Macro Topics in Development and Transition 2006-2007

1. Macro Topics in Development and Transition 2006-2007 Handout No 5 Interest Rates and Financial Liberalization - in Macro Policy for Development EC 938 2007 Handout No. 5

2. Three Sub-Topics • Low Nominal Interest Rate policies in the period to about 1980 –Normally meant negative real rates reasons and effects • Selective Arguments for Reform • 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 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: Directed Credit Governments 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) EC 938 2007 Handout No. 5

5. But - State ownership of banks is often a part of such problems EC 938 2007 Handout No. 5

6. Typical 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. EC 938 2007 Handout No. 5

9. Selected 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. Continued 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. Continued • Financial repression yield substantial revenue to the government – a common alternative to conventional taxation • First source: implicit tax on financial intermediationby 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. EC 938 2007 Handout No. 5

13. EC 938 2007 Handout No. 5

14. 2. Pressures 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 – JDE 1976 an Example of the Allocative Benefits 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 Supply rm Demand I2 r c S,I S2 Demand I 1 S1 + S2 EC 938 2007 Handout No. 5

16. Uncompetitive Banking and Financial Depth in Transition Economies Source: Steve Peachey and Alan Roe, Bank Consolidation in Central Europe and the FSU, World Bank, 2005 EC 938 2007 Handout No. 5

17. Supposed Advantages of Reform for Stabilisation - Kapur (JPE 1976). Seminar 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. Continued • 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 dexp/dt = 0 EC 938 2007 Handout No. 5

19. Results • 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 Snags • 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)? • Will high money balances represent a substitution away from alternative (but lower cost) informal finance? (van Wijnbergen JME 1983) • 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 High 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.Source: paper in Simon Commander (ed), Managing Inflation in Socialist Countries in Transition, 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 EC 938 2007 Handout No. 5

23. Continued 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 EC 938 2007 Handout No. 5

24. Continued 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 EC 938 2007 Handout No. 5

25. Calvo model with Endogenous Devaluation & 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” EC 938 2007 Handout No. 5

26. Corrosive 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. Continued • 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 Situations 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. 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 The Puzzle: Policy Response to Recent Crises EC 938 2007 Handout No. 5

30. Emerging 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 EC 938 2007 Handout No. 5

31. Rich 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 EC 938 2007 Handout No. 5

32. Standard Explanations of DifferencesSee 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. Diagnosis Excessive 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 Medicine Assume 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 Underlying Logic (IMF Model) EC 938 2007 Handout No. 5

34. 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. ……Continued 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 Feedbacks i.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 Crisis EC 938 2007 Handout No. 5

37. A Typical Asian Corporation EC 938 2007 Handout No. 5

38. Rich 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. 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. Rich and Poor Country - Differences EC 938 2007 Handout No. 5

40. IF Bankruptcy Institutions Exist a. Limited Insolvency > EFFICIENT rationalisation b.Systemic Insolvency > Bankruptcy Neutralised as an institution (insufficient capacity) > ChronicInformation 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 Financial Adjustment in the Poorer Economies EC 938 2007 Handout No. 5

41. Addendum to Handout Number 5 Problems in Monetary Control in Developing Economies EC 938 2007 Handout No. 5

42. How Central Banks Control Money Supply EC 938 2007 Handout No. 5

43. Basic Equations for Controlling Mb 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 position Delta Fcb = official interventions in forex { } = open market operations in govt securities Last two terms on RH = government loans to private sector and to banks EC 938 2007 Handout No. 5

44. Continued – the Money Multiplier Where the term in round brackets is the multiplier α= bank’s (chosen)reserve ratio (to deposits) β= public’s (chosen) ratio of cash (their part of MB) to deposits EC 938 2007 Handout No. 5

45. Possible Problems (using Kenya 1991-1994 as an example) • Large non-controllable elements of foreign exchangepayments/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 • 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. • 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 Inconsistencies The 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!Source: Roe and Sowa, EC 938 2007 Handout No. 5