EMPIRICAL INTEREST RATE-INFLATION-REGULATION RELATIONSHIPS

SYED ALAMDAR ALI (alamdar2000pk@yahoo.com)
Mar 30 - Apr 05, 2009

During the past two decades, economists have emphasized the critical role interest rate policies play in the development process. But the experience of many developing countries suggests that these policies should be reassessed in the context of economic adjustment programs.

Interest rate policies have been among the most contentious of the economic adjustment strategies pursued in the developing countries. While programs of financial liberalization aim at eliminating interest rate controls and achieving positive real interest rates on bank deposits and loans, there is no agreement on the best strategy for achieving these goals. Should interest rates be liberalized gradually or within a short period? What conditions are necessary before interest rates can be liberalized?

Does the sequence of policies differ for high-inflation countries compared with low-inflation countries? How important are banking, regulatory, and supervisory policies? While there is no set mechanism for attaining positive real interest rates, Mr. Abbas Mirakhor, Executive Director in the IMF's Executive Board and Mr. Delano Villanueva from the Philippines, Assistant to the Director in the Middle Eastern Department in their research paper titled "Interest rate policies in developing countries" have narrated that the experiences of many developing countries point to the importance of the initial state of the economy, in particular the financial position of the private sector and the quality of prudential regulations over the financial policy strategies. In this regard four policy strategies may be identified, depending on whether the initial macroeconomic environment is stable (SM) or unstable (UM), and whether bank supervision is adequate (AS) or inadequate (IS):

1) UM/IS strategy, in which macroeconomic instability interacts with weak bank supervision;

(2) UM/AS strategy, in which the potential interaction between economic instability and moral hazard (the decision of banks to undertake risky lending in the presence of deposit insurance) is largely offset by effective bank supervision;

(3) SM/IS strategy, in which the economy is stable but moral hazard in banks presents a potential problem because of inadequate supervision; and

(4) SM/AS strategy, in which the economy is stable and the banking system adequately supervised. The study on which this article is based examines the actual policy experiences in several developing countries corresponding to these strategies.

In theory, for all four situations, macroeconomic stabilization and stringent bank supervision must occur before complete interest rate liberalization. In only one situation--a stable economy and an effectively supervised banking system--is full and simultaneous interest rate liberalization likely to be successful. In the remaining three cases, regulated but flexibly managed interest rates aimed at attaining reasonably positive real levels should be the rule in anticipation of the full benefits from either economic stabilization, improved bank supervision, or both.

Further, in terms of specific interest rate strategies, two types of situations may be considered: low inflation and unacceptably high inflation. A gradual program of interest rate liberalization that maintains positive real rates can proceed in the low-inflation countries, provided that banking supervision is strong and effectively enforced and that demand-management and other policies are appropriate to maintain economic stability. Within this group, countries with relatively long periods of price stability, achieved largely through sound and credible macroeconomic policies, are good candidates for full interest rate liberalization, subject to a strengthened system of prudential regulations over the banking system. Low-inflation countries that have already liberalized their interest rates will want to maintain economic stability and continually improve bank supervision.

In high-inflation countries, a strong and credible stabilization program and an equally strong set of prudential regulations are generally the best initial policy measures. Postponing the removal of interest rate regulations may be appropriate until the monetary situation has been stabilized and banking supervision strengthened. The empirical evidence suggests that successful countries have combined price stability with flexible, even if regulated, nominal interest rates. When interest rates are raised, the increases must be pre-announced so that existing loan contracts can be renegotiated. Consequently, a high-inflation country that has deregulated interest rates can strengthen the system of prudential controls over the banking sector and implement a strong and credible stabilization program that will stimulate the private sector. Failure to integrate and effectively implement such policies in programs of financial liberalization could lead to financial instability, which, in turn, could exacerbate macroeconomic instability. In the interim, if interest rates appear out of control (perhaps reflecting increasingly severe moral hazard problems unchecked by existing prudential regulations), it may be necessary to go back to regulating nominal interest rates and maintaining them at positive real levels. Regulations on lending rates can be safely removed only after confidence in the banking system is restored (here, an appropriate set of prudential regulations will play a key role), policies aimed at price stabilization bear fruit, and the financial position of the business sector improves.