Posted by: mulrickillion | November 13, 2011

The Puzzle of Persistently Negative Interest Rate-Growth Differentials: Financial Repression or Income Catch-Up?

By Julio Escolano, Anna Shabunina, and Jaejoon Woo

International Monetary Fund (IMF), Working Paper, No. 11/260, November 2011

Summary: The interest rate-growth differential (IRGD) shows a marked correlation with GDP per capita. It has been on average around 1 percentage point for large advanced economies during 1999-2008; but below -7 percentage points among non-advanced economies – exerting a powerful stabilizing influence on government debt ratios. We show that large negative IRGDs are largely due to real interest rates well below market equilibrium – possibly stemming from financial repression and captive and distorted markets, whereas the income catch-up process plays a relatively modest role. We find econometric support for this conjecture. Therefore, the IRGD in non-advanced economies is likely to rise with financial integration and market development, well before their GDP per capita converges to advanced-economy levels.

[An excerpt from the Working Paper reads]:

Economic theory provides reasons to expect that the IRGD be positive, at least in advanced economies. The modified golden rule posits that, abstracting from temporary shocks, the real interest rate should exceed the growth rate in economies that are at, or near, their balanced growth path. The latter is generally thought to describe well the broad growth features of most advanced economies. The theoretical case for the modified golden rule rests on the efficiency of the dynamic equilibrium and the impatience of economic agents (see for example, Blanchard and Fischer (1989)). This theoretical conclusion is consistent with the evidence of the last three decades, as IRGDs for advanced economies have been generally positive.

In contrast, for economies undergoing an income catch-up process, growth theory is ambiguous as to whether the IRGD should be positive or negative, or be higher or lower than in advanced economies—but real interest rates should unambiguously be no lower than in advanced economies. Growth theory provides good grounds to expect faster growth, but also higher real interest rates. For economies closed to financial flows, but with competitive domestic financial markets, the real interest rate would reflect the domestic marginal product of capital—which should be higher than in advanced economies. Higher marginal product of investment is indeed what makes these economies grow faster. Open economies may have lower real interest rates than their domestic marginal product of capital since they can borrow in international markets at the aggregate world marginal product of capital. Thus, the real interest rate on government debt from these economies should be equal to the real interest rate paid by G-7 governments plus risk, liquidity, and other premia. In practice, one would expect to observe real interest rates that are at some point between the pure closed and open economy cases. In any case, the real interest rate on government debt from non-advanced economies should be generally higher—or at least certainly not lower—than that from G-7 economies.

This conclusion is however strongly counterfactual: real interest rates on non-advanced economy government debt are generally substantially lower than on advanced economy debt; and this is the primary reason for lower IRGDs in non-advanced economies. . . .

>>Read the full Working Paper here (wp11260.pdf).


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