What are the effects of high inflation and high interest rates on an economy?

April 4, 2009 1:12 AM

Economicsfilter: How do mortgages work in developing countries with high rates of inflation and high interest rates? For example, Pakistan has a 20% inflation rate and the average fixed term prime residential mortgage for people with good credit is priced at 17%. What are the effects of this on a market?

Can anyone point me to economics texts or real world examples of the results of the following:

USD:PKR exchange has gone from 1:60 to 1:81 in less than one year.
Inflation rate steady at 18 to 22% per year.
Minimum mortgage costs for residential consumers in the range of 16.5%+

The Pakistan central bank sets a rate which results in a KIBOR (Karachi Interbank Offered Rate) of approximately 15%. The various big name banks in Pakistan mark this up a couple of percent and sell residential mortgages on 10, 15 or 20 year amortization terms for around 16.5 to 18.0%. These are not "sub prime" type rates but are for people who can put 20-25% down, with good credit scores and job references, the Pakistani equivalent of a non-jumbo Prime mortgage.

This obviously makes the purchase of an average 3-bedroom flat quite a bit more expensive than in the US or Canada, where mortgages for anything would be under 8%.

How did this work in Argentina when the currency dropped drastically against the US dollar? I know of people who got into the Argentine market at exactly the right time with a USD exchange (or Euros, or GBP, or whatever) and were able to buy up property at amazing prices. Were interest rates similarly high in Argentina during the same period?

Does a high inflation rate somewhat offset the effect of having a mortgage with a 17% fixed interest rate? If the mortgage contract is fixed at a certain payment, but the inflation continues, a theoretical Rs125,000 monthly payment will continue to get less expensive as time goes on...

posted by thewalrus to work & money (13 comments total)

I am no economist, and know very little of such things, but I always assumed that in Pakistan and other developing countries people didn't get mortgages; if they could afford to buy houses, they just bought houses.
posted by koeselitz at 1:58 AM on April 4

Yes, there are a lot of direct purchases going on, since families tend to stay together... An extended group of people with three or four salaries coming in (father, sons, uncles, etc) pool their money together and buy a place.

But: Using the high end of the market for an example, a small "starter" house in the least expensive sectors of Islamabad costs the PKR equivalent of $125,000 US Dollars... (or ten million to twelve million rupees) That's something totally beyond the reach of an average Pakistani white collar wage earner without getting a mortgage.
posted by thewalrus at 2:03 AM on April 4

Your asking an excellent question which I can start my input for with a plug for my favorite charity kiva.org. Basically KIVA.org lets you lend directly to people in the developing world whereby you put up the capital and in exchange some person that you select gets a business loan to expand their business. It's person to person micro finance network. The reason I bring it up is that when you learn more about the site you find out that the lender operating in country is charging as much as 20% interest. Why should you be involved with this? Because individual money lenders in country often charge as much as 100%.

The reason that KIVA got started is because many economists studying development have been saying that access to affordable credit. Urban Pakistan is better then a lot of poorer areas of the world but it is still not ideal. Remember that a mortgage is a loan and a loan is a bet. You are betting that the person will pay you back. If you win you get the interest and if you lose you recoup their house. The value of the house however is offset by the difficulty of seizing the house. In some countries it is easy to throw someone out of their house and in others it is close to impossible. So the basic factors that determine the interest rate for a home mortgage are the laws regarding bankruptcy and foreclosure, the stability of the economy, the pricing and stability of the asset in question and the stability of the money supply. The stability of the money supply is what your question is about so lets focus there.

If you take a loan out for lets say 100,000 dollars and agree to pay it back over the course of 10 years. You pay 10,000 dollars a year plus interest which is lets say 10%. If the inflation rate is 10% as well then, assuming both interest and inflation are compounded at the same time, you are paying them back the same amount of value as they gave you ten years ago. So to the novice at econ, that means ten years ago you could have purchased 100,000 potatoes and today they can purchase 100,000 potatoes. Which means that the bank didn't make any profit which obviously doesn't make companies happy. So they will usually charge somewhere above the inflation rate in order to factor in the risk of default, transaction costs and of course their profit.

So how do people afford 20% mortgages? Well often in countries with inflation rates like this peoples salaries are adjusted in line with inflation. So yeah you have a loan that is increasing in value 20% every year but your salary is increasing at about the same value so no big deal. Also in Pakistan you have a lot of money coming into the country through foreign remittances, ie Pakistanis living in other countries sending money home, so as the exchange rate changes so does the value of the money coming home.

Which of course asks the real question of if inflation is 20% shouldn't the mortgage rate be above that? Well central banks have a lot to do with setting mortgage rates as you pointed out and often their actions are an indications of government desires as much as market realities. So even if the actual inflation rate is 20% the central bank may be setting mortgage rates lower to reflect the desires of the government.
posted by monkeywithhat at 3:39 AM on April 4

Is the interest rate really lower than the inflation rate? Because as long as that is the case, taking out a mortgage is a pretty good deal, isn't it?
posted by winston at 3:42 AM on April 4

In Egypt at least, mortgages are very uncommon.
posted by bluedaisy at 4:50 AM on April 4

n'thing the "they just don't have them" Even in parts of the developed world like Greece or Turkey mortgage penetration rates are much lower then you would think.
posted by JPD at 5:21 AM on April 4

I'm not at all conversant in the specifics of the Argentine or Pakistani economies, but it seems worth pointing out that high inflation rates, artificially low interest rates and a falling currency exchange rate are not independent or merely coincidental. I'm just speculating, but I'd think that if the government is setting KIBOR below the rate of inflation then it's doing so at a loss, and "paying" for that loss by printing more money. When the government prints a bunch of money for purposes of manipulating interest rates this way, that money doesn't represent new value that's being created in the economy; rather, it dilutes the existing value in a larger pool of currency, so each unit of currency is associated with a smaller amount of real value. This is inflation, and inflation results in falling currency exchange rates. These problems and the strategies the government uses to address them tend to reinforce each other.
posted by jon1270 at 7:03 AM on April 4

Look at it from another angle- by offering mortgages, the bank feels that they can make more money than just letting their cash sit there. But because the term is so long, the mortgage interest rate is going to reflect what the banks think the future of inflation will be. So when the mortgage rate is lower than the current inflation rate, it seems like a good deal, but may not be- the banks are expecting inflation to drop, and you are stuck with a high rate.
posted by gjc at 7:09 AM on April 4

Also, re: I know of people who got into the Argentine market at exactly the right time with a USD exchange (or Euros, or GBP, or whatever) and were able to buy up property at amazing prices.

Successfully doing this means knowing much more than you can learn from looking at interest, exchange and inflation rates. You can buy property whenever you feel like it (assuming you've got the funds/credit to do so), but whether it's a good investment depends on what will happen in the future. If you can't correctly guess when those property values will rebound, you're just playing roulette. You can't learn that future by reading these particular tea leaves.
posted by jon1270 at 8:07 AM on April 4

Over here in Poland, the answer to your initial question is: nobody had a mortgage. Back in the early 90s people feared loans of any kind like the devil, and the only people I know who actually talked about them were business owners. Companies would offer lower prices if a client pre-paid on many orders since credit lines were so expensive.

It's completely different right now. Mortgages that run between 20-40 years are the norm. Non-zloty loans are very popular: USD, EUR and CHF being the main currencies. As the zloty has fallen over the past 6 months, all my friends with mortgages have been freaking out about their monthly payments going up.
posted by jedrek at 8:25 AM on April 4

t's completely different right now. Mortgages that run between 20-40 years are the norm. Non-zloty loans are very popular: USD, EUR and CHF being the main currencies. As the zloty has fallen over the past 6 months, all my friends with mortgages have been freaking out about their monthly payments going up.

" I mean it almost riskless. Its inevitable we'll join the Euro, so your mortgage should only get cheaper. Free money"

Yeah not working out so well these days.

Even scarier is that all of the banks thought the same thing.
posted by JPD at 9:42 AM on April 4

On another angle if you are really thinking about speculating in Pakistani real estate you may be able to make a fortune since alot of people right now are betting that the entire country will collapse in the next year or so.
posted by monkeywithhat at 11:34 AM on April 4

"States can not go bankrupt in its own currency" (Greenspan)

States and individuals CAN go bankrupt when they take loans in a foreign currency (individuals can go bankrupt in any currency ;-) ). This is exactly what happened in Eastern Europe. The people took loans to buy a house but did not take a loan in Sloty or whatever, but in Euro or Swiss Francs to take advantage of the low interest rates. This whole scheme collapsed as soon as the local currencies strongly devalued against the Euro. East Europe and banks who did this (mainly Austria and Switzerland) are upside down.

Also an interesting read concerning Real Estate and 3rd world countries:
http://www.amazon.com/Mystery-Capital-Capitalism-Triumphs-Everywhere/dp/B00147QGZQ
posted by yoyo_nyc at 1:16 PM on April 4