Inflation and Interest Rates

The injunctions presented throughout this chapter against ceilings or subsidies on loan interest rates are widely applicable in economies with low or moderate inflation. However, under conditions of high inflation, and when drastic stabilization programs are being implemented, other economists have argued persuasively that releasing controls on interest rates should follow, not precede, the strengthening of bank supervision capacity and the achievement of relative price stability. The principal reason is that high interest rates during high and volatile inflation can give rise, to an unusual degree, to the problem of adverse selection, in which some of the less risky borrowers refuse to take out loans at high interest rates and lenders are left with a higher proportion of the more risky borrowers. If inflation is being brought down sharply, then a significant

151. M. J. Fry, 1995, pp. 467-468 [emphasis added].

share of these latter borrowers may end up defaulting, thus endangering the banking system.152

It also is the case that most farmers cannot afford to pay positive real interest rates when inflation is persistently of the order of 40-60% per year or more, as has been the case in Turkey for an extended period of time. The reason is that maintaining a policy of positive real interest rates for lending under high inflation causes total input costs, including interest, to rise geometrically, while output prices rise at a slower rate. Because a finance charge is attached to inputs, effectively the inflation on input prices is charged twice to the producer. An oversimplified example of the phenomenon may be stated as follows: (a) if inflation is 50 % per annum and real interest rates are maintained at 12 %, then the nominal interest rate will be 62%; (b) if, for simplicity, all inputs are financed for a year, then input costs rise by 50 + 62 = 112% each year, while output prices rise by only 50%.153 In addition to this problem, Joao Sayad has raised the concern that input prices may increase more rapidly than some output prices during high inflation, making it even riskier to borrow to finance production if real interest rates are positive.154

These caveats about interest rates during high inflation and while stabilization programs are in progress basically refer to the timing of interest rate reforms. Under some circumstances, a deregulation of interest rates may have to be postponed until inflation is reduced. However, this consideration does not undermine the basic contention that over the longer run loan rates controlled at an artificially low level are inimical to the development of sustainable rural financial systems.

The bottom line is that 'legal limits on loan interest rates, if enforced, will usually make commercially viable microfinance impossible',155 and microfinance represents an increasingly large share of agricultural finance.

Much of the commentary on interest rates from analysts of agriculture and the rural sector tends to concentrate on lending rates. In a period of transition out of high inflation rates, policy directed toward deposit rates can be more effective, as Fry has indicated. Fry's analysis also suggests that, in cases in which stabilization programs are being implemented in order to bring down inflation rates, a policy of reducing the rate of growth of the money supply combined with increases in deposit rates can also stimulate real growth. 'The simulations of my model suggest that stabilization policies raising the time deposit rate of interest are superior to policies relying solely on control over the nominal money supply. When the deposit rate is fixed below its equilibrium level, higher deposit rates can raise the rate of economic growth by increasing credit availability in real terms while slower monetary growth lowers the inflation rate'.156

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