Why are loan interest rates so high?

Despite declining over the last 10 years and a recent increase, interest rates in Brazil still remained exceptionally high compared to other emerging countries. What are the reasons that lead to such a high cost for money? Three main factors (and two other factors) explain the reason for such high interest rates in Brazil:

  • The recent history of hyperinflation;
  • The savings rate is low;
  • The high proportion of subsidized and directed loans in the economy.

History of hyperinflation

History of hyperinflation

Inflation rate in Brazil averaged well over 100% a year during the 1980s and exceeded 1,000% per year during the first half of the 1990s. Only in the second half of the 1990s, after a monetary introduced the Brazilian real, Brazil was finally able to stabilize inflation by one digit. The relatively fresh memory of these extraordinarily high inflation rates still has a profound impact on economic behavior in Brazil.

In particular, there is a tendency in Brazil to overestimate the risk of inflation in the medium term. As a result, the central bank has to be particularly vigilant, both in terms of rate levels, as well as the timing of rate hikes, in order to keep inflation expectations contained. Overestimating the risks of inflation also foster the tendency to lend even with high nominal rates and the reluctance to invest with fixed nominal rates, as rising inflation shocks benefit borrowers and harm creditors.

Low Savings Rate

eBrazil’s national savings rate is very low compared to more advanced and emerging economies. In 2010 it was only 16%. Compared with other emerging countries, only Turkey had a lower saving rate. Our Latin American neighbors have savings rates equal to or greater than 20%, and most Asian economies have rates around 30%.

The low saving rate in a country with substantial investment needs causes upward pressure on interest rates, since there is a shortage of savings to finance the investment with “normal” interest rates. Another way to look at this is through internal demand.

The other side of a low saving rate is a high consumption rate, which means that when combined with significant demand for domestic investments, that domestic demand is very high and needs to be controlled through higher interest rates, avoiding the overheating of the economy and the crisis.

High proportion of subsidized and directed loans in the economy

The third factor that is contributing to the pressure on interest rates is the large portion of directed and subsidized credit in Brazil. This occurs through government-supported financial institutions, especially the state development bank BNDES.

BNDES loans account for about 20% of total credit in the economy, while directed loans (including rural credit and housing credit) are around 35%. Most of the directed loans are linked to the “long-term interest rate”, which generally does not change.

The interest rate was last augmented in 2003 and has since been cut in half (from 12% to 6%). Lack of response to market rates weakens the transmission of monetary policy. Since a substantial part of the credit does not react to the Central Bank’s interest rates or market interest rates, the Central Bank has to compensate, maintaining the higher rates for unsubsidized credit, in order to achieve the same effect of credit tightening. The end result is a higher level of market interest rates.

Complementary causes

As an aggravating factor of this scenario described above, two causes can also contribute to the lending rates so expensive in Brazil: the inefficient judicial system (precarious laws to strengthen creditor protection) and the huge (and inefficient) government expenditures.

The former creates greater risks for the lender as there are no guarantees that the borrowers will repay the loans or that they may be charged judicially for the payment of what is owed. Higher risks and less collateral translate into higher interest rates for borrowers.

The second is very controversial, as it often involves ideologies of political parties. But in economics, when a government spends too much, it creates inflation. High interest rates drive inflation. Thus, to meet the inflation ceiling that the government defines for 12 months, the bank has to raise interest rates.

Interest rates attract foreign capital as the market becomes profitable for them. Foreigners can lend money to Brazilian companies, individuals, and the loans will be paid back with high interest rates. Thus, there is an influx of dollars in the Brazilian market, which causes the real to be overvalued. The overvalued real currency is good for people who want to import things, but it is bad for the economy, since Brazilian products cost more in the foreign market. These are no longer competitive because of high taxes, bureaucracy, low worker productivity and poor infrastructure in the country. Moreover, high interest rates are bad for the growth of the country once a business has a hard time growing when they have to pay high interest rates for their loans.

Final considerations

The ideal scenario would be low interest rates. But for that, it would be necessary for the Brazilian government to better control its debts and expenses and incentives for saving. Otherwise, it will be difficult for Brazil to have lower interest rates that are accessible to a larger portion of the population.

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