Gradual change in policy stance

The importance of a financial system in the process of economic development has been recognised by both academic circles and policymakers who develop the policy framework at the national level. However, the modus operandi of management of financial system and money are not the same, and is at times varied widely depending on the structure of the financial system and the types of economic policies pursued by the national policymakers. Marx and Lenin recognised the importance of the financial system more than a century ago. Lenin, in particular, being impressed by the powerful influence of the capitalist economic development, played a key role in nationalising banks after the Bolshevik revolution for promoting the fastest and most effective means of ending capitalism and taking control over the Russian economy.
This article reviews briefly the monetary policies pursued by most countries prior to financial sector reform undertaken by many developing countries including Bangladesh and the policy measures adopted in Bangladesh thereafter. It offers some suggestions in the light of developments that have taken place in monetary management over the years.
Lord Maynard Keynes argued that with price level remaining fixed, an expansionary monetary policy could reduce interest rate and thus encourage more investment. He argued that the rate of interest, unless it was curbed, would rise too high to permit an adequate inducement to invest. James Tobin showed in his money and growth model that the real rate of economic growth accelerates   during transition from low to high capital/labour ratios with the fall in the relative yield on money meaning thereby that the low rate of return on money increases welfare. Neo-structuralist economists argue that high interest rates increase inflation in the short run through a cost-push effect and lower the rate of economic growth.
ADMINISTRATIVE CONTROL OF INTEREST RATES & DIRECTED CREDIT PROGRAMMES: The works of Keynes, Keynesians and neo-structuralist economists had profound influence on the monetary and financial policies pursued in many developing countries. Immediately after independence of Bangladesh, the policy of low and stable interest was pursued. Interest rates were administratively fixed at relatively low level by the monetary authorities. The objective of low interest rate policy was to boost the growth of the economy in general and to promote the welfare of the disadvantaged sectors of the economy in particular. Ceiling on interest rates were imposed on bank deposits, and at times interest on bank deposits was fixed at relatively low level without any ceiling or floor.
The same policy was adopted in the case of lending rates. Coupled with the administrative control of interest rates, many developing countries used directed credit programmes to promote the priority sectors of the economy, and  administered low rate of interest on bank loans was used as one of the key elements of the directed credit programme. The weighted rate of interest on deposits was around 4.0 per cent, while the weighted rate of interest of lending was around 10 per cent giving a spread of about 6.0 per cent. In most of the years until September 1980, the real interest rates on deposits were negative. However, there was a major policy shift in interest rate policy towards the end of 1970s and in October 1980, interest rates of deposits and lending were raised substantially. Interest rates on deposits were raised probably to give the savers positive real rate of return. Interest rate for one-year  deposit, two-year  deposit and three-year  deposit was fixed  at 14 per cent, 14.5 per cent and 15 per cent respectively when the rate of inflation was around 12 per cent. While there was some change in interest rate policy, the policy of interest rate determination through administrative order continued. The policy of directed credit programme remained unchanged.
Prior to financial sector reform programme undertaken by the monetary authorities in Bangladesh, both aggregate supply and sectoral allocations of credit were regulated by direct controls. These controls took the form of administered interest rate, credit ceilings, margin requirements, preferential lending programmes, interest rate subsidisation and associated credit rationing.  With fully administered interest rates on deposits and lending, market forces of demand and supply could not operate to determine the price of bank products.  Credit ceilings on commercial banks sharply reduced their incentives to compete for new loans. The use of credit ceilings over time had injurious effects on financial sector development. In setting credit ceilings, the monetary authorities usually allocated the scope for future lending largely on the basis of banks' past share of total lending.
Sectoral credit allocation schemes included direct control on bank lending to priority sectors and lending targets for commercial banks. These schemes often proved costly in terms of allocative efficiency and effectiveness of monetary policy. Directed credit programmes in many cases resulted in investments with low rate of return, which subsequently burdened banks with large non-performing loans. As banks had to bear almost the entire burden of directed concessional lending, they incurred substantial losses. With a substantial growth in their non-performing assets and large losses incurred by them the financial viability of banks was affected.  The administered interest rates which often represented the status quo on market structure inhibited growth and competition and thereby contributed to disintermediation.  
 FINANCIAL SECTOR REFORM PROGRAMME (FSRP): R.I McKinnon and E.S. Shaw in their separate works argued that low and administered interest rates and selective credit control gave rise to widespread financial repression in most developing countries. They said the repressed financial markets discourage savings, act as deterrent to the efficient allocation of resources, and create financial disintermediation of the banking system. The essential message that was conveyed through their works to the national policymakers and international financial institutions is that a low or negative real rate of interest discourages savings and thereby reduces the availability of loanable funds, which, in turn, reduces investment and lowers the rate of economic growth. An increase in the real rate of interest, on the contrary, could encourage savers to save more, which will enable more investment to take place.   
The pioneering works of McKinnon and Shaw and the adverse effects of administratively fixed low interest policy that were visible  in many developing countries have brought a shift in their policy strategy. Bangladesh, like many other developing countries, undertook a financial sector reform programme (FSRP) in the early 1990s. Initial work prior to embarking on FSRP started with the issue of two circulars by the Bangladesh Bank in 1989, one on interest rate policy and the other one on loan classification and provisioning requirements. One of the key elements of the reform programme was to promote market-based interest rate policy.   
The main objectives of liberalised interest policy were (i) to introduce flexibility in the deposit and lending rates, permitting individual banks to establish their own rates, within limits set by the Bangladesh Bank, which would encourage competition among the banks and price their products based on market forces of demand and supply,  (ii)  to replace the refinancing facilities with a single window and that the bank rate would be adjusted by the Bangladesh Bank from time to time to control the volume of rediscounting in order to implement the central bank's monetary policy, and  (iii) to make subsidies for lending to explicit priority sectors, which remained so far hidden and reduced the profitability of banks. The new interest policy was made effective from January, 1990.   
Since 1990, there has been gradual change in policy stance with further reforms in many key areas including interest rate. It is not known whether moral persuasion is being used as one of the instruments for determination of interest rates rather than allowing the market forces to play its part to determine prices of bank products. It has been reported very frequently in the media, business circles and also, to certain extent, in the statement of some sections of civil society that the interest spread in Bangladesh is too high compared to many developing countries and there has been pressure on the banks to reduce the spread through reducing lending rates or reducing both deposit and lending rates.   The question then arises how the lending rates can be reduced from the rates determined by the interplay of market forces of demand and supply.  
If the profitability of banks is to be maintained, the interest rate on bank deposit has to be reduced in order to lower the lending rates.  The central bank will then have to use moral persuasion to determine interest rate of its own choice.  Such policy runs counter to the financial liberalisation policy adopted by the monetary authorities through various reform measures over the years.  Theoretically, the rate of interest on fixed deposit should be around 2.0 per cent above the rate of inflation to induce the savers to save in financial assets. Since there are other kinds of deposits and the rate of interests on those deposits are lower than those on fixed deposits, the weighted rate of interest on deposits becomes close to the rate of inflation or little less than the rate of inflation depending on the composition of deposits.
The profitability of banks depends on the spread between the weighted rate of interest on deposits and weighted rate of interest on lending, but also on a host of other factors such as cost of provision against classified loans, administrative cost and cost associated with meeting reserve requirement. Banks in Bangladesh, unlike the ones in many developing countries, are required to maintain a certain percentage of their demand and time liabilities as cash balances with the Bangladesh Bank to meet cash reserve requirement as prescribed by the central bank. These balances do not earn any interest and are therefore cost to the banks. Cost of provision is on the rise. The central bank has recently liberalised loan rescheduling criteria in an effort to reduce the burden of meeting the provisioning requirement but such measures seem to be a departure from international practice. Unless strong monitoring and surveillance system is put in place to recover the rescheduled loans, this policy could prove costly.  
Operating cost of the banks is likely to increase because of promoting financial inclusion in one form or other. The increase of pay scale of the government employees will have spillover effect on the pay structure of the banks, which would add to their operating cost. To maintain profitability, the banks might reduce rate of interest on deposit or increase rate of interest on loans or both. With indirect pressure on banks from various quarters for lowering lending rate, the banks instead of raising it, have chosen to reduce the deposit rate in recent times. Low interest rate may be justified in view of the current inflation rate but the policymakers will have to keep a close watch on the developments at home and abroad, which may trigger inflation rate or give rise to other factors that may reduce the demand for financial assets and end up with financial repression as many developing countries witnessed in the 1970s and 1980s.  
M Shefaque Ahmed, Actuary is
Chairman of Insurance Development
and Regulatory Authority (IDRA).
The views expressed in this article
are the author's own.
mshefaqueahmed@gmail.com