The transition strategy from administratively set interest rates to market rates is discussed. Despite worldwide trends toward financial liberalization, few monetary authorities are prepared to accept as reasonable any interest rate level that is market determined. The paper suggests some helpful indicators to assess the adequacy of interest rates and discusses factors that contribute to a smooth liberalization process. The main conclusion is that interest rate liberalization is not synonymous with laissez-faire policies, but requires the replacement of the administratively set interest rates by indirect monetary management techniques that operate through the market.


The transition strategy from administratively set interest rates to market rates is discussed. Despite worldwide trends toward financial liberalization, few monetary authorities are prepared to accept as reasonable any interest rate level that is market determined. The paper suggests some helpful indicators to assess the adequacy of interest rates and discusses factors that contribute to a smooth liberalization process. The main conclusion is that interest rate liberalization is not synonymous with laissez-faire policies, but requires the replacement of the administratively set interest rates by indirect monetary management techniques that operate through the market.

Modern economic thinking generally acknowledges the important role of interest rate policy as a demand management technique to achieve both internal and external balance and to ensure the efficient allocation of financial resources in an economy. Interest rates influence the demand for and supply of investable resources and the decisions of economic agents to invest or consume. They are at the center of any policies that the monetary authorities may choose to undertake to influence business conditions and economic activity. They affect exchange rate and capital movements as well as inflation.1

Despite the importance of this variable, many countries have chosen to maintain interest rates at unrealistic levels. A large number of developing countries have traditionally followed a policy of low and unchanging interest rates. These policies are normally the result of three factors: (1) the desire to increase the level of investment; (2) the desire to improve the allocation of investment among sectors; and (3) the desire to keep financial costs down so as to avoid possible inflationary effects of interest rate liberalization. A vast body of literature appeared in the 1970s to refute the validity of these considerations.

The belief that low interest rates stimulate investment and growth has been vigorously attacked by McKinnon (1973) and Shaw (1973), among others. They have shown that if real interest rates are reduced below market equilibrium levels, demand for investment will no doubt increase, but actual investment will decrease, since at low interest rates insufficient savings will be generated to finance these investments. Moreover, the excess demand for investment will require the rationing of existing resources among all competing investors willing to borrow at that rate. Where there is rationing and controlled lending rates, it is unlikely that financial intermediaries will choose to provide funds according to a ranking of rates of return on investment. Most likely, other factors, such as the capacity to provide collateral and political influence, will also play an important part in the decisions of financial intermediaries. Consequently, a policy of low interest rates not only inhibits investment, but also tends to reduce the average rate of return on investment below the maximum attainable rate.

Attempts to improve the allocation of resources are also an important factor behind the use of low interest rate policies by the authorities of many countries who assume that selective reductions of interest rates to preferred sectors of the economy will significantly improve the allocation of resources. Available evidence tends to contradict this assumption. In most cases in which this hypothesis was tested, results showed that the effect of selective credit policies on growth and investment was minimal. The key problem was the fungibility of money, which makes it very difficult to ensure that funds are in fact used for their original purposes (Johnson (1975) and Khatkhate and Villanueva (1978)).

The third reason often mentioned in defense of low interest rate policies is the possible inflationary impact of interest liberalization. There is no doubt that there will be some short-term price effects resulting from interest rate liberalization. However, the direction of these effects is a complex empirical issue that cannot be easily resolved on a priori grounds. In any case, the possible inflationary effects of interest rate liberalization tend to be somewhat overplayed by defenders of the status quo. Available estimates of the ratio between financial costs and total production costs in several countries indicate that it seldom exceeds 10 percent. Thus, the direct effect of an increase in interest rates on production is likely to be small. Moreover, this increase will not necessarily be completely passed on to consumers, because interest rate increases should reduce demand.2 Finally, interest rate increases are likely to reduce the hoarding of goods, thereby increasing aggregate supply.

The purpose of this paper is to emphasize some key elements that have proved important in the process of interest rate management and liberalization. This process, while relatively straightforward in the abstract, has a few pitfalls that can perhaps be avoided by learning from the experience of the several countries that have moved toward market-related interest rates in the last decade.

The first step in the process of interest rate management and liberalization should be an assessment of the appropriateness of the prevailing interest rate levels and structure. Section I discusses a number of indicators that can be used to gauge the appropriateness of prevailing interest rate levels.

Section II presents a discussion and assessment of the interest rate structure. If the level and structure of rates are found to be adequate, the only concern of the monetary authorities should be to ensure that they are flexible; that is, that changes in underlying economic conditions will be fully reflected in interest rate changes so as to keep them always adequate. However, if rates are not at acceptable levels, a strategy needs to be designed to move them to more realistic levels.

Section III discusses the transition from fixed to market-determined interest rates. For many countries, this transition can be traumatic if not properly managed. Thus, the monetary authorities should plan the proposed liberalization path carefully, so as to achieve this goal with minimal side effects to the economy.

Section IV examines government intervention in the economy and its relevance for interest rate policies, focusing on the impact of government financing on interest rates and on the financing of the rest of the economy. Section V presents concluding remarks.

I. Adequacy of Interest Rates

Determining the most adequate interest rate level is not a simple task, since there is no clear-cut method of assessing its appropriateness (see Leite (1982)). However, there are a number of indicators that together can help the policymaker judge whether the prevailing interest rate is grossly out of equilibrium. These indicators are discussed below.

Positive Real Rates

Saving instruments should bear a positive expected real interest rate; otherwise, there would be a strong tendency to substitute hoarding of goods and self-investment for financial saving. Clearly, not all real interest rates on financial instruments need to be positive. In most countries, demand deposits (and currency holdings) do not pay interest. However, up to a point, the services and convenience resulting from the use of these deposits make them attractive to hold. Nevertheless, in all cases, and specifically in hyperinflation situations, it is highly unlikely that under competitive conditions, the average real rate of return on saving instruments would be negative. Consistently negative returns are thus likely to be due to a lack of competition or to government ceilings on interest rates. This is even more so when real lending rates are negative. Occasionally, the real interest rates observed in the economy may be negative, even when rates are free and competitively determined. For instance, if the inflation rate is volatile, people may underestimate the future rate of inflation. This underestimation is likely to result in relatively low nominal interest rates that will turn out to be negative in real terms ex post. Also, the combination of bank-specific credit ceilings and unfettered growth in reserve money may lead to market-determined interest rates that are negative even in competitive banking systems.

Positive real rates give only a floor on nominal rates; other indicators would have to be used to assess how far above that floor interest rates should be. Moreover, a few caveats should be kept in mind when positive real rates are being used as a guide for interest rate policies. First, when there are price controls the calculated inflation rate is likely to underestimate underlying inflationary pressures. Therefore, calculated real rates may be overstated because of the artificially low measured inflation. Second, calculations of expected inflation rates are difficult without long, consistent time series, and even then may not be reliable. Third, the most appropriate deflator of interest rates is a broad-based price index that takes into account the prices of current consumption goods as well as the prices of assets that would produce future consumer goods (capital goods) (Brown and Santoni (1981)). Finally, taxation of interest incomes should also be taken into account when expected real interest rates are calculated (Tanzi (1980)).

World Interest Rates

If two economies are totally open to capital movements, the differential between their domestic interest rates will tend to be equal to the expected movements in the exchange rate between their currencies.3 Although most developing countries have some form of control on capital movements, these controls have limited effectiveness, resulting in different degrees of openness to capital movements. Consequently, a country’s leeway in determining domestic interest rates is limited, since failure to take foreign interest rates into account is likely to result in destabilizing capital movements. In particular, the ability to determine interest rates independently of international rates is limited if (1) there are no effective capital controls; (2) the currency is freely convertible; (3) the currency is widely accepted outside the country; (4) there is a thriving black market for foreign exchange; and (5) foreign firms have a large role in the domestic economy.

In cases where there is some but not perfect capital mobility, the interest rate differential, after allowance is made for exchange rate expectations, should not be too large so as to avoid destabilizing capital movements. For this purpose the relevant “world” interest rates are those of the countries to and from which capital movements are more likely to take place. Note also that if a country is hoping to attract foreign private capital flows, domestic rates should exceed world rates, in order to compensate foreign investors for the increased risks of international lending.

Rates of Return on Investments

Rates of return on investment projects should exceed the interest rate charged on the funds used to finance them. Therefore, one way of assessing the adequacy of interest rates could be to estimate the economy’s overall rate of return—probably on the basis of completed projects—and to compare prevailing interest rates to that overall rate.

The difficulty with this approach is that in most countries factors of production are not perfectly mobile, and there are special constraints to entry into the high return sectors. Also, there is no overall rate of return on investment for the economy, but rather a spectrum of rates. Moreover, to the extent that real interest rates have been kept below equilibrium levels because of regulation (“financial repression”), the rates of return of some of the projects undertaken exceed the actual lending rate but are below the maximum rates of return attainable under more competitive conditions. Those projects are clearly suboptimal. These facts have led to the suggestion that the lending interest rate be guided by the rate of return on the “modern” sector of the economy (see Galbis (1977) and Khatkhate (1980)). The problem with this approach is how to define the modern sector. Nevertheless, some guidance can be obtained by ranking the rates of return of different sectors and trying to gauge which lending rate would reduce the number of investment projects to a level that can be financed within the available resources (see Dasgupta, Sen, and Marglin (1972)).

Perhaps more interesting is to compare the rate of return on potential investments with the lending rate. If lack of financial resources seems to hamper the chances of a project being implemented even if its rate of return substantially exceeds the prevailing lending rate, the lending rate is probably artificially low and credit is likely being allocated according to other criteria (“credit rationing”). This is especially so if the rate of return on these potential projects also exceeds the rates of return on a number of completed projects.

Interest Rates in Informal Markets

In many countries interest rates in informal markets are substantially above the rates prevalent in the organized financial system. Unfortunately, it is doubtful that interest rates in these markets could be used as a guide to the proper level in the organized market. Although by their nature informal markets are unregulated, there is no evidence that they are always more competitive than organized markets. Also, informal markets handle high-risk loans and consequently require a higher premium to cover their expected losses by default (Wai (1956), Bottomley (1963), and Badhuri (1977)). Consequently, interest rates on informal markets, although contributing an additional piece of information, can only provide an upper bound for the rates prevailing in the organized market. Movements in these rates, however, may parallel required changes in the rates in the organized market.

Relative Price of Capital and Labor

Interest rates can be viewed as a component of the relative price of capital to labor.4 This relative price is the ratio of the rental price of capital to the nominal wage rate, with the rental price of capital defined as the product of the price of capital goods and the real (or nominal) interest rate. Therefore, the real interest rate could be chosen so as to restore this relative price to a target level, taking into account developments in the price of capital goods and the wage rate. This approach assumes that the authorities have some opinion on the adequate level of the relative price, perhaps based on past experience when interest rates were at adequate levels. Unfortunately, all this method can do is to say how the prevailing interest rate levels need to be changed so as to restore the relative prices of capital and labor to some target level. It is therefore not very helpful in situations in which the authorities have no idea of what the proper relative price between capital and labor is.

II. Structure of Interest Rates

The structure of interest rates also needs to be examined when the appropriateness of a system of interest rates is being evaluated. However, ready and easy rules on interest rate structure have yet to be devised, since so much depends on the specifics of each market. Interest rates on saving instruments (and lending rates as well) should differ according to their intrinsic characteristics, such as their riskiness, maturity, liquidity, and convenience of their use. Yields on saving instruments (and loan rates) should be positively related to their riskiness and negatively related to their liquidity, A term structure of interest rates that offers insufficient returns to longer maturity deposits could reduce the availability of term finance for investment.

Under competitive conditions the spread between lending rates and the average cost of loanable funds (that is, funds obtained by the financial intermediaries to on-lend) should be just enough to cover costs, risks, and “normal” profits. Large spreads common in many developing countries indicate, in many cases, the lack of competitiveness or government intervention in the financial markets.5 Sometimes they reflect high intermediation costs, often resulting from a large portfolio of non-performing loans or high operating costs. Whatever their cause, these spreads will most likely result in low deposit and high lending rates, with an inappropriate division of risk.

Against this background, any strategy to improve the interest rate structure should start by abolishing the most obvious causes of the initial distortions. Steps to be taken include the introduction of policies to reduce interest subsidies based on an assessment of their incidence and effectiveness in redirecting resource flows. Also, policies to streamline and monitor the cost-of-funds calculations of financial institutions should be introduced. Other policies that are likely to improve the interest rate structure include reduction and unification of liquidity requirements for various groups of financial institutions; the introduction of a prime rate or a base lending rate system; measures to monitor and improve the operating efficiency of financial institutions; and legal, regulatory, and institutional changes to minimize the incidence of bad debts. The use of indirect instruments of monetary control instead of direct credit controls is also likely to improve the interest rate structure.

Another possibility would be to use the interest rate differentials prevailing in some other countries as a basis for a first approximation of the relationships between interest rates in the domestic markets. One should be aware, however, of country characteristics and government intervention that could influence these relationships. Differences in country regulations that affect the operating costs of the financial intermediaries such as liquidity ratios, reserve requirements, and access to a rediscount window, will result in different interest rate structures. In sum, although international comparisons are useful, one should take these differences into account when assessing the appropriateness of a given interest rate structure.

One measure to minimize the complications of setting up an appropriate interest rate structure is to reduce the number of interest rates by eliminating (or at least streamlining) selective credit policies that artificially create new interest rate categories.6 Another possibility is to increase the integration of the financial markets, for example by moving toward universal banking—as opposed to narrowly defined specialized institutions.

Freeing all interest rates from government regulation is often advocated as a way to achieve an initial approximation of an equilibrium level and structure of interest rates.7 In practice, the conditions for optimality of this strategy are unlikely to hold strictly. However, many policymakers would argue that the application of this strategy would at least approach the optimal solution. That said, some concern remains about the speed with which this strategy can be implemented in the presence of macroeconomic imbalances and weak bank supervision. Given proper safeguards, it is, nevertheless, one of the best ways to eliminate the most important interest rate distortions.

III. Financial Liberalization Strategy

If a country’s interest rate system is inappropriate, and until conditions for free interest rates obtain, some kind of interest rate management policy may be necessary. This management can take various forms. The following are some alternatives.

The savings deposit rate can be used as the minimum basic rate and all other rates can be tied to it. The government would then intervene in the financial market by adjusting the savings deposit rate in line with the various criteria discussed earlier, while monitoring its effects on the interest rate structure.

Some governments have set a minimum deposit rate (or a structure of minimum rates by type of deposit) and a maximum lending rate, and over time adjusted the floor and ceiling rates to bring about a gradual liberalization of the system.

An alternative used in some countries is to set interest rate ranges for the deposit rates and lending rates separately, and allow the commercial banks to set rates within these ranges. The authorities then widen these ranges over time so as to phase in the liberalization of the rates.

An alternative that relies more heavily on market forces is for the government to fix the maximum spread between the average cost of funds to the financial intermediaries and their lending rate, while allowing them to determine the level of their interest rates. If the spread allowed by the authorities takes into account normal intermediation costs, risks, and profits (but not excessive monopolistic profits), the result, even in the presence of oligopolistic structures, could be an interest rate structure similar to the equilibrium rates under competitive conditions.

In any case, any move toward a more liberal interest rate regime should be associated with the development of appropriate monetary policy instruments that are capable of influencing the rates indirectly to reflect monetary policy objectives, such as containing credit expansion or ensuring that divergences from world rates are not excessive (resulting in large capital flows). In this regard, the appropriate choice of operating techniques of monetary policy becomes important to ensure that monetary control does not exert an undue impact on growth, and to promote further development of financial markets. For example, raising the level of interest rates and containing credit expansion through increases in unremunerated reserve requirements would result in a larger spread between deposit and lending rates and greater distortions in credit allocation than alternative methods of containing credit expansion such as open market operations.

Interest rate liberalization has a better chance of success if the following key questions are addressed at the outset of the liberalization process.

Will there be adequate competition?

To ensure adequate competition, the interest rate liberalization would have to be accompanied by a properly phased freeing and homogenization of various portfolio regulations. In particular, as stated above, various selective credit policies based on below-market interest rates would either have to be eliminated or reduced in scope. In addition, policies toward mergers, licensing, and branching would have to be modified, taking into account possible economies of scale. Also, it is important to provide adequate incentives to induce borrowers to behave in an interest-sensitive fashion by eliminating “soft” budget constraints that often apply to state enterprises or enterprises that are closely linked to banks. Insolvent banks are another obstacle to competition. Government banks are often not as competitively minded as private banks. Rehabilitation and restructuring of banks may be an important step to increase competition in the banking system. Without such a range of policy changes to improve competition, interest rate liberalization could produce significant distortions in the level, structure, and responsiveness of interest rates.

Are the money market and monetary policy instruments adequate to influence the marginal cost of funds to banks?

The issue of instrument adequacy takes on particular importance in the context of interest rate liberalization. Typically, such liberalization would have to be accompanied by, or preferably preceded by, measures to strengthen the money and interbank markets and to improve the effectiveness of monetary policy instruments. In particular, developing the technical ability to monitor the money market and intervene to stabilize and influence money market rates would become important, insofar as these rates serve as the marginal cost of funds to banks. In the absence of well-developed money markets, the authorities would have to develop and streamline primary issues of central bank or government securities and the rediscount mechanisms, so that the primary issue yields or the rediscount rates can serve as the marginal cost of funds to banks.8

The development of market-based instruments of monetary control and a fostering of money markets are mutually supporting processes. Therefore, the introduction of market-based monetary control instruments should be paralleled by measures to strengthen money and interbank markets—such as reforms of laws governing issuance and transfer of short-term securities, introduction of new instruments, and the development of well-capitalized and supervised dealers. Often, the clearing and settlement system for payment transactions needs to be strengthened to support an active money market. As money markets evolve, the indirect monetary control procedures can be progressively refined, and day-to-day money market intervention can become over time the primary means of both defensive and dynamic monetary policy implementation.

Will the market-determined lending and deposit rates respond rapidly to shifts in monetary policy and to developments in international interest rates and exchange rates?

A key factor to be considered in addressing this question relates to the relative importance of domestic and international factors in the determination of domestic interest rates. The relative weight of these two factors is likely to undergo a significant change following the liberalization, and this change must be closely monitored to judge the extent of monetary independence. To the extent that monetary policy can play a role in influencing interest rates—depending on the degree of openness to capital flows and other structural features—the speed of response of interest rates to monetary policy can become a critical issue.

In some countries, following interest rate liberalization, the authorities have introduced significant monetary reforms to develop money markets and strengthen monetary policy instruments. As a result, they have achieved the technical ability to influence money market rates or, more generally, the marginal cost of funds to banks. Nevertheless, the response of banks in adjusting the lending and deposit rates in line with the marginal cost of funds has been rather slow. Even if some of the lending rates respond rapidly, a wide range of lending rates and even deposit rates may respond sluggishly, often leading to large spreads, and in some cases to excessively and persistently high lending rates. This can frustrate policymakers and cause doubts as to the wisdom of liberalization.

Based on the recent experience of countries undertaking interest rate liberalization efforts, key factors that cause such sluggish response include inappropriate prudential limits on interbank borrowing; too restrictive limitations on the range of instruments and participants in the money market; the oligopolistic structure of the banking industry; significant differences in the maturity structure of assets and liabilities; excessive fluctuations in money market rates; and the inelastic demand for credit owing to a large share of nonperforming loans, highly leveraged borrowers, and weak bank supervision. Measures that can speed up the responsiveness to monetary policy are appropriate changes in money market regulations; changes in policies on licensing banks, mergers, takeovers, and branching so as to promote greater competition; a strengthening of defensive monetary policy operations so as to stabilize money market rates; and policies to reduce segmentation in the loan markets (for example, loans to related firms and discriminatory regulations on credit). In some cases, a financial restructuring of banks, supported by a strengthening of prudential regulations, may become necessary to ensure the effectiveness of interest rate liberalization based on active competition.

Is the banking system sufficiently sound to face interest rate competition? Is the bank supervision mechanism sufficiently strong to anticipate the effects of liberalization and react to it in a timely and efficient manner?

If many institutions are too weak—with a large share of non-performing loans and high operating costs—then, without adequate bank supervision machinery, unexpected failures of individual units can lead to systemic crises following liberalization. Moreover, a large share of nonperforming loans in the system can significantly reduce the interest elasticity of credit demand, because if interest rates rose, non-performing loans would tend to grow automatically, insofar as banks tried to keep these loans current by capitalizing interest; the resulting increase in nonperforming loans could offset any decrease in demand for performing loans as a result of the rise of interest rates. As a result, the flow demand for credit becomes fairly inelastic, leading to excessive increases or fluctuations in interest rates. These considerations suggest that a close review of the soundness of the banking system and adequacy of bank supervision and rapid reforms in these areas are critical for the effectiveness of interest rate liberalization.

A related issue in the liberalization of interest rates is the liberalization sequence for various segments of the market. Many countries liberalize segments of the financial system in steps. The sequence in which liberalization of nonbank institutions, private banks, state-owned banks, and government securities has proceeded varies from country to country. The appropriate sequence would depend on the initial regulatory and institutional features. For example, some countries may initially liberalize only parts of the loan or deposit markets (for example, short-term deposits) or free the rates of a select group of financial intermediaries (for example, nonbank financial institutions). After they are assured of the soundness of these financial institutions and of their ability to be competitive, the authorities liberalize other markets. In some socialist countries, interest rates in the enterprise deposit and loan markets have been liberalized first, and the household and enterprise markets are integrated in the second stage. However, a gradual approach to liberalization may introduce distortions of its own and raises the question of the political sustainability of the process.

Another issue is possible imbalances resulting from maturity transformation by financial institutions. Institutions that lend long term at fixed rates but whose funds are mostly short term can be caught in the liberalization process. If interest rates increase, their cost of funds will increase while interest income will change much more gradually. During the liberalization process, the monetary authorities will have to pay close attention to this problem to avoid the possibility of a financial crisis. To reduce exposure to interest rate risk, financial institutions that engage in maturity transformation should be encouraged to actively promote adjustable-rate loan contracts. However, these contracts should be designed in such a way as to avoid unduly increasing the risk borne by borrowers and, thereby, default rates. Some of these techniques, such as interest caps, have been used in many countries and may help strike the right balance between the interest risk borne by lenders and borrowers. The institutional solutions to the problem of long-term loans at fixed rates should ultimately deal with the question who should pay for the implicit subsidies following the liberalization of interest rates.9

IV. Government Intervention

Government intervention poses special problems, because while some types of government intervention can improve the allocation of resources, other forms might be the dominant reason behind the misallocation of resources. It is therefore important to separate those policies that may cause a distortion in interest rates without a corresponding improvement in the allocation of resources from those that may be beneficial.

Monetary policies are an important part of the array of policies a government can undertake. Thus, in most countries, even those that are market oriented, interest rates are influenced by the monetary authorities. It is important to note, however, that although in the past many countries chose to fix the interest rate by fiat, there has been a growing tendency for governments to influence interest rates indirectly through two main mechanisms: (1) financing of government deficits at market-determined rates;10 and (2) open market policies directed at influencing trends in monetary and credit aggregates to achieve given economic targets.

Government Deficits and Interest Rates

Government budget deficits are financed either from the financial markets or by recourse to the central bank.11 If the funds are raised in the financial market on equal terms with the private sector, and insofar as the social return on the government’s program financed by these funds exceeds the market rate, there need not be a misallocation of resources. A misallocation can arise more easily when the central bank accommodates the government’s credit needs directly or when special incentives are given to hold government debt—such as tax incentives or use of these government liabilities to fulfill liquidity requirements.

If the central bank provides the credit accommodation, purchasing power is redistributed in favor of the government, which results in the crowding out of the private sector, particularly if there is a concomitant increase in prices. The crowding out is even more pronounced when quantitative credit limits on private sector borrowing are simultaneously imposed to correct existing inflationary tendencies. The same is true when the crowding-out effect is achieved through an increase in liquidity requirements to levels above those that might be needed for prudential reasons, with the objective of tapping resources from the financial system at below-market rates.

Finally, in a number of countries, part of the government deficit is reflected in central bank losses that have the same inflationary effects as central bank financing of the deficit. These central bank losses often result from the government transferring to the central bank its foreign exchange risks, or from the central bank failing to charge proper interest rates on its loans to the government or preferred sectors of the economy. These policies clearly distort interest rates.

Open Market Policies

Open market operations can be conducted either in the primary market or in the secondary market. Many countries have used primary sales of some government securities—either central bank securities or treasury bills—as an instrument of monetary policy. By varying the timing and the volume of primary issues and by issuing them at market rates, it is possible to influence bank reserves and interest rates in the short run; this practice has provided an attractive alternative technique for influencing short-run interest rates and monetary developments, in the absence of active secondary markets in these securities. It has also served as a transitional device for fostering the development of secondary markets. Once a genuine secondary market develops, monetary policy can be implemented by operating in these markets. However, to the extent that budget deficits are large, requiring massive financing, primary sales of government securities tend to be the dominant influence in the financial markets, seriously limiting the use of open market operations as an effective short-run policy instrument and, at the same time, distorting the level and structure of interest rates.12

An appropriate level and structure of interest rates can therefore be brought about only if the government gradually reduces its budget deficit to a level that would permit it to borrow directly from the financial market in competition with the private sector, without crowding out the latter and without recourse to special regulations, such as high liquidity requirements. The elimination of such regulations and the move from captive to active markets in government securities call for a comprehensive approach to strengthening public domestic debt management that is well coordinated with monetary management.

Moreover, the government’s intervention should be limited to the financing of expenditures with (social) rates of return above the market interest rate.13 Unfortunately, this basic rule is of limited practical utility, since the authorities do not normally know what the socially optimum interest rate is, Dasgupta, Sen, and Marglin (1972) suggest that since the overall social rate of return is unknown, the government should estimate the internal rate of return on each proposed government project. Over the years, the accumulated experience of comparing the internal rates of return of individual projects and having to choose among them would slowly evolve into a basic agreement among policymakers about the smallest internal rate of return that would justify a project. This rate, when a consensus is finally developed, will be the socially optimum interest rate.

Open market policies can also be used to maintain interest rates constant without having to resort to direct regulation of financial intermediaries. Such a strategy would imply allowing the monetary and credit aggregates to find their own levels. What criteria could guide the authorities’ choice between interest rate and monetary (or credit) aggregate targeting? The generally accepted view is that interest rates should be the preferred short-run and intermediate target when the dominant source of instability in the economic system is the financial sector (for example, shifts in money demand due to financial innovations). The targeting of a monetary or credit aggregate should be preferred when real sector disturbances are more important (for example, shifts in terms of trade, or fluctuations in real demand for goods and services). In practice, of course, no simple rule of policy intervention can ensure economic and financial stability. In an economy that may be simultaneously subject to multiple disturbances of varying intensities on which there is imperfect information, policymakers may prefer to adopt a policy of discretionary adaptation by continuously reviewing the settings of policy targets in the face of the most recent information. Although it would still be necessary to choose between interest rate or money supply targets at any point in time, this choice would generally be subsidiary to the more important task of setting the consistent target levels for these variables. Thus, even in a liberalized interest rate regime, the authorities must constantly hold a view of the appropriate level of the interest rate and strive to achieve it. In addition, central banks generally attempt to smooth out short-term fluctuations in interest rates around their “fundamental” trends, partly to ensure that changes in trends are not obscured by day-to-day volatility. Such “defensive” monetary policy operations help to speed up the transmission of the effects of monetary policy and enable smooth functioning of the financial markets.

V. Concluding Remarks

Both in market and in centrally planned economies, it is important to avoid distortions in relative prices, if only to ensure the optimum allocation of resources. For this reason, an interest rate reform should be a component of any policy package aimed at improving the performance of these economies.

First, it should be well understood that lower interest rates will not lead to additional investment unless savings are forthcoming. Second, expected real interest rates must be positive in order to prevent unproductive hoarding of goods or the financing of economically unsound projects. Third, interest rates, after allowing for exchange rate expectations, should be set with due consideration to interest rate differentials vis-à-vis world financial markets, taking into account the economy’s degree of openness to capital movements. Fourth, whenever public sector dependence on the financial markets is due largely to fiscal imbalances, the servicing requirements of the government debt become a major stumbling block in the path of interest reform. Interest liberalization will thus have to go hand in hand with an improvement in the financial position of the government. Only after its borrowing requirements are reduced to manageable levels will the government be able to engage in a meaningful interest rate policy. Fifth, in centrally planned economies, as well as in countries where the public sector is a major borrower, it is important that the government projects that are carried out yield (social) rates of return that exceed those of the projects (private and government) that are refused financing. The calculation of internal rates of return for each project can assist policymakers in making rational choices among competing projects. In market economies, the socially optimum rate might be assumed, as a first approximation, to be equal to the rate that the market would freely determine in competitive conditions. The government has an important role in promoting competition, and also in ensuring that its financing operations do not distort market rates.


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Sérgio Pereira Leite is Chief of the Financial Sector Division of the Central Banking Department. He is a graduate of the Universidade do Estado da Guanabara and the Johns Hopkins University. V. Sundararajan is Assistant Director of the Central Banking Department. He is a graduate of the Indian Statistical Institute and Harvard University. An earlier version of this paper was presented at the CEMLA-ECCB Seminar on Interest Rate Management held in St. Kitts on March 28–29, 1988. The authors would like to thank Tomás Baliño, Barry Johnston, Linda Koenig, and Douglas Scott for their comments.


For an elaboration of these points, see International Monetary Fund (1983).


To the extent that higher interest rates shift savings from goods into financial instruments, the rate of inflation would decelerate.


However, some other country-specific variables such as political risk or reserve requirements may also play a role.


For a discussion of the empirical relevance of this variable in assessing the impact of interest rate policy, see Sundararajan (1987).


Most often, high reserve and liquid asset requirements that are not adequately remunerated contribute to widening the spread, particularly in times of high inflation.


Selective credit policies aim at granting credit to designated sectors (for example, agriculture or exports) under more favorable conditions (for example, amount, interest rate) than they would get in the absence of such policies.


This requires that certain conditions obtain, namely the existence of perfect competition, absence of externalities and government intervention, well-behaved risk distributions, and full information.


For a survey of developing country experiences in adapting such market-related policy instruments, see Johnston and Brekk (1989).


Similar problems may result from large changes in exchange rates, which often accompany or precede the financial reforms.


Although in this case the government allows interest rates to be market determined, it still can have a substantial impact on these rates because of the size of its financing operations.


In this section, we concentrate on the effects of government deficits on interest rates. The opposite effect is also relevant. Interest rate movements, by their effect on the cost of funds to the government, alter the financial flows and may force compensatory adjustments in taxation or inflation.


Large fiscal deficits would constrain the scope of open market operations by resulting in unacceptably high levels of interest rates for the specific debt instruments used in such operations. This is likely to be the case when the domestic debt management is not well developed and relies on a limited range of debt instruments. Also, a large and rising volume of treasury debt held by the non-bank sector could be associated with significant substitution away from bank deposits, with consequences for demand for reserve money and for the level and structure of interest rates.


The social rate of return may differ from the rate of return that a private investor might attribute to a project. For the social rate of return, all the benefits and costs of the projects are computed, even those that do not accrue to the owner of the project.

IMF Staff papers: Volume 37 No. 4
Author: International Monetary Fund. Research Dept.