EC 938 2007 Handout No. 5 1

Macro Topics in Development and Transition Macro Topics in Development and Transition 2006-20072006-2007

Handout No 5

Interest Rates and Financial Liberalization - in Macro Policy

for Development

EC 938 2007 Handout No. 5 2

Three Sub-TopicsThree Sub-Topics

1. Low Nominal Interest Rate policies in the period to about 1980 –Normally meant negative real rates reasons and effects

2. Selective Arguments for Reform3. Some Problems with High/Active Interest Rate

Policies in relation to Macro adjustment and crisis

EC 938 2007 Handout No. 5 3

1. Typical Policy Distortions pre 19801. Typical Policy Distortions pre 1980

• Controlled Interest Rates at Low Levels• Real Interest Rates determined by Inflation (see

charts)• Fiscal Deficits imposed large demands on system

(high reserve requirements, compulsory purchase of securities, excess liquidity via credit ceilings)

• Controls on Credit Allocation to “Preferred” Sector• Credit subsidies for some sectors• Much state ownership of banks• OVERALL - High Rate of Implicit Taxation of Sector

EC 938 2007 Handout No. 5 4

Example:Example: Directed Credit Directed CreditGovernments in low income and transition economies have shown a high propensity to take over the credit allocation decisions from banks. This almost often means:

large loan losses high rates of non-repayment low-risk adjusted returns even if repayment is achieved lower profitability and even distress in the banks affected (see example from the NBK Kenya opposite)

Capital & Reserves

Unprovided NPLsInterest-bearing

liabilities

Income-earning assets

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120

98 99 00 01 02 03 98 99 00 01 02 03

aggregate figures for six state-linked banks (Consonlidated, Co-op, DBK, IDB, KCB & NBK)

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EC 938 2007 Handout No. 5 5

But - State ownership of banks is often a But - State ownership of banks is often a part of such problemspart of such problems

EC 938 2007 Handout No. 5 6

Typical Problems pre-1980Typical Problems pre-1980

• Limited institutions resulting in restricted scope to MOBILISE, ALLOCATE and TRANSFORM Savings

• High Inflation resulting in Low Financial Savings and a Short Term View of Finance by both Borrowers and lenders

• Implicit/Illegal Access to Overseas Markets for some players

EC 938 2007 Handout No. 5 7

Financial Repression - Defined (Agenor Ch2)

•ceilings on nominal interest rates

•quantitative controls and selective credit allocation across government considered priority sectors, regions or activities

•high minimum reserve requirement

•loan decisions of state owned banks are guided by political factors

•forced allocation of assets or loans to the public sector by private commercial banks, for example, statutory liquidity ratios (required to hold a

proportion of assets in the form of government debt).

EC 938 2007 Handout No. 5 8

Figure 2.1bFinancial Depth and Per Capita Income 1/

(Average over 1980-95)

Source: World Bank. 1/ 44 developing countries and 15 industrialized countries are included. A dark circle refers to developing countries and a lighter circle to industrial countries.

0 5000 10000 15000 20000

0

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60

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140 Broad Money (in percent of GDP)

Per capita real GDP in 1987 US dollars

EC 938 2007 Handout No. 5 9

Selected ConsequencesSelected Consequences

Interest rate ceiling may distort the economy by: increasing the preference of individuals for current consumption as

opposed to future consumption, as a result, by reducing savings; reducing the supply of funds through the banking system

(disintermediation); leading (privileged) bank borrowers to choose more capital-

intensive project due to low interest rate on loans; financing low-yielding projects more heavily. Motivation for financial repression: inability to raise taxes either

due to administrative inefficiencies or political constraints (see also Handout No 3).

EC 938 2007 Handout No. 5 10

ContinuedContinued

Implications of financial repression: severe inefficiencies;

restrict the development of financial intermediation; increase the spread between deposit and lending rates; and reduce saving and investment in the economy;

encourage informal modes of financial intermediation;

alter substantially the transmission process of monetary policy.

EC 938 2007 Handout No. 5 11

ContinuedContinued

Financial repression yield substantial revenue to the government – a common alternative to conventional taxation

First source: implicit tax on financial intermediation by high reserve requirement rates.

Second source: implicit subsidy; government benefits by obtaining access to central bank financing at below-market interest rates.

Giovannini and De Melo (1993): on average, governments in their sample of developing countries extracted about 2% of GDP in revenue from financial repression. (e.g. bank deposits = 30% of GDP; reserve requirement = 20% of deposits. So hidden tax = 6% of GDP). See Mathieson, McKinnon reference in earlier handout)

EC 938 2007 Handout No. 5 12

Figure 2.2aDomestic Credit Provided by Banking Sector

(In percent of GDP)

Source: World Bank.

1995

Benin

Burundi

Côte d'Ivoire

Ethiopia

Gabon

Ghana

Kenya

Malawi

Nigeria

Tanzania

Zambia

Zimbabwe

0 50 100

Africa

Bangladesh

India

Indonesia

Korea

Malaysia

Pakistan

Philippines

Singapore

Sri Lanka

Thailand

0 20 40 60 80 100 120 140

Asia

1990

EC 938 2007 Handout No. 5 13

Figure 2.2bDomestic Credit Provided by Banking Sector

(In percent of GDP)

Source: World Bank.

1995

Algeria

Egypt

Jordan

Mauritania

Morocco

Oman

Saudi Arabia

Syria

Tunisia

Turkey

Yemen

0 35 70 105 140

Middle East and North Africa

Argentina

Bolivia

Brazil

Chile

Colombia

Costa Rica

Ecuador

Honduras

Jamaica

Mexico

Peru

Uruguay

Venezuela

0 50 100

Latin America

1990

EC 938 2007 Handout No. 5 14

2.2. Pressures for Change around 1980Pressures for Change around 1980

• The general Structural Adjustment movement from 1980 – pressures for more liberal markets/ greater efficiency

• Increasing Evidence of large bank losses (state and non-state) as elements in Fiscal Problems

• The globalisation tendencies - need for domestic finance systems to be less -taxed as a sequencing pre-requisite for more open capital accounts (see also Handout No 1)

• Evident need for Development Policies to require a larger role from Private Sector implying much enhanced flexibility of resource use.

EC 938 2007 Handout No. 5 15

Galbis Model – Galbis Model – JDE 1976 an Example of the JDE 1976 an Example of the Allocative Allocative Benefits to ReformBenefits to Reform

• At the controlled interest rate (rc), the low productivity sector intermediates only a part of its saving for the use of the high productivity sector•At the market interest rate, the low productivity sector provides all its savings for this purpose and aggregate output is thereby increased

•Excess credit demand in the repressed situation is matched by an excess demand for real resources that increases inflation and lowers real interest rates even more.

r

S,I

Supply

DemandI2

Demand I 1

S2

r c

S1 + S2

rm

EC 938 2007 Handout No. 5 16

Uncompetitive Banking and Financial Depth Uncompetitive Banking and Financial Depth in Transition Economies in Transition Economies Source: Steve Peachey and Alan Roe, Source: Steve Peachey and Alan Roe, Bank Bank

Consolidation in Central Europe and the FSUConsolidation in Central Europe and the FSU, World Bank, 2005, World Bank, 2005

WEIGHT OF OPERATING OVERHEAD

0%

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EC 938 2007 Handout No. 5 17

Supposed Advantages of Reform for Supposed Advantages of Reform for StabilisationStabilisation - Kapur (JPE 1976). - Kapur (JPE 1976).

Seminar discussion in Week 8Seminar discussion in Week 8

Essential of his model

• Output and growth is dependent on capital accumulation K (via Leontief technology)

• Bank credit is used to finance (a) working capital and (b) new investment capital

• There is a proportional link between the availability of working capital and the supply of total K(proportions are 1- and

• With ongoing inflation a certain amount of bank credit is needed just to finance the inflationary rise in working capital. Another part of total credit is needed merely to replace the depletion of working capital

EC 938 2007 Handout No. 5 18

ContinuedContinued

• Money demand is specified in terms of expected inflation and nominal interest rates (Cagan-type formulation)• Inflation is specified as dependent on excess commodity demand (inverse of excess money supply in this model) and expected inflation•Substitution results in two dynamic equations in terms of velocity (of money W) and expected inflation (exp) respectively. Equilbrium is achieved when dW/dt and dexp/dt = 0

EC 938 2007 Handout No. 5 19

ResultsResults• A conventional money supply contraction to stabilise

inflation causes an initial contraction in real output (via lower bank credit). It also causes an initial rise in W because inflation adjusts more slowly than output

• So long lag before output losses can be recovered• But with an non-conventional approach based on hikes in

nominal interest rates, money demand recovers instantly (W falls) and this increases net credit flows and so output (for given inflation)

• Also the reduced excess demand for commodities achieves a bigger downward effect on inflation

• CONCLUSION- output losses are less under the unconventional approach

EC 938 2007 Handout No. 5 20

Two SnagsTwo Snags

1. Will higher interest rates mean the cost of credit exceeds real rate of return on business investments (resulting in obvious problems including adverse selection etc)?

2. Will high money balances represent a substitution away from alternative (but lower cost) informal finance? (van Wijnbergen JME 1983)

3. In practice little support for Kapur although de facto extensive use of very high interest rates in stabilisation

EC 938 2007 Handout No. 5 21

3. Reservations about Liberal and possibly 3. Reservations about Liberal and possibly High Real Interest RatesHigh Real Interest Rates

Sargent T. J. & Wallace, N. (1986) Some unpleasant monetarist arithmetic, in: T. J. Sargent (ed.), Rational Expectations and Inflation (New York, Harper and Row).

This paper shows how tight monetary policy involving substantial hikes in interest rates can trigger harmful (govt.) debt dynamics.

In some circumstances (spelled out in detail in their paper) the rise in interest payments in the budget can swamp the effects of reduced monetary financing of the primary deficit and result in HIGHER not lower inflation

EC 938 2007 Handout No. 5 22

Reservations re Govt. Budget Guillermo Calvo -1991.Reservations re Govt. Budget Guillermo Calvo -1991. Source: paper in Simon Commander (ed), Source: paper in Simon Commander (ed), Managing Inflation in Socialist Countries in TransitionManaging Inflation in Socialist Countries in Transition , ,

World Bank, Report No. 9624, 1991 World Bank, Report No. 9624, 1991

Assume private wealth comprises only two competing assets: real money balances (m) and foreign assets (f). The former is remunerated by the interest rate (im) and the latter is remunerated by expected changes (depreciation) of the nominal exchange rate (S)So

If the authorities hike im then funds will shift into monetary balances. This will cause some downward pressure (appreciation) on S and so a downward pressure on inflation

] 7 [ 0' )( exp

*

fiSfm m

EC 938 2007 Handout No. 5 23

ContinuedContinued

But govt. interest payments are now higher (the state controls banks) and so is the fiscal deficit based on

In the case where the authorities intervene to defend the exchange rate (act to sterilise the movements of funds into the domestic economy), foreign reserves will increase by

] 7a [ )(. exp

*

. mmm iSfimi

] 8 [)( 0exp

*

miSf m

EC 938 2007 Handout No. 5 24

ContinuedContinued

IF reserves earn interest at rate “r”,Then the extra fiscal burden allowing for this is

A necessary condition for avoiding a rise in fiscal deficit is im<r. But this is very restrictive since (in recent times) r <6%. So little scope for hiking rates as an anti-inflation device IF authorities want no ER appreciation

] 8a [.)).(( 0

*

exp mrriiSf mm

EC 938 2007 Handout No. 5 25

Calvo model with Endogenous Devaluation Calvo model with Endogenous Devaluation & Perfect Foresight& Perfect Foresight

Steady-State is defined where money real balances are constant; actual inflation is equated to expected inflation; and govt is able to extract sufficient revenues from the inflation tax to finance (a) its primary deficit (=g) and (b) its interest outlays net of any return on foreign reserves. The SS condition is:

Now a hike in im must also result in a one for one hike in ACTUAL devaluation (and inflation) for the SS to be preserved. This is avoided only IF the higher interest rate is somehow linked to a lower primary deficit “g”

] 13 [.)().(0 0

**

mriSfiSrg mm

EC 938 2007 Handout No. 5 26

Corrosive Real Interest Rate EffectsCorrosive Real Interest Rate Effects

(id –) > (id – exp) [1]

Real interest rate (ex post) > Real interest rate (ex ante) The inequality in [1] implies a wealth redistribution from borrowers to lenders. If short-lived (i.e. expectations adjusts quickly), borrowers may be able to absorb the costs. This is “good” adjustment. However, if the inequality in [1] persists, we have “bad adjustment” then the costs to the borrowers will cumulate. “Bad adjustment” can also trigger ongoing corrosive effects on the financial system. In particular, corporate borrowers will face real interest charges higher than expected at the time when they contracted the debt.

EC 938 2007 Handout No. 5 27

ContinuedContinued• Some at least of these borrowing companies will face bankruptcy, will resort to additional borrowing or, where they fail, will resort to non-payment of their obligations (involuntary borrowing). • Most borrowers are likely to face declining profitability. • Banks and other financial institutions will also be caught out. They will be confronted with far more failed projects and businesses than seemed likely at the time when they granted credits. • If this is a systemic economy-wide problem, then banks may continue to provide facilities to those borrowers who remain solvent even though their profitability may be less than originally expected. This will further weaken overall credit quality in the system. •At some more advanced stage of this process the banks may even extend new facilities to non-current borrowers (ever-greening) in the vague hope that some of these will be able to save themselves and

repay earlier loans.

EC 938 2007 Handout No. 5 28

Reservations Related to Post-Crisis Reservations Related to Post-Crisis Situations of 1990sSituations of 1990s

See analysis in paper by Alan Roe 2003 Economic Systems Research, Vol 15 No 2 June 2003

EC 938 2007 Handout No. 5 29

The Puzzle: Policy Response to Recent The Puzzle: Policy Response to Recent CrisesCrises

Rich Countries

• Actions to strengthen Balance-Sheets

• Injection of Liquidity• Looser Monetary and

Fiscal Policies• Lower Interest Rates

Developing/Emerging Countries

• Tightening of Liquidity• Tighter Monetary and Fiscal

Policies• Very High Nominal and Real

Interest Rates• Most Actions weaken

Balance-Sheets

EC 938 2007 Handout No. 5 30

Emerging Market Economies: An ExampleEmerging Market Economies: An Example

Example of Mexico-1994

Money Market Rates (18% to 60%)Bank Lending Rate ( 15% - 58%)

Both Rates still > 30% 2 Years after Crisis

Bank Lending Rates still > 22% - 3 Years after crisis

Figure 1b: Mexico 1993-1998

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Money Market Rate Loan Rate Inflation - Beginning Inflation -End

EC 938 2007 Handout No. 5 31

Rich Economy ExampleRich Economy Example

United States

Note:• Sustained Modest Rates• Significant Drop in Rates at

time of LTCM Crisis in Autumn 1998

• Similar Moderation of Rates after Sept 11th 2001

• Ditto at time of Mini Bond Crisis in 1994

Figure 2a : USA

0

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Discount Rate Prime Lending Rate Inflation- Beginning Inflation-End

EC 938 2007 Handout No. 5 32

Standard Explanations of DifferencesStandard Explanations of DifferencesSee also Seminar Topic in Week 7- re Mishkin paperSee also Seminar Topic in Week 7- re Mishkin paper

1.Financial Structures of Poorer Countries – More Forex Denominated Debt– More Short Terms Debt

2. Macroeconomic Tendencies of Poorer Countries– Greater Tendency to use Inflationary Policies– Generally Weaker Policies and Fundamentals

EC 938 2007 Handout No. 5 33

Underlying Logic (IMF Model)Underlying Logic (IMF Model)

DiagnosisExcessive Borrowing (e.g. Tesobonos -

Mexico, hedged TBs - Ukraine, domestic bank loans, East Asia) has resulted in unsustainable upward pressures on:

• Assets Prices• Commodity Prices• Cost of Funds (maybe)• Nominal and Real Exchange Rates

It is the reversal of these movements that constitutes the crisis

MedicineAssume that the Excessive Borrowing

is attributable to Monetary (bank) Credit

TARGET just TWO of the FOUR Variables namely Commodity Prices (Inflation) and the Nominal Exchange Rate

Tighten Monetary and Fiscal Policy to redress the excessive borrowing and to hit the two targets

Treat Interest Rates as an INSTRUMENT in this process

EC 938 2007 Handout No. 5 34

What’s Wrong with That?What’s Wrong with That?Answer 1. Interest Rate Feedback Effects on Fiscal

• These feed-backs can theoretically be counterproductive in relation to the announced targets (Sargent and Wallace)

• Where govt. domestic debt is large relative to Forex debt, they may be as large a source of fiscal vulnerability as exchange rate movements (cf Mishkin argument)

• Where interest charges are already a large share of budget, i.e interest rate might be seen as a possible target not just an instrument of policy

• In some cases debt write-down has to be a part of the package if you are serious about allowing high interest rates

Large inter-country variability in these structural dimensions NOT reflected in policy package differences

EC 938 2007 Handout No. 5 35

…………ContinuedContinued

Answer 2. Feedback Effects via Corporate Balance-Sheets• There are theoretical reasons to expect very high R to

damage corporate balance-sheets (Calvo)• The actual numbers for East Asia confirm the near

CERTAINTY of serious deflationary effects from the 1997 hikes in rates

Answer 3: Risk Premium Feedbacksi.e. persistence of a gap Rd>Rf and then the effects

described by Calvo leading to much higher uncertainty and a higher risk premium

EC 938 2007 Handout No. 5 36

Corporate Characteristics in Asia -pre CrisisCorporate Characteristics in Asia -pre CrisisLeverage Debt Raised Altman's Fragility ROCE -Lending Rate1992-96 (% of Investment) Index 1995/96 1995/96(Average 1992-96 Average >3 = financially sound;

Crisis Countries <3>1.8 = vulnerable; <1.8=distress

Indonesia 92% 67% 2.6 -9%Korea 132% 69% 1.55 -2%Thailand 155% 78% 1.5 -8%Malaysia 62% 45% 3.9 3%Philippines 69% 25% 3.4 -9%

Comparator CountriesHong Kong 39% 45% 6.9 12%Latin America 31% 19% 1.9 naGermany 58% 6% na -8%USA 90% 8% na 4%

EC 938 2007 Handout No. 5 37

A Typical Asian CorporationA Typical Asian Corporation

Combined Operating and P&L Account

Year 1 Year 2 (A) Year 2 (B) Year 2(C) Year 1 Year 2 (A) Year 2 (B) Year 2 (C)(R=10%) (R=20%) (R=25%)

Costs RevenuesWages 150 165 165 165 Sales 490 539 539 539Materials 50 55 55 55Interest Charges 80 88 176 220Depreciation 130 143 143 143Balance-Profit 80 88 0 -44

Totals 490 539 539 539 Totals 490 539 539 539

Balance-Sheet

Year 1 Year 2 (A) Year 2 (B) Year 2(C) Year 1 Year 2 (A) Year 2 (B) Year 2 (C)Fixed Assets 1300 1287 1287 1287 Loans 800 880 880 880Cash 80 231 143 99 Shareholder Funds 500 500 500 500

Revaluations 0 50 50 50Retained Profits 80 88 0 -44

Totals 1380 1518 1430 1386 Totals 1380 1518 1430 1386

ROC (ex revaluation gains) 5.80% 5.80% 0.00% -3.19%

Revaluation Profit Fixed Assets 130

Table 4: Interest Rate Impacts on a Typical Company

EC 938 2007 Handout No. 5 38

Rich Countries -The Current ConsensusRich Countries -The Current Consensus

Crisis -Responses can be Supportive because

• After years of erratic progress, fiscal discipline is now high- fiscal deficits rarely exceed 1-2% of GDP

• Low inflation also sustained by formal commitments (e.g. Maastricht) and intensive global competition

• Small interest rate cuts do little either to re-fuel inflation or to damage confidence in financial markets

EC 938 2007 Handout No. 5 39

Rich and Poor Country - DifferencesRich and Poor Country - Differences

Poorer Countries• Thin Capital-Markets mean

that indirect effects of high interest rates on financial asset values can reasonably be ignored

• Inflation cost of borrowing is high because borrowing gets swiftly reflected in monetary/liquid assets

• Portfolio inflows from rich countries have relatively low risk-adjusted returns because they do not benefit from the hidden guarantee.

Richer Countries

• Huge pyramids of Capital-Market Credit means that large interest rate hikes need to be be avoided ( this fact provides a hidden guarantee for bond holders)

• Inflation cost of borrowing gets suppressed because of strong (but risky) portfolio preferences for capital market assets

• Portfolio outflows (to poorer countries) are immediately more risky even when economic management in those countries is very sound.

EC 938 2007 Handout No. 5 40

Financial Adjustment in the Poorer Financial Adjustment in the Poorer EconomiesEconomies

IF Bankruptcy Institutions Exist

a. Limited Insolvency > EFFICIENT rationalisation

b.Systemic Insolvency> Bankruptcy Neutralised as an

institution (insufficient capacity)

> Chronic Information problems for allocating any new Credit

> Cumulative growth of “Messy” Credit (Arrears etc.) as the major source of new Credit

Bankruptcy Institutions do NOT Exist or do NOT Function

> Confused Information about how to allocate any new Credit on offer

> Cumulative growth of “Messy” Credit (Arrears etc.) as the major source of new Credit - especially if Insolvency is systemic

EC 938 2007 Handout No. 5 41

Addendum to Handout Number 5Addendum to Handout Number 5

Problems in Monetary Control in Developing Economies

EC 938 2007 Handout No. 5 42

How Central Banks Control Money SupplyHow Central Banks Control Money SupplyBalance Sheet of Central Bank of Kenya 1991 (Ksh million)

Assets Liabilities

Net Foreign Assets (NFA) -7816 Base Money (B) 18005

of which

Net Domestic Asssets (NDA) 25820 Currency in Circulation (Cp) 14981

of which Commercial Bank Reserves (Cb) 3024

(Credit(net) to Government) 24620

Credit (net to Banks 864

Other Assets 336

(net of other liabilities and capital)

TOTAL ASSETS 18004 TOTAL LIABILITIES 18005

EC 938 2007 Handout No. 5 43

Basic Equations for Controlling Basic Equations for Controlling MbMb

LH = change in monetary base(MB) (changes in commercial banks reserves in CBK plus changes in currency holdings)[ ] = government’s domestic financing requirements with delta Fg = change in its own foreign assets/debt positionDelta Fcb = official interventions in forex{ } = open market operations in govt securitiesLast two terms on RH = government loans to private sector and to banks

nbbnbbcbnbbgggnbb LLTTFSSFRGCC }{)(][

EC 938 2007 Handout No. 5 44

Continued – the Money MultiplierContinued – the Money Multiplier

Where the term in round brackets is the multiplierα= bank’s (chosen)reserve ratio (to deposits)β= public’s (chosen) ratio of cash (their part of MB) to deposits

)1

(2

MBMMs

EC 938 2007 Handout No. 5 45

Possible Problems (using Kenya 1991-1994 Possible Problems (using Kenya 1991-1994 as an example)as an example)

1. Large non-controllable elements of foreign exchange payments/receipts (e.g NFA asset changes per month sometimes exceeded (Ksh 2 billion per month) 3% of broad money and >50% of bank reserves. So big exogenous (and hard to forecast) movement in Mb

2. Can Central Bank really control the discretionary elements of bank reserves? In election year 1992, CBK required to make huge advances (and rediscounts) to commercial banks = >Ksh 12 billion cumulatively. These have to be offset by tighter policies elsewhere if broad money growth is to remain stable.

3. Large swings in multiplier (bank reserves to bank NDA fluctuate seasonally but also in more random fashion) results in big disconnects from MB to M2

EC 938 2007 Handout No. 5 46

The Resulting Volatility and InconsistenciesThe Resulting Volatility and InconsistenciesThe control model involves TWO main intervention instruments for the Central Bank – Treasury Security transactions and Forex transactions (see equation)• Sales of Treasury Securities to absorb liquidity will need large interest rate movements if markets are thin on the demand side. If, in addition, the interventions need to absorb the huge MB instabilities just listed, those movements may be enormous• Sales of Forex to absorb liquidity obviously requires reasonable CB holdings of Forex – useless otherwise (see Kenya’s position)• Position even more complex if the INTERMEDIATE TARGETS of policy include some (implicit) stability of both the Exchange Rate and Interest Rates. In this case the CB must SELL forex. But this withdraws liquidity which will push up interest rates.

EC 938 2007 Handout No. 5 47

Kenya 1992 was a bad year!Kenya 1992 was a bad year!Source: Roe and Sowa, Source: Roe and Sowa,