Controlling interest rates
- Stabilizing interest rates
- Providing guaranteed interest rates
- Establishing system of interest on credit
Context
Because firms need finance to exploit investment opportunities, governments have often made the financial sector an instrument of industrial policy. For example, in a majority of developing countries, governments control at least some interest rates to encourage investment in some sectors. Interest rate controls also help governments finance their budget deficits: many state owned enterprises rely on low-interest loans from the banking system, and many governments require banks to buy low-yielding government bonds or place some of their assets in low interest reserves with the central bank. Many governments are convinced of the need for reform, but are concerned about the transition to market-determined interest rates which is easier to manage when inflation is low and real exchange rates are stable.
Implementation
In Colombia, interest rate controls reduced the funds available for smaller-scale industrial enterprises; the efficiency of investment fell as a result. A study of seven Asian developing countries found that interest rate controls reduced economic growth by roughly half a percentage point for every percentage point by which the real interest rate was below its market-determined rate.
Counter-claim
Although interest rate controls and selective credit policies may serve specific purposes, they tend to have broad and, on the whole, unfavourable effects on the behaviour of savers, lenders, and borrowers. They reduce the efficiency of investment, especially when controls on interest rates make them negative in real terms. As well as promoting investment in low-return projects, interest rate controls encourage firms to build up their inventories. Furthermore, faced with the need to ration credit, banks lend to the borrowers they know well - large-scale enterprises and parastatals - or even to the industrial groups that own them. Interest rate controls also keep credit cheap in relation to labour for those firms with unrestricted access to loans from the formal financial sector and thus encourage capital intensive investments in some parts of industry. These distortions ultimately affect growth. They inhibit savings. Where inflation is high, controls on deposit rates can make them negative in real terms. Even where interest rate ceilings apply only to loans, they control deposit rates indirectly by acting as a constraint on the yield and liquidity that banks can offer savers. When interest rates are kept low and the demand for credit outstrips its supply, the banking system must ration credit according to other criteria. Often the government directs the banks to lend to certain sectors, but this has usually failed to promote efficient and competitive industry.