SUBLOAN INTEREST RATES

Objective

To describe the policy guidelines to be applied for determining interest rates on subloans under global credit operations to productive sectors. Interest rates on these subloans should take into account the objectives and purposes of the Bank's global credit loans.

Basic Guidelines

Global credit loans have institutional, economic and other development objectives. Specific objectives of global loans for productive sectors are: a) to increase the supply of and access to credit for financing small and medium scale enterprises that meet requirements similar to those the Bank stipulates in its direct operations; b) to encourage intermediary financial institutions to become effective vehicles for the mobilization and channeling of domestic and external savings towards investment and other productive uses and, in this way, to contribute to an efficient allocation of resources and to the development and strengthening of national capital markets; and c) to strengthen the technical, economic, financial, administrative and managerial aspects of intermediary financial institutions and enable them effectively to play the role for which they were created, and in this context, to attain permanence, continuity and long-term financial viability.

The interest rates charged by financial intermediaries must be considered in the context of the interest rate policy and structure of the recipient country, as they constitute an important part of that structure. Specifically, the setting of the interest rate has a direct bearing on the supply of and demand for credit in the economy. In this regard, overall interest rates on subloans should be equitable and conducive to the encouragement and the efficient mobilization and allocation of financial savings. Interest rates on subloans are an important instrument associated with the achievement of the objectives of global credit operations as outlined above. For a financial intermediary, its lending rates are also of great importance, directly affecting earnings and hence the ability to maintain an adequate staff and administration, the potential and options for resource mobilization, and the degree of risk exposure that can be tolerated (and by extension, the type of clientele that can be served). Additionally, in this regard, various forms of governmental support may play a role.

In the ideal situation of economic equilibrium interest rates would be set at a level that would reflect the opportunity cost of capital. When the cost of mobilizing funds to a financial intermediary (without subsidies) can be taken as roughly equivalent to the opportunity cost of capital, allowance being made for an adequate operating margin, the determination of an appropriate interest rate is greatly simplified.

In practice, however, it is extremely difficult to measure the opportunity cost. In the absence of such a measure, an alternative benchmark would be a rate to the borrowers that is likely to be positive in real terms over the life of the debt obligation. In such cases, as a general rule, the nominal interest rates would be set sufficiently high to allow for expected inflation, in order to obtain positive real rates. These should facilitate, over the long run, the mobilization of private financial savings by financial intermediaries and should also permit adequate operating margins.

Higher rates of interest on subloans, particularly within the positive range, are more likely to be conducive to the financing of projects with higher financial rates of return. Conversely, excessively low rates of interest, particularly within the negative range, may result in the inefficient allocation of resources through the financing of projects with relatively low financial rates of return.

There are a number of policy and practical considerations to be taken into account in the setting of interest rates on subloans when existing conditions do not permit the immediate achievement of the general rule expressed above under "Basic Guidelines." For example, in most countries there are imperfections in the markets--both in the financial markets and in the markets for goods and services--which cannot be overcome in the relatively short term.

In addition, it may be the borrowing governments' policy and priority to utilize preferential rates of interest to encourage and stimulate development in specific sectors and regions. Preferential rates, however, may have unwanted side effects. Other instruments may be more effective in achieving governmental objectives, such as tax or expenditure policies and the provision of infrastructure among others.

Another consideration which has to be taken into account, is the borrowing countries macroeconomic policies. Clearly there has to be consistency between these and the approach to reaching positive interest rates on subloans. An illustration of a specific type of problem may be cited; In countries where the rise in the rate of inflation is very rapid or where there are chronic long-term high rates of inflation, it may be difficult and/or impractical to establish positive rates of interest within a specific time frame. The benchmark of establishing positive interest rates remains valid although a period of time may be required for its practical fulfillment. This situation should be set forth in the loan's submission to the Board for the global credit operations.

Given the above considerations, on occasion it may be necessary to accept on-lending rates in Bank-financed global credit operations to productive sectors which do not satisfy the general rule described above. The following approach would apply in such cases:

a) Within the above context of the subloan interest rate guidelines, that call for reaching the benchmark of positive interest rates over time, the borrower and the Bank should periodically review the situation of the subloan interest rates. The measure of progress made in the implementation of the aforementioned benchmark, taking into account the rate of inflation experienced during the life of the loan, should be reported to the Board of Directors.

b) During the interim period in which it may be necessary to depart from interest rates that would cover the cost of financing and administrative expenses, the authorities in the borrowing countries should make a commitment to transfer sufficient government resources to the financial intermediaries to prevent their decapitalization.

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Prevailing Reference Document: GN-1448-4 Rev. 2, March 1983.