The FINANCIAL — In Tehran, the official dollar-rial exchange rate hovers around 12,000, meaning that you will need twelve-thousand rials to buy one American dollar.
However, the official exchange rate is only offered to importers of certain essential products. Other importers have to buy dollars at a much worse rate, close to the black market that was 31,000 at the beginning of October, after a strong plunge in the value of the currency. In the case of Iran, the plunge in the value of the currency was mostly caused by a decrease in the country’s export revenues, because of an oil embargo imposed by Western countries, which meant that fewer dollars flowed into the country
To halt the currency’s free fall, the Iranian government and central bank took drastic measures. The police closed down most currency exchanges, and arrested many black market currency traders. Instead of allowing people to trade currencies at market prices, it tried to keep the exchange rate from changing by restricting people from participating in the market.
Still, while the official supply of dollars is low, many people still need them, for example, for their children studying abroad, for their businesses, or to protect their savings from inflation of the rial. Even though the government cracked down hard on illegal currency trading, transactions are still taking place. In a recent Washington Post article, a currency trader says “You can’t buy millions of dollars anymore, but you can still purchase about $100,000”.
In a normal market place, demand and supply come together to form an equilibrium: if there is more supply than demand, the price goes down, and vice versa. In the case of the Iranian currency, the government has tried to subvert the laws of supply and demand, by setting an artificially low price. This causes more demand than supply, and an equilibrium does not arise. Because there is more demand than supply, the quantity of dollars in the market stays artificially low.
However, what we see in the Iranian case is that it is very hard to fight a market: even though the central bank tried to intervene by setting artificially low exchange rates (and restricting supply) we still see trading on the black market at prices that are much closer to what an actual market price would be.
We can see similar dynamics at play in the financial sector: interest rates usually reflect demand and supply. I am often asked why interest rates in Georgia are so much higher than in other parts of the world, and the answer is quite simple: market forces. As in any market, there is market supply and market demand.
Let’s start with demand. Because of the low savings rate in Georgia, people often do not have any cash available for emergencies or other big purchases, which means they have to turn to financial institutions to borrow money. Also, compared to developed countries, the “marginal return on capital” is much higher in developing countries: if you already have a lot of “capital” (for example, equipment for your business), adding a little bit is not going to yield you a lot more profit. However, if you don’t have much capital to start with, a little bit extra can push your income up significantly. Economists often call this “diminishing marginal returns to capital”: the more capital you already have, the less a little bit more of it is going to help you generate extra income. These two characteristics of Georgia both significantly increase demand and thus push up the interest rates that are charged on loans.
On the supply side, there are numerous factors that come into play. First, Georgia is perceived by many investors as being a “risky” country, which means that they belief there is a high risk of something happening in the country that will cause them to lose their money. Because of this, they demand a higher return on their money when investing in Georgia. Second, because the lack of a well-developed credit bureau, general poverty, and a lack of social trust, Georgian clients are often more risky for credit institutions, which means that they will demand higher interest rates when lending to Georgian individuals and companies. Third, because loan sizes are on average relatively small compared to developed countries, the operational costs per loan are higher relatively to the size of the loan. For example, the cost to process ten loans is the same, no matter whether the total amount is $10,000 or $100,000. This means that the costs for the $10,000 are then times as high relative to the loan size, which will result in a higher interest rate charged by the lending institution.
A high demand for credit and a relatively limited supply result in high interest rates in Georgia. Often politicians or uninformed members of the general public argue for interest rate caps, which limit the interest rates that financial institutions can charge. By now you probably understand that it is very hard to fight a market. In fact, interest rate caps, meant to protect consumers, often defeat their purpose: instead of lending from financial institutions, which they cannot do anymore, because they are not profitable for these companies anymore, clients are forced to turn to informal moneylenders, operating in the black market, that often charge much higher interest rates.
If you can’t fight the market, use it to your advantage. Prices always reflect the perceptions of the participants in that market, and if your perceptions are different (and more correct) you can stand to make significant amounts of money. For example, as I explained, the interest in Georgia is higher compared to developed countries, because investors perceive country risk to be higher. If you believe that this an incorrect perception, go ahead, and invest your money in Georgia! Invest in a business, or put your money in a term deposit or promissory note: you will most likely get a significantly higher return than you would get in a developed country. If you have access to credit abroad, for example a home equity line of credit at 6%, you could invest this money in a 10% term deposit at a Georgian bank, and earn a handsome, safe return. If enough people do this, interest rates in Georgia will eventually go down, which will benefit the average Georgian citizen.
Understanding how demand and supply work is crucial to understanding how prices are determined. Fighting the market is tough, and it often ends up hurting the people you’re trying to protect. Instead, look for opportunities to use the market to your advantage.