During the past two decades, many developing countries have implemented financial liberalization aimed at eliminating credit controls and achieving positive real interest rates on bank deposits and loans. The general objective of this policy was to mobilize domestic savings, attract foreign capital, and improve efficiency in the use of financial resources. Initial economic and financial conditions across countries varied significantly and affected subsequent performance. Nonetheless, certain characteristics were common to the relatively successful cases of financial liberalization. These patterns included the establishment of a stable macroeconomic environment, prudential supervision of the banking system, and the sequencing of stabilization, banking regulations, and interest rate policies. Specifically, those economies that largely avoided the adverse consequences from large-scale financial liberalization—sharp increases in interest rates, bankruptcies of financial institutions, and loss of monetary control—were characterized by stable macroeconomic conditions, a strong and effective system of bank supervision, and a gradual removal of controls on interest rates. How stabilization, prudential supervision, and pace of liberalization affect financial reforms is the focus of this paper.
The particular mechanism for attaining positive real interest rates has tended to depend on individual country circumstances. In some cases there was an outright liberalization or deregulation of interest rates in a short period, whereas in other cases it involved gradual liberalization over the medium run in which frequent adjustments in regulated interest rates were made. Taiwan Province of China, Singapore, and the Republic of Korea (and to some extent, Sri Lanka) engaged in a gradual and flexible management of interest rates that resulted in positive real levels. Chile, Argentina, Uruguay, the Philippines, Malaysia, and Turkey liberalized interest rates within a relatively short period (generally three years or less). Of these, only Malaysia appeared to have avoided any adverse consequences from the liberalization, such as a sharp run-up in real interest rates. In the others in this group, output declined owing to bankruptcies of firms (banks and nonfinancial firms), inflation worsened, and external imbalances widened. These contrasting experiences between the two groups would suggest that, other things being equal, a gradual approach to interest rate reforms is more likely to be successful.
In the past, conventional wisdom was that credit rationing and low interest rates were solely the result of government intervention, and that removal of controls would lead to a more healthy, dynamic, and efficient financial system. Recent literature, however, has significantly increased our understanding of how commercial bank credit markets actually operate, in particular how asymmetric information between lenders and borrowers may lead to efficient credit rationing and optimal interest rates that are below market-clearing levels, even in a competitive, multibank structure and in the absence of interest rate ceilings. We now have a theoretical rationale for why the interaction of macroeconomic instability and inadequate bank supervision (the decision of banks to undertake risky lending in the presence of deposit insurance, sometimes referred to as “moral hazard”) often results in an immediate increase in real interest rates to risky levels. Progress has also been made involving the application of implicit contract theory to bank credit markets, demonstrating the critical importance of stable economic conditions in the smooth functioning of such markets, and showing that bank lending rates in a stable macroeconomic environment tend to be fairly rigid in relation to the (opportunity) costs of loanable funds, such as interest rates on treasury bills, deposits, interbank lending, and so on. Although such analytical breakthroughs have been developed in the context of commercial bank credit markets in the advanced countries (for example, the United States), little effort has been made to apply this analysis to financial reforms in developing countries.
The experiences of developing countries over the last two decades and recent advances in the theoretical analysis of bank credit markets raise the following major questions. What are the respective roles of imperfect information, risk-sharing, macroeconomic instability, and moral hazard in the determination of bank lending interest rates? And what is the appropriate sequencing of interest rate liberalization, macroeconomic stabilization, and financial regulatory policies? This paper is an attempt to address these questions, leading to a reassessment of interest rate policy and financial liberalization strategies.
Section I is in two parts. The first part reviews the recent theoretical literature relevant to interest rate and other financial sector policies. The second part details key policy considerations in the design and sequencing of such policies. Section II re-examines the historical experiences in the Southern Cone countries of Latin America (Argentina, Chile, and Uruguay), several Asian countries, and Turkey, in the light of the theoretical policy discussion. The final section summarizes the analysis and provides some concluding observations.
Arellano, José, “De la Liberalización a la Intervención: El Mercado de Capitales en Chile 1974–83,” Colección Estudios CIEPLAN, No. 11 (December 1983), pp. 5–49.
Atiyas, Izak, The Private Sector’s Response to Financial Liberalization in Turkey: 1980–82, PPR Working Paper WPS147 (Washington: World Bank, January 1989).
Behrens, R., “Los Bancos e Instituciones Financieras en la Historia Economica de Chile” (master’s thesis; Santiago: Catholic University of Chile, 1985).
Cho, Yoon Je, and Deena Khatkhate, “Lessons of Financial Liberalization in Asia: A Comparative Study,” Discussion Paper No. 50 (Washington: World Bank, April 1989).
Díaz-Alejandro, Carlos F., “Good-bye Financial Repression, Hello Financial Crash,” Journal of Development Economics, Vol. 18 (September/October 1985), pp. 1–24.
Dooley, Michael, and Donald Mathieson, “Financial Liberalization in Developing Countries,” Finance and Development, International Monetary Fund and World Bank (Washington), Vol. 24 (September 1987), pp. 31–34.
Dornbusch, Rudiger, and Alejandro Reynoso, “Financial Factors in Economic Development,” American Economic Review, Vol. 79 (May 1989), pp. 204–09.
Fried, Joel, and Peter Howitt, “Credit Rationing and Implicit Contract Theory.” Journal of Money, Credit, and Banking, Vol. 12 (August 1980), pp. 471–89.
Hanna, D., “Heads I Win: Tales of the Chilean Financial System” (doctoral dissertation; Cambridge, Massachusetts: Harvard University, September 1987).
Le Fort, Guillermo, “Financial Crisis in Developing Countries and Structural Weaknesses of the Financial System,” IMF Working Paper 89/33 (Washington: International Monetary Fund, 1989).
Luders, R., “Lessons from Two Financial Liberalization Episodes: Argentina and Chile” (unpublished; Washington: World Bank, November 1985).
Mankiw, N. Gregory, “The Allocation of Credit and Financial Collapse,” Quarterly Journal of Economics, Vol. 101 (August 1986), pp. 455–70.
McKinnon, Ronald L, “Domestic Interest Rates and Foreign Capital Flows in a Liberalizing Economy,” paper presented at the Annual Meeting of the American Economic Association, New Orleans, December 28–30, 1986 (unpublished; December 1986).
McKinnon, Ronald L, “Financial Liberalization in Retrospect: Interest Rate Policies in LDCs,” in The State of Development Economics: Progress and Perspectives, ed. by Gustav Ranis and T. Paul Schultz (New York: Basil Blackwell Inc., 1988).
Osano, Hiroshi, and Yoshiro Tsutsui, “Implicit Contracts in the Japanese Bank Loan Market,” Journal of Financial and Quantitative Analysis, Vol. 20 (June 1985), pp. 211–29.
Rothschild, Michael, and Joseph Stiglitz, “Increasing Risk: I. A Definition,” Journal of Economic Theory, Vol. 2 (September 1970), pp. 225–43.
Smith, Bruce D., “Private Information, Deposit Interest Rates, and the ‘Stability’ of the Banking System,” Journal of Monetary Economics, Vol. 14 (November 1984), pp. 293–317.
Snoek, Harry, “Problems of Bank Supervision in LDCs,” Finance and Development, International Monetary Fund and World Bank (Washington), Vol. 26, No. 4 (December 1989), pp. 14–16.
Stiglitz, Joseph E., and Andrew Weiss, “Credit Rationing in Markets with Imperfect Information,” American Economic Review, 71 (June 1981), pp. 393–410.
Stiglitz, Joseph E., and Andrew Weiss, , “Incentive Effects of Termination: Applications to the Credit and Labor Markets,” American Economic Review, Vol. 73, (December 1983), pp. 912–27.
Velasco, Andrés, “Liberalization, Crisis, Intervention: The Chilean Financial System, 1975–1985,” IMF Working Paper 88/22 (Washington: International Monetary Fund, 1988).
Wette, Hildegard C., “Collateral in Credit Rationing in Markets with Imperfect Information: Note,” American Economic Review, Vol. 73, (June 1983), pp. 442–45.
Delano Villanueva is Senior Economist in the Developing Country Studies Division of the Research Department. He is a graduate of the University of the Philippines and the University of Wisconsin and has published articles on monetary economies and aggregate growth theory.
Abbas Mirakhor, Senior Economist in the Middle Eastern Department, is a graduate of Kansas State University and has published papers on economic theory and Islamic banking and finance.
The paper benefited from comments by Yoon-Je Cho, Dean DeRosa. Mohsin Khan, Deena Khatkhate. Guillermo Le Fort. Ichiro Otani, and Ratna Sahay. Special thanks are due to Joshua Greene, who provided substantial input.
The importance of macroeconomic stability, in particular price stability, has been emphasized by Dornbusch and Reynoso (1989). Given large fiscal imbalances and unrealistic exchange rates, these authors have argued that financial liberalization could lead to higher inflation. They then present empirical evidence that high inflation, in turn, retards growth through its adverse effects on net investment and efficiency of resource use.
McKinnon (1988, p. 388). This issue is taken up later in this paper.
Similar results are reported by Mankiw (1986). For a formal summary of the Stiglitz-Weiss model, see the Appendix.
This issue is taken up in the next subsection.
For a derivation of these relationships as optimal responses of a bank and its borrowers under uncertainty, see the Appendix.
If the economy is stable, such moral hazard problems would not affect bank behavior, because the default rates of a large number of borrowers are uncorrected. Moreover, so long as regulation is fairly stringent, banks would be prevented from concentrating loans on a few large borrowers.
The United States during the mid-1980s and, more recently, the case of the failed Lincoln Savings and Loan (a California thrift institution), provide examples of this possibility.
For the purposes of Table 1, effective bank supervision should be taken to cover the following policies, among others: adequate reserves against loan losses; adequate bank capitalization; limits on bank exposure to shareholders, personnel, and large borrowers; limits on foreign exchange exposure; a deposit insurance scheme with appropriate costs that reflect the riskiness of the individual bank’s loan portfolio; adequate number and skills of bank examiners and supervisors; and the absence or minimization of political and other interference with the enforcement of bank supervisory and regulatory controls. For details, see Dooley and Mathieson (1987) and Snoek (1989).
The Appendix shows that an economically efficient interest rate policy generally establishes a bank lending interest rate greater than a representative risk-free interest rate. Thus, for example, taking the market-determined treasury bill rate (ρ) as the risk-free interest rate, the monetary authority would set an upper limit to the bank lending interest rate (r) equal to (α + ρ). To provide greater incentives for bank lending, the parameter (α) could be raised to a new level. This action, however, should be preannounced so that existing implicit contracts can be renegotiated between banks and their borrowers.
Inasmuch as the existence of nearly free deposit insurance was partly responsible for the distorted financial behavior of banks and firms in these countries, a case can be made for an imposition of a variable bankruptcy penalty on banking activity or an actuarially fair insurance premium adjusting to changes in the riskiness of the individual bank’s loan portfolio. See Le Fort (1989) for an elaboration of this point.
Interest rate ceilings were lifted in July 1980 in Turkey and in mid-1984 in the Philippines.
One exception is Turkiye Is Bankasi, which is the country’s largest private bank.
In October 1978 commercial banks were allowed to set their own interest rates on deposits and loans, except the prime rate, which was controlled by the monetary authority. Late in 1981 commercial banks were allowed to determine their own lending rates on the basis of their own cost of funds, signaling the virtual disappearance of controlled lending rates.
See also World Bank (1989). Korea began its liberalization in 1981 when the government divested its shares in commercial banks. From 1982 onwards interest rates became positive in real terms owing to stabilized inflation. To date, interest rate ceilings, albeit flexibly managed, are still maintained except in the markets for interbank transactions, unguaranteed commercial bills, and corporate bonds. Sri Lanka’s liberalization, which began in 1977 when regulated interest rates were sharply adjusted upwards, was basically similar to Korea’s in its accent on price stabilization. By contrast, Indonesia’s interest rate reform, which started in 1983, lifted the ceilings on nearly all bank deposits and loans before stabilization and effective bank supervision were fully achieved.