Interest rate reduction and borrowing from foreign banks

A suggestion has recently come from Planning Minister AHM Mustafa Kamal that investors should borrow from foreign banks and such borrowing would reduce the domestic interest rate.
Before assessing how much justified such assertion is, we should note one thing that the response of the banks to the current state of the country is optimal, and the banks shouldn't reduce interest rate. In fact, this suggestion (banks shouldn't reduce interest rate) is also misleading because when they see the prospect for increased demands for funds banks would extend their lending, and we don't need to advise them. They would find their optimal lending and rate and would instantly respond to the prevailing state.
The most crucial question that comes to mind is: If investors are so willing to get funds from banks and they can't afford to borrow at the current rate, why don't banks respond to their demand decreasing the interest rate? Obviously, such response would increase revenue for banks in terms of more business or lending. Who would miss such an opportunity? Before we blame banks for charging high interest rate, we have to get the answer to this question. If the answer turns out that banks are not in a state to reduce the interest rate given some factors that have aggravated their lending business, then the suggestion to reduce interest rate is totally untenable and lacks practical justification. But if the answer is that banks are in a position to reduce the interest and they, somewhat deliberately, don't reduce interest rate, then the suggestion to reduce interest rate is justified. But a business unit, which acts mostly on rational basis or maximising return, would hardly do this. And we maintain that banks in our country are not operating following such irrational business rule, and it is not possible for banks to operate following such a bad policy.
Let's see whether we find any justification in the claim that borrowing from foreign banks would reduce interest rate.
INTEREST RATE: A SIMPLE LENDER'S EXAMPLE: To give a very clear-cut answer to the above question, why banks don't reduce interest rate even in the face of lower demand for funds by investors and why they are quite rational in doing so, we assume a simple lender in market called Z. Z would determine his lending rate, given some constraints, at a point that maximises his return. We assume that in the pure perfect market setup with no frictions, he would act as an ideal lender who will adjust his lending rate according to demand and supply forces. Therefore, we think that his lending rate at a given time depends on the demand for funds by investors given the fixed deposit rate, constant supply of funds, rate of inflation, etc. In such a condition, he will raise and decrease his interest rate responding perfectly to the prevailing market condition. For example, if he sees that his rate of interest charged is very high and discourage investors from getting loans, then he will obviously reduce the interest rate given that other things remain constant. Same is true for the opposite case.
Now what happens if the lender Z's rate of interest rate doesn't directly depend on the demand for borrowed funds but on some other factors such as the degree of default risks? In this case, he will not respond to increased demands for funds by lowering the interest rate even if he considers that his rate is quite high. He is quite justified by doing so because his interest rate no longer depends directly on the conventional demand and supply forces but rather on some constraints that create special binding on the interest rate charged. If one translates this in simple language of formal economics, one sees that:
From the above analysis, we see that in the first case interest rate is determined by the pure market mechanism. However, interest rate in the second case is not determined by the pure market forces but by some constraints imposed on the lender, and he is not able to adjust interest checking the market condition alone, for example, examining that the current rate of interest discourages investors from borrowing. As long as constraints under X are binding on the lender, it doesn't seem justified in any sense to instruct this lender to reduce the interest rate. If the severity of such binding abates, then the lender will automatically reduce the interest rate before he hears any suggestion from any other instructing him as "your rate is so high and you should decrease the rate." It is in his objective of return maximisation that he will decrease the lending rate, if by analysing feasibility he sees that the current higher interest rate discourages investors from getting funds from him. He will definitely reduce interest rate because it is certainly beneficial for him since such reduction would bring more revenue for him. This answers one question and that is: Current rate charged by banks in our country may be higher but it is quite justified given the mechanism how interest rate is determined at this stage.  Now we can judge the possibility of interest rate reduction due to borrowing from foreign banks using the simple framework.
POSSIBILITY OF INTEREST RATE REDUCTION: Apparently it makes sense that if investors start borrowing from foreign banks, the domestic interest rate will decrease due to the competition generated by the lower foreign interest rate. Proceeding from this point of view, one can logically expect that interest rate will decrease. However, we argue that interest rate will not decrease significantly even if investors start borrowing from foreign banks. Why is this so? The answer to this question is illustrated with the help of the following graphs:
 In the above figures I and II, interest rate is measured off in the vertical axis and the demand and supply of funds on the horizontal axis. The graph shows three interest rates r0, r1, and r2. If the interest rate is directly determined by the pure market force or demand for funds given the supply, the interest rate will be r0. But if the interest rate is mainly determined by some non-market forces such as X constraints, then interest rate would not respond to the prevailing market demand and would exactly be unresponsive to the current demand for funds. For example, the rate r2 in the figure I is determined mainly by X given market demand and other variables such as supply. Now, since the interest rate (r2) is almost unresponsive to market demand, such rate would not decrease unless some changes in the X are made. For instance, the interest decreases from r2 to r1 only because a favourable change has occurred in X for this reason X changes from X0 to X1. Otherwise, the interest rate will not decrease. If this is the case, then what would happen if investors gather investment funds from some other sources which can render a lower interest rate?
The effect is analysed in the figure II. Let's say our domestic interest rate is r2 and it is primarily determined by X0. Since investors think that r2 is very high interest rate and they can't afford borrowing at such rate, they start borrowing from some outside banks that can offer funds at a much lower interest rate. Let's say, the foreign rate of interest is r1. Before investors started borrowing from foreign banks, total supply of lending by the domestic banks or the total lending by the domestic banks was q1. Now, investors borrow from foreign banks instead of borrowing from domestic banks. This indicates that the total lending by the domestic banks will decrease. But by how much? The graph shows that at present the total supply of lending including the inflow of foreign banks' funds is q3. As investors who stopped borrowing from the domestic banks now borrow from foreign banks, the domestic banks' lending will decrease exactly by the amount foreign banks' funds increase. The figure shows that foreign banks lending increases by (q3-q1) and domestic banks lending decreases by (q1-q2) where [(q3-q1)=(q1-q2)].
So, the expectation should be that the domestic banks will decrease interest rate since demand for their funds has decreased and such downward pressure on demand will create a downward pressure on the interest rate.
In fact, this would not happen and foreign banks' rate would not be able to reduce the domestic banks' rate significantly. The reason is that the domestic interest has no strong connection with the factor demand itself. If the case is such that domestic interest rate is strongly related to demand, then the interest rate will reduce even before the inflow of foreign funds in our country. This seems puzzling because banks will reduce interest rate if they face lower demand for funds. The current situation also tells us that banks are facing such lower demand case but even after that they are not willing to reduce the interest rate. Such unwillingness on the part of banks are not irrational but rational given the nature of the interest rate determining function in which the rate itself doesn't depend on the market demand for funds but on some other variables and constraints that are listed under X.
Therefore, borrowing from foreign banks will not significantly reduce the domestic rate. In the graph II, we see that the interest rate instead of coming down to r1 due to the competition from cheap foreign banks' funds, the interest rate still stays at r2. Rather than lowering the interest rate from r2 to r1, borrowing from foreign banks curtail the total supply of lending by the domestic banks and reduce it to q2 which is less than q1, the total amount of lending before the inflow of foreign banks' funds. The effect is now very clear-cut: borrowing from foreign banks will hardly reduce the domestic interest rate charged by domestic banks but such borrowing will certainly reduce the total amount of lending by the domestic banks.
A DILEMMA: The question arises: what should we do then? Should we discourage investors from borrowing from foreign banks or should we encourage them to do so? The answer would sound like a puzzle for two vital reasons. First, as banks are unwilling to cut down the interest rate even if they are facing sluggish demand for funds by investors, such prescription is not a good one at all. Rather it may cause further slowdown in the economy. It seems just a way to create another trouble while trying to get rid of one trouble. Second, if we discourage investors from getting funds from foreign banks, then the situation wouldn't improve also since banks will not reduce the interest rate in this case. So, getting out of such a problem doesn't lie, in a sense, with the market itself. Why is this so? The fact is that the present interest rate is a function of some non-market variables and constraints listed under X not of demand (D) itself. Therefore, to reduce the interest rate we have to eliminate the influence of X on interest rate determination. Otherwise, the interest rate will not decrease anyway unless the government takes some coercive action in terms of forceful imposition of ceilings on interest rate. The effect of the introduction of ceilings on interest rate will be more devastating than the effect of borrowing from foreign banks.
CONCLUSION: The main implications of the above analysis are summarised as follows. First, contrary to the prevailing view that banks should reduce interest rate and if banks want they can reduce interest rate, the reality is that banks can hardly be blamed for charging current high rate of interest. In fact, if banks could reduce interest rate, they must reduce the interest rate faced with the lower demand for funds by investors. But, banks are not willing to do that even if they are facing the sluggish demand for funds. Moreover, reducing the interest rate in the face of lower demand for borrowing seems totally rational since banks try to maximise their return.  This directly implies that the current interest rate charged by banks is justified given the present circumstances. Second, to reduce the present interest rate, we need to do something different, not just blaming banks for charging high rate and for not reducing the rate. Some of the factors that have caused the interest rate to be so high are high degree of default risks, political instability, and the risks arising from the political instability. If banks are the victim of such unruly politics in our country, then why should we blame banks for charging high interest rate? The current high interest rate is the exact feature of our economy, and the interest rate is just responding to it. If the situation gets better, we will not have to instruct banks to reduce the interest rate. Rather market mechanism will be on its way to determine the interest rate, and banks will obviously respond to it. Until, this is achieved, we don't see any prospect for a decrease in the interest rate.
The contributor writes from the University of Denver, USA.  [email protected]