Bangladesh Bank – the central monetary authority of the economy – typically uses the exchange rate and the interest rates to stabilise the economy if and when it deviates from its natural or desired production level, price and employment.
Given the recent inflationary landscape where the average inflation (CPI) rose to 7.56% in June 2022, the discourse regarding raising the interest rate has once again come to a head. Much of this discourse revolves around the 6%-9% interest rate introduced by Bangladesh Bank (BB) in April 2020.
Although initially introduced to help out industries and expand production to avert potential recession during the pandemic, we do not know whether the single-digit interest rates achieved their intended outcome. I will try to evaluate that in this article. But first, we need to understand the basics.
Why interest rates are important
Typically, an individual deposits the money in banks or other financial institutions for safekeeping. Banks can then invest or lend a portion of these deposits to firms looking to expand their production. In return, the firms have to pay a certain interest rate for receiving the fund in advance, known as the advance rate. The banks then pay the original depositors a different interest rate – typically lower than the advance rate. The difference between the advance rate and the deposit rate is known as the interest rate spread.
Currently we are under a pressing situation. The value of the Taka against the USD is depreciating fast, making exports cheaper. If we do not want Taka to devalue further, interest rates must become more flexible to market conditions
This financial system framework makes sense for depositors to deposit their savings in banks or other financial institutions. The higher the deposit rates, the more likely depositors are to deposit their money. On the same note, firms or debtors are less likely to take out loans. Contrarily, a comparatively low advance rate encourages firms to take out more loans, which increases the money supply, expands the productive capacity, reduces unemployment and raises household income.
Moreover, a low advance rate reduces the deposit rate further as banks want to maintain a roughly constant interest rate spread; usually around 3% in Bangladesh. This discourages households from saving.
Unfortunately, as households earn more (from increased production) and hold onto more money (from reduced savings), they demand more goods – both domestic and imported – which, on the one hand, increases domestic price levels and, on the other hand, reduces the exchange rate, making imports more expensive and exports more competitive. According to economists, this is precisely what happened over the past few months; at least partially contributing to the inflationary pressure we are experiencing today.
Why 6%-9% interest rates were introduced
During the Covid-19 pandemic, firms – except those producing essential supplies – had to shut down operations and no longer needed bank loans.
Raising the interest rates will increase the cost of financing products in the industries. Those of us who have to keep doing business will keep doing so, even at a double-digit advance rate. But the small and micro enterprises might be significantly affected by this decision.
On top of that, as many reports find, higher remittance inflow and a general precaution against potentially calamitous economic conditions, led people to save more during the pandemic.
Consequently, in April 2020, the government introduced the 6%-9% interest rate band, which on the one hand, would discourage deposits and increase the money supply and, on the other hand, would make it easier for firms to take out loans to counteract the credit crunch brought about by the Covid-19 pandemic.
Did the policy induce intended outcomes?
Throughout the pandemic, the effective average advance rate dwindled from 8.29% in April 2020 to only 7.4% one year later, a year-on-year decrease of 10.75%. During the same period, the deposit rate decreased from 5.37% to 4.36%, a year-on-year decrease of 18.8%. Until April 2022 (as far as data is available), both deposit and advance rates kept decreasing on a year-on-year basis and dropped to 4.02% and 7.09%, respectively.
In short, since the introduction of the fixed band, both the deposit and advance rates have slowly but consistently decreased. It appears that during this period, the interest rate spread, which typically accounts for banks' profit and operating expenses, has also fallen from 4% to around 3%. This is an important observation and I will come back to this later.
Under normal circumstances, there would have been a considerable surge, particularly in private sector credit, when the average effective advance rates were slashed from 9,58% to 8.29% in April 2020. But that did not happen.
Although the central bank introduced a 6% to 9% interest rate band in April 2020, as shown in figure-01, credit growth in the private sector remained stagnant; roughly within the 1% mark, including months like July 2020 and January 2021 when private sector credit shrunk.
In terms of absolute figures, since July 2019, private sector credit rose from Tk10,073.98 billion to Tk13,096.308 billion. The growth trend in private sector credit is roughly linear and shows no significant change in slope after the introduction of the interesting band in April 2020. That is, credit growth in the private sector remained consistent with pre-pandemic levels despite a reduction in interest rates.
To explain this, it may be argued that the reduction in interest rates actually counteracted the potential sharp decline in credit that the pandemic would have brought about. Another explanation might be the erratic growth of the public sector credit, which jumped by 20.99% in April 2020, as the fixed interest bands were introduced.
Moreover, Figure-02 shows that the long term trend in public sector credit growth is erratic, to say the least. Consequently, it is difficult for me as well as any investor, to predict/forecast investment in an economy where the government erratically crowds out the private sector in receiving domestic credit.
Public sector credit constitutes a relatively smaller share of domestic credit (roughly 13-18%), and its unpredictable nature may not explain the stagnant growth in private credit. And it is difficult to come to any conclusion without implementing more rigorous statistical techniques.
When asked about the impact of a 6%-9% interest rate, Dr Ahsan H Mansur, Executive Director, Policy Research Institute of Bangladesh said, "In reality, there are many variables that determine the credit and investment rate in Bangladesh. During the Covid-19 pandemic, the lending rate was considerably lower than 9% because firms were not seeking loans. Moreover, one size cannot fit all. The same interest rate might be too high for the small borrower compared to the large borrowers. Bangladesh's comparatively high advance rates have likely crowded out small creditors."
On the other hand, Abul Kashem Khan, a trustee of Business Initiative Leading Development (BUILD) said, "We have long asked for a single-digit interest rate regime as the interest rates in Bangladesh have always been higher than its competitors in the international market. While introducing the fixed interest rate band did ease access to credit, that did not always translate into an investment because of the poor investment climate, bureaucratic red tape, lack of tax reform etc."
Should the 9% interest rate cap be raised?
According to economists, raising the interest rate is one of the most important countercyclical stabilisation instruments at the BB's disposal. Raising interest rates makes credit less attractive and deposits more attractive as the opportunity cost of holding money increases.
Furthermore, the average inflation rate over the past few months has hovered around the 7% mark, which is significantly higher than the deposit rate which fell to 4% over the years. That is, even the debtors are losing their money by at least around 3%, making them less interested in depositing their money.
Raising the deposit rate to at least somewhere around the 7% mark will encourage the debtors to deposit with banks. Consequently, the money supply in the economy will decrease and the overheated economy should find relief.
As Dr Ahsan H Mansur said, "The prime objective of the central bank is to contain inflation and keep the exchange rate stable using monetary tools. If they are hung up on a fixed interest rate regime, one hand of the monetary policy gets stuck."
"Currently we are under a pressing situation. The value of the Taka against the USD is depreciating fast, making exports cheaper. If we do not want Taka to devalue further, interest rates must become more flexible to market conditions. Unfortunately, Bangladesh Bank has no teeth and has to rely on the finance ministry for its decisions," he added.
On the other hand, raising the interest rate will hurt domestic firms. The recent inflationary pressure was brought about not only by pent-up demand but also, in the case of Bangladesh, more significantly by the rising cost of imported inputs. Monetary policy can only address the demand side of the problem, and raising the interest rate too much can lead to further deterioration of the supply side problem.
"Raising the interest rates will increase the cost of financing products in the industries. Those of us who have to keep doing business will keep doing so, even at a double-digit advance rate. But the small and micro enterprises might be significantly affected by this decision and targeted credit support programmes and credit guarantee schemes should be extended to these firms," said Abul Kashem Khan.
Requesting to remain anonymous, another industry leader pointed toward an interesting solution; suggesting banks reduce the interest rate spreads, i.e., their profits and operating expenses.
As he said, "Why can we not reduce the interest rate spread, the area where the private banks make their profits and operating expenses? Since before the pandemic, the vast majority of banks in Bangladesh have been profitable and that trend continued into the pandemic as other firms and industries were struggling to survive."
"In this era of digitalisation, like most of the developed countries, we should have moved towards a cashless, branchless banking system, which would have brought down their operating cost and the interest rate spread could be reduced. In this way, you would not have to raise the advance rate significantly to stabilise the economy," he said.