Low administered institutional interest rates are prevalent in developing countries. Even where financial development programs have been initiated in some Asian countries, interest rates have not often been freed without delay or completely find their free-market equilibrium levels.
For example in Latin America and Turkey interest rate ceilings were abolished, but rates rose in unruly high levels in real terms.
Bank supervision and some degree of price stability are essential prerequisites for the success of financial liberalization.
Further literature on financial policies in economic development can be found in the work of some economists such as Villanueva and Mirakhor, 1990.
Interest rate ceilings distort the economy in three ways; low interest rates create a bias in favour of current consumption and therefore cut saving, potential lenders may engage in relatively low-yielding direct investment instead of lending to finance higher-yielding investments by depositing money in a bank, and bank borrowers who are able to obtain all the funds they want at low loan rates will prefer relatively capital-intensive projects.
Deposit and loan rate ceilings tend to deteriorate the distribution of income.
Firstly, most of the economic rent goes to larger borrowers relatively smaller than savers /lenders when deposit and loan rates are held well below their market equilibrium levels.
Income distribution is likely to worsen mostly when the borrowing firms are predominantly family-owned companies; secondly, capital- intensive production methods encouraged by low interest rates reduce demand for labour. Hence wages of unskilled labour falls.
Duality created by the inefficient small-scale direct investment on the one hand and large scale investments that are too capital-intensive on the other create greater dispersion in wages.
In practice, bank loans become concentrated in the hands of a small number of large and well-established customers.
Greater economic concentration tends to reduce economic efficiency.
Selective or directed credit policies are almost as common as interest rate ceilings. Indeed, the differentiation of interest rate levels for different sectors of the economy is possible only under a system of interest rate ceilings.
Selective credit policies or directed credit programs lessen the financial system’s flexibility while increasing its fragility.
However, there is no proof that they improve the economic efficiency of resource allocation.
Indeed, the portfolio constraints imposed by directed credit programs reduce the funds available for discretionary bank lending both directly and indirectly by reducing the attractiveness of deposits.
They also increase the fragility of financial systems by forcing financial institutions to increase their risk exposure with no compensating return.
Directed credit programs are partly responsible for the alarming amount of non-performing assets on the books of many financial institutions in developing countries.
Policy measures taken to deal with fiscal exigencies have often negated financial reform and retarded financial development.
Discriminatory taxes of one type or another have been imposed on financial intermediation. High reserve requirements, obligatory holding of government bonds by financial institutions, and deposit and loan rate ceilings represent a selection of the measures frequently used as fiscal devices that have repressed financial development.
Financial systems cannot achieve their full potential unless governments are prepared to compete for funds to invest on an equal footing with private sector borrowers.
In most developing countries, the financial sector plays a major role in mobilizing domestic resources and allocating them to investment projects.
Over the past two decades, developing countries have tended to assign a larger role in private initiative in the development process, implying that a larger proportion of investment is to be undertaken by the private sector.
At the same time, many of these developing countries are trying to increase their investment ratios in order to raise their growth rates.
In the face of contracting net inflows of external resources, national saving ratios must be raised and more emphasis placed on economic efficiency in resource allocation.
It has therefore become increasingly important to assess the potential role of improved financial intermediation in the process of economic development.
To accelerate the rate of sustained economic growth, the financial sector must mobilise domestic resources effectively; allocate them efficiently to finance new productive economic activities, and at the same time maintain macroeconomic stability.
Over the past three decades, developing countries have expressed repeatedly a commitment to improve the mobilisation and allocation of domestic resources through their financial sectors.
To this end, they have made various changes in the structure and operations of their financial systems under the rubric of financial development, liberalisation or reform.
However, the experience of these efforts has been disappointing in the extreme.
The driving force behind recent financial innovations and reforms in the industrialised countries has been market pressures.
The market is so distrusted in the majority of developing countries that market pressures are virtually nonexistent.
In these countries, the idea of Ronald McKinnon (1973) and Edward Shaw (1973) have had more impact, perhaps most obviously and effectively in the policy recommendations of the IMF and World Bank.
The competitive free-market equilibrium deposit rate of interest may be raised, so increasing the real supply of credit and hence the rate of economic growth, without affecting the loan rate.
This is done by reducing reserve requirements or by paying a competitive interest rate on required reserves.
However, experience shows that there are at least two prerequisites for successful financial liberalization-macroeconomic stability and adequate bank supervision.
Price stability, fiscal discipline, and policy credibility may well be the three key factors explaining Asian successes and Africa’s failures.
Indeed, high and variable inflation destroys existing financial markets and prevents potential financial markets from developing.
Containing inflation requires monetary control and fiscal discipline. Macroeconomic stability also necessitates consistent macroeconomic policies, in particular monetary and exchange rate policies.
In conclusion, however, it should be borne in mind that some techniques with which monetary policy is implemented retard financial development, while others promote it.
Global credit ceilings are perhaps the greatest deterrent to financial development. On the other hand, open treasury bill auctions and the promotion of secondary markets, particularly inter-bank money markets, encourage financial development.
Experience indicates that learning-by- doing with market-determined interest rates in short-term financial markets is the only viable way in which active and stable long-term security markets can be developed.
The author works with the Ministry of Finance and Economic Planning in Rwanda.