Fry makes an argument for government intervention with regard to interest rates, but not in the
direction of subsidizing them. His argument is that the banking sector in most developing countries is not fully competitive and therefore an approximation of a competitive outcome for deposit rates may have to be imposed by policy:
Holding interest rates low by administrative fiat to encourage investment does not work because it discourages financial saving, the source of investible funds. With a cartelized banking industry, abolishing interest rate ceilings is unlikely to achieve the optimum result either. Indeed, it may not even produce higher real institutional interest rates. In the light of the recent experiences of Argentina, Chile, Sri Lanka, Turkey and Uruguay with excessively high real loan rates of interest, continued government intervention in the determination of institutional interest rates may well be the best interim policy until price stability is achieved and bank supervision and competition within the financial sector are adequate. ... an administered interest rate policy should select an appropriate objective and not be hampered by pursuit of several incompatible aims.
Possibly the most appropriate objectives of interest rate policy in developing countries are the efficient mobilization and allocation of domestic resources. Efficiency of both the mobilization and allocation of saving is maximized when institutional interest rates are set at their free-market equilibrium levels.. . . Since most financial systems in developing countries are oligopolistic, the competitive solution may well have to be imposed. Provided adequate bank supervision is in place, there is probably little point in attempting to set loan rates of interest; they can so easily be evaded through [obligatory] compensating deposits. Instead, the monetary authorities might set deposit rates at levels that approximate the competitive free-market rates. Specifically, banks might be required to offer indexed six- or 12-month deposits with a modest (perhaps 3 percent) real return.
One way of stimulating rather than simulating a competitive interest rate solution is for the government to issue treasury bills and bonds with attractive yields. Typically, government securities in developing countries are held only by financial institutions as part of their required liquidity ratios.. . . Yields on government securities are so low that voluntary holdings are nonexistent. The appropriate interest rate structure, however, applies equally to the government and the private sector. Indeed, if the government is unwilling to compete in this way, financial development is doomed.151
South Korea in the late 1960s pioneered this approach to deposit interest rates, in fact carrying it so far that inverse margins (deposit rates above loan rates) were purposely created, and the Government compensated the banks for their consequent losses. The aim was to induce households to become accustomed to depositing their savings in banks, where they would be accessible to industry, instead of in informal financial structures or savings in kind.
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