World Bank Document

Box 3.2
Interest rate variability, risk shifting, and floating rate debt
For developing-country borrowers, it may appear that a to escape risk entirely, one must pay a premium.
switch from fixed rate to floating rate loans passed all the Moreover, a country should be concerned not only
risk on to them. That is not necessarily so. The switch about variability of interest payments on foreign debt,
does not have any consequence for real interest rates if but also about variability of national income, of which
changes in real interest rates are brought about by interest payments are only one (negative) component.
changes in inflation. However, if real interest rates fluc- Sometimes these offset each other. Take the example of
tuate because nominal rates do, the lender takes all the an exporter of primary commodities with a large foreign
risk under fixed rates while the borrower does so under debt.
floating rates.
When aggregate demand shocks are the main source of
Neither fixed nor floating rate loans provide complete global instability, interest rates will move up and down
protection from fluctuations in real interest rates. This with primary commodity prices. In those circumstances,
protection can be obtained from loans whose interest variable real rate debt may be attractive for a commodity
rate is indexed to inflation. Such instruments have exporter: when low primary commodity prices reduce
largely failed to materialize in international capital mar- export earnings, real rates are also likely to be low,
kets or in the domestic markets of most major industrial thereby reducing the country's debt service burden and
countries (an exception is the United Kingdom, where helping to shield national income from the fluctuations
part of government debt is index linked). And even with in export revenues.
indexed loans, a borrower will be more exposed to inter- This example demonstrates that reducing the variabilest
risk if the loan carries a short maturity since it will ity of one component of national income (in this case real
have to be refinanced frequently at potentially higher interest payments on foreign debt) may in fact increase
rates.
variability of national income itself if the shocks to differ-
In assessing their financing options, borrowers also ent components are correlated among each other.
need to consider an obvious, though occasionally over- Whether indexed debt is attractive for a borrower will
looked, point: their loan will be more expensive when- therefore depend on the source of shocks to the world
ever the lender bears some or all of the interest rate risk. economy and on the structure of trade of the country.
The analogy is with, say, house or automobile insurance:
service obligation will remain high for some time explain developments through 1982. As is to be
to come. expected in periods of tight money, inflation and
At least four factors have been proposed as output fell, the stock market declined, and real
explanations of the higher real interest rates in the interest rates went up. Monetary policy was
United States. tighter in the United States than abroad, contribu-
Monetary restraint. Tight money helps to ting to the real appreciation of the dollar. However,
such effects are temporary and should therefore
Figure 3.1 Inflation in the United States, raise short-term interest rates initially before fad-
Federal Republic of Germany, and France, ing away. Accordingly, after a tightening of mone-
1965-84 tary policy short-term rates should rise more than
Percent long-term rates. In fact, short-term rates rose less
than long-term rates. Therefore, other factors must
15 also be part of the explanation of why real interest
Franc\
rates stayed high after 1982.
* Expectations of high future inflation. If future
10 inflation is expected to be much higher than the
current rate, long-term interest rates are high in
Germany / t nominal terms but not in real terms. Such an argu-
5 s " / \ <
ment is not consistent with the high real exchange
,f+ 9 ~so\' s ' ___,\\^ - value of the dollar; high expected future inflation
-C it UnitedStates \^ should lead, other things being equal, to a dollar
so U depreciation, not the appreciation that in fact took
0 place. Thus, expectations alone cannot explain the
1965 1970 1975 1980 1984 rise in U.S. interest rates.
Source: OECD National Accounts, GDP deflators.
* A tax-induced investment boom. In 1981 the
United States changed its tax system in ways that
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