banks would tend to be favored over smaller or newer borrowers, and short-term credit for inventory accumulation might be favored over long-term credit for investment, especially in inflationary conditions. For these reasons, governments often feel obliged to intervene in the allocation of credit, even when there is no need for credit rationing.

As indicated earlier, interest rates significantly below the rate of inflation encourage business to transfer resources into inflation hedges, aggravating the scarcity of funds for productive investment, adding to inflationary pressures, and (in the case of imported inventories) wasting scarce foreign exchange resources. Finally, low administered rates, especially when accompanied by high real wages, bias investment in favor of capital-intensive techniques. The resulting rise in unemployment tends to lower the rate of social return and exacerbate an already severe social problem, while the additional demand for working capital and foreign exchange aggravates existing shortages.

Demand management

Through their direct effect on saving, investment, and the demand for money, interest rates—like wages and exchange rates—also exert a substantial influence on aggregate demand, output, and employment. The levels 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 policy chosen by the authorities is an important factor in determining the appropriate stance of other demand management policies.

Experience has shown that interest rates well below the rate of inflation are accompanied by excess aggregate demand, a rise in the velocity of circulation, an acceleration of inflation, and acute foreign exchange shortages, all of which reflect a reduced demand for domestic financial assets. As the resources of the financial sector shrink, the availability of credit declines while at the same time demand for it increases, owing to negative real interest rates. The emerging credit shortage causes increasing pressure to be brought on the authorities to maintain a high rate of credit expansion at current negative real interest rates, thus sustaining the inflationary process, and also necessitates the allocation of credit through nonprice mechanisms. Ultimately the acceleration of inflation and the rigidities arising out of extensive regulations lead to significant resource misallocations and economic dislocations that reduce the sustainable rate of economic growth.

The fall in the demand for domestic financial assets also has important implications for the balance of payments. Clearly, in a small and relatively open economy, noncompetitive interest rates cannot be sustained. As the demand for domestic assets falls, there will be an increase in the demand for foreign assets and capital outflows may become excessive, especially when the exchange rate is regarded as overvalued, as it frequently is in these cases. Large outflows compound the current account problems arising from lower domestic savings and force the authorities to either increase official borrowing or draw down international reserves. Often they introduce severe restrictions on capital movements, but capital flight typically continues through a variety of clandestine channels, such as overinvoicing of imports and underinvoicing of exports. In tandem with the development of unofficial domestic financial markets, parallel markets in foreign exchange may develop and flourish.

A prolonged period of administered rates that are highly negative in real terms tends to depress economic activity. The banking sector may shrink relative to gross domestic product; the rate of capital accumulation may fall despite a high demand for investment; while much, if not most, of actual investment is financed through unofficial markets or investors’ own funds. Prices tend to rise rapidly because of excess demand, as a result of which (under a regime of fixed exchange rates) the competitiveness of the foreign sector declines, leading to large current account deficits which, coupled with the capital outflows, result in major foreign exchange shortages.

Interest rate reform

It has been argued that interest rates are a key element in both development strategies and demand management policies. Since in developing countries—and in many industrial countries as well—these rates are largely administered rather than market-determined, choice of the level of these rates is a major policy decision. When interest rates are held below their market-clearing levels, and especially if they remain substantially negative in real terms for extended periods, they tend to reduce financial savings and thereby the funds available for lending to investors. Even when investment can be financed through other channels, its productivity tends to decline because of the inefficiencies arising from intermediation through unofficial markets, from selective credit controls, and from the uses to which borrowed funds are put where negative real interest rates prevail. Added to these growth-dampening effects of negative real interest rates are the effects of such rates on economic stability. The decline in the demand for domestic interest-bearing deposits leads to an increase in inflationary pressures and a deterioration in the balance of payments.

The process of correcting interest rates that have become highly negative is not an easy one. Interest rate reform must be carefully coordinated with fiscal, monetary, and exchange rate policies in order to avoid inconsistencies between targeted demand and supply in financial markets, undesired capital movements, and widespread bankruptcies both among firms with large financial liabilities and within the banking system itself. The difficulties of making these necessary adjustments underline the importance of preventing a situation of chronically negative real interest rates from developing in the first place.

Finance & Development, June 1983
Author: International Monetary Fund. External Relations Dept.