The Bangladesh Bank – the central monetary authority of the economy – generally uses the exchange rate and interest rates to stabilize the economy if and when it deviates from its level of output, prices and natural or desired employment.
Given the recent inflationary landscape where the average inflation (CPI) reached 7.56% in June 2022, the rhetoric about raising the interest rate has once again reached fever pitch. Much of this talk revolves around the 6% to 9% interest rate introduced by Bangladesh Bank (BB) in April 2020.
Although initially introduced to help industries and increase production to avoid a possible recession during the pandemic, we do not know if single-digit interest rates have achieved the desired result. I will try to assess this in this article. But first, we need to understand the basics.
Why Interest Rates Matter
Typically, a person deposits the money in banks or other financial institutions for safekeeping. Banks can then invest or lend some of these deposits to companies seeking to increase production. In return, businesses must pay a certain rate of interest to receive the funds in advance, known as the advance rate. Banks then pay initial depositors a different interest rate, usually lower than the advance rate. The difference between the advance rate and the deposit rate is called the interest rate spread.
Currently, we are in an urgent situation. The value of the taka against the dollar depreciates rapidly, making exports cheaper. If we don’t want Taka to devalue further, interest rates need to become more flexible to market conditions
By Dr Ahsan H Mansur, Executive Director, Bangladesh Policy Research Institute
This framework of the financial system allows 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. Similarly, companies or debtors are less likely to take out loans. On the contrary, a relatively low loan rate encourages companies to take out more loans, which increases the money supply, increases productive capacity, reduces unemployment and increases household incomes.
Moreover, a low advance rate further reduces the deposit rate because 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 (through increased production) and keep more money (through reduced savings), they demand more goods – domestic and imported – which, on the one hand, increases the level of domestic prices and, on the other hand, reduces the exchange rate, making imports more expensive and exports more competitive. According to economists, this is precisely what has happened in recent months; contributing at least partially to the inflationary pressures we are experiencing today.
Why interest rates of 6% to 9% were introduced
During the Covid-19 pandemic, businesses – except those producing essential supplies – had to cease operations and no longer needed bank loans.
Rising interest rates will increase the cost of financing products in industries. Those of us who need to keep doing business will continue to do so, even at a double-digit rate of advance. But small and micro businesses could be significantly affected by this decision.
By Abul Kashem Khan, administrator of Business Initiative Leading Development (Build)
On top of that, as numerous reports show, a higher influx of funds and a general precaution against potentially calamitous economic conditions have led people to save more during the pandemic.
Therefore, in April 2020, the government introduced the interest rate band of 6% to 9%, which would, on the one hand, discourage deposits and increase the money supply and, on the other hand, allow companies to take out loans more easily. to counter the credit crisis caused by the Covid-19 pandemic.
Has the policy produced the expected results?
Throughout the pandemic, the effective average advance rate fell from 8.29% in April 2020 to just 7.4% a year later, a decline of 10.75% year-over-year. During the same period, the deposit rate fell from 5.37% to 4.36%, a decline of 18.8% year-on-year. Through April 2022 (as far as data is available), deposit and advance rates continued to decline year-over-year and fell to 4.02% and 7.09%, respectively.
In short, since the introduction of the fixed tranche, deposit and advance rates have come down slowly but steadily. It appears that over this period the interest rate spread, which typically represents banks’ operating profits and expenses, also fell from 4% to around 3%. This is an important observation and I will come back to it later.
Under normal circumstances, there would have been a considerable surge, particularly in credit to the private sector, when the average effective rates for advances were reduced from 9.58% to 8.29% in April 2020. But that did not happen. is not produced.
Although the central bank introduced an interest rate band of 6% to 9% in April 2020, as shown in Figure 01, credit growth in the private sector has remained stagnant; roughly below 1%, including months like July 2020 and January 2021 when private sector credit declined.
In absolute figures, since July 2019, credit to the private sector has increased from Tk 10,073.98 billion to Tk 13,096.308 billion. The trend for private sector credit growth is roughly linear and shows no significant change in slope after the introduction of the attractive band in April 2020. In other words, private sector credit growth has remained in line with pre-pandemic levels despite an interest rate cut.
To explain this, it can be argued that the decline in interest rates actually counteracted the potential sharp decline in credit that the pandemic would have caused. Another explanation could be the erratic growth of credit to the public sector, which jumped 20.99% in April 2020, with the introduction of the fixed interest rate bands.
Moreover, Figure 02 shows that the long-term trend in public sector credit growth is erratic to say the least. Therefore, it is difficult for me and any investor to predict/forecast investing in an economy where the government is erratically crowding out the private sector to receive domestic credit.
Credit to the public sector constitutes a relatively smaller share of domestic credit (about 13-18 percent) and its unpredictable nature may not explain the stagnation in private credit growth. And it is difficult to arrive at any conclusion without implementing more rigorous statistical techniques.
Asked about the impact of an interest rate of 6-9%, Dr Ahsan H Mansur, Executive Director of the Bangladesh Policy Research Institute, said: “In reality, many variables determine the credit and investment rates in Bangladesh. Covid-19 pandemic, the lending rate was considerably lower than 9% because businesses were not looking for loans. Moreover, there is no single solution. The same interest rate might be too high for the small borrower compared to the large borrowers. Bangladesh’s relatively high advance rates have likely crowded out small creditors.”
On the other hand, Abul Kashem Khan, Administrator of Business Initiative Leading Development (BUILD), said: “We have been calling for a single digit interest rate regime for a long time because interest rates in Bangladesh have always been higher than those of its competitors on the international scene. Although the introduction of the fixed interest rate band has facilitated access to credit, this has not always translated into investment due to the poor investment climate, bureaucracy, lack of tax reform, etc.