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Prices and the Global Economy

I would like to buy better seed, fertiliser and pesticide but I can’t afford the loans that are being offered. Why do I pay higher rates of interest on loans than people in other countries? Are there alternatives?

Interest rates vary for many reasons. Of these, perhaps two are of greatest importance; inflation rates and property rights. 

1. Interest rates and inflation

The interest on a loan is, in part, a function of the rate of inflation (that is to say the rate at which prices are rising in general in the economy); because rates of interest must be higher than the rate of inflation in order to induce lenders to part with their money, countries with high inflation rates will have high interest rates.

Inflation is ultimately caused by the central bank printing too much money. Consider what happens when a country with $10,000 in circulation has a central bank which issues another $10,000 over the course of a year. Nothing else has changed except that there is now twice as much money in circulation ($20,000 instead of $10,000). Since the relative value of goods and services haven’t changed, the only way to maintain an equilibrium is for prices to double. Consider the example of a loaf of bread:

If a loaf of bread costs $1 when there are $10,000 in circulation, that means it costs 1/10,000 of the total currency. So if the amount of currency in circulation doubles to $20,000 but nothing else has changed, then the price of bread must have doubled to $2; which is 2/20,000 = 1/10,000.

Since all prices have doubled, banks will have to double the "price" they charge for lending. In this example, for banks to avoid making a loss, they would have to require borrowers to pay at least 100% interest.

2. Interest rates and property rights

If you are being offered loans at high rates, it would certainly be worth looking into the availability of microloan facilities from organisations in your locale.

The interest charged on a loan will vary from person to person based on the likelihood that each person will default on (that is, not pay back) that loan and the person’s ability to offer property as security against default.

The second aspect is of particular importance: If a money lender is offered property as a security, the lender will usually be willing to offer lower rates because the lender knows that in the event of default he will at least own the property. Moreover, if property is used as security, the borrower has a stronger incentive to repay in order to avoid risking the loss of their property. In places where property rights are not well defined, readily enforceable and easily transferable, it is more difficult to offer property as security, so the amount charged for a loan will typically be higher.

Weak property rights can result from many different causes. Usually they are a result of some combination of a weak legal framework, expensive and inefficient courts, and government interference in the ownership, use and exchange of property. Many countries have no land titling system, or – worse – a land titling systems that is highly bureaucratic and costly, making it difficult for small landowners to register their land and incentivising owners to transfer land without using the formal system; these would be examples of weak legal frameworks.  Many countries also have court systems that are slow and expensive; in such places, disputes over the ownership of land can take years to resolve – and often remain unresolved. In nearly all countries, governments interfere with the ownership, use and exchange of land – but in some places their interference is worse than others and it is these places where land owners will circumvent government interference by avoiding formal titling of land.

Resolution of these problems are beyond the capacity of most small individual farmers. To avoid inflation, central banks must keep a tight rein on the issuance of currency. To enhance the strength of property rights is likely to entail various legislative and other reforms – moreover, there is no one-size-fits-all solution.

While reform of the system is ultimately desirable in both cases, reform will not help farmers in the short term. However, there are alternatives to conventional bank loans that are becoming increasingly available – offering farmers access to credit at more favourable rates. In particular, microlending, such as that undertaken by the Grameen bank, seems to be very successful. If you are being offered loans at high rates, it would certainly be worth looking into the availability of microloan facilities from organisations in your locale.

How do I reduce the risk of losing money?