Bangladesh's financial system has, in recent years, experienced rapid expansion in terms of financial deepening and inclusiveness. Like most other countries, developing and developed, it has also faced a number of challenges. Challenges are many for any central bank of a developing country like Bangladesh. Three of such challenges are somewhat pressing and also interrelated.
Of them, the first issue relates to the long standing complaint of the private sector about high interest rates adversely impacting private investment and domestic economic activity. This is a legitimate concern. But the issue is complicated by high level of non-performing loans (NPLs) for public and private commercial banks. This signifies a huge loan loss burden for the banking system which has also reduced banking profitability. Furthermore, merchant banks incurred huge losses due to the bursting of the stock price bubble. Then again the underdeveloped nature of the bond market of Bangladesh is also hindering access to this source of financing for the investors. While development of the bond market is a medium-term challenge, a sustained reduction of domestic interest rate structure remains a major near-term challenge for Bangladesh Bank (BB).
The second related issue is the exchange rate dilemma of BB. While BB has successfully maintained exchange rate stability, given the underlying appreciation of the exchange rate in real effective terms, can the virtual peg against the US dollar be sustainable over the medium term?
Third and final issue is also related to the interest rate issue. To address the interest rate issue through enhanced competition and also as part of the process of gradual opening up of the capital accounts in terms of access to foreign funds, BB has recently liberalized borrowing in foreign currency by domestic enterprises. While this policy has some intended impact on the interest rate structure by forcing domestic lenders to compete with borrowing from abroad at lower interest rates, it has created some tensions in the money market due to higher liquidity and some resistance from some banks and analysts about the appropriateness of going for this liberalization.
It is worth mentioning that depositors getting a negative real rate of return on average, is not good for savers. Borrowers are getting funds in real term that is less than the spread charged by banks, which means the lowering of lending rates is coming at the expense of savers. Thus the high real interest rate needs to be explained in terms of developments in the spread in interest rate between lending and deposit rates.
DEVELOPMENTS IN INTEREST RATE SPREAD AND ITS DETERMINANTS: Following an increase in the interest rate spread - the difference between lending rate and deposit rate -- since June, 2011, the spread started to decline modestly since June 2012. Developments in the interest rate spread in recent years indicate that it generally remained at levels above 5.0%. As BB's fight against inflation started to bring inflation down, a sustained reduction in the inflation rate should help bring down the overall interest rate structure in nominal terms starting with the lowering of deposit rates. But this may not impact the real interest rates.
As of August 2013, the interest rate spread declined to 5.0%, with both deposit and lending rates showing modest downward trends. This was broadly in line with the easing of monetary/credit condition at that time with inflation coming down toward the target level. However the spread started to widen in recent months despite efforts by BB. This is the major problem for BB. In a well managed and relatively efficient banking system, the level of spread could be below 3.0%, compared to 5.0% or more for Bangladesh.
It must be emphasized that the higher spread in Bangladesh is a manifestation of structural weaknesses or inefficiencies of the banking system as a whole and needs to be understood properly. The spread could be explained by developments in some major components - administrative costs of banks, provisioning requirements associated with classified and bad loans as well as profitability of banks.
Provisioning requirements associated with classified/bad loans always significantly affect the interest rate spread. Bangladesh's gross and net non-performing loan (NPL) ratios have always been quite high relative to comparator countries. In particular, the very bad asset quality of state-owned banks has caused the gross NPL ratio to increase to 10.75% of assets in fiscal year (FY) 2013-14. Even the private commercial banks (PCBs) have suffered a reversal in gross NPL since December 2011. From a low of 3.0% in FY11, the gross NPL of PCBs increased to 5.7% of assets by June 2014 and the ratio is likely to deteriorate further in the coming years once proper accounting reflects the true provisioning requirements for stock market related losses.
Recent rapid deterioration of the situation about NPLs, and its likely further deterioration based on proper accounting, would continue to adversely impact lending rates and charges imposed by commercial banks. Corporate tax rate applied on pre-tax profits of commercial banks also effect interest rates. Bangladesh's corporate tax rate on banks at 42.5% is the highest in the region and adds to the wider spread.
The other important component contributing to the wider spread is the profitability of banks measured in terms of return on capital (ROC) and return on assets(ROA). While ROA and ROC both have declined in recent years, question may arise whether with proper accounting for loan loss provisions there could be scope for any dividend distribution by most publicly listed private commercial banks.
There are three key parties/players engaged in the operations of the banking system: depositors; banks as the financial intermediaries; and borrowers using the intermediated savings for investment and trading activities. For healthy growth in domestic savings and the deposit base, banks need to offer at least marginally positive real interest rates to the depositors. This means that for any significant reduction in the nominal deposit rate the domestic inflation rate needs to be brought down further.
At the same time, Bangladesh's very high gross non-performing loan (GNPL) -- at more than 12% compared with only 1.0%-3.0% for countries like China, Malaysia, Indonesia, Thailand and India-- points to the fact that inefficiencies in its financial intermediation will continue to adversely impact the spread and the borrowing rate. Banking sector governance, supervision and competition must be strengthened significantly if BB and the Government are serious about reducing the lending rate significantly without creating market distortions. Furthermore, BB needs to work on reducing the inflation rate further to 5.0% or less if it really wants to support a reduction of the nominal interest rate structure in a sustainable manner. The best example in this respect is China, where low and stable inflation rate (2.0-3.0 per cent) with low loan losses have helped maintain lending rates at low levels.
The reduction of interest rates should be on the basis of a medium term market-based process that involves reducing inflation, reducing the cost of doing banking operations, and lowering of loan losses through better lending practices. Any lowering of interest rates on an ad hoc basis and administratively will not work to reduce the interest rate structure in a sustainable manner. Systematic efforts to reduce the loan losses and required provisioning, continued lowering of domestic inflation, and related adoption of prudent monetary policy and enforcement of strengthened supervision would need to be taken by BB under a market-based strategy in order to reduce interest rates.
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Dr. Ahsan Mansur is Executive Director, Policy Research Institute, Bangladesh.
E-mail: ahsanmansur@gmail.com