Why lending rates must go down

MONETARY policy has been working fine particularly for the last three years.  The litmus test for an effective monetary policy is whether it can maintain low inflation because macro stability is impossible without moderate inflation.  Recently, Bangladesh Bank (BB) has brought down inflation from 11% in late 2011 to 7.4% even after maintaining output growth of more than 6%.  This is no mean feat.  BB targets to push inflation further down to 6.5% by 2015.  While BB's success in inflation is undoubtedly commendable, its handling of the lending rates seems insufficient.  Our average lending rate is as high as 13% while deposit rates are around 8%, leaving a big spread of 5% that appears to be detrimental to a developing economy.  Lending rates must go down to boost investment and thus to accelerate growth in the country.

The lending rates and the ensuing spreads (lending rates minus deposit rates) are remarkably high in Bangladesh, making the banking business a vigorous attraction of financial greed.  That is why many capitalists in our society form various syndicates and lobby for opening new banks when prospects of abundant profits in other sectors do not look that bright.  These lobbyists with huge political clout often pressurize the central bank to get new banking permits while BB knows it well that the existing banks are enough at this moment to serve the economy.   

Lending rates may go up and down based on inflation, which must be less than the lending rate to make the real interest rate (the lending rate minus inflation) positive.  A real interest rate of 3% or so is desirable in developing economies where real interest rates higher than 3% will simply impede investment growth.  That was the case in early 2012 when the average lending rate was 14% and inflation was 11%, making the real interest rate 3%.  Now inflation has come down to 7.4% and the lending rate should be in the vicinity of 10%.  The bankers, however, show an opportunistic ratchet effect in lending rates; they raise lending rates when inflation rises but do not lower the rates when inflation drops.  Here the central bank has to intervene and find out where the institutional factors lie that create this downward rigidity of lending rates.  What prevents lending rates from falling?   

Apart from inflation, another excuse for not lowering lending rates is the prevalence of high deposit rates.  But this should not be the case.  First, lending rates still can go down by another 2% without affecting deposit rates, lowering the existing spread of 5%, which is already high.  Second, deposit rates can be of 7% or lower if inflation can be pushed further down to 5 to 6% so depositors do not end up having a negative rate of real return.  Actually, the depositors in developing economies should be happy as long as their savings just fight inflation.  If savings have handsome real rate of returns, many potential entrepreneurs will like to save rather than to invest and take risks.  This saving-investment gap will create excess liquidity and dampen 'animal spirits' of investment in the economy.  Keynes viewed saving as a vice in this respect.

Essentially, the whole spectrum of interest rates should be pulled downward to make the economy more functional than it is now.  Based on the floor of inflation, deposit and lending rates should step up sequentially.  For example, if inflation is 6%, the deposit rate should be 6.5 or 7% and the lending rate should be 9 to 10%.  Of course in the face of huge non-performing loans, which were 9% of total loans in December 2013 and now are 11%, it is hard for the bank owners to reduce the lending rate.  Here comes the question of efficiency of fund management and careful disbursement of loans. If many banks can ensure close to 99% recovery, why others cannot?  

The issue of lowering lending rates is not simply normative, it is an issue of existence in the age of liberalization and free capital flows.  Bankers are digging their own graves by keeping lending rates stubbornly high when domestic investors can now borrow from foreign funds at a single-digit lending rate.  Fortunately, many investors are not still aware of these foreign funds or they do not like to encounter the bureaucracy to access these sources.  Time is coming when these obstacles to access foreign capital will die out, skyrocketing the demand for foreign funds.  Then many domestic banks will sit on idle liquidity.  Some desperate banks will extend a substantial chunk of credit to potential defaulters, wealth-loving politicians, money launderers, or stock market speculators – a group of overnight fortune-makers to which high lending rates do not matter at all.  

Lending rates in Bangladesh must go down to embrace the challenges of globalization and to avoid these unpleasant consequences.        

The writer is Associate Professor of Economics at the State University of New York at Cortland.