I wonder why people talk much about Bank rate in Bangladesh when it comes about boosting economic fundamentals such as investment, production, and GDP growth. According to the tradition, Bangladesh Bank (BB) – the central bank of Bangladesh announces its monetary policy statement (MPS) at the beginning of every July-June national fiscal year. Like other countries, much of the attention and discussion of media and experts center on the Bank rate announced in the MPS. However, the reality is that Bank rate perhaps is not the one that deserve the level of attention as it generally does in Bangladesh. In fact, other instruments covered in the MPS should be highlighted much more than the bank rate. The key reason is Bank rates historically show a minimal financial and economic impacts in the market, particularly because of our significantly weak and inefficient monetary and economic system in place. In this article, I will explain why we should perhaps rely more on instruments other than Bank rate when we are concerned about the effectiveness of MPS in boosting up economic activities. I will use a simplified approach so that anyone with a minimal finance or economics background can understand the reasoning.
What is bank rate and what is its purpose?
A bank rate is the interest rate at which a nation's central bank lends money to commercial banks, often in the form of very short-term loans such as few weeks or months. This means any of the 60 scheduled banks operating in Bangladesh needs to borrow funds, particularly for shorter term such as few weeks or one months or more, it can ask Bangladesh Bank (BB) for a loan. BB then would supply the requested amount as a loan to the scheduled bank for a certain period at a certain interest rate. The interest rate charged by BB is generally known as Bank rate. Scheduled banks (SBs) in Bangladesh may ask BB for such a loan either in the form of a pure cash loan or against a bills discounting.
So why
is this Bank rate important? Because it affects money supply. Take these two simple
cases.
(i) If the Bank rate is lowered, scheduled banks (SBs) can borrow funds from BB at a lower interest rate. SBs then could use the fund for lending to their retail customers at lower insterest rates. When retail loans are cheaper, you, I and probably many of us would be interested to take a loan, causing an increase in demand for loan. When banks increase granting loans in response, money supply in the economy rises. Increased money supply results in a rise in consumption, investment, production and employment, which eventually causes inflation and GDP to rise. In such cases, bank rate changes would be termed as an ‘Expansionary’ measure.
(ii) The opposite happens when bank rate is increased. If Bank rate is raised, cost of borrowing from BB goes higher for scheduled banks and demand for borrowing from BB by scheduled banks decreases. Even if scheduled banks still keep borrowing at a higher Bank rate, it will have to charge higher interest rates when they lend the money to retail borrowers. A higher interest rate on a retail loan would mean a higher cost of borrowing for general people and firms. As a result, demand for loans and money supply would decrease, and consumption, investment, production, and employment slows down, which eventually would slow down inflation and GDP. Such Bank rate changes would be viewed as a ‘Contractionary’ measure.
To sum up, if a government wishes to stimulate consumption, investment, and GDP through increased money supply to the economy, it would advise its central bank to decrease bank rate, and if it wishes the opposite, it would want an increase in bank rate. We need to remember however one central feature of this mechanism: Bank rate is generally the cost of short-term borrowing for SBs. This means, increases or decreases in Bank rate are likely to affect banks’ cost of short-term borrowing primarily and thereby short-term retail lending. In every economy, Bank rate alongside some other monetary policy instruments are central features of an MPS.
Bangladesh MPS 2020-21: A COVID-ian policy stance
On July 29, Bangladesh Bank (BB)
announced the MPS for 2020-21, where it introduced some very important changes
in monetary policy measures including the Bank rate. Given the massive economic
slowdown caused by the COVID-19 pandemic and that the recovery from the
slowdown remains completely uncertain, Bangladesh Bank’s MPS 2020-21 comes out
as Expansionary. It means, BB adopts the case (ii) described in the previous
section. In the MPS, following key changes are announced, some of which are
already in action and some are planned for fiscal year 2020-21.
Policy stance planned for FY2020-21
- Decrease of Bank rate from its 17-year stable rate of 5.0 to 4.0%;
- Decrease of overnight repurchase agreement (REPO) rate from 5.25 to 4.75%;
- Decrease of reverse REPO rate from 4.75% to 4.0%
Policy stance already in action in the backdrop of COVID-19
- Cash reserve ratio (CRR) has already been lowered from 5.5 to 4.0%;
- CRR has already been lowered from 5.5 to 4.0% domestic banking, from 5.5 to 2.0% for Offshore Banking Units (OBUs), and from 2.5 to 1.5% for non-bank financial institutions (NBFIs);
- Reduction of REPO rate from 6.0 to 5.25%;
- Increasing Advance to Deposit ratio (ADR) by 2% for commercial banks to 87% and IDR of Islami banks to 90%;
- Allocating BDT 55250 crore for refinancing schemes as a way of direct money supply.
Since the MPS released, there has been a lot of discussions going on about the reduction of Bank rate – mostly expressing hopes that the measure will boost up economic recovery from the COVID-19 effects. In this article, I will only highlight why the reduction of Bank rate may not help the economy to recover from the pandemic-driven slowdown. I will also show whey other measures such as changing CRR and Statutory Liquidity Reserve (SLR) are likely to be more effective than Bank rate, although they traditionally remain less-discussed.
Why Bank rate is likely to be not the answer to the economic
slowdown
To understand why Bank rate is likely to be not effective in Bangladesh’s context to launch and accelerate and economic recovery, we need to recall the main purpose of a bank rate. A Bank rate is charged by BB on short-term loans taken by SBs from BB. Lowering Bank rate is expected to lower cost of borrowing for SBs and thus for retail investors and borrowers, which in turn would increase money supply and investment.
Figure 1 shows the patterns of interest rates on deposits paid by SBs, weighted average interest rates on loans charged by SBs, the difference between the two (spread), and Bank rate over the period from 1990-2018 in Bangladesh. Expectedly, patterns of lending and deposit interest rates show strongly positive co-movement over the entire period. As both rates keep declining over time, so does the spread for banks. As stated earlier, Bank rate was constant at 5.0% since 2013 to 2018. But before becoming fixed in 2013, Bank rate’s movements were similar to those of market lending and deposit interest rates. It suggests that interest rates offered by SBs to their depositors and interest rates charged on their borrowers broadly change depending on the changes in Bank rate. Thus, the fact that Bank rate should allow banks to influence money supply by repricing their retail savings and loans seem to work. Given this, anyone would expect that since the 2020-21 MPS proposes reducing Bank rate from 5.0 to 4.0%, it should reduce deposit and lending interest rates in the market and thereby increase money supply. But is that likely to happen really?
Figure 1: Bank rates and market interest rates from
1990 to 2018
Source: author developed based
on Bangladesh Bank data
Figure 2 shows the patterns of bank deposits and borrowing as % of total credit & investment (TCI) made by SBs in Bangladesh. In other words, the patterns show how much deposits and bank borrowing from BB and the govt. finances total credit & investments disbursed by the SBs in the market. To make my point clear, I count only time and demand deposits made by private individuals and firms and exclude not government and inter-bank deposits. Considering the left-hand axis, it shows that total deposits as % of TCI remains above 87% over the entire period and above 90% since 2002 to 2018. It means on average roughly 90% of the TCI made by banks can be (or perhaps are) financed by private time and demand deposits made by firms and individuals. Furthermore, while Bank’s borrowing from BB was about 17% in 1990, it consistently declined over the entire period. In 2018, it stands only about 4%. Similar pattern is also evident for banks’ borrowing from the government, which in 2018 stands close to 3% only.
Figure 2: Bank deposits and borrowing; 1990 to 2018
Source: author developed based on Bangladesh Bank data
So what does the Figure tell us? The credit and investments disbursed by our banks are almost entirely financed by time and demand deposits made by private individuals and firms, while the necessity of banks’ borrowing from BB plays historically an insignificant role. This is plausible, since SB’s borrowing from BB at the Bank rate are generally taken for a very short term – such as few weeks or months and hence, these borrowings are not likely to be used to finance long-term loans and investments made by SBs in the retail market. It means the long-term, high return-generating, and productive loans and investments are mainly financed by private sector deposits in Bangladesh. To sum up, we see that in gearing up long-term productive investments in the economy through necessary money supply, Bank rate perhaps have ‘no’ to ‘minimal’ effectiveness. The only case where it could have some effectiveness is when the short-term borrowings from BB made by SBs at Bank rate are used for financing short-term working capital loans granted in the retail market.
The
ineffectiveness of Bank rate is more pronounced in Figure 3. Considering the period
from 1990 to 2003, the movement of Bank rate shows no noticeable correlation or
co-movement with scheduled banks’ borrowing as % of total TCI and broad money supply (M2) growth
rates. It is generally expected that declines in Bank rate will lead to larger
borrowing, greater money supply, and thus a larger M2 growth, and vice versa. But
Figure 3 shows the opposite story; when bank rate declined from 1990 to 1993, both
M2 growth and scheduled banks’ borrowings in fact declined consistently.
Similarly, from 1994 to 1999, Bank rate increased and alongside M2 growth also
increased, which completely contrasts general expectations. From 1999 to 2013, Bank
rate declined and scheduled banks’ borrowing from BB again declined
consistently. Since 2013 particularly, SBs’ borrowing moves largely opposite to
M2 growth, indicating that any money-supply growth happened perhaps were mainly
supported by private savings instead of banks’ borrowing from BB.
So what is the take away? Bank rate shows ‘very little’ to ‘no’ relevance to the patterns of SBs’ borrowing from BB and M2 growth. In other words, the hope that lowering Bank rate would spur money supply significantly perhaps may not be case in reality.
Figure 3:
Bank rate, bank borrowing from BB and money supply growth
Source: author developed based on Bangladesh Bank data
If not Bank
rate, what else to boost-up the economic recovery?
So
we already have a learning so far – Bank rate is not likely to be the answer to
the economic slowdown. What else can we opt for in the MPS? Remember that the
MPS 2020-21 has several other measures in consideration including the cash reserve
ratio (CRR), statutory liquidity reserve ratio (SLR), and open market operation
through REPO and Reverse REPO. Elaborating about all of these in one article will
be too lengthy, complex, and tiresome. In this article, among all of these, I consider
only CRR and SLR – two of the most power monetary policy measures and discuss
if they could be considered a more effective instrument instead of Bank rate
for Bangladesh’s economic recovery. CRR is the portion of customer deposits
that scheduled banks must keep as a reserve with BB; and SLR us a ratio of cash
deposits that banks have to maintain in the form of gold, cash, and other
securities approved by BB. Both CRR and SLR are determined by BB on a regular
basis.
Consider Figure 4, where Bank rate is the same as we saw before. This time we plot two other items: one is the growth rate of total credit & investments made by SBs and the other is their reserves kept in cash and with BB as % of total deposits. The second one is basically the combination of reserves as % of deposits maintained to satisfy SLR and CRR requirements. In line with our previous learning, Figure 4 shows that Bank rate and TCI growth show broadly a positive co-movement which is completely opposite to the general expectation of an opposite co-movement. This is clear when looked into smaller time-frame: from 1990 to 1994, both Bank rate and TCI growth declined and from 1996-2003, both Bank rate and TCI growth rise. The only temporary divergence is noted for the period from 2001-2003. Since from 2013 Bank rate became flat at 5%, it is not possible examine any co-movement. The patterns reconfirm that the expected boosting-up effect on credit and investment in the economy when Bank rate is lowered probably doesn’t happen much in Bangladesh’s case, i.e., Bank rate lowering perhaps has ‘no’ to ‘very little’ relevance or effect on credit and investment growth in Bangladesh economy.
Figure 4: Bank rate, banks’credit & investment growth and reserve
Source: author developed based on Bangladesh Bank data
However,
there are rays of hopes when the patterns are compared between total reserve as
% of deposits and TCI growth rates. The two series appear to have an opposite
direction effects or a negative co-movement, as one would expect. It is because
a higher reserve requirement limit banks’ liquidity and lending ability and
vice versa. For example, from 1992 to 1996, reserves increases and decreases
are associated with TCI growth decreases and increases. From 1996 to 2012, a similar
opposite direction movement is evident; the divergence is clearer particularly for
the period between 2003 and 2012. Similar trends tend to prevail until 2018
with some apparently disconnections in the middle when TCI growth continues to
fell while reserves remain more or less stable.
So what is the take from the Figure? Reserve requirements perhaps are relatively more effective than Bank rate. While Bank rate shows no to very little effect on TCI growth, Reserve requirements seem to do a slightly better job.
Final remarks
This discussions elaborated in this article makes a clear, simple point. Given the purpose of Bank rate, it is generally expected to increase money supply. However, as lower Bank rate makes primarily short-term (such as few months or weeks) borrowings cheaper, it is less likely to boost up long-term credit and investment in the economy. As a standard principle, no bank would borrow short-term at a lower Bank rate from BB and use it for financing long-term loans and investments as it could raise the level of maturity mismatch, refining cost and risk significantly. Thus, the only benefit lowering Bank rate could do is making short-term working capital loans chapter for firms; however, a cheaper working capital financing is not likely to generate the desired level of boost up effects as it will not facilitate new capital investments in the economy. Some positive effects could arise from increased production from existing capacities and increases in short-term consumer financing. Analyzing historical data, this article shows the ineffectiveness of Bank in Bangladesh’s economy particularly in accelerating credit, investment, and money supply growth. Rather at a very raw level, reserve requirements such as CRR and SLR could fare better in doing the job. One reason is reserve requirement directly affects the liquidity availability and lending capacity of banks, while Bank rate works relatively indirectly since its chances would arise only when scheduled banks opt for borrowing from Bangladesh Bank. The lessons of this article however should be taken with caution; the conclusions are derived based on observations of patterns and relationships between different variables. No statistical analysis has been made and therefore, the claims or arguments presented in this article have not been empirically tested. Doing a full-proof research empirical exercise could be the next step to verify and confirm the claims.
Interesting article! Thought provoking...
ReplyDelete