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How High Interest Rates Smother Innovation and Development

December 4, 2023 by Cezar Santos Leave a Comment


After the 2008 financial crisis, the tech sector in the United States boomed as efficient capital markets and low interest rates allowed new firms to exploit innovation. Yet in much of Latin America, the brilliant young innovator with a billion-dollar idea might find it hard or even impossible to raise the capital needed to turn similarly promising inspiration into a success.   

The average interest rate spread — or the difference between the interest rate paid by banks to depositors and the rates it charges to borrowers — tends to be higher in poorer countries, like those of Latin America, reflecting market imperfections or inefficiencies. This spread, according to a database maintained by the International Monetary Fund, is on average about 0.7% in Japan and 3% in the United States, but stands at 10% and 40% in Uruguay and Brazil respectively.

Examining Interest Rates in Brazil

The consequences of such high costs to borrowers in much of our region are significant. As my co-authors and I found in a recent study using high-quality data from Brazil, the effect of high interest rates weighs heavily on the growth of firms, employment, and ultimately the welfare of the nation.    

We used the Brazilian credit registry, a confidential loan-level dataset covering all credit operations in Brazil from January 2006 to December 2016, which contains information on loan characteristics and interest rates. We found that small and young firms pay particularly high interest rates. For example, a firm with three employees pays an interest rate spread above 75 percentage points, as does the average new firm. Meanwhile, a firm that is 10 years old pays spreads 10 percentage points lower and those with 100 employees on average pay 20 percentage points less.  What do brilliant, cash-poor entrepreneurs with fledgling companies do in such circumstances? They may have to watch their ideas die.

Effects on Productivity and Wages

We also created a novel macroeconomic model that introduced financial spreads into  a previous framework and demonstrated their important impact on entrepreneurship, firm dynamics, and economic development. The results showed that the financial frictions, or imperfections, in credit markets resulted in 41% less use of capital, 28% less aggregate productivity, 39% lower GDP per capita and 32% lower wages than in  a system with no market imperfections. The United States, though far from perfect, may be the closest to such a system.  

While we do not attempt to explain these market imperfections in our study, we can speculate. Two possible factors are the inefficiency of the courts in Brazil, which makes it hard for banks to recover a loan if a business defaults, and bureaucratic red tape and onerous regulations. These factors create added costs for  banks, which, in turn, pass them onto borrowers, pushing lending rates up. High levels of borrowing by the government also send interest rates — although not spreads — upwards, similarly increasing the burden on businesses eager for cash. And finally, there is the role of Brazil’s biggest banks in a system where a handful of banks control the lion’s share of the market, giving them the market power to charge interest rates far beyond a system with robust competition. Such problems, hardly unique to Brazil, need to be studied further, as do their relationship to high borrowing costs for firms. 

A Need for Research and Reform to Help Bring Interest Rates Down

High spreads and interest rates are a millstone around the neck of the innovative spirit, the creative entrepreneur, and the budding businesses  capable of boosting productivity, employment and economic growth. For the benefit of entrepreneurs and the welfare of society as a whole,  their causes should be further investigated and the appropriate reforms implemented.


Filed Under: Macroeconomics and Finance

Cezar Santos

Cezar Santos is Senior Research Economist at the Research Department of the Inter-American Development Bank. His research focuses on macroeconomic development, with an emphasis on labor markets, credit markets, family economics, climate change and infectious diseases. His work has appeared in academic journals such as Econometrica, AEJ: Macro, Journal of Development Economics, Economic Journal, among others. Prior to joining the Bank, he was an Associate Professor of Economics at Getulio Vargas Foundation (FGV EPGE) and a research economist at the Bank of Portugal. Previously, he was an Assistant Professor at the University of Mannheim. He completed his undergraduate studies in Economics at the Federal University of Pernambuco (UFPE), his master's at FGV EPGE and obtained a Ph.D. in Economics at the University of Pennsylvania.

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