A difficult line to hoe

The Bangladesh Bank (BB) imposed a cap on the lending rate at 9.0%, which came into effect in April 2020. It is inferred that BB took this decision to stimulate private investment and create opportunities for significantly.

Demand for loans has declined amid the Covid situation. Businessmen and industrialists did not seek new investment opportunities in this vulnerable situation. By lowering the lending rate, the central bank has made it easier for businesses to obtain credit to stimulate investment and create more employment opportunities.

We observe that credit growth to the private sector reached a 4-year high in FY22. When the central bank implemented the deposit and lending rate of 6-9, respectively, in April 2020 , credit growth to the private sector was 8.8%, which increased to 13.7% in June 2022.

This shows increased economic activity in the country under the interest rate cap regime, especially after the lifting of lockdown restrictions. However, the investment does not only depend on the interest rate; the savings rate, future expectations and other factors play a key role here.

Lower interest rates have a negative impact on savers, encourage risky behavior, distort financial markets and create problems for sustaining the economy. A low interest rate environment also has a significant impact on non-performing loans (NPLs). Empirical evidence reveals an ambiguous relationship between low interest rates and NPLs.

However, lately, we observe that amid the decline in the interest rate on loans by 9%, the country’s banking sector in 2021 observed a 16.38% increase in NPL year on year. the other. This has been the problem despite the relaxation of the BB’s loan classification policy.

A prolonged period of low interest rates also hurts the profitability of banks and life insurers. Lower lending rates mean banks are charging less for loans. This has an impact on the profitability of the bank, which increases the vulnerability of the financial sector. Lower rates lead to higher public and corporate debt, worsen inequality and make the economy more dependent on fiscal support. When the interest rate is low, the central bank cannot make the necessary adjustments because the rate is already too low.

Capping interest rates has side effects, including lower credit supply and loan approval rates for small, risky borrowers. Banks are even more disinterested in lending to SMEs at lower lending rates because they perceive SMEs as risky investors. The loan disbursement target for the handicrafts, micro, small and medium industries (CMSME) sector was BDT 20,000 crore in FY22. However, only 67.52% of the target loan was been disbursed.

A lower lending rate cap leads to lower interest rates on deposits. Due to yields as low as 6%, depositors tend to shy away from banks, especially in a high inflation scenario. In August of this year, the inflation rate soared to 9.5%, the highest rate in a decade. Several empirical studies suggest that a lower deposit interest rate leads to a lower rate of deposit growth.

At a time of high inflation, as other countries around the world raise interest rates, BB has maintained the operational interest rate ceiling, turning a deaf ear to the textbook solution. Turkey is a country that does not follow the classic solution of fighting higher inflation. The country cut interest rates amid runaway inflation.

In August 2022, the country recorded an inflation rate of 80.2%. Amid soaring current account and trade deficit, falling interest rates depreciated the Turkish lira by more than 27% on an annual basis. Lower interest rates make it difficult for Turkey to attract capital flows, as we know that higher interest rates tend to attract foreign capital flows and appreciate the national currency.

Due to falling interest rates on deposits, depositors are opting for government savings tools as they offer higher returns than bank deposit products. They may also choose to invest their funds in the capital market or real estate, and some may even turn to money laundering.

Deposits by Bangladeshi individuals and businesses in Swiss banks in 2021 saw a 55% increase compared to 2020, which could indicate an increase in money laundering cases. The overall filing growth rate was highest for Bangladesh in South Asia, followed by India.

Lower deposit rates are also creating a shortage in the amount of loanable funds for banks. On the contrary, a lower lending interest rate decreases the cost of borrowing, which leads to an increase in the demanded quantity of loanable funds. Thus, an imbalance in the loanable funds market is observed.

Another problem that needs to be solved is the alignment of policy rates with the interest rate. With lower lending rates still in effect, the inflation rate is expected to rise.

In 2020, due to the alarming Covid situation, the key rate, also known as the repo rate, was lowered to revive economic activity. However, BB gradually increased this repo rate due to rising inflation. But without removing the interest rate cap, a hike in the repo rate should not be successful.

Interest rate caps have a significant impact on the financial stability of an economy. Therefore, BB must seriously consider the existing lending ceiling to ensure the stability of the financial sector. Without removing the ceiling, the financial stability of the economy could be jeopardized due to the reduction of foreign exchange reserves, the depreciation of the currency, the dollar crisis and the increase in inflation rates.

Muhammad Nafis Shahriar Farabi is a research associate at the Bangladesh Institute of Governance and Management (BIGM).

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