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Conducting monetary policy by suasion

Abdullah A. Dewan
ON April 19. Bangladesh Bank (BB) asked the commercial banks to set a lending rate ceiling in five specific areas to a maximum 13%. to lessen the adverse effects of global recession.
On May 27, BB has advised the nonbank financial institutions (NBFI) to double their capital by the end of this calendar year, from Tk.250 million to Tk.500 million, in order to remain sound.
Governor Atiur Rahman asked the NBFIs not to depend mostly on bank loans and call money market, to meet their liquidity shortfall, and advised them to issue alternative financial instruments, like zero coupon bonds and asset-backed securities, to drum up funds.
These suasions seem like a tradition in terms of monetary policy in Bangladesh. In a meeting in February 2008, former BB Governor Salehuddin Ahmed asked bankers to reduce interest rate spreads (IRS) from an average of 6.98% to around 5%. Then Finance Adviser, Mirza Azizul Islam, warned the banks not to do whatever they like in the name of free market economy. Joining the choir at the time, Chief Adviser Fakhruddin Ahmed instructed the BB to find a way to reduce the IRS to 4-5%.
The bankers agreed that the lending rate was high and a lower rate is achievable through cost-cuttings, accompanied by a tax reduction of 1% from 2% on general provision.
The snapshot of data in the table indicate that neither monetary policy nor moral suasion have succeeded in having any desired effects on the lending rate. Paradoxically, inflation and interest rates moved in opposite direction instead of moving the same way.
The credit for lower inflation in recent months may be ascribed more to global price deflation than to BB's monetary policy. Also the little decline in the IRS, taking place recently, is attributable primarily to an increase in the deposit rate. It seems prima facie that the authority has been resorting to coercing banks to
cut lending rates, since monetary policy appeared to be ineffective in doing the job. One would then wonder why the lending rate is so sticky downward.
In his May 25 piece, "Some thoughts on the upcoming budget," Mirza Islam recommended that the tax rates on financial institutions be reduced, provided they reduce both the lending rate and the prevailing IRS while keeping the deposit rate unchanged. He is asking banks to guarantee an interest rate floor of around 8%, while lowering the lending rates. This is what banks want, and is a good recommendation, but it doesn't work even in a "less than" market economy like Bangladesh.
This can be graphically visualised from the demand and supply framework of the credit market. A 1% tax cut will shift the upward sloping credit supply curve to the right. If the credit demand is perfectly elastic (horizontal), there will be no change in the lending rate.
A full effect of the tax cut will be reflected in the lending rate if the credit demand is perfectly inelastic (vertical). In reality, the credit demand curve follows neither of these extreme cases - it should have a normal downward sloping curve. In that case, the equilibrium lending rate will fall but by less than the full percentage of the tax cut - the magnitude will depend on the relative slopes of the demand and supply curves.
Therefore, some downward adjustment of the deposit rate must be accommodated to achieve a lower lending rate.
Banks are reluctant to lower their lending rates for many different reasons such as loan default risk, inflation risk and so on. The BB statistics on bank lending from January to March showed a 5% increase in defaulted loans compared to December last year.
In an environment of global financial pandemic, an increase in loan default is prudent for banks to be a little risk averse. Besides, the inflation risk is not unfounded. Bangladesh Bureau of Statistics reported an increase in inflation rate in April to 5.36% after it was declining since January.
If banks have alternative default risk free investment opportunities, such as treasury bonds with guaranteed hefty returns, why should they be interested in lowering their lending rates? Banks also lend funds to microcredit NGOs and earn over 14% returns, which arc also nearly default free.
Recently, I met a microcredit credit NGO chief who told me that her NGO borrows funds from banks at 14% interest rate and lend those at 12.5% to small borrowers. Borrowing at a higher rate and then lending at lower rate is made possible because the NGO’s effective lending rate reaches up to or over 23% -- mostly from fees from early loan repayment and other fees.
Grameen bank charges simple interest at an annual rate of 20% compared to compound interest of 13-16% charged at commercial banks. In Grameen, principal is repaid first and interest is repaid only after the principal is paid off, making an effective interest rate of 10-12%.
Since moral suasion is not working in lowering the lending rate, BB has no choice but to make its policy instruments do the job.
Dr Abdullah A Dewan, founder of polibconomy com. is a Professor of Economics at Eastern Michigan University.