Bangladesh features prominently among nations which have achieved macro-economic stability. It is argued that such a condition in sine qua non to put the country In the same league as Korea. Taiwan. Thailand. and other vibrant Asian economies. This because stability releases policy makers from the trepidation of galloping inflation and short falls in foreign currency reserves. Consequently, they are not restricted to limited choices and have at their disposal an entire gamut of policy options. Macro>ecanomic stability is therefore a precondition for growth. However, far from embarking on a dynamic growth path, we are finding ourselves in the midst of economic stagnation.

Few doubt that investment has been sluggish over the last few years. The diagnoses that have hitherto been put forward relate to deteriorating law and order, lack of protection. Instability of policies, exchange rate overvaluation, labor militancy. illegal cross-border trade, red-taplsm. and so on. All these arguments have merit. Yet surprisingly, the level of interest rates for lending — specifically, the real rates have rarely been mentioned.

What are real Interest rates ? An example illustrates the concept: consider a textile mill which has borrowed at an interest rate of 10%. Suppose Inflation causes all prices in the economy to rise by 5%. This sales and costs go up by 5%, leading to a corresponding identical increase in profits. Now this gain, solely due to inflation:'can be used to service part of the debt. The actual interest burden is therefore that part of interest payments not compensated by inflation. Economists term this the real Interest. Correspondingly. the real interest rate is the inflation-adjusted nominal Interest rate. In such case, inflation covers half of the interest rate, the other half, or 5% is the real interest rate (Actually this is an approx imalion. The correct real rate, in this case is 4.76%).

While lending rates hive fallen somewhat, these are only the nominal rates. Giffen the dramatic fall in inflation, real interest rates have however risen considerably — presently ranging from a low of 8.5% to a high of 20%. and av-

eraging around 12.9%. This is an all-time high for Bangladesh. more so by global stan dards. Historically borrowers in the US have paid between l%-3% above inflation. Real Interest rates in the oft quoted East Asian miracle countries have rarely exceeded 5%. Closer to home. Pakistani borrowers, on average real terms, are currently paying around 4%. And although India is coping with a situation similar to Bangladesh, they are far from passively accepting the situation. Real rates have been explicitly mentioned in the media as a reason for investment sluggishness. As India Today reports. "Despite the fact that interest rates have been reduced by 5 per cent over the last two year, real (interest) rates . . . remain prohibitive at 8 per cent, as compared to 2-3 per cent in competitor countries."

Are firms in Bangladesh being affected by high real Interest rates? In lieu of hard empirical evidence, one may reason as follows: Many industrial enterprises rely on a high '

By Shafi n Hasan Ali

proportion of debt for both fixed and working capital financing. The slow rise in industrial product prices imply that only a small part of inter est payments are being offset by inflation. In other words, debt service could be exhausting a sizeable chunk of profits

— or investible surpluses.

Some may argue that luterest rates have very little to do with the present slack in investment behavior. It is hypothesized that the true explanations are lack of law and order, policy Instability, etc. These arguments are important. However, they do not tell the whole story. Consider the time of Ershad's regime: Can we really say that industrial disputes were rare? Who can swear that there were no violent political demonstrations which paralysed the whole bountry? Is there a single industrialist who believes that policies were more predictable? Yet during those turbulent years, the nation witnessed the birth of the readymade garments industry. Clearly, 'law and order' and

similar suppositions have their limitations. It is time to Investigate other possibilities. — namely, real interest rates.

So how can interest rates be lowerdB? Present bank regulations prescribe minimum deposit rates A possible solution is therefore, lowering of deposit floors’. The reduced deposit costs would allow banks to cut lending rates.

This strategy could be effective if competition was strong in the banking sector. Few believe that it Is. There are several arguments for this conviction. but I will mention only one. In 1988-89. the different between average lending ahd deposit rate was 5.8%. In 1992-93. this spread increased to 7.9%. despite lowering of deposit rates from 8.1% to 6.5%. A competitive environment would hardly permit this type of pricing behavior. Thus it seems unlikely, that banks left on their own would cut lending rates sufficiently to stimulate economic activity.

An alternative solution Is to "cap", or put a ceiling on lending rates. Banks would be

free to vary their rates-within the prescribed limits.

What should the maximum allowable interest rates be? This is an issue outside the scope of this article. However, it may be said that caps should be set by taking into account factors such as Inflation, economy wide profitability, cost of funds for banks, and so on. As these change, adjustments to the ceilings will be made accordingly. Eventually, it may be decided to dispense with interest rate controls altogether.

Nationalized Commercial Banks (NCBs) may argue that without high interest rates, it is impossible to offset the huge bad debt that has accumulated over the last two decades. High interest rates, however, may not necessarily be the answer. This is because high interest rates drive out good borrowers in favor of bad borrowers who either undertake very risky projects or have no intention of repayment. Bankers who can evaluate the true worth of these borrowers will stop lending under such conditions. But mistakes in evaluation are bOun^ to occur — resulting In bad loans.

to those who would argue that capping interest rates Is a move going against the spirit of financial sector reforms currently taking place, it is important to point out that shortterm regulation is not necessarily Indicative of ideological opposition to free-markets. Regulations are needed only to the extent io correct for Imperfections -- particularly in credit markets. •

Moreover. Interest rate liberalization. in a weak banking sector, often leads to high real interest rates. For example, when credit market controls were first relaxed in Latin America, real rates jumped to 40% in Chile, and 15% In Argentina and Uruguay. It is noteworthy, that after seeing the results. Ronald McKinnon, an eminent economist, who was initially in favor of interest rate liberalisation, argued that under certain conditions lending rates should be capped.

Slashing real Interest rates is necessary to reverse the slow down in economic activity. Direct controls may seem out of vogue in the era of liberalization. However, far from going back to days of mindless controls, short-term interest rate caps may be viewed as a stepping stone to a dynamic economy and truly market oriented banking Industry.

With inflation well under control (nearly 0%) and reserves at remarkably high levels (about 7 months imports). the time is appropriate to address the real IntereM rate Issue for generating investment. The tradeoff for generating investment by reducing real Interest rates could be inflation. However, unless there are valid reasons for believing that the resulting inflation would be unmanageable. it may prove a risk worth taking. The stable macro-economic atmosphere may Just be able to provide the cushion needed to take this risk.

Alternatively, policy makers could remain enamored by the status quo. condemning Bangladesh to become the lame tortoise of Asia, while Vietnam. India. Pakistan, et al. take-off towards prosperity.

(The author is an economic consultant and a doctoral candidate).