Until the late 1970’s Malawi experienced a high degree of financial repression, with administered interest rates, credit ceilings, segmented capital markets and excessive intermediation costs. As part of structural adjustment programs supported by the World Bank and the IMF, Malawi has been implementing structural reforms in the financial system for close to two decades now. The main objective of these reforms has been more efficient mobilization of resources and optimal resource allocation. One of the most important aspects of financial reforms was interest rate liberalization.

Interest Rate Policy in Malawi: Past and Present

The Pre- July 1987 Period
Prior to July 1987, the basic structure of interest rates was directly administered by the Reserve Bank (RBM) of Malawi. As a result, interest rates were infrequently adjusted during the period before July 1987. Less attention was paid to underlying macroeconomic conditions, especially inflation (See Table 1) as well as the demand and supply of funds. The main preoccupation was to keep interest rates low in order to reduce government expenditures and to promote private investment. During the regime of administered interest rates, deposit rates were set by Reserve Bank of Malawi while lending rates were set by commercial banks, but subject to a ceiling rate. In March 1980, however, interest rates which were in favour of the agricultural sector were introduced for the first time. The sector was given a preferential rate of 1 to 2 percentage points below the prime rate.

Post-July 1987 Period (Liberalization)

Rationale for Liberalization
The deregulation or liberalization of interest rates started in earnest in July 1987 when lending rates were freed. The advocates of interest rate liberalization and financial development as growth enhancing economic policies in developing countries have based their arguments on the theoretical works of Mckinnon (1973) and Shaw (1973). The policy of low interest rates was considered an important avenue for promoting investment by keeping interest costs low. Mckinnon and Shaw, however, showed that the policy of controlled or administered interest rates was tantamount to “financial repression”, which is a general distortion in financial prices like interest rates that reduces the real value of financial assets. Thus, the overall volume of savings decreases and investment is naturally adversely affected. The policy prescription for the financially repressed economy in the Mckinnon Shaw models is then to raise institutional interest rates or reduce inflation. In line with this thinking and in order to support the adjustment program, it was decided to gradually deregulate interest rates. This was done as follows:-

(a) In July 1987, commercial banks were given the freedom to set their own lending interest rates.

(b) In April 1988, deposit rates were deregulated.

(c) In August, 1988 preferential interest rates to the agricultural sector were abolished.

(d) By May 1990 all rates became fully liberalized.

Since complete interest rate liberalization was launched, the Bank rate (the rate at which commercial banks borrow from the central bank) has played a more important role in the financial system. The role of the bank rate has been enhanced by the development of the money market and the frequent use of open market operations as a tool of monetary policy. The Reserve Bank of Malawi now uses the Bank Rate as an indicator of the stance of monetary policy. Many times, the adjustment of the Bank Rate has led to adjustment of interest rates in the financial system. The Bank rate is set on the basis of interest rates on the Treasury Bill market as well as developments in inflation rates.

Interest Rate Movements Before and After Liberalization.
During the period 1985 to 1990, the bank rate and the savings rate hovered around 10.0 percent with hardly any changes while the minimum lending rate remained at 13.0 percent. As noted earlier, the full liberalization of interest rates in 1990 meant that commercial banks could set their own interest rates. However, in practice during the period 1990 to 1992 the commercial banks moved their own rates only after the central bank moved its bank rate. The bank rate was adjusted at least seven times by monetary authorities mainly to reduce excess demand for cash, particularly during the period 1994-1995. This is also the period when Malawi experienced high levels of inflation. From end 1994, to curb inflationary expectations, the bank rate was raised to 50.0 percent by May 1995. This was also in line with Treasury Bill (TB) yield which soared during this period. From 1996, however, the bank rate has been steadily adjusted downwards and currently stands at 47.0 percent (as of October 1999). This downward adjustment resulted from developments in the economy as both TB yield and inflation followed a downward trend.

Impact of Malawi External Debt Relief on Interest Rates